Description

Spin Master Corp. (“TOY” or the “Company”) is a TSX-listed $3.3B market cap toy company that caught

lightning in a bottle with a fad product called Hatchimals (20-25% of revenue and a higher percentage of

earnings) that is now in a rapid state of decline. This issue is compounded by the fact that TOY’s other

large platform, PAW Patrol (20% of revenue), has reached maturity and has begun to decline as well.

Collectively these two products drove +100% of the Company’s organic growth since 2016. This is

creating a major hole in its near-term P&L.

 

Sell-side is asleep at the switch, overlooking not only the magnitude of the impact on 2019 topline but

more significantly the impact on margins. The Street is taking management’s guidance of a large 2H

recovery at face value. This scenario is disconnected from reality and a setup for significant earnings

shortfalls. Looking out to 2020, it appears likely that EBITDA could be down over 50% from 2018. Over

the next few quarters the stock should trade commensurately, 40-60% below current. TOY is presently

GC.

 

SUMMARY OF CATALYSTS

We have been following this situation since 2017 and believe now presents a timely short based on the

following signals:

 

- YTD performance looks increasingly bleak for Hatchimals. Trends data indicates a 65% Y/Y interest

decline during Easter (#2 selling period) and only one of its SKUs appeared in the AMZN top 100 toy list

during the period (vs 4 as recently as December), the price of which was cut by 40% in the preceding

two months.

- Hatchimals is now being relegated to the “seasonal” category at retail (ie. Easter and Christmas) and no

longer on shelves outside those two holidays.

- Management has somehow convinced people that Hatchimals are a lower margin product than the

overall business and thus its decline will have a more muted impact on the bottom-line. Yet it is evident

that selling a small plush toy with limited marketing support for +$10 per unit yields a high margin. Q1

performance only confirmed this fact. The implication being that earning expectations are way off-base

and it is highly unlikely a new product will catch on to offset this gap in the near-term.

- Follow-on offering: Founders still own a majority of the shares and have sold in offerings each year since

the IPO. The Company just filed a $750M mixed shelf on May 29. Being a continued source of

underwriting fees may explain the sell-side’s blind support of the story.

 

SETUP & COMPANY BACKGROUND

For the first 15 years of its existence, Spin Master was a small, slow growth, also-ran in the toy category.

As the table below illustrates, it had a couple short-lived successes during the 2008 to 2011 period

(Bakugan and to a lesser extent Zoobies), stagnated again until the explosion of Hatchimals and PAW

Patrol doubled the size of the business.

 

 

 

 

 

Since 2015 the Company has done seven acquisitions. These have all been relatively small, mature toy

brands. The largest of which were Cardinal (boardgames and puzzles), SwimWays (a pool toy company),

GUND (puppets) and Etch-A-Sketch. These acquisitions have had limited discernable strategic rationale

or associated costs savings. They were most likely just a means to create the perception that the

Company has a more diversified product portfolio.

 

HATCHIMALS

Hatchimals consists of a plush toy bird encapsulated in an egg. The product launched in October 2016

and became a viral sensation during that holiday period with constrained availability leading to high

prices in the after-market. The viral nature of Hatchimals’ rise required relatively limited marketing

support and thus has been a high return product for TOY. It then went on to become one of the top

selling toys in 2017 as well. Several derivatives of the core concept have been developed but all have

been short-lived gimmicks with only marginal success. Sales of the products peaked in 2017 and then

began to plateau and decline in 2018. The product does not have any associated games, collectable or

digital components to sustain interest.

 

During the 2018 Black Friday selling period, Hatchimals NPD data showed a decline of 35%. In 2H’18

TOY’s Remote & Interactive category was down 25%, primarily due to Hatchimals. Easter is the second

largest selling period after the December holidays for this product. Easter was in Q2 this year so limited

color was provided with Q1 earnings and NPD data for the period has not been released yet but the

picture look increasingly bleak for Hatchimals: 1) Google Trends data indicates interest was down 65%

year-over-year; 2) only one of its SKUs appeared in the AMZN top 100 this Easter (vs 4 as recently as

December); and 3) product prices have been cut by 40% in the preceding two months.

