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JAKK - Jakks Pacific

January 08, 2008 | About:
MetCap

MetCap

0 followers
I'm looking for holes and comments in my analysis of JAKK as I believe it represents a solid investment opportunity with a margin of safety and reasonable expectation of return:

Jakks Pacific develops and markets over 3000 toys and consumer products through a diverse portfolio of licenses from many of America's best known brands. Jakks licensing partners include, Disney, Nickelodeon, Sony, MGM, Warner Bros. and many others. They hold the licenses for many of today's top children's brands such as Pokemon, Cabbage PatchKids, Care Bears , Shrek, Barney, Dora the Explorer and Pac-Man. They have been in business for over 12 years and have consistently grown revenue and earnings. The CEO/Co-Founder and Pres/Co-Founder have been with the company since inception and have a proven track record. They sell their toys through large retailers such as Wal-Mart, Target, ToysRus and Amazon.com. They also have a line of pet toys and products which they launched last year and are looking for growth from in 2008.

Jakks competes with much larger toy companies such as Mattel, Hasbro and Marvel. Over the last 6 months the toy industry has been hit hard by recalls resulting from quality control issues with Chinese manufacturing. Jakks to date has not had any of these problems. Additionally, I think the market expectation at this point is that holiday retail sales were weaker then forecasted for the toy industry and that given the state of the economy a weaker consumer will not spend as much on toys. I think these factors have resulted in the shares of these toy companies trading near or below their 52 week low levels. I believe this presents an excellent opportunity to purchase Jakks at a significant discount to it's intrinsic value as I think Jakks will be able to grow and take advantage of the problems that have hit their rivals, especially Mattel. I also think that in the long run people will continue to purchase toys, especially the toys that JAKKs sells, despite an economic slowdown.

In 2007 they won the licensing of Disney's Hannah Montana toys and accessories, including the full line-up of Hannah Montana dolls. Hannah Montana - aka Miley Cyrus, is one of the most popular musical acts and television shows for children today. The potential associated with her line of toys is very large and throughout the 2007 holiday season they were consistently listed as a top seller on both Amazon.com and ToysRus.

In 2007 Jakks launched EyeClops which many analysts considered one of the best selling toys of the 2007 holiday season. The week preceding Christmas, EyeClops was the #1 selling toy at both Amazon.com and ToysRus.

JAKK's balance sheet is strong, they have $186.8M of Cash, $6.62 of cash per share, and debt of only $98M, their debt to equity ratio is .149. Their book value is $23.23 per share, however their tangible book value is only $7.58 as they have a significant amount of Goodwill and Intangible Assets.

JAKKs is currently trading around $21, which I think is cheap based on the following fundamental valuations, especially when compared to MAT and HAS:

P/E (ttm) = 8.6

P/E (fwd) = 8.37

PEG = .83

P/S = .75

P/FCF ('07 proj) = 9.87

EV/EBITDA = 4.171

Market Cap = 600M

Revenue (ttm) = 810M

JAKK's gross margins have not been as strong as their peers, but their Operating Margins are in line with Mattel and they consistently generate solid Free Cash Flow. However, FCF as a percentage of revenue has been declining over the last 3 years, from 22% down to 7%. They claim that the new Hannah Montana and Eyeclops products will provide higher margins relative to their existing product lines, so as sales of these products ramp up they should see margin improvement and stronger FCF.

JAKKS's generated respectable Returns on Capital of 35% in 2006, up from 30% and 25% in 2005 and 2004 respectively. Their ROE, at 12.4 is significantly lower than MAT and HAS, however I believe this is due to the large amount of cash JAKKs carries on their balance sheet. They say they want to use the cash for an acquisition, but they've held the cash throughout the year and have received pressure from analysts to deploy it either through share repurchase or dividend. So it will be interesting to see how they use it in 2008.

For 2007 JAKKS provided ultra conservative guidance of $800M in Revenue and $2.39 EPS. This should be easily achieved given their cumulative revenue through Q3 is $572M and in Q4 06 they sold $238M (when they didn't have 2 of the top selling toys during the Christmas season). I think conservatively they will achieve at least $280M in Q4 sales resulting in $852M total '07 sales and $2.46 EPS. This represents top line growth of 11% over 2007.

Assuming they maintain FCF at 7% of Revenue for 2007, and they grow at only 10% for the next 3 years and 5% for the following 7 years, a DCF analysis gives me a per share value of $30.35, representing a 41% return. I think this is a very conservative estimate.

