Dream International – a dream investment?

Summary

Dream International is a Hong Kong listed plastic and plush stuffed toy manufacturer, with factories based in China and Vietnam. Most of the factories today are based out of Vietnam, which gives a cost advantage on China based producers. The company supplies toys to a limit number of larger companies, such as Disney, Oriental Land, Funko and Spin Master. The company has been growing revenue last 10 years with a CAGR of 12%. This has accelerated last 3 years to a CAGR of 21% for revenue and 38% for EBITDA. Although profits have been accelerating, the company is trading at a trailing P/E of about 6.8. Usually when something is trading so cheap, there is some catch, or is this the holy grail of Growth At a Reasonable Price (GARP)? I will try to give my views of what I have been able to find.

+ Fast growing company trading below 7x P/E.

+ Exposure to segment of toys with high growth (Marvel superheros, Star Wars, Disney figures etc).

+ As one of the worlds largest plush stuffed toy producers, Dream has a long track record with large customers like Disney.

+ Recently expanded the customer relationships to plastic toy sales which has given explosive growth and earnings.

– Poor liquidity in the stock.

– Old (69 years) majority shareholder and CEO, unknown what his plans for the future are.

– Probable margin deterioration due to higher material costs (mostly related to oil price).

– Recently bought it’s office premises in Hong Kong for 200m HKD instead of continuing to rent.

Background / History

Given the low coverage of this stock and children’s toys being a somewhat odd field for me to research, I felt I had to dig a bit deeper than I usually do. So i read/skimmed through all the annual reports back to 2001, taking some notes along the way. The company provides a historical timeline, but this section will rather be an explanation of what I gathered from Dream International’s (here after called Dream’s) history by reading its annual reports.

Dream started in the 80’s in South Korea, by the majority owner Kyoo Yoon Choi who is also Korean. Kyoo Yoon Choi is still heading the company and is its CEO and Chairman. He holds about 67% of the companies shares. The companies head quarters were in the 90’s moved to Hong Kong, as a natural gateway to China, where the toy factories at the time were located. In a fragmented market Dream has since the late 90’s, been one of the largest plush stuffed toy manufacturers in the world.  Already back in 2001 the plush stuffed toy sales for Dream was about 750m HKD in a total market of about 20bn HKD. The majority of sales throughout all these years has always been OEM, where the design and sales/distribution of the toys are lead by another company. Customers for these OEM plush stuffed toys in the early 2000’s have been companies like Disney, Warner Bros, Bandai etc. The two major markets have always been USA and Japan.

In early 2000’s when Dream had just listed on the HK exchange, the company had the ambition to climb up the value-chain. The first step was by start producing ODM (Original Design Manufacturing) plush stuffed toys. This meant Dream did the design and production but distribution was still done by someone else. The main distributors were Walmart, Costco and Target.

ODM product “Made to Love Made to Hug” Bear from Dream International

The next step was OBM (Original Brand Manufacturing), when investments were made in broadening the distribution network. As crude oil and other material prices started to increase in 2004-2005 the company was not able to transfer the increased material costs onto the customers.  On top of that China made changes in lowering the refunds on export VAT. This altogether hurt OEM toy manufactures and Dream to such a degree that it was posting losses for the first time in 2005. The company during these years and up until the Financial crisis, were struggling with both margins, as well as growing the business. What held up fairly well was the ODM business where customers like IKEA also had been signed. In the end the company gave up the push into OBM products and has since then stayed only with the OEM and ODM segments. From what I have been able to gather, this weak pricing power (especially in the short-term) seems to still be true, when mainly oil price rises rapidly. I have also confirmed this from other toy manufactures, that also showed deteriorating margins when oil price increased rapidly.

During the crisis years the company had also started to shift its production towards Vietnam, which with hindsight has been one of the main reasons for the companies continued success. With most of the smaller manufactures being based in China, they margins got significantly squeezed when minimum wages has been rising so rapidly in China, this is especially true for the last few years.

During the financial crisis a number of smaller toy manufactures when bust and a large consolidation of the market took place. The number of toy manufacturing companies world wide went down from about 8600 to 4400 during 2008. In late 2008 Dream secured a larger contract with Disney where the company is responsible for manufacturing Disney consumer toys. The final goods are then distributed to Tokyo and US Disneyland theme park stores for selling. Another contract was put in place with a large Brazilian client (which later scaled backed its purchases significantly). When the crisis subdued Dream was able to bargain down material costs and the company has since 2009 always been profitable. The free cash flow generated from the plush toys was used to explore some new product lines and at the same time move more and more of production to Vietnam. The ties to produce Disney, Marvel superhero products and Star Wars toys, has been working really well for Dream, especially on back of all the movies successes in recent years.

Dreamwork’s Trolls and Disney’s Frozen characters by Dream International

Not all venture has gone great though, the company has for almost 10 years tried to produce ride-on toys. The company has struggled with this segment for many years and have still not managed to either grow the business significantly, or make it profitable. But another other area has become the star segment of the company, and that was thanks to the decision to expand into the plastic toy business. Much of this success from what I gather is thanks to the long/strong ties Dream has supplying plush toys to these bigger US/Japanese companies. Dream has during the last few years managed to break into the plastic toy segment in a big way. A large part of recent growth of plastic toy sales is also thanks to newly US listed company Funko, where Dream is one of its main supplier of plastic toys.

