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Mattel, Inc. (NASDAQ:MAT)

Q2 2010 Earnings Call Transcript

July 16, 2010 8:30 am ET

Executives

Dianne Douglas – IR

Bob Eckert – Chairman and CEO

Kevin Farr – CFO

Analysts

Linda Bolton-Weiser – Caris

Sean McGowan – Needham

Robert Carroll – UBS

Drew Crum – Stifel Nicolaus

John Taylor – Arcadia Investments

Michael Kelter – Goldman Sachs

Hayley Wolff – Rochdale Securities

Margaret Whitfield – Sterne, Agee

Felicia Hendrix – Barclays Capital

Operator

Good day, ladies and gentlemen, and welcome to Mattel’s second quarter 2010 earnings conference call. At this time, all lines are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will be given at that time. (Operator instructions) And as a reminder, this is being recorded. I would like to introduce Ms. Dianne Douglas. Please go ahead.

Dianne Douglas

Thank you, Mary. As you know, this morning we reported Mattel's second quarter 2010 financial results. In a few minutes, Bob Eckert, Mattel's Chairman and CEO, and Kevin Farr, Mattel's CFO, will provide comments on the results and then the call will be opened for your questions.

Certain statements Bob and Kevin make during the call may include forward-looking statements relating to the future performance of our overall business, brands and product lines. These statements are based on currently available operating, financial, economic, and competitive information and they are subject to a number of significant risks and uncertainties, which could cause our actual results to differ materially from those projected in the forward-looking statements.

We described some of these uncertainties in the Risk Factors section of our 2009 annual report on Form 10-K as well as in our quarterly reports on Form 10-Q and in other filings we make with the SEC from time to time. Mattel does not update forward-looking statements and expressly disclaims any obligation to do so. Information required by Regulation G regarding non-GAAP financial measures is available on the Investors & Media section of our corporate website, mattel.com, under the headings Financial Information and Earnings Releases.

Now I would like to turn the call over to Bob.

Bob Eckert

Thank you, Dianne. And good morning, everyone. What a difference a year makes! Last year at this time, Mattel, along with many other consumer goods companies and retailers, was lamenting how much further the economy was going to decline. And while reports remain mixed on whether or not we are out of the woods, I can tell you that I’m very pleased with the company’s performance for the quarter with worldwide net sales up 13%, reflecting good performance in the US as well as internationally, and continued improvement in our profit margins.

Our positive top-line sales trend in this quarter in both the US and abroad benefited from our newest entertainment properties, Toy Story 3, World Wrestling Entertainment, and Thomas and Friends, as well as solid growth from core brands such as Barbie and Hot Wheels. As it relates to Barbie, the core fashion, beach and accessory product lines continue to perform well. In our spring entertainment offering, Barbie in Mermaid Tale nicely outperformed last year’s movie.

Our I Can Be line, driven by a very strong spring promotional program, continues to perform well at retail. And I’m proud to report that the Barbie leadership team hasn’t missed a beat and is continuing to drive the brand to deliver on fashion, aspiration and cultural relevance. I know there is a lot of interest in the watch of our Monster High franchise, which has just begun.

We know girls are becoming engaged with the brand as evidenced by the millions of Monster High episodes downloaded in the website. The Justice apparel program is just rolling out to more than 900 stores nationwide, and the Monsters will be taking over YouTube’s home page this summer with an all new Monster High music video.

Toy advertising begins around the back-to-school timeframe, which also coincides with sales of the first Little, Brown hardback chapter book, which hits retail in September. In the Wheels item, Hot Wheels performance has been solid, driven by both core play with basic tires and track sets, as well as the feature product lines like Custom Motors and Color Shifters.

And we are excited about the Matchbox launch and Stinky the Garbage Truck, following on the successful launch of Rocky the Robot Truck last year. These characters are now part of the new Big Rig Buddies line, which we are introducing to kids this fall via CGI animated episodes being packed with the products.

And of course, there is the incredible success of this year’s summer movie, Toy Story 3. Not surprisingly, our Toy Story 3 lines are selling well across all businesses, including infant and preschool, action figures, collectibles, play sets, vehicles, roll play, Barbie and Ken dolls and games. And now that Spain has taken home the World Cup title, the movie will be hitting theaters in the European markets.

The World Wrestling, WWE sales continue to be strong, driven not only by our core line that appeals to collectors, but by the Flexforce toys, which are more kid-focused and feature driven. As I said before, what’s most exciting about our newest license properties is that we expect them to perform more akin to evergreen toy brands than one hit wonders, which charter well for our business not only in 2010, but beyond.

In the infant and preschool, our Fisher-Price Friends business performed quite well, with Dora the Explorer rebounding nicely, and of course the addition of Thomas and Friends. We are also looking forward to Dora’s ten-year anniversary, which Nickelodeon is kicking off this fall.

This summer American Girl will launch the Shine On Now program, a new charitable initiative that harnesses the collective power of girls to help others in need. To further encourage and inspire girls, American Girl is also launching a brand new virtual campus, Innerstar University of fun, safe website for girls, access to the new virtual world that comes with each 18-inch My American Girl doll, the company’s newly enhanced contemporary product line, which is currently available.

From our Time Warner brands to our newest entertainment partners, I’m encouraged by the strong momentum in the first half of the year, as we begin to come down to the all important holiday season. We remain committed to maximizing long-term value for our shareholders. As you know, we are focused on controlling costs and effectively deploying capital.

