Description

OVERVIEW
Russ Berrie is in the business of designing, importing, marketing and distributing 8,700 plus gift, home decor, infant and other consumer goods to some 41,000 customers across a broad swath of retail categories, including: gift stores, pharmacies, card shops, home decor shops, apparel stores, craft stores, garden stores, book stores, stationery stores, hospitals, college and airport gift shops, resort and hotel shops, florists, chain stores, department stores, military post exchanges and internet companies. The company reports on two rather non-descript segments: Core Products (gift, home decor) and Non-Core (consumer, infant). Both product categories feature relatively low price points, appeal to consumer impulse, and are marketed through dedicated direct selling organizations.

Substantially all items are made by a gaggle of independent manufacturers spread throughout the Far East (86% of purchases), US (5%) and other countries (9%). Over 250 employees are posted in Hong Kong, Korea and China and are responsible for ensuring quality and timely product delivery. Products are designed to the specifications of a staff of 170 designers and pass through a network of distribution centers located in the US (New Jersey, California, Michigan and West Virginia), Canada (Toronto), UK (Southampton) and Australia (Sydney).

During 2003 RUS generated $329.7mm in total revenues, $49.2mm in EBITDA, and $34.7 mm in net income. Trading at $19.35, there are approximately 20.7 mm diluted shares outstanding for an equity market capitalization of roundly $400mm. The 3/04 balance sheet showed $239.4 mm in cash and marketable securities ($11.57 per share), not a speck of debt, and total liabilities of $32.9 mm. The cash hoard was a result of the sale in May 1997 of its Cap Toys, Inc. and OddzOn Products, Inc. divisions to a wholly owned subsidiary of Hasbro. for proceeds of $134.5 mm.

The first quarter of 2004 was a total wipeout. On $65.7 mm in sales (versus $87.6 during Q1 2003) the company earned $0.02 per share (versus $0.49). Subsequent to the close of the quarter the company generously returned $7 per share of its cash hoard to shareholders in a dividend.

The stock trades, on a TTM basis, at an EV/EBITDA multiple of 8.6x and a P/E of 15.9x. In addition, the shares pay $0.30 in quarterly dividends offering patient investors 6.2% in dividend yield. There have been timid grumbling about reducing the dividend, but the rationale for doing so is not particularly convincing as the company is still debt free, holds over $4 per share in cash, and continues to generate cash from operations. For reasons I’ll describe later, it is probably more likely that the remaining cash be distributed before the regular dividend is cut...if at all.

BACKGROUND/HISTORICAL CONTEXT
Russ Berrie and Company was founded some 41 years ago by an enterprising college drop out named (you guessed it!) Russell Berrie who launched the business out of a rented garage and on the backs of furry mice and animals collectively called The Fuzzy Wuzzies. A former toy company sales person, Russ traipsed across the country selling his product directly to retailers of all sort.

The company went public in the 1980’s, though Russell held on to a controlling position in the shares. With increasing success and wealth, Russell became a huge philanthropist, contributing over $36 million to Columbia University and many millions more to other educational, religious, and disease research organizations.

This little piece of history reveals the soul of the company as RUS continues to be a direct sales driven extension of a singular personality.

Russell died on 12/27/02 of heart failure at 69. Upon his death the 49% of the company he owned was distributed through trusts to the Russell Berrie Foundation, his estate and other entities as described in the 1/09/03 8-K. Angelica Berrie, a former VP/Corporate Development and Russell’s wife, took over the CEO position. Josh Weston, formerly CEO of Automatic Data Processing, was elected Chairman of the Board. Both Angelica and Josh are on the board of the Berrie Foundation.

Not long after the founder’s death the Board announced its intention to explore “strategic options”. After the announcement shares traded for almost a year in the $30-$37 per share range. Apparently no buyers were found willing to pay the asking price and meet the required terms. Earlier on, in the 1999 timeframe and with shares trading in the low $20’s, Evercore Partners with Russell Berrie attempted to buy out public shareholder at $27 per share. For whatever reason the sale never was consummated.

After concluding its exploration of “strategic options” the Board hired a seasoned Toys R Us executive named Andrew Gatto as CEO, moved Angelica into a lesser position and paid out the $7 per share referred to above. On 6/2/04 the Board granted Gatto 250,000 ten-year options to buy RUS shares at a strike of $19.53, just a hair above today’s price.

