Stock of the Week: JAKKS Pacific

Within every economy, there's one demographic that's always indifferent to a slowdown: children. Regardless of inflation levels or growth in gross domestic product, most kids are oblivious to recessionary periods and will continue to beg parents for the coolest and hottest toys around.

Yet despite an unwavering toy-lust among the kiddies, the toy industry suffered through quite a bit of negative publicity in 2007, because of a chain of China-related recalls. That drama, coupled with the concern that the newer generations are straying from traditional toys to more adult-like electronic gadgets, now has analysts concerned about the outlook for many toy manufacturers.

But I'm eyeing one player in this industry -- one whose toys have consistently topped "must-have" lists and whose commitment to safety allowed it to dodge the tainted-toy troubles that its rivals encountered last year.

This company's not toying around
Over the past 12 years, JAKKS Pacific (Nasdaq: JAKK  ) has established a diverse portfolio of more than 3,000 toys and consumer products. Still led by its co-founders, the company has grown to become one of the major toymakers in the U.S., thanks to a successful strategy of combining internal product development with the acquisition and licensing of high-profile names.

JAKKS generates a stable revenue stream from its licenses of "evergreen" brands, including Cabbage Patch Kids and Care Bears, while it also cashes in on the rights to high-profile faddish brand names, such as Disney's (NYSE: DIS  ) Princesses theme and Hannah Montana, to fuel higher growth. (The toy industry recently named Hannah Montana "Property of the Year.") And although the company does explore acquisition possibilities -- it purchased Pet Pal and Creative Designs in 2005 and 2006, respectively -- licensing provides a more cost-effective strategy. It allows the company to use a royalty to manufacture toys associated with popular brands, but it avoids the hefty expense of purchasing rights to brands that may not have a long-term life.

But the toy manufacturer doesn't simply rely on young pop stars and cartoon characters to fabricate its growth. The award-winning EyeClops device was one of the best sellers this past holiday season on Amazon.com (Nasdaq: AMZN  ) . JAKKS hypes up the products it has taken the initiative to develop as well. For example, its "Plug It In & Play" technology has been wildly successful.

JAKKS' line-up for the upcoming year appears to be a winner. It has added night-vision goggles as an extension for the EyeClops, and it has come up with new Plug It In & Play games that capitalize on the latest tween brands, Hannah Montana and High School Musical. Similar to LeapFrog (NYSE: LF  ) , JAKKS also attempts to appeal to parents offering toys that incorporate an education experience. For example, the company will release a new line based on the Discovery Kids brand.

Not all fun and games
Competing in an intense industry, JAKKS must consistently manufacture items that will capture the attention of fickle children and thus win limited shelf space. With its three largest customers -- Wal-Mart (NYSE: WMT  ) , Target, and Toys "R" Us -- contributing more than half of JAKKS' revenue, it's imperative that the company deliver products in line with what customers look for in the toy aisles at those retailers' stores.

Toy manufacturers earned significant negative publicity in the second half of 2007, as rivals Mattel (NYSE: MAT  ) and RC2 (Nasdaq: RCRC  ) sold millions of toys, all made in China, that were tainted with lead-based paint. Although JAKKS safely escaped the media's hype over the problem, management continues to reassure analysts and parents that it's taking precautions to ensure it doesn't encounter similar issues. Accordingly, JAKKS has a testing facility in China that's certified by the Chinese government, conducts in-house real-time testing with new laser equipment, and even employs third-party testing.

Most recently, the company lost its license to manufacture World Wresting Entertainment toys, but it has slugged back by signing a new five-year deal with Total Nonstop Action wrestling that will start in 2010, the same time the WWE deal will expire. Thus, the company will continue to have significant exposure to the popular sport.

A bargain buy
The toy industry is mature, but JAKKS has proved that it knows how to win hot theme licenses, create alluring products that meet the evolving demand of younger generations, and produce industry-topping growth rates. Many retailers are confronting depressed stock prices, and the chunk of change JAKKS has stashed away on its balance sheet positions it to keep propelling growth through acquisitions. This wealth of cash, combined with minimal debt, an attractive portfolio of licenses, and its own discounted stock price, makes JAKKS itself a potential buyout candidate.

Despite negative publicity from the recalls that consequently depressed Mattel's stock price, JAKKS continues to trade at a discount to its rivals, with a forward price-to-earnings ratio of just 9.5 and an enterprise value-to-EBITDA multiple of just 4.1.

Running a discounted cash flow valuation shows that the stock has significant upside potential given its undervalued price. In my model, I estimated a top-line slowdown in 2008 before revenues gear back up to 13% annual growth in the following four years (nearly half of the 22% annual rate the past five years have generated), followed by five years of 5% growth and trailing off at a terminal rate of 3%. On the margin front, I modeled in normalized net margins of 9.5% that will expand slightly over time. Cap that with an 11% discount rate, and I value the company at roughly $38 a share. This represents a 36% premium over its market price of around $28 a share.

Playtime
Whether it's wrestling over the last box on the shelf, camping outside a store, or forgoing items for themselves to afford items for their kids, parents will typically go the extra mile to provide their youngsters with what they want. This is the buy-what-you-know thesis, and from personal experience, I can tell you that even when overall consumer spending weakens, families still find ways to work toy purchases into the budget.

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