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Morningstar | Green Shoots Begin to Sprout as Mattel’s Turnaround Persists; Shares Undervalued

Mattel continues to attempt to pivot to changing consumer preferences in the toy industry, something it has struggled with the execution of over the last decade. But we contend that over the last two years (since Margo Georgiadis took the helm in February 2017 and through Ynon Kriez’s stint at the helm) massive alterations at the company have been undertaken, starting with a clean sweep of both the Board of Directors and the C-Suite as well as the reorganized focus on key power brands like Barbie and Hot Wheels (representing more than half of the company’s sales in 2018); Barbie has been able to put up double-digit growth metrics globally year to date. And while Fisher-Price and American Girl have languished, we don’t think the long-standing brand equity (which underlies our narrow moat rating) has decayed materially, rather that the messaging and distribution needs to be shifted and optimized, something that we assume will be a key priority for the recently reformed global commercial organization.

The upside from these changes, as well as benefit from the currently executed $650 million cost savings initiative, are incorporated into our long-term outlook for Mattel, calling for an operating margin that returns to positive in 2019, and then back to a low-double-digit level through 2022. We see some operating leverage also stemming from a return to 2.4% sales growth in 2019 (after five consecutive years of declines through 2018), and a long-term potential annual rise of around 3% as the focus on power brands, content and intellectual property supports faster growth ahead. In this vein, we don’t plan any material change to our $21.50 fair value estimate and view shares as undervalued. Admittedly, clarity should ensue in 2019 as Toys 'R' Us will be in the rear mirror, Toy Story 4 should support an incremental sales bump lapping Jurassic World, and the newly formed film division could mint some new content, providing upside to our existing forecast.

While third-quarter results weren’t good by many standards, they didn’t appear to outlie Hasbro’s struggles that were reported earlier this week. In fact, Mattel’s North American sales increased 4% relative to Hasbro’s 7% slide, but both companies continue to struggle abroad, with Mattel’s international sales falling 18%, slightly better than Hasbro’s 24% international decline, due to ongoing weakness in China. Gross sales in Power Brands fell 5%, worse than our flat estimate, but Toy Box sales fared a bit better than we anticipated by 100 basis points, contracting 9%, struggling to lap strong Cars 3 sales in 2017. American Girl sales continue to languish, down 31% globally, and we don’t anticipate a rapid turnaround at the brand given that it appears to fall lower on the company’s priority list (we’d expect the brand to come into turnaround focus in 2019).

More important was that Mattel had finally displayed operating income expansion, rising more than 40% and marking the first time in two years that the company has been able to stimulate a profit increase. Moreover, adjusted gross margin was 100 basis points higher than we anticipated, at 43%, helped by the structural simplification initiatives, pricing, and lower obsolescence and distribution costs. This marks the first quarter of adjusted gross margin expansion in 13 quarters, although it is still significantly below the high-water mark of 54% the company posted in the third quarters of 2012 and 2013. However, this gain was offset by the selling and administration ratios that came in higher than we anticipated, at 20.9%, with employee costs, investments and amortization more than offsetting gains from the structural simplification efforts.

Although we don’t think one quarter marks a trend at Mattel, we do think the third quarter offers some green shoots that support our theory that the company’s brands remain resilient and that turnaround efforts are beginning to take hold. Further evidence in this is seen in balance sheet metrics, where cash conversion is ramping up, with accounts receivable falling 13% and inventories contracting 26%, while payables have risen just 5% year over year, freeing up some working capital demand at Mattel and providing incremental liquidity which provides a wider safety net for the business to operate strategically through the key holiday season.