The latest new venture/segment for Dream, which is still in its infancy, is according to the company going to be “doll products”. How that will succeed is yet to be seen in company earnings. But if the success of the plastic toy segment can be copied, there is potential for further growth in the doll segment.

Is the company well run?

I have tried to look for if the company has been mismanaged in anyway, given that the company is in control of the majority shareholder and CEO. Something that caught my eye was that the company end of last year decided to invest about 200 million HKD in a new office premises in Hong Kong. Basically all the free cash flow from this record year went towards this investment. I have to say I don’t really like it, I don’t think a toy company should be investing such large amounts in property. It makes more sense to invest in the factories, R&D and even dividends. At the same time I can’t totally condemn a company, wanting to own it’s office premises instead of renting. Rents are horrendous in Hong Kong (although the price point they were buying at is equally horrendous) and this will free up future cash-flow which has gone towards paying high rents in the past. There were some accounting restatements back in 2012, but nothing major. All in all I haven’t really been able to find any major proofs of the company being mismanaged.

Overall, most of the signs in the Annual Reports are telling the story of a well run company. The directors are not highly paid, I would almost say very conservatively paid. Most of the leaders are staying in the company for a long time, with the majority owner always at the helm. They have weathered all kinds of business climates throughout the years and managed to keep customers like Disney for 15 years+. For me the signs are pointing more in the right than wrong direction.

Analyzing Financials

As of end 2017, the company is virtually debt free, runs a net cash position of about 400m HKD (before the office purchase). For the last year the company generated Net Income of about 400m HKD on a current MCAP of about 2.8bn HKD. The company has an impressive history of revenue growth, about 12% annualized over the last 10 years. Thanks to the new business segment of plastic toys, growth and earnings are accelerating sharply in the last years few years.

Funko (based in US) plastic toys sales is driving North America growth significantly.

When analyzing competitors, some of their toy sales have been very volatile. Although Dream experienced a drop in sales when the Brazilian customer withdrew its volumes in 2011, the sales has in general been remarkably stable for plush stuffed toys. Plastic figure sales have increased at an incredible rate lately. This growth pace is obviously not sustainable, but it’s also hard to forecast how much more it can grow. Dream states that they have further capacity in it’s factories and is also able to fairly quickly scale up with more factories.

As I was mentioning earlier, Dreams seems to be somewhat of a price taker, as material costs rise. One can see “some pattern” of increased EBITDA margins when oil price decreases. The plush stuffed toys EBITDA increase from the 200m HKD region, to 250-300m HKD I ascribe to the oil price decrease. Given what we have seen lately in terms of oil-price increases I expect 2018 figures to get back to the 200-250m EBITDA range. But even at 100 USD oil, the company was able to generate steady 200m EBITDA, so with larger volumes today, I’m positive in the long term that EBITDA can keep growing. Its not either written in stone that oil prices will hold up at these levels.

As can be seen the EBITDA margin for plush stuffed toys has been very nice and stable, the oil effect is probably there, but its far from the whole story. Plastic figure margins are still somewhat unknown, but it seems somewhat likely that plastic figures in the long run would some similar margins like the stuffed toys. A competitor in the plastic toys field, Matrix Holdings (also HK listed) has not shown as great margins, they have peaked at around 15% and are currently around 10%. So Dream is clearly enjoying better margins than the competitors. This margin advantage I ascribe to having low cost production in large scale in Vietnam as well as the products like Disney and Star Wars figures selling at significant premiums to general riff-raff Toy’s R’ Us toys.

Liquidity & Dividends

One obvious issue with this company is the free-float and daily liquidity. On a very good day the company turnovers some 2-3 million shares, meaning somewhat north of Us$1 million in traded volume. But on a more normal day the average is about 240 000 shares changing hands, meaning a volume of about US$125k. This is clearly a illiquid stock for anyone trading anything more than a small private portfolio. From that sense I have struggled if I should even bring this company up in this blog, or just keep this holding outside my GSP portfolio. In the end I decided to add it in, since it is possible to accumulate a decent sized position over time. Clearly this level of liquidity warrants some type of added liquidity risk premium.

The company has not been a very stable dividend payer. In the past that is fully understandable, first of all, the company was losing money around the financial crisis. After that is started to shift out money to investors, paying a very decent 11 cents in 2013, down to 8 cents 2014-2015, that was at the time a dividend yield between 11%-6%. Lately major investments were needed to expand so rapidly and rotate production from China to Vietnam. But in the last year, I would have liked to see higher dividends at least mentioned/planned. The purchase of the Hong Kong office space instead of increasing dividends this year is also frustrating. The jury is still kind of out, if this office purchase was a one-off and dividend will be raised sharply the coming year, alternatively that larger expansion investments are again needed (which would of course be even more positive). One sell side research report mentioned that management has stated an intention to increase dividend pay-out ratio to about 30%, still not great, but better than today.

