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JAKKS Pacific Inc. (NASDAQ:JAKK)

Q3 2007 Earnings Call

October 22, 2007 10:00 am ET

Executives

Genna Rosenberg - SVP of IR

Jack Friedman - Chairman and CEO

Stephen Berman - President and COO

Joel Bennett - VP and CFO

Analysts

Arvind Bhatia - Sterne, Agee & Leach

Jeff Blaeser - Morgan Joseph & Co.

Gerrick Johnson - BMO Capital Markets

Cheryl Cortez - Susquehanna Financial Group

Sean Mcgowan - Wedbush Morgan Securities

Steve Epstein - Defiance Asset Management

Operator

Good morning. My name is Ashley, and I will be your conference operator today. At this time, I would like to welcome everyone to the JAKKS Pacific Third Quarter Conference Call with the management. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions) Thank you.

I will now turn the call over to Ms. Rosenberg. You may begin your conference.

Genna Rosenberg

Thank you, operator. Good morning, ladies and gentlemen. This is Genna Rosenberg, Senior Vice President of Corporate Communications and Investor Relations for JAKKS Pacific. Thank you for joining our teleconference with JAKKS's management to review the results for our third quarter and first nine months of 2007, which ended on September 30.

On the call today are Jack Friedman, the Chairman and Chief Executive Officer of JAKKS Pacific; Stephen Berman, our President and Chief Operating Officer; and Joel Bennett, our Vice President and Chief Financial Officer.

Mr. Friedman will first provide an overview of the quarter and our operational results. Then Mr. Bennett will provide some comments regarding our financial results. Mr. Friedman will then conclude the prepared portion of the call with highlights of the current quarter. He will conclude with the current business trends prior to opening up the call for questions.

Before we begin, I would like to point out that any comments made about our future performance, events or circumstances, including the estimates of sales and earnings per share for 2007, as well as any forward-looking statements, are subject to Safe Harbor protection under federal securities laws. These statements reflect our 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 our forward-looking statements. For details concerning these and other such risks and uncertainties, you should consult our most recent 10-K and 10-Q filings with the SEC as well as additional reports subsequently filed with the SEC from time-to-time.

With that, I'll turn the call over to Mr. Friedman.

Jack Friedman

Good morning, ladies and gentlemen. This is Jack Friedman. Thank you for joining us this morning to discuss our results for the third quarter and first nine months of 2007. We issued our earnings this morning. Net sales increased to $318.4 million, we earned $47.3 million, or $1.45 per fully diluted share for the quarter. We're extremely pleased with our results for the year so far.

With just about two months to go until the holidays, we are confident that we will achieve at least the 2007 guidance we issued earlier this year of $800 million in sales and earnings of $75.8 million or $2.39 per diluted share.

Third quarter performance was in line with our internal expectations, despite some challenges that our industry faced as a result of recalls by some of our peers. In the face of container shortages, port delays, labor issues and other issues in dealing with China, we still had an excellent third quarter and we expect to have excellent full year results when we announce them this coming February.

We are very excited by the opportunities presented by several areas of our business for this year and in the future. We are especially excited about the Disney tween pop star Hannah Montana and our Hannah Montana product line. The star of the show is Miley Cyrus, a remarkable, hard-working young woman that has become America's dolly. And we are proud to be partnering with Disney consumer products for the Hannah Montana property.

USA Today identified rock star theme merchandise as a major trend for this holiday season, featuring our Hannah Montana line as part of their findings. Toys "R" Us also put out a trend release, which included our Hannah Montana dolls and our Toys "R" Us exclusive Hannah Montana Tour Bus Playset, which is perfect for fans who have been clamoring for tickets to her sold-out stadium arena concert tour. It's the top news story for weeks now.

And many of our Hannah Montana toys, including the fashion dolls, our Secret Celebrity Backstage Closet and Concert Stage Playsets have all been awarded top holiday honors by multiple hot holiday toy lists for this year, including eToys' Holiday Hot List, Toy Wishes, Hot Dozen, Toys "R" Us Top Holiday Toys, KB Toys' Top Holiday List, and the Toy Insider.

We are looking forward to more new Hannah Montana toys, playsets, electronics and role play products in 2008. We have developed and previewed recently at the Dallas Fall Toy Preview. Buyers were extremely positive about our execution on this brand and it seems Hannah Montana is definitely on fire.

