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OPINION

Toying with a breakout

Toying with a breakout
May 9, 2016
Toying with a breakout

It makes sense to do so because in the six months to end-February 2016, net funds more than trebled from £4.5m to £14.5m, a sum that equates to 13 per cent of the company's market capitalisation of £112m. The interim payout is covered almost five times over by half year EPS of 32.8p, so offering scope for a hefty hike in the final payout given the impressive cash generation.

If this story sounds familiar, that's because it is as the company I am referring to is the fourth largest distributor of toys in the UK, Character Group (CCT:525p). I first spotted the potential of this special situation last June when you could buy the shares for 415p ('Playtime', 1 Jun 2015). Many of you clearly did as I gather from your subsequent correspondence, and it's been financially rewarding too as the share price has risen by over 25 per cent during which time the company has paid out dividends of 11p a share excluding the half-year payout of 7p which goes ex-dividend on 7 July 2016.

The important point is that even after enjoying decent share price upside, the re-rating looks far from over. In fact, having analysed recent trading trends and taken a very close look at the company's latest financial results, I am pretty much convinced that there is potential for another 20 per cent-plus share price upside, both on fundamental grounds and having assessed the technical indicators. Indeed, chart watchers will have noted that the price has been moving sideways for several months now, but is now tantalising close to breaking out above last year's all-time high of 535p and taking the shares into blue-sky territory once again. The fundamental case is certainly supportive of a breakout above this key resistance level.

 

Sound business model

What I really like about the business model is that Character Group owns a portfolio of 10 long-lasting iconic toy brands that target the niche pre-school market (aged 3-4 years) where it is now the largest toy company in the UK. It's not a difficult business to understand as the company makes its money by licensing brands, working closely with the licenses 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 25 per cent of sales are overseas.

This portfolio of iconic brands accounts for three-quarters of Character Group's sales and means the business is less susceptible to the vagaries of a cyclical toy market characterised by the fleeting fads of children, and one also susceptible to general economic downturns which rein in spending by buyers of toys. The company's Doctor Who product range, licensed from BBC Worldwide, is a prime example of how this model works, as it is still generating a stable income stream for Character Group more than a decade after the company launched a range of toys when The Timelord returned to our screens.

The company's top performing brands in the latest six month trading period were Peppa Pig, licensed from Entertainment One (ETO), the largest film distributor in Canada and the UK and the distributor and joint-venture owner of the brand; Minecraft which is owned by Microsoft (US:MSFT) and out licensed to Jazzwares; Little Live Pets by Moose Enterprises; Fireman Sam, licensed from US toy giant Mattel (US:MAT); and Teletubbies owned by DHX Media. A new series of Teletubbies, the most recognised pre-school brand in the world, hit our screens at the tail end of last year after DHX Media commissioned a new series of 61 episodes. It's proving a hit not only with children, but with Character Group too as the company is the appointed 'Global toy partner'. Shipment of the new Teletubbies product range went on sale in the third week of January this year at all major UK retailers and "has already become a standout performer".

 

International sales growth driver

Moreover, although Character Group's international sales shot up by more than half in the six months to end-February 2016, to account for just under a quarter of total revenues of £65.2m in the period, it excludes any contribution from Teletubbies which is only just launching now in overseas territories. The potential for toy sales could be massive given 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.

In other words, if the craze for Tinky Winky, Dipsy, Laa-Laa and Po in Tellytubbyland is as strong in international markets as it has been in the UK, and there is no reason to suggest it's not, then Character Group could be in for a bumper second-half performance and beyond. I wouldn't bet against it given that Teletubbies is set to be launched in four countries this year, in the US next spring and multiple other countries thereafter. And neither are analysts.

Peter Smedley at brokerage Panmure Gordon notes that “the incrementally positive tone of the outlook statement, together with the accelerating broad-based momentum across the top 10 brands, product categories and geographies, suggests excellent scope for upgrades. We have even higher conviction in our buy recommendation”. He has a point as research consultancy Euromonitor predicts that global toy sales will grow at a compound annual rate of 6 per cent between 2016 and 2019. That's worth well worth noting given that this segment accounted for just under a quarter of Character Group's own sales.

