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Morningstar | Mix Shift and Lapping of Toys 'R' Us Headwinds Bolster Hasbro’s Profitability; Shares Overvalued

Narrow-moat Hasbro posted solid first-quarter profit metrics, with an operating margin of 5% well ahead of the slightly positive metric we had forecast. With sales growth of 2%, versus our expectation of a 3% decline, the company was able to benefit from modest cost leverage, and the selling, distribution and administration ratio contracted 270 basis points, to 30.8%. However, more important, profitability benefited from a mix shift, with higher-margin franchise brand sales rising 9% (well ahead of our 2% expected shortfall) and lower-margin partner brand sales declining 14% (faster than our 10% decline). However, given the small seasonal contribution from the first quarter (set to represent about 5% in 2019 earnings), the company maintained the outlook for many of its cost metrics provided at Toy Fair, as well as its outlook for 2020 revenue and operating margin to be similar to 2017 levels. In this vein, we don’t plan to make any material change to our $90 fair value estimate and view shares as modestly overvalued trading at more than 20 times our 2019 EPS versus low-double-digit EPS growth over the next five years.

We expect the mix shift benefits to neutralize over the remainder of 2019, with more content surfacing from partner relationships leading to higher royalty payments and lighter operating margin expansion, given that Hasbro will no longer be lapping the TRU liquidation. We have the firm reaching about the $5.2 billion in 2017 sales in 2020 and surpassing 2017’s 15% operating margin in 2020, at 15.8%. Unless Hasbro can sustainably grow franchise faster than partner brands, we suspect the company will be running close to peak operating margin levels and forecast only modest annual gains beyond 2020. Longer term, we think the top line could rise at around 4% on average thanks to ongoing content exposure from franchise brands and strong partner brand relationships; and scale will help lever expenses, leading to a terminal operating margin around 17%.

First-quarter sales growth of 2%, to $733 million, was helped by 24% growth in the entertainment, licensing, and digital business, while U.S. and Canada sales rose 1% and international revenue contracted 2% (rising 6% ex-foreign exchange). Point of sale remains down at a low-single-digit clip year to date, but progress appears to be surfacing, with Easter-to-Easter POS up at a mid-single-digit rate ex-TRU. Royalties fell 14% to comprise 8.2% of sales (versus 9.7% in the first quarter last year), but we expect the ratio to increase ahead with the launch of more partner-related content including Avengers, Spider-Man, Frozen and Star Wars as the year progresses. Lower royalty expense in our model was largely offset by higher than anticipated advertising costs, at 10.5% of sales, versus 9.5% in the year-ago period.

In our opinion, Hasbro continues to operate a very clean business overall, by way of inventory, as well as wholesale and partner relationships. We expect it will facilitate the continuation of the expiring Disney licenses in 2020 barring any egregious extraction of economics from current levels from the partner brand, given the success the existing relationship has provided for both parties. Despite ROICs that are set to surpass 24% over the next five years thanks to stellar marketing of its franchise and partner brands, shares appear to be priced to execute flawlessly, and we would not be more constructive on ownership until the shares pulled back from current levels.