Playmates Toys Limited (“Playmates”) is a HK-listed toy manufacturer and marketer. Since its inception in 1966, the company has brought to market a number of toy brands including the Teenage Mutant Ninja Turtles, Waterbabies, Space Jam, Nano and the Amazing Amy dolls. The company is a subsidiary of Playmates Holdings, a larger conglomerate that is also listed on the Hong Kong stock exchange and controlled by Thomas Chan.

Here is a snapshot of the company’s current trading statistics:

Franchise toy manufacturers such as Playmates tend to have lumpy earnings profiles that are often driven by the performance of movies or TV series related to their brands. For example, the company had a particularly strong 2014 as a result of the successful box performance of the Teenage Mutant Ninja Turtles movie released that year. Subsequent years, however, have been more pedestrian owing to increased competition from other toys and the lack of a movie catalyst (more on that later).

Unfortunately, it’s notoriously difficult to predict how movies are going to perform or what trends / toys are going to catch on with children. Attempting to do so in the context of Playmates would be more speculation than investment. Instead, a better approach might be to insist on significant downside protection while betting that earnings don’t deteriorate significantly in 2017. I would argue that Playmates shares today have these attractive risk / reward characteristics.

Just a quick side note here: I would classify this more as a catalyst-driven investment with a 12-18 month timeline than a long term holding. It is possible that the shares perform well over a longer term horizon but it’s not the type of company I would buy and hold Buffett-style. In terms of position sizing, I would recommend initiating with a relatively small position (1-3% max.) which mostly reflects my generally cautious outlook on the markets today.

Downside protection:
This is always the starting point. From my perspective, there are three components to the downside protection currently offered by Playmates shares: a strong balance sheet, an attractive entry valuation and the underlying franchise value of the Teenage Mutant Ninja Turtles. Let’s go through each of these components briefly.

First, the balance sheet. The company currently has a market cap of approximately US$217m, nearly 62% of which (US$135m) is covered by the net cash on its balance sheet. Since the company has no long term debt to pay down, its current cash balance provides ample protection for its dividend payments and capital expenditure requirements in 2017. Playmates shares yield just over 7% based on the current share price and assuming no growth in dividend payments from last year.

Next, let’s look at entry valuation. The company earned net profit of US$35.6m in 2015, implying a trailing earnings multiple of ~6x. Unfortunately, the first half of 2016 saw significantly weaker results versus the same period for 2015. The outlook for the remainder of the year is also poor and I would not be surprised if full year net profit came in at ~50% of 2015 results. Despite a sequel movie for the Teenage Mutant Ninja Turtles that was released in 2016, the company has seen strong competition from a number of other franchises within the boys action toys category over the past year. Total operating expenses for 2016 have also been higher as a result of greater marketing spend related to new toy and product releases.

Let’s say net profit for 2016 comes in at US$17.8m, which means an earnings multiple of ~12x based on 2016 results. That’s an 8% yield from day 1 of investment, which is attractive compared to a lot of the alternatives I am currently finding in the market. By the way, if you calculate the earnings multiple on an ex-cash basis, it’s closer to ~4.6x. I know there are ongoing debates about the validity of ex-cash multiples and whether it’s an accurate way to value an opportunity but I’m not going to get into that for now. All things equal, I generally just prefer lower earnings multiples, ex-cash or not.

Finally, let’s briefly look at franchise value of the Teenage Mutant Ninja Turtles. Playmates first introduced the Turtles at the 1988 New York Toy Fair. At the time, it was an unknown franchise and received a relatively unenthusiastic reception. Despite this, the company pushed forward with the toy line and funded the first five episodes of the cartoon series. From an initial 3,000 piece order, the Teenage Mutant Ninja Turtles has gone on to become one of the leading toy brands of all time.

