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Author: onparole Big red star, 1000 posts Old School Fool Coverage Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 1220  
Subject: Is Hasbro undervalued? Date: 6/21/2007 12:12 AM
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I originally got interested in Hasbro due to the interest that I had in Marvel. With Hasbro taking over the toy manufacturing portion from Marvel I decided to look into the Hasbro business to see if it was appealing (even with the recent run up in Hasbro).

Hasbro has been in the business of creating children's toys and family entertainment games for over 70 years. The bulk of the company's revenues come from its stable of core products (which include Tonka, Playskool, Parker Brothers, and Milton Bradley to name a few). The delta in Hasbro's business normally deals with the use of licensed products to create innovative toys. Sales of these licensed characters have helped buoy the faltering sales of Hasbro's core brands in recent years as they struck gold beginning in 1999 with the release of the second Star Wars trilogy as well as in 2003 with an unlikely winner in Beyblade.

Valuing Hasbro really hinges on two things:
1) Predicting the growth in the core brands
2) Predicting the growth in the licensed brands

Unfortunately, Hasbro does not break these two segments out and only gives minimal financial numbers for the licensed items (and even then it is only for the items that generated more than 10% of total revenue). So, valuing Hasbro is somewhat difficult and involves many assumptions that may or may not be accurate (lending itself to a wide spread in valuation).

Some information that Hasbro does provide are various sales segments such as:
• Boys toys
• Girls toys
• Tweeners

However, there are a couple of problems with this disclosure. The first problem is that the segments and corresponding sales figures have been classified and reclassified a few times over the years. Sales in 2003 that were classified in the “creative games” category have been reclassified into any number of other segments in 2004. This makes year over year segment comparisons very difficult. The second problem is that there is no specific breakout of licensed revenue. For example, determining how much of the Star Wars toys that falls into the “boys toys” category versus “electronic toys” or “games and puzzles” is impossible.

Historical Data

2002 2003 2004 2005 2006
Total Sales 2816.2 3138.7 2997.5 3087.6 3151.5
Gross Profit 1717.1 1850.7 1745.9 1801.4 1847.6
Op Inc 219.3 344.6 293.0 310.5 376.4
Net Income 75.1 175 196.0 212.1 230.1

Margins 2002 2003 2004 2005 2006
Gross Profit 0.610 0.590 0.582 0.583 0.586
Op Profit 0.078 0.110 0.098 0.101 0.119
Net Profit 0.027 0.056 0.065 0.069 0.073

The charts above show:
1) Sales have not been growing at a high pace (essentially flat since 2003)
2) Although gross margins have been slipping operating net profit margins have been up

Management has been doing a good job of making sure that as much cash as possible hits the bottom line.

Licensing

As mentioned previously licensed toys have been buoying sagging sales with the core brands. In 2003, Beyblade was responsible for 11% of total revenue ($345M). In 2005, the last installment of Star Wars generated more than 16% of total revenue ($494M). No other single item counted for more than 10% of revenue from 2001 to present. With core products being the lion's share of the revenue the future growth of the company either lies with a revitalization of the core products or continued licensing actions. Although the company does not have very good disclosure concerning licensed toy revenue it does give some small clues that may help us to predict future revenue.

Star Wars

In 2003 Hasbro renegotiated a licensing contract with LucasFilm that included the following terms:
• Minimum guarantee of $85M
• Warrants allowing Lucas to purchase 15.75M shares of Hasbro
• In Oct 2016 Hasbro can elect to repurchase these warrants back from Lucas for either $200M in cash or $220M in stock
• In Jan 2008 Lucas can elect to sell these back to Hasbro for either $100M in cash or $110M in stock

NOTE: These warrants have recently been repurchased by Hasbro

Hasbro paid a hefty price for the rights of Star Wars (especially since the last Star Wars film came out in 2005). In essence, the 15.75M shares amounts to about 8% of the company. Although the future of Star Wars revenue for Hasbro is not very clear at this point I believe that there are minor events that could spur some meaningful ongoing revenue (animated series, direct-to-dvd releases, 30th Anniversary of Star Wars, etc.).

