Table of contents
First of all, the disclaimer: I am invested in the JAKKS Pacific stock ($JAKK). This tends to be an illiquid stock where even small purchases, can trigger significant price movements. Nothing I say or write should be considered investment advice.
With an EV/FCF ratio of 4.5, an adjusted PE/Ratio of 4 and de facto no debt, the stock, valued at a market capitalization of $150 million at the time of this writing, actually has everything to attract investors' attention. There are good reasons why this has not been the case so far and equally good reasons why this could change soon.
Please also have a look at my detailed video (GERMAN):
JAKKS Pacific is a US company that primarily manufactures and sells toys and costumes. The group acts both as a licensee for well-known brands such as Disney, Star Wars and Nintendo and increasingly as a manufacturer of its own brands.
Although the production of the items is outsourced to Chinese manufacturers, JAKKS is usually the owner of the manufacturing tools and machines, that are needed for production. If the manufacturer changes, the location of the machines also changes. Thus, the company has a far-reaching influence on the manufacturing quality.
For distribution, the company relies on large partners such as Walmart and Target, which accounted for the largest share of total sales through Q3-2022 at 27.5% and 26.5%, respectively.
Regionally, sales have so far been strongly concentrated in the USA, although Europe in particular has shown significant growth as a market in recent quarters. It is precisely this US concentration that the company intends to increasingly reduce and has already taken steps to this end. In 2020, sales via distributors were replaced by direct sales in relevant markets such as Spain, France and Italy. COO Jack McGrath will also relocate full-time to the UK site from January 2024 and manage European operations from there.
History and relevant key figures
JAKKS slid into crisis at the latest with the bankruptcy of the Toys'R'Us toy chain, which at the time accounted for 11.3% of total sales. The downward trend in sales accelerated rapidly and EBIT slipped significantly into negative territory. The share price followed the falling turnover just as rapidly.
At the same time, net debt increased significantly and the negative interest coverage ratio (EBIT/interest expense) increasingly made interest payments a real threat. The cash position was cut in half from 2015 to 2018 - basically bad conditions to raise new capital. The company was well on its way to follow Toys'R'Us into the abyss and also become a Chapter 11 case. Investing in the share at this point would have turned into a pure gamble. But the picture has changed in the meantime.
The Investment Case - A Successful Turnaround
In the recently presented figures for the past FY 2022, the balance sheet appears to have been changed. Of the former 150 million net debt in 2019, only 2.46 million US dollars are left. Equity has increased significantly from 4.5 million to 148 million in the same period.
A look at the profitability figures strengthens the impression of a successful turnaround. Here, the Adjusted EBITDA and Net Income figures should be considered in any case, as a major non-cash one-off effect occurred. The Valuation Allowance of 52.64 million causes both key figures to swell to an unsustainable size, which is not to be expected in the coming years. The PE ratios and other profitability ratios that can currently be read on popular valuation websites and that are calculated automatically (this also applies to the profile at the beginning of this article) should therefore not be trusted, especially in this case. Instead of the reported PE ratio of 1.5 to 2, this results in a PE ratio of approx. 4 based on adjusted net income, which I have, however, again adjusted for the Stock Based Compensations, This results in a normalized net income of 38.35 million for the past year.
The picture also brightened considerably for sales, which are at their highest level since 2015. As a result of the significant reduction in operating expenses, EBIT is now clearly positive again. In the case of the significantly lower gross margin in the 2022 YoY comparison, a further special effect should be taken into account. JAKKS uses a form of co-op advertising in which buyers of the company's products promote them and receive a discount on the purchase price in return. According to 10-K 2021 The picture also brightened considerably for sales, which are at their highest level since 2015. As a result of the significant reduction in operating expenses, EBIT is now clearly positive again. In the case of the significantly lower gross margin in the 2022 YoY comparison, a further special effect should be taken into account. JAKKS uses a form of co-op advertising in which buyers of the company's products promote them and receive a discount on the purchase price in return. According to the 10-K 2021 2 to 10 percent and was previously recognized as selling costs, i.e. operating expenses. However, as of the beginning of 2022, these costs have been booked to sales allowances and thus reduce the gross margin. In the last earnings call, CFO John Kimble estimated the negative impact on gross margin at 200 to 250 basis points. Therefore, the gross margin tends to be stable, which also explains the low operating expenses in relation to sales.
Especially when one-off effects are at work, it is worth taking another look at the cash flow. The company itself reports an operating cash flow of 86 million for the full year 2022. Either minus the CapEx of 10.4 million or the Maintenance CapEx (I take D&A as a basis here) of 10.6 million, this results in a free cash flow of approximately 75 million.
However, I consider it fatal to take this as a given when it comes to valuation. Shifts in working capital were responsible to a not insignificant extent for the high operating cash flow. Since the 10-K had not yet been published at the time of this article, I have provisionally calculated the relevant shifts on the basis of the items in the balance sheet. Based on these and less stock-based compensations, the adjusted free cash flow for the full year 2022 is approximately 42 million. In short, this could at least be considered the more 'sustainable' free cash flow. However, a higher tax rate should also be expected in the medium term.
