Special Situation: Jakks Pacific (JAKK): A toymaker hated by Wall Street
Following years of mismanagement, JAKK is finally executing and Wall Street has yet to catch on to the story.
Quick Summary
Following years of mismanagement, JAKK is now ready for launch thanks to a new CFO doing God’s work: a death spiral convertible debt has been cleaned up, they refinanced their debt, margins have improved and we are seeing a significant rebound in their business. The stock is trading at a 4.8x EBITDA multiple despite its closest comparable trading at 8x
Company Description
Jakks Pacific develops and sells toys & costumes, primarily for content creators. The company’s business model has historically capitalized on licensing existing IP (e.g. They held the rights to Frozen to make costumes). Jakks’ licensing agreements usually contain minimum royalty guarantees; if the company does not meet a certain sales volume threshold, they are on the hook for the minimum royalty payment. They wholesale their products, which are in turn sold to retailers. The company is known for its partnerships with Disney, Nintendo, SEGA, and Black+Decker. JAKK’s 2019 revenue breakdown was as follows: 50% girl toys, 20% Halloween costumes (important), 15% seasonal products, 13% boy toys, and 2% preschool toys. 30% of their revenue is derived from Walmart and 21% from Target.
Background On The Stock
JAKK was founded by late toy pioneer Jack Friedman & current CEO, Stephen Berman. Mr. Friedman’s intended to consolidate the toy industry, create exclusive licensing agreements and make Jakks pacific a powerhouse in the sector. Following years of success, the company ended up losing one of its key licensing agreements (WWE) and all went downhill from there. The company started to become unable to meet their royalties agreements, which deteriorated their balance sheet.
Mr. Berman took over from Friedman in 2010 and his lack of experience in the role only made things worse: in a bid to save the business and protect Friedman’s legacy (my opinion), the CEO agreed to many unprofitable licensing agreements, which led to deteriorating profitability. He refused various takeover offers and spent money on useless investment bankers that were unable to find a better buyer for JAKK. On the brink of bankruptcy, the CEO took a desperate measure to save the business; he agreed to refinance Jakk’s pacific debt through a death spiral convertible debt. For those unfamiliar with the death spiral converts, they work as follows: The initial conversion price resets periodically. So, if the stock is 50% lower at the time of the reset, your new conversion price is also 50% lower. However, for JAKK, the reverse was not allowed; if the stock price jumped, the conversion price remained the same. This deal was catastrophic for shareholders and became an overhang on the stock. Over the next few years, JAKK continued to bleed, its balance sheet deteriorated and most institutional investors saw Mr. Berman as one of the least capable CEOs in public markets.
That started to change when at the end of 2019, the company hired Mattel’s previous CFO, John Kimble. Mr. Kimble started working vigorously on the company’s issues. The company hired a consulting firm to help them overhaul their cost structure, from sourcing to shipping (Mr. Kimble discusses it in detail in the Q3 2020 earnings call). They have started switching from a wholesale model to a direct-to-retail model in Europe. The company now believes it can now be profitable with evergreen products alone.
Finally, while Mr. Berman remains at the helm of the company, which many see as a problem for the stock, I believe the near-death experience of Jakks Pacific has made him a better CEO.
Catalysts
On June 3rd, 2021, the company refinanced its debt. The new debt has a principal of $99.0M and an interest rate of LIBOR+6.5-7.0%. While this is still high, it will be used to pay down the outstanding $128.9M, 10.5% interest rate term loan facility. The company expects to generate $5M in annual interest expense savings. This is extremely important, as $5M in debt repayment per year equals $0.50-$0.60 in share price accretion per year. More importantly, this refinancing triggered a key covenant: it accelerated the maturity of the convertible debt to September 1st, 2021. I expect the holders to convert their debt and dump them in the market over 91 days as they are not allowed to hold more than 4.9% of the common stock as per their agreement with JAKK. As such, expect a volatile stock until that date. However, this removes a significant overhang and will likely improve the liquidity profile of the stock.
The company also received backing from a prominent player in the toy space: Lawrence Rosen. Mr.Rosen has been accumulating shares and now owns 522K shares. He was the founder of Cra-Z-Art and currently acts as the chairman of the board. This signals to me that smart money is getting into the stock.
The next catalyst relates to their disguise (costume) business. Their costume business was hit hard by COVID. Generally, their third quarter, which coincides with the celebration of Halloween, is their best quarter. Following last year’s cancellation of Halloween, parties, and other events due to COVID, I expect a strong rebound in 2021.
Finally,post-Q3 2021, we should see continued strength in their business. Why? COVID has delayed the release of many movies that JAKK could have benefitted from. It seems like the slate of content for 2H2021 and 2022 will be one of the best ever, and JAKK should be able to capitalize on that given their relationships with major content creators.
Valuation
Before I get into the valuation, I want to spend a little bit of time on JAKK’s closest comparables. Many individuals look at Mattel and Hasbro as JAKK’s comparable. That said, both Mattel and Hasbro operate multi-billion dollar franchises that are not tied to licensing agreements, and this reduces significantly the lumpiness/risk of their businesses. Funko Inc (FNKO), a public comparable, resembles a lot more JAKK. Funko relies heavily on new content to drive growth and has agreements with major content creators as well (Disney). Funko has a history of blowing up their results following quarters with a minimal amount of new content (see Funko’s Q4 2019) and relies primarily on wholesaling its Pop! Collectibles. Funko trades at 8x EBITDA. I believe this is where JAKK could trade if they continue executing.
My valuation for JAKK is quite simple: In our dream scenario, JAKK trades at 8x EBITDA. Given the rebound in their Q3 results, they are likely to generate $45M+ in EBITDA, which gets us to a $29 stock. On the flip side, even if we use TTM EBITDA of $39.6M, and sticking to our 8x EBITDA multiple, it gives us a stock worth $25, and even at 6x EBITDA, the stock would be worth $17.
Why does this Opportunity Exist?
Jakks pacific is hated. Plain and simple. The company came up in various toy industry sell-side discussions. The sentiment over the CEO’s past performance is so negative, that one analyst I spoke to said that he would go to his grave before upgrading JAKK to a buy if Mr. Berman remains at the helm of the company. In addition, their death spiral convertible made it impossible for any reasonable long-term investor to accurately gauge the risk as any short-term weakness in the stock could have a devastating effect on the share count.
Risks
Risks to our story have been discussed above. These include:
The current CEO is, I believe, disliked on wall street, and negative sentiment on JAKK might persist despite a turnaround in the business
Short-term volatility as the owners of the convertible debt will unwind the stock
The company has a history of failing to deliver on its royalty licensing agreements. This could happen again. However, from my discussion with the IR department, the CFO has been doing a phenomenal job in renegotiating some agreements
Major customer concentration (Walmart and Target)
Disclaimer: I am long JAKK