DIS - JAKKS Pacific: My Coffee Can Portfolio King For May

2023-05-26 06:14:28 ET

Summary

• JAKKS Pacific was the king of my coffee can portfolio by far over these last 3 months.
• JAKKS is one of the highest-scoring companies currently on Joel Greenblatt's Magic Formula screener when combining the earnings yield of 36.9% with the ROIC of 31.27%.
• With current assets 4x greater than long-term debt, this is as good of a balance sheet that you'll get in a small cap outside of biotech.
• I will provide an impression of my own visit to Universal Studios Hollywood's "Super Nintendo World" and possible implications for JAKK's Nintendo toy line.

King of the coffee can

My third installment of the coffee can portfolio will include a comprehensive analysis of the winner of the portfolio so far, JAKKS Pacific ( JAKK ). For reference, the second portfolio article installment can be found here and the first here.

There have been winners and losers, but JAKKS Pacific has ripped higher and higher ever since adding it to my coffee can, a portfolio of small caps to lock in a coffee can and forget about. The catalysts that have turned the toy company's earnings fortunes higher have largely been attributed to the Encanto and Nintendo ( NTDOY ) Franchises.

Universal Studios owner Comcast ( CMCSA ), recently released both The Super Mario Brothers movie and opened the Super Nintendo World portion of Universal Studios Hollywood back to back. I have a previous article regarding Comcast that predicted the Super Mario Bros. movie grossing a Billion before it happened. As JAKKS Pacific manufactures licensed toys for the Nintendo franchise, this has been an awesome tailwind.

Per Christopher Mayer's book, 100 Baggers Stocks That Return 100-To-1 And How To Find Them. He points out that historical 100 baggers have qualities that can follow the acronym SQGLP. He recommends building a "coffee can" portfolio of these stocks and letting fate do the rest. Don't bet more than you can afford to lose:

• S-Size is small.
• Q-Quality is high for both business and management.
• G-Growth in earnings is high.
• L-Longevity in both Q and G.
• P-Price is favorable for good returns.

The above criteria were used in conjunction with Joel Greenblatt's Magic Formula screener, picking only the small cap high scorers out of the top 50 stocks.

Three month results

The metric used in Magic Formula/Little Book investing is quite simple, it takes all the stocks in the stock market, minus banks and utility companies (since their growth is regulated), and scores them by combining their earnings yield and their return on invested capital. The two percentages are added together and a score is derived from this. The earnings yield is calculated by dividing the earnings per share by the share price. He believed the earnings yield gives a better metric than P/E as values more positive are better, while in P/E a value of smaller proportions is better when analyzing the "cheap" part of the equation. There must be two "positive is better" metrics to add together to produce ascending scores.

The earnings yield is then added to the ROIC %. An example would be a stock with an EPS of $10, and a share price of $100. $10/$100 = 10% earnings yield. This would then be added to the ROIC. If ROIC was also 10%, then the stock would have a total score of 20. The higher the score the better. The screener allows you to set the market cap threshold from $50 million up to infinity.

The stocks picked in the original coffee can "buy and hold" portfolio were chosen based on a small market cap of under $1 Billion combined with the highest Magic Formula scores. Here are the results in month 3 since the first article:

JAKKS Pacific chart since purchase

What they do

From the most recent 10K :

We are a leading multi-line, multi-brand toy company that designs, produces, markets, sells and distributes toys and related products, kids indoor and outdoor furniture, and other consumer products. We focus our business on acquiring or licensing well-recognized intellectual property ("IP"), trademarks and/or brand names, most with long product histories ("evergreen brands"). We seek to acquire/license these evergreen brands because we believe they are less subject to market fads or trends. We also develop proprietary products marketed under our own trademarks and brand names, and have historically acquired complementary businesses to further grow our portfolio.

