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Morningstar | Tepid 2019 Outlook Weighs on Mattel as Turnaround Set to Occur More Slowly Than Investors Hoped For

While the messaging surrounding narrow-moat Mattel’s structural simplification plan and the monetization of its robust IP offerings hasn’t changed, the cadence of improvement appears to be slower than investors had hoped for, sending shares tumbling nearly 20% after its investor meeting on Feb. 15. We remind investors that shares have risen almost 40% year to date even after its drop while undertaking a multi-year turnaround under a new management and operating structure. Mattel’s resurrection has been on a protracted path since 2017, and we don’t anticipate the pace to accelerate as the secularly slow growing toy industry (which we expect to rise at just around 3% on average) remains a headwind to the successful execution of the cause.

Nearly every metric Mattel offered surrounding 2019 guidance was both disappointing and lighter than our prior forecast. First, while constant currency sales are forecast to be flat, foreign exchange is anticipated to provide a 75 - basis - point headwind at the midpoint, implying that Mattel is set for its sixth year of as-reported sales declines, below our projected 3% sales rise and marking sales at about two thirds of 2013 levels. Second, the gross margin outlook for the low-40% range was short of our 45% estimate, hurt by both input costs and currency. Finally, a slightly positive level of adjusted operating income is well below our $284 million estimate. At first glance, adjusting our projections more closely to align with Mattel’s updated guidance doesn’t materially alter our $21 fair value estimate. As we roll our model forward, a weak 2018 will be removed from our forecasting window and replaced by a lower loss in 2019, pushing improved cash flows through our DCF. Despite the delayed improvement, we are holding the line on our LT outlook for 14% operating margin in 2023 with operating changes underway. Shares are undervalued, but we caution that the road to improvement could be volatile, warranting longer-term time horizons.

Despite a frustrating pace of improvement on the financial front, current CEO Ynon Kreiz, who took the helm in 2018, has executed faster on Mattel's push to monetize its intellectual property through new channels than any of his past three predecessors. In recent periods, the company has announced new lines with BTS, the world’s leading Korean boy band, a multi-year licensing agreement with Universal’s Despicable Me franchise (ahead of the next Minions movie in 2020), and most recently, 22 new animated and live action television programs stemming from Mattel’s characters and franchises that are certain to raise visibility around the brands and build goodwill behind the company’s brand intangible asset, which is an underlying tenet of our narrow moat rating. Furthermore, the appointment of Adam Bonnett (of Disney Channel previously) to steer Mattel Television and Robbie Brenner (Academy Award-nominated director, Dallas Buyers Club) at the helm of Mattel Films has put further wheels in motion to take a page from narrow-moat Hasbro’s wildly successful multi-media playbook, launching content across new and different channels that it has been underrepresented in historically.

Such efforts continue to push Mattel in a forward direction, although until the firm can put a full stop to top-line declines, it could remain difficult to get excited about profit growth opportunities as cost leverage on shrinking sales can generally be a struggle. Exiting 2018, Mattel has already captured $521 million in savings (about 10% of 2017 expenses above the line) from its structural simplification program, but even with another $129 million in recurring savings set to come in 2019, we still aren’t confident the company will be able to deliver breakeven earnings in 2019 given debt service costs. Without any significant debt payments due until the final quarter of 2020, we aren’t terribly concerned about near-term liquidity. However, in order to lower debt service expenses ahead (the last two private placements priced at 6.75%), Mattel will need to show lenders a modest track record of rising profitability to facilitate either lower pricing of refinancings or have the ability to pay down existing debt as it comes due; the next few notes payable are between $250 million-$300 million each.

Overall sentiment on Mattel continues to struggle despite consistent performance at both Barbie and Hot Wheels, brands that represented 38% of 2018 gross sales. We attribute this to struggles at other key brands like Fisher-Price, Thomas, and American Girl, which represent another 30% of 2018 gross sales. Between 2016 and 2018, Fisher-Price and Thomas sales have fallen 23% while American Girls sales have tumbled 42%, more than offsetting gains that Barbie and Hot Wheels have earned. We suspect that when Mattel can stabilize Fisher-Price (American Girls is already a known longer-term turnaround story) sentiment will begin to turn on Mattel, as then more than 60% of gross sales will be perceived as improving with consumers, if Barbie and Hot Wheels continue on the solid path they have traveled on in recent periods.