It certainly makes financial sense to do so as buying back shares on an equivalent current earnings yield of 10 per cent (the reciprocal of the PE ratio) is smart business with cash deposit rates so low. It not only takes excess stock off the market, and enables larger shareholders to take some profit off the table without holding back the share price, but it's significantly earnings enhancing too.
Furthermore, shareholders have been enjoying a steady income stream through dividends as this small cap company has paid out £12.3m since listing its shares on the Alternative Investment Market (Aim) in late 2005. That's the equivalent of 39.5p a share. There is another bumper payout on the way too as the interim payout has just been raised by over half to 5p a share for the six months to end February 2015 (ex-dividend: 3 June 2015). Share buy backs and a decent dividend stream aside, the investment case is pretty compelling for the fourth largest distributor of toys in the UK, Character Group (CCT: 415p).
Long lasting iconic toy brands
What I like about the business model is that in recent years Character Group has developed a portfolio of long lasting iconic toy brands, both organically and by acquisition, targeting the niche pre-school market (aged 3-4 years) where it is now the largest toy company in the UK. It's not a hard business to understand as the company makes its money by licensing brands, working closely with the licensor to develop products, and then distributes the toys having sensibly outsourced the manufacturing to China. It's a global business as around half of the product range is for international companies, and 30 per cent of sales (and growing) are now overseas.
This portfolio of iconic brands means the business is less susceptible to the vagaries of a cyclical toy market characterised by the fleeting fads of children crazing after the next must have toy, and one also susceptible to general economic downturns which rein in spending by buyers of toys. These fads are all well and good for short-term profits, but they hardly make for a sustainable revenue stream. The company's Doctor Who product range, licensed from BBC Worldwide, is a case in point as it is still generating a steady revenue stream for Character Group a decade after the company launched a range of toys when The Timelord returned to our screens.
By far the company's biggest earner is Peppa Pig, licensed from Entertainment One (ETO: 328p), the largest film distributor in Canada and the UK and the distributor and joint venture owner of the brand. Aired in over 180 countries, the brand generated over £640m in global merchandising and television revenue last year. Character has been a partner of Entertainment One for over a decade now, and its toy products are distributed in almost 20 countries. Other key toy brand ranges include Fireman Sam, licensed from US toy giant Mattel (US: MAT), and Scooby Doo, licensed from media group Warner Bros Entertainment. In aggregate, analysts estimate that these four core brands account for around 80 per cent of Character's revenues.
In addition, the company sells product ranges based on five core brands designed by overseas toy companies including: Teksta by Toyquest; Chillifactor by IP owner Funtastic; Minecraft which is owned by Microsoft (US: MSFT) and out licensed to Jazzwares; Little Live Pets by Moose Enterprises; and Shimmer 'n' Sparkle by Cra-Z-Art.
Profits surging
And it was the ongoing success of these nine cornerstone brands which led to Character reporting record revenues and profits in the six months to end February 2015. In fact, even if you strip out the £1.5m currency benefit which flattered those figures, half year pre-tax profits of £7m were more than double the £3m reported in the same period in the prior fiscal year, and as high as the previous 12 month profit figure too.
Of course, the all-important Christmas selling period means there is a skew to the results - spending in the festive period accounts for 35 per cent of annual sales in the UK toy market. But even so I feel that Character Group should easily lift full-year pre-tax profits by more than half to £11m, based on a 15 per cent rise sales of £113m in the 12 months to end August 2015, as forecast by analysts Peter Smedley at Charles Stanley Stockbrokers, and Myles McNulty at Allenby Capital. On this basis, expect adjusted EPS to shoot up from 25.2p to 41.9p in the 12 month trading period to underpin a 35 per cent rise in the divided to just shy of 9p a share. So with the shares priced on a bid-offer spread of 408p to 415p, the prospective PE ratio is 10 and the forward yield is 2.2 per cent. That's hardly exacting for a company that is clearly prospering.
