Spin Master Corp

TSX:TOY

Earnings Call Transcript 2019-Q3

[Operator]

Good morning. My name is Tiffany, and I will be your conference operator today. At this time, I would like to welcome everyone to the Spin Master's Third Quarter 2019 Earnings Conference Call. [Operator Instructions] Thank you. You may begin your conference.

[Sophia Bisoukis, Vice President of Investor Relations]

Thank you, Tiffany. Good morning, everybody, and welcome to Spin Master's Third Quarter 2019 Financial Results Conference Call. I'm joined this morning by Ronnen Harary, Co-Chief Executive Officer; Ben Gadbois, President and Chief Operating Officer; and Mark Segal, Chief Financial Officer of Spin Master.For your convenience, the press release, MD&A and unaudited interim financial statements for the third quarter 2019 are available on the Investor Relations section of our website, at spinmaster.com, and on SEDAR.Before we begin, please note that remarks on this conference call may contain forward-looking statements about Spin Master's current and future plans, expectations, intentions, results, levels of activity, performance, goals or achievements or any other future events or developments. Forward-looking statements are based on information currently available to management and on estimates and assumptions made based on factors that management believes are appropriate and reasonable in the circumstances. However, there can be no assurances that such estimates and assumptions will prove to be correct. Many factors could cause actual results to differ materially from those expressed or implied by the forward-looking statements.As a result, Spin Master cannot guarantee that any forward-looking statements will materialize, and you are cautioned not want to place undue reliance on these forward-looking statements. Except as maybe required by law, Spin Master has no obligation to update or revise any forward-looking statements, whether because of new information, future events or otherwise.For additional information on these assumptions and risks, please consult the cautionary statement regarding forward-looking information contained in the company's earnings release, dated November 5, 2018.Please note that the Spin Master reports in U.S. dollars, and all other dollars amounts to be expressed today are in U.S. currency.I would now like to turn the conference over to Ronnen.

[Ronnen Harary, Co]