Valuation discussion

This company is trading so cheap, so in this case I don’t even see the need to try to estimate future revenue, profit margins and apply a DCF to that. If one beliefs they can maintain revenue and margins, the stock is clearly undervalued trading below 7x Price/Earnings. At current Net Income, Dreams will compound such returns that even without multiple expansion, this stock is going north. To see further upside potential one can just apply moderate growth to revenue with today’s margins.

If one wants to paint a blue sky scenario, where the stock expands the P/E multiple to international peers (Funko P/E 15, Hasbro P/E 18) and at the same time keeps profit margins and continues to grow in plastic/doll toy manufacturing, this stock could go about 3-4x in the coming years. Given the low liquidity and interest in the company that is highly unlikely to fully materialize. But it just shows the potential and how low the current valuation is.

I set an initial target price at 8 HKD, and will re-evaluate the case if/when the stock reaches that price.

What could go wrong?

Since we established that the stock is cheap, I would like to instead discuss what can go wrong? Is the stock cheap for a reason?

1. One reason why the stock is cheap, we already know, the low liquidity creates about zero institutional interest in the company. This could explain the valuation gap, rather than it’s something that something is wrong, that I haven’t caught at all. Share price direction does not either tell the story of something that is wrong, just a reluctance to expand the multiple.
2. The majority owner and CEO Kyoo Yoon Choi starts to become a fairly old man by now, aged 69 years. Although Asians are famous for more or less dying at the work-desk, one might wonder, what will happen with the company when he has health problems, or just decides to step down. I have not found information around any type of succession planing. But Mr Kyoo Yoon Choi does not seem all too alone steering the ship. For example not so young Mr Young M. Lee, aged 62 years have been with the company for a long long time. Looking at historical attendance numbers for board meetings, I would almost conclude that Mr Young M. Lee is the actual day to day leader of the company. But of course, it is worrisome what Mr Kyoo Yoon Choi wants to do with his company in the future.
3. I have mentioned the inability to transfer production costs to the 5-7 large customers that makes up most of Dream’s sales. This creates some short-term worries when oil price is just climbing higher and higher. To some degree this will probably hurt margins, at the same time, Dream’s volumes have been increasing. All else equal larger volumes, means more bargain power of material costs.
4. Mentioning large customers, as have been seen in the past when the large Brazilian customer withdrew its business, Dream takes a significant hit. For example if Funko would to shift to another supplier of its plastic Marvel Superhero and Star Wars toys, Dream’s Revenue would take a significant hit. The counter to that is how well Dream has managed to retain it’s other significant customers, except this one Brazilian case.
5. Another angle of a few large customers are their stability. We have recently seen Toy’s R’ Us defaulting in the US. Going far back in the annual reports, Toy’s R’ Us’ was mentioned as a customer, but I have not seen that it has been mentioned since. Due to the fact that Dream’s design so little of its own toys, I believe the exposure to this default is none to minimal. But in the future some of Dream’s big customers could be facing tough times. For example Funko does not seem to be on such solid grounds in terms of its Financials. Although the lawsuit which I looked into, was mostly referring to a Bloomberg article: Lawsuit alleges toymaker Funko misled investors about its financials prior to IPO.  Follow-up: Funko Looks to Rebound From IPO Meltdown With Overseas Push.

Summary

To me this company is as strong of a buy as I have been able to find in this market. I look at a lot of stocks, that never get mentioned here. I think the company has all the signs of a company with growth at a very reasonable price. Obviously there is some cyclical aspects in general toy consumption, visits to Disney land and purchases of Marvel superheros as birthday gifts. But not even there I think Dream should be overly punished. Toys are for example not nearly as cyclical as the car industry.  I was lucky to find this company, just by reading an article in Financial Times about the 1000 fastest growing companies in Asia. This company showed up somewhere around 800-900 on that list and I looked further into it.

I have struggled a bit on position sizing given the liquidity, but have decided to go with a fairly large position size of 6% of my portfolio. One thing that worries me a bit also mentioning this stock, given the liquidity, that I drive up the stock price with this post. Normally the stocks I mention here are large and liquid enough that my contribution will probably make nearly zero impact on the stock price. So I for once, although it always applies, I will actually ask specifically, please do your own due diligence.

I recently got contacted by some reader asking about my insight on my Dignity holding. I want to emphasize, this is for me still on hobby basis. I never talk to management and I have limited time to research, so I might have missed some very important facts, that goes for all the companies I own. For example in Dignity’s case I had missed a “short sell” report on the company, which you readers helped me find.

I hope you enjoyed this stock idea, which I think is off the beaten track and is a true value play (hard to come by these days)!

NetEase

As a bonus I also throw in another portfolio change. Since I always announce my purchases, I as of end of yesterday also double up my position in NetEase, on back of weak share performance. I still see them deliver great games and their Kaola e-commerce homepage is also gaining significant momentum.