 

 

 

The largest contributor to this decline has been the growing popularity of a similar product called LOL

Surprise, produced by MGA Entertainment (private). This platform of products is sold at a lower price

point than Hatchimals and due to its “ecosystem” qualities (interactive games and collectible figures),

fosters a much higher level of engagement, repeat purchase and in turn an extended lifecycle. Contrast

this profile to the user experience of Hatchimals which is limited to the single “reveal” when the egg is

initially opened. LOL presently has 10 SKUs in the Amazon top 100 vs Hatchimals with 0. Remarkably

some analysts are still characterizing Hatchimals as an “evergreen product,” the growth of which will

stabilize.

 

PAW PATROL

PAW Patrol is a cartoon show that accounts for 20-25% of TOY’s current revenue. The series premiered

on Nickelodeon in the US in August 2013 and proceed to be a huge success for the Company—growing

gross revenue from approximately $50M in 2013 to over $400M last year. It has now been around for six

years, a long time for a pre-school product and has entered a state of decline. On the Q3’18 earnings call

management said PAW Patrol was “doing incredibly well” with recent weakness being a one-time blip

related to TRU. Then in Q4 it experienced a 5% declined followed by a 20% decline in Q1.

 

PRODUCT DEVELOPMENT & GROWTH DRIVERS

In the near-term, longs are extrapolating historical growth rates and assuming another major hit will

reaccelerate growth in 2H’19. This is predicated on a very successful re-launch of a toy called Bakugan, a

concept that was popular, primarily in Japan, 10 years ago. Analysts have characterized this effort as a

“free option” and “wild card in the back pocket.” Restarting a dormant brand is anything but free. In

addition to ad spend, TOY is producing digital content and hosting tournaments and launch events to

promote the product. The revival of this concept itself strikes us as a sign management has run out of

new ideas. Unlike during Bakugan’s prior period of success, it is now competing against interactive

digital alternatives, an environment much more challenging for conventional TV concepts. The following

facts signal that Bakugan is challenged and that it will fail to offset the revenue decline of the Company’s

two largest products:

 

- It was only just re-launched in US and AUS in early Q1 with a digital launch this summer making it highly

unlikely to contribute to 2H revenue to the degree estimates assume.

- On the Q1 earnings call management noted that they are “taking a long-term view” as it relates to

Bakugan. This seems like code for lots of investment and limited near-term revenue contribution.

- Despite a large marketing blitz, Bakugan does not appear to have gained much traction at all. The data in

the chart below shows the Google Trends interest spiked at launch and then has stagnated since.

 

 

 

- It is also worth noting that the half-life of most toy products is short, typically 3-4 years. Bakugan itself

gained popularity in 2008 and declined to almost zero within just four years.

 

Longs are very complacent about the Company’s prospects beyond this year and are banking on its

ability to produce a new set of winners to replace the decliners and support the current valuation.

Following the success of Hatchimals and PAW Patrol, TOY has cultivated a perception of being an

innovative developer of kid’s products. To describe Spin Master, sell-side uses terms like “the Apple of

the toy industry” and have referred to its CEO as the “Steve Jobs of toys.” In reality, the Company has

shown limited innovation ability. The list of failed concepts that launched with high expectations is long

with the toilet toy called “Flushies” being one of the more colorful recent ones.

 

Some further indicators TOY was lucky with Hatchimals and will struggle to replace it is the fact that

most new products are released late in the year and featured at the annual trade show in Q1 for buyers

well in advance of holiday stocking. This is then supported by a large marketing push. Meanwhile,

Hatchimals was released off-cycle in October with very limited marketing spend but became the hottest

product that holiday season with widespread supply shortages—indicating that even the Company was

not anticipating its success and were more lucky than skilled. We found this perspective regarding the

product development process from a former brand executive at Spin Master to be informative, “there

are some technical and analytical elements but ultimately it comes down to throwing ideas at a wall and

seeing what sticks.” Our primary research with retailers has informed us that LOL and other established

products are taking increasing space in stores as buyers do not want to take the risk of a newer,

unproven concept.

 

VALUATION

The conventional toy category as a whole is facing secular pressure from the shift in consumption to

digital content (primarily tablet). Developers of apps and games have become very skilled at fostering

engagement/ addicting kids to their products. The liquidation of Toys “R” Us (TRU) has also had a large

and likely longer-term impact on the industry. Over the course of 1H’18 TRU closed all its US stores.

Over the last year, TOY and others have been using TRU as cover and characterize it as a one-time event

rather than a structural change in the channel. Regardless, the TRU closures will be lapped in Q2 so that

excuse for ongoing weakness is now less valid.

