November 15, 2019
Introduction
Toys are an integral part of everyone’s life, as most people will remember a part of their childhood that was dominated by toys. Toys provided an avenue for active play and make-believe, and continue to be loved by both kids and adults. The major toy companies in the world have been producing and entertaining millions of kids with popular brands of toys for decades. In Hong Kong, there are two toy companies that supply toys to major department stores and that have recognisable brand franchises. Let’s focus on one of these companies today.
Playmates Holdings Limited (SEHK: 0635) is an investment holding company that has three major divisions: property investments, portfolio investments and toys. The group’s major property investments include a commercial building called “The Toy House” located at 100 Canton Road in Hong Kong, a couple of residential units at Hillview, 21-23A MacDonnell Road, as well as the Playmates Toy Factory at 1 Tin Hau Road, Tuen Mun. These properties are leased out to earn rental income and are managed by Savills Property Management Limited.
The group’s portfolio investments consist of investments in listed equity shares and managed funds. The fair market value of this portfolio as of 30 June 2019 was HK$86.8 million, and the aim of the portfolio is to generate steady capital appreciation as well as dividend cum interest income.
Playmates Toys division is separately listed on the HKSE under Playmates Toys Limited (SEHK: 0869) and owns a few popular toy franchises such as Rise of the Teenage Mutant Ninja Turtles (“TMNT”), Ben 10, Power Players and Pikwik.
Too good to be true?
Playmates Holdings’ financials look pretty interesting indeed. Though revenue has been consistently declining over the last four financial years, operating profit has actually been fairly volatile, and has even risen in the last two years. Net profit has been equally volatile, with three out of four years registering a profit while FY 2016 displayed a loss.
What exactly is happening with the business?
It turns out that the Income Statement has been impacted by two key numbers: “revaluation surplus on investment properties“, as well as “net gain/(loss) on financial assets at fair value through profit and loss“.
The former relates to the annual revaluation of properties held by the group as a requirement for fair value disclosures, while the latter relates to the movement in share prices and fair values of the underlying securities held by Playmates Holdings.
After adjusting out these two items from the Income Statement, the adjusted operating margin shows that the core operating margin has been declining, from a high of 31.3% in FY 2015 to 24.2% in FY 2018. Operating profit also displays a declining trend, falling from HK$561 million in FY 2015 to just HK$177.5 million in FY 2018.
The declining importance of toys segment
To understand this better, I looked at the mix of revenue contributed by each segment. The above table clearly shows that the contribution from property investments has been increasing, going from 13.1% in FY 2015 to as high as 44.2% in 1H 2019. The toy business, on the other hand, has seen revenue contribution declining from a high of 86.6% to just 53.9% during the same period. What we are witnessing is Playmates Holdings gradually morphing from being a toy company to a property holding company.
Free cash flow
Free cash flow for the group continues to be strong even though toys segment revenue has seen a marked decline. In the five periods, I looked at (FY 2015 through FY 2018 and 1H 2019), there was a good level of free cash flow generated. This supports the group’s ability to continue paying some level of dividends, though the absolute amount will largely depend on the profitability of its core business.
Erratic dividends
In terms of dividends, Playmates Holdings has not been very consistent. FY 2015 and 2016 saw decent levels of annual dividends being paid out, but this plunged to just HK 6 cents in FY 2017 after the group reported a loss in FY 2016. Dividends began creeping back up again in FY 2018 as the property division’s revenue increased the overall group net profit, and 1H 2019 has seen total interim plus special dividend kept constant. It seems there is a high chance of continued dividend recovery for 2H 2019 if the property division delivers a good performance.
A deeper look into Playmates’ business segments
The segment revenue analysis (above) reveals interesting details about the business.
Property investment division regularly posts segment profit that is higher than revenue, principally due to the fair value changes in the real estate holdings. Toy business revenues are seeing a clear trend of decline over the last four years.
I took the liberty of adjusting the fair value changes to arrive at the adjusted segment profit before tax (PBT). I also did this for the investment business by removing the fair value changes in the underlying securities.
The adjusted segment profit before tax (PBT) margin for property investments has hovered around 65% to 70% and has been fairly consistent if we strip out the revaluation amounts. This division has a stable revenue source and sustainable margins that the group can rely on. On the other hand, the toy business has seen declining fortunes over the years. Not only has revenue fallen sharply from a high of HK$1.55 billion in FY 2015 to just HK$474 million in FY 2018, but net profit has also plunged from a high of HK$389.6 million to just HK$4.4 million. Segment margin has withered from a healthy 25.1% to just 0.9%.
1H 2019 saw revenue decline even further to HK$314 million (annualised), while the division reported a significant segment loss before tax of HK$21.3 million. This is a worrying trend as it shows that the toy business is starting to drag the group’s financials down.
Catalysts for the business
In terms of catalysts for the business, looking at Playmates Toys’ management discussion and analysis (MD&A) section provides some clues on upcoming plans for the business, though whether these will pan out well to enable the business to turnaround remains to be seen.
TNMT is being rolled out across the world, while the group is working to develop product line extensions for Ben 10. A new animated series for “ZAG Heroez: Power Players” will debut in late-2019 on Cartoon Network, accompanies by initial shipments of toys. This is a new master toy right secured by Playmates Toys in 1H 2019. Finally, a new full toy line is being developed for “Godzilla vs Kong”, in line with the blockbuster movie.
Toy Industry remains resilient
Despite the closure of Toys R Us during 2018, the toy industry has remained surprisingly resilient. The industry broke a four-year growth streak to post a minor 2% year-on-year decline in 2018. Considering Toys R Us made up around 10% to 15% of all toy sales, I feel that this 2% drop actually shows the amount of business retailers managed to capture back. It’s encouraging to see this as it means that demand for toys remains strong, but that there need to be new retailers to step up to the fore to ensure the supply chain remains strong and that the toys are being delivered to customers who desire them.
