Character Group

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The UK market is now offering us the opportunity to invest alongside a management team that has generated an average 50% return on invested capital p.a. over the last 20 years. This opportunity is being offered at an after-tax earnings yield of 25%. Downside protection is thrown in with tangible net assets representing 75% of market cap.

Meet Character Group (CCT), a UK-based toy developer formed in the early nineties still run by some of the original management team who own 20% of the equity.

Numbers

As I’ll explain below, we are not buying a business with any great moat so let’s dive straight into the numbers so we know where we’re at:

· Market cap is £50. Net cash is £16m. Surplus property value is £13m (more below). Enterprise value therefore = £21m

· Average operating profit/ROCE[1]:

o Last 5 years: £7.3m/54%

o Last 10 years: £9.5m/59%

· Peak/trough operating profit last 10 years: £13.3m/£5m

· Last reported loss was H1 2013 (but profitable on full year 2013) and only annual operating loss was £2.1m in 2009 (but operating cash flow was positive as working capital unwound and product development spend temporarily reduced below amortisation)

· P/E on normalised operating profit of say £7.5m at tax rate of 25% and adjusted for cash and surplus property is therefore around 4x.

· The surplus property consists of two properties:

i. A building in New Malden, some of which CCT occupies for HQ and the rest it lets out generating £230k annual rental income (which I have stripped out of historic operating profit above). Book value £1.3m, last valued at £2.9m in 2019.

ii. ‘Infinity House’ – a 157k sq. ft. distribution center that CCT bought in 2021 to use as an ‘overspill’ warehouse at the height of Covid. In the ESG section of its 2024 annual report it revealed it no longer intended to use this property and has begun marketing it. https://www.daviesharrison.com/property/642. The book value is around £8m, including £2.5-3m of upgrading works since purchase. A quick internet search reveals rent levels for prime big box (>100k sq ft) reached £9.5-10 per sq.ft in 2024 in the North West. I do not think Infinity House qualifies as prime so taking £5 per sq. ft. and using a 8% cap rate yields a £10m value. Yields on secondary distribution warehouses per various property consultancies based on recent deals have been lower than this in the 6-7% range, so there could be upside to this.

· Note that CCT bought a Scandinavian business in 2018 and from the rationale given in the annual report at the time it would seem this was principally as a hedge to maintain market access to Europe post-Brexit. That business went on to make losses (CCT didn’t pay contingent consideration and quickly got to work dealing with the business and it is now profitable), but stripping out the results for this business puts the average 5/10 year operating profit slightly higher at £7.9m/£9.9m

How good a business is Character Group?

Character Group does not have an identifiable moat but consistently earns high returns. I believe this is partly because noone else has an impregnable moat either. Products and brands – eg Barbie - go in and out of favour. Also noone has a monopoly on guessing the next hit toy. The latest megahit, Labubu dolls, is from a relatively new Chinese company. My 10-year old daughter tells me they are the best thing ever made as I remind her of the L.O.L. dolls we dropped off at Oxfam a few months ago.

Whilst not attributable to any obvious moat, Character Group’s high returns cannot be down to dumb luck either. This is not an easy industry - even Lego almost went bankrupt in 2003. Let’s consider what a toy developer like CCT needs to do to succeed:

· Convince master brand and IP owners you are the best company to monetise their assets

· Design toys children want to play with – year in year out. CCT consistently has toys in the annual Toy Retailer’s Association ‘Dream List’ - top 12 toys.

· Convince hard-nosed buyers at retailers to order your toys

· Get the toys made and delivered on time to your customers and at a cost that allows you to make a profit. And ensure your toys won’t kill or injure anyone (and convince regulators, customers and product recall and liability insurers they won’t). CCT has long had a presence in China to oversee its supply chain.

· Accurately predict the right amount of stock to have made for a 1-2 month sales window before Christmas when you make all your profit. Order too much and you take inventory losses; order too little and you lose credibility with your retailer-customers and licensors

· Be able to survive the inevitable fallow years when you miss the mark

I believe any company in this industry that earns CCT’s level of returns over so long a period must possess some advantage and it is reasonable to assume it will continue to earn good returns.

Potential outcomes

The company has traded at an average cash-adjusted PE of 10x in the last 5 and 10 years, peaking at 13x. Using the £7.3 – 9.5m range for normalised operating profit from earlier and taxing this at 25% yields a net income range of £5.5 - £7.1m. At a P/E of 10-13x and adding back the surplus cash/property we get a market cap of £84 – 120m or 1.7-2.5x the current market value.

Other toy companies trade on a wide range of multiples. Spin Master, a larger, listed Canadian competitor with a UK presence, currently trades on a multiple of 18 following a 50% drawdown this year.

CCT is a voracious repurchaser of shares, especially during periods of drawdowns. If the share price remains depressed it will undoubtedly step up repurchases, especially once there is clarity on tariffs (20% of its sales are to the US from China but it forecasts remaining profitable this year). This will be even more pronounced if it sells the Infinity House property it is currently marketing. With cash of £26m and at the current share price it could spend £16m retiring 1/3 of its shares.

I estimate CCT’s tangible asset value to be around £37m with property stated at fair value and applying a slight haircut to inventory and receivables in a liquidation scenario. I believe with their conservative balance sheet and history of positive cash flow, flexible cost base (all production outsourced) and Management’s experience of dealing with the vicissitudes of this industry, a distress scenario is unlikely. Let’s say I am wrong about that: if the business is intact but needs to raise equity to recapitalise, then I believe with the current margin of safety in the share price I am unlikely to make a loss. And in extremis in a liquidation scenario I expect to recover 75p in the pound, and with key management all holding significant stakes, I believe they would also want to protect value in such a scenario.

On balance, I believe the shares offer upside of 2x with a low probability of loss of capital, which are very good odds.

[1] Capital employed is calculated as net working capital plus PPE. The latter includes the book value of the surplus property, Infinity House, of around £7.5m which I have removed. The book value of CCT’s main Oldham distribution center is around £2.5m. I have adjusted this upward to £6m to reflect my estimate of replacement cost.