JAKK

JAKKS PACIFIC INC - 10-Q Summary (Quarter Ended September 30, 2006)

Business Context and Reporting Period

This report covers the quarterly period ended September 30, 2006. JAKKS Pacific, Inc. is a worldwide producer and marketer of children's toys, pet products, and related items. The company operates through three reportable segments: North America Toys, Pet Products, and International. The period includes the impact of the February 2006 acquisition of Creative Designs, a leading designer of dress-up and role-play toys.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 26.7% year-over-year for the quarter ($295.8M vs. $233.5M) and 6.4% for the nine-month period ($527.1M vs. $495.3M). The quarterly increase was driven by the Creative Designs acquisition and growth in traditional toys (WWE figures, dolls) and seasonal products.
• Profitability: While Net Income increased 23.7% for the quarter ($40.5M vs. $32.8M), it decreased 9.7% for the nine-month period ($49.2M vs. $54.5M). Operating income for the nine months declined due to higher selling, general, and administrative (SG&A) expenses.
• Expense Increases: SG&A expenses rose to $54.7M for the quarter (18.5% of sales) and $136.9M for the nine months (26.0% of sales). Increases were attributed to Creative Designs overhead, product development, amortization of intangibles, and share-based compensation.
• Cash Flow: Net cash provided by operating activities dropped significantly to $7.5M for the nine months ended Sep 30, 2006, compared to $55.8M in the prior year, primarily due to increased working capital needs (accounts receivable and inventory). Investing activities used $117.7M, largely due to the $101.7M cash payment for the Creative Designs acquisition.

Guidance, Outlook, Risks, and Contingencies

• Legal Proceedings: The company is involved in significant litigation with WWE regarding toy and video game licenses. WWE has filed lawsuits alleging breaches of contract and seeking termination of licenses. The company believes these claims are without merit but notes the outcome is uncertain. Additionally, shareholder class action and derivative suits remain pending.
• Joint Venture Arbitration: The preferred return rate for the THQ video game joint venture is subject to arbitration for the period beginning July 1, 2006. An estimate of $0.4 million was accrued for the quarter pending the outcome.
• Seasonality: The toy industry is highly seasonal, with sales peaking in the third and fourth quarters. Management notes that interim results may not be indicative of full-year performance.
• Customer Concentration: The three largest customers (Wal-Mart, Toys 'R' Us, Target) accounted for 54.6% of net sales for the nine months ended September 30, 2006. Loss of a major customer could materially impact operations.
• Acquisition Integration: The company is integrating Creative Designs and managing earn-out obligations totaling up to $20.0 million for Creative Designs and $25.0 million for the Pet Pal acquisition.

Investor Verification Checklist

• WWE Litigation Status: Verify the current status of the WWE lawsuits and the potential impact on the company's primary revenue-generating licenses.
• THQ Joint Venture Terms: Monitor the outcome of the arbitration regarding the preferred return rate for the video game joint venture.
• Creative Designs Performance: Assess whether the acquired Creative Designs business is meeting the financial performance criteria required to trigger the $20 million earn-out.
• Working Capital Trends: Review the trend in accounts receivable and inventory levels to ensure cash flow from operations stabilizes in the upcoming quarters.
• Convertible Notes: Note the $98 million in 4.625% Convertible Senior Notes due in 2023, which may be repurchased by holders in 2010, 2013, or 2018.