Jakks Pacific Inc: Form 10-Q for the period ended Jun 30, 2023

The following discussion and analysis of financial condition and results of operations should be read together with our condensed consolidated financial statements and notes thereto, which appear elsewhere herein.

Disclosure Regarding Forward-Looking Statements

This Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. For example, statements included in this Report regarding our financial position, business strategy and other plans and objectives for future operations, and assumptions and predictions about future product demand, supply, manufacturing, costs, marketing and pricing factors are all forward-looking statements. When we use words like “intend,” “anticipate,” “believe,” “estimate,” “plan” or “expect,” or other words of a similar import, we are making forward-looking statements. We believe that the assumptions and expectations reflected in such forward-looking statements are reasonable, based upon information available to us on the date hereof, but we cannot assure you that these assumptions and expectations will prove to have been correct or that we will take any action that we may presently be planning. We have disclosed certain important factors (e.g., see “Risk Factors”) that could cause our actual results to differ materially from our current expectations elsewhere in this Report. You should understand that forward-looking statements made in this Report are necessarily qualified by these factors. We are not undertaking to publicly update or revise any forward-looking statement if we obtain new information or upon the occurrence of future events or otherwise.

Critical Accounting Estimates

Our critical accounting policies and estimates are included in the 2022 Annual Report on Form 10-K and did not materially change during the first six months of 2023.

New Accounting Pronouncements

See Note 1 to the condensed consolidated financial statements.

Results of Operations

The following unaudited table sets forth, for the periods indicated, certain statement of income data as a percentage of net sales:

23

The following unaudited table sets forth, for the periods indicated, certain statements of operations data by segment (in thousands):

Comparison of the Three Months Ended June 30, 2023 and 2022

Net Sales

Toys/Consumer Products. Net sales of our Toys/Consumer Products segment were $117.9 million for the three months ended June 30, 2023 compared to $148.9 million for the prior year period, representing a decrease of $31.0 million, or 20.8%. The decrease was primarily driven by lower sales in North America, which were down $33.3 million, or 25.7%, as well as, customers placing FOB orders earlier in the prior year to get ahead of supply chain issues experienced a year ago. Now that the supply chain has returned to historical normal patterns, retailers have moved back to the pre-pandemic ordering patterns.

Costumes. Net sales of our Costumes segment were $49.0 million for the three months ended June 30, 2023 compared to $71.6 million for the prior year period, representing a decrease of $22.6 million, or 31.6%. The decrease in net sales was primarily related to earlier customer shipments versus a year ago to get ahead of supply chain issues experienced a year ago.

Cost of Sales

Toys/Consumer Products. Cost of sales of our Toys/Consumer Products segment was $77.6 million, or 65.8% of related net sales for the three months ended June 30, 2023 compared to $105.7 million, or 71.0% of related net sales for the prior year period, representing a decrease of $28.1 million, or 26.6%. The decrease in dollars is related to lower overall sales. The decrease as a percentage of net sales, year over year, is primarily due to lower freight costs.

Costumes. Cost of sales of our Costumes segment was $38.1 million, or 77.8% of related net sales for the three months ended June 30, 2023, compared to $53.8 million, or 75.1% of related net sales for the prior year period, representing a decrease in dollars of $15.7 million, or 29.2%. The decrease in dollars is related to lower overall sales. The increase as a percentage of net sales was driven by a higher average royalty rate.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $34.8 million for the three months ended June 30, 2023 compared to $36.9 million for the prior year period constituting 20.8% and 16.8% of net sales, respectively. The decrease in selling, general and administrative expenses as a percentage of net sales was primarily due to lower sales a year ago.

Interest Expense

Interest expense was $1.3 million for the three months ended June 30, 2023, as compared to $2.3 million in the prior year period. During the three months ended June 30, 2023, we incurred interest expense of $0.7 million related to our 2021 BSP Term Loan, $0.3 million related to our revolving credit facility and $0.3 million related to other borrowing costs. During the three months ended June 30, 2022, we incurred interest expense of $2.0 million related to our 2021 BSP Term Loan and $0.3 million related to our revolving credit facility.

Provision For (Benefit From) Income Taxes

Our income tax expense, which includes federal, state and foreign income taxes and discrete items, was $1.5 million, or an effective tax rate of 19.3%, for the three months ended June 30, 2023. During the comparable period in 2022, our income tax expense was $1.3 million, or an effective tax rate of 4.8%. The effective tax rate increased primarily due to the expectation of taxes owed in higher tax jurisdictions.

Comparison of the Six Months Ended June 30, 2023 and 2022

Net Sales

Toys/Consumer Products. Net sales of our Toys/Consumer Products segment were $215.8 million for the six months ended June 30, 2023 compared to $260.0 million for the prior year period, representing a decrease of $44.2 million, or 17.0%. The decrease in net sales was primarily related to customers placing FOB orders earlier in the prior year in order to get ahead of supply chain issues experienced a year ago. Now that the supply chain has returned to historical normal patterns, retailers have moved back to the pre-pandemic ordering patterns.

