Value Investors Club / HASBRO INC (HAS)

Description

Hasbro (HAS): Long

Hasbro, founded in 1923, has been a staple of children at play for generations and holds a plethora of iconic toy brands. However, there is pessimism surrounding the industry and the stock has become an underappreciated backwater (~3% hedge fund ownership) and a misguided ‘secular short’ candidate. In fact, this is a strong business and the core is more valuable than the market gives credit. It is large and liquid, trading 1.3mm shrs/day in average volume, so it is investable for large investors. And it is paying us to wait for value realization with a >3% dividend yield plus an often sizable buyback. We also believe that there are three additional drivers in the form of incremental margin upside and two hidden media assets. With the value from the media assets realized, our base case has the stock worth ~$80/shr for ~60% upside

Biz Intro: Hasbro is one the two top players in the traditional toys and games business after Mattel. It is the leader in boys toys (where it owns brands like Transformers, GI Joe and Nerf and has a long-term license for Marvel and Star Wars) and board games (e.g. Monopoly, Scrabble, Battleship, Twister, etc). It also has strong offerings in girls (e.g. My Little Pony, Furby, Littlest Pet Shop) and preschool (Play-Doh, Playskool, a long-term license from Sesame Street) although it is not the category leader here. Revenues have become ~50% international and a small (~5%) but growing portion comes from outright entertainment and licensing.

While the entertainment industry (particularly children's television) has always been an element of Hasbro’s business, it is now a much larger piece of HAS as toy spend becomes more focused on branded products (eg GI Joe vs generic army men) and blockbuster movies correspondingly drive the sale of many toys. Transformers, in particular, has become a huge property, grossing >$1bn globally at the box office for the most recent movie. As a result, developing brands is becoming quite important to HAS and will only be more essential over time. In our view, the company needs to move from a toy company that makes IP for its products to an IP company that partially monetizes IP through toys. HAS took some productive steps by starting Hasbro Studios to make children's television content but it must go further.

2012 Revenue breakdown: Boys (39%), Games (29%), Girls (19%), Preschool (13%)

Good business: This is a great business with 10-yr average ROE of 20.1% (25% in 2012) and high, stable gross margins (10-yr range: 57% to 59%) serving as a clear sign of high barriers to entry. The company has grown fairly reliably over time, even through 2008-2009, at a 10-yr revenue CAGR of 2.7% although we acknowledge that several categories have been problematic in recent years.

Industry Context/Refuting Shorts: However toy sales in the developed world have been basically flat over the last five years and the rise of the iPad and other accessible electronic devices leaves some concerned that toys – especially games - are irrelevant to today’s children and families. These factors inform a secular bear thesis around the company leading to a large short interest (~10.7%) that we believe is misguided.

1. While iPads are justifiably popular as childrens' playthings, they provide a fundamentally different play experience. Not only do these products represent an attractive content selling channel but we are also in our fourth decade of widespread electronic games leading to the end of physical toys. No sign of their demise yet.

2. International sales - The developing market represents a large and fast growing market for HAS which can carry a lot of the growth burden. Additionally, even though developed world growth has been sluggish, Hasbro has been able to take significant share in Europe through its branded content. As an indication, Hasbro movies have done remarkably well overseas (eg Battleship) which we think indicates latent brand awareness that can be monetized over time.

3. Entertainment - some shorts feel that there are short-term risks due to a weaker movie slate. However, Hasbro actually has 5 related-brand movies coming out this year, many of which are slated to be blockbusters both domestically and abroad.

4. Decline in Games/Magic – while we don't doubt that many traditional board games are less relevant to consumers today, Hasbro's decline in games sales has hardly been across the board. Most of the decline has been limited to puzzles, classic and traditional board games, partially because these businesses are being licensed out over time. Today these declining segments represent about 25% of game sales while the remainder of the segment has been flat or growing. Most important here is Magic: the Gathering which has been growing quite rapidly. Not only is it now 30+% of game sales but we anticipate it continuing on its positive trajectory. Magic alone will keep the dire warnings about the Games segment from coming true

MtG: Magic: the Gathering is a strategy card game that releases 4 new sets a year. Players must keep up with buying sets or else they will not be able to play with many of their friends, highlighting the 'lifestyle' nature of the brand. The number of players has been growing rapidly and as our proprietary survey of 200+ current players, the average age is actually ~27, with most players indicating they were both encountering more new players and were planning on spending more on the game next year. The street does not understand this segment since it does not show up in their channel data and the company has only begun to discuss the brand. However, based on our tournament attendance figure and proprietary survey results, we think Magic has a lot of growth runway ahead of it and will soon represent more than 10% of sales at undisclosed but ver yhigh margins (they are selling coated cardboard at $3.99+/15 cards). The game has also only begun to migrate online which is already resulting in many new players of both the physical and digital game.