But Hannah Montana is just one component of JAKKSs business this year. Other toys that drove sales in the quarter include Beautiful and Magical, Disney Role Play and Dress-up toys. WWE and Pokemon action figures, Special 25th anniversary collectible Care Bears plush dolls, XPV toy products and Plug It In & Play TV Games, the most notable of which has been our EyeClops Bionic Eye.

As I mentioned, we just completed the industry's first fall toy preview held in Dallas, and we had a terrific exhibition of our 2008 lines. The teams throughout our organization have been diligently working to develop a stellar portfolio of new products for 2008 and we are energized at the reaction we receive from the trade. We certainly know we have much work to do but with this initial feedback, we are buoyed to further strengthen the line and make 2008 the best year yet for JAKKS Pacific.

Our financial position remains extremely strong with working capital of approximately $342.2 million, which include cash and cash equivalents of $186.6 million as of September 30 this year.

Before I get more into details about our products' performance in the past quarter and our outlook for the future, I would like to turn the call over to Joel Bennett for a review of our financial performance for the third quarter and the first nine months of 2007.

Joel Bennett

Thank you, Jack, and good morning, everyone. Third quarter net sales for 2007 were $318.4 million, compared to $295.8 million in the same period last year. Net income for the third quarter was $47.3 million, or $1.45 per diluted share. This compares to net income of $40.5 million, or $1.26 per diluted share in the third quarter of 2006.

Net sales for the first nine months of 2007 were $572 million, compared to $527.1 million for the first nine months of last year. Net income for the nine month period was $55.6 million, or $1.75 per diluted share. This compares to net income of $49.2 million, or $1.57 per diluted share in the first nine months of 2006.

Now it’s time for me to discuss sales by product categories. As a reminder, our international sales are spread amongst these product categories and are broken apart separately. Sales of traditional toys, which include action figures, vehicles, electronics, plush, role play, dolls and promotional products were $286.4 million for the third quarter of 2007. This compares to $265.6 million in the third quarter of 2006.

In the first nine months of 2007, sales of traditional toys represented $498.5 million. This compares with $448.2 million in the comparable period last year. Traditional toys represented approximately (technical difficulties) 87.2% of JAKKS' overall sales in the third quarter and the first nine months of 2007 respectively versus approximately 89.8%, and 85% of JAKKS' overall sales in the third quarter in the first nine months of 2006.

Sales in the quarter were driven by our action figures, dolls and pretend-play products based on WWE, Pokemon, and Pop Disney licenses. Our current activity (technical difficulties) products consist primarily of our Pentech and Flying Colors product lines. Sales were reported at $12.2 million in the third quarter and $14.5 million in the first nine months of 2007. This compares to $32.9 million and $42.7 million respectively in the comparable periods of 2006.

This represents 3.8% of our total sales for the quarter and 5.7% of the sales year-to-date versus 4.9% of the total sales for the third quarter [and 8.1%] of sales for the first nine months of last year. Next year we will have several activities and products featuring Pokemon and other new innovative features. We expect this to increase our sales in this category.

Sales of our other products, which include seasonal outdoor products and pet products branded under Funnoodle, Go Fly a Kite, Hair Creations, XPV and JAKKS Pets, gave us sales of $18.7 million in the third quarter and $40.6 million for the first nine months of this year. This compares to $15.7 million for the third quarter and $36.1 million for the first nine months of 2006.

This represents approximately [5.9% and 7.1%] of overall sales in the third quarter year-to-date periods respectively in 2007. This compares to 5.3% and 6.9% of overall sales in the same periods in 2006. Sales in this category was led by AKC licensed products and XPV Flying Toys.

Gross margin for the third quarter of 2007 was 39%, as compared to 38.2% in the third quarter of last year. For the first nine months, gross margins were 37.6% as compared to 39.1% in the first nine months of 2006. The increase in gross margin for the quarter is due to our product mix which included higher margin products and lower license advances in 2007. We expect to see gross margin (technical difficulties) third quarter 2007, (technical difficulties) in the fourth quarter and continue on into 2008.

SG&A expenses in the third quarter of 2007 were $59 million, or 18.5% of net sales. This compares to $54.7 million, which was also 18.5% of net sales in the same period last year. For the nine month period, SG&A expenses were $140 million, or 24.5% of net sales. This compares to $136.9 million, or 26% of net sales in the same period of last year. This decrease as a percent of the nine month period is due to lower marketing costs in 2007.

