In Toyland, More Pain and Less Play


By Hal Diamond This is not a fun time for U.S. toymakers. Business risk has risen as the industry's growth prospects appear to be maturing. The culprits? Increasing competition from video games, children's changing tastes, and consolidation of the industry's retail customer base.

Despite the heightened business risk, Standard & Poor's Ratings Services maintains investment-grade credit ratings on the world's two largest traditional toy makers, El Segundo (Calif.)-based Mattel (MAT), rated BBB, and Pawtucket (R.I.)-based Hasbro (HAS), rated BBB-. The ratings outlooks on both companies are stable.

A CRUCIAL CLIENT. Nonetheless, Standard & Poor's is also concerned about how the two companies will be affected by the pending leveraged acquisition of a key customer, Toys "R" Us (TOY). On June 30, Standard & Poor's lowered its corporate credit rating on Toys "R" Us to B+, from BB, reflecting its substantial debt burden post-merger.

The investor group buying the retailer plans to have $6.2 billion in debt financing available (not all of which is expected to be drawn at closing). The result: Toys "R" Us will be more significantly leveraged -- and its financial profile will deteriorate after the transaction.

Toys "R" Us is Mattel's and Hasbro's second-largest retail customer, accounting for 15% of each company's 2004 sales. The retailer is important to the toy giants as it sells a broad selection of playthings year-round, unlike the mass merchants that focus on hot toys and keep inventories lean outside the Christmas season.

VALUABLE REAL ESTATE. The future credit profile of Toys "R" Us, its new strategic direction, and store disposals are among the key issues that could directly affect the ratings of Mattel and Hasbro. Toys "R" Us has announced that its CEO and chief operating officer will leave when the deal is closed. The new owners have not announced their plans for the company.

The chain, which owns almost half of its stores, may be viewed as more valuable for its real-estate assets. Standard & Poor's expects new management will likely sell some of its stores to other retailers in early 2006. In particular, Mattel and Hasbro will need to maintain their prudent financial policies and capital structures, which will help partially offset unfavorable demand trends.

Toys "R" Us faces significant challenges in turning around its performance, in Standard & Poor's view, given the sizable market share that Wal-Mart (WMT

; AA) has amassed and Target's (TGT

; A+) growing share, resulting from its rapid store-development program.

CUSTOMER CONCENTRATION. Wal-Mart and Target together account for roughly one-third of toymaker sales. Discount retailers' ability to expand and contract the amount of shelf space devoted to toys based on the season gives them strategic and cost advantages. Also, Toys "R" Us' increased debt leverage following the sale may handicap its ability to reinvest in the business.

Although the larger discount retailers are good credit risks, the ongoing consolidation of toy selling into the hands of a few dominant players poses certain risks for toymakers. Customer concentration is increasing mass merchants' bargaining power and limiting toymakers' pricing flexibility. Mass merchants' just-in-time inventory management practices are boosting the proportion of sales derived from the relatively brief Christmas selling season, making earnings less predictable.

GROWN UP FASTER. Toymakers face another daunting challenge. Growth is getting harder to come by as the number of years children are interested in traditional toys has diminished. Children are losing interest in toys at younger ages and turning to video games, DVDs, iPods, Web surfing and instant messaging for entertainment.

Video-game sales especially have depressed the growth rate of the traditional toy market. They have increased at a more-than-10% average annual rate since 1996. Video games accounted for $9.9 billion of $30 billion in total domestic retail toy industry sales in 2004, doubling their share of the total to about one-third, from only 16% in 1996.

Standard & Poor's expects video-game penetration of the toy industry will likely continue to increase over the next few years as the next generation of hardware consoles is introduced.

SIGNIFICANT REVERSAL. The traditional toy industry has been experiencing sales declines each year since 2002, with retail toy sales falling a total of about 8% over the past three years, to $20.1 billion in 2004.

Toy-store closures, price competition among the major mass merchants and specialty toy retailers, and increased competition from video games have contributed to the drop. The declining trend is a significant reversal of the traditional toy sector's average annual increase of about 5% in the 1990s.

It's clear that the macro environment for these toymakers is challenging. How does Standard & Poor's view their individual prospects -- and ratings outlooks? Here's a look.

Mattel

Standard & Poor's is concerned that Mattel's long-term revenue growth guidance in the mid-single-digit area may not be achievable over the intermediate term because of increased competition for its key Barbie product line. Its earnings before interest, taxes, depreciation, and amortization (EBITDA) declined 7% in 2004 and 12% in the three months ended Mar. 31, 2005, reflecting lower sales of the high-margin doll.

Barbie, Mattel's largest profit contributor, represents a business-concentration risk and may be somewhat less relevant to girls' interests today. Girls from age three to eight traditionally have been the core customer group, but they're now outgrowing the product line at an earlier age. Mattel's competitive position has also weakened because of competition from Bratz, a trendy fashion doll line.

Mattel has achieved only a mixed response to its introduction of new versions of Barbie to counteract competitive pressures. Worldwide sales of Barbie, accounting for roughly one-quarter of revenues, declined 8% in 2004 and 15% in the seasonally weak first quarter of 2005.

Barbie's domestic sales declined 15% in 2004 and 25% in the first quarter of 2005, and international volume declined 3% in 2004 and 7% in the first quarter of 2005, after total growth of about 40% in 2001-2003.

The Barbie brand is in transition, and Mattel is implementing a new product and marketing strategy in an effort to regain relevance with girls. This largely revolves around selling Barbie in certain settings or scenarios known as "Worlds of Barbie."

The company, in partnership with Clear Channel (CCU), is also creating a live-action Barbie theatrical show to tour 80 cities beginning in spring, 2006. However, retailers may be reluctant to devote extra shelf space and provide merchandising support until sufficient data reflecting the success of the new strategy are available.

Continued declines in Barbie sales, depending on their magnitude and especially if accompanied by a further decline in EBITDA, could result in Mattel's outlook revision to negative. The company's moderate capital structure and cash balances of $779 million currently provide only a partial offset to increasing business risk. Mattel's discretionary cash flow is good, even after dividend increases in 2003 and 2004, leaving modest financial capacity for share repurchases.

Hasbro

Although Hasbro's long-term goal is to achieve 3% to 5% sales growth and improve operating margins, recent trends have not been supportive. Sales dropped 4% over the 12 months ended Mar. 31, 2005, while EBITDA fell roughly 6% following a significant decline in the higher margin Beyblade promotional toy line, which had accounted for 11% of 2003 sales.

The outlook for good EBITDA growth in full-year 2005 is somewhat related to the success of new product introductions tied to the May, 2005, theatrical release of the new Star Wars movie. Increasing sales and earnings at the company's targeted rate over the intermediate term would be challenging, since it would require continued market-share gains and new-product introductions, including some in risky product categories.

Hasbro is making modest investments in moderately priced consumer-electronics products targeting children 8 to 12 years old, the age group most susceptible to competition from video games and Internet-related entertainment.

Hasbro recently reacquired, for $65 million, the digital gaming rights to its properties, which may enable it to exploit a number of its popular brands across new technology platforms. Although the move offers potential growth opportunities, price competition is fierce in the consumer-electronics field, and product life cycles are short.

Hasbro's outlook is stable, assuming that the focus on its core product line will result in continued robust cash-flow generation, which provides modest financial capacity for share repurchases. An important rating assumption is that share repurchases will remain within discretionary cash flow. Diamond is a credit analyst following the toy industry for Standard & Poor's Ratings Services


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