Mattel Is Not Safe To Play – Seeking Alpha

Every year parents are spending more on toys for their kids. The latest report from the NPD Group shows that toys sales in global markets recorded 3% growth during first six months of 2017. The market research firm estimates that the release of family-friendly movies will accelerate toys sales in the second-half – pushing full year growth to 4%.

Hasbro Inc. (HAS) is one of the biggest winners of continued growth trends but at the expense of its nearest rival, Mattel Inc. (MAT). Hasbro recorded a healthy 10.6% increase in revenue during the second quarter while Mattel reported a modest 2% sales growth over the same period. The robust performance of Hasbro’s top notch brands, including Transformers and Nerf toys, generated 21% increase in franchise brands sales during the quarter. In comparison, Mattel’s power brands failed to create buzz yet again despite all the turnaround efforts. In fact, Mattel’s net loss has spiked to $169.3 million in the first half 2017, up from $92.1 million in the same period last year.

Mattel has lost 42% value over the past one year, and yet it looks expensive due to continued weakness in fundamentals and deteriorated valuation. Mattel’s management is taking drastic initiatives, but turnaround efforts will take the time to materialize and trickle down to bottom-line. Thus, in my opinion, Mattel is expensive and not worth the risk, at least for now.

Mattel continues to struggle against Hasbro. The company’s Cars 3 toys failed to elevate second quarter performance as a mid-single digit drop in Barbie and 3% decline in Fisher-Price dragged the top-line. Mattel is collaborating with Disney to develop activations to boost demand for Cars 3 toys. In my opinion, Mattel is expecting a lot from Cars 3, which is the worst performer on the global box office in the Cars franchise, and continued soft sales performance may negatively impact Mattel’s third quarter.

Mattel looks optimistic about its dolls business, the fact of the matter is that its Barbie brand is consistently failing to recover from the slump, which is evident from of 9% drop in sales during the first half of 2017. As dolls business continues to disappoint, the management is putting stress on accessories to generate more sales with the release of products like DreamHorse, DreamCamper, and third-generation DreamHouse. However, the critical aspect of its turnaround strategy is to build a portfolio of connected toys with a focus on 360-degree play experience. According to Juniper Research, the market for smart toys will grow at a CAGR of 26% to reach $15.5 billion by 2022, though data protection regulations and privacy concerns will impact growth rate to some extent. Mattel has the chance to capture growth opportunities under new leadership as the U.S. toys market will lead the trend.

Mattel’s Hot Wheels basic cars are selling well and recently launched Hot Wheels Track Builder System Stunt Box is getting a lot traction. The company’s Wheels sales were down 6% during the second quarter, but the overall performance of this segment has remained comparatively resilient with just 1% sales drop during the first half of 2017. The release of new products, including an innovative RC racer and the Super Ultimate Garage, may help post encouraging results during the second half, but more importantly, the launch of Justice League toys and Star Wars: The Last Jedi vehicles will fuel Mattel’s Wheels segment sales.

Mattel plans to roll out new innovative product lines in almost every category to improve its market position, but the increasing intensity of competition in the domestic market will put more pressure on profit margins in the coming years. For instance, stiff competition from innovative content creators is negatively impacting Mattel’s kids and preschool segment sales and profit margins. The renewed focus on licensing partnerships, leveraging its app-based learning platform ”Think & Learn Smart Cycle”, and Thomas Super Station could improve Mattel’s growth prospects to some extent.

Mattel is performing comparatively better in the foreign markets, which is evident from a healthy 8% increase in international revenues during the second quarter of 2017, driven by a robust 16% increase in Asia-Pacific from where Mattel earns approximately 27% of total international segment sales. Mattel’s increased focus on foreign markets makes every bit of sense because emerging markets are expected to account for two-third of $20 billion incremental sales in the global toys industry over the next four years.

The toys industry of China, valued at $32.4 billion in 2016, is highly saturated and fragmented with no toymaker holding more than a 5% share. Mattel is the fourth largest player in China with just 2% share while its international rival Lego is ahead with 2.8% slice of the market. Mattel is executing several initiatives in China to grow its market share. The establishment of learning and development platform in strategic partnerships with Alibaba (BABA) and Baby Tree will help Mattel penetrate $30 billion early education and training market in China.

Mattel is placing right bets in China as supportive government policies and two-child policy will significantly fuel early education spending in the coming years. While the overall education industry in China is expected to grow at a CAGR of 12.7%, the early childhood learning market is expected to grow at a faster compounded annual growth rate of 20% by 2020. In this scenario, offering a combination of preschool educational services and interactive toys in child development learning clubs will enable Mattel to benefit from long-term growth prospects.

Although Mattel is facing cash constraints, the management should also explore opportunities in other growth markets like Indonesia. The toys and games industry in Indonesia is growing at double-digits, primarily due to new products, aggressive marketing, and expansion of modern retail networks. Mattel’s portfolio of brands with global recognition may help it grow faster in the midst of spiking interest in toys based on popular TV show and movies in the region. Mattel’s quest for growth in Asia-Pacific will materialize over the long run, but European markets are equally important to generate profitable growth.

Mattel drives approximately half of international sales from Europe. Last year, European toys industry returned to growth after several years of slump, which is a good sign for Mattel. Mattel’s performance in Europe also improved with 3% net sales growth during the second quarter 2017. However, the dynamics of toys industry in Europe will remain challenging in the future due to expected decline in the child population. While parents will continue to spend more on toys, Mattel should focus on reviving its brand appeal to protect its market share from Hasbro and Lego. The increasing demand for connected toys will drive consumer spending, and Mattel should tap the opportunity rather quickly. The global launch of digital toys like smart sensors-embedded cars VR based View-Masters, and Al integrated dolls will step up Mattel’s competitive position.

Concluding Remarks

Mattel’s turnaround efforts and simplification of business processes will take the time to move the needle. In the meanwhile, continued weakness in power brands due to intense competition will put more pressure on profitability over the next few quarters. Mattel’s deteriorated profitability is negatively impacting its cash flow and balance sheet position. Mattel’s cash balance has shrunk to $275 million due to an operating cash outflow of $549 million during the second quarter of 2017. The management continues to expect $800 million in cash on the balance sheet by the end of 2017, but the anticipated weakness in profit margins and investments in turnaround efforts will put more strain on cash and debt position.

Mattel is trading at a quite high forward PE multiple of approximately 24x despite almost 42% drop in stock value over the past one year. Mattel’s valuation is likely to deteriorate further due to continued weakness in top and bottom-line in the coming quarters. In comparison, Hasbro looks comparatively cheaper option at a forward PE multiple of 21x with much better growth prospects. Furthermore, Mattel’s decision to cut quarterly dividend is another hit to investors, and the cash reward to shareholders will remain lackluster due to weak cash position and increased investments in turnaround efforts. In the meanwhile, Hasbro has accelerated dividend growth from 7.5% in 2013 to 11.8% in 2017. The expected double-digit earnings growth, a comfortable payout ratio of 45%, and healthy operating cash from operations will help Hasbro sustain a similar dividend increase rate in the future. That said, in my opinion, Mattel is not safe to play, at least for now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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