The Character Group - A Playful Idea

http://www.thecharacter.com/


Finding profitable companies trading on low valuation multiples amongst small cap companies remains difficult despite the decline on the AIM since the highs made in early 2014. Whilst The Character Group matches that requirement, there are a number of challenges within the operating business to account for, especially when looking at the track record of the company over the past ten years, and the ultimate question is whether this means the relatively low valuation multiples are fair. Nonetheless, it is worth assessing the company from a fresh point of view, despite the fact that the share price is up over 25% over the past year.

Technicals
 

From a charting perspective, Character's chart is both bullish and it conforms to common technical patterns. For example, the share price is trading within a long-term bullish wedge characterised by a steeper upward sloping gradient along the major lows, than the slope connecting the major highs. Assuming this pattern continues to be conformed to, there is key lower support around 155p (and rapidly rising), whilst there is crucial resistance joining the major highs at between 220p - 225p. Any breakout past either of these levels would be significant, and likely news driven, and would be highly likely to attract technical trades.

To add to the bullish outlook, the pivotal level since 2006 has been 200p where the share price has been rejected from on numerous occasions. However, a drop earlier this year below 200p was quickly bought into and the share price rose back above 200p convincingly. That suggests that 200p has been transformed from resistance to support, which would be a significant achievement from a technical perspective. The shares are fairly illiquid at times with a published spread spanning 201p -> 208p, although the real tradable spread is within that range at present.

Management are large shareholders in the company with the top members of management - Kiran Shah and Richard King - holding 19% and 11.2% of stock respectively. Other significant institutional holders include Ruffer who took a stake off the management team, and collectively hold over 20%. Whilst there have been numerous transactions regarding a share buyback scheme, I'll cover that further later within the Financials section.

The flip side to the equation is that management have been steadily reducing their stake through share buybacks, albeit as a consequence maintaining their percentage holding. Typically when a member of management disposes of their shares it is a negative sign, so it is something to bear in mind, whilst also noting that this has been the case for an extended period of time. In any case, with the shares illiquid enough as it is, it is sensible that the shares taken out of circulation through buybacks are already not in the market's hands.

On that note, there have been a few recent director trades, which are conflicting in nature. Upon exercising options, Chairman and Managing Director Richard King disposed of all 363k exercised shares at 213p whilst Kiran Shah sold 241k of 363k of exercised shares. Another Group Managing Director sold 303k of 483k exercised shares. These were all largely bought back through the share buyback scheme so there were not large quantities of shares released into the open market (albeit it would have cost the company a seven-figure quantity of cash to fund). To the contrary, the Managing Director of Far Eastern operations purchased nearly £60,000 worth of shares and a further ~£21,000 in late September. Given the age of the top management members, it makes sense that they may wish to realise cash, so the share purchases may be a more relevant indicator for investors.

Operations

Character listed on AIM in late 2005 after previously being on the Official List of the London Stock Exchange. The company is involved in the design, development and international distribution of toys, games and gifts. That is achieved through a mixture of self-developing products, and also licensing products; that product development process occurs mainly in the UK, although actual production unsurprisingly is completed in Asia where labour costs allow for lower production costs; that process is overseen by the company's Hong Kong offices. Various brands licensed include Doctor Who, Disney Classics and Peppa Pig (which is experiencing strong growth at present).

The focus for Character has previously solely been on the UK, and that has inevitably had its disadvantages. Through focusing on just one core country, the company was exposed to domestic high-street spending fluctuations, and more broadly by consumer spending patterns, which have been highly unpredictable since 2008/2009. The result is that Character's financial performance has been difficult to forecast, and changing trends have had a pronounced impact upon results. That strategy has now changed once Character achieved critical mass, as there is now an increasing and strong focus on driving international sales, providing added revenue diversity and in theory increasing earnings quality, which is a welcome change.

