JAKKS Pacific Inc. (JAKK) - Value with a catalyst, or value trap?
A quick overview of the business- JAKK is a toy maker. This is normally a pretty steady business (sales were relatively stable during the 2000-2002 recession), but sales fell off a cliff during the “Great Recession”. The toy business may also be facing slightly secular headwinds as children grow more interested in electronics at an earlier age.
In 2008, the company completed some relatively disasterous acquisitions, buying three companies from October – December and then writing down almost all off the goodwill (almost $40m versus today’s market cap of $360m!) associated with the purchases by June. In terms of “I immediately regret this decision,” the purchases weren’t quite Bank of America buy Merrill Lynch (humorously, Merrill is one of JAKK’s financial advisors) bad, but they’re among the quickest/worst acquisitions I’ve ever seen.
Earlier this year, with JAKK’s priced ~$15, Oaktree Capital Management offered to buy the entire company for $20. JAKK’s rejected the buyout, saying it significantly undervalued the company… and then proceeded to turn in this bomb of a quarter that resulted in the stock dropping below where it was before Oaktree offered to buy them out.
With that in mind, let’s start talking valuation and see if there’s a value opportunity here. First, JAKK’s is in a very, very strong financial position at this point. They currently have ~$230m in cash versus $90m in debt (not due till 2014). However, the company’s last balance sheet is from September, when they have an A/R build up in preperation for the holiday selling season. As the season ends, A/R will come down. The company should easily end the quarter with ~$290m in cash. So let’s make that adjustment and say that JAKK’s currently has $200m in net cash, or a bit under $7.70 per share (26m shares outstanding). Given a current share price of $14, that’s not bad at all.
Once you consider that net cash position, JAKK’s looks pretty dang cheap on an earnings basis. Trailing twelve month EBIT comes in at $48.2m, or $1.46 per share. With an EV of ~$6.30 per share ($14 market price – $7.70 in net cash), the works out to an EV / EBIT of under 4.3x. That’s pretty dang cheap for just about any business.
And when you start thinking about it compared to peers, it’s downright ludicrous. Since all of their competitors have the same problem with working capital build, let’s just ignore it and pull numbers straight from yahoo finance for a comparision. JAKK’s trades for under 3x EV / trailing EBITDA, compared to over 9.1x for MAT and 7.2x for HAS.
Now, a lot of you are probably thinking “that’s true, but that’s on a trailing basis. JAKK’s 4th Quarter (by far their most important) is going to be a disaster and EBITDA will likely drop significantly. So how do they stack up considering that?”
I’m going to answer it by discussing why I think Oaktree saw value in JAKK, and then completely changing the valuation metric.
Oaktree likely thought to themselves- here’s a significantly underlevered business that generates pretty steady cash flows. The business is clearly consolidating and brands are going into larger players hands. No matter what we do in the short to medium term, the endgame is pretty clear: JAKK’s gets sold at a premium to one of the major competitors who can realize huge synergies.
Consider this- JAKK’s gross margin started off the decade in the high 30%s and has slowly drifted down to the mid to low 30%s throughout the decade. Mattel’s GM is in the high 40%s, Hasbro’s in the high 50%s. Mattel and Hasbro both enjoy operating margins in the mid-teens, JAKK’s (even when times are good) barely hits the double digits. That’s a sign that size (and scale) can make a difference in this business.
Now think about how much value one of the big players could capture if they improved JAKK’s operating margins. Full year 2010 margins came in at 6.7%. They’ll likely be lower this year given deleveraging and the poor fourth quarter, but let’s say they stay at 6.7%. Jakk preannounced full year sales would come in at $660m. If Mattel can increase their operating margins to 10% (well below what the rest of the company gets, and in line with what JAKKs made until the crisis), that would represent ~$20m in increased earnings power. At a 6x multiple, that synergy represents an increase in EV of $120m, or half of JAKK’s current EV. Then think about what happens if Mattel can get JAKK’s margins close to the rest of their business……
Given that a potential acquirer would likely be thinking about buying JAKK’s and creating huge value from synergies, it might not make sense to look at JAKK’s current earnings power. Instead, consider what they trade for on an EV / Sales basis compared to Mattel and Hasbro. JAKK’s trades for ~0.33x EV / Sales (if we use $660m, their pre-announced figure, as their sales number). Mattel trades for 1.67x, and HAS trades for 1.3x. Those are some huge, huge discrepancies. That’s what I think all these value investors saw in JAKK when they bought the shares, and that’s the type of end game scenario I think Oaktree was looking at when they offered to buy the company.
Let’s think about the full scenario. What thought they could improve JAKK’s margins to 12.5% through synergies (below company average), and JAKK’s long run revenue potential was $750m (remember, they went over $900m in 2008). That would give JAKK EBIT of ~$93m under Mattel’s rule, and I wouldn’t be surprised if that significantly underestimates the amount of synergies to be realized. Assuming all the debt converted, JAKK would have 33m shares out and net cash of $290m. If Mattel bought them for $25 per share, that would represent a multiple of 5.75x EV / potential EBIT. Seems like a good deal for everyone- Mattel buys them at a huge bargain and creates tons of value (plus plenty of upside if they can realize even more synergies or get sales back up to the $800-900m range) and JAKK’s current shareholders make out like bandits and get a huge premium.
So, I’m clearly thinking JAKK’s represents a great value at today’s price. The market is clearly valuing JAKK’s in its present form (or maybe even at a discount to its present form) but not assigning any value to their potential as a strategic target.
But, so far, I’m holding back on investing. There are some serious risks here that have me more than bit nervous.
First, insiders own basically no shares in this company. In total, insider ownership comes out to a measly 1.8%. That works out to total ownership of ~$5-6m. The CEO made more than $4m last year. If I were him, why the heck would I sell the company??? Same for the Chairman- the total he’d receive (not the profits, the total) on a buyout in the low 20s would be less than he made in 2008.
Second, capital allocation is terrible. Those acquisitions were just outrageous, and if the company truly believed they were- why aren’t they getting more aggressive with the stock repurchase plan? They haven’t bought a share back since the first quarter of this year. All of the debt is convertible, which would result in serious dilution for shareholders if it happened, and the company’s preferred method for raising money seems to be converitble debt, as they issued this convertible debt to pay off their last round of convertible debt. Convert debt is probably the worst way to raise money, as it allows debt holders to enjoy all the upside of equity while protecting their downside, so it again draws serious questions around the company’s capital allocation policies.
Finally, I’m not sure I really like the industry. My limited knowledge of toy companies suggests that they tend to find themselves in financial duress rather quickly if they don’t capitalize on the “next big trend” or have enduring, . While JAKK claims to focus on “evergreen” brands rather than trends, it seems they do like to chase after hot toys in acquisitions, and many of their toys are produced on license, rather than owned brands. This greatly increases their risk as they could lose the license (as the did with WWE characters) or have to pay minimum royalty fees if sales suffer (as they will this quarter).
That about sums it up for me- the company appears staggeringly cheap at today’s prices, but really questionable management incentives + capital allocation have kept me on the sidelines for now. I could see myself taking a position at some point,
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