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In my earlier post entitled Is Michael Eisner 'Stealing' Topps?, I said that I would look over the company's financials. I did and what I found is quite interesting.

Actual Offer
First, you need to forget the $9.75 a share number you've seen reported as the offer from Tornante and Madison Dearborn. Topps (TOPP) has $84.87 million in cash and no debt. So, the $9.75 a share offer from Eisner et al. includes the acquisition of $2.19 per share in cash.

The offer for Topps' operating business is $7.56 a share not $9.75 a share. When investors calculate standard valuation ratios such as price-to-earnings, price-to-sales, and price-to-book, they need to use the $7.56 a share number rather than the $9.75 a share number, because the utility of these ratios is in comparing an operating business to the price paid for that business.

For instance, although it first appears that Eisner et al. are making an offer that values Topps at over 100% of sales, this is an illusion. The offer values Topps at almost exactly one times sales – in fact, slightly less than one times sales.

Furthermore, Topps is expected to increase sales in the years ahead, because of certain favorable developments (brought on in part by management's recent actions) that seem to have improved the outlook for the industry. I'll address the issue of a "turnaround" later.

For now, it's important to note that Topps' current sales levels are not especially high – in fact, sales are roughly where they were in 2001.

Use of Cash
In that year, Topps spent close to $30 million to repurchase 2.81 million shares at $10.39 a share. Six years later, the entire company is set to be sold for $9.75 a share.

To be fair, Topps had more cash in 2001 than it has today. The difference in cash and investments is theoretically large enough to account for the $0.64 a share gap between the price at which Topps was enthusiastically buying in 2001 and the price at which Topps is now planning to sell itself. Regardless, this repurchase record betrays the fact that Topps' board accepted an offer even they don't believe to be substantially greater than what long-term shareholders will (eventually) be able to sell their shares for in the open market.

If that last statement is untrue, then either the 2001 repurchases were a negligent misuse of almost $30 million of company cash or unforeseeable events that occurred during the intervening years have permanently impaired the value of the business.

Which is more likely? Is management wrong now? Was it wrong then? Or, have circumstances conspired against the company?

If the 2001 repurchases were the error, perhaps they were an excusable error.

However, Topps' long history of squandering cash is inexcusable. Almost exactly six years ago, Topps had $158.74 million in cash. Today, the entire company is being sold for $385.4 million dollars.

Over the last several years, Topps has spent far more cash on share buybacks than it has paid out in dividends. In fact, despite a nearly $75 million reduction in cash on the balance sheet, Topps has paid out less than $25 million in dividends.

Why doesn't the company pay out a special dividend?

It's hard to imagine a company better suited for the payment of a special dividend. Topps is paying a regular dividend of just $0.16 per share while holding $2.19 per share in cash.

This miserly attitude makes even less sense when you realize what a consistent cash generating business Topps is. By my admittedly hasty calculations, I can find only one year among the last seventeen in which Topps failed to produce distributable cash.

In 1997, there was no cash for a theoretical 100% owner to withdraw from the business. In every other year since 1990, Topps has produced "owner earnings" at least in the sense that a 100% owner could pay himself a healthy cash dividend without negatively affecting continuing operations.

Reported Earnings vs. Owner Earnings
I hesitate to call this distributable cash "owner earnings" in the sense that Buffett intended the term, because Topps has seen its earnings power diminish over the years. However, this diminishment appears to be due to industry conditions and Topps' own failure to develop new hit products. The company's competitive position has not been weakened through underinvestment.

I've done my best to estimate Topps' per-share owner earnings for each year from 1990 - 2005. While my estimates aren't perfect, they undoubtedly reflect economic reality better than the earnings per share numbers reported on the income statement.

Topps' economic earnings are consistently higher than the company's reported net income. In other words, the company consistently underreports its true economic earnings.

There's nothing nefarious about this. It happens to some other public companies as well. It's a natural result of accrual accounting – and is more or less unavoidable within any system of accounting that applies general rules to a wide range of inherently different businesses.

