Case study: Toy company is tested in changing climate. (Inside the Books--Banking & Finance Special Report).

IT's been a smackdown kind of year for Jakks Pacific Inc.

The Malibu-based toymaker, known for its World Wrestling Entertainment action figures, has a goal to become a $1 billion-in-revenue company, challenging the likes of Mattel Inc. and Hasbro Inc. for toy industry leadership.

But Jakks has taken a few body slams in recent months.

Some of its largest customers -- retail chains such as Wal-Mart, Toys 'R' Us and Target -- have cut back on their inventory levels, sending shivers all the way through Jakks' Hong Kong-based procurement system. Other big buyers, such as Kmart and Ames Department Stores, are operating under bankruptcy protection. Ames said two weeks ago it would shut down.

On Wall Street, Jakks has been knocked around even worse. Investors have driven down the stock price by 41 percent year-to-date, amid a revenue shortfall and questions about an investment banking deal. To top it off, the company's executive compensation program has come under attack from a newly chaste crowd of analysts.

"Times have changed," said Joel Bennett, Jakks' chief financial officer.

Jakks isn't alone. It's a difficult time for companies large and small. From Walt Disney Co. to Citigroup Inc. to Gemstar International-TV Guide Inc., they all face a host of economic, financial and corporate governance issues in this most unusual of market downturns.

To get a better look at how companies are maneuvering in this tougher climate, the Business Journal chose Jakks as a case study on how one relatively small company faces the challenges of the new corporate America.

Jakks, which recently made Fortune magazine's list of fastest-growing companies, provides a striking microcosm of all the pertinent issues. Company executives agreed to cooperate for an in-depth profile that illustrates some of the new challenges facing corporate America. Their story may sound familiar.

Growth through acquisition

Jakks was founded in 1995 by veteran toy industry executives Jack Friedman and Stephen Berman. From the beginning, the strategy was growth through acquisition. Starting with the license for toys based on the World Wresting Federation (now World Wrestling Entertainment) characters, Jakks has expanded into arts and crafts, writing instruments and stationery, and pool flotation toys.

"People considered it the wrestling toy company. Being able to transform the company from that to a multiple product-line, really diverse company, was impressive," said Jeffrey S. Thomison, a Hilliard Lyons Inc. vice president covering Jakks.

The goal was to use the company as a vehicle to consolidate the fragmented toy industry. Mattel and Hasbro, with annual revenues of $4.8 billion and $2.9 billion, respectively, dominate one-third of the $16 billion-at-wholesale national toy industry. After that, there's a steep drop-off, with Jakks (estimated 2002 revenues $310 million to $330 million) and a few other medium-sized players and hundreds of smaller ones.

At a certain point, say $1 billion in revenues, Jakks could become a legitimate challenger to Mattel and Hasbro.

"What WWF has done for us is what Barbie did for Mattel or G.I. Joe for Hasbro," said Berman, president and chief operating officer. "We've capitalized on the success of WWF, taken the growth from WWF and the profits, and acquired other companies."

A key part of Jakks' strategy is to build "evergreen" brands -- perennials that won't rely on the fashion industry-like cycles of toy popularity that result in flash-in-the-pan hits. Often, they're recognizable, older brands that Jakks considers to be under-managed. Berman points out that where Mattel has Fisher-Price, and Hasbro has Playskool, Jakks has Child Guidance. Where Mattel has Hot Wheels, Jakks has Road Champs.

One of Jakks' most successful brands to date has been Flying Colors, a maker of craft and activity sets, and reusable compounds that are the modern-day successors to Play-Doh. Jakks has introduced new products, like Goooze and Skweeez, and matched them with licenses for characters from cartoons like "Blue's Clues" or "SpongeBob Squarepants."

"What they do best is take a product and then put the personality of the license into the product," said Reyne Rice, director of marketing and communications for NPD Funworld, a toy industry research firm. "They don't just slap stickers on (identical toys). So then the girls don't pick one or the other, they want them both."

Jakks doesn't own toy factories, a strategy that helps it operate more nimbly than some of its larger competitors. Earlier this year, for example, it quickly cut 15 percent of its more than 300-person workforce in response to slowing orders.

Jakks is also able to leverage some of its customers' buying power by having them take possession of orders in Hong Kong. This has kept financing costs down, although a larger part of its business now requires Jakks to order and ship toys based on estimates of demand. Even so, its U.S. warehouse, in City of Industry, employs only 12 full-time people, Berman said.

While it's possible that Jakks can achieve its goals, rolling up an industry contender isn't easy, even in the best of times.

"I realize they want to become like a Mattel or Hasbro, but the thing that Mattel and Hasbro have, that Jakks doesn't yet have, is decades of experience and evergreen brands," said Chris Byrne, an independent toy industry consultant in New York. "They would probably dispute this, but they have yet to have a real core business. That's not to say they haven't done well with what they have done."