Over the last seven years, we have repurchased about 114 million shares of our stock at a total cost of $2.2 billion, including repurchasing about 5 million shares this quarter, and distributed $1.6 billion in dividends. Effective capital deployment combined with solid top-line growth and improving margins will allow us to win the marketplace and for our shareholders.

At this time, I’d like to introduce Mattel’s Chief Financial Officer, Kevin Farr, who will take you through the financial review of the quarter. Kevin?

Kevin Farr

Thank you, Bob. And good morning, everyone. I will begin my review for the second quarter with a discussion of worldwide gross sales shown on Exhibit 2 of today’s press release. Total worldwide gross sales for the quarter were up 13%, including a 3 percentage point negative impact from changes in exchange rates. US sales were up 17% and international sales were up 9%, including a 5 percentage point positive impact from foreign exchange.

On a regional basis, sales in Europe were up 7%, including a 7 percentage point negative impact from exchange rates. Sales in Latin America were up 1%, including a 10 percentage point negative impact from foreign exchange. Sales in Asia Pacific were up 28%, including a 6 percentage point positive impact from changes in exchange rates.

Worldwide Barbie sales were up 6%, including a 4 percentage point negative impact from foreign exchange. Barbie sales in the US were up 16%, while Barbie sales in the international markets were up 1%, including a 6 percentage point negative impact from foreign exchange. Worldwide sales in the Other Girls brands were up 3%, including a 3 percentage point negative impact from exchange rates.

Continued good growth in Disney Princess was partially offset by international declines in High School Musical, Hanna Montana, and Polly Pocket. The sales of Other Girls brands in the US were up 15% and international sales were down 7%, including a 5 percentage point negative impact from foreign exchange.

Worldwide sales in Wheels increased 5%, including a 2 percentage point negative impact from changes in currency exchange rates. The growth in Wheels was led by strong worldwide sales of Hot Wheels. Hot Wheels increased 11% worldwide, including zero impact from foreign exchange. Hot Wheels sales increased 19% in the US and were up 5% internationally, including a 1 percentage point negative impact from foreign exchange.

Worldwide sales in our entertainment business, which included games and puzzles, were up 60%, including a 5 percentage point negative impact from changes in foreign exchange. Sales were up 90% in the US and up 40% internationally, including an 8 percentage point negative impact from changes in foreign exchange. Sales increases were primarily driven by our new Toy Story 3 products and continued momentum from other new entertainer properties, WWE Wrestling, as well as good growth in our core games business.

Fisher-Price brands. Worldwide sales for Fisher-Price brands were up 4%, including a 2 percentage point negative impact from changes in currency rates. On a regional basis, domestic sales in Fisher-Price brands increased 4% and international sales increased 5%, including a 5 percentage point negative impact from foreign exchange. Worldwide core Fisher-Price was flat, including a 2 percentage point negative impact from changes in exchange rates. International sales were up 1%, including a 5 percentage point negative impact from foreign exchange. And US sales of Fisher-Price core were down 1%.

Fisher-Price Friends worldwide sales increased 35%, including a 5 percentage point negative impact from foreign exchange rates. International sales were up 25%, including a 10 percentage point negative impact from foreign exchange while sales of Fisher-Price Friends in the US were up 45%. The growth in Fisher-Price Friends was driven primarily by the addition of products supporting the new Thomas and Friends property as well as growth in Dora the Explorer and Disney products.

American Girl brands. Sales of American Girl brands were down 4%, primarily the result of last year’s second quarter launch of Rebecca and a slightly earlier Easter this year, partially offset by continued strong sales of Laney, the 2010 Girl of the Year, and good performance from our new Denver store.

Now let’s review the P&L, which is shown on Exhibit 1. Gross margin was 48.1% compared to 45.2% last year. The improvement was primarily due to lower product costs, price increases, and savings from our Global Cost Leadership initiatives, partially offset by higher royalties. We continue to expect input cost pressures in our gross margin beginning in the second half of this year, given the current commodity and labor cost environments relative to year-ago levels.

Advertising expense was $101.9 million or 10% of net sales compared to $89.8 million or 10% of net sales in 2009. Selling, general and administrative expenses decreased approximately $34.5 million to $318.3 million. As a percentage of net sales, SG&A expenses were 31.3% compared to 31.6% last year.

The year-to-year dollar increase primarily reflects increased legal-related costs and employee-related related costs including incentive accruals and merit increases, as well as severance costs, partially offset by savings related to our Global Cost Leadership program. For the first half of the year, SG&A expenses were up $10 million or 2% and represent 32.2% of net sales compared with 35.7% for the first half of 2009.

For the quarter, our Global Cost Leadership program delivered overall gross savings before severance of about $12 million. The gross savings includes about $4 million in SG&A, $5 million in gross margin, and $3 million in advertising. For the quarter, we recorded severance charges of $9 million. The net year-over-year incremental savings related to Global Cost Leadership program is about $3 million for the quarter. We remain on track to deliver cumulative net savings at the high end of the target range for the program of $180 million to $200 million by the end of 2010.

Operating income during the quarter was $69.4 million compared to $32.5 million in 2009. The year-to-year improvement was primarily due to higher sales and gross margins, partially offset by higher SG&A and advertising expense. Interest expense of $13.4 million was down from $17.5 million last year, reflecting lower average borrowings as well as lower average interest rates. Interest income was $2.8 million versus $2.5 million last year. The higher interest income was due to higher average invested cash balances during the quarter.

