Blatant Undervaluation: Jakks Pacific
After a complete 180 degree turnaround with a recent debt restructuring, new additions to management, and a renewed directional focus, Jakks Pacific presents itself poised for significant upside with its better-than-ever fundamentals and strong outlook of future profitability. The Fortune Alerts team initially alerted this in the mid $3s, however still strongly believes that current market pricing heavily discounts it with a 2-3x potential. While there is a lot to cover about this toy company, there are many other recent analyses posted as well about this company, therefore we aim to review the highlights & key takeaways.
Here are our thoughts in a nutshell:
Largely forgotten and under-followed in the business and investment world, Jakks Pacific is still arguably a leading Top 5 toy company with annual revenue regularly in excess of half a billion dollars. Founded in 1995 by the now late Jack Friedman and current CEO Stephen Berman, the company took advantage of their uniquely strong relationships with Big Name partners such as WWE, Disney, Nintendo, Sony, etc for licensed product lines that drove explosive sales on a seasonal basis, similar to the rest of the industry.
However, things took a turn for the worst when one of the company's largest customers, Toys R Us, entered into bankruptcy forcing Jakks Pacific to enter into unfavorable debt obligations along with restrictive covenants, similarly known as debt spiral debt, to stay afloat and cover the losses. This was further supplemented when the company experienced declines in certain licensed product lines due to the "trend" nature of the business as what was popular in past doesn't always work for the future. Furthermore, many of these licenses were cost-ridden with high upfront license costs to acquire them along with expensive royalties that significantly affected overall company margins. Thus the volatility in company revenue from excess of $700 million to now revenues in the $500m's. In retrospect, the company took the necessary actions needed to stay afloat in hard times, maneuver through multiple takeover situations, and completed their transformative 3 year plan to turnaround the company while intentionally staying "silent" during this transformation. Now after officially restructuring their balance sheet in meaningful terms, the company is quite literally undervalued, especially compared to peers.
Opportunity: Diamond in the Coal
Glancing through the select 10 year financial comparisons, we can see the erosion in company fundamentals along with the market share price. However, one of the largest inhibiting factors to this reversal was the company's (now past) capital structure.
The CEO ,Stephen Berman, even notes this significant potential inflection point in the FY Q1'21 report:
"Finally, we are hard at work on strengthening our balance sheet, with a strong product and cost momentum we have built over the last year, we are in a good position to reduce our overall debt and realign our borrowings with our growth plans. If we can get our debt payment structured in a way that it can be paid down with our improved operating cash flow, we believe investors will see how much value there is in our shares. In closing, I would like to thank our incredible team as well as our extended team of customers, licensors and vendors for all their hard work and support over the last year, coming together to deliver these great results in the first quarter. We continue to take the steps needed to position the Company for profitable growth and we couldn't do it without the dedicated team we have around the world."
This statement qualifies management's efforts from their now basically completed 3 year plan started in 2018:
"For the last two years we have been working diligently to improve our profitability, even as we have faced significant revenue challenges. We've embarked on a 3-pronged plan to improve results. First was to reduce our product cost and operating expenses to allow us to be more profitable on the revenue that comes from our core product categories. Second, we've been working to drop lower-margin products and take into account the total cost of a product, not just its product cost. These 2 steps have lowered our breakeven level and positioned us well for even stronger profits when we do launch successful promotional products.
Their efforts have provided meaningful results from dropping low margin products like "Fun-Noodles", improving core evergreen product lines, and decreasing costs the company has consistently improved gross margins over the last 4 quarters from a measly 18% gross profit margin to now over 30% consistently, which is expected to be their "peak" margins, especially as a majority FOB type business unlike the majority DTC businesses Hasbro and Mattel which boast higher margins at a significant risk exposure. That distinction itself also has its benefits which we will touch upon later.
The company has finally switched from just creating more "sales" into refining current lines into "profitable sales", and has noted that their "base" annual sales with core product lines (without any "hits") are in the excess of half a billion range. Now that low margin product lines have been removed, the company has moved towards creating its own IP (c'est moi with influencer Liza Koshy, etc) while taking advantage of its uniquely strong relationships with Disney, Sony, Nintendo, for movie release toy lines (Raya & Encanto) and video games (Sonic & Mario).
Debt has been significantly reduced from the death spiral configuration, from an excess of $200 million at a high interest rate that exceeds 10% with dilutive convertible notes in 2018, to the recently restructured balance of $119m as of June 30, 2021 including a $99m term loan at roughly ~7% interest.
