By The Valuentum Team
Mattel's (NASDAQ:MAT) dividend is not as strong as it once was, and many investors probably have already forgotten that the firm cut its dividend shortly after the dot-com bust. Though its yield is sure to turn a few heads at more than 4.6%, we think the growth potential of its payout is well past its peak and its dividend safety could be better. As of the most recent update, its Dividend Cushion ratio was a meager 0.9. It's not something to worry to much about just yet, but any further deterioration in fundamentals could challenge the payout in a big way.
Mattel continues to work to transform its operations, and stabilizing its business remains the top priority for the near term. Monetizing its tried-and-true brand portfolio (Hot Wheels, Thomas and Friends and the like) and continuously driving cost improvement while expanding into emerging markets may be its best hope of keeping the dividend on solid ground. Net sales have dropped to $5.7 billion in 2015 from $6.5 billion in 2013, while gross margins have fallen 4 percentage points over the same time. Total debt of ~$2.1 billion isn't bad given that it holds ~$890 million of cash on the books, and free cash flow generation remains robust at $500+ million per annum in recent years (2013-2015), but annual dividend obligations are near that mark.
Mattel is simply hurting right now; there's no getting around it. Hasbro (NASDAQ:HAS) is eating away at its core Barbie franchise with Disney's (NYSE:DIS) Frozen princesses taking the doll market by storm. Mattel is working aggressively to get both it and its challenged Fisher-Price brands back on track, but competition won't let up in any toy vertical (barriers to entry are low). Delivering on the trend toward more technology in toys and responding to the phenomenon of "children getting older younger" (outgrowing toys at younger ages) remain both obstacles and opportunities. Consumer preferences are fickle, and as we've witnessed with Barbie, even storied franchises can be disrupted by new brands and/or unpredictable hit toys or trends.
Mattel's dividend is not as strong as it once was. But investing is never without risks. Let's take a more comprehensive look at shares.
Mattel's Investment Considerations
• 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. The company was founded in 1945 and is headquartered in California.
• 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. Competition remains tough, and such goals won't be easy.
• Mattel has been blindsided by the tremendous success of Disney's Frozen franchise. Sales of its blockbuster Barbie doll have tumbled as a result of the popularity of the Frozen princess-duo of Elsa and Anna. Mattel doesn't have an answer to this problem, and we haven't seen the end of Frozen's popularity.
• Mattel's 2016 financial outlook could be better. The company expects a more challenging first half of the year to challenge its goal to hold its top line relatively flat in constant currency. Currency is expected to have a 2%-4% negative impact on revenue and $0.30-$0.40 negative impact on earnings per share.
• A new CEO should offer investors hope, but Mattel has been shaken to the core. We do expect results to eventually improve, but peer Hasbro is doing a much better job. The strength of the company's dividend may come into question.
Economic Profit Analysis
In our opinion, 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 25.9%, 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 8.6% 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. At Mattel, cash flow from operations increased about 5% from levels registered two years ago, while capital expenditures expanded about 1% over the same time period.
We think Mattel is worth $26 per share with a fair value range of $20-$32.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 3.5% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -3.9%.
Our model reflects a 5-year projected average operating margin of 14.9%, which is above Mattel's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.3% 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.
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 $26 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 were 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 above, we show this probable range of fair values for Mattel. We think the firm is attractive below $20 per share (the green line), but quite expensive above $32 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 $26 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above 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 $31 per share in Year 3 represents our existing fair value per share of $26 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.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we 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.