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Toys R Us Apocalypse Might Kill Mattel

Toyland is looking pretty desolate these days. That image of a happy place overflowing with colorful toys and smiling children? Replace that with a barren landscape littered with broken toys and withered jump ropes.

The recent report that industry stalwart Lego suffered its first decline in sales in thirteen years is the icing on a poisoned cake for the toy industry.

The infamous Danish brand has deftly kept sales growing each year by sticking to its roots. It sells colorful Lego bricks that miraculously click together to create anything from Harry Potter’s Hogwarts School or Darth Vader’s spaceship.

Its innovation has been primarily in branded products like the Harry Potter and Star Wars ones noted above. But even these smart Danes are being outrun by the tough retail situation in the U.S.

Toy makers received another blow when news surfaced that Toys R Us, the struggling U.S. retailer, might have to liquidate its stores instead of exiting bankruptcy with the business intact.

Darker Days Ahead?

Is this crowning blow the horrible news that will send struggling Mattel (NYSE: MAT) into the arms of a merger? I think not.

Toys R Us filed for bankruptcy in September 2017. Although bankruptcy sounds like bad news to most of us on Main Street, it can be good news for a company. Filing for bankruptcy allows a company to renegotiate debt terms with the banks it has borrowed from.

Typically, some portion of that debt is written off. Creditors assume that receiving a portion of the money owed to them is better than receiving none at all. Once the bankrupt company is relieved of its debt burden, it can operate with less stress.

But Toys R Us is having a tough time getting its lenders to agree to new terms. If this happens, the company will be forced to shut all of its doors and liquidate its holdings. This is very bad news for toy makers of all shapes and sizes. It is hard to find a toymaker who doesn’t count Toys R Us as one of its top customers.

Mattel is known as a doll company. This was great news when Barbie was the must-have toy. Mattel introduced a bevy of friends for Barbie with closets begging to be filled with clothing. But the company has failed to keep pace with the morphing taste of children.

The company is haunted by its ill-fated loss of the Disney Princess contract in 2014 to Mattel. Despite playing down the detrimental impact of losing such a critical deal, the numbers speak for themselves.

  • Profit margins dropped from 18.5% in 2013 to (4%) in 2017
  • It now takes 84 days for Mattel to collect payment from customers, up from 70 in 2013.
  • Mattel has 73 days of inventory on hand versus 63 four years ago.
  • Mattel’s cash flow has not covered its dividend payment for three years.

Mattel’s revenue declined every year since 2014. Even worse, the rate of decline accelerated, with 2017 sales falling 10.5%. Prior years saw low single-digit declines.

There are some bright spots

Just this winter the company announced a partnership with Tynker, an educational coding platform used by many schools. Its two most recent acquisitions are in the technology space. In January 2016 it purchased the maker of nabi, a Leapfrog-like tablet for school-age children. It also bought Sproutling, a baby monitor product for parents.

While these new products might help Mattel find a few winners, the pool of technology toys is getting crowded. Lego is there with its Lego Boost coding toy where children create actual moving robots with legos and software and Hasbro has been ahead of the curve with some of its music mixing toys geared to slightly older children.

Analysts expect Mattel to lose just $.06 this year with flat sales. Competitor Hasbro (NYSE: HAS) is pegged to earn $5.34, a few percent less than 2017 when it enjoyed strong sales of Transformer and My Little Pony toys. Both brands enjoyed a surge in demand due to 2017 new movie releases.

Mattel can limp along only if it can continue to borrow more money. Its current business is not generating enough cash to cover its expenses and certainly not enough for a dividend. If lenders decide to cut off the spigot, the stock will be a lot lower.

Perhaps at the right price Hasbro, the most obvious acquirer, will step up to the plate. But my guess is that the “right price” is a lot lower than the one Mattel is trading at now. The smart money seems to agree. According to Whale Wisdom, a site that tracks hedge fund positions, 155 funds lowered their stake in Mattel versus 120 starting new ones.

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