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Is it all FUN and Games?

Is it all FUN and Games?

The following article was contributed by Harley, and gives a very detailed account of Funtastic as a possible turnaround story. If you have the skill to identify them, turnarounds can be very profitable investments, although its not an area of focus for us at Montgomery Investment Management. In 2006, Funtastic fell to a B5 on our quality and performance ratings, and since that time has been outside the range that we would normally consider “investment grade”.  However, as Harley points out, Funtastic may enjoy better times ahead if its portfolio of toys appears on enough Christmas shopping lists.

Funtastic is in the business of fun. As a leading toy distributor with domestic and international operations, as well an entertainment arm, Funtastic (ASX:FUN) make money by selling products that make us happy. The question is, would an investment in Funtastic at today’s prices set us up for pleasant future returns or is this one turnaround story that is worth avoiding?

History

Founded in 1994 and listed in 2000 Funtastic experienced tremendous growth as one of Australia’s leading toy distributors in the early to mid 2000’s. The strategy of racking up debt to acquire numerous businesses and licences to well known toy brands, accompanied with the bullish tendencies of the times, saw investors flock to Funtastic’s alluring growth potential and the share price soar to levels just below $3 in 2004.

In 2006 the tide began to turn for Funtastic, which unsurprisingly coincided with the start of the credit crunch. As Australian families experienced significant financial strain Funtastic’s high levels of debt meant the company had little room to move as global demand began to slow. If there was ever a company that was entirely designed for the easy credit years of pre-2006, it was Funtastic.

The response to the hardships that began in 2006 saw the beginning of the company’s quest to reduce their cost base. In what is now a well known and heavily reported error in judgment Funtastic entered into a 20 year exclusive global supply agreement with ABC Learning Centres. It seemed a good plan – ABC had over 1000 childcare centres across the globe and on paper it represented the securing of a significant long term customer. But when ABC Learning went under Funtastic shareholders did not come away unscathed. The event marked the beginning of what would become a string of enormous losses as a result of write downs and poor performance.

The question as to whether or not management should be held accountable for the failures of the company and the significant losses to shareholders is open to debate. Some may argue that managements oversight as to the financial position of ABC is unacceptable and further due diligence should have been conducted before a contract of such significance should have even been considered. The overreaching of management in regards to their acquisition of licences and businesses has attracted a significant amount of negative attention, and perhaps rightly so. I will let you come to your own conclusions as to what portion of responsibility management should assume regarding the pain experienced by Funtastic investors as the GFC hit, but what is not debatable is the fact that with sky high debt levels, substantial investment-related cash out flows, high levels of intangible assets and a reliance on discretionary spending, the company was not exactly crisis proof.

If there was anything positive to come out of the troubled years for Funtastic it was the performance of Stewart Downs who led the Toys and Sporting Division in 2007 and his subsequent promotion to CEO in 2008. Downs, who was formerly the GM Asia for Mattel – the world’s largest toy company – comes into this story a little later.

Funtastic did survive the GFC, although not without damage, and virtually since that point onwards talk of a turnaround story has been frequented in the media. But turnaround stories inevitably take longer than expected, if they occur at all, and Funtastic was no exception. In 2009 the company registered a $58m loss and another $38m loss in the year ended 31st July 2011 (the company made an adjustment to their reporting calendar). The continued losses and significant debt being held on the balance sheet meant the possibility of business failure became a real possibility, pushing the share price down to a low of just 2.7c amidst the doom and gloom of late last year. As we sit here today we can comfortably say, in hindsight at least that the market overreacted, as Funtastic survived yet another scare and the share price rebounded to over 20c after the market recognised its mistake.

Which brings us to today. While a turnaround story is nice to read about what you no doubt want to know is if an investment opportunity exists going forward. Has this company, after  falling from lofty heights as a market darling to a company presumed financially bereft of life, been able to stake a claim as a true turnaround story of the Australian stock market? And, more importantly, does it now represent an investment opportunity for savvy value investors? Let’s find out.

