Bigger Profits Ahead for Mattel

Core brand focus, the capture of new licenses, and a faster supply chain--bringing in-demand products to market quickly--could help restore Mattel’s sales growth, while supply-chain initiatives that realign the manufacturing footprint should improve profitability. Additionally, Mattel’s digital plan, which has focused on strategic relationships with Google, Alibaba, YouTube, Nickelodeon and others, should increase brand visibility, potentially stemming losses to other digital toy manufacturers and peers.

Despite recent challenges, Mattel still holds a top position in toy marketing thanks to its highly recognized brands, which we believe has allowed it to recapture key license relationships and win new ones, boosting its top-line prospects. Mattel has historically had some of the most popular toys in the industry, which could lead to better point-of-sale results once inventory and brands are rightsized, stabilizing recent brand equity volatility.

Market Share and Scale Support a Narrow Moat We assign a narrow economic moat rating to Mattel, which has historically captured more than 15% of sales in the domestic toy industry. Its share declined to around 10% over 2014-17 but should begin to stabilize in 2018 as the company reorganizes. Combined, three of the biggest constituents of the toy market--Mattel, Hasbro HAS, and Lego--control less than 30% of the very fragmented U.S. toy space, which constitutes around 30% of the global market. The significant share represented by these companies, along with the licensing and entertainment relationships already contracted by these industry incumbents, is enough to make most would-be competitors skeptical about entering the marketplace and directly competing for new licensing contracts, as Mattel, Hasbro, and Lego have more advertising dollars to offer. Its position as one of the largest toy companies allows Mattel to capture these partnerships with relative ease, as the company is a top choice for any partner to pair with, having one of the widest reaches and the deepest marketing pockets across the toy marketer space.

Mattel’s toy business is somewhat more capital-intensive than traditional retailing, thanks to the manufacturing segment and the longer inventory cycles in the channel tying up working capital; these cycles have been shrinking materially in recent years as retailers want inventory closer to demand. We think this discourages potential competitors without deep pockets or access to cheap financing from attempting to take share in the segment. We believe it would be difficult for a new competitor to enter the market and steal significant share quickly, as Mattel and Hasbro already offer most of the popular brands on the market and have numerous other brands under licensing contracts. Ongoing changes to the organizational strategy give us hope that product relevance will improve, although we expect it will take a few quarters before we see current initiatives begin to pay off. We expect adjusted returns on invested capital to average 22% over the next five years, versus 16% over the past five years, which remains above our weighted average cost of capital assumption of 8%.

Customer Concentration and Competition Are Risks Mattel faces a number of inherent risks that may affect its future enterprise value. First, significant customer concentration raises the risk that liquidity issues or changes to ordering patterns could affect profitability. The top three channels for distribution (Walmart, Target, and Toys 'R' Us) have constituted 37% of total sales, and brick-and-mortar retailing has become more competitive. Toys 'R' Us, which recently declared bankruptcy, represented 8% of sales in 2017, hindering holiday season sales (and representing around 30%-40% of the 9% sales decline for the year). Second, Mattel faces serious risk from litigation regarding product recalls or poor manufacturing of its products, which could be costly. Third, integration risk with acquisitions (most recently Fuhu and Sproutling) could disrupt management's focus and profits. Fourth, Mattel remains exposed to input costs like resins, which are difficult to predict and hard to hedge and can affect gross margin.

We remain concerned that any new toy manufacturer can incorporate and take share from Mattel. Although there are trademarks on the company’s brands, there is nothing to prohibit a competitor from developing a toy or capturing an expiring licensing relationship. We think Mattel is in a slightly protected position because its scale offers it distribution power, which would be difficult for a new entrant to replicate. We believe this drives potential licensing partners to pair with one of the three biggest players in the industry.

Near-term liquidity risk recently subsided with the issuance of $1 billion of high-yielding 2025 notes. However, if the company’s turnaround remains moribund, liquidity risk could again rear its head, with another $500 million in senior notes coming due in 2019.

The company maintains flexibility in its capital structure through stock repurchases and dividends, repurchasing no shares as cash flow waned and eliminating its dividend in mid-2017 to provide financing for its cost-saving initiatives in 2018-19. We don’t forecast a partial resumption of the dividend until at least 2020, when current initiatives have begun to pay off, improving cash flow.