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Shall we play with The Character Group?

Oscar Lara Rapp (@oscar_l_r)


Christmas is coming and so are toys! As an investor, a good present can be a good company but... why not a company full of toys?

 

Today we are going to talk about a toy company in the UK which is specialized in the design, development and distribution of toys: The Character Group ($CCT). One of the aspects that defines this company is the production of toys based on popular TV shows. They do it under license and, for example, they are the master toy distributors in the UK and Eire for Pokemon, Peppa Pig and Teletubbies toys (here you can take a look at some of their products). However, one of the key elements of their business model is that they don't own factories. Instead, they subcontract these activities to suppliers, mainly in China.

 

Sales are concentrated in the UK (59 % in 2017) and far east (41 %). Their main customers are big retail companies (e.g. Tesco or Harrods) and their 3 top customers represent 35 % of the revenue in 2017. As we can see, sales in the last 5 years have increased by an average of 9 % (CAGR). However, in 2017, sales decreased by 5 % with respect to 2016  due to the challenging market conditions in the toy sector (for example, Toys R Us, one of their main customers, entered into Chapter 11 in different countries and it underwent a reorganization in the UK) and a weakening sterling. Looking at them, it looks like these have been temporary problems which should not alarm a long-term investor. Indeed, The Character Group has just announced that they have reached record sales in the UK in 2018 (final results will be published in a few weeks) and they look optimistic for the financial year ending 31 August 2019. The net margin of the company can also see an improvement in the coming years thanks to the Finance Bill 2015, which reduced the Corporation Tax rate to 19 % with effect from 1 April 2017 and to 18 % from 1 April 2020.

 

One of the things I like the most about The Character Group is that it is a company with no debt, ROCE above 20 % and a Free Cash Flow (FCF) generator with very low capex expenses. The Character Group returns a considerably part of the FCF through share buybacks (in the last 5 years the number of outstanding shares has been reduced by 9 %) and dividends (17p in 2017, what means a dividend yield of 3.4 %).

 


 

Currently, they are considering an international expansion. In the last months, the company has bought a 55 % stake in PROXY for £ 3.3m. This is around 30 % of the FCF that the company generated in 2017. Thus, if it does not go as expected, the risk of this acquisition is very limited. Besides, PROXY is a company which has worked with The Character Group in the past, so they must know each other pretty well. The opportunity for The Character Group in this acquisition arises from the fact that PROXY is a Danish toy distributor whose sales are concentrated in the Nordic region, an area in which The Character Group is not present. Thanks to it, The Character Group can mitigate the possible Brexit effects, providing the company with an easy access to the European market for its future plans.

 

Looking at the management team, we observe that it is mainly composed of Shah (10 % of voting shares), Diver (6.5 %) and Kissane (2.5 %). They get an annual bonus of 7 % (4 %, 2 % and 1 % respectively) of the consolidated pre-tax profits when a certain threshold is reached. This ensures that their objectives are, at least, partially aligned with shareholders', even though I would prefer to see this bonus refered to EPS rather than pre-tax profits. Despite 7 % of pre-tax profits is a high figure, the quantity of the whole bonus in absolute terms is around £ 0.7m, not that much.
 

Taking into account a share price of 500p, we can see how this company is currently trading at PER 9 (discounting non-operating cash). Why is it trading at this multiple? I think the following points have to do with that:

  1. The stock trades in the AIM index. Usually stocks in markets with more flexible regulatory systems are penalized. However, this can be compensated with a deeper investment analysis. Indeed, fundamental investors should benefit from this kind of discounts.
  2. There have been some changes in the management team (e.g. Mark Dowding, the previous CFO, left the company some months ago). This alarmed investors, even though, so far, there is not an objective reason for that.
  3. The management team has reduced the number of shares that they own in the company. As Peter Lynchs says, this info per se should not worry investors. Since they did it, the business kept on expanding and this reduction might have been only a matter of diversification.
  4. Toy sector has been challenging in the last months. However, The Character Group has obtained very interesting results in this difficult environment. If the sector starts recovering, The Character Group is well positioned to benefit from it. Indeed, the management team thinks that this recovery can happen in 2019. However, as long-term investors, we should not be very worried about when this will exactly happen. The important aspect is that the future looks brighter, even though there is always uncertainty that investors should assume and manage via diversification.
  5. One of these uncertainties is Brexit. Despite the outcome of Brexit negotiations is unclear and very unpredictable, The Character Group only needs access to Far East for continuing their operations without significant changes. Of course, a negative Brexit deal can damage consumption in the UK, what may damage sales in this company, but it may also hamper the access to UK to some competitors, what may increase their sales. The result of these opposite forces is hardly predictable but, in any case, it is not clear that a bad Brexit can be an awful event for this company.

As we all know, investing means running risks. Having said that, I think that The Character Group can be an interesting company in a diversified portfolio. Their competitive advantage? They are the only ones who can sell toys with the image of famous TV shows in some markets, what lets them charge an extra price. Personally, I would consider rational if this company reaches, at least, a multiple of 14.

 

Let me remark that this is just a brief summary of a deeper research and analysis. If you want to invest in this company, take this just as a starting point. Please, always do your own research!


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