Other non-operating income expense was $3.3 million during the quarter versus $6.3 million in 2009. The income in both periods relates primarily to foreign currency exchange gains. The quarter’s income tax provision of $10.5 million includes discrete tax benefits of $4.6 million. This compares to prior year’s provision of $2.3 million, which included discrete tax benefits of $2.5 million. For the year, we continue to expect the worldwide effective tax rate to be about 24% to 25% based on current tax laws. Overall, we reported net income of $51.6 million or $0.14 per share versus last year’s net income of $21.5 million or $0.06 per share.

Now turning to cash flow and balance sheet, year-to-date cash flow used for operations was $372 million compared to $350 million in the first half of 2009. Our cash on hand at the end of the quarter was $545 million, up $122 million from prior year. The increase in cash is primarily due to higher beginning cash balances of $1.1 billion this year versus $618 million last year, partially offset primarily by a lack of short-term borrowings and capital deployment.

During the second quarter, the company repurchased approximately 5 million of its shares of common stock at an average price of $22.05 per share for a total cost of approximately $111 million. I’m pleased with our management of working capital, especially in light of 13% growth in the business.

Receivables were $805 million or 71 days of sales outstanding, four days lower than last year. Factoring decreased from $81 million to zero. Prior to factoring, days of sales outstanding decreased 12 days. During the first half of 2010, we made the decision not to factor receivables due to our current cash position and the availability of lower cost funding alternatives.

Inventories at $598 million were up $8 million or 1% versus 2009. Our total balance sheet debt was $710 million, a decrease of $344 million from the prior year, reflecting the lack of short-term borrowings and the pay-down of maturing long-term notes. Our debt-to-total-capital ratio ended the quarter at 22.1% versus 32.7% for last year’s second quarter. Capital expenditures were $33.4 million, down from last year’s $41.7 million.

So to summarize, we are pleased with this quarter’s results, but there is a lot of work to be done between now and year-end to deliver on our priorities; continued core brand momentum, maximize the opportunities surrounding our new entertainment properties, maintain cost and expense controls, and deliver another strong year of profits and cash flow.

That concludes my review of the financial results. Now we’d like to open the call to questions. Operator?

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Our first question comes from Linda Bolton-Weiser from Caris.

Linda Bolton-Weiser – Caris

Hi, how are you?

Bob Eckert

Great.

Linda Bolton-Weiser – Caris

Can you just elaborate a little bit more on the Other Girls sales performance, because that was really strong in the first quarter and I know FX is a little bit more negative? But is it that Polly Pocket decline or some other decline got a lot worse or exactly what? And then my second question would be just on incentive compensation accruals, I know you don’t like to disclose a lot, but can you give maybe year-to-date or something, what the dollar increase in compensation accruals is for the first half versus first half of ’09, like how much delta increase is year-over-year? Thank you.

Bob Eckert

Hi, Linda, this is Bob. I’ll start with Other Girls and then Kevin can talk about the incentive accrual. I think in constant dollars our Other Girls business was up 6% in the quarter. Maybe it was 3% in actual dollars. So there was a little bit of Forex. And we generally had pretty good trends in the Other Girls business. Clearly, Disney Princess continues to have very strong momentum, and we are excited about this fall’s Tangled movie, which is the story of Rapunzel. Monster High is in the Other Girls segment. It is a very small business in the second quarter, but obviously we are quite hopeful on that. Polly has seen improved results more recently in the US, including during the quarter, but we still have some work to do internationally with Polly. And we are also facing some declines from the prior year and things like High School Musical and Hanna Montana, which we distributed outside of the US. So it’s a portfolio of brands, generally speaking, will continue to do well than that if they cycle through.

Kevin Farr

And then on the incentive compensation, we don’t disclose the quarterly detail for incentive comp. You may recall that given the seasonality of our business, the vast majority of accrued incentive compensations reported in the second half of the year, driven primarily by the achievement of our annual performance goals in the key [ph] season. That being said, accounting rules require higher accrual in the second quarter versus last year due to year-to-date performance improvements.

And maybe I’ll take the opportunity as a result of the question really getting to the SG&A increase for the quarter. For the quarter, SG&A expenses increased approximately $35 million to $318 million. As a percentage of sales, SG&A expense was 31.3% or down 30 basis points compared to the prior year.

The year-over-year dollar increase primarily reflects $12 million of legal-related costs, $16 million of employee-related costs, and $7 million of incremental severance, which was partially offset by approximately $5 million of gross savings related to the Global Cost Leadership program. About one-third of the higher employee-related costs was due to merit increases affected in March and the other two-thirds was due to the timing of incentive accruals.

And as I said that due to seasonality, really most of the incentive compensation is accrued in the second half. As I said, the accounting rules require us our performances better to accrue more in the second quarter versus last year. In the second quarter of 2010, we incurred higher incentive costs of $9 million versus $2 million in the prior year related to Global Cost Leadership program. So it was $9 million of severance in the second quarter versus $2 million last year.

Linda Bolton-Weiser – Caris

Thank you.

Kevin Farr

You’re welcome.

Operator

Our next question comes from Sean McGowan from Needham.

Sean McGowan – Needham

Thank you. I also have a couple. Bob, could you comment on (inaudible) Barbie sales inclusive of the Toy Story SKUs or exclusive? And does Toy Story include the Barbie SKUs and vice versa?

