**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C.20549**

 

**FORM 10-K**

 

**(Mark One)**

 

| **o**                                                                           |   | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|---------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------|
|                                                                            |
| **For the fiscal year ended**                                                   |
|                                                                            |
| **OR**                                                                          |
|                                                                            |
| **ý**                                                                      |   | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                            |
| **For the transition period from January 1, 2003 to March 31,  2003** |

 

**Commission filenumber 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.) |
|                                                                        |   |   |
| **27001 Agoura Road  Calabasas Hills, CA**                                  |   | **91301** |
| (Address of principal executive offices)                                    |   | (Zip Code) |
|                                                                        |   |   |
| Registrant’s telephone number, including area code:**(818)  871-5000** |

 

----

 

Securitiesregistered pursuant to Section 12(b) of the Act:

 

**None.**

 

Securitiesregistered pursuant to Section 12(g) of the Act:

 

**CommonStock,  $.01 par valuePreferred Stock Purchase Rights**

 

Indicate by check mark whether the Registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes  ý  No  o

** **

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K (§229.405 of this chapter) is not contained herein,and will not be contained, to the best of Registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III of thisForm 10-K or any amendment to this Form 10-K  ý

** **

Indicate by check mark whether the registrant is an accelerated filer(as defined in Exchange Act Rule 12b-2). Yes  ý  No  o

** **

Theaggregate market value of voting stock held by non-affiliates of the registrantas of June 30, 2002 was approximately $1,172,257,000.  38,232,465 shares of common stock wereoutstanding as of June 2, 2003.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

The 2003 Notice of Annual Meeting of Stockholders and Proxy Statementis incorporated by reference into Part III herein.

 

 

----

 

**THQ INC.INDEX TO TRANSITION REPORT ON FORM 10-KFILED WITH THE SECURITIES AND EXCHANGE COMMISSIONFISCAL YEAR ENDED MARCH 31, 2003**

 
|           | **Items in Form 10-K**                                                                       |
|----------------|----------------------------------------------------------------------------------------------|
|           |                                                                                         |
| Facing page    |                                                                                         |
|           |                                                                                         |
| **Part I**     |                                                                                         |
| Item 1.        | Business.                                                                                    |
| Item 2.        | Properties.                                                                                  |
| Item 3.        | Legal  Proceedings.                                                                          |
| Item 4.        | Submission  of Matters to a Vote of Security Holders.                                        |
|           |                                                                                         |
| **Part II**    |                                                                                         |
| Item 5.        | Market  for the Registrant’s Common Equity and Related Stockholder Matters.             |
| Item 6.        | Selected  Financial Data.                                                                    |
| Item 7.        | Management’s  Discussion and Analysis of Financial Condition and Results of Operations. |
| Item 7A.       | Quantitative  and Qualitative Disclosures About Market Risk.                                 |
| Item 8         | Financial  Statements and Supplementary Data                                                 |
| Item 9         | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure.       |
|           |                                                                                         |
| **Part  III**  |                                                                                         |
| Item 10.       | Directors  and Executive Officers of the Registrant.                                         |
| Item 11.       | Executive  Compensation.                                                                     |
| Item 12.       | Security  Ownership of Certain Beneficial Owners and Management.                             |
| Item  13.      | Certain Relationships and Related Transactions.                                              |
| Item  14.      | Disclosure Controls and Procedures                                                           |
|           |                                                                                         |
| **Part IV**    |                                                                                         |
| Item 15.       | Exhibits,  Financial Statement Schedule and Reports on Form 8-K.                             |
|           |                                                                                         |
| Signatures     |                                                                                         |
|           |                                                                                         |
| Certifications |                                                                                         |

 

----

 

**This Transition Report on Form 10-K contains, or incorporatesby reference, certain statements that may be deemed “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995.  Such statements appear in anumber of places in this Report, including, without limitation “ManagementDiscussion and Analysis of Financial Condition and Results of Operations.”  These statements are based on current expectations,estimates and projections about our business based, in part, on assumptionsmade by management.  These statementsare not guarantees of future performance and involve risks, uncertainties andassumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from whatis expressed or forecasted in such forward-looking statements due to numerousfactors, including those described above and the following:  changes in demand for our products, productmix, the timing of customer orders and deliveries, the impact of competitiveproducts and pricing and difficulties encountered in the integration ofacquired businesses.  In addition, suchstatements could be affected by growth rates and market conditions relating tothe interactive software industry and general domestic and internationaleconomic conditions.  For specificinformation concerning these and other such factors please see the sectionentitled “Risk Factors” in “Item 7. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.”  The forward-looking statements contained herein speak only as ofthe date on which they are made, and we do not undertake any obligation toupdate any forward-looking statements to reflect events or circumstances afterthe date of this Transition Report.**

 

**PARTI**

 

**Item 1**.                                   BUSINESS

** **

**Introduction**

 

We area leading global developer and publisher of interactive entertainment softwarefor the major hardware platforms in the home video game market.  We currently develop and publish titles forSony PlayStation 2, Microsoft Xbox, Nintendo GameCube, Nintendo Game BoyAdvance, PCs and wireless devices.  Ourtitles span most major interactive entertainment software genres, includingaction, adventure, children’s, driving, fighting, puzzle, role playing,simulation, sports and strategy.

 

Oursoftware is based on intellectual property licensed or assigned from thirdparties or created internally.  Wecontinually seek to identify and develop titles based on content from otherentertainment media (such as movies and television programs), sports andentertainment personalities, popular sports and trends or concepts that havehigh public visibility or recognition or that reflect the trends of popularculture.  Our portfolio of licensedproperties includes *Finding Nemo*and two future Disney/Pixar properties*,**Hot Wheels, Power Rangers, Scooby-Doo, Sonicthe Hedgehog, SpongeBob SquarePants, WWE*,**as well as others.

 

Wealso develop software based on brands created by our eight internal developmentstudios and by external developers under contract with us.  Our original brands include *Red Faction**â, Alter Echo**Ô, MX*and*Summoner**â*.  Other than games that we release on PCs, themanufacturers(1) or their authorized vendors manufacture all of our productsfor us.

 

InNorth America, we market and distribute our software to customers includingWal-Mart, Toys “R” Us, Target, Best Buy, GameStop, Kay Bee Toys and otherregional and national general merchandisers, discount store chains, and specialtyretailers.  Outside North America, wemarket and distribute our software to retailers in 70 countries and territoriesthrough offices in the United Kingdom, France, Germany, Australia and Korea.

 

We area Delaware corporation that was re-incorporated in 1997.  We were formerly incorporated in New York in1989 under the name Trinity Acquisition Corporation, which changed its name in1990 to T.HQ, Inc. through a merger with T.HQ, Inc., a California corporation.  Our principal executive offices are locatedat 27001 Agoura Road, Calabasas Hills, California 91301, and our telephonenumber is (818) 871-5000.  Our web siteis at http://www.thq.com.  THQ and theTHQ logo are registered trademarks of THQ Inc.(2)

 

----

(1)                                  Microsoft,Nintendo and Sony are referred to herein collectively as the “hardwaremanufacturers” or the “manufacturers.” Nintendo®, Nintendo Entertainment System® (“NES”), Super Nintendo Entertainment System® (“SNES”), Game Boy®,Game Boy Color®, Game Boy Advance, GameCube and Nintendo 64® are trademarksand/or registered trademarks of Nintendo of America Inc. (“Nintendo”).  Sega®, Genesis®, Game Gear®, Saturn® andDreamcast® are registered trademarks of Sega of America, Inc. (“Sega”).  Sony PlayStation® and Sony PlayStation® 2are trademarks and/or registered trademarks of Sony Computer Entertainment Inc.(“Sony”).  Microsoft Xbox is a trademarkof Microsoft Corporation (“Microsoft”).

(2)                                  Red Faction, Summoner, Dark Summit, HeavyIron Studios®, Helixe, Outrage® Games, Pacific Coast Power & Light Company®,ValuSoft®, Volition, THQ Wireless, Rainbow Studios and Rainbow Multimedia,Cranky Pants Games and their respective logos are trademarks and/or registeredtrademarks of THQ Inc.  All othertrademarks are property of their respective owners.

 

1

----

 

**The Interactive Entertainment Industry and Technology**

 

Thehome interactive game market consists of software distributed on disc andcartridge media for use solely on dedicated hardware systems, and softwaredistributed on CD-ROM discs for use on PCs. Disc media includes DVD-ROM discs for use on the Sony PlayStation 2 andMicrosoft Xbox, proprietary discs for use on the Nintendo GameCube and CD-ROMdiscs for use on the Sony PlayStation. The Nintendo Game Boy Advance and Nintendo Game Boy Advance SP are theonly current platforms that use cartridges. Until 1996, most software for dedicated platforms was sold in cartridgeform.  Since then, disc-based productshave become increasingly popular because they have substantially greater datastorage capacity and lower costs than cartridges.

 

Thefirst modern platform was introduced by Nintendo in 1985 using 8-bittechnology.  8-bit means that thecentral processing unit, or chip, on which the software operates is capable ofprocessing data in 8-bit units. Subsequent advances in technology have resulted in continuous increasesin the processing power of the chips that power both the consoles and PCs.  As the technology of the hardware hasadvanced, the software has similarly advanced, with faster and more compleximages, more lifelike animation and sound effects and more intricatescenarios.  The larger data storagecapacity of disc-based media for systems such as the Sony PlayStation 2,Microsoft Xbox and the Nintendo GameCube enables them to provide richer contentand longer play.  This new generation ofsystems is based primarily on 128-bit technology.  The latest hand-held platforms, Game Boy Advance and Game BoyAdvance SP, use 32-bit technology.

 

Thefollowing table sets forth the year in which each of the manufacturers’platforms, for which we have published titles and technology, were released inthe United States:

** **
| **Manufacturer** |   | **Product Name**    |   | **Date of U.S.  Introduction** |   | **Media Format** |   | **Technology**    |   |
|------------------|--------|---------------------|--------|--------------------------------|--------|------------------|--------|-------------------|--------|
| Nintendo         |   | NES                 |   | 1985                           |   | Cartridge        |   | 8-bit             |   |
| Nintendo         |   | Game Boy            |   | 1989                           |   | Cartridge        |   | 8-bit (portable)  |   |
| Sega             |   | Game Gear           |   | 1991                           |   | Cartridge        |   | 8-bit (portable)  |   |
| Sega             |   | Genesis             |   | 1989                           |   | Cartridge        |   | 16-bit            |   |
| Nintendo         |   | SNES                |   | 1991                           |   | Cartridge        |   | 16-bit            |   |
| Sega             |   | Saturn              |   | 1995                           |   | Cartridge        |   | 32-bit            |   |
| Sony             |   | PlayStation         |   | 1995                           |   | CD-ROM Disc      |   | 32-bit            |   |
| Nintendo         |   | Nintendo 64         |   | 1996                           |   | Cartridge        |   | 64-bit            |   |
| Nintendo         |   | Game Boy Color      |   | 1998                           |   | Cartridge        |   | 16-bit (portable) |   |
| Sega             |   | Dreamcast           |   | 1999                           |   | CD-ROM Disc      |   | 128-bit           |   |
| Sony             |   | PlayStation 2       |   | 2000                           |   | DVD-ROM Disc     |   | 128-bit           |   |
| Nintendo         |   | Game Boy Advance    |   | 2001                           |   | Cartridge        |   | 32-bit (portable) |   |
| Nintendo         |   | GameCube            |   | 2001                           |   | Proprietary Disc |   | 128-bit           |   |
| Microsoft        |   | Xbox                |   | 2001                           |   | DVD-ROM Disc     |   | 128-bit           |   |
| Nintendo         |   | Game Boy Advance SP |   | 2003                           |   | Cartridge        |   | 32-bit (portable) |   |

 

Sonylaunched the PlayStation 2, the successor to the PlayStation, in the NorthAmerican market in October 2000. Nintendo launched the handheld Game Boy Advance platform inJune 2001 and the GameCube platform in November 2001.  Microsoft launched the Xbox inNovember 2001.  Nintendo launchedthe Game Boy Advance SP, which is a front-lit screen version of their Game BoyAdvance platform, in March 2003. Software for each new platform requires different standards of designand technology to fully exploit the platform’s capabilities.  The introduction of new platforms alsorequires that game developers devote substantial additional resources toproduct design and development.

 

**Business Strategy**

 

Ourcorporate goal is to expand market share while increasing profitability.  We believe that our success in the followingstrategic imperatives will position us well to exploit the current consolecycle and other growth opportunities:

 

•                  *Builda well-diversified product portfolio across brand, genre and platform.*  Due to constantly changing consumer demandand hardware platforms, we believe it is important to offer a diversifiedportfolio of titles.  We have worked togrow and diversify our product portfolio by securing additional contentlicenses, creating our own brands and content, seeking out uniqueco-development relationships (e.g. with Nickelodeon and Sega) and supportingmultiple platforms.  Through licensingagreements with Disney, Disney/Pixar, Mattel, Nickelodeon, Sega, Warner Bros.,Twentieth Century Fox, World Wrestling Entertainment and others, we havediversified our portfolio of popular licensed properties to include *Finding Nemo*and two future Disney/Pixarproperties*,**Hot Wheels, Power Rangers, Scooby-Doo, Sonic theHedgehog, SpongeBob SquarePants,*

 

2

----

 

*WWE*,**as well as others.  Our titles span a wide spectrum ofgenres.  We currently develop andpublish for all existing major interactive entertainment hardware platforms.  In July 2002, we expanded our productportfolio to include value PC titles with the acquisition of ValuSoft, Inc.(“ValuSoft”).  We will continue to worktowards building a well-diversified product portfolio by obtaining additionallicenses, increasing our internal brands and publishing titles across multipleplatforms.

 

•                  *Establishstrong technology and internal development capabilities*.  We believe it is important for us to expandour internal development capabilities. We have increased our internal development capabilities through theacquisition or formation of development studios, consisting of Cranky PantsGames (“Cranky Pants”), Heavy Iron Studios® (“Heavy Iron”), Helixe, OutrageGames (“Outrage”), Pacific Coast Power & Light Company (“PCP&L”),Rainbow Multimedia Group, Inc., also known as Rainbow Studios, (“Rainbow”) andVolition, Inc. (“Volition”).  InMarch 2003, we formed a new studio in Spring Hill, Australia, THQAustralia Studios Pty. Ltd. (“THQ Australia Studios”).  Since 2000, we have launched internallydeveloped games, including *Red Faction, RedFaction II, MX Superfly featuring Ricky Carmichael, Summoner, Summoner 2,Rocket Power: Dream Scheme,**Scooby-Doo!Night of 100 Frights*and *WWE Crush Hour.*  We will continue to expand our internal development capabilitiesby selectively acquiring or establishing development studios.

 

•                  *Expandglobal product development capabilities.*  We believe it is important for our business to establish globalproduct development capabilities.  Wehave implemented a new product development initiative that resulted in theglobalization of our product development staff.  The staff is located in three separate locations – United States,United Kingdom and Australia – and manages the development of product bothinternally developed through our eight development studios as well asexternally developed through independent developers.  The three production groups are each comprised of technical,creative, project management and quality assurance teams.  This structure allows us to more effectivelywork with product development talent worldwide and improve product quality.

 

•                  *Expandinternationally.* International markets represent a significant growth opportunity forus.  We operate offices in the UnitedKingdom, Germany, France, Australia and Korea and distribute our products in 66other countries and territories.  Wehave a dedicated group that adapts our titles for international markets bylocalizing language and other cultural features.  We will continue to expand internationally by establishingoffices in new territories, developing and acquiring content that hasinternational appeal, possibly acquiring foreign development studios andtargeting wireless gaming applications to appropriate foreign markets.

 

•                  *Prudentlyinvest in emerging applications such as wireless gaming.*  We are pursuing opportunities withinwireless gaming that we believe will allow us to benefit from the rapid growthprojected for this emerging market while remaining consistent with our focus onprofitability.  We are establishingrelationships with wireless operators and wireless software developersworldwide.  We have recently enteredinto a license agreement with Twentieth Century Fox for the worldwide rights todevelop and publish wireless games based upon the *Simpson’s* animatedtelevision series.

 

•                  *Increaseprofit margins through improved execution and disciplined management.*  Profitability continues to be a leadingcorporate focus.  We continue to (i)utilize ordering and inventory controls to reduce inventory risk; (ii)proactively work with key customers to manage inventories, reduce the need forallowances or price protection, accelerate cash collection and reduce accountsreceivable; (iii) scrutinize costs and manage corporate overhead and (iv) buildan experienced management team and a financial and operating systeminfrastructure based on sophisticated technology.  We believe that our continued emphasis on these practices willhelp us increase profitability and stockholder value in the future.

 

Weintend to continue pursuing potential acquisition transactions consistent withthese strategies.  In addition, in orderto create a closer relationship with independent developers, we may from timeto time make investments or acquire interests in independent developers.

 

**Intellectual Property Licenses**

 

Our strategyincludes the creation of exciting games based on licensed properties that haveattained a high level of consumer recognition or acceptance.  We have relationships with a number oflicensors, including Disney, Disney/Pixar, Mattel, Nickelodeon, Sega, WarnerBros., Twentieth Century Fox and World Wrestling Entertainment.

 

We payroyalties to our property licensors that generally range from 3% to 15% of ournet sales of the corresponding title. We typically advance payments against minimum guaranteed royalties overthe license term. License royalties tend to be higher for properties withproven popularity and less perceived risk of commercial failure.  To the extent competition intensifies forlicenses of highly desirable properties, we may encounter difficulty inobtaining or 

 

3

----

 

renewing these licenses.  See – “Competition.”  Licenses are of variable duration, may beexclusive for a specific title or line of titles, and may in some instances berenewable upon payment of certain minimum royalties or the attainment ofspecified sales levels.  Other licensesare not renewable upon expiration, and it cannot be assured that we and thelicensor will reach agreement to extend the term of any particular license.

 

Ourproperty licenses usually grant us exclusive use of the property for thespecified titles, on specified platforms, within a defined territory and duringthe license term.  Licensors typically,however, retain the right to exploit the property for all other purposes,including the right to license the property for use with other platforms, andhave general approval rights over the use of their content in our games.  Our games based on a particular property foruse with one or more particular platforms may compete with games published byother companies that are based on the same property but for a differentplatform.

 

**Intellectual Property Rights**

 

Eachgame we release embodies a number of separately protected intellectual propertyrights of the manufacturer, the property licensor and, to a lesser extent, theexternal developer and us.  In the caseof games based upon licensed content, the licensor of the property owns thetrademarks, trade names, copyrights and other intellectual property rightsrelating to the property on which the game is based.  In the case of games based upon internally-created property, weown or co-own such rights.  Themanufacturer owns the patents and substantially all of the other intellectualproperty embodied in the product; and the developer, whether internal orexternal, often owns proprietary tools and technology embedded in the gamesoftware.  While we own the gamesoftware embodied in the product, we believe that such software has littleindependent economic value.  Accordingly,we often must rely on the manufacturer and, in case of licensed content, theproperty licensor with respect to protection from infringement of the propertyrights by third parties.

 

Eachmanufacturer incorporates security devices in its platforms and products toprevent unlicensed use.  In addition,Nintendo requires its licensees to display the trademarked Nintendo Seal ofApproval to notify the public that the game has been approved by Nintendo foruse with a Nintendo platform.

 

**Platform Licenses**

 

Ourbusiness is dependent on our license agreements with the manufacturers.  All of these licenses are for fixed termsand are not exclusive.  Each licensegrants us the right to develop, publish and distribute titles for use on suchmanufacturer’s platform(s), and requires that each such title be approved bythe manufacturer prior to development of the software and embodied in productsthat are manufactured solely by such manufacturer or (in the case of Microsoft)its authorized vendor.

 

Thefollowing table sets forth information with respect to our platformlicenses.  In some instances, we havemore than one platform license for a particular platform.  In certain instances noted below, we havereached agreement with the platform manufacturer regarding business terms of alicense or license renewal but have not yet completed the contractdocumentation process.  In the interim,and as is customary in our business, both we and the platform manufacturer areoperating in accordance with the agreed business terms.

 

4

----

 
| **Manufacturer** |   | **Platform**           |   | **Territory**                                   |   | **Expiration Date(s)** |
|------------------|--------|------------------------|--------|-------------------------------------------------|--------|------------------------|
| Nintendo         |   | Nintendo 64            |   | All countries in the Western Hemisphere         |   | May 2003(1)       |
| Nintendo         |   | Nintendo 64            |   | Europe, Australia and New Zealand               |   | January 2004      |
| Nintendo         |   | Game Boy Color         |   | All countries in the Western Hemisphere         |   | March 2004        |
| Nintendo         |   | Game Boy Color         |   | Europe, Australia and New Zealand               |   | October 2002(2)   |
| Nintendo         |   | Game Boy Advance       |   | All countries in the Western Hemisphere         |   | July 2004         |
| Nintendo         |   | Game Boy Advance (3)   |   | Europe, Australia and New Zealand               |   | (3)                    |
| Nintendo         |   | GameCube               |   | All countries in the Western Hemisphere         |   | April 2005        |
| Nintendo         |   | GameCube (3)           |   | Europe, Australia and New Zealand               |   | (3)                    |
| Sony             |   | PlayStation            |   | United States, Canada, Mexico and Latin America |   | August 2006       |
| Sony             |   | PlayStation            |   | Europe, Australia and New Zealand               |   | December 2005     |
| Sony             |   | PlayStation 2          |   | United States and Canada                        |   | March 2004(4)     |
| **Sony**         |   | **PlayStation  2 (5)** |   | **Europe,  Australia and New Zealand**          |   | **(5)**                |
| Sony             |   | PlayStation 2          |   | Korea                                           |   | (6)                    |
| Microsoft        |   | Xbox                   |   | (7)                                             |   | November 2004     |

 

----

(1)                                  TheNintendo 64 agreement expired on May 8, 2003.  We will not be distributing any product on this platform and wedo not intend to renew this license.

(2)                                  Therenewal for this agreement is currently in negotiation with an expectedexpiration of October 2005.

(3)                                  Thelong form contract is currently in negotiation with an expected expiration ofthree (3) years from the date of execution.

(4)                                  ThePlayStation 2 Licensed Publisher Agreement provides for an automatic annual renewalunless either party terminates the agreement by January 31 of theapplicable year.  To date, thisagreement has not been terminated.

(5)                                  Thelong form contract is currently in negotiation with an expected expiration ofMarch 31, 2004 with an automatic annual renewal unless either partyterminates the agreement by February 28 of the applicable year.

(6)                                  Thelong form contract is currently in negotiation with an expected expiration ofMarch 31, 2004 with an automatic annual renewal unless either party terminatesthe agreement by January 31 of the applicable year.

(7)                                  Theterritory is determined on a title-by-title basis.

 

Nintendocharges us an amount for each Nintendo Game Boy Advance and Game Boy Colorcartridge.  This amount varies based, inpart, on the memory capacity of the cartridges.  Nintendo GameCube, Sony and Microsoft agreements include a chargefor every disc manufactured.  Theamounts charged by the manufacturers include a manufacturing, printing andpackaging fee as well as a royalty for the use of the manufacturer’s name,proprietary information and technology, and are subject to adjustment by themanufacturers at their discretion.  Themanufacturers have the right to review, evaluate and approve a prototype ofeach title and the title’s packaging.

 

Inaddition, we must indemnify the manufacturers with respect to all loss,liability and expense resulting from any claim against the manufacturerinvolving the development, marketing, sale or use of our games, including anyclaims for copyright or trademark infringement brought against themanufacturer.  As a result, we bear arisk that the properties upon which the titles are based, or that theinformation and technology licensed from the manufacturer and incorporated inthe products, may infringe the rights of third parties.  Our agreements with our independent softwaredevelopers and property licensors typically provide for us to be indemnifiedwith respect to certain matters.  If anyclaim is brought by a manufacturer against us for indemnification, however, ourdevelopers or licensors may not have sufficient resources to in turn, indemnifyus.  Furthermore, these parties’indemnification of us may not cover the matter that gives rise to themanufacturer’s claim.

 

Eachplatform license may be terminated by the manufacturer if a breach or defaultby us is not cured after we receive written notice from the manufacturer, or ifwe become insolvent.  Upon terminationof a platform license for any reason other than our breach or default, we havea limited period of time to sell any existing product inventory remaining as ofthe date of termination.  The length ofthis sell-off period varies between 90 and 180 days, depending upon theplatform agreement.  We must destroy anysuch inventory remaining after the end of the sell-off period.  Upon termination as a result of our breachor default, we must destroy any remaining inventory.

 

5

----

 

**Software Design and Development**

 

Afterwe acquire a property from a licensor or develop a concept internally, wedesign and develop a game with features intended to utilize the characteristicsof the property and to appeal to the game’s target consumers.  The development of our software is nowmanaged through offices in three separate territories – the United States,United Kingdom and Australia.  The headof each product development location and the head of each of our internalstudios reports to our Executive Vice President – Worldwide Studios.  Our software development process takes oneof two forms, Internal Development or External Development.

 

*Internal Development.*  The in-house development of product iscurrently conducted by our studios: Cranky Pants, Heavy Iron, Helixe, Outrage,PCP&L, Rainbow, THQ Australia Studios and Volition.  Our studios are staffed by producers, gamedesigners, software engineers, artists, animators and game testers.

 

*External Development.*  We contract with independent softwaredevelopers to conceptualize and develop games under our supervision.  Our agreements with software developers areusually entered into on a game-by-game basis and generally provide for thepayment of a fixed amount and/or royalty compensation based on actualsales.  The royalty compensation isgenerally based on a percentage of net sales ranging from 4% to 20%.  We generally pay our developers installmentsof the fixed fee (and, in the case of royalty compensation, advances againstfuture royalty payments) based either on specific development milestones or onagreed-upon payment schedules.  Wegenerally obtain ownership of the software code and related documentation.  We may make strategic investments in thirdparty developers for the purpose of securing access to proprietary software andtalented developers.

 

Uponcompletion of development, each game is extensively play-tested by us and sentto the manufacturer for its review and approval.  Related artwork, user instructions, warranty information,brochures and packaging designs are also developed under our supervision.  The development cycle for a new game,including the development of the necessary software, approval by themanufacturer and production of the initial products, typically has ranged from12 to 24 months for home console games and PC products and seven to 12 monthsfor handheld games.  This relativelylong development cycle requires that we assess whether there will be adequateretailer and consumer demand for a game well in advance of its release.

 

**Manufacturing**

 

Otherthan games that we release on PCs, all of our home interactive entertainmentproducts are manufactured for us by the manufacturers or their authorizedvendors.  We contract with various PCreplicators for the manufacturing of our PC products.

 

Theplatform game manufacturing process begins with our placing a purchase orderwith a manufacturer and prepaying the manufacturer, opening either a letter ofcredit in favor of the manufacturer or utilizing credit granted by themanufacturer.  We then send the softwarecode and a prototype of the game to the manufacturer, together with relatedartwork, user instructions, warranty information, brochures and packagingdesigns, for approval, defect testing and manufacture.  Nintendo typically delivers products to uswithin 10 to 60 days of its receipt of an order and a payment or correspondingletter of credit.  Sony typicallydelivers products to us within 10 to 24 days. Microsoft’s authorized vendors typically deliver products to us within10 to15 days.

 

We arerequired by the platform licenses to provide a standard defective productwarranty on all of the products sold. Generally, we are responsible for resolving, at our own expense, anywarranty or repair claims.  We have notexperienced any material warranty claims, but there is no guarantee that wewill not experience claims in the future.

 

**Marketing, Sales and Distribution**

 

We aredependent on the popularity of our games based on licensed properties andpositive awareness of our original game concepts to attract customers and toobtain shelf space in stores.  Ourdomestic sales activities are directed by our Senior Vice President – U.S.Sales and Distribution, who maintains contact with major retail accounts andmanages the activities of our internal sales staff.  Our marketing activities are directed by our Senior VicePresident – Worldwide Marketing, who manages the activities of our worldwideinternal marketing staff.

 

*North American Sales.*  Our games are promoted to retailers bydisplay at trade shows such as the annual Electronic Entertainment Expo (E3).  We also conduct print and cooperative retailadvertising campaigns for most titles and prepare promotional materials,including product videos, to increase awareness among retailers and consumers.

 

Ourmarketing efforts for products released in the three months endedMarch 31, 2003 included national television, print, radio and Internetadvertising and promotional campaigns.  *Pride*FCreceived television support in the three months ended March 31, 2003.  Our games were supported by promotions suchas trailers, demo discs, over-sized boxes, standees, posters, and pre-sellgiveaways at retail stores, game kiosks at sporting and outdoor events, rebatesand contests with national packaged goods companies and fast food restaurantsand co-marketing efforts with the

 

6

----

 

hardwaremanufacturers.  Product public relationsfor the three months ended March 31, 2003 included cover, feature,preview, review and round-up coverage in broadcast, print and online mediatargeting enthusiast, lifestyle and major mainstream outlets.  Additionally, we continue to increase ourcorporate public relation efforts, establishing relationships with leadingtechnology and business reporters.

 

Weutilize electronic data interchange with most of our major domestic customersin order to (i) efficiently receive, process and ship customer product orders,and (ii) accurately track and forecast sell-through of products to consumers inorder to determine whether to order additional products from themanufacturers.  The electronic datainterchange system is integrated with our enterprise resource planning system,which allows for further efficiencies in the items mentioned above.  We ship most of our products to our domesticcustomers from public bonded warehouses located in Ohio, Tennessee andMinnesota.

 

Thedomestic retail price for our titles currently ranges between $20 and $35 forGame Boy Advance, $20 for Game Boy Color, between $10 and $25 for PlayStation,between $20 and $55 for PlayStation 2, between $20 and $55 for Xbox, between$20 and $55 for GameCube and between $10 and $35 for PC games.

 

*International Sales.*  Our international sales activities aredirected by our Senior Vice President – International Publishing via ourinternational offices in the United Kingdom, France, Germany andAustralia.  We recently opened an officein Korea, which began to sell product in March 2003.  International offices market and distributedirect-to-retail and through sub-distributors in both their home territoriesand to 66 additional territories.

 

*Concentration of Sales.*  Some of our individual titles make up asubstantial portion of our gross sales. The following includes games that generated more than 10% of our grosssales during the three months ended March 31, 2003 and the years ended2002, 2001 and 2000:

 

•                  In the three months endedMarch 31, 2003, no title generated more than 10% of our gross sales.

 

•                  In 2002, *WWE SmackDown! Shut Your Mouth*for the Sony PlayStation 2was the only title to generate more than 10% of our gross sales at 10.8%.

 

•                  In 2001, *WWF SmackDown! “Just Bring It”* for the Sony PlayStation 2was the only title to generate more than 10% of our gross sales at 14.6%.

 

•                  In 2000, *WWF SmackDown!*and *WWFSmackDown! 2: Know Your Role*for the Sony PlayStation and *WWF No Mercy* for the Nintendo 64 generatedmore than 10% of our gross sales at 16.9%, 16.0% and 15.5% of gross sales,respectively.

 

Oursales are made directly to retailers and independent distributors.  We distribute our games primarily to massmerchandisers and national retail chain stores, including Wal-Mart(representing 24.7% of gross sales in the three months ended March 31,2003 and 16.4% of gross sales in the twelve months ended December 31,2002) and Toys “R” Us (representing 10.8% of gross sales in the three monthsended March 31, 2003 and 12.6% of gross sales in the twelve months endedDecember 31, 2002).  Some of ourother retailers include Target, Best Buy, GameStop and Kay Bee Toys.  Sales to our ten largest customers collectivelyaccounted for approximately 67.3% in the three months ended March 31, 2003and 63.9% of our gross sales in each of the twelve months endedDecember 31, 2002 and 2001.  We donot have any written agreements or other understandings with any of our customersthat relate to their future purchases, so our customers may terminate theirpurchases from us at any time.

 

*Revenue Fluctuations and Seasonality.*  We have experienced, and will likelycontinue to experience, significant quarterly fluctuations in net sales andoperating results due to a variety of factors. The software market is highly seasonal with sales typicallysignificantly higher during the quarter ending December 31st(due primarily to the increased demand for interactive games during the year-endholiday buying season).  Other factorsthat cause fluctuations include the timing of our release of new titles, thepopularity of both new titles and titles released in prior periods, changes inthe mix of titles with varying gross margins, the timing of customer orders,the timing of shipments by the manufacturers, fluctuations in the size and rateof growth of consumer demand for software for various platforms, the timing ofthe introduction of new platforms and the accuracy of retailers’ forecasts ofconsumer demand.  Our expenses arepartially based on our expectations of future sales and, as a result, operatingresults would be disproportionately and adversely affected by a decrease insales or a failure by us to meet our sales expectations.  There can be no assurance that we canmaintain consistent profitability on a quarterly or annual basis.

 

Profitmargins may vary over time as a result of a variety of factors.  Profit margins for cartridge products forthe Game Boy platforms can vary based on the cost of the memory chip used for aparticular title.  The other platformssupport disc-based products that have significantly lower per unitmanufacturing costs than cartridge-based products; however, they also havehigher development costs than cartridge-based products.

 

7

----

 

**Agreement with JAKKS Pacific, Inc.**

 

InJune 1999, we entered into an agreement with JAKKS Pacific, Inc. (“JAKKS”)that governs our relationship with respect to the World Wrestling Entertainmentlicense we jointly obtained from World Wrestling Entertainment, Inc. (the“WWE”).  This agreement was amended inJanuary 2002.  Our relationshipwith JAKKS was established to develop, manufacture, distribute, market and sellvideo games, as well as sublicense products pursuant to the license from theWWE.  The principal terms of thisoperating agreement are as follows:

 

•                  We are responsible for funding alloperations of the venture, including all payments owed to the WWE.

 

•                  For the period commencingNovember 16, 1999 and ending June 30, 2006, JAKKS is entitled toreceive a preferred payment equal to the greater of a fixed guarantee, payablequarterly, or specified percentages of the net sales from the WWE-licensedgames (as defined) in amounts that vary based on the platform.  The payment of these amounts is guaranteedby us.  We are entitled to the profitsand cash distributions remaining after the payment of these amounts.

 

•                  For periods after June 30, 2006,the amount of the preferred payment will be subject to renegotiation betweenthe parties.  An arbitration procedureis specified in the event the parties do not reach agreement.

 

•                  We are responsible for the day-to-dayoperations of the venture.  We areresponsible for development, sales and distribution of the WWE-licensed games,and JAKKS is responsible for the approval process and other relationshipmatters with the WWE.

 

Forfinancial reporting purposes, we are deemed to control the venture; therefore,all venture operating results are consolidated with our results.

 

InNovember 2001, through the venture, we entered into a letter of intent toexpand the WWE license to include exclusive rights to other wrestling contentproduced by the WWE.  In exchange forthese rights we have agreed to increase the minimum guarantee payable to theWWE through December 31, 2009.

