Holdings: Oaktree, founded by Howard Marks, made an offer of $20. David Dreman holds 5.9% of the company. The management holds 2.3%, chiefly because of stock rewards. This is surprising because the current CEO was the co-founder of the company.
Business: I don’t particularly like Jakks' business. On the surface, it is toy-maker and marketer but it does not own (almost) any of the brands. It licences the trademarks from companies who own the brands, e.g. Disney (DIS), Warner Bros, Star Wars, Hello Kitty, Nickelodeon. Once it licenses them, it produces toys and other consumer products and sells them in Toys ‘R’ Us, Walmart and Target (these three represents 41% of the sales for the last six months). It has to pay an upfront guarantee and also license fees in return of using the brand name.
There are several problems with the business, the chief being children outgrowing toys at a much younger age, in favor of more interactive and high technology products. The life cycle of individual products is also decreasing and they are becoming obsolete sooner. The toys that Jakks sells at the mega stores like Walmart are not really top notch quality. This also acts as a detriment for customers who expect quality, and functionality (for example: Hasbro, Mattel and Lego toys).
Fueled by acquisitions, the company’s sales increased quite dramatically and had nearly tripled by 2008. But the situation turned during the recession and the sales are plummeting. The company gave another sales warning last quarter.
Profitability & Cash flows: The cash flow history of the company is strong. But this does not complete the picture. The company’s gross margin has declined year after year. Given that the company does not own the brands, it acts as a “laborer” for the license owners. Companies like Disney take a guarantee and charge license fees from Jakks, which gets stuck with producing and selling the toys and assuming all business risk. It has to manufacture the toys, and hope that it remains famous until it can earn enough money to justify the fee it paid. It seems that with time, the situation has become bleaker.
Management: The company generated a lot of cash in the last 10 years -- at an average rate of $52.6 million a year. The management made some really awful acquisitions and wrote off nearly $400 mn of goodwill in 2008. To put that figure in perspective, the company had a market cap of $500 million at that time (it has a market cap of $112 million now).
The question is - why did the company not sell itself to Oaktree? Taking a page from Charlie Munger there is a one word explanation -- incentives.
As I pointed out, it is surprising that the management, which includes the cofounder as the CEO, holds less than 3% of the company. This too is due to option and stock rewards.
For the management, the company is a golden egg laying goose. Their profit is aligned with increasing the sales and not by realizing value for the shareholders by the sale of the company.
For a company with such a small market cap, the executive compensation is truly outrageous. The five directors get paid an average of $200k. They sit of the compensation committee and group Jakks with its “peers” -- Activision, Electronic Arts, Hasbro, Leapfrog, Mattel ... for the purpose of deciding the executive compensation. I just want to make it clearer that Jakks is not in the same peer group as these other companies. Chiefly because they own their brands. Furthermore, they don’t just produce the toys but also design and own the intellectual rights for new ones. Even if they outsource the production of their products, they will still earn money on the licensing fees.
Balance sheet: The company has $69 million in cash and $96 mn in long term debt. Although not particularly burdensome, I must point out that all this debt is convertible. In situation of extreme duress the shareholders will be diluted if the debt is converted into shares. The balance sheet is quite strong at the moment. If the company continues to lose money -- the situation might not remain so.
Bottomline -- I don't know why Oaktree offered $20 a share for the company. At the time of the offer, the company had a much better balance sheet with nearly $200 million in net cash. It might be that Oaktree expected to sell the business for a higher price. When the going gets tough, there are a wave of acquisitions and bankruptcies. Synergies could be achieved to drive the gross margin higher -- if the company makes toys of its own brands.
I will advise staying away from the company. I don’t like the business and I don’t like the management. I will cede that at these prices the incentive of the management will be to turn the company around. Given their history of acquisitions, I lack faith in their ability to do so.
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