INTRODUCTION

Mattel is world’s #1 toy company with global distribution, supply chain expertise and retail relationships. Despite a challenging 2014, plagued by inventory pile up and weak toy line-up, Mattel is still a dominating brand - #1 in Doll (<18-19% market share in the US, half that size in Europe), #1 in vehicles, #1 preschool and good business in games and starting in construction (MEGA brands competitor to LEGO). Barrier of entry to the toy industry is low, the challenge is to sustain in the toy industry, something which Mattel has done since 1945. Mattel has the best brands in the industry with the best global distribution structure. There are great opportunities to grow in structurally growing markets like Eastern Europe, Latin America and Asia. Kids are incredibly brand loyal, which benefits the largest toy company in the world possessing the largest amount of brands and intellectual property. Its main competitors are Hasbro, Lego, Jakks Pacific, Bandai, …

The question to ask as an investor today is:

Is Mattel structurally broken or is most of the 2014 pain self inflicted and fixable?

Is the decade long track record of TSR until 2013 broken or can it be fixed again?

MATTEL BASICS

Mattel mkt cap: 8,63B USD (5M shares ADTV = 135M USD/day = very liquid), 403/500 on Forbes list.

Founded in 1945, IPO in 1963. Top 100 companies to work for with very low staff turnover (1.000 employees with company for longer than 15 years) out of total 28.000 employees. Example: CFO has been same since 2000.  

Current Stock price: 25.60 USD (close to 52w low of 24,88 USD).

Mattel is a centered around following toys/ listed per category

45% girls category          vs 25% Hasbro

23% boys category          vs 34% Hasbro

29% preschool                 vs 12% Hasbro

3% games                         vs 29% Hasbro

Mattel is geographically diversified:

54% from North America                    vs 52% Hasbro

25% from Europe                                 vs 31% Hasbro

14% from Latin America                      vs 10% Latin America

7% from Asia Pacific                            vs 7% Asia Pacific

Mattel stock price peaked on 30 December 2013 at 47.82 USD. Today we are close to 52-week low of 24,88 USD. Mattel’s share price has been weak in the past 14 months in tandem with consensus downgrades. Consensus earnings estimates were cut by approximately 20% over the next three years since its 4Q results in early Feb 2015. We estimate that earnings consensus already declined by more than 20%, after 5 consecutive quarters of earnings decline.  Mattel currently trades near 52-week low, or 16x one year forward PE, slightly below 14-year average of 16.4x PE. The positive about is that earnings are now reset and should be easy to beat. Another remarkable fact is that out of 15 or so analysts covering the stock all but one have NEUTRAL or SELL ratings on it.

Key concerns #1 : A portfolio dominated by large mature brands

Just over 50% of MAT’s business is in three core lines: Barbie (15% of sales), Fisher-Price (28% of sales) and Hot Wheels/Matchbox/Tyco (11% of sales). Based on 2014 figures, all three lines will have declined over the past decade. The company’s plan to extract more value from these seemingly mature brands –through innovation and increased marketing support – comes at a time of fierce competition and growing disruption within the industry.

In fact, a close review of MAT’s growth composition in Exhibit 63 (source: Goldman Sachs industry study November 2014) points to Other Girls – home to Monster High and Disney Princess – as the main driver of revenue growth at Mattel over the past decade. The prospects for both properties suggest that this segment may come under pressure over the next few years. Monster High, while now considered to be one of the company’s “core brands” (i.e., with more resource allocation, and greater management focus), has declined in 2014 after a meteoric run in 2010-2013. Given its meteoric rise and subsequent fall, the brand’s run rate sales contribution is yet to be determined.

Key concerns #2 : Disney Princess, meanwhile, is a key licensed property that will expire in 2016 and move to Hasbro. Ever After High, a new brand with growth, may help offset some of these declines but is not likely to be material enough of offset this completely. We believe MAT is equipped to incubate new brands and/or forge new licensed relationships. We look for evidence of either before modelling growth in this struggling segment. It is estimated that the loss in revenue from Disney Princess amounted to USD300m or 5% of total sales.

