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Toys R Us Bankruptcy Casts Its Shadow on Hasbro and Mattel Earnings

The news of Toys R Us' bankruptcy sent waves through the industry, but the two biggest toymakers, Hasbro (NASDAQ: HAS) and Mattel (NASDAQ: MAT), are showing different stripes in their latest quarterly results.

In this episode of Industry Focus: Consumer Goods, Vincent Shen is joined by Fool.com contributor Danny Vena as they dive into earnings and the long-term vision that leadership at both companies are currently pursuing. For Mattel, all eyes are on the early stages of their turnaround, but Hasbro is pouring resources into its own growth initiatives.

A full transcript follows the video.

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This video was recorded on Oct. 31, 2017.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Tuesday, Oct. 31, and I'm your host, Vincent Shen. Happy Halloween, Fools! I had a few people ask me this week if I would be picking Halloween-themed topics for this show, looking at candy companies or something similar. Well, the companies we're focusing on today are only tangentially related to the holiday, and they're toy companies. One of the two biggest names in that industry shared news last week that gave plenty of investors a scare, if we're sticking to that Halloween theme. But overall, the stock has been making huge moves over the past few days. And we haven't talked about this sector in some time. I'm welcoming Danny Vena, one of our Rool.com contributors, who's joining us via Skype, to the show to help us cover our latest earnings results. Hey, Danny -- how's it going? Welcome back!

Danny Vena: It's going really good. I'm glad to be back. How's it going with you?

Shen: Going really well. It's great to have you with us. We have the latest earnings, as I mentioned, Hasbro and Mattel, to cover. But before we dive in, I know you wanted a little bit of time to revisit Toys R Us as well. If you missed our previous coverage of the Toys R Us bankruptcy, that news came out in September, you'll need some background on that news and developments since then to have an idea of what's happening with the retailer, obviously an important partner for Hasbro and Mattel, who we will cover shortly. Danny, can you bring our listeners up to speed?

Vena: I sure can, Vince. Going back, you may recall that Toys R Us was acquired by some private equity firms and a real estate developer back in 2005 in a leveraged buyout for about $6.6 billion. Unfortunately, $5.3 billion of that was debt. And because of all that debt maintenance, because of the interest payments, a lot of people felt, and I concur, that basically Toys R Us was pretty much doomed to failure. They had a little bit of bad luck with the timing because of the emergence of e-commerce, and the prevalence of toys starting to be carried by places like Target and Wal-Mart. But the biggest part of that story was the leveraged buyout. With so much interest, they just didn't have a lot of wiggle room in order to take on new initiatives to make the store a little bit better competitor in the current day.

Shen: Yeah, absolutely. I mentioned this last time when we talked about this on the show, the fact that Toys R Us just ran into a few different headwinds, big challenges, challengers, really, to the brick-and-mortar business model that they've always operated with. The investors that took the company private have tried to harvest their investment twice now, with one IPO that was filed and ultimately pulled off the table, rumors last year or the year before that they would be pursuing another IPO. Obviously, the results for the company haven't been strong enough, with the bankruptcy proceedings that we have now.

But you have kids now these days, busier than ever. There's less playtime. Children are turning to smartphones and electronics at really young ages, which means less of the traditional action figures, puzzles, and games at Toys R Us has previously featured heavily in their stores. But at the same time, the bankruptcy, I think it's important to note, does not mean that all Toys R Us stores will be closing their doors. The company will be open for business, and it's really important, obviously, this time of year as we approach the holiday shopping season. The company will actually be focusing on a few initiatives during this period to attract customers. They want to make sure that 1) shoppers know that Toys R Us is open for business during the holidays. Make sure that, if necessary, they spend on the marketing to make that known to their core customers. They want to stress, for example, their price-match guarantee as well, which they've always had but start focusing on that more, making that more known to customers, helping to potentially change the perception of the brand, take a little bit of market share.

