At first glance, toy maker Mattel's (NASDAQ:MAT) first quarter earnings report looks pretty dire. Sales in North America fell 2%, with global sales slumping 7%, and the company posted a small loss on lower gross margins and higher spending. Weakness in core brands like Barbie and Fisher Price outweighed strength in other areas, such as toys based on Walt Disney (NYSE: DIS) properties like Frozen, and international markets performed particularly poorly. But revenue alone doesn't tell the whole story, and there are signs that Mattel's troubles aren't nearly as bad as they seem.
Mattel records revenue when it sells its products to retailers, but if retailers can't move that product at a fast enough rate, inventory begins to build up. Mattel pointed to these inventory problems as the main driver of weak revenue, with retailers working to sell the inventory that they already have instead of buying more from Mattel.
The toy industry was stable in the U.S. through February, flat compared to last year, and in Europe the industry grew by 5%, according to NPD.This throws cold water on the idea that electronics like tablets are eating into traditional toy sales, and it suggests that Mattel is simply working through both inventory problems and weakness in some of its brands, not facing a more serious decline in the overall demand for toys.
Easter being much later in 2014 compared to last year also complicates things, and a clear picture of where inventory levels stand after the holiday won't be available until the second quarter earnings report. From the company's conference call, it's clear that progress is being made on these inventory issues, although "pockets of inventory" still exist in certain markets. Latin America is a problem area, with revenue declining by 21% in the first quarter, but actual sales at retail in the region suggests that excess inventory is the main culprit.
So while there was certainly weakness in certain brands, the revenue declines during the quarter are not necessarily proportional to the actual demand for Mattel's products.
Disney partnership and a Mega acquisition
Mattel has long been partners with Disney, and the success of Frozen in 2013 has been a boon for both companies. Frozen brought in more than $1 billion at the global box office for Disney, and Mattel's line of Disney Princess dolls have been performing well.
Mattel is also partnering with Disney to launch toys based on its Marvel and Star Wars properties, which Disney acquired in 2009 and 2013 respectively. Competitor Hasbro (NASDAQ:HAS) currently has a license with Marvel to make toys and games based on characters in the Marvel universe until 2017, but Mattel will be introducing Marvel-themed Hot Wheels cars this year. The company has a die-cast license for both Marvel and Star Wars, and with Hot Wheels being one of Mattel's line of toys that grew in the first quarter, this could be the first step toward Disney eventually choosing Mattel over Hasbro for the rest of its Marvel-themed toys.
Another development during the quarter that bodes well for Mattel is the company's acquisition of MEGA Brands (NASDAQOTH:MBLKF), a small Canadian toy company that specialized in construction toys. Construction is one of the fastest growing areas of the toy market, and combining MEGA with Mattel's massive scale should help both grow the MEGA brand as well as increase profitability. MEGA makes Mega Bloks, a direct competitor to LEGO, and Mattel is hoping that the construction category can help drive growth going forward.
Mattel paid $460 million for MEGA, which recorded $405 million in revenue and $21 in net income in 2013. This acquisition gives Mattel a serious competitor to LEGO, and it puts Mattel into a market with significant growth prospects.
The bottom line
Mattel is facing some weakness in certain brands like Barbie and Fisher Price, but inventory problems were the main factor behind Mattel's revenue declines during the quarter, especially in emerging markets like Latin America. Earnings may be flat or even decline in 2014 due to these problems, but investors shouldn't be too worried about Mattel's long-term prospects. The company's strong partnership with Disney, along with the MEGA Brands acquisition, should drive growth and make up for weakness in other categories.
Mattel's earnings were nowhere near as bad as they seem, and for long-term investors willing to look past the company's short-term issues, Mattel's P/E ratio of 14.5 and dividend yield in excess of 4% looks fairly attractive.
Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Hasbro, Mattel, and Walt Disney. The Motley Fool owns shares of Hasbro, Mattel, and Walt Disney. 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.