Base Valuation: Without any of the following drivers, we think HAS is probably roughly fairly valued at $50/shr (~15x P/E) although we think HAS may grow faster than it's currently given credit for

Margin Catalyst

Prior to 2009, Hasbro led Mattel in EBIT and net income margins. However, a series of cost cutting measures by Mattel left Hasbro lagging significantly. We believe Hasbro’s margins could again rival Mattel’s. Base case margin upside represents $9.60 per share in additional value. Mattel overtook Hasbro when it began its first of four large-scale cost cuts that resulted in $412MM of gross cost savings. Hasbro is effectively four years behind Mattel and now just beginning resizing with an announced 100MM of savings. We think there are another $124MM of savings that would bring Hasbro’s 2015 net income margins to 12.9%, still 100bps below Mattel’s 2012 margins. These cuts include packaging optimization, procurement of materials and division reorganization ($43Mm in savings). As a result of its investments in the Hub, Hasbro can also lower advertising spend by $26MM because Hub content “plugs the gap” between product advertisement in movie and non-movie years. There is also another $34MM in R&D spend that can be cut as there are diminishing returns to U.S. R&D spend (Note: that $34MM is net as some R&D should be shifted to Asia where there is higher return on this type of spend). The final source of margin expansion is better execution of off-market royalty payments tied to Hasbro related IP as management should focus more on executing as a brand company rather than toy company ($21MM of savings). In total, there are many areas in which Hasbro significantly lags Mattel and we do not think Mattel’s cuts are 100% unique to one firm. As a base case, we estimate this incremental margin opportunity to be worth ~$10/shr.

Hidden Assets

The first of Hasbro's hidden media assets is the The Hub. The Hub is a children's television channel started in 2010 as a 50/50 JV between Discovery and Hasbro where Hasbro creates the characters and content and Discovery handles the operations. Discovery is perhaps the premier cable channel operator today and The Hub is its 6th largest channel by number of subscribers. Channels tend to develop slowly and The Hub has actually been a drag on earnings at Hasbro to date. However data suggests this drag is ending and, when going through the numbers from SNL Kagan, the media industry standard, The Hub looks to start generating significant cashflow over the next few years. Base Kagan data suggests a PV of $6 net to Hasbro but if The Hub was to converge towards industry or network peers, it could be worth upwards of ~$16/shr. This does not include the possibility that Discovery takes the Hub international, as it has with other channels. We use a base case of $6/shr based on SNL Kagan's economic projections.

The second source of hidden value is IP. We would argue the following:

1. Globally recognized and compelling IP not sitting in the hands of a major player is an increasingly scarce commodity

2. IP value is a function of its monetization potential
3. Monetization potential is a function of global interest and latent brand awareness
4. Global interest and latent brand awareness are both best evaluated via global box office grosses where available since it’s an expression of a global audience putting its money where its mouth is as far as entertainment preferences go.

5. There are only a handful of relevant transactions, but if we look at the acquisition of Marvel Entertainment in '09, Disney paid $4.3bn, approximately 1.2x the sum of Marvel's prior three years worth of character movies which suggests a value of $14/shr to Hasbro based on the past three years of its movies after royalty netting. We admit that this methodology cannot fix on a precise value of Hasbro’s IP, but this is the same valuation methodology that Disney indicated it used with its Lucasfilm transaction as well. While Hasbro does not have the same quality IP as Lucasfilm, the point is that this methodology has been implicitly endorsed by the industry leader multiple times.

Moreover, Marvel didn't hold the film rights to most of this IP including Spider Man, X-Men and the Fantastic Four at the time of acquisition and still doesn't hold most of it today. If we haircut the global box office for these characters' films by 50% to reflect the value to Disney being significantly impacted by the lack of film rights, this suggests an almost 2x multiple or an additional ~$30/shr to Hasbro after royalty netting.