They want to emphasize, also, in their marketing, the bond that kids can have with their brand, and changing up the in-store experience so it's more interactive, more experiential, to boost foot traffic. We've talked about that trend for a lot of brick-and-mortar retailers in the past. At the same time, they also want to change the way they used some of their stores, offering classes, event spaces as a way to win over both parents and their children. The company generates about 40% of its sales in this last quarter of the year. Toys R Us has been able to reassure and essentially renegotiate through the bankruptcy proceedings with most of its vendors and suppliers in order to keep their store shelves stocked, which is obviously very important. They can't be entering this very busy time with lower inventory levels, or weak inventory levels, for this period. Hopefully, coming out of the bankruptcy proceedings, they'll be a little bit leaner, they'll make the right investments in their stores and in the online channel and the company brand can survive. Any other thoughts from you, Danny, looking forward for Toys R Us? Things they might need to focus on? Your thoughts?

Vena: I do know that, listening to Hasbro's conference call, they made a point to say that they had just renegotiated with Toys R Us, that they had temporarily suspended shipments to them, but they had come to an agreement. So I think, that's probably indicative of what's happening with a number of the major toy suppliers. I think Toys R Us will have supplies going into the all-important holiday shopping season. We'll see here and the next couple of months how that turns out for them.

Shen: Absolutely. If I recall correctly, Toys R Us said that they've been able to iron out the relationships and the deals they have with 49 of their 50 top suppliers, again, to make sure that their stores are ready to go with the hottest toys as parents roll in for the holidays. At the same time, even though they announced their bankruptcy filing in September in the closing weeks of the third quarter, it still had quite an impact, as you mentioned, Danny, on Mattel and Hasbro in their earnings. It was a topic of major interest in the earnings calls for both companies, analysts asking a lot of questions about what this might mean, how it impacted the company specifically in the quarter, how it impacts them going forward. To start with Mattel, which reported earnings on Oct. 26, there's a lot to digest here in this report. Danny, what were the highlights?

Vena: When we talk about Mattel, I'm going to go back a little bit into the past, Mattel was already in trouble. Mattel's flagship Barbie doll sales have been either flat or declining going all the way back to 2012. They've been through several CEOs. And they've been trying to revive the Barbie sales, revive some of the sales of their key brands. Back in February, Mattel's new CEO, Margo Georgiadis, came on and set out a plan to help the company get back on track. At the time, they planned to cut about $200 million worth of costs, and they slashed the dividend by 61%. And that was the beginning. That's how they were planning on moving forward. You may recall, a couple of years back, Mattel had lost the Disney Princess and Frozen lines in a coup to Hasbro. That was a big deal to them. That was adding insult to injury. Mattel has finally put together a plan going forward, and we'll talk about that in just a minute.

For the current quarter, Mattel's net sales fell to about $1.56 billion, which was down about 13% year over year, and that was far below the consensus estimate, which was about $1.8 billion. Unfortunately, because of the Toys R Us situation, or partly due to that, their North American gross sales fell 22% year over year. North America is their biggest market, so they took a huge hit there. Sales fell across the board in every major category. Some analysts estimated that about half of the falling sales in North America were the result of the Toys R Us bankruptcy. They had a net loss of over $600 million, per share loss of $1.75. They announced on their earnings conference call that they were going to cut $650 million in costs over the next two years vs. the $200 million that they had previously announced, and they suspended the dividend entirely. So all in all, it was really hard to find anything positive in Mattel's earnings conference call and their financial release. There just really wasn't anything good there.

