Description

Let me put the investment thesis right up front: Boyds has some of the finest economics of any public company, and since we value investors seldom run across such a business selling at a discount to appraisal, I recommend a look. The company is a designer and importer of high-quality, hand-made collectibles and giftware. In short, they sell stuffed animals and figurines. What's not evident from that prosaic description is how much money they rake in, and how management has used the company's free cash flow to reward the
owners.

Started in 1979 by a husband and wife team, Boyds grew rapidly throughout the '80s and '90s, first selling antiques, then specializing in plush teddy bears and resin figurines. The company elected to only sell to department stores and gift retailers, a practice that continues today. The company maintains a continuity line of collectibles, introducing new versions each year and retiring the older pieces. Boyds has significant brand equity and collectors search out the company's products by name. The company's collectors club, the
Friends of Boyds (thus the trading symbol) has 130,000 members, each paying $35 a year to receive the company's newsletter and special offers. This contributes to the company's $154 million in sales in 2001, a decline from 1999's record sales of $211 million.

Back in 1998, when the founding family was taking home 35 cents on every dollar of sales (income tax was the largest corporate expense), Kohlberg Kravis came calling and performed a leveraged buyout, providing a windfall to the founders and leaving KKR with majority ownership. A year later, Boyds was flipped to the public at $18 a share, but saddled with debt more than twice yearly sales. Since then, the company's revenues have largely treaded water as their retailer base consolidated, but that's just the headline. Underneath, the business continues to yield incredible economics. On sales of
$154 million in '01, the company booked net income of $39 million and operating cash flow of $58 million. Capital expenditures were a whopping $6 million (they must have repaved the parking lot), so the business generates free cash flow equaling one third of sales.

Excess Profits:
Boyds imports everything from third-party manufacturers in Asia, so the vast majority of the company's employees work in the shipping department. In short, they have no depreciating assets save for a big warehouse. Boyds, a designer and licensor, works with buying agents in China to create the products to their specifications. Once sold to the company's 18,000 accounts in the United States, the company laughs all the way to the bank.

Amounts are in millions, except EPS:

1999        2000        2001

Sales                 211.1       184.0       153.5

Net income             53.1        41.4        35.8

Net income margin     25.2%       22.5%       23.3%

Diluted EPS             .89          .70         .60

Free cash flow           66.9        48.8        52.0


Because the company has little plant and equipment, maintenance-level capital expenditures are just a rounding error at less than $3 million per year. Retained earnings are used to buy back stock and repay the company's debt, and since the IPO, debt has been reduced from $443 million to today's $140 million. In short, this company is using its excess profitability to rapidly change its capitalization. When the company was private and unleveraged, net
income margins held at 35%. Public and still leveraged, net income margins are in the 23-24% range. In the coming years, the company could well be debt-free and owned by the equity owners outright, with net income margins around 30%. Not bad for a company with a trailing P/E of 10-11.

The Brand:
Though not well known outside of its loyal customer base, Boyds has a significant brand. They actively trademark, copyright, and protect their products, and though their manufacturers could sell the company's products to others, Boyds maintains a substantial barrier to entry in their 18,000 domestic accounts totaling 24,000 different shops. The company licenses its designs to others, including manufacturers of clothing, wallpaper, and home furnishings. Third-party price guides show that the company's products retain
their value as collectibles, and the company has never cheapened the brand by selling to value-priced retailers. To further their brand and showcase their extended line of products, Boyds is constructing a flagship museum/store in Gettysburg, Pennsylvania to open in September. The company has budgeted $16 million to construct the store, the company's first ever capital expenditure of any size. Called Bear Country, it will be the largest teddy bear store in the world and will undoubtedly attract busloads of visitors who would rather
shop than tour Civil War memorials.

Free Cash Flow Machine:
Free cash flow over the last five years totaled $318 million. The stock
market recently valued the company at $420 million, or about eight times normalized free cash flow. KKR is partially to blame for the discount, since they retain 60% of the common and thus voting control. The flip side is that KKR, the definition of a willing seller, would readily sell the business if the opportunity availed itself. They are certainly not wedded to the teddy bear business.

Liquidity concerns:
Debt totals $140 million, but is rapidly being paid down. Interest expense runs around 8% of sales, well below the company's operating margin of 40% in '01. In what was probably the worst year in the company's history, Boyds reported free cash flow of $52 million last year, comfortably providing a cushion to what would normally be an aggressive debt structure. In '02, principal payments of $14 million come due, followed by $17 million in '03 and $23 million in '04. This is no longer an overleveraged company.

Shareholder governance:
Management has demonstrated that they run the company for the benefit of the owners. Of course, that includes KKR. Ignoring the modest consulting fees that KKR charges Boyds, management has done all the right things. They have bought back 3.1 million shares since '99 and repaid more than half their debt. This is a straight-talking management team, many of whom have been
long-time employees from the pre-KKR days. One concern is that the CFO, who quit in January, has not been replaced, though this isn't a complicated business.

Valuation:
The stock market values Boyds at around $430 million. Based on management's comments on past conference calls and some incremental sales from the Gettysburg store, I think it likely that the company will have sales of $160 million and EPS of 70 cents for 2002. Consider that gross margins in '01, a down year, showed year-over-year improvement before an extraordinary charge
for early debt repayment, and inventory and accounts receivable levels are extremely conservative. Interest expense continues to decline as debt is paid down and expense controls have been excellent. No heroic assumptions are needed for modest EPS gains.

Though not exactly the same, their closest comparable is Russ Berrie (RUS). RUS sells for a P/E of 16, also on declining sales and profitability, though RUS's net income margin at around 14% pales against Boyds's 23%. I think it likely that Boyds will trade near RUS's multiple as investor concern over declining sales dissipates. At a 15 multiple on EPS of 70 cents, shares of Boyds are likely to sell above $11 a share, a significant increase from today's level. This ignores the incredible, and growing, levels of free cash flow the business generates. Remember that in three years or so, all the debt will likely be paid down. From that point forward, the equity owners will own
all the cash flow and the glorious opportunities $50+ million in cash will provide each year.

Catalyst

Catalyst:
1) As Ben Graham wrote, "Value will out." Boyds's superior economics will out over time, especially as the company reduces debt and corresponding interest expense.
2) KKR, not wedded to the teddy bear business, will entertain offers at a price significantly higher than eight times annual free cash flow.
3) Excessive concern over declining sales will vanish, especially as the company relies on its core continuity line for most of its annual sales.
4) The company is rapidly running out of debt to repay, and the equity owners will soon own the company outright. Unleveraged and public, as it likely will be in the years ahead, the company will have net income margins well north of today's 23%. The public markets are unlikely to continue to hang a 10-11 P/E multiple on such an operation, and the company is selling at a significant discount to appraisal.
5) With substantial brand loyalty, a diverse customer base, a continuity line of figurines, and absolutely nothing to spend the profits on, Boyds will one day command a stock market valuation commensurate with its superior economics.