Description

4Kids Entertainment, Inc. (4Kids) is in bankruptcy and not a great business, yet I think it’s an interesting opportunity.  My general thesis is it’s an underfollowed name with a share price that is reflecting the current balance sheet, but fails to reflect the possibilities that are about to be unlocked by an auction of one of its assets, the Yu-Gi-Oh business. 

I’ll keep the background brief, but it is relevant to understand the current situation.  On March 24, 2011 the licensors of the Yu-Gi-Oh! Property, Asatsu-Dk Inc (ADK) and TV Tokyo, filed a lawsuit against 4Kids claiming 4Kids failed to pay the licensors $4.7mm with regard to certain audit claims asserted by the licensors, and ADK and TV Tokyo were terminating the agreement between 4Kids and themselves due to this alleged breach.  As a result, 4Kids filed for Chapter 11 to protect its interests in April 2011.

The docket can be accessed here:

http://dm.epiq11.com/KDS/Docket#Debtors=4178&RelatedDocketId=&ds=true&maxPerPage=25&page=1

On December 29^th, 2011, Judge Chapman issued her Opinion which was largely in favor of 4Kids. 

On Feb 27^th, 2012, 4Kids and the Licensors entered in a settlement for $8mm (+$1mm desposit that the Debtors had previously paid), which settled all claims brought by the Licensors and all counterclaims brought by 4Kids against the Licensors in the litigation.  This settlement was important, for many reasons, but most importantly, the Debtors can now move toward concluding their Chapter 11 case.

The next step is to sell the Yu-Gi-Oh business.  In fact, the Debtor is in advanced discussions with a bidder that are expected to result in an auction in the near term, according to the recently filed Fourth Motion to Extend Exclusivity.  [Doc 571]*  Ideally, after that, they would sell the other properties and liquidate, but another option could be to operate on a much smaller scale and emerge from bankruptcy with equity intact.  But so far, they’ve only alluded to the first sale.

It’s difficult to put a price on what the Yu-Gi-Oh business is worth, but for now, I’m going to use an estimate of $10mm, which I think should ultimately prove to be conservative.  The real negative here is that 4Kid’s US license expires on Aug 31, 2015, and a year later for the international license, which puts an effective ceiling on the auction.

First, ADK and TV Tokyo just settled for $8mm in the recent settlement.  I think it’s fair to say that should be considered a floor on the business.  As it stood, 4Kids was not in a position of strength, even despite the favorable ruling.  Their cash stood at 1.6mm 2011 year end, and a lengthy delay in resolving the issue would prevent them from taking the next steps to exit bankruptcy.

Second, in May 2010, as noted by Alfred R. Kahn on the conference call, the company had received an indication of interest from a third party to acquire 4Kids, when the share price was around $1.10.  Here is a link to the transcript and the mention:

http://seekingalpha.com/article/204296-4kids-entertainment-inc-q1-2010-earnings-call-transcript

 “Alfred R. Kahn

Thank you, Bruce. Good morning everyone. Before discussing the first quarter, I’d like to bring you up to speed on a new development late Friday night, May 7. The company received a non-binding indication of interest of a third party to acquire 4Kids for a price representing a premium over the recent closing prices for the company’s common stock. This non-binding indication would be subject to the satisfactory completion of due diligence and negotiation of definitive agreements during a requested exclusivity period.

A special committee of the Board of Directors formed in 2009 in connection with the valuation of strategic alternatives met yesterday and authorized the company’s management to provide the potential acquirer with the due diligence information requiring the company’s assets and operations and [inaudible] to enter into discussions with the potential acquirer regarding exclusivity and the acquirer’s indication of interest.

Given the timing of the delivery of the non-binding indication of interest, we have not yet spoken to the third party regarding the substance of the indication of interest. We will obviously be in contact with the third party later today in accordance with the decision of the Board. Let me suggest that obviously this is in continuum of what we had started over a year ago in terms of trying to increase shareholder value in any which way possible.“

Assuming a potential indication of interest of around $1.50 vs the then current price of ~$1.10, that would equate to around $20mm for the whole company, and assuming Yu-Gi-Oh business value is around half of the value of the company, that’s about a $10mm valuation for Yu-Gi-Oh.  While one could argue Yu-Gi-Oh was only 25% of the revenues at that time so only $5mm of value should be attributed, I would counter with the other properties were declining in revenues and were worth much less than their static percentage of annual revenues.