Shen: Yeah, the sentiment was definitely very negative during the earnings call in the commentary from management. And it's interesting to note, you pointed out that sales for the company overall are down 13%, but for that very important North American segment, down 22%. For their brand categories within that North American segment, across the board, you're down anywhere from 20% to 34%. If you look at some of their key franchises, their key brands, for example, American Girl, Fisher Price, again, all double digit declines above 20%. As early as the first weeks of September, Mattel had already begun cutting down on their shipments to Toys R Us as a result of the bankruptcy. Thus, some of the estimates and the comments that half of the decline that they saw in North America was driven by that latest development with a pig partner of theirs, whereas the international sales, on the other hand, were relatively flat. So a lot of the losses driven here at home. Profitability, too, I want to add, their gross margin was down 7 percentage points year over year. I think that was also a big development that was driving what you mentioned in terms of the $650 million of additional cost cuts in the next two years. Management is implementing zero-based budgeting, which we've brought up a few times in the show before. Basically, with each year, for every department, for every division, as they're setting up their budget, instead of basing it on the prior year's budget, they start from scratch, having to justify every expense, every line item. It's a common way for companies to try to cut down and make their budgets as lean and efficient as possible. With that dividend cut that you mentioned, Danny, it's expected to free up about another $200 million a year for management to spend elsewhere. 

I wanted to talk a little bit about what the company is looking to do going forward to right the business, and what it's focusing on in terms of its strategy. In terms of where that money will go, the several hundreds of millions of dollars they're looking to save with the dividend cut and the other expense cuts, they're looking at their omnichannel capabilities. As you can imagine, e-commerce is very important right now for the company. They're looking at their emerging markets, where the industry growth is focused across the toy industry, and the company is positioned very well, especially in China. They're focused on their IT infrastructure, spending there so that the company can have better tools at its disposal for things like demand forecasting. Then, lastly, they want to focus and put some investments into content and gaming, which is essentially the next step for their brand and product development. They've spent about $30 million so far in 2017 as a result of these plans they announced over the summer, another $170 million expected to be spent in the next two years. I want to give you a second here, Danny, to talk about the five strategic pillars they also laid out during their investor day earlier this year as the guiding model that they're going to follow to try and restore the business to growth and some of the stronger operating results they saw in the past. Can you tell us about those?

Vena: Sure can, Vince. I'm going to take these in reverse order. Some of them are really common sense. The last one that they talked about was reigniting the culture and the team. A couple of things that have come up with Mattel in the past, the first is that they had become bogged down in a bureaucracy. It seemed like, in order to get anything done, there were layers and layers and layers of approvals that had to be done. It was disheartening for the folks that worked there, seeing these quarter after quarter of poor results, year after year of declining or flat sales for Barbie. So what they wanted to try to do was, first, they wanted to clear up some of those layers of bureaucracy and get that out of the way so that they could reignite their corporate culture and get their team back to where they could have a little positive spin on the business, so they'd get their belief back in their company. And part of that was, again, reshaping the operations. One of the things that they've talked about on the investor day presentation was, in order to get a new toy approved, it had to go through a really long and complicated approval process.

And when the new CEO came in, she decided that was something else holding them back, so they're going to get rid of those layers of bureaucracy, try to speed up the approval process, get some more toys out there faster. That was part of reshaping their operations. That also fed into strengthening their innovation pipeline. They had spent so much time focusing on their core brands -- Barbie, Hot Wheels, Fisher Price, Thomas the Tank Engine, the American Girl brand -- that they were really not looking forward, they weren't developing any new toys or new ways for kids to connect with those toys. As a result of that, they wanted to strengthen their innovation pipeline. As you mentioned, they also wanted to accelerate their entry into emerging markets. They think one of the reasons they fall in behind is that North America represents so much of their sales and they figure, if they can bring in new geographies, new international markets, that's going to help take care of some of those ebbs and flows in the business. If sales aren't going well in North America, they might pick up in some of the international markets, and that'll help stabilize their sale somewhat. Finally, the biggest thing, which I wanted to save for last was, they said they wanted to build their Power Brands into connected 360-play experiences, which is kind of a mouthful.

Shen: Absolutely.