 

The toy industry is forecasting flat domestic growth this year while consensus is calling for TOY to grow

revenue 7% this year and 5% in 2020 with flat EBITDA margins. For the reasons we have discussed, will

become painfully evident that the Company is not going to reach these targets but is in fact declining. In

the 2007-2010 period, two fad products doubled the size of the business and then fell off. Now PAW

Patrol and Hatchimals are following a similar, if not more rapid, course of decline as those products did

then. The below table builds on the earlier historical one and illustrates what we believe to be the

course Spin Master is now on. The source for the historical Bakugan data comes from a table that

appeared in the Company’s investor deck prior to the Hatchimal craze and curiously stopped being

presented shortly thereafter.

 

 

 

 

Some of TOY’s deceleration has started to get priced into its stock but much of that is likely due to the

TRU aftermath and selloff in the space as a whole. Meanwhile management has led the market to

believe that Hatchimals are actually lower margin relative to the business overall and thus consensus is

assuming flat margins this year and next. The Q1 print clearly showed that was not the case, making it

nearly impossible for them to make FY EBITDA guidance. Its ability to make EBITDA estimates are further

challenged by the fact that 400bps of fixed overhead ($5.4M per quarter) was added in Q1 from the

opening of 3 new DCs. Q1’19 margins were the lowest since its IPO and this fixed cost deleveraging will

only compound the impact from the revenue decline and lead to significant earnings misses.

 

TOY is currently trading at 18x LTM EBITDA, 12x adjusted (full credit for all add-backs including forex).

On an absolute basis this is a rich multiple for a short product lifecycle business with its largest revenue

generator facing obsolesce. Peers Hasbro (HAS) and Mattel (MAT) trade at 13-15x EBITDA. The sell-side

is enamored of Spin Master and contend that it deserves a comparable or even premium multiple. We

contend that Spin Master deserves a much lower relative multiple given the short duration of its

products relative to its peers. Portfolio turnover at TOY is high with few, if any, products still in existence

from as recently as five years ago. Contrast this with Mattel which derives 80% of revenue from just five

platforms that have been around for decades. While Barbie and other legacy brands are facing secular

headwinds, these are true “evergreen” platforms that have been around for decades with slow annual

declines relative to Hatchimals which is facing near-term extinction. The most appropriate comparable

to Spin Master in terms of business profile is Funko (FNKO) which trades at 7x EBITDA. Near-term

earnings misses are setting up to expose this fact and result in TOY trading to below 8x EBITDA. This

represents a 40-50% return on the short.

 

RISKS

- Bakugan catches on and TOY pulls a rabbit out of a hat with a new hit product.

Spin Master has a relatively clean balance sheet so is less constrained in its ability to acquire growth

through M&A or aggressively bid for future royalty deals.

- Last year Spin Master won a royalty deal to produce the boys action toys associated with DC Comics’

theatrical lineup. This was a competitive bid process with limited details provided regarding its terms.

The program starts in January 2020 and was won away from incumbent Mattel.

 

ACCOUNTING RED FLAGS & OTHER CONSIDERATIONS

- A/R outstripped revenue growth by 26% in Q4, suggesting aggressive recognition/ pulling forward of

sales. Spin Master’s use of a Hong Kong FOB could be considered questionable. That entity takes

possession of inventory and enables the Company to perhaps recognize revenue counter to convention.

- While not named in the first round of tariffs, there is speculation that toys may be added if another

round of actions is taken. The majority of Spin Master’s goods are produced in China so such a scenario

would be problematic for these discretionary items.

 

Catalyst

- YTD performance looks increasingly bleak for Hatchimals. Trends data indicates a 65% Y/Y interest decline during Easter (#2 selling period) and only one of its SKUs appeared in the AMZN top 100 toy list during the period (vs 4 as recently as December), the price of which was cut by 40% in the preceding two months.

- Hatchimals is now being relegated to the “seasonal” category at retail (ie. Easter and Christmas) and no longer on shelves outside those two holidays.

- Management has somehow convinced people that Hatchimals are a lower margin product than the overall business and thus its decline will have a more muted impact on the bottom-line. Yet it is evident that selling a small plush toy with limited marketing support for +$10 per unit yields a high margin. Q1 performance only confirmed this fact. The implication being that earning expectations are way off-base and it is highly unlikely a new product will catch on to offset this gap in the near-term.     

- Follow-on offering: Founders still own a majority of the shares and have sold in offerings each year since the IPO. The Company just filed a $750M mixed shelf on May 29. Being a continued source of underwriting fees may explain the sell-side’s blind support of the story.