Bob Eckert

Yes. Toy Story is spread throughout the product line. So there is Toy Story – like the Barbie and Ken dolls are in the Barbie numbers, there are some Fisher-Price, Shake n Go, as an example, in the Fisher-Price number. So those things that are within our kind of mainstream categories are within the category numbers.

Sean McGowan – Needham

Okay. Thank you. And can you comment on Barbie sales, excluding the Toy Story SKUs? Is that short of mid-single digit increase there?

Bob Eckert

Well, we probably won’t get that granular, but I can tell you that the kind of a core fashion and beauty and the aspiration or the I Can Be segment, the spring entertainment, they continue to perform well. Barbie is continuing to gain share. We have good plans in place to carry the momentum through the holiday, like the Video Girl Barbie. And we are seeing improved momentum outside of the US. So, for those of you who saw the Toy Story 3 movie, clearly Barbie and Ken stole the show. And not surprisingly, those dolls are selling well. But we are seeing continued good momentum around the globe in Barbie POS.

Sean McGowan – Needham

Okay, thanks. Another question, I hope it’s for you, Kevin. On the legal expenses, and I assume that’s being driven by your friends up north or little further north, can you give us an update on what’s going on there?

Bob Eckert

Yes. Let me start and then Kevin, if you want to chime in, feel free. If you recall back in December, the Ninth Circuit Court heard arguments surrounding the trial court’s orders from the phase one of the case, which had resulted in a unanimous jury verdict in favor of Mattel. The court hasn’t yet issued any opinion on that. So nothing has changed from that front. But you will recall the bid issue in order to sustain the equitable relief, which included the transfer of the Bratz copyright registrations and trademarks to Mattel.

So there is nothing new on phase one of the case other than we are still awaiting the Circuit Court’s opinion. We are now moving forward with phase two of the case at the District Court level. That’s the phase that alleges among other things that MGA systematically stole Mattel’s trade secrets, and there hasn’t been a trial date set yet for phase two. So overall, I’d say we continue to have faith in the judicial system and confidence in our claims and the evidence, just as we did in phase one, and we will pursue this as long as we need to.

Sean McGowan – Needham

And so it’s really phase two then that’s driving the $12 million increase in the spending?

Bob Eckert

Yes, it’s virtually all phase two, as we are preparing for trial and we are ready to go any time the court is ready to start the trial.

Kevin Farr

Let me give you a little bit more clarity, Sean, on sort of our legal fees and settlements have been packed in the first quarter and the first half results. In the second quarter of 2010, we incurred incremental legal fees of approximately $8 million, primarily related to preparing for phase two of the MGA trial, which could occur in 2010. If you look at the first half of 2010, we incurred incremental legal fees of approximately $14 million, again primarily related to the preparing for phase two of the MGA trial.

And then moving on to settlements, legal settlements related to the recall, if you remember, in the first quarter 2009, we took a $21 million charge for legal settlement reserve for product liability related litigation. And then in the second quarter of 2009, we adjusted this charge down by $5 million, primarily due to insurance recovery. So in the first half of 2009 – sorry, in the first half of 2010, we reversed $9 million of the recall-related charges to reflect the actual settlement amounts approved by the court in 2010. So altogether for the first half of 2010, the total year-over-year improvement pertain to the 2009 recall-related legal settlement was $25 million. And if you look at both legal fees and legal settlements for the first half of 2010, we incurred incremental legal fees of $14 million primarily related to MGA. These incremental fees were more than offset by the year-to-date favorable change in recall settlement charges of $25 million.

Sean McGowan – Needham

Okay. That’s helpful clarification. Last question for you, Kevin, can you comment on whether or not any additional shares have been bought back since the end of the quarter?

Kevin Farr

We don’t comment on activity after the quarter.

Sean McGowan – Needham

Okay. Thank you very much.

Bob Eckert

Thanks, Sean.

Operator

Our next question comes from Robert Carroll from UBS.

Robert Carroll – UBS

Hi, guys, how are you doing?

Bob Eckert

(inaudible).

Robert Carroll – UBS

Good to hear. I was – you might be able to comment on the progression during the quarter. I mean, given the timeline of the release around Toy Story 3, are you guys able to comment if there was kind of a groundswell after the movie for Barbie and Ken products as well as just kind of Toy Story 3 in general?

Bob Eckert

Yes. I guess I’d say overall the momentum built not surprisingly. We had pretty good sales early in the quarter, as retailers were gearing up for Toy Story 3. And then POS did very well for Toy Story 3. But I’d also tell you that the POS momentum was more broadly based than just Toy Story. If you look at the quarterly flow of the point-of-sale, clearly the momentum is picking up broadly around the globe. Today I’m probably more concerned about supply than demand. In China, we see labor supply tightening, the rates are up, shipping containers are in short supply, freights taking longer to move than it sometimes does.

In Mexico, there was a hurricane near one of our facilities in Monterrey and there has been floods from essentially Monterrey to Laredo, Texas. So all this was occurring while our business was picking up and orders were strong. The good news is we have a long history of overcoming supply chain obstacles like this. So, as always, we are continuing to focus on getting the right toys at the right place at the right time. But I think right now and certainly in the near-term, in my view, the supply chain is relatively more important to POS momentum, which continues to be quite strong.

Robert Carroll – UBS

Okay, thank you. And then focusing just on Barbie, I mean, given that I guess Barbie doll in the movie was probably a little more prominent than many people expected going in, I mean, those are pronounced uptick in kind of Barbie POS during the last couple weeks in the quarter.

