Mega Brands attempts to reduce debt

One of the annoying things about continuously researching investments is that you may spend a lot of time on research yet end up with nothing. For me, such a scenario (lots of research but neither a buy nor a sell in the end) is one of the most depressing things about investing. Small investors like me—I suspect this applies to majority of the readers—don't do this as a full-time job so any "wasted" time seems like a mistake. Unlike professionals, I don't get paid to spend hours searching for information or thinking about industries; a hundread hours spent on research with no final investment is always a disapointment.

Sometimes, though, what seems like a fruitless pursuit can turn out to be a potential investment years down the road. Such is the case with Mega Brands (TSX: MB). I can't remember if I mentioned this stock on this blog before but I have had it on my watchlist for a while now.

Mega Brands is one of the major toy companies in North America. It is a Canadian company whose main competitor is Lego (this was the case when I was researching the company an year or so ago, but keep in mind that things like market share, competitors, etc can change.) I became interested in it because it ran into severe problems after a toddler died from ingesting one of its toys. Needless to say, the shares collapsed and it was very close to bankruptcy. It took on massive debt—numbers that would make any shareholder run away scared—in order to keep it afloat.

As most readers probably know by now, I am attracted to distressed investments—it's just that I haven't made any serious money on them yet :| . Usually when a stock collapses 50%+ or if there is some scandal that makes the newspaper, I check it out. I did some research on Mega Brands and I liked the company. Essentially, the Canadian company was pretty good, with popular toys, good relations with retailers, and so forth. What happened was that it bought out a US company that turned out to be a disaster (toddler death, toy recall, etc.) It looked very much like the classic case of some big mistakes by the sons of the founder (the sons took over the company and were the ones who made the mistake of buying the US toy company.)

I ruled out any immediate investment in Mega Brands because the debt was extremely high. Even if a rosy scenario unfolded and the company recovered, most of the profits generated by the company would go to the bondholders. The company would also have zero financial flexibility for a decade or more! So it was banished to the watchlist with a low priority.

But an important event unfolded today. It's time to re-visit the situation.

The Globe & Mail is reporting that Mega Brands is going to pay down its debt by raising capital from the stock market. Remember how I said the size of the debt was scary? Watch how much dilution is involved here. Pay attention to the share count increase. (As usual, any bolds are by me.)

Financially troubled toy maker Mega Brands Inc. has put in place a restructuring plan aimed at significantly paring its hefty debt.


The Montreal-based maker of children's construction blocks and other toys said Thursday it has hammered out a refinancing plan that eliminates about $300-million (U.S.) of its $430-million debt.

The move triggered a massive selloff of Mega Brands shares on the Toronto Stock Exchange on concerns that the plan will result in a massive dilution of the equity as the company issues millions of new shares. The existing 36.6 million shares – 60.1 million on a fully diluted basis – will balloon to about 556 million shares.

Mega Brands will also issue about 285 million new common shares at 50 cents (Canadian) per share, as well as 234 million warrants exercisable into common shares at 50 cents a share.

...

The complex plan will see Mega Brands get a capital infusion of $100-million in a bought-deal financing led by GMP Securities. The company also plans a $121-million private placement to Fairfax Financial Holdings Ltd.

As well, Wachovia Capital Finance Corp. has agreed to provide a $50-million asset-based facility The debt reduction will take place as the result of a series of transactions, including the repayment – in cash and equity – of all of its outstanding senior secured indebtedness of about $357.2-million, at a recovery rate of about 70 per cent to holders of the secured debt.

...

Mega Brands has been hit hard by a series of challenges over the past few years, including the massive recall of its Magnetix line of construction toys after the death of one child in the U.S. following ingestion of small powerful magnets that came loose; 27 other children suffered injuries after swallowing the magnets.

Yes, you read that right: the share count will go from 60.1 million to 556 million! The good news is that some prominent investors, such as Fairfax Financial, is backing a portion of the deal. But bondholders will own a big chunk of the firm and I don't know what they plan to do with this company.

I think most stock market investors will still run away scared after seeing that 556 million share-count number. Me, not so much. I'm actually interested in the company now and will start looking to see if it's worthy of an investment. My main concern before, the debt, will be reduced if this deal goes through.

I liked the company initially for its competitive positioning. Sure, it's not a wide moat company like most mega-caps but it seems to have carved up a portion of the toy industry between itself and Lego. I still have to figure out the macro situation, particularly the threat of cheap foreign toys (from China et al.) When I looked at it an year or so ago, Mega Brands did have identifiable brand loyalty. The question now is whether any of that has deteriorated given its financial troubles over the last year or two. The toy industry is also kind of flaky and driven by hits so one needs to be confident that Mega Brands' toys have staying power. Given the consumption slowdown in America, consumer discretionary items like toys may see some cutbacks but I'm not too concerned with that here.

Finally, one of the most important questions is to figure out who will be running the firm. Are these bondholders, who probably have zero interest in owning shares in a company, going to stick around? Are they going to pursue short-term strategies to boost the likelihood of cashing out their shares, at the expense of long-term performance? And most importantly, how is the management team? If the prior executives will still be running the firm, were they incompetent or did they make a mistake anyone could have made?


Anyway, if anyone has any thoughts feel free to chime in. I'll start researching this company again. Just to be clear, this is a high-risk potential on the surface (but as any value investor would say, just because the company is down 90% and trading at $0.50 doesn't necessarily mean it's any riskier.)