 

**Geographic Information**

 

Weoperate in one reportable segment in which we are a developer and publisher ofinteractive entertainment software for the leading hardware platforms in thehome video game market.  Wireless gamingmay become a new reportable segment as our activity in this marketincreases.  The following informationsets forth geographic information on our sales generated by our regionaloffices for the three months ended March 31, 2003 and 2002 and the yearsended December 31, 2002, 2001 and 2000 (also See Note 16 to theconsolidated financial statements for additional geographic information on oursales and long-lived assets):

 

**Sales to Unaffiliated Customers**

**($ in Thousands)**

 
|                |   | **Three Months Ended  March 31,** |   | **Years Ended December 31,** |   |
|---------------------|--------|----------------------------------------|--------|-----------------------------------|--------|
|                |   | **2003**                               |   | **2002**                          |   | **2002** |   | **2001** |   | **2000** |   |
| North America       |   | $                                      | 56,649 |                              | $      | 56,540 |   | $ | 358,124 |   | $ | 262,676 |   | $ | 270,116 |   |
|                |   |                                   |   |                              |   |   |   |   |   |   |   |
| United Kingdom      |   | 4,361                                  |   | 10,391                            |   | 67,218 |   | 60,240 |   | 44,638 |   |
| Germany             |   | 2,802                                  |   | 6,648                             |   | 26,051 |   | 25,517 |   | 20,442 |   |
| France              |   | 1,259                                  |   | 3,829                             |   | 14,556 |   | 18,185 |   | 7,979 |   |
| Asia Pacific        |   | 1,729                                  |   | 2,274                             |   | 14,580 |   | 12,374 |   | 3,828 |   |
| International Total |   | 10,151                                 |   | 23,142                            |   | 122,405 |   | 116,316 |   | 76,887 |   |
| Consolidated        |   | $                                      | 66,800 |                              | $      | 79,682 |   | $ | 480,529 |   | $ | 378,992 |   | $ | 347,003 |   |
|                     |        |                                        |        |                                   |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

8

----

 

**Competition**

 

Theinteractive entertainment software industry is intensely competitive.  We compete with hardware manufacturers forboth property licenses and software sales. Each of the manufacturers is typically one of the largest developers andpublishers for its proprietary platform. These companies may increase their own software developmentefforts.  As a result of theircommanding positions in the industry as the manufacturers of platforms andpublishers of software for their platforms, the manufacturers generally havebetter bargaining positions with respect to retail pricing, shelf space andpurchases than any of their licensees, including us.

 

Inaddition to the manufacturers, our competitors include Activision, Inc., Atari,Inc., Electronic Arts Inc. and Take-Two Interactive Software, Inc.

 

Atvarious times, toy companies, large software companies, movie studios andothers have entered the video game market resulting in greater competition forus.  Additionally, many of ourcompetitors are developing on-line interactive games and interactive networksthat will be competitive with our interactive products.

 

Eachof the manufacturers has a broader software line and greater financial,marketing and other resources than we do, as do some of our othercompetitors.  Accordingly, some of ourcompetitors may be able to market their software more aggressively or makehigher offers or guarantees in connection with the acquisition of licensedproperties.

 

Competitionis intense among an increasing number of newly introduced entertainmentsoftware titles and hardware systems for adequate levels of limited retail shelfspace and promotional support and resources.  Competition for retail shelf space is expected to increase, whichmay require us to increase our marketing expenditures from time to time tomaintain sales of our titles.  Competitorswith more extensive lines and popular titles frequently have greater bargainingpower with retailers.  Accordingly, wemay not be able to achieve the levels of support and shelf space that suchcompetitors receive.  Similarly, ascompetition for popular properties increases, our cost of acquiring licensesfor such properties is likely to increase, possibly resulting in reducedmargins.

 

Inaddition, the market for our products is characterized by significant pricecompetition, and we may face increasing pricing pressures from our current andfuture competitors.  Accordingly, thesecompetitive pressures have, from time to time, required us to reduce our priceson certain products.  Any materialreduction in the price of our products would adversely affect operating incomeas a percentage of net revenue and would require us to increase unit sales inorder to maintain net revenue.  Prolonged price competition, increased marketing costs, increasedlicensing costs or reduced operating margins would cause our profits todecrease significantly.

 

**Recent Developments**

 

OnFebruary 13, 2003, we announced that the Board of Directors approved achange of our fiscal year end from December 31 to March 31, effectiveJanuary 1, 2003.  This changeresulted in a three month transitional reporting period ended March 31,2003.

 

InFebruary of 2003, we closed Genetic Anomalies (“GA”), a small internaldevelopment studio located in Lexington, Massachusetts that developed andmaintained an online collectible gaming environment.  The closing of this studio had no material impact on ouroperations.

 

**Employees**

 

As ofMarch 31, 2003, we had 714 full-time employees, of whom 576 are located inthe United States; 49 are located in the United Kingdom; 52 are located inGermany; 14 are located in France; 21 are located in Australia; and two arelocated in Korea.  None of our employeesis represented by a labor union or covered by a collective bargainingagreement, and we consider our relations with employees to be favorable.

 

**Available Information**

 

Wefile annual, quarterly and current reports, proxy statements and otherinformation with the Securities and Exchange Commission (“SEC”).  Our SEC filings, including our annual reporton Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, andany amendments to those reports filed or furnished pursuant to Section 13(a) ofthe Exchange Act, are available to the public free of charge over the Internetat our website at http://www.thq.com or at the SEC’s web site athttp://www.sec.gov.  Our SEC filingswill be available on our website as soon as reasonably practicable after wehave electronically filed or furnished them to the SEC.  Our Internet address ishttp://www.thq.com.  You may also readand copy any document we file at the SEC’s Public Reference Room at 450 FifthStreet, N.W., Washington, D.C. 20549.  You may obtaininformation on the operation of the Public Reference Room by calling the SEC at1-800-SEC-0330.

 

9

----

 

**Item 2**.                                   PROPERTIES

** **

At March 31, 2003, we leased the facilities listedbelow:

 
| **Location of Offices**      |   | **Approximate Square  Footage** |   | **Use**                                                                         |
|------------------------------|--------|---------------------------------|--------|---------------------------------------------------------------------------------|
|                         |   |                            |   |                                                                            |
| Calabasas  Hills, California |   | 67,000                          |   | Executive, sales and marketing, product development  and administrative offices |
|                         |   |                            |   |                                                                            |
| Woking, England              |   | 25,000                          |   | Sales and marketing, product development and  administrative offices            |
|                         |   |                            |   |                                                                            |
| Krefeld, Germany             |   | 14,000                          |   | Sales and marketing, product development and  administrative offices            |
|                         |   |                            |   |                                                                            |
| Phoenix, Arizona             |   | 13,000                          |   | Software development studio                                                     |
|                         |   |                            |   |                                                                            |
| Champaign, Illinois          |   | 13,000                          |   | Software development studio                                                     |
|                         |   |                            |   |                                                                            |
| Santa Clara, California      |   | 12,000                          |   | Software development studio                                                     |
|                         |   |                            |   |                                                                            |
| Lexington, Massachusetts     |   | 10,000                          |   | Software development studio                                                     |
|                         |   |                            |   |                                                                            |
| Culver City, California      |   | 8,000                           |   | Software development studio                                                     |
|                         |   |                            |   |                                                                            |
| Waconia, Minnesota           |   | 5,000                           |   | Sales and marketing, product development and  administrative offices            |
|                         |   |                            |   |                                                                            |
| Melbourne, Australia         |   | 5,000                           |   | Sales and marketing and administrative offices                                  |
|                         |   |                            |   |                                                                            |
| Spring Hill, Australia       |   | 4,000                           |   | Software development studio                                                     |
|                         |   |                            |   |                                                                            |
| Paris, France                |   | 4,000                           |   | Sales and marketing and administrative offices                                  |
|                         |   |                            |   |                                                                            |
| Seattle, Washington          |   | 3,000                           |   | Software development studio                                                     |
|                         |   |                            |   |                                                                            |
| Grass Valley, California     |   | 2,000                           |   | Software development studio                                                     |
|                         |   |                            |   |                                                                            |
| Ann Arbor, Michigan          |   | 1,000                           |   | Software development studio                                                     |
|                         |   |                            |   |                                                                            |
| Seoul, Korea                 |   | 500                             |   | Sales, marketing and administrative offices                                     |

 

Inaddition to the leased facilities listed above, we also own 10,820 square feetof office space located in Phoenix, Arizona.

 

OnFebruary 27, 2003, we entered into a lease agreement with an entitypartially owned by the head of one of our development studios.  The lease is for approximately 29,000 squarefeet of office space to be occupied by the development studio in Champaign,Illinois.  The property is currentlyunder development and should be ready for occupancy in April 2004.

 

We believe that these facilities are adequate for our currentneeds.  We believe that suitableadditional or substitute space will be available as needed to accommodate ourfuture needs.

 

10

----

 

**Item 3**.                                   LEGAL PROCEEDINGS

** **

We andcertain of our officers and directors are defendants in a class action lawsuitfiled in the United States District Court for the Central District ofCalifornia entitled *In re THQ Inc.*Securities Litigation, Master File No. CV-00-1783-AHM.  On December 20, 2000, the courtdismissed this action with prejudice as to all of the defendants.  On April 23, 2001, the United StatesDistrict Court for the Central District of California modified itsDecember 20, 2000 order and permitted plaintiffs to file a third amendedcomplaint on that date.  Defendantsfiled an answer denying all of the material allegations of the third amendedcomplaint and asserting legal and factual defenses.  The third amended complaint alleges that defendants violated Rule10b-5 and Section 20(a) of the Securities Exchange Act of 1934, includingallegations that defendants manipulated our stock price; distributed false andmisleading information concerning revenue recognition, forecasts and earningsestimates; selectively disclosed material information; and engaged in insidertrading.  The complaint seeks anunspecified amount in damages.  As ofDecember 31, 2002, we entered into a settlement agreement with theplaintiffs.  While we continue to denyplaintiffs’ allegations, we agreed to pay $10.2 million under the terms of thesettlement agreement to resolve all claims by plaintiffs against alldefendants.  The District Court grantedpreliminary approval of the settlement on March 17, 2003, and a hearing toconsider final approval is currently scheduled for June 30, 2003.  Our directors’ and officers’ insurancecoverage provides for $10.0 million towards the settlement agreement andrelated legal fees.

 

However,a dispute has arisen between us and our directors’ and officers’ insurancecarrier.  The insurance carrier assertsthat it is only obligated to contribute $5.0 million in coverage towards thesecurities litigation settlement. Pursuant to the terms of our insurance policy, the matter has beensubmitted to arbitration under the rules of the American ArbitrationAssociation.  Although we expect toprevail, at this early stage we cannot predict the likely outcome of thisdispute.

 

As aresult of a court order in an action filed in the United Kingdom by the WorldWide Fund for Nature (the “Fund”) against World Wrestling Entertainment, Inc.(“WWE”) the use of the initials “WWF” was prohibited directly or indirectly bythe WWE after November 10, 2002. On November 10, 2002, upon instruction from the WWE, we ceasedsales of certain of our interactive entertainment software games containing the“WWF” brand.  These games containartwork files with the initials WWF and/or the WWF logo that cannot practicablybe removed from the games. Contemporaneously, in November 2002, we (through our joint ventureTHQ/JAKKS Pacific LLC (“THQ/JAKKS”)) filed an application for relief from thecourt order.  That application wasdenied by the trial court and an appeal was filed and heard on February 24and 25, 2003.  The appeals courtrendered its opinion on March 27, 2003, ruling that our continuedmarketing of these video games, with the “WWF” initials and brand removedexcept to the extent embedded in the games, is neither a breach of the courtorder against WWE nor a contempt of court. Following this ruling, we recommenced sales of the affectedproduct.  In addition, sinceOctober 2002 we have been incorporating the “WWE” brand in place of the“WWF” brand in all of the new wrestling games that we publish, including the recentlypublished *WWE Road to WrestleMania X8*for Game Boy Advance and *WWE SmackDown! ShutYour Mouth* for PlayStation 2. We are involved in other routine litigation arising in the ordinarycourse of our business.  In the opinionof our management, none of the other pending litigation will have a materialadverse effect on our consolidated financial condition or results ofoperations.

 

**Item 4**.                                   SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS

** **

Therewere no matters submitted to a vote of security holders during the three monthsended March 31, 2003.

 

11

----

 

**PARTII**

 

**Item 5**.                                   MARKET FOR THEREGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

** **

Thecommon stock is quoted on the NASDAQ National Market under the symbol“THQI.”  The following table sets forth,for the periods indicated, the high and low closing sales prices of our commonstock as reported by the NASDAQ National Market:

 
|                          |   | **Closing  Sales Prices** |       |
|-------------------------------|--------|---------------------------|------------|
|                          |   | **High**                  |       | **Low** |   |
| **2003**                      |   |                      | ** ** |   | ** ** |
| Three-Month Transition Period |   | 14.18                     |       | 11.15 |   |
| **2002**                      |   |                      |       |   |   |
| First Quarter                 |   | 34.79                     |       | 26.29 |   |
| Second Quarter                |   | 36.17                     |       | 28.05 |   |
| Third Quarter                 |   | 27.79                     |       | 19.82 |   |
| Fourth Quarter                |   | 23.17                     |       | 12.22 |   |
| **2001**                      |   |                      |       |   |   |
| First Quarter                 |   | 25.92                     |       | 14.96 |   |
| Second Quarter                |   | 39.75                     |       | 23.17 |   |
| Third Quarter                 |   | 39.81                     |       | 26.03 |   |
| Fourth Quarter                |   | 42.19                     |       | 27.49 |   |

 

Thelast reported price of our common stock on June 2, 2003, as reported byNASDAQ National Market, was $14.45 per share.

 

**Holders**

 

As ofJune 2, 2003 there were approximately 296 holders of record of our commonstock.

 

**Dividend Policy**

 

Wehave never paid cash dividends on our common stock.  We currently intend to retain future earnings, if any, to financethe growth and development of our business and, therefore, we do not anticipatepaying any cash dividends in the future. Our principal banking agreement provides that we will not pay any cashdividends.

 

**Securities Issued in Private Transactions**

 

None.

 

**Changes in Securities and Use of Proceeds**

 

OnNovember 21, 2002, we announced that our Board of Directors authorized therepurchase of up to $25.0 million of our common stock from time to time on theopen market or in private transactions. As of March 31, 2003, we repurchased approximately 568,000 sharesof our common stock for $7.8 million.

 

12

----

 

**Item 6**.                                   SELECTEDCONSOLIDATED FINANCIAL DATA

Thisselected consolidated financial data should be read in conjunction with“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” and the Consolidated Financial Statements and Notes theretoincluded elsewhere herein.

 

**STATEMENT OF OPERATIONS DATA**

**(In thousands, except per share data)**

 
|                                                 |   | **Three  Months Ended March 31,** |   | **Years  Ended December 31,** |   |
|------------------------------------------------------|--------|-----------------------------------|--------|-------------------------------|--------|
|                                                 |   | **2003 (a)**                      |   | **Unaudited  2002**           |   | **2002 (b)** |   | **2001** |   | **2000 (c)** |   | **1999** |   | **1998 (d)** |   |
| Net sales                                            |   | $                                 | 66,800 |                          | $      | 79,682 |   | $ | 480,529 |   | $ | 378,992 |   | $ | 347,003 |   | $ | 303,483 |   | $ | 216,716 |   |
| Costs and expenses:                                  |   |                              |   |                          |   |   |   |   |   |   |   |   |   |   |   |
| Cost of sales                                        |   | 26,378                            |   | 33,680                        |   | 185,593 |   | 154,898 |   | 140,699 |   | 134,563 |   | 100,019 |   |
| License amortization and royalties                   |   | 5,576                             |   | 7,064                         |   | 40,476 |   | 33,144 |   | 34,675 |   | 28,858 |   | 19,390 |   |
| Software development amortization                    |   | 12,018                            |   | 10,800                        |   | 83,698 |   | 35,144 |   | 42,875 |   | 19,512 |   | 28,740 |   |
| Product development                                  |   | 9,730                             |   | 7,646                         |   | 38,572 |   | 21,154 |   | 19,151 |   | 15,511 |   | 8,925 |   |
| Selling and marketing                                |   | 14,294                            |   | 9,759                         |   | 66,443 |   | 46,745 |   | 42,446 |   | 35,440 |   | 20,326 |   |
| Payment to venture partner                           |   | 644                               |   | 1,572                         |   | 10,146 |   | 8,673 |   | 17,707 |   | 6,119 |   | — |   |
| General and administrative                           |   | 7,611                             |   | 6,059                         |   | 31,117 |   | 25,090 |   | 19,530 |   | 14,970 |   | 10,107 |   |
| In-process research and development                  |   | —                            |   | —                        |   | — |   | — |   | — |   | — |   | 7,232 |   |
| Total costs and expenses                             |   | 76,251                            |   | 76,580                        |   | 456,045 |   | 324,848 |   | 317,083 |   | 254,973 |   | 194,739 |   |
| Income (loss) from operations                        |   | (9,451                            | )      | 3,102                         |   | 24,484 |   | 54,144 |   | 29,920 |   | 48,510 |   | 21,977 |   |
| Interest income, net                                 |   | 878                               |   | 1,322                         |   | 5,277 |   | 2,572 |   | 1,323 |   | 1,109 |   | 819 |   |
| Other expenses                                       |   | (2,403                            | )      | —                        |   | (10,006 | ) | — |   | — |   | — |   | — |   |
| Income (loss) before income  taxes              |   | (10,976                           | )      | 4,424                         |   | 19,755 |   | 56,716 |   | 31,243 |   | 49,619 |   | 22,796 |   |
| Income taxes                                         |   | (3,290                            | )      | 1,659                         |   | 6,761 |   | 20,703 |   | 13,054 |   | 18,293 |   | 9,343 |   |
| Net income (loss)                                    |   | $                                 | (7,686 | )                             | $      | 2,765 |   | $ | 12,994 |   | $ | 36,013 |   | $ | 18,189 |   | $ | 31,326 |   | $ | 13,453 |   |
| Net income (loss) per share —  basic       |   | $                                 | (0.20  | )                             | $      | 0.07 |   | $ | 0.33 |   | $ | 1.10 |   | $ | 0.60 |   | $ | 1.10 |   | $ | 0.50 |   |
| Net income (loss) per share —  diluted     |   | $                                 | (0.20  | )                             | $      | 0.07 |   | $ | 0.32 |   | $ | 1.01 |   | $ | 0.56 |   | $ | 0.99 |   | $ | 0.42 |   |
| Shares used in per share calculation —  basic   |   | 38,319                            |   | 39,067                        |   | 39,203 |   | 32,717 |   | 30,136 |   | 28,560 |   | 26,894 |   |
| Shares used in per share calculation —  diluted |   | 38,319                            |   | 41,725                        |   | 41,243 |   | 35,623 |   | 32,352 |   | 31,796 |   | 31,844 |   |

 

**BALANCE SHEET DATA(In thousands)**

 
|                      |   | **March 31,** |    | **December  31,**   |   |
|---------------------------|--------|---------------|---------|---------------------|--------|
|                      |   | **2003**      |    | **Unaudited  2002** |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
| Working capital           |   | $             | 286,899 |                | $      | 325,992 |   | $ | 320,588 |   | $ | 319,605 |   | $ | 110,269 |   | $ | 91,860 |   | $ | 48,342 |   |
| Total assets              |   | $             | 472,949 |                | $      | 476,735 |   | $ | 537,860 |   | $ | 487,966 |   | $ | 229,942 |   | $ | 184,057 |   | $ | 128,218 |   |
| Lines of credit           |   | $             | —  |                | $      | — |   | $ |  — |   | $ | — |   | $ | 15,473 |   | $ | 16,702 |   | $ | 9,909 |   |
| Stockholders’ equity |   | $             | 396,413 |                | $      | 406,834 |   | $ | 408,866 |   | $ | 398,862 |   | $ | 132,125 |   | $ | 108,306 |   | $ | 62,065 |   |

 

 

13

----

 

Notes:

 

Thetable above reflects the May 1999 pooling of interests with PCP&L, theDecember 1999 pooling of interests with GA and the August 2000pooling of interests with Volition.  Allprior period information has been restated accordingly.

 

(a)          Net incomeincludes a charge of $1.8 million due to the other than temporary impairment ofour investment in Yuke’s Co., Ltd.  (See– “Note 8 – Other Long-Term Assets"). We also changed our fiscal year end from December 31 toMarch 31, effective January 1, 2003.

 

(b)         Net incomeincludes a charge of $7.9 million, net of tax for the cancellation of 20 SKUsas well as a charge of $4.6 million, net of tax related to the settlement of aclass action lawsuit (See – “Item 3. Legal Proceedings”) and a charge of $1.1million, net of tax related to the write-off of inventory and softwaredevelopment for “WWF”-branded games that we had been prevented from shippingpursuant to an action by the World Wide Fund for Nature against World WrestlingEntertainment, Inc. (See – “Item 3. Legal Proceedings”) and a charge of $2.8million, net of tax related to the discontinuation of our online joint venturein the United Kingdom (Network Interactive Sports, Ltd.).

 

(c)          Net incomeincludes a charge of $5.9 million, net of tax related to a regular impairedasset review and also as a result of changing technology in the video gamemarket.  The charge consisted of costsassociated with software development and related costs for products that hadbeen discontinued or whose values were deemed unrecoverable through futureundiscounted cash flows.

 

(d)         Net incomeincludes a charge of $7.2 million, net of tax for in-process research anddevelopment in connection with the acquisition of Game FX.

 

 

14

----

 

**Item 7****.****           MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Change in Fiscal Year**

 

On February 13, 2003, weannounced that the Board of Directors approved a change of our fiscal year endfrom December 31 to March 31, effective January 1, 2003.  This change resulted in a three monthtransitional reporting period ended March 31, 2003.  This discussion compares: (i) the three months ended March 31,2003 with the three months ended March 31, 2002; (ii) our fiscal year 2002(twelve months ended December 31, 2002) with fiscal year 2001; and (iii) ourfiscal year 2001 with fiscal year 2000.

 

**Critical Accounting Policies**

 

The Management’s Discussion andAnalysis of Financial Condition and Results of Operations discusses ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States of America.  The preparation of these consolidatedfinancial statements requires management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and the disclosure ofcontingent assets and liabilities at the date of the consolidated financialstatements and the reported amounts of revenues and expenses during thereporting period.  The policiesdiscussed below are considered by management to be critical because they areboth important to the portrayal of our financial condition and results of operationsand their application places the most significant demands on management’sjudgment, with financial reporting results relying on estimates about theeffect of matters that are inherently uncertain.  Specific risks for these critical accounting policies aredescribed in the following paragraphs. For all of these policies, management cautions that actual results maydiffer materially from these estimates under different assumptions orconditions.

 

*Allowances for price protection, returns and doubtful accounts.*  We derive revenues from sales of packagedsoftware for video game systems and personal computers, sales of software andservices for wireless devices and from licensing software.  Product revenue is recognized net ofallowances for price protection and returns and various customer discounts.  We typically only allow returns for ourpersonal computer products.  We maydecide to provide price protection or allow returns for our video game systemand personal computer products after we analyze: i) inventory remaining in theretail channel, ii) the rate of inventory sell through in the retail channel,and iii) our remaining inventory on hand. We maintain a policy of giving credits for price protection and returns,but do not give cash refunds.

 

We establish sales allowancesbased on estimates of future price protection and returns with respect tocurrent period product revenue.  Weanalyze historical price protection granted, historical returns, current sellthrough of retailer and distributor inventory of our products, current trendsin the video game market and the overall economy, changes in customer demandand acceptance of our products, and other related factors when evaluating theadequacy of the price protection and returns allowance.  In addition, management monitors the volumeof our sales to retailers and distributors and their inventories, becausesubstantial overstocking in the distribution channel can result in therequirement for substantial price protection or high returns in subsequentperiods.  In the past, actual priceprotection and returns have not generally exceeded our reserves.  However, actual price protection and returnsin any future period are inherently uncertain as unsold products in thedistribution channels are exposed to rapid changes in consumer preferences, marketconditions or technological obsolescence due to new platforms, product updatesor competing products.  While managementbelieves it can make reliable estimates for these matters, if we changed ourassumptions and estimates, our price protection and returns reserves wouldchange, which would impact the net revenue we report.  In addition, if actual price protection and returns weresignificantly greater than the reserves we have established, the actual resultsof our reported net sales would decrease. Conversely, if actual price protection and returns were significantlyless than our reserves, our reported net sales would increase.

 

Similarly, management must usesignificant judgment and make estimates in connection with establishingallowances for doubtful accounts in any accounting period.  Management analyzes customer concentrations,customer credit-worthiness and current economic trends when evaluating theadequacy of the allowance for doubtful accounts.  Material differences may result in the amount and timing of ourbad debt expense for any period if management made different judgments orutilized different estimates.  If ourcustomers experience financial difficulties and are not able to meet theirongoing financial obligations to us, our results of operations may be adverselyimpacted.

 

For the three months endedMarch 31, 2003 and 2002 (unaudited) and the years ended December 31, 2002, 2001and 2000, we recorded allowances for future price protection, returns anddoubtful accounts of approximately $10.0 million, $12.3 million, $69.6 million,$47.4 million and $35.4 million, respectively, during such periods.  As of March 31, 2003 and 2002 (unaudited)and December 31, 2002, 2001 and 2000, our aggregate reserves against accountsreceivable for price protection, returns and doubtful accounts wereapproximately $43.4 million, $35.1 million, $59.9 million, $40.6 million and$31.5 million, respectively.

 

*Licenses.* Minimum guaranteed royalty payments for intellectual property licensesare initially recorded as an asset (licenses) and as a liability (accruedroyalties) at the contractual amount upon execution of the contract when nosignificant performance remains with the licensor.  When significant performance remains with the licensor, we recordroyalty payments as an asset (licenses) when actually paid rather than uponexecution of the contract.  Royaltypayments for intellectual property licenses are classified as current assetsand current liabilities to the extent such royalty payments relate to anticipatedsales during the subsequent year and long-term assets and long-term liabilitiesif such royalty payments relate to anticipated sales after one year.

 

15

----

 

Licenses are expensed tolicense amortization and royalties at the higher of (i) the contractual royaltyrate based on actual net product sales or (ii) the ratio of current units soldto total projected units sold.  When, inmanagement’s estimate, future cash flows will not be sufficient to recover previouslycapitalized costs, we expense these capitalized costs to license amortizationand royalties.  See – “*Long-Lived Assets*” below.  If actual revenues, or revised forecastedunits, fall below the initial forecasted units, the charge to license amortizationand royalties may be larger than anticipated in any given quarter.  As of March 31, 2003, the net carrying valueof our licenses was $35.4 million.  Ifwe were required to write off licenses, due to changes in market condition orproduct quality, our results of operations could be materially adverselyaffected.

 

*Software Development*.  We utilize both independent softwaredevelopers and internal development teams to develop our software.  We account for software development costs inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 86,“Accounting for the Costs of Computer Software to be Sold, Leased, or OtherwiseMarketed.”  We capitalize softwaredevelopment costs once technological feasibility is established and wedetermine that such costs are recoverable against future revenues.  For products where proven game enginetechnology exists, this may occur early in the development cycle.  We evaluate technological feasibility on aproduct-by-product basis.  Amountsrelated to software development for which technological feasibility is not yetmet are charged immediately to product development expense.  We capitalize the milestone payments made toindependent software developers and the direct payroll costs for our internaldevelopment teams.

 

Capitalized softwaredevelopment is expensed to software development amortization at the higher of(i) the contractual rate based on actual net product sales or (ii) the ratio ofcurrent units sold to total projected units sold.  When, in management’s estimate, future cash flows will not besufficient to recover previously capitalized costs, we expense these costs tosoftware development amortization.  See– “*Long-Lived Assets*” below.  If actual revenues, or revised forecastedunits, fall below the initial forecasted units, the charge to softwaredevelopment amortization may be larger than anticipated in any givenquarter.  As of March 31, 2003, the netcarrying value of our software development was $57.5 million.  If we were required to write off softwaredevelopment, due to changes in market condition or product quality, our resultsof operations could be materially adversely affected.

 

*Goodwill.* In conjunction with the implementation of the new accounting rules forgoodwill as of the beginning of 2002, we completed a goodwill impairmentreview.  According to our accountingpolicy, we also performed an annual review during the quarter endedJune 30, 2002, and in both reviews we found no impairment.  We will perform a similar review in thequarter ended June 30, or more frequently if indicators of potentialimpairment exist.  Our impairment reviewprocess is based on a discounted future cash flow approach that uses ourestimates of revenue for the reporting units, driven by assumed success of ourproducts and product release schedules, and estimated costs as well asappropriate discount rates.  Theseestimates are consistent with the plans and estimates that we use to manage theunderlying businesses.  We performedsimilar impairment tests for indefinite lived intangible assets and found noimpairment.  The success of our productsis affected by the ability to accurately predict which platforms and whichproducts we develop will be successful. Also, our revenues and earnings are dependent on our ability to meet ourproduct release schedules.  Due to theseand other factors described in the subsection entitled “Risk Factors” in “Item7. Management’s Discussion and Analysis of Financial Condition and Results of Operations”we may not realize the future net cash flows necessary to recover our goodwill.

 

Based on these judgments andassumptions, management determines whether we need to take an impairment chargeto reduce the value of the goodwill and indefinite lived intangible assetsstated on our balance sheet to reflect their estimated fair values.  Judgments and assumptions about futurevalues are complex and often subjective. They can be affected by a variety of factors, including but not limitedto, significant negative industry or economic trends, significant changes inthe manner or use of the acquired assets or the strategy of our overallbusiness and significant underperformance relative to expected historical orprojected future operating results. Although we believe the judgments and assumptions management has made inthe past have been reasonable and appropriate, there is nonetheless a highdegree of uncertainty and judgment involved. We continue to encounter the risks and difficulties faced with launchingor acquiring a new business.  When thebusiness is a development studio, we look for ways to maximize the talent andintellectual property within the studio. We make judgments and assumptions as to the commercial success andquantity of games developed by a particular studio.  Different judgments and assumptions could materially impact ourreported financial results.  Forexample, if we do not develop games with the same commercial success or thesame number of games as we have estimated, we may need to take an impairmentcharge against goodwill in the future. More conservative assumptions of the anticipated future benefits fromthese businesses would result in greater impairment charges, which woulddecrease net income and result in lower asset values on our balance sheet.  Conversely, less conservative assumptionswould result in smaller impairment charges and higher net income.

 

*Long-Lived Assets.*  We evaluate long-lived assets, including but not limited tolicenses, software development, property and equipment and identifiableintangible assets with finite lives, for impairment whenever events or 

 

16

----

 

changes in circumstancesindicate that the carrying amount of an asset may not be recoverable.  Factors we consider in deciding when toperform an impairment review include significant under-performance of a productor platform in relation to expectations, significant negative industry oreconomic trends, and significant changes or planned changes in our use of theassets.  Recoverability of the assetsare measured by a comparison of the carrying amount of an asset to futureundiscounted net cash flows expected to be generated by the asset.  If such assets are considered to beimpaired, the impairment to be recognized is measured by the amount by whichthe carrying amount of the asset exceeds its fair value.

 

Judgments and assumptions aboutfuture values are complex and often subjective.  They can be affected by a variety of factors, including but notlimited to, significant negative industry or economic trends, significantchanges in the manner or use of the acquired assets or the strategy of ouroverall business and significant underperformance relative to expectedhistorical or projected future operating results.  Although we believe the judgments and assumptions management hasmade in the past have been reasonable and appropriate, there is nonetheless ahigh degree of uncertainty and judgment involved.  More conservative assumptions of the anticipated future cashflows from these assets would result in greater impairment charges, which woulddecrease net income and result in lower asset values on our balance sheet.  Conversely, less conservative assumptionswould result in smaller impairment charges and higher net income.

 

We also make judgments aboutthe remaining useful lives of long-lived assets.  When we determine that the useful lives of assets are shorterthan we had originally estimated, and there are sufficient cash flows tosupport the carrying value of the assets, we accelerate the rate ofdepreciation charges in order to fully depreciate the assets over their newshorter useful lives.

 

*Income taxes.* As part of the process of preparing our consolidated financialstatements, we are required to estimate our income taxes in each of the jurisdictionsin which we operate.  This processinvolves estimating our current tax exposures in each jurisdiction includingthe impact, if any, of additional taxes resulting from tax examinations as wellas making judgments regarding the recoverability of deferred tax assets.  To the extent recovery of deferred taxassets is not likely based on our estimation of future taxable income in eachjurisdiction, a valuation allowance is established.  Tax exposures can involve complex issues and may require anextended period to resolve.  Theestimated effective tax rate is adjusted for the tax related to significantunusual items.  Changes in thegeographic mix or estimated level of annual pre-tax income can affect theoverall effective tax rate.

 

*Recently Issued Accounting Pronouncements*.  In November 2002, FASB issuedInterpretation (“FIN”) No. 45, “*Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others.*”  FIN No. 45 elaborates on the disclosures to be made by aguarantor in its interim and annual financial statements about its obligationsunder certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at theinception of a guarantee, a liability for the fair value of the obligationundertaken in issuing the guarantee. The initial recognition and initial measurement provisions of thisInterpretation are applicable on a prospective basis to guarantees issued ormodified after December 31, 2002. The adoption of FIN No. 45 did not have an impact on our financialstatements.

 

In December 2002, the FASBissued SFAS No. 148, *“Accounting forStock-Based Compensation –Transition and Disclosure.”*  This statement amends SFAS No. 123, toprovide alternative methods of voluntary transition to change to the fair valuebased method of accounting for stock-based employee compensation.  Additionally, this statement amendsdisclosure requirements of accounting for stock-based employee compensation andthe effect of the method used on reported results.  Currently, we do not expect to adopt the fair value based methodof accounting for stock-based employee compensation under SFAS No. 123.  We have adopted the new disclosurerequirements of SFAS No. 148 as included in the Summary of SignificantAccounting Policies, Stock-Based Compensation.

 

In May 2003, the FASBissued SFAS No. 149, *“DerivativeInstruments.”*  This statementamends SFAS No. 133, by requiring that contracts with comparablecharacteristics be accounted for in a similar fashion.  In particular, the Statement: (1) clarifiesunder what circumstances a contract with an initial net investment meets thecharacteristic of a derivative discussed in paragraph 6(b) of Statement 133;(2) clarifies when a derivative contains a financing component; (3) amends thedefinition of an underlying to conform it to language used in FIN No. 45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others*; and (4) amends certain otherexisting pronouncements.  This Statementis effective for contracts entered into or modified after June 30, 2003,and for hedging relationships designated after June 30, 2003.  We are currently evaluating the provisionsof SFAS No. 149 and have not determined the impact, if any, they will have onour financial statements.

 

In May 2003, the FASBissued SFAS No. 150 “*Accounting for Financial Instruments with theCharacteristics of Both Liabilities and Equities*”.  SFAS No. 150 establishes standards regardingthe manner in which an issuer classifies and measures certain types offinancial instruments having characteristics of both liabilities and equity.

