A Sustained Recovery in the Cards for Mattel

With a renewed focus on brand purpose, product innovation, and consumer engagement we think

Before the beginning of 2015, Mattel was very operationally driven, trying to focus on developing products aligned with consumer demand while continuing to cut costs. However, the company wasn't spending its dollars tactically on enhancing the creative and content landscapes of the business, which have been primary areas for growth across the toy industry. But despite its past shortcomings, in our opinion, the outlook for Mattel's brand equity has changed under the current management team (including CEO Christopher Sinclair and COO Richard Dickson), which has restored the company's creative bent.

We believe a sustained recovery in revenue is set to occur and expect the company should be able to regain lost market share from 2016 (the company's North America sales fell 1.5% in 2016, while the industry rose 5% according to NPD). But we don't expect the benefits from these efforts to stop at improving top-line trends. Rather, our long-term forecast includes high-teens operating margins (well above our and Street expectations over the next two years), in line with margins before sales began to languish in 2014, positioning the company for improving free cash flow and returns.

Management's Strategic Path Could Bolster Brand Equity Ahead Despite some of the progress to beef up its brand equity over the past two years, we think there are opportunities to drive further gains. In that vein, Mattel highlighted at its November 2016 investor day what we view as a more focused and replicable five-pronged plan across brands that had been crafted out of its initial strategy under CEO Sinclair and COO Dickson designed to stimulate interest in both the company's owned and licensed properties.

The first focus, brand purpose, is set to build an enduring, value-based connection to both kids and parents. The management team now appears to understand that consumer stickiness stems from brands created with a purpose from the beginning. For example, Barbie was originally created to inspire the potential of young girls, Fisher-Price was founded for early childhood development, and Thomas the train engine was developed to teach the value of friendship, all topics that resonate loudly with parents, the ultimate purchaser of toys. But over time, Mattel skewed away from focusing on these key brand concepts, which eroded brand equity and opened the door for customers to switch to other products that met consumer preference. This took North American market share to around 12% by our estimate in 2016, from more than 15% in 2012. Despite its past stumbles, we now believe the company is focused on bringing this authenticity back to the business and restoring market share leadership.

The second angle, improving innovation, had been severely lacking prior to 2015, but as the new management team took over this has been an area of heightened focus within the company's culture. As evidence, the organizational structure was amended in 2015 when Sinclair and Dickson took over, removing the siloed structure that existed and evolving into a more creative-focused business with creative leadership at the top of each brand function. The removal of structural barriers to innovation has led Mattel to highlight three areas for innovation: the revitalization of traditional toys, the addition of technology to enhance play value, and improved aesthetics to engage a wider set of customers.

In our opinion, consumer engagement (the third prong) is the most likely factor to enhance the stickiness of a customer's relationship with Mattel's brands. As information delivery and digestion has evolved, so has Mattel's ability to remain front of mind. Traditional marketing and advertising programs don't always work as well as in the past, as toy consumers prefer to receive more information flow digitally. But we believe Mattel is working to correct this and has the ability to develop stickier relationships with social media, content, and improved direct marketing--utilizing as many touch points as possible keeps the brand front of mind, a critical factor in growing direct transactions with the company and through key retailers, which bolsters brand equity, supporting our narrow-moat rating.

The other two prongs of the company's strategy regard licensed partnerships and commercial execution, areas that largely live outside the wholly owned, core brands of Mattel, but should also help bolster brand equity ahead. These factors are still important, but we think evidence of the brand equity improvement will stem from the creative side of the business, while the distribution part will help further leverage expenses. Licensed partnerships, representing about one third of Mattel's business, can become a much bigger piece of the enterprise as the team focuses on winning new licenses and partnering with content creators like Warner Brothers, Disney, and Microsoft. Key licenses, including DC Comics, Jurassic World (which Mattel recently won from Hasbro), and Minecraft highlight the company's dedication to growing the entertainment part of the business.

