SIF Folio: amp;ldquo;Confidentamp;rdquo; Character Group is back in the game

With Christmas approaching fast, now seems like a good opportunity take a closer look at a company whose profits depend heavily on festive trading.

Toy manufacturer Character Group has had a tough year, thanks to the bankruptcy of top customer Toys ‘R Us last October. But the company’s year-end trading statement in September made it clear that it’s back in the game. Management expect results for the year to 31 August to “comfortably reach market expectations”. That sounds to me like a modest earnings beat is possible when the firm reports at the end of November.

The right time to buy?

You can read Graham Neary’s thoughts on September’s trading update here.

What interests me today is that this £106m firm is also back in my Stock in Focus screen, making it a potential buy for the SIF Fantasy Fund. This is a business that’s always tempted me, thanks to high returns on capital and strong free cash flow.

At the same time, it’s not a stock for which I’d want to overpay. The main reason for this is that the business doesn’t own much in the way of brands or tangible assets. Popular toy ranges such as Peppa Pig are all produced under licence. So the firm is dependent upon its reputation and commercial success to keep winning new contracts.

I’m not too concerned about the near-term outlook. The company has already said that “strong demand from our customers” makes it “confident of the prospects for the autumn/winter trading period”.

What interests me more is the stock’s valuation. The shares have four-bagged since July 2013. But most of these gains came during an explosive re-rating that took place from November 2014 to August 2015. Since then, the share price has basically flatlined:

I’d argue that the chart could support another leg up from this level. But to form a more informed view, I think we need to drill down into the group’s quality, value and momentum scores.

Spread: Sharp-eyed readers may notice that Character doesn’t actually appear in the results of the SIF screen. The reason for this is the stock’s spread, which is perilously close to my maximum limit of 4%:

I’m guessing this figure is being rounded up to 4% by the Stocko screening system, and then excluded from my screening results.

For what it’s worth, both of the online brokers I use quoted 504p to buy CCT at the time of writing, well inside the published spread of 490p – 510p. As always with small caps, dealing in size may require a little extra finesse and patience in order to secure the best possible price.

Understated value?

Stockopedia’s algorithms seem to like Character, awarding it a StockRank of 82. By far the weakest component of this score is the ValueRank, at just 42:

The good news is that I think the company’s value credentials may be stronger than this score suggests. Let’s take a closer look at the breakdown of the ValueRank:

P/E: Starting at the top, the stock’s trailing price/earnings ratio of 21.1 appears pricey. But a look at the firm’s half-year accounts reveals that Stockopedia’s computers have used the statutory earnings per share figure of 2p per share for H1, rather than the underlying figure of 16.6p.

The main adjusting item in this case is a £3.9m non-cash ‘mark-to-market’ loss on foreign exchange derivatives. These are used to hedge the company’s exposure to the US dollar, which is used for much of its purchasing.

I’m prepared to accept this adjustment as it relates to a single spot rate on the balance sheet date. I share the company’s view that this isn’t a representative view of underlying profit or cash flow.

Using the adjusted H1 earnings figure of c.16p gives trailing 12-month earnings of about 36p per share, equivalent to a more modest P/E of 14.

P/B: This isn’t an asset-based business. Manufacturing is outsourced to Chinese factories and the company doesn’t own much intellectual property. So the price/book ratio is largely irrelevant, in my view.

P/FCF: Trading during the first half was hit by the closure of Toys R Us stores. Sales were down 18% to £50.5m compared to the same period last year. Tax costs were also higher, due to the large movement in the value of the group’s FX derivatives.

Character’s net cash balance means that coping with short-term cash outflows shouldn’t be a problem. I expect free cash flow to improve when this year’s accounts are published.

Earnings yield: An earnings yield (EBIT/EV) of 11.9% is impressive and tells me that the business is still attractively valued relative to operating profit.

Calculating the earnings yield in this way was a technique favoured by fund manager Joel Greenblatt, who developed the magic formula system of investing. The appeal of EBIT/EV is that it looks at profit from an owner’s perspective, ignoring capital structure and tax. Greenblatt’s work has had a big influence on my investing, so I’m pleased to see Character scores well with the Magic Formula:

Overall, my view is that Character’s poor value score is caused by short-term issues that should be resolved over the coming year.

A magic score for Quality?

Like Warren Buffett, Greenblatt realised that the holy grail of modern value investing is buying good companies that are cheap. Character’s QualityRank of 91 suggests to me that it could be a good company:

ROCE: Greenblatt’s favoured measure of quality is return on tangible capital employed. Stockopedia’s  standard measure of ROCE includes intangibles, which normally results in a lower return. However, the stock’s long-term average ROCE of 57% is still exceptionally good.

The only comment I’d make here is that ROCE does seem to have trended lower as the group  has expanded in recent years:

I’m not concerned yet, but hopefully this year’s full-year figures will lift the firm’s ROCE back above 50%.

Piotroski F-Score: The shares’ fundamental health score of 6/9 is the minimum permitted by my screen. However, I don’t see any serious concerns in the F-Score results. I expect the figures to improve as the Toys ‘R Us failure and FX losses fall out of the figures.

Momentum: an inflection point

At the start of this piece I suggested that after several years of treading water, Character’s share price could be set for another leg up. Of course, I can’t predict when or if this might happen.

What does seem clear from the stock’s MomentumRank is that price momentum is currently stronger than earnings momentum:

What this suggests to me is that if the company’s bullish outlook translates into earnings upgrades over the next few months, the shares could perform well.

On the other hand, if Character somehow manages to disappoint the market, the positive price momentum could unravel quite quickly.

My decision

My view is that management guidance is fairly credible. The firm can’t be blamed for the failure of Toys ‘R Us and appears to have recovered from this setback any real financial damage.

The stock’s earnings yield of 11.9% suggests good value, as does the well-covered dividend yield of 4.2%.

I’m comfortable with the outlook and valuation here. I will add the shares to the SIF Folio and to my own holdings after this article has been published.

As always, I’d welcome your view on this previously popular stock. Has Character Group had its day in the sun, or can it still deliver for shareholders?

Stockopedia