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JAKK > SEC Filings for JAKK > Form 10-Q on 9-Nov-2012All Recent SEC Filings

Show all filings for JAKKS PACIFIC INC

Form 10-Q for JAKKS PACIFIC INC


9-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of financial condition and results of operations should be read together with our Condensed Consolidated Financial Statements and Notes thereto, which appear elsewhere herein.

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 management's assessment of the business environment, customers' 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 customer's 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 customers' accounts are monitored on an ongoing basis; more in-depth reviews are performed based upon changes in a customer's 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.

Goodwill and other indefinite-lived intangible assets. Goodwill and indefinite-lived intangible assets are not amortized, but are tested for impairment at least annually at the reporting unit level.

Factors we consider important that could trigger an impairment review include the following:

? significant underperformance relative to expected historical or projected future operating results;
? significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and ? significant negative industry or economic trends.

Due to the subjective nature of the impairment analysis, significant changes in the assumptions used to develop the estimate could materially affect the conclusion regarding the future cash flows necessary to support the valuation of long-lived assets, including goodwill. The valuation of goodwill involves a high degree of judgment. Based upon the assumptions underlying the valuation, impairment is determined by estimating the fair value of a reporting unit and comparing that value to the reporting unit's book value. If the implied fair value is more than the book value of the reporting unit, an impairment loss is not indicated. If impairment exists, the fair value of the reporting unit is allocated to all of its assets and liabilities excluding goodwill, with the excess amount representing the fair value of goodwill. An impairment loss is measured as the amount by which the book value of the reporting unit's goodwill exceeds the estimated fair value of that goodwill.


Goodwill, Trademarks (net) and Intangible assets amounted to $119.1 million as of September 30, 2012 and $48.1 million as of December 31, 2011.

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 management's estimates in establishing our inventory provision.

Management's 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 $1.0 million related to a reduction in tax reserves resulting from closed statutes of limitation was recognized during the nine months ended Septembere 30, 2012. During this same period in 2011, we recognized a discrete tax benefit of $1.3 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 management's assessment of all relevant information and is periodically reviewed and adjusted as circumstances warrant. As of September 30, 2012, our income tax reserves were approximately $3.9 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 related 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 "Plan"), 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 over a requisite service period, the net total deferred restricted stock expense based upon the fair value of the stock on the date of the grants. 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

Oaktree Capital Management L.P.

On September 13, 2011, we received an unsolicited letter from Oaktree Capital Management L.P. ("Oaktree") expressing a non-binding indication of interest in acquiring our company for $20 per share, subject to due diligence and Oaktree's 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 Oaktree's 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 remains-as it has been for over a year-subject to both due diligence and financing. We also noted that their letter did not even contain a price.

Clinton Group, Inc.

On April 22, 2012, we entered into an agreement (the "Clinton Group Agreement") with Clinton Group, Inc. and its affiliated funds ("Clinton") providing for the following matters.

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 Clinton's reasonable approval. We also approved Mr. Reilly's 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. Brodsky's appointment to the Nominating and Corporate Governance Committee and the Compensation Committee of the Board.

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 four million shares at $20.00 per share for a total of $80.0 million, excluding offering costs of approximately $0.6 million.

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.

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.

Acquisitions

On July 26, 2012, we acquired all of the stock of Maui, Inc., an Ohio corporation, Kessler Services, Inc., a Nevada corporation, and A.S. Design Limited, a Hong Kong corporation (collectively, "Maui"). The total initial consideration of $37.6 million consisted of $36.2 million in cash and the assumption of liabilities in the amount of $1.4 million. In addition, we agreed to pay an earn-out of up to an aggregate amount of $18.0 million in cash over the three calendar years following the acquisition based on the achievement of certain financial performance criteria, which has been accrued and recorded as goodwill as of September 30, 2012. We have not finalized our purchase price allocation for Maui and have engaged a third party to perform studies and valuations of the estimated fair value of assets and liabilities assumed. Maui is a leading manufacturer and distributor of spring and summer activity toys and impulse toys and was included in our results of operations from the date of acquisition.

