Description

JAKKS Pacific was originally written up in VIC in August 2000. With the valuation considerably cheaper and the timing quite compelling, it’s time to revisit the idea. The stock is currently trading at 9x C02 EPS and 8x C03 EPS. The company has $101 million in cash and no debt. On a cash-adjusted basis, the stock is trading at 6.5x C02 EPS and 5.8x C03 EPS, a low valuation, especially relative to its peers. With earnings poised to reaccelerate in 2003 and with a potential share repurchase now possible, the investment also appears quite timely.

JAKKS Pacific is the third largest U.S. toymaker, after Mattel (MAT) and Hasbro (HAS). Founded in 1995, the company has grown from revenue of $12.1 million and EPS of $0.23 in 1996 to revenue of $310+ million and EPS of $1.64+ this year. Though the company has not given guidance for 2003, Street estimates (four banks) are for revenue of $351 million and EPS of $1.86.

JAKK has grown both internally (an average internal revenue growth rate of 19% since inception) and through purchasing and improving upon a series of small toymakers. Though I generally dislike highly acquisitive companies, JAKK’s management team has shown a remarkable ability to do accretive deals that work. The management team is solid with an average of 19 years of experience in the toy industry. CEO Jack Friedman was the CEO of THQ from 1989-1995 before starting JAKK. Typically, they pay 6-8x net income for the toymaker, then reduce headcount by up to 80-90% and refocus the product line on its strengths, improving gross margins. As a result, each toymaker is usually purchased for 3-6x net income after improvements. For example, Pentech was purchased in July 2000. Gross margin from Pentech is now 46% from 32% before and headcount was reduced to 10 currently from 153. SKUs went to 70 from 350 before without revenue loss.

The U.S. toy sales were a $24 billion market in retail in 2001. The industry is relatively mature, but is projected to continue growing around 4% a year, as it has since 1996 (per JP Morgan). Mattel and Hasbro represent about a third of U.S. toy sales. After JAKK, no other company represents more than 2% of the U.S. market, which creates an opportunity for JAKK to selectively purchase small vendors at the right price. The purchases include Berk ($3.3 million, closed June 1999), Flying Colors Toys ($52.9 million, October 1999), Pentech ($20.6 million, July 2000), Kids Biz ($12.4 million, December 2001) and ToyMax ($54.7 million, October 2002). The company has repeatedly demonstrated that they are able to successfully manage these new businesses, with gross margin improving from 38.3% in 1997 to 42.2% in 2001 and EPS growing markedly over the last seven years:

EPS (FY ending Dec.)
F96 0.23
F97 0.37
F98 0.59
F99 1.31
F00 1.47
F01 1.71
F02E 1.66
F03E 1.86

Brands that the company owns include Road Champs, Remco, Child Guidance, Laser Challenge, Go-Fly-A-Kite, and Funnoodle. Brands that the company licenses includes Disney, Nickelodeon and Hello Kitty. The company is generally number one or two in each of its product categories. The company is number two in the action figure category with its line of WWF action figures, number two in the wheels category and number two in the craft activities segment behind Crayola. Its Go-Fly-A-Kite line is the number one kite line in the U.S. The company will ship over 150 million packaged units this year. The company is generally number one or two in each category and most products retail for under $10, so risk of price attrition is relatively low. The vast majority of products are manufactured in Asia.

JAKK has a joint venture with THQ for which it shares the profits from WWE video games through 2009. This joint venture generated operating profit to JAKK of $3.6 million, $15.9 million and $6.7 million in 1999, 2000 and 2001, respectively. Operating profit from this venture is guaranteed to be at least $2.6 million in 2002 and 2003. The company’s overhead associated with this joint venture is around $400,000. JAKK has no capital commitment or off-balance sheet obligations from this venture. This deal is an example of the company’s ability to do profitable deals with low risk.

RECENT DEVELOPMENTS

JAKK stock was more than halved this summer, falling from its high near $24 to $10. In its earnings conference call on July 22, the company took a more cautious stance towards 2H02, reduced its headcount by 15% ($2 million in annualized savings) and lowered its guidance to sales of $310-330 million and EPS of $1.64-1.70 (versus prior guidance of $1.80-1.92). The company is now “very comfortable with its new guidance” for the balance of this year.

The stock remained in a $10-12 trading range for several months due to the prospect of the west coast Longshoreman strike (which the company successfully executed around) and the delay of closing of the ToyMax acquisition (including rumors that the integration was going poorly). With ToyMax finalized on October 25, the stock has lifted somewhat to around $15, but remains cheap, especially relative to 2003.

VALUATION

The stock is currently trading at 9x C02 EPS and 8x C03 EPS. The company has $101 million in cash and no debt. On a cash-adjusted basis, the stock is trading at 6.5x C02 EPS and 5.8x C03 EPS. FCF approximates net income, so the stock is trading at under 6x 2003 FCF, a low valuation for a company that has demonstrated its ability to grow revenues and do accretive deals that work. Downside is limited with book value per share of $14.5. Tangible book value per share is $7.5. Cash per share is $4.5.

COMPS

Competitors Mattel and Hasbro trade at significantly higher multiples. MAT trades at 19x C02 EPS and 17x C03 EPS. HAS trades at 21x C02 EPS and 14x C03 EPS. Though it is possible to argue that MAT and HAS have higher-quality and more durable brands than JAKK, it appears greatly undeserved that JAKK should trade at such a steep discount. Last year, JAKK’s operating margin was over 10%, versus 13% for MAT and 7% for HAS.

Over the last few years, JAKK has also shown an ability to grow revenues and earnings at a considerably greater rate than MAT and HAS. JAKK’s long-term earnings growth rate is projected at 14.6% versus 13% for MAT and 7% for HAS. Moreover, the softness that JAKK experienced in the June quarter appears to have been industry-wide and not specific to the company. JAKK’s core business was down 8% y/y in the June quarter, while industry leader Mattel’s U.S. sales were down 7% in the same period.

RISKS

There is risk that the company goes after a larger acquisition, which could add considerable integration risk to the story. It appears that much of JAKK’s undervaluation is due to this concern. However, the JAKK management team has repeatedly shown that it can do accretive deals and has the depth and discipline to do further deals at the right price.

Another potential risk is the dilutive effect of further public offerings. Since 1998, the company has had three public offerings: raising $58 million in April 1999 ($14 price split-adjusted), $75 million in December 1999 ($25 price) and $62 million in May 2002 ($17.75 price). However, despite the dilutive impact of these public offerings, EPS has grown from $1.31 in 1999 to around $1.70 in 2002, a CAGR of 9%.

Catalyst

In May, the company sold 3.5 million shares at $17.75. With the stock sale, the company has over $100 million in cash. In 2000, the company repurchased 1.5 million shares. The company’s lawyers have advised management to wait until six months after the stock sale before considering the share repurchase, which means the company can now actively consider a repurchase. Management recently indicated that they are seriously considering a share repurchase at current levels.

In February, the company should give guidance for 2003. Guidance that meets or exceeds current consensus estimates would be another catalyst for the stock.

In the recent quarter, the company began disclosing sales by product category. Ongoing disclosures like these should help investors get more comfortable with the story over the next few quarters.