Description

BUSINESS DESCRIPTION

Mattel is the largest physical toy manufacturer in the world by revenue with several large franchises (Barbie, Hot Wheels and Fisher Price/Thomas the Tank Engine) and many smaller owned and licensed products.  The toy industry is experiencing a secular shift toward digital properties, learning toys and collectibles where MAT has a limited presence which has driven share losses over the past 5 years.  Shrinking top line coupled with a bad balance sheet and FCF generation makes MAT a weak competitor.  The potential for Chinese tariffs on toys would be the death knell as MAT produces ~2/3 of its toys in China and would struggle to pass through pricing increases. Furthermore, the company’s solvency has recently been called in to question after a whistleblower case was raised related to the death of somewhere between 10-50 children due to a faulty Fischer Price sleeper product, which caused the company to pull its bond offering. This case may result in a multi-hundred million dollar liability, which equates to multiple years of free cash flow generation.

MAT is a posterchild example of a company that was focused on hitting short term earnings while sacrificing long term competitiveness.  MAT was highly profitable in the 2010-2013 timeframe as it had strong volumes from Monster High and the Disney Princess line.  The company decided to report strong profits rather than invest in innovation.  The Toy business is largely hit driven and the lack of innovation ended up hurting MAT once the Monster High fad passed. The lack of innovation also drove the loss of the Disney Princess contract (to HAS).  Despite the lack of innovation, MAT continued to raise prices on key products ultimately driving volumetric declines.  American Girl was the best example where they maintained a >50% price premium to competitive products driving a 50% decline in the business. MAT made expensive acquisitions of Mega and Sproutling which had limited synergies and drove financial leverage higher.  They also paid a $500m dividend through 2016, depleting much needed capital to pivot to the new competitive environment. 

The turmoil has driven 3 CEO changes in 5 years.  Each new CEO comes with a plan to cut costs (furthering hurting competitiveness) and pivot to digital/licensing.  Most recently MAT hired Ynon Kreiz, a TV and movie executive to pivot the company toward new IP driven revenue streams.  Ynon was formerly the CEO of Fox Kids Network in Europe, CEO of digital production company Endemol and most recently CEO of web video network Maker Studios which he sold to Disney in 2014 for $500m.

While we believe that the current strategy to pivot towards IP has merit, we also believe MAT is structurally impaired as its financial leverage, weak operating performance and underinvestment have caused irreparable damage.  MAT is a strong short candidate on a standalone basis with the potential for extreme downside in the event of Chinese tariffs and/or a large legal liability from the Fischer Price sleeper deaths.

THESIS

Mattel is a structural short with shrinking volumes, a challenged balance sheet and a potential exogenous shock from Chinese tariffs.  While the toy industry continues to grow LSD, MAT has shrunk LSD to MSD per annum as they have underinvested in innovation and lost relevance in a rapidly evolving child content environment. 

MAT’s top line has fallen from $6.5bn in 2013 to $4.5bn in 2018.  Over that period of time EBITDA has shrank from $1.4bn to ~$200m in 2018.  Net debt expanded from $600m to $2.3bn and leverage exploded to over 7x.  MAT has not generated free cash flow since 2016. Over that period the company announced gross cost savings initiatives of ~$1.2bn.  The cost savings resulted in significant layoffs that impacted company culture.  We believe that the weak culture, high leverage and limited free cash flow constrains investment and accordingly that MAT is structurally impaired.   

BULL CASE

The bull case is predicated on a turnaround.  The ‘new’ CEO at Mattel (Ynon) has set out a plan to “transform Mattel into an IP-driven, high performing company”.  The pillars of the plan are predicated on cost cutting/reshaping operations, accelerating organic revenue growth by innovating in core brands and accelerating in-license opportunities and driving additional intellectual property revenue streams (license content for movies/TV, etc).

Cost Savings – MAT has announced perennial cost savings programs.  Over the past 5 years MAT has announced two large structural cost savings plans targeting gross savings of $1.15bn ($250-300m in 2014-2016 and $850m plan from 2017 to 2020).  Cost savings have made there way to the income statement with cost of goods falling ~$450m and opex falling ~$450m, however EBIT has fallen over $1bn of that period.  Said differently, despite the significant cost savings EBIT has fallen from $1.15bn to $150m expected in 2019.  While the company claims that they have another large cost savings plan ahead through reducing their manufacturing footprint, we believe a fair amount of those savings will go towards offsetting the ~$100m of incremental inflationary costs in materials and labor.

Accelerating Organic Revenue Growth – MAT is attempting to innovate around its core brands by launching new “digital” add on features to mature products Recently MAT launched a Hot Wheels Digital play system (exclusively in Apple stores) and a partnership between Hot Wheels and Nintendo to create Mario Kart die-cast toys.  They also in-licensed Sanrio’s Hello Kitty portfolio to produce toys in all markets outside of Asia as well as the rights to produce action figures for BTS (the Korean boy band).

