Mattel's Turnaround Set to Begin

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New CEO Christopher Sinclair's background is impressive; he has led companies across the information technology, venture capital, and packaged goods industries. We expected Mattel to seek out a leader with experience across retail, digital (an area in which the firm has seriously lagged), and supply chain, making Sinclair a good fit with his breadth of knowledge and experience.

Despite this change at the top, we don't think Mattel's financial performance will improve overnight. The firm has been plagued by stagnant sales growth and contracting profits, as it has been slow to cater to the increasing shift to digital play and changing consumer demands, with legacy brands like Barbie and Fisher-Price experiencing inconsistent revenue performance. Although we think the company could benefit from recent acquisitions (like Hit Entertainment and Mega Brands) and growth in emerging markets, the increase in e-commerce retailers and continued growth of digital options outside the analog toy space--which Mattel hasn't responded to aggressively enough--will continue to counter this tailwind at least over the near term. However, with Sinclair's experience, we think Mattel could be poised to regain its competitive edge longer term.

We think Sinclair's background with the packaged goods industry in particular will be useful with regard to managing Mattel's retail distribution flow as well as its supply chain processes. Retailers have wielded more power over toy manufacturers in recent years, changing the traditional pattern of merchandise delivery and demanding product just in time, leading to inventory acquisition closer to sales. This has caused toy companies to hold more internal inventory, carrying the cost of ownership longer. Additionally, retailers have pressed for more promotions, as consumers have required more discounting and persuasion to make each incremental purchase. Over time, this has increased the burden on Mattel to help facilitate the sale at retail. In our opinion, a CEO like Sinclair, with thorough knowledge of relationships at key outlets like Target or Wal-Mart, could be important to restoring Mattel's negotiating power with retailers (although this didn't occur with former CEO Bryan Stockton, who came over from Kraft). This could steer better tactical marketing, lower promotional fees, and more full-priced sell-through for current merchandise, all of which could support retailers' willingness to pay up for future products. Ultimately this should allow for improved profitability and brand equity, driving higher ROICs and strengthening our narrow moat rating.

Sinclair's experience with supply chain processes could also lead to profit improvement. Supply chain expenses have been part of Mattel's focus throughout its operational excellence programs, and we believe a leader who remains focused on controlling costs through both the sourcing and distribution channels will help turn around profitability faster than expected. Highlighting the importance of controlling costs could lead to higher profits and ROICs, increasing our confidence surrounding our narrow moat rating. Our base-case outlook includes the firm's Funding Our Future initiative, which targets $250 million-$300 million in gross savings by 2016 through structure and process improvements and supply chain optimization. This should help restore growth in operating margins, which we expect to rise to 13.0% in 2016 from 11.8% in 2014. These savings can be reinvested in the business to develop the stronger merchandise lineup that will benefit the overall business and brands longer term and could aid growth in ROICs to above 20% again within the next five years, from a projected 15% in 2015.

Improvement Isn't a Slam Dunk We think the appointment of Sinclair could still leave a gap in expertise in certain areas that would have helped Mattel repair its competitive positioning, most importantly in improving its presence in the digital and entertainment space, including film, television, and mobile applications. Sinclair has broad technology experience, with stints at Cambridge Solutions, a business process outsourcing company, and Scandent Holdings, the parent company of Cambridge, but we think this might not be directly relatable to the technology know-how Mattel needs to further develop its digital presence. While numerous employees throughout the firm have relationships across the digital, entertainment, and licensing arenas, we think a leader with more experience in or around these categories might have helped Mattel build brand awareness for some of its struggling product lines (like Barbie or Fisher-Price, which have experienced multiple-year declines), raising demand through increased brand loyalty, and supporting a stronger narrow moat. We suspect that this is being addressed at a level below the C-Suite, but we would like to hear more concrete evidence that this key area for development has not been tabled and will be a focus going forward. Peer Hasbro HAS has benefited disproportionately from its heavy exposure to film and digital over the past few years, thanks to its Marvel and Disney partnership as well as its stake in Backflip Studios. Mattel is positioned to benefit from the DC Comics film lineup, but its overall presence in media and digital is significantly narrower than Hasbro's.