Key concerns # 3 execution issues: Mattel was doing well until 4Q13. The Toy industry has be doing well too. Even after 2014, the toy industrial is still growing quite solidly at 3-4% (source: Mattel Analyst Day October 2014). There were issues with execution at Mattel in 2014– 1) Mattel may not have the best toy products, 2) advertising did not work. Advertising spending on 2Q13-1Q14 was not effective, where Mattel focused on providing support to the retailers. This was not executed well, retailers ended up with a lot of inventories and Mattel as well. As Mattel has its own manufacturing arm (50% of all toys made), the situation exacerbated to the entire supply chain. In 2014, the group relooked at A&P exercise and plan to load up 4Q with more A&P. This hurt sales for the first 9M and missing out sales on Black Friday, but they were encouraged to see new products under the A&P campaign in 4Q14 selling well. Measures taken include cleaning up inventories worldwide and improving A&P efforts

Management believes these issues are fixable and is working on product innovations and more effective A&P campaigns to revive the situation. Key is: there is no problem with the overall toy industry but rather with Mattel’s execution. As the interim CEO said: most of Mattel’s problems are self-inflicted. See link to Wall Street Journal article http://www.wsj.com/articles/mattel-vows-urgency-to-improve-results-after-latest-sales-decline-1422617567

INVESTMENT MOTIVATION

Impressive dividend payer, impressive free cash flow generation

In the last 24 years, Mattel never cut its dividends except for2000-2001, when they made a very poor acquisition, The Learning Company (there was a large write off of the entire acquisition) http://www.telegraph.co.uk/finance/4467013/Mattel-sale-ends-3.6bn-fiasco.html

The stock provides a dividend yield of above 4% if based on 70% payout (average of the past 10 years). If the group maintained flat dividend as per 2014 of USD1.52 (note that Mattel upped dividend by 5% in 2014 despite a 40% decline in core earnings), we are looking at a potential dividend yield of 5.9%. Company publicly says dividend is nr. 1 priority. It pays quarterly dividend and for the first quarter 2015 it announced 0.38 USD/share which indicates NO change to dividend vs 2014.

The stock offered an average low FCF yield of 5.1% and average high FCF yield of 7.9% during the 24-year period. The average ROE over the last 24 years is 21%, average ROE over the last 5 years is 25%. ROE in 2014% was down to 18%

We believe the group’s ability to pay dividend is high – 1) the group demonstrated its commitment to pay dividends by raising dividends by 5% YoY despite a 40% drop in earnings in FY14; 2) free cash flow is still positive despite earnings contraction in FY14; net gearing looks healthy at 38%, although it has increased from 17%. Even assuming dividends to be cut to USD1.10 (from USD1.52 in FY14), based on 70% dividend payout, the stock still provides an attractive yield of above 4%. Apart from dividend the company also spent 1,7 billion USD on buybacks between 2010 and 2014 which decreased the share count  23,1 million shares or by 6% (more than offsetting any options expense).

Mattel always make a strong come back, strong track record

In its long operating history, Mattel had its ups and down, core profits declined 22% YoY in 2005 but rebounded back 44% in 2006; In 2008, profits declined 36% YoY but made a strong come back of 38% rebound in 2009. What is different this time around is that Mattel is facing more intense competition, threats from technology and a totally new management team (CEO resigned end January 2015 on the back of weak results). Against the more challenging operating environment and a new management team, clearly market is losing its confidence. The group’s dividend increase in 2014 shows the board’s confidence that the ship can be turned around.

Barbie MAT’s biggest toy properties (Barbie, Fisher Price, Hot Wheels) remains key drivers for the stock. While the brand’s dominance of the doll category is no longer, Mattel has managed to maintain its share of the category with other brands like American Girl and Monster High. Barbie’s recent declines have been steep and are reminiscent of the early mid 2000s, a period where the brand lost its relevance. Richard Dixon, who ran the brand and engineered its turnaround in 2009-2011, has returned to Mattel as its Chief Brands Officer. He recently presented a set of initiatives for 2015, notably a greater focus on “girl power”, creating an opportunity for the brand to stabilise. The brand has a history of volatility and one turnaround already accomplished, suggesting that it may be premature to call Barbie a secular share loser. Recently the company launched the first talking Barbie at the NY Toy Fair which you can watch here https://www.youtube.com/watch?v=OpPbN-GueZQ

Another interesting observation is that both Moschino and Zara are using the Barbie brand in their latest clothing collections for Summer 2015.

