JAKKS Pacific - An amusing revival
One trait that the market devalues the most is uncertainty, especially earnings volatility from quarter to quarter. Uncertainty creates a haze in the future, disabling financial projections from painting a clear picture of what’s to come. JAKKS Pacific is an exemplary instance of this. The US-based toymaker’s performance features wild swings from negative to largely positive quarterly EPS ratios throughout one fiscal year.
Company Background
JAKKS Pacific, headquartered in Santa Monica, CA, produces its own toys marketed largely for children. The company produces a range of toys, from action figures, electronics, dolls, dress-ups, costumes, kids' furniture, seasonal products, and construction toys. Some of its notable products include toys from the Super Mario Bros. franchise, the Sonic franchise, Disney Princesses, and APEX Legends. Furthermore, the company has licensing agreements with Nickelodeon, Pixar, Disney, Marvel, Netflix, and many other companies within the entertainment industry.
The company outsources its manufacturing to various third-party producers in China and sells FOB from China, meaning the title changes hands at the point of origin of freight. This improves working capital utilization at the expense of some interest cost. Contract manufacturing also provides the flexibility to tune operating rates to fit different sale cycles while avoiding the burden of fixed costs.
The founder, Stephen Berman, is still active in the company but only holds a minority position, roughly 2% of the company, while the rest of the shares are held by mostly institutions and the largest position held by individual named Lawrence Rosen with 18.6%.
Macro trends
We may think the digital age has hampered the demand growth for toys because children have begun obtaining access to electronic entertainment devices at an earlier age, but there are other forces counteracting that.
Trends driving toy demand growth
Digital transformation—Interactive and electronic toys have become smarter and smarter in recent times. In the 2000s, we had the robot dog that could perform simple actions, but as AI and machine learning capabilities improve, the possibilities of a toy reach far beyond “fun” interactions and into “instructive” ones. Furthermore, younger children still prefer physical and material objects to digital ones until a certain age.
Rising disposable income - toys are discretionary items. Lower-income households are not able to afford the same amount of toys as middle and higher income. As the economy improves and the middle-income segment grows, the demand for toys will follow suit.
E-commerce boom - the access to purchase and receive toys at the doorstep through the internet cuts short the time wasted walking around shopping malls to find a certain brand or theme.
Licensing and branding collaboration - the meteoritic rise of Marvel, Disney princesses, and similar fantasy genres of entertainment have provided a complimentary boost to the toy industry, driving demand through strong brand recognition.
Educational focus - the themes flooding news headlines and the investing world is tech. This has precipitated the emphasis on STEM, and in that, the preference to enhance skills in problem solving, science and mathematics through toys designed for infants/toddlers.
The US is the largest toy market in terms of revenue in the world, estimated to be about $40b in 2024, and still growing at 3.65% CAGR. Below is the breakdown of revenue by category.
Worldwide demand for toys and games
Source : Statistica market insights
The trends point to a stable growth of the toys market. We will likely see more interest in smarter toys due to new technological capabilities and the growing importance of education in the success of the next generation.
JAKKS Pacific - catchy and classic toys
Though JAKKS Pacific does not produce smart toys, the company has a long track record in the sector of around 30 years and is a well-known brand. The collaboration chart below displays the caliber of household names that have partnered with JAKKS to produce their thematic toys. Out of the aforementioned 5 drivers above, the toymaker drives primarily on trends 2-4 (rising income, e-commerce, and licensing/collaboration).
JAKKS revenue is split roughly 80/20 between US and International sales, and international sales have shown to be a profit center that the company could continue to grow. Even though competition remains fierce there, JAKKS has grown firmly at a 4.3% CAGR in that market over the past five years.
The company primarily sells through distributors (Target, Amazon, and Walmart), which accounts for roughly 65% of its net sales.
In recent times, there has been an apparent shift in adult culture, seen in the popularity of anime, ComicCon, and video games among young adults. Within the toy sector itself, “kidults” have been a growing consumer base, accounting for roughly 1/4 of the total toy sales. Understanding the market dynamics within this segment would be insightful as it provides feedback on the preferences for these products.
To get a glimpse of their opinions on the company’s new releases, we examine the online reviews on Reddit provided by these consumers on the previews.
Comments on Reddit thread Jakks Pacific Simpsons figures preview March 20 2024
Source: https://www.reddit.com/r/ActionFigures/comments/1bke3uy/jakks_pacific_simpsons_figures_preview/
The general sentiment points towards better product releases and understanding of demand in the older population. The Simpsons is a brand new product theme line that the toymaker obtained the license for in late 2023.
The Sonic and Super Mario Bros series over the past few years were influential revenue contributors, cited in various earning call transcripts. With the upcoming Sonic TV show and Sonic 3 in 2024, we expect the company to be able to maintain a similar performance to last year.
Income Metrics
Successful theme launches in the past few years have revived revenues back to $700+m per year in the past couple of years, with the most recent year (2023) clocking $711.6m
Annual Revenue of JAKKS Pacific (2006- 2022)
Source: Statistica
Superficially, the revenue trend does not instill confidence in the company as a growth prospect; the revenue numbers display uneven revenue changes YoY and overall downward trending sales, additionally, QoQ numbers also rise and fall drastically throughout the year. However, a closer look gives us a clearer picture of this attribute.
Source: StockAnalysis.com
Starting with quarterly figures, the toy maker experiences large swings in the top line due to the cyclical nature of the business. This makes logical sense; demand for toys increases drastically towards the end of the year when the holiday season and film releases drive up gift-giving activity and interest in the entertainment industry together.
Unfortunately, during the first half of each year, when JAKKS experiences negative quarterly EPS, uncertainty peaks. Unprofitability breeds numerous questions about the business's condition in the near future. What if the company cannot hit the targets during its next(best) quarters? This is a cause of concern worth examining.
To answer this question, we need to differentiate the revenue stream by nature. Analyzing sales by segment can clarify some of the doubts that derive from oscillating quarterly revenues. The revenue composition by segment depicted below breaks down the areas responsible for that and, ultimately, whether these have longer-term implications.
Source: JAKKS Pacific Q4 2023 Presentation materials
This graph indicates that JAKKS’ peak year in 2022 was propelled by a bumper year in Costumes and Content-led Action toys (seasonal). The release of Sonic the Hedgehog 2 and Encanto boosted this segment of sales by roughly 3x in comparison to the previous year, as cited in the Q4 2023 earnings call.
Fast-forward to 2024, the management team stated in the Q4 2023 earnings call they expect the release of Moana 3, Sonic the Hedgehog 3, Knuckles, and Sonic Prime this year. JAKKS will follow with the release of its own corresponding collection of toys. Considering the success of their respective predecessors, this will likely boost, or at worst retain, the level of sales in the seasonal segment.
Nevertheless, the combined sales of the Evergreen Action Play, Costumes, and Outdoor/Seasonal Toys segment has continued to grow in the past five years from $423m to $567m in 2023, which gives us confidence in the company's more foundational and sustainable revenue stream.
And if we observe holistically, this revenue drop was not company-specific. The graph below depicts that purchasing has been down across the board in the sector. Total tracking data from the Toy Association indicates a pullback after the strong growth between 2019 to 2022.
US retail sales of toys per catagory in the past 5 years
Source: The Toy Association, Circana/Retail Tracking Service/US/Jan-Dec.2023
The segment experienced a correction of $2.3b in the data that has been tracked by Circana, representing a drop of roughly 8% YoY.
The main risks in revenue stability and growth lie in JAKKS’s ability to retain and renew its contracts with major licensors SEGA and Nintendo. SEGA's latest renewal was in 2021, and Nintendo's was in 2020. These two licenses have driven revenue durability in recent times as they constitute the evergreen action play revenue segment. We will need to rely on the management’s ability to execute and renew these contracts.
Moving down the P/L statement, the margin growth is an impressive aspect that the company has recently been able to improve heavily on. Although sales have dropped, they have increased profitability through cost reduction.
JAKKS Pacific Gross Margin 2019-2023
Source : Q4 2023 Earnings presentation
JAKKS has been able to control costs mainly at the COGS and interest expense levels. Plastics and other petrochemical products have been suppressed lately due to excess supply and weakened demand in China, pointing towards better cost measures for JAKKS.
The company used excess cash flow in the past few years to focus on repaying debt fully. This expensive long-term senior debt was priced at SOFR + 5.5% - 7% (based on the net leverage pricing grid) and issued to Benefit Street Partners. It also contained negative covenants that restricted the company's ability to incur additional indebtedness and make investments. With the facility's release, JAKKS can explore M&A activities and use a larger pool of resources to drive revenue growth.
SG&A and other expenses have grown in line with revenue in this time period.
In Q3 of 2023, which is annually its best-performing quarter, revenues dropped by ~$13 m YoY, but concurrently, the cost of sales dropped even larger, by ~$28 m. The highlighted items in the P/L statement below display some areas where the company has improved.
Q3 2023 Current report
Source: Form 10-Q JAKKS Pacific
The second and third highlighted improvements in expenses (change in fair value of preferred stock derivative liability and interest expense) are long-term benefits that will be considered for projection purposes as both liabilities (preferred stock and long-term debt) have been extinguished.
Although the GP Margin % trend points upward, past records show that there is a ceiling. JAKKS has historically been comfortable and capped around the 30% level, as seen during 2010-2011 and 2014-2017.
With these crucial points in mind, the company’s bottom line has made a tremendous recovery from its state five years ago, and there does not seem to be any obstacle in sight that can materially change this.
Balance Sheet and Cap Structure
As of the latest report (Q4 2023), the company has a fairly healthy and simple balance sheet. As mentioned above, it runs an asset-light strategy, holding IPs and design licenses while offloading its manufacturing requirements to China. It boasts a healthy current ratio of 1.71 while maintaining a $38m reserve for sale return and allowances (~5% of annual sales) and does not have any long-term debt, leading to a book value of $190m. Goodwill is minor at $35m.
One concern is the preferred stock derivative liability, which has accrued dividends over the past years.