I wouldn't bet against the company continuing to outperform peers either. Analyst Miles McNulty at brokerage Allenby Capital certainly isn't as he raised his target price from 650p to 700p post the recent bumper half-year results which revealed a 23 per cent rise in underlying pre-tax profits to £8.6m on revenues up 12 per cent to £65.1m. True, there is a strong first-half seasonal bias due to Christmas sales, but with over two-thirds of the full-year profits in the bag the company looks nailed on to deliver the 11 per cent rise in revenues to £110m for the full year to end-August 2016 as Mr McNulty predicts. On this basis, expect pre-tax profit of at least £12.6m, EPS of 49p and a full-year payout of 15p a share, up from 11p a year earlier.

If anything, I feel these forecasts are on the light side as around 20 per cent of the aforementioned full-year sales forecast occurs in the final two months of the financial year (July and August) in the build up to the Christmas retail toy selling period with a significant free on board (FOB) sales element. This is when Character Group delivers goods on board a vessel designated by the buyer and in effect fulfils its obligations to deliver when the goods pass over the ship's rail. With sales momentum strong, then the risk looks to the upside to me.

However, even if Character Group only hits these estimates then the shares are hardly expensive on little over 10 times full-year earnings forecasts. But even that underplays the value on offer as the company's £14.5m cash pile is worth 68p a share, so the cash-adjusted multiple is only 9 times forward earnings. Furthermore, the prospective dividend yield is a healthy 2.8 per cent.

 

Potential for multiple expansion

To put the current valuation into some perspective, US toy giants Mattel (US:MAT) and Hasbro (US:HAS) are rated on 23 times and 21 times, forward earnings respectively, or double the rating of Character Group. Even after taking into consideration a small-cap liquidity discount the extent of the undervaluation seems overly harsh. Indeed, smaller peer Spin Master Corporation (CAN:TOY) which has a market value of £246m, or just over double that of Character Group, is rated on 18 times forward earnings and has a similar earnings growth profile.

From my lens at least there is ample scope for the PE ratio of Character Group to narrow the gap with peers especially as there is a possibility of the company beating the aforementioned full-year earnings estimates. In fact, even if we only value the shares on 11 times cash adjusted earnings estimates for the 12 months to end-August 2016, then this implies a fair value of 625p for the equity. On this metric, a valuation of 12 times cash adjusted earnings implies a value closer to 675p.

My instinct is that fair value lies somewhere in between those prices, suggesting around 19 per cent to 28 per cent upside to the current share price. There is also a useful dividend too.

 

Risk assessment

Clearly, I am positive on the investment case, but it's worth assessing the risks, the most obvious of which is that the company miscalculates demand and ends up with unsold inventory. Brands can go out of fashion too, albeit there was no indication in the trading update that Character Group's iconic brands have lost their appeal. In fact, one of the reasons for the robust cash flow performance in the half-year results was a sharp reduction in stocks. I would also point out that excluding working capital movements the company generated £10.4m of cash flow from operations in the six months to end-February 2016, bang in line with underlying cash profits, so cash conversion rates are high.

The surge in the use of tablets, gaming consoles and App games is another potential threat for all toy companies. However, Character Group has defensive qualities as its leading market position in the pre-school segment means it is under far less pressure from such technological advances. Furthermore, this segment of the retail toy market is enjoying a decent tailwind as market research firm NPD estimates that UK toy sales increased by 8 per cent in the first quarter of 2016, representing an acceleration on the 5.9 per cent growth rate in 2015. Interestingly, entertainment-backed brands with traditional play patterns were the key drivers behind this growth, the precise area of Character Group's core brands.

Loss of key personnel is always an issue for any company, but Character Group has been unaffected by the retirement of founding director Richard King who after 25 years on the main board has taken the role as non-executive chairman. I would flag up that the board have plenty of skin in the game: joint managing directors Kiran Shah and Jon Driver, executive directors Joe Kissane and Michael Hyde, and finance director Mark Dowding own in aggregate over 20 per cent of the issued share capital between them, so their interests are well aligned with outside shareholders. That's another reason why we can expect the progressive dividend policy to continue.

 

Valuation

The bottom line is that no matter which way I look at this Character Group's shares are significantly undervalued and there appears a strong likelihood of the price rallying in the months ahead of the pre-close trading update in early September as other investors cotton on to the good news story set to emerge.

A breakout above the 535p key resistance level would also confirm the multi-month share price consolidation period is over, a signal well worth following in my view. Trading on a bid-offer spread of 510p to 525p, I rate Character's shares a strong buy and have a fair value price range between 625p and 675p. Buy.