Shares in Character Group (LON:CCT) dipped as much as 25% in early trading today as it issued a statement warning that profits this year would fall below expectations. Early traders would have been annoyed, as the share price has made a substantial recovery since then:
This reinforces my belief never to sell immediately on a profit warning. We can see that the share opened at 275p and price degraded slightly to 262p, but since then the price has steadily gained, at the time of writing adding almost 100p from that low. If we look at our analysed results so far, purchasing each share at a profit warning (instead of selling) would see you roughly break even, and even if you could not get the best price you would not be too far off.
Character Group are not well known as a company but most would definitely be familiar with their products. They hold licences to produce toys and games, the most notable one being Peppa Pig, a wildly successful cartoon. They have executed well, and this licence has been a superb money-maker for the company.
Perhaps this warning is one of the most easily telegraphed, as it is already known that this lucrative contract seems likely not to be renewed, thanks to Hasbro acquiring the rights to Peppa Pig and hinting they would like to take the licence back. There has been little comment on that from the company until today, but the share price has already declined massively from the 500-600p region we have seen this year.
The warning comes in a trading update today. Perhaps of more concern for investors is that there are other things out there which are troubling the company, on top of the Peppa Pig contract loss, although neither really compares massively to the latter.
First we have some troubles in their Danish acquisition where their largest customer has gone bust. Previous guidance was bullish on this point, with Character being confident that this demand would come from elsewhere in the market.
Secondly, the weaker GBP has affected margins as most purchases are made in USD. This seems reasonable although the decline in the Pound has been relatively benign this year. These two factors are quantified as such:
Through a combination of these factors, the profit before tax for the Group for the year ended 31 August 2019 is likely to be in the range of £11.0m – £11.5m., slightly under the lower end of current market expectations.
Finally we have some comment about Peppa Pig:
Shareholders will have noted the recent announcement by Hasbro, Inc. of its intended takeover of Entertainment One Limited (“eOne”), the Peppa Pig brand owner. To date, there has been no dialogue between the Company and Hasbro as to its future intentions for Peppa Pig and, although it is unlikely that a definitive position in that regard will be known for some time, discussions have taken place with eOne and it has been agreed that the Group’s current Peppa Pig licence (due to expire on 31 December 2020) will be extended for an additional six months to expire on 30 June 2021. This assures the Group of a continued contribution to sales from its Peppa Pig product lines for two further financial years.
On the positive side, Character is a fantastic business. Stockopedia rates it 91, and this is fully deserved based on historic results and there is really little to fault about it and we can take our pick from many positive factors: growing profits, great cash conversion, solid balance sheet, strong cash position, great margins, generous dividend, buying back shares.
The business model indicates a relatively capital light business, with not many expenses being treated as capital expenditure. Character sub-contracts production out to China and does not own any factories. This can make some sense, as absolute quality is not particularly important and ownership of production may not necessarily bring any benefits.
However, such metrics are backward looking, and the share price is forward looking: just how much will the loss of Peppa Pig affect Character, and will this loss be able to mitigated?
We do not have much information on this as the segment reporting does not drive down that far, but a clip from the Annual Report reveals:
Our top performing brands during the year ended 31 August 2018 included Peppa Pig, Little Live Pets, Stretch, Mashems, Teletubbies, Soft ‘n Slo Squishies and Cra.Z.Slimy.
Out of this lineup, Peppa Pig is the most recognisable name by far. It would be going as far to say that this may be irreplaceable and generates a significant portion of revenues. The fact that the contract does not run out for two years says that revenue does not necessarily need to fall off a cliff, but it may do if measures are not taken.
Thus, using current profit figures to attempt to determine a valuation is largely a useless exercise. At the stated £11.0-£11.5m the company represents terrific value, but profit at these levels may only be held at these levels for another two years. What then? Assuming the loss drops straight through to the bottom line and that Peppa Pig counts for anything between 20-40% of profits, this does not look so good anymore.
Good news for dividend seekers is that the payout is held for this year and the payout rate has always been a manageable level of cashflow, so we do not see the cash balance dropping. However, in the longer run it seems difficult to see this being maintained.
A lot of this will depend on personal opinion. Clearly, like other contracting companies this shows the risk of investing in equities where there may be excessive customer concentration. If something happens to that customer, it may be really difficult to make up for it.
Character is also relatively asset-light, and the only real value it has are the licences it holds. It is hard to envisage any competitive advantage being held in the actual toy design.
There are several points for a bull case. The Peppa Pig contract might not actually disappear. New owners Hasbro might simply be happy to keep it going, although this seems unlikely. However, the way that Character have performed on this licence may give strong credence to them winning new contract deals. In the world of toys and games, a new fad can appear relatively quickly and there is the scale to deliver that.
It sounds rather easy in retrospect, but the low of 262p was clearly a good price. At almost 100p more than that I am not so sure that this is the same, and recent broker updates have cut their target price to 430p which removes quite a lot of the upside. Much will depend on their new products, but is isn’t really clear at the moment how this will perform and it could be sensible to wait a while for further updates. 3/5.