The New Strategy

Since 2009, and under the leadership of the new CEO Stewart Downs, Funtastic have decided to adopt a more concentrated approach to its product portfolio and business process. This strategy involves choosing only those brands that management have a high degree of confidence in for the future, with their view usually supported by the experience of that product in other countries. Take Pillow Pets for example. The product was a smash hit in the US and Funtastic now own the worldwide intellectual property rights (outside North America, China and Hong Kong) and hope its past success in the US market is paralleled by its performance in Australia, New Zealand and Europe.

The company has also undergone a dramatic divestment process, offloading a number of businesses and deciding to focus on organic growth over growth by acquisition. According to the company they have reduced total divisions from 22 to 3, sold 5 businesses and closed another, reduced headcount by 59%, suppliers by 61% and warehouse space by 72%.

The change in strategy for Funtastic is akin to a ‘traditional’ investor switching over to become a value investor. The initial strategy involved acquiring a large number of assets, many of which are of questionable quality, all in the name of diversification and top line growth. The idea was that if one product performed badly, the average performance of the range of other products would ensure disaster was avoided. In contrast the new strategy involves investing only in brands with a proven track record of strong financial performance and a clear competitive advantage – ideally one with raving customers who have a strong connection to the brand – and ensuring one pays a price that will allow a sufficient return to be generated. In this sense, Funtastic have swapped their portfolio of numerous B3’s, B4’s and B5’s for what they believe is a more concentrated portfolio of A1’s.

The most significant factor in Funtastic’s turnaround story was their recent capital raising. As you will see from reading what follows Funtastic have a number of fundamental strengths working for them and the potential for future earnings growth is certainly in place. But prior to the capital raising the company was saddled with too much debt. Their senior lender, NAB, prevented them from paying dividends to shareholders until August 2013 and imposed a number of requirements regarding timing of repayments of borrowed funds. This put pressure on the company’s cost of capital (weighted average around 19% as of last year’s annual report) and meant funding for growth and/or shareholder returns was limited.

But in June of this year the company announced a non-renounceable entitlement offer to raise $24.6m, of which $15m will be used to pay down debt. This is in addition to further debt repayments of $10m by July 2013 to be funded by operating cash flows. Under normal circumstances a company raising money to pay down debt is not something investors would deem as a positive. But for Funtastic it is simply a necessary evil in order to complete the turnaround story. It means that the potential growth in the pipeline that management have worked hard to create can flow through to shareholder returns, further supported by management now forecasting a dividend in FY13 of around 50% of EPS. Ironically it is also this capital raising that may present an opportunity for new shareholders to benefit from the company’s completion of the turnaround story.

What’s Cool Today? Understanding The Business Model

Funtastic are essentially in the business of predicting what toys and accessories will be popular amongst kids. The company acquires the licences to manufacture and/or distribute popular brand name toys both in Australia and across the world, depending on the specific agreement for each product. Hence, unless Funtastic develops brands in-house, much of its growth is – by definition – growth by acqusition, resulting in a significant balance of intangible and other assets sitting on the balance sheet, which we look at in more detail in a moment.

It is true that, like any manufacturer/distributor, Funtastic’s success relies on effective inventory management, cost control, relationships with customers and the ability to enter into licencing agreements that generate a great return on the cost of acquisition. But in the end what decides this company’s fate is their ability to predict what toys and games will be a success. In essence, Funtastic are in the business of deciding what kids think is cool.

The high fixed cost nature of this business means that it only takes one product to strike big for the company to post tremendous results. If the majority of their brands have mediocre years but Pillow Pets, Power Rangers or any of their other household name brands turn out to be the toy of the year then it is likely that Funtastic will do very well. And if a couple of their brands really hit the big time then the operating leverage present in the business means the potential for rapid earnings growth, particularly around Christmas, is always a possibility.

