Time To Put The Toys Away: Sell Hasbro As Earnings Fall

Must Read
|
|
 |  About: Hasbro, Inc. (HAS), Includes: MAT
by: Jeffrey To

Several weeks ago, Mattel (NASDAQ:MAT) reported disastrous earnings, missing both earnings and revenues by over 10%. The stock fell 16% in the days following the report. Similarly, Hasbro (NASDAQ:HAS) missed earnings and revenues on February 10, but HAS stock actually increased due to a raised dividend. This 3.3% dividend yield, however, would not protect HAS against a slowdown in its fundamentals in future years. Just look at MAT, which has a 4.1% (3.5% before the 16% drop in stock price) dividend yield.

While HAS stock has been, relatively, a winner, compared to MAT, the underlying problems in the toy industry remain. Since 2000, HAS has noted in each annual report that "children [are] getting older younger." Although HAS enjoyed years of growth since then, the market trend has accelerated in recent years: electronic toys are becoming more popular among children, and HAS has been unable to adapt, despite pointing out the industry weaknesses year-over-year.

Growth Strategy

As a manufacturer of action figures and board games, HAS has very few products that cater to the rising demands of electronic toys. However, there are several bright spots. Through partnerships with companies such as Electronic Arts and Gameloft, HAS is able to bring some games, such as Monopoly and My Little Pony, to Android and Apple platforms. This year, the releases of Transformers: Age of Extinction, Captain America: The Winter Soldier, The Amazing Spider-Man 2, and X-Men: Days of Future Past will also benefit HAS, which is licensed to manufacture and sell action figures relating to those movies. HAS' licenses also encompass Star Wars, which will see high action figure and toy sales in 2015 as Star Wars VII comes out. Moreover, over the past year, HAS nearly doubled its capital expenditures, up to $222,729 thousand from $112,091 thousand in 2012. Its aggressive strategy, plus future catalysts, may have also helped prevent HAS' large stock depreciation, despite the earnings miss.

Despite the potential for growth, HAS has historically been unable to deliver. Revenue, cash flows from operations (minus adjustments for accruals), and operating earnings have consistently been negative. Even in 2013, when the rate of decline of revenues and CFO slowed, the magnitude of the drop in operating earnings increased due to higher amortization costs.

Click to enlarge

By comparison, MAT has been increasing revenues and operating earnings, although given the competitive space and market trends, sales growth has slowed in recent years. Moreover, these marginal gains, despite MAT's large capital expenditures, may also shed a light on the effects of HAS' doubling of capex in 2013. MAT increased capex from $152,415 thousand in 2010 to $242,000 thousand in 2013 (58.8% increase) at a steady pace, yet the effects on free cash flow (minus accruals) have only experienced 8.8%. Although the added investments would be an improvement for HAS, it seems they are a little late to the game.

Click to enlarge

Along with the flat to negative revenues, negative CFO, and falling operating earnings, HAS' margins have been, comparative to MAT, strained. Gross margins, using cost of goods sold plus royalties to increase comparability between the two companies, are 50.7% and 53.7% for HAS and MAT, respectively. More importantly, in 2010, these margins were 51.6% and 50.5%, showing that HAS and MAT went opposite directions: HAS' margins decreased, while MAT was able to increase margins. If this competitive environment persists, margins may have further to fall.

International Sales

HAS has continued to increase its sales outside of Canada and the United States. Almost half (46%) of sales are made in international markets, up from 39% in 2010. Emerging markets, which makes up 14% of revenues, grew 25% last year. Two headwinds exist for HAS in emerging markets: competition from MAT; and foreign exchange. Firstly, similarly to HAS, nearly half of MAT's sales are in international markets, where HAS is experiencing the highest growth. This figure was 45.8% in 2010, and increased to 48.7% in 2012. Given MAT's larger size (nearly double that of HAS in terms of market cap), it can be implied that MAT's economies of scale will give MAT more resources to land strong footholds into new markets, thus putting HAS at a disadvantage. Moreover, MAT will also be able to invest more than HAS in markets where they currently operate. Secondly, the rising U.S. dollar will put strains on foreign-exchange-adjusted profits.

Valuation

Currently, HAS is trading at a premium in terms of price to earnings, price to operating earnings, and price to cash flows from operations (without accruals).

