JAKKS Pacific: Down 40% But Still Too Expensive

| About: JAKKS Pacific, (JAKK)
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JAKKS Pacific (NASDAQ:JAKK) is a developer, manufacturer and marketer of toys and consumer products for children in the US and internationally. The company, based in Malibu, California, operates in two segments, the first of which is comprised of traditional (low-tech) toys and electronic toys and the second, role play, novelty and seasonal toys, respectively. In a nutshell, the company wholesales its toys that are made under licensing agreements with various companies and its own private brands to retailers who then sell them to the public. JAKK sells action figures, toy vehicles, dress-up accessories, costumes, etc. The common stock was fetching nearly $30 as recently as 2008 and traded in the mid-teens in 2012. However, since that time, the stock has cratered to under $7, much of which was damage due to Thursday's horrendous earnings report and guidance and indeed, the stock was down more Friday. The question for investors now is whether or not this company has any value following the 40%+ decline in just the past two days. This article will take a look at JAKK in light of the information we received during the quarterly report to see if the company has value at $7 or if there is more downside to come.

In order to determine what JAKK's future business is worth, I believe it is instructive to examine the recent past for some context. Below, you'll see net sales and operating income for the past five full fiscal years.

As you can see, sales (columns) once exceeded $900 million but have fallen off of a cliff and this year are barely expected to surpass $600 million. Additionally, operating income, which is a number I calculated by removing one-time, non-cash charges from the income statement such as goodwill write downs, has been volatile but the trend is clearly down. In fact, since 2009, there has only been one year with positive operating income.

Next, we'll see JAKK's cost of goods sold, SG&A expenditures and operating income as percentages of total revenue for each respective year over the same timeframe.

As you can see, not only do COGS and SG&A make up very high proportions of revenue respectively but, importantly, the total of the two crests 100% in many years, including estimates for 2013. This means that not only does the company not produce net income but it doesn't even produce positive EBIT. Management believes the company will produce positive EBIT next year and we'll take a deeper look at that a bit later.

The mix of rapidly declining sales, even in the face of five acquisitions in the past five years, and stable to rising costs means that JAKK's financial performance deteriorates virtually every year. Indeed, the updated guidance from the earnings release linked above lets you know that the preliminary guidance for 2013 has been completely blown out of the water and the new guidance is materially weaker. The point is it looks as though nothing has changed at JAKK to make me think the company will actually become relevant again.

Looking forward to management's guidance for this year, revenue is expected to come in at $620 million and a net loss of $56 million. That net loss figure includes some one-time non-cash charges that amount to ~$26 million so on an operating basis, we are looking at something like a $30 million loss. Originally, 2013 guidance was for $700 million in revenue and $14 million in profit. The fact that the revised guidance is on a different planet from the original guidance either suggests that management has zero ability to forecast its business correctly or the business is deteriorating so quickly that even the people running the place can't get in front of it. Neither of those things are good and it highlights the dire situation JAKK finds itself in now.

Now, management is aware that the situation is ever worsening and has decided to do something about it. The company is reducing headcount, leased space and overhead expenses. Reducing headcount is a classic move from struggling companies and it can work to save huge sums of money but as the old saying goes, you can only cut your way to profitability once. Eventually, fundamentals must improve. Also, the company only has just over 800 employees some I'm not sure what kind of material impact can be gained from reducing headcount without impacting the business adversely. We are probably talking about only a few million dollars per year in terms of savings from the headcount reduction and as we saw earlier, a couple million dollars is not JAKK's problem. That is speculation on my part but we didn't receive any kind of guidance on this issue from management.

In terms of the leased space reduction, it's about time because JAKK had no less than twenty different leased spaces in its first quarter 10-Q. For a company with 800 employees that is a laughable number of locations. It appears JAKK keeps open whatever offices exist when it acquires a company so instead of consolidating to its headquarters (or somewhere else), JAKK simply collects office space all over the world. I'm glad to see the company taking this step because it is way past overdue. As with the headcount reductions, I think this will be very incremental in terms of improving operating expenses but it is a start.

One last note before we dig into the problems with the actual business of JAKK; management recently completed a share repurchase program wherein they bought 1.77 million shares for an aggregate consideration of approximately $30 million. If you're keeping score at home, that is an average price of $16.93, or more than double the current share price. In other words, those 1.77 million shares are now worth roughly $12 million. This is one more example of a company buying at the top but in JAKK's case, the company can ill afford to keep making mistakes and in particular, ones that are of this magnitude.