Global Gross of all MVL movies 2005 - 2009 DIS Acquisition
Film	Date	Global Gross
Origins Wolverine	5/1/2009	$373.1
Punisher War Zone	12/5/2008	$10.1
Incredible Hulk	6/13/2008	$263.4
Iron Man 2	5/8/2008	$585.2
Fantastic Four 2	6/15/2007	$289.0
Spider Man 3	5/4/2007	$890.9
Ghost Rider	2/16/2007	$228.7
X-Men 3	5/26/2006	$459.4
Fantastic Four	6/29/2005	$330.6
Total		$3,430.4
Total w Full Rights Only		$848.6

Acq Price/Full Rights Gross		4.95x

Full Rights Grosses + 50% others		$2,139
Acq Price/Full + 50% Gross		1.96x

Pro Forma HAS IP Valuation at MVL Multiple
Film	Date	Global Gross
Battleship	5/18/2012	$303.0
Transformers 3	6/9/2011	$1,123.7
GI Joe 1	8/7/2009	$302.5
Transformers 2	6/24/2009	$836.3
Total		$2,565.5

At Full Rights Mult (4.95x)		$12,698
Per Share Value to Hasbro:		$98.63

At Full + 50% Mult (1.96x)		$5,036

Per Share Value to Hasbro (pre-royalty netting):		$39.12

Again, the point is not that this is exactly the right number for valuing Hasbro's IP, but simply an indication of the going price for the untapped value in Hasbro's vast vault of IP. We assign the lower valuation of $14/shr. Bear in mind that these box office grosses reflects a tiny fraction of Hasbro's overall IP library.

In addition, note that we have gone from talking about toy sales to cable channels and movie grosses. This is well outside the expertise of most Hasbro analysts following the name and this complication is part of what creates this valuation disconnect.

The Hub is largely in Discovery's hands and some of the margins story is being addressed by Hasbro's management but the additional cost cuts we see as well as effective monetization of IP (perhaps via film production) seems not to be central to their agenda now. A sale or spin-out of entertainment assets to the shareholders (perhaps as a tracking stock) would force the market to value these assets and, based on extensive work around such transactions, we think the market would converge on our numbers outlined above.

However, we look at the Marvel example of bringing in talented people (Kevin Feige, especially) to make truly compelling content based on its IP and library would prefer HAS continue this in house and think of a spin-off, tracking stock or sale as mainly back-up options for realizing value. Management may initially be resistant to cutting and adjusting spend as well as adjusting its strategy for recognizing IP value so the involvement of a friendly activist to outline these opportunities, potentially to the public, might be a more productive set of actions since management is ok but lacks the experience and focus on these issues and therefore probably needs a jolt.

In closing, we think that Hasbro is a misunderstood company that represents a compelling risk-reward case, especially for an activist who would be best positioned to recognize value.

Summary Valuation:

Base Value	$50/shr
Incremental Margin	$10/shr
Hub Valuation	$6/shr
Untapped IP Value	$14/shr

Total	$80/shr

Investment Risks and Mitigants:

•Greater than anticipated weakness in action figures
–Mitigated by healthy slate of supporting movies and growing international interest

•Failure to execute Hasbro Studios strategy both domestically and internationally
–Mitigated by strong television partner in Discovery and established data showing strong overseas brand interest

•Risk that a new product (for example tablet computers) takes material market share from the traditional toy business
–Hasbro has successfully grown despite the proliferation of video games over the past several decades
–Management is actively merging its strong brands with games on mobile and tablet devices

•Failure to improve margins through cost savings initiatives and execution of new royalty contracts
–Possible, but MAT has already provided a blueprint and shown that it’s very achievable

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

- Strong Transformers 4 performance globally

- Further cost custs announced

- Partnerships to better develop more IP

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			2014	2015
Price:	49.12	EPS	$2.62	$3.35
Shares Out. (in M):	130	P/E	18.75x	14.66x
Market Cap (in $M):	6,374	P/FCF	15.4x	13.0x
Net Debt (in $M):	991	EBIT	574	660
TEV (in $M):	7,365	TEV/EBIT	12.83x	11.16x