Thank you, Sophia. Good morning, and thanks for joining us on the call today.Our strategy is designed to achieve long-term growth, and we are delivering on that strategy.Since 2015, we have generated gross product sales growth of 20% and 10% over the last 10 years, well in excess of industry growth rates.Our team remains diligently focused on successfully executing against our growth pillars. Despite an ever evolving toy and content consumption landscape, we remain focused on the execution of our plan. As a result, the strength, diversity and depth of our innovative brand and entertainment franchise portfolio gives us confidence in delivering our long-term organic gross product sales growth target of mid- to high-single digits.This is evident in 2019 as we have grown the business 12%, excluding the significant decline in Hatchimals, from 2018 to 2019.The traditional toy and games industry representing an approximately $80 billion-plus global market is stable and growing at a compound growth rate of approximately 4% to 5% per year.In the last few years, the U.S. market has faced challenges that have created disruption and change, but also opportunities.We've had a major retailer, TRU, exit the market in 2018, and in response, volume has been redistributed to new customers and channels, creating changes in order patterns and distribution requirements.The growth and trend towards online purchasing, away from brick-and-mortar, has continued to accelerate.The content landscape has continued to shift from traditional linear models to SVOD and AVOD and digital mobile platforms. As all of this has occurred in a political environment, characterized by trade tensions between the U.S. and China with ever-changing risk of U.S. tariffs.Through all this change, we remain focused on executing our strategy. We expect an overall growth in top line and double-digit growth of our product portfolio for 2019. Excluding the decline of Hatchimals, is a testament of health and overall brand portfolio as well as our ability to adapt and change.We planned for a decline in Hatchimals in 2019 and assured we have -- had a broad and diverse portfolio including: new product introductions, such as Owleez, Juno, My Baby Elephant; partnerships such as Monster Jam, How to Train Your Dragon; and entertainment franchise, such as Bakugan and Paw Patrol that are driving revenue, offsetting the decline.Our growth is driven -- has been driven by our ability to identify, develop and acquire new and innovative products and brands; create and license evergreen entertainment content and grow internationally in partnerships with the vendors, broadcasters, production studios, distributors and license source.In 2010, we operated in only 7 of the 11 categories in the toy industry as tracked by NPD.Today, we have diversified the business with representation in categories and now operate in all of 11, providing solid diversified base in positioning us for future growth.We continue to go deeper in our categories through internal innovation, strong partnerships and acquisitions, constantly fueled by our disciplined 36-month brand innovation pipeline.Innovation at the core of our success -- is at the core of our success and will continue to be a significant contributor to our future growth.We have demonstrated that we are able to excite kids, and we remain confident that we will continue to bring innovative, hip products to market.We've been able to generate highly successful properties, such as Paw Patrol, Hatchimals and Bakugan, which contributes significantly to our growth and then generate resources that we can reinvest in future growth opportunities.This allows us to diversify and build broader reoccurring revenue streams across our toy, entertainment content and mobile digital direct-to-consumer markets.At the core of Spin Master is our ability to create engaging kid storytelling for multi-platform consumption.Through the success of our properties, such as PAW Patrol and others, we have proven that creating evergreen, compelling and engaging kids content and combining that with the retail initiatives, such as toys, helps optimize brand equity, and in turn, drives higher-growth, alternate revenue streams for licensing and merchandising and higher margins.In Q2, we launched a new season of PAW Patrol franchise and products based on the Season 6 Mighty Pups theme.Since the launch, PAW Patrol has grown through the third quarter. PAW Patrol has higher consumer engagement than ever before. This is a testament to our strategy of refreshing themes to keep the characters and stories relevant.Progress continues for the first ever theatrical animated PAW Patrol film, which we are targeting for release in 2000 -- in late 2021, and we believe PAW Patrol will set the foundation for other properties to follow on to the big screen.Regarding Bakugan, we are taking a long-term multi-generational view of the franchise. We're pleased with the response to Bakugan in the first year of its relaunch.We relaunched in Q1 in North America and Australia, and then Japan, U.K. and Germany in Q2. We continue to roll it to rest of Europe and internationally, during the third quarter. And by the end of 2019, we'll be in full distribution globally.We have worked with our partners at Cartoon Network to build a multi-channel content approach and make content available on television, SVOD and YouTube.During the third quarter, we launched Bakugan on Netflix, which has accelerated it's awareness and growth trajectory.This multi-channel approach helps us to ensure that we reach as many kids as possible.We have strategically invested and focused in all areas of content consumption, which includes our mobile digital presence with Toca Boca and Sago Mini. For years, we've been studying play patterns, which have been converging between physical brands, entertainment franchises and mobile digital platforms.Children are increasingly accessing and consuming entertaining content on mobile devices. The acquisition of Toca Boca and Sago Mini, 3 years ago, provided us with a strong brand presence in the digital mobile space and allowed us to develop a leadership position in the kids mobile app and direct-to-consumer space.Today, Toca Boca and Sago Mini average over 20 million monthly active users on a combined basis globally, giving us a strong base of users to expand, both app sales and direct-to-consumer subscription-based products.In 2020, we'll be enhancing our offering from 1 to 4 subscription products.These will include Sago Mini World and Sago School, along with an innovative subscription offering of Sago Mini physical boxes, which integrate with the digital worlds.We continue to actively look for potential strategic acquisition targets, while maintaining a measured and disciplined approach. While we will only acquire assets that fit our long-term strategic and financial criteria and are able to generate value for shareholders, we are currently observing an inflation for acquisition multiples for companies that are our targets.This is being caused by the entry of private equity players into the mid- to large size toy space. We believe these multiples are unsustainable and will not create value. Over time, we believe these companies will come back to the market in more reasonable multiples in line with their true underlying growth potential.Our brands, partnerships, entertainment and mobile digital franchises are resonating strongly with children. We're confident in the success of our strategic direction and are proud of our global teams for their commitment to delivering our success.With that, I will now turn it over to Mark.

