Description

Dream International (1126:HK) – March 1, 2018

Dream International is a leader in the plush and plastic toy manufacturing industry with a net cash balance sheet trading for about 6.5x 2017 P/E and less than 6x 2018 P/E.  The company stands to benefit from continued industry consolidation over the medium to long-term given cost advantages over their subscale family-run competition.  A focus on capacity growth to meet the requests of major customers has driven 50% annualized growth in earnings per share since 2014; as capex spending moderates and free cash flow rises, the resumption of a regular dividend policy could serve as another catalyst for valuation rerating along with continued earnings growth.

A visit to the company requires one to take the MTR to Tsim Sha Tsui in Hong Kong and walk down Kimberly Street, a two block stretch of Korean-run supermarkets and restaurants that make you feel like you could be in Seoul, apart from the towering high-rises in all directions.  Your meeting will be held in a show room housing every Disney character you can think of in plush form, which will make you wish you could have brought your kids to work.  Then you might feel like you are back in school learning about a case study in globalization: a company primarily owned and run by Korean management, headquartered in Hong Kong, moving most of its production base from Southeast China to Vietnam, manufacturing toys made mostly of crude oil by-product for MNCs to be sold primarily in the U.S., Europe and Japan.  While every part of that last sentence may initially highlight a potential business risk that could explain the stock’s persistently low valuation, I think the bulk of evidence points to the current level of earnings being sustainable with potential for further growth and a stock that is unlikely to get much cheaper from here, with the probability of a significant rerating over time.

Dream’s Chairman, Mr. Choi, set up the company in 1984 after about a decade of experience working as the toy trading manager in Daewoo Corporation’s plush toy business, where he developed relationships with Disney and Namco Bandai.  Due to rising labor costs in Korea as the economy transitioned to higher value-added manufacturing, the Company searched for a new location for its production base and settled on the Special Economic Zone in Shenzhen, which at the time only required companies to pay payroll tax with no corporate tax, with all revenues booked in Hong Kong.

In the early days of toy manufacturing in China, barriers to entry were very low and the economics of running a small-scale factory attracted mostly family-run businesses.  The cost of building a manufacturing facility with 500 to 600 workers was about $200k, set-up time less than 6 months, gross margins were as high as 80% and the payback period was less than one year.  Prior to 2007, there were still an estimated 3,000 OEMs that a customer like Disney could use.

Plush toy manufacturing is like garment manufacturing in that it is difficult to automate and thus very labor intensive (40% of production costs).  Each piece is made by hand with a sewing machine and an average plush toy pattern is significantly more complex than a standard garment pattern, raising the likelihood of defects.  Dream’s ability to meet the demand of Japanese customers, who were willing to pay more if stringent quality requirements were met, kept the company afloat during the first two decades of intense market competition.  Today Dream supplies about 90% of the plush toys sold at Tokyo Disneyland, operated by Japan-listed Oriental Land, which contributed about 25% of annual revenue in 2016.  Oriental Land has tried in the past to diversify their supplier base with little success, as smaller suppliers have been unable to meet their quality standards while matching Dream on cost.

The Global Financial Crisis in 2007 initially killed consumer confidence and hurt consumption in developed markets, which negatively impacted sales in discretionary categories like toys.  In the years following the crisis, confidence bounced back but the wheels were already in motion for industry consolidation in manufacturing, as large customers leaned harder on suppliers with extended payment terms and inventory requirements.  At the same time, minimum wages in China were growing at double digit rates, with labor shortages and higher operating costs in China’s coastal region pushing lower value-added manufacturing to inland China or Southeast Asia.  Today, the favorable tax regime that Dream initially enjoyed in Shenzhen is no longer in force, and the Pearl River Delta region’s economy is quickly moving on to higher value-added activity.

http://www.scmp.com/news/china/economy/article/2128316/why-chinas-hollowed-out-manufacturing-hub-pinning-its-hopes-hi

https://www.mckinsey.com/business-functions/operations/our-insights/a-new-era-for-manufacturing-in-china

According to Dream, about 40% of China’s toy manufacturing capacity has been shut down over the past five years.  A handful of corporate players like Dream with the financial capability and flexibility to expand capacity in lower cost locations in Vietnam and inland China are reaping the benefits of lower competition as margins improve.  The industry is still quite fragmented, as Dream is one of the largest players yet estimates its overall market share at less than 3%.  There is not a lot of public information available on competitors; Dream considers HK-listed Matrix Holdings, which focuses on McDonald’s Happy Meal plastic figures and generates just over half of Dream’s revenue to be one of their largest competitors.

