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JAKKS Pacific, Inc. (NASDAQ:JAKK)

Q2 2013 Earnings Call

July 17, 2013 4:45 pm ET

Executives

Stephen G. Berman - Co-Founder, Chief Executive Officer, President, Secretary and Director

Joel M. Bennett - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Analysts

Stephanie S. Wissink - Piper Jaffray Companies, Research Division

Edward M. Woo - Ascendiant Capital Markets LLC, Research Division

Sean P. McGowan - Needham & Company, LLC, Research Division

Operator

Good afternoon, ladies and gentlemen. Thank you for joining the JAKKS Pacific Second Quarter 2013 Earnings Call with management. Today, JAKKS will review the results for the second quarter ended June 30, 2013, which the company released earlier today.

On the call today are Stephen Berman, President and Chief Executive Officer; and Joel Bennett, Executive Vice President and Chief Financial Officer. Mr. Berman will first provide an overview of the quarter, then Mr. Bennett will provide detailed comments regarding JAKKS Pacific's financial and operational results. Mr. Berman will then conclude the prepared portion of the call with highlights of the product lines and current business trends prior to opening up the call for your questions. [Operator Instructions]

Before we begin, the company would like to point out that any comments made about JAKKS Pacific's future performance, events or circumstances, including the estimates of sales and earnings per share for 2013, as well as any forward-looking statements concerning 2013 and beyond are subject to Safe Harbor protection under the federal security laws. These statements reflect the company's best judgment based on current market trends and conditions today and are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected in forward-looking statements. For details concerning these and other such risks and uncertainties, you should consult JAKKS' most recent 10-K and 10-Q filing with SEC, as well as the company's other reports subsequently filed with the SEC from time to time.

With that, I will now turn the call over to Mr. Berman.

Stephen G. Berman

Good afternoon, everyone, and thank you for joining us today. The toy landscape continued to be challenging and we are disappointed in our second quarter results and lower guidance for 2013. Several factors contributed to the downturn, including poor sales performance on some of our key product lines, including Monsuno and the Winx Club. Unusually cool weather also affected some seasonal toy sales, and we can see more aggressive markdowns occurring at retail, thus being cleared for back-to-school products selling season. Movie properties have shorter windows at retail now, which has impacted sales of our Smurf products and, throughout the industry, few movie toys sales are meeting expectations.

Struggling retailers both in the U.S. and internationally are plagued with slow toy sales and weakening international currencies, which have resulted in decreased orders and changes in purchasing policies, including one of our largest international customers in Europe experienced financial issues, which resulted in the discontinuation of their credit insurance coverage. Retailers in general are more focused on mitigating risks and, thus, managing their orders tightly. Higher expenses and operating costs are also contributing factors to our 2013 performance.

In response to this, we are undertaking several initiatives to return the company to profitability and growth, including a suspension of our quarterly dividends and a deep restructuring plan designed to reduce operating costs. In addition, we are working to accelerate our initiatives and process to develop our DreamPlay Toys offerings for 2014 and beyond in an effort to keep up with today's evolving play patterns. We believe the decline in sales reflect the growth of the digital age with kids increasingly turning to smart devices for play and entertainment.

To successfully compete in such an environment and to cater to the growing new digital market, we are working to develop product that creatively combines the power of digital content with the inherent value of the physical product. Combining all the capabilities of the iD technology with amazing content, kids will be able to bring their toys to life from the physical world to the digital world starting this fall with DreamPlay Little Mermaid products. This will give kids the best of both worlds, the toys they love and the smart devices and gaming that they increasingly spend more time on combined into a one seamless experience. This marks an effortless evolution in entertainment. The possibilities are endless. With the convergence of this historic technologies and expansive product line, we will be bringing a vast library of content to life like never seen in any way.

