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Morningstar | Toys 'R' Us Hangover Lasts Longer Than Anticipated for Hasbro With Limited Growth Set Through 2020

The dislocation that the Toys 'R' Us liquidation has caused across the toy industry is set to subside slowly as inventory find its ways to new distribution outlets and channels over the next few years. For narrow-moat Hasbro, this has waylaid profit growth as the firm now anticipates it will revisit 2017 sales and operating margin levels again ($5.2 billion and +15%, respectively), but not until 2020. This implies mid-single-digit sales and double-digit operating margin increases over the next two years. In our opinion, these metrics appear reasonable as they imply only modest market share gains versus industry growth as the firm is set to capitalize on its new brand, Power Rangers (with product set to launch in April), and margin correspondingly benefiting from another franchise brand added to margin mix. We don’t anticipate that melding Hasbro’s midterm outlook more closely into our model will change our $92 fair value estimate materially, as we expect Hasbro’s long-term prognosis to remain static, calling for around 4% sales growth and midteens operating margin averages. In this vein, we view shares as slightly undervalued but would wait for a wider margin of safety before building a position in shares.

While Hasbro shares were penalized for their relative underperformance to Mattel in the most recent quarter, performance in recent years supports the thesis that Hasbro has generally been a better operator, focusing on its brand blueprint and winning key master licensing relationships (Disney Princess, UglyDolls, amongst others). However, given the slow secular growth of the toy industry and the clean operating model Hasbro has already implemented, we suspect raising operating margin levels above prior midteens rates will be difficult. We surmise investor perception considers more downside risk than upside opportunity, given the outlook for $600 million-$700 million in operating cash flow over the medium term, in line with the $646 million achieved in 2018.

Investments to elevate Hasbro’s brands should remain pervasive as the firm perpetually introduces newness into its product line up, with management calling out investments in Magic and development spend on Power Rangers over the year ahead. Furthermore, expenses like amortization costs will nearly double in 2019-20 versus 2018 levels, as Hasbro accounts for the acquisition of Power Rangers, pressuring earnings growth. In our opinion, inflated expenses in these arenas aren’t uncalled for, as they protect both the company’s brands and ability to grow, helping hold Hasbro’s leadership in the toy category for years ahead. The company’s outlook for most other cost items in 2019 were neutral overall, with expected declines in cost of goods sold and SD&A offset by increases in product development and advertising. These neutralizing costs have given Hasbro the ability to generate flattish operating cash flow performance over the next few years.

Given low capital expenditure demands at around $160 million (versus $600 million-$700 million in operating cash flow), we expect return of shareholder capital to remain an ongoing benefit of share ownership. Hasbro shares currently yield 3% and expectations for $100 million-$150 million of share repurchases in 2019 should leave a fair amount of cash on the balance sheet to provide operating flexibility. Another banner year for content driven partner brand initiatives, including Captain Marvel, The Avengers: Endgame, Spiderman: Far from Home, Frozen 2, and Star Wars: Episode IX should all generate demand for Hasbro developed product, leading to a modest rise in the top line in 2019. While the content line up remains robust over the next few years, we remind investors that Hasbro has been growing on top of elevated content related sales levels since the resurrection of the Star Wars franchise in 2015, making years since then relatively more difficult to grow demand, which the company had successfully still done until Toys 'R' Us' recent demise. We expect Hasbro to be back on a positive top-line trajectory in 2019 with a pivot to reposition distribution after Toys 'R' Us' liquidation well underway.