EUR 850.00 For Business Accounts Only

Morningstar | Despite Industry Demand Pressure, Mattel Holds Its Market Position; Shares Attractive

Total U.S. retail sales for the toy industry clocked their first decline since 2013 amid disruption by the Toys 'R' Us liquidation, stalling Mattel’s top line turnaround, which was hurt by the mid-single-digit demand declines implied in the key holiday season. This headwind masked some success stemming from Mattel’s $650 million cost savings initiative as the top line declined (2018 was the fifth year of shrinking sales at Mattel), hindering its ability to maximize the leverage of fixed costs. However, as we get through the first half of 2019 and lap the Toys 'R' Us liquidation, comparables ease and working capital metrics should improve, given better inventory management and a repositioned distribution channel, strengthening cash flow.

While the firm exited 2018 pocketing $521 million in sustainable cost savings, we expect further efforts to streamline the business will follow. More importantly though, we believe top line growth will stem from content and product initiatives rather than structural simplification, bolstering profit growth. Our 2019 3% sales growth forecast is predicated on a rebounding second half (without TRU in the distribution mix) and rising efforts to extract economic rents from owned intellectual property. While the company avoided giving insight ahead of its investor day at Toy Fair next week, we suspect management will guide to financial metrics that continue to trend in an improving direction, supporting the thesis that the turnaround is underway. While we do anticipate operating margin expansion ahead (we forecast 6% operating margin in 2019 previously), we don’t see Mattel returning to midteen operating margins until 2023, and still expect the metric to peak below the 18% the company reached in the 2012-2013 period. In this vein, we don’t plan any material change to our $21 fair value and view the shares as attractive.

While some brands remain slow to turn (American Girl, Fisher-Price), both Barbie and Hot Wheels remain solid performers that display the brand equity such legacy lines hold. Long-lasting brands that resonate with parents (key purchasers) as well as children underlie our narrow-moat rating and our long-term outlook for sales that rise 3% annually. We note this growth rate remains below the 4% Euromonitor anticipates for the category through 2022 but in line with population demographics we outlined in our April 2018 report, “Tailwinds Stand to Wind Up Mattel and Hasbro After Weak 2017.” Furthermore, efforts to capitalize on underutilized IP should come to fruition, with both Barbie and Hot Wheels motion pictures in place through the firm’s Warner Bros partnership, and with additional focus on television content, further taking a page from narrow-moat peer Hasbro’s playbook. While these pushes don’t imminently pay dividends through their respective development cycles, they position Mattel to participate in the benefits of owning more connected-to-consumer evergreen properties in their lineups.

In the fourth quarter, Barbie and Hot Wheels remained the strong performers, with gross sales up 12% and 9% respectively on a global basis. The other power brand businesses, Fisher Price/Thomas and friends, and American Girl, which represent more than 40% of power brand sales, languished, with sales contracting 17% and 27%, respectively. Furthermore, the Toy Box remains messy, with both owned and partner brands falling more than 20% collectively, hindered primarily by lapping Cars 3 sales in the year ago period and weak MEGA sales. Impressively, the adjusted gross margin expanded more than 1450 basis points, to 46.6%, despite a 350 basis point headwind from raw material and labor cost inflation. Structural simplification and lower inventory obsolescence also helped boost the metric. Selling and administrative expenses were a touch higher than we anticipated, at 25.5% of sales, as incentive comp more than outweighed structural simplification efforts.

While there are not imminent liquidity issues with Mattel’s next piece of debt maturing in 2020 and a $1.6 billion credit facility on hand, recent performance of the business and higher debt service costs (the company’s most recent refinancings in 2017/2018 priced at 6.75%) indicate that net debt/adjusted EBITDA is unlikely return to reasonable levels (below 3 times) until 2020. That said, we expect Mattel to reinvest any excess cash to right the ship, rather than reinstate a dividend or buy back shares, helping leverage metrics naturally return to normalized levels via improved product offerings.