Depreciation and amortization was approximately $6.2 million in the third quarter and $18 million for the first nine months of 2007. This compares to $5.9 million and $17.3 million for the comparable periods in 2006.

Stock-based compensation for the third quarter and first nine months of 2007 was $1.5 million and $5.2 million respectively. This compares with $1.1 million and $4.5 million respectively for comparable periods last year.

Operating margins for the third quarter and first nine months of 2007 were 20.4% and 13.1%. This compares with 19.7% and 13.2% in 2006, respectively. This is primarily due to lower gross margins offset, in part, by the decrease in direct selling expenses.

During the quarter, we posted $900,000 in profits from the video game joint venture with THQ. This brought the JV contribution to $3.1 million for the first nine months of this year. This compares to a loss of $200,000 and profit of $700,000 for the comparable periods of last year. WWE SmackDown vs. Raw 2008 is scheduled for a North American release on November 13; Sony's PlayStation 3, PlayStation 2, PSP HandHeld is (technical difficulties) and a Wii console, [handheld] and Xbox 360 console. The wireless version of the game is slated to launch on various mobile carriers worldwide throughout (technical difficulties).

Cash provided by operations for the third quarter was $13.8 million. This compared to [$20 million] in the same period last year. For the first nine months of the year, operations provided cash flow of $30 million, compared to $7.5 million in 2006. Our financial position remains very strong and as of September 30, 2007, our working capital was approximately $342.2 million. This included cash and equivalents of $186.6 million.

Accounts Receivable at the end of the third quarter was $209.1 million. This compares to $182.8 million at the end of the third quarter of 2006. This is consistent with the higher sales in 2007. DSOs were 59 days, higher than the 56 days in the same period in 2006.

Inventory was $93.8 million at the end of the quarter, up from $86.7 million at the end up the comparable period in 2006. DSIs increased slightly higher to 52 days, from 50 days at the end of the third quarter of 2006. Capital expenditures for the quarter and first nine months were $6.1 million and $13.8 million, respectively. We expect capital expenditures for the full year to be approximately $18 million.

Based on our current financial position and third quarter results, we're comfortable with our prior 2007 earnings guidance. We expect to achieve at least $800 million in revenue, as well as earnings of $75.8 million or $2.39 per diluted share.

With that, I will return the call to Jack Friedman.

Jack Friedman

Thank you, Joel. As we've mentioned, we are feeling great about our line-up for this holiday season. Next year is well underway as well. There are a number of products that are tracking at or ahead of expectations for this year. Many of our drivers have been topping the industry's hot holiday toy lists, keeping JAKKS Pacific and our products in the spotlight. Our EyeClops Bionic Eye extended the Plug & Play category for JAKKS and kids are discovering EyeClops, both at home and in the classroom.

New York Times writer, Warren Buck recently said that EyeClops was his favorite 2007 educational toy. This product might be sold in toy stores, but don't be fooled; EyeClops is a powerful microscope that can transform a TV screen into a world of wonder. We are extremely pleased with our sales of EyeClops so far. We are working on line extensions for next year as well.

Our PacMan Gold TV game, also featured in the New York Times recently, is the perfect stocking stuffer for nostalgic gamers. Our 1 vs. 100, Jeopardy, Deal or No Deal and other game shows, TV games, as well as kid-driven titles based on Dora, Sponge Bob, Star Wars, Hannah Montana, are also well placed for the fourth quarter. Next year we will bring our original Atari TV games back into the assortment, along with High School Musical and TV games. These feature new technology that we expect will again expand on our Plug & Play category.

Puppy in My Pocket line of our Play Along division has been performing ahead of expectations so far this year, and we have new Puppy in My Pocket accessories and playsets at retail for the holidays. Kitties and ponies will be joining the line next year. Sweet Secrets, mini-dolls and our special 25th Anniversary Silver Care Bear, with real Swarovski crystals in its eyes, are well positioned for the holidays and have been trending to our expectations. We launched the Silver Care Bears Plush on September 25 in New York City. We expect to sell out of the collectible anniversary bear by the holidays.

New Cabbage Patch Kids Little Sprouts has been doing well. We are gearing up for Cabbage Patch Kids 25th Anniversary in 2008, with the focus program celebrating the original kids. Geico Insurance has been running a very funny television commercial now, featuring a Cabbage Patch Kids doll. This has succeeded in getting attention for the brand.