 

17

----

 

Pursuant to SFAS No. 150, suchfreestanding financial instruments (i.e., those entered into separately from anentity’s other financial instruments or equity transactions or that are legallydetachable and separately exercisable) must be classified as liabilities or, insome cases, assets.  In addition, SFASNo. 150 requires that financial instruments containing obligations torepurchase the issuing entity’s equity shares and, under certain circumstances,obligations that are settled by delivery of the issuer’s shares be classifiedas liabilities.  The Statement iseffective for financial instruments entered into or modified after May 31,2003 and for other instruments at the beginning of the first interim periodbeginning after June 15, 2003.  Weare currently evaluating the provisions of SFAS No. 150 and have not determinedthe impact, if any, they will have on our financial statements.

 

**Results of Operations**

 

***Comparison of the Three Months EndedMarch 31, 2003 to the Three Months Ended March 31, 2002***

 

Sales by Platform

 

Thefollowing table sets forth our net sales by platform as a percentage of salesfor the three months ended March 31, 2003 and 2002:

 
|                      |   | **Three Months Ended  March 31,** |   |
|---------------------------|--------|----------------------------------------|--------|
| **Platform  Revenue Mix** |   | **2003**                               |   | **2002** |   |
| Sony PlayStation 2        |   | 37.2                                   | %      | 12.1 | % |
| Sony PlayStation          |   | 10.1                                   |   | 11.7 |   |
| Microsoft Xbox            |   | 1.8                                    |   | 21.1 |   |
| Nintendo Game Boy Advance |   | 26.7                                   |   | 35.7 |   |
| Nintendo Game Boy Color   |   | 2.1                                    |   | 8.6 |   |
| Nintendo Game Cube        |   | 5.3                                    |   | 1.5 |   |
| Nintendo 64               |   | —                                 |   | 0.4 |   |
| PC                        |   | 15.4                                   |   | 7.2 |   |
| Other                     |   | 1.4                                    |   | 1.7 |   |
|                      |   | 100.0                                  | %      | 100.0 | % |

 

Thefollowing table sets forth our net sales by platform for the three months endedMarch 31, 2003 and 2002:

 
| **Net Sales  for the Three Months Ended  (In thousands)** |   | **March 31,  2003** |   | **March 31,  2002** |   | **Increase/  (Decrease)** |   | **%****Change** |    |
|-----------------------------------------------------------|--------|--------------------------|--------|--------------------------|--------|---------------------------|--------|-----------------|---------|
| Sony PlayStation 2                                        |   | $                        | 24,818 |                     | $      | 9,620                     |   | $               | 15,198  |   | 158.0 | % |
| Sony PlayStation                                          |   | 6,716                    |   | 9,332                    |   | (2,616                    | )      | (28.0           | )%      |
| Microsoft Xbox                                            |   | 1,195                    |   | 16,776                   |   | (15,581                   | )      | (92.9           | )%      |
| Nintendo Game Boy Advance                                 |   | 17,799                   |   | 28,451                   |   | (10,652                   | )      | (37.4           | )%      |
| Nintendo Game Boy Color                                   |   | 1,432                    |   | 6,887                    |   | (5,455                    | )      | (79.2           | )%      |
| Nintendo Game Cube                                        |   | 3,538                    |   | 1,178                    |   | 2,360                     |   | 200.3           | %       |
| Nintendo 64                                               |   | —                   |   | 336                      |   | (336                      | )      | (100.0          | )%      |
| PC CD-ROM                                                 |   | 10,258                   |   | 5,769                    |   | 4,489                     |   | 77.8            | %       |
| Other                                                     |   | 1,044                    |   | 1,333                    |   | (289                      | )      | (21.7           | )%      |
| Net Sales                                                 |   | $                        | 66,800 |                     | $      | 79,682                    |   | $               | (12,882 | ) | (16.2 | )% |

 

*Sony PlayStation 2 Net Sales*

 

We hadtwo new releases of PlayStation 2 titles in the three months endedMarch 31, 2003 whereas we had one new PlayStation 2 release in the threemonths ended March 31, 2002. Titles for PlayStation 2 released in the three months ended March 31,2003 were *PrideFC*and *WWE Crush Hour.*  The only title for PlayStation 2released in the same period of 2002 was*Tetris Worlds.*  We had continued strong sales of back catalog titles such as *WWESmackDown! Shut Your Mouth, SpongeBob SquarePants Revenge of the FlyingDutchman* and *Scooby-Doo! Night of 100 Frights*in thethree months ended March 31, 2003*.*

 

18

----

 

*Sony PlayStation Net Sales*

 

We didnot release any PlayStation products in the three months ended March 31,2003 or in the three months ended March 31, 2002.  We do not anticipate releasing any newPlayStation products in the future, due to the transition to PlayStation2.  We do not anticipate that this willhave a material effect on our overall net sales because of the increase inPlayStation 2 net sales and the continued demand for our current PlayStationcatalog titles in the children’s genre.

 

*Microsoft Xbox*

 

We didnot release any Xbox titles in the three months ended March 31, 2003,whereas we released two new Xbox titles in the three months endedMarch 31, 2002 including *WWF Raw*.

 

*Nintendo Game Boy Advance Net Sales*

 

Wereleased two new Game Boy Advance titles in the three months endedMarch 31, 2003, *Sonic Advance 2* and *GTAdvance 3,* whereas we released seven Game Boy Advance titlesduring the three months ended March 31, 2002, including *SonicAdvance, Baseball Advance, MotoGP*and*Columns Crown*.

 

*Nintendo Game Boy Color Net Sales*

 

We didnot release any Game Boy Color products in the three months endedMarch 31, 2003 or in the three months ended March 31, 2002.  We do not anticipate releasing any new GameBoy Color products in the future, due to the transition to Game BoyAdvance.  We do not anticipate that thiswill have a material effect on our overall net sales because of the increase inNintendo Game Boy Advance net sales.

 

*Nintendo GameCube Net Sales*

 

Wereleased two GameCube titles in the three months ended March 31, 2003, *Summoner 2*and*WWE CrushHour*.  We released one newGameCube title in the three months ended March 31, 2002.

 

*PC CD-ROM Net Sales*

 

Wereleased 15 PC titles published from our ValuSoft division in the three monthsended March 31, 2003 whereas we only released two PC titles in the threemonths ended March 31, 2002.  Theincrease in PC CD-ROM titles released and net sales for the three months endedMarch 31, 2003 as compared to the three months ended March 31, 2002is attributed to the acquisition ofValuSoft.

 

19

----

 

Sales by Territory

 

Thefollowing table sets forth, for the three months ended March 31, 2003 and2002, our net sales for the North America and international territories:

 
| **Net Sales  for the Three Months Ended  (In thousands)** |   | **March 31,  2003** |   | **March 31,  2002** |   | **Increase/  (Decrease)** |   | **%****Change** |    |
|-----------------------------------------------------------|--------|--------------------------|--------|--------------------------|--------|---------------------------|--------|-----------------|---------|
| North America                                             |   | $                        | 56,649 |                     | $      | 56,540                    |   | $               | 109     |   | 0.2 | % |
| International                                             |   | 10,151                   |   | 23,142                   |   | (12,991                   | )      | (56.1           | )%      |
| Net Sales                                                 |   | $                        | 66,800 |                     | $      | 79,682                    |   | $               | (12,882 | ) | (16.2 | )% |

 

*North America Net Sales*

 

Ournet sales during the three months ended March 31, 2003 remained constantfrom the three months ended March 31, 2002.  During the quarter, we released six new SKUs, including *Pride*FC for PlayStation 2 and *Sonic Advance 2* for Game Boy Advance ascompared to 16 releases in the three months ended March 31, 2002.  A higher proportion of our net sales for thethree months ended March 31, 2003 is also attributed to sales of catalogtitles, including continued strong sales of our *SpongeBob*and *WWE*brands as compared to the same period in 2002.

 

Two ofour key genres, wrestling and children’s, are best suited to the broaderdemographic which occurs as the hardware platforms reach a larger installedbase.  Based on the higher installedbase of all four hardware platforms, particularly PlayStation 2 and Xbox, andour increasing product line, we believe that our net sales in North Americashould increase in our fiscal year ending March 31, 2004.

 

*International Net Sales*

 

Netsales in the international territories decreased for the three months endedMarch 31, 2003 as compared to the three months ended March 31, 2002.  This decline in net sales resulted from nonew releases during the three months ended March 31, 2003 as compared tosix new releases during the three months ended March 31, 2002 including *MotoGP, FilaDecathlon*and *Tetris Worlds.*  We expect our international net sales to increase at a fasterrate in our fiscal year ending March 31, 2004 as we release new productsin the international markets and as the hardware platforms reach a largerinstalled base.

 

20

----

 

Costs and Expenses, Interest Income, net, OtherExpenses and Income Taxes

 

Informationabout our costs and expenses, interest income, net, other expenses and incometaxes for the three months ended March 31, 2003 and 2002 is presentedbelow:

 
|                               |   | **Percent of Net Sales**               |   |
|------------------------------------|--------|----------------------------------------|--------|
|                               |   | **Three Months Ended  March 31,** |   |
|                               |   | **2003**                               |   | **2002** |   |
| Costs and expenses:                |   |                                   |   |   |   |
| Cost of sales                      |   | 39.5                                   | %      | 42.3 | % |
| License amortization and royalties |   | 8.3                                    |   | 8.9 |   |
| Software development amortization  |   | 18.0                                   |   | 13.5 |   |
| Product development                |   | 14.6                                   |   | 9.6 |   |
| Selling and marketing              |   | 21.4                                   |   | 12.2 |   |
| Payment to venture partner         |   | 1.0                                    |   | 2.0 |   |
| General and administrative         |   | 11.4                                   |   | 7.6 |   |
| Total costs and expenses           |   | 114.2                                  |   | 96.1 |   |
| Income (loss) from operations      |   | (14.2                                  | )      | 3.9 |   |
| Interest income, net               |   | 1.3                                    |   | 1.7 |   |
| Other expenses                     |   | (3.6                                   | )      | — |   |
| Income (loss) before income taxes  |   | (16.5                                  | )      | 5.6 |   |
| Income taxes                       |   | (4.9                                   | )      | 2.1 |   |
| Net income (loss)                  |   | (11.6                                  | )%     | 3.5 | % |

 

*Cost of Sales*

 

Costof sales as a percentage of net sales decreased for the three months endedMarch 31, 2003 as compared to the three months ended March 31, 2002as a result of a larger portion of net sales during the three months endedMarch 31, 2002 of Game Boy Advance games which carry higher manufacturingcosts than disc based products.  Weexpect our cost of sales to decrease as a percentage of net sales in our fiscalyear ending March 31, 2004 due to an expected higher percentage of salesin such period of higher-margin disc-based products.

 

*License Amortization and Royalties*

 

Licenseamortization and royalties decreased in absolute dollars and decreased slightlyas a percentage of net sales for the three months ended March 31, 2003 ascompared to the three months ended March 31, 2002 primarily because ournew releases have lower overall royalty rates than the titles that werereleased in the March 31, 2002 period. This decrease was also due to the sale of titles published byValuSoft.  ValuSoft products carry lowerlicense rates compared to our standard console and PC CD-ROM products.

 

*Software Development Amortization*

 

Softwaredevelopment amortization increased as a percentage of net sales for the threemonths ended March 31, 2003 as compared to the three months endedMarch 31, 2002 primarily due to lower than anticipated sales of *WWE CrushHour* and *Pride FC* which resulted in higher thanaverage amortization rates during the three months ended March 31, 2003.

 

*Product Development*

 

Productdevelopment expenses increased in absolute dollars and as a percentage of netsales for the three months ended March 31, 2003 as compared to the threemonths ended March 31, 2002.  Thisincrease is primarily due to the costs incurred by the new development studios,Outrage and Cranky Pants, and by ValuSoft. We also increased the number of personnel in our corporate productdevelopment department to support the increased number of SKUs underdevelopment and our increased emphasis on product quality, thereby contributingto the higher product development expenses in 2003.

 

21

----

 

*Selling and Marketing*

 

Sellingand marketing expenses increased by $4.5 million and have increased as apercentage of net sales for the three months ended March 31, 2003 ascompared to the three months ended March 31, 2002.  The increase in selling and marketingexpenses is primarily due to an increase in television media expenditures for *Pride*FCwhich generated lower sales than anticipated and higher promotional support for*Disney/Pixar’sFinding Nemo* which was released in May 2003*.*  We expect sales and marketing expenses to be approximately 16% ofnet sales for the fiscal year ended March 31, 2004.

 

*Payment to Venture Partner*

 

Thepayment to JAKKS has decreased as a percentage of total net sales for the threemonths ended March 31, 2003 as compared to the three months endedMarch 31, 2002 primarily due to *WWE Raw* which was released in the threemonths ended March 31, 2002.  Therelease of the next *WWE* wrestling title will be in fiscal2004.

 

*General and Administrative*

 

Generaland administrative expenses increased by $1.6 million due to the addition ofValuSoft’s general and administrative expenses and the additional expensesrequired for Wireless operations.  Wealso increased the number of personnel in our international territories tosupport the increased number of SKUs expected to be released in thoseterritories.

 

*Interest Income, net*

 

Interestincome, net decreased for the three months ended March 31, 2003 ascompared to the three months ended March 31, 2002 due to lower interestrates and lower average cash, cash equivalents and short-term investmentbalances.

 

*Other Expenses*

 

Otherexpenses includes a $1.8 million write-down of our long-term investment inYuke’s Co., Ltd.’s due to an other than temporary decline in the market valueof the investment.  (See – “Note 8 – OtherLong-Term Assets")  Fair value wasdetermined by using the closing price on the Japanese stock market atMarch 31, 2003.  We believe thatthis decline in market value is due to the decline in the overall Japanesestock market.  We also had realized losseson other short-term investments of approximately $550,000.

 

*Income Taxes*

 

Theeffective tax rate for the three months ended March 31, 2003 was 30.0% andthe effective tax rate for the three months ended March 31, 2002 was37.5%.  This decrease in the effectivetax rate is due primarily to the other than temporary impairment of ourlong-term investment in Yuke’s Co., Ltd., which is not deductible for taxpurposes.  We expect our effective taxrate for our fiscal year ending March 31, 2004 to be approximately 37%.

 

22

----

 

***Comparison of the Year EndedDecember 31, 2002 to the Year Ended December 31, 2001***

 

Sales by Platform

 

Thefollowing table sets forth our net sales by platform as a percentage of salesfor the years ended December 31, 2002 and 2001:

 
|                      |   | **Years Ended  December 31,** |   |
|---------------------------|--------|------------------------------------|--------|
| **Platform  Revenue Mix** |   | **2002**                           |   | **2001** |   |
| Sony PlayStation 2        |   | 34.8                               | %      | 29.2 | % |
| Sony PlayStation          |   | 7.8                                |   | 15.9 |   |
| Microsoft Xbox            |   | 7.1                                |   | 1.4 |   |
| Nintendo Game Boy Advance |   | 24.9                               |   | 22.1 |   |
| Nintendo Game Boy Color   |   | 5.4                                |   | 16.5 |   |
| Nintendo Game Cube        |   | 10.2                               |   | — |   |
| Nintendo 64               |   | 0.1                                |   | 4.5 |   |
| PC                        |   | 9.4                                |   | 9.7 |   |
| Other                     |   | 0.3                                |   | 0.7 |   |
|                      |   | 100.0                              | %      | 100.0 | % |

 

Thefollowing table sets forth our net sales by platform for the years endedDecember 31, 2002 and 2001:

 
| **Net Sales  for the Years Ended  (In thousands)** |   | **December 31,  2002** |    | **December 31,  2001** |   | **Increase/  (Decrease)** |   | **%****Change** |    |
|----------------------------------------------------|--------|-----------------------------|---------|-----------------------------|--------|---------------------------|--------|-----------------|---------|
| Sony PlayStation 2                                 |   | $                           | 167,032 |                        | $      | 110,642                   |   | $               | 56,390  |   | 51.0 | % |
| Sony PlayStation                                   |   | 37,270                      |    | 60,340                      |   | (23,070                   | )      | (38.2           | )%      |
| Microsoft Xbox                                     |   | 34,143                      |    | 5,111                       |   | 29,032                    |   | 568.0           | %       |
| Nintendo Game Boy Advance                          |   | 119,614                     |    | 83,830                      |   | 35,784                    |   | 42.7            | %       |
| Nintendo Game Boy Color                            |   | 26,185                      |    | 62,569                      |   | (36,384                   | )      | (58.2           | )%      |
| Nintendo Game Cube                                 |   | 49,004                      |    | —                      |   | 49,004                    |   | N/A             |    |
| Nintendo 64                                        |   | 277                         |    | 17,097                      |   | (16,820                   | )      | (98.4           | )%      |
| PC CD-ROM                                          |   | 45,046                      |    | 36,814                      |   | 8,232                     |   | 22.4            | %       |
| Other                                              |   | 1,958                       |    | 2,589                       |   | (631                      | )      | (24.4           | )%      |
| Net Sales                                          |   | $                           | 480,529 |                        | $      | 378,992                   |   | $               | 101,537 |   | 26.8 | % |

 

*Sony PlayStation 2 Net Sales*

 

We had12 new releases of PlayStation 2 titles in 2002 whereas we had five newPlayStation 2 releases in 2001.  Keytitles for PlayStation 2 released in 2002 include*Red Faction II, Scooby-Doo! Night of100 Frights, SpongeBob SquarePants:Revenge of the Flying Dutchman, Summoner 2*and*WWESmackDown! Shut Your Mouth*.  Key titles for PlayStation 2 releasedin 2001 included *WWF SmackDown! “Just Bring It”, Red Faction*and *MX 2002featuring Ricky Carmichael.*

 

*Sony PlayStation Net Sales*

 

We didnot release any PlayStation products in the year ended December 31, 2002,whereas we released ten PlayStation titles in the year ended December 31,2001.

 

*Microsoft Xbox*

 

Wereleased seven Xbox titles in the year ended December 31, 2002 including *MotoGP, Tetris Worlds*and *WWF Raw*. We released our first two Xbox titles in the fourth quarter of 2001.

 

23

----

 

*Nintendo Game Boy Advance Net Sales*

 

Wereleased 31 new Game Boy Advance titles in the year ended December 31,2002, including *Scooby-Doo! The Movie, SonicAdvance, SpongeBob SquarePants: Revenge of the Flying Dutchman*and*Star Wars Episode 2: Attack of the Clones,*whereas we released 15 Game Boy Advance titles during 2001, including *Disney/Pixar’sMonsters, Inc., Jimmy Neutron: Boy Genius, MX 2002 featuring Ricky Carmichael, Rocket Power: Dream Scheme, Rugrats:Castle Capers*and*TetrisWorlds*.

 

*Nintendo Game Boy Color Net Sales*

 

We didnot release any Game Boy Color products in the year ended December 31,2002, whereas we released 16 Game Boy Color titles in the year endedDecember 31, 2001.

 

*Nintendo GameCube Net Sales*

 

Wereleased 11 GameCube titles in the year ended December 31, 2002, including*Disney/Pixar’sMonsters, Inc. Scream Arena, MX Superfly featuring Ricky Carmichael, Rocket Power Beach Bandits, Scooby-Doo! Night of 100 Frights, SpongeBobSquarePants: Revenge of the Flying Dutchman*and*WWEWrestleMania X8*.  We had noreleases of GameCube titles in the year ended December 31, 2001, as theGameCube platform did not launch until November 2001.

 

*Nintendo 64 Net Sales*

 

We didnot release any Nintendo 64 (“N64”) products in the year endedDecember 31, 2002.  We released twoN64 titles in the year ended December 31, 2001.

 

*PC CD-ROM Net Sales*

 

Wereleased 52 PC titles in the year ended December 21, 2002 whereas we onlyreleased 13 PC titles in 2001.  Theincrease in PC CD-ROM titles released and net sales for 2002 as compared to thesame period of 2001 is attributed to the acquisition of ValuSoft.  This increase innet sales for 2002 attributed to ValuSoft is offset by lower net sales of ourregular priced PC CD-ROM products.

 

24

----

 

Sales by Territory

 

Thefollowing table sets forth, for the years ended December 31, 2002 and2001, our net sales for the North America and international territories:

 
| **Net Sales  for the Years Ended  (In thousands)** |   | **December 31,  2002** |    | **December 31,  2001** |   | **Increase/  (Decrease)** |   | **%****Change** |    |
|----------------------------------------------------|--------|-----------------------------|---------|-----------------------------|--------|---------------------------|--------|-----------------|---------|
| North America                                      |   | $                           | 358,124 |                        | $      | 262,676                   |   | $               | 95,448  |   | 36.3 | % |
| International                                      |   | 122,405                     |    | 116,316                     |   | 6,089                     |   | 5.2             | %       |
| Net Sales                                          |   | $                           | 480,529 |                        | $      | 378,992                   |   | $               | 101,537 |   | 26.8 | % |

* *

*North America Net Sales*

 

Theincrease in net sales in North America for the year ended December 31,2002 as compared to the same period of 2001 was primarily due to thesignificant increase in the number of titles released domestically.

 

Ournet sales during the quarter ended December 31, 2002 were lower thanexpected due to sales of *Red Faction II* for PlayStation 2, ourGameCube portfolio not meeting our expectations and a cautious retailenvironment.  Although we expect thecautious retail environment to continue, we believe we have taken measuresnecessary to meet net sales expectations in the future.  These measures include reducing the numberof SKUs for the GameCube platform, canceling the development of SKUs that didnot meet quality or marketability standards and implementing a new productdevelopment structure with a heightened focus on product quality.

 

Two ofour key genres, wrestling and children’s, are best suited to the broaderdemographic which occurs as the hardware platforms reach a larger installedbase.

 

*International Net Sales*

 

Netsales in the international territories, with the exception of France, increasedslightly for the year ended December 31, 2002 as compared to the sameperiod of 2001.  This slight increasewas primarily due to the launches of next generation hardware platformsoccurring at later dates in foreign territories, resulting in a smallerinstalled base.

 

Netsales in France declined by $3.6 million or 20% for the year endedDecember 31, 2002 as compared to the same period of 2001.  This decline in net sales was due to thedemand for *RedFaction II* for PlayStation 2 being lower than anticipated and slowerthan anticipated growth of the GameCube installed base.

 

25

----

 

Costs and Expenses, Interest Income, net, OtherExpenses and Income Taxes

 

Informationabout our costs and expenses, interest income, net, other expenses and incometaxes for the years ended December 31, 2002 and 2001 is presented below:

 
|                               |   | **Percent of Net Sales**           |   |
|------------------------------------|--------|------------------------------------|--------|
|                               |   | **Years Ended  December 31,** |   |
|                               |   | **2002**                           |   | **2001** |   |
| Costs and expenses:                |   |                               |   |   |   |
| Cost of sales                      |   | 38.6                               | %      | 40.9 | % |
| License amortization and royalties |   | 8.4                                |   | 8.7 |   |
| Software development amortization  |   | 17.4                               |   | 9.3 |   |
| Product development                |   | 8.0                                |   | 5.6 |   |
| Selling and marketing              |   | 13.8                               |   | 12.3 |   |
| Payment to venture partner         |   | 2.1                                |   | 2.3 |   |
| General and administrative         |   | 6.6                                |   | 6.6 |   |
| Total costs and expenses           |   | 94.9                               |   | 85.7 |   |
| Income from operations             |   | 5.1                                |   | 14.3 |   |
| Interest income, net               |   | 1.1                                |   | 0.7 |   |
| Other expenses                     |   | (2.1                               | )      | — |   |
| Income before income taxes         |   | 4.1                                |   | 15.0 |   |
| Income taxes                       |   | 1.4                                |   | 5.5 |   |
| Net income                         |   | 2.7                                | %      | 9.5 | % |

 

*Cost of Sales*

 

Costof sales as a percentage of net sales decreased for the year endedDecember 31, 2002 compared to the same period of 2001 as a result of alarger proportion of sales in 2002 of next generation console games which havelower manufacturing costs than handheld games and a reduction in themanufacturing costs for the Game Boy Advance in 2002.

 

*License Amortization and Royalties*

 

Licenseamortization and royalties increased in absolute dollars but decreased slightlyas a percentage of net sales for the year ended December 31, 2002 ascompared to the same period of 2001 primarily due to the sale of key titles in2002 that have lower royalty rates than our average titles and the titles thatwere sold in 2001.  This decrease wasalso due to the sale of titles published by ValuSoft.  ValuSoft products carry lower license rates compared to our standardconsole and PC CD-ROM products.

 

*Software Development Amortization*

 

Softwaredevelopment amortization includes a write-off of approximately $11.2 millionfor the discontinued product development of 20 SKUs, which means that one ormore platform versions of an individual product title may have beendiscontinued.  We discontinued thedevelopment of these SKUs after reviewing the quality of these SKUs anddetermining that the SKUs were not marketable. Excluding this write-off, software development amortization was $72.5million or 15.0% of net sales for the year ended December 31, 2002.  The increase as a percentage of net salesfrom the year ended December 31, 2001 is primarily due to lower thananticipated sales during the fourth quarter of 2002 and the increasedpercentage of next generation console games sold during 2002 as compared to2001, which have longer development cycles and higher development costs thanhandheld games and games for legacy platforms.

 

26

----

 

*Product Development*

 

Productdevelopment expenses increased in absolute dollars and as a percentage of netsales for the year ended December 31, 2002 as compared to the same periodof 2001.  This increase is primarily dueto the costs incurred by the three new development studios:  Rainbow, Outrage and Cranky Pants.  We also increased the number of personnel inour corporate product development department to support the increased number ofSKUs under development, thereby contributing to the higher product developmentexpenses in 2002.  We also had increasedexpenses for our wireless division.

 

*Selling and Marketing*

 

Sellingand marketing expenses increased by $19.7 million and have increased slightlyas a percentage of net sales for the year ended December 31, 2002 ascompared to the same period of 2001. The increase in selling and marketing expenses as a percentage of netsales for the year ended December 31, 2002 is primarily due to an increasein television media expenditures as a percentage of net sales for a greaternumber of SKUs in 2002 as compared to 2001 and the lower than anticipated salesduring the fourth quarter of 2002.

 

*Payment to Venture Partner*

 

Thepayment to JAKKS has remained relatively constant as a percentage of total netsales for the year ended December 31, 2002 as compared to the same periodof 2001.

 

*General and Administrative*

 

Generaland administrative expenses increased by $6.0 million due to the expensesrequired to support the increased net sales, an increase in our allowance fordoubtful accounts related to the Chapter 11 bankruptcy filing of Kmart and theaddition of ValuSoft’s general and administrative expenses, but it remainedrelatively constant as a percentage of net sales as compared to the same periodof 2001.

 

*Interest Income, net*

 

Interestincome, net increased for the year ended December 31, 2002 as compared tothe same period of 2001 as a result of higher average cash, cash equivalentsand short-term investment balances which increased as a result of our publicoffering of our common stock in November 2001.

 

*Other Expenses*

 

Otherexpenses includes a $7.0 million charge related to the settlement of the classaction lawsuit.  See – “Item 3. LegalProceedings.”  The $7.0 million includes$2.0 million for the portion of the settlement and legal fees that exceeds ourdirectors and officers insurance coverage and $5.0 million as a reserve againstthe receivable from our insurer due to a dispute in the amount ofcoverage.  We are currently inarbitration with the insurer.  See –“Item 3. Legal Proceedings.”  Any amountreceived in arbitration will be recognized as other income in a futureperiod.  Other expenses also includes a$3.0 million non-cash charge related to the discontinuation of our online jointventure in the United Kingdom (Network Interactive Sports, Ltd.).

 

*Income Taxes*

 

Theeffective tax rate for the year ended December 31, 2002 was 34.2%, and theeffective tax rate for 2001 was 36.5%. The decrease in the effective tax rate from 2001 to 2002 is dueprimarily to tax benefits related to our international business activities.

 

27

----

 

***Comparison of the Year EndedDecember 31, 2001 to the Year Ended December 31, 2000***

 

Salesby Platform

 

Thefollowing table sets forth our net sales by platform as a percentage of salesfor the years ended December 31, 2001 and 2000:

 
|                      |   | **Years Ended  December 31,** |   |
|---------------------------|--------|------------------------------------|--------|
| **Platform  Revenue Mix** |   | **2001**                           |   | **2000** |   |
| Sony PlayStation 2        |   | 29.2                               | %      | 2.6 | % |
| Sony PlayStation          |   | 15.9                               |   | 41.0 |   |
| Microsoft Xbox            |   | 1.4                                |   | — |   |
| Nintendo Game Boy Advance |   | 22.1                               |   | — |   |
| Nintendo Game Boy Color   |   | 16.5                               |   | 20.3 |   |
| Nintendo 64               |   | 4.5                                |   | 28.6 |   |
| PC                        |   | 9.7                                |   | 3.2 |   |
| Other                     |   | 0.7                                |   | 4.3 |   |
|                      |   | 100.0                              | %      | 100.0 | % |

 

Thefollowing table sets forth our net sales by platform for the years endedDecember 31, 2001 and 2000:

 
| **Net Sales  for the Years Ended  (In thousands)** |   | **December 31,  2001** |    | **December 31,  2000** |   | **Increase/  (Decrease)** |   | **%****Change** |    |
|----------------------------------------------------|--------|-----------------------------|---------|-----------------------------|--------|---------------------------|--------|-----------------|---------|
| Sony PlayStation 2                                 |   | $                           | 110,642 |                        | $      | 9,064                     |   | $               | 101,578 |   | 1,120.7 | % |
| Sony PlayStation                                   |   | 60,340                      |    | 142,429                     |   | (82,089                   | )      | (57.6           | )%      |
| Microsoft Xbox                                     |   | 5,111                       |    | —                      |   | 5,111                     |   | N/A             |    |
| Nintendo Game Boy Advance                          |   | 83,830                      |    | —                      |   | 83,830                    |   | N/A             |    |
| Nintendo Game Boy Color                            |   | 62,569                      |    | 70,379                      |   | (7,810                    | )      | (11.1           | )%      |
| Nintendo 64                                        |   | 17,097                      |    | 99,176                      |   | (82,079                   | )      | (82.8           | )%      |
| PC CD-ROM                                          |   | 36,814                      |    | 11,035                      |   | 25,779                    |   | 233.6           | %       |
| Other                                              |   | 2,589                       |    | 14,920                      |   | (12,331                   | )      | (82.6           | )%      |
| Net Sales                                          |   | $                           | 378,992 |                        | $      | 347,003                   |   | $               | 31,989  |   | 9.2 | % |

 

*Sony PlayStation 2 Net Sales*

 

We hadfive new releases of PlayStation 2 titles in 2001 whereas we only had one newPlayStation 2 release in 2000.  Keytitles for PlayStation 2 released in 2001 include *Red Faction, WWF SmackDown! “Just BringIt”*and *MX 2002 featuring Ricky Carmichael*.

 

*Sony PlayStation Net Sales*

 

PlayStationnet sales decreased for the year ended December 31, 2001 compared to thesame period of 2000 for two reasons: 1) decreased sales of *WWF SmackDown!* and *WWF SmackDown! 2: Know Your Role* whichwere both released in 2000 (we released no new World Wrestling Federationtitles on PlayStation in 2001) and 2) the declining market for PlayStationproducts due to the transition to PlayStation 2.

 

*Microsoft Xbox*

 

Wereleased our first two Xbox titles in the fourth quarter of 2001.  The two titles were *Dark Summit* and *MX 2002featuring Ricky Carmichael*.

 

*Nintendo Game Boy Advance Net Sales*

 

Wereleased 15 Game Boy Advance titles during 2001 including *Rocket Power: Dream Scheme,**MX 2002featuring Ricky Carmichael, Tetris Worlds, Disney/Pixar’s Monsters, Inc., JimmyNeutron: Boy Genius*and *Rugrats:Castle Capers*.

 

28

----

 

*Nintendo Game Boy Color Net Sales*

 

GameBoy Color net sales decreased during 2001 as compared to the same period of2000 due to the introduction of the Game Boy Advance platform.

 

*Nintendo 64 Net Sales*

 

We hadtwo releases of Nintendo 64 (“N64”) product in 2001 versus four N64 releases in2000.  Net sales decreased by 83% due tothe weaker market for N64 product as the industry transitioned to the nextgeneration of hardware.

 

*PC CD-ROM Net Sales*

 

Thesignificant increase in PC CD-ROM net sales for 2001 as compared to the sameperiod of 2000 is attributed to the worldwide release of *Red Faction*for the PC, numerous children’s titlesincluding, *Rocket Power:**ExtremeArcade Games, Bob The Builder: Can We Fix It?, SpongeBob SquarePants: Operation Krabby Patty, JimmyNeutron: Boy Genius* and *Rugrats: AllGrowed Up*, as well as salesfrom *HotWheels* and*Matchbox*titles released under our licenseagreement with Mattel.  We released 13PC titles in 2001 whereas we only released six PC titles in 2000.

 

29

----

 

Sales by Territory

 

Thefollowing table sets forth, for the years ended December 31, 2001 and2000, our net sales for the North America and international territories:

 
| **Net Sales  for the Years Ended  (In thousands)** |   | **December 31,  2001** |    | **December 31,  2000** |   | **Increase/  (Decrease)** |   | **%****Change** |   |
|----------------------------------------------------|--------|-----------------------------|---------|-----------------------------|--------|---------------------------|--------|-----------------|--------|
| North America                                      |   | $                           | 262,676 |                        | $      | 270,116                   |   | $               | (7,440 | ) | (2.8 | )% |
| International                                      |   | 116,316                     |    | 76,887                      |   | 39,429                    |   | 51.3            | %      |
| Net Sales                                          |   | $                           | 378,992 |                        | $      | 347,003                   |   | $               | 31,989 |   | 9.2 | % |

 

*North America Net Sales*

 

Thedecrease in net sales in North America for the year ended December 31,2001 as compared to the same period of 2000 was primarily due to the industry’stransition to four new hardware platforms, two of which were released inNovember of 2001.  In addition, twoof our key genres, wrestling and children’s, are best suited to the broaderdemographic which occurs as the hardware platforms reach a larger installedbase.

 

Althoughthe total amount of actual units shipped in 2001 was 24% higher than in 2000,our net sales decreased due to declining pricing on legacy products and no newreleases of N64 products which sell at a higher price than other products.

 

*International Net Sales*

 

Theincrease in net sales in the international territories for the year endedDecember 31, 2001 as compared to the same period of 2000 was primarily dueto:

 

•                  Our offices in France and Australiaconducting business for the full year as compared to only nine months and threemonths, respectively, in 2000.

 

•                  The release of five PlayStation 2titles in 2001 as compared to no titles in 2000.

 

•                  A 105% increase in net sales oftitles for the handheld gaming systems Nintendo Game Boy Color and NintendoGame Boy Advance.

 

•                  A 48% increase in PC CD-ROM net salesprimarily due to *Red Faction* forPC CD-ROM.

 

•                  This increase was offset by a 52%decrease in PlayStation net sales due to the transition to PlayStation 2.