[Mark L. Segal, CFO & Executive VP]

Thanks, Ronnen, and good morning.Q3 gross product sales were down $75 million or 11.4% compared to last year, and on a currency-adjusted basis were down $70 million or 10.6%. The gross product sales decline this quarter was driven primarily by the difficult year-over-year comp for Hatchimals in the radio control and Interactive Characters (sic) [ Remote Control and Interactive Characters ] business segment.Excluding Hatchimals, which declined over 69% in the quarter, gross product sales increased by over 10%, led by the strong performance of the Boys Action and High-Tech Construction business segments.At a high level, we saw 4 key factors affecting Q3 results and the cadence of shipments in the second half of 2019, which include: one, a decision to manage our portfolio brands more tightly using domestic replenishment; secondly, the evolving retailer trend away from FOB or direct import orders towards domestic orders, due to a combination of the demise of Toys"R"Us, the threats of U.S. tariffs and increased online purchases that drive more just-in-time shipments later in the year; thirdly, we saw increased inventory levels arising from our decision to bring in inventory earlier to avoid U.S. tariffs; and finally, our U.S. East Coast warehouse consolidation from 4 warehouses into 1 caused short-term disruption and created congestion in our U.S. supply chain.This shifted approximately $40 million of Q3 shipments, primarily in the U.S., from the last week of September to early-October in Q4.Ben will explain these dynamics in more detail in a few minutes, but I wanted to take a moment to review the seasonality of our business and how the factors above have affected and will continue to affect the underlying -- sorry, the timing underlying our financial results.The toy industry operates on 2 seasons, Spring and Fall, which correspond to H1 and H2 from a calendar perspective.Typical toy industry sales seasonality is around 30% to 33% H1 and 67% to 70% H2.This half year perspective is the way, both we and our customers, manage the toy business.Having emphasized the H1/H2 split, there are some dynamics around the quarterly split within H2, which we need to explain further.Historically, we have shipped most of our H2 sales in Q3 on an FOB or direct-import basis, where our customers take ownership of the goods directly at the ports in Asia.We relied less on domestic replenishment using our own distribution network, which was then equated to Q4 sales. Toys"R"Us in particular was historically a large FOB purchaser from us in Q3, as they wanted to manage their full purchases earlier and directly through their own distribution network.Q3 was, therefore, typically a much larger proportion of our H2 sales than those of our larger competitors, who emphasized more domestic replenishments.FOB shipments, which are priced lower as the retailers taking inventory risk, favors cash flow whereas domestic sales at higher prices offers net incremental margin due to higher pricing with some offset from increased inventory carrying costs and higher working capital investments due to increased inventory and longer receivable payment terms.For the reasons described above, both through our own decisions related to the management of our product line and because of industry changes over time, our Q3 will decline in size and Q4 will increase correspondingly.We are seeing this play out meaningfully this year.While quarters are important in public markets, we do encourage you to also remain focused on measuring our performance on a semiannual basis.This quarter, in the Boys Action and High-Tech Construction business segment, we have seen solid performance from the Bakugan franchise, following its debut on Netflix and continued strong performance from Monster Jam. With Bakugan's expanded global rollout, we view this property as a driver of growth going into 2020. In Pre-School and Girls, our core brand showed strong double-digit year-over-year sales growth, led by Twisty Petz and PAW Patrol up 6% in Q3 and sales of Candylocks, Pre-School, offset by sales of Party Popteenies in Q3 2018, which was unsuccessful and did not carry forward into 2019.As expected, we continue to see declines in the Remote Control and Interactive Characters business segment, largely driven by Hatchimals. Year-over-year, Hatchimals declined over a $120 million in Q3 and over $200 million year-to-date.As we have said for some time, the decline in Hatchimals has been expected and planned, and we are sharing this detailed information with you, which we do not normally do, to put our Q3 results into the proper perspective.Gross product sales in Activities, Games & Puzzles and Plush saw a slight decline as most of our significant new product launches began in the back half of the quarter, timed with the movie releases, such as Frozen 2, Toy Story 4 and The Lion King.Geographically, gross product sales in North America declined 15.3%, driven primarily by the decline in Hatchimals.Excluding Hatchimals, gross product sales in North America increased 6.6%.Gross product sales in Europe increased 1.6%, while the Rest of the World was down 12.1%. The decline in the Rest of the World is partially attributable to move of Russia, Switzerland, Greece and Austria into direct markets in Europe, which were previously reported in our third-party distributed category in the Rest of the World.Overall, international growth product sales in the third quarter was strong, growing to 36% of total gross product sales, up from 33% last year.Sales allowances as a percentage of gross product sales were 10.6% for the quarter compared to 9.7% last year.As a reminder, sales allowances are typically between 10% to 12% of annual gross product sales and vary by quarter due to the timing of promotional and markdown spending.Other revenue, which includes television distribution income, merchandise royalty income as well as app revenue from Toca Boca and Sago Mini, increased by 3.4%, driven by higher licensing in merchandising income and higher app sales.Gross profit for the quarter was $287 million, representing 52.3% of revenue compared with $318 million or 51.3%.The 1 percentage point increase in gross margin was largely driven by a favorable shift in product mix towards higher-margin brands and the net impact of higher other revenue.This was partially offset by higher ocean freight costs arising from the uncertainty caused by the U.S.