P/E

P/Operating earnings

P/CFO

P/Sales

HAS

24.50

15.01

13.62

1.72

MAT

14.24

11.02

11.93

1.99

Click to enlarge

Even though HAS has the potential for growth in 2014, this cannot explain the huge premium investors would need to pay over MAT. It seems the market overlooked HAS' poor fundamentals, in favour of the higher dividend yield after earnings. Conversely, the market was able to see MAT's poor performance, but considered this a company-specific event, which should not be the case given the macroeconomic and demographic trends.

Similarly, a discounted net income to find the market's implied discount rate using NASDAQ analyst projections show HAS earnings are discounted much less than MAT's-14.9% versus 16.5%. Investors may not have sold out of HAS, as mentioned before, due to the belief that MAT's poor earnings were company-specific. Thus, if the competitive environment persists, HAS stock has farther to fall than MAT.

Earnings Quality

Two lines on the balance sheet were addressed on the conference call that should be noted: accounts receivables and inventories. Both of these increased significantly in 2013. Although I am not accusing HAS management of manipulating earnings, the increases in accounts receivables and inventories have positive effects on sales and COGS, putting a more optimistic spin on earnings, which the market may not have accounted for.

The biggest risk for HAS' increase in days of sales outstanding is that management may be too optimistic about collections. The increase in days outstanding (DSO), from 72 days in 2012 to 77 days in 2013, was claimed to be due to the 25% growth in emerging market sales, which generally have longer sales terms. However, considering emerging markets only make up 14% of HAS' revenues, the huge increase in DSO must also be explained by other factors, such as a decreased level of allowance for doubtful accounts ($31,200 in 2010 to $19,600 in 2012), and higher credit sales. This optimism may pave the way for higher write-downs in the future, particularly with the contagious depreciation of emerging market currencies.

More importantly, excess inventories may cause strains on future gross margins, as revenues fall due to price cuts, and COGS increase due to write-downs. Days of inventory outstanding (DIO) increased almost 5 days in 2013, to 63.3 days. Given the market dynamics, this is not due to management ramping up inventories for a big year: it is more likely due to HAS' inability to sell its inventories in 2013 with the poor economic environment. I expect DIO to revert back down to more normal levels in 2014, as HAS sells and writes-down its surplus inventories. The expected drop in gross margins can be compared to 2010, when DIO spiked to 68.6 days. In the subsequent year as DIO fell, gross margins decreased over 2.4 basis points, from 51.56% to 49.24%.

The accrual effect captures both the changes in inventories and accounts receivables. As accruals increase, earnings are much more likely to revert down below cash flows in future years.

HAS

2010

2011

2012

2013

Accruals

$22,405

$38,928

$-75,412

$200,906

Accrual ratio

1.02%

1.67%

-3.25%

8.51%

Click to enlarge

The huge spike in accruals in 2013 helped aid HAS' earnings for FY2013, but the underlying numbers are not sustainable. Next year, the results, all other things being equal, would not look as rosy, as earnings with such an increase in accruals tend to be mean-reverting.

Return on Invested Capital

HAS is also not enjoying the same economies of scale MAT is: HAS' return on invested capital has been decreasing since 2011, and this figure is consistently lower than MAT's (almost 9% lower in 2013).

ROIC

2010

2011

2012

2013

HAS

19.42%

19.81%

17.64%

15.17%

MAT

23.56%

24.97%

22.31%

24.06%

Click to enlarge

This reflects MAT's ability to scale its operations in emerging markets. Thus far, HAS has been unable to do this to the same extent, and given the competitive environment, HAS' comparatively smaller size will disadvantage it as it expands. This is particularly important since sales in the U.S. and Canada fell 5.2% last year. Thus, HAS must rely largely on emerging markets for growth, which requires substantial investments-- an area in which HAS' biggest competitor has an advantage.

Conclusion

As of January 31, 2014, a little over 12% of shares outstanding were sold short. There is still much potential for shorts to pile in, although the current short interest is a little higher than ideal. Compared to MAT, HAS has had lower (and negative) sales, CFO, and operating income growth since 2012. Despite their poor execution amidst changing demographics and a more competitive landscape, HAS is trading at a premium in terms of a discounted cash flow, P/E, P/Operating earnings, and P/CFO due to HAS' potential for growth in 2014 with the release of several Marvel and Transformers movies. Moreover, earnings, at least on the surface, only missed to a small degree. However, digging deeper, these earnings may not be sustainable in 2014, and HAS' premium should not be warranted.

Disclosure: I am short HAS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.