In my view, the biggest problem with JAKK's business is the structural headwinds that are built into an "old tech" toy company. JAKK is attempting to diversify its revenue streams by combining traditional toys with digital entertainment and learning but it is very late to the party. Most of JAKK's revenue still comes from toys that have very little or no electronics in them. The problem with this is that consumers (even kids) trend more and more everyday towards electronic devices that can deliver content and entertain them. JAKK management acknowledges this risk but the only solution offered is that they are trying to mesh traditional and "new tech" into their toys in order to fix this problem. A six year old is more likely, in my view, to pick up an iPhone than an action figure. I'm not suggesting that there is no market for traditional toys, because there obviously is, but I'm trying to highlight the fundamental shift that has occurred in the toy industry and how I believe JAKK is behind the curve. This has served to shrink the potential market for toys like JAKK offers and makes it even harder for this company to break even. This issue, and JAKK's success or failure in dealing with it, will likely decide whether this is a $2 stock or a $15 stock in the coming years. Obviously, given JAKK's mismanagement to this point, I don't have a lot of confidence the company will succeed.

This brings us to the next big problem JAKK faces and that is the very content on which its toys are based. A huge portion of the company's revenue is derived from licensed content and even the in house toys that are unlicensed rely on kids walking by the toys in a store and wanting to own it. While this is not an inherent problem it becomes one when product lifecycles get shorter and shorter, as management has acknowledged is occurring. This means that JAKK must spend proportionally more to bring a product to market because the lifecycle of the revenue produced by that product has been shortened relative to the recent past. For instance, management cites licensed products based upon movies or TV shows that have very short lifecycles in terms of their popularity in stores but cost a significant amount of money to obtain the license, produce and distribute the toys. This is a huge problem and unfortunately, the only way for JAKK to overcome this challenge is to distribute products with lasting consumer demand. Obviously, the company isn't doing this right now and it is showing up in the financials. In fact, during the earnings call, management took a $12.2 million impairment on inventory due in part to this very phenomenon.

Next, JAKK is in a fiercely competitive industry and as such, it is often relegated to the pile of also-rans you can find at any children's toy retailer. This means that not only does JAKK face significant marketing challenges in creating consumer awareness, but it also must compete on price as that could be the determining factor in a parent's mind when it comes time to buy. I know when my wife and I buy things for our daughter, we have no way of knowing which toy is better quality and as a result, we sometimes choose based upon price. I suspect we are not the only people who do this and the implication of this is that JAKK is getting squeezed on both ends by external pressures; the cost side is being aggravated by shorter product lifecycles (and commensurate license acquisition and development costs) and the revenue side is being squeezed by competitive pressures. This is not a pretty picture and it has resulted in the terrible financial performance of JAKK for the past few years.

Finally, JAKK has made it a habit to consistently acquire smaller companies in order to grow. There are two problems with this strategy as it relates specifically to JAKK. First, a problem which applies to every company who employs this strategy is that it is very expensive. Nobody will sell their company for whatever the current market value is; you have to pay a premium. This means that the amount of time it takes JAKK to recoup its investment is lengthened, all else equal. Second, the fact that JAKK has acquired five companies since 2008 but has somehow managed to post a decline of nearly 30% of total revenues is astonishing. This means either the JAKK legacy business is terrible or its acquisitions aren't playing out the way the company had hoped. In fact, it could be both. Regardless, something isn't working and I suspect it has at least something to do with the acquisitions the company has made and continues to seek, per the conference call.

The bottom line is that JAKK guided for a "profitable" 2014 but declined to say exactly what that means in terms of earnings. But before you get too excited, management originally guided for 63 to 68 cents per share in earnings for 2013 and has since revised it to a loss of $2.56. Therefore, I'll believe it when I see it. As I said earlier, I don't see any kind of strategy shift that I can get excited about here. The company operates in an extraordinarily competitive industry and has cost pressures combined with revenue pressures and its only viable growth strategy, acquisitions, appears not to be working. Where is the revenue growth going to come from? How will JAKK possibly cut enough expenses out of its budget in order to slash its way to profitability? When will the margin compression stop? The problem is that I don't have any good answers to these questions and as such, I'm staying away from JAKK.

If, by some miracle, JAKK can produce a profit of at least 30 or 40 cents per share next year, a notion which analysts are still somehow clinging to, there may be some value in the stock at current levels based upon the belief that earnings will begin to grow. However, $6.50 is way too much to pay for a stock based upon hope (which is not a valid investing strategy) that a turnaround will take place. If you must be long, wait until at least $5 before pulling the trigger. If JAKK can return to sustainable profitability, $5 will be a good entry point. If not, look out below.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.