Does Mattel’s Purchase of MEGA Brands Contradict its Strategy?

Mattel crosses the border to enter the construction toy market. Was acquiring MEGA Brands always the plan, or is it Mattel's Plan B?

Mar 20, 2014 at 11:58AM

Mattel (NASDAQ:MAT) acquiring another toy business might sound about as exciting as clean-up time. But shelling out $460 million in cash for Canada's MEGA Brands is no mismatch. By acquiring MEGA, Mattel gains a foothold in what's proven thus far to be an elusive construction-play market for the toy giant.

At the heart of Mattel's acquisition is its entry into the toy construction segment dominated by No. 1 Lego, whose sales in 2013 jumped 10% to $4.6 billion, and No. 2 MEGA Brands, with annual sales eclipsing $400 million.  Mattel has primarily been watching from the sidelines, with not even a 1% share. And while tablets and game consoles may have changed the rules, kids still play with traditional toys. 

"Parents love the construction category," Jim Silver, CEO and editor in chief of TTPM, a consumer website featuring toy product reviews, videos, and price updates, told me. "It has a very high perceived value with parents because you can play over and over ... build different concepts and create story lines. And kids enjoy it. These toys stay in the house for many years." 

Silver touted the deal as inevitable in light of a partnership already in place between the toy brands. But in other ways the deal seemed to come out of left field and clashes with what Mattel had painted as a picture of content-driven growth.

The toy industry hit a rough patch in 2013 amid a series of headwinds ranging from harsh weather to the absence of blockbuster films from which to drive sales of toy-related merchandise. It's possible that the deal with MEGA Brands is Mattel's attempt to regroup, a Plan B if you will. That theory might not be that far fetched. As Goldman Sachs analysts recognized, the acquisition seems to contradict Mattel's other strategy. 

[T]his further entrenches [Mattel] into traditional toys, in contrast to its stated goal to become more character and content driven. -- Goldman Sachs report

Mattel execs on the conference call about the deal responded to such claims defensively:    

When we talk about creating content, I think I have always said we're not an entertainment company. We don't want to be an entertainment company. -- Bryan Stockton, Mattel CEO

Nevertheless, Mattel has some pretty close ties with the folks who do.

Licensing wars  
Mattel has license and distribution agreements with the likes of Walt Disney that grant the toy company access to characters like Mickey Mouse and the cast from from Cars. These partnerships prove especially lucrative during years of major studio releases; and as Silver pointed out to me, Planes: Fire & Rescue, a Cars spinoff, is set for release in July. 

Now the acquisition isn't too far removed from those partnerships, as it presents Mattel with the opportunity to incorporate the characters onto the MEGA Brands platform. And on the content side, perhaps Mattel can strengthen its partnership with Netflix, where the toy maker recently launched Team Hot Wheels programming.

That wouldn't be a bad idea, especially in light of the fact that Lego becomes more of a direct competitor to Mattel amid the MEGA Brands acquisition. Lego recently partnered with Twentieth Century Fox for licensing rights to the Simpsons brand; that deal includes forthcoming Lego/Simpsons television programming in May. 

Lego similarly has a licensing deal with Disney. But MEGA just inherited megascale with its new owner. If it came down to it, Disney may opt to side with Mattel and MEGA over Lego for the licensing rights to Cars

Mattel's own financial performance has been suffering of late, particularly in the U.S. North American gross sales fell 2% last year and overall net sales of $6.5 billion represented a meager 1% increase versus 2012.

By adding MEGA Brands, Mattel expects to bolster its top line. Of MEGA Brands' $400 million in annual revenue, nearly three-quarters is generated by construction toys. And with the addition of RoseArt, MEGA's arts and crafts brand, Mattel can celebrate Christmas twice per year. In addition to the obvious holiday season, the summer months will take on a whole new meaning.

"July is the slowest month for toy sales, mid-July to mid-August. That season is booming for back to school sales. This puts [Mattel] into competition for the back to school market and it can bring huge sales at [an otherwise] dormant time of year," Silver told me. 

So the acquisition of MEGA Brands tucks neatly into Mattel's portfolio. But not without some hurdles. 

Deal headwinds
MEGA will continue to operate independently out of its Montreal facility, a high-cost region in which to do business, as pointed out by Goldman analyst Michael Kelter. And the Canadian company has been suffering from below-average operating margins. In Mattel's quest to engineer higher margins at MEGA, it plans to heavily invest in marketing activities, which threatens to slow the results. For the deal to work and to be more efficient, perhaps Mattel should entertain the possibility of relocating MEGA's home base closer to its home in Southern California. 

Conclusion 
Whether it was kismet or a Plan B that brought Mattel and MEGA Brands together, the deal awaits shareholder approval. One thing is clear -- there's no turning back or Mattel will be hit with a hefty $12 million breakup fee.

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Gerelyn Terzo has no position in any stocks mentioned. The Motley Fool recommends Mattel. The Motley Fool owns shares of 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.

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