Misunderstood Toy Maker Presents Opportunity

I’ve been following Jakks Pacific (JAKK) since September, and since then it has become more attractive as an investment. I originally wrote about JAKK in a small blog post in which I covered two charts I was interested in. I gave a rough presentation about the company and why I thought the stock was mis-priced. However, back in those days of the website, not many people read my work. Because of this, I want to do a deeper investigation into JAKK as it’s share price has fallen to all time lows, yet the value remains the same if not larger to me.

JAKK is a vastly undervalued company with tremendous branding power in the United States coupled with dynamic partnerships with companies that produce high-grossing movies and characters. JAKK will never run out of ideas for products, and as long as movies are made, there will be toys to be made after them. Best of all, you can place a long bet on the movie industry in a company trading at half of its book value, and nearly its cash value.

Passing the Circle of Competence

JAKK is an easy business to understand. In general, the company makes toys and then sells those toys. According to GuruFocus, JAKK produces traditional toys and electronics such as action figures, toy vehicles, dolls and accessories, ride-on toys, and toys for pets. The company also offers role play, novelty and seasonal toys such as dress-up and pretend to play toys. The company divides its toy market sales into proprietary toys and partnership toys. Their “in-house” toys include Road Champs, Spy Net, Fisher Price, Kawasaki, and JAKKS Pets. The company also partners with many popular brands such as Disney & Black & Decker to produce toys specific to movies. The company sells their product in the US, Europe, Canada, and Hong Kong.

Fundamental Foundation

The company is cheap from a fundamental metrics basis, no doubt. The company trades at roughly half book value, 0.08x sales, and 2.26x FCF. Further, the company trades at nearly its Price to Operating Cash Flow, and its EV/Revenues is 0.27. Finally, the company is trading at 1.59 NCAV. All of these metrics make it one of the cheapest, if not the cheapest company in its industry.

So why the extreme cheapness? Well, the company isn’t operating effectively. The company has some of the worst margins in the industry. Operating Margin of -6.21%, Net Margin of -9.36%, an ROE of -44.96%, ROA of -13.38%, and a ROC of -25.46%. Those are ugly numbers. Secondly, the company has quite a bit of debt, with a Cash-to-Debt ratio of 0.29, the worst ratio in the company’s history.

You’re probably wondering why I’m even bothering looking into this company with margins and returns mentioned above. Fear not, keep reading and you might find a nugget or two of value. Like I have mentioned many times, I like to travel to the most beaten down sectors and industries in the market, find beaten down companies in those markets with short – term struggles, and see if I can find value, rub off the dirt a little bit, and wait for the market to see the diamond underneath. This company fits that profile.

Industry Overview

Before diving into the nuts and bolts of JAKK’s balance sheet and income statements, it’s important to see where the toy industry is heading in 2018 and beyond. According to Toy Industrial Journal a website written by Steve Reece, CEO of Kids Brand Insight, global toy industry sales are set to grow a few percentage points in 2018. The biggest category of toys that will grow in 2018 will continue to be Licensed Toys. Licensed Toys are the Elsa from Frozen dolls, Andy from Toy Story, etc. The journal admits to a strong correlation between the amount of ‘toyable’ blockbuster movie hits and strong sales in toys. The more movies Hollywood churns out, the more material toy companies have to make and sell products. Taking a brief look into 2019, we can hypothesize strong growth with new movies such as Toy Story 4 and even a Minecraft movie.

The Need to Diversify Manufacturing

The article from Toy Industry Journal makes an interesting point in reference to the ongoing price inflation in China, which is the Mecca of toy manufacturing. Steve sees more and more companies diversifying their manufacturing facilities away from a centralized form of management in China. The companies that are divesting their productions are moving to India, Vietnam, and Thailand. The companies that have been switching their production from China have saved around $4M in operating costs.

Global Strength of Toy Sales

It isn’t the United States that’s driving the demand for toys, rather emerging markets. The graph below from NPD.com gives a great visual representation of the global toy sales performance by region. As you can see, Mexico and Russia lead the way, with the US growing by a mere 1%.

Business Deep Dive

We already know the types of products the business sells, but digging deeper will reveal just what types of products drive revenues and sales. First, the company divides its sales into three categories on its income statement: US & Canada, International, and Halloween. US & Canada hold the lion’s share of sales representing 58.70% over the most recent quarter. Halloween sales come in second with 22.20% of the pie, and International filling in the rest.

Major Customers

JAKK has three major customers, Wal-Mart, Target, and Toys ‘R’ Us. It goes without saying that the filing of bankruptcy and rapid closure of stores for Toys ‘R’ Us didn’t help the sales and bottom line figures for JAKK. Although Toys ‘R’ Us made up about 6% of the sales volume, that 6% was virtually wiped completely off 3Q17. Wal-Mart makes up over a quarter of JAKK sales, and Target filling in the remaining 17%.

