Is JAKKS Pacific Oversold?

Is JAKKS Pacific Oversold?

Growing up, most children enjoy playing with toys. There is nothing more fascinating to a child than getting a toy they've been eyeballing and letting their imagination take them away into the great unknown. It is for this reason, that I became drawn to JAKKS Pacific , a Malibu, California based toy company that is responsible for the production and sale of some of the biggest name toys on the market today.

Founded in California in 1995, the company has catered to the youngest of audiences through its extremely diverse product lines. Just to name a few of its areas of interests, the company designs, produces, markets and distributes toys, pet toys, electronics, kids indoor and outdoor furniture, and Halloween costumes through major players like Wal-Mart , Target , and Toys "R" Us.

Among these product lines are franchise agreements like Pokemon, Batman, SpyNet, Disney Princess, Disney Fairies, Creepy Crawlers, and Dora the Explorer. However, since 2008, the company's sales have been heavily driven by products that were brought to the company through strategic acquisitions, and less by license/franchise agreements. For instance, in 2011, 32.2% of net sales were due to acquisitions, whereby that number increased to 42.5% of sales in 2012.

Sales trends and covenant violations
Based on this information, a Foolish investor should be intrigued. I mean, here we are with big name franchises and a company that is making strategic acquisitions that are accretive to its product mix. But, there is a dark side to JAKKS Pacific. Since 2008, the company has been contending with a continuous and steady decline in revenue, going from over $900 million to about $667 million in 2012.

For the most part, the company blames its declining sales to lower revenue in its Role Play, Novelties and Seasonal Products segment, mainly as a result of lower costume sales (which themselves have been mostly affected by a decline in their Disney lines). In response to these sales declines, the company has effectively written off all of its goodwill, causing book value to drop from $26.75 per share in 2008 to $5.81 per share in June of 2013.

Meanwhile, the company has seen marginal growth in its Traditional Toys and Electronics segment, with revenue increasing from $358.4 million in 2010 to $363.7 million in 2012. Unfortunately, this has come at the cost of some of the company's gross profit, as margins dropped from 33.5% in 2010 to 31.3% in 2012. To further the company's pain, sales in this segment have fallen off steeply since the end of 2012, as physical toys are being displaced by a higher demand for electronic devices. The company's Role Play, Novelty and Seasonal Product segment is performing even more poorly, with its gross profit margin falling from 32.1% in 2010 to 27.8% in 2012.

These factors indicate that the company's cost of producing goods is increasing, while its ability to pass these costs on to consumers is declining. This is further demonstrated by the company's days sales outstanding or DSO. For instance, in 2010, the company had DSO of 56. This compares to a 30.4% increase in 2012, leading to a DSO of 73. Such a large rise suggests the company is losing supplier power, a sign that more troubles may be on the horizon.

In addition to sales issues, the company recently had some minor issues with one of its creditors, Wells Fargo , over two covenant violations relating to its $75 million line of credit. This was quickly resolved when the company received waivers and a further advance on the facility of $30 million ($29 million of which it tapped into) and subsequently paid off the balance in full from its cash on hand. Nevertheless, violating covenants can signify financial trouble.

Moving forward, there seems to be little hope for JAKKS Pacific. The company has significant sales issues, as well as financial statement infractions. A flood of recent class action lawsuits alleges it misrepresented its financial condition when it did not previously announce the negative impact that electronic devices would likely have on its business. Some feel this may be the final nail in the company's coffin.

Realistically speaking, the only redeeming qualities the company offers right now is that it is A) trading at a discount to book value (which may well decline further as its business deteriorates), and B) the hope that its $8 million investment for a 50% stake in a joint venture with NantWorks called DreamPlay Toys, and a $7 million investment (which NantWorks may buy back for $7 million) for a 5% economic interest in DreamPlay LLC, a related entity, will pay off. This deal is focused on providing toys with more interactive qualities to consumers.

In the end, JAKKS Pacific sounds like one of those investments that will either soar as profitability rebounds, or crash and burn. There shouldn't be any middle road because of everything that is happening with it. Although I hate the thought of missing out on a potential multi-bagger, I am personally staying by the sidelines unless something truly phenomenal comes out that points to a brighter future.

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Daniel Jones has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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