-China trade dispute.As we discussed, as part of our risk management program, we've been diversifying our manufacturing footprint for several years. We continue to accelerate the supply diversification program out of China, resulting in higher-than-normal supply chain costs, which we expect to normalize over time and generate cost savings.SG&A expenses for the quarter remain flat overall compared to 2018. We saw higher selling expenses from increased sales of licensed product, increased marketing expenses, higher distribution expenses resulting from increased inventory storage costs, due to high inventory levels, and costs associated with the distribution center consolidation in the U.S., offset by improvements in administration expenses related to lower employee cost.As a percentage of revenue, SG&A increased to 29.7% from 26.2%. The increase was mostly driven by lower sales volumes.We expect to see improved operating leverage in Q4.I want to emphasize 2 additional points on distribution and selling costs.In the long term, the investments we've made in UTCs located in the East Coast U.S., Hungary, servicing our expanded Eastern European market and Moscow, are largely complete. We expect our new supply chain infrastructure will enhance operational efficiencies in the long term, improve customer service levels and drive operating leverage.Selling expenses increased as a mix of licensed products, including Monster Jam and How to Train Your Dragon increased, resulting in higher royalties.We expect variable selling expenses to be slightly higher throughout 2019 due to the success of these properties and remain at the levels in 2020 as we roll out the DC Comics product line.Adjusted EBITDA for the quarter was $150 million compared to $180 million last year, primarily as a result of the lower gross product sales and higher distribution and selling expenses.Our adjusted EBITDA margin was 27.4% compared to 29% last year. Please note that adjusted EBITDA for Q3 2018 was not restated by IFRS 16 and would've been higher by approximately $3.4 million, if adjusted.Net income for the quarter declined to $92.1 million from $107.9 million the prior year. Adjusted net income for the quarter declined by $24.5 million to $93 million.On a Q3 year-to-date basis, gross product sales are down 8% or $102 million. However, excluding Hatchimals, gross product sales grew 12%. This growth in our broader portfolio more than offset -- offset more than half of the Hatchimals decline so far this year and this will accelerate further in Q4.Despite the year-to-date decline in gross product sales, October orders and shipments have been strong and include approximately $40 million of shipments that shifted from September to October, as I described earlier. Importantly, as at the end of October, our sales for the month, together with shippable October orders have more than recovered our year-over-year Q3 year-to-date gross product sales decline.Turning to our balance sheet. Total net working capital as a percentage of revenue at the end of Q3 increased to 16.7% from 14.9%. This was primarily attributable to increased inventory levels arising from our decision to bring in inventory earlier, to emphasize domestic replenishment, to mitigate U.S. tariffs and together with the impact of our U.S. East Coast warehouse consolidation.Our core working capital comprising trade receivables, inventory and trade payables increased to 19.5% of revenue compared to 18.6%.Overall, our cash conversion cycle increased by 10 days to 53 days, mainly from higher days inventory on hand.Free cash flow was $128.6 million declining from $149.8 million in the prior year, driven primarily by lower profitability and investments in the entertainment franchise development.Our balance sheet remains very strong, and we ended Q3 with $151 million of cash, up $56 million compared 2018.We do not see any change to our outlook for gross product sales for the full year 2019. As I described earlier, Q4 orders and sales at this point are further ahead than last year at the same time, giving us confidence that we remain on track to grow gross product sales for the full year at low-single digits compared to 2018, as previously guided.To be clear, we still need to perform well during the order replenishment cycle in November and December, as is the case every year, but we are confident that we can achieve our sales outlook for 2019.It is important to reiterate that Hatchimals started to decline in the fourth quarter, 2018 and continued through the first 3 quarters of 2019.As such, we expect any further decline in Hatchimals to have less impact on the fourth quarter of 2019, that it has so far year-to-date in 2019.With regards to adjusted EBITDA margin, we continue to be focused on cost management and productivity initiatives. Given some of the distribution and supply chain issues described earlier, we now expect our adjusted EBITDA margin in 2019 to be slightly below the adjusted EBITDA margin we achieved in 2018.To conclude, we remain committed to our growth strategies and long-term financial framework, which targets organic gross product sales growth of mid- to high single digits.While we acknowledge the short-term uncertainty caused by the various factors which affected this quarter, Spin Master's track record of generating growth, backed by a diverse portfolio and healthy balance sheet, gives us a strong position to take advantage of growth opportunities.With that, I will now turn it over to Ben.