 

30

----

 

Costs and Expenses, Interest Income, net, andIncome Taxes

 

Informationabout our costs and expenses, interest income, net, and income taxes for theyears ended December 31, 2001 and 2000 is presented below:

 
|                               |   | **Percent of Net Sales**           |   |
|------------------------------------|--------|------------------------------------|--------|
|                               |   | **Years Ended  December 31,** |   |
|                               |   | **2001**                           |   | **2000** |   |
| Costs and expenses:                |   |                               |   |   |   |
| Cost of sales                      |   | 40.9                               | %      | 40.6 | % |
| License amortization and royalties |   | 8.7                                |   | 10.0 |   |
| Software development amortization  |   | 9.3                                |   | 12.4 |   |
| Product development                |   | 5.6                                |   | 5.5 |   |
| Selling and marketing              |   | 12.3                               |   | 12.2 |   |
| Payment to venture partner         |   | 2.3                                |   | 5.1 |   |
| General and administrative         |   | 6.6                                |   | 5.6 |   |
| Total costs and expenses           |   | 85.7                               |   | 91.4 |   |
| Income from operations             |   | 14.3                               |   | 8.6 |   |
| Interest income, net               |   | 0.7                                |   | 0.4 |   |
| Income before income taxes         |   | 15.0                               |   | 9.0 |   |
| Income taxes                       |   | 5.5                                |   | 3.8 |   |
| Net income                         |   | 9.5                                | %      | 5.2 | % |

 

*Cost of Sales*

 

Costof sales as a percentage of net sales remained relatively constant for the yearended December 31, 2001 compared to the same period of 2000.

 

*License Amortization and Royalties*

 

Licenseamortization and royalties decreased as a percentage of net sales for the yearended December 31, 2001 as compared to the same period of 2000 primarilydue to sales of *Red Faction*and*Summoner*whichcarry no license amortization and royalties because we own the intellectualproperty.

 

*Software Development Amortization*

 

Softwaredevelopment amortization decreased as a percentage of net sales for the yearended December 31, 2001 as compared to the same period of 2000 primarilydue to:

 

•                  An increase in the percentage ofhandheld games sold during the period, which generally carry lower softwaredevelopment costs than console games.

 

•                  The May 2000 non-cash charge whichincluded a $7.1 million charge to software development amortization related todiscontinued games or unrecoverable milestone payments.  Before the May 2000 non-cash charge,software development amortization for the year ended December 31, 2000 was10.3% of net sales.

 

*Product Development*

 

Productdevelopment expenses remained relatively constant as a percentage of net salesfor the year ended December 31, 2001 as compared to the same period of2000.  Product development expensesincreased by $2.0 million for the year ended December 31, 2001 as comparedto the same period of 2000.  Thisincrease is related to the increased headcount of our corporate productdevelopment department required to support the launch of four new hardwareplatforms over a twelve-month period and the increased number of titles underdevelopment.

 

31

----

 

*Selling and Marketing*

 

Sellingand marketing expenses increased by $4.3 million for the year endedDecember 31, 2001 as compared to the same period of 2000.  This increase is directly related to theincrease in net sales.  Selling andmarketing expenses have remained relatively constant as a percentage of net salesfor the years ended December 31, 2001 and 2000.

 

*Payment to Venture Partner*

 

Paymentto JAKKS has decreased as a percentage of total net sales and in absolutedollars for the year ended December 31, 2001 as compared to the sameperiod of 2000 in direct relation to the decrease in World WrestlingEntertainment related sales as a percentage of our total net sales for the yeardue to fewer titles released in 2001.

 

*General and Administrative*

 

Generaland administrative expenses increased by $5.6 million due to the expensesrequired to support the increased net sales and an increase in our allowancefor doubtful accounts.  General andadministrative expenses also increased as a percentage of net sales to 6.6%from 5.6% in the same period of 2000. The increase as a percentage of net sales is primarily due to anincrease in our bad debt allowance related to the Chapter 11 bankruptcy filingof Kmart.

 

*Interest Income, net*

 

Interestincome, net increased for the year ended December 31, 2001 as compared tothe same period of 2000 as a result of higher average cash, cash equivalentsand short-term investment balances due to the proceeds from our secondaryoffering on November 13, 2001.

 

*Income Taxes*

 

Theeffective tax rate for the year ended December 31, 2001 was 36.5%, and theeffective tax rate for 2000 was 41.8%. The decrease in the effective tax rate from 2000 to 2001 is dueprimarily to the relocation of our warehouse to a state that has a loweroverall tax rate.  In addition, theeffective tax rate for 2000 was negatively impacted by the acquisition ofVolition, which increased the rate by 2.5%.

 

**Liquidity and Capital Resources**

 

**Transition Period 2003:**

 

Ourprincipal source of cash is sales of our packaged software for video gameconsoles and personal computers.  Inaddition, we obtained $154.6 million in cash from a public offering of ourcommon stock in November 2001.  Ourprincipal uses of cash are product purchases, payments to licensors, paymentsto developers and the costs of internal software development.  In order to purchase products from themanufacturers, we typically open letters of credit in their favor, obtain aline of credit from the manufacturer or make prepayments for the product.

 

Ourcash, cash equivalents and short-term investments decreased from $242.8 millionat March 31, 2002 to $216.0 million at March 31, 2003.  Cash, cash equivalents and short-terminvestments were $196.6 million as of June 2, 2003, which reflects theamounts collected on accounts receivable. Cash provided by operating activities for the three months endedMarch 31, 2003 was $38.5 million compared to $34.9 million duringMarch 31, 2002.

 

Weentered into approximately 6 new license agreements during each of the threemonths ended March 31, 2003 and March 31, 2002.

 

Weused approximately $19.3 million to fund external and internal softwaredevelopment of approximately 122 games during the three months endedMarch 31, 2003 and used approximately $17.4 million to fund external andinternal development of approximately 100 games during the three months endedMarch 31, 2002.

 

Weused approximately $7.8 million to repurchase shares of our common stock duringthe three months ended March 31, 2003 whereas we did not repurchase anystock during the three months ended March 31, 2002.

 

Theamount of our accounts receivable is subject to significant variations as aconsequence of the seasonality of our sales and the timing of shipments withinthe quarter.

 

**Fiscal Year 2002:**

 

Ourcash, cash equivalents and short-term investments decreased from $206.2 millionat December 31, 2001 to $186.8 million at December 31, 2002.  Cash provided by operating activities forthe year ended December 31, 2002 was $16.3 million.

 

Weentered into approximately 20 new license agreements during the year endedDecember 31, 2002.

 

32

----

 

We usedapproximately $75.0 million to fund external and internal software developmentof approximately 203 games during the year ended December 31, 2002 andused approximately $53.1 million to fund external and internal development ofapproximately 120 games during the same period in 2001.

 

Weused approximately $25.0 million to repurchase shares of our common stockduring the year ended December 31, 2002.

 

Theamount of our accounts receivable is subject to significant variations as aconsequence of the seasonality of our sales and the timing of shipments withinthe quarter.  Accounts receivable istypically highest at the end of the calendar year.

 

*Settlement of class action lawsuit.*  We paid approximately $10.2 million underthe terms of a settlement of the class action lawsuit.  See – “Item 3. Legal Proceedings.”  We have $10.0 million in directors’ andofficers’ insurance coverage, however, our insurer is currently disputing $5.0million of our coverage and related reimbursement.  See — “Item 3. Legal Proceedings.”  Accordingly, we have placed a $5.0 million reserve on thereceivable from the insurer.  Theinsurance carrier has previously reimbursed us approximately $1.6 million forlegal fees incurred.  The net receivableat March 31, 2003 was $3.4 million and is included in prepaid expenses andother current assets in the accompanying balance sheet.

 

*Cybiko Claim*.  We received a demand from *Motorola*for indemnification under our license to it of certain wirelessgames distributed in France.  The demandarises out of litigation commenced in France against *Motorola* and their distribution partners for trademarkinfringement and unfair competition, which seeks $10.0 million in damages plusan unspecified amount and an accounting. We in turn have made a claim for indemnification against the developerof the games.  Although we expect toprevail, at this early stage we cannot predict the likely outcome of the demandfor indemnification.

 

*Guarantees and Commitments.*  We enter into contractual arrangements withthird parties for the rights to intellectual property and for the developmentof products.  Under these agreements, wecommit to provide specified payments to an intellectual property holder ordeveloper, based upon contractual arrangements.  Assuming all contractual provisions are met, the total futureminimum contract commitment for contracts in place as of March 31, 2003 isapproximately $102.3 million.

 

Inaddition, we have advertising commitments under most of our major licenseagreements.  These minimum commitmentsgenerally range from 2% to 12% of net sales related to the respectivelicense.  We estimate that our minimumcommitment for advertising in fiscal 2004 will be $25.6 million.  We also have various operating leasecommitments of $18.0 million expiring at various times through 2014.  As of March 31, 2003, we hadapproximately $3.5 million in obligations under our credit facilities withrespect to outstanding letters of credit and no outstanding borrowings.  We also have a commitment for $2.4 million undera sponsorship agreement contingent upon certain events, the occurrence of whichwill require us to make payments over the next three years.

 

Summaryof minimum contractual obligations and commercial commitments as ofMarch 31, 2003 (in thousands), are as follows:

 

**Contractual Obligations and CommercialCommitments**

 
| **Fiscal****Years  Ended  March 31,** |   | **License  Guarantees** |   | **Software  Development  Milestone  Payments** |   | **Advertising** |   | **Leases** |   | **Letters of  Credit** |   | **Other** |   | **Total** |   |
|--------------------------------------------|--------|-------------------------|--------|------------------------------------------------|--------|-----------------|--------|------------|--------|------------------------|--------|-----------|--------|-----------|--------|
| 2004                                       |   | $                       | 26,134 |                                           | $      | 33,014          |   | $          | 25,613 |                   | $      | 3,207     |   | $         | 3,537  |   | $ | 1,583 |   | $ | 93,088 |   |
| 2005                                       |   | 16,817                  |   | 8,152                                          |   | 9,923           |   | $          | 3,697  |                   | — |      | 792    |      | $      | 39,381 |   |
| 2006                                       |   | 15,679                  |   | 2,185                                          |   | 3,083           |   | $          | 3,223  |                   | — |      | — |      | $      | 24,170 |   |
| 2007                                       |   | 300                     |   | —                                         |   | 2,800           |   | $          | 1,545  |                   | — |      | — |      | $      | 4,645 |   |
| 2008                                       |   | —                  |   | —                                         |   | 2,800           |   | $          | 1,299  |                   | — |      | — |      | $      | 4,099 |   |
| Thereafter                                 |   | —                  |   | —                                         |   | 2,420           |   | $          | 4,982  |                   | — |      | — |      | $      | 7,402 |   |
|                                       |   | $                       | 58,930 |                                           | $      | 43,351          |   | $          | 46,639 |                   | $      | 17,953    |   | $         | 3,537  |   | $ | 2,375 |   | $ | 172,785 |   |

 

OnFebruary 27, 2003, we entered into a lease agreement with an entitypartially owned by the head of one of our development studios.  The lease is for approximately 29,000 squarefeet of office space to be occupied by the development studio in Champaign,Illinois.  The property is currentlyunder development and should be ready for occupancy in April 2004.

 

33

----

 

*Warrants. *We arecommitted under various license and software development agreements to issuewarrants to purchase a total of approximately 430,000 shares of common stock.  At this time, the warrant terms related tothese various agreements are being negotiated. We will record the fair market value of these warrants when the termsare finalized.**The fair marketvalue will be included in license or software development in the accompanyingbalance sheet and will be amortized to license amortization and royalties orsoftware development amortization over estimated sales for games not releasedand a portion may be recognized immediately for games that have been previouslyreleased.

 

*Credit Facility.*  On September 27, 2002, we entered into an Amended andRestated Revolving Credit Agreement (“Credit Facility”).  On May 30, 2003, we amended the CreditFacility (“Amended Credit Facility”). Under the terms of the Credit Facility, we were permitted to borrow andmaintain obligations under outstanding letters of credit up to an aggregate of$35.0 million.  Due to our current levelof cash, cash equivalent and short-term investment balances and because we donot anticipate the need for borrowings in the future, we reduced the capacityof our credit facility.  Under theAmended Credit Facility we can maintain outstanding letters of credit up to$25.0 million and we removed our ability to borrow.  As a result of the May 30, 2003 amendment, we were in compliancewith all the covenants under the Amended Credit Facility.  At December 31, 2002 we were inviolation of the specified minimum net worth covenant of the Credit Facilitydue to the $25.0 million share repurchase and the calendar fourth quarteroperating results.  On February 21,2003 a waiver of this covenant was executed. 

 

TheAmended Credit Facility is secured by a lien on substantially all of our assetsand contains customary financial and non-financial covenants, commencing withthe quarter ended March 31, 2003, which require us to maintain specifiedoperating profits and liquidity and limits our ability to incur additionalindebtedness, sell assets, pay cash dividends and enter into certain mergers oracquisitions.  Amounts outstanding underthe Amended Credit Facility bear interest, at our choice, at either (a) thebank’s prime rate (4.3% at March 31,2003) or (b) the London Interbank Offered Rate (1.3% at March 31, 2003) plus 1.60%.  As of March 31, 2003, we hadoutstanding letters of credit of approximately $3.5 million and no borrowingson the Credit Facility.

 

Accordingly,we believe that our cash, cash equivalents and short-term investments, fundsprovided by operations and our borrowing capacity will be adequate to meet ouranticipated requirements, on both a short-term and long-term basis, foroperating expenses, product purchases and payments for licenses and softwaredevelopment.

 

**Risk Factors**

 

Ourbusiness is subject to many risks and uncertainties which may affect our futurefinancial performance. Some of those important risks and uncertainties whichmay cause our operating results to vary or which may materially and adverselyaffect our operating results are as follows:

 

**We Must Continue to Develop and Sell New Titles in Order toRemain Profitable.**

 

Ourhistorical profitability has directly resulted from our ability to timelydevelop and sell successful new titles for use on various platforms.  We may not be able to develop and secure therights to new titles at a rate that will maintain our current development andrelease schedule or release new titles by the dates we have scheduled.  If the revenues from our new titles fail toreplace declining revenues from existing titles, our revenues and profits wouldbe materially and adversely affected.

 

Consumerpreferences for games are difficult to predict, and even the most successfultitles remain popular for only limited periods of time, often less than sixmonths.  The life cycle of a gamegenerally consists of a relatively high level of sales during the first fewmonths after introduction, followed by a decline in sales.  Accordingly, substantially all of our netsales for a particular year are generated by titles released in that year andin the latter part of the prior year. In some instances, a sales decline may also be accompanied by decreasingsales prices, which may result in credits or allowances to our customers.

 

Inaddition, the development cycle for a new game, including the development ofthe necessary software, approval by the manufacturer and production of theinitial products, typically has ranged from 12 to 24 months for home consolegames and seven to 12 months for handheld games.  In order to distribute a product, we must develop the necessarygame software, obtain approval from the platform manufacturer and licensor, ifrequired, and produce the initial order of cartridges, DVD-ROMs orCD-ROMs.  During the development cycle,the market appeal of a title may decline.

 

**Our Inability To Identify, License And Renew Properties UponWhich Our Products Are Based, Or A Sudden Decrease In Popularity Of TheProperties We License, Could Harm Us.**

 

Thedevelopment of most of our new games is dependent upon our ability to identifyand license desirable properties. Examples of properties that we seek to license are entertainmentprojects, such as movies, television programs and arcade games, sports andentertainment personalities, and popular sports, fads or concepts that have 

 

34

----

 

highpublic visibility or recognition or that reflect the trends of popularculture.  The inability to renewsuccessful licenses, the sudden decrease in popularity of the underlyingproperties of our licenses, or changes in property content of our licensescould limit our economic success.

 

Wehave developed and are developing a limited number of internal brands, titlesfor which no license is required.  Thesuccess of internal brands relies heavily on substantial marketing, innovativetechnology and original ideas.  Thesetitles can be expensive to develop and market. Further, it is difficult to determine what level of consumer acceptancewill be achieved, as opposed to licensed titles, which generally have abuilt-in consumer base and licensor support.

 

**We Rely On A Relatively Small Number Of Brands For ASignificant Portion Of Our Net Sales.**

 

Asmall number of our products make up a substantial portion of our netsales.  For the three months endedMarch 31, 2003, sales of titles for our three top selling brands, *SpongeBob, World Wrestling Entertainment*and*Sega* were 12.6%, 11.6% and 10.8%of net sales, respectively.  For thethree months ended March 31, 2002, sales of titles for our three topselling brands, *World WrestlingEntertainment,**Sega* and *Disney/Pixar’sMonsters, Inc.* were 21.4%, 15.4% and 9.1% of net sales,respectively.  For the year endedDecember 31, 2002, sales of titles for our three top selling brands, *World Wrestling Entertainment, SpongeBob*and *Scooby-Doo* were 22.0%, 9.3%and 8.7% of net sales, respectively and for the year ended December 31,2001, sales of our titles for our three top selling brands, *World Wrestling Entertainment, Red Faction*and *Championship Motocross/MX featuringRicky Carmichael* were 23.5%, 9.5% and 6.1% of net sales,respectively.  A limited number ofbrands may continue to produce a disproportionately large amount of our netsales.  Due to this dependence on alimited number of brands, the failure of one or more products based on thesebrands to achieve anticipated results may significantly harm our business andfinancial results.

 

**Unexpected Declines In The Popularity Of Platforms Could HaveA Negative Effect On Consumer Demand For Titles, Which Could Have A MaterialAdverse Effect On Us.**

 

Theinteractive entertainment software industry has experienced periods ofsignificant growth in consumer interest, followed by periods in which growthhas substantially declined.  Our salesare dependent, among other factors, on the popularity and unit sales of thegame platforms of the various manufacturers. The popularity of the game platforms marketed by the manufacturers hasexperienced wide fluctuations.  We mustcontinually anticipate and adapt our offerings to emerging platforms andevolving consumer preferences. Unexpected declines in the popularity of a particular platform can beexpected to have a material adverse effect on consumer demand for titlesreleased or scheduled for release for that platform.

 

**Development And Distribution Of Wireless Games Is Subject ToDifferent Risks And May Adversely Impact Our Existing Products.**

 

In2001, we announced a new division, THQ Wireless, for the development anddistribution of games on mobile platforms, including cellular telephones andmobile handheld devices.  Because we areless experienced in developing games for these devices and such platformspresent additional and different risks than those related to traditionalconsole games, we cannot predict with any degree of certainty the financialimpact that our approach to wireless games will have.

 

**Customer Accommodations Or Unsaleable Inventory CouldAdversely Affect Our Earnings.**

 

Wesometimes negotiate accommodations to retailers or distributors when demand forspecific games falls below expectations, in order to maintain our relationshipswith our customers.  Theseaccommodations include our not requiring that all booked orders be filled.  We also negotiate price discounts, creditsagainst future orders and the return of products with our customers.

 

Althoughwe believe that the reserves that we have established for customeraccommodations are adequate, there is the possibility that actual customeraccommodations could exceed our reserves. The effect of this would be a reduction in our earnings.  We cannot predict with certainty the amountor nature of accommodations that will be provided to our customers in futureperiods.

 

Wewrite down slow-moving or obsolete inventory to net realizable value.  An unsuccessful title requires that we writedown the inventory for that title to its estimated net realizable value.  We work to minimize this risk bycommunicating frequently with our customers and by attempting to accuratelyforecast retailer and consumer demand for each of our titles.

 

35

----

 

**For The Three Months Ended March 31, 2003, 67.3% Of OurGross Sales Were Made To Our 10 Largest Customers.  For The Three Months Ended March 31, 2002, 62.3% Of OurGross Sales Were Made To Our 10 Largest Customers.  For The Year Ended December 31, 2002, 63.9% Of Our GrossSales Were Made To Our 10 Largest Customers. We Could Be Adversely Affected If Any Of Them Reduced Or TerminatedTheir Purchases From Us.**

 

Salesto our 10 largest customers collectively accounted for approximately 67.3% and62.3% of our gross sales for the three months ended March 31, 2003 andMarch 31, 2002, respectively. Sales to our 10 largest customers collectively accounted forapproximately 63.9% of our gross sales for the years ended December 31,2002 and December 31, 2001, respectively. Our largest single customer in those periods was Wal-Mart.  Wal-Mart accounted for 24.7% of our grosssales for the three months ended March 31, 2003, 15.6% of our gross salesfor the three months ended March 31, 2002, 16.4% of our gross sales forthe year ended December 31, 2002 and 14.1% of our gross sales for the yearended December 31, 2001.

 

Wehave no written agreements or other understandings with any of our customersthat relate to future purchases, so purchases by these customers or any otherscould be reduced or terminated at any time. A substantial reduction or a termination of purchases by any of ourlargest customers would have a material adverse effect on us.

 

**A Business Failure By Any Of Our Largest Customers Could HaveA Material Adverse Effect On Us.**

 

Oursales are typically made on credit, with terms that vary depending upon thecustomer and other factors.  Normally wedo not hold any collateral to secure payment by our customers, and currently wedo not factor any of our receivables. While we attempt to carefully monitor the creditworthiness of ourcustomers and distributors, we bear the risk of their inability to pay ourreceivables and of any delay in payment. A business failure by any of our largest customers would have a materialadverse effect on us.  For example,Kmart filed for bankruptcy protection as of January 22, 2002.  As of May 6, 2003, Kmart has petitionedthe courts to remove the bankruptcy claim. Because Kmart is one of our largest customers, if it is no longer ableto do business with us, we could be materially adversely affected.

 

**Because We Cannot Publish Or Manufacture Titles WithoutPlatform Manufacturers’ Approval, Our Ability To Continue To Develop And MarketSuccessful Console Titles Is Dependent On The Manufacturers Continuing To DoBusiness With Us.**

 

We aredependent on the platform manufacturers and our non-exclusive licenses withthem, both for the right to publish titles for their platforms and for themanufacture of our products for their platforms.  Our existing platform licenses for Sony PlayStation 2 andPlayStation, Nintendo GameCube, Game Boy Advance SP, Game Boy Advance and GameBoy Color, and Microsoft Xbox, require that we obtain approval for thepublication of new games on a title-by-title basis.  As a result, the number of titles we are able to publish forthese platforms, and our revenues from titles for these platforms, may belimited.  Should any manufacturer choosenot to renew or extend our license agreement at the end of its current term, orif any manufacturer were to terminate our license for any reason, we would beunable to publish additional titles for that manufacturer’s platform, whichcould negatively affect our operating results.

 

Eachof the manufacturers or their authorized vendors is the sole source for the fabricationof the products we publish for that manufacturer’s platforms.  Each platform license provides that themanufacturer may change prices for products at any time and includes otherprovisions that give the manufacturer substantial control over our release ofnew titles.  Since each of themanufacturers is also a publisher of games for its own platforms, and alsomanufactures products for all of its other licensees, a manufacturer may givepriority to its own products or those of other publishers in the event ofinsufficient manufacturing capacity. Unanticipated delays in the delivery of products could also negativelyaffect our operating results.

 

**If We Needed To Write Down Licenses Or Software DevelopmentCosts Below The Current Recorded Value, Our Results Of Operations Could BeAdversely Affected.**

 

Wetypically enter into agreements with licensors of properties that requireadvance payments of royalties and/or guaranteed minimum royalty payments.  We also enter into agreements withdevelopers of titles that require a development fee and additional compensationbased on the respective title sales performance.  Sales of products for which such royalties are paid or guaranteedpayments are made may not be sufficient to cover the amount of these requiredpayments.  In addition, we capitalizeour advances to developers on our balance sheet as a part of “softwaredevelopment costs.”  When, inmanagement’s opinion, future revenues will not be sufficient to recoverpreviously capitalized costs, we expense these items in the currentperiod.  If we needed to write downlicenses or software development costs below the current recorded value, ourresults of operations could be adversely affected.

 

36

----

 

**Increased Foreign Operations Subject Us To DifferentBusiness, Political And Economic Risks.**

 

Foreignsales are subject to inherent risks, including different consumer preferences,higher distribution and operating expenses, unexpected changes in regulatoryrequirements, tariffs and other barriers, difficulties in staffing and managingforeign operations, and possible difficulties collecting foreign accountsreceivable.  These factors or otherscould have an adverse effect on our future foreign sales or the profits generatedfrom these sales.

 

Salesgenerated by our European and Australian offices will generally be denominatedin the currency denomination of the country in which the sales are made or, ifmade in Europe, European Currency Units (“Euros”), if made in the UnitedKingdom, Great British Pound (“GBP”) and if made in Australia, the AustralianDollar.  To the extent our foreign salesare not denominated in U.S. dollars, our sales and profits could be materiallyand adversely affected by foreign currency fluctuations.

 

**Fluctuations In Our Quarterly Operating Results Could ResultIn Substantial Losses To Investors.**

 

Wehave experienced, and may continue to experience, significant quarterlyfluctuations in net sales and operating results.  The interactive software entertainment market is highly seasonal,with sales typically significantly higher during the calendar fourth quarter,due primarily to the increased demand for games during the year-end holidaybuying season.  Other factors that causefluctuations include:

 

•                  the timing of our release of newtitles;

 

•                  the popularity of both new titles andtitles released in prior periods;

 

•                  changes in the mix of titles withvarying profit margins;

 

•                  the timing of customer orders;

 

•                  the timing of shipments by themanufacturers;

 

•                  the competition in the industry forretail shelf space;

 

•                  fluctuations in the size and rate ofgrowth of consumer demand for titles for different platforms; and

 

•                  the timing of the introduction of newplatforms and the accuracy of retailers’ forecasts of consumer demand.

 

Webelieve that quarter-to-quarter comparisons of our operating results are not agood indication of our future performance. We may not be able to maintain consistent profitability on a quarterlyor annual basis.  It is likely that insome future quarter, our operating results may be below the results of publicmarket analysts and investors and as a result of the factors described aboveand others described throughout this “Risk Factors” section, the price of ourcommon stock may fall or significantly fluctuate.

 

**Competition For Qualified Personnel Is Intense In TheInteractive Entertainment Software Industry And Failure To Hire And RetainQualified Personnel Could Seriously Harm Our Business.**

 

Werely to a substantial extent on the management, marketing, sales, technical andsoftware development skills of a limited number of employees to formulate andimplement our business plan, including the development of our titles andbrands.  Our success depends to asignificant extent upon our ability to attract and retain key personnel.  Competition for employees can be intense andthe process of locating key personnel with the right combination of skills isoften lengthy.  The loss of services ofkey personnel could have a material adverse effect on us.

 

**Failure To Adequately Protect Our Intellectual Property CouldCause Us To Lose Competitive Advantage And Any Intellectual Property LitigationCould Be Time Consuming And Expensive To Prosecute And Defend.**

 

Unauthorizedproduction occurs in the computer software industry generally, and were asignificant amount of unauthorized production of our DVD-ROM or CD-ROM productsto occur, we could be materially and adversely affected.  We hold copyrights on the products, manuals,advertising and other materials owned by us and we maintain trademark rights inthe THQ name, THQ studios, names of certain products and their respective logosowned by us.  We regard our titles,including the underlying software, as proprietary and rely on a combination oftrademark, copyright and trade secret laws in the United States and underinternational law, employee and third-party nondisclosure and confidentialityagreements, among other methods to protect our rights.  We include with our products a “shrink-wrap”or “click-wrap” license agreement or limitations on use of the software.  It is uncertain to what extent theseagreements and limitations are enforceable, especially in foreign countries.  Third parties may infringe our rights and itis possible that third parties may assert infringement claims against us.  From time to time we receive communicationsregarding such claims and we investigate each claim individually.  Prosecuting or defending valid claims couldbe costly and could result in a diversion of management’s attention. Further,adverse 

 

37

----

 

determinationsin any claims or litigation could also have a material adverse effect on ourbusiness, operating results and financial condition.

 

**Defects In Our Game Software Could Harm Our Reputation OrDecrease The Market Acceptance Of Our Products.**

 

Ourgame software may contain defects.  Inaddition, we may not discover software defects until after our products are inuse by retail customers.  Any defects inour software could damage our reputation, cause our customers to terminaterelationships with us or to initiate product liability suits against us, divertour engineering resources, delay market acceptance of our products, increaseour costs or cause our revenue to decline.

 

**The Interactive Entertainment Industry Is Consolidating. InMaking Acquisitions, We Face Significant Competition From Other Companies SomeOf Which Have Greater Financial And Other Resources.  We Also Face Integration Challenges With The Companies That WeSuccessfully Acquire.**

 

Consistentwith our strategy to enhance our distribution and product developmentcapabilities, we intend to continue to pursue acquisitions of companies,intellectual property rights and other assets that can be acquired onacceptable terms and which we believe can be operated or exploitedprofitably.  As the interactiveentertainment industry continues to consolidate, we face significantcompetition in making acquisitions, which may constrain our ability to completesuitable transactions.  This isparticularly of concern for us because many of our competitors for potentialacquisitions have greater financial and other resources.

 

Further,as we acquire other companies we are faced with additional challenges.  The integration of newly acquired companies’operations with our existing operations takes management time and effort.  Additionally, there is a risk of loss of keyemployees, customers and vendors of the recently acquired companies.  Also, if we issue equity securities to payfor an acquisition, the ownership percentage of our existing stockholders wouldbe reduced and the value of the shares held by our existing stockholders couldbe diluted.  If we use cash to pay foran acquisition, the payment could significantly reduce the cash that would beavailable to fund our operations or to use for other purposes.  Acquisition financing may not be availableon favorable terms or at all.  We mayalso be required to amortize significant amounts of identifiable intangible assetsin connection with future acquisitions, which could adversely affect ourreported earnings.  Future acquisitionsmay also require us to assume contingent liabilities that could have a negativeeffect on our future results of operations.

 

**Competition In The Interactive Entertainment SoftwareIndustry May Lead To Reduced Sales Of Our Products, Reduced Profits AndReduced Market Share.**

 

Theinteractive entertainment software industry is intensely competitive.  We compete, for both licenses to propertiesand the sale of games, with the platform manufacturers and other externaldevelopers.  Each of the platformmanufacturers has the additional advantage of being the largest developer andmarketer of titles for its platforms. These companies may increase their own software developmentefforts.  As a result of theircommanding positions in the industry, the manufacturers generally have betterbargaining positions with respect to retail pricing, shelf space and retailer accommodationsthan do any of their licensees, including us.

 

Someof our competitors have greater name recognition among consumers and licensorsof properties, a broader product line, or greater financial, marketing andother resources than we do. Accordingly, these competitors may be able to market their products moreeffectively or make larger offers or guarantees in connection with theacquisition of licensed properties.  Wealso believe that other technology and entertainment companies are increasing theirfocus on the interactive entertainment software market, which might result ingreater competition for us.  Inaddition, many of our competitors are developing on-line interactive games andinteractive networks that will be competitive with our interactive products.

 

Ascompetition for popular properties increases, our cost of acquiring licensesfor such properties may increase, resulting in reduced margins.  In addition, as competition for retail shelfspace becomes more intense, we may need to increase our marketing expendituresto maintain sales of our titles. Prolonged price competition, increased licensing costs or reduced profitmargins would have a negative effect on our business and financial results.

 

**We Rely On External Developers For The Development Of Many OfOur Titles.**

 

Manyof our titles are developed by external developers.  We have no control over the business, finances and operationalpractices of these external developers. A delay or failure to complete the work performed by external developersmay result in delays in, or cancellations of, product releases.  The future success of many of our titleswill depend on our continued ability to maintain relationships and obtaindeveloper agreements on favorable terms with skilled external developers.  We cannot guarantee that we will be able toestablish or maintain such relationships with external developers and failureto do so could result in a material adverse effect on our business andfinancial results.

 

38

----

 

**The Development And Marketing Of PC Titles Differ FromConsole Titles And Entail Additional Risks.**

 

Thedevelopment and marketing of PC games subject us to some different risks thanthose we encounter in connection with console games.  These risks include the ability to accurately predict whichtitles have appeal to the purchasers of games for PCs, greater reliance ondistributors in order to obtain retail distribution, and higher retailerreturns experienced for PC games.  Wemay not be able to successfully develop and market titles for the PC market.

 

**Rating Systems And Future Legislation May Make ItDifficult To Successfully Market And Sell Our Products.**

 

Currently,the video game industry is self-regulated and rated by the EntertainmentSoftware Rating Board.  Our retail customerstake the Entertainment Software Rating Board rating into consideration whendeciding which of our products they will purchase.  If the Entertainment Software Rating Board or a manufacturerdetermines that a product should have a rating directed to an older or moremature consumer, we may be less successful in our marketing and sales of aparticular product.

 

Recently,legislation has been introduced at the local, state and federal levels for theestablishment of a government mandated rating and governing system in theUnited States and in foreign countries for the video game industry.  Various foreign countries already allowgovernment censorship of interactive entertainment products.  We believe that if the video game industrywere to become subject to a government rating system, our ability tosuccessfully market and sell our products could be adversely affected.

 

**Any Significant Downturn In General Economic Conditions WhichResults In A Reduction In Discretionary Spending Could Reduce Demand For OurProducts And Harm Our Business.**

 

Ourproduct sales are affected by a retail customer’s ability and desire to spenddisposable income on the purchase of our game titles.  Any significant downturn in general economic conditions whichresults in a reduction in discretionary spending could result in a reduction indemand for our products and could harm our business.  Such industry downturns have been, and may continue to be,characterized by diminished product demand and subsequent erosion of averageselling prices.

 

**Our Business And Future Operating Results Are Subject To AWide Range Of Uncertainties Arising Out Of The September 11, 2001Terrorist Attacks And Current Military Actions.**

 

Ourbusiness and operating results are subject to uncertainties arising out of theterrorist attacks on the United States, including the potential worsening orextension of the current global economic slowdown and the economic consequencesof military action or additional terrorist activities.  Accordingly, while the terrorist attacks andcurrent military actions have not had a material impact on our financialposition or results of operations to date, we cannot determine if the attacks,current military actions or any events arising as a result of such events willhave a material impact on our business in the future.

 

Becauseof these and other factors affecting our operating results and financialcondition, past financial performance should not be considered a reliableindicator of future performance, and investors should not use historical trendsto anticipate results or trends in future periods.

 

39

----

 

**Item 7A**.                          QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK

** **

We areexposed to certain market risks arising from transactions in the normal courseof business, principally risk associated with interest rate and foreigncurrency fluctuations.

 

**Interest Rate Risk**

 

Wehave interest rate risk primarily related to our investment portfolio.  A substantial portion of our short-term investmentsis in a mutual fund made up of non-mortgage United States GovernmentSecurities, corporate notes and commercial paper and fixed and floating rateasset-backed securities.  The value ofthese investments may fluctuate with changes in interest rates.  However, we believe this risk is immaterialdue to the short-term nature of the investments.  The credit facility is based on variable interest rates.  At March 31, 2003, we had no borrowingson the credit facility.

 

**Foreign Currency Risk**

 

Wetransact business in many different foreign currencies and may be exposed tofinancial market risk resulting from fluctuations in foreign currency exchangerates, particularly the GBP and the Euro which may result in a gain or loss ofearnings to us.  The volatility of theGBP and the Euro (and all other applicable currencies) is monitored frequentlythroughout the year.  While we have notengaged in foreign currency hedging, we may in the future use hedging programs,currency forward contracts, currency options and/or other derivative financialinstruments commonly utilized to reduce financial market risks if it isdetermined that such hedging activities are appropriate to reduce risk.