The final prong, improving commercial execution, surrounds better reception at the retail level, and we think that movement to wholesale sales more closely in line with point-of-sale data will help improve throughput in the retail channel. Over the last five years, the commercial organization has been realigned a few times, but we think the current strategy contemplates the distribution chain differently than in the past, considering the network beyond just the traditional big-box retailers that have represented more than half of company sales historically. In brick and mortar locations, the company is adding in-store activities to boost Hot Wheels sales and adding Wellie Wishers to stimulate American Girl demand, broadening the reach and engagement of the product line.

Considering some opportunities differently, we believe the e-commerce strategy is now being incorporated more thoughtfully into the commercial execution plan, as partners like Amazon can offer up content through Prime that helps convert sales at a better pace than in the past, engaging incremental consumers through different channels. Similarly, Mattel is also trying to get closer to consumers with direct marketing, particularly for Fisher-Price, given it is the entry-level brand into the Mattel portfolio. However, acceptance and demand for this brand is contingent on innovation that incorporates the newer technology parents are seeking, which requires the firm to execute on one of the earlier focuses mentioned previously.

Shares Modestly Undervalued, But Dividend Remains Attractive Our $33 per share valuation is predicated on low-single-digit growth over the long term, as we expect established markets (with the U.S. representing nearly 50% of sales) to act as a drag due to its maturity and tepid birth rate levels. We forecast international and emerging markets to grow slightly faster, at a mid-single digit pace, as penetration in new and existing markets rises and more consumers move into the middle income class with the ability to spend more in the toy category. Over the next two years, we have revenue rising 5%-6% bolstered by media exposure from Cars 3, Wonder Woman, and Justice League licenses in 2017 and Jurassic World in 2018. We suspect the market is including limited progress over the near term on operating margin growth, as the business turns around.

Our model similarly sees tepid near-term operating margin acceleration but forecasts Mattel surpassing 15% operating margins by 2019 (and coming in just below 15% in 2018), which we think is a more normalized and sustainable level for Mattel's business model. However, if changes to the business fail to take hold, we could see top-line growth stall in very low-single-digit or negative territory and gross margins fail to reach the targeted 50% goal by 2020. This would lead to free cash flow levels that would likely not be able to support the current dividend, leaving Mattel to raise debt to maintain its payout rate, potentially jeopardizing its credit rating. If these results were to occur, our bear-case scenario would include a valuation of $22.50 for Mattel.

With a 5% dividend yield, Mattel remains one of the highest yielding companies in our discretionary universe, partly because the dividend has remained stable, while the share price has fallen from $47 at the end of 2013 to below $20 in 2015 to near $26 today. With a payout ratio that has been above 100% over the past few years, the board has been unable to grow dividends as it had in the past (Mattel delivered 13% dividend growth on average between 2009 and 2013).

Historically, the company had targeted paying out between 50%-60% of net income, growing in line with earnings growth. However, with the crimped cash flow generation over the last few years (down to 8% of sales in 2015 from a double-digit rate in prior periods), dividends exceeded free cash flow in 2013, paring back the ability for the company to continue to grow its dividend in light of its increasing credit risk. Free cash flow declined from over $1 billion in 2012 to less than $450 million in 2013 hindered by a meaningful swing in payables within working capital. We think the focus on capital allocation ahead will remain on maintaining the dividend, which we have falling to a payout ratio of around 75% by the end of the decade from recently inflated levels. Even with dividend growth of just 4% on average over time (and our model has the payout increasing in much later years within the model), we fall to about 70% payout by 2022. We think the board will be hesitant to reduce the payout from current levels, impairing the company’s ability to get the payout rate to prior levels without sustained, higher-than-expected sales improvement.

Shares at current levels appear fair versus historic metrics on a multiple basis, trading at more than 16 times our 2017 earnings forecast, with about 12% earnings growth forecast between 2016-20. Over the last five- and 10-year periods, Mattel has traded at an average multiple of 20 times and 17 times, respectively. However, shares are trading at a wide enough margin of safety to fall into 4-star territory, offering a compelling opportunity to own shares of an operator in the toy industry. We think the current management team at Mattel has the right perspective to restore healthy brand equity ahead, with a cohesive vision for the brands within its portfolio to remain successful.