Mattel's Inventory Situation Is Now Clean, And Near-Term Growth Is Expected

Overview

My recommendation for Mattel (NASDAQ:MAT) is a buy rating, as I expect the business to continue to see strong growth in the near term due to market share gains and the potential for further growth acceleration if any of its partnerships turn out to be big hits like Barbie. Importantly, the inventory situation is now in safe territory, which means there is less likelihood for gross margin compression. That said, my valuation expectation is now lower than what I previously modeled, given the current state of the macro-economic environment.

Note that I previously gave a buy rating for MAT due to my expectation that the business should continue performing in 2H23 and FY24 as retail inventory issues ease. As a result, MAT's valuation should revert back to its historical average as it continues to execute just as it has so far, which will convince the market that this growth trajectory is sustainable.

Recent results & updates

Revenue for MAT 3Q23 was $1.919 billion, up 9% year over year and ahead of the consensus estimate of $1.845 billion. The $580 million in adjusted EBITDA reported was also above the $491 million expected by consensus. MAT's adjusted EPS of $1.08 surpassed the consensus estimate of $0.85, demonstrating a similar dynamic. All three power brands performed well in terms of top line, but Barbie saw the biggest boost thanks to the success of the summer's blockbuster film, as I had predicted. Down the revenue line, MAT also saw very strong gross margins expansion, which were up by around 300 bps y/y to 51%.

I will start off by addressing the main issue that plagued MAT previously – inventories. There is a continued positive trend observed in the latest quarter's data. The monetary value of MAT's inventory experienced a decrease of 27% to $791 million compared to the previous year, with a significant reduction in channel inventory. Importantly, management has indicated that the sell-in figures are now generally aligning with the POS figures, meaning that the quantity of products sold to retailers is now closely matching the quantity of products sold to end consumers. In particular, the sales performance of Barbie products exhibited a year-on-year increase of 14%. Similarly, the sales of Vehicles experienced a growth of 15%. Conversely, the sales of Infant, Toddler, Preschool items witnessed a decline of 5%, while the sales of Challenger products decreased by 21%. The key takeaway here is that the four category metrics exhibited a correlation with their corresponding gross billings growth, suggesting that the channel has reached a state of stability following a period where POS exceeded sell-in during the first half of 2023. From my perspective, a significant implication of this situation is that MAT has improved its ability to effectively control its gross margins. This is due to the elimination of the need to offer substantial discounts in order to sell excess inventory and generate cash from working capital tied up in unsold goods. This development is particularly crucial given the current decline in consumer spending in the United States, as discretionary shopping is experiencing significant pressure.

Having addressed that point, I now redirect my attention towards the anticipated growth of MAT. At the level of the industry, I concur with management's perspective that the near-term outlook is unfavorable as a result of the prevailing inflationary conditions. According to the statement made by management, it is anticipated that the toy industry will continue to experience a decline in performance. The current projection suggests that the category will witness a decrease in the mid-single-digit range in 2023, which is a more significant decline compared to the previously anticipated modest decrease. Nevertheless, it is imperative to emphasize to potential investors that the portfolio of MAT exhibits remarkable performance, surpassing expectations, as it consistently acquires a larger market share. This notable achievement can be attributed primarily to the exceptional performance of its flagship product - Barbie. The success of the movie, particularly in relation to the Barbie brand, resulted in a significant increase in segment sales growth of 17%. Additionally, the overall sales of Barbie dolls experienced a notable increase of 24%. It is worth noting that there was an accelerated growth observed in the 3Q23 POS. This observation has led me to believe that the growth is expected to remain robust in the near future, particularly considering the positive commentary regarding the positive performance of the current quarter-to-date in the 4Q. Christmas is anticipated to serve as a significant catalyst in the fourth quarter of 2023, potentially leading to a notable upsurge in growth. The intention of management to augment its advertising expenditure in the final quarter, and conclude the entire year with advertising expenditure as a proportion of net sales similar to that of 2022, instills a greater sense of assurance that growth is likely to persist robustly in the immediate future. It is worth noting that historically, MAT has consistently generated approximately two-thirds of its revenue in the latter half of the fiscal year. Management has indicated that this pattern is expected to continue in 2023.

Valuation and risk

According to my revised model, MATT is valued at $22.44 in FY24, representing a 26% increase. This is a downward revision from my previous target price, as I now expect valuations to inflect at a much slower rate. Previously, I modeled MAT to re-rate back to its historical average of 11.5x EBITDA, which is over-bullish as I reassess the current macro environment. Given these “headwinds”, I expect valuations to re-rate at a much lower pace—to 9x forward EBTIDA in FY24. Multiples should rerate upwards as I expect MAT to revert back to positive mid-single-digit growth just like it did previously, with potential for growth acceleration if any of the consumer product partnerships turn out to be a big hit (like what happened with Barbie).

My EBTIDA growth expectation has also been revised modestly upwards in FY23 to reflect management’s guidance, and I do not see any issues given the Christmas catalyst and a much cleaner inventory. Following FY24, my growth expectation is the same at 15%, given that FY23 is an easy comp year. For FY25, MAT should see a normalized growth of mid-single-digit.

There are two key risks at play here. The most glaring obstacle is the current weak macroeconomic environment. I anticipate that a further weakening of consumer spending will naturally lead to a decline in underlying toy demand. Secondly, gross margin is going to face a tough comp in FY24. 3Q23 gross margin improvement was driven primarily by a shift in the product mix toward higher-margin licensed and movie-related merchandise. The remainder of the Barbie benefits should trickle down into 4Q23, but next year's results will be measured against that high margin mix. Investors may be concerned about weak profit growth on a year-over-year basis, which could put pressure on the stock's valuation in the near future, despite my confidence that MAT has several other consumer product partnerships (refer to my previous post) that could drive higher growth and margin expansion.

Summary

My recommendation for MAT is a buy, supported by expectations of continued growth in the near term. The inventory situation has significantly improved, reducing the risk of gross margin compression. While my valuation expectations have been adjusted downward due to the current macroeconomic environment, MAT is expected to revert back to its historical average valuation as it sustains its growth trajectory. Despite industry challenges related to inflation, MAT's market share growth and strong product performance, especially in the Barbie brand, position it for continued growth in the near future. Christmas is expected to be a significant catalyst, and management's commitment to advertising expenditure adds confidence in future growth prospects.