If you think about the business Topps is in, this underreporting isn't surprising. It's the result of non-cash charges that have no economic importance. Don't let these charges fool you.

Although the reported earnings per share numbers bear the auditor's imprimatur, the estimated per share owner earnings below better reflect economic reality.

Per Share Owner Earnings

1990 - $1.49

1991 - $1.51

1992 - $0.52

1993 - $0.71

1994 - $0.42

1995 - $0.30

1996 - $0.36

1997 - $0.00

1998 - $0.46

1999 - $1.56

2000 - $2.31

2001 - $0.75

2002 - $0.47

2003 - $0.43

2004 - $0.42

2005 - $0.22

The above numbers have been adjusted to reflect today's lower share count. This is a necessary adjustment that investors should always perform when considering historical earnings per share numbers.

A few things immediately jump out from the above numbers. The first is the sad realization that Topps' current sixteen cent annual dividend is lower than what the company's owner earnings had been in sixteen of the last seventeen years.

In other words, despite already having a whopping $2.19 a share in cash, the company's dividend payment is not working down the cash hoard at all. In fact, if Topps performs much as it has in the past, it will continue to add cash to the balance sheet each and every year. Topps has managed to obscure this fact through share repurchases – some of which look ill considered now that the company is planning to sell itself for $9.75 a share.

If Topps is sold for $385.4 million, the decision to buy back shares would be demonstrably inferior to the decision to disburse the cash to owners through a special dividend. Until Topps is sold, it might be argued that the share repurchases created value that has not yet been realized in the market for the company's stock.

But, once the company is sold (at such a low price), the share repurchases of years past will be exposed as value destroying measures. After all, the company could have simply returned that cash to its rightful owners.

I call them "rightful" owners, because Topps' financials clearly show that the business had no use for this cash. A business that has generated positive owner earnings in sixteen of the last seventeen years and had never in that period had a year in which operations caused a material consumption of cash is hardly a business that requires a cash cushion.

Inherent Economics
I've seen businesses that could benefit from a cash cushion. Topps isn't one of them. In fact, Topps is their polar opposite. The kind of businesses that can benefit from a cash cushion are dependent upon a few large customers who are themselves exposed to the full fury of a capricious economy. They are businesses that can not insulate themselves from short-term trends within their industry – and thus must endure down years even when they do everything right. Above all else, they are businesses that can not outrun the ill effects of their dumbest competitor's dumbest move.

Topps is about as far from that somber scenario as you can get. It is a consistent cash generator – not because it's brilliantly run or because it has outsmarted its wily competition, but because it has very little competition. It is fully insulated from the whipsaw whims of the general economy for a simple reason – it sells a simple product.

That may sound like a silly thing to say. But, it's true. The ideal product, from a business perspective, is a relatively cheap discretionary item that its purchasers are passionate about. Some people are passionate about their cars. But, even then, they tend to be too reasonable at the time of purchase. A great product is one that is sold in a fit of unreasonableness. It can't be too expensive, because that leads to the twin sins of comparison and hesitation. Ideally, it is a product that can not be evaluated point by point, aspect by aspect, but must be assessed in its entirety. Above all else, it must be a product with positive associations for the prospective buyer.

Topps meets these criteria quite nicely. If you use the above paragraph as a checklist to run against each of Topps' products, you will find that the company occupies a competitive space where profits are likely to be plentiful and destructive competition is likely to be scarce.

Just as importantly, Topps has minimal capital spending requirements. For more on this topic, please see my post entitled Reading Beyond the Numbers: Maintenance Cap-Ex and the 'Pleasant Surprise' Effect. In that post, I made this important point:

if I were forced to invest every dime I had in a single business and hold it for the rest of my life, the first characteristic I would look for is a business with virtually no need for maintenance cap-ex.