As a toy maker, it is very sensible to assume that the ongoing technology revolution could lead to a decrease in demand for physical toys, and a move towards virtual games on tablets, smartphones or other technology mediums. However, that is not necessarily translating materially through to reality in terms of growth rates. The toys market globally is estimated to be around $80 billion and is forecast to grow at a CAGR of between 4% and 6% heading towards 2018. That provides a solid backdrop for the industry, and as a smaller player within the industry, there should be plenty of scope for Character to expand its operations, assuming that they underlying strategy is sound.

Within the overall trend, Latin America is forecast to be one of the faster growing regions (11% CAGR) with even North America forecast to be expansionary at low single digit growth rates. Aside from that, leading independent surveys have found that average physical toy play time has not diminished over the past three years, but rather there had been an increasing focus on TV/DVD branded products such as Frozen toys in recent months. The other major trend was a move towards online purchases versus dedicated bricks and mortar stores, and Character is well placed on that front through its online shop (www.character-online.com).

One of the biggest challenges from a shareholders perspective is whether the company can keep on top of toy trends. After all, if the toys that Character produces are sub-par, their sales will decline and as a consequence it is a direct concern for an investor. This is a point that is particularly difficult to gauge with real confidence aside from corporate statements. Arguably, this has been the reason for a couple of Character's trading downturns since 2000, so it is a risk to be acutely aware of.

One of the ways to gauge product development pathways is to examine their product license pipeline; new major licences with popular brands are often a decent indication of toy trends. On this point, Character achieved a major milestone alongside its H1 results released in September; Character secured a master worldwide toy licence agreement for Teletubbies ahead of the first new series since around the turn of the century, set to show in 2015. Teletubbies is a well-known children's brand, and the deal - struck with DHX Brands - is a major achievement as a proof-of-concept regarding Character's industry position and capabilities. Previous licence agreements had been on a smaller scale; for example a Postman Pat master toy licence for the UK and Ireland, and a recently renewed Peppa Pig deal with Entertainment One. This Teletubbies enables them exclusive access on a global basis, albeit products are only forecast to enter sales pipelines in 2016, so there is a one-year time lag before any of those revenues kick in.

Commenting on the deal, Richard King, Executive Chairman, said: "This partnership is a good example of how we work to seek out and develop exciting products which meet domestic and international market demand. Teletubbies is a worldwide phenomenon. The series has been screened across 120 countries in 45 languages. It has retained a global, iconic profile and is instantly recognised and keenly followed by many."

DHX Brands EVP Peter Byrne commented: "Teletubbies is one of the most recognisable pre-school brands globally which we believe represents a remarkable consumer products opportunity. We're very excited to be partnering with Character Options, who have an incredible track record in building and nurturing pre-school brands for the long term."

Also positively, Character had toys feature in the Annual Top 12 "Dream Toys" in 2014. This is essentially a proxy list for products that are expected to be high in demand over the Christmas period. Whilst it is not new that the company has products within this range, the presence of two toys within the top 12 and seven within the top 72 bodes relatively well heading towards a seasonally important period. No product range within Character's portfolio accounts for more than 20% of UK sales.

Financials

Given the reliance on toy trends, you would expect the company's financial results to be volatile, and although that is the case, it is partly also down to exogenous factors.


Taking each line in turn, revenues have been down year-on-year four years out of the six comparable years shown. The numbers for revenues were inevitably impacted in 2008 and 2009 as a result of the financial crisis, although the 2012 and 2013 downswings were down to a tough UK trading environment, but likely also relating to the product ranges on offer; that is an example of trends within the toy industry likely impacting sales figures over any particular period. Aside from 2012 and 2013, the sales figures are largely static. Gross profit figures are also erratic in-line with revenue movements, but what the operating profits show is that Character did not fair particularly badly in terms of profitability during the financial crisis, demonstrating the underlying resilience of the business with respect to the financial performance. The net current assets figure is seemingly worrying with it declining from £11.9m in 2007 to just £2.4m in 2013, but there is a positive underlying story; share buybacks and dividends.

