Few companies have got so close to the brink and lived to tell about it as Mega Brands Inc.
Although badly weakened by the trauma, the company is starting to thrive again, thanks to a strong management team. Yet few seem to notice. It looks like a good opportunity to make a decent return with relatively little risk.
The Montreal-based toy maker has been around for 30 years. It’s most famous for its Mega Bloks building sets. The line is so successful Lego tried for years to shut it down with legal challenges, which Mega Brands won decisively.
Mega Brands is most infamous for its Magnetix construction sets, consisting of very powerful magnets. Mega Brands acquired the line as part of its acquisition of Rose Art Industries in 2005. The acquisition included an crafts and stationery business as well, and it left the company burdened by a lot of debt.
Shortly after purchase, a handful of children swallowed magnets that had come loose. One died, others were injured. Expensive litigation and product recalls followed. Next came another court battle, with the founders of Rose Art. Then the financial crisis hit and the creditors started sharpening their knives.
To its great credit, management somehow kept the company going while negotiating a recapitalization in 2010, issuing an enormous amount of stock to get rid of most of its debt.
Fairfax, Invesco Trimark and the founding Bertrand family participated in the new financing, as did other strong hands, who now own about half the stock.
After the recap, new chief executive officer Marc Bertrand put in place a plan to get revenue back above $500-million (U.S.) and earnings margins (before interest, taxes, depreciation and amortization) to the mid-teens within five years.
To put that in context, Mega Brands sold $547-million worth of toys and stationery in 2006 and posted EBITDA of 12 per cent. A year earlier, EBITDA rang in at 16 per cent. Last year, the first of the five-year plan, saw revenues of $368-million and EBITDA at 12 per cent with the same basic lineup of products.
Mr. Bertrand’s goal is reasonable, but investors don’t seem enthusiastic. I am, and bought stock at current prices for several reasons.
The Bullish Case
Mega Brands is quoted at about 10 times forward earnings. Given the growth prospects, and the low starting point, that seems like a bargain. If management can pull off a turnaround, investors will benefit from rising earnings and a rising multiple.
And the turnaround seems well under way. Mega Brands reported second-quarter sales growth of 7 per cent. The toy division continued a winning streak and the stationery unit finally posted an increase after repeated declines.
What’s the secret? Innovation. Mega Brands has always invested generously in new ideas and licensing; it hasn’t lost its touch. For example, branding its toys with hot-selling video games such as Halo is a paying off.
This, in turn, encourages retailers to give the company’s toys more shelf space. After the disaster of the past few years, retailers were somewhat worried about stocking Mega Brands products. But in the second quarter, sales at the retail level outpaced shipments from the company’s warehouses, which is a good sign of bigger future orders from retailers.
A small rise in second-quarter stationery sales was also a nice surprise, as it reversed the trend. (The company put its stationery business up for sale in 2008; it was later called off but sales withered.) Mr. Bertrand thinks there’s $50-million of sales to win back in that segment based on historical figures. I would guess that EBITDA margins in that business can be in the low teens. Winning back those sales alone could add about 20 cents of EBITDA per diluted share.
Mega Brands has $115-million of debt. However, there are also warrants outstanding to purchase 12.2 million shares and I’m fairly sure they will be exercised. The proceeds have to be applied to the debt. The dilution will be partly offset by interest saved (the rate is 10 per cent) and by any repurchases (Mega Brands has bought back $20-million worth so far this year).
If you look out to the end of the four remaining years in the turnaround plan, which looks ahead of schedule, and figure $550-million in revenues with EBITDA margins of 15 per cent, earnings approach $1.50 a share. Apply a reasonable multiple of 12 and you get more than a double from here.
The economy is always an issue, but given the market share gains Mega Brands is racking up, it looks as though it can buck the macro trend.
Fabrice Taylor publishes The President's Club investment newsletter, focusing on off-the-radar small to mid-cap companies trading at a discount to net asset value. His letter and The Globe and Mail have a distribution agreement. He can be reached at email@example.com.