Early on, Jakks' strategy worked quite well. From 1997 to 2001, revenue surged to $284.3 million from $41.9 million. Net income increased 10-fold, to $28.2 million, from $2.8 million. The stock price rose to $18.95 from $5.33.

Debt-free growth

Jakks was able to grow without incurring any debt, using cash and stock as currency. It took its acquisitions, lopped off the administrative and distribution departments and any products it didn't consider to be reliable earners, and incorporated the business into its leaner structure.

"We do not enjoy fixed overhead," Berman said.

Last year, though, revenue growth began to slow, while net income actually fell. This year, the company hit additional snags. The main problem was that in an uncertain economy, big retailers like Wal-Mart got nervous about carrying as many weeks of inventory on hand.

Bennett said customers are still buying the toys, but the company is having to bring in larger amounts of inventory from Asia to keep them in stock. "Basically we now have to react quicker so we don't have any out-of-stock product on the retailers' shelves," he said. "Retailers are less concerned about that these days."

In the first half of the year, Jakks' inventory levels ballooned, to $49.9 million from $32 million at Dec. 31. Its accounts receivable also soared, to $78 million from $52.8 million, representing about one quarter's worth of sales.

Bennett contends that the customers' inventory reductions are a one-time shock that doesn't represent a lower rate of sales for the company's products. But Wall Street analysts aren't convinced.

"Excluding acquisitions, there's been no sales growth," said Bob DeLean, a Morgan Keegan analyst, He believes the inventory is bloated, which could signal a writedown. "I don't know if the numbers are going to hold up for the year."

Earlier this year, analysts were taken by surprise when Jakks lowered its revenue guidance by $50 million, to a range of $310 million to $330 million. The company blamed it on the inventory shift by customers, as well as a sudden drop-off in sales of its Road Champs line, which got inundated with competitors.

Analysts were upset that the lowered guidance came so soon after the company, and top executives, had raised money in a secondary offering (see page 22). There began a bit of sniping over just how much the guidance came down on its recently acquired Toymax subsidiary. Jakks purchased 65 percent of Toymax in February, and is in the process of purchasing the remaining 35 percent.

Several analysts have lowered their figures for the 2002 revenue contribution from Toymax, from $60 million or above to the current views of $50 million to $60 million.

"I think there was some confusion on it," said Bennett, although he said the company didn't oversell the Toymax deal.

DeLean, the only analyst on Wall Street who has a version of a "sell" rating on Jakks (he rates it "underperform"), wonders whether the business model can be characterized as a "leaky bucket" - where new acquisitions are needed to make up for revenue being lost at fading lines.

Others more optimistic

Not everyone on Wall Street feels so strongly. Thomison, from Hilliard Lyons, said he's not so uncomfortable about Jakks' management that he can't recommend the stock.

"Jack Friedman has a style about him, and has some flair that maybe is viewed as overly optimistic, feeling invincible or what have you," Thomison said. "Some people listen to Jack and wonder if he's too optimistic about things."

Thomison said Jakks' management has been wrong about some of its forecasts, but he doesn't believe they've told Wall Street anything they've known to be untrue. He also noted that the shortfall is coming at a pretty rough time in the economy, so he's willing to give them the benefit of the doubt.

In early August, Thomison raised his rating on Jakks stock to a buy, based on valuation. The stock, at a recent price of around $11, is trading for as little as six or seven times projected earnings for next year.

For it to get to the multiples of a Hasbro or Mattel -- which trade at P/E multiples of 25 and above -- Jakks must gain back Wall Street's favor.

The company has essentially no debt, but it will need to take some on if it wants to gain the heft that would put it in the Mattel and Hasbro league. Bennett said the company -- which has an untapped $50 million credit line and more than $81 million in cash -- will likely seek to issue bonds in the future to do larger acquisitions. Raising that kind of debt will require Wall Street's backing. Its stock could also be a weapon, and analysts -- and their institutional customers -- are key constituencies for helping to get the stock price higher.

Jakks officials say they recognize these issues, and are addressing them. The company hired a consultant to propose a solution to some of the questions about executive pay and corporate governance (see page 20). In order to reinstate their backing of the company, Wall Street also wants insiders to own more of its stock, not just in options.

Restoring confidence in is projections and representations is a more difficult matter. Some analysts wonder whether they should place a permanent discount on projections coming from the company, an unfortunate situation that doesn't speak well of management.

"It saddens me when I think of how much shareholder value could be created," said Brett Hendrickson, director of research at B. Riley & Co. "They could really become a credible player, somebody who's big enough for Hasbro and Mattel to worry about."

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