We view the dramatic drop in Jakks Pacific Inc. (NMS:JAKK) shares as a gift that won’t last long – an immediate buying opportunity. Shares came under pressure in yesterday’s trading session, sliding 13% to $8.77 on a downgrade by an analyst at BMO Capital Markets. BMO downgraded Jakks Pacific to market perform from outperform and maintained its $10 price target using a P/E of 13 on his 2016 EPS estimate.
- Shares of Jakks Pacific Inc. (JAKK) fell 13% in yesterday’s (July 7, 2015) trading session. We think shares will quickly rebound to recent highs of around $10.00.
- Shares fell due to a downgrade by a BMO analyst. However, we are challenging the shares outstanding and EPS calculation used to support BMO’s price target.
- Our worst case scenario still yields a higher price target than BMO’s price target.
We are using this opportunity to add to our long position since we believe that the BMO analyst’s fully diluted share count assumption (especially taking into consideration that JAKK just approved a $30 million share buyback program) used to maintain his price target of $10.00 is too high. However, it appears the analyst made an even more glaring oversight. It does not look like his fully diluted share scenario eliminated the interest expense associated with the convertible notes baked into his fully diluted share count.
If the analyst would have applied his P/E assumption for 2016 EPS to an 2015 EPS figure that we feel more accurately reflects JAKK’s near-term fully diluted share count, he would have arrived at a price target of $13.26, not $10.00. Referencing his 2016 EPS estimates would yield a price target of $14.30. Even our worst case fully diluted share count produces a price target above BMO’s target. If we compare JAKK’s valuation to its closely publicly traded competitors, shares would trade ~$20.00.
Information Arbitrage Buying Opportunity Strikes Again
On June 16, 2015 we initiated a long position @ $8.85 and highlighted JAKK as a possible prime buyout target. We stated recent 13D activity, value on analyst EPS estimates, and a Seeking Alpha article discussing the involvement of an activist investor had piqued our interest. The Seeking Alpha article does a good job in describing the bullish thesis. We believe that the drop in JAKK’s shares has presented investors with way to profit from an information arbitrage opportunity.
We define an information arbitrage as an opportunity that arises when public information is available that has not been fully or properly digested by market participants.
We have been highly successful in identifying such opportunities. Our most recent info arbitrage calls include quickly capturing 60 % returns in Supercom Ltd. (NASDAQ:SPCB) and 35 % in Mer Telemanagement Solutions Lt (NASDAQ:MTSL) .
With regards to JAKK, we noticed that the fully diluted share assumption made by BMO does not agree with our calculations. According to our sources it appears that the analyst applied a P/E of 13 on a 2016 EPS estimate of $0.80 to arrive at a price target of $10.00.
We believe BMO’s share count assumptions are too high. The analyst arrived at a FD share count of 45.6 million and 46.2 million for 2015 and 2016, respectively. The analyst appears to be assuming that all 23 million shares arising from convertible notes that are due in 2018 and 2020, respectively, and 1.5 million warrants with an exercise price of $16.28 issued in September 2012, will convert in the near-term. But his assumptions don’t appear to take into account:
- JAKK’s recently approved $30 million share buyback.
- The possibility of more buybacks in the future. We think it is fair to assume that activist investor involvement will incentivize management to continue to return capital to shareholders.
- It is not likely that all of the 23 million shares from convertible notes will be converted since the notes are due in 2018 and 2020. So even if the notes are in the money, some note holders will probably hang on to the notes and collect interest.
- There are interest savings resulting in a positive impact to net income arising from the conversion of convertible instruments.
Here is our calculation of what we believe a more accurate representation of JAKK’s fully diluted share count should be. It assumes that:
- Management will execute on its $30 million buyback sooner rather than later
- 11.4 of the 23.4 million shares convertible from convertible notes might convert in the near-term
- $4.25 million in interest savings from conversion of convertible notes due in 2018 with annual interest rate of 4.25%.
There are two convertibles notes, one with principle of $100 million and conversion price of $8.74, and the other of $115 million and conversion price of $9.64. It is hard to estimate or model how many convertible notes will be converted into common shares, but in order to calculate the EPS, we have to make assumptions.
We think it might not be very reasonable to assume that there will be no conversion from the convertible notes. However, it is also not very likely that all the convertible notes will be converted very soon since they are due in 2018 and 2020, respectively.
Convertible notes holders would not intend to convert all the notes even if the stock price is higher than the conversion price because on one hand, they can collect interest from the convertible notes, and on the other hand, it’s like they are holding an in-the-money call option, and they might want to wait for the stock to go higher in the future.
Since the former $100 million convertible notes have a conversion price lower than the current stock price and it accounts for almost half of the total convertible notes outstanding, we assume that all of this $100 million worth of convertible notes are converted into common shares, which will add 11.4 million shares to the diluted share count. In addition, since there are 1.5 million warrants whose exercise price is $16.28, we assume that they will not get exercised soon, ultimately subtracting from the common stock equivalents count.