Dream had either the foresight or good fortune to first enter Vietnam in 2004, as it saw a need to diversify its production base as competition intensified and business in China temporarily dipped into the red.  It took about five years to break even in Vietnam despite lower labor costs, due to some differences in the Vietnamese operating environment.  Unlike in China, where migrant workers live in factory dorms with a sole focus on earning money, Vietnamese workers prefer to commute by motorbike and spurn working overtime.  Dream’s first factory included a dormitory, but to their surprise nobody used it.  The relative lack of migration means that when a foreign employer comes into an area, they are effectively employing entire communities, making it increasingly difficult for latecomers to hire enough employees.  Vietnam’s less developed economy also makes it difficult to find subcontractors with excess outside capacity, which was readily available in China.

In Dream’s early days in Vietnam, Namco Bandai, who was looking to diversify its production base from its 30-odd suppliers in China for plastic figures, encouraged Dream to set up a plastic figures factory in Hanoi and transferred some know-how to the company.  Namco Bandai ultimately did not become a customer, but Dream continued to pursue expansion in the plastic figures market as it was larger than the plush toy market and offered higher margins.  The plastic figures segment is now the company’s main growth driver.

At scale, the cost advantage proved to be well worth the initial difficulties.  Dream now has 12 out of 16 production sites in Vietnam, and they estimate costs in Vietnam to be about 60% cheaper than China.  As the majority of global toy production is still coming from China, no major competitor in toy manufacturing has attempted to follow Dream into Vietnam, and doing so is bound to pose numerous challenges for Chinese management teams, I expect this cost advantage to persist for the foreseeable future. Dream has been actively exploiting this advantage, ramping up capacity in Vietnam and doubling sales with higher margins in what has otherwise been a relatively benign market for global toy sales.

Segments

Plush Toys

The main customers are Disney and related companies (Oriental Land), and to a lesser extent Dreamworks, Funko, Wal-mart, Costco, and Bandai.  It is difficult to avoid customer concentration in the plush business given Disney’s dominance at the IP level.  Plush makes up only 7% of the toy market in the US, and several of the major players have not historically focused on plush (Mattel, Hasbro, Lego).

The industry does not operate on long-term or written contracts; essentially every order is a contract.  Dream processes 50 to 60 thousand orders each year.  On average, a customer will use 30 to 40 suppliers for an order.  Dream will usually receive around 10% of an order with the top ten taking up to 80%.  As mentioned earlier, Dream receives up to 90% of some orders when quality is the most important consideration (Oriental Land).

Oriental Land is well positioned to benefit from Japan’s ambitions to grow inbound tourism leading up to the 2020 Tokyo Olympics, and has plans to expand the capacity of their two theme parks 30% by 2025.

https://www.japantimes.co.jp/news/2017/11/30/business/corporate-business/tokyo-disney-parks-operator-planning-%C2%A5300-billion-expansion-aimed-overseas-older-visitors/#.Wj0OKRNL9mA

There are 12 Disney theme parks around the world; the most recent opening was in Shanghai in 2016.

Plush is a mature business for Dream, as customers will always prefer to use multiple suppliers and there is a limit to what share Dream can take, but it should be a cash cow going forward. Ongoing industry consolidation boosts prices and margins, and Dream can still move more of its production over to Vietnam as necessary.  There may be a few select opportunities for new business, such as Funko’s brand extension into plush from plastic figures, or Hasbro/Mattel mulling entry into plush.  Results were weaker in the first half of 2017 as Oriental Land is still attempting to diversify its supplier base.

Plastic Figures

Dream’s main customers in this rapidly growing segment are Funko and Spinmaster.

Funko

Dream supplies an estimated 90% of Funko plastic figures, which accounted for about 80% of plastic figure segment revenues in 2016 and 60% of segment revenues in H1 2017.  Funko went public toward the end of 2017, and its prospectus confirmed that sales had indeed grown at a 100% CAGR from 2014 to 2016 to about $400m and were still growing ~20% yoy through Q3 2017.  Dream’s factory price is about 25% of retail price, which averages under $10 per figure.  In 2017, Funko surpassed Oriental Land as Dream’s largest customer.