And there is little reason to expect the profit growth to end at this point either. That's because the five strong executive board, who between them boast 106 years combined service to the company, including chairman Richard King, finance director Kiran Shah and managing director Joe Kissane, have made some notable additions to the product portfolio in the past year.
Last month a cult children's classic from my day, The Clangers, returned to the BBC on CBeebies after 43 years. Character has developed a product range for the brand which will hit the shops in the coming weeks. Yummy Nummies, an innovative new children's 'food play' collection whereby ingredients are used to make mini version of everyday food, such as pizza and cookies, is already a web and YouTube hit in the Far East. It could take the UK by storm when Character's product range hits the shops this month.
But the greatest upside of all could come from the re-launch of Teletubbies, the most recognised pre-school brand in the world. Even now, 18 years after the series first hit the screens, the episodes still draw in 50m monthly views on YouTube. The BBC's CBeebies children's channel is airing repeats of the original episodes, and a new series of 61 episodes has been commissioned by the Teletubbies brand's owner DHX Media, with the new season scheduled to run late this year. Bearing this in mind, Character Group has been appointed 'Global toy partner' by DHX Media, and its Teletubbies range of toys will be launched shortly thereafter.
The potential for sales could be huge given that analysts at Allenby Capital estimate that Teletubbies was generating $2bn (£1.3bn) in revenues globally at its peak, having been screened in 120 countries and produced in 45 languages since 1997. In aggregate, more than 1bn children worldwide have viewed the programme. To put that into perspective, Character's best selling product range, Peppa Pig, is currently generating around $1bn in annual revenues, or half the level of Teletubbies at its peak.
Potential for upgrades
So, with the benefit of strong current trading, and the addition of new brands to the portfolio, not to mention a potential blockbuster in Teletubbies yet to come, it's fair to say that Character Group is playing the toy market rather well.
Furthermore, with global economic growth forecast at north of 3 per cent for the next three years, then there is a benign economic backdrop benefiting consumer spending habits too. Indeed, industry experts predict compound annual growth rate of over 4 per cent in the global toy market between 2013 and 2018, implying a market worth north of $100bn (£65bn) by 2018. That's important for Character Group as overseas sales are set to become a greater portion of the mix in the years ahead especially with the re-launch of Teletubbies.
There is also scope for growth in the £2.8bn UK market where the company is the fourth largest player overall behind The Lego Group, Mattel and Hasbro (US: HAS), which between them hold a 30 per cent share. But with only 4 per cent of the domestic toy market, there is potential for market share gains to complement the underlying growth.
The bottom line is that I feel analyst Peter Smedley at Charles Stanley is being far too cautious by only predicting a modest 2 per cent rise in sales to £115m in fiscal 2016 to lift pre-tax profits by 4 per cent to £11.5m. In fact, he said as much when Character Group reported its interim results a month ago, noting “a high and increasing level of confidence that our fiscal 2015, 2016 and 2017 estimates can be upgraded over the next three to 12 months, giving scope for further substantial share price performance”.
Allenby Capital look nearer the mark with their prediction that revenues in the financial year to end August 2016 will rise to almost £124m and boost pre-tax profits and EPS by 10 per cent to £12.1m and 46.5p, respectively. I can still see these estimates being surpassed. But even on this conservative looking basis, the shares are still only priced on a lowly prospective PE ratio of 9, a rating way out of sync with a company generating double digit earnings growth.
For good measure, analysts at Charles Stanley believe the board, who own 38.9 per cent of the shares in issue, will raise the dividend again by around 17 per cent to 10.5p a share in fiscal 2016, implying a forward yield of 2.5 per cent. It could easily be more given the company is forecast to generate cash profits of £14.3m and its capital expenditure is in line with non-cash depreciation and amortisation charges of £2.3m, leaving ample cash flow spare for ramping up share buybacks and dividends.
