This is a guest post by Mike, aka The Dividend Guy. He authors The DividendGuy Blog since 2010 and manages portfolios at DividendStocks Rock. He is a passionate investor.

Founded in 1923, Hasbro (HAS) designs, manufactures and markets games and toys for children and families. It owns several toy brands and also excels in producing licensed toys related to movies and TV shows. Their main competitors are Mattel (MAT) for toys and Nickelodeon, Cartoon Network and Disney Channel (DIS) for viewers, advertising revenue and distribution.

• Seven Year Revenue Growth Rate: 1.56%
• Seven Year EPS Growth Rate: 7.18%
• Seven Year Dividend Growth Rate: 15.18%
• Current Dividend Yield: 2.93%
• Balance Sheet Strength: Medium

Overview

Did you know the company started by selling textile remnants and first manufactured pencil boxes and school supplies? It’s almost 20 years after its founding that Hasbro created its first toy in the 1940s. In 1952, Mr. Potato (my 3 years old still play with it!) was created. Today, Hasbro owns several franchise brands such as Transformers, Monopoly, Play-Doh, My little Pony, Magic and NERF.

Business Segments

Since 2001, Hasbro has focused reviving their old existing brands and divided their business into three segments: Canada & USA, International and Entertainment & Licensing. They all work around four axes of development:

#1 Toy & Game Product Innovation

This is where HAS works on re-imaging their existing brand such as Transformers as well as creating new ones. This segment represents about 45% of their total revenue. Hasbro has a talent for creating licensed toys. Among their partners, we count Disney, Marvel, Star Wars and Sesame Street.

#2 Digital Media

Hasbro Studios is responsible for brand-driven storytelling content for television. By producing TV shows and movies related to their toy brands, Hasbro is creating 20min+ long advertising for their toys in stores. It’s a great way to add income while boosting sales of their core products.

#3 Immersive Entertainment Experiences

Since technology becomes more important in our children’s lives, Hasbro has created an immersive entertainment division. The goal is to use technology (such as 3D) to keep children playing with their toys. It usually builds on their efforts with television and animation movies.

#4 Lifestyle Licensing

The lifestyle licensing category operates through the out-licensing of the Company’s intellectual properties to third parties for promotional and merchandising uses in businesses which do not compete directly with the Company’s own product offerings, such as apparel, publishing, home goods and electronics, or in certain situations, to utilize them for toy products where the Company consider the out-licensing of brands to be more effective. (source: Reuters)

 Ratios

• Price to Earnings: 19.20
• Price to Free Cash Flow: 62.92
• Price to Book: 5.31
• Return on Equity: 26.42%

Revenue

After 2006, the company saw an explosion in its revenues. Since 2009, the revenue growth is almost flat (1.56% annualized for the past 7 years). However, most recent data shows a boost in revenues (+5% from 2014 to 2015) as the US economy strengthens. The Entertainment & Licensing division show the smallest numbers in dollars but highest in percentage.

Earnings and Dividends

We can clearly see that both dividends paid and payout ratio are moving along almost perfectly. This is a good sign as the company doesn’t sacrifice more profit to keep up the 15% annualized dividend growth over the past 7 years. The dividend yield has increased over the past three years, a direct consequence of such high dividend growth.

Historical dividend yield at the beginning of each year:

• Current Yield:  2.92%
• 2014 Yield:  3.08%
• 2013 Yield:  3.16%
• 2012 Yield:  4.70%
• 2011 Yield:  2.61%
• 2010 Yield:  2.71%
• 2009 Yield:  2.96%
• 2008 Yield:  3.30%
• 2007 Yield:  2.10%

How Does HAS Spend Its Cash?

With a 15% annualized dividend growth, it is pretty obvious Hasbro has a clear focus on giving back to investors. Once again in February 2015, it has announced another 6.97% increase of its quarterly dividend from $0.43 per share to $0.46 per share.

From 2005 to 2013, the company has also repurchased 92M shares. In 2013, the Board of Directors authorized the company to repurchase another $500 million of HAS. This is part of $2.1 billion that was returned to shareholders over the past five years through shares buybacks and dividend payments.

Their goal is to generate over $500M in cash flow each year to generate additional value for investors.

Balance Sheet

Hasbro doesn’t show the cleanest balance sheet ever. Since lots of its strength remains in their franchise brands, goodwill represents an important weight on the balance sheet. This is 35% of shareholders equity.