Costumes. Net sales of our Costumes segment were $58.6 million for the six months ended June 30, 2023 compared to $81.3 million for the prior year period, representing a decrease of $22.7 million, or 27.9%. Similar to Toys/Consumer Products, the decrease in net sales was primarily related to earlier customer shipments versus a year ago to get ahead of supply chain issues experienced a year ago.

Cost of Sales

Toys/Consumer Products. Cost of sales of our Toys/Consumer Products segment was $146.3 million, or 67.8% of related net sales for the six months ended June 30, 2023 compared to $188.7 million, or 72.6% of related net sales for the prior year period, representing a decrease of $42.4 million, or 22.5%. The decrease in dollars is related to lower overall sales. The decrease as a percentage of net sales, year over year, is due to lower freight costs.

Costumes. Cost of sales of our Costumes segment was $45.5 million, or 77.6% of related net sales for the six months ended June 30, 2023, compared to $61.8 million, or 76.0% of related net sales for the prior year period, representing a decrease in dollars of $16.3 million, or 26.4%. The decrease in dollars is related to lower overall sales. The increase as a percentage of net sales was driven by a higher average royalty rate.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $70.6 million for the six months ended June 30, 2023 compared to $67.6 million for the prior year period constituting 25.7% and 19.8% of net sales, respectively. Selling, general and administrative expenses increased as a result of higher professional services and employee related expenses.

Interest Expense

Interest expense was $4.3 million for the six months ended June 30, 2023, as compared to $4.5 million in the prior year period. During the six months ended June 30, 2023, we incurred interest expense of $3.2 million related to our 2021 BSP Term Loan, $0.4 million related to our revolving credit facility and $0.7 million related to other borrowing costs. During the six months ended June 30, 2022, we incurred interest expense of $4.0 million related to our 2021 BSP Term Loan and $0.5 million related to our revolving credit facility.

Provision for (Benefit From) Income Taxes

Our income tax expense, which includes federal, state and foreign income taxes and discrete items, was $0.1 million, or an effective tax rate of 9.9%, for the six months ended June 30, 2023. During the comparable period in 2022, our income tax expense was $1.8 million, or an effective tax rate of 7.3%. The effective tax rate increased primarily due to the expectation of taxes owed in higher tax jurisdictions.

Seasonality and Backlog

The retail toy industry is inherently seasonal. Generally, our sales have been highest during the third and fourth quarters, and collections for those sales have been highest during the succeeding fourth and first quarters. Our working capital needs have been highest during the second and third quarters as we make royalty advance payments for some of our licenses and buy and sell inventory subject to customer payment terms.

While we have taken steps to level sales over the entire year, sales are expected to remain heavily influenced by the seasonality of our toy and costume products. The result of these seasonal patterns is that operating results and the demand for working capital may vary significantly by quarter. Orders placed with us are generally cancelable until the date of shipment. The combination of seasonal demand and the potential for order cancellation makes accurate forecasting of future sales difficult and causes us to believe that backlog may not be an accurate indicator of our future sales. Similarly, financial results for a particular quarter may not be indicative of results for the entire year.

Liquidity and Capital Resources

As of June 30, 2023, we had working capital (inclusive of cash, cash equivalents and restricted cash) of $65.5 million, compared to $97.4 million as of December 31, 2022, representing a decrease in working capital of $31.9 million during the six-month period ended June 30, 2023. The decrease in working capital is primarily attributable to the $30.2 million principal payment made during the quarter related to our 2021 BSP Term Loan.

Operating activities provided net cash of $20.8 million during the six months ended June 30, 2023, as compared to net cash provided of $36.5 million in the prior year period. The decrease in net cash provided by operating activities year-over-year is primarily due to lower overall sales and higher working capital usage, partially offset by higher non-cash charges related to the valuation adjustment for our preferred stock derivative liability. Other than open purchase orders issued in the normal course of business related to shipped product, we have no obligations to purchase inventory from our manufacturers. However, we may incur costs or other losses as a result of not placing orders consistent with our forecasts for product manufactured by our suppliers or manufacturers for a variety of reasons including customer order cancellations or a decline in demand. As part of our strategy to develop and market new products, we have entered into various character and product licenses with royalties/obligations generally ranging from 1% to 21% payable on net sales of such products. As of June 30, 2023, these agreements required future aggregate minimum royalty guarantees of $70.8 million exclusive of $3.9 million in advances already paid. Of this $70.8 million future minimum royalty guarantee, $41.5 million is due over the next twelve months.

Investing activities used net cash of $4.9 million and $5.3 million for the six months ended June 30, 2023 and 2022, respectively, and consisted primarily of cash paid for the purchase of molds and tooling used in the manufacture of our products.

Financing activities used net cash of $70.4 million and $11.5 million for the six months ended June 30, 2023 and 2022, respectively. The cash used in financing activities during the six months ended June 30, 2023, primarily consists of the repayment of our 2021 BSP Term Loan of $69.2 million and the repurchase of common stock for employee tax withholding of $1.2 million. The cash used in financing activities during the six months ended June 30, 2022, primarily consists of the repayment of our 2021 BSP Term Loan of $10.9 million, and the repurchase of common stock for employee tax withholding of $0.6 million.