Major Competitors

In the toy space there are two major competitors JAKK faces: Hasbro (HAS) and Mattel (MAT). Both MAT and HAS are much larger companies, with Hasbro coming in at $12.3B and Mattel sporting $5.7B market caps, with JAKK coming in at $64MM. This doesn’t concern me because the discount to intrinsic value isn’t there with its competitors. For instance, JAKK trades at half of book value, compare that to Mattel which trades at 4x book, and Hasbro which trades at 6.3x book. Hasbro is trading at 13x EV to EBITDA, and Mattel is even more expensive, trading at nearly 20x its EV/EBITDA.

Hasbro is the clear frontrunner when it comes to margins, sporting a net profit margin of 11%. Yet when you take a closer look at the numbers, JAKK isn’t that far behind MAT in efficeincy, yet Mattel trades nearly 4x that of its book value. When it comes to Operating Cash Flow Margins, JAKK beats MAT by 120bps sporting 4.8%. Looking at Net Profit Margin, MAT’s most recent report of -11.7% is nearly 200bps worse than JAKK’s of -9.4%.

Where’s the Moat?

The company’s moat is it’s sheer outrageous value. It’s hard to give a concrete answer to the question of which toy company has a better brand, because when you look at face value, Hasbro seems to have that down pat. However, JAKK’s partnership with Disney & Black and Decker give it a huge competitive advantage to produce toys and outfits specifically off of the latest Disney movie hit. This is a tremendous competitive advantage built into the partnership the company has with Disney. Disney creates the demand for the products, all JAKK has to do is produce them.

Besides the value, the biggest moat for JAKK when it comes to its major competitors is its FCF Yield of 31.5%. This number trumps that of Hasbro with 5.1%, and Mattel with -2.3%. In fact, JAKK has the highest FCF Yield in the entire industry, only Fossil comes close at 26%. The most recent quarterly report showed a 50% increase in FCF from -44.5MM in 2016 Q3 to -$22.3MM Q3 2017.

Assessing the Balance Sheet

The company is lightening their balance sheet by reducing their total assets from $560MM to $453MM period ending Sept 16 – 17. The company reduced its cash balance by roughly $40MM which was used to pay cash charges related to the minimum royalty guarantees and bad debt, as well as goodwill from acquisitions. The company used less cash to fund its operations however, spending $19.4MM compared to $39.4M.

Accounts receivables came in lower than last years same quarter due to lower shipments, most of which can be traced back to Toys ‘R’ Us bankruptcy. The company is aggressively working to reduce its working capital in order to continue to generate strong FCF yields like they were able to this quarter.

On the liabilities front, the company reduced its Accounts payable by $5M for the period ending, and substantially reduced its long – term debt with reductions of $76MM. In whole, the company reduced its total liabilities by nearly $100MM.

The company does have a good amount of debt, which is a red flag that could eat away at the intrinsic value of the business. It doesn’t destroy the value proposition outright, but it will be something to watch closely in the coming quarters to see if management can do something to reduce its debt obligations. The company’s Debt/Total Capital is 74%, which is well above the industry average of 37%.

The Jockey & Management

The company is lead by Stephen Berman. Before becoming CEO, Berman served as the Co-CEO from 2009-2010 and was previously the COO from 1995 – 2011. Prior to founding JAKKS, Stephen was VP and Managing Director of THQ International. Berman’s CFO is Joel Bennett. Before joining the company, Bennett served in several financial management capacities at Time Warner Entertainment. Finally, rounding out management is Jack McGrath, COO. Jack is a real stud in the toy industry with 16 years experience. He joined JAKKS in 1999 as the VP of Marketing and Product Development. Prior to his work at JAKKS McGrath worked at Mattel Toys, becoming the lead Director of Marketing for the Hot Wheels brand.

Money Where Their Mouth Is

Management has a lot of skin in the game, something that helps me sleep at night if I were to become a part owner of this business. JAKK has close to 17% insider ownership, with CEO Stephen Berman owning almost 9% of shares outstanding. This level of insider ownership is part of a longer uptrend. In November 2017, management was holding 8.64%, not bad. Insider ownership has since doubled, a great sign.

Institutional ownership also increased substantially. In September of 2017 there was around 55% institutional ownership. Flash-forward to December 2017, Institutional ownership is at 94.67%. This goes against my liking for companies with low institutional ownership, but to me it gives a signal that others are starting to recognize the value proposition that management sees.

In tandem with insider ownership, the company has a 3-Year Average Share Buyback ratio of 5.10, meaning it bought back 5x the amount of shares it issued over the last three years.