Reasons for the turnaround
Sales increased, EBIT strongly positive, net debt close to 0 and large cash reserves. The question is how the picture could change so much. CEO and co-founder Stephen Berman sees 3 points as relevant.
1. rationalization of SKUs, i.e. streamlining the product portfolio to eliminate low-margin products.
The entire cost of the product was considered, not just the costs incurred during production. In particular, the costs of product warranties and the positive consequences of streamlining the entire business.
2. reduction of product costs and operational costs.
Both are very clearly reflected in the sustainably higher gross margin and lower SG&A costs. I am basically a friend of arguing that we as investors do not need to understand 'every' point in detail. This point is one of them. I see that the streamlining at SG&A level has been marked by success and the organization as a whole does not seem to be suffering as a result. The development seems to be sustainable.
3. the restructuring of debt.
These included above all the reduction of high-interest debt and the extension of maturities. In 2021, a large part of the loans existing until then were replaced by a new term loan. This point is more relevant than it first appears, as it also has an influence on the company's decisions beyond pure interest and redemption service.
Term Loan & Preferred Shares Prevent Buybacks & Dividends
With a cash balance of 85 million as of Dec. 31 and virtually no net debt, just looking at the balance sheet one might wonder why the company has not yet considered buybacks, dividends or acquisitions. Given the low market capitalization, the company could mathematically buy all outstanding shares within 3 years.
In addition to the considerable interest rate, the reasons for this are to be found in the specific capital structure. The terms of the term loan prohibit restricted payments and takeovers. In principle, the term loan puts the management on a short leash with regard to all financial decisions.
Looking into the Term Loan Agreement in the "Restricted Payments" section, we find a note stating that dividends may only be paid to preferred shares, which in turn prohibits dividends to ordinary shareholders. Incidentally, the covenants are unrestricted in this respect until the term loan has been repaid in full.
The mentioned Preferred shares, which were issued to the lenders, represent the ultimately more relevant part with regard to dividends and buybacks. These are included in the balance sheet of JAKKS with a par value of 21.92 million as of December 31, 2022.
The interest rate is 6% per annum and can be structured as PIK (payment in kind), i.e. the dividends do not have to be paid out in cash but can be added to the liability. JAKKS has made use of this right to date. The preferred shares can be repurchased at any time after repayment of the term loan (Note: This may refer to the term loan of 2019. In the Terms and conditions of the preferred shares however, it states that the regulations also apply to loans replacing the term loan. This applies to the Term Loan of 2021).
Furthermore, it is clear from the terms and conditions that the prefs have no end date and, moreover, are only repurchased at 150% above par value, consequently 150% of the value on the balance sheet, i.e. $32.87 million as of Dec. 31. The 20% mentioned at the same point is not relevant for our case here.
The preferred shares are also subject to the condition that they must be repaid in full before dividends can be paid or buybacks executed. Long story short: No dividends or buybacks before term loan and preferred shares are repaid.
However, both are components that could be a significant price catalyst, so it is definitely of interest to us if and when a repayment is intended. With regard to this, there have already been some developments after December 31.
Of the term loan, only 30.8 million was still outstanding as of March 3, while the cash balance was still 40.2 million. So a mandatory payment due to the high cash flow and a voluntary payment significantly reduced the outstanding amount. I know from a direct email from CFO John Kimble that paying off the term loan in full is also just priority 1 over other options for the use of funds. I understand that this is primarily due to the fact that the other options are limited by the loan and also the quite high interest payments. After that, at least the way would be clear for acquisitions. Not surprisingly, I would be less interested in this than in buybacks or dividends.
So what are the chances of the preferred shares being bought back? Low as of today. The 6% interest rate on the Prefs, compared to the alternatives, is a low interest rate for JAKKS, which is also not paid out in cash. Replacing this liability in the current interest rate environment with a loan covering 150% of the current par value would seem insane. The company would have to be flush with cash to take this option, although I think it is quite conceivable that the pref holders would be willing to accept a lower amount. Why do I think that? The Prefs have no end date and the interest is not paid in cash. The pref holders have no interest in having their capital tied up ad infinitum. Especially in this interest rate environment. Such conflicts of interest between buyer and seller are usually settled on price. This is exactly what I think is realistic after the repayment of the term loan.
Valuation - Significantly below peers, but...
Although JAKKS has now paid off a significant portion of the term loan, we don't know how the other items have shifted away from cash, so I'm assuming the enterprise value is as of Dec. 31, 2022.