[Benoit J. Gadbois, Former Global President, COO & Director]

Thank you, Mark, and good morning. We remain confident in the underlying strength of our business, the health of our portfolio and the operational model we've built, which enables us to move quickly and align to changing industry dynamics.At a high level, as Mark mentioned, we saw 4 key factors affecting the second half of our year and which resulted in a significant shift of both shipments and order from the third quarter to the fourth quarter. Let me walk you through this in a little more depth as it is important to understand our Q3 performance and build confidence in Q4 and our full year outlook.We have evolved towards a more domestic replenishment model to ensure our collectible product lines, such as Bakugan, Monster Jam and Colleggtibles, which are a big part of our business in 2019, remain fresh on shelf. This strategy gives us more control to ensure that we have the right product mix on the shelf at the right time. Keep in mind further that as we continue to increase our European presence, the proportion of domestic orders increases as Europe largely operates on the domestic order fulfillment model.The absence of Toys"R"Us in the third quarter had an important underlying effect on the industry this year. TRU was a large direct import or FOB Asia buyer and purchased most of their goods early for the Fall season in Q3. This shifted volume more domestically and added to the pressure on our's and industry's supply chains.Also, with an ever-growing e-commerce penetration, retailers' order lead times have narrowed, shifting the buying patterns closer to the holiday season in Q4. The on-again, off-again, on-again, but less items, news on tariff on list 4 items, including toys during Q3, was disrupted to our's and the industry's supply chain. At times, we saw some retailer facing stretched domestic warehouses' capacity issues as they also employed mitigation strategies on unrelated list 1 through 3 tariffed product lines.This situation caused a degree of uncertainty in retailers' order patterns as retailers shifted orders in anticipation of the tariff implementation, which then put pressure on our supply chain as we brought in inventory earlier and domestically in order to avoid tariffs. With long lead times of Asia, we could not flex as quickly as the news unfolded. And as a result, we tried to maintain a measured approach, whilst at the same time, continuing to diversify production outside of China.As we discussed in Q2, we consolidated distribution into an East Coast DC to serve our customer better, and at the same time, consolidated Gund, Cardinal and Swimways warehouses into the new DC. This was disruptive to our third quarter shipment flow, but it's the right long-term strategy to advance our supply chain and gain cost synergies from our acquisitions.We estimate that approximately $40 million worth of shipments were delayed from last week of September to early-October.Even though this will have a short-term cost impact, we have now invested in additional capacity at many of our warehouses to ensure all products ship on time in Q4.Furthermore, Hatchimals, which has been one of the most successful product launches in our history, exploding in popularity in 2017 and '18, continued its decline in Q3, which began at the end of 2018 and was fully anticipated by us.Excluding Hatchimals, we grew gross product sales 12% for the year-to-date, which is due to our relentless focus on our 36-month brand innovation pipeline. Our performance has remained strong through October, driving orders and shipment to date ahead of where we were at the same time last year on an October year-to-date basis. We now have orders and shipments that have made up the decline of 8% in Q3 year-to-date gross product sales.We still need to perform well during the order replenishment cycle in November and December, but are feeling confident that we can achieve our low-single digit gross product sales outlook for the year.From a POS perspective, our overall performance this quarter was solid, with high-single-digit growth of 8% globally, despite the decline of Hatchimals. Global POS, excluding Hatchimals, was up 19% this quarter year-over-year.The POS growth ultimately leads to shipment growth, but for the first 3 quarters our -- of 2019, our key U.S. retailers were rightsizing the inventory coming out of the 2018 rates to capture TRU share.In total, Q3 U.S. POS, including Hatchimals, was up 6% and inventory -- retail inventories were down 7%. It was pleasing to see U.S. Q3 POS, excluding Hatchimals -- the territory in which Hatchimals had the highest proportion of loss, showed POS up 17% year-over-year. At our Top 3 U.S. customer, Q3 year-to-date, POS was up 12% and inventory was down 5% -- retail inventory was down 5%.We continue to see positive momentum internationally in Q3 in many key markets. In Europe, we saw strong double-digit POS growth overall. In Germany, we saw POS growth of 