Mega Brands is a Montreal based company engaged in designing, manufacturing and marketing of two product lines: toys and stationary products. Between 2006 to 2009 the company had a slew of lawsuits and product recalls that left it teetering on the brink of bankruptcy, but after a recapitalization and the signing of new brand licenses Mega Brands is poised to be a prime turnaround candidate. While the stock should also do well, a large outstanding issue of in the money warrants will dilute the company's upside. The bonds on the other hand are reflecting a much higher risk profile than is warranted.
Before the company's troubles began, Mega Brands built itself from its humble beginnings as a toy distribution business run by the Bertrand family into a design and marketing entity with $550mm in sales in 2006. Part of this growth was through its 2005 acquisition of Rose Art, which is primarily responsible for its woes from then on. Rose Art's Magnetix line, representing 40% of the new acquisitions sales, was responsible for the death of a toddler from magnet ingestion. What ensued was mass product recalls, abandonment of the product line, and charge-offs totalling $123mm. In addition, the company engaged in costly litigation ($55mm set aside as loss provision) with the former owners of Rose Art regarding earn-outs on the acquisition. The resulting public relations nightmare caused sales to fall from $550mm in 2006 to $338mm in 2009, while at the same time the company was saddled with over $400mm in debt from the Rose Art purchase. It also did not help that these events coincided with the worst recessions in a generation.
In 2009 the company's independent directors met several times to discuss the possibility of recapitalization or the sale of some or all of the company's operations. They settled upon a complete recapitalization, in early 2010 cancelling existing debt with the issuance of $229mm of new equity, warrants, senior 10% coupon bonds, plus the establishment of a $50mm asset based credit facility (senior to the bonds) for working capital requirements. Existing holders Fairfax Financial, AIM Trimark and the Bertrand family all bought the issuance, which reduced total debt by $300mm and reduced interest expense by $30mm/year. Pro forma numbers suggest interest coverage (adjusted EBITDA to interest expense) increased to 1.3x from -4x for 2009 and 2.8x from -11.7x for 2008 post recapitalization. Not stunning numbers, but manageable even during years that were complete disasters.
A string of positive developments makes the recapitalization look like it will have a more positive effect than the pro forma historical numbers suggest. In September the company's legal battle with LEGO ended in Europe, freeing up Europe as a growth market for its traditional Mega Blok product. Mega Brand toys are now regaining shelf space at key retailers such as Wal-Mart, Toy's R Us, Target, etc... The company has seen strong sales of its proprietary Dragon's brand, as well as in its Thomas and Friends (named on the hot 20 toys of 2010 list), Iron Man II , and Halo licenses. In early December Mega Brands inked a new licensing agreement with Electronic Arts for Need For Speed. Q3 2010 toy sales were 18% higher YoY and the company is back in the black, earning $16mm on sales of $128mm.
What I am betting on is that Mega Brands can return to its previous profitability before the Rose Art fiasco. The company successfully built relationships with licensors and distributors, and was able to run a very profitable business of proprietary and licensed toys. The bad PR and litigation has battered the company, though if it can regain its past operating performance the recapitalized entity will vastly increase its interest coverage ratio and the now in-the money warrants will be exercised to repay the principal on the bonds. Management thinks that if they implement this turnaround they can reach $500mm in sales in 5 years with EBITDA margins in the mid teens in 3-5 years. The actions management have shown since recapitalization point to them being vigilant and hungry to return to what made them successful pre Rose Art. Even if they stumble, a base case scenario is a return to 2009 sales levels where pro forma numbers show that they will still be able to cover interest payments. I view that scenario as less likely given how quickly the chains have restocked Mega Brand products and the pipeline of upcoming products, plus management's undivided attention to the core business and not litigation or financial difficulties.
I am avoiding the common stock because of the dilution of warrant exercise. The warrant exercise is why the bonds look good, because the stock will be worth more than the $0.50 strike should the company prosper and the cash injection pays back the principal, regardless of whether the company is able to refinance the debt. Its not that I think the stock is a bad investment, I just like that the bonds are marginable and benefit indirectly if the stock does well. The street however is bullish on the stock, with 4 analysts with buys on the stock and a target price of 0.89 vs. 0.65 currently.
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