Considering Mattel’s strong track record of  making a come back, we are confident that they could fix the issues this time round which include lack of popular toys and poor advertising.

Below chart from Goldman Sachs study (November 2014) shows that Barbie is used to volatility.

Now the key is the brands here and their long history

Barbie is 55 years old, Fisher Price 84 years old, Thomas 69 years old, Hot Wheels 46 years old and American Girl 28 years old. In 2014 bought MEGA brand (competitor of LEGO out of Canada) for +/- 500M USD. Other brands you will know are Scrabble, Pictionary, Uno, Matchbox.

Apart from their own brands both Hasbro and Mattel depend on partnerships with Hollywood studios. See below overview (source Goldman Sachs November 2014 report).

Growth strategies in place

#1: Cost savings program. Mattel has delivered cost savings that exceeded expectations. The program exceeded expectations, by delivering USD179m in gross savings over the two year period. Previous cost saving s programs have all exceeded expectations and delivered almost USD600m in gross savings to date. The group recently announced the fourth cost saving initiative with target to deliver USD250m-300m in cumulative gross savings by end of 2016. This will be the most aggressive and largest program to date. USD100m of savings targeted from supply chain optimisation. USD150m-200m targeted from structure and process improvement initiatives.

Since 2004, Mattel’s SG&A costs has been above its close peer Hasbro. As of FY14, Mattel’s, SG&A as a % of sales stood at 26.8% compared to 20.9%. Longer term, management has a target to reduce SG&A as a % of sales to more normalise levels 22-23%. The ability to bring down SG&A costs would provide a lift to margins and earnings momentum.

#2 product innovation – Relaunch of the ViewMaster in collaboration with Google at affordable pricing of USD30 which according to management, received positive feedback from retailers. http://www.view-master.com/en-us/index.html . Recent conference call with IR was hinting at more collaboration with Google and other Silicon Valley players. Note: HQ of Mattel is in California close to Silicon Valley and all tech companies vs Hasbro which is based in Rhode Island on the east coast.

They also recently launched trial Barbie that can speak (like SIRI at Apple). This is a collaboration with Toytalk which includes child secured WIFI communication. They are going to launch similar product for Thomas and Friends. https://www.youtube.com/watch?v=OpPbN-GueZQ

Mattel has its success on product innovation, for instance its proprietary brand, Monster High achieved a meteoric rise in 2010-2013. Mattel launches 5000-8000 SKUs per year, there are bound to be good toys and bad toys. One great single toy is enough to be a game changer. We believe Mattel as a global toy leader with centuries of product innovation is at the forefront of developing appealing toy products and will in the future be able to put out some newly successful brands which do not exist today.

#3 MEGA brand is clear #2 in construction, only present in N America, S.Africa and Australia. Clear opportunity ahead to grow outside core markets. MEGA can integrate Mattel Brand names to CONSTRUCTION space. Mega Brands is competitor to LEGO. Mattel has an aggressive plan to integrate the brand since acquisition of Mega in April 2014. A lot of work has been done. They are trying to eliminate third party distributors for Mega as Mattel has its own internal distribution. So far, they are about 95% there. There are a lot of opportunities to grow this business, for instance, Mega has virtually no international network. Mega also has interesting franchise opportunities with characters like Despicable Me, Teenage Ninja Turtles, Dora and Sponge Bob.

#4 Mattel to benefit from strong movie pipeline: At its investor day, Time Warner’s Brothers division announced plans for 10 new DC Comic movies through 2020, as the studio attempts to capitalise on the popularity of super hero movies. We view Mattel as a key beneficiary of this pipeline given its recently extended toy license with DC (through 2017). Movies to be expected are Batman vs Superman (2016), Wonder Woman (2017), Acquaman (2018). Mattel is also working on bringing Monster High and Barbie to the big screen. Both have had numerous DVD/online releases but no large screen Hollywood release. As seen with the LEGO movie last year this can really help the sales of associated toys.