33% year-to-date. In the U.K., despite the turbulence of the market due to Brexit, we continue to see low-single-digit POS growth compared to a double-digit decline in the toy market overall.PAW continues to be the leading pre-school license globally. We saw a positive POS growth in Europe, and especially, strong POS growth in Germany, Russia, Poland and Slovakia, in particular. In Asia, the launch in Japan continues to gain momentum in Q3. In the U.S., POS for PAW Patrol declined mid-single digit. We saw an effect on POS through the launch of Toy Story 4, which both targeted at the same consumer. Overall, however, we expect PAW POS to grow in Q4 with the launch of the new higher-price point item, including the Mighty Lookout Tower as well as the Fire Truck and Jet. In the last few quarters, we discussed various initiatives, which we have undertaken during the year aimed at driving long-term efficiency. Briefly, the integration of Gund, Cardinal, LA Games and Swimways into 1 office in New York, will drive increased innovation, better communication and significant cost savings as we move into 2020. Our diversification program out of China accelerated this year due to the U.S.-China tariff dispute.Although, new factories in Vietnam, India and Mexico will drive cost savings in the near future, we have incurred additional costs this year as we expedited the changes. We expect to below 50% source from China by the end of 2020, down from 70% from over 70% 2 years ago and over 90% when we went public in 2015.From a business segment perspective, the Activities, Games & Puzzles and Plush segment is a strong platform for Spin Master. Twisty Petz, Candylocks and our innovative Cool Maker, Go Glam nail painter have generated a lot of excitement so far. We launched Games & Puzzles aligned with the release of Frozen 2, Toy Story 4 and The Lion King.In the Remote Control and Interactive Characters segment, we launched Juno, My Baby Elephant and Owleez and interactive flying pet.Retailers are excited about these products and initial orders have been very positive. Juno and Owleez are both a testament to our team's ability to continue to innovate in this high-tech space and merge technology with great play.We are very happy with the performance of our Monster Jam RC trucks. And in Hatchimals, where we have over 90% brand awareness with U.S. moms and closer to the same level with kids, we are continuing to innovate and stretch the brand. Hatchimals Pixies is a cross between a Colleggtible and a Dollhouse in an egg and has allowed us to break into the small doll category.The Boys Action and High-Tech Construction category was our strongest performing business segment. We continue to see momentum and solid contribution from the 3 major launches this year. How to Train Your Dragon, Monster Jam and Bakugan are performing well from a POS perspective.Regarding Bakugan, we started seeing growth happening in the U.S.A. in mid-September -- we started to seeing acceleration in the growth happening in the U.S.A. in mid-September around the Netflix launch. France, U.K., Germany are leading our strong international launch results. We have great placements in the Fall category line up and very strong positive brand feedback. The innovative product line for Monster Jam was introduced in January and continues to show very strong POS results globally, especially, Mexico and Australia, in addition to the U.S.Beginning Spring 2020, we will be the new toy licensee for the DC Entertainment Boys Action category, including Remote Control and robotic vehicles; water toys and Games & Puzzles. Our teams are already hard at work, developing the line for 2020 and initial customer reaction has been very positive.The Pre-School and Girl category -- and Girls category saw a strong performance, driven by fresh teams in PAW Patrol and innovative new product lines.In Q2, we began shipping the new Mighty Pups line and volume grew globally in Q3.This Fall, we introduced the Ready Race Rescue TV-special and new toy items that brings the theme to life.Overall, we've seen significant growth and views of our content. The Mighty Pups trailer was our top-performing PAW Patrol content ever with 34 million views.We are excited about the launch of our lower-price point die-cast line, which was successfully launched in the beginning of Q3. We remain confident in PAW Patrol's prospect for 2019 and beyond, based on upcoming content, new themes and innovative products.To conclude, we are confident in our projected performance for the fourth quarter. We have built a strong diversified portfolio of products and brands and entertainment franchises that are resonating well with consumers. Our team remains focused, and we are proud of the effort and results our employee have delivered around the world.We also remain focused on driving growth and value through our 4 key growth strategies that you are familiar with.Ronnen, Mark and I are pleased to take the questions. Operator, please open the lines.

