Description

Summary

• Business with durable competitive advantage
• Business with low capital requirement and high ROI
• Proven track record and shareholder friendly management
• Continuous share buyback program, at value creating level
• Under researched, only 1 analyst coverage / sporadic updates
• Low valuation at 7.9x normalised and 6.5x this years expected earnings

Description

All figures in Sterling: Character Group is a UK based, AIM-listed company engaged in the design, development and international distribution of toys, games and giftware. The Company had already been the subject of an early 2012 write-up, and in our view deserves an update after recent back-on-trend performance and positive outlook. The Company was founded in 1991 by its current management who still retains 39% of the shares outstanding. The Company is primarily focussed on the pre-school / early school age groups. Although the tablet/digital market is already showing signs of acceptance in this age group, it is still majority driven by a curriculum of age old, tested, recurring characters like for example Fireman Sam, Postman Pat, Peppa Pig, and more recently Doctor Who, Zhu Zhu Pets and Scooby Doo. I speak of personal experience having raised children in the UK that the toys and interaction have moved on over the years, however the characters easily stand this critical test of times and over many generations.

Activity

The business initially started out by industry veterans as an in-house designed, Far East manufactured pure licensee taker. Through some turbulence, including the divestiture of a troubled digital camera distribution business, the company found its stride in the mid-2000s, morphing itself into a toy designer and marketer.

Character Group Plc is now the fourth largest U.K. toy company behind Mattel, Hasbro, and Lego. Based in Surrey on the outskirts of London. The company’s products are typically priced between £9.99 and £14.99, making them less susceptible to online games and other new age distractions. The process is well documented; the licensed toys or in-house created content are designed by the company’s UK based development team, the final sketch then gets outsourced for production in the Far-East, managed by their Hong Kong office, after which the company takes control again of transport and delivery to the large UK based retailers (75% of revenue - mainly Tesco, Toys-R-Us, Argos) as well as International buyers, in the US, Australia, Italy and Spain. The Company has a solid track record of designing, manufacturing and selling a diversified mix of successful products over a long period of time, whilst satisfying all regulatory issues controlling this sector. The product range allowes for certain toys to be seasonal hits, however they never bet a season on one product.  The main competitors have also remained the same over the years. We see these points as a strong competitive advantage over new competitors, who have mostly entered and left this tight market on lack of profit generation.

Growth vs Value Creation

We conservatively value the Company with a no-growth potential, where 80% of FCF generated flows back to shareholders ( = long term average), either through dividends or share buy backs, depending on what is most opportunistic vs the current valuation. Indeed management has a formidable track record of large buybacks over a long period of time. The company has bought back 21.5ml shares since 2008 for approx. £27ml and returned £8.5ml via dividends. The company bought back shares from 3i during the crisis. 3i owned 11,5ml shares or 27,67% of the company at that time. Character bought back a large number of shares at approx. 5x average Net Income and FCF over 2007-13 creating substantial value for shareholders. By doing so management earned top marks for capital allocation. FCF permitting, management also stated it has no intention of changing this policy. Recently, a UK investment manager ( Ruffer) took a 9% position purchased from the two largest shareholders, Richard King and Kiran Shah, respectively Executive Chairman and Group Finance Director / Joint Managing Director. However, the usual pattern for buybacks sees the company buying back shares in the open market from the public and management. In doing so, the management maintains its percentage stake.

Recent trading - return to normalized earnings

We started analysing the company mid-2012 after a combination of weak seasonal product mix, UK high street recession and excess stock, took a toll on earnings and depressed the share to levels were we became interested and started to accumulate shares in the name. Using our estimate of conservative normalised earnings for the 2007-13 period, which includes the disasterous 2008 Christmas period, we see a P/E multiple of 7.9x on £4.5ml average after tax profit. However, the company has made excellent progress and with this year’s expected earnings of £5.4ml, the multiple drops to 6.5x. Good cost control, reducing debt and expanding the business internationally leave further upside potential. Additionally, the board continuously renews its share repurchase program, having opportunistically bought back 50% of the outstanding shares since 2008, FCF permitting.

Risk

• Concentration risk amongst top clients (for example Woolworth was a large customer before it went bankrupt in 2009, 48% of current sales are with Top 3 clients)
• Macro headwinds / wrong product mix, both of which we see of temporary nature.

Catalyst

• Low capex intensive business and efficient use of FCF for buybacks or dividends.
• With cashflow generation returning to normalised levels, the Company recently increased the level of share buy backs. 
• Company now has good visibilty after a strong Christmas season and follow up sales, we therefore anticipate that high level of share buy backs will be maintained.