The year is 2023 and the new Super Mario animated film has been released. Children everywhere flock to the theaters to see the small Italian man and his signature mustache on his quest to save the princess. The kids rush out of the theater, talking about their cartoon friend, obsessed now with reenacting every Mario scene and jump on every Goomba that gets in their way.

This is where our investigation begins. The suspect profile can be found below:

• Market Cap - $204.47 Million

• Forward P/E - ~5

• Price-to-FCF - < 2.5

• Price-to-Cash - < 3

So who are we investigating this week?

JAKKS Pacific, Inc. (JAKK)

You may have heard rumblings about the products that this company has been producing, but trust me when I say that those are just the start.

Company Description

You could read the boring description on their website or trust me when I lay it out simply. JAKKS makes toys and costumes. That is literally what they do and have been doing since they were founded in 1995. Since that time they have made some significant acquisitions to continue to grow the company.

MOAT

Simply put the moat is the BRAND on this one. While licensing and royalty deals are made so that JAKKS can produce many of the famous toys and figures they sell, there is something to be said about the buzz around a company that gets these deemed “collectibles”. Head over to reddit, search JAKKS, and you will see that there are entire communities dedicated to certain collectible figures that they produce.

Beyond this, the cult-like following that certain characters have (Sonic the Hedgehog to name one) and their communities are excited enough about the products to drive “first image” posts. Whenever I see this type of hype, I can believe that the company is doing something competitively right.

PROS

The Following. This was just covered in the moat but I can’t reiterate it enough when it comes to a company in the toy industry. The following of the brand and what is seen as the next great collectable is everything. Remember when Funko, Inc. (FNKO) released those weird looking characters and not every investor took notice? Well their revenue has more than doubled since 2017 and most of that is due to the following that it produced in the collectible crowd. JAKKS looks to be on the edge of the same thing with some of their new products with the buzz growing with each new license, the largest of which may be incoming with the Nintendo line.

Close to Net Zero Debt. There is nothing better than a balance sheet that doesn’t have many blood stains. JAKKS doesn’t disappoint here as they have just over $90M in total debt (calculated using debt plus capital lease agreements) and around $76M in cash and equivalents. This ratio is close enough to see a net zero debt company in the near future as long as nothing catastrophic happens, and leads me to like them even more.

Limited Analyst Coverage. There are a few things that make a company fly under the radar and one of them is when no one is watching. The analyst coverage on JAKKS is next to nothing, with only two, yes two, analysts currently writing them up. If it wasn’t for a couple of guys from BMO Capital Markets and Jefferies LLC, JAKKS would fly completely under the market radar. This leaves retail investors with a lot of opportunity as they can potentially sneak in before the coverage craze begins. Also of note, only ~45% of the shares are owned by institutions.

CONS

Is it a fad? Toys are great and they are never going to go away as long as we humans keep reproducing, but what toys are hot is somewhat tough to speculate. While characters seem to stick around, the toy makers can come and go. Remember Beanie Babies? Well if Ty had wanted to go public during that time is would have made an absolute fortune, then left investors reeling as the obsession with their little furry babies took a backseat to common sense. Could JAKKS be heading to part of the same world? I would guess not, judging by their track record and diversification, but you never know.

Toy Sales Sentiment. Toys do sell, there is no doubt about that, but it also isn’t necessarily as consistent as many may want. The current sentiment around toy sales isn’t great, with JAKKS themselves guiding down their upcoming Q4 results to a YOY decline. Much of this may be due to the increase in their Q3 sales due to the previous year’s inventory issues, but they aren’t the only one that are casting doubt on the toy game. Hasbro (HAS) recently reported, and it was a disaster. Not only did Hasbro guide significantly lower than expected, but they also released that they would be laying of around 15% of their global workforce.

Gross Margin Destruction. Inflation is a criminal and no one is safe from its deeds, including JAKSS and their gross margin. Year-over-year measures show that the gross margin has declined and in the most recent earnings call JAKKS CFO John Kimble spoke on it.

In unpacking gross margin, we're down just over 310 basis points in the quarter year-over-year, with a number of factors in play. Higher costs associated with importation and delivery of domestic product, particularly earlier in the year ultimately exceeded any price increases that we've slipped through. Royalty expenses are bit higher, but was in line with our expectations consistent with last quarter.

While there is still hope that much of this gets corrected, there is no guarantee and there is only so much price increase that a toy manufacturer can produce when they rely on selling affordable goods.

CONCLUSION

The case has been laid out and it seems that there is some hard evidence against JAKKS and the cool toys that they make. But while many may be looking the other way, the Profit Investigator always takes it a bit deeper and looks at what really matters when it comes to a company like this: cash flow.

The increase in revenue in JAKKS toys over the past few years has been a revelation, and even with some margin compression it is well in the range of being highly profitable and continuing to produce significant cash flow. Add to this that the company has some big catalysts incoming with licensing deals that should allow for exclusive releases for the Super Mario Brothers movie, The Little Mermaid, Wish, Dungeons & Dragons, Transformers, and much more. Add to this the opening of the new Super Mario World this year and it could be a revenue explosion.

But what do other investigators have to say? Well the current estimates for 2023 are actually for a revenue decline with an EPS coming in just slightly higher, then recovering in 2024 when many are looking for a lot of the cost pressures to be alleviated. This is one way of putting it, but I think that the analysts may be downplaying the sustainability of the toys and costumes that JAKKS has in their repertoire. Even in a recession, many of these will be able to hold up, and the hype around what is licensed is just too much to ignore. While it may not be the stellar 20% growth that led JAKKS to increase over 150% this past year, it will be enough in my opinion to drive value to shareholders.

I am labeling this stock as a BUY for my portfolio and expect it to reach a PE of at least 7-8 over the next few years, which should drive it to an almost $30 price target. I am purchasing this company as long as it holds below a $23 dollar level, but may not take a full position until after their next report in February.

As always, thanks for reading, and happy investing!

The Profit Investigator