Another doll line that we're excited about is based on the Disney Tween group -- the Cheetah Girls. The Cheetah Girls sold out an 80 city concert tour. Recently one of them, Sabrina Bryan, has caught America's attention while competing on the TV show, Dancing with the Stars.

Our action figures are doing great, with strong sales of WWE and Pokemon both positioning JAKKS with two of the top five action figures lines at retail. Internationally, WWE also gives us one, if not the strongest boy's property in both the UK and Australia.

Our new Pokemon Diamonds and Pearls figures playsets and accessories are also doing very well. A new generation of kids is catching and embracing the new Pokemon characters and play patterns. We had a terrific expansion for both properties planned for 2008, including our new WWE four-inch figures and the largest scale ring ever, as well as new plush figures, stationery and playsets that we will ship to Pokemon fans around the world.

A line of XPV Xtreme Performance Vehicles also shipped to retail in the quarter, including our RAD, Mini RAD, Mini XPV and Super Terranator. We have new XPV items in development for 2008. Our Laser Challenge has been doing well internationally and a new version that we previewed in Dallas should do well for us in the 2008 year, both domestically and internationally.

Small (technical difficulties) toys, interactive large playsets and classic role play toys, based on popular Disney and Nickelodeon licenses, as well as our non-licensed brands from our CDI division, are all doing excellent at retail. In Child Guidance, our Bonnie line hit Toys "R" Us and KB Toys stores during the quarter. These were supported by [Igmonte] bus tours to our Sweepstakes and a promotion with American Airlines and Kiwi Magazine.

New phone playsets in our Child Guidance line, KnockWood and Gorilla Blocks, also hit Toys "R" Us and KB Toys stores in the second half of this year. Next year, we will add the Wiggles and other popular preschool properties to this line-up. We also have extensive new initiatives for our girls activities and stationery areas for next year. These are both licensed and non-licensed.

We will be updating you on a bunch of other products -- Fancy Nancy, the new Nickelodeon programs, Pokemon stationery products, and a new craze with writing instruments, on our year end call. We predict that we will introduce these products to kids the same way we sped stacks to the masses last year.

American Kennel Club pet products have been doing great. We shipped a new product in the quarter called AKC Travel Convenience Meals. This was launched this week at Petco stores nationwide. The AKC meal packs are, basically, a week's supply of single-served meals and throwaway dishes for no-mess portion controlled meals for on-the-go pet owners. This is a soft launch, but if it takes off, it could be a nice business for JAKKS.

Pet Halloween costumes, White Bites with Arm and Hammer, a toy based on Cat Fancier's association and other popular licenses for dogs and cats are on-shelf and selling through nicely. We are pleased with the growth of this area since we acquired it. We expect more for 2008.

In recent weeks we have announced a number of new initiatives that we believe will lead to exciting opportunities for growth in 2008. We have two new master toy agreements with Nickelodeon and Viacom, Neopets and SpongeBob SquarePants. Neopets is the largest global youth-focused virtual world with more than 40 million registered users. Featured in this are 54 species of Neopets, 16 lands and hundreds of characters, stories (technical difficulties). We will utilize our collective strategy to create a plush line that, we believe, is highly appealing and which we will ship to retail for next year.

SpongeBob SquarePants is still the number one television show for children six to eleven. In 2008, we will lay serious groundwork with our line of plush figures and playsets for the property that currently generates $1 billion annually in consumer products, leading up to 2009 when SpongeBob and Nick celebrate its 10th anniversary.

The portfolio that we have developed and nurtured, along with our relationships with retailers, licensors and consumers, has positioned us well for this year. We are working hard to execute on our strategy on behalf of our shareholders and are excited about the opportunities that lie ahead for JAKKS Pacific.

With that, I will open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question will come from Arvind Bhatia.

Arvind Bhatia - Sterne, Agee & Leach

Good quarter, guys.

Jack Friedman

Thank you, Arvind.

Arvind Bhatia - Sterne, Agee & Leach

You touched on the toy recall aspect of the industry today. I would like to get your take on what you're hearing out there from retailers? And then second, if you could comment on the acquisition environment. Obviously, that's going to be one of the things you're going to consider with your cash situation. My third quick question is on licensing deals. What are you seeing out there in terms of royalties, etc.? Is there any change in what the licensors are asking for in terms of rates, etc.?