That's a strange statement to make. But, it's one I'm happy to stick by. I wrote another post On Inflexible Enterprises discussing a related topic. That post outlined the perils of businesses that put down roots. Inflexible enterprises are tied to a particular line of business, mode of production, or labor force in such a way that extricating themselves from a dying or unprofitable operation becomes exceedingly difficult – often to the permanent detriment of investors.

But, that's only half the story. A business with minimal maintenance cap-ex requirements isn't merely a less risky business. It also tends to be a highly profitable business – or, at least it tends to have the potential to become a highly profitable business. Given the kind of business it is, Topps has the potential to do a lot with very little capital. Private equity buyers see this. Many current shareholders don't appreciate this point fully.

That's understandable given Topps' past record. For years, the company left piles of cash sitting idle while the operating business dithered along under an uneasy malaise. The performance was poor; but, the strength inherent in the business provided an air of adequacy to an otherwise inadequate performance.

This is not an inherently bad business; in fact, it's an inherently good business. Topps is blessed with an enviable competitive position in more ways than one.

Beyond the minimal capital spending requirements and the type of product the company sells, it is also fortunate enough to be involved in businesses where there is little incentive to allow excessive competition.

The sports card business is, in a sense, a regulated business. The companies that market sports cards need licenses from the professional sports leagues that have established themselves as clear monopolies.

Although it may seem nonsensical at first, the leagues have little incentive to allow a large number of market participants. The dynamics of the sports card business are such that you would expect a lower number of suppliers would not (after a brief adjustment period) lead to a large decline in total sales. Furthermore, the long-term benefits of reduced competition are substantial.

This is not an industry in which innovation is particularly important. If it were, a large number of competing suppliers might improve the industry from the league's perspective.

It's an industry in which familiarity is especially important – perhaps more important than in almost any other industry. For that reason, second-tier competition is detrimental to the long-term health of the industry. It merely serves to reduce familiarity with specific products while offering little benefit in terms of higher overall sales. Essentially, a smaller number of competitors can successfully supply roughly the same number of cards while fostering greater long-term product loyalty.

For this reason, a league can establish a satisfactory market structure with the use of only a couple licenses. In the case of Major League Baseball, the number of licenses is now literally "a couple" – as in two. In one year, the number of licenses was cut in half. These important changes were engineered by Topps. If the less crowded market structure is sustained, it will undoubtedly benefit the company in the long-run. Similar arrangements have been made (or likely will be made) between other leagues and their licensees.

Turnaround
These licensing changes made at Topps' instigation bring us to an important yet imprecise discussion – is Topps successfully implementing a turnaround?

The sports card industry has been in decline for several years. Why? I don't know. I could vaguely blame it on the internet, the pace of change in all things media, a generation growing up with MTV, etc. Since I don't actually know, let's go with that explanation. It sounds superficially plausible, even though the actual answer is undoubtedly more complex and more industry specific.

Regardless of why the sports card industry was shrinking, it's worth noting that it isn't shrinking at present. It's growing. How much? How fast? I don't know. In fact, no one knows. Believe it or not, there are actually a lot of little industries like this where no one really knows the exact figures. But, it is growing.

If you listen to Topps' third quarter conference call, you'll hear mention of a survey that suggested the incidence of card collecting tripled in the last year. As a rule, any survey that claims something tripled in a year is highly suspect. That's probably why the survey was downplayed in the conference call. I'd be skeptical too. Whatever the merits of the survey, it certainly does suggest the last year was a good one for the sports card industry – and something meaningful has changed.

As for Topps itself, the company has said it is on track to meet or exceed its full year earnings guidance of $0.25 to $0.30 per diluted share (before special charges) for fiscal year 2007. The company constantly throws around the word turnaround; so, you can forgive me for bringing up that oft used, hopeful phrase "turnaround story".

A summary of the changes the company has made in this turnaround effort is provided on the first page of the 2006 annual report. These changes include:

Restructuring the Business to Focus on Operating Profit: Topps has greatly increased the number of employees reporting to someone with direct profit and loss responsibility. Previously, this number had been very low (20%). Financial reporting changes for the two business units (Confectionary and Entertainment) accompanied this restructuring.