What does this have to do with anything? I am hoping to use this information in order to get some insight as to what the Marvel deal will mean for Hasbro going forward.


Marvel (ticker: MVL)

The license with Marvel runs through 2012 and once again Hasbro paid a pretty hefty fee for these rights. The minimum guarantee to MVL is $205M in royalty and service fee payments. The breakdown is as follows:
• $70M was payable with the release of Spider-Man 3 (SM3
• $35M is payable with the release of SM4 (probably 2010)
• $100M was already paid in 2006

In addition to the above $15M was required to go toward SM3 advertising in 2007.

A look at MVL's historical toy sales (with the corresponding movie releases) as well as the future may give us a glimpse at minimal Hasbro licensed revenues.

mvl toys 2000 2001 2002 2003 2004 2005
rev 167.3 91.7 155 85.2 212.8 68

xmen sm dd sm2 Elektra
hulk FF
xmen2


mvl toys 2006 2007 2008 2009 2010
rev 116.1

xmen3 sm3 im ca sm4
ff2 hulk2 xmen4 ff3
gr avengers

(Anything beyond 2008 has not been formally acknowledged by Marvel yet and are simply somewhat educated guesses by me)...

One thing that is apparent is that any year with a Spider-Man release is a great year for toys. The deal that HAS and MVL struck, although expensive for HAS, is probably quite fair for both parties. MVL's toy revenue was limited due to the marketing, manufacturing, and distribution reach of their ToyBiz subsidiary. HAS will most certainly greatly improve upon the above revenue figures.

The major item to consider with the MVL deal is access to the entire library of characters (especially the characters that exist within a group). Although the Spider-Man and Hulk toys tend to center around the central hero and one or two main villains other popular properties contain a group of heroes and a group of villains. One movie (such as X-Men) can center around 10 major characters and introduce many more. MVL has shown the ability to introduce a “b-level” character and make it successful. Given the nature of how MVL and HAS are joined at the hip to some degree HAS will likely see some significant revenue from the MVL line between 2007 and 2010.

Valuation

In the above commentary we see the revenue impact that one hit concept can have. Beyblade had numerous characters that could be used on toys, trading cards, action figures, etc. Star Wars also has many characters that can be capitalized upon in the same manner. However, what does the deal with MVL buy HAS? Well, the assumption that MVL is a one-trick pony with Spider-Man is not a good one. MVL has over 5000 proprietary characters, but there is a misconception that only a few are actually bankable.

Here are some of the assumptions that went into building the valuation model:
• SM3, FF2, and GR new revenue: $350M
• Transformers new revenue: $300M
• Core sales decline: 5%
• Gross profit margin: 58%
• % of MVL toy sales kicked back to MVL as royalties: 10%
• SDA to revenue ratio: 22%
• Tax rate: 35%
• Previous year royalty rolloff: 75%
• Amortization rate: 40%
• Royalty percentage for previous licenses: 10%

When a movie comes out the demand for that toy line is extremely high and the next year the demand drops dramatically. However, the extent of that drop is not revealed by HAS. So, I created three scenarios in which the residual revenue from the licensed product represents 5%, 3%, and 1% of the next year's total revenue.

residual rev 0.05 0.03 0.01
2007 2007 2007 2006 2005 2004 2003
Revenues 3801.5 3738.5 3675.4 3151.5 3087.6 2997.6 3138.7
Cost of sales 1303.9 1286.3 1251.7 1288
Gross profit 2204.9 2168.3 2131.8 1847.6 1801.4 1745.9 1850.7

Expenses
amort 117.5 114.4 111.4 78.9 102 70.6 76.1
royalties 293.7 285.9 278.4 169.7 247.3 223.2 248.4
r and d 171.4 171.4 171.4 171.4 150.6 157.2 143.2
advertising 369 369 369 369 366.4 387.5 363.9
SDA 836.3 822.5 808.6 682.2 624.6 614.4 674.5
Oper inc 416.9 405.2 393.0 376.4 310.5 293 344.6