 

**Item 8**.*                                  *FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

** **

TheReport of Independent Auditors, Consolidated Financial Statements and Notes toConsolidated Financial Statements follow below on pages 41 through 69.

 

40

----

 

**INDEPENDENT AUDITORS’ REPORT**

 

To theStockholders of THQ Inc.,

 

CalabasasHills, California

 

Wehave audited the accompanying consolidated balance sheets of THQ Inc. andsubsidiaries (the “Company”) as of March 31, 2003 and December 31,2002 and 2001 and the related consolidated statements of operations,stockholders’ equity and cash flows for the three months ended March 31,2003 and each of the three years in the period ended December 31,2002.  These financial statements arethe responsibility of the Company’s management.  Our responsibility is to express an opinion on these financialstatements based on our audits.

 

Weconducted our audits in accordance with auditing standards generally acceptedin the United States of America.  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

In ouropinion, such consolidated financial statements present fairly, in all materialrespects, the financial position of the Company as of March 31, 2003 andDecember 31, 2002 and 2001 and the results of its operations and its cashflows for the three months ended March 31, 2003 and each of the threeyears in the period ended December 31, 2002 in conformity with accountingprinciples generally accepted in the United States of America.

 

Asdiscussed in Note 2 to the financial statements, the Company adopted Statementof Financial Accounting Standards No. 142 “Goodwill and Other IntangibleAssets” effective January 1, 2002.

 

**DELOITTE & TOUCHE LLP**

 

LosAngeles, California

 

May 30,2003

 

41

----

 

**THQ INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

**(In thousands, except per share data)**

 
|                                                                                                                                                                                                        |   | **March 31,** |    | **December 31,** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|---------|-----------------------|--------|
|                                                                                                                                                                                                        |   | **2003**           |    | **2002**              |   | **2001** |   |
| **ASSETS**                                                                                                                                                                                                  |   |               |    |                  |   |   |   |
| Current assets:                                                                                                                                                                                             |   |               |    |                  |   |   |   |
| Cash and cash equivalents                                                                                                                                                                                   |   | $                  | 199,860 |                  | $      | 132,898 |   | $ | 171,059 |   |
| Short-term investments                                                                                                                                                                                      |   | 16,151             |    | 53,951                |   | 35,106 |   |
| Cash, cash equivalents and short-term investments                                                                                                                                                           |   | 216,011            |    | 186,849               |   | 206,165 |   |
| Accounts receivable, net of allowances                                                                                                                                                                      |   | 35,976             |    | 146,508               |   | 126,011 |   |
| Inventory                                                                                                                                                                                                   |   | 24,339             |    | 24,362                |   | 9,917 |   |
| Licenses                                                                                                                                                                                                    |   | 15,330             |    | 15,897                |   | 16,758 |   |
| Software development                                                                                                                                                                                        |   | 54,824             |    | 45,633                |   | 34,664 |   |
| Deferred income taxes                                                                                                                                                                                       |   | —             |    | 1,334                 |   | — |   |
| Income taxes receivable                                                                                                                                                                                     |   | 1,116              |    | —                |   | 290 |   |
| Prepaid expenses and other current assets                                                                                                                                                                   |   | 11,316             |    | 12,092                |   | 7,498 |   |
| Total current assets                                                                                                                                                                                        |   | 358,912            |    | 432,675               |   | 401,303 |   |
| Property and equipment, net                                                                                                                                                                                 |   | 16,408             |    | 16,103                |   | 13,891 |   |
| Licenses, net of current portion                                                                                                                                                                            |   | 20,053             |    | 19,525                |   | 8,345 |   |
| Software development, net of current  portion                                                                                                                                                               |   | 2,640              |    | 1,785                 |   | 4,466 |   |
| Deferred income taxes, net of current  portion                                                                                                                                                              |   | 8,346              |    | —                |   | — |   |
| Goodwill, net                                                                                                                                                                                               |   | 58,609             |    | 58,609                |   | 48,202 |   |
| Other long-term assets, net                                                                                                                                                                                 |   | 7,981              |    | 9,163                 |   | 11,759 |   |
| TOTAL ASSETS                                                                                                                                                                                                |   | $                  | 472,949 |                  | $      | 537,860 |   | $ | 487,966 |   |
|                                                                                                                                                                                                        |   |               |    |                  |   |   |   |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                                                                              |   |               |    |                  |   |   |   |
| Current liabilities:                                                                                                                                                                                        |   |               |    |                  |   |   |   |
| Accounts payable                                                                                                                                                                                            |   | $                  | 21,001  |                  | $      | 41,148 |   | $ | 27,186 |   |
| Accrued expenses                                                                                                                                                                                            |   | 20,090             |    | 32,548                |   | 16,293 |   |
| Accrued payment to venture partner                                                                                                                                                                          |   | 676                |    | 5,845                 |   | 6,651 |   |
| Accrued royalties                                                                                                                                                                                           |   | 22,893             |    | 30,215                |   | 30,001 |   |
| Income taxes payable                                                                                                                                                                                        |   | —             |    | 2,331                 |   | — |   |
| Deferred income taxes                                                                                                                                                                                       |   | 7,353              |    | —                |   | 1,567 |   |
| Total current liabilities                                                                                                                                                                                   |   | 72,013             |    | 112,087               |   | 81,698 |   |
| Accrued royalties, net of current portion                                                                                                                                                                   |   | 4,523              |    | 15,373                |   | 6,686 |   |
| Deferred income taxes                                                                                                                                                                                       |   | —             |    | 1,534                 |   | 720 |   |
| Commitments and contingencies                                                                                                                                                                               |   | —             |    | —                |   | — |   |
| Stockholders’ equity:                                                                                                                                                                                  |   |               |    |                  |   |   |   |
| Common stock, par value $.01, 75,000,000  shares authorized; 38,007,879, 38,416,002 and 38,979,747 shares issued and  outstanding as of March 31, 2003, December 31, 2002 and 2001,  respectively |   | 380                |    | 384                   |   | 390 |   |
| Additional paid-in capital                                                                                                                                                                                  |   | 305,328            |    | 310,963               |   | 316,758 |   |
| Accumulated other comprehensive income  (loss)                                                                                                                                                              |   | 1,496              |    | 624                   |   | (2,187 | ) |
| Retained earnings                                                                                                                                                                                           |   | 89,209             |    | 96,895                |   | 83,901 |   |
| Total stockholders’ equity                                                                                                                                                                             |   | 396,413            |    | 408,866               |   | 398,862 |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                             |   | $                  | 472,949 |                  | $      | 537,860 |   | $ | 487,966 |   |

 

See notes to consolidatedfinancial statements.

 

42

----

 

**THQ INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(In thousands, except per share data)**

 
|                                                 |   | **Three  Months  Ended  March 31,** |   | **Three  Months  Ended  March 31,** |   | **Years Ended December 31,** |   |
|------------------------------------------------------|--------|------------------------------------------|--------|------------------------------------------|--------|-----------------------------------|--------|
|                                                 |   | **2003**                                 |   | **2002**                                 |   | **2002**                          |   | **2001** |   | **2000** |   |
|                                                 |   |                                     |   | **Unaudited**                            |   |                              |   |   |   |   |   |
| Net sales                                            |   | $                                        | 66,800 |                                     | $      | 79,682                            |   | $ | 480,529 |   | $ | 378,992 |   | $ | 347,003 |   |
| Costs and expenses:                                  |   |                                     |   |                                     |   |                              |   |   |   |   |   |
| Cost of sales                                        |   | 26,378                                   |   | 33,680                                   |   | 185,593                           |   | 154,898 |   | 140,699 |   |
| License amortization and royalties                   |   | 5,576                                    |   | 7,064                                    |   | 40,476                            |   | 33,144 |   | 34,675 |   |
| Software development amortization                    |   | 12,018                                   |   | 10,800                                   |   | 83,698                            |   | 35,144 |   | 42,875 |   |
| Product development                                  |   | 9,730                                    |   | 7,646                                    |   | 38,572                            |   | 21,154 |   | 19,151 |   |
| Selling and marketing                                |   | 14,294                                   |   | 9,759                                    |   | 66,443                            |   | 46,745 |   | 42,446 |   |
| Payment to venture partner                           |   | 644                                      |   | 1,572                                    |   | 10,146                            |   | 8,673 |   | 17,707 |   |
| General and administrative                           |   | 7,611                                    |   | 6,059                                    |   | 31,117                            |   | 25,090 |   | 19,530 |   |
| Total costs and expenses                             |   | 76,251                                   |   | 76,580                                   |   | 456,045                           |   | 324,848 |   | 317,083 |   |
| Income (loss) from operations                        |   | (9,451                                   | )      | 3,102                                    |   | 24,484                            |   | 54,144 |   | 29,920 |   |
| Interest income, net                                 |   | 878                                      |   | 1,322                                    |   | 5,277                             |   | 2,572 |   | 1,323 |   |
| Other expenses                                       |   | (2,403                                   | )      | —                                   |   | (10,006                           | )      | — |   | — |   |
| Income (loss) before income taxes                    |   | (10,976                                  | )      | 4,424                                    |   | 19,755                            |   | 56,716 |   | 31,243 |   |
| Income taxes                                         |   | (3,290                                   | )      | 1,659                                    |   | 6,761                             |   | 20,703 |   | 13,054 |   |
| Net income (loss)                                    |   | $                                        | (7,686 | )                                        | $      | 2,765                             |   | $ | 12,994 |   | $ | 36,013 |   | $ | 18,189 |   |
| Net income (loss) per share — basic             |   | $                                        | (0.20  | )                                        | $      | 0.07                              |   | $ | 0.33 |   | $ | 1.10 |   | $ | 0.60 |   |
| Net income (loss) per share — diluted           |   | $                                        | (0.20  | )                                        | $      | 0.07                              |   | $ | 0.32 |   | $ | 1.01 |   | $ | 0.56 |   |
|                                                 |   |                                     |   |                                     |   |                              |   |   |   |   |   |
| Shares used in per share calculation —  basic   |   | 38,319                                   |   | 39,067                                   |   | 39,203                            |   | 32,717 |   | 30,136 |   |
| Shares used in per share calculation —  diluted |   | 38,319                                   |   | 41,725                                   |   | 41,243                            |   | 35,623 |   | 32,352 |   |

 

See notes to consolidated financial statements..

 

43

----

 

**THQINC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITY(In thousands, except per share data)**

 
|                                                           |   | **Years  Ended December 31, 2000, 2001 and 2002 and Three Months Ended  March 31, 2003** |   |
|----------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------|--------|
|                                                           |   | **Common  Shares**                                                                                 |   | **Common  Stock** |   | **Additional  Paid-in  Capital** |   | **Accumulated  Other  Comprehensive  Income (Loss)** |   | **Retained  Earnings** |   | **Total** |   |
| Balance at January 1, 2000                                |   | 29,845,851                                                                                         |   | $ | 298 |   | $ | 79,151 |   | $ | (842 | ) | $ | 29,699 |   | $ | 108,306 |   |
| Exercise of warrants and options                               |   | 844,956                                                                                            |   | 9 |   | 4,296 |   | — |   | — |   | 4,305 |   |
| Stock compensation                                             |   | —                                                                                             |   | — |   | 406 |   | — |   | — |   | 406 |   |
| Tax benefit related to the exercise of employee  stock options |   | —                                                                                             |   | — |   | 1,792 |   | — |   | — |   | 1,792 |   |
| Comprehensive income:                                          |   |                                                                                               |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                                     |   | —                                                                                             |   | — |   | — |   | — |   | 18,189 |   | 18,189 |   |
| Other comprehensive income                                     |   |                                                                                               |   |   |   |   |   |   |   |   |   |   |   |
| Foreign currency translation adjustment                        |   | —                                                                                             |   | — |   | — |   | (873 | ) | — |   | (873 | ) |
| Comprehensive income                                           |   | —                                                                                             |   | — |   | — |   | — |   | — |   | 17,316 |   |
| Balance at January 1, 2001                                |   | 30,690,807                                                                                         |   | 307 |   | 85,645 |   | (1,715 | ) | 47,888 |   | 132,125 |   |
| Exercise of warrants and options                               |   | 2,405,413                                                                                          |   | 24 |   | 16,697 |   | — |   | — |   | 16,721 |   |
| Issuance of common stock from secondary offering               |   | 4,596,222                                                                                          |   | 46 |   | 154,559 |   | — |   | — |   | 154,605 |   |
| Issuance of common stock for Rainbow acquisition               |   | 1,287,305                                                                                          |   | 13 |   | 48,635 |   | — |   | — |   | 48,648 |   |
| Stock compensation                                             |   | —                                                                                             |   | — |   | 299 |   | — |   | — |   | 299 |   |
| Tax benefit related to the exercise of employee  stock options |   | —                                                                                             |   | — |   | 10,923 |   | — |   | — |   | 10,923 |   |
| Comprehensive income:                                          |   |                                                                                               |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                                     |   | —                                                                                             |   | — |   | — |   | — |   | 36,013 |   | 36,013 |   |
| Other comprehensive income                                     |   |                                                                                               |   |   |   |   |   |   |   |   |   |   |   |
| Foreign currency translation adjustment                        |   | —                                                                                             |   | — |   | — |   | (703 | ) | — |   | (703 | ) |
| Unrealized gain on investments                                 |   | —                                                                                             |   | — |   | — |   | 231 |   | — |   | 231 |   |
| Comprehensive income                                           |   | —                                                                                             |   | — |   | — |   | — |   | — |   | 35,541 |   |
| Balance at December 31, 2001                              |   | 38,979,747                                                                                         |   | $ | 390 |   | $ | 316,758 |   | $ | (2,187 | ) | $ | 83,901 |   | $ | 398,862 |   |

 

See notes to consolidated financial statements.

 

44

----

 
|                                                                             |   | **Years Ended December 31, 2000, 2001 and 2002  and Three Months Ended March 31, 2003** |   |
|----------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------|--------|
|                                                                             |   | **Common  Shares**                                                                                |   | **Common  Stock** |   | **Additional  Paid-in  Capital** |   | **Accumulated  Other  Comprehensive  Income (Loss)** |   | **Retained  Earnings** |   | **Total** |   |
| Balance at January 1, 2002                                                  |   | 38,979,747                                                                                        |   | $ | 390 |   | $ | 316,758 |   | $ | (2,187 | ) | $ | 83,901 |   | $ | 398,862 |   |
| Exercise of options                                                              |   | 932,234                                                                                           |   | 9 |   | 7,741 |   | — |   | — |   | 7,750 |   |
| Issuance of common stock for ValuSoft acquisition                                |   | 166,600                                                                                           |   | 2 |   | 4,626 |   | — |   | — |   | 4,628 |   |
| Issuance of warrants                                                             |   | —                                                                                            |   | — |   | 1,214 |   | — |   | — |   | 1,214 |   |
| Repurchase of common stock                                                       |   | (1,671,531                                                                                        | )      | (17 | ) | (24,988 | ) | — |   | — |   | (25,005 | ) |
| Adjustments related to 2001 secondary offering                                   |   | —                                                                                            |   | — |   | 52 |   | — |   | — |   | 52 |   |
| Stock compensation                                                               |   | 8,952                                                                                             |   | — |   | 436 |   | — |   | — |   | 436 |   |
| Tax benefit related to the exercise of employee  stock options                   |   | —                                                                                            |   | — |   | 5,124 |   | — |   | — |   | 5,124 |   |
| Comprehensive income:                                                            |   |                                                                                              |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                       |   | —                                                                                            |   | — |   | — |   | — |   | 12,994 |   | 12,994 |   |
| Other comprehensive income                                                       |   | —                                                                                            |   | — |   | — |   | — |   | — |   |   |   |
| Foreign currency translation adjustment                                          |   | —                                                                                            |   | — |   | — |   | 4,318 |   | — |   | 4,318 |   |
| Unrealized (loss) on investments                                                 |   | —                                                                                            |   | — |   | — |   | (1,507 | ) | — |   | (1,507 | ) |
| Comprehensive income                                                             |   |                                                                                              |   |   |   |   |   |   |   |   |   | 15,805 |   |
| Balance at January 1, 2003                                                  |   | 38,416,002                                                                                        |   | 384 |   | 310,963 |   | 624 |   | 96,895 |   | 408,866 |   |
| Exercise of options                                                              |   | 144,411                                                                                           |   | 2 |   | 1,406 |   | — |   | — |   | 1,408 |   |
| Tax benefit related to the exercise of employee stock  options                   |   | —                                                                                            |   | — |   | 181 |   | — |   | — |   | 181 |   |
| Repurchase of common stock                                                       |   | (568,307                                                                                          | )      | (6 | ) | (7,752 | ) | — |   | — |   | (7,758 | ) |
| Stock compensation                                                               |   | 15,773                                                                                            |   | — |   | 530 |   | — |   | — |   | 530 |   |
| Comprehensive (loss):                                                            |   |                                                                                              |   |   |   |   |   |   |   |   |   |   |   |
| Net (loss)                                                                       |   | —                                                                                            |   | — |   | — |   | — |   | (7,686 | ) | (7,686 | ) |
| Other comprehensive (loss)                                                       |   | —                                                                                            |   | — |   | — |   | — |   | — |   |   |   |
| Foreign currency translation adjustment                                          |   | —                                                                                            |   | — |   | — |   | (404 | ) | — |   | (404 | ) |
| Unrealized (loss) on investments                                                 |   |                                                                                              |   |   |   |   |   | (1,127 | ) |   |   | (1,127 | ) |
| Reclassification adjustment for net (gains)  losses  included in net income |   | —                                                                                            |   | — |   | — |   | 2,403 |   | — |   | 2,403 |   |
| Comprehensive (loss)                                                             |   | —                                                                                            |   |   |   |   |   |   |   |   |   | (6,814 | ) |
| Balance at March 31, 2003                                                   |   | 38,007,879                                                                                        |   | $ | 380 |   | $ | 305,328 |   | $ | 1,496 |   | $ | 89,209 |   | $ | 396,413 |   |

 

See notes to consolidated financial statements.

 

45

----

 

**THQ INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

 
|                                                                                             |   | **Three  Months  Ended  March 31,** |    | **Three  Months  Ended  March 31,** |   | **Years Ended December 31,** |   |
|--------------------------------------------------------------------------------------------------|--------|------------------------------------------|---------|------------------------------------------|--------|-----------------------------------|--------|
|                                                                                             |   | **2003**                                 |    | **2002**                                 |   | **2002**                          |   | **2001** |   | **2000** |   |
|                                                                                             |   |                                     |    | **Unaudited**                            |   |                              |   |   |   |   |   |
| Cash flows from operating activities:                                                            |   |                                     |    |                                     |   |                              |   |   |   |   |   |
| Net income (loss)                                                                                |   | $                                        | (7,686  | )                                        | $      | 2,765                             |   | $ | 12,994 |   | $ | 36,013 |   | $ | 18,189 |   |
|                                                                                             |   |                                     |    |                                     |   |                              |   |   |   |   |   |
| Adjustments to reconcile net income (loss)  to net  cash provided by operating  activities: |   |                                     |    |                                     |   |                              |   |   |   |   |   |
| Depreciation and amortization                                                                    |   | 1,956                                    |    | 1,383                                    |   | 6,385                             |   | 5,416 |   | 3,225 |   |
| Amortization of licenses and software  development                                          |   | 13,323                                   |    | 14,413                                   |   | 91,677                            |   | 35,335 |   | 50,193 |   |
| Provision for price protection, returns and  doubtful accounts                                   |   | 10,046                                   |    | 12,340                                   |   | 69,641                            |   | 47,374 |   | 35,387 |   |
| Loss on disposal of property and equipment                                                       |   | —                                   |    | 7                                        |   | 137                               |   | 117 |   | 114 |   |
| Stock compensation                                                                               |   | 530                                      |    | 57                                       |   | 436                               |   | 299 |   | 406 |   |
| Tax benefit related to the exercise of  employee stock options                              |   | 181                                      |    | 2,105                                    |   | 5,124                             |   | 10,923 |   | 1,792 |   |
| Deferred income taxes                                                                            |   | (1,180                                   | )       | 27                                       |   | (730                              | )      | 11,338 |   | (112 | ) |
| Other than temporary impairment on  investments                                             |   | 2,403                                    |    | —                                   |   | —                            |   | — |   | — |   |
| Write-off of Network Interactive Sports  Ltd.                                                    |   | —                                   |    | —                                   |   | 3,006                             |   | — |   | — |   |
| Changes in operating assets and  liabilities:                                                    |   |                                     |    |                                     |   |                              |   |   |   |   |   |
| Accounts receivable                                                                              |   | 100,976                                  |    | 56,738                                   |   | (85,012                           | )      | (37,665 | ) | (74,770 | ) |
| Inventory                                                                                        |   | 233                                      |    | (2,243                                   | )      | (12,112                           | )      | 743 |   | (5,442 | ) |
| Licenses                                                                                         |   | (4,027                                   | )       | (18,507                                  | )      | (33,918                           | )      | (22,596 | ) | (6,680 | ) |
| Software development                                                                             |   | (19,305                                  | )       | (17,433                                  | )      | (75,049                           | )      | (53,095 | ) | (28,763 | ) |
| Prepaid expenses and other current assets                                                        |   | 771                                      |    | 3,088                                    |   | (2,101                            | )      | (2,901 | ) | (2,374 | ) |
| Accounts payable                                                                                 |   | (20,374                                  | )       | (16,535                                  | )      | 11,067                            |   | 5,517 |   | 8,797 |   |
| Accrued expenses and accrued payment  to  venture partner                                   |   | (17,712                                  | )       | (5,727                                   | )      | 13,577                            |   | (4,197 | ) | 10,494 |   |
| Accrued royalties                                                                                |   | (18,181                                  | )       | 3,711                                    |   | 8,834                             |   | 6,952 |   | (1,427 | ) |
| Income taxes                                                                                     |   | (3,479                                   | )       | (1,247                                   | )      | 2,374                             |   | (6,336 | ) | 7,107 |   |
| Net cash provided by operating activities                                                        |   | 38,475                                   |    | 34,942                                   |   | 16,330                            |   | 33,237 |   | 16,136 |   |
| Cash flows provided by (used in)  investing  activities:                                    |   |                                     |    |                                     |   |                              |   |   |   |   |   |
| Proceeds from sale of property and  equipment                                               |   | —                                   |    | —                                   |   | —                            |   | 65 |   | 64 |   |
| Proceeds from sales and maturities of  short- term investments                                   |   | 65,019                                   |    | —                                   |   | 90,732                            |   | — |   | — |   |
| Purchases of short-term investments                                                              |   | (28,809                                  | )       | (20,445                                  | )      | (110,072                          | )      | (35,124 | ) | — |   |
| Acquisition of property and equipment                                                            |   | (2,099                                   | )       | (901                                     | )      | (7,794                            | )      | (5,750 | ) | (7,877 | ) |
| Acquisitions, net of cash acquired                                                               |   | —                                   |    | —                                   |   | (9,373                            | )      | — |   | — |   |
| Investment in Network Interactive Sports  Ltd.                                                   |   | —                                   |    | (221                                     | )      | (221                              | )      | (3,325 | ) | — |   |
| Investment in Yuke’s Co., Ltd.                                                              |   | —                                   |    | —                                   |   | —                            |   | — |   | (5,020 | ) |
| (Increase) decrease in other long-term  assets                                                   |   | 1,510                                    |    | (107                                     | )      | (1,422                            | )      | 50 |   | (114 | ) |
| Net cash provided by (used in) investing  activities                                             |   | 35,621                                   |    | (21,674                                  | )      | (38,150                           | )      | (44,084 | ) | (12,947 | ) |
| Cash flows provided by (used in)  financing  activities:                                    |   |                                     |    |                                     |   |                              |   |   |   |   |   |
| Net (decrease) in short-term borrowings                                                          |   | —                                   |    | —                                   |   | —                            |   | (15,473 | ) | (1,229 | ) |
| Repurchase of common stock                                                                       |   | (7,758                                   | )       | —                                   |   | (25,005                           | )      | — |   | — |   |
| Principal payments on long-term debt                                                             |   | —                                   |    | —                                   |   | —                            |   | (1,806 | ) | — |   |
| Proceeds from issuance of common stock                                                           |   | —                                   |    | 99                                       |   | 52                                |   | 154,605 |   | — |   |
| Proceeds from exercise of warrants and  options                                             |   | 1,408                                    |    | 3,234                                    |   | 7,750                             |   | 16,721 |   | 4,305 |   |
| Net cash provided by (used in) financing  activities                                             |   | (6,350                                   | )       | 3,333                                    |   | (17,203                           | )      | 154,047 |   | 3,076 |   |
| Effect of exchange rate changes on cash                                                          |   | (784                                     | )       | (161                                     | )      | 862                               |   | (139 | ) | 279 |   |
| Net increase (decrease) in cash and  cash  equivalents                                      |   | 66,962                                   |    | 16,440                                   |   | (38,161                           | )      | 143,061 |   | 6,544 |   |
| Cash and cash equivalents — beginning of  period                                            |   | 132,898                                  |    | 171,059                                  |   | 171,059                           |   | 27,998 |   | 21,454 |   |
| Cash and cash equivalents — end of period                                                   |   | $                                        | 199,860 |                                     | $      | 187,499                           |   | $ | 132,898 |   | $ | 171,059 |   | $ | 27,998 |   |

** **

**See notes to consolidatedfinancial statements.**

** **

**46**

----

** **
|                             |   | **Three  Months  Ended  March 31,** |   | **Three  Months  Ended  March 31,** |       | **Year  Ended  December 31,** |       | **Year  Ended  December 31,** |       | **Year  Ended  December 31,** |       |
|----------------------------------|--------|------------------------------------------|--------|------------------------------------------|------------|------------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
|                             |   | **2003**                                 |   | **2002**                                 | ** ** | **2002**                           | ** ** | **2001**                           | ** ** | **2000**                           | ** ** |
|                             |   |                                     |   | **Unaudited**                            |       |                               |       |                               |       |                               |       |
| Cash paid during the period for: |   |                                     |   |                                     |       |                               |       |                               |       |                               |       |
| Income taxes                     |   | $                                        | 2,616  |                                     | $          | 1,127                              |       | $                                  | 3,257      |                               | $          | 8,204 |   | $ | 4,350 |   |
| Interest                         |   | $                                        | 11     |                                     | $          | 25                                 |       | $                                  | 76         |                               | $          | 74 |   | $ | 354 |   |

 

On July 1, 2002, we paid$9.6 million in cash and issued approximately 167,000 shares of common stock aspart of the purchase price of ValuSoft. The issuance increased common stock and additional paid-in-capital by$2,000 and $4.6 million respectively, and was allocated among the assetsacquired.  (See Note 3)

 

| Estimated Fair Value (in thousands): |   |   |   |
|--------------------------------------|--------|--------|--------|
| Tangible assets acquired             |   | $      | 2,837  |   |
| Software development acquired        |   | 1,491  |   |
| Licenses acquired                    |   | 1,109  |   |
| Liabilities assumed                  |   | (2,940 | )      |
| Goodwill                             |   | 12,042 |   |
| Purchase price                       |   | $      | 14,539 |   |

 

On December 21, 2001, weissued approximately 1,287,000 shares of common stock and assumed approximately159,000 stock options as part of the purchase price of Rainbow MultimediaGroup, Inc.  The issuance increasedcommon stock and additional paid-in-capital by $13,000 and $48.6 millionrespectively, and was allocated among the assets acquired.  (See Note 3)

 

| Estimated Fair Value (in thousands): |   |   |   |
|--------------------------------------|--------|--------|--------|
| Tangible assets acquired             |   | $      | 5,838  |   |
| Intangible assets acquired           |   | 3,531  |   |
| Liabilities assumed                  |   | (5,411 | )      |
| Goodwill                             |   | 44,972 |   |
| Purchase price                       |   | $      | 48,930 |   |

 

On June 8, 2001, WorldWrestling Federation Entertainment exchanged all of its warrants for 302,490shares of common stock in a non-cash transaction.  On July 23, 2001, Stanley Shenker Associates, Inc. (arelated party to the World Wrestling Federation Entertainment) exchanged all ofits warrants for 37,923 shares of common stock in a non-cash transaction.

 

**See notes to consolidatedfinancial statements.**

** **

**47**

----

** **

**THQ INC. AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**1.   Description ofBusiness**

 

*Business*.  THQ Inc., a Delaware corporation, is aleading global developer and publisher of interactive entertainment softwarefor the major hardware platforms in the home video game market.  We currently develop and publish titles forSony PlayStation 2, Microsoft Xbox, Nintendo GameCube, Nintendo Game BoyAdvance, personal computers (“PCs”) and wireless devices.  Our titles span most major interactiveentertainment software genres, including action, adventure, children’s,driving, fighting, puzzle, role playing, simulation, sports and strategy.  Our customers include Wal-Mart, Toys “R” Us,Target, Best Buy, Game Stop, Kay Bee Toys, and other national and regionalretailers, discount store chains and specialty retailers.

 

Unlessthe context otherwise requires, references in this document to “THQ” or the“Company” include THQ Inc. and all of its wholly owned subsidiaries.

 

*Fiscal Year.*  Effective January 1,2003, we have changed our fiscal year end from December 31 toMarch 31.  Accordingly, thetransitional period ended March 31, 2003 represents three months ofoperations.  The unaudited financialinformation for the three months ended March 31, 2002 is presented forcomparative purposes.

 

*Platform License Agreements.*  We have a license agreement with Sonypursuant to which we have the non-exclusive right to utilize the Sony name,related trademarks, and its proprietary information and technology in order todevelop and market software for use with the 128-bit Sony PlayStation 2 in theUnited States and Canada which expires in March 2004.  We are currently renegotiating the SonyPlayStation 2 license agreement for Europe, Australia and New Zealand andKorea.  We also have two licenseagreements with Sony pursuant to which we have the non-exclusive right toutilize the Sony name, related trademarks, and its proprietary information andtechnology in order to develop and market software for use with the 32-bit SonyPlayStation in the United States, Canada, Mexico and Latin America and Europe,Australia and New Zealand which expire in August 2006 andDecember 2005, respectively.

 

Wehave a license agreement with Nintendo pursuant to which we have thenon-exclusive right to utilize the Nintendo name, related trademarks, and itsproprietary information and technology in order to develop and market softwarefor use with the Game Boy Advance handheld game console in all countries in theWestern Hemisphere which expires in July 2004.  We are currently in negotiation for the Nintendo Game Boy Advancelicense agreement for Europe, Australia and New Zealand.  We have a license agreement with Nintendopursuant to which we have the non-exclusive right to utilize the Nintendo name,related trademarks, and its proprietary information and technology in order todevelop and market software for use with the 128-bit Nintendo GameCube in allcountries in the Western Hemisphere which expires in April 2005.  We are currently in negotiation for theNintendo GameCube license agreement for Europe, Australia and New Zealand.  We also have a license agreement withNintendo pursuant to which we have the non-exclusive right to utilize theNintendo name, related trademarks, and its proprietary information andtechnology in order to develop and market software for use with the Game BoyColor handheld game console in all countries in the Western Hemisphere which expiresin March 2004.  We also have alicense agreement with Nintendo pursuant to which we have the non-exclusiveright to utilize the Nintendo name, related trademarks, and its proprietaryinformation and technology in order to develop and market software for use withthe Game Boy Color handheld game console in Europe, Australia and New Zealandwhich expired in October 2002.  Therenewal is currently in negotiation, and provides for an expiration ofOctober 2005.  We have two licenseagreements with Nintendo pursuant to which we have the non-exclusive right toutilize the Nintendo name, related trademarks, and its proprietary informationand technology in order to develop and market software for use with the 64-bitNintendo 64 in all countries in the Western Hemisphere and Europe, Australiaand New Zealand which expire in May 2003 and January 2004,respectively.  We will not bedistributing any product on this platform and we do not intend to renew theselicenses.

 

Wehave a license agreement with Microsoft pursuant to which we have thenon-exclusive right to utilize the Microsoft name, related trademarks, and itsproprietary information and technology in order to develop and market softwarefor use with the 128-bit Microsoft Xbox which expires in November 2004.  The territory is determined on atitle-by-title basis.

 

Ourbusiness is dependent on these license agreements with Sony, Nintendo andMicrosoft.  Substantially all of ourproducts are manufactured by Sony, Nintendo and Microsoft authorized vendorswho charge us an amount for each disc-based product or cartridgemanufactured.  This charge includes amanufacturing, printing and packaging fee as well as a royalty for the use oftheir respective names, proprietary information and technology.

 

48

----

 

In addition, we mustindemnify Sony, Nintendo and Microsoft, as appropriate, with respect to allloss, liability and expense resulting from any claim against Sony, Nintendo andMicrosoft involving the development, marketing, sale or use of our titles,including any claims for copyright or trademark infringement brought againstSony, Nintendo and Microsoft.  As such,we bear the risk that the properties and information and technology licensedfrom Sony, Nintendo and Microsoft and incorporated in the software may infringethe rights of third parties.  Generally,we are entitled to indemnification from our software developers and propertylicensors to cover our indemnification obligations to Sony, Nintendo andMicrosoft but no assurance can be given that, if any claim is brought againstus, the developers and/or licensors will have sufficient resources to indemnifyus.

 

**2.   Summary ofSignificant Accounting Policies**

 

*Principles of Consolidation.*  The consolidated financial statementsinclude the accounts of THQ Inc. and our wholly owned subsidiaries.  Investments in business entities in which wedo not have control, but have the ability to exercise significant influenceover operating and financial policies (generally 20-50% ownership), areaccounted for by the equity method.  All material intercompany balancesand transactions have been eliminated in consolidation.

 

*Foreign Currency Translation.*  Assets and liabilities of foreign operationsare translated at current rates of exchange while results of operations aretranslated at average rates in effect for the period.  Translation gains or losses are shown as a separate component ofaccumulated other comprehensive income (loss). The translation gain (loss) on long-term intercompany balances includedin the foreign currency translation was ($0.4) million for the three monthsended March 31, 2003.  Thetranslation gain (loss) on long-term intercompany balances included in theforeign currency translation was $1.8 million and ($0.6) million for the yearsended December 31, 2002 and 2001, respectively.  The gain (loss) for the year ended December 31, 2000 wasimmaterial.  Foreign currency transactiongains and losses result from exchange rate changes for transactions denominatedin currencies other than the functional currency.  Foreign currency transaction gains and losses are not materialand are included in general and administrative expenses.

 

*Cash, Cash Equivalents and Short-Term Investments*

 
| **(In  thousands)**                                |   | **March 31,2003** |    | **December 31,** |   |
|----------------------------------------------------|--------|------------------------|---------|-----------------------|--------|
|                                               |   | **2002**               |    | **2001**              |   |
| Cash and cash equivalents                          |   | $                      | 199,860 |                  | $      | 132,898 |   | $ | 171,059 |   |
|                                               |   |                   |    |                  |   |   |   |
| Short-term investments                             |   |                   |    |                  |   |   |   |
| Available for sale                                 |   | 12,143                 |    | 44,940                |   | 30,106 |   |
| Held to maturity                                   |   | 4,008                  |    | 9,011                 |   | 5,000 |   |
| Short-term investments                             |   | 16,151                 |    | 53,951                |   | 35,106 |   |
|                                               |   |                   |    |                  |   |   |   |
| Cash, cash equivalents and short-term  investments |   | $                      | 216,011 |                  | $      | 186,849 |   | $ | 206,165 |   |

 

Weconsider all highly liquid investments purchased with maturities less thanthree months to be cash equivalents.

