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Executive summary

  • Mattel's international presence creates key opportunity.
  • Several upcoming licensing deals should build sales.
  • Relatively small market share (10%) with a chance to take on a giant (85%).
  • Key existing licensing deals with strong brands.
  • Growing market category approaching $5 billion in total sales.

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In a rather unsurprising move, the number one toy maker Mattel (NASDAQ:MAT) acquired Mega Brands Friday morning. I say unsurprising because Mattel has several licensing deals with Mega and has been a rumored targeted acquirer of Mega Brands. However, Mattel is now acting at the right time with the popularity of Lego at an all-time high and several upcoming licensed brand sets from Mega Bloks.

Mattel is acquiring Canadian based Mega Brands for $460 million, including debt. Mattel will pay for the deal with cash, but will hit the debt market to raise $500 million to maintain its current debt to equity ratio. The acquisition is being done to give Mattel a better spot in the growing construction sets market and also additional space in the arts and crafts category. Mattel paid a 36% premium to Thursday's closing share price, as Mega Brands shares traded in Toronto.

Last year, Mega Brands posted revenue of $405 million, with $300 million of that total coming from construction toys. The company owns brands Mega Bloks, Mega Puzzles, Board Dudes and Rose Art. Mega Brands' key piece is Mega Bloks, which is the biggest rival to Lego. The rivalry has even spawned several lawsuits, where Lego was told it could not trademark an eight piece interlocking brick.

Prior to the acquisition, Mattel had a 1% market share for construction toys. Lego, the clear market leader, had an estimated 85% market share. Mega Bloks holds a share of around 10%, which gives Mattel a double digit share and a chance to take Lego head on. Mattel said construction toys was "the single largest toy category where Mattel does not play." Mattel's big rival Hasbro (NASDAQ:HAS) recently got into construction toys with its new brand Kre-O launched in 2011. The brand has sets revolving around Hasbro properties Transformers, Battleship, G.I. Joe and also the licensed Star Trek. The big difference is Kre-O toys are compatible with Lego.

I love this deal for two big reasons: international sales and licensing. In 2013, Mega Brands saw 70% of its sales come from the United States and Canada. That is an extremely high total for a company listed as one of the top 15 toymakers in the world. Lego reported single digit growth in the United States and United Kingdom, and said it saw double digit growth in other markets like Asia. Consider that Mega Brands had employees in only 17 countries and has a relatively small sales force. Mattel is present in over 150 countries and should easily be able to expand the brand into new territories.

Lego is headquartered in Denmark and has a loyal following in Europe. This is one possible risk for Mattel and its newly acquired company. However, with a market share of 85% with a similar product, Lego could see its market share hit, even if only by a few percentage points. In 2013, Mega Brands saw record sales of preschool construction toys. Now imagine sales hitting new records every year as new territories are added and its easy to see why Mattel was glad to pay $460 million for the company.

Mega has slowly been building its licensing base for Mega Bloks, with several of the announced properties coming later in 2014. In 2013, Mega launched a line of Call of Duty Mega Bloks. Later in 2014, Mega will release a line of blocks with SpongeBob Squarepants characters and Assassin's Creed characters. Mega currently has blocks branded after Barbie, Thomas & Friends, Caterpillar, John Deere, NYPD, Dora the Explorer, Smurfs, HALO, Skylanders, Power Rangers, and Hot Wheels. Several of these properties are existing Mattel brands, which should provide some cost synergies on the deal as Mattel will now see all sales from these blocks rather than licensing fees.

Down the road, I think Mattel will be more aggressive at signing deals with Mega Bloks branded after popular characters and upcoming movies. Mattel can also use its own brands like Little People, Fisher Price and Power Wheels as additional cross branding opportunities.

In case you haven't noticed, Lego is on a tear right now with a huge box office take for "Lego Movie." The company also announced on Thursday that 2013 sales grew 10% to $4.6 billion. Net income grew 9% for Lego's full year. In the last 10 years, Lego has now quadrupled its revenue. Lego has seen tremendous growth thorough new product offerings like Lego Friends and Ninjango. Key growth has also come from partnerships with brands like Star Wars and Harry Potter.

In the last fiscal year, Mattel saw sales increase 1%. North American sales grew 2%, while international sales saw 5% growth. American Girl led the way on the year, with 11% sales growth. Mattel is coming off a horrid fourth quarter report, which caused shares to plunge double digits. North American sales were down 10% and international sales were flat in the fourth quarter. Total company sales were down 6% in the fourth quarter.

My last article on Mattel recommended buying the stock, as it was at 52 week lows and offered a recently increased 4% yield. Since that time, shares have barely moved and still offer a dividend yield of 4%. Analysts are expecting minimal sales growth to $6.5 billion in fiscal 2014. In fiscal 2015, revenue is expected to increase 3.4% to $6.7 billion.

These estimates are prior to the Mega Brand acquisition. I see the acquisition adding some real value and growth to Mattel. As the toy leader, Mattel has seen its growth days come to an end. Worse yet, the company is failing to maintain current sales levels as its key brands face strong competition. The company's entry into construction sets could be a key growth driver, along with the international sales potential that will be coming from Mega Bloks.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in HAS, MAT over the next 72 hours. 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.