Hasbro could have been just another toy maker groaning under a litany of economic issues and raw material cost inflation. Instead, the company chose to rewrite its destiny. What makes the company interesting is its resilience in the face of sluggish demand and quest for new horizons. As traditional toys take a backseat to video games, the toymaker is on a crusade to resurrect its core toy brands by turning to video games, Hollywood and even casinos. The stock has gained about 75% since mid-Jan and is now trading close to an all-time high. Even as licensing opportunities and Hollywood tie-ins ramp up, high oil prices lead to higher resin and transportation costs. Will Hasbro continue to outclass the challenges?
As recently as July 21, the toy maker turned in a spectacular second quarter, topping analysts' earnings estimate by 13.6%. The results were despite seasonal softness, and due largely to toy sales tied to films. Ignoring a spooky economy, the company has outperformed earnings estimates in the last 5 quarters by 13.6%, 78.6%, 3.7%, 9.9% and 33.3%, in the same order.
Hasbro said its boys' business sales rose 13% for the quarter, thanks to movie-related toys like Star Wars, Indiana Jones and the Kingdom of the Crystal Skull, and Marvel lines -- Iron Man and The Incredible Hulk.
The "Iron man" toy line, part of Hasbro's Marvel properties, performed well at retail during the quarter, thanks to the box-office strength of the namesake movie. The company expects "Iron Man" sales this year to exceed its original expectations. Hasbro has been making Marvel-based products since 2007, under a deal signed in the previous year. The agreement granted Hasbro game and toy rights to Marvel's superhero universe that includes characters like Spider-Man and The deal is valid for 5 years.
Sales of the timeless "Star Wars" line were up 82% in the boys category for the quarter, ahead of the upcoming theatrical release of the animated Star Wars movie, "Star Wars: The Clone Wars", and a television debut in the fall. The company forecasts another strong year for the Star Wars toy line.
Hasbro is in fact, making such toys for a slew of Hollywood movies and the reverse is also true. Hollywood is also making movies based on Hasbro's toy lines. "Transformers" is what brought about Hasbro's real transformation to the celluloid world.
The inroads into Hollywood last year with the "Transformers" movie, based on the Hasbro toy line, met with astounding success. The Transformers product line generated about $480 million in 2007 revenue for the company. Building on the success, the company is working with DreamWorks and Paramount pictures on a sequel that is slated for release next summer. Year-to-date sales of transformers were up 31% in the boys business.
Hasbro also has a six-year pact with Universal, a General Electric unit, to bring at least four movies based on the toy maker's intellectual properties to the large screen. The brands included in the deal are Hasbro's board games Monopoly, Candy Land, Ouija, Clue and Battleship. Under the deal, Universal will release a Hasbro board-game derived movie in 2010 or 2011, and at least a film a year thereafter.
Paramount pictures is also bringing out an action movie next year based on Hasbro's long-dormant G.I. Joe action figures.
The toy maker is certainly taking its Tinseltown ambitions seriously. In May, the company hired Hollywood veteran Bennett Schneir for a newly created position called managing director of motion pictures. Schneir helped produce "Forrest Gump," "Beowulf" and "Polar Express". The company has also been in talks with "Ridley Scott, the director of "Gladiator, who is known to usually do $100 million movies.
Recently, video game publisher Electronic Arts Inc. (ERTS) released a Scrabble application on Facebook, as part of a licensing agreement with Hasbro. The deal, which runs through 2013, gives EA the global, exclusive rights to create digital versions of Hasbro's popular games including Monopoly, Scrabble and Yahtzee.
Despite the release of the official Scrabble, Facebook users continued to use an unauthorized version of the game called Scrabulous, created by Rajat and Jayant Agarwalla, brothers in Calcutta, India. Scrabulous has been attracting some half-million users daily, posing a more formidable threat to the official game. So, Hasbro filed a lawsuit against the creators of Scrabulous, who have now cut-off the service for U.S. and Canadian Internet users.
This fall, the Hasbro-EA partnership will launch digital games of Littlest Pet Shop, Nerf and Monopoly -- strong performers in Hasbro's girls, tweens and games and puzzle business categories, respectively.
The licensees and theatrical releases lined up for the next several years to support its brands -- places Hasbro in good stead with credit rating firm Fitch Ratings.
Early July, Fitch Ratings affirmed the credit ratings of Hasbro, while lifting ratings outlook. Fitch affirmed Hasbro's Issuer Default Rating or IDR, unsecured bank facility, and senior notes at 'BBB' or investment grade and boosted its ratings outlook to "positive" from "stable".