As the middle-income class grows in countries and regions such as China, South America and Asia, more and more families will have increased amounts of disposable income to spend on toys. The propensity to spend also increases in line with increased resources, and this will create long-term consistent demand for more toys.
Though video games (on mobile phones and iPads) are more commonplace now and are wrestling some market share away from traditional toys, I feel that physical toys will always have their place as kids still need to engage in physical activity and play. This bodes well for the industry as it can continue to remain resilient even in the face of technological change and disruption.
Competitive Analysis
For the competitor analysis, I have used the numbers from Playmates Toys Holdings. Other similar competitors include Vtech Holdings Ltd (SEHK: 0303), Hasbro Inc (NASDAQ: HAS) and Mattel Inc (NASDAQ: MAT).
From the table, Playmates sports a healthy gross margin of 51% in its latest 1H 2019 earnings, and this is the mid-point of the two toy giants Hasbro and Mattel. However, a high layer of expenses renders the division unprofitable for 1H 2019. Unless Playmates Toys can somehow increase its revenue, the division looks set to remain unprofitable. All the players report decent top-line growth, demonstrating the resilient aspect of the industry.
Risks to the business
The main risk to the business is that of an economic downturn. This will crimp consumer sentiment and the propensity for spending, resulting in lower demand for toys as families cut back. For Playmates’ property investment segment, weaker business sentiment may result in tenants being unwilling to pay more for rent, while vacancy rates may also rise during a period of economic stress as tenants’ businesses suffer.
Valuation and conclusion
Playmates Holdings has a net asset value (NAV) per share of around HK$3.41 (as of 30 June 2019), while the share price is around HK$1.07. The shares are trading at a price-to-book ratio of just 0.31x, which is a significant 70% discount to NAV. This may be explained by the fact that the Toy segment is starting to bleed, and investors may perceive that the group is being dragged down by this division. However, the property segment is fairly stable and still contributes to revenues and cash flows.
Though the historical dividend yield may look enticing, investors should note that the share price is probably pricing in further declines in the Toys business. There is also no guarantee that Playmates Holdings can continue to dish out the same absolute level of dividends as FY 2018 as history has shown that the group has been willing to slash dividends before.
Also, it is mind-boggling as to why Playmates chooses to have two listed entities. With the Toy business under stress, the group ends up paying more in terms of listing fees and compliance expenses. A sensible thing to do might be to delist Playmates Toys Holdings since the division has no requirement to raise cash through the capital market.
Playmates Holdings is fast morphing into a real estate play as the contribution from its Toys segment shrivels, but investors are probably better off buying a REIT or am established real estate development company as this is not Playmates’ core competence.
Editor’s Note
The good thing about having someone else write up your idea is that you get a differing viewpoint which is of immense value. We tend to bullshit ourselves alot when we make individual decisions and having someone call you on it and challenge you is good for you as a retail investor. I highly suggest everyone surround themselves with people more intelligent than them capable of pointing out major errors in their investment thesis. It’s highly beneficial.
Moving on.
I’ve mentioned before that our Conservative Net Asset Value Strategy aims to simply buy a business at an outstandingly cheap price relative to its good assets. There’s a discount here of up to 70% on NAV. The company is telling you that you can own their entire business for $0.30 on the dollar – and still own their business for free. There’s no question here that the company is undervalued. The question is if you are willing to own a company with declining toy revenue. I am.
There are 3 simple reasons here and they’re all connected.
- Ownership.
- Yield.
- A margin of safety.
- Low Debt
Ownership
Insiders own 63.1% of the shares within the company. What does this tell you? For me, this means we’re in the same boat as management. They have skin in the game and it isn’t just us who gets screwed if the company goes under. That means actions taken by management is more likely than not to actually be beneficial if not aligned with retail shareholder interests. I’m not likely to sink the ship my shareholders are on if I’m on it too. This is proven well in the yields segment.
Yields
To date, whenever possible and whenever it can be done, the company has chosen to return cash to its shareholders. Why? Because management also owns shares. That’s why. Further, I see the slashed dividends as a bonus – dividends have to be sustained by free cash flow. If it is not, then the company’s value over time will shrink. Think about it like spending from your bank more than you save every month; you go broke sooner or later. And we don’t want the company going broke, so a sensible dividend policy is best.
A margin of safety
How wrong can I be when I purchase a company for $0.30 on the dollar and they start retuning me yields every year? How wrong can I be when management owns 63.1% of shares on the market?
The answer is very wrong.
That’s why it’s important to have a margin of safety.
In this case, my margin of safety is a 184% potential upside as implied by its discount to Net Asset Value. I don’t need all 184% of it for the company to have been a good investment. I just need a fraction of it combined with the yields over three years (my holding period) to make it good. In this case, management has already returned 13.3% yields this year. The company is literally paying you to own shares with a solid opportunity for upside gains.
Low Debt at 15% Debt to Equity
This is the next part I’m reasonably happy to see. A solid business requires capital. But mismanagement of debt is how companies like Hyflux exploded so spectacularly. And we are keen to avoid such companies as we are to avoid the bubonic plague. At 15% debt to equity and at a current ratio of 2.46, along with 3 years of positive free cash flow, this assures me that the company will not be uselessly throwing money at a losing venture and destroying capital. Also, a company with minimal debt will have minimal exposure to shocks in the interest rates when the Feds inevitably run out of QE bullets and interest rates adjust upwards.
Caveat Emptor. DYODD.
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