The Market’s View

When it comes to toy companies, the market seems to only care about one metric, total sales. Judging by that one metric, it makes sense why JAKK stock has taken a murderous path down to where it sits at $2.40/share. Total sales were down 13% over the last quarter. For Mr. Market, if sales aren’t increasing every year, it must be because of some structural problem with the company. Mr. Market sees companies like Mattel and Hasbro with massive market caps and strong margins and says, ‘Those companies are the better value, see how well they’re currently doing?”. To an extent, Mr. Market is right, those companies are doing well. However, Mr. Market fails to see the underlying business value inside of JAKK.

Big Plans Ahead

Launching a New Line of Skin Care

The company also developed their proprietary line of skin care and cosmetics ‘C’est Moi’. This line of skin care is designed for the tweens categories (ages 10 – 13). This new product line launched in January 2018, so it will be interesting to see how sales did come next earnings report. The company expressed that numerous retailers lined up for this product, and they are mainly excited about it due to its high-growth / high-margin potential.

Existing Sales Figures

On their last quarterly report, management didn’t sound beaten down. They didn’t sound concerned with their business model, and they didn’t appear worried about the future solvency of the company. In fact, it was quite the opposite. Management is excited for the future, and the company has every reason to be. With regards to sales, the company’s POS results during the quarter were stronger compared to a year ago. The company is also seeing a strong upwards trend in their new line of Tsum Tsum products. Four out of their five major product categories saw sell-through that was better than their sell-in. This indicates solid retail inventory levels.

The company saw strong increases in their licensed products, particularly from Disney’s Moana and the DC toddler dolls. For Disney girl products, the company recognized strong POS increases despite continued decline from their Frozen line. The company attributes much of its third quarter internal success to the fruits of their IP (internal product) initiative. Products such as Mr. Dusty, Squish-Dee-lish, and Unicone Rainbow Swirl Maker saw enough revenues to extend that line for new offerings in the coming year.

The company is also released the first phase of their consumer-facing website. Management says the second phase should land somewhere early first half of 2018, with a strong commitment to a direct-to-consumer e-commerce approach.

Goals for 2018

The company is excited about 2018-2019 due to several licensed brands which will drive sales: Incredibles 2, Moana, Tangled, DC Superheroes, Star Wars, and various Nintendo Products. The potential for growth is present in each of these avenues. Plus, as of yesterday, the company partnered with Warner Bros. Consumer Products to bring a new line of Harry Potter and Fantastic Beasts toys that are set to drop this coming fall.

The company hopes to achieve its goals of continuing to build its IP with the addition of animated content through a JV with Meisheng. The company also plans to grow its sales with Amazon in the coming quarters. Total sales to online retailers are up modestly, but the company anticipates faster growth in that space.

Where is Intrinsic Business Value?

Assuming a discount rate of 10.5%, a perpetuity growth rate of 2.0%, FCF 5Yr CAGR of 1.3%, 5Yr Avg EBITDA margin of 5.2%, and 5Yr Revenue CAGR of -0.2%, the company’s fair value is between $4.04 – $5.61. This range represents an implied Revenue multiple of 0.2x on the low end and 0.3x on the upper end. Implied exit EBITDA multiples are 4.1x and 5.2x respectively.

Where is My Fallibility?

Like every investment idea, there are numerous ways in which the intrinsic value could be deteriorated to the point where margin of safety is all but gone. Below are a few ways in which JAKK could fail to extract its intrinsic business value:

1. Their new cosmetic line is a dud, a sunk cost that the company can’t get back, and becomes a burner of cash rather than a generator of cash.
2. The company fails to reduce its debt obligations.
3. In order to finance operations, the company issues shares rather than using cash from operations.
4. Demand growth for toys in emerging markets declines significantly.

Let’s Get Technical

Price action has formed a downward channel on the weekly charts since the end of 2016, but if you notice there appears to be consolidation and support at the 2.30 – 2.40 level. I am looking for price to break out to 2.65 – 2.70 before putting on a position. I would like to stagger my entries in blocks of 25bps investments before sizing up to a 100bps total open risk. Stop-losses would be placed at $2.00

Variant Perception

Mr. Market fails to see the intrinsic business value that propagates through JAKK. Although sales decreased 13%, the rest of the company experienced strong growth in areas such as IP sales, licensed sales, as well as POS sell-throughs. The company trades at nearly its NCAV while sporting a FCF Yield of 31.5%. There is a clear runway for growth heading into the next two years with various blockbuster hits that are sure to drive demand for such licensed products. Finally, the margin of safety appears to be extremely large at current price levels of $2.40/share, its lowest price in history. It’s not everyday you can snag a company trading at 0.1x sales with a clear and obvious runway for future growth and expansion.