It wasn't all fun and games for toymaker and Inside Value selection Mattel (NYSE:MAT) in its most recent quarter. Though the news wasn't all bad, there are a few things to be concerned about.
The good news is that sales were up a solid 10% -- 8% if you back out currency effects. The increase in sales was fairly broad-based as the Mattel brands, Fisher-Price brands, and the American Girl brands all participated. American Girl was a particular bright spot with sales up 20%, though that is on a relatively small base. However, the increase in American Girl is important, because the company's Barbie line continued to decline with sales off 4%.
The bad news is that gross margins took a 2% hit and SG&A expenses took a 0.2% hit. And with no improvement elsewhere on the income statement, operating margin was down by 2.2%. On the company's conference call, CEO Bob Eckert mentioned that the increased costs are being driven by increasing petroleum costs and a higher percentage of sales that the company has to pay royalties on.
Assuming higher fuel costs are here for a while, it will become increasingly important for the toymaker to pass on a portion of its higher costs to retailers such as Wal-Mart (NYSE:WMT) and Target (NYSE:TGT). That will be difficult, and from an investor's perspective it doesn't help that competitor Hasbro (NYSE:HAS) did not feel the same squeeze in its margins.
The final bit of "news" in the quarter really isn't as big as it might appear. Mattel did turn in a net loss, but it was due entirely to the company's decision to repatriate past profits from overseas operations. In the past, doing so would have been prohibitively expensive because of taxes. However, for 2005 companies have the opportunity to repatriate earnings at a lower rate under the American Jobs Creation Act. Back out this charge, and the company turned in a profitable quarter on a GAAP basis.
While there is reason to be concerned about Mattel, I think there is still a solid value thesis in place because the company generates plenty of free cash flow. More importantly, Mattel's balance sheet is far stronger now than it was three years ago, meaning the company can weather any temporary struggle with margins. The final piece of the puzzle is that the first half of the year represents only 30% of the company's shipments. It's the second half and more importantly Christmas that make or break the company's results on an annual basis.
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Nathan Parmelee has no financial interest in any of the companies mentioned. The Motley Fool has an ironclad disclosure policy.