Bob Eckert

I’d say POS has been strong fairly consistently over a year. Obviously week-to-week it does change a little bit, but we’ve seen good momentum before the Toy Story 3 products hit. We clearly saw good success for the Toy Story 3 products, which wasn’t a surprise. We’ve been in pretty good stock on those products. So I would say there is no question that the Toy Story 3, Barbie and Ken have done well, but there is broad based strength across the line. And Barbie POS momentum has looked good even in markets where Toy Story 3 is yet to air.

Robert Carroll – UBS

Okay, thank you.

Operator

Our next question comes from Drew Crum from Stifel Nicolaus.

Drew Crum – Stifel Nicolaus

Hi, great, thanks. Good morning, everyone. Bob, could you comment a little further on Toy Story 3 overseas? I think you alluded to the fact that the film has been delayed in order to avoid the competition from the World Cup. Can you talk about the opportunities you see there in terms of sell-in, given the delay in the film release?

Bob Eckert

I mean, there is no question Toy Story 3 has been a home run, broadly speaking, not just for our product line, but I’m sure for others in the toy business who have Toy Story 3 licenses or for other categories in consumer products. The movie, as you all know, did very, very well. From our vantage point, it’s an incredibly poetic movie. And the business has done well in response to the movie and in response to retailer promotions surrounding movie. I think there are some key European markets that air the movie in July. I believe by the end of July, all the key European markets, Italy, France, Germany, Spain, will have aired the movie. And I don’t have any reason to believe it won’t be home run outside the US as well. So I think we are ready for it. The inventory is in place. Retailer promotions are set up. And I would not be surprised if it does well outside of the US like it has done well in the US.

Drew Crum – Stifel Nicolaus

Okay. Bob, let me ask this question then. Has that – just the timing of the film release impacted the timing of your sell-in for the product overseas?

Bob Eckert

No –

Drew Crum – Stifel Nicolaus

Is there more in the third quarter or is that pretty balanced in the second quarter domestic versus international?

Bob Eckert

More balanced than that, and it will get into effect – the timing of the movie has not affected our shipment calendar of the products.

Drew Crum – Stifel Nicolaus

Okay. Got it. And then just shifting gears to Thomas and Friends, doing our channel checks, we still see a lot of legacy products from the predecessor licensee. Are you seeing that in your results? And at what point do you think that corrects itself?

Bob Eckert

I think we are pretty close on that. I (inaudible) that enough stores that I’m starting to see our product appear particularly in the die-cast segment. So I think we’ve finally cycled through the sell-off period from someone else’s product line. And generally speaking, some of our products were a little slower to come through the pipeline than we expected, but the business is doing well and is tracking everywhere where we thought would be.

Drew Crum – Stifel Nicolaus

Okay. And Kevin, a question for you. The advertising spend as a percentage of revenue, 10% in the quarter. I think you are below the historic average as a percentage of revenue. Where do you see that going in the balance of the year? Can you give us an update as far as your thoughts are concerned for 2010?

Kevin Farr

Yes. I think the advertising expense as a percentage of sales for the quarter is consistent with last year. And I think in 2009 our advertising expense was 11.2% of net sales, which was on the low end of our historical range, reflecting the benefit of GCL initiatives as well as the challenging environment. Our rate has historically been in the 11% to 13% range, and we expect to be at the lower end of the range for 2010.

Drew Crum – Stifel Nicolaus

Okay. And then just last question, housekeeping item, you’ve got $250 million of long-term debt classified as short-term now, can you just give us a sense as of timing of those repayments?

Kevin Farr

Yes. I think they become due next year. They are actually due next year in June, $240 million of the $250 million; and $10 million of it is actually due this fall in October.

Drew Crum – Stifel Nicolaus

Okay, great. Thanks, guys.

Operator

Our next question comes from John Taylor from Arcadia Investments.

John Taylor – Arcadia Investments

Hi, good morning. I’ve got a couple of questions, if I may. In the way the order book looks for Toy Story 3 in the US, I guess I want to focus on – do you see anything different about the pacing of the way retailers want to bring that product in that might be different from what you’re seeing with entertainment properties and summer entertainment properties in the past? And any forward, backward weighted, anything that is different from the norm?

Bob Eckert

No, JT, I wouldn’t describe it as being unusual in anyway. Clearly, a lot of people and retailers everywhere thought Toy Story 3 would be a great toy movie, and the good news is it has turned out to be a great toy movie. But I don’t think their pacing was unusual.

John Taylor – Arcadia Investments

Okay. And then you bought back some shares in the quarter. I know there has been talk about buybacks versus dividend increases versus whatever in terms of maximizing shareholder value. Have there been any sort of recent in-depth discussion, studies, whatever that might help you figure out which way to lean on that? Because it seems like share buybacks, while they have done a good job in decreasing the share base, say, over a period of time and they have been that effective. So maybe any update on that?

Bob Eckert

Not particularly. And as I’ve mentioned, I believe Kevin may have mentioned in the last quarter, this is a Board-level decision and the Board has continued to be actively engaged in the discussions, particularly after last year when you recall that given the macro environment, we were sort of in hunkered-down mode. We set our priorities last year. We’re going to be having a stronger balance sheet, increasing cash, reducing debt, and we also wanted to protect the dividend. We did all of that. We improved our credit metrics and we improved our credit ratings. And so this year, we re-engaged in discussions at the Board level, reaffirmed the capital investment framework that I think we went public with in early 2003 or thereabouts, Kevin?