And finally, for a sanity check, the business been producing around 6mm per year of revenues over the last few years, so <2x revenues for a this business doesn’t seem like a stretch.

Moving on, a look at the Dec31st, 2011 balance sheet shows assets of 16mm vs liabilities of 22mm.

Current Assets:

                                Cash: 1.6mm

                                Accounts rec: 6.2mm

                                Prepaid: 1.3mm

Total: 9.1mm

Other Assets:

                                Film and TV: 2.465mm

                                Other: 3.3m

                Total: 5.765mm

Total Assets: 16mm

Liabilities:

                                Liabilities not subject to compromise: 14.5mm

                                Liabilities subject to compromise: 7.5mm

Total Liabilities: 22mm

There are two assets, a LBI claim and a Chaotic Property Transaction that has been fully reserved for, that are not on the year end balance sheet that I will note briefly.  I’m going to assign no value to these, although the face numbers are large and could be meaningful to 4Kids in the event that it goes their way:

1) LBI Claim:

Lehman Brothers, Inc. Claim - The Company believes that Lehman Brothers, Inc., the securities broker-dealer that purchased the auction rate securities on behalf of the Company violated its legal obligations to the Company.  As a result, the Company took various measures to obtain appropriate legal relief, including initiating an arbitration on April 3, 2008 against Lehman Brothers, Inc. and the brokers who had serviced the Company’s Lehman account with the Financial Industry Regulatory Authority.  On September 15, 2008, Lehman Brothers Holdings, Inc., the parent company of Lehman Brothers, Inc., filed for bankruptcy.  The Company’s arbitration proceeding was stayed by the Lehman bankruptcy.  On September 16, 2008, Barclays PLC announced that it had reached an agreement to purchase the assets of Lehman Brothers Holdings, Inc.’s North American operations, including substantial assets of Lehman Brothers, Inc.  The Lehman-Barclays transaction was approved by the United States Bankruptcy Court for the Southern District of New York on September 20, 2008.  On September 19, 2008, the Securities Investor Protection Corporation (“SIPC”) filed a proceeding, placing Lehman Brothers, Inc. in liquidation under the Securities Investor Protection Act (“SIPA”).  SIPC, pursuant to its authority under SIPA, has acted to facilitate the transfer of Lehman Brothers, Inc.’s customer accounts (including the Company’s accounts) to Barclays, PLC.  In late September, 2009, the Company filed a proof of claim against Lehman Brothers, Inc. in the United States Bankruptcy Court for the Southern District of New York. The principal amount of the claim was approximately $31,500 plus interest. In addition, the proof of claim requested treble damages. The proof of claim is a general unsecured claim. The Company’s claim against Lehman Brothers, Inc. is still pending and there has been no determination made as to the validity or allowed amount of the claim.  On October 18, 2011, the Company entered into a settlement agreement and general release with the brokers who had serviced the Company’s account with Lehman Brothers, Inc. for approximately $489.

2) Chaotic Transaction:

As of December 31, 2011, the Company had entered into the following transactions with CUSA and CUSA LLC, or parties related to Gannon and Milito that are summarized below:

The company has been roughly cash-flow breakeven over the last few months.  I’ll make a few adjustments to the year end balance sheet to get an estimated company value:

+Add LBI and Chaotic, but assign no value

+Add in settlement case

+Add in Yu-Gi-Oh value

+Add in non Yu-Gi-Oh value (for simplicity, I’ll estimate the value of these properties by saying if the non binding indication of interest above was 20mm, and Yu-Gi-Oh value was 10mm, these properties were worth 10mm at that time…because revenues have declined, I’ll use 5mm for a current estimate).

+Add bankruptcy costs of $4mm

-Subtract “other assets” above while only including Cash, Accts Rec, and Pre-paid

-Subtract ADK claim (while keeping all other liabilities intact)

Estimated balance sheet:

Current Assets:

                                Cash: 8.3mm (taken from March MOR)

                                Accounts rec: 6.2mm

                                Prepaid: 1.3mm

                                LBI Potential Claim: 0

                                Chaotic Transaction Reserve: 0

                                PotentialSaleof Yu-Gi-Oh: 10mm

                                Non Yu-Gi-Oh properties: 5mm

Total Assets: 30.8mm

Liabilities:

                                Liabilities not subject to compromise: 14.5mm

                                Liabilities subject to compromise: 2.8mm

                                Bankruptcy Costs: 4mm

Total Liabilities: 21.3mm

Assets-Liabilities: 9.5

Shares outstanding = 13.7mm

Recovery: $0.70

This recovery estimate should provide a margin of safety against the current price.  I’ve tried to err on the conservative side in the write-up, and there is the potential for larger gains (larger sales price, LBI Claim, Chaotic, etc).