On September 14, 2012, we acquired all of the stock of JKID, LTD., a United Kingdom corporation for an initial cash consideration of $1.1 million and deferred cash payments of $5.5 million payable in five semi annual payments of $1.1 million each. In addition, we agreed to pay an earn-out of up to an aggregate amount of $4.4. million in cash over the two year period of 2015 through 2016, based upon the achievement of certain financial performance criteria, which has been accrued and recorded as goodwill as of September 30, 2012. We have not finalized our purchase price allocation for JKID and have engaged a third party to perform studies and valuations of the estimated fair value of assets and liabilities assumed. JKID is the developer of augmented reality technology that enhances the play patterns of toys and consumer products.


Results of Operations

The following unaudited table sets forth, for the periods indicated, certain
statement of income data as a percentage of net sales.

                                                  Three Months Ended            Nine Months Ended
                                                     September 30,                September 30,
                                                  2011           2012            2011        2012

Net sales                                           100.0 %        100.0 %        100.0 %       100.0 %
Cost of sales                                        68.2           69.2           67.4          68.7
Gross profit                                         31.8           30.8           32.6          31.3
Selling, general and administrative expenses         16.7           18.9           25.7          28.0
Income from operations                               15.1           11.9            6.9           3.3
Profit from video game joint venture                    ?            0.3            1.1           0.6
Equity in net income of joint venture                   ?              ?              ?             ?
Interest income                                         ?              ?            0.1           0.1
Interest expense, net of benefit                     (0.6 )         (0.6 )         (1.1 )        (1.1 )
Income before provision for income taxes             14.5           11.6            7.0           2.9
Provision for income taxes                            4.0            1.9            1.7           0.2
Net Income                                           10.5 %          9.7 %          5.3 %         2.7 %

The following unaudited table summarizes, for the periods indicated, certain income statement data by segment (in thousands).

                                           Three Months Ended           Nine Months Ended
                                              September 30,               September 30,
                                           2011          2012          2011          2012

Net Sales
 Traditional Toys and Electronics        $ 163,199     $ 171,156     $ 269,096     $ 285,197
 Role Play, Novelty and Seasonal Toys      169,220       143,335       267,576       248,058
                                           332,419       314,491       536,672       533,255
Cost of Sales
  Traditional Toys and Electronics         106,646       116,822       178,364       191,669
  Role Play, Novelty and Seasonal Toys     120,103       100,957       183,275       174,415
                                           226,749       217,779       361,639       366,084
Gross Profit
  Traditional Toys and Electronics          56,553        54,334        90,732        93,528
  Role Play, Novelty and Seasonal Toys      49,117        42,378        84,301        73,643
                                         $ 105,670     $  96,712     $ 175,033     $ 167,171


Comparison of the Three Months Ended September 30, 2012 and 2011

Net Sales

Traditional Toys and Electronics. Net sales of our Traditional Toys and Electronics segment were $171.2 million for the three months ended September 30, 2012, compared to $163.2 million for the prior year period, representing an increase of $8.0 million, or 4.9%. The increase in net sales was primarily due to the launch of Power Train, action figures based on the animation series Monsuno, Disney large dolls and accessories, Winx Club® 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 Force®, Real Construction®, Spy Net®, action figures and playsets based on the Smurfs movie and electronics based on the Plug it in and Play TV Games® brand.

Role Play, Novelty and Seasonal Toys. Net sales of our Role Play, Novelty and Seasonal Toys were $143.3 million for the three months ended September 30, 2012, compared to $169.2 million for the prior year period, representing decrease of $25.9 million, or 15.3%. The decrease in net sales was primarily due to decreases in unit sales of our Disney Princess® dress up and role play items, Halloween costumes and accessories and our kids outdoor furniture and activity tables, offset in part by the sales contribution of our recently acquired Maui Toys division.

