Description

Some key points

• Price / LTM Pretax Cash Flow – 4.1x
• ~50% reduction in shares outstanding since the end of 2007 through open market buybacks and the Company continues to buy back shares aggressively
• Business generates very high cash ROE and ROIC (Pretax CF/Total Equity ~ 120%)
• Very high insider ownership with top three shareholders active in the business and owning 46%
• Simple business with nearly no technological risks and durable/stable end markets

Summary

This is a good business which has excellent ROE/ROIC and very attractive valuation metrics - magic formula eat your heart out!

In addition it has a capable management team that thinks and acts like owners (due to high insider ownership) and aggressively buys back very large amounts of stock.  At their current rate of cash flow and buybacks there will either be no shares left in relatively short order or the stock price will move to reflect a fairer value.

Business

The Character Group plc was founded in 1991 by Richard King, Kiran Shah and Joe Kissane (Executive Chairman and the Joint Managing Directors owning 17%, 24% and 3% of the shares today respectively).  They all had backgrounds in the toy business before forming Character and building it into a ~£95m sales business that designs, develops and internationally distributes toys and games.  Basically they design the toys, source them out of their Hong Kong office, put up the working capital for the process, and import them to the U.K. to sell to various toy stores.

In 2003 Character made the decision to develop its own products to market alongside those that it sourced from third party distributors and today over 75% of its products are developed in-house. The business is very capital light since the actual manufacturing of the toys is done in China.  Their toys are now sold in more than 30 countries worldwide but almost all of the sales are in England.   

They have such phenomenally fun toys (targeted at the very young) as Fireman Sam, Zhu Zhu Pets, Doctor Who action figures, Scooby Doo, the license for Bob the Builder, Postman Pat, Xploderz, and many more!  While these are no Barbie they aren’t earning 100% of their profits from pet rocks or hula-hoops either and there will likely be some portfolio churn but the appeal of their long-term product mix seems durable (how much do pre-schooler’s tastes change?)

Their website is linked below and this should help anyone to get a sense of their general product portfolio.

http://www.character-online.com/

The business has had positive CFO-Capex in each of the past 10 years showing a good bit of consistency in that regard.  In that time period, the business has consumed very little capital as its developed and grown, going from a £2.5m equity business in 2002 to a £7.6m equity business today.  Equity would be larger of course except it has utilized more than its current market cap in cash for share repurchases and dividends since 2006. 

Share Repurchases

This company has bought back a lot of shares at very attractive prices.  Looking to the future they have basically communicated that this is not about to change.  Since the business has grown organically without requiring significant CapEx it seems likely that future FCF will either be allocated towards more repurchasing of shares if they stay attractively priced or towards dividends if they do not (at which point the stock will likely have appreciated).  Thus to the extent that the business continues to perform and one has a long enough time frame, the upside of the investment should increase with a consistently declining share count.

Between August 31 (fiscal year end) and the issuance of the annual report (November 29) the company reported that it had repurchased an additional 925k shares for £1.6m (average price of £1.74/share) and has begun repurchasing opportunistically again with an additional 220k shares in February and they have recently authorized a LARGE new buyback that has 5.7m remaining shares authorized!

The below is a quote from the company chairman (Richard King, 17% owner) regarding capital allocation in their 2010 annual report.

“Since June 2006, the Company has followed a policy of buying back its own shares in the market, whenever the Directors felt that the share price undervalued the Group and, when they considered it to be the best use of Group funds.

As at 31 August 2005, there were approximately 52.8 million ordinary shares of 5 pence each (“Ordinary Shares”) in issue and today that number has been more than halved to approximately 24.57 million Ordinary Shares (excluding shares held in treasury). This has enabled significant enhancement in earnings per share. Had the buy-back not taken place, the basic earnings per share for the year under review would have been 11.7 pence compared to 20.12 pence. The implementation of the buy-back programme has been a great success and has: benefitted all those who wished to take the opportunity to liquidate some or all of their investment in the Company; made better use of cash generated by the Company’s businesses than would otherwise have been the case; and, not least, been undertaken at times when the Board believed that the price of Ordinary Shares in the market undervalued the Company.”

Insider Ownership

Insiders/managers also own enough of the company where they should be properly incentivized to think of the business rationally as owners (as they have).  Given that they have kept remuneration reasonable and are clearly deploying capital in a beneficial manner there is reason to feel generally comfortable with corporate governance.

Income Statement (£ in millions)

The maintenance CapEx for this business is extremely low (my estimate is ~£200k last year) as there is a very small amount of non-working capital assets employed in the business.  The below balance sheet shows the relatively asset and equity light nature of their business (relative to produced cash flow).

Balance Sheet (£ in millions)

Valuation

It seems reasonable that a simple business such as this, possessing no technological obsolescence risk, very high ROIC and ROE, an ownership-like management, a demonstrated ability to effectively allocate capital and improve operations should be worth approximately a 6-8x pretax free cash flow (since FCF comes back to you as the business needs no additional capital and strong buyback/divided traits).  If it takes a little longer to reach an appropriate valuation at least it will likely have fewer shares outstanding at that point in time.

I am using the LTM Aug 11’ period financials below and the company has guided that it expects the 2012 period to meet its own forecasts/market expectations.

As a note – at the current 5.4x FCF multiple with its current capital allocation policy it won’t be long before the company retires ALL of the shares outstanding (which is not going to happen so what will happen to the price/share?) 

We have heard from brokers who trade the stock that they are usually competing against the company for its shares (and that the company is aggressively engaged in the market for blocks.)  If the insiders don’t sell pro-rata with other holders the float will obviously decrease faster.

Risks

• High degree of customer concentration with top 3 customers accounting for 48% of total sales
• Exposure to USD/Sterling exchange rates
• Management has a controlling stake so if they become aggressive in policy towards minority that’s going to be bad
• Large amounts of options authorized for issuance

DISCLOSURE

Ownership interest in Character Group at the time of this write-up that can change at any time without notice. There are no plans to provide future updates on the authors buying or selling activities for this or other stocks. The author may buy or sell shares of Character Group without notice for any reason at any time.

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