1. Mattel is skewed toward big old brands.
· Fisher Price (79 years old)
· Matchbox (57 years old)
· Barbie (50 years old)
· Little People (50 years old)
· Hot Wheels (41 years old)
· And American Girl (22 years old)
2. Mattel sells toys in developed and developing countries.
a. Mattel’s Sales By Region (2006-2008)
United States: 52.64%
Latin America: 13.68%
Asia Pacific: 4.16%
3. Mattel’s American operations are built around 3 businesses.
a. Mattel’s U.S. Sales By Business (2006-2008)
Fisher Price: 43.46%
Mattel Brands: 43.36%
And American Girl: 13.18%
4. Mattel’s margins inside and outside the U.S. are almost identical.
Mattel’s Operating Margin By Country (2006-2008)
United States: 15.03%
· Mattel’s highest margin business - American Girl - is not part of the International business.
· That means sales of Fisher Price and Mattel brands in the U.S. and overseas have operating margins within 1 percent of each other.
· In other words: Mattel’s foreign sales are as profitable as its domestic sales.
Why is Mattel a Great Business?
1. Mattel has good margins wherever it sells toys.
· That means pricing power - not just scale - is driving Mattel’s profits.
· It also means Mattel’s toy brands translate well into other countries.
· In my Kraft article I said food brands do not translate well from country to country. You see that in Kraft’s margins. Mattel’s margins tell you its toys do translate well in other countries.
2. Mattel earns great returns on tangible equity.
· Most established toy companies earn higher returns on tangible assets and equity than businesses in other industries.
· The value in a toy company is the goodwill of its brands not its physical equipment.
· From 1991-2008 Mattel’s return on tangible assets averaged 10.14%.
· Its cash return on tangible assets was higher: 12.59%.
· With moderate leverage Mattel can earn 20% to 30% on tangible equity.
· Mattel averaged a 30% return on tangible equity from 1991-2008.
· Cash returns were higher.
3. Mattel generates a lot of free cash flow.
· The company gets 8 cents in free cash flow from every dollar of toys it sells.
· Mattel’s capital spending needs are low.
· Maintenance cap-ex is less than 5% of sales.
· Investment is discretionary.
· Advertising is the most important investment in the business.
4. Mattel owns some of the world’s best toy brands.
5. The company’s size makes it a favorite to win large licensed properties like Disney’s.
6. And Mattel’s own brands make the company less dependent on licenses than its competition.
Why Mattel is Not a Great Business
1. Mattel’s toy prices have not gone up fast enough.
· The company’s 2008 gross margin (45.36%) was below its long-term average (48.42%).
· Material costs have gone up faster than toy prices over the last 5 years.
· Mattel’s CEO set a goal for 50% gross margins. It has been 10 years since the company had margins that good.
2. Mattel is spending more on non-advertising expenses than ever before.
· In 2008 Mattel spent $1.98 on non-advertising operating expenses for every dollar it spent on advertising.
· In the early 1990s Mattel spent $1.25 on non-advertising operating expenses for every dollar it spent on advertising.
· Mattel’s advertising has gone from 15% of sales to 12% of sales.
Reasons Not to Buy Mattel Stock
1. Mattel is barely growing.
· Sales have inched along at 1% a year for the last 10 years.
· Other toy companies - like Jakks and RC2 - are growing faster than Mattel.
2. Mattel is strongest in slow growing countries and weakest in fast growing countries.
Mattel’s Sales By Region (2006-2008)
United States: 52.64%
Latin America: 13.68%
Asia Pacific: 4.16%
3. Mattel is not spending enough on advertising.
· Most of Mattel’s toys (83%) are meant for kids under 10 years old.
· Since 1999 Mattel has cut advertising from 17% of sales down to 11%.
· On $6 billion in sales that means a difference of $350 million in advertising each year.
· Most of Mattel’s potential customers were born after the advertising cuts.
· Today’s kids were born in a world where fewer ads supported each toy Mattel sells.
· Mattel’s non-advertising expenses now make up 2/3 of the company’s operating expenses. Those costs do not gain mindshare with kids the way ads do.
· The biggest long-term danger for Mattel is failing to support and defend its best brands.
· The biggest long-term opportunity for Mattel is widening the moat around its best brands. Advertising does that better than anything else.
Why Am I Worried About Mattel’s Lack of Advertising?
I share David Ogilvy’s belief that brand dependent businesses like Mattel should treat advertising as part of the cost of making their product. Supporting a brand with less advertising is as harmful to its image as using cheap parts.
Sometimes cost cuts are needed. Sometimes there are ways to get the same bang for fewer bucks. That is true for ads as well as materials. But in most cases you are selling off part of tomorrow’s franchise to pay for today.
Higher non-advertising expenses have offset Mattel’s lower advertising as a percent of sales. The company is moving in the wrong direction for a branded business. Normally you want to squeeze other operating costs to free up cash to build your brand.
Mattel’s lower advertising helped hide its gross margin problems. The company’s gross profit - sales less cost of goods sold - has been falling as a percent of sales for years. Material costs are a big part of the problem.
Mattel has avoided taking the full hit from these declining gross margins by cutting advertising as a percent of sales. Because of this Mattel has had more money left over for general operating expenses.
A lot of these savings have not gone to the bottom line. Some has. But too much has gone to general operating expenses as you can see here:
What is Mattel Worth?
Mattel has a good balance sheet. Investors should value the company based on its sales and free cash flow.
Mattel’s Free Cash Flow
3-year Average: $1.29/share
10-year Average: $1.31/share
17-year Average: $0.99
I adjusted those averages to reflect Mattel’s current - lower - share count. The graph below is adjusted as well:
Mattel’s normal free cash flow is around $1.30/share. AAA corporate bonds yield 5.30%. That means Mattel should be worth about 18.87 times its free cash flow (1/0.053 = 18.87).
Mattel’s normal free cash flow of $1.30/share suggests the stock is worth $24.52.
Mattel’s long-term average free cash flow margin is around 8%. With $6 billion in sales that means about $1.33/share in free cash flow.
In other words: $1.30/share in normal cash earnings seems about right. So does an intrinsic value of $24.50 a share on the stock.
Should You Buy Mattel Stock?
With Mattel at$20 a share there is not much room for error. The business’s intrinsic value is only $24.50 a share. That means a 25% drop in the business’s value would erase all profit potential in the stock and leave investors with a chance of losing money.
Mattel’s growth prospects are not great. There is not a lot of reward to offset the risk in buying a stock this close to its intrinsic value.
Until Mattel turns its business around by taking control of general operating expenses and increasing advertising I don’t think investors should buy Mattel stock.
At $20 a share Mattel looks like it can outperform the S&P 500. But there are risks. And the chance for terrific returns are slim.
Mattel pays a dividend. The stock has a dividend yield of 3.74% at $20 a share. And the balance sheet is clean.
But there is no evidence of lasting improvement in the business. It is a bad idea to buy a stock with modest future growth potential at a price more than 75% of intrinsic value.
At $15 a share I would feel differently.
But at $20 a share?
You should not buy Mattel unless you are totally confident in the business. Mattel’s history of increasing costs and decreasing advertising from 2000 through 2008 makes me uncomfortable.
Mattel is a great business. It might be a good stock. But it is not a great stock.
Investors should pass on Mattel until the stock price drops or the management mends its wasteful ways and reinvests in the brands that made Mattel great.