We are building our DreamPlay infrastructure with talented individuals, who have come to JAKKS from across content development, animation and technology companies. Our DreamPlay development team is working aggressively to create rich and compelling content, game features and more to deliver genre-defining innovation this fall. 2013 is the year we laid down the foundation of our DreamPlay venture, and we expect to see the fruits of our labor in 2014 with new consumer demand for our products. We expect DreamPlay to help JAKKS achieve substantial long-term and long-range growth and profitability, justifying the investment in the technology and content that we are making.

At the same time, we remain focused on our core evergreen brands and categories that continue to do a solid business day in and day out. We are looking to our core business to continue as the constant platform of our business. These are the areas in which we are one of or the category leaders such as CDI role-play and Dress-Up, Moose Mountain foot-to-floor ride-ons and play environments, Kids Only! kids licensed outdoor furniture and outdoor kids products, Maui Toys Sky Balls for all different areas of sports, hula hoop and Funnoodles, Tollytots pre-school products including Disney Dolls, Graco dolls and evergreen doll accessories and our Disguise Halloween business. Our core JAKKS boys' and girls' basic non-promoted product lines such as MXS, Train World, Kidfetti, El Chavo product, our successful 31-inch figure line of giant licensed action figures and our Nintendo licensed line of Plush figures and other toys are all constant evergreen businesses. The list goes on and are great examples of everyday toys that are under-tween crowd loved to play with and enjoy, and that parents and caregivers feel good about buying.

Our industry prospects are increasingly tied to developing countries, rising middle class and their newfound willingness to spend money on toys for their kids. Growing our International business continues to be a top priority, and we recently finalized agreements to ship our Disney Princess products to Brazil, Mexico and other Latin American countries. Our Tollytots Disney Princess Dolls are shipping to Mainland China, and we are in the process of fulfilling reorders for these products for China. With this strong approach, our basic business and our DreamPlay initiatives, we believe we will lay the groundwork for a more profitable 2014 and beyond.

I would now like to turn the call over to Mr. Joel Bennett to review our financial results for the second quarter of 2013, and then I will give a further update of our business this year and beyond. Joel?

Joel M. Bennett

Thank you, Steven, and good afternoon, everyone. Net sales for the second quarter of 2013 were $106.2 million compared to net sales of $145.4 million reported in the comparable period in 2012. The reported net loss for the second quarter was $46.9 million or $2.14 per diluted share, which included charges for license minimum guarantee shortfalls of $14.1 million and inventory impairment charges of $12.2 million. This compares to net income of $200,000 or $0.01 per diluted share reported in the comparable period in 2012, which included $1.7 million or $0.05 per diluted share for legal and financial advisory fees and expenses related to the 2011 unsolicited indication of interest.

Net sales for the 6 months ending June 30, 2013, were $184.3 million compared to $218.8 million in 2012. The net loss reported for the 6-month period was $74.4 million or $3.40 per share, which includes $800,000 of pretax charges for the financial and legal advisory fees and expenses, and charges for license minimum guarantee shortfalls of $14.1 million and inventory impairment of $12.2 million. This loss compares to a net loss for the first 6 months of 2012 of $15.8 million or $0.61 per diluted share, which included $3.1 million of pretax charges or $0.09 per diluted share of financial and legal advisory fees and expenses.

Worldwide sales of products in our traditional toys and electronics segment, which includes dolls, action figures, vehicles, electronics, plush and pet products were $45.6 million for the second quarter of 2013 compared to $72 million for the second quarter of 2012. And sales for traditional toys were $83.7 million for the first 6 months of 2013 versus $113.6 million for the first 6 months of 2012. Sales this quarter in this segment were led by our Disney Princess Dolls, foot-to-floor ride-ons and Smurf toys, though it was down overall this quarter.

