Description

I am recommending a long position in Hasbro (HAS) as it is in the early innings of a long-term strategy to extend its valuable brand portfolio beyond traditional toy markets and into movies, television, video games, and mobile applications.  This strategy, which is similar to the one successfully executed by Marvel over the last 5-10 years, will transform Hasbro from a toy manufacturer heavily reliant on 3^rd party license agreements to more of a brand management/media company with a vast portfolio of valuable intellectual property.  As this transformation takes place, the result will be a company with larger and more diverse revenue streams with less seasonality, higher margins, more attractive returns on capital, and significantly less risk than the current business model.  Disney's recent purchase of Marvel for 13x EBITDA validates the value inherent in this type of intellectual property. 

Key investment highlights:

1. The core toy business earns high returns and generates a ton of cash - double-digit margins, ROEs in excess of 20%, and an average of $400mm/year in FCF over the last three years. 
2. In very early stages of a transformative business model shift that will result in higher margins and returns as well as a higher valuation.   
3. Significant acceleration of earnings in 2011 and 2012
   1. Powerful movie lineup anchored by Transformers 3 and Spider-Man 4
   2. Universal making movies based on Hasbro brands (Monopoly, Stretch Armstrong, etc.)
   3. Discovery Kids JV will drive a $0.30-$0.40 EPS improvement in 2011
   4. Sesame Street toy license takes effect in 2011 (~$100-$150mm of incremental revs
4. Underpenetrated international markets provide Hasbro with a long-term growth opportunity.  Hasbro generates only 34% of its revenue outside of the U.S. vs. 47% for Mattel. 
5. Hasbro is gaining market share / shelf space in the highly-fragmented U.S. market
6. New CEO has an outstanding track record and the necessary qualifications to execute the strategy.
7. Durable business, strong balance sheet, cash flow generation, low valuation, and 2.6% dividend provide downside protection while there are plenty of upside drivers.  Great risk-reward profile.

Hasbro has a Market Cap of approximately $4.8 billion and, treating the in-the-money converts as equity, will have year-end net debt of less than $200 million, for an Enterprise Value of about $5.0 billion.  Trading at approximately 11x 2011 EPS and 6x EBITDA, investors are not appreciating the enormous value of Hasbro's intellectual property or the significant earnings acceleration that will occur beyond 2010.  Using a 15x multiple of my estimated 2012 EPS of $3.30 warrants a year-end 2011 stock price of $50, 60% higher than the current price. 

Company Overview

With approximately $4 billion in 2009 revenues, Hasbro is the second largest toy and game manufacturer.  Historically this has been a high-quality business, with double digit EBIT margins and returns on equity of over 20%.  Hasbro's strong competitive position and the relatively defensive nature of the category make the business very durable.  Since 2006 Hasbro has generated almost $1.5 billion in FCF, paid $275mm in dividends, and repurchased $1.4 Billion worth of stock. 

The company segments its revenue by product category as follows (2009E):

The Games & Puzzles segment includes several well-known brands such as Monopoly, Scrabble, Trivial Pursuit, Cranium, etc.  It is the highest margin segment (estimated high-teens EBIT margins vs. ~12% for the overall company) and also the most durable, as demand trends are generally stable and Hasbro has a dominant competitive positioning.  The Boys business, which consists of entertainment-backed action figures as well as brands like Nerf and Super Soaker, is more volatile year-to-year due to the timing of movie releases but has great long-term growth prospects.  The Girls category includes brands like Littlest Pet Shop, My Little Pony, and Furreal Friends, while the key Preschool brands are PlaySkool, Tonka, and Play-Doh.

In its core toy and game business, Hasbro will benefit from retailers like Wal-Mart and Target reducing their number of SKUs but allocating greater shelf space to larger manufacturers with strong media-backed consumer brands, sophisticated sourcing/manufacturing infrastructures, and the ability to navigate increasingly onerous safety regulations.  With only a 10% share of the domestic toy industry, Hasbro has room to grow despite the maturity of the overall market.

Hasbro is also the beneficiary of an attractive 2011-2012 movie release schedule, anchored by Transformers 3, Spider-Man 4, Captain America, and Thor and supported by several movies based on Hasbro brands, including Monopoly, Stretch Armstrong, and Battleship.  The toy sales associated with these movie releases should contribute to double-digit revenue growth in 2011 and 2012 after a weaker movie schedule in 2010.   

Expanding share in the rapidly growing international markets will also be an important revenue driver for Hasbro.  According to a recent Keybanc report, the international toy market has experienced a five-year CAGR of 7.4% vs. 0.9% for the U.S. market.  Yet industry penetration in these markets is still well below the U.S., with approximately $350 spent per kid, per year in the U.S. vs. $17 in Asia and $40 in Latin America (source: Keybanc).  Hasbro generates a much lower percentage of its sales outside of the U.S. than Mattel does, but will close this gap as they have invested heavily over the last two years building out their sales and distribution infrastructure in rapidly growing emerging markets.  In 2008 alone the company invested ~$60 million to expand its global operations in key markets such as Brazil, China, Russia, the Czech Republic and Korea.  As evidence of the broad international appeal of Hasbro's brands, after only 10 days in theaters Transformers: Revenge of the Fallen became China's highest grossing movie of all-time.

New Business Model - Monetize Hasbro Brands Beyond Toy Market

Historically, Hasbro's business model has been highly dependent on licensing agreements to sell toys associated with third party intellectual property.  These licenses, the largest of which are with Marvel and Lucasfilm, required Hasbro to make significant up-front payments and guarantee large minimum royalty payments.  Meanwhile, Hasbro's revenue potential was restricted to toy sales and profits were limited by the associated royalty payments.   

