JAKKS Pacific, Inc.
Q2 2019 Earnings Call Transcript

Published: 9 Aug 2019

[Operator:]

Good morning, and welcome to the JAKKS Pacific Second Quarter 2019 Earnings Conference Call with Management, who’ll review financial results for the quarter ended June 30, 2019. JAKKS issued its earnings press release earlier today. Presentation slides containing information covered in both today’s earnings press release and call are available on our website in the Investors section. This presentation includes videos showing some of our key products.And on the call this morning are Stephen Berman, Chairman and Chief Executive Officer; and Brent Novak, Chief Financial Officer. Mr. Berman will first provide an overview of the quarter and provide highlights of product lines and current business trends. Then Mr. Novak will provide detailed comments regarding JAKKS Pacific’s financial and operational results prior to the opening up of the call for questions.[Operator Instructions] Before we begin, the company would like to point out that any comments made about JAKKS Pacific’s future performance, events or circumstances including the estimates of sales and/or adjusted EBITDA in 2019 as well as any other forward-looking statements concerning 2019 and beyond are subject to safe harbor protection under federal securities laws. These statements reflect the company’s best judgment based on current market trends and conditions today and are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected in forward-looking statements.For details concerning these and other such risks and uncertainties, you should consult JAKKS’s most recent 10-K and 10-Q filings with the SEC as well as the company’s other reports subsequently filed with the SEC from time to time. In addition, today’s comments by management will refers to non-GAAP financial measures such as adjusted EBITDA. Unless otherwise stated, the most directly comparable GAAP financial metric has been reconciled to the associated non-GAAP financial measure within the company’s earnings press release issued today or previously. As a reminder, this conference is being recorded.With that, I will now like to turn the call over to Stephen Berman.

[Stephen Berman:]