At first glance, Funko may look like a busted IPO with a bit too much debt, but I think that there is a reasonable chance that their business model is sustainable and will continue to be a source of profitable growth for Dream.  Funko management is predictably positive about their business and has cited aggressive medium-term goals for revenue at 2-4x the current level.

https://investor.funko.com/presentations

Funko bills itself as “fast fashion for pop culture.”  It has licenses to create products for over 1,000 properties from more than 100 content providers.  About 400 of those properties were active in Q3 2017; of those about 44% were considered evergreen (Harry Potter), 27% from movies, 14% from television, and 14% from gaming.  No single property made up more than 10% of sales, and no retailer accounted for more than 12% of sales.  Major retailers are Gamestop, Hot Topic, Target; about 20% of sales are online.  The customer demographic is evenly split between male and female and well distributed among different age groups; the idea is that everyone is a fan of something in pop culture, whether it be a sports team, musician, book, movie, cartoon, etc., which makes them a potential customer.  Only 20% of sales are outside of the U.S., which Funko sees as a large opportunity for growth given the increasing globalization of content.

Funko emphasizes the importance of their superior speed to market.  Many figures are based on content like television shows or movies that the company doesn’t necessarily get to see before anybody else.  In a typical case, Funko designs a character that references a particular plot point that is relevant to fans.  They have to submit the design to a licensor, develop a mold and prototype with the manufacturer, receive a final license approval, manufacture the product and get the figure on retail shelves while the content is still relevant to consumers (think the latest Star Wars movie or Stranger Things season).  Funko boasts that they can do this in as few as 70 days while their competitors may take four or five months longer, and according to Dream, a normal lead time is 60 days.  It seems like this model requires tight integration between the licensee and manufacturer, which is one reason that Funko is not yet attempting to distribute its supplier base.

The other important driver of sales is the low price point and quality at that price point.  Dream offers Funko significant cost savings over China-based plastic figure suppliers, which enables that sub-$10 retail price. Now that Funko has given itself a decent amount of debt for its private equity owners to cash out, it seems highly unlikely that they would use more expensive suppliers at the risk of hurting sales or margins.  They seem quite comfortable with the current situation, as they asked Dream for $100m of capacity in 2017, compared with US$63m in 2016.  Funko has asked for a further capacity increase in 2018.  Dream is in the unique position to build out dedicated factories in Vietnam and bring them up to scale as needed.

Spinmaster

Spinmaster is a new customer for Dream in 2017 and contributed US$12m of revenue in H1 2017.  Dream is one of three suppliers for Spinmaster’s new Colleggtibles, an extension of the Hatchimals brand.  Here are some notes from Spinmaster’s 2017 Q3 Earnings Release:

“Hatchimals became the number one total property in the US toy industry by the end of the third quarter. This is the first time that a Spin Master property has taken the number one spot since NPD started its US tracking.”

“We had very strong initial shipments of Hatchimals Surprise in the quarter, and it’s been tracking as the number one toy in the industry since its launch. We have now successfully established Hatchimals as a brand that includes a successful low price point collectible line, Hatchimals Colleggtibles.”

“In Q3 2017, our revenue increased 27.6 percent from last year, growing from 475 million to 606.1 million. Revenue growth was driven by Hatchimals, Hatchimals Colleggtibles, PAW Patrol, and Cardinal Games.”

“Gross product sales increased 78 percent to $264 million, driven by the ongoing success of Hatchimals, Hatchimals Colleggtibles, and strong initial shipments of Luvabella, which offset declines in Air Hogs and Zoomer”

“In the week of October 8th, according to NPD, Spin Master had four products among the top ten best-selling toys in the United States. Our two Hatchimals Surprise SKUs were at number one and two, followed by Luvabella, number six, and the PAW Patrol Sea Patroller at number 10. We were the third largest toy manufacturer in the US for that week, the very first time we have achieved that milestone.”

Spinmaster sales have grown at a 30% CAGR since 2013.  This new relationship could be a significant growth opportunity for Dream, as the company has a diversified portfolio of successful products.

http://www.spinmaster.com/presentations.php

Ride-on Toys

I have included this segment because it is broken out in the financial reports, but for now it appears to be inconsequential to overall results.  The main customer in this segment is RadioFlyer.