Cost of Sales

Traditional Toys and Electronics. Cost of sales of our Traditional Toys and Electronics segment was $116.8 million, or 68.3% of related net sales, for the three months ended September 30, 2012, compared to $106.6 million, or 65.3% of related net sales, for the prior year period, representing an increase of $10.2 million, or 9.6%. The dollar increase in cost of sales consisted of a $8.0 million increase of product cost, which is mostly due to a higher volume of sales and also due to a higher volume of lower margin sales. Royalty expense increased by $1.3 million and is consistent with the higher volume of sales. 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 $101.0 million, or 70.4% of related net sales, for the three months ended September 30, 2012, compared to $120.1 million, or 71.0% of related net sales, for the prior year period, representing a decrease of $19.1 million, or 15.9%. Product costs decreased by $16.1 million, which is in line with the lower volume of sales and is comparable as a percentage of net sales year over year. Royalty expense decreased by $3.3 million, which is in line with the lower 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 $59.4 million for the three months ended September 30, 2012 and $55.6 million for the prior year period, constituting 18.9% and 16.7% of net sales, respectively. Selling, general and administrative expenses increased $3.8 million from the prior year period, primarily due to increases in media buys to advertise our product ($4.2 million), travel expenses ($0.4 million), legal and financial advising fees related to the unsolicited indication of interest to acquire the Company ($0.3 million), product development ($0.5 million) and bad debt expense ($0.4 million), offset in part by a decrease in salaries and employee benefits, including bonus ($1.9 million). Selling, general and administrative expenses increased as a percentage of sales due to the lower 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 ten equal consecutive monthly non-interest bearing payments of $0.4 million 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, August and October 2012 we received the scheduled payments from THQ in the amounts of $2.0 million, $1.0 million plus interest and $1.0 million plus interest, respectively. 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 nominal income for the three months ended September 30, 2012, and a nominal loss for the prior year period.


Interest Income

Interest income for the three months ended September 30, 2012 was $0.1 million, compared to $0.1 million for the three months ended September 30, 2011.

Interest Expense

Interest expense was $2.0 million for the three months ended September 30, 2012, compared to $2.1 million for the prior period. For both periods, interest expense of $2.0 million related to our convertible senior notes payable 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 expense, which includes federal, state and foreign income taxes and discrete items, was $6.0 million, or an effective tax rate of 16.5%, for the three months ended September 30, 2012. During the same period of 2011, our income tax expense was $13.3 million, or an effective tax rate of 27.6%.

Comparison of the Nine Months Ended September 30, 2012 and 2011

Net Sales

Traditional Toys and Electronics. Net sales of our Traditional Toys and Electronics segment were $285.2 million for the nine months ended September 30, 2012, compared to $269.1 million for the prior year period, representing an increase of $16.1 million, or 6.0%. The increase in net sales was primarily due to the launches of our Monsuno® toy line and Winx Club® dolls, increased unit sales of our large baby dolls and accessories based on Disney Princess® characters and the inclusion of our recent acquisition, Moose Mountain. This was offset in part by decreases in unit sales of some products, including Max Force®, Real Construction® activity products, electronics based on the Spy Net™ brand, action figures and plush items based on the Club Penguin®, Smurfs® and Pokémon® figures and accessories and electronics based on the Plug it in and Play TV Games® brand.

Role Play, Novelty and Seasonal Toys. Net sales of our Role Play, Novelty and Seasonal Toys were $248.1 million for the nine months ended September 30, 2012, compared to $267.6 million for the prior year period, representing a decrease of $19.5 million, or 7.3%. The decrease in net sales was primarily due to decreases in unit sales of our role play and dress-up toys, including those based on Disney Princess® and Disney Fairies®, offset in part by increases in unit sales of our Halloween costumes and accessories and our kids outdoor furniture and activity tables.

Cost of Sales

Traditional Toys and Electronics. Cost of sales of our Traditional Toys and Electronics segment was $191.7 million, or 67.2% of related net sales, for the nine months ended September 30, 2012, compared to $178.4 million, or 66.3% of related net sales, for the prior year period, representing an increase of $13.3 million, or 7.5%. The dollar increase is in line with the sales volume increase. 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 $174.4 million, or 70.3% of related net sales, for the nine months ended September 30, 2012, compared to $183.3 million, or 68.5% of related net sales, for the prior year period, representing a decrease of $8.9 million, or 4.9%. Product costs decreased by $10.6 million, which is in line with the sales volume decrease. Royalty expense increased by $1.3 million and increased as a percentage of 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. Depreciation of molds and tools for the segment was comparable year over year.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $149.2 million for the nine months ended September 30, 2012 and $137.8 million for the prior year period, constituting 28.0% and 25.7% of net sales, respectively. Selling, general and administrative expenses increased $11.4 million from the prior year period . . .

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