The shares are cheap, but this is a question of Character

Toy designer Character Group (CCT) is a highly profitable enterprise valued at just nine times adjusted profit in the year to August 2017. It looks like a bargain, but there’s a saying about cut price goods: They’re not bargains unless you would have paid the full price anyway.

One of the attractive things about companies earning big profits is they can invest the money to earn even more in future, bringing prosperity to shareholders for decades.

I’m not sure I can say that about Character.

Run for profit

Most years, Character earns a return of capital of over 20% and, in the last two, it’s bettered 40%. The company outsources manufacturing so it does not have capital tied up in factories, and its leading position in the UK preschool category means brands reward the company handsomely to bring their characters to the toy market, from Teletubbies to Marvel.

Occasionally, though, Character suffers big reversals because of the faddish nature of the toy market, and disruption when big toy retailers, like Woolworths in 2008 and Toys R Us last month, go bust. In 2013, the company barely broke even. In 2008 it made a loss. As toy retailing moves online, and customers can more readily compare prices, perhaps retailers are putting their suppliers under pressure to reduce prices too.

Nevertheless, in a typical year, Character prospers and it could be a very good long-term investment. I have doubts, though, which start with how the directors pay themselves. This table is from Character’s Annual Report:

Three of the first four directors, Richard King, Kiran Shah and Joseph Kissane founded the company in 1991, and they were joined six months later by Jon Diver. Between them, the quartet, the first four in the list above, own more than 20% of the company’s shares. Shah is the company’s biggest shareholder, and the directors’ combined stake gives them a big say in how the company operates including their own remuneration.

All executives get an annual profit-related bonus. Diver, Shah and Kissane, receive an additional profit related bonuses of 4%, 2% and 1% of pre-tax profit respectively, as long as profit is above a threshold level.

The profit targets for 2017 and 2018 are not disclosed in the annual report, but it’s not necessary for Character to increase profit for the directors to win handsomely. In 2017, revenue fell 7% and operating profit fell 5%, yet Diver received a bonus of more than three times his annual, and not insubstantial, salary. Shah received about twice his salary in bonuses, and Kissane’s bonus more than equaled his salary.

I think the salaries and bonuses are excessive.

In 2016, ShareSoc, which represents the interests of private investors, published guidance to help us evaluate remuneration. Basing its recommendations on median salaries for companies of the same size, ShareSoc proposed that at companies like Character with revenues of around £100 million, the chief executive should not earn a salary of more than £300,000. For companies of Characters’ market capitalisation (also about £100 million), executives should not earn more than £244,000. My own rule of thumb is executives should not earn more than 10 times the median UK salary, which is currently less than £25,000, so I favour a similar maximum of £250,000.

While only one of Character’s directors earns more than £250,000, five are earning close to the benchmark, so it is funding not one chief executive but, in salary terms, five. That’s one of the reasons why the overall executive remuneration bill is so high (£4 million).

The other reason is the bonuses. ShareSoc recommends a maximum annual bonus of 100% of salary, but I think that puts too much emphasis on the current year. I would prefer at least half of the bonus to be paid in shares held until the executives leave the company. By either of our standards, Characters’ bonuses are generous.

Summing up the year in the annual report, chairman Richard King said the company is confident in its “ability to generate profits and cash”. There’s no mention of growth in his statement, and although Character has grown modestly and haphazardly over the years, the directors appear to be running the company for profit, which they are harvesting.

Perhaps they’re collecting too much of the harvest for themselves.

Returning cash

Character hasn’t grown impressively over the years, but that needn’t make it a bad investment. It’s not my kind of investment, the kind that reinvests and grows, but it is a kind of stalwart, growing modestly and returning some its still copious earnings to shareholders by paying big dividends or buying back and cancelling shares. Reducing the share count increases the claim of each of the remaining holders on the company’s profits, which, other things being equal should make the shares more valuable.

If profits are sustainable at the current level and Character were to return all profit attributable to shareholders, the equivalent yield, would be 9%.

In fact, Character returned £3.6 million in dividends and spent £2.6 million in buybacks in 2017, which is about 7% of its enterprise value, so it is returning substantial amounts. It’s also accumulating cash, which begs the question, what is Character planning to do with it?

Questions like this invite speculation, another reason why Character is not my kind of share. But the bonuses make me nervous because they may be a sign the executives are already treating the company as something of a honey pot.

Cheap but not cheerful

Character shares probably are cheap, but when I think about a long-term investment I want to be thinking about the business and how its going to grow, not the directors and how much of the spoils they’ll share.

That’s not just because I believe large disparities in income are unfair on the employees at the other end of the distribution, and shareholders, who, as ShareScope says have a right to a fair allocation of the company’s profits, but also because when managers are so heavily encouraged to maximise profit in the current year, they’ll surely do that, perhaps at the expense of growing the business for the long-term.

Contact Richard Beddard by email: [email protected] or on Twitter: @RichardBeddard

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