The former factor is a strong attraction for investors, despite the weak net current assets position the company is in. Indeed, since 2008, the company has re-purchased well over 20m shares and paid out over £8m in dividends, reflecting the investor-friendly attitude the management team adopts, which is a positive sign. As if to emphasise that point, Character carries a rare shareholder perk whereby you can receive 20% off sales through their online platform if you own shares in the company.

The interim results for 2014 were released in May and the company headlined by saying they were "Witnessing solid trading both at home and internationally":
-   Revenues up at £46.87m vs. £30.59m
-   Margin of 30% vs. 26.6% for FY 2013
-   EBITDA of £4.27m
-   Pre-tax profits of £3.07m after £2.93m IFRS exchange rate non-cash charge relating to USD weakness
-   Basic EPS of 11.37p
-   Interim dividend maintained at 3.30p

Those numbers are encouraging with revenues back towards the top of the historic range (when annualised), and strong underlying profitability. Robust sales were recorded across the product portfolio, and that was reflected in EBITDA rising year-on-year to £4.27m. Very importantly, international growth was up 50% year-on-year which is absolutely key to defining whether the recent jump in revenues is simply product-cyclical. That signals that the rise in revenues is far more likely to 'last' given increased diversity; for example, Peppa Pig product sales were strong in Europe and Australia, whilst Doctor Who product sales were strong in the US. In reality, the UK-derived revenues are not up to previous peaks.

Although the company takes a large proportion of its sales in the US dollar, there are various hedging mechanisms in place to offset the impact, which is a sensible move. The focus upon buying back shares continued unabated during H1 with over £3.3m worth of shares taken out of circulation, which will act as an earnings driver in itself, albeit that is partly offset by the exercising of options. Encouragingly, Character noted: "The company will pay a maintained interim dividend of 3.30p... The board, however, will recommend returning to its progressive dividend policy as soon as is practical" and will review at the year-end, potentially paving the way to future dividend rises. Of course, the all-important line was that financials were on track to achieve expectations for the year; a message that was re-iterated in September.

The balance sheet does remain one of the biggest financial risks given that current assets are only 1.03x current liabilities and there is net debt of around £4.6m, but that is once again as a result of maintaining a good dividend and completing various share buybacks at a rapid pace. I'd therefore deem is acceptable as the finance cost during H1 was just £0.22m again suggesting sound cash management. Tangible assets amounted to 1.27x total liabilities, which is slightly more comfortable.

Richard King commented in the September trading update, "Character Group continues to benefit from a strong product range that is also well received by its retail partners; this coupled with the number of new innovative and exciting range launches will reinforce the Group's position as one of the UK's leading toy companies with a growing international sales base, providing the Group with the engine for further growth."

Forecasts for Character are particularly encouraging albeit there are only one set of numbers from broker Charles Stanley. 2014 forecasts - with results due out during the first week of December - are for circa 23.31p in EPS and a dividend per share of 6.60p. That would put Character on what is essentially a trailing price-earnings ratio of 8.77, and a yield of 3.23%. 2015 forecasts are for 26.64p in EPS and a dividend of 6.70p suggesting a price-earnings multiple of 7.68 and a yield marginally high at 3.28% (although in all likelihood, if they increase the dividend, it would be by more than forecasts). Those earnings forecasts I would suggest look incredibly harsh given the momentum within the international sales that could see double digit growth north of 15% in 2015, and would drive EPS north of 30p.

Those figures compare favourably to a few listed peers, which I have deemed to be US listed Hasbro, JAKKS Pacific and Mattel. To a lesser extent (given the bricks and mortar presence), UK listed Games Workshop could be considered a peer given it is also involved with 'hobby' goods. Particularly with reference to Hasbro and Mattel, they deserve premium ratings from both a brand and size point of view given the additional diversity it brings, combined with the comparative long-term strength of their product ranges (e.g. Mattel and Hot Wheels). Nonetheless, they represent useful comparators. Mattel trades on a 2015 PE ratio of around 14 with a material debt pile, alongside and that is a similar story with both JAKKS and Hasbro, who have 2015 PE ratios of 11.6 and 15.8 respectively. Games Workshop has a cash-adjusted 2015 PE of circa 13.

