Description
Filed with the SEC from Oct 11 to Oct 17:
JAKKS Pacific (JAKK)
California Capital Z, an investment vehicle of pharmaceutical-industry billionaire Patrick Soon-Shiong, reported that it owns 1,975,782 shares (9%) after purchasing 1,588,789 from Aug. 17 through Oct. 12 at $13.68 to $16.52 per share.
BUSINESS OVERVIEW
Company Overview
We are a leading multi-line, multi-brand toy company that designs, produces, markets and distributes toys and related products, pet toys, consumables and related products, electronics and related products, kids indoor and outdoor furniture, and other consumer products. We focus our business on acquiring or licensing well-recognized trademarks and brand names, most with long product histories (āevergreen brandsā). We seek to acquire these evergreen brands because we believe they are less subject to market fads or trends. We also develop proprietary products marketed under our own trademarks and brand names, and have historically acquired complementary businesses to further grow our portfolio. For accounting purposes, our products can be divided into two segments: (i) traditional toys and electronics and (ii) role play, novelty and seasonal toys. Segment information with respect to revenues, assets and profits or losses attributable to each segment is contained in Footnote 3 to the audited financial statements contained below in Item 8, Our products include:
Traditional Toys and Electronics
āAction figures and accessories, including licensed characters, principally based on Ultimate Fighting Champion (UFC), Total Non-Stop Action (TNA) wrestling, PokĆ©mon Ā® franchises;
āToy vehicles, including Road Champs Ā®, Fly WheelsĀ® and MXS Ā® toy vehicles and accessories;
āElectronics products, including SpyNet spy products, EyeClopsā¢ Bionic Eye products, Laser Challenge Ā® and Plug It In & Play TV Games ā¢ based on DisneyĀ® brands and other popular brands;
āDolls and accessories, including small dolls, large dolls, fashion dolls and baby dolls based on licenses, including Disney PrincessĀ®, Disney FairiesĀ®, Cabbage Patch KidsĀ®, Hello KittyĀ®, GracoĀ® and Fisher PriceĀ® plush, infant and pre-school toys;
āPrivate label products as āexclusivesā for a myriad of retail customers in many product categories; and
āPet products, including toys, consumables, and accessories, branded JAKKS PetsĀ®, some of which also feature licenses, including Kong Ā® . In 2011, we launched our proprietary brand of assorted pet products under American Classics ā¢ .
Our Business Strategy
In addition to developing our own proprietary brands and marks, licensing popular trademarks enables us to use these high-profile marks at a lower cost than we would incur if we purchased these marks or developed comparable marks on our own. By licensing trademarks, we have access to a far greater range of marks than would be available for purchase. We also license technology developed by unaffiliated inventors and product developers to enhance the design and functionality of our products.
We sell our products through our in-house sales staff and independent sales representatives to toy and mass-market retail chain stores, department stores, office supply stores, drug and grocery store chains, club stores, toy specialty stores and wholesalers. Our three largest customers are Wal-Mart, Target and Toys āRā Us, which accounted for approximately 24.6%, 19.4% and 12.6%, respectively, of our net sales in 2011. No other customer accounted for more than 10.0% of our net sales in 2011.
The execution of our growth strategy, however, is subject to several risks and uncertainties and we cannot assure you that we will continue to experience growth in, or maintain our present level of net sales (see āRisk Factors,ā beginning on page 11). For example, our growth strategy will place additional demands on our management, operational capacity and financial resources and systems. The increased demand on management may necessitate our recruitment and retention of additional qualified management personnel. We cannot assure you that we will be able to recruit and retain qualified personnel or expand and manage our operations effectively and profitably. To effectively manage future growth, we must continue to expand our operational, financial and management information systems and to train, motivate and manage our work force. While we believe that our operational, financial and management information systems will be adequate to support our future growth, no assurance can be given they will be adequate without significant investment in our infrastructure. Failure to expand our operational, financial and management information systems or to train, motivate or manage employees could have a material adverse effect on our business, financial condition and results of operations.
Moreover, implementation of our growth strategy is subject to risks beyond our control, including competition, market acceptance of new products, changes in economic conditions, our ability to obtain or renew licenses on commercially reasonable terms and our ability to finance increased levels of accounts receivable and inventory necessary to support our sales growth, if any.
Furthermore, we cannot assure you that we can identify attractive acquisition candidates or negotiate acceptable acquisition terms, and our failure to do so may adversely affect our results of operations and our ability to sustain growth.
Finally, our acquisition strategy involves a number of risks, each of which could adversely affect our operating results, including difficulties in integrating acquired businesses or product lines, assimilating new facilities and personnel and harmonizing diverse business strategies and methods of operation; diversion of management attention from operation of our existing business; loss of key personnel from acquired companies; and failure of an acquired business to achieve targeted financial results.
Industry Overview
According to Toy Industry Association, Inc., the leading toy industry trade group, the United States is the worldās largest toy market, followed by Japan and Western Europe. Total retail sales of toys, excluding video games, in the United States, were approximately $21.2 billion in 2011. We believe the two largest United States toy companies, Mattel and Hasbro, collectively hold a dominant share of the domestic non-video toy market. In addition, hundreds of smaller companies compete in the design and development of new toys, the procurement of character and product licenses, and the improvement and expansion of previously introduced products and product lines.
Over the past few years, the toy industry has experienced substantial consolidation among both toy companies and toy retailers. We believe that the ongoing consolidation of toy companies provides us with increased growth opportunities due to retailersā desire to not be entirely dependent on a few dominant toy companies. Retailer concentration also enables us to ship products, manage account relationships and track point of sale information more effectively and efficiently.
Products
We focus our business on acquiring or licensing well-recognized trademarks or brand names, and we seek to acquire evergreen brands which are less subject to market fads or trends. Generally, our license agreements for products and concepts call for royalties ranging from 1% to 14% of net sales, and some may require minimum guarantees and advances. Our principal products include:
Traditional Toys and Electronics
Electronics Products
Our electronic products category includes our Plug It In & Play TV Games, Spynet Spy products , EyeClops ā¢ Bionic Eye products and Laser Challenge Ā® product lines. Our current Plug It In & Play TV Games titles, geared to the pre-school and leisure gamer segments, include licenses from Namco Ā®, Disney , Marvel Ā® and Nickelodeon , and feature such games as SpongeBob SquarePants Ā®, Big Buck HunterĀ® Pro, Golden Tee Golf, Dora the Explorer Ā®, Disney Princess Ā®, Ms. Pac-Man Ā® and Pac-Man Ā®.
In 2012, we expect to launch a game based on the popular arcade game Walking Dead as well as portable baby monitors and digital cameras.
Wheels Products
āMotorized and plastic toy vehicles and accessories.
Our extreme sports offerings include our MXS line of motorcycles with generic and well-known riders and other vehicles include off-road vehicles and skateboards, which are sold individually and with playsets and accessories.
Action Figures and Accessories
We currently develop, manufacture and distribute other action figures and action figure accessories including those based on the animated series PokƩmon, UFC and TNA wrestling, capitalizing on the expertise we built in the action figure category. In 2011, we launched a line of action figures, playsets and accessories based on the Pirates of the Caribbean and Real Steel movie franchises; and figurines based on Smurfs and Phineas and Ferb .
In 2012, we expect to launch a line of action figures, playsets and accessories based on the boys animated television show Monsuno premiering domestically on Nick Toons in February 2012 and internationally beginning in the fall of 2012.
Dolls
Dolls and accessories include small dolls, large dolls, fashion dolls and baby dolls based on licenses, including Disney PrincessĀ®, Disney FairiesĀ®, Cabbage Patch KidsĀ®, Hello KittyĀ®, GracoĀ® and Fisher PriceĀ® , including an extensive line of baby doll accessories that emulate real baby products that mothers today use; plush, infant and pre-school toys, and private label fashion dolls for other retailers and sold to Disney Stores and Disney Parks and Resorts.