Additionally, Mattel has suffered from a lack of innovation and creativity in certain segments, which has led to weaker sales and lower demand for its toys, as indicated by a 7% sales decline in 2014 (versus a 5% increase at Hasbro). We think a leader with a creative bent may have been better to drive creative change and vision at the enterprise level. While we don't think Sinclair necessarily brings this talent to the management team, we believe COO Richard Dickson will be the driver of many creative initiatives, with the ability to support innovation and better tailor products to current trends, at least across some brands, as indicated by some of his early comments after returning to the company.

Sinclair's ability to surround himself with the right players to drive change at the enterprise level will be necessary for the company's turnaround to be a success. Leaning on leaders like Dickson and chief commercial officer Tim Kilpin will be necessary for Sinclair to grasp the nuances of the business and industry, which could lead Mattel back to sales and earnings growth through better product launches and wider reach of categories. We think the broad experience that Dickson and Kilpin share across brands and operating segments brings tremendous overall insight into the day-to-day workings of the company.

Ratcheting Down Inventory Levels Will Take Time Even with the appointment of a new CEO, Mattel still has near-term issues to address, including lowering the suboptimal inventory position it has built over the past 18 months. More than four quarters of elevated inventory levels suggests that merchandise has not been as relevant as it should have been with consumers. Hasbro has had inventory as a percentage of sales well below Mattel in seven of the past eight quarters (the eighth quarter had inventory as a percentage of sales that matched Mattel's level).

Management called out inflated levels of inventory during the fourth quarter of 2013, when it reported that point-of-sale results fell at a high-single-digit pace. Mattel failed to reduce retail inventory, which was one of its goals, with domestic retail inventory rising slightly year over year in this period. While international statistics are vague, Mattel did say it saw "pockets of inventory that vary by market and brand," implying global brand equity weakness and marketing tactics that were off-mark with consumers in both domestic and international markets. While some commentary in following quarters indicated incremental improvement, inventory levels remained higher than historical levels.

In fairness, Mattel has acted nimbly where possible to alleviate inventory overhang by attempting to better adapt its products to the evolving demands of its consumers--at times a source of struggle in certain categories--as well as the key retail partners it relies on to deliver its products. Inflated inventory levels are a result of changing demands among both consumers and retailers, both of which have gained increasing power in their respective relationships with the toy company.

With retailers like Target and Wal-Mart, Mattel has been accommodative, delivering merchandise closer to demand, carrying more inventory on its own balance sheet at times, and raising the risk that some product becomes stale or obsolete if technology changes or demand falls short of expectations. Furthermore, we believe that retailers are leaning on toy companies to participate in more marketing and promotional campaigns at the end of the year, closer to the likelihood of consumer purchases, helping facilitate sales to the consumer.

Mattel has noted in the past that some promotions that historically worked had been unsuccessful when repeated, spurring management to reassess its spending mix to better understand the consumer path to purchase through both the e-commerce and retail channels. This led to a shift in marketing in timing and avenue in 2014. Despite these changes to improve marketing in recent periods, we still see only a few rational options for Mattel to clear current inventories in order to obtain lower inventory days and higher turnover in future periods, which have ticked in an unfavorable direction in recent years.

First, Mattel can run aggressive one-time promotional programs with its key retail partners to clear inventory quickly in order to get fresh merchandise on the shelves. Managing a promotion on a national level could be difficult, since leftover inventory could be different across regions, but we believe Mattel's healthy experience with these campaigns make this option likely--and we don't anticipate that promotions will stop after higher inventory clears. Second, the company can claw back stale inventory at retail and write it down. We don't view this as likely, as Mattel doesn't offer recourse on its products and has never tried to implement such a plan in times of high inventory.

Finally, Mattel can focus on innovation and timely delivery of better merchandise, so that inventory on shelves will better resonate with consumers, leading to higher product demand and lower inventory dollars at both retail and in-house. This is the choice that will not only facilitate turns, but also restore equity to the long-lived brands that the company was built on and strengthen the narrow economic moat. Mattel has produced some of the most desired toys in the past, and we believe it can do so again with the right amount of vision, effort, and determination. We expect management to control inventory through the first and last options in order to restore merchandise to proper levels. Our balance sheet includes a forecast for flat inventory over the next four years, as the team focuses having the right product, in the right channel, at the right time.

