2023-11-17 18:22:34 ET
Summary
- The relatively new CEO has visions for growth, which is welcome considering the historically flat earnings over the years.
- Though the core business of infant bedding has recently been experiencing revenue declines, hopefully this is macro related and will improve with the economy.
- The acquisition will also likely help with international sales growth, diversifying retail partnerships and helping pivot to direct to consumer sales.
- Investors should look to the coming holiday sales and earnings for indicators of acquisition success, as Manhattan Toy is a seasonal business.
Overview
In July, I wrote about Crown Crafts ( CRWS ) and how it appeared that their acquisition of the Manhattan Toy Company would be accretive to shareholder value. Since then, the company has incorporated the acquisition in two reportable quarters, and I wanted to check back in to see how that has been going. Of note, having a larger proportion of revenue coming from toys likely makes the company's earnings more seasonal, so perhaps investors can look forward to a better Q3. I have a few questions I want answered. Is the acquisition showing signs of being accretive to shareholder value? Has there been any sign of cost synergies? Has the extra debt and lease expense been manageable while still paying the dividend? I wanted to explore these questions.
Takeaways from IDEAs conference
I listened to the most recent IDEAs conference, which gave a bit of color on what management is thinking and their plans. The bad news is that the core business of infant and child bedding is showing declines in revenue in recent years, which management attributes partially to the economic environment and inflation. Their retail partners are also still more conservative after the inventory glut following the pandemic, and are holding lower weeks worth of inventory. Hopefully they are correct here, and once the macroeconomic picture improves there will be a significant increase to more historic sales numbers.
On the acquisition side, the company has reiterated that over the years it has been an acquisition oriented company that has had to reinvent itself over time. It initially starting as an adult bedding manufacturer, transitioned to infant and child bedding, and now the company's largest product is toys, which makes up 44% of revenue. Additionally, they indicated that more acquisitions of toy companies could be part of their strategy moving forward. They feel that Manhattan Toy is complimentary to their pre-existing Sassy Toy brand, with the former being a "best" type brand, and the latter being a "better" brand. In addition to this, Manhattan Toy's London office is now the international sales office for the entire company, and the website has assisted the overall corporation transition to direct to consumer sales.
Cash Generation and Profitability
So far, cash generation has continued to be robust, despite the debt servicing costs. Indeed, net of stock based compensation, the company reported approximately $3.7 million in free cash flow over the last 6 months alone. This is all while inventories actually increased $1.4 million, but of note there was also a $2.5 million receivables benefit. This has translated to $2.2 million in net income, which is a significant decline from the prior year.
Though revenue is 20% higher, lower gross margins and higher SG&A costs as well as debt servicing costs from the acquisition weighed on earnings. Here, we can hope the core business sales decline is related to macroeconomic factors, and that the new toy business will be accretive to EPS as management has predicted for this fiscal year. Q3 is likely going to be an important bellwether as the toy industry is highly cyclical and holiday shopping often leads to better sales.
Balance Sheet and Debt
When I first invested in this company in Q1 of 2023, the company carried no debt and appeared to be an outlier as a capital light business with robust dividends in a low moat industry. As I mentioned in my previous article, the investor base may have gotten used to this conservative balance sheet and the large amount of capital returned to investors via special dividends. Of course this has changed with the change in CEO and recent acquisition.
After the acquisition of Manhattan Toy in March, the company carried approximately $11 million in net debt, and that has been reduce to $8 million in the MRQ. That is in addition to returning $1.6 million to shareholders over the same time period. Clearly maintaining the dividend and deleveraging are the two main priorities here and are being supported for the most part by free cash flow.
Valuation
I am not going to make changes to my valuation model at this time, but it appears so far the company has been outperforming my expectations as it has already generated $3.7 million in FCF net of stock based comp. Even so, debt principal payments technically are not flowing to equity holders, so investors should keep this in mind when valuing this company. If Q3 is a strong quarter as it should be due to seasonality, the company may generate far more than my estimated $5 million in free cash flow. It remains to be seen how well this acquisition will be incorporated, and what kind of margins the overall business will have on a full year basis.
Risks
Reliance on a Few Large Companies
In my previous article, I mentioned the over-reliance on Walmart ( WMT ) for retailing as being a major risk. It is encouraging that the most recent acquisition has helped to mitigate some of this, increasing sales at Amazon ( AMZN ) and even helping the company transition to direct to consumer.
Low Moat Business
Baby and infant products are a low to no moat business, and it requires excellent execution. A risk operationally now is the relatively new CEO who is looking to grow the company through acquisitions. The previous capital light business model was definitely a strength for shareholders, and incorporating too much debt for more acquisitions could severely reduce equity returns. So far though, I am happy with the Manhattan Toy purchase.
Historically No Growth Business
Another risk mentioned in my previous article, that is perhaps addressed a bit more with this acquisition. The company was able to grow revenue by 20% so far with this acquisition, and we will see if this can translate to significant gains in free cash flow. It additionally is looking for more growth opportunities within this market. Though this adds more risk, I am happy with the plan for potential higher gains in the future. Of course, the risk of failing to adapt and grow also cannot be discounted.
Conclusion
Though a conservative balance sheet, high ROIC and special dividends was an initial draw for me to the company, the lack of growth combined with stock dilution was concerning as a long term investor. I think the growth plan offered by the relatively new CEO offers a more compelling reason to invest in the company. I like how the story is unfolding here, and we will see in the coming quarter if Manhattan Toy can execute well this holiday season. I have not changed my valuation model, which estimates the company to be worth approximately $65 million, indicating modest upside from the current market value of $48 million.
For further details see:
Crown Crafts: Value Story Changing To Growth