Pet Products
We entered the Pet Products category with our acquisition of Pet Pal, whose products include pet toys, treats, beds, clothes and related pet products. These products are marketed under JAKKS PetsĀ® and licenses include Kong Ā®, as well as numerous other entertainment and consumer product properties. In 2011, we launched our own proprietary brand of assorted pet products under the brand American Classics ā¢ .
Role Play, Novelty & Seasonal
Role-play and Dress-up Products
Our line of role-play and dress-up products for boys and girls features entertainment and consumer products properties such as Disney Princess Ā®, Disney Fairies Ā® , Dora the Explorer Ā® , and Black & Decker Ā®. These products generated a significant amount of sales in 2011, and we expect that level of sales to continue in 2012.
Seasonal/ Outdoor Products
We have a wide range of seasonal toys and outdoor and leisure products. Our Funnoodle pool toys include the basic Funnoodle pool floats and a variety of other pool toys.
Indoor and Outdoor Kidsā Furniture
We produce an extensive array of licensed indoor and outdoor kids' furniture and activity tables, and room decor. Our licensed portfolio includes character licenses, including CrayolaĀ®, Disney PrincessĀ®, Toy Story Ā®, Mickey Mouse Ā®, Dora the Explorer Ā® , and others. Products include childrenās puzzle furniture, tables and chairs to activity sets, trays, stools and a line of licensed molded kiddie pools, among others.
Halloween and Everyday Costume Play
We produce an expansive and innovative line of Halloween costumes and accessories which includes a wide range of non-licensed Halloween costumes such as horror, pirates, historical figures and aliens to animals, vampires, angels and more, as well as popular licensed characters from top intellectual property owners including Disney Ā® , Hasbro Ā® , Marvel Ā® , Sesame Workshop Ā® , Mattel Ā® , and many others.
World Wrestling Entertainment Video Games
In June 1998, we formed a joint venture with THQ, a developer, publisher and distributor of interactive entertainment software for the leading hardware game platforms in the home video game market. The joint venture entered into a license agreement with the WWE under which it acquired the exclusive worldwide right to publish WWE video games on all hardware platforms. Pursuant to a Settlement Agreement and Mutual Release dated December 22, 2009, the joint venture was terminated on December 31, 2009 and we received and recorded as income as received fixed payments from THQ of $6.0 million in each of June 2010 and 2011 and are to receive the remaining additional fixed payments of $4.0 million on each of June 30, 2012 and 2013 which we will record as income on a cash basis as received (see āLegal Proceedingsā).
Sales, Marketing and Distribution
We sell all of our products through our own in-house sales staff and independent sales representatives to toy and mass-market retail chain stores, department stores, office supply stores, drug and grocery store chains, club stores, toy specialty stores and wholesalers. Our three largest customers are Wal-Mart, Target and Toys āRā Us, which accounted for approximately 53.4% of our net sales in 2010 and 56.6% of our net sales in 2011. With the Pet Pal Ā® product line, we distribute pet products to key pet supply retailers Petco and Petsmart in addition to many other pet retailers and our existing customers. We generally sell products to our customers pursuant to letters of credit or, in some cases, on open account with payment terms typically varying from 30 to 90 days. From time to time, we allow our customers credits against future purchases from us in order to facilitate their retail markdown and sales of slow-moving inventory. We also sell our products through e-commerce sites, including Toysrus.com and Amazon.com.
CEO BACKGROUND
Stephen G. Berman has been our Secretary, Chief Operating Officer (until August 23, 2011) and one of our directors since co- founding JAKKS in January 1995. From January 1, 1999 he has also served as our President. From February 17, 2009 through March 31, 2010 he has also been our Co-Chief Executive Officer and since April 1, 2010 he has been our Chief Executive Officer. From our inception until December 31, 1998, Mr. Berman was also our Executive Vice President. From October 1991 to August 1995, Mr. Berman was a Vice President and Managing Director of THQ International, Inc., a subsidiary of THQ. From 1988 to 1991, he was President and an owner of Balanced Approach, Inc., a distributor of personal fitness products and services.
Dan Almagor has been one of our directors since September 2004. Since March 1992, Mr. Almagor has served as the Chairman of ACG Inc., a global private equity organization which provides equity capital financing primarily to private companies.
Robert E. Glick has been one of our directors since October 1996. For more than 20 years and until May 2007, Mr. Glick was an officer, director and principal stockholder in a number of privately held companies which manufacture and market womenās apparel. Since May 2007, Mr. Glick has been a consultant to a publicly held company which manufactures and markets womenās apparel.
Michael G. Miller has been one of our directors since February 1996. From 1979 until May 1998, Mr. Miller was President and a director of a group of privately-held companies, including a list brokerage and list management consulting firm, a database management consulting firm, and a direct mail graphic and creative design firm. Mr. Millerās interests in such companies were sold in May 1998. Mr. Miller is currently President of Zenith Technologies, LLC, a private home appliance manufacturer.
Murray L. Skala has been one of our directors since October 1995. Since 1976, Mr. Skala has been a partner of the law firm Feder Kaszovitz LLP, our general counsel.
Marvin W. Ellin has been one of our directors since October 2010. Mr. Ellin was a founding partner and the managing partner of Miller Ellin & Company LLP, a public accounting firm, for 50 years. The firm consisted of over 40 professionals and had extensive experience handling diverse clients with domestic and international operations including SEC filings, audit, tax compliance and financial advisory services. Mr. Ellin holds a Bachelor of Business Administration degree and a Juris Doctor degree and is a member of the AICPA, NYSSCPA and the New York State Bar Association. Miller Ellin & Company LLP was also a registered accounting firm with the PCAOB and a member of the Center for Public Company Audit Firms of the AICPA. Effective January 1, 2009 the firm merged into Rosen Seymour Shapss Martin & Company LLP and Mr. Ellin is a retired partner of such firm.
Peter F. Reilly has been one of our directors since April 21, 2012. Mr. Reilly has been the president and chief operating officer of Strategic Industries, LLC (āStrategicā) since 2007 and prior thereto was its chief financial officer from 2000 to 2007. Strategic is a diversified holding and management company operating in the automotive products and consumer product segments. Prior to joining Strategic, from 1991 to 2000, Mr. Reilly served in various senior financial positions of various entities affiliated with Hanson Industries, PLC. Mr. Reilly began his career at Ernst & Young LLP as an auditor from 1986 to 1991. Mr. Reilly also serves on the boards of directors of several private companies and has previously served on the board of directors of Dura Automotive Systems, Inc. and Jackson Hewitt Tax Service Inc. Mr. Reilly is a Certified Public Accountant (Inactive). He received his Bachelor of Arts degree in Accounting from Rutgers University in 1986.
Leigh Anne Brodsky has been one of our directors since May 8, 2012. Ms. Brodsky is a 25-year veteran of the childrenās entertainment and toy industry. Until September 2011 she served as President of Nickelodeon Consumer Products, Inc., where she oversaw parent company Viacomās worldwide licensing and merchandising business, which included Nickelodeon, MTV and Comedy Central. Prior to her nearly 13 years with Viacom, Ms. Brodsky worked in senior executive roles for Golden Books Entertainment Group, Lorne Michaelsā Broadway Video and Scripps Howardās United Media. Ms. Brodsky is currently a Board member of the Childrenās
Brain Tumor Foundation and served from 2010 to 2011 as an elected Board member of the Toy Industry Association.