Worldwide sales from our role play, novelty and seasonal toys segment, which includes role-play products, novelty toys, Halloween costumes, indoor and outdoor kid's furniture and outdoor activity and pool toys were $60.6 million in the second quarter of 2013 compared to $73 million for the second quarter in 2012. And sales for role-play, novelty and seasonal toys were $100.6 million for the first 6 months of 2013 compared to $104.9 million for the first 6 months of 2012. Disney Princess dress up and role-play, Halloween costumes from Disguise and outdoor products dominated in this category this quarter though it was also down overall this quarter.

Included in the category numbers are International sales of $19.9 million for the second quarter of 2013 compared to $29.5 million for the second quarter of 2012. International sales for the first 6 months of 2013 and 2012 were $36.6 million and $39.1 million, respectively. Disney Princess Dolls and Smurfs drove second quarter sales in the International market.

Gross margin for the second quarter of 2013 and 2012 were 2.1% and 32.3% of net sales, respectively. And gross margin for the first half of 2013 was 13.9% of net sales compared to 32.2% of net sales in the first half of last year. The significant decrease as a percentage of net sales in 2013 is primarily due to charges taken in the second quarter, a $14.1 million for license minimum guarantee shortfalls and a $12.2 million for related inventory impairment charges due to lower-than-expected sales. Normal margins are expected to be achieved in the third and fourth quarters.

SG&A expenses in the second quarter of 2013 were $46.5 million or 43.8% of net sales as compared to $46.8 million or 32.2% of net sales in 2012. SG&A for the first half of 2013 was $93.7 million or 50.9% of net sales compared to $89.8 million or 41% of net sales. The increases as a percentage of net sales for the quarter and year-to-date are primarily attributable to lower net sales and the addition of incremental overhead and amortization related to our Maui acquisition, DreamPlay start-up and development expenses, as well as the write-off of tools and molds related to underperforming or discontinued products, though offset in part by the full quarter impact of Q4 2012 and Q1 2013 headcount reductions.

Operations used cash of $36.9 million for the second quarter of 2013 compared to having used cash of $25.4 million in 2012. As of June 30, 2013, the company's working capital was $117 million, including cash and equivalents and marketable securities of $70 million. Depreciation and amortization was approximately $5 million in the second quarter of 2013 compared to $5.5 million for the second quarter of 2012.

As for our tax rate, the anticipated tax benefit of $5.3 million that shifted from the first quarter to the third quarter will not be realized due to the expected U.S. full year taxable loss. Capital expenditures were $1 million for the second quarter of 2013 compared to $4.4 million for the second quarter of 2012 and in line with our expectations. For the full year, we expect capital expenditures to amount to around $14 million. Accounts receivable as of June 30, 2013 were $94.9 million, down from $121.6 million at the end of the second quarter of 2012 due to lower sales in 2013. DSOs in 2013 increased modestly to 80 days, up 5 days from 2012. Inventory as of June 30, 2013, was $56.7 million, down from the June 30, 2012, level of $60.8 million as we continue to manage inventory levels in light of sales levels resulting in slightly lower DSIs of 69 days in 2013, down from 68 days in 2012.

Turning to our revised guidance for 2013, the company currently anticipates net sales for the full year of approximately $620 million with revised net loss of approximately $56.1 million or $2.56 per diluted share, including the second quarter charges taken and also third and fourth quarter nonrecurring restructuring and other charges of $4.5 million. The revised guidance represents a reduction from our previously anticipated full year net sales of $694 million to $700 million and diluted earnings per share in the range of $0.63 to $0.68 per diluted share, excluding financial and legal advisory fees relating to the 2011 unsolicited indication of interest. In addition, due to current business conditions, our Board of Directors has suspended the company's quarterly dividend, which it will reevaluate upon a return to profitability.

Lastly, we will commence a restructuring plan in the third quarter to substantially reduce leased space, employees and other overhead expenses. Despite the reported loss this year, JAKKS is expecting to return to profitability in 2014.

And with that, I will return the call back to Stephen Berman.