The table below contains calculated diluted shares outstanding with and without considering the recently announced $30 million share buyback program. If we incorporate this buyback program, the estimated diluted shares outstanding will be 29.3 million; otherwise it would be 32.7 million.
| Common shares issued and outstanding1 | 23.3 | 23.3 |
| Less: Treasury stock1 | (3.1) | (3.1) |
| Less: $30 million announced share buyback program2 | (3.4) | – |
| Common stock equivalents (including options and warrants)1 | 2.6 | 2.6 |
| Less: Deep Out-of-money warrants @$16.283 | (1.5) | (1.5) |
| Shares from convertible notes4 | 11.4 | 11.4 |
| Diluted shares outstanding (in millions) | 29.3 | 32.7 |
Note 1: listed in 10Q filed on May 11, 2015
Note 2: assume $30 million buyback at price of $8.77, which is announced on June 16, 2015
Note 3: listed in page 65, 2014 10K
Note 4: assume convertible notes due in 2018 are all converted at price of $8.74
The table below shows the EPS calculation for the each of the diluted shares outstanding calculated above.
| 2015 E with $30 million buyback | 2015 E without $30 million buyback | |
| Net income estimate provided1 | $26.2 | $26.2 |
| Plus: saved interest expense after tax2 | $3.6 | $3.6 |
| Net income after conversion | $29.8 | $29.8 |
| Diluted shares outstanding | 29.3 | 32.7 |
| Diluted EPS | $1.02 | $0.91 |
Note 1: net income estimate for 2015 is from analyst report
Note 2: use 16% effective tax rate in 2015 from analyst report
Applying a P/E of 13 in either scenario gives a price target higher than BMO’s target of $10.00:
- 13 X $1.02= $13.26
- 13 X $0.91= $11.83
Now let’s take a look at an absolute worst case scenario where all convertible debt is converted and the way out-of-money warrants are also exercised. We will also show both cases with and without the $30 million worth of shares buyback program.
| Common shares issued and outstanding | 23.3 | 23.3 |
| Less: Treasury stock | (3.1) | (3.1) |
| Less: $30 million share buyback program | (3.4) | – |
| Add: | ||
| Common stock equivalents | 2.6 | 2.6 |
| Shares from convertible notes1 | 23.5 | 23.5 |
| Diluted shares outstanding | 42.8 | 46.2 |
**Share counts in millions
Note 1: listed in 10Q filed on May 11, 2015
The $100 million of convertible notes due in 2018 have an annual interest rate of 4.25% and the $115 million in convertible notes due in 2020 have annual interest rate of 4.875%. A simple calculation would tell us that if both of these convertible notes are fully converted, the company can save $9.86 million worth of interest expense. We believe that management will execute on its recently announced $30 million share buyback program sooner rather than later, Therefore, we think even when we consider the worst case scenario, we will want to consider the effect of this buyback program, giving us 42.8 million fully diluted shares outstanding.
The table below shows the EPS calculation in 2015 and 2016 based on 42.8 million shares:
| 2015 E | 2016 E | |
| Net income estimate provided1 | $26.2 | $28.6 |
| Plus: saved interest expense after tax2 | $8.3 | $8.3 |
| Net income after full conversion | $34.5 | $36.8 |
| Diluted shares outstanding | 42.8 | 42.8 |
| Diluted EPS | $0.81 | $0.86 |
Note 1: net income estimate for 2015 is from analyst report
Note 2: use effective tax rate of 16% and 17% for 2015 and 2016, respectively, from analyst report
As we can see that even if all the convertible notes are converted into shares, the calculated EPS in 2015 and 2016 are materially higher than those ($0.75 and 0.80 in 2015 and 2016, respectively) from the analyst report. Applying a P/E of 13 on 2016 EPS of $0.86 equates to $11.18.
What Has Changed? Nothing.
The only thing that has changed for JAKK over the last two days is that it is now cheaper. The activist investors are still involved in the story. The company still has a $30 million buyback program, and shares are still trading well below its peers, Hasbro Inc. (NMS:HAS) andMattel Inc. (NMS:MAT)
| HAS | MAT | Average | |
| P/E based on 2015 EPS Estimate1 | 23 | 19 | 21 |
| P/E based on 2016 EPS Estimate | 19 | 17 | 18 |
Note 1: Estimate is from Yahoo Finance
What’s even better is that MAT has been facing headwinds, yet it is being priced higher than JAKK. So, there is a strong possibility that JAKK can experience an expansion in its P/E multiple if management fully executes its turnaround plan to return to meaningful profitability in 2015 and 2016 after several years of financial underperformance.
A Seeking Alpha article highlights bullish catalysts at JAKK (activists, new Disney relationship) and outlines why shares could be worth $16 based on an EBITDA multiple of just 2.5x. Due to the involvement of the activist investors we think it is highly unlikely that JAKK will complete a dilutive financing transaction the near-term.
Disclosure: Long JAKK at time of article
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