NI 271.0 263.4 255.5 230.1 212.1 196 244.1

The above corresponds to the following margins:

0.05 0.03 0.01
Margins 2007 2007 2007 2006 2005 2004
Op Inc 11.0% 10.8% 10.7% 11.9% 10.1% 9.8%
NI 7.1% 7.0% 7.0% 7.3% 6.9% 6.5%

The real questions in all of the above should be:
1) How much toy revenue will be driven by MVL properties (especially non-SM characters)?
2) How popular will the Transformers be?

With Beyblade bringing in nearly $350M and Star Wars nearly $500M I believe that at a minimum Spider-Man and Transformers can bring in at least $300M each (especially if MVL's ToyBiz sales are any indication at all).



Using some other minor assumptions we can derive some semblance of FCF.

0.05 0.03 0.01
2007 2007 2007
NI 271.0 263.4 255.5
Dep & Amort 85 85 85
Other Amort 117.5 114.4 111.4
Cap Ex 90 90 90

FCF 383.5 372.7 361.8

I used the following inputs to calculate a fair price:
Growth rate years 1 – 5: 5.5%
Growth rate years 6 – 10: 5%
Growth rate years 11 – 20: 4.5%
Growth rate years 21+: 3.5%
Discount rate: 11%
Shares outstanding: 181M
Cash per share: $1.16

Using these inputs and $372.7M FCF I get a share price of $34.74.

The “what if” scenario?

I think that there is an absolute possibility that the numbers projected above for MVL (SM, GR, and FF2) and Transformers revenue is low. It is entirely realistic that either (or even both) properties can turn in Star Wars-like numbers (close to $500M). With that in mind I have created a “what if” scenario that utilizes the same variables as the FCF above with the following exceptions:
• MVL toy revenue: $500M
• Transformers toy revenue: $500M
• Core toy sales growth: 2.5%

Most of the other factors in my spreadsheet (such as royalty payments, distribution costs, etc.) are built upon a percentage of revenue so these costs are adjusted accordingly.

In this upper bound scenario I arrive at a FCF value of $487.4M which implies a fair valuation at $45.

Conclusion

Recent events have shown that HAS management can grow the core brand (even though the past few years may suggest otherwise). My initial thoughts were such that it would be unlikely for HAS to be able to grow the core brand, market the licensed toys, market the Transformers line, and keep margins in check. If this trend continues (I am not sure that two consecutive quarters constitutes a trend) then the valuation above could be entirely too low.

The last couple of things that I need to mention are:
• HAS had a $70M payment due to MVL on May 4th 2007. I treated this as an ongoing cost of business and not a one-time event.
• 2008 comparisons are going to be ridiculously difficult. To my knowledge there currently aren't any other irons in the fire beyond the MVL schedule. Naturally, this will affect the influx of cash and will impact the overall valuation (hence the upper bound of the “what if” scenario). I was concerned that beyond the MVL movies there was little going on in 2008. However, there has been a recent signing for the Indiana Jones sequel
• Hasbro has recently increased their dividend and continues to repurchase undervalued stock in an effort to reduce the share count. It is probably fairly likely that the $350M share buyback will be exhausted before the end of the year.
• Two-thirds of the full year revenues occur in the 2nd half of the year. The numbers for the first quarter are in the books and HAS scored a HUGE revenue surprise to the upside. With a May release of SM3, a July release of FF2, a July release of Transformers, and a 30th anniversary release of Star Wars 2007 will probably be huge.

This valuation has really been an exercise of trying to fill in a lot of pieces that HAS hasn't fully disclosed (or at least I hadn't discovered). Therefore, I am entirely fearful of a “garbage in, garbage out” valuation. With that in mind, I believe that my low end valuation of around $33 represents a fair valuation with plenty of room for upside growth and a much smaller potential for downside movement.

comments are welcome!

thanks,

Royce
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