What struck me in some other JAKKS valuations was that preferred shares were completely left out of the calculation of enterprise value. For mezzanine capital, which is located between debt and equity, I think it is the worst idea not to include it in either debt or equity when calculating EV. Especially when EBIT or EBITDA including the 'payments' to the holders of the preferred shares is considered. Without repayment of the Prefs, the FCF cannot be expected to be used in the interests of the shareholders. I therefore include them in the following with the potential liquidation value of 32.87 million in order to take a prudent approach.
With regard to the cash position, I assume for simplicity that 20 million is required for the operating business and consider the rest as excess cash. 20 million corresponds to the amount that has to be held as a minimum under the term loan, which will soon no longer be relevant. I take the minimum balance as a pure reference point for this consideration.
This results in an enterprise value of 197 million.
JAKKS is therefore valued at approx. 4.5 times FCF, 2.75 times EBITDA and 3 times EBIT as of April 5. Initially, Mattel and Hasbro appear to be suitable peers, as both operate in the same business segment and also report according to US GAAP. Thus, we do not need to make adjustments for leases to obtain comparable figures. In various Seeking Alpha articles and on Twitter, the two companies are also repeatedly used for comparison, and it is precisely with this that I have my difficulties, as they are not appropriate peers.
I have adjusted the free cash flow, net income, EBITDA and EBIT of the respective peers for one-off effects in the same way in order to obtain 'actually' comparable figures as far as possible. For the forward P/E, I have used the reported multiple based on analysts' estimates. This already reveals the difficulty in comparing the apparently correctly selected peers. All calculated multiples suggest a clear undervaluation. However, JAKKS EBIT margin is not even remotely comparable to those of its major competitors and never was in the past. Assuming such a strong operational improvement for the company is also not serious. Hasbro and Mattel already have significantly higher gross margins because they have much higher margin product lines that JAKKS will not be able to match in the foreseeable future. That is precisely the problem with such peer group comparisons.
Taking the historical multiples of JAKKS as a basis also seems wrong due to the significant improvements in both gross and operating margins. Apart from the US peers, Vtech is a comparable company with similar margins. However, as it is based in Hong Kong, it will be traded at a discount.
Taking Vtech's rating as a lower limit therefore seems tempting, but ultimately I'm not a fan of direct comparisons here either. However, these are not even necessary. With JAKKS, assuming stagnating sales, margins and cash flows, I get a company that has a strong FCF yield, would enable a dividend yield of approx. 24% with a simplified assumption of full distribution of earnings, and is also de facto debt-free. As soon as the company starts buying back shares or paying dividends, the stock should also be granted a higher multiple. However, it is not unlikely that management will favor acquisitions. This should be considered, but according to John Kimble's statements, I do not think a long-term overriding of the interests of the invested is likely.
How sustainable are JAKKS' figures?
So measured by FCF and earnings, the company seems cheap, but how sustainable are the reported numbers? The company does not issue guidance, so we have no clue, at least from this side. Q4 revenues were significantly lower than last year, triggering a rapid short-term drop in the share price. However, there was actually a convincing explanation for the decline. Already in the Q3 call, the CEO communicated that JAKKS has recently preferred Free on Board (FOB) as an Incoterm, i.e. as soon as the container with the goods on the ship has arrived at the port, costs and risks are transferred to the buyer. In the earnings call, the Management Board also reiterated that Q3 will henceforth be the relevant quarter in which most sales are generated. For the year as a whole, sales increased significantly by 28%.
In general, he said, one should not look at individual quarters, but rather look at an entire year, as there will always be major game and movie releases that will have a positive impact on the company's respective quarter. For example, the Super Mario movie released on April 05, to which JAKKS. distributes merchandise.
Since the company can certainly be considered a cyclical company, it is also worth taking a look at past crises. For example, the years 2008-2010. In these years, JAKKS had to contend with falling sales and high goodwill write-downs, which were unsurprisingly accompanied by significant losses. However, even in those years, operating cash flow ex SBC and Movements in Working Capital was still clearly positive at 28.55 million. The company was clearly in a different position then, but it may well be an indicator of future crises.
What can at best serve as a small indicator of the sustainability of the results are the recently published targets to which the executives' bonuses are linked. The lower limit of these targets is 57.6 million EBITDA. One could assume that, from the executives' point of view, this is apparently an achievable target that has been negotiated. Last year the lower limit was 40 million, the upper limit 70 million. The final result was above this.
If JAKKS can at least repeat last year's figures, I believe it is already significantly undervalued. Even if Mr. Market does not immediately prove me right about the undervaluation, I firmly believe that the preferred shares will be bought back in the foreseeable future and that buybacks or dividends are approaching as a realistic short- to medium-term goal. Consequently, I get my return via multiple expansion or dividends at some point. Before that, however, we must assume that the company will again make acquisitions.
In the short term, however, I continue to expect increased volatility in the share price, as quarterly results have already been overvalued once and led to a rapid fall in the share price. Should this be the case, I would again significantly increase my position. As of this writing, JAKKS has a 5.8% stake in my portfolio and I got in at an average of $15.53.
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