Innovation is at the core of the toy industry.  Most toys are fad like in nature and require constant investment to change the core product to keep it fresh. MAT produces over 8k different SKUS a year and there is a constant ebb and flow of new hits and waning products. We believe that all of the above innovations are thoughtful incremental steps to maintain their core franchises and potentially replace maturing licensed products (Jurassic World, etc.).  That said, we believe the innovation is marginal and, in many cases, has been attempted in the past with limited success. 

Drive Additional Intellectual Property Revenue Streams – The current CEO of MAT has extensive experience in content creation for television, streaming and movies.  Of late, MAT has accelerated partnerships with movie studios to produce new content on owned IP including Magic 8 (a horror movie), Barbie (partnering with Margo Robbie), Masters of the Universe and a number of other movies and streaming TV shows.  MAT is employing a capital lite strategy where they contribute the intellectual property and the studios contribute the capital. 

While we credit MAT for its creativity in exploiting its IP library we believe that the company will generate limited revenue and earnings for the foreseeable future from these efforts and at best can hope to boost toy sales.  When speaking with management they admit that they receive limited upfront payments for the contributed IP and will take a small royalty on the back end. 

Content creation is highly risky as it is expensive and competitive.  In the world of Netflix, YouTube, Hulu and Amazon Prime there is a copious amount of content and a highly competitive market for eyeballs. MAT has attempted this strategy in the past as they have produced Barbie and Thomas the Tank engine content on Netflix and YouTube with marginal success.  

M&A Target – Another bull case assumes an acquisition by Hasbro or another industry competitor.  In the past it has been rumored that HAS would like to acquire MAT likely due to significant synergies in supply chain and overhead.  A combination would likely create a more powerful company to negotiated with retailers allowing for superior margins.  MAT was trading at ~$13 pre-deal rumors and rebuffed the acquisition as they did not believe they were being fairly valued.  Since then the company has continued to shrink and leverage has continued to expand making a combination more challenging.  In August 2019, Hasbro announced the acquisition of Entertainment One, the owner of Peppa Pig IP. We believe this severely limits the likelihood of an acquisition of MAT by HAS over the foreseeable future.

In June 2019 MGA attempted to acquire MAT but the talks dell apart.  MGA has a long-standing blood feud with MAT with a decade long lawsuit revolving around Bratz.  Bratz was developed by an ex-MAT employee whom pitched it to MGA to compete with Barbie in the fashion doll category.  MGA was forced to pay modest fines to MAT and ultimately scaled back sales and production of Bratz but filed a counter suit alleging unfair competitive practices.  The cross suits were valued at over $1bn.  MGA attempted to offer a settlement of the law suit as its “equity” in the combination but required the entire MAT management team to leave and the board to be reconstituted.  MAT balked at the idea and Issac Larian (the CEO of MGA) suggested Mattel was barely worth $6 a share (current price of ~$9.30) and that the company “could go bankrupt in a year” noting their heavy debt load a potential class action lawsuit on Fisher Price products that resulted in between 10-50 infant deaths.

While a take out is always a risk, the uncertainty around the balance sheet, law suits and more recently China tariffs likely will prevent most competitors from wanting the baggage that would come along with an acquisition.

VARIANT PERCEPTION

We believe that MAT is a “turnaround that won’t turn.” The Toy business is a hit-driven business that requires constant investment just to maintain the top line, let alone grow it. We expect the company to continue to lose share to Hasbro, MGA, Lego and SPIN and lose “time spent” share of kids’ eyeballs to other digital properties and streaming platforms. The required investment in content, product innovation and marketing coupled with ongoing raw material and labor inflation will be a constant drag on profitability and will more than offset future cost savings programs. Heavy financial leverage, coupled with the potential for a multi-hundred million dollar liability from the Fischer Price whistleblower case, coupled with Chinese tariffs, makes this a short with multiple ways to win.

In a base case, we expect the company to generate $500M of EBITDA in 2020 (10% below the street), driven by incremental cost inflation and merit increases and required ongoing strategic investments that will more than offset incremental cost savings. In a reward case, where MAT is unable to pass on pricing to offset list 4 tariffs and continues to lose market share with shrinking volumetric growth, we expect the company to generate ~$350M of EBITDA (35% below the street)

FRAMEWORK: STRUCTURAL SHORT

Total Addressable Market: The global toy market typically grows LSD to MSD per annum with volumes flattish and modest pricing.  The core US market grows LSD but has been flat since 2016 with a 2% decline in 2018 partially driven by the closure of Toys R Us.  Over the past decade time spent by children in the core age group [0-12] has shifted toward digital content and video games which has put a lid on growth of physical toys.  Each year there are significant market share changes as new products are launched with varying degrees of success while more mature products typically experience declines after year 2 or 3 of launch.  Movie launches and new fads drive dramatic growth for short periods of time. 

MAT Share and Growth: Over the past 5 years MAT has ceded material share with revenue down ~30% or MSD per annum.  The key drivers of the decline were (i) losing the Disney Princess contract to HAS (ii) significant declines from increased competition in American Girl (iii) significant declines in Monster’s High/Ever After High.  Mega Blocks and Fischer Price/Thomas the Tank Engine have experienced more modest declines while Barbie and Hot Wheels have been flat.

