EUR 850.00 For Business Accounts Only

Morningstar | Mattel Continues to Pivot its Business in a Multiyear Effort to Restore Brand Equity

With nearly the entire C-suite turning over since the beginning of 2017, we think the current management team has the ability to take a no-holds-barred effort to righting the ship at narrow-moat Mattel. While the Toys 'R' Us liquidation added complexity to turning around a slow secular growth business, the time that it has taken Mattel to heal its self-inflicted wounds has been painstaking, leaving investors frustrated for yet another quarter, sending shares tumbling nearly 10% on the company's profit report. Any progress the team is making on the $650 million cost savings plan is masked by ongoing struggles to stimulate top-line growth, leading to massive deleverage in expense lines. However, the company is attempting to right size its business by reducing jobs, selling a manufacturing facility, and investing strategically in its power brands.

Despite weaker than anticipated top line growth that fell 14% versus our high-single-digit decline forecast and a lowered gross margin outlook calling for a high 30%-range (from low 40% prior, and our forecast of 41%) we don’t plan any material change to our $21.50 fair value. This is predicated on Mattel resuming top line growth of 2% with gross and operating margins back to 47% and 8%, respectively, in 2019 with cleaner inventory and less obsolescence risk ahead, still well below historical gross and operating margin metrics (which have run at 49% and 12%, respectively, on average over the past decade). We think the company will maintain share which informs our 3% average top line growth rate, as we expect low-single-digit global sales growth in developed markets and slightly faster increases (4%-5%) in emerging markets.

But it is clear that to get back to these normalized growth metrics it could still take some time. While there were some bright spots in the power brands segment, thanks to gross Barbie sales growth of 12% and a Hot Wheels uptick of 21% (in aggregate representing 35% of second-quarter sales), Fisher-Price/Thomas and Friends and American Girl languished, with revenue that tumbled 14% and 33%, respectively (accounting for 30% of gross sales). Furthermore, both owned and partner brands in the Toy Box segment declined 23%, leaving little excitement to be had across the product portfolio.

This lower level of sales led to deleverage across expense lines, with the adjusted gross margin contracting nearly 1,100 basis points, to 30.4%. We were most disappointed in the fact that one fifth of the decline stemmed from inventory obsolescence, something we thought the company had largely concluded. This, along with other factors like higher freight expense and structural simplification costs, were what drove the earlier mentioned change to gross margin for 2018. On the flip side, the SG&A outlook was modestly improved, now anticipated to be slightly down versus slightly up prior, but this doesn’t come close to offsetting the magnitude of gross margin declines, leading to operating margins that could still be lower than breakeven in 2018.

We still believe that untapped brand equity resides in Thomas, American Girl, and Fisher-Price, but that turning around the goodwill surrounding these product lines has been a difficult nut to crack. With CEO Ynon Kriez recently taking the helm, we expect he will search to capitalize and monetize on the IP of these lines, and resurrect top-line growth to a modestly positive level. Given commentary surrounding some potential obsolescence ahead, we may not be completely out of the woods on stable sales growth yet, but we think solid positive growth should be able to resume in 2019 and expense items should leverage nicely. Given the announcement today to slice 2,200 out of the corporate workforce (22% of the global non-manufacturing workforce) and shutter and sell its Mexico manufacturing facilities, both operating expenses and capital expenses should be significantly lowered in 2019, supporting our high-single-digit operating margin rate.