MANAGEMENT DISCUSSION FROM LATEST 10K
Critical Accounting Policies
The accompanying consolidated financial statements and supplementary information were prepared in accordance with accounting principles generally accepted in the United States of America. Significant accounting policies are discussed in Note 2 to the Consolidated Financial Statements, Item 8. Inherent in the application of many of these accounting policies is the need for management to make estimates and judgments in the determination of certain revenues, expenses, assets and liabilities. As such, materially different financial results can occur as circumstances change and additional information becomes known. The policies with the greatest potential effect on our results of operations and financial position include:
Allowance for Doubtful Accounts. Our allowance for doubtful accounts is based on managementās assessment of the business environment, customersā financial condition, historical collection experience, accounts receivable aging, customer disputes and the collectability of specific customer accounts. If there were a deterioration of a major customerās creditworthiness, or actual defaults were higher than our historical experience, our estimates of the recoverability of amounts due to us could be overstated, which could have an adverse impact on our operating results. The allowance for doubtful accounts is also affected by the time at which uncollectible accounts receivable balances are actually written off.
Major customersā accounts are monitored on an ongoing basis; more in depth reviews are performed based on changes in customerās financial condition and/or the level of credit being extended. When a significant event occurs, such as a bankruptcy filing by a specific customer, and on a quarterly basis, the allowance is reviewed for adequacy and the balance or accrual rate is adjusted to reflect current risk prospects.
Revenue Recognition. Our revenue recognition policy is to recognize revenue when persuasive evidence of an arrangement exists, title transfer has occurred (product shipment), the price is fixed or readily determinable, and collectability is probable. Sales are recorded net of sales returns and discounts, which are estimated at the time of shipment based upon historical data. JAKKS routinely enters into arrangements with its customers to provide sales incentives, support customer promotions, and provide allowances for returns and defective merchandise. Such programs are based primarily on customer purchases, customer performance of specified promotional activities, and other specified factors such as sales to consumers. Accruals for these programs are recorded as sales adjustments that reduce gross revenue in the period the related revenue is recognized.
Reserve for Inventory Obsolescence . We value our inventory at the lower of cost or market. Based upon a consideration of quantities on hand, actual and projected sales volume, anticipated product selling prices and product lines planned to be discontinued, slow-moving and obsolete inventory is written down to its net realizable value.
Failure to accurately predict and respond to consumer demand could result in the Company under producing popular items or overproducing less popular items. Furthermore, significant changes in demand for our products would impact managementās estimates in establishing our inventory provision.
Management estimates are monitored on a quarterly basis and a further adjustment to reduce inventory to its net realizable value is recorded, as an increase to cost of sales, when deemed necessary under the lower of cost or market standard.
Income Allocation for Income Taxes. Our annual income tax provision and related income tax assets and liabilities are based on actual income as allocated to the various tax jurisdictions based upon our transfer pricing study, US and foreign statutory income tax rates, and tax regulations and planning opportunities in the various jurisdictions in which the Company operates. Significant judgment is required in interpreting tax regulations in the US and foreign jurisdictions, and in evaluating worldwide uncertain tax positions. Actual results could differ materially from those judgments, and changes from such judgments could materially affect our consolidated financial statements.
Income taxes and interest and penalties related to income tax payable. We do not file a consolidated return with our foreign subsidiaries. We file federal and state returns and our foreign subsidiaries each file in their respective jurisdictions, as applicable. Deferred taxes are provided on a liability method whereby deferred tax assets are recognized as deductible temporary differences and operating loss and tax credit carry-forwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.
We accrue a tax reserve for additional income taxes and interest, which may become payable in future years as a result of audit adjustments by tax authorities. The reserve is based on managementās assessment of all relevant information, and is periodically reviewed and adjusted as circumstances warrant. As of December 31, 2011, our income tax reserves are approximately $5.0 million and relate to the potential income tax audit adjustments, primarily in the areas of income allocation, foreign depreciation allowances and state taxes.
We recognize current period interest expense and the reversal of previously recognized interest expense that has been determined to not be assessable due to the expiration of the related audit period or other compelling factors on the income tax liability for unrecognized tax benefits as interest expense, and penalties and penalty reversals related to the income taxes payable as other expense in our consolidated statements of operations.
Share-Based Compensation . We grant restricted stock and options to purchase our common stock to our employees (including officers) and non-employee directors under our 2002 Stock Award and Incentive Plan (the āPlanā), which incorporated the shares remaining under our Third Amended and Restated 1995 Stock Option Plan. The benefits provided under the Plan are share-based payments. We estimate the value of share-based awards on the date of grant using the Black-Scholes option-pricing model. The determination of the fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price, as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, cancellations, terminations, risk-free interest rates and expected dividends.
Recent Developments
In December 2009 we entered into a Settlement Agreement and Mutual Release pursuant to which our joint venture with THQ was terminated as of December 31, 2009 and we are to receive fixed payments from THQ in the aggregate amount of $20.0 million. We received and recorded as income $6.0 million in each of June 2010 and 2011 and we expect to receive $4.0 million on each of June 30, 2012 and 2013 which we will record as income on a cash basis as received.
On October 14, 2011, we acquired all of the stock of Moose Mountain Toymakers Limited, a Hong Kong company, and a related New Jersey company, Moose Mountain Marketing, Inc. (collectively, āMoose Mountainā). The total initial consideration of $31.5 million consisted of $16.0 million in cash and the assumption of liabilities in the amount of $15.5 million, and resulted in goodwill of $13.5 million. In addition, the Company agreed to pay an earn-out of up to an aggregate amount of $5.3 million in cash over the three calendar years following the acquisition based on the achievement of certain financial performance criteria. The fair value of the expected earn-out is included in goodwill and assumed liabilities as of December 31, 2011. Moose Mountain is a leading designer and producer of foot to floor ride-ons, inflatable environments, wagons, pinball machines and tents and was included in our results of operations from the date of acquisition.
Net Sales
Traditional Toys and Electronics. Net sales of our Traditional Toys and Electronics segment were $348.9 million in 2011, compared to $358.4 million in 2010, representing a decrease of $9.5 million, or 2.7%. The decrease in net sales was primarily due to lower unit sales of our UFCĀ® and TNAĀ® action figures and accessories, JAKKSā¢ dolls based on Taylor SwiftĀ®, JAKKSā¢ dolls based on Disney FairiesĀ® and Disney PrincessĀ®, electronics based on TV Games and EyeClopsĀ® brands, and other JAKKS products, including Real Constructionā¢ activity products , Girl GourmetĀ® and pet toy products. This was offset in part by increases in unit sales of some products, including In My Pocket & Friendsā¢, Cabbage Patch KidsĀ®, SmurfsĀ® and PokĆ©monĀ® figures and accessories.
Role Play, Novelties and Seasonal Products . Net sales of our Role Play, Novelties and Seasonal Products were $328.9 million in 2011, compared to $388.9 million in 2010, representing a decrease of $60.0 million, or 15.4%. The decrease in net sales was primarily due to decreases in unit sales of our Halloween costumes and accessories, and role-play and dress-up toys, including those based on Disney PrincessĀ® and Disney FairiesĀ®.
Cost of Sales
Traditional Toys and Electronics . Cost of sales of our Traditional Toys and Electronics segment was $248.0 million, or 71.1% of related net sales, in 2011, compared to $238.2 million, or 66.5% of related net sales in 2010, representing an increase of $9.8 million, or 4.1%. This percentage cost of sales increase is primarily due to charges in 2011 of $12.8 million related to the write-down of license advances and minimum guarantees that are not expected to be earned through sales of that licensed product. Excluding these one-time charges, cost of sales was $235.2 million in 2011, representing a decrease of $3.0 million in 2011 , or 1.3%, which primarily consisted of a decrease in product costs of $4.6 million, which is in line with the lower volume of sales. Excluding the one-time charges, product costs as a percentage of sales increased primarily due to the mix of the product sold and higher sales of closeout product. Excluding the one-time charges, royalty expense for our Traditional Toys and Electronics segment increased by $3.0 million and increased as a percentage of net sales due to changes in the product mix to more products with higher royalty rates from products with lower royalty rates or proprietary products with no royalty rates. Our depreciation of molds and tools decreased by $1.4 million primarily due to decreased purchases of molds and tools in this segment.