Jack Friedman

I'll take it, Arvind. I'll start with your third one and go backwards. We're finding royalty rates to be pretty constant. There are no dramatic increases. Everything is a case-by-case, but it's pretty consistent. I think licensors generally know that there is a limit to what you can add to the retail value of a toy with a license on it. It doesn't seem to be an impediment in moving forward with our business.

Number two, in terms of acquisitions, we are always looking at acquisitions. We did find in the past year or so, with private equity jumping over stuff, that values were excessive to our valuations on companies. We're starting -- it might be a hopeful deal that valuations are coming down a bit and there aren't that many people jumping over opportunities. Our eyes are getting a bit bigger as we grow our working capital. As we grow the management team at JAKKS, we would be in a position to do larger deals than we've done in the past.

In terms of recalls, we've all read the same thing from day-to-day in the newspapers. There have been a number of recalls. We do know that, for us and other companies, there are more and more careful inspections. And we hope that it slows down any recalls for the whole industry.

Arvind Bhatia - Sterne, Agee & Leach

And in terms of how retailers are reacting to other toy companies outside of Mattel, I would just like to get your take on the reaction there.

Jack Friedman

Okay. I can't say it's a specific statement from any retailer, but I think that it's going to get more difficult for the small guy than to do business with the big retailers. If the small guy is selling particularly on a letter of credit basis to retailers and there is a recall, that small guy might not be able to stand behind, or wish to stand behind, and might just pull a bankruptcy and walk away and leave the retailer stuck. So, that might add to our acquisition strategy, there might be a number of smaller companies that wish to get out of the business and walk away before they get into trouble, not being able to do business with the big retailers.

Arvind Bhatia - Sterne, Agee & Leach

You indicated that you expect to at least hit your guidance out there. From where we were in terms of our expectation, you certainly did better this quarter. Walk us through your thinking, in terms of not raising guidance out right. Is that just the environment, or is there anything else that’s making you take a look and hold back?

Jack Friedman

No, we're just taking a conservative approach. So far our deliveries are okay, we don't expect any slow down in that. Our sales at retail are right on schedule so far. It's just a conservative approach.

Arvind Bhatia - Sterne, Agee & Leach

Great. I hope the fires out there are not affecting you guys?

Jack Friedman

No, they’re not.

Arvind Bhatia - Sterne, Agee & Leach

Thanks.

Operator

And your next question will come from Jeff Blaeser.

Jeff Blaeser - Morgan Joseph & Co.

Thanks for taking my question. On terms of profitability, specifically Hannah Montana and Pokemon, can you give us an idea where they fit in the larger scheme versus other products that you sell?

Jack Friedman

They're pretty consistent with our margins. Some of them are generic products like our Foam products are lower margin, but they're consistent with our margin criterias.

Jeff Blaeser - Morgan Joseph & Co.

Okay. Do you receive any sales when Hannah Montana, the Cheetah Girls and the Wiggles go out on their concert tours? Is that an additional distribution channel for you? Is there any change in the matrix selling in those venues?

Jack Friedman

No, not at all. If they were viable -- and those (technical difficulties) it wouldn't mean very much business to us. It would be negligible sales.

Jeff Blaeser - Morgan Joseph & Co.

Okay. Finally, looking at your '08 line, it certainly looks to be more expansive than those in the past. Any expense impacts in the third quarter or going forward with this more robust rollout expected?

Jack Friedman

I'm not 100% sure what you mean by that. Our product development is done primarily internally. And we haven't been adding headcounts in that area, supplementing where we need. So our cost structure hasn't changed from an internal perspective. Certainly, the volume increases, we do more samples, and we do have a bigger presence in Toys "R" Us, etc. However it's proportionate to the increase in sales. We're not expecting any out-of-the-ordinary increases of any consequence.

Jeff Blaeser - Morgan Joseph & Co.

Okay, great. Thank you very much.

Jack Friedman

You're welcome.

Operator

And your next question will come from Gerrick Johnson.

Gerrick Johnson - BMO Capital Markets

Hi. Good morning. I have a question on the Pets business. Can you break that business out for us for the third quarter? Can you discuss any new channels of distribution for that business?

Jack Friedman

We don't break that out specifically, it's still a small division for us, but it’s consistently growing. It does offer us additional distribution to the big box pet retailers, as well as new sections in our major retailers.