[Operator]

[Operator Instructions] Our first question this morning comes from the line Sabahat Khan from RBC Capital Markets.

[Sabahat Khan, Analyst]

Just starting with the top line, I just want to clarify the comment you made earlier around -- that you've already made up the Q3 drag year-to-date, so you're sort of flat year-over-year. Is that the right way to read it? And then also second part, can you, maybe, talk about, at this point of the year, the kind of visibility you have to your orders for the remainder of Q4? And I guess, what part of those orders are still variable? Or is it the replenishment that you don't have a lot of visibility? Just trying to understand you know over the next 7 weeks, what kind of visibility you have from this point onwards?

[Mark L. Segal, CFO & Executive VP]

Saba, I'll take the first part of the question, and then I'll pass it over to Ben for the second part. Yes, what I said in the script was that as of the end of the October, we have actually shipped during the month of October a significant increase over our previous October and have shippable orders in October that will actually land up shipping in November. But if you actually take those shipments, plus the shippable orders for October, we've essentially caught up the $100 million decline that you saw in our cumulative top line at the end of Q3 year-to-date. Is that clear?

[Sabahat Khan, Analyst]

Yes. That helps.

[Mark L. Segal, CFO & Executive VP]

Okay, great.

[Benoit J. Gadbois, Former Global President, COO & Director]

Okay. And then, Saba, for the second half of your question on our confidence, I'll build into what Mark has said is, with the way we manage our forecast, we look at it monthly in terms of FOB or orders and domestic orders. We do global rollout at the country level, so where we review all the plans with every one of our countries. And then we're able to see as we track the orders on the books this year versus last year. And what -- and as Mark said is, when we exited Q3, we were down approximately 8% to last year or $100 million. And in October, we recovered these $100 million of shipment and orders. And now when you look at November and December, we can say with confidence, without going into too much detail, that the orders are ahead of where they were last year at this time in order for us to achieve our Q4 target. And we -- and our portfolio has been doing well in Q3 and our inventories at retail, as we mentioned, at the end of Q3 in the U.S. alone was down 7%, our retail inventory. So we continue to see very healthy order pattern as we speak now.

