Character Group PLC: What’s not to like?

If I had to list five things I like about the Character Group PLC, the London AIM listed small cap, they would be:

• simple unchanging business;
• business with a strong competitive advantage, demonstrated by consistently high returns earned on invested capital;
• highly cash generative;
• strong balance sheet supported by healthy cash balance and real estate; and,
• a management team with significant skin in the game and a solid track record.

Add to the above the 4.2% dividend yield and 12% free cash flow yield implied by the current share price, and you have a stock with significant value. I believe that the recent fall in share price - ~14% fall over a year – owing mainly to fall in international sales resulting from Toys R US’s bankruptcy is a temporary blip and offers a good opportunity to buy.

The business

CCT is the largest independent toy company in the UK. It designs and manufactures toys and games, mostly under licence and based on popular television, film and digital characters. It also partners on an exclusive basis with other overseas based toy producers to market and distribute their product in the UK. Its customers include the major UK toy retailers, UK Independent toy stores and a wide selection of overseas distributers.

With an impressive portfolio of tried and tested winners in Peppa Pig, Little Live Pets, Stretch, Mashems and Teletubbies and an eye catching list of new comers which include the Pokémon products to be launched in summer 2018 and two new award winning toys in Stretch Armstrong and Laser X, CCT’s immediate customers should have no difficulty in grabbing the attention of their immediate customer base: the Pre-school child. There is no doubting the fact that the contents of many a parent’s wallet will continue to flow smoothly, ultimately to CCT (most parents with pre-school kids will attest to the fact that Peppa Pig is the dictator who rules childhood).

CCT’s management appear extremely enthused with their product line, calling it the best ever in the company’s history. I believe their optimism is justified; the second half of 2018 and onwards augurs well for sales growth, profitability and free cash flow.

Consistently high returns on average equity

For a business with no long-term debt or liability, return on equity is a good measure of quality of operations. One can do all kinds of qualitative analysis to gauge a business’s competitive advantage, but numbers speak lounder than words. If a business has consistently earned high returns on capital, it has an edge. CCT’s competitive advantage becomes apparent when you look at the consistently high return on average equity the business has generated.

Bar a couple of bad years, the business has consistently generated superior return on average capital, generating an average spread over my expected cost of capital of 41% over the past 11 years. This is no mean feat and would not be possible without an edge in my opinion.

Highly cash generative

A businesses cash generating capacity is the single most important yardstick in judging its value. The returns on equity and earnings matter very little if there is no free cash flow backing it. Earnings are a matter of opinion, but cash is a matter of fact, and CCT definitely packs a punch by this measure. It is a business that is highly cash generative, including in down years for earnings. Add to the free cash flow CCT’s track record of consistently buying back shares and paying a dividend, and you have winning combination.

Strong balance sheet

The cash generative nature of the business combined with no long-term liabilities and owned real estate assets means that CCT has a strong balance sheet. CCT’s net cash balance of ~£12m and £5.2m book value of owned real estate equates to £0.82 a share or ~19% of the current share price. Based on current share price of £4.75, this implies a per share value for the operating business of £3.75 equating to a free cash flow yield of 14%.  

Management with skin the game and a solid track record

CCT’s directors own ~22.6% of the company, with its two joint managing directors alone holding 16.6% of the shares. These are individuals with a long track record with the business, with the two joint managing directors having been with the business since inception. The board is by far the biggest shareholder in the company and has significant skin in the game. These are individuals who know the business very well, have deep relationships in the industry and have consistently generated shareholder value.

CCT has generated a total return of 333% over 10 years and an annual return of 13% over the same period. This compares to the total return during the same period of 1.18% for the AIM as a whole. During this period, it has reduced its share count by ~47% through buybacks, using a total of £38m of its free cash flow to buy back its shares. This has had a positive net effect on the earnings and cash flow yield for its shareholders. There is no reason to suggest this track record cannot continue.                                                                                                                                                           

A company generating 13% per annum over 10 years for its shareholders is doing well.

Valuation

At a cash flow yield of 12% (14% FCF yield accounting for net cash and real estate on balance sheet), a price to earnings ratio of 9x and a dividend yield of 4.2%, CCT is a compelling value opportunity. The recent share price dip due to overseas sales fall, owing mainly to the Toys R US bankruptcy, offers a great buying opportunity. Add to this the best ever portfolio of toys in the company’s history, management’s optimism for future trading and solid track record over a very long period, the odds should be in favour for a long-term buy and hold strategy.