Good morning, everyone, and thank you for joining us today. This morning, we’re going to review our performance during the second quarter of 2019. I will start with some general comments about the recently completed recapitalization transaction, which we announced this morning and then talk generally about our second quarter performance. After my comments, Brent will discuss our financial performance, after which I will come back with some additional comments.I am very pleased that we have executed a comprehensive recapitalization transaction and we can finally move forward with a keen focus on the business without the overhang and uncertainty of needing to complete some type of transaction. We are grateful to have such great business partners and friends supporting us, including our customers, licensors, suppliers, shareholders and other stakeholders, advisers and, of course, our employees.Moving on to our results. The quarter ended June 30 was the first quarter in which we had no sales to Toys"R"Us in the U.S. either this year or the prior year. Even with no sales in the U.S. to Toys"R"Us, in Q2 2018, the industry still saw considerable disruption from the liquidation sales and the response of other retailers to those sales. Therefore, the clean comparisons are just beginning.Some of the highlights in the quarter were, we saw a strong growth in the quarter in our Disguise division, which was up almost 50% even ahead of its peak quarter. We also saw strong sales contributions from new licensed properties, notably Aladdin, Godzilla, Toy Story 4 and Nintendo. POS of our Disney products was up over 50% in Q2, setting us up well for the second half with the key licenses shipped. Our evergreen seasonal business performed well in the quarter with introduction of our play tents, adding to strong sales of activity tables and ball pits. These areas of strength were more than offset by the declines in Incredibles 2 and Squish-Dee-Lish, both of which were particularly strong in the second quarter of last year with above-average gross margins.As a result, net sales in Q2 declined approximately 10% compared to last year. Essentially, all of the decline can be accounted for by the decline in Incredibles 2. However, we achieved our expected growth sales target in the first half of the year of approximately 27% of our expected full year sales. As we said on our 2018 year-end first quarter call, we expected sales in 2019 to be skewed much more to the second half due to the timing of key entertainment content and related product launches, notably Frozen 2, which is launching in November, but also the Toy Story 4, which was released late in Q2 and should drive sales into Q4.Several of our most important Disguise licenses, such as Lion King live action, Pokemon, LEGO Movie 2, Descendants 3, Kim Possible and Top Wing, to name a few, are also skewed to the second half. The increased sales of closed-out goods coupled with a shift in product mix reduced our gross margins further than expected in 2019 second quarter. Though we do expect our gross margins to return to more normal levels in 2019 third quarter based on our bookings today. As was the case in first quarter, we were able to partially offset the effects of lower sales and gross margin in 2019 second quarter due to the steps taken last year to reduce our SG&A cost.On the tariff front, we are in the process of evaluating the impact that the tariffs proposed to go into effect on September 1 would have on our business. Generally, there are a number of levers we can pull to mitigate the impact, including changing in sourcing, modify logistics and price increases where possible. These steps in the past have been effective at offsetting the negative effect of tariffs. Given how close to peak shipping periods these recently announced tariffs would take effect and how broad they are, there may be some negative impact in near-term results. We are currently evaluating the impact that this could have in the third quarter and fourth quarters. We will continue to work with our suppliers and retail partners to find an optimal path.Before I hand the call over to Brent, I want to summarize some of the aspects of the recapitalization transaction. We had outstanding convertible debt with a face amount of approximately $140 million due next year in 2020. Approximately $140 million of that debt has been extended and matures in 2023.Our credit facility with Wells Fargo has been amended and extended and now matures three years, in August 2022. The $20 million term loan from Great American will be prepaid. The collateral use to support the Great American term loan is now included in the Wells Fargo credit facility, which we believe will increase our ability to borrow under the facility. We issued $30 million of new secured debt maturing in January 2023, which will help to fund the payoff of the Great American term loan.As part of the extension of our convertible debt, approximately $104 million of the convertible debt held by the Ad Hoc Group was essentially converted to secured debt. We issued 19.9% of our outstanding common stock and issued preferred stock with a face amount of $20 million to the Ad Hoc Group. The preferred stock is not convertible into common stock. And the preferred stock does not include a mandatory reduction provision at the option of the holders.We also adjusted the conversion price to $1 of the convertible debt that remains outstanding of roughly $38 million, which is held by Oasis. This is just a summary of some of the features of the recapitalization transaction. For all of the details, please refer to the Form 8-K and related supporting exhibits that were filed with the SEC today.With the recapitalization transaction complete, we can pursue our business objectives through the near term and beyond with new vigor and resolve. One final point, while we did not complete a transaction with Meisheng, Meisheng continues to be a strategic supplier of JAKKS and a large shareholder.I will now turn the call over to Brent Novak. Brent?

[Brent Novak:]

Thank you, Stephen, and good morning, everyone. I will first review the financial highlights from the P&L and then provide more color on the sales composition before finishing up with some balance sheet commentary.Net sales for the 2019 second quarter were $95.2 million, down 10% compared to $105.8 million last year. As Stephen said, the decline was essentially due to the fact that our Q2 2018 sales benefited significantly from Incredibles 2 that declined year-over-year, as expected, with other notable declines from the prior year, including Squish-Dee-Lish, all of which were partially offset by a newer properties.As Stephen noted, our 2019 first half gross sales approximated 27% of our full year target, with increased growth driven by licensed product expected in the 2019 second half compared to 2018. Gross margin in the quarter was 18.6%, down from 26.4% in Q2 of last year. The main driver of the decrease was a substantial shift in sales away from certain higher-margin licensed and owned IP products toward some of our lower-margin, evergreen products as well as closing out some older products at lower margins.Product mix also drove royalty cost higher as a percentage of net sales, impacting our gross margin. Our direct selling expenses declined 19% in Q2 on a year-over-year basis, the result of lower co-op advertising expenses and other costs. Total SG&A expenses declined by approximately 9% in Q2 on a year-over-year basis, in line with the reduction in net sales.Excluding acquisition-related and other costs associated with the strategic transaction and refinancing process, total SG&A of last year. The variability of the income tax provision is based on changes in taxable income levels in various tax jurisdictions in which we operate. Reported net income attributable to JAKKS shareholder was a loss of $22.5 million in the 2019 second quarter or $0.96 per diluted share compared to a net loss of $18.6 million or $0.80 per diluted in Q2 of last year.Adjusted EBITDA for the second quarter of 2019 was negative $11.5 million compared to negative $8.5 million in the second quarter of 2018. The sales drivers in the second quarter of 2019 by category were as follows