Kevin Farr

Correct.

Bob Eckert

And so, Kevin and the Board and the rest of us continue to look at what’s the highest and best use of capital in our judgment at any given point in time. And we also talk to investors about their preference for dividends and share repurchases and what tax rates might – what implications there might be from tax rates and those sorts of things. But from an overall strategic macro sort of basis, there is no real change in our strategy or approach.

Kevin Farr

I guess I think that they are consistent with our framework in the second quarter. We repurchased 5 million shares of our stock at a total cost of about $111 million. And as Bob said, we remain committed to core capital, build shareholder value pretty much as we’ve done for the last ten years.

John Taylor – Arcadia Investments

Okay. And then last question, on the Chinese labor front, the contracts in place are pretty firm at this point in terms of allowing you to predict what your input costs are going to be on the labor side? Or is there some variability there that you might have to take some pricing to protect margin from?

Kevin Farr

Go ahead – just from the perspective of what’s going on, I think as expected in 2010, China announced the minimum wage to go about 20% and our key providence [ph] is effective May 1st. If you look at our 2010 pricing, we have tuned the majority of this double-digit increase in wages and we’re keeping an eye on further rollout of wage increases in our key manufacturing processes or providences. That said, we continue to execute our Global Cost Leadership program and other cost and manufacturing efficiency programs in 2010. We priced our products consistent with making progress against our long-term goal of 15% to 20% operating margins.

Bob Eckert

We are really, JT, not looking at additional price increases this year. We haven’t yet priced next fall line. And given the labor cost, given oil – where the oil today is probably 76 – $75 versus $67 maybe a year ago, given what’s going on in the supply chain and costs and currencies and those sorts of things, it’s more likely than that that we will be pricing next year and – at least my current point of view is we’d probably be pricing more aggressively, as we did in 2009 than we have in 2010. I said about next year issue, not this year issue.

John Taylor – Arcadia Investments

Right. Okay, good. And then can you give us any sense of the sentiment of major retailers in European terms, of their outlook and their willingness to sort of stock-out for holiday. Last year was a low water point. I guess we’re trying to find out what the new normal is. Could you give us any (inaudible) what they are telling you?

Bob Eckert

I guess I’d just say in general, we’ve seen good momentum across the portfolio and around the globe. The business has actually done pretty well in markets like Italy, Portugal, Spain, Southern Europe. We continue to have a good quarter. I think we remain cautious and conservative. Retailers remain cautious and conservative. My view is they are going to continue to be tight through this holiday season, not surprising to us, and that was baked into our expectations for the year. But the business in general has held up pretty well. And I don’t know whether or not we are yet at the new norm, but there is no real change in sentiment, Kevin, I’d say in the last three or six months.

Kevin Farr

Right. I’d agree, Bob.

John Taylor – Arcadia Investments

Okay, great. Thank you.

Operator

Our next question comes from Michael Kelter from Goldman Sachs.

Michael Kelter – Goldman Sachs

Hi, guys. I guess, first, maybe you could just follow on what we were just talking about with respect to the holiday season. When you said you thought that retailers might remain high on inventory, were you referring to Southern Europe or were you referring to more broadly, all of Europe, United States, et cetera?

Bob Eckert

I’m referring more broadly to all around the globe. Retailers continue to be tight on inventory. That’s not surprising to us. I don’t think they are going to broadly rebuild inventory anywhere around the world. I think that’s just their view of the marketplace. It’s consistent with our view of the marketplace. So, similar to last year, people are going to be cautious and they tend to buy what they are selling as opposed to buying a lot in advance of selling. If we look at – the US is our best data.

If we look at retail inventories in the US, which we calculate from shipments and point-of-sale information that receive from retailers, on a year-to-date basis, the inventories today – let me put it that way, the inventories today in the US at retail are up maybe low-to-mid single digits, but most of that – all of that’s really due to the natural build for these entertainment properties that are very strong right now. If you exclude the entertainment properties, the retail inventories are down below a year ago. And people are pretty tight with inventory last year. And so my view is that trend is going to continue this year. I don’t think retailers anywhere, as I’m aware, are looking to rebuild inventories. And it’s – when the consumer buys it, we will buy more.

Michael Kelter – Goldman Sachs

That’s helpful. The next question I have is on gross margins. What I’m surprised about I guess is the gross margins normally go up at least 100 basis points from first to second quarter on seasonality. And this time, they went down 100. And you mentioned that (inaudible) higher royalties from the entertainment properties, but the only thing new in the quarter was Toy Story, which would be less than 10% of sales. So how – is there anything else going on that why gross margins would have gone 200 basis points different than the normal seasonality in the business?

Kevin Farr

Again, I think we did – we did improve by 290 basis points to 48.1% compared to last year. And as I said earlier, gross margin benefited from favorable product costs, price increases, and savings from the Global Cost Leadership program, partially offset by mix due to higher royalties related to our new entertainment properties. I think your focus on royalties are correct this quarter versus the first quarter and that we did see more entertainment license property sales in the second quarter.

