The Perils of Nostalgic Investing

I remember with fondness when I was 10 years old collecting and playing with Hasbro's (NASDAQ: HAS) Transformers.  I was obsessed with them.  I kept lists of the ones I had and I had checklists of the ones I wanted.  I anticipated every new lineup that came out.  I used to watch the cartoon and pretend that my toys were on the show and repeat the script verbatim. Eventually the Transformers lineup was reinvented for a new generation and I moved on to new interests such as comic books. When I learned the value of saving and investing, my obsessions turned to the stock market.

Over the years I kept casual track of this beloved saga as it was reincarnated into various forms such as Beast Wars, Transformers Energon and the more recent live action movies. I reasoned that a company that could reinvent this product over and over again and continue its popularity has to be pretty successful and would probably make a good investment. Right? Well, maybe.

Stock market investing involves research that is very scientific.  When one buys a share of a company they are becoming part owner. As a potential part owner of a company one has to go beyond emotional attachment toward a beloved product and ask some important questions such a: Is the company generating cash flow?  Does it have too much debt? I don't like debt in my life so I look for companies with minimal debt. Is the company growing? What are the risks and opportunities?  One could do their due diligence and find the company is not what it's cracked up to be.

With that in mind I decided to go to Hasbro's investor relations website and download the annual reports, 10-Ks and Proxies. I also downloaded their latest quarterly report where they discussed net loss versus a profit and had weaknesses in sales in the North American continent. I am a long-term investor so I decided that this could be a short term problem. I went on to the annual reports.

I read the Chairman's Letter for 2011 before researching the straight-up numbers. The letter highlighted some encouraging things about opportunities and addressed weaknesses. In regard to domestic demand weakness management stated they were putting in place new leadership and plans to improve performance as we go forward. They also bragged about growing diluted earnings per share for the 11^th consecutive year and recording record revenue. Two upcoming movies are planned for two of their brands: Battleship and G.I. Joe Retaliation which would mean increased interest in these products.

Reinvention and Leverage

The letter went on to discuss, to my delight, how the Transformers product line grossed more than $483 million dollars in 2011.  The word leverage caught my eye since it normally refers to debt. They talked about how they were going to leverage their brands into other mediums. The Transformers line was leveraged into an interesting new product line called Kre-O; a Lego style construction set. I also took note of Beyblades, which grossed over $477 million, a product line that involves playing games online and collectible toys that could be reinvented over and over much like Transformers. Reading all of this had me jazzed up.

Bubble Busted by the Numbers

When I started crunching the numbers my bubble burst. The letter said they had 11 consecutive years of diluted EPS growth; however, cash flow and net income was a different matter:

Source: Hasbro Annual Reports (-) Denotes down years. *Before Cumulative Effect of Accounting Change

Operating cash flow has been up and down since 2001.  Free cash flow was variable as well.  There was a net loss in 2002 and 2008 and 2011 were down years on net income.  This is one of the reasons I totally disregard earnings per share.  This is a topic for discussion for another day.

The Deal Breaker

I think the dealbreaker came when I calculated the debt to equity^ ratios on my spreadsheets. I want the long-term debt/equity ratio to be less than 50% in my investments. That ratio has increased steadily since 2004 from 27.59% to 124.93% in 2011 (see note below). The times interest earned (operating income/interest expense) shrunk from 15 in 2007 to 6.67 in 2011 according to my calculations. Interestingly, Mattel (NASDAQ: MAT) also has an increase in its debt to equity ratio over the past 3 years. It debt to equity ratio currently stands at 77% which is still too high.This leads me to wonder if low interest rates are enticing companies to take on debt. I minimize debt in my personal life so I like to invest in companies that do the same. I also like to invest in companies that don't have to maintain increasing interest payments.

The Decision

As much as I like Transformers I have to pass on Hasbro. Nostalgia alone can't justify an investment. I do believe that there will be keen interest in the company by people in the Market because of the new movies coming out and the ability for the company to reinvent its products continually. However, I am bound by personal charter not to invest in companies with high amounts of debt and increasing interest expense when I question long-term viability.

Note: Debt to Equity=(Long Term Debt+Other Liabilities+Deferred Liabilities/Stockholder's Equity)x100