 

Investmentswith a maturity greater than three months, but less than one year, at the timeof purchase are considered to be short-term investments.  We invest in highly liquid debt instrumentswith strong credit ratings.  Thecarrying amounts of the investments approximate fair value due to their shortmaturities.  Unrealized gains and(losses) are recorded as a separate component of accumulated othercomprehensive income (loss) for investments classified as available-for-sale.  For the three months ended March 31,2003, the unrealized loss on the investments and securities was $44,000.  At March 31, 2003 we reclassified$556,000 of unrealized net losses to net income (loss).  The unrealized gains and (losses) on theinvestments in securities for the years ended December 31, 2002 and 2001,were ($492,000) and ($20,000), respectively.

 

49

----

 

Short-term investments atMarch 31, 2003, December 31, 2002 and 2001 were as follows:

 
| **(In  thousands)**                  |   | **Amortized  Cost** |       | **Gross  Unrealized  Holding  Gains** |       | **Gross  Unrealized  Holding  Losses** |       | **Fair  Value** |       |
|--------------------------------------|--------|---------------------|------------|---------------------------------------|------------|----------------------------------------|------------|-----------------|------------|
| **Available-for-sale:**              |   |                | ** ** |                                  | ** ** |                                   | ** ** |            | ** ** |
| **March 31, 2003**              |   |                |       |                                  |       |                                   |       |            |       |
| Corporate notes and bonds            |   | $                   | 6,346      |                                  | $          | —                                 |       | $               | —     |   | $ | 6,346 |   |
| U.S. government and agencies         |   | 5,797               |       | —                                |       | —                                 |       | 5,797           |       |
|                                 |   |                |       |                                  |       |                                   |       |            |       |
| Total available-for-sale investments |   | $                   | 12,143     |                                  | $          | —                                 |       | $               | —     |   | $ | 12,143 |   |
|                                 |   |                |       |                                  |       |                                   |       |            |       |
| **December 31,  2002**          |   |                | ** ** |                                  | ** ** |                                   | ** ** |            | ** ** |
| Corporate notes and bonds            |   | $                   | 22,953     |                                  | $          | —                                 |       | $               | (259       | ) | $ | 22,694 |   |
| U.S. government and agencies         |   | 22,499              |       | —                                |       | (253                                   | )          | 22,246          |       |
|                                 |   |                |       |                                  |       |                                   |       |            |       |
| Total available-for-sale investments |   | $                   | 45,452     |                                  | $          | —                                 |       | $               | (512       | ) | $ | 44,940 |   |
|                                 |   |                |       |                                  |       |                                   |       |            |       |
| **December 31,  2001**          |   |                | ** ** |                                  | ** ** |                                   | ** ** |            | ** ** |
| Corporate notes and bonds            |   | $                   | 13,798     |                                  | $          | 2                                      |       | $               | (12        | ) | $ | 13,788 |   |
| U.S. government and agencies         |   | 16,328              |       | 3                                     |       | (13                                    | )          | 16,318          |       |
|                                 |   |                |       |                                  |       |                                   |       |            |       |
| Total available-for-sale investments |   | $                   | 30,126     |                                  | $          | 5                                      |       | $               | (25        | ) | $ | 30,106 |   |
|                                 |   |                | ** ** |                                  | ** ** |                                   | ** ** |            | ** ** |
| **Held-to-maturity:**                |   |                | ** ** |                                  | ** ** |                                   | ** ** |            | ** ** |
| **March 31, 2003**              |   |                |       |                                  |       |                                   |       |            |       |
| Municipal securities                 |   | $                   | 4,008      |                                  | $          | —                                 |       | $               | —     |   | $ | 4,008 |   |
|                                 |   |                |       |                                  |       |                                   |       |            |       |
| Total held-to-maturity investments   |   | $                   | 4,008      |                                  | $          | —                                 |       | $               | —     |   | $ | 4,008 |   |
|                                 |   |                |       |                                  |       |                                   |       |            |       |
| **December 31,  2002**          |   |                | ** ** |                                  | ** ** |                                   | ** ** |            | ** ** |
| Corporate debt securities            |   | $                   | 5,000      |                                  | $          | —                                 |       | $               | —     |   | $ | 5,000 |   |
| Municipal securities                 |   | 4,011               |       | —                                |       | —                                 |       | 4,011           |       |
|                                 |   |                |       |                                  |       |                                   |       |            |       |
| Total held-to-maturity investments   |   | $                   | 9,011      |                                  | $          | —                                 |       | $               | —     |   | $ | 9,011 |   |
|                                 |   |                |       |                                  |       |                                   |       |            |       |
| **December 31,  2001**          |   |                | ** ** |                                  | ** ** |                                   | ** ** |            | ** ** |
| Municipal securities                 |   | $                   | 5,000      |                                  | $          | —                                 |       | $               | —     |   | $ | 5,000 |   |
|                                 |   |                |       |                                  |       |                                   |       |            |       |
| Total held-to-maturity investments   |   | $                   | 5,000      |                                  | $          | —                                 |       | $               | —     |   | $ | 5,000 |   |

 

Theinvestment in Yuke’s Co., Ltd. is also classified as available-for-sale and isincluded in other long-term assets in the accompanying balance sheets.  In March 2003, the Yuke’s investmentwas written down to $3.2 million and a realized loss of $1.8 million wasrecorded in the period ending March 31, 2003.  For the three months ended March 31, 2003, the unrealizedloss was $1.1 million.  AtMarch 31, 2003 we reclassified $1.8 million of unrealized net losses to netincome (loss).  For the years endedDecember 31, 2002 and December 31, 2001, the unrealized holding gain(loss) on the investment in Yuke’s Co., Ltd. was ($1,015,000) and $249,000,respectively.

 

*Fair Values of Financial Instruments.*  The carrying value of certain financialinstruments, including cash and cash equivalents, short-term investments heldto maturity, accounts receivable, accounts payable, accrued expenses andaccrued royalties approximate fair market value based on their short–termnature.  Short-term investmentsclassified

 

50

----

 

as available for sale arestated at fair value.  The value ofshort-term investments are determined using quoted market prices.

 

*Concentrations of Credit Risk.*  Financial instruments which potentiallysubject us to concentration of credit risk consist principally of cash and cashequivalents, short-term investments and accounts receivable.  We place cash and cash equivalents andshort-term investments with high credit-quality institutions and limit theamount of credit exposure to any one institution.  We believe this risk is immaterial due to the short-term natureof our investments.  Most of our salesare made directly to mass merchandisers and national retailers.  Due to the increased volume of sales tothese channels, we have experienced an increased concentration of credit risk,and as a result, may maintain individually significant receivable balances withsuch mass merchandisers and national retailers.  We perform ongoing credit evaluations of our customers and maintainan allowance for potential credit losses.

 

Sales (before returns andallowances) to a major customer represented 25%, 16%, 14% and 17% of grosssales in the three months ended March 31, 2003 and the years endedDecember 31, 2002, 2001 and 2000, respectively.  This customer accounted for approximately 38%, 17% and 18% ofaccounts receivable at March 31, 2003, December 31, 2002 and 2001,respectively.  Sales (before returns andallowances) to another major customer represented 11%, 13%, 12% and 16% ofgross sales in the three months ended March 31, 2003 and the years endedDecember 31, 2002, 2001 and 2000, respectively.  This customer accounted for approximately 39% of accountsreceivable at March 31, 2003 and 16% of accounts receivable at bothDecember 31, 2002 and 2001.

 

*Inventory.* Inventory, which consists principally of finished products, are statedat the lower of cost (moving weighted average) or market.  We estimate the net realizable value ofslow-moving inventory on a title by title basis, and charge the excess of costover net realizable value to cost of sales.

 

*Property and Equipment.*  Property and equipment are stated atcost.  Depreciation is computed usingthe straight-line method over the estimated useful lives of the assets.  Leasehold improvements are amortized overthe shorter of their useful lives or the remaining lease term.  Property and equipment consist of thefollowing:

 
| **(In  thousands)**                              |   | **Useful  Lives** |     | **March 31,  2003** |     | **December 31,** |   |
|--------------------------------------------------|--------|-------------------|----------|--------------------------|----------|-----------------------|--------|
|                                             |   |              | **2002** |                     | **2001** |                  |
| Building                                         |   | 30 yrs            |     | $                        | 719      |                  | $      | 719 |   | $ | 689 |   |
| Land                                             |   | —            |     | 401                      |     | 401                   |   | 401 |   |
| Computer equipment and software                  |   | 3-10 yrs          |     | 24,795                   |     | 23,138                |   | 16,860 |   |
| Furniture, fixtures and equipment                |   | 5 yrs             |     | 3,535                    |     | 3,375                 |   | 2,579 |   |
| Leasehold improvements                           |   | 3-6 yrs           |     | 1,576                    |     | 1,443                 |   | 1,137 |   |
| Automobiles                                      |   | 2-5 yrs           |     | 121                      |     | 74                    |   | 111 |   |
|                                             |   |              |     |                     |     |                  |   |   |   |
| Less: accumulated depreciation and  amortization |   |              |     | (14,739                  | )        | (13,047               | )      | (7,886 | ) |
|                                             |   |              |     | $                        | 16,408   |                  | $      | 16,103 |   | $ | 13,891 |   |

 

*Licenses.* Minimum guaranteed royalty payments for intellectual property licensesare initially recorded as an asset (licenses) and as a liability (accruedroyalties) at the contractual amount upon execution of the contract when nosignificant performance remains with the licensor.  When significant performance remains with the licensor, we recordroyalty payments as an asset (licenses) when actually paid rather than uponexecution of the contract.  Royaltypayments for intellectual property licenses are classified as current assetsand current liabilities to the extent such royalty payments relate to anticipatedsales during the subsequent year and long-term assets and long-term liabilitiesif such royalty payments relate to anticipated sales after one year.

 

Licenses are expensed tolicense amortization and royalties at the higher of (i) the contractual royaltyrate based on actual net product sales or (ii) the ratio of current units soldto total projected units sold.  When, inmanagement’s estimate, future cash flows will not be sufficient to recoverpreviously capitalized costs, we expense these capitalized costs to licenseamortization and royalties.  See – “*Long-Lived Assets*” below.  If actual revenues, or revised forecastedunits, fall below the initial forecasted units, the charge to licenseamortization and royalties may be larger than anticipated in any given quarter.  As of March 31, 2003, the net carrying valueof our licenses was $35.4 million.

 

*Software Development*.  We utilize both independent softwaredevelopers and internal development teams to develop our software.  We account for software development costs inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 86,“Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise

 

51

----

 

Marketed.”  We capitalize software development costsonce technological feasibility is established and we determine that such costsare recoverable against future revenues. For products where proven game engine technology exists, this may occurearly in the development cycle.  Wecapitalize the milestone payments made to independent software developers andthe direct payroll costs for our internal development teams.  We evaluate technological feasibility on aproduct-by-product basis.  Amountsrelated to software development for which technological feasibility is not yetmet are charged immediately to product development expense.

 

Capitalized softwaredevelopment is expensed to software development amortization at the higher of(i) the contractual rate based on actual net product sales or (ii) the ratio ofcurrent units sold to total projected units sold.  When, in management’s estimate, future cash flows will not besufficient to recover previously capitalized costs, we expense these items tosoftware development amortization.  See– “*Long-Lived Assets*” below.  If actual revenues, or revised forecastedunits, fall below the initial forecasted units, the charge to softwaredevelopment amortization may be larger than anticipated in any givenquarter.  As of March 31, 2003, the net carryingvalue of our software development was $57.5 million.

 

*Goodwill and Other Intangible Assets.*  Effective January 1, 2002, we completedthe adoption of Statement of Financial Accounting Standards (SFAS) No. 142,“Goodwill and Other Intangible Assets.” As required by SFAS No. 142, we discontinued amortizing the remainingbalances of goodwill as of January 1, 2002.  All remaining and future acquired goodwill and indefinite livedintangible assets will be subject to an impairment test in the second quarterof each calendar year, or earlier if indicators of potential impairment exist,using a fair-value-based approach.  Allidentifiable intangible assets with finite lives will continue to be amortizedover their estimated useful lives and assessed for impairment under SFAS 144, “Accounting for theImpairment or Disposal of Long-Lived Assets.” In conjunction with the implementation of SFAS No. 142 as of thebeginning of 2002, we completed a goodwill impairment review.  According to our accounting policy, we alsoperformed an annual review during the quarter ended June 30, 2002, and inboth reviews we found no impairment.

 

A reconciliation of previouslyreported net income (loss) and earnings per share to the amounts adjusted forthe exclusion of goodwill amortization, including $196,000 of goodwillamortization associated with an equity method investment in 2001, is asfollows:

 
| **(In  thousands, except per share data)** |   | **March 31,2003** |   | **December 31,** |   |
|--------------------------------------------|--------|------------------------|--------|-----------------------|--------|
| **2002**                                   |   | **2001**               |   | **2000**              |
| Reported net income (loss)                 |   | $                      | (7,686 | )                     | $      | 12,994 |   | $ | 36,013 |   | $ | 18,189 |   |
| Add back: Goodwill amortization            |   | —                 |   | —                |   | 404 |   | 215 |   |
| Adjusted net income (loss)                 |   | $                      | (7,686 | )                     | $      | 12,994 |   | $ | 36,417 |   | $ | 18,404 |   |
|                                       |   |                   |   |                  |   |   |   |   |   |
| **Basic earnings per  share:**             |   |                   |   |                  |   |   |   |   |   |
| Reported net income (loss)                 |   | $                      | (0.20  | )                     | $      | 0.33 |   | $ | 1.10 |   | $ | 0.60 |   |
| Goodwill amortization                      |   | —                 |   | —                |   | 0.01 |   | 0.01 |   |
| Adjusted net income (loss)                 |   | $                      | (0.20  | )                     | $      | 0.33 |   | $ | 1.11 |   | $ | 0.61 |   |
|                                       |   |                   |   |                  |   |   |   |   |   |
| **Diluted earnings per share:**            |   |                   |   |                  |   |   |   |   |   |
| Reported net income (loss)                 |   | $                      | (0.20  | )                     | $      | 0.32 |   | $ | 1.01 |   | $ | 0.56 |   |
| Goodwill amortization                      |   | —                 |   | —                |   | 0.01 |   | 0.01 |   |
| Adjusted net income (loss)                 |   | $                      | (0.20  | )                     | $      | 0.32 |   | $ | 1.02 |   | $ | 0.57 |   |

 

*Long-Lived Assets.*  We evaluate long-lived assets, including but not limited tolicenses, software development, property and equipment and identifiableintangible assets with finite lives, for impairment whenever events or changesin circumstances indicate that the carrying amount of an asset may not berecoverable.  Recoverability of assetsis measured by a comparison of the carrying amount of an asset to futureundiscounted net cash flows expected to be generated by the asset.  If such assets are considered to beimpaired, the impairment to be recognized is measured by the amount by whichthe carrying amount of the asset exceeds its fair value.

 

52

----

 

In January 2002, we adopted SFAS No.144, “Accounting for theImpairment or Disposal of Long-Lived Assets”, which addresses financialaccounting and reporting for the impairment or disposal of long-livedassets.  The adoption of SFAS 144 didnot have a material impact on our financial statements.

 

*Revenue Recognition.*  Our revenue recognition policies are incompliance with American Institute of Certified Public Accountants Statement ofPosition (“SOP”) 97-2, “Software Revenue Recognition”, as amended by SOP 98-9,“Modification of SOP 97-2, Software Revenue Recognition, With Respect toCertain Transactions”, which provide guidance on generally accepted accountingprinciples for recognizing revenue on software transactions.

 

InDecember 1999, the Securities and Exchange Commission (“SEC”) issued StaffAccounting Bulletin No. 101 (“SAB 101”), “Revenue Recognition in FinancialStatements”, which outlines the basic criteria that must be met to recognizerevenue and provides guidance for presentation of revenue and for disclosurerelated to revenue recognition policies in financial statements filed with theSEC.  The adoption of SAB 101 did nothave a material impact on our consolidated financial position and results ofoperations.

 

ProductSales: We recognize revenue for packaged software when title and risk of losstransfers to the customer, provided that no significant vendor supportobligations remain outstanding and that collection of the resulting receivableis deemed probable by management. Although we generally sell our products on a no-return basis, in certaincircumstances we may allow price protection, returns or other allowances on anegotiated basis.  We estimate suchprice protection, returns or other allowances based upon management’sevaluation of our historical experience, retailer inventories, the nature ofthe titles and other factors.  Suchestimates are deducted from gross sales (See Note 5).  Software is sold under a limited 90-day warranty against defectsin material and workmanship.  To date,we have not experienced material warranty claims.

 

SoftwareLicenses:  For those agreements thatprovide the customers the right to multiple copies in exchange for guaranteedminimum royalty amounts, revenue is recognized at delivery of the productmaster or the first copy.  Per copyroyalties on sales that exceed the guarantee are recognized as earned.

 

Revenuefrom the licensing of software was $4.1 million for the three months endedMarch 31, 2003 and $2.0 million, $1.4 million and $346,000 for the yearsended December 31, 2002, 2001 and 2000, respectively.

 

*Advertising.*  Advertising and sales promotion costs are generally expensed asincurred, except for television airtime and print media costs associated withmedia campaigns, which are deferred and charged to expense in the period theairtime or advertising space is used for the first time.  Advertising costs were $4.6 million for thethree months ended March 31, 2003 and $23.4 million, $14.8 million and$27.1 million in the years ended December 31, 2002, 2001 and 2000,respectively.

 

*Stock-Based Compensation.*  We account for our employee stock optionplans under the intrinsic value method prescribed by Accounting PrinciplesBoard (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” andrelated interpretations.  We account forequity instruments issued to other than employees for acquiring goods andservices, typically rights to intellectual property, using the fair value atthe date of grant.

 

AtMarch 31, 2003, we had three stock-based compensation plans, which aredescribed more fully in Note 11.  Stockoptions granted under these plans had an exercise price equal to the marketvalue of the underlying common stock on the date of grant.  The following table illustrates the effecton the net income (loss) and earnings per share if we had applied the fairvalue recognition provisions of FASB Statement No. 123, *Accounting for Stock-Based Compensation*,to stock-based employee compensation.

 

53

----

 
| **(In thousands, except per share data)**                                                                                                                             |     | **Three  Months  Ended  March 31,** |     | **Years Ended December 31,** |     |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|------------------------------------------|----------|-----------------------------------|----------|
|                                                                                                                                                                  | **2003** |                                     | **2002** |                              | **2001** |   | **2000** |   |
| Net income (loss)-as reported                                                                                                                                         |     | $                                        | (7,686   | )                                 | $        | 12,994 |   | $ | 36,013 |   | $ | 18,189 |   |
| Add:   Stock-based employee compensation expense included in  reported net income (loss), net of related  tax effects                                       |     | 119                                      |     | 104                               |     | 182 |   | 240 |   |
| Deduct:   Total stock-based employee compensation expense determined  under fair value based method for all  awards,   net of related tax effects |     | (4,033                                   | )        | (19,436                           | )        | (12,269 | ) | (7,734 | ) |
| Net income (loss)-pro forma                                                                                                                                           |     | $                                        | (11,600  | )                                 | $        | (6,338 | ) | $ | 23,926 |   | $ | 10,695 |   |
| Earnings per share:                                                                                                                                                   |     |                                     |     |                              |     |   |   |   |   |
| Basic-as reported                                                                                                                                                     |     | $                                        | (0.20    | )                                 | $        | 0.33 |   | $ | 1.10 |   | $ | 0.60 |   |
| Basic-pro forma                                                                                                                                                       |     | $                                        | (0.30    | )                                 | $        | (0.16 | ) | $ | 0.73 |   | $ | 0.35 |   |
|                                                                                                                                                                  |     |                                     |     |                              |     |   |   |   |   |
| Diluted-as reported                                                                                                                                                   |     | $                                        | (0.20    | )                                 | $        | 0.32 |   | $ | 1.01 |   | $ | 0.56 |   |
| Diluted-pro forma                                                                                                                                                     |     | $                                        | (0.30    | )                                 | $        | (0.16 | ) | $ | 0.67 |   | $ | 0.33 |   |

 

The fair market value ofoptions granted under the stock option plans during the three months endedMarch 31, 2003 and each of the years ended December 31, 2002, 2001and 2000, respectively, was determined using the Black-Scholes option pricingmodel utilizing the following assumptions:

 
|                                     |     | **Three  Months  Ended  March 31,** |     | **Years Ended December 31,** |     |
|------------------------------------------|----------|------------------------------------------|----------|-----------------------------------|----------|
|                                     | **2003** |                                     | **2002** |                              | **2001** |   | **2000** |   |
| Dividend yield                           |     | 0                                        | %        | 0                                 | %        | 0 | % | 0 | % |
| Anticipated volatility                   |     | 73                                       | %        | 73                                | %        | 74 | % | 73 | % |
| Weighted average risk-free interest rate |     | 3.46                                     | %        | 3.46                              | %        | 4.33 | % | 6.12 | % |
| Expected lives                           |     | 4 years                                  |     | 4 years                           |     | 4 years |   | 4 years |   |

 

*Income Taxes.*  Deferred income taxes are provided for temporary differencesbetween the financial statement and income tax bases of our assets andliabilities, based on enacted tax rates. A valuation allowance is provided when it is more likely than not thatsome portion or all of the deferred income tax assets will not be realized.

 

*Basic and Diluted Earnings PerShare.*  The followingtable is a reconciliation of the weighted-average shares used in thecomputation of basic and diluted earnings per share for the years presented:

 

54

----

 
|                                                                          |   | **Three  Months  Ended  March 31,** |   | **Three  Months  Ended  March 31,** |   | **Years  Ended December 31,** |   |
|-------------------------------------------------------------------------------|--------|------------------------------------------|--------|------------------------------------------|--------|------------------------------------|--------|
| **(In  thousands, except per share data)**                                    |   | **2003**                                 |   | **(Unaudited)  2002**                    |   | **2002**                           |   | **2001** |   | **2000** |   |
| Net income (loss) used to compute  basic  and diluted earnings per share |   | $                                        | (7,686 | )                                        | $      | 2,765                              |   | $ | 12,994 |   | $ | 36,013 |   | $ | 18,189 |   |
| Weighted average number of shares  outstanding — basic                   |   | 38,319                                   |   | 39,067                                   |   | 39,203                             |   | 32,717 |   | 30,136 |   |
| Dilutive effect of stock options and  warrants                           |   | —                                   |   | 2,658                                    |   | 2,040                              |   | 2,906 |   | 2,216 |   |
| Number of shares used to compute  earnings per share — diluted      |   | 38,319                                   |   | 41,725                                   |   | 41,243                             |   | 35,623 |   | 32,352 |   |
|                                                                               |        |                                          |        |                                          |        |                                    |        |  |  |  |  |  |  |  |  |  |

 

Stockoptions to purchase 4,676,000 shares of common stock in the three months endedMarch 31, 2003 were outstanding but are not included in the computation ofdiluted earnings per common share because we recorded a net loss for theperiod.  Stock options to purchase600,000, 677,000, 2,462,000, 724,500 and 2,118,000 shares of common stock inthe three months ended March 31, 2003 and 2002 and each of the years endedDecember 31, 2002, 2001 and 2000, respectively, were outstanding but notincluded in the computation of diluted earnings per common share because theoption exercise price for these options was greater than the average marketprice of our shares of common stock.

 

*Recently Issued Accounting Pronouncements. *In November 2002,FASB issued Interpretation (“FIN”) No. 45, *“Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others.”*  FIN No. 45 elaborates on the disclosures to be made by aguarantor in its interim and annual financial statements about its obligationsunder certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at theinception of a guarantee, a liability for the fair value of the obligationundertaken in issuing the guarantee. The initial recognition and initial measurement provisions of thisInterpretation are applicable on a prospective basis to guarantees issued ormodified after December 31, 2002. The adoption of FIN No. 45 did not have an impact on our financialstatements.

 

InDecember 2002, the FASB issued SFAS No. 148, *“Accounting for Stock-Based Compensation –Transition and Disclosure.”*  This statement amends SFAS No. 123, toprovide alternative methods of voluntary transition to change to the fair valuebased method of accounting for stock-based employee compensation.  Additionally, this statement amendsdisclosure requirements of accounting for stock-based employee compensation andthe effect of the method used on reported results.  Currently, we do not expect to adopt the fair value based methodof accounting for stock-based employee compensation under SFAS No. 123.  We have adopted the new disclosurerequirements of SFAS No. 148 as included in the Summary of SignificantAccounting Policies, Stock-Based Compensation.

 

InMay 2003, the FASB issued SFAS No. 149, *“DerivativeInstruments.”*  This statementamends SFAS No. 133, by requiring that contracts with comparable characteristicsbe accounted for in a similar fashion. In particular, the Statement: (1) clarifies under what circumstances acontract with an initial net investment meets the characteristic of aderivative discussed in paragraph 6(b) of Statement 133; (2) clarifies when aderivative contains a financing component; (3) amends the definition of anunderlying to conform it to language used in FIN No. 45, *Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers*; and (4) amends certain other existing pronouncements.  This Statement is effective for contractsentered into or modified after June 30, 2003, and for hedgingrelationships designated after June 30, 2003.  We are currently evaluating the provisions of SFAS No. 149 andhave not determined the impact, if any, they will have on our financialstatements.

 

InMay 2003, the FASB issued SFAS No. 150 “*Accounting for Financial Instrumentswith the Characteristics of Both Liabilities and Equities*”.  SFAS No. 150 establishes standards regardingthe manner in which an issuer classifies and measures certain types offinancial instruments having characteristics of both liabilities andequity.  Pursuant to SFAS No. 150, suchfreestanding financial instruments (i.e., those entered into separately from anentity’s other financial instruments or equity transactions or that are legallydetachable and separately exercisable) must be classified as liabilities or, insome cases, assets.  In addition, SFASNo. 150 requires that financial instruments containing obligations torepurchase the issuing entity’s equity shares and, under certain circumstances,obligations that are settled by delivery of the issuer’s shares be classifiedas liabilities.  The Statement is effectivefor

 

55

----

 

financialinstruments entered into or modified after May 31, 2003 and for otherinstruments at the beginning of the first interim period beginning afterJune 15, 2003.  We are currentlyevaluating the provisions of SFAS No. 150 and have not determined the impact,if any, they will have on our financial statements.

 

*Pervasiveness of Estimates.*  The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesof America requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.  The most significantestimates relate to licenses, software development, accrued returns andallowances and the allowance for doubtful accounts.

 

*Reclassifications.*  Certain reclassifications have been made tothe prior years consolidated financial statements to conform to current periodconsolidated financial statements.

 

**3.   BusinessCombinations**

 

*ValuSoft.* On July 1, 2002, we completed the acquisition of substantially allthe assets of ValuSoft, Inc. (now referred to as “ValuSoft”), a publisher anddeveloper of value-priced interactive entertainment and productivitysoftware.  The results of ValuSoft’s operationshave been included in the consolidated financial statements since thatdate.  This acquisition has provided uswith a channel for value-priced personal computer products.  We paid $9.6 million in cash and issuedapproximately 167,000 shares of our common stock valued at $4.6 million as theinitial purchase price.  In addition,former shareholders of ValuSoft, Inc. are entitled to additional considerationof up to $11.0 million if ValuSoft reaches certain pre-tax income targets inthe five years following July 1, 2002. The annual payments of the additional consideration, if any, range from$1.0 million to $2.8 million per year and may be paid, at our discretion, incash or shares of our common stock and will be added to goodwill.

 

Theacquisition has been accounted for using the purchase method under SFAS No.141. The purchase price includes the cash paid, the fair value of our commonstock issued, transaction costs and an adjustment for ValuSoft’s accountsreceivable and net book value at July 1, 2002.  The total amount of goodwill is expected to be deductible forincome tax purposes.  The allocation ofthe purchase price is as follows:

 

| Estimated Fair Value (in thousands): |   |   |   |
|--------------------------------------|--------|--------|--------|
| Tangible assets acquired             |   | $      | 2,837  |   |
| Software development acquired        |   | 1,491  |   |
| Licenses acquired                    |   | 1,109  |   |
| Liabilities assumed                  |   | (2,940 | )      |
| Goodwill                             |   | 12,042 |   |
| Purchase price                       |   | $      | 14,539 |   |

* *

*Rainbow Multimedia Group, Inc.*  On December 21, 2001, we completed theacquisition of Rainbow Multimedia Group, Inc., an Arizona corporation.  The results of Rainbow’s operations havebeen included in the consolidated financial statements since that date.  Rainbow designs entertainment content forvideo game consoles and personal computers. Rainbow’s team of artist and engineers helps strengthen our internaldevelopment and our ability to create original content.

 

In theacquisition, each share of Rainbow was converted into 0.05397 of a share of ourcommon stock, or approximately 1,287,000 shares valued at $44.6 million.  In addition, outstanding vested Rainbowemployee stock options were assumed by us and converted, at the same conversionrate, into options to purchase approximately 159,000 shares of our commonstock.

 

Theacquisition has been accounted for using the purchase method under SFAS No.141.  The purchase price includes the fairvalue of our common stock issued, fair value of vested stock options assumed,the transaction costs, and an adjustment for Rainbow’s net book value atDecember 21, 2001.  In 2002, anadjustment was made to the initial allocation of the purchase primarily due todeferred tax assets that were not previously recognized.  The allocation of the purchase price is asfollows:

 

56

----

 

| Estimated Fair Value (in thousands): |   |   |   |
|--------------------------------------|--------|--------|--------|
| Tangible assets acquired             |   | $      | 5,841  |   |
| Intangible assets acquired           |   | 3,531  |   |
| Liabilities assumed                  |   | (5,411 | )      |
| Goodwill                             |   | 44,972 |   |
| Purchase price                       |   | $      | 48,933 |   |

 

Thepurchase agreement and a related royalty participation agreement calls forcontingent compensation based on the future revenue generated by certain titlesbeing developed by Rainbow prior to the acquisition.  The contingent compensation is expensed to software developmentamortization.  The contingent compensationmay be paid, at our discretion, in cash or shares of our common stock.  For the three months ended March 31,2003, we issued 15,773 shares of our common stock and recognized $341,000 ofstock compensation related to the contingent compensation.  For the year ended December 31, 2002,we issued 8,952 shares of our common stock and recognized $267,000 of stockcompensation related to the contingent compensation.

 

*Volition, Inc.*  On August 31, 2000, we completed the acquisition ofVolition, Inc., a Delaware corporation (“Volition”).  In the acquisition, each share of Volition was converted into0.16484 of a share of our common stock, or approximately 1,335,000 shares.  In addition, outstanding Volition employeestock options were assumed by us and converted, at the same conversion rate,into options to purchase approximately 165,000 shares of our common stock.

 

Theacquisition has been accounted for as a pooling of interests under AccountingPrinciples Board Opinion No. 16. Accordingly, all prior period consolidated financial statementspresented have been restated to include the combined results of operations,financial position and cash flows as if Volition had always been part of ourcompany.

 

Alltransactions between us and Volition have been eliminated in the consolidatedfinancial statements.

 

**4.   Credit Facility**

 

OnSeptember 27, 2002, we entered into an Amended and Restated RevolvingCredit Agreement (“Credit Facility”). On May 30, 2003, we amended the Credit Facility (“Amended CreditFacility”).  Under the terms of theCredit Facility, we were permitted to borrow and maintain obligations underoutstanding letters of credit up to an aggregate of $35.0 million.  Due to our current level of cash, cashequivalent and short-term investment balances and because we do not anticipatethe need for borrowings in the future, we reduced the capacity of our creditfacility.  Under the Amended CreditFacility we can maintain outstanding letters of credit up to $25.0 million andwe removed our ability to borrow.  As aresult of the May 30, 2003 amendment, we were in compliance with all the covenantsunder the Amended Credit Facility.  AtDecember 31, 2002 we were in violation of the specified minimum net worthcovenant of the Credit Facility due to the $25.0 million share repurchase andthe calendar fourth quarter operating results. On February 21, 2003 a waiver of this covenant was executed.

 

TheAmended Credit Facility is secured by a lien on substantially all of our assetsand contains customary financial and non-financial covenants, commencing withthe quarter ended March 31, 2003, which require us to maintain specifiedoperating profits and liquidity and limits our ability to incur additionalindebtedness, sell assets, pay cash dividends and enter into certain mergers oracquisitions.  Amounts outstanding underthe Amended Credit Facility bear interest, at our choice, at either (a) thebank’s prime rate (4.3% at March 31,2003) or (b) the London Interbank Offered Rate (1.3% at March 31, 2003) plus 1.60%.  As of March 31, 2003, we hadoutstanding letters of credit of approximately $3.5 million and no borrowingson the Credit Facility.