Clients

Also from the MRFY 10K :

Currently, among others, we have license agreements with Nickelodeon®, Disney®, Pixar®, Marvel®, NBC Universal®, Microsoft©, Sega®, Sony®, Netflix® and WarnerMedia®.

The 10K lists a huge catalog of licensing partnerships including the deal with Nintendo. The Nintendo deal has seemed to grab the most attention. I would point out NBC Universal being the most important at this moment. They operate the Universal Studios theme parks under the Comcast parent company.

My own visit to Super Nintendo World

I finally had the pleasure of visiting Super Nintendo World at Universal Hollywood this month and here were some of my observations:

• We had to get an early pass to get in, an extra $20 for that pass. The lines were still packed at 8 am before the actual 9 am opening of Universal.
• 60-70% of the crowd were decked out in Super Nintendo and Super Mario attire, hats, and accessories, the full nine yards.
• The shops at Universal Studios have now all been tuned into quasi-Super Nintendo shops outside of the Harry Potter shop. The shops inside the actual Super Nintendo World are exclusively Super Nintendo based.
• Nintendo-based toys had the highest customer-facing exposure of any toys or accessories in the entire park by far.
• Purchasing on that day appeared to be very high volume on an eyeball test basis. This was as weekday, not a weekend.
• I flipped over several toys to look for some evidence of JAKKS Pacific producing the toys, but they all simply read Nintendo or Universal Studios.
• I cannot confirm whether all the toys and clothing at the park were produced by JAKKS Pacific. The 10K does point out a partnership with NBCUniversal. NBCUniversal is the Comcast subsidiary that operates the theme-parks.
• There are vending machines that dispense point accumulating bracelets that sync with the Super Nintendo app. Virtually every child's parents were purchasing these Super Mario themed bracelets at $20 a pop. I could not confirm who manufactures these.

Right now I can confirm, there is Nintendo fever in Hollywood. There are so many people visiting The Super Nintendo World area at Universal Hollywood that you need an early entrance pass to guarantee you can get in.

Whether or not the toys in the park are produced by JAKKS Pacific is kind of a moot point, because all the patrons are purchasing accessories before they even get to the park. The hit box office film, Super Mario Bros. has already started to create a brand new TAM for Nintendo products similar to what Star Wars did for Disney ( DIS ). These are all just my opinions and observations.

On a final note, leading me to believe the toys and items at the park are produced by JAKKS Pacific was the 10K language I included under the clients header. It indicates a partnership with NBC Universal.

Valuation model

While the company just recently became profitable in 2022 after a chain of negative years, a growth model valuation would be inappropriate until they could link together at least 2-3 years of growth. The same would be true for a Graham number model as Benjamin Graham also advised making sure a company has net earnings in years previous to purchase as well.

Since this is a small cap with an unpredictable future, I will use the Buffett owner earnings NPV model and ratchet up the required return using their high beta and CAPM to get my required rate or return, RRR. The model normally uses the risk-free rate of the 10-year treasury as the required rate of return, but that's only for companies with stable, predictable cash flow.

The inputs I will use are:

• TTM net income- $89.9 million
• Plus TTM depreciation and amortization-$10 million
• Minus TTM CAPEX- $12.1 million
• Equals owner earnings cash flow of- $87.8 million

Now for the required rate of return. JAKKS Pacific has a Beta of 2.18, more than double the volatility of the market. We are also going to assume an 11% market return, really turning up the heat on this small cap.

The NPV of a company with $87.8 million in owner earnings at RRR of 19.73% would price the company at $445 million. With 9.87 million shares outstanding per the most recent 10Q , that gives us a per-share value of $45 a share . This is a very conservative model if JAKKS Pacific can simply keep up the current rate of owner earnings without growth. The $45 a share price would represent a P/E ratio of a bit over 5 X based on the current price.