From the 10k fillings here is a brief overview of the past debt structure compared to the new:
Past Debt Structure (2020):
-Term Loan with 2023 Maturity of $129 million at ~10.5%
-2023 Maturity Convertible Notes of $19 million convertible notes at 3.25%
-Preferred Notes of $20 million at 6%
New Debt Structure(2021):
-New Term Loan with 2027 Maturity of $99 million at ~7.5%
-Convertible Notes of $14.1 Million, matured this September, thus the increase in O/S with dilution. (this is now resolved completely, so $0 convertible note balance now)
-$6.2 million PPP Loan, company already applied for forgiveness and the debt repayment is suspended
In theory, the debt at face value should technically be only $99 million, which is just the Term Loan at favorable terms with an extended maturity date (assuming PPP is forgiven). Along with this, the company also has a credit facility with JPMorgan set to Mature in 2026 of $67.5 million, but no balance as of the Q2 report.
There are quite a bit of details overall here, but the main take aways so far in this story is:
-Refined Product Lines towards profitable sales
-Fixed Balance Sheet and Resolved Convert Overhang
Now on to the Management Changes.
In 2019 the company replaced the previous CFO with former Mattel Exec John Kimble who brings a rich history of license acquisitions and corporate development.
"With Jakks’ recent recapitalization in the rear window, I believe that my skill sets, which include experience in finance, licensing, gaming, and international sales, will allow me to assist Jakks in the development and implementation of its business strategies aimed at increasing shareholder value,” Kimble said in a statement.
The company has also been on a role by expanding their board of directors with former execs from Disney, Rubies, Christy's, etc to build their Disguise Costume brand and also improve their core product offerings.
So far we have quite a few take aways:
-Refined Product Lines towards profitable sales
-Fixed Balance Sheet and Resolved Convert Overhang
-New Management Team with renewed Directional Focus
The company has quite literally changed as the fundamentals are at pre-2013 levels where we should be valued at more than $300 million market cap or a $25+ per share valuation. We believe a bullish case of $30+ per share most definitely exists if the company can continue with its execution of driving consistent, profitable sales along with its unique big time "hits".
Several metrics have been used in evaluating what Jakks Pacific should be worth, but EV/ EBITDA (TTM) along with some other ratios should arguably work. For 2021, it can be reasonably expected that the company will produce $45-55 million in Adj EBIDTA. Overall, an easily tenable argument can be made that Jakks Pacific should be priced in the mid to high $20s at minimum.
For EV/ Adj EBITDA, Hasbro generally trades at roughly 16x, Mattel at 12x, and Funko at 11x. Jakks Pacific trades at a measly ~4.5x EV/EBITDA. Until we get better sell side and buy side interest, we don't think we will match competitors just yet. However, we do believe a 8x valuation is easily warranted at minimum with current company fundamentals which places the expected share price in the $20s. With growing interest in the name and recent institutional purchases (522k share buy from Toy Insider Rosen Lawrence (Chairman of Cra-Z-Art)), we believe Jakks Pacific has room for significant upside.
Looking at the certain ratios, Jakks trades at a minimum in Price to Sales while industry competitors trade at a multiple. Trading at less than half of sales still gets us to the expected share price. Similar story for other ratios as well.
With the historically strongest quarter coming up within the industry (Q3 on Oct 27th), one can expect a decent run up to earnings as this quarter alone is expected to do $250 million. At the end of the day, Jakks Pacific presents itself as a company that finally turned around and is trading at just a fraction of what it should be, especially when compared to its fellow competitors.
With the season pointing to supply chain issues, one advantage that Jakks Pacific has on its side is that its a FOB type business in which buyers assume risks and liabilities of transport which comes at the cost of lower margins (30%s vs DTC of 40%+). Therefore, it can be expected that a majority of its revenue is already "guaranteed". Additionally, management explained in the previous earnings that they pulled a higher amount in inventory in anticipation of potential supply chain issues, thus we expect Jakks Pacific's supply chain to be relatively intact.
In conclusion, after struggling for years, Jakks Pacific has finally undergone a transformational fundamental change and presents itself at a heavy discount relative to peers and the fortune alerts team recognizes this as a buying opportunity with significant upside, especially going into the holiday season. This ~$600 million in annual revenue company is just getting started on the road to its former glory, and the market should soon catch onto it.