When investors think about opportunities in the video-game sector, two of the names most likely to pop up are Activision (NASDAQ:ATVI) and Electronic Arts (NASDAQ:ERTS). They're arguably the two biggest brands in the business, and they're low-risk in nature over the long term. Not as many observers would think so quickly of THQ (NASDAQ:THQI), but taking a similar long-term view of this company reveals some healthy potential. Let's take a closer look.

One of the best ways to vet an opportunity is to check out a company's 10-K document -- otherwise known as its annual report. THQ just released its yearly filing, so let's see what it might tell us.

(Numbers in thousands except for per-share statistics)

Metric

2006

2005

2004

Net sales

$806,560

$756,731

$640,846

Operating income

$33,754

$73,918

$48,858

Net income

$34,269

$62,790

$35,839

Net income per diluted share

$0.52

$1.04

$0.61

Net cash from operations

$42,789

$60,455

$71,154

Capital expenditures and acquisitions

$35,394

$35,885

$9,938

Free cash flow

$7,395

$24,570

$61,216


Between 2004 and 2006, net sales gained by a solid 26%. Operating income, however, went from $49 million to $34 million over the same two-year timeframe, for a not-so-hot 31% drop, and net income on a dollar basis remained flat. The decline was pretty significant on a per-diluted-share basis, going from $0.61 to $0.52. And in terms of cash flows, there were very precipitous declines, especially in regard to the all-important free cash level. In addition, while there were share buybacks in 2004 and 2005, the company didn't repurchase a single share last year.

Track the cash
Let's take a deeper look at the decline in cash flows. Net cash from operations declined every year between '04 and '06 -- costs for software development and various accrued expenses are taking their toll. Free cash flow has really been cut down in size, going from approximately $61 million in 2004 to a little more than $7 million in 2006.

You'll notice that I went beyond the usual rule of thumb regarding the calculation of free cash flow. Oftentimes, Fools will deduct only additions to property, plant, and equipment -- the infamous capital-expenditure or "capex" requirements we're all so fond of -- from net operational cash flow when deducing the free cash. I believe it is important to consider acquisitions here, since they are arguably inextricably linked to THQ's future performance.

I think it's a wonder that THQ is able to hold on to any free cash -- by way of comparison, Electronic Arts had no cash left over in 2006 after capital expenditures and acquisitions. The selling environment is tough out there as consumers increasingly refuse to invest in current-generation consoles and balk at $49.99 price points for game titles. Promotional programs, meanwhile, cost money, but publishers have no choice if they want to move inventories through the retail channels.

But think about this: THQ has no debt. It also increased its level of cash and cash equivalents, from $81 million in 2004 to approximately $92 million in 2006. That's a pretty good position to be in, and it's proof that the company is being competently stewarded through a difficult time. The acquisition investments will prove to be valuable down the line -- they are requisite if THQ wants to keep up with the increasing technical complexity that the PlayStation 3 and its contemporaries possess. Great talent and even greater development systems will be needed for THQ to stay ahead of the curve.

I'd say this is indicative of a healthy software company, one that is poised to benefit from new consoles. If you go just by the raw data, THQ is an easy sell. But when you consider that the numbers on the chart should improve and grow over the next few years, then the thesis becomes more sanguine.

Why will THQ prosper?
THQ, like all software companies dedicated to entertainment, is preparing for the future. As such, it is aggressively spending to develop titles that will appeal to gamers who buy the new console systems. Sony (NYSE:SNE) and Nintendo are set to release their new technologies in the latter part of the year; Microsoft (NASDAQ:MSFT) already has its Xbox 360 in the marketplace. When all three platforms reach a critical mass -- something that will take a bit of time, especially as both investors and consumers wait for the eventual price cuts that will fuel significant mass sales -- the costs of shelling out today will pay off handsomely.

To get a feeling of why THQ will benefit from the next wave of gaming units, we have to look at the company's portfolio of products. THQ has a great business model that's buttressed by a strong licensing program. The company makes games based on Disney's (NYSE:DIS) Pixar properties, like the just-released titles based on the animated flick Cars. The publisher has also made titles based on Finding Nemo and The Incredibles. Kids are naturally drawn toward these brand names, so they're an easy sell; plus, as others have mentioned, they also make buying decisions simple for gift-givers. When Grandma goes in to get a Christmas gift for her grandson, she might immediately be drawn to the Disney/Pixar brand and grab it off the shelf to end her search as quickly as possible.

But Pixar cartoons aren't the only properties THQ can take advantage of. It also licenses Nickelodeon cartoons, a few of which I've played in my time. Nicktoons Unite! was a fun one on the GameBoy Advance. Games based on the underwater universe of SpongeBob SquarePants have also brought in a lot of cash for THQ. Meanwhile, Time Warner's (NYSE:TWX) Scooby-Doo character has been given the game treatment, as have as the superstars of World Wrestling Entertainment, both thanks to a joint venture between THQ and Jakks Pacific. In addition, THQ produces great original titles, including franchise-in-the-making Destroy All Humans! A sequel is on its way.

But what about the price?
Let's say you believe that THQ is a great company. The big question then is whether the shares are cheap.

The company expects to earn between $0.90 and $1.00 per share in fiscal 2007, minus stock compensation. The effect of such equity-based payment is expected to be $0.16 per share. If we say that earnings fall in the middle of the range and then add in the stock compensation, we've got $0.79 per share. THQ is trading, as I write this, at around $20 per stub. Analysts believe that the company could grow by about 19% over the next several years. That comes out to a PEG ratio of about 1.33.

That's not exactly cheap, but for a company on the verge of the next console revolution, I don't think it's exorbitantly expensive, either. Also keep in mind that the stock isn't far from its 52-week low. And both Electronic Arts and Activision currently sport higher PEG ratios.

Foolish final words
I'd say THQ is worth some serious consideration, especially if the price of the shares gets cheaper from here. Like all stocks, it has the potential to become more attractively valued because of the current marketplace volatility. A strategy that might work here is initiation of a small position, followed by dollar-cost averaging -- but only after a full round of Foolish due diligence, naturally.

Read over the company's annual report to get a full feel of its approach to the video-game business and the various hot titles it has released over the past several years. Overall, THQ is a well-managed operation just waiting for the next-generation cycle to rev up its free cash flow. This isn't to say that either EA or Activision are bad ideas -- they, too, will rise the next few years. But THQ should nevertheless be thrown into the mix for consideration.

Plug these Takes into your Motley Fool Entertainment System:

Electronic Arts, Disney, and Time Warner, and Activision are Motley Fool Stock Advisor recommendations. Try out Tom and David Gardner's newsletter service free for 30 days.

Microsoft is a Motley Fool Inside Value pick.

Fool contributor Steven Mallas owns shares of Disney. The Fool has a disclosure policy.