 

**5.   Allowance forPrice Protection, Returns and Doubtful Accounts**

 

Theallowance for price protection, returns and doubtful accounts at March 31,2003, December 31, 2002 and 2001 consists of the following:

 

57

----

 
| **(In  thousands)**                                                    |   | **March 31,  2003** |    | **December 31,** |   |
|------------------------------------------------------------------------|--------|--------------------------|---------|-----------------------|--------|
|                                                                   |   | **2002**                 |    | **2001**              |   | **2000** |   |
| Balance at January 1                                              |   | $                        | (59,919 | )                     | $      | (40,616 | ) | $ | (31,534 | ) | $ | (24,171 | ) |
| Provision for price protection, returns and  doubtful accounts         |   | (10,046                  | )       | (69,641               | )      | (47,386 | ) | (35,387 | ) |
| Actual deductions for price protection,  returns and doubtful accounts |   | 26,559                   |    | 50,338                |   | 38,304 |   | 28,024 |   |
| Ending balance                                                         |   | $                        | (43,406 | )                     | $      | (59,919 | ) | $ | (40,616 | ) | $ | (31,534 | ) |

 

**6.   Goodwill**

 

Thechanges in the carrying amount of goodwill for the three months endedMarch 31, 2003 and the years ended December 31, 2002 and 2001 are asfollows:

 
| **(In  thousands)**                       |   | **March 31,****2003** |   | **Years Ended  December 31,** |   |
|-------------------------------------------|--------|----------------------------|--------|------------------------------------|--------|
|                                      |   | **2002**                   |   | **2001**                           |   |
| Balance at beginning of period            |   | $                          | 58,609 |                               | $      | 48,202 |   | $ | 1,717 |   |
| Goodwill acquired during the period       |   | —                     |   | 12,042                             |   | 46,688 |   |
| Adjustments to goodwill during the period |   | —                     |   | (1,716                             | )      | — |   |
| Amortization during the period            |   | —                     |   | —                             |   | (208 | ) |
| Effect of foreign currency exchange rates |   | —                     |   | 81                                 |   | 5 |   |
| Balance at end of period                  |   | $                          | 58,609 |                               | $      | 58,609 |   | $ | 48,202 |   |

 

**7.   Intangible Assets**

 

Intangibleassets include licenses, software development and other intangible assets.  Other intangible assets are included inother long-term assets, net, except licenses and software development, whichare reported separately in the accompanying balance sheets.  Intangible assets are as follows:

 
|                                   |   |              |   | **March 31,  2003**    |    | **December 31,  2002**   |   | **December 31,  2001** |   |
|----------------------------------------|--------|-------------------|--------|-----------------------------|---------|-------------------------------|--------|-----------------------------|--------|
| **Intangible  Assets  (In thousands)** |   | **Useful  Lives** |   | **Gross  Carrying  Amount** |    | **Accumulated  Amortization** |   | **Gross  Carrying  Amount** |   | **Accumulated  Amortization** |   | **Gross  Carrying  Amount** |   | **Accumulated  Amortization** |   |
| Amortized  intangible assets           |   |              |   |                        |    |                          |   |                        |   |   |   |   |   |   |   |
| Licenses                               |   | Varies            |   | $                           | 100,065 |                          | $      | (64,682)                    |   | $ | 95,299 |   | $ | (59,877) |   | $ | 52,435 |   | $ | (27,332) |   |
|                                   |   |              |   |                        |    |                          |   |                        |   |   |   |   |   |   |   |
| Software   development            |   | Varies            |   | 171,335                     |    | (113,871                      | )      | 152,263                     |   | (104,845 | ) | 88,707 |   | (49,577 | ) |
|                                   |   |              |   |                        |    |                          |   |                        |   |   |   |   |   |   |   |
| Trade secrets                          |   | 5 years           |   | 1,800                       |    | (450                          | )      | 1,800                       |   | (360 | ) | 1,800 |   | — |   |
| Non-compete / Employment contracts     |   | 6.5 years         |   | 706                         |    | (136                          | )      | 706                         |   | (109 | ) | 706 |   | — |   |
| Subtotal, other                        |   |              |   | 2,506                       |    | (586                          | )      | 2,506                       |   | (469 | ) | 2,506 |   | — |   |
| Total amortized intangible assets      |   |              |   | 273,906                     |    | (179,139                      | )      | 250,068                     |   | (165,191 | ) | 143,648 |   | (76,909 | ) |
|                                   |   |              |   |                        |    |                          |   |                        |   |   |   |   |   |   |   |
| Unamortized intangible assets          |   |              |   |                        |    |                          |   |                        |   |   |   |   |   |   |   |
| Trade name                             |   | indefinite        |   | 1,025                       |    | N/A                           |   | 1,025                       |   | N/A |   | 1,025 |   | N/A |   |
| Total                                  |   |              |   | $                           | 274,931 |                          | $      | (179,139                    | )      | $ | 251,093 |   | $ | (165,191 | ) | $ | 144,673 |   | $ | (76,909 | ) |

 

58

----

 

Theuseful lives of licenses and software development are based on units of productsold and therefore not disclosed in years. The estimated amortization expense for licenses and software developmentis based on anticipated release dates and forecasts of units to be sold.  For the three months ended March 31,2003 and for the years ended December 31, 2002, 2001 and 2000, ouraggregate amortization expense related to intangible assets was $13.9 million,$91.7 million, $35.3 million and $50.2 million, respectively.

 
| **Estimated Amortization Expense  (In thousands):** |   | **Fiscal****Years Ended  March 31,** |   |   |   |
|-----------------------------------------------------|--------|-------------------------------------------|--------|--------|--------|
|                                                |   | 2004                                      |   | $      | 70,623 |   |
|                                                |   | 2005                                      |   | $      | 11,079 |   |
|                                                |   | 2006                                      |   | $      | 9,817  |   |
|                                                |   | 2007                                      |   | $      | 1,219  |   |
|                                                |   | 2008                                      |   | $      | 949    |   |
|                                                |   | Thereafter                                |   | $      | 1,080  |   |

 

**8.   Other Long-TermAssets**

 

Inaddition to other intangible assets (see Note 7), other long-term assets alsoincludes the following:

 

OnJune 13, 2001, T.HQ International Ltd. and HotGen Studios Ltd. enteredinto a Joint Venture Agreement pursuant to which T.HQ International Ltd.acquired a 44% interest in Network Interactive Sports Limited (“NI Sports”),formerly wholly owned by HotGen Studios Ltd. In exchange for this interest, T.HQ International Ltd. agreed to invest$3.3 million in cash.  Goodwill, whichresulted from the investment, net of accumulated amortization was $1.9 millionat December 31, 2001.  InJuly 2002, we announced plans to discontinue operations and took a chargeof $3.0 million, including the write-off of associated goodwill of $1.9million, in June 2002 for the write-off of this investment, which isincluded in other expenses in the accompanying statements of operations.  Prior to the write-off, this investment wasincluded in other long-term assets in the accompanying balance sheet and wasaccounted for using the equity method. For the year ended December 31, 2001, our equity in the net loss ofthe joint venture was immaterial and was included in general and administrativeexpenses in the accompanying statements of operations.  The financial statements of the jointventure are immaterial and have therefore not been included.

 

OnMarch 21, 2000, we acquired less than a 20% interest in Japanesedeveloper, Yuke’s Co., Ltd., which at the time was privately held.  In December 2001, Yuke’s Co., Ltd. hadan initial public offering of its common stock which is now traded on the JapaneseNASDAQ stock market.  Accordingly, weaccount for this investment under SFAS No. 115 “Accounting for CertainInvestments in Debt and Equity Securities”. (See Note 2)  Unrealized holdinggains and losses are excluded from earnings and are included as a component ofother comprehensive income until realized. The original cost of this investment was $5.0 million.  The agreement provides that for a certaintime period, under separate development agreements, Yuke’s Co., Ltd. willcreate exclusively for us wrestling games for the PlayStation and PlayStation 2in North America and Europe.  Due to thelong-term nature of this agreement, this investment is included in otherlong-term assets in the accompanying balance sheet.  The investment in Yuke’s Co., Ltd. was $3.2 million as ofMarch 31, 2003.  InMarch 2003, we incurred a $1.8 million charge which is related to theother than temporary impairment of Yuke’s Co., Ltd.  Fair value was determined by using the closing price on theJapanese stock market at March 31, 2003. The investment in Yuke’s Co., Ltd. was $4.3 million and $5.3 million asof December 31, 2002 and 2001, respectively.

 

During2002, we loaned Minick Holding AG (“Minick”) $1.5 million.  On January 24, 2003, the loan wasconverted to an equity investment in Minick. We now own approximately 25% of the outstanding common stock ofMinick.  This investment is accountedfor under the equity method.  Equity innet income for the period ended March 31, 2003 is not material.  Minick develops and operates interactivemobile applications.  We will work withMinick to provide licensed wireless gaming through their mobile applications.

 

59

----

 

**9.   Income Taxes**

 

Income(loss) before provision (benefit) for income taxes consisted of:

 
| **(In  thousands)** |     | **Three Months  Ended March 31,** |     | **Years Ended December 31,** |     |
|---------------------|----------|----------------------------------------|----------|-----------------------------------|----------|
|                | **2003** |                                   | **2002** |                              | **2001** |   | **2000** |   |
| United  States      |     | $                                      | (5,871   | )                                 | $        | 16,471 |   | $ | 52,569 |   | $ | 29,540 |   |
| Foreign             |     | (5,105                                 | )        | 3,284                             |     | 4,147 |   | 1,703 |   |
|                |     | $                                      | (10,976  | )                                 | $        | 19,755 |   | $ | 56,716 |   | $ | 31,243 |   |

 

Theprovision (benefit) for income taxes consists of the following:

 
| **(In  thousands)**                  |   | **2003** |   | **2002** |   | **2001** |   | **2000** |   |
|--------------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
| **Current**                          |   |     |   |     |   |     |   |     |   |
| Federal                              |   | $        | (139   | )        | $      | 6,742    |   | $        | 8,000  |   | $ | 9,048 |   |
| State                                |   | —   |   | 814      |   | 434      |   | 3,395    |   |
| Foreign                              |   | (1,960   | )      | 1,765    |   | 1,231    |   | 712      |   |
|                                 |   | (2,099   | )      | 9,321    |   | 9,665    |   | 13,155   |   |
| **Deferred**                         |   |     |   |     |   |     |   |     |   |
| Federal                              |   | (1,295   | )      | (1,940   | )      | 9,223    |   | 209      |   |
| State                                |   | (125     | )      | (194     | )      | 1,524    |   | (200     | )      |
| Foreign                              |   | 229      |   | (426     | )      | 291      |   | (110     | )      |
|                                 |   | (1,191   | )      | (2,560   | )      | 11,038   |   | (101     | )      |
| Provision (benefit) for income taxes |   | $        | (3,290 | )        | $      | 6,761    |   | $        | 20,703 |   | $ | 13,054 |   |

 

Areconciliation of the provision (benefit) for income taxes at the federalstatutory rate to the provision (benefit) recorded in the accompanyingfinancial statements is as follows:

 
| **(In  thousands)**                                       |   | **2003** |   | **2002** |   | **2001** |   | **2000** |   |
|-----------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
| Federal provision (benefit) at statutory  rate            |   | (35.0    | )%     | 35.0     | %      | 35.0     | %      | 35.0     | %      |
| State taxes (net of Federal benefit)                      |   | (1.1     | )      | 2.0      |   | 2.2      |   | 4.1      |   |
| Preacquisition loss from Volition, Inc.                   |   | —   |   | —   |   | —   |   | 2.5      |   |
| Other than temporary impairment in Yuke’s  Co., Ltd. |   | 5.9      |   |     |   |     |   |     |   |
| Rate differences in foreign taxes and  other, net         |   | —   |   | (2.8     | )      | (0.7     | )      | 0.2      |   |
|                                                      |   | (30.0    | )%     | 34.2     | %      | 36.5     | %      | 41.8     | %      |

 

60

----

 

Deferredincome taxes were:

 
|                             |   | **March 31,  2003** |   |
|----------------------------------|--------|--------------------------|--------|
|                             |   |
| **(In thousands)**               |   | **Federal**              |   | **State** |   | **Foreign** |   |
| **Current**                      |   |                     |   |   |   |   |   |
| Deferred income tax assets:      |   |                     |   |   |   |   |   |
| Allowance for doubtful accounts, |   |                     |   |   |   |   |   |
| discounts and returns            |   | $                        | 9,756  |   | $ | 906 |   | $ | 201 |   |
| Accrued vacation                 |   | 1,314                    |   | 122 |   | — |   |
| Accrued bonus                    |   | 637                      |   | 59 |   | — |   |
| Deferred compensation            |   | 730                      |   | 68 |   | — |   |
| State income taxes               |   | 133                      |   | — |   | — |   |
| Other — net                 |   | 2,650                    |   | 246 |   | — |   |
| Total deferred income tax assets |   | 15,220                   |   | 1,401 |   | 201 |   |
|                             |   |                     |   |   |   |   |   |
| Deferred income tax liabilities: |   |                     |   |   |   |   |   |
| Software development costs       |   | (19,089                  | )      | (1,772 | ) | — |   |
| Other — net                 |   | (3,039                   | )      | (275 | ) | — |   |
| Deferred income taxes            |   | $                        | (6,908 | ) | $ | (646 | ) | $ | 201 |   |
|                             |   |                     |   |   |   |   |   |
| **Non-Current**                  |   |                     |   |   |   |   |   |
| Deferred income tax assets:      |   |                     |   |   |   |   |   |
| Net operating loss               |   | $                        | 9,046  |   | $ | 748 |   | $ | — |   |
| Credits                          |   | —                   |   | 109 |   | — |   |
| Other — net                 |   | 2,197                    |   | 211 |   | — |   |
| Valuation reserve                |   | (930                     | )      | (86 | ) | — |   |
| Net deferred tax assets          |   | 10,313                   |   | 982 |   | — |   |
|                             |   |                     |   |   |   |   |   |
| Deferred income tax liabilities  |   |                     |   |   |   |   |   |
| Software development costs       |   | (919                     | )      | (85 | ) | — |   |
| Depreciation and amortization    |   | (417                     | )      | — |   | — |   |
| Identifiable intangible assets   |   | (825                     | )      | (77 | ) | — |   |
| Other — net                 |   | (613                     | )      | (13 | ) | — |   |
| Deferred income taxes            |   | $                        | 7,539  |   | $ | 807 |   | $ | — |   |

 

Thevaluation reserve increased by $706,000 during the three months endedMarch 31, 2003.

 

As ofMarch 31, 2003 we had federal net operating loss carryforwards ofapproximately $26.0 million (expiring from 2009 to 2023).

 

AtMarch 31, 2003 we had accumulated foreign earnings of $6.3 million.  We do not plan to repatriate these earnings,therefore, no United States income tax has been provided on the foreignearnings.  Additionally, we have not taxeffected the cumulative translation adjustment as we have no intention ofrepatriating foreign earnings.

 

61

----

 
|                                                    |   | **December 31,** |   |
|---------------------------------------------------------|--------|-----------------------|--------|
|                                                    |   | **2002**              |   | **2001** |   |
| **(In  thousands)**                                     |   | **Federal**           |   | **State** |   | **Foreign** |   | **Federal** |   | **State** |   | **Foreign** |   |
| **Current**                                             |   |                  |   |   |   |   |   |   |   |   |   |   |   |
| Deferred income tax assets:                             |   |                  |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts, discounts and  returns |   | $                     | 12,065 |   | $ | 1,120 |   | $ | 430 |   | $ | 8,400 |   | $ | 779 |   | $ | 4 |   |
| Litigation reserve                                      |   | 3,553                 |   | 330 |   | — |   | — |   | — |   | — |   |
| Package design costs                                    |   | —                |   | — |   | — |   | 664 |   | 62 |   | — |   |
| Deferred compensation                                   |   | —                |   | — |   | — |   | 280 |   | 26 |   | — |   |
| State income taxes                                      |   | 106                   |   | — |   | — |   | 391 |   | — |   | — |   |
| Net operating loss                                      |   | 1,023                 |   | 3 |   | — |   | 246 |   | — |   | — |   |
| Credits                                                 |   | —                |   | 109 |   | — |   | — |   | — |   | — |   |
| Other — net                                        |   | 3,126                 |   | 290 |   | — |   | 558 |   | 54 |   | — |   |
| Total deferred income tax assets                        |   | 19,873                |   | 1,852 |   | 430 |   | 10,539 |   | 921 |   | 4 |   |
|                                                    |   |                  |   |   |   |   |   |   |   |   |   |   |   |
| Deferred income tax liabilities:                        |   |                  |   |   |   |   |   |   |   |   |   |   |   |
| Software development costs                              |   | (16,029               | )      | (1,477 | ) | — |   | (11,924 | ) | (1,107 | ) | — |   |
| Other — net                                        |   | (3,039                | )      | (276 | ) | — |   | — |   | — |   | — |   |
| Deferred income taxes                                   |   | $                     | 805    |   | $ | 99 |   | $ | 430 |   | $ | (1,385 | ) | $ | (186 | ) | $ | 4 |   |
|                                                    |   |                  |   |   |   |   |   |   |   |   |   |   |   |
| **Non-Current**                                         |   |                  |   |   |   |   |   |   |   |   |   |   |   |
| Deferred income tax assets:                             |   |                  |   |   |   |   |   |   |   |   |   |   |   |
| Other — net                                        |   | $                     | 1,287  |   | $ | 123 |   | $ | — |   | $ | 284 |   | $ | 26 |   | $ | — |   |
| Valuation reserve                                       |   | (284                  | )      | (26 | ) | — |   | — |   | — |   | — |   |
| Net deferred tax assets                                 |   | 1,003                 |   | 97 |   | — |   | 284 |   | 26 |   | — |   |
|                                                    |   |                  |   |   |   |   |   |   |   |   |   |   |   |
| Deferred income tax liabilities                         |   |                  |   |   |   |   |   |   |   |   |   |   |   |
| Software development costs                              |   | (622                  | )      | (69 | ) | — |   | — |   | — |   | — |   |
| Depreciation and amortization                           |   | (575                  | )      | (12 | ) | — |   | — |   | — |   | — |   |
| Identifiable intangible assets                          |   | (1,276                | )      | (80 | ) | — |   | (1,030 | ) | — |   | — |   |
| Deferred income taxes                                   |   | $                     | (1,470 | ) | $ | (64 | ) | $ | — |   | $ | (746 | ) | $ | 26 |   | $ | — |   |

 

The valuationreserve increased by $310,000 during 2002. The valuation reserve was zero for the year ended December 31,2001.

 

**10.   Employee PensionPlan**

 

Wesponsor for our United States employees, a defined contribution plan underSection 401(k) of the Internal Revenue Code. The plan provides that employees may defer up to 12% of annualcompensation, and that we will make a matching contribution equal to eachemployee’s deferral, up to 4% of eligible compensation.  We may also contribute funds to the plan inthe form of a discretionary profit-sharing contribution.  Expenses under the plan were $389,000, $1.5million, $1.3 million and $1.1 million in the three months ended March 31,2003 and each of the years ended December 31, 2002, 2001 and 2000,respectively.

 

**11.   Stock OptionPlans**

 

Wehave three stock option plans (the 1990 Plan, the 1997 Amended Plan andNon-executive Employee Stock Option Plan (the “NEEP Plan”)).

 

The1990 Plan and the 1997 Amended Plan provide for the issuance of up to 2,193,750and 10,537,500 shares, respectively, available for employees, consultants andnon-employee directors.

 

As ofMarch 31, 2003, no options under the 1990 Plan and 1,951,020 options underthe 1997 Plan were available for grant. Stock options granted under the option plans may be incentive stockoptions or non-statutory stock options. Options may be granted under the option plans to, in the case ofincentive stock options, all employees (including officers) of THQ; or, in thecase of non-statutory stock options, all employees (including officers),consultants and non-employee directors of THQ.

 

62

----

 

OnJuly 20, 2001, our stockholders approved an amendment to the Amended andRestated 1997 Stock Option Plan to increase the number of shares of commonstock for which options may be issued. The 1997 Amended Plan now provides for the issuance of up to 10,537,500shares of common stock for option grants to directors, officers and keyemployees.  The purchase price per shareof common stock purchasable upon exercise of each option may not be less thanthe fair market value of such share of common stock on the date that suchoption is granted.  Generally, optionsgranted under this plan become exercisable over three years and expire withinfive years from the date of grant.

 

OnJune 8, 2000, the Board of Directors approved the THQ Inc. NEEP Plan.  The NEEP Plan has primarily the sameattributes as the 1990 Plan and the 1997 Plan, but participation is reservedfor employees who are not executive officers and under the NEEP Plan onlynonqualified options will be granted. The NEEP Plan provides for the issuance of up to 2,142,000 shares, ofwhich no more than 20% is available for awards to our non-executive officersand no more than 15% is available for awards to the non-executive officers orgeneral managers of our subsidiaries or divisions.  As of March 31, 2003, 323,772 options were available forgrant.

 

Theexercise price per share of all options granted under the plans in the yearsended December 31, 2000, 2001, 2002 and the three months endedMarch 31, 2003 has been the closing market price of the stock on the dateof the grant.

 

| **Stock  Options**                             |   | **Weighted Average  Exercise Price** |   | **Number of  Shares** |       |
|------------------------------------------------|--------|--------------------------------------|--------|-----------------------|------------|
| Balance at January 1, 2000                |   | $                                    | 10.07  |                  | 3,863,887  |   |
| Granted                                        |   | $                                    | 10.52  |                  | 2,278,439  |   |
| Exercised                                      |   | $                                    | 6.10   |                  | (377,498   | ) |
| Canceled                                       |   | $                                    | 9.69   |                  | (644,873   | ) |
| Balance at December 31, 2000              |   | $                                    | 10.61  |                  | 5,119,955  |   |
| Granted                                        |   | $                                    | 26.01  |                  | 3,206,811  |   |
| Exercised                                      |   | $                                    | 9.43   |                  | (1,628,538 | ) |
| Canceled                                       |   | $                                    | 13.47  |                  | (331,016   | ) |
| Balance at December 31, 2001              |   | $                                    | 18.42  |                  | 6,367,212  |   |
| Granted                                        |   | $                                    | 26.54  |                  | 2,192,639  |   |
| Exercised                                      |   | $                                    | 9.58   |                  | (545,937   | ) |
| Canceled                                       |   | $                                    | 24.54  |                  | (1,042,064 | ) |
| Balance at December 31, 2002              |   | $                                    | 20.93  |                  | 6,971,850  |   |
| Granted                                        |   | $                                    | 12.40  |                  | 487,500    |   |
| Exercised                                      |   | $                                    | 9.83   |                  | (143,148   | ) |
| Canceled                                       |   | $                                    | 20.46  |                  | (442,410   | ) |
| Balance at March 31, 2003                 |   | $                                    | 20.58  |                  | 6,873,792  |   |
|                                           |   |                                 |   |                  |       |
| Options exercisable at December 31,  2000 |   | $                                    | 8.98   |                  | 1,826,669  |   |
| Options exercisable at December 31,  2001 |   | $                                    | 11.51  |                  | 1,759,140  |   |
| Options exercisable at December 31,  2002 |   | $                                    | 16.75  |                  | 3,164,326  |   |
| Options exercisable at March 31, 2003     |   | $                                    | 18.03  |                  | 3,382,098  |   |

 

Optionsgranted and shares exercised relating to options granted outside of our stockoption plans during the years ended December 31, 2000, 2001, 2002 and thethree months ended March 31, 2003 are listed below.  Share exercise prices for these optionsequal the market price of our common stock at the date of the grant except foroptions issued by PCP&L and GA prior to the acquisitions, which were issuedat below market value.  These optionswere accounted for under APB Opinion No. 25 and we have recognized stockcompensation of $189,000, $169,000, $299,000 and $406,000 for the three monthsended March 31, 2003 and each of the years ended December 31, 2002,2001 and 2000, respectively.  Generally,options granted outside of our stock option plans become exercisable over threeyears and expire within five years from the date of grant.

 

63

----

 
| **Stock  Options**                             |   | **Weighted Average  Exercise Price** |   | **Number of  Shares** |      |
|------------------------------------------------|--------|--------------------------------------|--------|-----------------------|-----------|
| Balance at January 1, 2000                |   | $                                    | 3.35   |                  | 1,434,862 |   |
| Exercised                                      |   | $                                    | 1.30   |                  | (317,459  | ) |
| Canceled                                       |   | $                                    | 0.46   |                  | (45,648   | ) |
| Balance at December 31, 2000              |   | $                                    | 4.07   |                  | 1,071,755 |   |
| Granted                                        |   | $                                    | 13.78  |                  | 159,398   |   |
| Exercised                                      |   | $                                    | 3.17   |                  | (436,737  | ) |
| Canceled                                       |   | $                                    | 0.57   |                  | (932      | ) |
| Balance at December 31, 2001              |   | $                                    | 6.53   |                  | 793,484   |   |
| Granted                                        |   | $                                    | — |                  | —    |   |
| Exercised                                      |   | $                                    | 6.95   |                  | (386,297  | ) |
| Canceled                                       |   | $                                    | 11.00  |                  | (8,554    | ) |
| Balance at December 31, 2002              |   | $                                    | 6.05   |                  | 398,633   |   |
| Granted                                        |   | $                                    | — |                  | —    |   |
| Exercised                                      |   | $                                    | 0.57   |                  | (1,263    | ) |
| Canceled                                       |   | $                                    | 0.62   |                  | (166      | ) |
| Balance at March 31, 2003                 |   | $                                    | 6.07   |                  | 397,204   |   |
|                                           |   |                                 |   |                  |      |
| Options exercisable at December 31,  2000 |   | $                                    | 4.48   |                  | 965,028   |   |
| Options exercisable at December 31,  2001 |   | $                                    | 6.83   |                  | 755,777   |   |
| Options exercisable at December 31,  2002 |   | $                                    | 6.06   |                  | 397,492   |   |
| Options exercisable at March 31, 2003     |   | $                                    | 6.07   |                  | 397,204   |   |

 

Thefollowing table summarizes information about stock options outstanding atMarch 31, 2003:

 
| **R****ange ofExercise Price** |   | **Number  Outstanding at  March 31, 2003** |   | **Weighted Average  Remaining  Contractual Life** |   | **Weighted  Average Exercise  Price** |   |
|--------------------------------|--------|-------------------------------------------------|--------|---------------------------------------------------|--------|---------------------------------------|--------|
| $   0.25 - $10.25    |   | 1,457,876                                       |   | 2                                                 |   | $                                     | 6.89   |   |
| $ 10.42 - $17.15               |   | 1,455,319                                       |   | 3                                                 |   | $                                     | 13.33  |   |
| $ 17.19 - $22.08               |   | 1,456,186                                       |   | 3                                                 |   | $                                     | 19.24  |   |
| $ 22.30 - $30.04               |   | 2,211,737                                       |   | 4                                                 |   | $                                     | 28.18  |   |
| $ 30.93 - $39.11               |   | 689,878                                         |   | 4                                                 |   | $                                     | 34.85  |   |
|                           |   | 7,270,996                                       |   | 3                                                 |   | $                                     | 19.78  |   |

 
| **Range of  Exercise****Price** |   | **Shares  Exercisable at  March 31, 2003** |   | **Weighted  Average Exercise  Price** |   |
|---------------------------------|--------|-------------------------------------------------|--------|---------------------------------------|--------|
| $   0.25 - $10.25     |   | 1,201,097                                       |   | $                                     | 6.51   |   |
| $ 10.42 - $17.15                |   | 690,484                                         |   | $                                     | 13.43  |   |
| $ 17.19 - $22.08                |   | 851,543                                         |   | $                                     | 17.97  |   |
| $ 22.30 - $30.04                |   | 769,444                                         |   | $                                     | 28.23  |   |
| $ 30.93 - $39.11                |   | 266,734                                         |   | $                                     | 34.78  |   |
|                            |   | 3,779,302                                       |   | $                                     | 16.77  |   |

 

Theestimated fair value of the options granted in the three months endedMarch 31, 2003 and the years ended December 31, 2002, 2001 and 2000was $3.4 million, $31.3 million, $47.0 million and $12.7 million,respectively.  We apply APB Opinion No.25 and related Interpretations in accounting for stock option plans.  Accordingly, no compensation cost for ourstock option plans has been recognized in the three months ended March 31,2003 and each of the years ended December 31, 2002, 2001 or 2000, exceptfor options issued by PCP&L and GA prior to the acquisitions, which wereissued at below market value.

 

64

----

 

**12.   Capital StockTransactions**

 

OnNovember 21, 2002, we announced that our Board of Directors authorized therepurchase of up to $25.0 million of our common stock from time to time on theopen market or in private transactions. As of March 31, 2003, we repurchased approximately 568,000 sharesof our common stock for $7.8 million. On September 10, 2002, we announced that our Board of Directorsauthorized the repurchase of up to $25.0 million of our common stock from timeto time on the open market or in private transactions.  As of December 31, 2002, we repurchasedapproximately 1,672,000 shares of our common stock for $25.0 million.

 

OnJuly 1, 2002 we issued approximately 167,000 shares of common stock aspart of the purchase price of ValuSoft (See Note 3).

 

Inconnection with obtaining the Nickelodeon master license, inFebruary 2002, we issued to MTV Networks, a division of ViacomInternational Inc., warrants to purchase 75,000 shares of common stock at$29.13 per share having a fair value of $1.2 million at the time ofissuance.  The fair value of thewarrants is included in licenses in the accompanying balance sheet.  The warrants expire December 31, 2005.

 

OnDecember 21, 2001, we issued approximately 1,287,000 shares of commonstock as part of the purchase price of Rainbow (See Note 3).

 

OnNovember 13, 2001, we issued 4,125,000 shares of our common stock in asecondary public offering.  As part ofthe offering, on December 12, 2001, the underwriters exercised their rightto purchase an additional 471,222 shares. The net proceeds from these issuances were $154.6 million.

 

On July 20, 2001, our shareholders approved anamendment to our Certificate of Incorporation to increase the number ofauthorized shares of our common stock from 35,000,000 to 75,000,000.  On July 24, 2001, we amended ourCertificate of Incorporation to reflect this increase in authorized shares.

 

Inconnection with obtaining the World Wrestling Entertainment license (See Note13), in August 1999, we issued to World Wrestling Entertainment and arelated party to World Wrestling Entertainment, warrants to purchase 421,875shares of common stock at $6.95 per share having a fair value of $3.1 millionat the time of issuance.  The warrantsexpire December 31, 2009.  OnJune 8, 2001, World Wrestling Federation Entertainment exchanged all ofits warrants for 302,490 shares of common stock in a non-cash transaction.  On July 23, 2001, Stanley ShenkerAssociates, Inc. (a related party to World Wrestling Federation Entertainment)exchanged all of its warrants for 37,923 shares of common stock in a non-cashtransaction.  The issuance of shares ofour common stock upon the exchange of warrants to both World Wrestling FederationEntertainment and Stanley Shenker was made pursuant to the exemption fromregistration provided in Section 4(2) of the Securities Act of 1933, asamended.

 

OnAugust 31, 2000, we issued 1,335,165 shares of common stock as part of thepurchase price for Volition.  (See Note3)

 

Otherthan World Wrestling Federation Entertainment and Stanley Shenker warrants thatwere exchanged for common stock mentioned above, there were no additionalwarrants exercised in 2001 and no warrants exercised in 2002.  During the year ended December 31,2000, the number of warrants to purchase our common stock exercised were150,000.  We received proceeds from theexercise of such warrants totaling $1.6 million in the year endedDecember 31, 2000.

 

**13.   Agreement withJAKKS Pacific, Inc.**

 

InJune 1999 we entered into an agreement with JAKKS Pacific, Inc. (“JAKKS”),that governs our relationship with respect to the World Wrestling Entertainmentlicense we jointly obtained from World Wrestling Entertainment, Inc. (the“WWE”).  This agreement was amended inJanuary 2002.  Our relationshipwith JAKKS was established to develop, manufacture, distribute, market and sellvideo games, as well as sublicense products pursuant to the license from theWWE.  The principal terms of thisoperating agreement are as follows:

 

We areresponsible for funding all operations of the venture, including all paymentsowed to the WWE.

 

Forthe period commencing November 16, 1999 and ending June 30, 2006,JAKKS is entitled to receive a preferred payment equal to the greater of afixed guarantee, payable quarterly, or specified percentages of the net salesfrom the WWE-licensed games (as defined) in amounts that vary based on theplatform.  The payment of these amountsis guaranteed by us.  We are entitled tothe profits and cash distributions remaining after the payment of theseamounts.

 

Forperiods after June 30, 2006, the amount of the preferred payment will besubject to renegotiation between the parties. An arbitration procedure is specified in the event the parties do notreach agreement.

 

65

----

 

We areresponsible for the day-to-day operations of the venture.  We are responsible for development, salesand distribution of the WWE-licensed games, and JAKKS is responsible for theapproval process and other relationship matters with the WWE.

 

Forfinancial reporting purposes, we are deemed to control the venture; therefore,all venture operating results are consolidated with our results.

 

InNovember 2001, through the venture, we entered into a letter of intent toexpand the WWE license to include exclusive rights to other wrestling contentproduced by the WWE.  In exchange forthese rights we have agreed to increase the minimum guarantee payable to the WWEthrough December 31, 2009.

 

**14.   StockholdersRights Plan**

 

OnAugust 15, 2001, the Board of Directors (the Board) approved an amendedand restated Stockholders Rights Plan (the Plan).  Each share of common stock has one preferred stock purchase right(“Right”) associated with it.  Pursuantto the Plan, each Right entitles the holder to buy one one-thousandth (1/1000)of a share of a new series of preferred stock at an exercise price of $10,subject to adjustment.  The Rightsbecome exercisable 10 days after any person or group acquires, or 10 businessdays after any person or group has announced its intention to commence a tenderoffer for, 15% or more of the outstanding common stock.

 

In theevent that any person or group acquires 15% or more of our outstanding commonstock, each holder of a Right (other than such person or group) will beentitled to purchase, at the exercise price, the number of shares of commonstock having a current market value equal to two times the exercise price ofthe Right.

 

If weare acquired in a merger or other business combination, each holder of a Rightwill be entitled to purchase, at the exercise price, a number of shares ofcommon stock of the acquirer having a current market value equal to two timesthe exercise price of the Right.

 

We mayredeem the Rights at a redemption price of $.001 per right at any time until 10days after the acquisition of 15% of our common stock.  At any time after a person or group hasacquired 15% or more but less than 50% of our common stock, we may exchange allor part of the Rights for shares of common stock at an exchange ratio of oneshare of common stock for each Right or 1/1000 of such new series of preferredstock per Right, subject to adjustment. The rights expire on June 21, 2010.

 

**15.   Commitments andContingencies**

 

*Advertising.*  We have certain minimum advertisingcommitments under most of our major license agreements.  These minimum commitments generally rangefrom 2% to 12% of net sales related to the respective license.  We estimate that our minimum commitment foradvertising in fiscal 2004 will be $25.6 million.  We also have a commitment for $2.4 million under a sponsorshipagreement contingent upon certain events, the occurrence of which will requireus to make payments over the next three years.

 

*Leases.*  We are committed under operating leases withlease termination dates to 2014. Certain leases contain rent escalations.  Minimum future rentals pursuant to these leases as ofMarch 31, 2003 are as follows:

 
| **(In  thousands)** |   | **Facilities** |   | **Equipment** |   |
|---------------------|--------|----------------|--------|---------------|--------|
| 2004                |   | $              | 2,752  |          | $      | 455 |   |
| 2005                |   | $              | 3,298  |          | 399    |   |
| 2006                |   | $              | 2,950  |          | 273    |   |
| 2007                |   | $              | 1,370  |          | 175    |   |
| 2008                |   | $              | 1,234  |          | 65     |   |
| Thereafter          |   | 4,982          |   | —        |   |
|                |   | $              | 16,586 |          | $      | 1,367 |   |

 

Rentexpense was $1.1 million, $3.4 million, $2.7 million, and $2.2 million for thethree months ended March 31, 2003 and the years ended December 31,2002, 2001 and 2000, respectively.

 

OnFebruary 27, 2003, we entered into a lease agreement with an entitypartially owned by the head of one of our development studios.  The lease is for approximately 29,000 squarefeet of office space to be occupied by the development studio in Champaign,Illinois.  The property is currentlyunder development and should be ready for occupancy in April 2004.

 

*Warrants. *We arecommitted under various license and software development agreements to issuewarrants to purchase a total of approximately 430,000 shares of common stock.  At this time, the warrant terms related tothese 

 

66

----

 

variousagreements are being negotiated.  Wewill record the fair market value of these warrants when the terms arefinalized.**The fair market valuewill be included in license or software development in the accompanying balancesheet and will be amortized to license amortization and royalties or softwaredevelopment amortization over estimated sales for games not released and aportion may be recognized immediately for games that have been previouslyreleased.