Stephen G. Berman

Thank you, Joel. Although technology is becoming more and more prevalent in children's play habits, parents and caregivers are still looking for a balance in the toy box. The top contributors for the quarter were centered on many of our evergreen core brands and categories such as dolls, dress-up, role-play and pre-school toys, which continue to be the foundation of our business. Toys from the Disney animated show Sofia the First have exceeded initial sales expectation for the second quarter. Ads and end-caps and catalogs have been secured across accounts to maximize this brand throughout fall this year and beyond. Disney Princess Dolls dress-up and role-play continue to be a big segment of our portfolio with our Little Mermaid product line launching at all key accounts this fall, and excitement is picking up for our first Disney Frozen line of dolls dress-up and role-play launching later this year.

Sales have met or exceeded expectations this quarter at our major retail partners for our Fisher-Price, foot-to-floor ride-ons and ball pits and arcade games. And the trade excitement is starting to pick up for the launch of our Duck Commander Deluxe TV games based on A&E's hit show Duck Dynasty. And although the boys properties are down overall within the industry, we are staying optimistic with the launch of our 31-inch Darth Vader figure line this fall.

New items we introduced at our spring previews have caught a lot of interest with the trade, and we are optimistic for spring 2014 main line launches for Kidfetti, a line of sprayable, washable chalk art, and My World is a line of mini-play boutiques and environments based on young girls' favorite brands including Claire's Fashion boutiques, Sweet Factory Candy Shop, Dairy Queen food store, Opi Nail Salon and Sprinkles bakery, to name a few. This will also be enhanced with our DreamPlay technology and innovation.

The future of the industry clearly lies in the marriage of technology and toys as increasingly to where children are turning more and more to smart devices for additional entertainment. For that reason, we are developing a very large segment of our portfolio and integrating gadgets, technology and interactive elements to new toy offerings to entice the children of the digital age. We are in the midst of developing some really amazing products for 2014 under the DreamPlay umbrella with JAKKS' own brand and other licenses. Maximizing digital play is integral to our strategy to compete in this changing landscape, and our DreamPlay line will bring us to the forefront of digital play and innovation. The industry as a whole, toy makers, retailers and content owners, need to view digital, now and in the future, as complementary to the traditional toy plays.

Beyond the strength of our evergreen core brands, core business and core categories, our new DreamPlay portfolio, we believe there's a lot of value in JAKKS. We have licensing relationships with top kids' entertainment companies and our diverse product portfolio combines popular licenses and proprietary brands. We have products across multiple categories with value-driven and strategic pricing. We have retail customers in virtually every sales channel and an experienced management team to drive our business forward. We continue to expand upon our International opportunities, and we believe the joint venture we entered in with NantWorks to produce DreamPlay technology, enhanced with toys, will bring countless new opportunities for our business.

Thank you for your time. And with that, we will wrap up the prepared portion of the call and open up the call to Q&A. Thank you very much.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Steph Wissink from Piper Jaffray.

Stephanie S. Wissink - Piper Jaffray Companies, Research Division

I just had a couple of questions from us guys. First and foremost, Joel, if you could give us an insight into how we should pace the back 2 quarters for the year from a sales and earnings perspective, I think that would be really helpful. Full year, it looks like right around 6 20, but how should we think about the balance between Q3 and Q4? Is it consistent with prior years or slightly different just given the comments that you made around the industry-buying patterns? And then secondly, if we could just get some insight into the restructuring plan. What's the timeline? How sizable? Kind of where are you at in that evaluation process.

Joel M. Bennett

Sure. The back half will be consistent between 3 and 4 as we've been historically, third quarter being our highest volume quarter.

Stephanie S. Wissink - Piper Jaffray Companies, Research Division

And then on the restructuring plan, guys, any comments there in terms of size or pacing around timing, when we can anticipate that in the model?

Joel M. Bennett

It'll start in the third quarter and roll into fourth quarter. We have a number of different operations that have different seasonality, so it's deep in general. But as far as the specific timing, again, it'll be pretty balanced over the third and fourth quarter, again, managing the ongoing needs of the business.