Vena: It's important to note that their new CEO has a history at Google, so really has a technology background and has spent a lot of time working with technology and wants to bring tech to Mattel. So they wanted to start at those core brands of theirs, and they wanted to evolve them from, instead of being just the toys themselves, they wanted to give kids new ways to interact with the toys. One example that they used was the Barbie Dreamhouse that's a connected toy, and you can download the app and customize some of the features on the Barbie Dreamhouse -- you can customize sounds that come out of particular rooms. So they wanted to use that as a starting point and look at all of their brands and see if there were other ways that they could connect with kids. So other ways to, perhaps using Internet of Things as an option, they wanted to make these more connected play systems, they wanted to develop online communities where people who are interested in chatting with one another about Barbie, for instance, they could go online and have Barbie Chat. So there are a number of different things that they were looking at. They're hinging their change here, their [evolution] here, their change, that they want to evolve from here into a more technology-based toy company.

Shen: Thanks, Danny. With those pillars, management, during this latest earnings call, had some progress reports, essentially, for how they're doing. I think you touched on some good examples. Going back to something you mentioned with reshaping the operation and how they wanted to improve their time to market, some numbers behind that. They were looking at a goal of 50% improvement from the traditional 12 to 18 months it would take in order for a toy to hit the market. They've already released four new products, and they launched them with their new process in three to nine months, so seeing an improvement there. Then, on the culture and team side, I think it's important to note, the company has also brought on a new chief financial officer, chief technology officer, communication officer, people officer, I believe, head of manufacturing, and head of product development. So a lot of new management, new people brought in for leadership to refresh their approach to things.

The trends, the last thing we'll talk about for Mattel that they've identified that are really shaping their industry, and these will bleed into our discussion of the Hasbro earnings as well, but management mentioned specific trends they think are really changing the toy industry. One, it's still growing each year, but the bulk of that growth is concentrated in emerging markets, hence some of the strategic pillars they've established. Two, kids are adapting to and growing up in a very digital and mobile-first world, so toys and entertainment need to be very engaging, they need to be personalized, they need to be customizable. That also plays into their Power Brands and 360 experiences. The last point is with parents, and this is more on the brand-building side, that connection with customer loyalty. They want their kids to be able to succeed and adapt in a very fast-changing world. They also want strong, genuine, responsible brands. So the company overall is rethinking the brands, how it's presenting them, trying to create more of a connection with customers, both the kids and parents alike. 

We'll see that flow through to our next company, the other big toy maker in the industry, which is Hasbro. The company reported its latest results on Oct. 23. I'll pass the ball to you again, Danny, to give us some highlights from that report and what's going on with the company.

Vena: Sure. The same thing with Hasbro as I discussed with Mattel, there's a little bit of history that brought us to where we are today. If you go back to 2008, Hasbro as a company wasn't doing very well. They had kind of lost focus on some of their key brands. They were letting Mattel essentially run away with the ball. When CEO Brian Goldner took over, one of the first things he did was sent a team of 25 people out into the marketplace, and they traveled around the country talking to kids and parents, and tried to see how it was that folks engaged in their toy shop. And one of the key things they found out was that the toys that kids wanted were all connected with movies or television shows, so they could engage with the characters, their toys, in another way. So that was kind of a genesis for a big development at Hasbro, where they went back into creating more television shows, creating more movies. That was the big push behind the Transformers movies, and also the My Little Pony movies and television shows, those were all a result of what they found out.

Then, also, they won that Disney Princess and Frozen licensing contract away from Mattel. That was announced in September of 2014, and took place in January of 2016. That was a key loss for Mattel, but it was a key gain for Hasbro. Now, looking at their individual results worldwide, Hasbro grew its net revenue 7% year over year to $1.79 billion, and it's important to note that for the last few quarters, Hasbro has actually become the world's largest toy maker by sales, because they've beat out Mattel. Pretty much the exact opposite of what we saw with Mattel, Hasbro had strong sales across all of their segments. The one laggard was partnered brands, which is the companies like Disney, where they license the characters and create toys. In that same period last year, DreamWorks had released the Trolls movie, so there was a big run-up in toy sales for that. So that wasn't really a concern in my book. A weaker movie slate, you're going to see that happen.