But high operating leverage works both ways. Just as stellar earnings can seemingly appear out of nowhere, so too can sudden losses if products flop or kids tastes for what is cool does not align with the predictions made by management. A good example of this is the third quarter results released on the 1st of May this year. Funtastic registered revenue of $37m for a net profit of just $0.4m. But management have forecast fourth quarter revenues to be $49m and net profit over the two quarters to reach $4.5m. All else equal the company will only break even at $37m revenue, but with a further $12m will see $4.5m of that drop down to the bottom line. From this example it becomes clear that a top selling product can translate to massive earnings growth, while a couple of flops could result in surprise losses for shareholders. Clearly the company’s fate is determined by their ability to choose the next big thing amongst perhaps the pickiest consumers going around – kids. (Note: the $400k profit in the third quarter of FY12, while it appears low on face value, is actually a strong performance for the company given the seasonal aspect of earnings and the fact that the company usually registers a loss during that period. Rather it is used as an example to highlight the operating leverage present in the business model).

Trends in Toys

Since any investment in Funtastic would be made based on a view of the future it is worth examining what the future may look like for the industry in which this company operates. There are a number of key trends occurring in this industry, far more than can be included in this report. Nevertheless let’s take a brief look at some of the main trends for toys.

Kids Are Gamers

I was recently chatting to a mother of two young daughters and decided to ask her about her views on some of Funtastic’s products. She quickly replied “Kids are gamers” and explained her view that the transition from physical toys to virtual toys is a powerful and ongoing process. This is undeniably true and is seen in the growing popularity of products like Nintendo Wii, Playstation 3, online games, and the rapidly growing market for gaming applications on smartphones. She added that of those toys from the Funtastic line the early learning toy Leap Frog and Pillow Pets stand out but that she generally looks elsewhere for her daughters.

While the idea of kids continually moving towards electronic games and away from physical toys certainly holds merit this view needs to be taken in context. Firstly, the views of my ‘trends-in-toys’ source are guided by the fact that she has two daughters. Many of Funtastic’s products are targeted at young boys and, in general, boys are more likely to want a physical toy or action figure they can hold, bend, break and throw around. As such while the growth of virtual toys over physical toys will continue to occur it is unlikely that the market will be revolutionised to the extent that stores no longer stock aisles of Ben 10 figurines, Power Rangers dolls and Pillow Pet plush toys. Secondly, despite my source only being a fan of two of Funtastic’s products the fact is that the combination of Leap Frog and Pillow Pets will likely form the majority of Funtastic’s revenue over the next year, which stands as yet more evidence of how a few hugely successful products can make or break Funtastic’s performance.

Generics

In the face of declining retail sales the big retailers are likely to continue to seek cost reduction strategies and ways to maintain or increase their margins. One of these methods has been the introduction of generic toys. Funtastic has already seen the impact of one of their major customers going generic so this is certainly something to keep an eye on.

While certain toys are at risk of being replaced by generics, the newer, more concentrated portfolio of Funtastic helps to negate this risk to a large degree. The company is focused solely on household brands and products with strong followings. No-brand action figures and soft toys can be replaced but licensed, well known brands cannot. After all there is only one Ben 10, one Buzz Lightyear and one red Power Ranger.  Want proof? Try promising your child the latest Power Ranger figurine only to surprise him with Target’s in-house generic range of freedom fighters, and observe his reaction. My guess is it won’t be pretty. The more Funtastic continues to focus on well known brands the more they reduce their risk of loss should customers choose to go generic.

Online Shopping – Bypass the Distributor

Funtastic sell their product to retail stores who then resell it on to the consumer. Rather than deal directly with end-customers the big international toy brands sell the license to distribute their product in Australia (and elsewhere) to companies like Funtastic, who then go about marketing and distributing the product themselves. But with the growth of online shopping it becomes possible for a consumer to buy direct from the supplier effectively bypassing the traditional supply chain.

The nature of Funtastic’s distribution agreements means that Funtastic are, in most cases, the exclusive distributor. In other words if you buy a Pillow Pet at any store in Australia you can be sure that Funtastic distributed it. Therefore this risk is not material for products that Funtastic already have the license for – after all CJ Products, the owner of Pillow Pets, would not be wise to push the sale of their product through their website over the sale through distribution by Funtastic, and the price online is virtually the same as in store (and higher when including postage). Where some small amount of risk exists is in Funtastic’s ability to secure future distribution rights for new products, where the owner may see value in bypassing a distributor. While I personally see the risk as minimal it is something to be aware of.

