Tuesday, April 17, 2012

Mattel (MAT): Entering Shleifer Effect Watchlist

The NY Times headline sums it up...In Season of Slow Toy Sales, Mattel’s Profit Plunges 53%. From that article...

Mattel said Monday that its first-quarter profit dropped 53 percent, pulled down by costs tied to an acquisition and lower sales for Barbie and Hot Wheels.
Results were below expectations and its shares fell more than 9 percent. But the disappointing results came in what is typically a slow time for toy sales, so Mattel executives said they remained optimistic.
This is the first real earnings miss or piece of bad news that has the potential for making a big impact on the way investors view the business. It's only a notice to pay attention, not a call to action. 

What are the potential outcomes? 

One, the business improves its results next quarter (or with some interim reporting period), investors cling to their previous view of the business (conservativeness heuristic), and the price stabilizes.

Two, the business reports another one or two periods of earnings trouble, investors change their view of the businesses future (a new representativeness heuristic) deciding that it's now in a down trend, and they overreact by selling off its shares...creating an opportunity to buy the business at a price below a reasonable estimate of its intrinsic value.

And the finviz.com chart below shows the sell-off yesterday. The nine percent drop is significant as a one day decline on high volume. But the price investors are willing to pay for the stock has been heading up for several months now. There has been a sense of optimism about Mattel's future.


Some Thoughts On the Toy Business Model - Dependence on Blockbusters

I spent some time with Mattel and Hasbro in a few posts in January 2012 (here). I never completed the valuation of Hasbro (sorry), but the research highlighted some key characteristic of the toy industry. 

Toy sales are pretty volatile. Mattel and Hasbro have several brands they own outright. Mattel has Barbie, American Girl dolls, Hot Wheels, etc. Sales from these brands tend to be somewhat stable, smoothing out the ups and downs from the huge chunk of their business that depends on licensing entertainment-based brands. 

Here are a few big things to keep in mind about the entertainment brands...

One, there are not very many big ones out there. The biggies are Sesame Street, Star Wars, Marvel Comics, etc. They are very valuable to the intellectual property owners who want licensing partners that will generate a lot of revenue for them, obviously. 

Two, Hasbro and Mattel must bid against each other for the rights to make and sell toys based on the big brands. They pay guaranteed money and a portion of each revenue dollar to the brand owners. Their eagerness to win rights to the big brands creates an epidemic of the winner's curse in which there is a tendency to overpay in order to beat out your rival. Hasbro had a big problem with this several years ago after winning the Star Wars contract. Lucas Ltd. demanded major dollars upfront. Hasbro paid and then saw the popularity of Star Wars toys go on the decline as movie after movie saturated demand. They took a hit. 

Three, and this is the most important trait of the toy business to understand, the blockbuster element of toy sales creates peaks and valleys in sales and earnings. Sales and earnings don't creep onwards and upwards to a steady drumbeat. When a big movie hits, toys associated with that movie spike. Kids are fickle and tend to buy (rather, their parents and grandparents buy for them) the most popular items that all the other kids are buying. The toy companies must anticipate demand, design the right toys, and get them into retail channels in tight coordination with the movie release. So, when Transformers movies come out, Hasbro tends to kill it (especially since, in this case, they own that brand outright and don't have to pay licensing royalties). They'll sell a hundred million in a year. But then the brand popularity wanes when the movie goes away, and if Hasbro can't find something to replace it...sales and earnings tank the following year. 

The Shleifer Opportunity

And so here we are with Mattel showing a 50 percent drop on earnings over last year as Barbie (its own brand) shows weakness. This is not the first time...it won't be the last time. It creates a trailing P/E of 14 after the nine percent drop in the stock price yesterday. Is that cheap? 

Doubtful. 

I'll add this to the Shleifer Effect watchlist, but given the volatility of the toy business I'll require two things to take Mattel seriously as in investment. 


First, it must drop significantly below its current price. Therefore, it's going to need more bad earnings reports to create the overreaction bias necessary to get investors selling.



Second, based on a price driven down by overreaction, I must see a clear and conservative path for Mattel earning profits that would easily exceed depressed expectations over the next few years. 


To be very clear, Mattel would not be a long-term holding for my portfolio. If the right confluence of events happen to justify an investment, it would be based on a tremendously cheap price that bakes in low expectations for future performance that Mattel would have little trouble exceeding based on conservative assumptions. I would sell after a new optimistic representativeness heuristic set in, causing overreaction to the upside. 

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