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How to Seek a Winner in the Toy Industry
Posted by: Patricio Kehoe (IP Logged)
Date: October 29, 2013 10:22AM

The toy industry is known for high returns on invested capital, increasing dividend payouts, and constant share buybacks. However, there are also low barriers to entry that make for fierce competition while companies push for a greater market share. Hasbro (HAS) and Mattel (MAT) are the two largest players in the $22 billion U.S. toy industry, and are constantly reinventing themselves to maintain a leading position. As customer preferences change, largely due to the predominant role technology has acquired, these two firms have adapted differently to the changing scenario.

An Industry Giant Struggling to Adapt to a New Audience

Mattel is the largest manufacturer in the toy industry, with a portfolio spreading from products for infants, to children and youth, including electronics, puzzles and educational toys. The firm owns several very well-known brands, such as Barbie, Hot Wheels, Fisher Price and American Girl. Despite the company’s market share and good reputation, the maturity of the U.S. market has motivated a focus on international growth projects, particularly in BRIC nations.

The toy manufacturer’s leading market-share position and scale, provides Mattel with a narrow economic moat. However, due to the high-ROIC and low barriers to entry for which the industry is known, fresh competition is bound to arise. Continuous reinvention, along with global expansion are seen as key factors when seeking to maintain the strategic advantage over rival manufacturers. The company has attempted to apply these elements to its business model, for example, by expanding its business in countries where per capita income is on the rise. However, secular headwinds are challenging the firm’s market dominance, leading to risks not all investors are willing to take.

The largest threat to Mattel is the rapid change its main customer base is experiencing. As children move away from traditional toys towards more sophisticated forms of entertainment at an increasingly younger age, the firm will need to present new products to stay on top of market preferences. The electronic gaming industry is particularly threatening in this sense. Also, since the company distributes around 40% of its consolidated sales through three large U.S. outlets – Toys 'R' Us, Wal-Mart and Target – issues regarding profit margins can arise. Negotiations with these retailers reduce the company’s pricing power, while making them dependent on the outlets’ own success.

John Hussman has surely recognized the inherent risks Mattel is facing, as he recently sold out his entire stake in the firm. The company’s 3.2% annual dividend yield and frequent share buybacks were simply not enough to keep the investment guru interested in this toy manufacturer. I also have a bearish stance regarding this stock, as Mattel’s future looks quite uncertain, due to the new challenges it is facing.

Leading the Way Towards New Forms of Entertainment

Hasbro is the second largest company in the toy industry, with a portfolio that includes everything from toys and games, to television programs and motion pictures. The firm operates highly recognizable brands such as Transformers, Monopoly and My Little Pony, and has a majority stake in Backflip Studios, a mobile game developer. Due to its exposure to the entertainment segment, Hasbro has achieved a differentiated business model, which other toy manufacturers envy.

Unlike Mattel, Hasbro recognized the importance of the digital entertainment sector early on, building significant business relationships with Backflip Studios and Activision. Through a joint venture with Discovery called The Hub, Hasbro Studios has brought productions to television. These initiatives have allowed the toy manufacturer to widen its audience and appeal to children, whose interest for traditional toys seems to be vanishing. Furthermore, Hasbro Studios’ productions for television and movie theaters, has allowed the firm to cultivate brand loyalty, while generating new streams of revenue. Productions such as Star Wars and Marvel are internationally known and appeal to a huge audience, composed by children and teenagers. The company’s operations in these segments give it a distinct advantage over rival toy manufacturers and are bound to produce further positive results.

In addition to Hasbro’s competitive advantage, stemming from its early entry into the entertainment business, the company implemented a savings initiative in 2013. The aim was to cut costs by $100 million annually, through the improvement of processes, and the trimming of workforce and facilities. The initiative seems to have paid off, as margins and cash flow levels are increasing much to the pleasing of shareholders. Joel Greenblatt recently increased his stake in the firm significantly, and I share his bullish sentiment in regards to the stock’s future. Risks stemming from the nature of the industry are mitigated by the incursion into the entertainment and gaming segments, differentiating Hasbro from Mattel decisively. Also, considering the stock is currently available at a slight price discount relative to the industry average, entry into the firm is not limited by high share prices.

Appealing to the Core Customer Base Is Critical

Mattel and Hasbro control around 30% of the fragmented U.S. market when combined. However, there are key differences between the two industry giants. While Mattel has struggled to adapt to the changing customer base, which increasingly prefers digital entertainment over traditional toys, Hasbro’s strategy has been exemplary. Hasbro’s ability to obtain lucrative entertainment contracts gives it a significant advantage over industry rivals, making it a savvy long-term investment.

Disclosure: Patricio Kehoe holds no position in any stocks mentioned

Guru Discussed: Joel Greenblatt: Current Portfolio, Stock Picks
Stocks Discussed: MAT, HAS,
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