Duration of Strong Dollar Remains Wild Card In addition to inventory concerns, foreign exchange headwinds have plagued Mattel, particularly over the past six months, and could continue to do so over the next few quarters. International exposure has grown at Mattel over the past decade, rising from 42% to 46% of total revenue (and as high as 49% in 2007-08). When international currencies are strong, they provide a lift to sales in the translation process, but the recent strength in the dollar and weakness in key partner currencies, and the cadence of the change, are likely to affect top-line and gross margin growth in 2015, particularly since the euro and the Canadian dollar have fallen 13% and 10%, respectively, over the past six months. Europe represented around 25% and Canada equaled just under 5% of Mattel's gross revenue in 2014, and Canada should bump up a bit with Mega included for all of 2015.

Mattel uses foreign currency forward exchange contracts to hedge its purchase and sale of inventory and other transactions that occur outside the U.S. dollar, for as long out as 18 months. The greatest hedged positions are in the euro and the Mexican peso, neither of which are in amounts that will fully defer current fluctuations from these currency rates. We don't view Mattel's exposure to foreign exchange unfavorably, as it is a necessity in order to operate a global business. However, awareness of the exposure to certain currencies with respect to forward spot rates and the potential impact on profitability over the next few years is relevant. Current futures contract rates at the Chicago Mercantile Exchange imply that the euro could rise again beginning around 2017, but the Canadian dollar could remain depressed through the end of the decade.

During the fourth quarter, Mattel's 3% decline in total sales partly resulted from a 4% foreign exchange impact, while the 5% decline in international revenue included an 8% foreign exchange headwind (Europe had 9% downside and Latin America had a 7% charge from foreign exchange, specifically). While we don't forecast currency explicitly in our model, we expect it to weigh on total sales through 2016, as we forecast flat 2015 sales and a 1% increase in 2016 sales, currency adjusted.

Revenue Declines, Higher Inventory, Foreign Exchange Put Cash Flow and Dividend at Risk Factors including turnover in leadership, underperforming inventory management, and volatile currency movements could in aggregate temper earnings growth and jeopardize Mattel's power to generate increasing cash flow, which in turn could put its coveted dividend at risk. Mattel's free cash flow generation has historically been healthy, averaging more than $500 million per year over the past decade (9% of sales). Over the same time frame, Mattel has tripled its dividend on a per-share basis (rising from $0.49 to $1.52), increasing its total payout more than 10% on average and dividends per share by nearly 15% per year. Thus far, the board of directors has kept the dividend intact despite the tepid free cash flow we have projected in the year ahead, leading the company to offer best-in-class dividend yields if the payout remains unchanged in 2015. Mattel's current dividend yield is 5.5% versus Hasbro's 2.6%, while the remaining stocks on our coverage list are yielding below 2% on average.

Mattel could borrow funds to cover the dividend, with a net lease-adjusted debt/EBITDAR of 1.8 times at the end of 2014, but increased leverage could threaten the investment-grade status of the business, jeopardizing one of the firm's previously stated financial goals.

We believe it will be difficult to for Mattel to turn around its cash flow decline in the current year, but we think it could feasibly begin to return to free cash flow growth in 2016, when we forecast a 30% rise over our 2015 free cash flow estimate, to more than $470 million. This will still be below 2014's $623 million by around 25% and well under the $1 billion the firm delivered in 2012. Our model incorporates a slow recovery in the business, which will lead to free cash flows that surpass 2014 levels again in 2019; we expect a moderated but steady return to success.

If the board of directors does not reduce the payout per share, Mattel could pay out more than it earns in net income in 2015 and nearly 90% of our forecast net income in 2016, depending on corporate performance and the team's ability to turn around the earnings power of the enterprise. In our opinion, shareholders would be better served by a reduced dividend, leaving the company with the ability to reinvest cash in the business to repair brands that have fallen out of favor and to develop a more compelling product lineup to drive improved long-term cash flow generation.

Our forecast includes a dividend payout ratio that retreats to 80% over the next two years. Management previously targeted paying out 50%-60% of net income in dividends, growing in line with earnings per share. This goal has not recently been reiterated, but if management chose to reinstate such a target, the current dividend would have to be cut by around one third. Some excess cash should be freed up from reduced share repurchases to support the dividend in the year ahead, when we expect less than $100 million to be allocated to share buybacks (down 50% or more year over year depending on price of shares at acquisition). The company has acquired significant shares over the past five years--$340 million on average annually--but we expect little incentive to spend in this manner, when it could be reinvesting to reposition itself, rebuild its brand, and reinvigorate its product offerings to improve brand equity and profits, better ensuring that its narrow moat remains intact.