The price point for many of Funtastic’s goods is such that impulse buying is a frequent occurrence. And if there are any consumers out there more impulsive than children I am yet to meet or hear about them. So long as parents continue to walk through the toy aisle with their children, impulse buying of toys and confectionery will continue.

But this may not be the case for some of the higher margin, more expensive products in the Funtastic range. In these situations it is likely that parents will practice the classic “Maybe Santa will buy it for you if you are a good boy/girl” before finding the best possible price.

If you do not have kids or haven’t had to buy toys in years I would recommend taking a quick glance at the prices of some of the toys available today. In the process of doing my own research (and reliving my childhood) I was quite surprised to see how expensive some of the toys are, particularly when I also have a general idea of their cost of production. Certainly consumers have reason to seek the best possible price for these higher priced goods and if online presents such an opportunity then that is likely the option they will take.

MadMan Entertainment

Madman is Australia’s leading independent theatrical, home entertainment distribution and rights management company, specialising in the wholesale distribution of DVD and Blu Ray product into sales channels throughout Australia and New Zealand. Funtastic acquired MadMan Entertainment in 2006 and the original founders continue to manage the business to this day. In addition to controlling 93% of the Australian anime market (as of 2009) Madman have a diverse range of programs from a variety of genres including children’s shows, sport, comedy, documentaries and feature films. A quick glance at their website will help you become accustomed with the range on offer from Madman.

In the latest half yearly report Madman contributed $27m to Funtastic’s revenues, which was down around 7% from the following year. The threats to the Madman business model are the many technological headwinds facing the company and the industry it is operating within. The potential exists, however, for smart management to position the company as a leader in the industry as it undergoes rapid change and to turn the current headwinds into tailwinds.

The two most significant threats to Madman’s business model are the rampant growth of online piracy and the fading significance of DVDs, both of which are strongly interrelated. Today online audiences can download virtually any content they please at the click of a button and at no expense, while those who would have benefitted from a traditional purchase process receive no financial benefit. We saw what it did to the music industry and as internet speeds continue to increase and unlimited download plans become more widely available we will no doubt see a comparable transformation in the film and DVD markets. Unfortunately for Madman the market where they possess the most significant market share, anime, is also one whose target audience is typically young and tech savvy, which means that a significant portion of the anime viewed by Australians is done so online and through illegal means.

There are signs that the authorities are willing to crack down on online piracy, the most recent example being the shutdown of ‘MegaUpload’ – an extremely popular online streaming site where all manner of content was available for free. But what happened when the site was shutdown by authorities? Many more popped up and consumers wasted little time to find their next favourite website for online pirated content. The question of whether or not the authorities can win this battle remains unanswered. My personal experience from communication with those who work in related industries and whose job it is to stay one step ahead is that online piracy is an unstoppable juggernaut that will only increase in velocity. In their view any business reliant on authorities putting an end to online piracy should brace for what is coming.

Even if the views of my knowledgeable contacts are entirely accurate it does not mean that companies like Madman cannot make money or continue to grow in this environment. One need only look at the music industry to see the opportunities present for companies willing to think outside the box and embrace the new trends. Faced with revenues that were falling off a cliff as a result of online sharing sites like Napster the music industry wholly embraced Apple and its solution, which today has sparked a mini-revival in online music sales. Without doubt many billions of dollars continue to be lost every year as consumers download music illegally or stream it online but without Apple’s iTunes store the current figure for music sales would likely be substantially lower.

The same opportunity is present today in the downloading and streaming of video, and the media giants of the world are well aware of it. This year Google announced plans to join Telstra, Sony, Microsoft and Apple in the Australian on-demand movie rental market. If you are a subscriber to Foxtel you will have noticed the ability to stream movies from your living room and the same can be said for owners of iPhones, iPads and new Samsung and Panasonic TV’s. These companies know that the future is in online streaming, straight from the cloud, and the race is on to secure control over a potentially lucrative market. While the medium term future may not be so bright for your local Video Ezy (which, ironically, is very likely to be a Madman customer) Madman still has an opportunity to transform their business model and benefit from the technological trends that look certain to unfold in the years to come.