[Stephen Berman:]

Thank you, Brent. Before we get to Q&A, I will share some thoughts on the properties and trends we think will be important in the second half of 2019. As you all know for the past 18 months, in addition to dealing with the liquidation of Toys"R"Us and its effect on our sales and financial conditions, we’ve also been working extremely hard to consummate a strategic transaction with Meisheng or other interested parties as well as a recapitalization transaction with our bondholders and banking partners.This effort has been disruptive and distracting, and we are pleased that we have an agreement in place and can now focus on our efforts solely on running the business. Near term, we continued to be optimistic about the second half of 2019 for a number of reasons. 2019 continues to be a great year for entertainment content and in the second half, we have some strong licenses. We expect Frozen two, Toy Story four Nintendo, Pokemon, Lion King, Gigantosaurus and others to drive our holiday sales. We continue to expand our owned IP, consistent with our strategic goal of having our own IP constitute a higher portion of our total sales. The X-Power Dozer, TP Blaster, Sheet Storm, Slap Ninja and the Chocolate Poop Maker to name a few are retailer favorites.Our Disguise business has been very strong. It typically sees the best sales in third quarter and is looking solid at the year-over-year growth in 2019. C’est Moi, which we haven’t spoken much about lately is showing strong growth. While the base is still very small, we continue to be optimistic about the brand’s potential. Our Seasonal business has rebounded nicely and has several segments that are either new or are showing good growth versus last year, including play tents. From Disney, the 30th anniversary release of the Little Mermaid should lead to renewed interest in this line. Frozen two will be out in time for Thanksgiving. We have a broader array of projects shipping ahead of the box office release, including special feature dolls, Dress Up and Role Play.We expect the Frozen brand to be a significant factor in both the second half of 2019 and well into 2020. Video game-related toys continue to sell well for us and other companies. In addition to Nintendo, which continues to perform well, we have Mega Man and Sonic the Hedgehog benefiting from new entertainment content. More forward, our exciting activity system continues to see distribution broaden. The addition of an electric motor has been pushed into next year, which should allow the system to grow into 2020.In conclusion, while we are focused on improving our disappointing first half gross margins, our first half sales came in as we expected, and we believe we are well positioned for sales growth and gross margin improvement in the second half. This coupled with our continued fiscal discipline puts us in a good position to improve our profitability in 2019. The recapitalization transaction is like the dawning of a new day for JAKKS. We’re invigorated and look forward to taking advantage of our many opportunities. With that, we will now take questions. Operator?

[Operator:]

[Operator Instructions] And our first question is from Steph Wissink from Jefferies.

[Steph Wissink:]

Thanks, good morning everyone. And, Stephen, I wanted to ask you a question about Disguise. This has been a perennial outperformer and really strong in the first half. I’m curious if you can talk about the evolution of that platform into more of a year-round business versus just a purely Halloween business?

[Stephen Berman:]

Sure. Good morning, Steph. Firstly, I think as we expressed before, Disguise has seen a very strong growth year, and we have quite a few new properties compared to last year. And Halloween is actually seeing growth year-over-year as an industry. So since we had a tremendous amount of new properties, which allowed us to ship more in Q2 than in the past and it allowed us to build a stronger Q3 due to the growth of Disguise.

[Steph Wissink:]

Stephen, are you seeing retailers taking that merchandise earlier and placing it on the floors earlier? Or is that a buildup in advance of what they expect to be a stronger Halloween?