Role Play, Novelties and Seasonal Products . Cost of sales of our Role Play, Novelties and Seasonal Products segment was $235.8 million, or 71.7% of related net sales in 2011, compared to $264.2 million, or 67.9% of related net sales in 2010, representing a decrease of $28.4 million, or 10.7%. This percentage cost of sales increase is partially due to charges in 2011of $5.3 million related to the write-down of license advances and minimum guarantees that are not expected to be earned out through sales of that licensed product. Excluding these one-time charges, cost of sales was $230.5 million, representing a decrease of $33.7 million in 2011, or 12.8%, which primarily consisted of a decrease in product costs of $28.0 million, which is in line with the lower volume of sales. Product costs as a percentage of net sales increased primarily due to the mix of the product sold. Excluding the one-time charges, royalty expense decreased by $5.8 million, which is in line with the lower volume of sales. Royalty expense as a percentage of net sales was comparable year over year. Our depreciation of molds and tools is comparable year over year.
Selling, General and Administrative Expenses
Selling, general and administrative expenses were $192.7 million in 2011 and $194.8 million in 2010, constituting 28.4% and 26.1% of net sales, respectively. The overall decrease of $2.1 million in such costs was primarily due to decreases in direct selling expenses ($5.5 million), stock based compensation ($2.8 million), and depreciation and amortization ($1.4 million), offset by increases in general and administrative expenses ($6.5 million), and product development ($1.1 million). The increase in general and administrative expenses is primarily due to increases in legal and financial advising fees related to the unsolicited indication of interest to acquire the Company ($3.7 million), legal expense ($1.6 million), other professional fees ($0.7 million) and travel expenses ($1.2 million), and employee relocation expenses ($0.5 million), offset in part by decreases in donation expenses ($0.9 million) and insurance expense ($0.4 million). Product development expenses increased as a result of new product line launches in 2012 such as Monsunoā¢ and Winx ClubĀ®. The decrease in direct selling expenses is primarily due to decreases in variable selling expenses related to the lower volume of sales in 2011. The decrease in depreciation and amortization is mainly due to a decrease in amortization expense related to intangible assets other than goodwill ($0.9 million).
Provision for Income Taxes
Our income tax benefit, which includes federal, state and foreign income taxes, was $9.0 million, or an effective tax rate of 1,671% for 2011. During 2010, the income tax expense was $2.7 million, or an effective tax provision rate of 5.41%.
Included in the tax benefit of $9.0 million are discrete tax benefits of $2.1 million. These tax benefits are comprised of $0.3 million reduction of uncertain tax positions related to foreign depreciation due to statute expiration, $1.7 million benefit related to state tax apportionment changes and an adjustment to record various outstanding state tax refunds . (see Note 12 of the Notes to Condensed Consolidated Financial Statements). Absent these discrete tax benefits, the Companyās effective tax rate for 2011 is 1,288%, primarily due to a decrease in the Companyās consolidated earnings.
In 2010, included in the tax expense of $2.7 million were discrete tax benefits of $10.3 million. These tax benefits were comprised of $4.7 million reduction of uncertain tax positions due to settlement of 2003-2006 IRS exams and statute expirations, $4.0 million benefit related to a refund received from the IRS for previously filed amended returns, and $1.7 million benefit attributable to a transfer pricing adjustment. Absent these discrete tax benefits, the Companyās effective tax rate for 2010 would have been 26.2%.
As of December 31, 2011, we had net deferred tax assets of approximately $81.6 million.
Comparison of the Years Ended December 31, 2010 and 2009
Net Sales
Traditional Toys and Electronics. Net sales of our Traditional Toys and Electronics segment were $358.4 million in 2010, compared to $439.4 million in 2009, representing a decrease of $81.0 million, or 18.4%. The decrease in net sales was primarily due to lower unit sales of our WWEĀ® and PokĆ©monĀ® action figures and accessories, JAKKSā¢ dolls based on Hannah MontanaĀ®, electronics based on Ultimotionā¢ and EyeClopsĀ® brands, and other JAKKS products, including GX RacersĀ® and other vehicles, Cabbage Patch KidsĀ®, In My Pocket & Friendsā¢, Girl GourmetĀ® and pet toy products. This was offset in part by increases in unit sales of some products, including UFCĀ® and TNAĀ® action figures and accessories, Real Constructionā¢ activity products, electronics based on the Spy Netā¢ brand, JAKKSā¢ dolls based on Disney FairiesĀ®, and Disney Princess.
Role Play, Novelties and Seasonal Products . Net sales of our Role Play, Novelties and Seasonal Products were $388.9 million in 2010, compared to $364.3 million in 2009, representing an increase of $24.6 million, or 6.8%. The increase in net sales was primarily due to increases in unit sales of our kidās indoor and outdoor furniture products, Halloween costumes and accessories, and role-play and dress-up toys, including those based on Disney PrincessĀ® and Disney FairiesĀ®.
Cost of Sales
Traditional Toys and Electronics . Cost of sales of our Traditional Toys and Electronics segment was $238.2 million, or 66.5% of related net sales, in 2010, compared to $339.8 million, or 77.3% of related net sales in 2009, representing a decrease of $101.6 million, or 29.9%. This percentage margin decrease is primarily due to charges in 2009 of $24.0 million related to the write-down of certain excess and impaired inventory and $28.4 million related to the write-down of license advances and minimum guarantees that are not expected to be earned through sales of that licensed product. Excluding these one-time charges, cost of sales was $287.4 million in 2009, representing a decrease of $49.2 million in 2010 , or 13.7% of net sales, which primarily consisted of a decrease in product costs of $41.1 million, which is in line with the lower volume of sales. Product costs as a percentage of sales increased primarily due to the mix of the product sold and higher sales of closeout product. Excluding the one-time charges, royalty expense for our Traditional Toys and Electronics segment decreased by $2.2 million due to lower volume of sales. Royalty expense as a percentage of net sales was comparable year-over-year. Our depreciation of molds and tools decreased by $6.0 million primarily due to decreased purchases of molds and tools in this segment.
Role Play, Novelties and Seasonal Products . Cost of sales of our Role Play, Novelties and Seasonal Products segment was $264.2 million, or 67.9% of related net sales in 2010, compared to $261.0 million, or 71.6% of related net sales in 2009, representing an increase of $3.2 million, or 1.2%. This percentage margin increase is partially due to charges in 2009 of $4.8 million related to the write-down of license advances and minimum guarantees that are not expected to be earned out through sales of that licensed product. Excluding these one-time charges, cost of sales was $256.2 million in 2009, representing an increase of $8.0 million in 2010, or 2.1% of net sales, which primarily consisted of an increase in product costs of $7.0 million, which is in line with the higher volume of sales. Product costs as a percentage of net sales decreased primarily due to the mix of the product sold. Excluding the one-time charges, royalty expense increased by $0.8 million and decreased as a percentage of net sales due to changes in the product mix to more products with lower royalty rates or proprietary products with no royalty rates from products with higher royalty rates. Our depreciation of molds and tools is comparable year over year.
Selling, General and Administrative Expenses
Selling, general and administrative expenses were $194.8 million in 2010 and $227.0 million in 2009, constituting 26.1% and 28.2% of net sales, respectively. The overall decrease of $32.2 million in such costs was primarily due to decreases in general and administrative expenses ($14.1 million), product development ($5.3 million), direct selling expenses ($9.0 million) and depreciation and amortization ($3.8 million). The decrease in general and administrative expenses is primarily due to decreases in salary and employee benefits expense ($3.5 million), temporary help expense ($1.3 million), rent expense ($4.5 million) and legal expense ($3.7 million), net of insurance reimbursements, offset in part by increases in travel and entertainment expenses ($0.8 million). Product development expenses decreased as a result of tighter control of spending on product development. The decrease in direct selling expenses is primarily due to decreases in advertising and promotional expenses of $4.0 million in 2010 in support of several of our product lines, sales commissions ($1.7 million) and other direct selling expenses of $3.3 million that support our domestic operations. The decrease in depreciation and amortization is mainly due to a decrease in amortization expense related to intangible assets other than goodwill ($3.2 million).
