The words of Peter Lynch echo throughout the ages of investing history: "Buy what you know." As I admitted in a column on Monday, I didn't know much at all about Japanese culture-hawker 4Kids Entertainment (NYSE:KDE). But the numbers were really, really intriguing -- and so I've spent the past couple days getting acquainted with the force behind Yu-Gi-Oh!,Pokemon, Cabbage Patch, and Teenage Mutant Ninja Turtles. Fools, I really liked what I saw, and now I want to share it with you.
First off, let me emphasize how I became interested in 4Kids in the first place. I am a value investor. In fact, a deep value investor. I have been a Motley Fool Hidden Gems subscriber since its very first issue, and I love the newsletter's focus on finding super-high-quality small-cap companies, swimming in a river of free cash flow that keeps rising every quarter yet for whatever reason utterly ignored and unloved on Wall Street.
You see, if a company is making money, it doesn't really matter whether the Street considers it "sexy" right now. In fact, it's better if the Wise men don't know it and don't love it at all. When a company is unnoticed and unwanted, its current owners will often sell it to you for a song. Then all you have to do is wait until someone up in NYC begins to wonder why you, the little investor, should be getting all the cash out of this investment -- and ask you for a piece of the action. It's when Wall Street finally gets interested that your little hidden gem can really begin to appreciate in value.
Sometimes it takes a while. A couple of Tom Gardner's recent Hidden Gems selections have taken a big hit, though he still believes in their three- to five-year success potential. Sometimes, you get lucky, and the stock gets noticed soon after you buy in. Then you have a success story such as Gems finds Middleby (NASDAQ:MIDD), Mine Safety Appliances, or Saucony on your hands (up an average of 150% since they were first "discovered" here about a year ago). On average, you may get something like the current Hidden Gems results, with Tom and his guest analysts up an average of 19% in just more than a year, versus a flat S&P 500.
Ah, but we were talking about 4Kids, weren't we? Let's get back to that, then. I think 4Kids is a success story in the making not just despite the fact that Wall Street hates it -- but because Wall Street hates it. It's the Street's disdain that keeps a stock's price down, making its appreciation all the more dramatic when the professional investors change their opinion. And 4Kids has all the elements necessary to create an explosive success story: a low price, lots of cash, plenty of free cash flow, and a substantial existing short interest. Let's address each of those elements separately.
Cheap price
At the end of last week, a share of 4Kids was selling for $15.52. According to Yahoo! (NASDAQ:YHOO) Finance, the company has 13.8 million shares outstanding, giving it a market cap of $215 million. That makes 4Kids a definitive small cap and puts it just within the range of companies that Tom Gardner looks at when choosing his hidden gems. Analysts agree that the company will probably earn about $1.32 in fiscal 2004, giving the company a forward P/E of 11.8 -- just a little more than half the average P/E on the S&P 500. That's cheap.
Cash
So 4Kids is cheap on a P/E basis. But hard as it may be to believe, the P/E actually overstates the company's price. If you net out 4Kids' cash on hand to calculate its enterprise value, you will find that well more than half of the company's market cap is made up of ready cash. In other words, 4Kids has a market cap of $215 million but an enterprise value of just $100 million.
Free cash flow
Longtime readers of the Fool already know that we prefer valuing companies according to their enterprise values, divided by their free cash flow. New Fools (and by the way, welcome!) can read all about our reasons by clicking right here. When looking at 4Kids, there are actually two free cash flow numbers you need to consider: trailing numbers and forward "run-rate" numbers.
Trailing numbers are the most reliable, because they are factual and not subject to seasonal variations in profit-making. In 4Kids' case, they are also the most attractive numbers. With $28.3 million in trailing free cash flow, 4Kids scores a trailing EV/FCF of just 3.5 -- a fraction of the valuation of the market at large.
The forward numbers are less attractive, in large part because you calculate them by multiplying the numbers accrued to date for the current fiscal year. Because Q2 was so weak in comparison both with Q1 and with the previous four quarters, on a forward basis, 4Kids' EV/FCF becomes a still cheap -- but much less so -- 9.2.
Short interest
As I warned once already in a column about Lifeway Foods (NASDAQ:LWAY), it can be incredibly foolish (small "f") to short a stock -- however richly valued -- when it is debt-free and free cash flow positive. No company with those kinds of fundamental statistics is going to go bankrupt, which severely limits a shorter's potential profit. On the other hand, if the company is successful, any good news can drive its price higher, creating a short squeeze. Investors in Taser (NASDAQ:TASR) and Delta (NYSE:DAL) can tell you all about short squeezes.
If 4Kids makes good on its CEO's upbeat statements about the rest of 2004, if the company is able to return to its historical levels of free cash flow production -- or even before then, if Time Warner's (NYSE:TWX) Yu-Gi-Oh! movie turns out to be a success -- 4Kids shorts are going to get squeezed mighty hard.
Final word
If you have read through everything above, it should by now be obvious that I believe 4Kids to be a compelling investment idea. In my utterly fallible opinion, if the laws of investing physics have any constancy, 4Kids will almost certainly rise in value at some point. But that's just my opinion. As a numbers guy, a valuation nut, whatever you want to call it, I see 4Kids as an investment with a high probability of success. Even so, I almost certainly would have said the same thing in March, in April, and in July, when 4Kids' stock was at $30, $24, and $23, respectively, had I been looking at the company back then. If you recall, 4Kids is now selling for just a few pennies more than its 52-week low. So clearly, the stock's price can move in utter disregard of valuation arguments. Bear that in mind when deciding whether to invest in it.
And while pondering whether to buy or not to buy, in between your due diligence sessions of proxy-statement reading and 10-K flipping, spend some quality time with your kids. Find out what they think of the new Yu-Gi-Oh! movie, the attempts to revive the Cabbage Patch doll craze, and the return of mutant amphibian cartoons to Saturday morning television. After all, while it's your money they'll be spending, the ultimate decision on the company's success or failure will be 4 the Kids 2 decide.
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Fool contributor Rich Smith owns no shares in any company mentioned in this article. The Motley Fool has a disclosure policy.