In 2001, current CEO Brian Goldner joined the company as President of the US Toys segment.  He noticed that they were devoting substantial resources developing and marketing third party brands, yet Hasbro had hundreds of well-known brands that were being neglected.  He pushed the company to focus marketing and brand development efforts on internally-owned brands, with the goal of leveraging these brands beyond traditional toy markets.  The strategy, "Re-Invent, Re-Imagine, and Re-Ignite," focused on revitalizing core brands through entertainment tie-ins (movies, television, video games), resulting in not only more toy sales but additional high-margin revenue streams from box office participation, television licensing fees, and royalties from the sale of DVDs, video games, mobile phone applications, apparel, and publishing. 

Transformers is a great case study that highlights the potential of this strategy.  The brand was generating minimal revenue for Hasbro despite being very well known and having a large fan base that grew up with the brand.  In 2007 Paramount made the first Transformers movie which was a huge success (over $700mm worldwide box office).  The following year Hasbro came out with an animated series on the Cartoon Network and in 2009 Paramount made a sequel that brought in $830mm at the box office.  For Hasbro, they took a brand that was essentially dormant and, with minimal investment of their own capital, generated close to $1.5 Billion of high-margin revenues over a three-year period.  Transformers 3 is set for release in 2011. 

In putting together this strategy, Hasbro has developed key strategic relationships with movie studios, television networks, video game publishers, and numerous other licensees.  By leveraging these relationships and building off of the enormous success of Transformers and GI Joe, Hasbro is now applying this strategy to its other owned properties.  For example, in 2008 Hasbro entered into an agreement with Universal whereby Universal will make at least four movies based on Hasbro brands, with Hasbro getting a percentage of the box office.  Stretch Armstrong (Brian Grazer), Monopoly (Ridley Scott), Battleship (Peter Berg), Ouija (Michael Bay), and Candyland (Etan Cohen) are all expected to be released in the next five years.  Hasbro also has a partnership with Electronic Arts to make video games and mobile phone applications based on Hasbro brands. 

Discovery JV

Last April Hasbro invested $300mm to acquire a 50% ownership in the Discovery Kids cable network.  The investment has been a source of confusion and contention for some investors who are concerned about the price paid (24x EBITDA), near-term dilution ($0.15-$0.20 in 2009 and $0.25-$0.30 in 2010) and Hasbro's apparent foray outside of its core business (the stock was down 7% on the news).

Despite the rich valuation, I think this was actually a shrewd investment for Hasbro that at worst will be a valuable strategic asset and in a best case will generate a high-return on a stand-alone basis.  Discovery Kids is distributed in approximately 60 million homes and at the time of acquisition was generating about $50 million of revenues and $25 million of EBITDA.  Viewership was low (it is not currently Nielson-rated) as the programming was focused on education more than entertainment.  The plan is to re-launch the channel in the fall of 2010 with a new name ("The Hub") and new programming centered around (but not exclusive to) Hasbro brands.  On a stand-alone basis there is a huge opportunity to improve the operating and financial metrics and increase the value of the channel.  Monthly sub fees are approximately $0.06 vs. ~$0.16 for Cartoon Network and ~$0.44 for Nickelodeon, both of which are fully-distributed (~95mm-100mm homes).  Advertising revenues are only ~$5 million (10% of revenues) vs. estimates for Cartoon Network of $350mm (58% of revs) and $1 billion for Nickelodeon (50% of revs).  There will be a lot of execution risk with this investment but it does seems logical that by creating higher-quality programming based on well-known brands the network can improve its ratings which will lead to higher advertising revenues and, over time, higher affiliate fees.  By growing distribution to 70 million homes, increasing sub fees to $0.14/month, and taking advertising to 50% of revenues the network has the potential to earn ~$150 of EBITDA (assume a 50% margin).  At 8x EBITDA, this would represent a $600 million value for Hasbro's 50% interest.  Admittedly this is an optimistic scenario, but the upside potential does exist.

More interesting, having ownership/control of a broadly-distributed kids network will be a valuable piece of the overall Hasbro strategy of increasing the value of its owned brands.  Successful franchises like Power Rangers and SpongeBob were launched on television and for other brands like Transformers and Star Wars, television generates incremental licensing revenues and keeps the brand in front of the consumer in non-movie years.  And of course television shows drive toy sales - Hasbro figures it can generate "hundreds of millions of dollars" of incremental toy sales as a result of its Discovery investment.  Without control of a network, Hasbro would have trouble obtaining the programming schedule needed to effectively build its brands.       

Forecasts / Valuation

Investment Risks

The biggest risk of this investment, other than the obvious (exposure to consumer spending, product cycles, input costs, currency, and customer concentration), is the possibility that management invests too heavily in television programming and does not earn an adequate return.  I think management is generally conservative and they will approach this investment in the same manner.  They have committed to spend up to $80-$100mm/year on programming once the network is fully ramped-up.  The downside here is that they spend up to $200 million over a couple years and realize that they are not getting an adequate return, at which point they sell their interest for something less than the $300 million they paid for it.  So at worst you have a total loss on the investment of $300-$400 million, which is an acceptable risk for the upside potential.

Catalyst

Investor Day in conjunction with Toy Fair next month where Hasbro should talk more about their long-term strategy and outlook.  Soon investors will begin to focus on the earnings ramp in 2011.