Why Wall Street is What's Wrong with Hasbro

At first glance, you'd probably assume Hasbro (NASDAQ: HAS  ) is doing poorly. After all, shares of the toy maker slumped 3% after reporting second-quarter earnings. The financial media didn't have many good things to say about Hasbro's performance, saying that the company missed estimates on revenue and posted declining profits.

But underneath the surface, a different image emerges. Hasbro didn't perform nearly as badly as its share price performance suggests. It did much better this quarter than rival Mattel's (NASDAQ: MAT  ) .

And yet, Hasbro's share price sank anyway. The reason might be that once again, unreasonable analyst expectations, and a misguided desire on the part of management to keep up with these expectations, are to blame.

Fortunately, its problems can be easily solved by tinkering with its capital allocation priorities.

Hasbro's second quarter, by the numbers
Overall, Hasbro's revenue grew 8% in the second quarter. This was an acceleration from last quarter's measly 2% sales growth, and far better than Mattel's 9% second-quarter sales decline.

Hasbro's net earnings dipped 7%, but that was mostly due to an unfavorable tax charge that shaved $0.10 off profits. Excluding this adjustment as well as a $2.5 million pension settlement charge that weighed down the comparison period, Hasbro's core operating profits increased 24%.

The biggest contributor from a product standpoint was Hasbro's boys category, thanks to robust performance of Transformers and Marvel products. In all, the boys segment posted 32% revenue growth, which more than made up for the 12% drop in sales of games, which is Hasbro's second-biggest category.

Among its major geographies, Hasbro is hurting in the United States and Canada. Sales fell in these markets by 2%. Fortunately, Hasbro is hitting it out of the park in the emerging markets. The company realized double-digit growth in Europe, Latin America and Asia, which resulted in 17% revenue growth in international markets.

And yet, Hasbro shares sold off after reporting results. Here's why.

Why Wall Street is to blame
What's happening to Hasbro is all-too-common in the stock market. As a company's share price gains momentum, as Hasbro's did after reporting first-quarter earnings, analysts try to one-up each other's estimates for future quarters, to try to convince investors that they didn't miss the company's improving performance.

The problem with this is the inevitable snow-ball effect. As analyst estimates go up, a company's stock price usually feeds off that and keeps grinding higher. Sooner or later, this builds unreasonable expectations on a company. That has the potential to bring a company back down, even if it reports earnings that are actually quite good.

In Hasbro's case, the stock was bid up to 21 times trailing earnings and 15 times forward earnings. This valuation level was perhaps too aggressive, since Hasbro produced flat revenue and less than 1% earnings growth last year.

Hasbro's flawed spending priorities
Hasbro is spending a lot of money on share repurchases. Unfortunately, its lofty valuation has blunted the impact of Hasbro's aggressive share repurchase program, which is where the company utilizes the bulk of its cash flow. Over the first half of the year, Hasbro repurchased 4 million shares of its own stock at an average price of $54.17 per share. This has cost the company $216 million, which looks like a foolish use of cash since the share price now sits at $51 per share.

Hasbro's balance sheet has deteriorated over the past year as it aggressively deploys cash. Its cash and cash equivalents fell from $1.02 billion one year ago to $586 million at the end of last quarter.

Meanwhile, the number of Hasbro's diluted shares outstanding has barely declined, despite all the cash spent on share repurchases. The company has only reduced its share count by less than 1% over the past year.

Instead of using such large amounts of cash on buying back stock to keep its valuation afloat, allocating that cash on its key strategic initiatives to restore growth, or holding onto more of the cash to improve the balance sheet, might be better alternatives.

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