Funtastic have made it clear that a significant transformation is needed for Madman, what they term a ‘digitilisation.’ One step in this process was announced recently with Madman Digital establishing itself as an official aggregator of content for iTunes, meaning it “will now offer management and distribution services to third party producers and entities seeking to place their content on iTunes.” In simple terms it means if you are an artist who wants to sell your content online through iTunes, Madman is able to provide all of the services required to get your product to its target audience. This does represent somewhat of a barrier to entry since as of this writing Apple have allowed only four official music aggregators and three official movie aggregators for Australia and the Asia Pacific market (last updated in April and January of this year, respectively). While significant it represents only the initial steps towards competing in the digital age and much more will need to be done as the transition progresses.

The issue is that with online downloads the owner of the content does not need a physical distributor in order to get its content to its audience. If for example HBO wanted to get its smash-hit ‘Game of Thrones’ into DVD players across Australia then they would need a wholesale distributor like Madman to help them get it into stores where, hopefully, the consumer would come along and pick up a copy. But today, and given that the target audience of ‘Game of Thrones’ is likely to be relatively tech savvy, all HBO need do is make the content available on iTunes where a consumer can download and watch it all from the comfort of their own home. Madman, realising that they may be cut out as the middle man in the traditional distribution process, are looking to take on the role of a Home Box Office Inc or Viacom Entertainment as a content aggregator, responsible for getting the content produced and made available on iTunes. Their fate, as a result, depends on their ability both to deliver quality service to their artists, as well as to find the next big hit amongst TV watchers and online streamers alike.

Time To Think Like A Kid

As mentioned earlier the company’s success depends on whether or not children will take to their products and brands. As an investor you need to be confident not only in management but in the products being sold by the company. For those of you with young children or grandchildren this should be easy. But for those without kids consider it an excuse to think like a kid again, all in the name of work. Funtastic currently have more than 20 brands in their product portfolio so investors will need to look at each and every one of them and determine whether they believe they will increase or hinder the company’s performance. But remember that the majority of Funtastic’s revenue will likely come from a handful of products, so picking the next big thing is more effective than forming a view of each and every toy the company sells. With that said, let’s take a brief look at some of the new and best selling brands in the Funtastic portfolio.

Pillow Pets

Pillow Pets, a soft plush toy that doubles as a pillow, has been a smash hit in all markets it has entered. From October to December of 2010 it was the number one plush toy in the US and number nine amongst toys overall, racking up sales of $150m in December of that year alone. In Australia the success has so far continued with 500,000 units sold from August to December last year. Now, CJ Products is looking to take Pillow Pets truly international with Funtastic enlisted to play a vital role in the process after the company secured the worldwide intellectual property rights (excluding North America and China). There is significant growth potential for Pillow Pets and Funtastic is positioned to benefit strongly from the success with numerous partnership and licensing arrangements being announced recently with well known brands and associations including Thomas the Tank Engine, Hello Kitty, English Premier League and the Australian Football League. The international pillow pets expansion means Funtastic has the opportunity to start generating a more substantial proportion of revenue outside of Australia and, in my view, is an incredibly important part of any investment thesis in favour of investing in Funtastic.

Toy Story, Power Rangers, Ben 10 and Others

This range of figurines includes characters of well known films, cartoons or TV programs. Do be aware that Funtastic only hold the distribution rights to certain varieties of these products, not all products associated with the brand name. The upside here is that less marketing is required for these products and that which is needed is easily targeted – airing advertisements in between the actual programs on television. Every time Ben 10 comes on TV Funtastic receives a little more marketing for their products and the same can be said for Power Rangers, Toy Story, Disney shows and others from the range of well known children’s programs.

Leap Frog

A range of educational toys and electronic games, Leap Frog has been a bestseller in the Funtastic portfolio in the recent past. Leapfrog products are designed for infants all the way up to children of 9 years of age. While the product has been around for a while it seems to remain popular amongst parents and children alike.