Two concerns to consider:

1) Insiders hold less than 2% of the equity and have set up 10b5-1 plans through which they consistently sell large chunks of stock. There's been no insider buying despite the low price and valuation. It appears that the CEO and Pres continue to sell their shares each year as their options vest.

2) They still have a lawsuit pending from WWE, World Wrestling Entertainment, in the state of CA, however the lawsuit was thrown out at the Federal level last month. WWE has a licensing agreement with JAKKS for their wrestling action figures, which WWE claims through the lawsuit, JAKKS used bribery to win. JAKKs vigorously denies the claims, and given the fact that the suite was thrown out at the Federal level I expect it will not move forward against JAKKs at the state level either, however it is still pending. Also, I expect that JAKKs will lose the WWE license when it expires, and the revenue associated with it's toys. I don't know what this is.


SUMMARY:

Currently trading at $21 per share I think JAKKs is cheap relative to a conservative intrinsic value of $30.35 and the market's current value of it's competitors, Mattel and Hasbro. I believe the market is selling off all toy companies based on the expectation of soft 2007 holiday sales, the overhang of the recalls due to the manufacturing issues in China, and expectations for less consumer spending. Given that JAKKs had two of the best selling products this holiday I think they will beat their conservative revenue and EPS forecasts and will show margin improvement. I also believe that they have an opportunity to win top brand licenses going forward as they have not had any manufacturing issues, unlike the high profile problems with their primary competitors Mattel and Hasbro. Lastly, JAKKs has a significant amount of cash to deploy, which, if done well could represent an additional upside for shareholders. The downside looks very limited here as I think the likelihood of JAKKs having a major mistep is low and I think consumers will continue to buy the types of toys JAKKs produces even if the economy heads into a recession.

Here's my conservative view of the possible outcomes, their odds of occurring, and their respective returns over the next 12 months:

1) 2007 Growth comes in above forecast. 2008 forecast of revenue growth at or above 10% with margin improvements from solid impact of Eyeclops and Hannah Montana product lines. Also expect continued performance of existing products - Odds = 45%, Return = 40%.

2) JAKKs meets 2007 forecast, and provides 2008 forecast of growth below 10% and limited to no margin improvement. - Odds = 30%, Return = 20%

3) 2007 Growth much higher than forecast due to strong Q4 and high impact of Eyeclops and Hannah Montana. 2008 Expectation of growth above 10% with strong margin improvements - Odds = 10%, Return = 75%

4) JAKKS misses 2007 forecast due to much weaker Q4 results than expected and expectation for growth in 2008 is tempered by overall economic conditions - Odds = 10%, Return = -20%.

5) Due to low valuation JAKKs is acquired by a competitor or Private Equity firm - Odds - 5%, Return = 40%.

Based on the above scenarios, the average expected return on an investment in JAKK is 30%.


Rating: 3.0/5 (11 votes)

Comments

highroi
Highroi - 6 years ago
MetCap,

I did a similar analysis back in August and bought a position at 20.80.

I agree that the market is mispricing this one.

I am waiting for earnings to add to my position. If they miss with the fear in this market you will be able to get the shares for less.

The insider sales are a little scary but for the year are not too bad when you consider that Jack Friedman has bought and sold roughly an equal amount if you consider options as a freebee.

highroi

MetCap
MetCap premium member - 6 years ago
Thanks for your comments.

Do you have an expectation that they will miss their earnings guidance for Q4 and if so, why?

Given the strength of Eyeclops and HM, and their Q3 performance, it seems highly unlikely to me that they would not be able to at least achieve the same level of sales as Q4 '06, which would put them past their $800M forecast by $10M.
highroi
Highroi - 6 years ago
I have no reason to believe they will miss their earnings target.....

It is just that I have a position already....if there is any bad news it will be disclosed in

February. I am happy with my position, currently, and would be more than pleased to add to it in the $15 to $18 range. This stock trades with such volatility as can be seen with the 5 year chart combined with the excessive fear in this market that I truly believe

somewhere in that range is possible with the wrong kind of news.

If I had no position now I would buy half a position and the other if the stock tanks in February.

