Mattel Q3 2007 Earnings Call Transcript

| About: Mattel, Inc. (MAT)

Mattel, Inc. (NASDAQ:MAT)

Q3 2007 Earnings Call

October 15, 2007,8:30 am ET

Executives

Michael Salop - EVP, External Affairs

Robert Eckert - Chairman, CEO

Kevin Farr - CFO

Analysts

Michael Savner - Banc of America

Tony Gikas - Piper Jaffray

Sean McGowan - Wedbush Morgan

Felicia Hendrix - Lehman Brothers

Linda Bolton - Oppenheimer

Margaret Whitfield - Sterne Agee

John Taylor - Arcadia

Gerrick Johnson - BMO Capital Markets

Tim Conder - Wachovia

Operator

Welcome to the Mattel, Inc. third quarter 2007 earningsresults conference call. Today's call is being recorded. At this time foropening remarks and introductions, I would like to turn the call over to Mr.Mike Salop, Treasurer and SVP, External Affairs. Please go ahead, sir.

Michael Salop

Thanks, Connie andgood morning, everyone. Today we issued a press release which detailed Mattel'sthird quarter 2007 results. On the call this morning Bob Eckert, Mattel'sChairman and Chief Executive Officer, will give some remarks on the quarter andrecent events; and Kevin Farr, Chief Financial Officer, will provide moredetail on our financial results. After Kevin's comments, we will open the callfor your questions.

Before we begin, let me note certain statements made duringthe call and in the question-and-answer session that follows may includeforward-looking statements about management's expectations, strategicobjectives and anticipated financial performance and other similar matters.

Such forward-looking statements may include commentsregarding performance of our brands and product lines, product safety, newproduct introductions, brand strategies, international growth opportunities,American Girl retail expansion, profits and margins, the impact of productrecalls, supply chain operations, export and import licenses, capital spending,income tax provisions, share repurchase and our capital and investmentframework.

A variety of factors, many of which are beyond our control,affect the operations performance, business strategy and results of Mattel andcould cause actual results to differ materially from those projected in suchforward-looking statements. Some of these factors are described in our 2006report on Form 10-K filed with the SEC and Mattel's other filings made with theSEC from time to time, as well as in Mattel's other public statements. Matteldoes not update forward-looking statements and expressly disclaims anyobligation to do so.

Information required by Regulation G regarding non-GAAPfinancial measures is available on the investors and media section of ourwebsite, Mattel.com, under the subheading “Financial Information and Earnings Releases”.

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

Robert Eckert

Thank you, Mike and good morning, everyone. Since we lastspoke in July, Mattel has faced more than its share of challenges. As I'vealways said, it's my sincere hope that we'll not be judged solely on the issuesthat have confronted us, but also on the manner in which we have responded tothose issues; on the prompt, corrective actions we've taken and on theimprovements we've made for the future. As an organization, we've tackleddifficult issues before and we've demonstrated an ability to make change forthe better; within our own company, and also throughout the broader industry.

As you know, in August and September, Mattel announcedvoluntary recalls on two very different issues. One issue was impermissiblelevels of lead paint which affected a relatively small portion of productsrecalled, but attracted a lot of attention. The other issue was the expansionof an initial list of toys with very small and powerful magnets that werecalled last November. We expanded the list voluntarily because we wanted toapply retroactively new and more rigorous standards that we helped pioneer forthe retention of those magnets.

The lead paint recalls have been particularly disappointingfor me, because Mattel has long applied what we believe are some of the most rigoroussafety protocols in the toy industry. Unfortunately, despite these manysafeguards, some toys with unacceptable levels of lead paint made it throughour safety system and into the marketplace. We moved quickly and vigorously toaddress the immediate issues and tightened those safety protocols even further.We held back all products in Asia, whether made at aMattel facility or a vendor facility, and we undertook additional testing on amassive scale.

With respect to the products in Asia,for example, we examined a comprehensive range of samples of the toys to ensurethat we identified any products with paint that violated applicable leadstandards. This testing was applied to even the smallest part of each toy toidentify any non-compliant paint, no matter how minor the use.

In addition, we immediately implemented a strengthened,three-point check system to enforce compliance with all regulations andstandards applicable to lead paint. That three-point check system is as follows:

First, every batch of paint must not only be purchased froma certified paint supplier, but also be retested before it's used, to ensurecompliance with lead standards.

Second, to further ensure that our toys are safe before theyreach store shelves, paint on samples of finished products from everyproduction run must be tested for lead, either by Mattel's own laboratories orby laboratories certified by Mattel.

Third, Mattel has increased the frequency of random,unannounced inspections of vendors and subcontractors for compliance with ourquality and safety procedures, including the applicable lead paint standard.

Mattel has also implemented additional protections. Vendorsand subcontractors must segregate all production for Mattel, and they must havededicated storage for paint used on Mattel products. No subcontractor mayfurther subcontract out any part of a job to other locations. Before using asubcontractor's components in Mattel products, a vendor must test samples ofsix components for lead paint. Finally, the vendor as well as the subcontractorare both subject to unannounced audits, and are held accountable for our rulesand requirements.

More generally, we have also created a new corporateresponsibility organization, reporting directly to me. This new organizationadds an even greater level of accountability, internally and externally, foradherence to the company's safety and compliance protocols. I just went to Chinato check on progress firsthand. I had the opportunity to meet with our safetyexperts, as well as with some of our key vendors there to ensure theyunderstand our tightened procedures and our absolute requirement of strictadherence to them. I'm confident that our new three-point check system is fullyimplemented, and more importantly, that it's working.

I know that many of you are interested in an update on ourprogress in testing toys that were produced prior to our new safety systembeing implemented. It's important to emphasize that nothing is being shippedfrom China -- oranywhere else -- before it's been tested. We have tested just about everythingwe expect to ship for the holidays and because we have prioritized our testingbased primarily on expected shipment levels, we believe that any issues thatmay still be uncovered through our current testing program would be relativelysmall. We have tested thousands and thousands of products and the testingprogram is ongoing as we continue to look for the needle in the haystack.

Despite the considerable focus on these enhanced measuresand some supply chain disruptions that impacted our shipments in the quarter,the business has held up fairly well. International has continued to drivegrowth in every major region, and while the U.S.was down slightly in the quarter, we did continue to see strong performancefrom several lines, especially core Fisher-Price and our Cars entertainmentproperty.

U.S. Barbie performance was somewhat disappointing andremains an area of focus, although a good portion of the decline in the quarterwas directly related to the supply chain disruptions.

As we move into the all-important holiday season, Mattel andFisher-Price toys are already topping must-have holiday lists everywhere. WithBarbie Girls, the next generation of fashion doll and MP3 player combined; andFisher-Price's Smart Cycle, a stationary bike, learning center, and an arcadegame system, making it onto the coveted Toy Wishes Annual Holiday Hot Dozen.

For the holiday, Mattel also has a plethora of tech toys,gadgets and games for both tweens and tykes, including U.B. Funkeys by Radica,offering a hybrid play experience in both the real and virtual worlds; and ICan Play Guitar from Fisher-Price, for the youngest of rock stars. Younger kidscan also get connected with Easy Link Internet Launchpad and Digital Arts andCrafts Studio from Fisher-Price.

As I have said every holiday season since I arrived atMattel, there will be a Christmas, and Mattel, Fisher-Price, Radica andAmerican Girl toys will be under the tree. That said, we're acutely aware thatparents have many choices when it comes to buying toys. Many of us at Mattelare parents ourselves and we know that nothing is more important than thesafety of children. We have taken significant actions to further ensure thesafety of our toys and I'm working hard to let parents everywhere know that I'mconfident that this year's toys will be the safest ever.

Despite all of the unexpected challenges we have facedrecently, we're keenly focused on delivering what we believe is a strong falllineup to our retail customers and consumers around the world. I'm proud of thethousands of dedicated Mattel employees who have worked countless hours behindthe scenes to ensure our products are some of the safest on the shelves. I'vesaid often that how we achieve success is just as important as the successitself; that statement has never run more true. At Mattel, our priority is thesafety of children who play with our toys; our long record of safety is whywe're one of the most trusted names with parents.

Now I would like to turn the call over to Kevin for afinancial review of the quarter.

Kevin Farr

Thank you, Bob and good morning, everyone. Before I providemy usual remarks on the third quarter financial results, I would like to take afew minutes to explain the impact of product recalls. As a reminder, in oursecond quarter 10-Q filing, we established reserves totaling $28.8 million forthe first and second product recalls. We based the reserve estimates onexpected levels of affected product at retail and historical consumer returnrates. As we have now experienced a couple of months of actual returns, it isapparent that return rates are going to be higher than originally expected,particularly in international markets. Consequently, in the third quarter wehave increased the reserves related to the first two recalls by $13.3 million.We have also taken additional reserve charges of $9.1 million for subsequentproduct recalls.

In addition to these charges, we have incurred incrementalcosts for legal fees, recall advertisements and recall administration aroundthe globe. These recall-related costs totaled approximately $17 million duringthe third quarter.

Collectively, our third quarter results includeapproximately $40 million of charges and costs related to product recalls.Breaking this amount down by line item in the P&L, third quarter net saleswere reduced by approximately $19 million and costs of sales increased by $3million, advertising by $4 million, and SG&A by $14 million.

Another financial impact to the product recall relates toour supply chain. As you know, we intentionally slowed down our shipments outof Asia while we conducted extensive product testing.Also, export licenses at several manufacturing facilities in Chinawere temporarily suspended in September while safety procedures were reviewed.While nearly all the licenses are now back in place, delays of one to two weeksin shipments from some facilities did prevent us from filling some ordersduring the quarter. We estimate the impact on sales in the third quarter atapproximately $30 million to $50 million, particularly affecting the Barbie andFisher-Price brands.

Our ability to import products into certain countries wasalso impacted by product recalls, as certain countries and regulatoryauthorities reviewed our safety procedures. These issues have since beenresolved in most countries, and did not have a significant financial impact onour third quarter results. The import license situation in Brazil,however, is still unresolved. We had sufficient inventory on hand in Brazilto fulfill most third quarter orders, and were working closely with Brazilianauthorities to satisfy their needs. If the situation does not change in thenear future, it could present a risk to Mattel's fourth quarter sales volume.Obviously, we're working very hard to reopen our business there.

I will now provide my remarks on Mattel's overall thirdquarter financial performance. As I walk through the financial review for thequarter, I will try to highlight areas in which the recall has had a notableeffect.

Let's begin with the discussion of worldwide gross salesshown on exhibit 2 of today's press release. Total worldwide gross sales forthe third quarter were up 4% over the prior year, with a 3 percentage pointpositive impact from changes in currency exchange rates. U.S.sales were down 2%, while international sales were up 10%, including a 6percentage point benefit from foreign exchange.

On a regional basis, sales in Europewere up 9%, including a 6 percentage point benefit from changes in currencyexchange rates. Sales in Latin America were up 17%, witha 6 percentage point benefit from foreign exchange rates. Sales in Asia Pacificwere up 16%, including a 6 percentage point benefit from foreign exchangerates.

I will now review our core categories and brands. MattelGirls and Boys brands: worldwide sales for Mattel Girls and Boys brands were up6% with a 4 percentage point benefit from changes in currency exchange rates.International sales of Mattel Girls and Boys brands increased 13%, whichincluded a 7 percentage point benefit from foreign exchange, more thanoffsetting U.S.sales declines of 4%.

Worldwide Barbie sales were down 4%, including a 4percentage point benefit from changes in currency exchange rates. Barbie salesdeclines in the U.S.of 19% were partially offset by sales increases in international markets of 6%,including a 6 percentage point benefit from changes in currency exchange rates.We attribute approximately half of the weakness in the U.S. Barbie business to shippingdelays caused by short-term disruptions to our supply chain resulting fromproduct recalls. The remaining decrease is attributed to ongoing softness inour Barbie Fantasy business.

Worldwide sales of other girls brands were down 10%,including 3 percentage point benefit from foreign exchange. The sales decreasewas primarily driven by sales declines in Polly Pockets in the U.S.

Sales in the wheels category were up 9% including a 3percentage point benefit from currency exchange rates. Strong growth in HotWheels internationally and Matchbox worldwide more than offset sales declinesin Hot Wheels and Tyco RC in the U.S.

Our entertainment sales remained strong with sales increasesof 29%, including a 4 percentage point benefit from changes in currencyexchange rates. Sales of the Cars property continued to be strong and onceagain surpassed last year's levels. Sales contributions of $58 million fromRadica and solid growth in our games business also contributed to thedouble-digit increase in the entertainment business.

Fisher-Price brands: worldwide sales for Fisher-Price brandswere up 1% for the quarter, including a 2 percentage point benefit from changesin currency exchange rates. On a regional basis, U.S.sales of Fisher-Price brands decreased 1%, while international sales grew 5%,including a 5 percentage point benefit from foreign exchange. Worldwide, coreFisher-Price was up 19%, with a 2 percentage point benefit from foreignexchange. U.S.sales of Fisher-Price core were up 20%, and international sales were up 18%,including a 6 percentage point benefit from foreign exchange. The overallgrowth in Fisher-Price core was related to continued worldwide strength in ourinfant, baby gear and newborn products as well as preschool and learningproducts, including the top selling item, Smart Cycle.

Fisher-Price Friends was down 30% worldwide, including a 1percentage point benefit from foreign exchange. Sales of Fisher-Price Friendsin the U.S. wasdown 34%, while international sales were down 21%, including a 3 percentagepoint benefit from foreign exchange. The decrease in Fisher-Price Friends wasprimarily driven by sales declines of Dora the Explorer. The supply chaindelays caused by the product recalls also negatively impacted sales ofFisher-Price Friends during the quarter, as previously mentioned.

American Girl brands; sales of American Girl brands wereflat in the third quarter, despite better than expected performances from our Atlantaboutique and bistro and the September launch of our newest historicalcharacter, Julie. The softness in our American Girl business is primarilyattributable to our catalog business.

Now, let's review the P&L, which is shown on exhibit 1.For the quarter, gross margin was 47.0%, a 60 basis point decrease versus theprior year, driven primarily by a 70 basis point negative impact from theproduct recall cost. During the quarter, the positive impacts stemming from thealignment of our prices with increased input cost and favorable foreignexchange were largely offset by cost pressures.

Advertising expense in the quarter was $211.4 million, or11.5% of net sales, consistent with last year. Selling, general andadministrative expenses were $342.8 million, up $19.5 million from last year's$323.3 million. As a percentage of sales, SG&A increased 50 basis points to18.6% in the third quarter from 18.1% of net sales last year.

As previously mentioned, the 2007 third quarter resultsinclude approximately $14 million of incremental costs related to productrecalls. Also as a reminder, the 2006 third quarter results were negativelyimpacted by a cumulative adjustment for non-cash compensation expense of $19.3million related to our historical stock option review. Absent these costs, theincrease in 2007 third quarter SG&A expense was driven by higheremployee-related costs, increased investments in the business, the negativeimpact of foreign exchange, and the inclusion of Radica, partially offset bylower incentive expenses.

For the quarter, operating income was $310.5 million,compared with $322.2 million in last year's third quarter. The negative impactof the product recall costs dampened otherwise good top line performances fromour international markets and our entertainment and Fisher-Price corebusinesses and stable gross margins.

Interest expense was $16.4 million in the quarter comparedwith $22.6 million in 2006. The decrease in interest expense versus last yearis due to lower average borrowings.

Interest income for the quarter was $6.2 million, comparedto $6.7 million in 2006. The lower interest income is primarily due to loweraverage invested cash balances during the quarter. Other non-operating incomeitems in the quarter consisted of income of $7.4 million versus expense of $1.7million a year ago. The current year income relates primarily to foreigncurrency exchange gains.

Income tax expense for the quarter was $70.9 million, or23.1% of pretax income, compared to $65.6 million or 21.5% in the third quarterof 2006.

So to summarize the P&L for the quarter, we reported netincome of $236.8 million, or earnings per share of $0.61 versus last year'sthird quarter net income of $239 million or $0.62 per share. This quarter's netincome and earnings per share included pre-tax product recall-related chargesand costs of approximately $40 million, which represents approximately $0.08per share.

Turning to the cash flow statement and balance sheet, cashused for operations in the first nine months of 2007 was $611 million, drivenprimarily by the use of cash for working capital requirements, partially offsetby net income of $272 million and depreciation and amortization of $128million. Cash used for investing activities for the first nine months of 2007was $237 million, and includes $105 million for acquisitions and $98 millionfor capital expenditures. Cash used for financing and other activities was $81million, and reflects the utilization of cash for share repurchases andrepayment of medium-term notes offset by the proceeds from short-termborrowings and the exercise of stock options.

During the third quarter, the company repurchasedapproximately 28.3 million shares of stock at a cost of $645 million. AtSeptember 30th, there was approximately $162 million left on the outstandingshare repurchase authorization. Our cash on hand at the end of the quarter was$276.8 million, down from $552.4 million at the end of last year's thirdquarter. The decrease in cash was due primarily to the utilization of cash forshare repurchases and investments in our business including acquisitions,partially offset by cash from operations and stock option exercise.

Receivablesat $1.6 billion were up $252.4 million from last year's third quarter, andrepresented 80 days of sales outstanding, which is ten days higher than lastyear. Factoring was down $128 million from 2006 levels and days salesoutstanding prior to factoring was four days higher than last year. Inventoriesat $732.3 million, were up $60.1 million, or 9% versus the third quarter of2006, and represented 62 days of supply, which was consistent with last year.

Ourtotal balance sheet debt increased by $31.5 million from the third quarter oflast year, primarily as a result of higher short-term borrowings, partially offsetby the repayment of international term loans and the maturity of medium-termnotes. As of quarter end, our debt to total capital ratio was 29%,consistent with last year.

We continue to operate under our established capitalinvestment framework, targeting year end debt to total capital ratio of around25% and year end cash balances of around $800 million to $1 billion.

Capital expenditures for the quarter were approximately $40million versus $34 million in the third quarter of 2006; the increase wasprimarily driven by investments in American Girl and information technology.

So to recap the third quarter, our top line benefited fromcontinued international strength, foreign exchange and strong contributionsfrom our Fisher-Price core, entertainment and wheels businesses. However, thepositive top line growth was eclipsed by additional charges, cost and supplychain delays stemming from product recalls.

As we enter the all-important fourth quarter, we remainfocused on executing our business and we'll continue to take the actionsnecessary to ensure the safety of our products, partnering with retailers andposition Mattel for a successful holiday season.

That concludes my review of the financial results. Now we'dlike to open the call to questions.

Question-and-AnswerSession

Operator

Your first question comes from Michael Savner - Banc ofAmerica.

Michael Savner - Banc of America

It seems like this quarter's results were a little bit moretricky to get into what the apples-to-apples would have been, since you hadsome supply chain issues related to the recall. But when we look atFisher-Price, which has been a great growth engine at least in the first halfof the year, it would seem that ex the core brands there was a huge falloffbeyond just Fisher-Price Friends. Maybe if you could give us a little morecolor on what's going on there and where else the weakness was and to theextent that could you even quantify what was related to recall slowdown,shipments and what was maybe organic weakness?

A similar question about Barbie. We've been hearing for thelast year that that brand is being revitalized, and I think your target was forthis fall you would see a nice improvement. Obviously, there's some recallissue going on there as well, but it still doesn't seem to be materializing.Maybe if you could just revisit your conviction level that this fall and winteryou're going to see a revitalization in that brand domestically. Thanks.

Robert Eckert

The basic Fisher-Price toy business continues to grownicely. We did benefit early in the year from rebuilding retail inventorieswhich were depleted last holiday season, but since then, we've seen solidperformance at retail. The digital camera is doing well, Imaginex Dinosaur isdoing well, Shake and Go Cars is doing well and most recently, the Fisher-PriceSmart Cycle seems to be a real winner. Also the baby gear business, which arethe non-toy items from Fisher-Price, they continue to grow at very good ratesall around the world.

The second part of the Fisher-Price business, which is theFriends or licensed character brands, it's still a nice-sized business, butDora has begun to decline and I believe I have mentioned that in the lastquarter or two. The Sesame Streetportion of that business benefited last year from the September 19th launch ofTMX. This year's Elmo, which is a surprise, launches in November. I know someof you got a clue from one of our customers who put it on their top toy list.But the decline of the Dora business was more important than the shipmentdeclines related to supply chain issues in the quarter.

Moving over to Barbie, we do need to work more on Barbie.Following some encouraging results in the U.S.last year, we have slipped again in '07. Some of it's related to supply chaindisruptions, but some of it is related to point of sale needs. Internationalcontinues to perform better than the U.S.The reality segment everywhere continues to perform better than fantasy. Thatsaid, through three weeks, the DVD sales for Barbie and the Island Princess,this year's movie launch, are ahead of a year ago but that hasn't yettranslated to doll sales.

MyScene is doing well internationally, the collector dollsare growing worldwide. We've had good traffic on Barbie Girls. We have launchedthe MP3 device. It's still early in the season. We still do have strong holidayplans, and I guess I would characterize it by, we'll have to see how theholiday season plays out.

Operator

Your next question comes from Tony Gikas - Piper Jaffray.

Tony Gikas - Piper Jaffray

Maybe just a quick update on what you're hearing from someof your key retail partners concerning the recalls. Do they expect thatconsumers will be deterred by the recalls?

Second question, housekeeping, what was the share count atthe end of the quarter?

Robert Eckert

I would say in general, retailers are probably a littleanxious about the impact of recalls, but they're at least as anxious about theoverall economy and consumer plans for the holiday. At this time of year, wealways call it the early fall jitters. There are a lot of toys in the pipeline-- in our pipeline and retailer's pipeline -- and we're waiting for theconsumer to come and start shopping. I think it will happen again this year.

Related to that, we have fielded several consumer trackingstudies related to the recalls. The most recent results indicate that there hasbeen widespread awareness of the recalls, more than three-quarters of peopleare aware of toy recalls. The vast majority of those believe that Mattel andFisher-Price have handled the recalls quite well. Image perceptions of toymanufacturers have stabilized in the past month; they haven't yet returned topre-recall levels, but they've clearly bottomed out.

By brand, Polly Pocket is showing weakness in the U.S.That's true both in imagery and at retail sales. We're responding with whatwe're calling the Polly Promise, which will begin later this week. It's asignificant coupon on-shelf and online. Plus, for any reason, if consumersaren't satisfied with anything that they buy from Polly Pocket, we'll refundthe purchase price in full over the next year. So we want to re-engage,particularly parents, with the Polly brand.

Finally, I'd note on the brand imagery work, thatFisher-Price continues to enjoy the best brand imagery in the toy business. Sooverall, it looks like from a consumer standpoint, I think the anxiety aboutthe recalls is largely behind us.

Kevin Farr

Tony, with regard to your second question, if you look atthe end of September 30th, basic shares outstanding are about 370 million.

Tony Gikas - Piper Jaffray

It sounds like the recalls are essentially behind us, andthe testing is essentially behind us and there were some incremental costsduring the quarter. Going forward, what will those ongoing costs be forincreased product safety testing? Is it a measurable dollar amount or reallynot material?

Kevin Farr

Tony, the ongoing costsassociated with our three-point check system will reflect in cost of sales. Wecurrently expect the ongoing test procedures to be well under 1% of our totalcost of sales.

Operator

Your next question comes from Sean McGowan - Wedbush Morgan.

Sean McGowan - Wedbush Morgan

Bob, could you talk a little bit about American Girls in thequarter? With the first new historical doll in five years, one might have anexpected an increase there. Do you think that's just going to be showing up inthe fourth quarter, or is there something else going on there?

Robert Eckert

We'll have to see.The girl of the year doll this year, which was Nikki, continues to do well. Julie,the character you referred to, the 1970s-based historical character -- which Ithink is an oxymoron, at least from my vantage point, it would be. We alsoopened the Atlanta boutique whichKevin mentioned, which is off to a good start although it's very early; and Dallasopens, which is a larger boutique, early in November.

But the base business is soft. The holiday wish book mailstoday. We have high expectations for that. Regionally, we're going to be doingsome testing of some television marketing for the brand. So we're hopeful. Iwould have liked to have seen the quarter do a little bit better than it did,but we'll have to see how the holiday season plays out.

Sean McGowan - Wedbush Morgan

Can you give us some framework for looking at the riskpresented by Brazil?How much of an impact in the third quarter might there have been and what's upfor grabs in the fourth quarter?

Kevin Farr

Maybe I'll step back,Sean, and give you an overall view of the fourth quarter. I think it'sdifficult to gauge at this point where the overall impact of supply chaindisruptions may be on the year. Certainly some and possibly most of the lateshipments could be recovered in the fourth quarter. I think in my speech wesaid about $30 million to $50 million of shipments were delayed in the thirdquarter. That said, our fourth quarter shipments for Brazilmay be at risk. If import licenses are not reinstated soon, that couldrepresent approximately 2% risk to Mattel's fourth quarter sales.

Sean McGowan - Wedbush Morgan

2% of the quartersales, you mean?

Kevin Farr

That's correct.

Robert Eckert

If that were to materialize, we would work hard to move thatproduct to some other market, if we could.

Sean McGowan - Wedbush Morgan

Have there been any shares repurchased since the end of thethird quarter?

Robert Eckert

I don't think wedisclose any share repurchases at any time in the middle of a quarter, do we,Mike?

Michael Salop

No, we don't.

Operator

Your next question comes from Felicia Hendrix - LehmanBrothers.

Felicia Hendrix - Lehman Brothers

I have a follow-up on American Girl. You have talked for severalquarters about catalog declines and if I understand what you were saying -- andplease correct me if this isn't the case -- are the catalog declines completelyoffsetting any of the strength you're seeing from Julie and the new Atlantastore? If that's the case, what can you do to help generate better sales fromthe catalog business?

Robert Eckert

They did in the quarter, Felicia, but also the Atlantastore opened quite recently and Julie just launched this month, so I think ourexpectations continue to be pretty high on both of those launches. But the basebusiness has been soft. We are doing some more marketing this quarter and thebig book, which is what counts and will feature Julie in terms of catalogshopping, mails I think literally today.

We also have, as I may have referenced in previous calls, afull length feature film next year, which could stimulate some sales ofhistorical dolls. That film features Kit Kittredge, which is one of the earlycharacters.

Felicia Hendrix - Lehman Brothers

When did Julie ship?

Robert Eckert

Julie doesn't ship like toys ship into retailers. Julie waslaunched late in the third quarter. But the real marketing of Julie starts nextweek.

Felicia Hendrix - Lehman Brothers

I know it's not a big deal because it's not that manystores, but when does it ship into the stores that you do have?

Robert Eckert

I believe it's in thestores. But that wouldn't count as a sale until consumers buy it.

Felicia Hendrix - Lehman Brothers

A follow-up on the Barbie front. You're pretty clear aboutwhat's going on there, but I'm also wondering, do you think there's a systemicweakness in the fashion doll business in general?

Robert Eckert

I don't know if Iwould use the word systemic. But looking at girls toys overall, they do looksoft to me. I haven't seen really anything on a competitive front that seemsoverly important right now. I guess the exception to that will be the continuedpopularity of Webkinz, which is not exactly fashion doll play. But I have seenmore softness in our girls business overall than I've certainly seen in boys orin infant and preschool. The obvious exception to that are things like HighSchool Musical, which are selling quite well. But the base business, I wouldsay across girls, is a little bit soft right now.

Felicia Hendrix - Lehman Brothers

Of the $40 million charge, $9.1 million was related tosubsequent recalls or future recalls. Is that just a “just in case” kind ofthing or is that for something specific?

Kevin Farr

The $9.1 millioncharge includes a cost for the third recall and it is related to specificrecalls.

Operator

Your next question comes from Linda Bolton - Oppenheimer.

Linda Bolton - Oppenheimer

Just going back to your discussion of the impact of thesupply chain disruptions on U.S. Barbie sales, could you explain better why theimpacts would be greater on the U.S.than in other regions in terms of Barbie sales? Is it just because the productneeds to travel further to get here or can you further explain that?

Robert Eckert

I would say it'sbecause the product needs to travel, because of the timing of shipments thatvaries by market and because of the amount of direct import business -- that isFOB Chinabusiness -- which is largely done in the U.S.and not as pronounced internationally. That's also why the supply chain disruptionsimpacted Fisher-Price Friends more than other brands, because that's anotherbrand that has more FOB Chinashipments. Title transfers in China,and that's when the sale is recorded. Because we missed some of those sales,that was the impact.

Linda Bolton - Oppenheimer

Also just in terms of your discussion of the potentialfuture impact of the incremental testing, when we're thinking of unit orvariable testing costs, you're going to be increasing the number of times thatyou're testing a bunch of units. It seems that that would make a very large --maybe five times, 10 times even -- impact on the costs because it's mostlyvariable costs. So even though it's only 1% of COGS, if that were to increaseby five or ten times, that would be significant. Can you just explain better?

Robert Eckert

I don't think, Linda, the 1% would be increased by five orten times. I think the point is the less than 1% of total COGS cost isassociated with testing. So when you have the new testing on an ongoing basis, costof goods would increase by less than a percentage point.

Kevin Farr

Yes, that's correct.The incremental testing that we'll be doing with regard to products will haveless than a 1% impact on our total cost of goods sold.

Robert Eckert

Our COGS are still going to be heavily influenced by basiccommodity costs and labor costs and shipping costs and those sorts of things. Asthose sorts of things continue to increase, we'll look at pricing again,probably in the January through April timeframe next year.

Linda Bolton - Oppenheimer

Finally, you had mentioned that in the other income line,there was a favorable effect of currency and that made that line item positive.I would expect then that that same concept would apply to the fourth quarter of'07 in terms ofcurrency still being favorable?

Kevin Farr

Again, we don't, asyou know, Linda, project or give guidance; but not necessarily. It's going todepend upon what the currency does relative to the U.S. dollar. So that foreignexchange gain related to our Latin America operationsand we'll have to see whether exchange rates go up or down with respect to thevarious currencies.

Operator

Your next question comes from Margaret Whitfield - SterneAgee.

Margaret Whitfield - Sterne Agee

Good morning, everyone. Per Wal-Mart's remarks the otherday, could you give us the commentary on the state of consumer activity interms of retail toy sales here in early fall?

Robert Eckert

Well, I think we are clearly anniversarying last year's TMXElmo launch, which not only did well for Fisher-Price and Fisher-Price brands,but I think everybody understands drove people into the toy aisle earlier lastyear. Now, we do have news coming on Elmo but it will be later this year, and Ibelieve that most retailers planned for the season to be later this year thanit was last year. I think that's being reflected in today's retail sales.

Margaret Whitfield - Sterne Agee

Would you say the toysales are down double-digits at this stage, Bob, given the difficult compareand the environment in general and the concern over the recalls?

Robert Eckert

No, I wouldn't saythat. When it comes to kind of that level of detail, I'd steer you towards theretailers, because obviously the results vary by retailer.

Margaret Whitfield - Sterne Agee

is there any unusual cancellation activity, given the factthat you've had delays in the supply chain and given the environment?

Robert Eckert

No, I wouldn'tdescribe it as an unusual. Clearly we work very, very hard to get these exportlicenses back; in some markets to get the import requirements met. We haddelays but I wouldn't say, Kevin, that there was a larger than usual number ofcancellations, would you?

Kevin Farr

I would agree withthat, Bob.

Margaret Whitfield - Sterne Agee

On Polly Pocket, is this a competitive issue, a recallissue, why the Polly Promise campaign?

Robert Eckert

I think it's more ofa recall issue than a competitive issue. There's a lot of competition in girlstoys and that's been true for the last couple of years. But the fact is, whenwe do our consumer tracking studies, Polly Pocket is the one brand that has themost pronounced consumer issue right now. That's the background on the Polly Promise,is to re-engage moms with the brand. We know girls love the brand. The brand isan evergreen property, has done well. It continues to grow internationally. Theissue is here in the United Statesright now and we want to provide some extra motivation for moms to re-engagewith the brand.

Margaret Whitfield - Sterne Agee

Kevin, what was the bottom line benefit from currency in thequarter?

Kevin Farr

It was about $0.05per share.

Operator

Your next question comes from John Taylor - Arcadia.

John Taylor - Arcadia

Given the reassessment of export license policy in Chinaand so on and the press coverage of sort of inflationary pressures over there,do you guys get the sense that you'll be facing any more than an average annualincreased demand in pricing for products next year? It seems like we might havesome inflationary pressures that are getting a little bit too hard to handleover there, and I'm wondering what the capacity implications of that is?

Aside from American Girl and aside from the Polly Promise,I'm wondering if your retailers are expecting you guys to step up or toymanufacturers in general to step up a little bit more with just some generaldemand creation spending to jumpstart the holiday this year?

Kevin Farr

We will be again modestly increasing prices in the January toApril timeframe. That's going to vary by country to reflect the current costenvironment, as you've indicated. We're seeing upward cost pressures on keyinput costs, including wages, commodities, like resins and packaging, andcontinued appreciation in the Chinese currency.

Robert Eckert

Retailers do expect manufacturers to step up for theholiday. We have worked hard with them to develop plans to make sure that thereis strong demand for toys this holiday season. As I mentioned on the consumertracking studies, I'm optimistic about the consumer coming back to the toyaisle. I think we're going to spend somemarketing dollars, particularly with retailers, to partner up to make sure wecan stimulate as many sales as we can.

John Taylor - Arcadia

Let me follow up, Kevin, if I can, on the inflation thing.So I guess what I'm looking for here is you guys have been facing cost pressureincreases for some time now and you get a little here, get a little there sortof thing. I'm wondering if the testing requirements and particularly the newlicensing requirements may take some capacity offline with subcontractors, etcetera, whether you expect that to have any unusual impact on negotiations thisyear.

Kevin Farr

Overall I don'texpect that to have any unusual impact on negotiations. I think every year weface these input cost issues and challenges and we've been successful over thelast several years in putting in place modest price increases.

Operator

Your next question comes from Gerrick Johnson - BMO CapitalMarkets.

Gerrick Johnson - BMO Capital Markets

Follow up on Margaret's question, could you tell us whatyour point of sale data is looking like since the fall toy resets at retail?

Robert Eckert

No. Again, Gerrick, Iwould say that kind of question is better sent to retailers instead of to us.

Gerrick Johnson - BMO Capital Markets

Dallas toy fairwas last week. Can you describe the mood of retail buyers at that event?

Robert Eckert

I was not at thatevent. I was in China. I can tell you the general mood ofretailers is, as it is about every September/October, anxiety about the holidayseason, anxiety about the economy, anxiety to make sure we get the recallsbehind us, particularly should there be future recalls. But I think we all recognizealso that there will be a Christmas and toys have historically sold well, evenin tough economic times.

Gerrick Johnson - BMO Capital Markets

Switching over to the recall, what has the return rate beenon recalled items?

Robert Eckert

It's been a little bithigher on the lead paint-related recalls than normal. I would say normal recalls is mid to highsingle-digits. So we've seen higher than that level of returns on the leadpaint. On the other hand, as it relates to the magnet recall, we have seenlower than historical recall averages and that's not that surprising, since werecalled toys made in some cases two, three, four years ago and since toys tendto move pretty quickly in and out of somebody's home, it's unlikely that wewould get a lot of those back.

We have seen more recall returns internationally than thehistorical practice. I think that's a function of the widespread publicity allaround the world that these recalls have achieved. So overall, the return ratesfrom both retailers and from consumers have been higher than typical.

Gerrick Johnson - BMO Capital Markets

So international hasbeen a little bit more than U.S. Would you also characterize the consumer moodin international markets as anxious as well?

Robert Eckert

I wouldn't say thatthe recall rate has been higher internationally than the U.S.In fact, it's higher in the U.S.than internationally. It's just compared to a typical recall, the internationalrecall has been higher than normal. Point of sales, again, we encourage peopleto talk to retailers but I would say just if you look at our shipments in forthe quarter, if you look at point of sale for the quarter, internationalmarkets continue to grow.

Gerrick Johnson - BMO Capital Markets

Do you have a domestic wheels number?

Kevin Farr

It's minus 5%.

Robert Eckert

Gerrick, on that one, our basic Hot Wheels business, the carbusiness is doing well domestically and all over the world. Matchbox is doingwell, up double-digits all over the world, I think. The issue really is a yearago, particularly in September and late August we were shipping the radar gun,a higher-priced Hot Wheels branded item.

Operator

Your next question comes from Tim Conder - Wachovia.

Tim Conder - Wachovia

A couple follow-ups on the previous line of questioning.Bob, you were mentioning that overall the U.S.returns were greater than the international, it sounds like on an absolutebasis. What are your historical benchmarks for returns domestically versusinternational? Is it that high single-digits you were alluding to? Is that forboth? Is that a collective? If you could break that down.

Secondly, your marketing spend. Again, we saw that marketingspend drop last year on the strength of multiple different product lines. Canyou give us any directional indication, if it's going to be up whatever X -- ifyou want to about X that's great -- but can you give us any directionalindication of how much that increased marketing spend would be related torecalls versus just sort of priming the pump due to retailer fears over theeconomy?

Robert Eckert

Well, you're right,Tim, we won't talk about X. But I appreciate your asking it that way. I wouldsay my recollection, Kevin, is that advertising spending was up, at least inthe second half last year. It was that sales were up so high that as a percentof sales basis, it declined, but I think dollars were up last year.

Kevin Farr

That is correct, Bob.

Robert Eckert

Tim, in response to your question, the advertising this yearwill largely be related to stimulating product demand, not related to recalls.Now, we have certainly spent money. You've seen newspaper ads and things likethat. We've been online with Yahoo! and Google and other places, specificallytalking about recalls. But I don't think that will continue into the future. Itwill be product-based advertising.

Tim Conder - Wachovia

Then on the returns,the historical rate, again, the high single-digits?

Robert Eckert

The high single digits was a U.S.number. We tend to get more products returned in the U.S.than internationally.

Tim Conder - Wachovia

Any benchmark for the international historical returns?

Robert Eckert

No, I don't know itoff the top of my head.

Kevin Farr

It's generally less,obviously.

Operator

We'll take afollow-up question from Sean McGowan - Wedbush Morgan.

Sean McGowan - Wedbush Morgan

Are there any other products that you're shipping betweennow and the holiday season like Elmo that might be significant? Second, on theFisher-Price Friends decline, could you compare the impact of the decline inDora versus TMX, which was more significant?

Robert Eckert

There is an Elmo which could be quite surprising and I thinkone of the retailers put it on its hot dozen list that will launch in Novemberof this year. Our plans for that are not public, but we'll see. But it's apretty cute Elmo, I'll tell you that.

Sean McGowan - Wedbush Morgan

Other than that, youmade reference to that before. But are there additional products that you'reexpecting to ship that could be significant?

Robert Eckert

No, I don't thinkthere is really anything that we're unveiling that late in the year this year.Kevin, does that seem reasonable to you?

Kevin Farr

I think that'scorrect. Then your second question, the biggest impact on the decline atFisher-Price Friends really was the decline in Dora.

Robert Eckert

Now, TMX was clearlydown, if you look at this year's Elmo versus a year ago. But we have all yearlong had some pretty good halo benefit across all of Sesame Street from the TMX launch last year.

Sean McGowan - Wedbush Morgan

That leads to anotherquestion about that. Would you say that the combination, at least in the thirdand fourth quarter, combination of TMX ongoing shipments and the Ernie andCookie Monster or whatever he is called these days, could that roughly equalwhat TMX was last year?

Kevin Farr

I think it's in theballpark. I don't want to get into the specifics. We have done well with Sesame Street all year. But now we're facing certainly inthe third quarter, we faced the tough comp on TMX.

Operator

With no further time left for questions, I would like toturn the conference back over to your presenters for any additional or closingremarks.

Michael Salop

There will be a replay of this call available beginning at 11:30 a.m. Eastern time today. The number forthe replay is 719-457-0820. The passcode is 1976462. Thanks for participatingin today's call and I would like to wish everybody a good day.

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