[Stephen Berman:]

It’s actually simply just a buildup for Halloween. It’s for them to actually order – remember, we’re a strong FOB business so they need to order on a FOB basis earlier than on the domestic. And since there’s quite a large percentage of growth year-over-year, we shipped more in Q2 than our normal past years. And going forward into Q3, it’s an extremely strong Q3 of – for disguise.

[Steph Wissink:]

Okay. So we should expect that segment to contribute to growth in Q3 as well? It’s not pull-forward into Q2?

[Stephen Berman:]

Correct. And also we have newer licenses that are internationally based, so we’re shipping more Disguise international than we have in the past year.

[Brent Novak:]

Yes, full year, Steph, we are expecting good growth for disguise year-over-year.

[Steph Wissink:]

And by good growth, you mean over-indexing your total company. Should we think about it that way, kind of above or below the company average?

[Brent Novak:]

Yes.

[Steph Wissink:]

Okay. And then Stephen, another one for you. A lot of exciting things coming to the pipeline into the second half. But I am wondering if we can talk a little bit more about Frozen two, just given that, that was such a meaningful driver for you a few years ago. How should we think about the scale of that property this year, both domestically but also internationally? How are you looking at the international market opportunity this time around?

[Stephen Berman:]

Well, we have worldwide rights for Frozen two, and we actually – since we had it in the past in 2013, we’ve actually figured out what SKUs performed better from the experience we had in the past. So the expectations are extremely strong worldwide. In addition, Disney Princess sell-throughs for the first half of the year are extremely strong, which is giving retailers even additional strength for more placement of Frozen two. And the buildup both in – both brick-and-mortar and as well as online retailers has continued and has increased over the past few months. So the placement and expectations and excitement is extremely strong.

[Steph Wissink:]

That’s encouraging. Good to hear, and Brent, last one for you is just on the gross margin. I just want to make sure we understand the drag that came from the closeout. I know you expect some of the gross margin going to persist, but would you be willing to quantify of that decline from 26% to 18.5%. What portion of that closeout so we can at least model a phasing out of that portion of the drag?

[Brent Novak:]

Yes. Modeling out or quantifying, I would say that it was smaller than the overall. I would say, mix had a bigger contribution than the closeouts. Closeout was still, I would just – in terms of qualification qualitatively, it would’ve been meaningful. So really the big driver was that. For example, you had high-volume products like Incredibles two and Squish last year that were sold at high margins. This year, we sold them at lower volume.And unfortunately, the margins were much lower than we expected for those two lines. So I’d say the largest contributor was mix/pricing. And then we did have closeout sales as well. The other impact on margins was because of the mix issue, so it was more licensed products versus owned IP that negatively impacted our margins as well, just a higher royalty percentage as a percentage of revenue. So as we mentioned on the call, we do believe that the pressures may persist into the second half. But we are off to a good start in the third quarter.And we do expect margins to be more at normal levels in the third quarter. So you can look at last year where we came in at. But even with that disappointing gross margin in Q2, we were able to hold cost down and achieve higher-than-expected sales that brought our adjusted EBITDA number in line with our previous expectation. So that was certainly a positive.

[Steph Wissink:]

Okay. That’s great. And then just two housekeeping, if we could, from a modeling perspective. The interest expense for back half and then on a full year basis, and then with the new capitalization structure, what’s going to be the new share count on a fully diluted basis?

[Brent Novak:]

So the common stock that we issued is roughly $5 million, $5.8 million $5.9 million. So it’s about 20% of the – of our outstanding shares. So that will be added to the count. Where the stock price is right now, it doesn’t look like they’ll be any impact from the outstanding convertible notes. And then from an interest perspective, you can see the details when we file the overview of the 8-K later today. That will all the interest rates in there. But you’re going to see probably an annualized interest expense – actually that’s just a cash interest expense of about $3 million-ish, maybe $3.5 million, something in that range. But those will be – there will be some amortization costs as well for the financing cost. But all of that is non-cash.

[Steph Wissink:]

Very helpful, thank you guys.

[Operator:]

[Operator Instructions] And our next question is from Gerrick Johnson from BMO Capital Markets.