Best of luck

highroi
warelf
Warelf - 6 years ago
"JAKKS's generated respectable Returns on Capital of 35% in 2006, up from 30% and 25% in 2005 and 2004 respectively. Their ROE, at 12.4 is significantly lower than MAT and HAS"

Nice write-up & thesis. One thing I don't understand is your ROC figures. Surely they should be lower than ROE since 'E' is one component of 'C'

Standard & Poor's CapitalIQ has ROC as follows & as far as I can see their calcs are correct

2002 6.7%

2003 2.0%

2004 6.5%

2005 9.4%

2006 8.7%

TTM 8.5%

Also you must subtract the cost of acquisitions as well as capex from OCF to get FCF otherwise growth from acquisitions is "free". This company is a serial acquirer and relies on acquisitions for growth. Over the last 5 years average OCF, Capex, Acquisition Capex & FCF

OCF $71.9m

Capex $9.0m

Acquisitions $45.5m

FCF $17.4m

To normalize these figures you can say that OCF has averaged 12.5% of revenues, Capex + acquisitions 9.5% and FCF 3%

The ROC figures over the last 5 years would suggest that this company is barely covering its cost of capital & that the acquisitions have mostly failed to enhance shareholder value - now of course Hannah Montana may single-handedly change the course of the company's future but for how long??

Based on past performance I wouldn't be too happy to hear that the company wants to use cash for acquisitions

Hasbro & Mattel are infinitely better on ROC & ROE which is why they deserve a higher P/E multiple to JAKK

Mattel ROE 23.9% ROC 14.2%

Hasbro ROE 22.2% ROC 15.5%

I think that Mattel at a 2008 forward P/E of 10.5 could be a much better buy

I reserve the right to be wrong as I haven't done much research here

warelf
MetCap
MetCap premium member - 6 years ago
Thanks for your comments, they're very helpful and perhaps explain why JAKK is being valued as it is in the market.

I calculated ROC using EBIT/(Net Working Capital + Tangible Assets). Do you know how S&P defines ROC?

Good point about breaking out OCF, as you could tell I just subtracted CapEx from OCF to get the FCF figure I used. Where did you get the $45.5M Acquisition figure?

You may also be right about MAT being a better buy for the long term, especially as it goes lower. Barbie and Fisher Price are tremendous brands that probably aren't going away.


warelf
Warelf - 6 years ago
Hi MetCap,

CapIQ uses ROC = EBIT * (1 - tax rate) / (Equity + Debt)

They average the beginning & ending equity & debt.

It's a good approximation for ROIC which is usually

ROIC  =      After Tax Operating Earnings  /                                        Total Assets - Excess Cash - Non-Interest-Bearing Current Liabilities


Your ROC method boosts the numerator & decreases the denominator & thus gives a much larger ROC. EBIT must be adjusted for taxes because shareholders ain't gonna get that money. I wouldn't deduct goodwill & intangibles because they have been bought with cold hard cash as the company made its acquisitions - I want to see what return they are getting on that investment.

Acquisitions are pretty lumpy - just $15.6m in the trailing 12 months but $109.8m in 2006. I average the acquisition expenditure over the last 5 years to get $45.5m average. Then to adjust for increasing revenues I average the revenues over the same period and then get the % of acquisitions (I do it for capex too) to revenue. That way if you predict $900m revenues in 2008 you can get a normalised figure for capex & acquisitions.

If you don't do this the FCF base used in a DCF (or P/FCF) will be distorted because of the variability in capex & acquisitions.

Of course the company could dial back on acquisitions & increase its FCF but then we'd have to dial back on expected growth because that's been the growth engine

warelf

highroi
Highroi - 6 years ago
I believe Mattel is a good buy and has great brands but trades at almost 2 X the EV / EBITDA as JAKK.

I don't think you can go wrong with Mattel I just think JAKK is underfollowed, underappreciated and thus more under valued.
MetCap
MetCap premium member - 6 years ago
Hi Warelf, thanks again for your comments. I'm going to retrace your analysis to make sure I understand it because it provides good insight into the value of JAKK's business model. It's what I was trying to achieve, but it looks like you're doing it correctly!

It will be interesting to see their Q4 results and determine the impact of the new line of toys. Management said they were higher margin products, so if they were a significant contributor to sales I would think that would result in stronger FCF.

The best growth engine would be great toys, so let's see if that's what they have.

MetCap


warelf
Warelf - 6 years ago
Hi MetCap,

I agree with you on the best growth engine to be great toys & Hannah Montana is very popular which generally = higher sales & better margins.

I view most toy companies as cyclical and not long term investments. So I think you are right to concentrate on the business near term to medium term outlook

http://finance.yahoo.com/q/bc?s=JAKK&t=2y&l=on&z=m&q=l&c=MAT,HAS

warelf

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