Mattel's Turnaround Too Slow for Investors

While the messaging surrounding Mattel’s MAT structural simplification plan and the monetization of its robust intellectual property hasn’t changed, the cadence of improvement appears to be slower than investors had hoped for, as the share price tumbled after the company’s recent analyst meeting. 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--where we see growth around 3% on average--remains a headwind to the successful execution of the cause.

Nearly every metric that Mattel offered regarding 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; this is below our projected 3% sales rise and marks sales at about two thirds of 2013 levels. Second, the gross margin outlook for the low 40s was short of our 45% estimate, hurt by 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 discounted cash flow model. Despite the delayed improvement, we are holding the line on our long-term outlook for a 14% operating margin in 2023 with operating changes underway. We think the shares are undervalued, but we caution that the road to improvement could be rocky, warranting a longer time horizon.

Despite a frustrating pace of improvement on the financial front, 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 three predecessors. In recent periods, the company has announced new lines with BTS, the world's leading Korean boy band, a multiyear licensing agreement with Universal's Despicable Me franchise (ahead of the next Minions movie in 2020), and 22 new animated and live-action television programs based on 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 (previously of Disney Channel) to steer Mattel Television and Robbie Brenner (Academy Award-nominated director of Dallas Buyers Club) to lead Mattel Films has put more wheels in motion to take a page from narrow-moat Hasbro's HAS wildly successful multimedia playbook, launching content across new and different channels where it has underrepresented historically.

Such efforts continue to push Mattel forward, although until the company can put a full stop to top-line declines, it could be 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 that the company will be able to deliver break-even 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 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 $250 million-$300 million each.

Overall sentiment on Mattel continues to languish despite consistent performance at 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 represented another 30% of 2018 gross sales. Between 2016 and 2018, Fisher-Price and Thomas sales have fallen 23% while American Girl sales have dropped 42%, more than offsetting gains that Barbie and Hot Wheels earned. We suspect that when Mattel can stabilize Fisher-Price (American Girl is already a known longer-term turnaround story) sentiment will begin to turn on Mattel; 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 in recent periods.