Cut Costs: The company reduced the headcount at HQ, froze the pension plan, made changes to medical insurance, etc. Supposedly, these cuts will provide savings of about $4.5 million.

Market Structure Changes: These are the licensing agreement changes I mentioned earlier. They effectively cut a large portion of the competition out of several of the company's sports card markets.

As a result of all this, Topps is expected to deliver a much greater operating performance improvement than it has in years. The business had seen essentially no improvement for some time. These changes are real and shouldn't be overlooked when evaluating the $9.75 a share offer.

Valuation
Now, to the hard part. How much is Topps worth?

There are a few different metrics we can use to evaluate the offer price. For the fiscal year ended February 25, 2006 Topps had $293.84 million in sales. Right now, it's on pace to top that number. But, we'll use total sales of $293.84 million for our calculations.

Here is what the company's share price would look like if it traded at 0.5 times sales, 1 times sales, 1.5 times sales, 2 times sales, and 2.5 times sales (cash has been added back because it's independent of the value assigned to operations):

50% of sales: $5.99

100% of sales: $9.78

150% of sales: $13.58

200% of sales: $17.38

250% of sales: $21.17

As you can see, the offer from Eisner et al. values the company at almost exactly 100% of sales – no more, no less. Is that a fair multiple? You decide.

Next, we could look at Topps' price-to-book ratio. But, there's no reason to; really, we would just be counting the cash. Nothing else is recorded at a value that's indicative of its earnings power. Topps is an intangible business and book value is a tangible measure. So, it's useless in this case.

The next common valuation measure is the price-to-earnings ratio. But, as we've seen, accrual accounting obscures Topps' true economic earnings. For that reason, we would be better off looking at the owner earnings estimates I provided for the last seventeen years.

Owner earnings over the last five years averaged $0.46 a share. Over the last ten years, owner earnings averaged $0.66 a share. Over the last fifteen years, they averaged $0.70 a share. These numbers don't exclude interest earned on Topps' sizeable cash hoard. The diminishment in average operating earnings is actually worse than it first appears, because interest helped some of the recent years look better than they really were.

Overall, even if we assumed the fifteen year average is the most accurate (and considering the decline in the card business, that's a bit of a stretch), Topps doesn't look terribly undervalued on an owner earnings basis. At $9.75 a share, the offer values Topps at 13.93 times its estimated owner earnings over the last fifteen years.

That's cheaper than it first appears, because many low P/E stocks tend to have higher accrual earnings than economic earnings. In other words, an owner earnings multiple of 13.93 is quite reasonable (one might even say cheap). Of course, my estimates for owner earnings in more recent years were much lower. For 2005, the estimate fell all the way to $0.22 a share. That would give the $9.75 a share offer an outrageous owner earnings multiple of 44.32.

Here, we have to consider two factors. Was 2005 a representative year? Has the company's earnings power diminished over time?

Topps has certainly earned less over time. So, the answer to the second question would seem to be "yes". Let's leave it at that for now. The company's potential is a different issue. As for 2005 being a representative year – if, by that we mean that future years will see similar owner earnings numbers, I doubt it. Topps will probably earn more in future years than it did in 2005.

It's important to remember that these estimates work well over time (when multiple years are averaged together). My estimate for any single year will tend to be way off. I haven't tried to smooth the numbers unnecessarily, because that would make the averages of multiple years less useful. As a result, while the figure for any single year is open to interpretation, we can be quite confident that for the full period from 1990 through 2005, Topps produced around $460 million in distributable cash. The average amount of distributable cash generated in a year was close to $30 million. That's after taxes on a business that is now set to be bought for $385.4 million – including $84.87 million in cash.