Stephanie S. Wissink - Piper Jaffray Companies, Research Division

Okay, then maybe just one follow-up. Joel, with respect to the model again, I'm looking at the first half, looks like the sales were down kind of mid-teens. The second half the guidance would imply down low-single digits. Can you just give us some insight into your confidence and acceleration at that pace from kind of down mid-teens to down low-single digits here in the second half?

Joel M. Bennett

Sure. Percentage-wise, it's going to be much higher than the front half, which is proportionately lower in sales overall. And at this point, more of the sales are on an FOB basis. I mean, historically, on the back half, they're more on an FOB basis. And at this point, we're booked at 6% higher than we were at this time last year. Also with FOB sales, we have purchase orders well in advance compared to when we have sales and orders on a domestic basis, so we're very comfortable about the numbers.

Operator

Our next question comes from Ted Woo from Ascendiant Capital.

Edward M. Woo - Ascendiant Capital Markets LLC, Research Division

Yes, I had a question. When is your DreamPlay product being launched? And what is your anticipation and retailer anticipation of the product?

Stephen G. Berman

The retail product is actually starting to ship it off first week of August; it will be on shelf the latter part of September. The app launches -- September 1. The receptiveness from the retailers that we had our initial plans with, extremely strong, not just on the product but on the advertising and signage. And going forward into 2014, one of the biggest areas that we are expecting from what we've gone through over the last 6 months with retailers is the DreamPlay product offering both be rolled out in domestic and U.S. and having quite a nice growth that we see going forward.

Edward M. Woo - Ascendiant Capital Markets LLC, Research Division

Was there a change in guidance related to DreamPlay at all?

Stephen G. Berman

I'm sorry?

Edward M. Woo - Ascendiant Capital Markets LLC, Research Division

Was that change in guidance related to your DreamPlay expectations at all?

Stephen G. Berman

No.

Operator

Our next question comes from Sean McGowan from Needham.

Sean P. McGowan - Needham & Company, LLC, Research Division

I have a couple of questions starting probably with the simplest, should we infer from this proposed convert that there is no bank line or did you get a bank line? What's the status of that?

Joel M. Bennett

That is correct. The convert is one of our or has been one of our options, and it was decided to go with that. Having said that, we're limited to what we can say because it's currently being marketed, so we'll just refer you to the press release.

Sean P. McGowan - Needham & Company, LLC, Research Division

Okay. I just didn't know if there had been an extension of the other bank line or you've been operating without one since... Well, didn't it expire in April?

Joel M. Bennett

Yes, that one expired in April, and we have been working on the new one with a similar structure -- an asset baseline.

Sean P. McGowan - Needham & Company, LLC, Research Division

Okay. All right, so we'll just see. As long as this gets done, then that's a moot point. Second question, this isn't the first time, by any means, that minimum license guarantees have been the source of some reduction and I'm surprised at this point that there would be the magnitude of $14 million. What does this say about the viability of those underlying licenses? I mean, this must be some pretty big properties if there's $14 million of guarantees being written off.