On August 9, 2019, the company issued 200,000 Series A Preferred stock at $100 per unit to recapitalize its balance sheet. This could be construed as a debt issuance through the instrument of a preferred share instead of a long-term loan, which helps the construction of the balance sheet. The preferred stock features a perpetual and accreting feature, meaning that the 6% fixed dividends must be either paid in cash or accrued, increasing the inherent value of the preferred stock by that accrued amount (if no cash dividends are paid, the 6% will compound). Furthermore, there is no maturity date, and the redeemable feature is quite favorable to the holder, to say the least.
“…holders of the Series A Preferred Stock are entitled to receive an amount (the “Liquidation Preference”), in preference to holders of Common Stock or other junior stock, equal to (i) 20% of the Accreted Value in the case of a certain specified transaction, or (ii) otherwise, 150% of the Accreted value, plus any accrued and unpaid dividends.”
- Form 10-K JAKKS Pacific
Through accounting procedures, the liquidation value set out in (i) and (ii) must be included as a long-term liability, which we see in the balance sheet as a preferred stock derivative liability of $29.9m (calculated through a DCF under various assumptions). To date, the company has not issued any dividends, and as a result, the dividends have accrued to $6m, meaning that the company will need to pay out ($20 + $6)m *1.5x = $39m to redeem the shares.
Recent Development—JAKKS announced that it has negotiated a redemption settled at $35m on March 12, 2024. This represents a discount of roughly $4m from its liquidation value and could be perceived as a positive development, as the multiplier on accrued amounts in the liquidation/redeemable value means that the true interest rate is closer to 9%+ rather than 6%. The amount was split between $20 m in cash and $15m in shares.
In 2022, the company had a large gain in assets for deferred tax assets from losses incurred in years before. The valuation release performed in that year through standard GAAP procedures indicates that the tax benefits are more likely than not to be realized in the coming years, and JAKKS can use that to reduce its future effective corporate income tax rate.
Overall, the balance sheet does not show any major red flags. The toymaker has been able to accomplish a robust balance sheet through a conservative strategy during times of waterfall profits.
Valuation and Estimated Return Profile - DCF
The assumptions made will reflect a fairly conservative stance as we see historically that the company has not proven its ability to grow revenues consistently over the long term. Though we have seen a revenue CAGR% growth of 4.9% in the past 5 years, we will sensitize and use a conservative 3% to match current inflation. Below is the assumptions table that underpins the DCF valuation model.
Assumptions table ($ in USD mms)
-Inflation follows long-term inflation targets set by Federal Reserve
-Preferred dividend expense disappears, redeemed on 12 March 2024
-Terminal Value based on EV/EBITDA Exit, lower than large peers Hasbro and Mattel
-Tax rate calculated at current rates, lower than standard due to deferred tax assets
Preferred shares would have been counted as debt as the structure governed in the agreement seems to present more debt-like characteristics than equity ones, but these quasi-equity units have been redeemed already.
Discount Rate
Discount rate follows WACC and cost of equity through the CAPM model. We use the reference rates in the US for the RFR and Retail General category for the market beta. Since the company is free of debt, there is no weightage effect for debt.
DCF Model
DCF built by writer
Before going into the value per share of JAKKS, a couple of notes: Stock-Based Compensation (SBC) is not added to the calculation of Free Cash Flow to Firm because it will have a moderate dilution effect over the course of five years. At current stock prices, the company pays about $8m in shares every year. We have also assumed NWC changes will even themselves out over the long term, as the company has not laid out any plans to modify its working capital strategy. CAPEX stays in line with the TTM levels; historical numbers indicate there is little to no deviation from this number.
The model outputs an equity value of $54.5 per share using Q4 2024 outstanding shares.
Market Comparable
EV/EBITDA and P/E comparison between all near comparables
Source: Market Screener
JAKKS Pacific’s valuation ratios have been far below the mean and median numbers throughout the past three years. Using a valuation graph, we can visualize the company's undervalued position among its peers.
Range of valuations
Light blue represents the 25th percentile to the median, and dark blue represents the median to the 75th percentile.
We can observe the sizable distance that sits between the company and the market. The market clearly has yet to reward the US-based toymaker well over the past few years. If we use the median market comparable case for EV/EBITDA and P/E, it translates to a fair value per share of $51.57 and $53.93, respectively, near our discounted cash flow output of $54.50 as the base case.
Based on the total analysis I have presented above, the equally weighted average of the 3 methods represents a fair value for the toymaker. JAKKS will need to prove it can sustain its seasonal releases, which have been big hits over the past two years. Propitiously, the company has laid out its plans for product releases in 2024, and it looks to be another quality year.
Understanding the quality of earnings historically gives us a sense of security in the stability of earnings in the future. External factors such as competitor dynamics and the global macroeconomic outlook may reduce the company's profitability, but those factors would suppress the whole industry anyway, introducing the possibility of a pair trade.
Suitable entry
NASDAQ: JAKK has seen a sizable drop post Q-4 earnings report due to missing expectations, but the Q4 results do not warrant the market overreaction. The $12 reduction in price from ~$ $35 to $23 per share gives us a decent entry point into a long-term call option or outright purchase of shares. But since the first two quarters are typically slow, we foresee recovery later this year when Q3 results are released.
