On its face, Mattel (NASDAQ:MAT) seems like a terrible stock to own. Mattel stock is hovering near $12, and the company has a market capitalization in excess of $4 billion. Yet the company isn’t profitable, is barely growing revenue, and has a significant debt problem.
Of course, those headline metrics miss a key part of the story here. Mattel is undergoing a turnaround that includes hundreds of millions of dollars in cost savings and a transition to a new “capital-light” operating model.
Its intellectual property has value, and for years there have been off and on rumors about a combination with rival Hasbro (NASDAQ:HAS).
But the problem with MAT stock after a rally since its third-quarter earnings beat last month is simple. The turnaround is working — yet even in that context, Mattel stock hardly seems attractive. And so there is a real risk to the downside here if Mattel stumbles, but questionable upside even if it succeeds.
The Case for Mattel Stock
Admittedly, the news is getting better for Mattel. Third-quarter earnings were nicely ahead of Wall Street estimates. And the quarter was particularly impressive given that Hasbro stock plunged 17% after its Q3 release, thanks in part to tariff impacts.
Mattel after the quarter raised its full-year outlook for Adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) to $400-$425 million. That’s more than double the $198 million the company generated in 2018. Operating cash flow has improved and is guided positive for the year.
There have been some cost-cutting benefits helping those higher profits — but Mattel also is doing a better job on the sales front. Revenue has increased 1% year-over-year in the first nine months of 2019, and 4% excluding the impact of currency. Products like Barbie dolls and Hot Wheels cars are bouncing back.
Indeed, 18 months ago I advised caution on Mattel stock, noting that the company had a lot of work left to do. Results so far in 2019, along with guidance for a solid fourth quarter, suggest that Mattel has accomplished quite a bit over that stretch.
The Valuation Problem for MAT Stock
But what’s interesting is that those accomplishments haven’t done anything for Mattel stock, which still is down ~13% over that period. And it’s hard not to wonder if a similar scenario could play out over the next 18 months.
Indeed, a core problem here is that Mattel stock isn’t cheap. It closed Q3 with over $3 billion in debt. Cash will be generated over the holidays in the fourth quarter, but with the current market capitalization over $4 billion, Mattel likely still closes the year with an enterprise value (net debt plus market cap) around $7 billion.
That’s still an EV/EBITDA multiple above 16x — a multiple in line with that of Hasbro. Net debt probably will be over 6x, which leaves the company with a still-weak balance sheet. Indeed, Mattel’s longer-dated bonds, which mature in 2040 and 2041, trade at 85 and 80, respectively. Yields to maturity above 7% for both issues show that the bond market, at least, is pricing in real risk going forward.
As far as the equity goes, yes, 2019 earnings have doubled. But Adjusted EBITDA is guided to increase $202-$225 million year-over-year. The company expects to capture at least $333 million in cost savings this year, based on commentary in last year’s Q4 earnings release and on this year’s third-quarter conference call.
In other words, the underlying business isn’t growing profits. Mattel simply is reducing expenses. That can’t last forever.
There are more savings coming in 2020, as Chief Brands Officer Richard Dickson noted on the Q3 call, but the bulk of cost-cutting has been realized. Mattel still is driving negative free cash flow. Mattel stock still isn’t cheap. Revenue growth of 4% is OK in that environment, but it hardly makes MAT stock compelling. And in a recession, those top-line increases likely reverse — and earnings decline.
Considering valuation and the balance sheet, it certainly seems like continued success is priced in. So what happens if the economy reverses — or if Mattel stumbles?
The Culture Problem for Mattel
At the very least, investors need to have a great deal of faith in Mattel management to own Mattel stock, even at $12. Having that kind of faith seems close to delusional at this point.
This is a company whose sleepers weren’t recalled until more than 30 infants had died. It’s a company whose CFO is leaving after a whistleblower letter led to an investigation. Mattel said its investigation showed no evidence of fraud, and the error the whistleblower cited simply shifted an expense between quarters in 2017, and thus had no impact on full-year results.
But the error was not disclosed to the then-CEO, and a former Mattel executive told the Wall Street Journal this month that senior executives at Mattel and auditor PricewaterhouseCoopers attempted to cover up the error. In the wake of the investigation, Mattel admitted to material weaknesses in its financial reporting, another red flag.
Mattel is not a quality company running on all cylinders. It’s a company whose executives are excellent at slashing costs and apparently have trouble in other aspects of the business. Starting in 2020, Mattel needs to prove it can drive profit growth and margin expansion without those significant cost cuts. It’s far from guaranteed this time is different.
Be Careful with MAT
Maybe this time is different. Nothing is certain in the market. It’s possible the earnings improvement will continue. Mattel is looking to better monetize its intellectual property, with a Barney movie on the way and a new Masters of the Universe series for Netflix (NASDAQ:NFLX). Barbie looks better positioned in this new consumer environment. Key customers Walmart (NYSE:WMT) and Target (NYSE:TGT) can offset the lingering effects of the Toys ‘R’ Us bankruptcy.
And indebted, challenged stocks can rally. The former Valeant Pharmaceuticals, Bausch Health (NYSE:BHC) is one obvious example.
But there are many more that don’t. And it hardly seems like Mattel stock is cheap enough, yet, to bet on it being different. The turnaround is on schedule, but it hasn’t yet done anything for MAT stock. Barring something close to perfect execution, I doubt MAT will perform much better going forward.
As of this writing, Vince Martin has no positions in any securities mentioned.