A lot of the value for Playmates comes from the fact that the brand (and therefore the toys) can be regularly rejuvenated over time. It might not be timeless but every generation of children probably sees a reincarnation of the Teenage Mutant Ninja Turtles. It’s similar to the Marvel / DC library of characters in that the brand owners can choose to periodically re-tell the story, add an off-shoot or even develop an “origins” type backstory to the franchise.

So, what are the toy manufacturing rights worth exactly? I don’t know, but let’s look at it another way. Given net cash currently covers 62% of the company’s market value and zero long term debt, all the other net assets only need to be worth ~US$82m to cover the market cap completely. This seems reasonable, meaning an investor today can potentially get the entire operating business for free.

Earnings outlook for 2017:
Given the downside protection outlined above, all I need is some indication that earnings won’t deteriorate significantly in 2017 and that the company can continue paying its dividends out of cash flow. Worst case, however, they can make these payments out of the cash on their balance sheet. From my perspective and based on their valuation today, not a lot has to go right for the shares to do okay. Any upside will probably lead to a positive reaction from the market.

Based on their latest interim report, management expects competitive pressures for the Teenage Mutant Ninja Turtles to intensify in 2017, with a full schedule of kid-friendly movies to be released throughout the year. More importantly, however, the company plans to release three new toy brands over the course of 2017. These include action figures for Voltron, Ben 10 and Mysticons. Let’s look at each franchise briefly.

Voltron
DreamWorks Animation and World Events Productions launched their new animated series Voltron: Legendary Defender as a Netflix original series in June 2016. It is a reboot of both the Beast King GoLion anime series as well as the Voltron franchise and follows five teenage pilots of mystical robot lions in their quest to the protect the universe.

The first season premiered in June 2016 and consisted of 11 episodes. Critical and popular reception for the first season was overwhelmingly positive. The second season premiered in January 2017 and will consist of 13 seasons. Playmates is the global master toy licensee and will launch a brand new line of Voltron toys in Spring 2017.

Ben 10
The original Ben 10 series premiered on Cartoon Network in 2006 and tells the story of a ten year old boy (Ben) who can transform into different alien heroes with the help of a mysterious watch.  The original series received high ratings and spawned three additional animated series and two live-action movies. It was a proven ratings and merchandise success in major markets around the world.

The new Ben 10 animated series will premiere in selected markets in the fall of 2016 and across North America in 2017. Playmates, which will serve as the global master toy partner for this re-launch, will release their Ben 10 toy line in the fall of 2017.

Mysticons
This is a brand new animated action television series developed by Nelvana Studio, in partnership with Nickelodeon and the Topps Company. It’s about four girls who are selected to be become the legendary heroes known as the Mysticons and undertake a quest to find the Codex. Playmates will serve as the global master toy partner for the new series.

Overall, although I have serious concerns about the cartoons that children are watching these days, I am quite positive in my outlook for Playmates. 2016 was over-reliant on the Teenage Mutant Ninja Turtles and, in the face of increased competition from other franchise toys, results suffered. 2017 should see some much-needed product diversification for the company. The commercial success of the new TV series is also encouraging and should hopefully be reflected in the toy sales numbers.

Historical financials:
Below is a snapshot of the company’s key financials (last five years):

Playmates is a low capital intensity business and, as a result, has generated nearly its entire market cap in free cash flow in the past three years alone. To maintain its dividend payments and capital expenditures at 2015 levels, the company only needs to generate an incremental ~US$16m in cash from operations. This seems quite reasonable for both 2016 and 2017 even with an expected reduction in sales and overall profitability for the company.

On a final note, some readers have mentioned they would like to see more in-depth analysis of the numbers and overall case when I write up an investment idea. I will try to do more of that over time. In the meanwhile, here is a short explanation for my “back of a napkin” approach. It is most often a result of me trying to find opportunities that are so obvious that they don’t need really complicated financial analysis. Admittedly, these don’t come along very often, but I don’t invest very often either. Furthermore, I write so that an audience without a finance or accounting background can also understand the investment thesis. In my (albeit limited) experience as an investor, I’ve often found that the best ideas are the simple ones.