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Morningstar | Domestic Toys 'R Us Headwinds Largely Subside at Hasbro; Shares Modestly Overvalued

With the domestic Toys ‘R Us liquidation largely in the rearview mirror, Hasbro could be set to deliver modestly positive top-line growth again beginning in its fiscal third quarter. Hasbro’s second-quarter sales were already trending better than we expected, falling 7% versus the 10% decline we anticipated. Sales in the U.S. and Canada contracted just 7%, around the percentage of sales Toys ‘R Us represented in 2017, while International business sales continued to struggle, falling 11%, as Europe works through its own Toys ‘R Us wind down and excess inventory problems. That said, after three consecutive quarters of sales declines, we expect Hasbro to return to positive growth ahead, and forecast second-half sales rising around 2%. Given that inventory levels have already been reduced at existing retailers and are in good condition, we think Hasbro is set up for a better 2018 holiday season than last year.

We don’t plan any material change to our $95 fair value estimate and view shares as modestly overvalued (following a double-digit gain post quarterly results), trading at more than 20 times our 2018 estimate with mid-single-digit EPS growth embedded in our five-year outlook (falling 3% in 2018 hindered by the Toys 'R Us bankruptcy). We also plan to maintain our outlook for total expenses over the next five years, with a cost of goods sold ratio improving slightly to 38% from historical averages (39% over the last five years) as franchise brands increase as a percentage of the total mix. Our model incorporates operating margins that return to 16% in 2019, ahead of the company's long-term goal of 15% or higher. With expense ratios that we expect to remain stable over the next five years, given the maturity of the business, we think Hasbro can reach peak operating margin between 17%-18% by 2021.

In our opinion, the most promising metrics from Hasbro’s quarterly release stemmed from the company’s solid control of costs. Nearly all cost line items were better than we had modeled, with cost of goods sold 60 basis points lower than we forecast (37.4%), product development 40 basis points ahead of our outlook (6.6%), advertising 30 basis points better than we expected (9.7%), and selling, distribution, and administrative costs 200 basis points ahead (28%, as we expected more deleverage from TRU), all helping drive EPS for the second quarter well ahead of our model. Furthermore, not only were costs well controlled, but the cash conversion cycle was managed diligently, with receivables down 13% and payables up 10% versus the second quarter of 2017. While inventory on the balance sheet has increased 10%, the company reiterated that levels at retail had declined, indicating that retailers should be able to accept fresh inventory for back to school and the key holiday shopping seasons ahead. These factors should put Hasbro on track to meet the $600 million to $700 million in operating cash flow it expects to generate in 2018.