It doesn’t take much imagination to think that the Yu-Gi-Oh auction could yield more than $10mm, and if not, then the other properties should be worth more than $5mm.  Before the recent turmoil, the stock traded above $1.  With 13.6mm shares outstanding, any upside in my estimates makes a large difference to the share price.  The Chaotic and LBI claims together represent over 40mm of face value, or ~$3 share.  The odds are slim, but the price is right.

Catalyst:

A potential 363 sale of the Yu-Gi-Oh business to unlock value

Risks:

1)      The figures in this case are very small.  Bankruptcy costs, and other costs/litigation, etc can eat away at a recovery very quickly.

2)      An EC was requested, but denied.  Without full representation, the equity might be disadvantaged.  While disappointing, having 4 large equity holders on board should hopefully provide some checks and balances.

3)      Prescottis the largest holder.  It’s possible that they try to negotiate a deal which favors themselves over other holders, similar to their PBSOQ attempt.  I am somewhat comforted by the language differences from the 3^rd to the 4^th Motions for Extension (see aside below).

4)      The company could squander any cash received from the sale on trying to maintain the business or buy new properties.  It’s possible, but selling your biggest property to rebuild doesn’t make much sense.  Stranger things have happened though…

*As an aside, I think it’s relevant to point out a difference in the language between the 3^rd and 4^th Extension requests.  In the 3^rd, the Debtors seem to be engaged with potential plan sponsors, but that strategy looks to have been abandoned by the 4^th.  I believe this means the Debtors feel liquidity is adequate to exit Chapter 11.

[Doc 447]

“14. Early in the cases, the Debtors also retained the services of BDO Capital

Advisors, LLC (“BDO”) as financial advisor and investment banker. BDO has been assisting the

Debtors in analyzing their business, operations and financial position and assisting the Debtors in

pursuing debtor-in-possession financing, strategic asset sales and/or a plan of reorganization. In

furtherance of these efforts, BDO (i) set up a data room with key contracts and financial

information regarding the Debtors, (ii) commenced a significant marketing process and contacted

potential investors regarding debtor-in-possession financing, strategic asset sales and/or plan

funding, (iii) assisted the Debtors with their business plan and financial projections.

15. Based upon those marketing efforts, the Debtors received written plan

proposals from potential plan sponsors. The Debtors, with the assistance of their professionals,

have engaged in extensive negotiations with those potential sponsors. Significant progress has

been made but the negotiations are on-going and, more importantly, each proposal was

contingent upon the Debtors obtaining a favorable ruling in the first phase of the Yu-Gi-Oh

litigation. The sponsors are reviewing the Court’s decision and the Debtors expect to move

forward with a proposal shortly. Under the circumstances, the Debtors have taken all reasonable measures to make good-faith progress toward a reorganization.”

[Doc571]

“13. Early in the cases, the Debtors retained the services of BDO Capital

Advisors, LLC (“BDO Capital”) as financial advisor and investment banker. BDO Capital has

been assisting the Debtors in analyzing their business, operations and financial position and

assisting the Debtors in pursuing debtor-in-possession financing, strategic asset sales and/or a

plan of reorganization. In furtherance of these efforts, BDO Capital (i) set up a data room with

key contracts and financial information regarding the Debtors, (ii) commenced a significant

marketing process and contacted potential investors regarding debtor-in-possession financing,

strategic asset sales and/or plan funding, and (iii) assisted the Debtors with their business plan

and financial projections.

14. As recently reported to the Court, the Debtors are now in advanced

discussions with a bidder that are expected to result in a auction for the Yu-Gi-Oh business in the

near term. That sale, if successful, should result in a substantial recovery by the Debtors’

unsecured creditors. The foregoing constitutes good-faith progress toward a reorganization.”

Catalyst