Write-down of Intangible Assets
As of June 30, 2009, we determined that the tradenames āChild Guidance,ā āPlay Alongā and certain tradenames associated with our Crafts and Activities product lines would either be discontinued, or were under-performing. Consequently, the intangible assets associated with these tradenames were written off to āWrite-down of Intangible Assetsā, resulting in a non-cash charge of $8.2 million.
Write-down of Goodwill
As of June 30, 2009, we determined that the significant decline in our market capitalization is likely to be sustained. Our market capitalization did not change significantly despite the dismissals subject to appeal of the WWE lawsuit, and the lower revenue expectations for 2009 versus 2008 were factors that indicated that an interim goodwill impairment test was required. As a result, we determined that $407.1 million, or all of the goodwill related to previous acquisitions, including the acquisition of Disguise in December 2008, was impaired. This amount is included in āWrite-down of Goodwillā in the accompanying condensed consolidated statements of operations.
Reorganization Charges
We incurred reorganization charges in 2009 to consolidate and stream-line our existing business functions. This was necessary given the decreased volume of consolidated sales in 2009 from 2008 and the added general and administrative expenses from the three acquisitions made at the end of 2008. Restructuring charges relate to the termination of lease obligations, one-time severance termination benefits, fixed asset write-offs and other contract terminations and are accounted for in accordance with āExit and Disposal Cost Obligationsā, ASC 420-10. We established a liability for a cost associated with an exit or disposal activity when a liability is incurred, rather than at the date we commit to an exit plan.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Critical Accounting Policies and Estimates
The accompanying consolidated financial statements and supplementary information were prepared in accordance with accounting principles generally accepted in the United States of America. Significant accounting policies are discussed in Note 2 to the Consolidated Financial Statements set forth in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011. Inherent in the application of many of these accounting policies is the need for management to make estimates and judgments in the determination of certain revenues, expenses, assets and liabilities. As such, materially different financial results can occur as circumstances change and additional information becomes known. The policies with the greatest potential effect on our results of operations and financial position include:
Allowance for Doubtful Accounts. Our allowance for doubtful accounts is based upon managementās assessment of the business environment, customersā financial condition, historical collection experience, accounts receivable aging, customer disputes and the collectability of specific customer accounts. If there were a deterioration of a major customerās creditworthiness, or actual defaults higher than our historical experience, our estimates of the recoverability of amounts due to us could be overstated, which could have an adverse impact on our operating results. Our allowance for doubtful accounts is also affected by the time at which uncollectible accounts receivable balances are actually written off.
Major customersā accounts are monitored on an ongoing basis; more in-depth reviews are performed based upon changes in a customerās financial condition and/or the level of credit being extended. When a significant event occurs, such as a bankruptcy filing by a specific customer, and on a quarterly basis, the allowance is reviewed for adequacy and the balance or accrual rate is adjusted to reflect current risk prospects.
Revenue Recognition. Our revenue recognition policy is to recognize revenue when persuasive evidence of an arrangement exists, title transfer has occurred (product shipment), the price is fixed or readily determinable and collectability is probable. Sales are recorded net of sales returns and discounts, which are estimated at the time of shipment based upon historical data. We routinely enter into arrangements with our customers to provide sales incentives and support customer promotions and we provide allowances for returns and defective merchandise. Such programs are primarily based upon customer purchases, customer performance of specified promotional activities and other specified factors such as sales to consumers. Accruals for these programs are recorded as sales adjustments that reduce gross revenue in the period in which the related revenue is recognized.
Reserve for Inventory Obsolescence . We value our inventory at the lower of cost or market. Based upon a consideration of quantities on hand, actual and projected sales volume, anticipated product selling prices and product lines planned to be discontinued, slow-moving and obsolete inventory is written down to its net realizable value.
Failure to accurately predict and respond to consumer demand could result in us under-producing popular items or over-producing less popular items. Furthermore, significant changes in demand for our products would impact managementās estimates in establishing our inventory provision.
Managementās estimates are monitored on a quarterly basis and a further adjustment to reduce inventory to its net realizable value is recorded, as an increase to cost of sales, when deemed necessary under the lower of cost or market standard.
Income Allocation for Income Taxes. Our quarterly income tax provision and related income tax assets and liabilities are based on estimated annual income as allocated to the various tax jurisdictions based upon our transfer pricing study, US and foreign statutory income tax rates and tax regulations and planning opportunities in the various jurisdictions in which we operate. Significant judgment is required in interpreting tax regulations in the US and foreign jurisdictions, and in evaluating worldwide uncertain tax positions. Actual results could differ materially from those judgments, and changes from such judgments could materially affect our consolidated financial statements.
Discrete Items for Income Taxes. A discrete tax benefit of $0.4 million related to a reduction in tax reserves resulting from closed statutes of limitation was recognized during the six months ended June 30, 2012. During this same period in 2011, we recognized a discrete tax benefit of $1.5 million related to a reduction in tax reserves resulting from closed statutes and an adjustment to record various outstanding state tax refunds.
Income taxes and interest and penalties related to income tax payable. We do not file a consolidated return for our foreign subsidiaries. We file federal and state returns and our foreign subsidiaries each file returns as required. Deferred taxes are provided on an asset and liability method, whereby deferred tax assets are recognized as deductible temporary differences and operating loss and tax credit carry-forwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.
Management employs a threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Tax benefits that are subject to challenge by tax authorities are analyzed and accounted for in the income tax provision.
We accrue a tax reserve for additional income taxes, which may become payable in future years as a result of audit adjustments by tax authorities. The reserve is based upon managementās assessment of all relevant information and is periodically reviewed and adjusted as circumstances warrant. As of June 30, 2012, our income tax reserves were approximately $4.6 million and relate to the potential income tax audit adjustments, primarily in the areas of fixed asset depreciation in Hong Kong and ongoing state audits. As of December 31, 2011, our income tax reserves were approximately $5.0 million and relate to the potential income tax audit adjustments, primarily in the areas of income allocation, foreign depreciation allowances and state taxes.
Share-Based Compensation . We grant restricted stock awards to our employees (including officers) and to non-employee directors under our 2002 Stock Award and Incentive Plan (the āPlanā), which incorporated the shares remaining under our Third Amended and Restated 1995 Stock Option Plan. The benefits provided under the Plan are share-based payments. We amortize the net total deferred restricted stock expense based on the fair value of the stock on the date of the grants over a requisite service period. In certain instances the service period may differ from the period in which each award will vest. Additionally, certain groups of grants are subject to an expected forfeiture rate calculation.
Recent Developments
On September 13, 2011, we received an unsolicited letter from Oaktree Capital Management L.P. (āOaktreeā) expressing a non-binding indication of interest in acquiring our company for $20 per share, subject to due diligence and Oaktreeās ability to raise the necessary debt financing. Oaktree had initially contacted us in March 2011 regarding an earlier non-binding and highly conditional indication of interest in acquiring our company. With the advice and assistance of its independent financial advisors and special counsel, our Board of Directors reviewed and analyzed the terms of Oaktree's indication of interest. After several Board meetings, a meeting with Oaktree attended by its independent financial advisors and special counsel and other communications, in July of 2011 our Board unanimously determined that pursuing Oaktree's initial indication of interest would not be in the best interest of our shareholders. The Board communicated its conclusion to Oaktree in July 2011. We heard nothing further from Oaktree until we received the September 13, 2011 letter, which Oaktree simultaneously made public. Once again, after a thorough review with the advice and assistance of our independent financial advisors and special counsel, our Board unanimously determined that Oaktreeās highly conditional and non-binding indication of interest was inadequate and not in the best interest of our shareholders. On October 5, 2011, our Board sent a letter to Oaktree conveying its determination.