The ratings firm said the outlook revision encompasses Hasbro's positive operating trends, and the management's commitment to maintaining a moderate leverage at a maximum debt-to-EBITDA of 1.5x and interest coverage of at least 12x at the end of each fiscal year.
In other words, Hasbro aims to keep its total debt at 1.5 times its EBITDA or Earnings Before Interest, Taxes, Depreciation and Amortization, which is deemed to be a plus by Fitch. Usually, a healthy company's total debt is expected to be no more than five times its EBITDA.
Also, Hasbro targets an interest coverage ratio of 12x, which Fitch views as a positive. Interest coverage ratio is a measurement of the number of times a company could make its interest payments with its earnings before interest and taxes. Generally, the lower the ratio, the higher is the company's debt burden. As a general rule, an interest coverage ratio of 1.5 or lower indicates that the company's ability to meet interest expenses may be questionable. An interest coverage ratio below 1 signals that the company may not generating sufficient revenues to satisfy interest expenses.
Earlier this year, the company boosted its quarterly cash dividend by 25% to 20 cents per share from previous 16 cents per share. Hasbro shares its wealth with its shareholders in the form of regular quarterly dividends since November 2003. The dividend has grown from 3 cents a share in 2003 to 20 cents this year. The company's five-year dividend growth rate is 39.77%, compared to 41.37% for the industry, 23.81% for the sector and 11.93% for the S&P 500.
While the scenario seems picture perfect, the toy maker certainly has its own share of woes. The company acknowledges rising oil costs as a challenge impacting resin costs, ocean freight charges, and transportation costs to customers. To mitigate the impact and maintain its industry-leading margins, Hasbro is hiking toy prices in the mid-single-digit range, effective September 1.
Hasbro's gross margin for the trailing twelve months is 50.87%, higher than rival Mattel's 46.34% and the industry's 38.64%. The company's operating margins for the period is 13.38%, higher than Mattel's 11% and the industry's 2.75%.
The company also faces customer concentration risk, with its top three customers Wal-Mart Stores, Inc. (WMT), Target Corp. (TGT) and Toys "R" Us, Inc. representing about 24%, 12% and 11%, of its total 2007 revenues, respectively. Collectively, the top three represented about 70% of the company's North American revenues last year. Combined sales to top five customers accounted for about 52% of Hasbro's total 2007 revenues. If any of these large customers opt to scale back business with Hasbro, the impact may be significant.
The possibility of recalls is another nagging fear that the toy industry has to constantly live with. The 2007 summer was characterized by a string of recalls of lead-tainted, China-made toys. The recalled toys had excessive amounts of lead paint that can be hazardous when ingested by children.
Lead paint has been banned in the U.S. since 1978 on being linked to brain and neurological problems, particularly in children. China supplies more than 80% of the toys sold worldwide. Although a substantial portion of Hasbro's manufacturing is done in China, the company steered clear of the lead-paint related recalls that plagued fellow toy makers Mattel and RC2 Corp. However, Hasbro was still involved in a recall of China-made Easy-Bake-Ovens last year, due to a design problem that could cause entrapment and burn hazards.
Surprisingly, the toy industry has been less sensitive to the recalls, and the sharp downturn in the U.S. economy. According to consumer and retail information company, the NPD Group, U.S. retail sales of toys generated $22.1 billion in 2007, down by just 2% compared with $22.6 billion in 2006, despite the distress signals.
Yet another major concern for the toy industry is 'Age Compression', an unnatural phenomenon that shows tweens or preadolescents aged between 8 and 12 rejecting traditional toys for more sophisticated products like mobile phones and music players that were previously targeted at teenagers. Every year, the transition happens at a younger age shrinking the age-range and thereby the market for selling toys to the tween group, a multi-billion market that is too large to be ignored. A 2007 report from Euromonitor International estimated Tween spending worldwide at about $170 billion.
Hasbro has weathered the economic issues quite well thus far, by seeking out new revenue avenues like Hollywood, video gaming and casinos, to breathe life into its core toy brands. The company's pipeline for the next several years is pumping with licensees and theatrical releases. On the flip side, the company's top line may experience some volatility due to the tie-ins with movie releases. Although the toy maker has been less susceptible to the U.S. downturn, it is certainly not immune to the weakness. Broader risks include input cost inflation, fickle and whimsical customer following, recall possibilities and the pressures to come up with the next blockbuster toy.
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