So, we're talking about a roughly $300 million purchase price for a business that has thrown off about $30 million a year in cash since 1990. Again, that's after taxes. With the use of debt, the math gets a lot more enticing. Before taxes, it would be closer to $45 million on a $300 million purchase price. Remember, this does include interest income over the years – which has been a much larger item for Topps than it is at many public companies, because Topps has held a lot of cash. The interest income shouldn't be included. So, you need to keep that in mind here.

Still, we're talking about a pre-tax yield on the purchase price that is somewhere between 10% and 15% based on average distributable cash generation since 1990. So, if you wanted to think of the buyout as a bond (and you wanted to use an average "coupon" going all the way back to 1990), you'd be looking at a bond yielding somewhere between ten and fifteen percent. It would be closer to fifteen percent. There's another tax complication in here; but, for the sake of brevity, I'm going to ignore it entirely. Just know that the tax treatment makes me even more confident in estimating the yield on our imaginary buyout bond to be 15%.

Of course, there's an obvious argument against asserting a buyout at this price is equivalent to the purchase of a 15% bond. Topps hasn't generated that much distributable cash for quite some time. In fact, it's been five years since Topps has provided the kind of free cash flow you would need to mimic a bond with a fifteen percent yield.

On the other hand, a bond has no upside – ownership of a business does. If Topps improves its operating performance either as a result of actions it has already taken or as a result of actions that will be taken after the buyout, the yield on our imaginary bond would go through the roof.

So, we've come full circle. The price-to-sales ratio is probably the best way to evaluate the $9.75 a share offer. It's an offer made at 100% of sales. Every dollar in sales is being translated into a dollar of market value at the offer price of $9.75 a share.

Should a deal be done at just 100% of sales? Is that fair?

That doesn't sound like the right multiple to me – and I certainly don't see a premium here. The offer is for the entire company, not the tiny pieces of the company that trade every day. An offer of 100% of sales doesn't sound like a particularly high price to pay for a non-controlling, passive stake in a business like Topps – much less complete ownership of the entire company.

Thoughts from Shareowners
I ended my first post on Topps by asking for thoughts from actual owners of Topps shares (as I don't own shares). I was surprised by how quickly the responses came. They ranged from emails from money managers to emails from individual investors with small, long-held positions in the company.

Many of them had questions. Sadly, some of the Topps shareholders who found their way to my site did not realize the buyout would leave them without any interest in the company. It wasn't fun breaking the news. Here is one such email:

I am a long time owner of Topps, perhaps close to ten years. Call me crazy, but I was raised a buy and hold guy. I’m a little saddened by the price that Mr. Shorin has decided to sell the company because I’m quite certain with the cash position it is worth more. Still, it has been frustrating with Mr. Shorin at the helm, for I feel he was an old school guy who struggled keeping up with the changes of the world. Recently over the past year, I believe they have really begun to take the company in a new direction and to start to innovate value into the brand. So, it seems selling to Eisner is not a bad thing at all, but I’m not sure if I will still be an owner to see if he can take the company somewhere to which Shorin was unable, because I’m not sure when a company goes private if the shareholders are bought out. Still, besides all that, I’m disappointed in the price and I’m hopeful someone else will step in and white-knight us.

Here we have a tragic twist on the term "white knight". Its narrow meaning is a subsequent bidder who comes to rescue (management) from a hostile bid. Of course, it also has the broader sense of a savior and a champion. There's no hostile bid here. For this shareholder it's the Chairman and CEO, Arthur Shorin, who is the black knight.

Every one of the responses I received was critical of the deal. But, that's to be expected. The post I wrote wasn't a positive one and it's always the people with a problem who are most likely to voice their opinion. So, it's far from a random sample.

Still, I was surprised by the number of emails along the lines of: "I wish I understood this situation.", "Why are they doing this?", etc.

The most telling comment may have been: "I thought that when a company got bought out, the stockholders benefited." In my experience, investors are often quite pleased with the pop in a stock the day a company announces it's being acquired. In fact, they usually don't worry too much about whether the deal is fair, because the stock is suddenly well above where it's been. In this case, the deal's very poor reception from shareholders may have been exacerbated by the small premium over the (then) current stock price and the fact that the offer was actually a bit below the high for the year. Shareholders didn't see a pop and they certainly didn't feel any richer the day the deal was announced.