But also this quarter we continued to benefit from lower commodity costs that occurred last year when we were buying inputs and manufacturing to our 2010 spring line relative to the near record high input cost that we experienced in late 2008 when we were purchasing inputs for the manufacture of spring 2009 product line. And our 2010 gross margins also improved due to continuous improvement program as well as our Global Cost Leadership program and other manufacturing programs across the supply chain. So I think we’ve made good progress in rebuilding our gross margins and our goal is to sustain gross margins consistent with our long-term goal.

Michael Kelter – Goldman Sachs

All right. And then – go ahead.

Kevin Farr

No. I think again – I think royalties was part of that. I think also cycling through the commodity costs, as we were building 2010 product, those commodity costs got more expensive as we moved from the second quarter into the third quarter – I’m sorry, the first quarter to the second quarter.

Michael Kelter – Goldman Sachs

Okay. And then lastly on the capital structure, debt, share repurchase, et cetera, can you say you have $250 million coming due? Is there any reason why you wouldn’t refinance that amount or do you plan on paying it down? And then even beyond that, maybe – have you considered refinancing for a greater amount and picking on a more aggressive capital structure and deploying cash back to shareholders?

Bob Eckert

I’d say overall it’s a little early to have those discussions. As Kevin always talked about, this is a Board-level decision and we review those things with the Board in turn and use capital as best we can at the time. So I just – we’d go back to the capital and investment framework, which we’ve articulated publicly, and there is no reason to believe we’re going to come off of that set of guidelines.

Kevin Farr

Yes. I think the important thing in those guidelines supporting our credit metrics and credit ratings, and I think that’s key to having year-end cash of $800 million to $1 billion target and a debt-to-total-capital ratio of around 25%. So I don’t see that changing.

Michael Kelter – Goldman Sachs

Thank you very much.

Operator

Our next question comes from Hayley Wolff from Rochdale Securities.

Hayley Wolff – Rochdale Securities

Hi, guys.

Bob Eckert

Hi, Hayley.

Kevin Farr

Hi, Hayley.

Hayley Wolff – Rochdale Securities

Couple of questions. First, Bob, you and, I think, David Stockton [ph] have been quoted in publications as being thoroughly upbeat about the holiday period. Can you elaborate on that?

Bob Eckert

Well, I think in general, if you look at we all thought in the industry a year ago we were all fairly pessimistic. We’ve come off a tough Christmas in 2008 when the global economy tanked. And retailers and manufacturers like us were all anxious about what the holidays would look like in 2009. We were pretty cautious about the inventories going into 2009. Retailers were quite cautious about inventories. The good news is the market cleared, everybody did well, products sold, and holidays were good.

So if you fast forward now, our view of the world this year is, okay, from a POS and consumer standpoint, we are hopeful the worst is behind us. So we don’t have that pessimism that we had a year ago at this time. That being said, I don’t think anybody thinks we are back to good growth in the macro economy and I don’t think anybody is building inventory in anticipation of renewed consumer spending. So I think we’re going to continue with sentiments that we probably had for the last six or eight months.

Hayley Wolff – Rochdale Securities

But we go through this current slowdown, do you have internally any need to reset expectations? Are retailers more conservative, maybe pushing back a little bit?

Bob Eckert

No, I’d say retailers continue to be conservative. I wouldn’t describe them broadly as more conservative. I think if you look at how we calculate their inventories, they have been tight with toys for some period of time now. And I really don’t expect that to change much one way or the other. They – a lot of retailers saw the market clear pretty quickly last year and I’m sure they are hopeful to continue that again this year. They’re not going to ahead themselves.

Hayley Wolff – Rochdale Securities

And the Other Girls segment, how much longer do we have tough comps of High School Musical and the Hanna Montana? And then regarding Polly Pocket, I know there has been a re-launch, re-tooling. What’s been the response to that? Do you think Polly can turn around?

Bob Eckert

I think we’re about done with some of the older Disney properties in the cycle through. Polly has shown pretty good momentum of late here in the US, but it’s early. So, you know what, see how the holiday season goes. We still have opportunity to do a better job overseas with Polly.

Hayley Wolff – Rochdale Securities

Okay. And then last question, on the legal expenses, so you are now building up with the expectation of going to trial on phase two of the Bratz. So, as we think about – I know you don’t like to give any guidance. But as we think about legal as getting in the way of any kind of SG&A improvement, how should we think about your legal expenses going forward?

Kevin Farr

I think – probably the only thing I can give you is look back in history when in full year 2008 we incurred legal incremental litigation fees related to primarily the MGA trial, which incurred in May through mid-July 2008, those incremental legal costs were about $37 million. For 2009, when we weren’t in trial and weren’t preparing for trial, litigation-related legal cost increased by $33 million that primarily related to MGA. So that’s probably the guidance I can give you. And while we reduced expenses in 2009, we will continue to make the appropriate level of investments in legal fees and certain legal matters are resolved.

Hayley Wolff – Rochdale Securities

Okay. All right. Thanks a lot.

Operator

Our next question comes from Margaret Whitfield from Sterne, Agee.

Margaret Whitfield – Sterne, Agee

Yes. Few questions. If you could comment on how your inventories are overseas relative to point-of-sale, Bob, also I wondered – I’ve seen a few holiday lines topping up at retail as well as a few SKUs for Monster High at Justice, if you could give us your thoughts on the early read there? And finally, two small questions. When will the Toy Story 3 DVD debut? And what was the Forex impact to the bottom line in Q2? Thank you.