[Gerrick Johnson:]

All right, thank you. So you mentioned changes in source of your potential changes in sourcing to get around tariffs. How easy or difficult is that to do? And how quickly can that be done?

[Stephen Berman:]

Good morning, Gerrick. How quickly it could get done, to move a material amount of the manufacturing out of China would take a couple of years. But we have moved and have been traveling to Vietnam and other areas with regards to cut and sew and also injection molding in addition to Mexico. So we have different areas that we’ve been working with and preparing for. But we also have been hit with the tariffs before in our Kids Only! furniture business in the previous, call it, tariff wars.And what we ended up doing is increasing prices to various retailers, which had accepted the increased prices, which actually increase the retail price slightly. But at the same time, what we’ve seen in our outdoor furniture, indoor furniture, the sell-throughs haven’t changed a bit. They’ve actually stayed extremely strong. So for the most part, we’ve seen an increase that we’ve done and retailers done at the same time. And going through the different areas of businesses, we will be moving some of our manufacturing to other areas but generally, majority of it will still be in China for the last, at least two years.And we have been speaking very closely with our retail partners worldwide of where price increases will be achieved. In addition, we’ve also done and are doing continuously cost reductions where possible on areas of business to allow a lower price for us to sell – or continue to keep our pricing in the same by just lowering the amount of spray-ups or amount of stitching in different areas of our businesses.

[Gerrick Johnson:]

Okay, great. And you guys are traditionally an FOB shop, how is that mix of FOP versus domestic changing this year? And how do you see that playing out, say, over the next couple of years?

[Stephen Berman:]

We’ve been consistent year-over-year. It’s anywhere from 56% FOB, 43% domestic or 60-40. And that’s been our split for years. It seems based up, even with the tariffs, that it’ll stay very similar to what we’ve had in the past. We preferably like an FOB business, when it’s less use of capital. We get to benefit from it as well, as well as our retailers worldwide, as they get to add their own loads to it. So our goal would be to increase it as time goes on.

[Gerrick Johnson:]

Okay. And lastly, are you able to comment on 2020 projections. Last quarter, we saw your projection for $640 million in sales, $46 million in adjusted EBITDA. Can you comment on that?

[Stephen Berman:]

Not at this time. It’s too early based on the holiday season coming up. But we feel very strong with this year going forward as well as we have a strong lineup for 2020. And if you remember in the past, with Frozen, the second year was actually the highest and strongest year. And we’re expecting that the same.

[Gerrick Johnson:]

Expecting that to be the same even…

[Stephen Berman:]

We’re expecting it to be the same, very similar growth as what we’ve had in the past.

[Gerrick Johnson:]

Okay. Well, the last time was a complete surprise. This time everyone’s prepared for it. So I would assume that would be a little bit more shifted towards this year, would that be a correct assumption?

[Stephen Berman:]

No, the – it’s a stronger year because people have had experienced it – experience in the past. And the way Disney is promoting it and the expectations of the movie, we definitely – because it was an unknown before, we definitely have the stronger first part but the second part – remember, it’s only on air for five weeks prior to Christmas. In the second half in 2020, we’ll have a full year of sales.In addition we’ll have Disguise that’ll partake very strongly in it because Disguise is a very minor forecast for Frozen two because there’s no real awareness of it. So the lines that we have going into next year, like our interactive doll, which was our number one performer in the past, shipped the following year. So we have a lot of new SKUs for spring and going into fall, the retailers' expectations are still strong for 2020.

[Gerrick Johnson:]

Okay, great. Thank you, Stephen.

[Operator:]

And we have no further questions at this time.

[Stephen Berman:]

Ladies and gentlemen, thank you for the call today. We appreciate the time and apologize that the earnings announcement was done at a later date. But we’re very happy with the closing of our financing and looking forward to this coming year and years to come. Thank you very much.

[Operator:]

Thank you, ladies and gentlemen. That concludes today’s call. Thank you for participating, and you may now disconnect.