Conclusion
So, what should shareholders do? What is the right course of action for Topps?

The simplest answer is that private equity doesn't have a monopoly on value enhancing activities. Nothing but institutional inertia and investor apathy prevents the undertaking of serious capital restructurings without a change in ownership. A public company can attempt its own do-it-yourself buyout. Or, rather, it can adopt the best aspects of some buyouts while charting a sustainable course all its own.

Topps already has a lot of cash and it will continue to generate more each and every year. The cash has nothing to do with its operations. It's surplus cash. It needs to be returned to owners one way or the other. There are two good options here. Topps can either pay out a special dividend; or, it can engage in a major share buyback with the aim of recapitalizing the business to provide better returns for owners.

When I say a share buyback, I do not mean the kind of much publicized buyback programs many companies have these days. Topps is well situated for a large one-time share repurchase. It could be done through an auction or through a fixed price tender offer. Obviously, the $9.75 a share offer provides a convenient level at which the company could buy back potentially large amounts of its own stock and in so doing provide investors the opportunity to opt out of the company's uncertain future by taking a cash offer equal to that made by Eisner. The shareholders who wanted to leave would get their cash; those who wanted to stay would see their piece of the pie grow.

At $9.75 a share, there might not be nearly enough stock offered for sale as the company would like to repurchase. However, $9.75 would be a good starting point, considering that it's both the actual offer price and yet still a price that an objective observer (or at least this observer, objective or otherwise) would say adds sufficient value to warrant an attempt to bring in as much stock as possible.

Then, there's the issue of debt. Topps is a consistent, relatively strong cash generator (at least relative to its accrual earnings). You can do your own math to determine what kind of interest payments you'd be comfortable seeing the company burdened with. I'm not advocating an absurdly high debt load here. But, some debt would make sense for this kind of company – especially if it could be used to buy back shares.

It's clear that Topps needs to return at least $85 million to its shareholders through share buybacks, special dividends, or some combination thereof. If the company were to take on debt (and I think that would be advisable provided the debt burden is reasonable) it could and should return more than $85 million to shareholders.

The best course for Topps (and thus the plan that shareholders need to be advocating loudly and unceasingly) is as follows:

1. Reject the Eisner Offer

2. Remove Mr. Shorin

3. Solicit Bids For the Company and its Constituent Segments for a Set, Limited Time Period

4. Engage in Major Share Repurchases and/or Pay Out a Large Special Dividend

5. Take on an Appropriate Amount of Debt (in conjunction with #4 above)

It's important to note that while now is an appropriate time to entertain other bids, shareholders must not resign themselves to selling the company at any marginally better price. Instead, it is likely the company will have to make changes – certainly to its capital structure and quite likely to operations as well. Ultimately, the goal is to create value for shareholders. That end might be achieved with or without a sale. For this reason, it may be appropriate to consider bids while simultaneously developing a plan for a complete overhaul of the company's capital structure. But, at some point (relatively soon) the company needs to move forward with an executable plan to create value on its own.

Of course, all of this is predicated on rejecting the Eisner deal and removing Mr. Shorin.

Many people have asked me what Topps is really worth. I don't know anything with certainty and I don't want to suggest a false precision here. However, I don't see how reasonable people could disagree about any offer of less than $12.00 a share. Offers below that amount are clearly inadequate. There is no reason to prefer them to an energetic effort to create value through improving the capital structure and removing the current CEO.

Removing Shorin is an absolute necessity. After accepting this deal, he can never be trusted again. This is not merely a problem of ineffective management. It has clearly gone beyond that. The problem now is not ineffectiveness; it's faithlessness.

TOPP 1-yr chart:

TOPP 1-yr chart

Disclosure: author has no position in Topps.

Source: Topps Shareholders Should Reject Eisner's Offer