Mattel is (NASDAQ:MAT) losing the "toy wars" with Hasbro (NASDAQ:HAS). Shares of Mattel have dropped from nearly $48 per share to under $40 since the beginning of the year, while Hasbro's shares have advanced modestly since the start of 2014. Let's examine Mattel's cash flow-derived intrinsic value to see if further declines may be coming or if there is potential upside on the basis of its fair value estimate.
For those that may not be familiar with our boutique research firm, we think a comprehensive analysis of a company's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolio. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Mattel posts a Valuentum Buying Index score of 3, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and bearish technicals. A 3 is below average, and while our rating system is not a step-function, we don't see Mattel registering a 9 or 10 anytime soon (a "we'd consider buying" rating.) Let's dig deeper into the company.
Mattel's Investment Considerations
- Mattel earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 46% during the past three years. It should be no surprise that Mattel is a great company. However, the company is a good example of the old saying that "a good company doesn't mean that it's a good stock." This has been true, at least so far in 2014.
- Mattel makes toys and family products, including brands such as Barbie, Hot Wheels, Matchbox, American Girl, Radica, Tyco R/C, Fisher-Price, Thomas & Friends, Little People, and Power Wheels. Its brand portfolio is top-notch, and we point to the portfolio of its brands as the core reason for its excess economic returns.
- Mattel has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 15.1% in coming years. Total debt-to-EBITDA was 1.2 last year, while debt-to-book capitalization stood at 33%.
- Mattel's stated objectives are to grow market share, sustain gross margins of about 50%, and leverage its scale to deliver cost savings by reducing overhead expenses. Though competition remains tough, we think such goals are achievable.
- The firm sports a very nice dividend yield of about 4%. We expect the firm to pay out about 57% of next year's earnings to shareholders as dividends. However, we point to peer Hasbro as our preferred dividend growth idea out of the two. It has a modestly stronger Valuentum Dividend Cushion score.
- Mattel has a Valuentum Buying Index rating of 3. Though much of this score is influenced by its poor technical and momentum assessment (the third pillar of the process; the first two are its DCF fair value and relative valuation assessment), it is telling of its underperformance and reveals that a quick rebound may not be in the cards. We'd grow to like Mattel if it were to register a 9 or 10 on the index -- this would imply significant valuation and pricing support.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Mattel's 3-year historical return on invested capital (without goodwill) is 46%, which is above the estimate of its cost of capital of 10.1%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead, based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Mattel's free cash flow margin has averaged about 10.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Mattel, cash flow from operations increased about 5% from levels registered two years ago, while capital expenditures expanded about 32% over the same time period.
Our discounted cash flow model indicates that Mattel's shares are worth between $30-$50 each. Shares are trading at $38 each (roughly at the midpoint of the range). The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $40 per share (the mid-point of the range) represents a price-to-earnings (P/E) ratio of about 15.4 times last year's earnings and an implied EV/EBITDA multiple of about 10.7 times last year's EBITDA.
Our valuation model reflects a compound annual revenue growth rate of 2.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 3.5%. Though we're building in slowing growth, we're building in expansion nonetheless. Though the winter holiday season (Christmas) is much more important for assessing the performance of the company, revenue did face declines in its first-quarter 2014 results. Said differently, we're viewing its first-quarter performance as a mere hiccup on a path to moderate expansion during the next few years. Physical toys aren't dead, in our view.
Our model reflects a 5-year projected average operating margin of 19.9%, which is above Mattel's trailing 3-year average. We're building in operating margin expansion as the firm manages costs and streamlines its workforce (the firm had $16 million in severance expense during the first quarter). Beyond year 5, we assume free cash flow will grow at an annual rate of 2.2% for the next 15 years and 3% in perpetuity. For Mattel, we use a 10.1% weighted average cost of capital to discount future free cash flows. We think the long-term growth rate and discount rate are appropriate for a firm of Mattel's risk profile.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Mattel to Hasbro, among others. Hasbro registers a 7 on the Valuentum Buying Index, a much more optimistic score. Mattel's relative valuation metrics are neutral, as a relatively attractive P/E is largely offset by an in-line PEG ratio (the PEG ratio considers Mattel's five-year earnings trajectory).
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $40 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety, or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Mattel. We think the firm is attractive below $30 per share (the green line), but quite expensive above $50 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Mattel's fair value at this point in time to be about $40 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Mattel's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $49 per share in Year 3 represents our existing fair value per share of $40 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.