Why I Bought Shares of Mattel Inc.

Mattel was once the largest toy maker in the world, with time-tested brands like Barbie, Hot Wheels, and Fisher Price driving exceptional profits. The company lost that crown to privately owned Lego during the first half of last year, due to both Lego's impressive growth, and Mattel's sinking sales. Demand for Mattel's key brands have declined in recent quarters, and net income was nearly cut in half during 2014.

I've been watching Mattel for a while, waiting for the price to reach bargain levels, and I recently pulled the trigger around $25 per share. Despite the company's terrible performance in recent quarters, I believe that Mattel's issues are temporary. While it may take years to fully right the ship, the depressed price of the stock looks like a good deal to me.

Trouble at MattelDeclining demand for Mattel's products is really only a symptom of the company's troubles, not the underlying cause. Stifling bureaucracy has paralyzed the company's decision-making process, leaving it unable to adapt to shifting demand.

According to interviews conducted by The Wall Street Journal, Mattel employees would sit through multiple meetings to deal with every issue, ranging from marketing to product features, and would often walk way without coming to a decision. Making Power Point presentations measuring in the hundreds of slides would consume vast quantities of time and effort, leaving little time for actual work.

The problem got so bad that former CEO Bryan Stockton, who was replaced in April, attempted to fix the problem by instituting new rules around meetings:

  • No meeting should be held without a specific purpose
  • No more than 10 people should participate unless the meeting is for training purposes
  • There should be no more than a total of three meetings to make any decision

With employees overwhelmed with bureaucracy and meetings, the creative work necessary to continually come up with new hit toys became increasingly difficult. It's no wonder, then, that Mattel's sales began to fall across the board.

Can Mattel be fixed?Crushing bureaucracy is certainly not unique to Mattel, and any company that is successful for so long can fall into this trap. Mattel adopted a "don't fix what's not broken" attitude, becoming averse to taking the kinds of creative risks necessary to remain on top of the toy industry. This type of strategy works until it doesn't.

Fixing the problem of slumping sales can't be done until the culture at Mattel is revamped, and new CEO Christopher Sinclairwill have his hands full with that task. This will certainly take some time, and I doubt 2015 will end up being a particularly great year for Mattel.

The slump in sales for Mattel's key brands isn't unprecedented, and Mattel has turned things around before. Back in 2005, Mattel's earnings took a hit in multiple quarters as sales of Barbie and Hot Wheels slumped. In the third-quarter of 2005, Barbie sales fell 18% as competition ate away at demand, and competitor Hasbro was posting much better results. A very similar scenario is playing out today.

Once Mattel gets a handle on its bureaucracy issues, there's no reason to believe that the company can't recover from its current sales decline, whether it's through reviving its current brands, or introducing new ones. How long it takes the company to get to that point, though, is anyone's guess.

A bargain turnaround playBased on last year's depressed earnings, Mattel stock doesn't look like a great deal. The stock trades at nearly 18 times last year's earnings, far from an obvious bargain, and analysts aren't expecting earnings to improve this year or the next.

But Mattel's operating margin was well below typical levels last year. Operating expenses actually increased in 2014 despite a decline in revenue, and it's clear that Mattel's costs have gotten a bit out of control. In 2011, SG&A expenses accounted for 33.6% of revenue. In 2014, this number rose to 39%. Cost-cutting will be a key component of Mattel's turnaround plan.

Cost-cutting can sometimes seem like a bad thing, but in Mattel's case, the company has clearly become bloated in recent years. Mattel needs to be a far leaner company, and once that happens, there's no reason why Mattel's operating margins can't get back to the mid-teens.

Based on last year's revenue and tax rate, a 15% operating margin would lead to net income of about $2.05 per share, putting the P/E ratio based on this assumption at about 13. If Mattel can also bring revenue back to where it was in 2013, the P/E ratio would fall to about 11.7.

This is all hypothetical, of course, and it will likely take Mattel years to recover from its current issues. But if and when the company does recover, the current stock price will look like a bargain.

Mattel also currently pays a dividend, and because of the slump in the stock price, that dividend yields nearly 6%. There's a chance that Mattel will need to cut its dividend, depending on whether earnings continue to deteriorate; but for now, investors are receiving a nice quarterly payment for sticking with the toy maker.

The article Why I Bought Shares of Mattel Inc. originally appeared on Fool.com.

Timothy Green owns shares of Mattel. The Motley Fool recommends Hasbro. The Motley Fool owns shares of Hasbro. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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