As of June 30, 2023, we have no outstanding indebtedness under our first-lien secured term loan (the “2021 BSP Term Loan Agreement”) and under our senior secured revolving credit facility (the “JPMorgan ABL Facility”), aside from utilizing $9.3 million in letters of credit.

See Note 5 – Debt and Note 6 – Credit Facilities for additional information pertaining to our Debt and Credit Facilities.

As of June 30, 2023 and December 31, 2022, we held cash and cash equivalents, including restricted cash, of $32.4 million and $85.5 million, respectively. Cash, and cash equivalents, including restricted cash held outside of the United States in various foreign subsidiaries totaled $25.8 million and $39.4 million as of June 30, 2023 and December 31, 2022, respectively. The cash and cash equivalents, including restricted cash balances in our foreign subsidiaries have either been fully taxed in the U.S. or tax has been accounted for in connection with the Tax Cuts and Jobs Act, or may be eligible for a full foreign dividends received deduction under such Act, and thus would not be subject to additional U.S. tax should such amounts be repatriated in the form of dividends or deemed distributions. Any such repatriation may result in foreign withholding taxes, which we expect would not be significant as of June 30, 2023.

Our primary sources of working capital are cash flows from operations and borrowings under our JPMorgan ABL Facility (see Note 6 – Credit Facilities).

Typically, cash flows from operations are impacted by the effect on sales of (1) the appeal of our products, (2) the success of our licensed brands in motivating consumer purchase of related merchandise, (3) the highly competitive conditions existing in the toy industry and in securing commercially-attractive licenses, (4) dependency on a limited set of large customers, and (5) general economic conditions. A downturn in any single factor or a combination of factors could have a material adverse impact upon our ability to generate sufficient cash flows to operate the business. In addition, our business and liquidity are dependent to a significant degree on our vendors and their financial health, as well as the ability to accurately forecast the demand for products. The loss of a key vendor, or material changes in support by them, or a significant variance in actual demand compared to the forecast, can have a material adverse impact on our cash flows and business. Given the conditions in the toy industry environment in general, vendors, including licensors, may seek further assurances or take actions to protect against non-payment of amounts due to them. Changes in this area could have a material adverse impact on our liquidity.

As of June 30, 2023 off-balance sheet arrangements include letters of credit issued by JPMorgan of $9.3 million.

Interest Rate Risk

Our exposure to market risk includes interest rate fluctuations in connection with our JPMorgan ABL Facility (see Note 6 – Credit Facilities). Borrowings under our JPMorgan ABL Facility bear interest at either (i) LIBOR plus 1.50% - 2.00% (determined by reference to an excess availability pricing grid) or (ii) Alternate Base Rate plus 0.50% - 1.00% (determined by reference to an excess availability pricing grid and base rate subject to a 1.00% floor). Borrowings under the JPMorgan ABL Facility are therefore subject to risk based upon prevailing market interest rates. Interest rate risk may result from many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors that are beyond our control. During the three-month period ended June 30, 2023, we utilized the revolving credit facility to borrow $10 million, and subsequently, the entire amount was repaid, resulting in no outstanding balances as of June 30, 2023.

In Q1 2023, we entered into an amendment to our JPMorgan ABL Credit Agreement which changed the interest reference rate on our revolving line of credit from LIBOR to the Secured Overnight Financing Rate (“SOFR”).

Foreign Currency Risk

We have wholly-owned subsidiaries in Hong Kong, China, the United Kingdom, Germany, France, the Netherlands, Canada, Italy and Mexico. Sales are generally made by these operations on FOB China or Hong Kong terms and are denominated in U.S. dollars. However, purchases of inventory and Hong Kong operating expenses are typically denominated in Hong Kong dollars and local operating expenses in the United Kingdom, Germany, France, the Netherlands, Canada, Italy, Mexico and China are denominated in local currency, thereby creating exposure to changes in exchange rates. Changes in the U.S. dollar exchange rates may positively or negatively affect our results of operations. The exchange rate of the Hong Kong dollar to the U.S. dollar has been linked to the U.S. dollar by the Hong Kong Monetary Authority at HK$7.75 - HK$7.85 to US$1.00 since 2005 and, accordingly, has not represented a currency exchange risk to the U.S. dollar. We do not believe that near-term changes in these exchange rates, if any, will result in a material effect on our future earnings, fair values or cash flows. Therefore, we have chosen not to enter into foreign currency hedging transactions. We cannot assure you that this approach will be successful, especially in the event of a significant and sudden change in the value of these foreign currencies.

Our Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Report, have concluded that as of that date, our disclosure controls and procedures were effective. There has been no change in our internal control over financial reporting identified in connection with the evaluation required by Exchange Act Rule 13a-15(d) that occurred during the period covered by this Report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Risk factors with respect to us and our business are contained in “Part I, Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2022. There have been no material changes from the risk factors previously disclosed in such filing. The disclosures made in this Quarterly Report should be reviewed together with the risk factors contained therein.