JAKKS Pacific: Considerable Upside If The Turnaround Is Successful
Summary
- JAKKS has been struggling with declining revenues and losses for a few years.
- Q1 results show promising signs of a turnaround, with increased revenues and expanded margins.
- Q3 and Q4 are the most important quarters for JAKKS, and revenues as well as margins tend to increase.
- If the performance in Q1 continues into the end of the year, JAKKS has considerable upside from these levels.
JAKKS Pacific, Inc. (NASDAQ:JAKK) is a manufacturer of toys and costumes. JAKKS has some very interesting licensing deals with major brands that allows them to sell toys and costumes with those trademarks. The company has been struggling over the last few years, with declining revenues and losses. The Q1 results show some promising signs, and JAKKS seems to be turning around, and could soon return to profitability. Historically, the second half of the year is the best period for revenues, and typically margins also increase. If margins remain around 31%, and revenues continue to increase at the same rate as in Q1, JAKKS could generate ~$44.48M in free cash flow. For that reason, it will be highly dependent on the results of Q3 and Q4. If JAKKS is able to sustain the good performance throughout 2021, the stock has a considerable upside from these levels.
Market overview
At first sight, you would think that toys are a thing of the past. In reality the toy and games retail sales in the US is still growing. Total toys and games retail sales in the US were estimated at ~$25.14B in 2020. Toy sales decreased from 2018 to 2019, but the pandemic has driven higher demand for toys in general. With the lockdowns and kids forced to stay at home, parents found in toys a great way of bringing their kids some joy during a tough period.
Source: Statista
Based on the total toy retail sales in the US, we can estimate JAKKS’ market share of the toy market to be around 2%.
Health benefits of toys
It is true that video games are slowly gaining more importance in children’s lives, but the data shows that there is still plenty of demand for traditional toys. One of the reasons is that pediatricians consider them a healthier pastime for kids, than staring at screens. According to the American Academy of Pediatrics (AAP), traditional toys have a more positive impact on children’s development than video games. Although this is not the main point of the article, it is still important to emphasize that some parents still prefer that their kids play with traditional toys, and the research backs up that choice.
Q1 results and valuation
Q1 results
JAKKS had great results in Q1, with revenues increasing by 26% YoY. It also managed to improve its gross margins to 31.1%, in what is historically the worst quarter for the company.
From the operational point of view, management continues to focus on reducing interest expense, and increasing the maturities of its debt. Net debt as of Q1 was ~$78M, compared with ~127M in 4Q20, which shows a great deal of progress and commitment to clean up the balance sheet. At the end of the quarter it had ~$80.4M in cash and cash equivalents,
Historically, the 3Q and 4Q have been the best performing quarters for JAKKS, and Q1 is usually the weakest. This is why the improvement in results in 1Q21 is so promising.
(All numbers in millions of dollars)
Source: TIKR.com
Management remains committed to reduce its low margin products, and continue to reduce product costs. Additionally, it will continue to reduce operational expenses, which are currently the lowest since 2004.
Valuation
Due to the lack of profitability, JAKKS has been trading at a low valuation. Price-to-sales is just 0.16, and even if we consider EV/Sales, it is still low at 0.35. Operating cash flow in 2020 was ~$43.57M, which is just 4.6x its enterprise value. Cash flow from operations has consistently grown, and management has been able to significantly reduce capex.
(All numbers in millions of dollars)
Source: TIKR.com
In 2020 it managed to generate ~$35.3M in free cash flow, mainly attributed to Q3 and Q4. In those two quarters JAKKS was able to generate ~$51.5M in free cash flow.
If we consider the increase in revenues continuing in Q2 and Q3, we can expect FY21 revenues to be ~$650M. Gross margins over the last few years always tend to be higher in Q2 and Q3, and we could see even higher gross margins in the second half of the year.
(All numbers in millions of dollars)
Source: TIKR.com
Even if margins stay around 31%, and with revenues increasing 26% YoY, we are looking at a gross profit of ~$201.5M for 2021. JAKKS could generate ~$44.48M in free cash flow, which is slightly over 2x the current market cap and slightly above 4x EV. If the expectations materialize, we could see the stock price increase significantly. With the improvement in operations JAKKS cost of capital will be lower, and management can finally clean the balance sheet.
Risks
JAKKS has seen its revenues decline consistently since 2014, and since 2017 it has been continuously losing money. JAKKS is a cyclical stock, it is highly dependent on some months of the year to achieve its guidance. Its cyclicality is a risk to some extent, but it is also the reason why the stock is trading at such a low valuation.
Depends on the turnaround
JAKKS is currently in the middle of a turnaround, as management tries to improve its operations and profitability. The outcome of the turnaround will be a key factor in determining the results going forward and its stock price.
Still a heavy debt load
JAKKS still has ~$154.96M in long-term debt, and this has been a burden on the company. Interest expense in Q1 was ~$4.875M, which was reduced by 12% compared with 1Q20. It still represented ~18.7% of gross profit.
Results lagged general sales
Although the results in Q1 show promising signs, compared with general toy retail sales, JAKKS seems to have slightly lagged the overall market. It increased sales by 26%, while the toy market saw its sales increase by 27%.
Losing licenses
JAKKS is highly dependent on the licensing deals it holds. If the company was to lose some of those licenses from well known brands, it could see its revenues decline.
COVID-19
Total toys retail sales declined by ~4.54% from 2018 to 2019, and increased by 16% from 2019 to 2020. This is partially attributed to the pandemic, as more and more parents were forced to work from home, and take care of their kids. Toys were a good way to keep kids occupied, and active during the lockdowns. Although this does mean that toys retail sales will decline, the growth going forward will be minimal. The toy industry is expected to grow at just 2.5% CAGR from 2021 to 2027. A decline in sales could severely impact JAKKS.
Dilution
The number of shares outstanding increased significantly since 1Q20. Last year, the total number of shares outstanding was 3.021M and at the end of 1Q21 there were 5.379M shares outstanding. JAKKS had and still has outstanding convertible senior notes that could cause further dilution to existing shareholders. At the end of Q1, it had ~$37.71M of convertible senior notes, yielding 3.25%, that are due in 2023.
Bottom line
Taking into account the large valuations across markets, and sectors JAKKS stands out as a deep value stock. Considering the good results so far in 2021, and extended maturity on its debt the outlook is looking increasingly positive. With deep value stocks it is wiser to wait for positive signs before you jump on it. JAKKS is clearly signaling that it might turn around faster than expected and the results in Q1 show just that. It can even beat analyst expectations, if margins expand in Q3 and Q4, which has happened historically.
The stock price should remain volatile, until there is a clearer sign that the company has finally returned to profitability. If that happens, there is plenty of upside on the stock price from the current levels. The results in Q3 and Q4 will be a deciding factor to determine if JAKKS is able to return to profitability or not.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in JAKK over 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.
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Comments (6)
Convertibles have been pretty much converted in full.
Q2 results were outstanding.