Why You Shouldn't Panic Over Mattel's Earnings

Mattel's sluggish performance this year is due to inventory and cost issues that should ease with time.

Jul 17, 2014 at 3:36PM

Judging by its stock drop this year, you'd think Mattel (NASDAQ:MAT) had lost the toy wars. After all, its stock is down roughly 23% just since the start of the year. This includes a 6% drop when it reported second-quarter earnings that were worse than expected.

Contrast this to the relatively strong performance of close rival Hasbro (NASDAQ:HAS), which is down just 4% year to date. While that's not good performance by any means, it's measurably better than Mattel.

However, while Mattel's results are sluggish, it still has a lot to offer. It's a reasonably priced stock with a compelling dividend and a path to growth.

While it's easy to panic based on Mattel's weak earnings reports and poor stock performance this year, Foolish investors understand the merits of long-term thinking. Its growth strategy, based on a significant acquisition earlier this year, is impacting its financial performance in the near term, as is built-up inventory.

Assuming it keeps making progress, Mattel is set up for better results down the road.

First, the dirty details
Mattel's quarterly results landed with a thud, and rightly so. Worldwide net sales fell 9%, driven by its flagship Barbie brand, which posted a 15% revenue decline. Fisher-Price, another key category, suffered a 17% drop in sales.

Earnings per share clocked in at $0.08 per share, far below the $0.21 per share earned in the year-ago period.

Hasbro is treading water much better in this challenging environment. It actually posted revenue growth last quarter, thanks to double-digit growth in its entertainment and licensing business.

Mattel is looking a little bloated right now, which it's working its way through. Costs are elevated as a result of its Mega Brands acquisition. Inventories are also too high, as Mattel is dealing with the aftereffects of a poor holiday season. That left the company stocked with an inventory overhang.

But while challenges remain, Mattel is making progress.

Growth strategy intact
Earlier this year, Mattel acquired Mega Brands for $423 million, net of cash. Acquisition and integration costs shaved $0.06 per share off Mattel's earnings. While this is having an adverse effect on its cost structure right now, Mattel's strategy in buying Mega was spot on.

Mega is the second-largest maker of construction-based toys that compete directly with Lego. The construction line is a $4 billion market in the United States and Europe, and now Mattel has the No. 2 player on board.

The deal also provides Mattel an instant solution to a hole in its product categories. Rather than start up its own construction toy line, which would have been an extremely time-consuming and costly effort, it made a lot of sense to quickly snatch up Mega Brands.

But the acquisition is going to make Mattel's results look worse than many might expect in the near term. That's because Mega's products carry a lower margin that Mattel's existing business. The acquisition was responsible for nearly half of the 490-basis-point drop in gross margin.

Going forward, though, Mattel believes the ongoing headwind from Mega Brands to be only 100 basis points.

It's likely that Mattel should actually realize synergies as it fully integrates Mega. Mattel will be able to expand the brand rapidly with its distribution capabilities. Mega only operates in about half of Mattel's geographic markets. And Mattel's global manufacturing will provide scale opportunities as well.

As far as the inventory situation is concerned, Mattel is slowly working through it. Excluding Mega, the company's U.S. retail inventory fell by the mid-single digits. Moreover, Mattel-owned inventories dropped by $100 million in the first half of the year, as compared to the end of last year.

Don't panic
Mattel's results over the past year and its ensuing stock drop are discouraging to say the least. But for forward-looking Fools, there's a path to recovery. Mattel's challenges are factored into its valuation; the stock trades for just 14 times 2014 earnings, and pays a solid 4.2% dividend yield.

In addition, the problems weighing on Mattel right now, namely an inventory overhang and bloated costs, should ease with time. Plus, the Mega Brands acquisition will provide an opportunity for growth in new markets and in an attractive category that diversifies Mattel's product line.

That's why long-term buy-and-hold Fools should still feel comfortable owning Mattel.

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Bob Ciura owns shares of Apple. The Motley Fool recommends Apple, Hasbro, and Mattel. The Motley Fool owns shares of Apple and Hasbro. 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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