On April 17, 2012, we received another letter from Oaktree Capital Management, L.P. reiterating its interest in acquiring us. By a letter dated the same day, we responded that we acknowledged receipt of their continuing indication of interest and stated (i) that there was nothing new in their letter as they have not now and never have made a "cash offer" to acquire us; (ii) the only thing our Board of Directors and its independent financial and legal advisors have been presented with are non-binding indications of interest and invitations to negotiate; and (iii) that their indication of interest remainsāas it has been for over a yearāsubject to both due diligence and financing. We also noted that their letter did not even contain a price.
On April 22, 2012, we entered into an agreement (the āClinton Group Agreementā) with Clinton Group, Inc. and its affiliated funds (āClintonā) providing for the following matters.
Increase in Size of our Board of Directors (the āBoardā) from Six to Eight Members
Pursuant to the Clinton Group Agreement, we agreed to expand the Board from six to eight directors, approved the election of Peter F. Reilly as an independent director to fill one of the new board seats and agreed that the new independent director to fill the remaining vacancy on the Board would be subject to Clintonās reasonable approval. We also approved Mr. Reillyās appointment to the Nominating and Corporate Governance Committee and Audit Committee of the Board. On May 8, 2012, we approved the election of Leigh Anne Brodsky as an independent director to fill such vacancy. We also approved Ms. Brodskyās appointment to the Nominating and Corporate Governance Committee and the Compensation Committee of the Board.
Tender Offer
We agreed to commence a tender offer to our shareholders to purchase our common stock with an aggregate value of at least $80.0 million at a price per share equal to at least $20.00 per share no later than May 25, 2012. On July 5, 2012, we completed the tender offer for 4 million shares at $20.00 per share for a total of $80.0 million, excluding offering costs of approximately $0.6 million.
Meeting with Oaktree
We also authorized our representatives to meet with Oaktree and to provide Oaktree with a reasonable opportunity to conduct diligence on us, subject to execution of a customary confidentiality agreement. We could not agree upon the terms of a confidentiality agreement that appropriately protected our interests, and on June 15, 2012, we received a letter from Oaktree that it was terminating discussions about the confidentiality agreement because it could not agree to the terms we had proposed and, accordingly, the meeting never occurred and due diligence was not conducted.
Standstill
Clinton agreed to certain standstill restrictions until, generally, 60 days prior to the 2013 annual meeting of our stockholders. They further agreed to support and vote for our incumbent Board at our 2012 annual meeting of stockholders and, until the expiration of the standstill period, in connection with any special meeting or written consent solicitation.
Net Sales
Traditional Toys and Electronics. Net sales of our Traditional Toys and Electronics segment were $72.0 million for the three months ended June 30, 2012, compared to $67.7 million for the prior year period, representing an increase of $4.3 million, or 6.4%. The increase in net sales was primarily due to the launch of the Winx ClubĀ® dolls and sales contribution of our recently acquired Moose Mountain division. This was offset in part by decreases in unit sales of some products, including Max ForceĀ®, Creepy CrawlersĀ®, Spy NetĀ® and electronics based on the Plug it in and Play TV GamesĀ® brand.
Role Play, Novelty and Seasonal Toys . Net sales of our Role Play, Novelty and Seasonal Toys were $73.3 million for the three months ended June 30, 2012, compared to $64.2 million for the prior year period, representing an increase of $9.1 million, or 14.2%. The increase in net sales was primarily due to increases in unit sales of our Halloween costumes and accessories.
Cost of Sales
Traditional Toys and Electronics . Cost of sales of our Traditional Toys and Electronics segment was $47.9 million, or 66.5% of related net sales, for the three months ended June 30, 2012, compared to $43.1 million, or 63.7% of related net sales, for the prior year period, representing an increase of $4.8 million, or 11.1%. The dollar increase in cost of sales consisted of a $2.5 million increase of product cost, which is in line with the higher volume of sales. Royalty expense increased by $2.0 million and as a percentage of sales due to changes in product mix from products with lower royalty rates or proprietary brands with no royalty rates to products with higher royalty rates. Our depreciation of molds and tools for the segment was comparable year over year.
Role Play, Novelty and Seasonal Toys . Cost of sales of our Role Play, Novelty and Seasonal Toys segment was $50.6 million, or 69.0% of related net sales, for the three months ended June 30, 2012, compared to $43.7 million, or 68.1% of related net sales, for the prior year period, representing an increase of $6.9 million, or 15.8%. Product costs increased by $5.3 million, which is in line with the higher volume of sales and is comparable as a percentage of net sales year over year. Royalty expense increased by $1.4 million, which is in line with the higher volume of sales. Our depreciation of molds and tools for the segment was comparable year over year.
Selling, General and Administrative Expenses
Selling, general and administrative expenses were $46.8 million for the three months ended June 30, 2012 and $43.1 million for the prior year period, constituting 32.2% and 32.7% of net sales, respectively. Selling, general and administrative expenses increased $3.7 million from the prior year period, primarily due to increases in foreign currency exchange losses ($1.9 million), product development costs ($1.6 million), travel expenses ($0.7 million), legal and financial advising fees related to the unsolicited indication of interest to acquire the Company ($0.6 million), legal fees ($0.5 million) and bad debt expense ($0.1 million), offset in part by a decrease in salaries and employee benefits, including bonus ($1.7 million). Selling, general and administrative expenses decreased as a percentage of sales due to the higher sales volume.
Profit from Video Game Joint Venture
Pursuant to a Settlement Agreement and Mutual Release dated December 22, 2009, the video game joint venture with THQ was terminated on December 31, 2009. In each of June 2010 and 2011, we received a fixed payment from THQ in the amount of $6.0 million, which was recognized as income during the respective quarters. On June 27, 2012, the settlement agreement was amended, whereby the payment terms for the remaining $8.0 million owed by THQ will be paid as follows: $2.0 million on June 29, 2012, $1.0 million each on August 30, 2012 and October 30, 2012 and $0.4 million each in ten consecutive monthly non-interest bearing payments beginning February 28, 2013. Each of the 2012 payments due after June 2012 carry an interest rate of 5%, calculated from June 30, 2012 to the date of payment. In June 2012, we received the scheduled payment from THQ in the amount of $2.0 million. Future payments will be recorded as income on a cash basis.
Equity in Net Income (Loss) of Joint Venture
Operations of the animated television show joint venture commenced in the fourth quarter of 2010. We recognized a net loss of $0.1 million for the three months ended June 30, 2012, and there was nominal activity for the prior year period.
Interest Income
Interest income for the three months ended June 30, 2012 was $0.3 million, compared to $0.1 million for the three months ended June 30, 2011.
Interest Expense
Interest expense was $2.0 million in the three months ended June 30, 2012 and 2011. For both periods, the interest expense of $2.0 million related to our convertible senior notes payable and was comprised of coupon interest of $1.1 million and amortization of debt discount and debt issuance costs of $0.9 million.
Provision for Income Taxes
Our income tax benefit, which includes federal, state and foreign income taxes and discrete items, was $0.1 million, or an effective tax rate of 25.7% for the three months ended June 30, 2012. During the same period of 2011, our income tax expense was $1.8 million, or an effective tax rate of 30.3%.
Comparison of the Six Months Ended June 30, 2012 and 2011
Net Sales
Traditional Toys and Electronics. Net sales of our Traditional Toys and Electronics segment were $113.6 million for the six months ended June 30, 2012, compared to $105.9 million for the prior year period, representing an increase of $7.7 million, or 7.3%. The increase in net sales was primarily due to the launches of our MonsunoĀ® toy line and Winx ClubĀ® dolls, increased unit sales of Cabbage Patch KidsĀ® dolls, large baby dolls and accessories based on Disney PrincessĀ® characters and the inclusion of our latest acquisition, Moose Mountain. This was offset in part by decreases in unit sales of some products, including Max ForceĀ®, Real ConstructionĀ® activity products, Creepy CrawlersĀ® and electronics based on the Plug it in and Play TV GamesĀ® brand.
Role Play, Novelty and Seasonal Toys . Net sales of our Role Play, Novelty and Seasonal Toys were $105.2 million for the six months ended June 30, 2012, compared to $98.4 million for the prior year period, representing an increase of $6.8 million, or 6.9%. The increase in net sales was primarily due to increases in unit sales of our Halloween costumes and accessories and our kids outdoor furniture and activity tables, offset in part by decreases in unit sales of our role play and dress-up toys, including those based on Disney PrincessĀ® and Disney FairiesĀ®.
Cost of Sales
Traditional Toys and Electronics . Cost of sales of our Traditional Toys and Electronics segment was $75.2 million, or 66.2% of related net sales, for the six months ended June 30, 2012, compared to $71.7 million, or 67.7% of related net sales, for the prior year period, representing an increase of $3.5 million, or 4.9%. The dollar increase is in line with the sales volume increase and the decrease of product costs as a percentage of sales was due to the change in product mix. Royalties and depreciation of molds and tools for the segment were comparable year over year.
Role Play, Novelty and Seasonal Toys . Cost of sales of our Role Play, Novelty and Seasonal Toys segment was $73.1 million, or 69.5% of related net sales, for the six months ended June 30, 2012, compared to $63.2 million, or 64.2% of related net sales, for the prior year period, representing an increase of $9.9 million, or 15.7%. Product costs increased by $5.2 million, which is in line with the sales volume increase. Royalty expense increased by $4.6 million and increased as a percentage of sales due to a one-time credit for the period ended June 30, 2011. Depreciation of molds and tools for the segment was comparable year over year.
Selling, General and Administrative Expenses
Selling, general and administrative expenses were $89.8 million for the six months ended June 30, 2012 and $82.2 million for the prior year period, constituting 41.0% and 40.2% of net sales, respectively. Selling, general and administrative expenses increased $7.6 million from the prior year period primarily due to an increase in advertising expenses related to the launch of MonsunoĀ® ($1.4 million), legal and financial advising fees related to the unsolicited indication of interest to acquire our company ($1.9 million), salaries and employee benefits, including bonus ($1.4 million), legal fees ($1.1 million), product development and testing ($1.9 million), travel expenses ($0.7 million) and foreign currency exchange losses ($1.8 million), offset in part by bad debt recovery ($1.2 million) and a decrease in amortization of intangible assets ($1.2 million). Selling, general and administrative expenses increased as a percentage of sales due to additional overhead resulting from the incorporation of Moose Mountain (which was not included in prior year) and other non-variable expenses.
CONF CALL
Genna Rosenberg - SVP, Corporate Communications & IR
Thank you, operator. Good morning, ladies and gentlemen. This is Genna Rosenberg, we apologize for the delay in getting this call started. Thank you for joining our teleconference with management of JAKKS Pacific today to review the results for our third quarter and first nine months ended September 30, 2009
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On the call today are Jack Friedman, Chairman and Co-Chief Executive Officer of JAKKS Pacific; Stephen Berman, our President and Co-CEO; Joel Bennett, Executive Vice President and CFO.
Mr. Friedman will first provide an overview of the quarter and our operational results and then Mr. Bennett will provide detailed comments regarding our financial results. Mr. Friedman will then conclude the prepared portion of the call with highlights of the current business trends prior to opening up the call for your one-on-one questions.
Before we begin, I would like to point out that any comments made about our future performance, events or circumstances, including the estimates of sales and earnings per share for 2009, as well as any other forward-looking statements, are subject to Safe Harbor protection under the federal security laws.
These statements reflect our best judgment based on current market trends and conditions today and are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected in our forward-looking statements. For details concerning these and other such risks and uncertainties, you should consult our most recent 10-K and 10-Q filings with the SEC as well as our company's other reports subsequently filed with the SEC from time to time.
With that, I will turn the call over to Mr. Friedman.
Jack Friedman - Chairman & CEO
Good afternoon, ladies and gentlemen. This is Jack Friedman. Thank you for joining us this afternoon. Today we announced our results for the third quarter and first nine months of 2009 for JAKKS Pacific.
While this year has been extremely challenging on many levels, sales for the third quarter met our expectations. Last quarter we announced we will be implementing a company-wide restructuring plan and comprehensive cost saving initiatives in light of lower than expected sales and we have been diligently working on this implementation process.
Weāve been working closely with key management in every area of business around the world to implement changes that confront these obstacles affecting our top and bottom line and turn to our outlook for 2010 in a very positive direction.
On a non-GAAP basis, third quarter 2009 net sales were $351.4 million compared with sales of $357.8 million for the third quarter of 2008 and for the first nine months of 2009, sales on a non-GAAP basis were $605 million compared with $634.1 million for the first nine months of 2008.
These non-GAAP net sales figures exclude one-time charges related to the recall of one of our products. On a non-GAAP we had earnings for the third quarter of $35.9 million or $1.13 per share and net income on a non-GAAP basis of $24.3 million or $0.83 per share for the first nine months.
We began shipping many of our new items in the third quarter, including Halloween products from our Disguise division and continue shipping reorders and spring orders in the fourth quarter. Our Halloween portfolio is doing quite well with items based on popular licenses including Transformers, Marvel characters, Sesame Street and Toy Story leading the way and we have many value-driven toy items that have good placement at retail, including a myriad of product based on Disney Princess and Fairies, our UFC action figures that are just hitting shelves and look extremely well so far.
Girl Gourmet, Food Play products, new Plug It In & Play TV Games products including our Big Buck Hunter, which has been a bit of an upswing surprise for us. However, as I mentioned, we are seeing underperformance of several lines that have been strong contributors in the past, particularly Hannah Montana toys, and both WWE and PokƩmon action figures and accessories.
Given all that, we have been very focused, analyzing every area of our business, executing on our restructuring plan, shipping our Fall line into retail, and developing our portfolio for 2010.
We previewed next year's lines to many of our customers at the JAKKS' 2010 Fall Toy Preview held at our new Santa Monica Showroom during the past two weeks. A line which was very well received by our retail partners from every sales channel.
Several new initiatives resonated as favorites based on our early reads, including our robust Disney range, some new internally developed JAKKS brands, a number of key line extensions into other areas in our diverse portfolio.
Our commitment to product coupled with our commitment to running a lean and profitable business, along with our strong balance sheet, excellent relationships and a seasoned team should position us well for future growth.
In addition, we believe the costs savings initiatives we set in motion will help JAKKS improve profitability for the next year and beyond. This month, we began consolidating offices in Hong Kong and New York, where we had excess office space and overlapping operations from previously acquired businesses, and also carried out headcount reductions companywide.
Our goal is to streamline processes, reduce costs and lower capital expenditures, doing more with less for future enhanced profitability and growth. We continue to anticipate sales of our core JAKKS products to be lower for this year, and are navigating through these considerable challenges.
While there is still uncertainty as how sales for JAKKS will be this holiday season, with a healthy contribution coming from our Disguise, Halloween costume division, at this point we still believe we are on track to achieve our revised guidance.
For the 2009 fiscal year, the company is expecting GAAP net sales of approximately $810 million, with a net loss on a GAAP basis of $375.6 million or $13.54 per share, well, that doesn't sound very good, and is expecting non-GAAP net sales of approximately $810.7 million, with net income on a non-GAAP basis of $30 million, or $1.01 per share.
Our financial position remains extremely strong with working capital of approximately $322.5 million, including cash and equivalents and marketable securities of $154 million as of September 30, 2009, enabling us to continue to execute on our acquisition strategy and internal product development without interruption.
I would like at this point to turn the call over to Joel Bennett for a review of our financial performance for the third quarter and first nine months.
Joel Bennett - EVP & CFO
Thank you, Jack and good afternoon everyone. Net sales for the third quarter were $351.4 million compared to $357.8 million reported in the third quarter of 2008, and net sales for the first nine months of 2009 were $604.9 million, compared to $634.1 million for the first nine months of 2008.