 

*Legal Proceedings.*  We and certain of our officers and directorsare defendants in a class action lawsuit filed in the United States DistrictCourt for the Central District of California entitled *In re THQ Inc.* Securities Litigation,Master File No. CV-00-1783-AHM.  OnDecember 20, 2000, the court dismissed this action with prejudice as toall of the defendants.  OnApril 23, 2001, the United States District Court for the Central Districtof California modified its December 20, 2000 order and permittedplaintiffs to file a third amended complaint on that date.  Defendants filed an answer denying all of thematerial allegations of the third amended complaint and asserting legal andfactual defenses.  The third amendedcomplaint alleges that defendants violated Rule 10b-5 and Section 20(a) of theSecurities Exchange Act of 1934, including allegations that defendantsmanipulated our stock price; distributed false and misleading informationconcerning revenue recognition, forecasts and earnings estimates; selectivelydisclosed material information; and engaged in insider trading.  The complaint seeks an unspecified amount indamages.  As of December 31, 2002,we entered into a settlement agreement with the plaintiffs.  While we continue to deny plaintiffs’allegations, we agreed to pay $10.2 million under the terms of the settlementagreement to resolve all claims by plaintiffs against all defendants.  The District Court granted preliminaryapproval of the settlement on March 17, 2003, and a hearing to considerfinal approval is currently scheduled for June 30, 2003.  Our directors’ and officers’ insurance coverageprovides for $10.0 million towards the settlement agreement and related legalfees.

 

However,a dispute has arisen between us and our directors’ and officers’ insurancecarrier.  The insurance carrier assertsthat it is only obligated to contribute $5.0 million in coverage towards thesecurities litigation settlement. Pursuant to the terms of our insurance policy, the matter has beensubmitted to arbitration under the rules of the American Arbitration Association.  Although we expect to prevail, at this earlystage we cannot predict the likely outcome of this dispute.

 

As aresult of a court order in an action filed in the United Kingdom by the WorldWide Fund for Nature (the “Fund”) against World Wrestling Entertainment, Inc.(“WWE”) the use of the initials “WWF” was prohibited directly or indirectly bythe WWE after November 10, 2002. On November 10, 2002, upon instruction from the WWE, we ceasedsales of certain of our interactive entertainment software games containing the“WWF” brand.  These games containartwork files with the initials WWF and/or the WWF logo that cannot practicablybe removed from the games. Contemporaneously, in November 2002, we (through our joint ventureTHQ/JAKKS Pacific LLC (“THQ/JAKKS”)) filed an application for relief from thecourt order.  That application wasdenied by the trial court and an appeal was filed and heard on February 24and 25, 2003.  The appeals courtrendered its opinion on March 27, 2003, ruling that our continuedmarketing of these video games, with the “WWF” initials and brand removedexcept to the extent embedded in the games, is neither a breach of the courtorder against WWE nor a contempt of court. Following this ruling, we recommenced sales of the affected product.  In addition, since October 2002 we havebeen incorporating the “WWE” brand in place of the “WWF” brand in all of thenew wrestling games that we publish, including the recently published *WWE Road to WrestleMania X8* for Game BoyAdvance and *WWE SmackDown! Shut Your Mouth*for PlayStation 2.

 

Wereceived a demand from Motorola for indemnification under our license to it ofcertain wireless games distributed in France. The demand arises out of litigation commenced in France against Motorolaand their distribution partners for trademark infringement and unfaircompetition, which seeks $10.0 million in damages plus an unspecified amountand an accounting.  We in turn have madea claim for indemnification against the developer of the games.  Although we expect to prevail, at this earlystage we cannot predict the likely outcome of the demand for indemnification.

 

We areinvolved in other routine litigation arising in the ordinary course of ourbusiness.  In the opinion of ourmanagement, none of the other pending litigation will have a material adverseeffect on our consolidated financial condition or results of operations.

 

67

----

 

**16.   Segment andGeographic Information**

 

Weoperate in one reportable segment in which we are a developer, publisher and distributorof interactive entertainment software for the leading hardware platforms in thehome video game market.  The followinginformation sets forth geographic information on our sales and long-livedassets for the three months ended March 31, 2003 and each of the yearsended December 31, 2000, 2001 and 2002:

 
| **(In  thousands of dollars)**               |   | **United  States** | ** ** | **United  Kingdom** | ** ** | **Germany** | ** ** | **France** | ** ** | **Australia** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------|--------|--------------------|------------|---------------------|------------|-------------|------------|------------|------------|---------------|------------|------------------|------------|
|                                         |   |               | ** ** |                | ** ** |        | ** ** |       | ** ** |          | ** ** |             | ** ** |
| Year ended December 31, 2000:           |   |               |       |                |       |        |       |       |       |          |       |             |       |
| Sales to unaffiliated Customers              |   | $                  | 270,116    |                | $          | 44,638      |       | $          | 20,442     |          | $          | 7,979            |       | $ | 3,828 |   | $ | 347,003 |   |
|                                         |   |               |       |                |       |        |       |       |       |          |       |             |       |
| Long-lived assets at  December 31, 2000 |   | $                  | 16,792     |                | $          | 1,957       |       | $          | 1,971      |          | $          | 320              |       | $ | 235 |   | $ | 21,275 |   |
|                                         |   |               |       |                |       |        |       |       |       |          |       |             |       |
| Year ended December 31, 2001:           |   |               |       |                |       |        |       |       |       |          |       |             |       |
| Sales to unaffiliated Customers              |   | $                  | 262,676    |                | $          | 60,240      |       | $          | 25,517     |          | $          | 18,185           |       | $ | 12,374 |   | $ | 378,992 |   |
|                                         |   |               |       |                |       |        |       |       |       |          |       |             |       |
| Long-lived assets at  December 31, 2001 |   | $                  | 80,289     |                | $          | 3,541       |       | $          | 2,370      |          | $          | 267              |       | $ | 196 |   | $ | 86,663 |   |
|                                         |   |               |       |                |       |        |       |       |       |          |       |             |       |
| Year ended December 31, 2002:           |   |               |       |                |       |        |       |       |       |          |       |             |       |
| Sales to unaffiliated Customers              |   | $                  | 358,124    |                | $          | 67,218      |       | $          | 26,051     |          | $          | 14,556           |       | $ | 14,580 |   | $ | 480,529 |   |
|                                         |   |               |       |                |       |        |       |       |       |          |       |             |       |
| Long-lived assets at  December 31, 2002 |   | $                  | 101,104    |                | $          | 759         |       | $          | 2,721      |          | $          | 356              |       | $ | 244 |   | $ | 105,184 |   |
|                                         |   |               |       |                |       |        |       |       |       |          |       |             |       |
| Three Months ended March 31, 2003:      |   |               |       |                |       |        |       |       |       |          |       |             |       |
| Sales to unaffiliated Customers              |   | $                  | 56,649     |                | $          | 4,361       |       | $          | 2,802      |          | $          | 1,259            |       | $ | 1,729 |   | $ | 66,800 |   |
|                                         |   |               |       |                |       |        |       |       |       |          |       |             |       |
| Long-lived assets at  March 31, 2003    |   | $                  | 109,779    |                | $          | 2,323       |       | $          | 1,236      |          | $          | 392              |       | $ | 307 |   | $ | 114,037 |   |

 

68

----

 

**17.   QuarterlyFinancial Data (Unaudited)**

 

*Twelve Months Ended March 31,2003*

 
|                                               |   | **Quarters  Ended**     |   |
|----------------------------------------------------|--------|-------------------------|--------|
| **(Amounts in thousands,  except per share data)** |   | **June 30,  2002** |   | **September 30,  2002** |   | **December 31,  2002** |   | **March 31,  2003** |   | **Pro Forma  Total** |   |
|                                               |   |                    |   |   |   |   |   |   |   |   |   |
| Revenues                                           |   | $                       | 85,762 |   | $ | 97,335 |   | $ | 217,750 |   | $ | 66,800 |   | $ | 467,647 |   |
| Expenses                                           |   | 80,893                  |   | 89,895 |   | 214,728 |   | 77,776 |   | 463,292 |   |
| Income before income taxes                         |   | 4,869                   |   | 7,440 |   | 3,022 |   | (10,976 | ) | 4,355 |   |
| Income taxes                                       |   | 2,578                   |   | 2,636 |   | (112 | ) | (3,290 | ) | 1,812 |   |
| Net income                                         |   | $                       | 2,291  |   | $ | 4,804 |   | $ | 3,134 |   | $ | (7,686 | ) | $ | 2,543 |   |
|                                               |   |                    |   |   |   |   |   |   |   |   |   |
| Net income per share                               |   |                    |   |   |   |   |   |   |   |   |   |
| Basic                                              |   | $                       | 0.06   |   | $ | 0.12 |   | $ | 0.08 |   | $ | (0.20 | ) | $ | 0.07 |   |
| Diluted                                            |   | $                       | 0.05   |   | $ | 0.12 |   | $ | 0.08 |   | $ | (0.20 | ) | $ | 0.06 |   |

* *

*Twelve Months Ended March 31,2002*

 
|                                               |   | **Quarters  Ended**     |   |
|----------------------------------------------------|--------|-------------------------|--------|
| **(Amounts in thousands,  except per share data)** |   | **June 30,  2001** |   | **September 30,  2001** |   | **December 31,  2001** |   | **March 31,  2002** |   | **Pro Forma  Total** |   |
|                                               |   |                    |   |   |   |   |   |   |   |   |   |
| Revenues                                           |   | $                       | 55,236 |   | $ | 68,045 |   | $ | 196,383 |   | $ | 79,682 |   | $ | 399,346 |   |
| Expenses                                           |   | 49,696                  |   | 62,930 |   | 151,664 |   | 75,258 |   | 339,548 |   |
| Income before income taxes                         |   | 5,540                   |   | 5,115 |   | 44,719 |   | 4,424 |   | 59,798 |   |
| Income taxes                                       |   | 2,086                   |   | 1,901 |   | 16,234 |   | 1,659 |   | 21,880 |   |
| Net income                                         |   | $                       | 3,454  |   | $ | 3,214 |   | $ | 28,485 |   | $ | 2,765 |   | $ | 37,918 |   |
|                                               |   |                    |   |   |   |   |   |   |   |   |   |
| Net income per share                               |   |                    |   |   |   |   |   |   |   |   |   |
| Basic                                              |   | $                       | 0.11   |   | $ | 0.10 |   | $ | 0.81 |   | $ | 0.07 |   | $ | 1.09 |   |
| Diluted                                            |   | $                       | 0.10   |   | $ | 0.09 |   | $ | 0.75 |   | $ | 0.07 |   | $ | 1.01 |   |

 

*Twelve Months Ended March 31, 2001*

 
|                                                   |   | **Quarters  Ended** |   |
|--------------------------------------------------------|--------|---------------------|--------|
| **(Amounts in thousands, except per share data)** |   | **June 30,  2000**  |   | **September  30,  2000** |   | **December  31,  2000** |   | **March 31,  2001** |   | **Pro Forma  Total** |   |
|                                                   |   |                |   |   |   |   |   |   |   |   |   |
| Revenues                                               |   | $                   | 32,401 |   | $ | 53,293 |   | $ | 190,931 |   | $ | 59,328 |   | $ | 335,953 |   |
| Expenses                                               |   | 45,397              |   | 50,468 |   | 157,330 |   | 57,986 |   | 311,181 |   |
| Income before income taxes                             |   | (12,996             | )      | 2,825 |   | 33,601 |   | 1,342 |   | 24,772 |   |
| Income taxes                                           |   | (5,227              | )      | 1,510 |   | 13,644 |   | 482 |   | 10,409 |   |
| Net income                                             |   | $                   | (7,769 | ) | $ | 1,315 |   | $ | 19,957 |   | $ | 860 |   | $ | 14,363 |   |
|                                                   |   |                |   |   |   |   |   |   |   |   |   |
| Net income per share                                   |   |                |   |   |   |   |   |   |   |   |   |
| Basic                                                  |   | $                   | (0.27  | ) | $ | 0.04 |   | $ | 0.66 |   | $ | 0.03 |   | $ | 0.48 |   |
| Diluted                                                |   | $                   | (0.27  | ) | $ | 0.04 |   | $ | 0.61 |   | $ | 0.03 |   | $ | 0.45 |   |
|                                                   |   |                |   |   |   |   |   |   |   |   |   |

 

 

Due torounding some of the figures above may differ slightly from the 10-Q’spreviously filed.

 

Forthe quarter ended December 31, 2002, net income includes a charge of $7.9million, net of tax for the cancellation of 20 SKUs as well as a charge of $4.6million, net of tax related to the settlement of a class action lawsuit and acharge of $1.1 million, net of tax related to the write-off of inventory andsoftware development for “WWF”-branded games that we have been prevented fromshipping pursuant to an action by the World Wide Fund for Nature against WorldWrestling Entertainment, Inc.

 

Forthe quarter ended March 31, 2003, net income includes a charge of $1.8million due to the other than temporary impairment of our investment in Yuke’sCo., Ltd.

 

69

----

 

**Item 9**.*                                  *CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

** **

None.

 

70

----

 

**PARTIII**

 

**Item 10**.*                           *DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT

** **

Theinformation required under this Item relating to members of our Board ofDirectors and Executive Officers will be included in our 2003 Notice of AnnualMeeting of Shareholders and Proxy Statement under the headings “Election ofDirectors,” “Executive Officers,” “Key Employees,” “Compliance with Section 16of the Securities Exchange Act of 1934” and “Director and Officer Holdings,”which will be filed within 120 days after the close of our fiscal year, and isincorporated herein by reference.

 

**Item 11**.*                           *EXECUTIVECOMPENSATION

** **

Theinformation required under this Item relating to executive compensation will beincluded in our 2003 Notice of Annual Meeting of Shareholders and ProxyStatement under the heading “Executive Compensation,” which will be filedwithin 120 days after the close of our fiscal year, and is incorporated hereinby reference.

 

**Item 12**.*                           *SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

** **

Theinformation required under this Item relating to security ownership of certainbeneficial owners and management will be included in our 2003 Notice of AnnualMeeting of Shareholders and Proxy Statement under the heading “PrincipalShareholders,” which will be filed within 120 days after the close of ourfiscal year, and is incorporated herein by reference.

 

**Item 13**.*                           *CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

** **

Therewere no reportable relationships or transactions with management during thethree months ended March 31, 2003.

 

**Item 14**.*                           *DISCLOSURECONTROLS AND PROCEDURES

** **

Our Chief Executive Officer and Chief Financial Officer,as of a date within 90 days before the filing of this Form 10-K, have evaluatedour disclosure controls and procedures (as defined in Rules 13a-14 and 15d-14under the Securities Exchange Act of 1934) and have concluded that suchcontrols and procedures are effective. There have been no significant changes in internal controls or in otherfactors that could significantly affect these controls subsequent to the dateof their evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 

71

----

 

**PART IV**

** **

**Item 15**.                            EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

** **

**(a)**          *Financial Statements and FinancialStatement Schedules*

** **

The following financial statements of the Company areincluded in Part II Item 8:

 
| INDEPENDENT AUDITORS’ REPORT                                                                                                                                                                                            |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| CONSOLIDATED FINANCIAL STATEMENTS                                                                                                                                                                                            |
| Consolidated Balance Sheets — March 31, 2003, December 31,  2002 and 2001                                                                                                                                     |
| Consolidated Statements of Operations for  the Three months  Ended March 31,  2003, the Three Months Ended March 31, 2002 (Unaudited) and Each of the  Three Years in the Period Ended December 31, 2002 |
| Consolidated Statements of Stockholders’  Equity for March 31, 2003 and Each of the Three Years in the Period  Ended December 31, 2002                                                                        |
| Consolidated Statements of Cash Flows for  the Three months  Ended March 31,  2003, the Three Months Ended March 31, 2002 (Unaudited) and Each of the  Three Years in the Period Ended December 31, 2002 |
| NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                                                                                                                                                                                   |

** **

**(b)**          *Reports on Form 8-K.*

** **

Current Report on Form8-K dated February 12, 2003, reporting under Item 5 and 8.

 

**(c)**          *Exhibits.*

** **

The following exhibitsare filed herewith or are incorporated by reference to exhibits previouslyfiled with the SEC.  We will furnishcopies of the exhibits for a reasonable fee (covering the expense of furnishingcopies) upon request:

 
| **Exhibit  Number** |   | **Title**                                                                                                                                                                                                                                                                                                                                |
|---------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |   | Certificate  of Incorporation (incorporated by reference to Exhibit 3.1 to Post-Effective  Amendment No. 1 to the Registration Statement on Form S-3 filed on January 9,  1998 (File No. 333-32221) (the “S-3 Registration Statement”)).                                                                                       |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.2                 |   | Amendment to  Certificate of Incorporation (incorporated by reference to Exhibit 3.2 to  Post-Effective Amendment No. 1 to the S-3 Registration Statement).                                                                                                                                                                              |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.3                 |   | Amendment to  Certificate of Incorporation (incorporated by reference to Exhibit 3.3 to the  Registrant’s Quarterly Report on Form 10-Q for the period ended June 30, 2001  (the “June 2001 10-Q”)).                                                                                                                      |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.4                 |   | Amended and  Restated Bylaws (incorporated by reference to Exhibit 3 to the Registrant’s  Current Report on Form 8-K, dated June 22, 2000).                                                                                                                                                                                         |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.5                 |   | Certificate  of Designation of Series A Junior Participating Preferred Stock of THQ Inc.  (incorporated by reference to Exhibit A of Exhibit 1 of Amendment No. 2 to  the Registrant’s Registration Statement on Form 8-A filed on August 28, 2001  (File No. 001-15959) (the “August 2001 Form 8-A”)).                   |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 3.6                 |   | Amendment to  Certificate of Designation of Series A Junior Participating Preferred Stock  of THQ Inc. (incorporated by reference to Exhibit 3.6 to the Registrant’s  Quarterly Report on Form 10-Q for the quarterly period ended September 30,  2001 (the “September 2001 10-Q”)).                                      |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 4.1                 |   | Amended and  Restated Rights Agreement, dated as of August 22, 2001 between the Registrant  and Computershare Investor Services, LLC, as Rights Agent (incorporated by  reference to Exhibit 1 to Amendment No. 2 to the Registrant’s August 2001  Form 8-A).                                                                       |
|                |   |                                                                                                                                                                                                                                                                                                                                     |
| 4.2                 |   | First Amendment to  Amended and Restated Rights Agreement, dated April 9, 2002 between the  Registrant and Computershare Investor Services, LLC, as Rights Agent  (incorporated by reference to Exhibit 2 to Amendment No.3 to the Registrant’s  Registration Statement on Form 8-A filed on April 12, 2002 (file No.  000-18813)). |

 

 

72

----

 
| 10.1†  |   | Amended and  Restated Employment Agreement dated as of January 1, 2001, between the  Company and Brian J. Farrell (incorporated by reference to Exhibit 10.1 to  the Registrant’s Annual Report on Form 10-K for the fiscal year ended  December 31, 2000 (the “December 2000 10-K”)).                                     |
|-------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.2†  |   | Amended and  Restated Employment Agreement dated as of January 1, 2001, between the  Company and Jeffrey C. Lapin (incorporated by reference to Exhibit 10.2 to  the Registrant’s December 2000 10-K).                                                                                                                               |
|        |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.3†  |   | Letter Agreement, dated November 16, 2002, between the Company and  Jeffrey C. Lapin (incorporated by reference to Exhibit 10.3 to the  Registrant’s Annual Report on Form 10-K for the fiscal year ended December  31, 2002 (the “December 2002 10-K”)).                                                                  |
|        |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.4†  |   | Employment Agreement between Fred A. Gysi and the Company dated  October 1, 1997 (incorporated by reference to Exhibit 10.6 to the  Registrant’s Annual Report on Form 10-K for the fiscal year ended December  31, 1998 (the “December 1998 10-K”)).                                                                      |
|        |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.5†  |   | Form of Severance Agreement with Executive Officers (incorporated by  reference to Exhibit 10.7 to the December 1998 10-K).                                                                                                                                                                                                               |
|        |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.6†  |   | Amended and Restated 1990 Stock Option Plan  (incorporated by reference to Exhibit 10.1 to the Registrant’s Registration  Statement on Form S-2 filed on December 23, 1996 (File No. 333-18641)).                                                                                                                                    |
|        |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.7†  |   | Stock Option  Agreement dated as of August 28, 1996, between the Company and Brian J.  Farrell (incorporated by reference to Exhibit 10.31 to the Registrant’s  Annual Report on Form 10-K for the fiscal year ended December 31, 1996).                                                                                             |
|        |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.8†  |   | Amended and  Restated 1997 Stock Option Plan (incorporated by reference to Appendix A to  Registrant’s Proxy Statement On Schedule 14A filed on June 25, 2001).                                                                                                                                                                      |
|        |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.9†  |   | Form of  Stock Option Agreement for the Amended and Restated 1997 Stock Option Plan  (incorporated by reference to Exhibit 10.8 to the Registrant’s Annual Report  on Form 10-K for the fiscal year ended December 31, 2001 (the “December 2001  10-K”)).                                                                  |
|        |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.10† |   | Form of  Stock Option Agreement dated as of December 23, 1998, between the Company and  each of Messrs. Lawrence Burstein and James Whims (incorporated by reference  to Exhibit 10.9 to the Registrant’s June 1999 10-Q).                                                                                                           |
|        |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.11† |   | Second  Amended and Restated Nonexecutive Employee Stock Option Plan dated as of  March 6, 2002 (incorporated by reference to Exhibit 10.2 to the Registrant’s  Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2002).                                                                                        |
|        |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.12† |   | Form of  Nonexecutive Employee Stock Option Agreement for the Second Amended and  Restated Nonexecutive Employee Stock Option Plan (incorporated by reference  to Exhibit 4.10 to the Registrant’s Registration Statement on Form S-8 filed  on June 21, 2002 (File No. 333-90986)).                                                 |
|        |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.13       |   | Second  Amendment to Revolving Credit Agreement, dated as of February 20, 2001,  between the Company, Union Bank as Agent and as Lender, BNP Paribas, and  Pacific Century Bank, N.A. (incorporated by reference to Exhibit 10.3 to the  Registrant’s Quarterly Report on Form 10-Q for the quarterly period ended  March 30, 2001). |
|        |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.14       |   | Third  Amendment to Revolving Credit Agreement, dated as of June 12, 2001, between  the Company, Union Bank as Agent and as Lender, BNP Paribas, and Pacific  Century Bank, N.A. (incorporated by reference to Exhibit 10.2 to the  Registrant’s June 2001 10-Q).                                                                    |
|        |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.15       |   | Fourth  Amendment to Revolving Credit Agreement, dated as of July 31, 2001, between  the Company, Union Bank as Agent and as Lender and BNP Paribas (incorporated  by reference to Exhibit 10.3 to the Registrant’s June 2001 10-Q).                                                                                                 |
|        |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.16       |   | Fifth Amendment to  Revolving Credit Agreement, dated as of August 28, 2001, between the Company,  Union Bank as Agent and as Lender and BNP Paribas (incorporated by reference  to Exhibit 10.1 to the Registrant’s September 2001 10-Q).                                                                                           |
|        |   |                                                                                                                                                                                                                                                                                                                                      |
| 10.17       |   | Sixth  Amendment to Revolving Credit Agreement, dated as of October 26, 2001,  between the Company, Union Bank as Agent and as Lender and BNP Paribas  (incorporated by reference to Exhibit 10.2 to the Registrant’s September 2001  10-Q).                                                                                         |
|        |   |                                                                                                                                                                                                                                                                                                                                      |

 

 

73

----

 
| 10.18  |   | Seventh  Amendment to Revolving Credit Agreement and First Amendment to Security  Agreement, dated as of January 8, 2002, between the Company, Union Bank as  Agent and as Lender and BNP Paribas (incorporated by reference to Exhibit  10.18 to the Registrant’s December 2001 10-K).                                                                                                                                                                                                                                                                                                          |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.19  |   | Eighth Amendment to  Revolving Credit Agreement, dated as of May 1, 2002, between the Company,  Union Bank as Agent and as Lender and BNP Paribas (incorporated by reference  to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q for the  quarterly period ended June 30, 2002 (the “June 2002 10-Q”)).                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.20  |   | Ninth  Amendment to Revolving Credit Agreement, dated as of July 26, 2002, between  the Company, Union Bank as Agent and as Lender and BNP Paribas (incorporated  by reference to Exhibit 10.2 to the Registrant’s June 2002 10-Q).                                                                                                                                                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.21  |   | Waiver under  Revolving Credit Agreement, dated as of September 10, 2002 by and between the  Company and Union Bank (incorporated by reference to Exhibit 10.1 to the  Registrant’s Quarterly Report on Form 10-Q for the quarterly period ended  September 30, 2002 (the “September 2002 10-Q”)).                                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.22  |   | Amended and  Restated Revolving Credit Agreement, dated as of September 27, 2002 by and  between the Company and Union Bank (incorporated by reference to Exhibit 10.2  to the Registrant’s September 2002 10-Q).                                                                                                                                                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.23  |   | First  Amendment to the Amended and Restated Revolving Credit Agreement, dated  November 21, 2002, by and between the Company and Union Bank (incorporated by  reference to Exhibit 10.24 to the Registrant’s December 2002 10-K).                                                                                                                                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.24  |   | Waiver under  Amended and Restated Revolving Credit Agreement, dated February 21, 2003, by  and between the Company and Union Bank (incorporated by reference to Exhibit  10.25 to the Registrant’s December 2002 10-K).                                                                                                                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.25  |   | Second Amendment to Security Agreement, dated as of September 27,  2002 between the Company and Union Bank (incorporated by reference to Exhibit  10.3 to the Registrant’s September 2002 10-Q).                                                                                                                                                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.26  |   | Confidential License  Agreement for Game Boy, Game Boy Color and Game Boy Pocket Handheld Video  Game Systems (Western Hemisphere), dated as of March 9, 1999, between  Nintendo of America Inc. (“NOA”) and the Company (incorporated by reference  to Exhibit 10.4 to the Registrant’s September 2002 10-Q).  (Portions have been omitted and filed  separately with the Securities and Exchange Commission pursuant to a request  for confidential treatment in accordance with Rule 24b-2 under the Securities  Exchange Act of 1934, as amended (“Exchange Act”)). |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.27  |   | First  Amendment to the Confidential License Agreement for Game Boy, Game Boy Color  and Game Boy Pocket Handheld Video Game Systems (Western Hemisphere) dated as  of March 8, 2002, between NOA and the Company (incorporated by  reference to Exhibit 10.5 to the Registrant’s September 2002 10-Q).                                                                                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.28  |   | Confidential License  Agreement for Game Boy Advance (Western Hemisphere), dated as of July 18,  2001, between NOA and the Company (incorporated by reference to Exhibit 10.6  to the Registrant’s September 2002 10-Q).   (Portions have been omitted and filed separately with the Securities  and Exchange Commission pursuant to a request for confidential treatment in  accordance with Rule 24b-2 under the Exchange Act.).                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.29  |   | Confidential  License Agreement for Nintendo GameCube (Western Hemisphere), dated as of  April 5, 2002, between NOA and the Company (Western Hemisphere) (incorporated  by reference to Exhibit 10.7 to the Registrant’s September 2002 10-Q).   (Portions have been omitted and filed separately with the Securities  and Exchange Commission pursuant to a request for confidential treatment in  accordance with Rule 24b-2 under the Exchange Act.)                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.30  |   | Microsoft Corporation  Xbox TM Publisher License Agreement, dated as of March 20, 2001, between  Microsoft Corporation and the Company (incorporated  by reference to Exhibit 10.8 to the Registrant’s September 2002 10-Q).  (Portions have been omitted and filed  separately with the Securities and Exchange Commission pursuant to a request  for confidential treatment in accordance with Rule 24b-2 under the Exchange  Act.)                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.31  |   | Licensed  Publisher Agreement, dated as of August 28, 2002, by and between Sony  Computer Entertainment America Inc. (“Sony”) and the Company (incorporated  by reference to Exhibit 10.9 to the Registrant’s September 2002 10-Q).   (Portions have been omitted and filed separately with the Securities  and Exchange Commission pursuant to a request for confidential treatment in  accordance with Rule 24b-2 under the Exchange Act.)                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |

 

 

74

----

 
| 10.32  |   | PlayStation ® 2 CD-Rom/  DVD-Rom Licensed Publisher Agreement, dated as of April 1, 2000, between Sony  and the Company (incorporated by  reference to Exhibit 10.10 to the Registrant’s September 2002 10-Q).  (Portions have been omitted and filed  separately with the Securities and Exchange Commission pursuant to a request  for confidential treatment in accordance with Rule 24b-2 under the Exchange  Act.)                                             |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.33  |   | PlayStation® Licensed  Publisher Agreement, dated as of June 25, 1998, between Sony Computer  Entertainment Europe and THQ International Limited (incorporated by reference to Exhibit 10.11 to the Registrant’s  September 2002 10-Q).  (Portions have  been omitted and filed separately with the Securities and Exchange Commission  pursuant to a request for confidential treatment in accordance with Rule  24b-2 under the Exchange Act.)                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.34  |   | PlayStation® Licensed  Publisher — Supplemental Agreement, dated as of June 25, 1998, between Sony  Computer Entertainment Europe and THQ International Limited (incorporated by reference to Exhibit  10.12 to the Registrant’s September 2002 10-Q).  (Portions have been omitted and filed separately with the  Securities and Exchange Commission pursuant to a request for confidential  treatment in accordance with Rule 24b-2 under the Exchange Act.) |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.35* |   | Second  Amendment to the Amended and Restated Revolving Credit Agreement and Third  Amendment to the Security Agreement, dated May 30, 2003, by and between the  Company and Union Bank of California, N.A., as sole lender, and Union Bank of  California, N.A., as administrative agent for the Lender (incorporated by  reference to Exhibit 10.24 to the Registrant’s December 2002 10-K).                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 21*    |   | Subsidiaries  of the Registrant.                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 23.1*  |   | Consent of  Deloitte & Touche LLP.                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 99.1*  |   | Certification  of Brian J. Farrell, Chief Executive Officer, Pursuant to Section 1350 of  Chapter 63 of Title 18 of the United States Code.                                                                                                                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 99.2*  |   | Certification of Fred A. Gysi, Chief Financial Officer, Pursuant to  Section 1350 of Chapter 63 of Title 18 of the United States Code.                                                                                                                                                                                                                                                                                                                                             |

 

----

†                                          Managementcontract or compensatory plan or arrangement required to be filed as an exhibithereto pursuant to Item 14(c) of Form 10-K.

 

*                                         Filedherewith.

 

75

----

 

**SIGNATURES**

** **

Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this report to be signed on its behalf bythe undersigned thereunto duly authorized.

 
| Dated:  June 11, 2003 | THQ INC. |
|---------------------------------|----------|
|                            | By:      | /s/ Brian J. Farrell |   |
|                            |     | Brian  J. Farrell, Chairman of the Board,  President and Chief Executive Officer |

 

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities and on the dates indicated.

 
| **Signature**                 |   | **Title** |                                                                                                                                                       | **Date** |
|-------------------------------|--------|-----------|------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|
|                          |   |      |                                                                                                                                                       |     |
|                          |   |      |                                                                                                                                                       |     |
| /s/  Brian J.  Farrell   |   |      | Director, Chairman of the Board, President and Chief  Executive Officer (Principal Executive Officer)                                                      |     | June 11, 2003 |
| Brian J. Farrell              |   |      |                                                                                                                                                       |
|                          |   |      |                                                                                                                                                       |     |
|                          |   |      |                                                                                                                                                       |     |
| /s/  Fred A.  Gysi       |   |      | Senior Vice President -  Finance and Administration, Chief Financial Officer and Secretary (Principal  Financial Officer and Principal Accounting Officer) |     | June 11, 2003 |
| Fred A. Gysi                  |   |      |                                                                                                                                                       |
|                          |   |      |                                                                                                                                                       |
|                          |   |      |                                                                                                                                                       |     |
| /s/  Lawrence  Burstein  |   |      | Director                                                                                                                                                   |     | June 11, 2003 |
| Lawrence Burstein             |   |      |                                                                                                                                                       |     |
|                          |   |      |                                                                                                                                                       |     |
|                          |   |      |                                                                                                                                                       |     |
| /s/  James L.  Whims     |   |      | Director                                                                                                                                                   |     | June 11, 2003 |
| James L. Whims                |   |      |                                                                                                                                                       |     |
|                          |   |      |                                                                                                                                                       |     |
|                          |   |      |                                                                                                                                                       |     |
| /s/  L.  Gregory Ballard |   |      | Director                                                                                                                                                   |     | June 11, 2003 |
| L. Gregory Ballard            |   |      |                                                                                                                                                       |     |
|                          |   |      |                                                                                                                                                       |     |
|                          |   |      |                                                                                                                                                       |     |
| /s/  Brian  Dougherty    |   |      | Director                                                                                                                                                   |     | June 11, 2003 |
| Brian Dougherty               |   |      |                                                                                                                                                       |     |
|                               |        |           |                                                                                                                                                            |          |  |  |  |  |  |

 

76

----

 

**CERTIFICATIONS**

 

I,Brian J. Farrell, Chief Executive Officer of THQ Inc., certify that:

 

1.                                       Ihave reviewed this transitional report on Form 10-K of THQ Inc., theregistrant;

 

2.                                       Basedon my knowledge, this transitional report does not contain any untrue statementof a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this transitionalreport;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this transitional report, fairly present in all material respectsthe financial condition, results of operations and cash flows of the registrantas of, and for, the periods presented in this transitional report;

 

4.                                       Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

a.                                      designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this transitional report is being prepared;

 

b.                                     evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this transitional report (the“Evaluation Date”); and

 

c.                                      presentedin this transitional report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.                                       Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

a.                                      allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b.                                     anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officers and I have indicated in thistransitional report whether there were significant changes in internal controlsor in other factors that could significantly affect internal controlssubsequent to the date of our most recent evaluation, including any correctiveactions with regard to significant deficiencies and material weaknesses.

 

 
| Date:  June 11, 2003 |   |                     |
|--------------------------------|--------|--------------------------|
|                           |   |                     |
|                           |   |                     |
|                           | By:    | /s/  Brian J. Farrell    |   |
|                           |   |                     |
|                           |   | Brian  J. Farrell        |
|                           |   | Chief  Executive Officer |

 

----

 

**CERTIFICATIONS**

 

1.                                       Ihave reviewed this transitional report on Form 10-K of THQ Inc., theregistrant;

 

2.                                       Basedon my knowledge, this transitional report does not contain any untrue statementof a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this transitionalreport;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this transitional report, fairly present in all material respectsthe financial condition, results of operations and cash flows of the registrantas of, and for, the periods presented in this transitional report;

 

4.                                       Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

a.                                      designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this transitional report is being prepared;

 

b.                                     evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this transitional report (the“Evaluation Date”); and

 

c.                                      presentedin this transitional report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.                                       Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

a.                                      allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b.                                     anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officers and I have indicated in thistransitional report whether there were significant changes in internal controlsor in other factors that could significantly affect internal controlssubsequent to the date of our most recent evaluation, including any correctiveactions with regard to significant deficiencies and material weaknesses.

 

 
| Date:  June 11, 2003 |   |                    |
|--------------------------------|--------|-------------------------|
|                           |   |                    |
|                           |   |                    |
|                           | By:    | /s/  Fred A. Gysi       |   |
|                           |   |                    |
|                           |   | Fred A. Gysi            |
|                           |   | Chief Financial Officer |

 

----