But as a result of Toys R Us, Hasbro announced they had temporarily suspended shipments with the company, and they expected growth in their fourth quarter, which is that important Christmas season, were going to be in a range of 4% to 7%. Now, it's important to note that analysts were expecting growth in a range of 11% over that same period, which was part of the reason that Hasbro's stock fell the way it did. I disagree with that. I think Hasbro, coming in with a conservative forecast was probably the right thing to do. There's a lot of uncertainty around the Toys R Us bankruptcy, and even just going into the call, they said it was only the day before, or that day, I don't remember exactly, but they had just announced that they had come to an agreement with Toys R Us, and they would resume shipments of toys to them in advance of the holiday season. So I think Hasbro is doing just fine, and that drop in the stock price, I saw that as a buying opportunity.

Shen: The stock took about a 10% hit after their earnings were released. Otherwise, especially after just having discussed Mattel and all of the challenges that they were running into, the issues they were having, you have a company here where revenue was up 7%. That was both in their U.S. and Canada segment, and also their international segments. And among the four different brand categories that they have, their franchise brands, which includes Transformers, which you mentioned, Danny, Play-Doh, Nerf, My Little Pony, that was up 7%. The partnered brands was only down 2%, again, because of the changes in the theatrical release schedule. The fact of the matter is, their partnerships with Marvel, think about all the big superhero movies, the Disney Princesses, Trolls, Sesame Street, that's a very significant part of their business. Then, the Hasbro gaming brands, think Pie Face, Connect4, Jenga, Scrabble, did phenomenally well, up 22%. Then, they have some of their emerging brands, which is what they categorize as the smaller names that haven't quite reached franchise brand status, but those are also growing quite well, 9%. The company has about $1.2 billion cash on the balance sheet. I think that gives it quite a bit of dry powder to return capital to shareholders. They have their dividends, they have their share repurchases, also to continue investing in growth, staying focused on their product pipeline, new toys, the additions and the more interactive investments they're making, the technology that they're also incorporating into the toys that they release.

So combining all that, it seems like the Toys R Us jitters or concerns there plus the lower guidance is really what had investors running off with that short-term hit. Otherwise, obviously, the much stronger player in this industry, and big picture, I think, the company is similarly focused on emerging markets -- they've stated that -- about having the right brand images and stories, similar to Mattel, and again, having these immersive and engaging product experiences. Final takeaways, Danny, as we close out this episode, for these two companies, for the toy industry at large? Anything you think our listeners want to leave out with?

Vena: One thing that I saw it yesterday was, Mattel's stock took a jump. At one point, it was up probably 10%, and that was on rumors that the company could be acquired. Whether or not it is, I don't think that's a good basis for an investing decision. If you think Mattel can operate their turnaround over the next few years, and I think there's a good possibility of that, I actually still own Mattel stock, even having taken a bath in it thus far, I think there's a good chance of a turnaround. We're starting to see some evidence of that, the Toys R Us bankruptcy notwithstanding. But I've been a Hasbro shareholder for years. They've been executing on pretty much every level over the last two or three years. The stock price is up significantly, and if there's a surefire bet in the toy industry, if there is such a thing, I think Hasbro is probably it.

Shen: Alright. Thanks again, Danny, for joining us. It's really great to have you back!

Vena: It was good to be here. Thanks, Vince!

Shen: Thanks, Fools, for listening. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear. Fool on!

Danny Vena owns shares of Hasbro, Mattel, and Walt Disney and has the following options: long January 2018 $80 calls on Walt Disney, short December 2017 $75 calls on Wal-Mart Stores, long January 2018 $57.50 calls on Wal-Mart Stores, and long January 2018 $55 calls on Wal-Mart Stores. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Hasbro and Walt Disney. The Motley Fool has a disclosure policy.