#5 Long Term growth drivers:  Mattel has strongest distribution network in world and 2013 headwinds now better as Mattel enters 2015 on stronger footing. Asia has been growing at 14% CAGR since 2010, Russia also very strong market with sales up 10x since early 2012. Richard Dickson is chief brand officer who is back at Mattel (he led last resurgence in Barbie sales in 2010/2011 period) = now head of brands. Another is M&A where deals like MEGA can add value as only N.America brand = opportunity to compete with LEGO worldwide. HIT Entertinament acquisition also gives 2 great brands (Thomas & Friends and Bob the Builder). Have new 15-yr deal with Warner Brothers as discussed before.

Barbie #BESUPER campaign in 2015 launch (more diversity as well with black/Asian/brown hair/black hair friends of Barbie). Hot Wheels other key brand where when you buy car can now scan package and get exciting CAR games on your iPad. Also deals with Marvel and Star Wars for themed cars. Fisher Price is Mattel first interaction with parents/kids. New deal with Spokeswoman Shakira (110M followers online).

Major toy players undeterred by digital evolution

The toy industry has over time, proven adaptive to change with a history of modest growth and strong returns. While the threat of technology displacing traditional toys remains real, EBITDA at Mattel, Hasbro and Lego has combined to grow 15% per year since the launch of the original iPhone. This suggests that toys have a place in a world that is increasingly mobile and digital. In addition, investor may be underestimating the benefits that technology brings. Technology allows companies – of all sizes  - the ability to create and distribute brands as never before. Monster High, Mattel’s doll line that saw explosive growth in 2010-2013, was created with media distributed through online webisodes and YouTube – 2 low-cost channels. In addition to media, 3D printing is another potential innovation that could increase development speeds and introduce a new product distribution model.

The toy industry is expected to sustain mid to high single digit growth

The global toy industry grew a 9 year CAGR of 2.7%, led by emerging markets. International markets accounts for 75% of the market. We consider the rise of the global middle class, indexed to emerging markets, as the key driver of the global toy growth. The OECD is projecting the middle class spending growth in Asia Pacific Region to be almost 2x as fast as the rest of the world.

Consolidation has strengthened MAT and HAS’ position

We estimate that MAT and HAS have approximately 15-20% combined market share of the USD80 billion global toy market. The figure is closer to 20-30% when including Lego (#2 to MAT, based on sales) and even larger when excluding generic toys. Industry consolidation during the 1970s, 1980s and 1990s has led to a toy vendor base that is highly concentrated with each company benefiting from the global scale, strong retail relationships, access to capital and licensing opportunities. The end result is a set of companies that, as of 2013, was operating at or near historically high gross margins, operating margins and returns.

Key risks

*Barbie, Fisher-Price, Hot Wheels had not grown sales consistently in the past 10 years,… yet the company posted impressive total shareholder returns over this period.

*Lack of leadership: CEO fired, Interim CEO taking a deep dive into the business

*Loss of licenses+ deteriorating relationships with principals such as Disney: Loss of Disney princess licence to Hasbro, 5% loss in revenue. Offset by fact they signed new agreement with Marvel (also owned by Disney) for Hot Wheels.

*SG&A way above peer Hasbro, needs to be cut

*currency risk - A change in 1% in USD, usually has a 0.5 percentage point impact to topline. It usually has a $0.01-0.02 impact to bottomline EPS. They do have a hedging policy which they look 12-18 months out. Mattel generally target a 50% hedge on transactional and then obviously with regard to translational we are subject to that on a current basis. The strength of the USD is going to impact in 2015.

*Poor strategic acquisition track record (The Learning Company was large fiasco 15 years ago)

*High concentration to top 3 retailers (35% of sales to Wal Mart, Toys R Us, Target).