Here's the caveat, Wall Street does not expect JAKKS Pacific to keep up that earnings rip. The average estimate for EPS next year is $4.59/share. Multiply that by 9.87 million shares outstanding and we get a net income prediction of only $45.3 million next year. If we keep the $2 million gap constant between depreciation and amortization versus CAPEX, we get $43.3 million in owner earnings. The present value of $43.3 million/RRR of 19.73%=$217.94 million market cap. Divide that by 9.87 million shares and we get $22 a share fair value.

As Wall Street tends to be inaccurate and usually low on their estimates, let's blend the high and the low prices. The average of the two would be $33.5 a share . This would imply a roughly 42% discount to fair value. The share dilution has held flat since 2021, but if that increases faster than expected and if earnings gravitate closer to Wall St. estimates, this would revert to a hold pretty quickly.

Current assets vs LT debt

As part of my checklist on balance sheet management, I like to compare current assets to LT debt. Long-term debt is low, current assets seem to be dropping in lockstep but leveling off. They have certainly been spending to ramp up growth and pay down debt at the same time. With current assets 4 X greater than long-term debt, this is as good of a balance sheet as you'll get in a small cap outside of biotech.

Of some concern here is the large increase in shares outstanding. Dilution is ok if the growth from the raised capital is sufficient. With a current GAAP earnings yield of 36.9%, it's been fabulous. The company is one of the highest-scoring companies currently on Joel Greenblatt's Magic Formula screener when combining the earnings yield with the ROIC of 31.27%. That would currently give us an updated score of 68.17. Let's hope the trends for return on capital continue.

Seasonality

Similar to the trends for Funko ( FNKO ), JAKKS Pacific likes to point out that their income is seasonal:

In 2022, 57.1% of our net sales were made in the third and fourth quarters.

However, with both catalysts from the Super Mario Bros. film, Encanto franchise and the Universal Hollywood theme-park, they are booking more consistent revenue than they probably would otherwise. I would expect this to cool at some point and the earnings trends to adjust back to a seasonal basis.

Catalysts

With the bulk of revenue, $644 million of the company's $782 million, coming from the United States, this is a US-based story. If the US economy stays healthy and the consumer remains strong, revenue seems to have a solid footing. A further capitalization of the Super Mario franchise by Comcast should help toy sales continue to be strong by way of trickle down economics.

Risks

Recession will hit all discretionary products and toys are one of those. Luckily these are rather inexpensive discretionary products and should not see as large of an impact as higher ticket items. Toys, especially in Q3 and Q4 nearing Christmas, are almost staples in the United States.

Company specific risks from the 10K

• Our current licenses require us to pay minimum royalties.
• Some of our licenses are restricted as to use and include other restrictive provisions.
• A limited number of licensors account for a large portion of our net sales. We derive a significant portion of our net sales from a limited number of licensors, one of which accounted for over 61% of our net sales in 2022. If one or more of these licensors were to terminate or fail to renew our licenses or not grant us new licenses, our business, results of operations and financial condition could be adversely affected.

As we can see, picking the right catalog is important as royalties need to be paid on a minimum basis regardless of profitability. The Nintendo catalog could float their boat for years to come, but much of the marketing and popularity will depend on Comcast's ability to market the business. Encanto, the popular Disney franchise also accounted for a large portion of the sales growth in 2022. They also need Disney to keep producing popular content within the scope of their licensing catalog.

Conclusion

JAKKS Pacific was the king of my coffee can portfolio by far over these last 3 months. The even-weight portfolio of small caps I put together gives me a great tracker of where to search for possible additional asset allocation. JAKKS Pacific has been a strong buy/buy on Seeking Alpha for quite some time and the list of good qualities the company has going for it right now are many.

I still consider this, and any small cap in general a high-risk position. I ratcheted up the required rate of return on their current cash flow as it may not last. They are also raising equity. If everything goes well, this company could have a lot of runway in front of it. I can also see the fortunes dimming with a few wrong moves by management. With a $33.5 price target, the stock has a lot of upside if it can maintain this current earnings streak.

For further details see: