Stephen Berman - Co-Founder, Chairman, CEO, President & Secretary Brent Novak - EVP & CFO.

Stephanie Wissink - Jefferies Linda Bolton-Weiser - D.A. Davidson & Co..

Welcome to the 2018 JAKKS Pacific Second Quarter Earnings Conference Call. My name is John, and I'll be your operator for today's call. [Operator Instructions]. Please note that the conference is being recorded. And now I'll turn the call over to Stephen Berman. Stephen, you may begin..

Good morning, everyone and thank you for joining us today. This morning, we are going to review our performance during the second quarter of 2018. I will talk about how our brands and products performed in the quarter compared to last year and to our expectations, as well as the impact of the liquidation of Toys"R"Us stores in the U.S.

and the disruption of Toys"R"Us international operations. After my comments, Brent will discuss our financial performance. After that, I will talk about some of the things we are looking forward to over the course of the rest of 2018 and beyond. Not surprisingly, our business was significantly affected by the Toys"R"Us liquidation in March this year.

Not only due to the loss of a significant customer, [indiscernible] the Toys"R"Us liquidation activities in the second quarter, which disrupted the broader retail market. Our sales declined 11% during the quarter and are down approximately 7% year-to-date, due primarily to the lost sales to Toys"R"Us.

As we have expressed, we expect the disruption caused by the Toys"R"Us liquidation to continue throughout the back half of this year as current inventory levels are sold through and our existing customer base both traditional and online began to fill the void left by the Toys"R"Us liquidation.

Net revenues in the quarter declined to $105.8 million from $119.6 million in the 2017 quarter. The decline of which is roughly equivalent to the amount of sales we did in the U.S. with Toys"R"Us in the second quarter of last year.

Underneath that larger trend, there are a number of crosscurrents with strong performances from several new products and growth with some retailers offsetting the declines in sale of older products.

During the second quarter, we had strong sales of several new or recently launched products led by Incredibles 2, Squish-Dee-lish, Fancy Nancy PERFECTLY CUTE, MorfBoard, JigglyDoos. MorfBoard, an innovative product in a new category launched earlier this year on a limited basis, continue to sell well.

It remains -- targets number one scooter skateboard brand and their section. It has also continued to be a top item at Amazon with stellar sales. Incredibles 2 has sold well since the movie launched in June and momentum is carrying through the summer.

Jack-Jack is a break-out character and is selling well in everything from basic figures to the Jack-Jack Attacks feature figure, which leads the marketing campaign.

A fall DVD launch and streaming will provide a second opportunity for kids to engage with the property, which we believe will ignite sales through the holiday season and into 2019 similar to the patterns of other successful films. We continue to see growth in C'est Moi. Our property line of innovative skincare products for tweens and teens.

Sales each month are showing strong growth. And the distribution is widening. We expect to add new retailers during the second half. As we have said, while we are encouraged by the progress so far, C'est Moi will take sometime before becoming a significant piece of our business.

Our sales through online channels were down in the quarter but again, primarily by the decrease in sales to Toys"R"Us. Another factor that affected our online sales was that a major customer of Disguise was bought by a competitor.

Excluding the sales of Toys"R"Us and this retailer, our sales through online retailers rose by 9% year-over-year during the quarter. Continuing the trend of growing as a percentage of our total sales, which has been one of our major strategic goals, we expect this trend to continue.

Offsetting the very strong positive contribution of the products we just mentioned, there were some that saw declines, mostly older lines that are late in their cycle or properties that benefited from strong entertainment content in the first half of last year. These include Tsum Tsum, Moana, Beauty and the Beast, Elena of Avalor, and Frozen.

We also saw a decline in sales at Disguise for the reason I just mentioned as well as the buying shifting of several significant orders for the second quarter that turned into third quarter. And Disguise is now on track to meet or exceed our internal forecast.

So as we said, after the first quarter, in spite of the decline in sales, which is effectively due to the reduction in sales to Toys"R"Us, we have seen quite a number of pockets of strength including growth in our international segment driven by Europe.

Before I hand the call over to Brent, let me just address the letter that we received back in January from Meisheng. The committee of independent directors continues to evaluate Meisheng's expression of interest, which was recently affirmed.

And buying additional shares to bring its holding to 51% of JAKKS outstanding shares, as well as other possible interests. We will provide an update when we are able to. With that, I will turn the call over to Brent Novak.

Brent?.

sales of Dolls, Role Play and Dress up, Plush and activity products in our girls category amounted to $43.6 million for the 2018 second quarter compared to $51.3 million in the comparable quarter last year.

We continue to see strong sales of Squish-Dee-lish slow-rise foam collectibles, the girls portion of Incredibles 2 and PERFECTLY CUTE, a private label brand we produced for one customer. And we just started shipping Fancy Nancy in the quarter.

These brands were more than offset by the expected declines in a number of girls lines, including Tsum Tsum, Moana, Beauty and the Beast and Gift 'ems.

Sales of Action Figures, Vehicles, Role Play and Electronic products, in our boys and other category for the second quarter, were $21.2 million compared to $15.2 million last year, driven by Incredibles 2, which more than offset the expected declines in Max Tow Truck, Star Wars and XPV.

Sales of seasonal products, including licensed write-downs, ball pits, kids furniture and Maui outdoor activity products and MorfBoards were $15.6 million in the 2018 second quarter, down from $19.9 million in 2017 as solid sales from the launch of MorfBoard were more than offset by declines in our Maui branded products, Kids Only! furniture products and some licensed write-downs.

Sales in our Halloween category, which is also one of our business segments, totaled $24.4 million in the second quarter of 2018 compared to $31.9 million in 2017. The result of weaker sales of licensed products such as Power Rangers and Beauty and the Beast and some delays in orders.

Sales of Baby Doll accessories, Figures and Plush in our Pre-School category were $1 million in the second quarter of 2018, down from $1.3 million in 2017. Looking at sales by business segment, U.S.

and Canada net sales for the second quarter were $59.4 million compared to $70.1 million in the prior year quarter, driven by the drop in sales to Toys"R"Us as well as the same puts and takes described earlier in the product group descriptions.

International sales for the 2018 second quarter were $22 million compared to $17.5 million in 2017, with strong sales to customers that fill the void left by Toys"R"Us particularly in Europe. And we already mentioned Halloween sales in the category breakdown earlier. Moving down the P&L.

Reported gross margin in the 2018 second quarter was 26.4%, down from 28.2% in the 2017 second quarter due primarily to an increase in sales reserves as well as lower selling prices for certain licensed products at the end of the cycle.

SG&A expenses, including direct selling expenses and depreciation and amortization, in the 2018 second quarter totaled to $40.1 million or 37.9% of net sales compared to $47.8 million or 40% of net sales in 2017. These expenses, last year, included $2.3 million in bad debt expenses related to a specific customer.

And there was a benefit of about $1.3 million in the 2018 second quarter related to previously reserved Toys"R"Us receivables that were collected in Q2 mostly from Toys"R"Us in Canada. Excluding such items, expenses were still down in the 2018 second quarter and roughly flat as a percentage of sales.

Income tax expense for the second quarter of 2018 was $2.1 million compared to $316,000 in Q2 of last year. The variability of the tax provision is based on changes in taxable income levels in various tax jurisdictions in which we operate.

Net cash provided by operating activities was $2.7 million for the second quarter of 2018 compared to net cash provided by operating activities of $3.3 million in the second quarter of 2017. Free cash flow was negative $1.3 million in the 2018 second quarter and positive by approximately $100,000 in 2017 second quarter.

The decline in cash flow from operating activities is largely due to lower profitability and changes in working capital. As of June 30, 2018, our cash and cash equivalents including restricted cash totaled $63 million compared to $67.6 million at the end of the second quarter of 2017 and $65 million as of December 31, 2017.

We continue to focus on improving the company's liquidity position while also balancing the need to invest in the business and secure new licenses. As noted on our previous call, a top priority for us was to repay our $21.2 million of 2018 convertible notes, which are due on August 1 of this year.

On June 14, we closed a $20 million term loan with Great American Capital Partners to help refinance the 2018 notes. On that same day, we amended our credit facility with Wells Fargo to include additional receivables in the borrowing base calculation effectively increasing our liquidity under the facility.

And lastly, we recently exchanged a portion of the 2018 convertible senior notes held by Oasis Management with new convertible senior notes with terms similar to the notes issued to Oasis Management in November of 2017. The new notes mature in November 2020. The balance of the 2018 notes will be repaid next week.

Accounts receivable as of June 30, 2018 was $100.3 million, down from $110.5 million at the end of the second quarter of 2017, due to lower shipments during the quarter. DSOs for the 2018 second quarter were 86 days compared to 84 days a year ago.

Inventory as of June 30, 2018, was $62.2 million versus $81.2 million at the end of the second quarter of 2017. DSIs in the 2018 second quarter were 93 days compared to 113 days in the 2017 second quarter. Capital expenditures during the quarter were $3.9 million compared to $3.2 million in the second quarter of 2017.

The diluted loss per share calculation in the 2018 second quarter includes an average of 23.1 million common shares outstanding during the quarter and excludes 21.2 million shares underlying the convertible senior notes. And with that, I will turn the call back over to Stephen.

Stephen?.

Thank you, Brent. Before we get into Q&A, I will share some thoughts on how we see the rest of this year playing out. Starting with a few properties that will be important. As I said earlier, MorfBoard is doing extremely well.

Consumers are buying into this ecosystem as we are seeing 90% conversion rate with the extensions with customers that buy the combo set. We expect it to do well in the holidays because it's a great product at a great price point and because it's a great gift. Incredibles 2 is now the highest grossing animated feature of all time in North America.

Disney has high hopes for the success of the Incredibles 2 movie globally and we anticipate our product sales to be strong through the end of 2018 and into 2019 given the family appeal of the film, the characters and the story and the wide range of products we are bringing to market.

There also remain key international markets in Europe and Asia where the film has not yet been released. Other seasonal products where we're seeing good sales include Master A Million, which has performed extremely well in Europe. Maui POS increased at Walmart and at Target with Funnoodles, Hoops and Sky Balls.

POS sales of licensed Fly Wheels strikes are driving increases at major retailers while our core areas, ball pits and kids furniture Minnie, Paw Patrol, Mikey, PJ Masks and Peppa were all brands that performed well. Our Activity Table's POS is up over 26% at Walmart versus this time last year.

Squish-Dee-lish had a strong performance in Q2 due to continued solid POS as well as new introductions of Wacky and Jumbo. Fancy Nancy items are rolling out at retail in the coming weeks.

As a master toy licensee, we have a solid line of dolls and accessories tied to this beloved book series with an animated TV series that premiered on Disney Junior TV on July 13, which has already been picked up for a second season.

Fancy Nancy opened at Disney Junior #1 debut in 2 years among girls 2 to 5 and the premier Fancy Nancy stands as TV's #1 telecast of the week to date amongst girls 2 to 5. Additionally, Fancy Nancy ranked #1 in its 11:00 a.m. time period among girls 2 to 5, and also won its slot with kids 2 to 5 beating Paw Patrol on Nickelodeon by 11%.

As noted earlier, Disguise is on track to meet or exceed our internal forecast with strong contributions expected from several properties including Overwatch based on a hugely popular video game, and Transformer Bumble Bee based on a movie opening this fall.

Despite the fact that international sales were negatively impacted by the loss of Toys"R"Us in many of Europe and Asia-Pacific markets, we saw sales increase of approximately 25% in the second quarter of this year compared to last year, largely in part to our geographic expansion, new warehouses and the launch of Incredibles 2 and Squish-Dee-lish.

We continue to see new content production at Studio JP in addition to WEE WHIMSIES, which has an app launching this fall and a physical product line coming out in spring 2019.

We also announced in May that Paramount Players, a division of Viacom's Paramount Pictures had acquired the feature film rights to Creepy Crawlers, which is planned as a part live-action and animated feature film. In addition, Studio JP and Meisheng, the teams in the U.S.

and in China continue to work on new franchises with innovative and exciting toy lines in multiple categories.

In conclusion, as expressed earlier this year, we see some disruption as we are still cycling against Toys"R"Us' sales from a year ago, but we are very encouraged by the performances of some of our new brands and our evergreen strong categories of businesses as well as some of the new opportunities that allow us to be well positioned for the future.

Speaking about the whole industry and not just JAKKS, we expect the toy industry will see the lost Toys"R"Us sales shift over to other retailers, although that shift will take a bit more time to play itself out.

We continue to expect 2018 to see a validation of our strategic goals, expansion of licensing partnerships, strong performance from our owned IP, online sales growing as a percentage of total sales, expansion of our Studio JP effort, entry into new categories and international expansion. With that, we will now take questions.

Operator?.

[Operator Instructions]. And our first question is from Steph Wissink from Jefferies..

Stephen, I wanted to start with a question on Incredibles 2. Certainly fitting that Jack-Jack is the best seller.

But I'm wondering if you can talk a little bit about the breadth of that product line, and then how should we think about the cadence of flows of newness as the year progresses through the home entertainment window and then into the holiday season..

So as you did say, Jack-Jack is the star of the show and it's a star of our product line. And Jack-Jack is primarily in a breadth of SKUs that we developed. And we've done some exclusive products through different retail outlets.

But the breadth of the product of Incredibles goes really, really broad, and we thought Jack-Jack was going to be just the number one character in it. But actually -- it actually stood out to where the whole family has turned out to be a super seller. So the initial launch was a breadth of approximately 12 SKUs, in Pre-School and in toy.

And then the fall launch, which is the streaming and DVD release goes into a much deeper launch of playsets and accessories as well as our Halloween Costumes that turn in October and Role Play. So it really goes into a deep launch during the fall period of time both U.S. and internationally..

Okay, that's actually a good segue into the international business, it was nice increase there. I know you've been working several years to really build out your network of distributors and direct.

Can you talk a little bit about where you are in that pathway of progress? What we should be thinking about for the balance of '18? And then maybe even looking ahead the next couple of years? What percentage of markets are you in that you're direct? What is the goal? And how should we think about the international business contributing to growth?.

International will be a strong area of growth project for JAKKS for the few years going forward. One of which, we just started, over the last year, getting multiple licenses that are worldwide, for instance, Nintendo, Incredibles 2 and our own IP and various other licenses as well.

We go direct now, and we have a split initiative, which -- because we're in so many different segments of going direct on portions of our business and working through partnerships in other portions of our business.

But pretty much through the EMEA from U.K., France, Germany, Italy, we go direct as well as we have different partnerships in Latin America and then in Russia, we go direct as well in those territories. But we split it up very methodically based on the categories of the business in which we're in.

So in different -- in Latin America, there is duties in some of the products that we make, we have to bring in unassembled into the countries and then assemble it based off the duties issues. And as you have seen before, in North America, we have pallet programs and in-store programs that we are very large in the U.S.

And those have been now multiply developed and now distributed internationally. So we have pallet programs, which we never had before as much in the international markets..

Okay, that's helpful, Stephen.

And one for you, Brent, it's just on the SG&A, cuts that you're and the savings that you're seeing there? Where are we in that track? Do you feel like there is additional cuts to be made, savings to be realized? How should we think about your ability to kind of tighten up the cost structure over the next 6 to 12 months?.

Right now, I think, from a cost structure perspective, you can see that total operating expenses went to about 40% of revenue, which is good, coming down from where we were in the first quarter. So I think there is still potentially some opportunity. We talked about what cost vary with revenues on the last call.

So just to give you a little bit more flavor there, I would say, there is probably about 5 points of revenue in that operating expense line item that moves with revenue. So we don't have as much control of those, it will be cost be like commissions co-op marketing fees. But some of the other costs we can move and control.

And that's how we've been able to just exercise that fiscal discipline that you noted..

All right the last one for us. Stephen, this is a bigger picture question. I know you've been working to develop some of your own IP.

But I want to ask about the idea of creating sustainability within the portfolio of assets, a brand asset? How should we think about the portion of your business that you see as year in and year out sustainable or more evergreen style versus what you're taking advantage of in terms of licensing opportunities or event-driven opportunities? How has that ratio evolved? What should we be thinking about over the next couple of years in terms of that balance? And maybe give us just a status update on some of your owned brand initiatives..

Okay. Thank you Steph. So as you know we are a category business and -- of evergreen categories, within those we do have a tremendous amount of licensing partnerships. So we will always have the licensing partnerships that we value extremely strong in order to keep our basic strong business in these categories such as Halloween, Seasonal.

And that basic business is approximately about $0.5 billion annualized. And that's an evergreen part of our business in which we've developed, and we are continuing to develop with licenses and innovation in those categories. So that's an area that we see is very gradual growth and healthy growth.

And on top of that, it's just then taking the innovations in which we are focusing on in new categories such as C'est Moi, which we discussed previously and with C'est Moi and an update we are entering into many new areas of retail such as Amazon and the Indie Beauty platform and we're seeing continued growth since June.

Target.com, we're just recently launching, Walmart.com will be in August. So those are the initiatives that we're taking in our own category, which is a separate consumer kids category of non-toy.

On top of that, we have developed some really nice initiatives such as MORF as we discussed, which is performing and exceeding better than we expected in North America and now launching fall internationally, Master A Million, the line that we developed internally is going extremely well.

A product line called TP Blasters, which is a really nice innovative item is getting new distribution and thrown into areas that are not normal for the toy industry such as GameStop is taking not just our Action Figures but it's also taking the novelty items like TP Blasters.

So for us, we are going to continue to grow our licensing partnerships and the categories in which we're in and master toy license such as we have with Nintendo and Mega Man and Incredibles, but at the same times we're developing our own IP, which is like Squish-Dee-lish, JigglyDoos, FAN HEADS, Power Trains and a lot of areas in which what retailers are asking us to do, which is developing their own private labels as well, which is an area that we have been very focused on because of over the last 23 years, we've acquired 22 companies or so.

So we have a plethora of tools we that we can work with retailers for their private label. And it seems that's a very strong area in which many of the retailers are moving in. So for growth, it's really building on our existing platforms with licenses.

New innovation of IP, distribution channels, which are growing and further distribution and not just in the U.S. but internationally, some of which will be like in U.S. Party City. The Toy area and -- I'm sorry, Wayfair and places like that. There's different distribution channels that we're looking at. And our own IP with Studio JP.

There's a lot of exciting initiatives that we're taking. But we had to get over this hurdle with Toys"R"Us that's hurt the industry very much, very similar to sports authority. We think that's going to last through this year. But after the liquidation, we're seeing clear skies ahead going into the next year..

Our next question is from Linda Bolton-Weiser from D.A. Davidson..

So in looking ahead to 2019, which should be a better year. It'll be a year with the next Frozen movie. So you'll play a part of that. I seem to remember that in the year preceding the first Frozen movie, there was a big working capital need to have moulds and working capital in anticipation of the launch of those Frozen products.

So do you anticipate a big working capital need and impacts on cash flow related to the second Frozen movie?.

No, we actually have been working on the product line currently right now. You have to work on the products in R&D well in advance of the movie, and the tooling and with regards to manufacturing and planning of the manufacturing and the different markets, you know there's languages you have to work with, with the chips and the music.

So as we have been working on it now, it's part of our capital expenditure. And going forward, we don't see any additional needs than what we normally have done even with Incredibles and other categories and properties..

Okay.

And then, with the C'est Moi, can you talk about -- like of the sales that you're now seeing is -- what's the breakdown between e-commerce versus brick-and-mortar sales for C'est Moi? I mean, are you in any brick-and-mortar or is it just really vast majority of e-commerce?.

Actually it's a very good question. So we are -- the sales are higher on e-commerce. So we're at target.com, cestmoi.com, Dermstore. We are entering into Riley Rose, which is a subset of Forever 21, in October. Amazon is an extremely strong customer and the Indie Beauty platform, which we launched in June.

So primarily, we are more online than brick-and-mortar. But we go into Target stores later this year, which is the brick-and-mortar stores but we primarily focused, through the marketing team here, is to be more online than go into brick-and-mortar, but the brick-and-mortar starts fall this year and go into spring next year..

So can we expect that annual sales of C'est Moi could be $30 million in 2018? Or is that accurate? Or....

No. I don't know where that number came from. It's a very slow growth. We just launched it this year. It will be a wonderful thing to launch it and do $30 million in this category. But it's a very slow launch, it's a very methodical launch. And it's something that we're looking to build and grow.

As you know the beauty category well, but we're getting extremely well receptiveness from retail and from consumers..

And then finally, what does it mean now that Meisheng owns 51% of the shares? What does that mean for the company?.

So right now there's a letter of interest that he gave to acquire 51% of the company, the company Meisheng. In addition, we have the special committee that was developed, working B of A Merrill and Skadden, Arps. And they are reviewing his interest as well as other potential interests of letters that have come in.

And at that time, they're reviewing it and will get back with any further addition based off of their interest or other companies' interest..

So I think I misunderstood the press release.

It's not that they have already bought additional shares?.

No, they are not. They gave interest to acquire 51% of the outstanding shares. 51% of JAKKS Pacific common shares..

Right.

And when is the targeted -- maybe you said it but when are you targeting to have a decision reached on that proposal?.

It's hard to say, but I would gather a decision should be dealt with within the next couple of months..

[Operator Instructions]..

Ladies and gentlemen, thank you for the call today. We appreciate the questions and answers, and everyone attending our call. Thank you very much..

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating, and you may now disconnect..