Mattel Undervalued Based On Normalized Free Cash Flow Valuation

Mattel Inc (MAT, Financial) is most famous for the Barbie brand. The U.S. company designs, manufactures, and markets a lot of other toy products as well, both direct to customers (see its website) and through 3rd party retailers. Products include fashion dolls, toy cars and even apps nowadays. My first instinct when I noticed how cheap Mattel really is was: “Oh no, Barbie.” I had to kick myself to get going and dive into the filings, as Mattel is not really my cup of tea. To the great detriment of the financial industry it is still dominated by males. Is there a possibility Mattel is getting overlooked because the financial community did not exactly grow up loving Barbie? I was surprised how cheap this is:

Chart: Mattel price action vs revenue per share.

Financial strength

Mattel’s debt-to-equity ratio is 0.79. The ratio has been more robust in the past but that is to be expected if the stock price takes a hit. The company still produces close to $1 billion in EBITDA and that should easily cover the $2 billion of long term debt. Especially considering it also has about $600 million of cash on its balance sheet. If you want to spent time looking at the weaknesses of Mattel, it is better spent evaluating its product portfolio and competitive position. If it can maintain these, Mattel is a cash cow.

Management

Christopher Sinclair took over from CEO Bryan Stockton in January 2015. Years where a company transitions from one management to another tend to be rocky and I believe this is the case with Mattel. New CEOs (in this case rightfully so) want to make changes and this can result in growing pains. Mattel just released a brand new strategic plan which is one of the reasons I’m writing it up right now but these also tend to create a bit of turmoil within an organization.

Most importantly, the company has a disciplined culture of creating long-term shareholder value. Mattel is paying out a sizeable dividend of close to 6%. Management has also been buying back stock quite aggressively reducing the shares outstanding by quite a bit. If Mattel manages to find its groove again and increase cash flow back to 2012 heights EPS is going to be record breaking.

Management owns a bit of stock but as is often the case with management teams taking over, it could be more. Management also benefits from significant compensation packages which helps but in the end there is nothing I like to see more as management owning loads of shares and greedily acquiring more on the open market.

Valuation & Investment thesis

Mattel is a company with a stable business model and it achieved high returns on equity throughout its history. Lately, it is struggling with its bottom line but there is ample time to try new strategies. With a new leadership installed, that is exactly what I expect to see. The CEO himself put it like this on the most recent earnings call:

I don’t want to waste time in moving forward with the necessary changes to revitalize the business.

Other comments on the earnings call that support my investment thesis we are going to see the right kind of change to the bottom line (emphasis mine):

Okay, shifting to toy leadership, here it means building on our heritage as an entrepreneurial toy maker with a greater emphasis on product invention, speed to market, rapid socialization, promotion and again to new partnerships. There is no reason why with our expertise and skill we shouldn’t be a leader in this space. And once again be the manufacturer of choice for licensors and inventors. And with our global supply chain, we will continue to build on our position as the industry cost leader in fashion dolls and die cast manufacturing. In addition we are making changes in how we manage global procurement and contract manufacturing. And we have recently hired an experienced executive from Amazon to lead our efforts here. Going forward we will aggressively reduce total system costs across our network while maintaining our focus on improving quality, safety, speed to market and customer satisfaction.

We remain committed to deliver on the high-end of our range of $250 million to $300 million in gross savings by the end of next year. So, in total, we are pushing hard across a number of important fronts.

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If you put management guidance in perspective of historical numbers it is certainly not unfeasible. My 2016 estimate is based on no growth and management succeeding in part and it looks quite good:

The above valuation leaves ample room for management to do better. If you are a little bit more generous with the FCF multiple that also helps to quickly turn Mattel into an excellent investment opportunity. I am not the only one who is enamoured with Mattel at its current price as John Rogers (Trades, Portfolio) of Ariel Appreciation and Thomas Gayner of Markel Asset Management have been buying Mattel. I would not put it past Buffett to try and buy the whole thing as it seems a natural fit with his portfolio. He has a widely published appreciation of strong consumer brand companies if for sale at a reasonable price. Mattel fits those criteria.

Risks

What I think is a key risk is the company’s reliance on a few major retail channels. Toys ‘R’ Us, Wal-Mart and Target represent over a third of sales. The company’s dependence on these brick-and-mortar behemoths could very well explain the company’s terrible website experience. Mattel’s website looks truly bad. It looks amateurish, boring and it is hard to buy something. Try clicking on the shop now button… You are asked if you want to be taken to another website with a pop-up like this is some sort of scammer site. What is so great about this terrible website (kids could not possibly be entertained by it by the way) is that it will take so little for it to do much, much better. Just a little bit of CapEx should make a world of difference on this front. It is possible the company is being held back on this front because of its retail partners. I do not think the current status-quo is working very well for the company so something got to change in this regard.

Outlook

Management is moving aggressively to change things. The team is also quite ambitious as evidenced by comments like this, made by management on the recent earnings call:

First, in an important commitment to our future, we are pleased to announce an exclusive partnership with Autodesk, the world leader in 3D design software. 3D printing is quickly moving from the exotic to the everyday, thanks to the growth of the Maker movement and consumer accessible print outlets. That’s why we are focusing strategically on the design and software side to drive future leadership and growth. We want Mattel to be at the forefront as the 3D printing becomes an important component of the toy industry. And through this partnership, Mattel’s 3D printing apps activated by Autodesk will soon deepen brand experiences for kids, parents and collectors alike by offering them the opportunity to customize their favorite toys.

The new team is tuned into the changes technological advancement (3D printing, online sales, mobile computing) are forcing upon the company. That should result in a more effective approach of these challenges. The company is also optimistic about sales growth in Russia and China which could unlock growth beyond my projections quite easily. Meanwhile, overhauling the website is one of those pieces of low-hanging fruit management can pluck to easily improve the top and bottom line. I fully expect that, with effort and proper execution Mattel can perform in line with its historical performance. If the management team is in fact able to return the company to a sustainable free cash flow number of around $1.8 the stock price can easily appreciate 20%. With the company yielding an impressive 5.9% dividend investors can afford to take a wait and see approach.