SHAREHOLDER REGISTER

Mattel’s shareholder base is highly institutionalised, which Blackrock (7.67%), Vanguard Group (7.47%) and T Rowe Price (7.41%) being the top three shareholders. No significant insider ownership. One good aspect about the low share price is that the Long term Incentive Plan given to management was given at prices between 35 and 42 USD according to latest 10-K filing and therefore the management would be incentivised to hopefully restore the value of Mattel or the options will expire worthless.

Short interest in Mattel at 8.43% of market capitalisation. For the short case you are betting that Mattel’s model is broken and its 24 yr track record of FCF generation, high ROE and high dividends is broken. It also implies a bet that no PE group or strategic buyer might want to own this FCF machine at current valuations to try and turn it around.

EARNINGS ESTIMATES AND VALUATION

Earnings upside if company meets internal targets

Our recent call with the interim management assured us that there is unlikely to be a major change in strategy going forward, even with the new leadership. The company is positive that the group’s long term financial objectives are intact. These long term financial objectives were communicated at its analyst day on 30/10/2014.

Assuming Mattel achieved the high end of its internal target in the next 5 years, we estimate an earnings CAGR of 19% over 2014-2019. Assuming that Mattel is able to achieve the low end of its financial objectives in the next three years, we estimate an earnings CAGR of 15% over 2014-2017, 30% above consensus estimate.

Attractive risk reward

In the most bullish scenario that Mattel is able to achieve the high end of its financial objectives in the next 5 years, we estimate an IV of USD45 or 75% upside + dividend. At the end of 2013 the company was trading slightly above this level.

In the bear case which we assume flat earnings in the next three years and the stock got de-rated to historical low PE of 13x, we estimate a bear case IV of USD21 (18% downside + dividend).

Using a simplistic and conservative ten year average EPS as advocated by Benjamin Graham of USD1.76, and applying 15x PE, we estimate the stock should be trading at USD26.4( slightly above the current market price). This excludes a potential 4 to 5,9% year dividend.

IV

We derived an IV of USD35 for Mattel, taking into account the potential bull and bear case scenario and giving a large weight to the fact that Mattel can deliver on its long term objectives. Clearly each investor should decide which weight they give to each scenario panning out.

Peer comparison

Compared to close peer Hasbro, Mattel is trading at around 10% discount on one year forward PE of 16x. In terms of P/B, Mattel trades at 2.8x FY15 P/B, 45% discount to Hasbro. Although Mattel’s ROE is lower at 18% in 2014 vs Hasbro’s 28% we believe there is room for Mattel to catch up in the long run considering its effective cost savings program and focus to reduce SG&A costs to similar level to Hasbro over time. With the slew of earnings downgrade, Mattel currently trades at 16x PE, near to 14-year historical average of 16.4x. At its lows during the global financial crisis, we saw Mattel de-rated to 7x and it trades at a historical peak average of 20x. 

In terms of P/B, Mattel trades near trough P/B of 2.8x, apart from the Global Financial Crisis where it traded on 1.5-1.8x P/B. In the past 15 years, Mattel trades at an average P/B band of 2.8-4.2x. P/B trough at 2.5-2.7x in 2000-2001 when it made a bad acquisition in The Learning Company which we explained earlier.

In terms of P/S, Mattel is trading 1.49x, at the 14 year average. Historically, Mattel trades within an average P/S of 1.2x-1.8x. Compared to direct peer Hasbro, Mattel trades at a 17% discount to Hasbro’s P/S of 1.8x in 2015.

SUMMARY

This bring us back to question in our INTRODUCTION section:

Is Mattel structurally broken… or is most of the 2014 pain self inflicted and fixable? YES

Is the decade long track record until 2013 broken or can it be fixed again?  YES

We recommend to invest in Mattel where we see strong upside to 35-40 USD level in case of turnaround and strong downside protection because of solid dividend support in 0% interest rate world. Mattel should be bought in view of its strong branded portfolio, robust free cash flow generation and impressive dividend track record. We believe that short term issues about the slow down sales, higher inventory, weak A&P strategies, lack of popular new toy products and lack of a proper CEO are all fixable issues.