Their long term debt tripled from 2005 to 2014 and their total debt doubled for the same period. They also show a debt to equity ratio of 2.092 which is higher than Mattel (MAT) at 1.2. In other words, Hasbro is using important leverage to boost its profit but the weight of the debt could be a problem in the future. At one point, I’d like to see Hasbro deleverage during their good years to make sure they can face upcoming storms.

Investment Thesis

Over the past two years, Hasbro has taken an important place compared to Mattel by publishing better than expected results while its main competitor posted disappointing sales for its main brand names such as Barbie.

As Superhero movies gained in popularity, Hasbro’s ability to create fun derivative products became one of their best competitive advantages. In 2014, it won their bid to gain Disney’s super successful Frozen license for toy products. With the coming of a new Star Wars trilogy at the end of this year, Hasbro seems to be in line to generate additional growth in the upcoming years.

Risks

There are several risks around a company such as Hasbro. First, their international division is getting hit by currency exchange. In Q4 2014, they took a $93M FX hit alone. Since the US dollar will remain strong this year, this could hurt Hasbro profitability in 2015.

Then, we always have the spectrum that children are moving away from classic toys to electronic gadgets. Most little boys and girls have more fun with their parents’ iPad or their new PlayStation 4 than with their Transformers and Little Ponies. This is one of the reasons why Hasbro shows very slow sales growth over the past seven years. Children’s interests are simply moving elsewhere and it remains an important challenge to keep their attention toward classic toys.

The toy industry is not only shrinking due to the profit of electronic devices, but also because the number of chains selling toys is smaller today. This leaves Hasbro stuck with behemoth outlets such as Wal-Mart, Target and Toys ‘R’ Us which account for 35% of its sales.

The balance sheet remains a concern as the debt level is relatively high over the past seven years. The company seems to use a lot of leverage to improve their earnings. Let’s hope measures taken in 2013 to cut $100M in spending per year will continue to be beneficial to investors.

Conclusion and Valuation

When I look at the upcoming years for Hasbro, I see lots of sales with lots of profit. Its business model really works and a stronger partnership with Disney (DIS) will guarantee growth in the year to come. Their partnership in digital media such as Backflip Studios Activision ensures a good diversification. Without a doubt, Hasbro is the leader in the big screen media with product licensing for almost each superhero movies and animation characters.

While 2015 numbers may be affected by the FX compared to 2014, the biggest part of the US dollar appreciation has been made already. Therefore, Hasbro can now build their sales numbers on solid ground.

Ending cash flow has been erratic over the past couple of years (from $849M in 2012 to $682M in 2013 to $893M at the end of 2014). However, considering the bright future ahead, we can expect better cash flow generation for the future. Annual free cash flow generation has also been inconsistent ($422M, $290M, $341M for the same period).

Speaking of cash flow, let’s use the Discounted Cash Flow Analysis to find a fair market value. The point is to assess the value of the company by considering its cash flow generation capacity. Considering free cash flow to increase by 4% per year and a discount rate of 10%, we get a fair value at $47. This is definitely lower than the current trading price. We can factor the hype around Hasbro and the hope the company will continue to show additional growth. Simply by increasing cash flow generation by 5% instead of 4%, we arrive at a fair value of $57 which is pretty much in line with the current value.

After looking at a cash flow based valuation model, we will use The Gordon Growth Model to estimate ranges of fair value for the stock according to its dividend growth rate. The dividend growth rate averaged 15% over the last seven years but I don’t think it will continue at this pace. I would rather use the past 2 year dividend growth that was around 7% (2015) and 8% (2014).

Using an expected 7.5% dividend growth rate and a 10% discount rate, the fair value is $56.51, which is about 10% under current trading price. I use an 11% discount rate since the company balance sheet is not incredible.

Both methods arrive about the same price if we consider a free cash flow growth of 5%. In comparison, MorningStar values HAS at $59, which is also in line with my analysis.

Finally, we can use the Price Earnings Ratio method. Hasbro follows economic cycle as demonstrated on the following graph:

After an important hype around the stock in 2013, the P/E ratio came back to a more appreciable value.

Overall, Hasbro shows interesting growth perspective but is also priced accordingly. A reasonable entry price would be between $55 and $60. A quick drop in the market could make this happens.