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JAKKS Pacific ($JAKK): Value Potential with Risk

December 22, 2011 | About:
10qk

Barel Karsan

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This week was rough for JAKKS Pacific (JAKK), the California toy maker. It issued a profit warning on its all-important Christmas quarter as a result of its toys not picking up traction among consumers. (In keeping with the standard corporate practice of blaming the economy for poor results, management of course cited a "difficult retail sales environment for toys" as the only cause for the nearly 40% reduction in its estimate for holiday quarter sales.) The stock fell 20% in one day and now appears quite cheap relative to its cash flow.

The company trades for just $350 million despite a net cash position of $140 million and free cash flow above $50 million in each of the last two years. Last year, the company generated a return on equity of more than 11%.

If you think it's cheap, you wouldn't be alone among value investors. Oaktree Capital, which is run by Howard Marks (whose recent book is summarized here) made a bid earlier this year to buy the entire company for $20/share (it currently trades for under $14). Oaktree owned almost 5% of JAKKS at last check, while Dreman Value, run by David Dreman (whose books are summarized here) owns 6% of the company.

But there is enough hair on this company to give investors at least some pause. First, the company's debt is convertible into equity in a couple of years. The conversion price is only about 10-15% higher than the current price, but would result in the share count rising by more than 20%! As a result, under certain circumstances, equity investors may encounter significantly reduced upside potential.

Second, while the cash flow in recent years appears strong, whether this is sustainable is a little suspect. First, depreciation and amortization are far higher than capex. Therefore, the company is likely enjoying all the cash flows associated with licensing certain brands without making the investments that will generate the same cash flows in the future.

Exacerbating the company's issues is its goodwill situation. In 2009, the company didn't just take a big bath, it drowned itself in a 12-foot swimming pool. And it wrote down hundreds of millions of dollars of goodwill in the process. On the other side of the coin, the companies it purchased are contributing healthy amounts to the its cash flow. This is noteworthy because the company is paying earn-outs to the sellers of the companies it has bought! This means the purchased companies' financial targets are being met/exceeded, even though their goodwill has been wiped out. This suggests the company's return on equity is overstated at best, and prevaricated at worst.

The management issue is tough to figure out. Though the current CEO was a co-founder of JAKKS, he only assumed the CEO role in 2009 (and was a co-CEO at that). He has been sole CEO since 2010. Despite being a founder, his ownership position is rather small at 172,000 shares, most of which are restricted stock grants he has received in the last couple of years! He takes home $4 million in salary, however, suggesting his incentives lie in growing the company rather than delivering shareholder value. This may explain why he rejected Oaktree's approximately $650 million purchase offer; he's not likely to think like an owner the way his incentives are lined up.

Because 2011 is only his first full year running the company on his own, it's difficult to evaluate his ability as a manager. But, as discussed in the first paragraph of this article, the year did not go well.

Finally, the company has an issue with its cash position. Most of its cash is likely stuck overseas and subject to repatriation taxes if brought back home. This would serve to explain why the company needs debt despite a sizable cash position: The cash is stuck.

JAKKS definitely shows a lot of value potential, but it clearly involves some risks. Let me know what you decide, or what other factors you considered before making your decision.

Disclosure: No position

About the author:

Barel Karsan
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.1/5 (15 votes)

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