Movies, TV Shows and Other DVDs

While my own long term view for the sale of DVDs is quite bearish the truth is that MadMan Entertainment are still doing strong sales and will likely do so for some time (while the growth potential seems minimal sans a successful digitilisation process the fact remains that DVD sales in JB Hi-Fi and the like will continue, and Madman seem to be growing their own online store for DVDs with 22k+ Facebook ‘likes’). DVDs from the SBS range of shows was a top performer for Funtastic over recent quarters and there are no obvious signs that this should slow down materially in the near future. Again, it is worth checking out the MadMan site in order to see what you think of their range and the potential for those markets today and in the future.

Nuttfles and Rio Mints

The newest introductions into the Funtastic confectionery portfolio, Nuttfles are American owned while Rio Mints are owned by a Swiss company. From my perspective both these products have great potential in the Australian market and is a good sign of managements renewed focus on quality over quantity when it comes to securing distribution agreements. But again, that is only my opinion. I guess you will have to pick up an almond truffle coated with Belgian chocolate and a packet of sweet mango sugar free gum in order to form your own view!

Management and Significant Investors

Funtastic have some well known businessmen associated with the company, both in management and as investors. And while the recent performance of Fairfax and Channel Ten seem to suggest that following the investing process of the mega rich is not exactly advisable, it is worth having a general idea of who is rowing your boat and with whom you are sharing the cabin.

Stewart Downs, who was appointed CEO in 2008 is largely credited with directing the turnaround of the company, something he is well known for achieving during his time with other companies. Having worked as GM Asia for Mattel he certainly has experience working with the big manufacturers, distributors, marketers and retailers of this industry and is credited with his divisions success while at the firm. Shareholders in Funtastic hope he can utilise some of this experience to right the ship once and for all and set Funtastic on the course for long term shareholder returns. He currently owns around 1m shares.

Craig Mathieson, nephew of pub-king Bruce Mathieson, is a non-executive director and significant shareholder, with his stake currently around 20% of the company. He has been a financial supporter throughout the tough times and has been consistently buying shares in the company for some time now. Mathieson chose to participate in the recent entitlement offer.

Nir Pizmony has built two successful toy businesses, both of which he sold to Funtastic, and is on the board of the company. He was first appointed as an executive director in 2002 when he sold JNH to Funtastic for $30m. He left the board in 2004 only to return in 2009 with the acquisition of another of his companies, NSR Toys, for $7m. Pizmony participated in the entitlement offer, bringing his holding to 30m shares, or around 5% of the company.

Lachlan Murdoch, son of media tycoon Rupert, owns shares in Funtastic through his investment fund, Antium. As of last notice his fund held 50m shares in Funtastic. He has held these shares since 2008 and paid from 14-15c for his shares. All indications point to this being a passive investment for Murdoch.

Financials

NPAT for FY12 will come in around $10.4m, or EPS of 1.92c. The significant improvement in earnings is the result of the reduction in costs and the newly focused approach finally bringing benefits to the bottom line. This financial year management expect EBITDA growth of almost 20% which if we extrapolate to NPAT growth (admittedly risky) we can expect around $12.4m in NPAT, or EPS of 2.29c and 50% to be paid as a fully franked dividend. For this to occur sales would only need to increase by 5-8%, the majority of which will be generated by annualised returns from the range of new products in the Funtastic portfolio that are already recording strong performance. Management are expecting no improvement in retailing conditions when they make these forecasts and appear careful to emphasise conservatism. My personal opinion is that a couple of the new products in the Funtastic range will at the very least go close to beating those forecasts, driven primarily by the performance of Pillow Pets. I should emphasise that this is entirely my own opinion and you may agree or disagree with my point of view.

Equity per share at the end of FY12 should come in at about 13.5c, rising to 15.7c in FY13. Debt to equity levels are still high at this stage but are under control and should consistently fall as the company progresses. The rate of debt reduction should start to accelerate with the capital raising and improved cash flows which will flow through to reduced funding costs and better margins.

