We continue our coverage of Mattel (MAT). After a strong third quarter, the company continues to see momentum and is now guiding for Q4 gross sales in constant currency to be approximately 5%. For the full fiscal year, gross sales in constant currency are projected to be flat to plus 1%. That compares favorably to the gross sales decline of 13% during its first half, as the company was affected by retail closures and the defensive inventory position of many retail partners.

Mattel continues to execute on becoming an IP-driven company. The company has recently announced a new film project based on Thomas & Friends. Also, there are two new Masters of the Universe animated series in production and expected to be released on Netflix (NFLX) in the fall of 2021. To capitalize on the momentum and the re-introduction of the animated series to the public, Mattel is launching a new collector’s toy line. We believe the relaunch of this iconic series on NFLX to be a growth driver for the next fiscal year. To give some context, The Container Store (TCS) was featured on the release of The Home Edit show on Netflix in September. TCS is an exclusive partner with The Home Edit, and many products were shown during the airing. After the show released, TCS saw an increase in sales of approximately 17%. Although we cannot expect the same results, we believe a show on Netflix does create momentum, which Mattel can take advantage of. If the response to the release of Masters of the Universe is positive, new greenfield opportunities can be developed to grow the IP.

According to management, and per NPD data, the company gained market share in categories such as dolls, vehicles, and games & other:

Mattel was the #1 manufacturer in the third quarter in the U.S. and gained share throughout the quarter per NPD.

Source: Company Q3 conference call

Mattel reached our valuation target of $14 per share. While we believe it trades at our approximation of fair value, the company is still undervalued when compared to Hasbro (HAS) on an EV/sales basis. Currently, Mattel trades at 1.77x sales, while Hasbro fetches 3.12x.

The big discrepancy could be an opportunity for more gains in Mattel in the coming quarters. There is operating momentum behind the company, and opportunities for margin expansion as it continues its transition towards an IP-driven strategy. Mattel also wants to de-lever its balance sheet, which would reduce financial risk and could push the market to re-rate it at a multiple closer to Hasbro. Overall, we still feel bullish about the company.

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Strong third-quarter and guidance

Mattel delivered strong third-quarter results. The company reported net sales of $1.63 billion, up 10.1% on a year-over-year basis, beating the consensus by $170 million. It also reported non-GAAP EPS of $0.95, ahead of the consensus by $0.57.

Besides its Infant, Toddler, and Preschool category, which saw a decline in gross sales of minus 5% on a year-over-year basis, every category saw revenue growth in the high-single to the double-digit ranges. Mattel’s doll category was the strongest category, posting sales growth of 24% compared to its prior-year period, driven by Barbie and a newly launched Cave Club doll line.

Barbie continues its strong momentum by growing 30% during the quarter with POS growth of more than 50%, becoming the #1 toy property in the U.S. Management has done an excellent job in revitalizing the Barbie IP, as highlighted in our first article, and we believe there is room to grow the brand as the company starts growing its audience through its film division:

Per NPD, in the third quarter, Mattel was the #1 doll manufacturer in the U.S., Europe and Latin America and gained share in all 3 regions.

Source: Company Q3 conference call

Gross sales for Action Figures, Games, and Other grew 14% year over year. Growth was driven by Games, which achieved its seventh consecutive quarter of year-over-year growth, with Uno leading the way. Mattel’s Vehicle category gross sales were also up 8% year over year, driven by Hot Wheels and Matchbox, with POS sales growth up 16% for the quarter.

Strong demand for the company’s products, coupled with the benefits from its cost savings program, drove an improvement in adjusted gross margins of 410 basis points to 51%, compared to its prior-year period. Mattel’s cost savings program contributed to 150 basis points of adjusted gross margin expansion consisting of savings from its structural simplification program and its capital-light program, bringing year-to-date savings of $149 million. Mattel has reduced its SKU count by over 30% and remains on track to exceed $1 billion in savings.

With the fiscal year almost over, the company is guiding gross sales in constant currency to be flat to plus 1%, offsetting the 13% decline in the first half. Mattel also expects adjusted gross margins to increase between 350 and 400 basis points, or 48.5-49% as a percent of sales for the year, compared to last year’s gross margins of 44.9%. Full-year adjusted EBITDA is expected to be between $625 million and $650 million.

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What’s next

Mattel continues to see strong POS growth and momentum, ending the quarter with lower retail inventories year-over-year. Meanwhile, its retail partners are restocking shelves and preparing for the holiday season. Due to extraordinary growth, the company is chasing inventory in certain categories:

And while our supply chain is fully operational, we are chasing extraordinary growth in demand.

Source: Company Q3 conference call

Management estimates they gained market share in the quarter by growing at 1.4x the industry rate in the U.S., while growing double the industry rate in Europe. There is a strong demand for Mattel’s products, with POS growth outpacing shipments.

That said, Mattel still has room for improvement, and its transition to become an IP-driven company should help it drive profit margins in line with Hasbro. We like how the company is making progress in this area with 10 new film projects and integration of some IPs into digital gaming. During the quarter, the company integrated its Hot Wheels franchise into the World of Tanks game in consoles and is launching Hot Wheels Open World on Roblox. Roblox has 115 million active users worldwide.

There are two overall themes we like about the progress at Mattel. The first one is the continued growth in its power brands, mainly Barbie and Hot Wheels. It shows the company is having success in revitalizing both brands, which is stabilizing the decline in sales for the past 5 years.

We also believe Mattel can sustain mid-double digit operating margins moving forward as the company focuses on its IP strategy, which should require fewer capital expenditures that can be reinvested back into growing brand awareness. The fact that the company ended the quarter with lower retail inventories also bodes well for the future profitability of Mattel, as it gives an opportunity to align production with demand, lowering the need to discount merchandise and sustain margins. A stable top line with the possibility to expand margins would increase the company’s return on equity.

Bottom Line

We believe Mattel’s continued improvement in profit margins and debt repayment will cause the market to re-rate it at a sales multiple closer to Hasbro. Right now, we believe the discrepancy is too big, with Hasbro trading at 3.12x sales, while Mattel trades at 1.77x sales.

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To close the gap, we believe the company needs to focus all resources on the repayment of debt. Mattel ended the quarter with a net debt-to-leverage ratio of 5.3x. The company spends approximately $200 million annually on interest expense alone. With adjusted EBITDA expected to be $635 million at the mid-point, interest expense accounts for a good portion. We believe the use of cash to pay down debt to be a good capital allocation decision, as it would de-risk the balance sheet and be accretive to EPS. Mattel’s debt doesn’t mature until 2025, so the company has enough time to maneuver. Management is targeting an investment-grade rating in the meantime:

Our intent is to pay down debt going forward to improve our leverage ratio. If you combine that with the adjusted EBITDA performance and the trajectory we expect, our leverage will continue to decline and improve over time. And we are targeting an investment-grade rating.

Source: Company Q3 conference call

We believe the company is on the right track and still offers value to investors. Steady top line growth, improved margins, and repayment of the debt would re-ignite EPS growth.

That said, the value gap has significantly narrowed since our first recommendation, which adds to the risk from a return perspective. With a lower margin of safety, there is not much room for error. The increasing number of COVID-19 infections could slow down Mattel’s momentum once again, with possible lockdowns affecting sales. However, from a long-term perspective, we believe Mattel should close down the valuation gap with Hasbro. Improved margins and a successful transition to a capital-light business model could be the catalyst to re-rate Mattel at a multiple in line with its peer. At just 2x forward sales, the company could be valued at $19 per share. Overall, we feel bullish about the company.

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.

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