Net income for the third quarter of 2009 was $33.7 million or $1.06 per diluted share, compared to net income of $54.1 million or $1.70 per diluted share reported in the third quarter of 2008.
For the nine-month period, we reported a net loss of $383.7 million, or $14.11 per share, compared to earnings in the first nine months of 2008 of $59.2 million, or $1.88 per diluted share. The loss primarily related to the write-off of the goodwill on a non-cash basis in the second quarter to the amount of $415 million.
On a non-GAAP basis 2009 net sales for the third quarter were $351.4 million and $605.5 million for the nine month period, compared to non-GAAP net sales of $357.8 million and $634.1 million for the third quarter and nine months of 2008 respectively.
On a non-GAAP basis, JAKKS reported net income for the third quarter of $35.9 million, or $1.13 per diluted share, compared to non-GAAP net income of $46.6 million, or $1.47 per diluted share in the third quarter of 2008.
Non-GAAP net income for the first nine months of 2009 was $24.3 million, or $0.83 per diluted share, compared to non-GAAP net income of $53.4 million, or $1.70 per diluted share for the first nine months of 2008.
2009 GAAP results include the following, which were excluded from the non-GAAP results I just spoke of. Pre-tax non-cash goodwill impairment charge of $407.1 million, due to the sustained decline in the company's market capitalization taken in the second quarter of 2009; a pre-tax non-cash impairment charge of $8.2 million related to under-utilized trademarks, also taken in the second quarter of 2009.
Pre-tax charge to royalty expense were $33.2 million taken in the second quarter related to abandoned or underperforming licenses and of the $33.2 million, $19.7 million is non-cash, $13.7 is expected to be paid out to third parties through 2011. A pre-tax charge to cost of goods is $23.3 million was taken in the second quarter of 2009 and $2.9 million in third quarter of 2009 related to the impairment of inventory of which $17.4 million is non-cash and $8.8 million is expected to be paid out to third parties during the remainder of 2009.
Pre-tax non-cash charge of $2.3 million related to the write-off obsolete tools and molds. Pre-tax charge of $1.3 million related to the recall of one of the companyās products taken in the second quarter of 2009. Then finally for 2009 pre-tax non-cash charge of $23.5 million related to the reduction of the receivable from our video game joint venture with THQ as a result of the recent arbitration decision, which reduced our preferred return payment rate from 10% to 6% of the joint ventureās net sales of which $22.5 million was taken in the second quarter of 2009 and $1 million was taken in the third quarter of 2009.
The goodwill impairment charge taken during the nine month period does not affect the companyās liquidity or business operations and does not limit or change our ability to continue to generate positive future cash flows from these intangible assets.
Now for our sales by product categories; worldwide sales of toy products, which is basically everything other than crafts, activities and writing instruments were $328 million for the third quarter of 2009 compared to $337.2 million for the third quarter of 2008.
Traditional toy sales for the first nine months of 2009 were $551.1 million compared to $596.8 million for the first nine months of 2008.
Sales in the quarter were driven by Halloween costumes, Pretend Play products, electronic toys and action figures. However, we did see year-over-year declines in some of these products based on WWE, Hannah Montana, PokƩmon, Neopets and several others.
Worldwide sales of craft, activity and writing instruments amounted to $23.4 million in the third quarter of 2009, compared to $37.3 million in the comparable period in 2008. For the nine month period, we had sales of $45.8 million, compared to $37.3 million for the comparable period in 2008. Sales of our Girl Gourmet line of activity items drove sales in this category this year.
Included in the numbers are international sales of $63.1 million for the third quarter and $106.1 million for the first nine months of 2009, down from $77.3 million and $133 million for the same periods respectively for 2008.
On a non-GAAP basis, gross margin for the third quarter of 2009 was 33.6% as compared to 36.1% in the third quarter of last year. Gross margin for the first nine months of 2009 was 34.1% as compared to 36% for the first nine months of last year. The 190 basis point decrease in gross margin is due primarily to the change in product mix, which included more lower margin sales, close-outs, and we also experienced lower than expected sales of our higher margin products.
SG&A in the third quarter of 2009 were $63.4 million or 17.8% of net sales as compared to $62.7 million or 17.5% of net sales in the same period last year. SG&A expenses for the first nine months of 2009 were $171.7 million or 28.4% of net sales, as compared to $157.5 million or 24.8% of net sales for the first nine months of last year. This increase is due primarily to the addition of overhead related to our recent acquisitions and higher legal cost related to various litigation not being reimbursed by the insurance company as well as product testing cost.
As Jack mentioned, weāve began executing on our restructuring plan and cost savings initiatives that we set in motion to improve profitability for the next year and beyond. These cost savings efforts are intended to reduce spending, given the lower than expected sales forecast and lower gross margins. Going forward, our operations will be focused on fewer SKUs, but of basic everyday, every season products.
Depreciation and amortization, excluding the disposal of obsolete tools and molds in the amount of $2.3 million was approximately $13.2 million in the third quarter and $24.2 million for the first nine months of 2009. This compares to $6.9 million and $18.9 million for the comparable periods in 2008.
Stock-based compensation for the third quarter was a credit of $700,000 and $2 million for 2008, and $3.3 million for the first nine months of 2009 and $6 million for the comparable period in 2008.
For the quarter, we posed a loss of $1.9 million from the video game joint venture with THQ as a result of increased legal fees and the final adjustment to our preferred return rate compared to profit of $700,000 for the comparable period last year.
For the nine month period, we posted a loss of $21.9 million after the adjustment to the cumulative receivables of $23.5 compared to profit of $4.5 million in 2008.
Operations providing cash in the third quarter of 2009 were approximately $35.9 million compared to using cash of $39 million in Q3, 2008. Our financial position remains very strong.
Accounts receivable at the end of the third quarter were $251.6 million compared to $230 million at the end of the third quarter of 2008. DSOs were 64 days compared to 58 days in the same period of 2008.
Inventory was $71.1 million at the end of the quarter down from a $110.8 million at the end of the comparable period in 2008. The decrease is due primarily to the sell-off of closed inventory after write downs in the second quarter of 2009, as well as tighter inventory management.
DSOs decreased to 33 days from 53 days at the end of third quarter of 2008 and finally capital expenditures for the quarter were $5.3 million and we expect CapEx to be approximately $18 million for the full year of 2009 down from $23 million in 2008.
With that I will return the call back to Jack.
Jack Friedman - Chairman & CEO
Thank you Joe. We are approaching the most crucial shopping season of the year for the toy business and so far things are looking pretty good. We expect to benefit from some strategic value-pricing initiatives as consumers are increasingly cost conscious. We are trending higher on items like our line of novelty toys and have been to looking to such of our low cost electronics products Girl Gourmet and Pretend Play products to drive sales in the portfolio.
With the restructuring and cost savings initiatives we are implementing, we expect to begin to see normal benefits by the end of this year. These cost saving efforts are intended to reduce spending, given the lower than expected sales forecast across a number of product lines in the portfolio, and lower gross margins overall and will include headcount reductions, a consolidation of office spaces and other efficiencies that will be implemented during the remainder of 2009. The annual savings are expected to be in the vicinity or upwards of $40 million on an ongoing basis.
While there is no certainty about the level of sales for the holiday season, at this point we still believe that our previously announced guidance is achievable. For the 2009 fiscal year, the company is expecting GAAP net sales of approximately $810 million with a net loss on a GAAP basis of $378 million or $13.72 a share, and is expecting non-GAAP net sales of approximately $810.7 million with net income on a non-GAAP basis of $30 million or $1.01 per diluted share.
Despite the uncertainties related to the US recession, we remain committed to running a profitable JAKKS Pacific and are working hard to execute on our strategy on behalf of our shareholders for 2009 and beyond.
With that, I will open the call to questions.
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Fund Letters