Of course, you have to account for the strength of the US stock market at present, but regardless, the forward toy industry average price-earnings ratio is approximately 14, and Character effectively trades at a near 50% discount to that figure giving a comfortable margin for earnings forecast adjustments.

International expansion taking hold

International expansion is undoubtedly the main theme for investors to consider at present. The strong and rapid growth being seen overseas is a welcome move to diversify revenues, thereby increasing earnings quality in the medium-run. That is already being reflected in the share price, which has seemingly held above 200p for now, and is potentially primed to target the top of the long-term formation in the event of positive news in December's results. There is residual potential for a potential trade sale as an exit route in the event the existing management team (who were also founders back in 1991) wish to monetise their significant stakes, but the main play is a narrowing of the valuation gap with the wider industry, assuming that 2015 targets are hit. The potential for a return of a progressive dividend programme combined with an ongoing share buyback programme look to be reasons to be optimistic that an upside breakout is a realistic outcome and that the international expansion will provide a more attractive investment dynamic to the more product-cyclical UK investment case of the past. On that basis, I have place a Buy tag on Character at 204.50p targeting circa 250p as a potential first target, which would suggest a long-term breakout of the trading range.

UPDATE (25/02/15) - I have moved Character Group from Buy to No Rating at 374.40pfor a 83.08% profit, in line with the cessation of company reviews. The shares remain attractively priced.

7 comments:

  1. Good spot. If the share price smashes through 230 pence Gbp then this is headed for 300p over 2015 as there is v little resistance and blue sky would be a head. Watchlist time

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  2. Fun shareholder perk :0)!
    http://www.thisismoney.co.uk/money/markets/article-2748215/Toy-maker-Character-Group-set-cash-relaunch-Teletubbies.html

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  3. Seems very shareholder friendly which is always a good sign. How many companies offer shareholder perks out of interest? Is there a list?

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    Replies
    1. A list of companies with shareholder perks can be found here: http://www.hl.co.uk/shares/shareholder-perks

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  4. Hi -
    As usual a thorough and in-depth analysis; and conclusions I agree with.

    One point of clarification please which is entirely due to my lack of understanding and it concerns the treatment of derivatives.
    * Net debt is stated to be £4.64m for 1HY2014. Looking at the balance sheet I think this ignores the derivatives liability of £3.3m. Why?
    * In the operating cash flow, there is an entry of +£2.9m for financial instruments fair value adjustments. But I can't see a corresponding entry in either the balance sheet or income statement. Again my lack of understanding in the treatment of financial derivatives (I am not an accountant).

    Many thanks

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  5. 1. The derivatives liability is not typically referred to as debt in the sense of debt in name form referring to issued bonds, overdrafts or standard bank debt. Hence why it makes sense to look at current liabilities versus current assets as a whole

    Previously that liability was far smaller, but as a result of currency swings, it does fluctuate and the US Dollar was weaker against the Pound in H1. That situation has now essentially fully reversed (over and after period end). There is a corresponding line within the cash flow statements referring to the revaluation: " Financial instruments fair value adjustments - 2,933".

    2. "A significant proportion of the Group's purchases are made in US dollars. The Group is therefore exposed to foreign currency fluctuations and manages the associated risk through the purchase of forward exchange contracts and derivative financial instruments. Under International Financial Reporting Standards (IFRS), at the end of each reporting period the Group is required to make an adjustment in its financial statements to incorporate a 'mark to market' valuation of such financial instruments. The recent weakness of the US dollar against sterling has resulted in a related charge to the income statement of £2.93 million (2013: £0.09 million). The profit before tax of £3.07 million is stated after charging £2.93 million in relation to this 'mark to market' valuation. This charge is a non-cash item in these financial statements"

    The visible presence or lack of presence within the income statement is mainly down to specific accounting rules and the set of rules followed (and how far each term is 'broken down', but it makes sense that it is shown within the operating cash flow since it is a non-cash charge.

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  6. From a first read of the results this morning, it looks like a home run. Spot on for analysis and judgement.

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