When calculating returns on equity it is wise to do so on the basis of returns generated from this point onwards. Funtastic is an entirely different business to the one that existed just a few years ago and the accumulated losses that still stand on the balance sheet from the tough years warp any calculation that uses them to determine returns in the future. The high levels of debt also artificially raised returns on equity but with debt now returning to more sustainable levels a more accurate reflection of the profitablity of the company can be gathered. The issue that remains is that a large portion of the equity raised recently as well as a significant slice of operating cash flows will be used to pay down debt, which pushes down the returns until the point where debt levels are manageable and excess cash can be reinvested in more profitable ventures. I would argue that this masks the potential profitability of this company but that provided cash flows come in at or greater than expectations over the next year then shareholders will be rewarded in time as the potential profitability becomes realised profitability, returns on equity start rising and the balance sheet starts to look a lot stronger.

An Opportunity?

The recent entitlement offer was conducted at 14.5c and, unsurprisingly, the share price has been hovering around that level ever since. The retail offer closed on 25 July and while there is no guarantee that the price will stay around these levels for long, for the benefit of this demonstration we will use that price in our calculations. The question then is, does 14.5c represent an opportunity for future investors in Funtastic?

Using the figures from earlier at 14.5c Funtastic is trading on a multiple of 7.5 times last year’s earnings and a PE of just 6.3 for FY13. This is of course dependent on forecasts being met but since earnings are weighted heavily to the December quarter we won’t have to wait long to find out if this is the case. Management expect to pay a dividend equal to 50% of earnings in FY13, which should equate to a dividend yield of 7.9%.

While these metrics are indeed attractive it is vital that you look beyond simple measures like price multiples and dividend yields. What do you think of the company and it’s prospects? Will products like Leap Frog and the international expansion of Pillow Pets drive sales and earnings over and above management’s expectations or will sales fall short of guidance? Will MadMan be successful in its digitilisation process or is it doomed to be a relic of old technology? Does Funtastic have the potential to earn returns on equity of 20% and above or will its historically high debt levels remain a financial deadweight well into the future? Hopefully this report, which I believe highlights both the positives and negatives for the company in equal light, helps you to answer those questions, but at the end of the day you need to form your own opinion as to the worthiness of Funtastic as an investment opportunity.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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2 Comments

  1. Very good and interesting post Harley.

    I see some parallels between the business mdoel for Funtastic and one of my overseas watchlist companies Disney. They are both in the business of needing to try and work out what their target market will like in the future (Funtastic=toys, disney=movies, rides etc). Predicitng fashion and trends especially for a demographic that can change its mind rapidly is an extremley tough thing to do.

    The fact that they are reducing their exposure to only those that have significant brand equity behind them seems like quite a good strategy. Just like all things that fit into the fads and fashion world, the more others like it the more likely more people will want it and if it comes with a brand attached that means there is already a market than it is even bigger to get that happening. I guess you could say that toys have an element of it being a “network” good.

    The network leverage acts the same as financial leverage in that the good becomes more valuable as others like it as if you want to play toys with your friends you need to have the same toys as them but if a toy doesn’t take then it can be an absolute failure as who wants to be the one kid in the sandbox trying to play with ‘Tickle me Warren’ (creepy thought i know) when everyone else is playing with “Fireball shooting Charlie”.

    The issue will be as you have mentioned that they need to predict what will be popular and fads and fashion change, technology increases allowing for new entertainment options etc. The key will be how they deal with this, but it is an interesting business to look at as its business is very different to most others on the ASX such as mining and banking and looks into these types of companies allow us to learn more.

    • Hi Andrew,

      I agree with your comments. Your point about the network effect in toys is also interesting.

      Yes, the key to the business model is certainly picking a handful of toys or brands that will shoot the lights out. But even the most popular of toys are only popular for a certain period of time. I believe Pillow Pets will perform well this and next with the product pipeline they have and the licences with some big brands in sport and entertainment. But beyond that time frame I do not know what toys will be popular or what licences FUN will purchase, which makes me believe FUN is the kind of company you would be best to purchase when cheap and get out at a fair price, rather than hold long term – unless of course you had a lot of faith in management’s ability.

      Harley

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