Those of you with children and/or market memories stretching back to the 1998 – 1999 period may remember the explosive profit growth at 4Kids Entertainment driven by the Pokemon brand. It is my belief that a similar profit boom is imminent at 4Kids, except that this time the ramp will be based on a wider mix of products, a stronger platform from which to launch these products and greater cross-selling leverage. Further, if I am wrong, the downside is limited by $7.60 per share in cash and tangible book value of $10.30.
4Kids Entertainment is a diversified entertainment and media company specializing in the youth oriented market with operations in the following business segments: Licensing 50% of sales, Advertising Media and Broadcast 25% of sales, and Television and Film Production/Distribution 25% of sales. Their base business, and their only business as recently as calendar 2000, is licensing. To paraphrase the company’s 10Q, KDE is “engaged in the business of licensing the commercial rights to popular children’s properties, personalities and product concepts in the areas of toys, electronic games, trading cards, food, toiletries, apparel, house wares, footwear and publishing rights.” Specifically their brands include Yu-Gi-Oh!, Pokemon, Cabbage Patch Kids, Teenage Mutant Ninja Turtles (yes they’re back) Cubix, Tama & Friends, Ultimate Muscle, Monster Jam, Ultraman Tiga, Fighting Foodoons, The Dog, Cramp Twins, and Pirate Islands.
This has been a very profitable base business for KDE. For some metrics: KDE has grown top line at a 20% CAGR over the past 10 years and 40% over the past 5. Tangible book value (mostly cash) has grown at 25% over the past 10 years and 50% over the past 5 years. They carry no debt, goodwill or intangibles on the balance sheet. Over the past 12 months the company had sales of $67 million on which it earned $36 million of EBITDA and generated $11 million in free cash flow.
The driver for the earnings ramp that I am forecasting is based on the company leveraging its base business by entering/expanding two complimentary business lines. The most significant of these is the purchase of the “Fox Box.” Through a multi-year agreement with the Fox Broadcasting Co. KDE is leasing Fox’s Saturday morning programming block (the Fox Box.) Since September of ’02 KDE provides all programming content to be broadcast during the Fox Box, which airs on Saturday mornings from 8am to 12pm eastern/pacific time, and retains all of the revenue from network advertising sales for the four-hour time period. The four-year deal cost KDE $101.25 million ($25.3 million per year) with an option on two additional years. Purchase of the Fox Box gives KDE both the ability to sell sixty 30-second slots, but more critically, the ability to control programming to its key demographic segment 6 – 12 year old boys. By controlling both the shows and the advertisements on Fox, they can maximize their licensing revenues. This is the source of the aforementioned cross-selling opportunity.
The final portion of their business, 4Kids Productions, Inc. produces and acquires animated and live-action television programs for distribution to the television, home video and theatrical markets. 4Kids Productions adapts foreign programming for the US market and also produces original animated television programming for domestic and international broadcast. The primary driver of revenue here is a flat fee paid by WB for each episode of Yu-Gi-Oh! and Pokeman. A natural question to ask is why management would want to sell its most popular programming to Fox’s primary competitor. My view is that the company’s primary interest is getting as strong a hold on the Saturday morning time slots as possible to drive licensing revenue. Further, WB in recent years was putting price pressure on KDE. Now that KDE has an obvious alternative and could threaten WB’s #1 Nielsen spot, pricing power shifts to KDE. What KDE has achieved is a near monopoly position (aka deep moat) for content and licensing during a key time slot.
I am modeling a sales increase from $53 million in 2002 to $95 million in 2003 and $115 in calendar 2004. The primary driver of top line growth in 2003 being $35 million in incremental sales from the Fox Box. First quarter results were solidly in line with that estimate. On $115 million in sales, the company should conservatively earn $30 million in ’04 operating profit. At today’s price you are buying the company at an enterprise value of $140 million or less than 5x ’04 operating profit for a business with double digit top line growth and double digit EBITDA margins. For those of you who prefer your valuations on non-extrapolated numbers, the stock is selling at 3.8x EV / trailing EBITDA.
The primary catalyst is an expected acceleration in top line and operating profit growth based on purchase of the Fox Box. With $100 million in cash, no debt, and strong cash flow the company has several alternative catalysts. It could easily institute a dividend, buy back stock or broaden its franchise.