Has JAKKS Been Naughty or Nice?

Christmas is, without a doubt, my favorite time of year. The lights, festivities, food, family, and friends all seem to come together to make my year complete. The most exciting part of Christmas for me is watching my kids open their presents. As the joy rushes over their little glowing faces, any past agonies of the holiday shopping season are quickly erased.

But earlier this year, I have to admit, I thought Santa's sleigh would be a little lighter this time around. The summer's record-high oil and fuel costs, combined with the tragedies of the devastating hurricanes, sent shockwaves through the markets and exerted pressure on multiple industries. Toymakers Mattel (NYSE:MAT), Hasbro (NYSE:HAS), and JAKKS Pacific (NASDAQ:JAKK) got hammered, and in October, their share prices were dropping to full-year lows. And while it's true that I think long-term investors could do quite well investing in both Mattel and Hasbro, I really like JAKKS' potential for growth.

But first, let's see whether the environment for toymakers is changing enough to warrant the gift of giving from investors.

Just last week, the outlook for the holiday shopping season appeared to reverse as the consumer confidence index rose in November to a two-month high of 98.9, up from 85.2 in October. Gas prices have dropped substantially from their record of more than $3 per gallon, and oil has steadily declined from its perch of more than $70 per barrel. In addition, the third quarter showed a GDP uptick that yielded the best numbers in more than a year. Inflation also remains in check, with consumer spending at its highest since the final quarter 2004. The economy gurus are now predicting holiday spending to be about 6% higher than last year.

With a brighter Christmas expected for the toymakers, let's now compare JAKKS with the world's largest toymakers, Mattel and Hasbro.

Looking at the data, we can quickly tell that JAKKS stacks up well against both Mattel and Hasbro, as JAKKS appears less valued, with a higher expected growth rate. In fact, JAKKS beats Mattel and Hasbro in every metric. So is JAKKS a good gift for your Christmas portfolio? To find out, we need to check the list and see whether JAKKS has been naughty or nice.

The naughty list
So now it's time for the naughty. The biggest problem for me has been one word -- growth. Although JAKKS has delivered a five-year sales growth rate of 25.6%, an increase in earnings per share of only 1.4% for the past five years is depressing. In fact, for the past five years, JAKKS' earnings per share have increased by only eight pennies -- from $1.41 to $1.49.

Digging deeper, you'll find that JAKKS has used share dilutions to aid in funding major acquisitions -- like the Play Along purchase -- reportedly doing nicely here. For the first nine months of this year, share dilutions have been 20.6% versus the 21.8% during the first nine months of last year. These dilutions may be fine and dandy as long as top-line growth continues, but I think investors would like to see more share buybacks in the future.

A little over a year ago, a civil lawsuit was filed against JAKKS by World Wrestling Entertainment (NYSE:WWE) regarding both video game and toy-licensing agreements. The news sent JAKKS' share price down by more than 20%, and the stock has been stagnant ever since. While the risk for a WWE victory would diminish profits by about 10%, I think this is already reflected in JAKKS' share price. I think that WWE and JAKKS will work out an agreement, since WWE surely realizes that the action figure and video game business boost revenues and make for a great advertising channel.

Another check on the naughty list has been TV games. While TV game sales have climbed internationally, JAKKS' recent flooding of domestic markets with TV games has delivered a net sales decrease in TV games for the first nine months this year.

Looking at these black clouds, it's easy to see why JAKKS sports a trailing P/E below those of its peers. But will Santa bring another lump of coal this year?

The nice list
For the past nine months, JAKKS has earned $1.77 per share versus the $1.14 during the same time period last year. In fact, just five days before JAKKS' third-quarter earnings announcements, some very prominent analysts in the toy biz were still predicting fiscal year estimates to come in at $1.75 or less per share. But JAKKS beat the third-quarter consensus estimate by 18% and inevitably succeeded to beat the fiscal year estimates in just three quarters.

For the first nine months, total net sales have increased from $389 million to $495 million. Big improvements in selling, general, and administrative expenses throughout the year -- which are nearly 400 basis points lower as a percentage of net sales versus the same time frame in 2004 -- helped deliver a nine-month operating income improvement from $43 million to $75.5 million. Net income increased to $54.5 million from $33.1 million for the first nine months.

Total assets have increased from $697 million to $794 million, year to date, with net tangible assets increasing from $148 million to $206 million, year to date. Cash and cash equivalents have also grown nicely from $177 million to $228 million.

In the cash-is-king department, for the trailing 12 months, JAKKS has produced a price-to-cash flow ratio of 9.8, which is significantly better than the industry's average. However, as pointed out here by one of my favorite Fools, Rich Smith, JAKKS' free cash flow can be deceiving, depending on which numbers are thrown into the mix.

To make next year's nice list, here's what JAKKS needs to do:

• Deliver innovative products: This year, the Flywheels brand was a huge success and an example of why growth should continue next year. In addition, I'm excited about the Pet Pal acquisition and the recent partnership with Scholastic (NASDAQ:SCHL) to market interactive children's books.

• Grow international sales: Net sales have been stellar, increasing more than 20% in North America and 73% internationally year to date. Looking to the future, JAKKS' ability to cater to overseas customers is compelling. Hong Kong sales have been phenomenal, growing from $2.5 million to $20.4 million over the first nine months -- more than an eightfold increase.

• Increase presence at the "Big Three": Another encouraging sign I like to see is increasing sales at the biggest three toy sellers, Target (NYSE:TGT), Toys "R" Us, and Wal-Mart (NYSE:WMT). Sales at these stores increased from 44.9% to 47.8% of total sales for the first nine months of 2005.

Foolish final thoughts
JAKKS, like all companies, carries inherent risk factors, as mentioned above. And let's just say if naughty prevails and JAKKS loses the WWE business, next year's earnings per share could drop from the estimated $1.98 to $1.68. If this happens, I still think JAKKS could pull out a forward multiple in line with Mattel and Hasbro, which is currently near 15. In that case, JAKKS' shares could trade at around 25. However, in my book, JAKKS' "nice" list is much longer than its "naughty" list, and I would be willing to suspect that JAKKS may again beat analysts' expectations -- which it has done in three of the past four quarters. And if JAKKS continues to play nice, $30 per share looks pretty easy to me.

Happy shopping!

Mattel is a Motley Fool Inside Value recommendation. Hasbro is a Motley Fool Stock Advisor pick.

Fools, now is the time to open your hearts and wallets to worthy causes! Please support our five Foolish charities at www.foolanthropy.com.

Fool contributor M.D. Mitchell owns none of the above mentioned companies.