Gerrick Johnson - BMO Capital Markets

Okay. You've seen nice growth in your traditional toys. How about addressing some of the other categories, specifically arts and crafts? What's holding that division back and how can you extract similar performance from that segment of the business?

Jack Friedman

We do expect better performance from it next year. We do have, for the most part, a new team in place to manage that division for us. We're delighted so far with the reaction from the Dallas Toy Fair towards some of the new initiatives actually within that division. Two of the most popular offerings came out of that division. It looks like a very bright future.

Gerrick Johnson - BMO Capital Markets

Okay. And finally, a comment was made at a recent competitor's conference about cash and use of cash and, perhaps, building up a cash cushion. Can you explain exactly what you guys meant by that comment?

Jack Friedman

We didn't make a comment.

Joel Bennett

A competitive…

GERRICK JOHNSON

No, a competitor to me. Joel, you made the comments, actually.

Joel Bennett

Oh. I'm sure it was (technical difficulties

Gerrick Johnson - BMO Capital Markets

It had to do with the lawsuits.

Joel Bennett

No. We are accumulating cash flow for acquisitions and funding our other initiatives, and to continue to get licenses. On the call this morning, we indicated there were at least two master licenses. We're investing in developments, but we're not retaining any cash for anything outside of our normal business at this point. There's a three point strategy in acquisitions, new (licensing and inventory) development. Some of the context of the comments, but that's basically what I would have (technical difficulties)

Jack Friedman

I would add to that, we do on a regular basis meet with our Board and discuss the possibility of a stock (technical difficulties).

Operator

The next question will come from Cheryl Cortez.

Cheryl Cortez - Susquehanna Financial Group

Hi. Congratulations on your quarter. I was just trying to figure out, just in seeing a lot of Hannah Montana toys fly off the shelves lately, have your retailers already fully placed their orders for the rest of the Christmas season? Is there still room to make more toys and have them delivered in time for Christmas? And how would that affect your margins, if at all?

Jack Friedman

Good question. The retailers continue to place orders or change their forecasts up or down, based on the west matrixes that they use, as well as the ones that we use. Hannah Montana products were less than 10% of our revenue in Q3. Going into Q4, we have ramped up production on it and are prepared to ship a bigger portion of Hannah Montana in Q4 and product for spring '08.

Cheryl Cortez - Susquehanna Financial Group

Thank you very much. I'm glad to know everyone in the JAKKS family is safe from the fires.

Jack Friedman

Thank you.

Operator

Your next question will come from Sean McGowan.

Sean Mcgowan - Wedbush Morgan Securities

Hi, thank you. I have a couple of questions. First, could you talk a little bit about the performance of some of the brands that were strong last year? Which have continued to be strong and which have not? I don't mean individual items as much as the overall brand, like Care Bears, Cabbage Patch, Speed Stacks, etc.

Jack Friedman

I would say that it’s an anticipated disappointment. We saw a slowdown in Q4 last year of our Doodle Bears Line, which continued into this year. Our estimated sales on it are in line, but it has not made a turn on the upside. That would probably be our only downsized brand for this year. I can't think of any other.

Sean Mcgowan - Wedbush Morgan Securities

Okay. I think Stephen might have made a comment at Dallas, that rather than spend money on an acquisition, money has been put into developing all these organic brands. Is that to say that you would not expect to see an acquisition in the next six months?

Jack Friedman

No, not at all. Maybe that was misinterpreted. What Steve meant, is that as we look for acquisitions and don't find the proper ones, we use our capital for internal development, but that wouldn't prevent us at all from going into an acquisition. I mentioned earlier that we're even looking at, potentially, doing larger deals than we've ever done before with our capital on hand, our access to credit and our internal management team.

Sean Mcgowan - Wedbush Morgan Securities

Okay. Can you give us an update on the status of the arbitration proceeding with THQ? Why is that taking so long?

Jack Friedman

I can't -- any kind of legal process seems to take forever, like our WWE lawsuit. It's been over three years now since it's began. We’re, basically, nowhere in the process. There have been arbitrator's names put up. It hasn't worked out and it's gone to the court for choosing an arbitrator. As soon as that process is in place, it will get done. We look forward to it. We think that the marketplace for high powered videogames is extremely strong, maybe stronger than ever. And we look forward to the arbitration and getting it down behind us and look at it as a positive note for JAKKS.

