Mattel: Beware of Toymakers Bearing Gifts

Charles is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Christmas is to Christianity as revenue and profits are to retailers worldwide. Retailing's most important holiday is just a few days away, which means there are only a few days remaining to capture pre-Christmas sales at the registers before post-holiday markdowns go into effect.

Mattel (NASDAQ: MAT) is the world's largest manufacturer of toys and is highly dependent on retailers in its major markets -- the U.S., Europe, and Latin America (e.g., Brazil) for its sales.  The toy maker will report revenue and earnings on Jan. 28 for its quarter ending Dec. 31.  Analysts' consensus estimate is for $1.15 per share earnings on $2.30 billion in revenue.  If Mattel meets estimates, this will represent a 7.48% earnings increase, and a 6.97% revenue increase, from last year.

First, let's look at Mattel's revenue history:

<table> <tbody> <tr> <td> <p>Ratios:</p> </td> <td> <p>9/30/2012</p> </td> <td> <p>6/30/2012</p> </td> <td> <p>3/31/2012</p> </td> <td> <p>12/31/2011</p> </td> <td> <p>9/30/2011</p> </td> <td> <p>6/30/2011</p> </td> <td> <p>3/31/2011</p> </td> <td> <p>12/31/2010</p> </td> </tr> <tr> <td> <p>Revenue</p> </td> <td> <p>$2,077.82</p> </td> <td> <p>$1,158.71</p> </td> <td> <p>$928.45</p> </td> <td> <p>$2,153.75</p> </td> <td> <p>$1,998.76</p> </td> <td> <p>$1,161.67</p> </td> <td> <p>$951.86</p> </td> <td> <p>$2,124.55</p> </td> </tr> <tr> <td> <p>% Chng YoY</p> </td> <td> <p>4%</p> </td> <td> <p>0%</p> </td> <td> <p>-2%</p> </td> <td> <p>1%</p> </td> <td> <p>9%</p> </td> <td> <p>14%</p> </td> <td> <p>8%</p> </td> <td> <p> </p> </td> </tr> </tbody> </table>

Source: Capital IQ

The first thing that should be apparent is that Mattel's revenues are seasonal, with the peaks in the fourth quarter, and the valleys in the first quarter each year.  The next thing to understand is that year over year revenue growth has slowed down, with the average of the last four quarters producing only 1% growth.  Both of these factors give rise for concern because the company relies too heavily on Christmas sales for its revenue, and because despite price increases, revenue is not growing as expected.

<img height="446" src="/media/images/user_13083/mat2_large.JPG" width="569" />

Source: YCharts

The first chart is meant to help gain an understanding of the relationship between inventory metrics and earnings per share.  Days Sales in Inventory (DSI) measures how long it takes Mattel to turn inventory into sales to retailers, who in turn sell to consumers. The chart shows DSI with higher lows and higher highs, albeit with the seasonality previously discussed.  Secondly, inventory levels are also rising year over year, adjusted for seasonality.  Inventory is the largest component of the cost of goods sold. Despite these upward trends, Mattel's inventory value last four quarters was actually less than the previous year.  Intuitively, we can understand that earnings will be lower when the inventory drag on revenue is higher, and the chart bears this out.  The peaks and valleys of EPS are the opposite of the inventory metrics.


<img height="370" src="/media/images/user_13083/mat1_large.JPG" width="568" />

Source: YCharts

The second chart depicts the relationship between earnings and accounts receivable metrics.  Days Sales Outstanding (DSO) shows the time needed to collect receivables, and is also a measure of credit terms extended to customers.  Higher DSO means more relaxed terms, and higher receivables balances generally mean customers are given more time to pay.  Sometimes a company will offer better sales terms in order to get customers to purchase in the current quarter -- referred to as "stuffing the channel."  This allows revenue to be recognized sooner.  This is why the earnings line tracks with the receivables line. Revenue is recognized which should increase earnings, but money hasn't been collected yet.


<img height="408" src="/media/images/user_13083/mat3_large.JPG" width="569" />

Source: YCharts

The third chart shows cash from operations, free cash flow (CFO minus capital expenditures), shares outstanding, and long-term debt.  It makes sense that operating cash and free cash flow track with one another.  And we see that cash levels are highest as a result of the peak selling season, as are earnings.  Note, however, that cash levels are not increasing even though earnings are on an uptrend.  This means earnings are not translating into greater cash flow.  The other concern is that cash is negative approximately two of four quarters each year.  Despite this, Mattel has been reducing its float (i.e., outstanding shares) while it has taken on more debt.  It takes cash -- either generated from the business or borrowed -- to buy back shares, and in this case it should be clear that Mattel is using debt for this purpose.  

One of my previous blogs, "How to Boost EPS 101," argues that it is better to return earnings to shareholders in the form of dividends rather than to boost earnings through float reduction because the former method benefits shareholders whereas the latter method often benefits management more than shareholders.  Either method should drive up the stock price, but unfortunately the market often prefers share buybacks. Okay, so Mattel pays a 3.3% dividend. My point is that a higher dividend would also attract buyers and the stock price would go up as a result.

Mattel competes with other companies such as Hasbro (NASDAQ: HAS) and JAKKS Pacific (NASDAQ: JAKK), and it is perhaps unfair to end the discussion without a quick comparison.  Hasbro's stock price has appreciated 12.57% in 2012 so far, and trades at a PE multiple of 13.8.  It also pays a decent 3.9% dividend.  Despite the expected seasonality, revenue has declined year over year by an average of 5% during the past 3 quarters. Net income has declined by an average 36% for the past 4 quarters from the previous year, and earnings have been down an average of 47% for the last 3 quarters from last year.  Like Mattel, Hasbro's operating and free cash flow are consistently negative 2 out of 4 quarters every year.  Lastly, Hasbro is leveraged with debt at 52% of total capital.

JAKKS exhibits the same seasonal trends as its competition but is no better off from a fundamental financial standpoint.  Revenue and margins are declining year over year; the EBITDA margin has declined by 8% over the past 8 quarters and earnings are way off last year's pace.  Metrics affecting working capital and cash flow are weak. Inventory levels are 31% higher than last year same quarter; inventory as a percentage of revenue is up 39%;  and the ratio of finished goods to raw materials has doubled from last year to a whopping 2,150%. JAKKS' stock price has declined from $13.85 to $12.93 this year so far.

Take Away

As a present to investors, Mattel's shares have risen 35.95% this year, from $27.76 to $37.74, and the PE ratio trailing 12 months is now at 15.5. Year over year earnings last four quarters have averaged only 3% growth, however.  With analysts projecting revenue and earnings increases only half this percentage increase, it may be timely to take some profits -- unless you like lemons and coal in your Christmas stocking.

CACody has no positions in the stocks mentioned above. The Motley Fool owns shares of Hasbro and Mattel. Motley Fool newsletter services recommend Hasbro and Mattel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus