Consumer preferences can change rapidly and catch companies off guard. When this happens, even leaders in their industries are at risk. Nowhere is this more evident right now than in the toy business. Global toy giant Mattel (NASDAQ:MAT), which used to be the king of its industry, is crumbling under the weight of shifting consumer demand. As younger people increasingly embrace smartphones and tablets, traditional toys are declining in prevalence and status.
As Mattel enters its most crucial time of the year, investor worries are rising that the company's flagship products, including Barbie, are about to lose their place under the tree. The fourth quarter is by far the most important one for toy makers like Mattel because it derives one-third of its annual sales and about 40% of its operating profits in this time. Unfortunately, this holiday shopping season is likely to see a continuation of the downward trend in toy sales. On December 19, shares of Mattel declined 6% due to a report from analysts with BMO Capital that U.S. toy sales were set to decline by 2% industry-wide.
If Mattel suffers a poor holiday season, it would cap off an overwhelmingly bad year. Shares of Mattel are down 38% year-to-date, as the company's fundamentals have deteriorated throughout the year. Investors may see Mattel's 5.2% dividend yield as reason to go bargain-hunting and buy the stock now, but it's best to wait until Mattel's next earnings report to better understand the scope of the decline the company is facing.
Results are ugly, and the bottom may not be in
Mattel's financial results over the first three quarters are unimpressive to say the least, and the reason why investors shouldn't be quick to jump in and buy the stock yet is because we can't say with enough certainty that earnings are at a floor. Mattel's revenue and earnings per share are down 8% and 33%, respectively, through the first nine months of the year. This is squarely due to pronounced weakness in Mattel's key product categories, which is very concerning. Last quarter, for example, sales of Fisher-Price fell 16% and Barbie was down 21%. By comparison, close competitor Hasbro (NASDAQ:HAS) has done much better. Its revenue is actually up 6% through the first nine months. This was due primarily to 20% revenue growth in its Boys category, thanks to strong sales of Nerf, Transformers, Marvel, and Star Wars products.
To be fair, part of the reason for Mattel's declining earnings is due to the effects of a bloated inventory at the end of last year. Gearing up for the holiday season in 2013, Mattel took on a lot of inventory based on its sales forecasts. Unfortunately, fourth quarter sales came in well below expectations, and left Mattel with a lot of inventory. For instance, last quarter Mattel's gross profit margin fell 330 basis points. Half of this was attributed to an inventory fair value adjustment associated with the MEGA Brands transaction, and the rest was due to adjustments made for retail and Mattel-owned inventory adjustments.
Mattel has had to deal with this all year, and its profits look abnormally bad because of this. To its credit, Mattel is slowly working through its inventory problem. Last quarter, Mattel's U.S. retail inventory declined in the high-teens on a percentage basis. Mattel-owned inventory dropped by $50 million. Mattel is making progress in getting inventory under control, and one would have to assume Mattel will not mismanage inventory in the same fashion this time around. Still, analysts are slashing earnings forecasts for the current quarter. BMO Capital believes Mattel has continued to lose market share this quarter. Overall, analysts expect Mattel to earn $0.97 per share this quarter, which would represent a 9% decline year-over-year. This would actually be a substantial improvement from Mattel's much steeper earnings declines over the first three quarters, and I'm skeptical that Mattel will make that much progress, given how bad the year has been.
Let earnings be your guide
It's tempting to consider buying shares of Mattel. After such a brutal year, the stock is cheap at just 14 times earnings. This is a measurable 22% discount to the broader market, which trades for about 18 times earnings. In addition, Mattel offers a 5.2% dividend yield. Based on its low valuation and high dividend yield, it's easy to see Mattel as an attractive stock pick for both value investors and income investors. And, indeed, at some point Mattel's sell-off could go too far. But I do not believe that point has arrived, just yet.
Rather than buy Mattel now and risk another earnings flop, investors should wait on the sidelines and let the smoke clear in case Mattel drops another bomb this quarter. The fourth quarter is too important to take the risk that Mattel will miss estimates again, which would likely send the stock even lower.
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