Other Prospects

Now that Dream is operating at scale in both plush and plastic figures, this puts them in a position to pursue a larger category that includes both: dolls.  The big players in this segment are Hasbro and Mattel, which currently keep a high proportion of their production in-house.

http://www.nytimes.com/2007/07/26/business/26toy.html

Working with Dream could generate considerable cost savings, but these are relatively slow-moving giants.  Each of these customers would insist on dedicated facilities, and after a year of feasibility studies and trial runs, Dream is now waiting for Hasbro to pull the trigger and increase orders.  Management notes that they are not finding it difficult to fill new capacity with existing customers, so while these two customers would be a big win they are not critical to growth in the medium term.

Valuation

Assuming continued growth in plastic figures in H2 and some weakness in plush, full year numbers will come in at about HK$2.5 billion revenue, HK$500m EBITDA, HK$445m EBIT, and HK$356m net income.  With a market capitalization of HK$2.45 billion and an estimated HK$600m of net cash at the end of 2017, the stock is trading at a trailing P/E of 6.8x and EV/EBIT of 4.1x.

Management is targeting US$550m revenue by 2021.  Capacity expansion will be self-financed from internal cash flows.  Payback period of their new facilities in Vietnam is about 2 years, and these high incremental returns on capital have helped the Company exceed management targets in recent years.

Prior to 2015, Dream used to maintain a payout ratio over 40%. In the past several years, that ratio has dropped to about 10% as the company has invested in capacity expansion while maintaining a conservative cash position.  Management does communicate to investors that they plan to resume the previous payout policy once growth capex requirements subside as a percentage of earnings, perhaps as soon as next year.

In January 2018, Dream announced that they are acquiring an office property several blocks away from their headquarters in Tsim Sha Tsui for HK$207m.  The company was facing a rental increase and running out of space at their old address, so this acquisition will provide room to grow and hedge against rising commercial rents with minimal disruption to staff.  Based on my discussions with management over the past couple of years, I do not think this event marks the beginning of a Hong Kong property investment spree.  Management is very much focused on strengthening their core business.

The model below reflects management’s long-term target of $550m revenue by 2021.  It does not assume any margin improvements, although margins have increased in the past two years due to economies of scale.  The model also assumes a steady level of investment rather than an exponential ramp-up, which drive revenue and earnings growth higher.

As Dream grows larger and diversifies their customer base, there is a scenario in which the stock rerates significantly.  This has played out in garment manufacturers as the industry has consolidated, as leader Shenzhou International has grown share of major customers like Nike and improved margins through vertical integration.  Shenzhou’s P/E has expanded from 5x to 28x while earnings have grown at double digit rates since 2008, leading to phenomenal returns for buy and hold investors.  I think Dream has the long-term potential to be viewed as the Shenzhou of toys.

Future Issues/Risks

Factories in China – Existence, ownership, and size can be verified online, as the author below has done:

https://weiwenku.net/d/100625249

Race to the Bottom – Vietnam is the hot manufacturing destination now, but it is inevitable that costs will rise and force low-end manufacturers elsewhere.  Minimum wages are rising at high single digit rates and the Vietnamese government has expressed its desire to limit land allocation to low value-added economic activity.  I estimate that the Vietnamese economy is about 15 years behind China.  Management thinks they have another 8 to 10 years of good years left in Vietnam, and it’s still too early to enter a new market.

Succession Plans – While the Chairman plans to ultimately hand the reigns over to his next of kin, the company is for the most part professionally managed.  I think the fact that the company is domiciled in Hong Kong greatly reduces the risk of succession-related shenanigans that plague many listed Korean companies, as there is zero estate tax here.

Global Recession – Dream says they are reserving some excess capacity in case of a recession.  They think that a downturn would be good for them as weaker players would hurt the most and industry consolidation would accelerate.  We do have hard evidence of this in the listed garment manufacturers:  Shenzhou International, for example, delivered impressive revenue and earnings growth from 2007 to 2009.  The stock price, however, could go down regardless in the short term.

Customer Concentration – Dream seems to be successfully diversifying their customer base and has been lucky to hitch their fortunes on to successful products in the past several years.  However, I think they are less exposed to the “hit” nature of the toy business in the long run, as their value proposition is that they can be the lowest cost manufacturer of whatever happens to be hot.  I do think it is important to track Funko’s progress, as Dream is reserving capacity for them which could hurt if there is slack in sales.

Catalyst

Ongoing consolidation of toy manufacturing industry driving double-digit earnings growth