Shares of Dividend Growth Newsletter portfolio holding Hasbro dropped after the company reported its second quarter earnings.

By Kris Rosemann

Dividend Growth Newsletter portfolio holding Hasbro (HAS) has been knocking the proverbial cover off the ball with returns (its stock has nearly tripled since being added to the Dividend Growth Newsletter portfolio) and the company has rival Mattel’s (MAT) back against the wall, but the toy giant’s shares recently hit a speed bump. In its second-quarter results, released July 24, Hasbro reported revenue growth of 11%, operating profit margin expansion of 60 basis points, and net earnings-per-diluted-share growth of nearly 30%, but shares faced significant pressure following the release. On the surface, it looks to be another strong quarterly report from one of our favorite dividend growth ideas, but there are a few things we’re watching closely.

For starters, the pressures of the intense-discounting dynamic we’re currently seeing across the retail space have been well covered of late, and Hasbro’s strategy in the second quarter of fiscal 2017 to increase the level of close-out sales--which carry lower gross margins--in an attempt to clean up inventory heading into the entertainment-heavy back half of the year caused meaningful downward pressure on its gross margin in the period. Cost of goods sold rose to 37.9% of sales in the second quarter of 2017, up from 36.6% of sales in the year-ago period. However, these sales also carry lower advertising and other costs, making the impact on the operating profit line far less meaningful. Importantly, management does not expect its full-year margin performance to be unusual compared to a typical year.

Another issue nagging Hasbro in its second quarter of 2017 was the timing of key entertainment events, and the impact that had on the performance of partner brand revenue. Through the first half of 2017, ‘Partner Brands’ segment revenue--licensed brands for which Hasbro develops products--fell 9% on a year-over-year basis. Though this licensing business model is a core piece of our dividend growth thesis for Hasbro, 2016 results benefited from the blockbuster Star Wars release, and 2017 results have yet to see the true benefit of the recently-released Spiderman movie. We’re giving management the benefit of the doubt for the time being that the issues are timing-related.

Hasbro’s issues have our attention, but we’re not ready to part with shares just yet. It is important to note that the company was added to the Dividend Growth Newsletter portfolio at less than $32 per share, a near triple. Also, despite licensed brand products facing pressure in the first half of 2017, Hasbro continues to generate robust free cash flow, which leapt more than 25% in the first six months of the year from the year-ago period to nearly $300 million, more than twice cash dividends paid in the period. We’re not all that concerned with the company’s ~$1.7 billion total debt load impacting its dividend growth potential after considering its free cash flow generating ability and ~$1.4 billion cash and cash equivalents position.

All things considered, we’ll continue to include shares of Hasbro in the Dividend Growth Newsletter portfolio, while we closely monitor developments. Among our list of potential reasons to trim the position are a) continued meaningful pressure on gross margins and/or free cash flow generation, b) any substantial deterioration of its balance sheet health, or c) a technical breakdown in its pricing chart. Hasbro’s shares continue to trade near the upper bound of our fair value estimate range, and the selloff in shares following the quarterly report may very well have been tied to a significant amount of profit-taking across the market.

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