Risk assessment
Clearly, I am taken by the investment case, but it's always worth assessing the risk too, the most obvious of which is that the company miscalculates demand and ends up with unsold stock on its books. And of course, brands can go out of fashion. That's what happened in 2000 when the hyped re-launch of the Star Wars franchise failed to deliver the level of associated toy sales predicted. That said, there is no indication that Character Group's core iconic brands have lost their lustre.
Perhaps a greater threat is posed by the rapid rise of tablets, gaming consoles and App games. However, even here the business has defensive qualities as its leading market position in the pre-school segment means it is under far less pressure from such technological advances. That's not to say that management don't embrace technological change as Mr McNulty at Allenby Capital rightly points out that some of the company's best-selling games have been technologically advanced products, citing Teksta's Robotic puppy as a good example.
Loss of key personnel is an issue worth noting in light of the retirement of chairman Richard King in the coming years. He still owns 2.07m shares, or 9.9 per cent of the share capital, and is looking to sell down his stake in the next 12 to 24 months. But any share sale would enable the shareholder base to widen and given the company has authority to buy back a further 4.5m of the 20.8m shares in issue, there is a ready buyer in the market in any case. Character Group had net funds of £4m on its balance sheet at the end of February, so has ample fire power.
Target price
From my lens at least, Character's shares are lining up for another assault on the 430p intraday high hit on the day of the half year results at the end of April, a price level that coincides with the all-time high dating back to April 1999. I don't expect the resistance level to hold especially as we could be in line for some earnings upgrades when the company issues a pre-close trading update at the end of the summer.
So, with the shares on the cusp of breaking into blue sky territory, I feel buying now is a smart play and a target price of 525p should be achievable by the year-end, implying 26 per cent share price upside. Even then the shares would only be rated on a forward PE ratio of 11.5 for fiscal 2016. Buy.
MORE FROM SIMON THOMPSON...
At the end of April, I published an article with all the share recommendations I have made this year and have published articles on the following 26 companies in May:
■ Marwyn Value Investors: Buy at 220p, target price 260p ('Exploiting a value play', 5 May 2015)
■ Pure Wafer: Buy at 113p, target 140p to 150p; Paragon: Run profits at 440p, but buy on a confirmed breakout above the 445p and new target of 500p; 600 Group: Buy at 16.5p, target 24p; Fairpoint: Buy at 127p, target 190p; AB Dynamics: Buy at 207p, target 230p ('Repeat buy signals', 11 May 2015)
■ Globo: Buy at 56p, target 69.5p; Greenko: Hold at 70p; Pittards: Buy at 128p ('Break-out looms for mobile wonder', 12 May 2015)
■ Macau Property Opportunities: Buy at 214p; Dragon-Ukrainian Properties & Development: Hold at 28p; Raven Russia: Hold at 53p ('Overseas property plays', 13 May 2015)
■ Trakm8: Run profits at 135p; Redde: Buy at 120.75p, target 140p; STM: Run profits at 45p, but conditional buy on close of 48p and new target of 60p ('Smashing target prices', 14 May 2015)
■ Bilby: Buy at 75p, target 100p ('Buy to build' growth play, 18 May 2015)
■ Bioquell: Buy at 148p, target 170p to 185p; Somero Enterprises: Buy at 140p, target 185p; KBC Advanced Technologies: Buy at 109.5p, target 165p; Inspired Capital: Hold at 14.25p ('Three value plays', 19 May 2015)
■ Renew Holdings: Buy at 315p, target range 350p to 375p; Manx Telecom: Buy at 198p, target 210p ('Renewing old acquaintances', 20 May 2015)
■ Marwyn Value Investors: Buy at 228p, target 260p; Charlemagne Capital: Hold at 13.5p; Bloomsbury Publishing: Hold at 178p ('Lights, camera, action', 21 May 2015)
■ Anite: Buy at 91.5p, target 110p ('Testing a break-out', 26 May 2015)
■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.95 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'