Bob Eckert

Let me start, Margaret, with inventories overseas. The data isn’t as good as it is here in the US. But broadly speaking, I’d say the trend is consistent. So without going through numbers, I’d say in general, retailers remain tight with inventories. We’re certainly tight with credit, continuing to be tight with credit. And I don’t think that the United States is atypical of what’s going on around the world in terms of retail trends. I haven’t yet seen Monster High at Justice. So you are ahead of me. Frankly, I haven’t seen Monster High toys on the shelf either. So you’re ahead of me. So I have been out looking for them. It’s too early, but clearly we’ve got high expectations for Monster High at least in terms of starting to build the franchise, which we are committed to do. So the Justice program is appearing now.

I’ve heard the toys are starting to appear, but I haven’t seen any. And in general, I think that some of the fall toys coming out of either Mattel or some of our competitors are starting to appear at retail. And my sense is based on sort of the POS in the last several weeks. Things are off to a pretty good start. I think in answer to your question on the Toy Story 3 DVD, my recollection is it comes out around Thanksgiving or sometime in the November time period in time for the holiday season.

Kevin Farr

On the final question on Forex, Forex was negative 3 percentage point impact worldwide gross sales for the quarter. It had no impact on EPS for the quarter as well as to the first half.

Operator

Does that answer your question?

Margaret Whitfield – Sterne, Agee

Yes. I was wondering, Bob, if you have any more specifics on the holiday toys, Sing-a-ma-jigs! or the video cam Barbie or anything else that’s out in terms of yearly read along with the Barbie entertainment line for Q4.

Bob Eckert

It’s very early, Margaret. Things that you have seen, I haven’t yet seen on the shelf and I go to retailers every weekend at this timeframe of year. So I’d say it’s too early to get excited one way or the other. But we’ve got good momentum. Retailers are supportive of some of these key lines that you’ve mentioned, like Sing-a-ma-jigs! or like Video Girl Barbie. I’ve heard they are selling, but I wouldn’t get excited one way or other. You just look at the absolute number of pieces that are out there. It’s just not – it's not material yet.

Margaret Whitfield – Sterne, Agee

Okay, thanks.

Dianne Douglas

Operator, we have time for one more question.

Operator

And our next question comes from Felicia Hendrix from Barclays Capital.

Felicia Hendrix – Barclays Capital

Hi, guys. Kevin, just back on the SG&A, you had said – obviously usually you think it’s early talking more on the second half of the year, but because of accounting (inaudible) in the second quarter, does that mean that the typical timing of incentive accruals will change through the whole year? Should we expect less in the second half?

Kevin Farr

I think that’s going to depend upon our performance in the second half. So – but again, the majority of the incentive accrual occurs in the second half of the year. That’s been the reason we split between the third and fourth quarters based upon history.

Felicia Hendrix – Barclays Capital

Okay. So there is nothing really like a material pull-forward into the second quarter? That’s what I was trying to figure out.

Kevin Farr

No. No.

Felicia Hendrix – Barclays Capital

Okay. And then Wal-Mart has seen some leadership changes. I’m just wondering – it might be too early, but if you are seeing any changes there, in particular with how they are assigning shelf-based things like toys and other items.

Bob Eckert

No, we haven’t seen any change at all. There hasn’t been any impact on the folks who work in the toy business. And I’m not aware of any change in strategy broadly because of the change in leadership.

Felicia Hendrix – Barclays Capital

Okay. That’s good. And then just minor one, but I’m just wondering what effective core Fisher-Price in the quarter. It seems to underperform a lot of the other line items.

Bob Eckert

Yes, let’s say, in general, Felicia, from a POS standpoint, as we’ve talked for probably the last, I don’t know, eight months or for a year, we are a little bit disappointed in the POS trends on Fisher-Price last year. We think a lot of that was driven by price points on key drivers, which we’ve rectified this year. Some of those products are just starting to sell right now. I did see iXL, for example. I did find one of our products out there. I saw iXL the other day.

So I think in general, Fisher-Price – if you go back over the last ten years, it’s probably been the best performing major brand in the toy industry or certainly one of the best. Fisher-Price is a terrific franchise. But from a core product standpoint, we’ve been a little disappointed in the POS. Fortunately, if you look at recent weeks, the momentum is improving a bit. We’re also hampered in that segment by things like Power Wheels, which is a very large expensive item. So when – it's disproportionate because of the retail dollars involved. And Power Wheels have not done particularly well since the economy started to contract.

Felicia Hendrix – Barclays Capital

So those reasons just seem kind of fundamental to your specific business in general. I’m wondering if you are seeing any kind of uptick competitively as well.

Bob Eckert

Well, there is always competition. Certainly, the infant and preschool category over the decade, I’ve been looking at the numbers, has been a growth category within the toy business. Fisher-Price has led that growth, has gained share more times than that in the ten years I’ve been looking at the data. It is a competitive category. We do see new competitors coming all the time, but Fisher-Price has held its own and continue to hold its own and is continuing to build share as we speak.

Felicia Hendrix – Barclays Capital

Okay. Okay, great. Thank you.

Bob Eckert

Thank you, Felicia.

Dianne Douglas

Thank you for participating in our call today. There will be a replay of the call available beginning at 11:30 AM Eastern Time today. The number for the replay is 706-645-9291 and the passcode is 79744049. Thank you all.

Operator

Ladies and gentlemen, that does conclude today’s program. You may now disconnect and have a wonderful day.

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Source: Mattel, Inc. Q2 2010 Earnings Call Transcript
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