Stephen G. Berman

They come from several different licensee content -- licensor content holders. Some of them were previous deals done back with previous management in specific divisions. So the deals that were done and set forth were quite rich and due to the environment and the, call it the shrinkage of retail space, the minimum guarantees were not met with the decline in sales. The other license shortfall is from a property that was no longer put on air as we had expectations that this property was being on air for quite a few years of obligation and on strip. So based off of what we see, those 2 areas of businesses, we ended up having to take the write-off of the shortfalls. But we -- in addition to what you're asking, Sean, there's about a -- 85% to 90% of our business is extremely constant, solid and evergreen, which goes from our Kids Only! outdoor furniture product to our foot-to-floor ride-on Moose product to our Tollytots Pre-School division to Maui to so on. What we've realized in this new environment is we need to enhance that play pattern with the, call it, iD technology, which is enhancing the, call it, physical world with the digital world. You can play with the physical world without the digital component. You can play with the digital component without the physical. But when you combine them both when a child wants to, it just is a magical experience, and we've seen it from working with Lego with our technology and they do a lot of testing. Their feedback and their focus groups was truly breathtaking. So with our core business is where we're really solid, what we realize now and what the industry is and we've seen it, the likes and days of launching an item, and I'll use as we launched 4 years ago, our night vision goggles that did 20 million, 30 million, 40 million, 50 million in sales and a Furby, call it, that has done, those days of the euphoric items of marketing and TV advertising and looking for these euphoric items to take off is few and far between because retailers won't bid on the inventory. There's not the top 20 retailers anymore. Where our segmentation of retail, which we're very proud of, spans throughout the mass retailers that we all know about -- the Target, the Walmart, the Toys"R"Us', the Sears, but it goes to Sports Authority, Dicks Sporting Goods, Sports Chalet, Big 5, Kohl's, Spencers, Ross, Party City. So while we're diversifying the customer base, we're focusing on the basic play pattern, which is primarily we see around under 6 is where the key play pattern for children are with playing with toys. But at the same time, they're utilizing smart devices. So the enhancement of what we're doing, and we've seen it, is a magical combination.

Sean P. McGowan - Needham & Company, LLC, Research Division

I can't disagree. This actually dovetails into my final question. I can't disagree, the kids are certainly interested in these technology products. But this isn't like it happened overnight and yet your sales shortfalls go back several years and you say 80%, 90% of it is rock solid. The sales decline suggests that maybe even there's weakness there. But my question is how much confidence can you have that you're making the right bet when there's still going to be a lot of business that needs to be done in basic, traditional toys that don't have a technology element? I'm saying that other companies are not seeing their business decline as much as your business is declining. Lego couldn't be lower tech and they just keep crushing it year after year. So somebody else is doing something that you guys aren't doing to generate sales of traditional non-technical toys. So I'm not disagreeing that there needs to be some technology component to your toys, but you can't abandon the non-tech part either and you got to get that right.

Stephen G. Berman

I would say on our basic evergreen singles and doubles business, which is probably about 85% to 90%, we do have it right. We're the category leaders. What we also have had to address is some of our major customers, both International and the U.S., the credit facilities that we've had or insurance were discontinued, and we also, at that time, don't want to take a financial risk as we've had in the past when Woolworths claimed bankruptcy or years ago when Kmart claimed bankruptcy or KB, so we're taking a very prudent step of not taking that type of risk factor. So when we're looking forward, we are taking in that in consideration. But when you take our non-tech area of business, Halloween is a extremely solid area of business for us, our Kids Only! our Moose, our Tolly, but that area of business, Sean, is an area of business that primarily is, I'll use 6 and under, where we've seen that's where kids are truly still continuing to play. We're very close with Lego and we understand what they're doing in the -- from their sales in both U.S. and abroad. They have done a great job in managing their businesses and diversifying with their hotels, with their parks and so on. So they're an anomaly and I think they're a terrific company as well, but we are also looking at the retail environment and not -- we won't allow ourselves to get caught where we were years ago with any of the retailers that are maybe less with strength in their balance sheet and less able to pay us in the future, so we're also taking that into consideration.

Operator

And we have no further questions in queue at this time. I'll now turn the call over to Stephen Berman for closing remarks.

Stephen G. Berman

Thank you, everyone, for joining the call. We are getting ready for our fourth quarter, second half of the year fourth quarter, but more primarily the restructuring and consolidating the offerings of the core JAKKS business. And at the same time, we are very aggressively engaging with the launch of our DreamPlay technology with our current application in toys and future. And to the parties that have seen it, from some of the top Fortune 100 companies, the receptiveness from them has been tremendous and from our trade. So with that, we appreciate the time and effort of everyone taking this call. Thank you.

Operator

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.

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