The Height of Private Equity: Topps, Inc. - Part II

Recently, I provided an analysis of investing in Topps, Inc. (TOPP). The article made many salient points, but the argument was not articulate enough. This article will revisit the TOPP issue and provide the evidence that TOPP is a lackluster investment opportunity. First, I will address the response to my first article and then continue to a discussion of valuation which shows TOPP to be an inferior investment.

Response to Statements Stemming from My First Article:
My first article attempted to provide salient points as to why Topps, Inc. seems to be an inferior investment. The crux of my argument was that competition in the sports card industry led to hyper-inflation, which left two competitors in a stagnant industry. My statements elicited a response from Mr. Thomas Kircher:

Mr. Kircher's Discussion of Topps, Inc.

The article by Mr. Kircher argues that the hyper-inflation is a direct result of a rent seeking monopolist: Major League Baseball. If the hyper-inflation I describe was the result of a rent seeking monopolist, then baseball card collectors would have experienced such inflation during the 1950s and 60s. The chart below illustrates our disagreement with the rent seeking monopolist thesis.

Table 1: Hyper-Inflation in Baseball Card Prices

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The table as well as the following discussion of baseball card history at Wikipedia shows that prices did not rise due to a rent seeking monopolist.

Wikipedia: History of Baseball Cards, See Section 1980s to Present.

If anything, MLB and MLBPA limited the number of licenses in order to stop the plethora of sets due to extensive competition. Investors need look no further than the innovation that Upper Deck introduced in 1997: cards with swatches of memorabilia. The result of the memorabilia cards was a fan frenzy and rising prices. These memorabilia cards made buying unopened packs more like a lottery than pursuit of a true hobby.

We will concede that Upper Deck’s offer for Topps, Inc. might not encounter anti-trust risk. Nevertheless, there is always risk when the smaller fish tries to swallow the whale (Upper Deck has revenue of $60M, whereas Topps, Inc.’s revenue is $326M). The problem is that we still believe that Topps, Inc. is an inferior investment.

Lastly, we believe that “nostalgic baby boomers with inelastic demand curves are inelastic” is incorrect. I do not see how anyone can make an argument that demand curves for baseball cards are inelastic. One might make a reasonable argument for secondary sales of high quality vintage memorabilia and cards experiencing inelastic demand, but not unopened packs of current baseball cards. I believe that a simple pole of regular card dealers would support the fact that baby boomers are interested in vintage material rather than current product. If baby boomers were willing to pay anything for a card, then vintage baseball cards would not have declined in prices during the last decade.

Valuation:
My first article lacked a thorough discussion of the value of Topps. I will start with a discussion of profitability and the business, followed by a DCF analysis, then a comparison of DCF value for competitors, and end with relative analysis.

In theory, Topps has a great business, since it enjoys both product differentiation by providing a better product, and perceived differentiation through a trusted brand. The problem is that financial metrics do not support the previously stated theory. Return on Assets and Equity are a paltry 4.8% and 5.5% on a trailing twelve month basis according to Yahoo! Finance. Secondly, I calculate the WACC for Topps to be 13.95%, but the Return on Invested Capital [ROIC] is only 6.0%. This discrepancy between WACC and ROIC tells investors that Topps is efficiently eroding shareholder value.

Table 2: Discounted Cash Flow Analysis for Topps, Inc.

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The discounted cash flow analysis of Topps presented above reinforces the fact that TOPP is an inferior investment. First, TOPP has a DCF value of $2.66 per share, well below the current price and below the two offers on the table. I decided to be generous and use a 10% growth rate for operating cash flow from 2008 to 2014. I also used a rolling three year average for CAPEX expenses in order to keep them flat. My rosy assumptions certainly did not help to increase the DCF value per share.

Table 3: Comparison of DCF Values for Confectioners

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Since the main business of Topps, Inc. is bubble gum, the confectioner industry seems most appropriate for comparison. Table three shows different discounted cash flow values for selected companies in the confectioner industry. A purchase of Topps at current levels suggests that an investor has a rosy outlook for the baseball card industry. The comparison suggests that investors are better suited to consider some of Topps competitors in the confectioner space.

Table 4: Relative Analysis Metrics for Confectioners Industry

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Topps once again disappoints on a relative analysis basis, since it is overvalued on a price to earnings, price to EBITDA, and enterprise value to EBITDA. The company is undervalued on a price to sales and price to book value basis.

Current investors in Topps should expect two outcomes: (1) a 6% rise to the upside, which is the price of Upper Deck’s offer; or, (2) a 10% decline to the price of Mr. Eisner’s offer. Holding Topps at current levels represents a significant opportunity cost. There are many other equities, some within the confectioner industry, which offer greater investment returns. If you think Topps is a superior investment, I have some Ron Kittle rookie cards I would like to sell you; I hear they could be a good investment!

Disclosure: The author owns the following: A, BRP, BTEL.OB, COP, IMOS, VRGY.