INVESTMENT THESIS
This is a good business that is experiencing some weakness but trades at levels even the most miserly should recognize as cheap. Here’s a quick rendering of the point:


1999 2000 2001 2002 2003
Sales $277.5 $300.8 $294.3 $321.4 $329.7
Net Income 36.4 47.9 40.2 46.0 34.7
FCF 37.0 48.5 45.8 40.7 19.6
Cash/Securities 229.0 237.9 224.0 232.1 239.4
Equity 394.4 398.4 406.0 415.0 412.7

NI Margin 13.1% 15.9% 13.7% 14.3% 10.5%
Asset Turn 0.8 0.8 0.8 0.8 0.7
Leverage 1.1 1.1 1.1 1.1 1.1
ROE 11.5% 14.0% 12.1% 12.6% 8.1%

Adjusted For Cash:
NI Margin (1) 10.6% 13.2% 10.8% 11.1% 9.9%
Asset Turn 2.2 2.3 1.8 1.6 1.5
Leverage 1.4 1.3 1.3 1.3 1.3
ROE 32.8% 39.4% 25.4% 23.2% 19.3%

(1) Adjustment made by reducing reported net income by total interest income and applying a 35% tax rate to the result.

A slight deterioration in adjusted margins and asset turnover indicates to me some amount of competitive pressure and a weakening in the area of working capital management. In fact, when you go through the components of working capital you would notice a marked trend beginning in 2001 of slower inventory and receivable turnover compensated for by lengthened payable turns.

There is obviously a competitive element to the above as slower inventory and payable turnover often indicate tougher customer service requirements (broader product assortment, weakened trade terms, higher product availability etc). A slightly weaker margin reinforces the point.

These blemishes are not pustular but there are a few things that must be reckoned with.

Performance during Q1 2004 was quite weak. Angelica on a recent earnings conference call attributed the weakness to poor reception among traditional independent gift store customers of a new product line and to overall weakness in its core product channels. Her explanations possess a whiff of verity but don’t seem to tell the whole story.

As mentioned earlier, the company sells thousands of items sourced from lowest cost manufacturers to tens of thousands of retail customers worldwide. This has been and is a very strong business model as witnessed by the solid adjusted ROE’s put up over the years presented and many years preceding them.

It’s hard to see view Angelica’s problem diagnosis fully accounts for the 25% reduction in sales though. The profit annihilation flows largely from this lower sales volume, some gross margin compression and flat dollar SG&A spending. Can a poor product launch and a consolidating, slow growth channel really be THE culprits?

I think there are other explanations for the weaker trends and a punk Q1 2004 and proffer a few.

PLAUSIBLE EXPLANATION #1: A push to husband cash.
Against a backdrop of preparations being made for the eventual and likely not unexpected death of a 69-year-old beloved founding CEO (like efforts to sell or take the business private), a weakening domestic retail environment for gifts, toys and impulse consumer goods, and operational missteps (see below) it seems reasonable to me that a conservative management team might want to reign things in a bit. Tracing through inventory purchases made during Q1 2004 relative to those made during Q1 2003 it looks like RUS purchased 20% less product for resale year over year.

PLAUSIBLE EXPLANATION #2: Challenges implementing a new ERP system.
During the period leading up to The Year 2000 RUS began an effort to implement a new enterprise resource planning system. Early going was tough and RUS reported in its 2000 10-K:

“ During the second quarter of 1999, the Company completed replacement of the Company's custom software that had been utilized to operate and manage its domestic business. The Company experienced post-implementation difficulties with this new packaged computer software system that significantly affected the service levels provided to customers and other operational efficiencies. After attempts to resolve these difficulties, the Company decided to terminate the use of this recently implemented packaged computer software system.“

A charge to earnings was taken in that year related to the abandoned system.

Two years later this appears in the 2002 10-K:

“During the year ended December 31, 2001, the Company successfully completed the replacement of its warehouse management system in its main United States distribution facility. Beginning in early 2002, the Company began a project to implement a NEW packaged computer software system for the Company and its wholly owned subsidiaries and convert its second United States distribution facility to the new warehouse management system. The Company’s current custom software that has been utilized to operate and manage its business, and other third party software systems will be replaced using a strategic and phased approach.”

Then there was this in the 2003 10-K:

“During 2002, the Company began a project to implement a new Enterprise Resource Planning ("ERP") system for the Company's core businesses and successfully completed the replacement of its warehouse management system in its South Brunswick, New Jersey and Petaluma, California, Canadian and European distribution facilities in addition to the implementation of the purchasing module of its new ERP system worldwide. The Company's prior custom software that had been utilized to operate and manage its business and other third party software systems are being replaced using a strategic and phased approach. The Company's worldwide headquarters in the United States has also successfully completed the implementation of the finance module of the new ERP system and anticipates that it will transition to the order management and inventory modules during the second quarter of 2003. The Company's international subsidiaries have begun to phase in certain aspects of the Company's new ERP system and the transition to order management, inventory and finance modules is anticipated during 2003.”

