The Decline Of A Buy-And-Hold Stock

Dig through a 1990s edition of Kiplinger’s Magazine, and you will find many lists of long-term investment suggestions that include Mattel (MAT). This is understandable. The net profits on each toy sold during this period was over 10%, and the best long-term performance range during this era came between 1982 and 1996 when the stock returned 16% annually.

If you could hop into the wayback machine, it’s easy to see why Mattel would earn a spot on the list of buy-and-hold investments when you were considering the question in, say, 1993. Barbie dolls, the signature Mattel product, used to earn over 30% net profits. Back then, it cost the United States Treasury 4.5 cents to coin a nickel, and you could be technically correct in arguing that ownership of the Barbie franchise was a better license to print money than that of the U.S. Treasury.

The Hot Wheels brand proved to be a durable profit generator that poured tens of millions of dollars into the residue pot for common stockholders each year, and Mattel was even diversified into brands that we typically associate with Parker Brothers or Milton Bradley (both of which are owned by Hasbro.) For instance, to this day, Scrabble is owned and manufactured by Hasbro in the United States and Canada, but Mattel has a license to manufacture and sell the game throughout the rest of the world.

When you considered the dominance of Mattel among games and children’s toys–it was the Coke to Hasbro’s Pepsi in the toy aisles of the 1990s–you could rightly conclude that Mattel was one of the top four or five dozen publicly traded corporations in the world on the basis of earnings quality.

But the rise of the Internet, and the generational switch to a childhood dominated less by games and toys in favor of iPads and apps, makes it very difficult to achieve satisfactory top-line revenue growth. Instead of kids demanding a new toy to play with every month, they will be the occasional purchase by a parent trying to get their kids to take a break from their electronic device or a nostalgic purchase designed to get a kid interested in something that once excited their parents back in the day.

The numbers are starting to bear this out. In 1998, the average eight-year old child received 17 toys over the course of a year (this includes Christmas gifts, and toys received from parents, family members, friends, etc.). Now, that figure is down to 8. My guess is that it’s more likely the number will hit 4 rather than ever return to the 1990s highs.

There is also the politicization of some of Mattel’s key products. Over 28% of mothers say they won’t buy a Barbie doll for their daughter because they believe it promotes an unrealistic body image. If the next edition of Barbie makes it look like the doll had a couple cheeseburgers, you’ll have counter protests from those now refusing to buy Barbie on the theory that the brand is bending to political correctness.

The days of just mindlessly throwing a Mattel product into your cart are nearly gone. It’s almost certain that any strategy will result in some amount of lost sales. Maybe Mattel doesn’t have a black Barbie in a particular location. Maybe Hot Wheels is marketed towards boys, and a mother grows upset that Mattel doesn’t adequately market its trucks to her daughter so she now refuses to buy them for her son.

Mattel doesn’t share any of its proprietary research on the projected effect the culture wars are having on its business, but the survey of current Barbie protesters suggest the effect is probably material even if we can’t define it precisely.

This is a sharp contrast to a corporation like Colgate-Palmolive. When you buy toothpaste, you’re not thinking about being a man or a woman, gay or straight, black or white, rich or poor. The purchase of toothpaste doesn’t implicate your social or political identity. If I had to speculate, Mattel’s earnings each year are probably affected 5% to 10% by the ongoing effects of social protests to how they market their brands.

Mattel, which earned $1.25 in profits last year, has masked some of its troubles by trashing the balance sheet and taking on debt. In 2003, Mattel also made $1.25 per share. But Mattel was actually a more profitable business back then, as the corporation had 428 million shares that were earning a total profit of $535 million. The $1.25 per share that Mattel earns now is the result of retiring 92 million shares of stock and reducing the share count to 336 million shares outstanding.

The company made $535 million in 2003 profits but only made $425 million in 2015 profits. And these buybacks were not funded primarily by free cash flows. It was funded by leveraging the balance sheet.

A little over a decade ago, Mattel only had $525 million in long-term debt. It basically had a total debt obligation that was equal to one year’s worth of net profit. Now, there is $2.2 billion in debt on the balance sheet while Mattel’s profit engine has declined to $425 million. It now carries 5x the amount of annual net profit as debt on the balance sheet. And the strong cash position, which sat at over $1 billion in 2013, is now down to $289 million.

If Mattel didn’t junk out its balance sheet, and still had 428 million shares of common stock outstanding, the current profits per share would be $0.99 instead of $1.25. Absent financial engineering, the earnings per share growth rate would have been a decline that amounted to -1.92% annually. With financial engineering, it was 0.00%. The business appears to be stagnating, but really, the core economic engine has been declining in the internet era except some debt-fueled repurchases have removed enough shares to make it look like the business is holding steady.

The interesting question is trying to figure out whether Mattel is more like “The Kellogg Model” or “The Blackberry Model.” For those of you that haven’t visited my site before, the Kellogg Model refers to the very slow decline of a business that permits it to diversify into other business declines successfully because the advance notice is so extreme it gives management a very long time to adjust. THe Blackberry Model refers to technological cliffs–sudden changes in demand that can wipe out an earnings engine seemingly overnight and destroy the capital you contribute towards the investment.

Right now, I consider Mattel more like Kellogg, but not close enough that I would want to hold it and see. I’d rather focus on studying investments that come with long-term industry tailwinds or neutral winds rather than a business like Mattel facing a secular headwind in the toy sector. Matter already spends an extraordinary amount of cash each year marketing to kids–it spent $672 million last year advertising its toys. The advertising costs were greater than the net profits accretive to shareholders. It’s troublesome to see net profits decline over a twelve-year period in which advertising costs are high as it suggests a limited possibility for further improvements (and even revenue declines when the advertising budget tightens).

As to whether Mattel is a suitable medium term investment, I am agnostic on that. It has fallen from $48 to $31 per share in the past three years, and it will pick up about $0.18 per share in earnings if the dollar strength reverts to 2013 levels against a basket of global currencies. Low expectations are often the friend of someone owning a beaten-down business with a once-great track record. But the demand for toys is not what it used to be, and I suspect it will continue to be disfavored by kids in favor of iPad games and equivalents. I’d cross it off the 1990s Kiplinger’s list of stocks to consider as a generational holding.