We believe that there are both company specific and industry wide drivers of MATs underperformance that are extremely challenging/near impossible to fix.  The company specific issues stem from under investment and a lack of innovation.  Primary research suggests that previous MAT management was highly focused on hitting their short-term revenue and earnings targets.  Rather than invest in R&D and content to support their franchises and grow new franchises MAT cut costs, made marginal acquisitions, raised prices and paid a significant dividend.   The poor capital allocation decisions have driven leverage to >7x EBITDA which has further hindered innovation and potentially content producers desire to work with MAT as there are some concerns about their financial stability. 

Competitors like Lego, MGA, SpinMaster and Hasbro have invested in R&D to develop new toys and content to support core franchises driving superior market share.  Over the past 5 years as the company’s top line shrank, MAT cut SG&A and Advertising and Promotion ~20% whilst peers have continued to continued to grow their investment fortifying their franchises.

Industry wide headwinds are challenging the entire industry.  Digital content (Netflix, YouTube, Amazon Prime etc) and has continued to grow time spent.  Historically in a linear TV world, Toy companies could either create or partner with studios to create content to drive toy sales.  As time spent becomes more fragmented children have less attachment with each program driving lower affinity for toys.  Video games (both traditional and learning games) continue to increase their share of time spent.  With the advent of the smartphone and tablet children are getting started earlier and playing longer.  Direct to consumer retailing has also dramatically changed toy selling.  Historically, Toys R Us and similar toy retailers would curate their stores and toy companies could influence the retailers with incentives to drive improved adoption.  As toy sales shift online there is more competition and less differentiation.  The shift online requires a completely different set of advertising skills which MAT has not displayed to date.

Operating Leverage/disleverage: As the top line shrinks MAT has been forced to cut costs aggressively. Despite that, MAT has experienced a dramatic decline in margins with adjusted EBITDA margin falling from >20% to ~5% in 2018.  

Over the past 5 years decremental margins have averaged over 50% implying that the majority of costs at MAT are fixed.  On top of the high fixed operating expense, interest expense runs at ~$180m or ~35% of projected 2019 EBITDA. 

If MAT toy volumes continue to struggle, FCF (which was negative ~$180m in 2018) could get materially worse bringing the balance sheet into question.

Balance Sheet/Liquidity:

MAT is >11x leveraged on a 2018 basis and ~6.5x leveraged on TTM basis.  Gross debt stands at $2.9bn with cash at $200m.  MAT also has >$1bn of excess capacity on its revolver.

The balance sheet is termed out with $250m due in 2020, $350m in 2021, $250m in 2023, $1.5bn in 2025 and another $550m due in 2040 and 2041.  The long-dated bonds trade in the high 70s to mid 80s implying a yield of 7.5%.

We believe that MATs liquidity is strong enough to prevent a filing but leaves little room for error.  In a recession or in a scenario where the US places tariffs on toys produced in China or where the whistleblower liability is larger than expected, MAT could see its capital structure come into question as they would likely have to refinance at high and punitive rates further tightening the noose around their neck.

KEY INVESTMENT FACTORS

·        Revenue growth at Barbie/Hot Wheels and the broader portfolio

·        Cost cuts vs inflation/investment

·        Liquidity/Solvency

TOP DOWN DRIVERS

·        Structural shift from physical to digital toys

·        Rising cost of wages in China + rising cost of materials to produce toys

RISKS

·        Acquisition by a competitor

·        New unexpected hit product

·        Proof of concept on license-based revenue

·        Cost cutting that falls to the bottom line

·        Turnaround at American Girl/Fisher Price removing the downside leg in the decision tree

PRE-MORTEM

·        Acquisition by HAS or MGA

·        New unexpected hit product

SIGNPOSTS

·        Signpost to size up – Revenue in the core franchises (Barbie and Hot Wheels) declines

·        Signposts to size down – better than expected drop through on expenses

VALUATION

We value MAT based on a FCF yield and discounted cash flow analysis, using an 8% discount rate and a 2% terminal growth in line with nominal GDP.

Critical base case assumptions include:

·        0% organic growth CAGR

·        $270M/$240M incremental cost savings in 2019/2020 and $90M per annum thereafter as part of an assumed continuous improvement program

·        $110M of raw material and labor inflation per annum (including both COGS and SG&A)

·        $100M whistleblower liability

·        10% FCF Yield

·        $5 stock price

Reward case assumptions include:

·        Negative LSD organic growth CAGR

·        $270M/$240M incremental cost savings in 2019/2020 and $90M per annum thereafter as part of an assumed continuous improvement program

·        $110M of raw material and labor inflation per annum (including both COGS and SG&A)

·        $60M tariff-related net headwind in 2020

·        $300M whistleblower liability

·        $0 stock price

Catalyst

List 4 tariffs go in to effect in December, whistleblower liability quantified, weakness in Q4 driven by competition for Barbie from Frozen