Heads were tossed along the way, sacrificed for the bumbling and embarrassment...and then Andrew Gatto was hired. Here’s a brief on his prior experience from the company website:

“Gatto has more than 30 years of experience in the toy industry, most recently as Senior Vice President, Product Development, Imports and Strategic Sourcing for Toys "R" Us... At Toys "R" Us, Gatto created two of the most successful brands, Animal Alley Plush and Home Depot Tools, and established a global private brands division. He also was responsible for operations of the Asia Sourcing Divisions in Hong Kong and Shenzen.”

PLAUSIBLE EXPLANATION #3: Multi-year instability/upgrading of the senior ranks.

During Russell’s tenure as CEO and immediately after the ascension of Angelica the company engaged in a bit of senior management shuffling. I’ll leave the details to others to ferret out, but this had to cause some disruption.

INDUSTRY OVERVIEW
RUS competes in a number of product categories both domestically and internationally, though the company considers itself to be in the “gifting industry” (an amorphous amalgam if ever there was one). Accurate estimates of the size of its major product categories are time consuming to come by and may not be all that useful to evaluating the company. I view RUS as a direct selling organization of low priced impulse purchased items with the flexibility to move among product sub-segments as the demand patterns of its customers shift. Product design and development, sourcing capabilities and increasingly branding are the differentiators and can provide for long cycles of profitable growth.

Nonetheless, the toy industry is tough and competitive worldwide with domestic companies like Mattel ($5 billion in sales) and Hasbro ($3 billion) really swinging it around. Private companies like Ty Inc. of Beanie Baby fame ($750 million) are also quite well entrenched. Sales at competitors in this category grew in the single digit range last year.

RUS also competes against the likes of American Greetings, Enesco Group and Boyds Collection in gifts and collectibles and Blyth Industries, Yankee Candle, and many others in home decor.

THOUGHTS ON MANAGEMENT

1994 2003 CAGR
Sales 278.1 329.7 1.9%
Net Income 5.3 34.7 23.2% 1994 a trough in earnings
Free Cash Flow 0.9 19.6 40.8%
Net Cash/Securities 48.0 239.4 19.6%
Dividends $0.60 $1.20 8.0%

From this snapshot it is apparent that the company has not achieved consistent and meaningful top line growth (the period includes the sales of businesses mentioned above). Management, it would appear, aims for long-term profitability, cash flow generation and dividends. Looking at the narrower the 1999-2003 period, of the cumulative operating cash flow generated fully 72% of it was returned to shareholders in the form of dividends (47%) and share buybacks (25%). There is no reason to expect that this private company mentality will change much, even under a new CEO. Also telling is the fact that huge portions of marketable securities held prior to the distribution were in tax saving municipal securities.

I view the operating strategy as rational considering the markets served by the company. RUS runs a portfolio of unique products, each of which presumably reach some terminal level of sales and then levels off. Top line growth is likely to require adding to the SKU count or intensified efforts in brand building. The former adds complexity and leads to increasing capital intensity while the later might impact margins. I’ll take slow, profitable growth and distributed cash!

There are likely few Pet Rocks in the RUS product portfolio, but how many of you remember this: “Fuzzie Wuzzie was a bear/Fuzzie Wuzzie had no hair/Fuzzie Wuzzie wuzn’t fuzzie/Was he?” Fuzzie Wuzzies were launched in 1963.

VALUATION
Developing a value estimate for this business is tough, but we do have a few data points to work with. We know that a private buyer was willing to pay $27 per share back in 1999 and that the market ran up to $37 in anticipation of a sale earlier this year. We also know the following:

1) RUS is a structurally attractive business
2) Recent peak earnings of $2.37 were achieved in 2000 and we are currently in the trough
3) Earnings have been capitalized as low as 9x (at the 2000 peak) and as high as 20x (earlier this year, prior to the cash distribution)
4) There is over $4 per share of cash on the balance sheet
5) RUS likes to pay a growing regular dividend and has, on more than one occasion, made extraordinary payments
6) A new CEO recently joined the company with significant experience and incentives to move the business forward

I’m expecting a total return on the order of 100% within two years resulting from a rebound in earnings capitalized at the mid point of the range shown above, a flushing of all cash in the business in the form of an extraordinary dividend, and the continued payment of the regular dividend at the current level.

WHAT COULD GO WRONG?
1) CEO runs afoul of the culture of the firm and assimilates poorly or not at all

WHAT COULD GO RIGHT?
1) New CEO really knocks the ball out of the park
2) Successful small acquisitions made at reasonable prices (like the Sassy acquisition and others in the past which I didn’t address above)
3) Sale of business after the turnaround at a price approaching $40 per share

Catalyst

A few quarters of performance.