Sean Mcgowan - Wedbush Morgan Securities

So, there's no arbitrator named. Has there been any indication from the court as to when an arbitrator could be named?

Jack Friedman

Well, actually, one had been named, but he had some conflicts. So we sort of went back to square one. I guess it turns out it's a small world out there, with people expecting to have ongoing business in the industry. So there's a lot at stake, so they want to be careful about it, we want to be careful about how we proceed.

Sean Mcgowan - Wedbush Morgan Securities

Yes, of course. Okay, Joel, but as far as your best guess, once the arbitrator is named and agreed on and in place, does that start another clock that could be very long? Or should that be a pretty quick process then?

Joel Bennett

I wouldn't expect it to be an extended period of time. I'm sure we're both preparing. But, identifying the arbitrator is the key at this time. I can't expect that it would be an extended process once he or she is identified.

Sean Mcgowan - Wedbush Morgan Securities

Okay. And then back on WWE, has any kind of trial date or anything been set?

Joel Bennett

No, we're still waiting to hear the judge on the motion to dismiss. This was poorly argued back in September of 2006. In fact, it was recently the [three year anniversary] of the original filing of the suit.

Sean Mcgowan - Wedbush Morgan Securities

I'm sure the lawyers are having a nice cake, if they get paid for this. Okay. Well, thank you very much.

Jack Friedman

Thank you.

Operator

And your next question will come from Steve Epstein.

Steve Epstein - Defiance Asset Management

Good morning. I have two questions. Is the 40% gross margin for the second half? Is that possible for the second half still? Can you discuss the drivers of the gross margin improvement that you mentioned for the fourth quarter in 2008?

Joel Bennett

The drivers are the product mix, the proportion of new products. In the third quarter, we didn't quite make it, in part because of the better than expected contribution, and part of that was timing of the [CDI fines] which have a number of lower margins for a generic private label product. So it was a benefit overall, but there was a little pressure on the margins, but it was more than (technical difficulties).

Jack Friedman

But, we sell a greater proportion of those generic products. This brings down our marketing expenses, because they don't require marketing.

Steve Epstein - Defiance Asset Management

Okay. Is the roughly 40% margin that you had previously referred to for the second half, is that possible?

Joel Bennett

Well, we hit 39% in third quarter and right now we would measure it individually. We believe we'll be there for fourth quarter, but we didn't get there for third. On average, we probably will be shy of the average of 40% for the second half, since we hit 39% in the third quarter. We'll probably be closer to the 40% in fourth quarter. And because of the relative volume, it will be somewhat less than the 40%.

Steve Epstein - Defiance Asset Management

Okay. I have a broader version of Cheryl's question. You have a number of large top sellers and the revenues are exceeding expectations on those products. Is there a risk of broader product shortages at retail during the holidays? How does that translate into pent-up demand for 2008?

Jack Friedman

Well, as we head to the holiday season, we believe that with our production capacities, we will be able to reasonably meet the demand of the most exciting products that are out there. By working with retailers, we tell them what we can make and what they can expect to get. We usually are able to come to a satisfied level with our retailers. And there is nothing right now to throw that off. That being said, could a Hannah Montana, if you will, take off even further when she starts her concert tour and when her new albums are out? Would we be able to meet that demand? Yes, that could happen. In a sense it would be a good problem, but we do like to supply our retailers with the product.

But all of our plans and those hot issues look like they'll go very nicely into 2008. We expect the Hannah Montana show to continue to be a very important show on the Disney channel. Pokemon seems to be expanding. Wrestling is doing quite well. Our Disney Princess line is doing well. Our Black & Decker line is doing well.

So, we expect to grow in almost all areas in 2008. Usually there are a few hiccups, something that doesn't go the way you anticipate it, but that's the industry that we're in. But overall, things are great. We're producing goods on a regular basis. I'd complement the operational team at JAKKS. I think they've done a great job over a labor shortage and shipping problems and everything else, to get the goods out there and hit a record quarter for us. We’re expecting a good fourth quarter.

Steve Epstein - Defiance Asset Management

Okay. Thank you.

Jack Friedman

You're welcome. Thanks. I thank you all very, very much for being on our call today. And we look forward to another great call in February. Thank you all very much.

Operator

This concludes today's conference call. You may now disconnect.

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Source: JAKKS Pacific Q3 2007 Earnings Call Transcript

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