[Sabahat Khan, Analyst]

And then just on the margin side, I guess, the guidance revision took slightly lower margins. The commentary and the press release was around this being attributed to higher shipping and storage costs. Just wanted to understand if you could provide some color on, maybe, the magnitude of the expenses that you realized that were unexpected? And then your visibility, I guess, for the rest of Q4, is there flex in your expenses to ensure that you come within this new kind of guidance range. Just trying to understand your visibility to the, I guess, for some margin side for the rest of the year as well?

[Mark L. Segal, CFO & Executive VP]

Yes. So the reason for the margin revision, Saba, was primarily due to 2 factors. One is, supply chain costs, and that's really warehousing increased storage costs from high inventory average levels. We've also put on more shifts, so we've increased capacity at our warehouses to make sure we can ship the higher amounts that are going to flow through in Q4.There's also a transportation impact around increased volume and expediting some of our freight. There's also some impact from Asia, where we've got diversified procurement activities going on now, which we accelerated because of tariffs. And then finally, the tariff impact, which we estimate in Q4, is around $3 million, is part of that guidance revision.As to our visibility, we feel comfortable that margin revision guidance is reasonable. You know there's a fixed cost, obviously, that we understand very well, but we think that the pressure on cost that we've described to you in supply chain and tariffs are going to be the primary drivers of the margin for Q4 and for the full year.

[Sabahat Khan, Analyst]

And then as you, I guess, look forward into 2020 and you think about that dynamic now with a bit more direct shipment versus prior years, do you feel that -- I guess, you indicated you get a higher price from your customers because they're not picking up the product in Asia. Is that -- basically, is that enough to offset the additional cost. I guess, how do you think about the -- or managing those incremental supply chain costs go forward, if more retailers are taking domestic shipping?

[Mark L. Segal, CFO & Executive VP]

Well look, we'll get into 2020 in more detail later in March. But Saba, we'll, obviously, build that into our thinking. In general, domestic is higher pricing. There are higher costs associates with that through the inventory carrying costs, and we carry receivables longer as well. But overall, there's a net incremental margin benefit to that, but there is a negative effect on our cash flow.So all of that, kind of, has to get offset. But overall, we feel that we're okay in terms of our guidance for 2020. Nothing is going to fundamentally change, and we'll get back to you in March when we normally do around our guidance for 2020.

[Sabahat Khan, Analyst]

And just one last one on DC Comics, just a 2-parter. I guess, is it fair to assume that even in non-movie years you're able to make products for a character that may not have a movie out? And then the second part, being, I guess, is there a difference in the royalty you pay? So for example, say, there's a Batman movie, is there a different royalty when you make products related to specific movies versus just generally putting out DC Comics products in the market? Just trying to understand the dynamics in movie years versus non-movie years?

[Ronnen Harary, Co]

Yes. Saba, I'll take that question. The royalty remains the same during the course of movie years and non-movie years. It's just a flat royalty rate. And obviously, during the movie years, you're going to see a spike in sales, but DC and Warner Brothers works very hard to generate a year-round business with other promotional activities and other marketing to keep their characters top in line with the kids. And so we're able to benefit from that. So there's a base business and there's definitely a spike in the business during the movie years.

[Operator]

Your next question comes from the line of Steph Wissink with Jefferies.

[Stephanie Marie Schiller Wissink, Equity Analyst and Managing Director]

I'm wondering if we can compartmentalize Hatchimals into the 2 core pieces of the business. You've got the iconic and viral larger scale form factor piece, and then this underlying piece, that is the Colleggtibles or the Hatchimals piece. If we can look at those 2 pieces separately, I'm just trying to understand Q3 versus Q4. It looks like the comparison in Q4 to that iconic view becomes much easier. But how should we think about the longer-term value of the underlying or foundational business as you move through Q4 and into 2020?

[Benoit J. Gadbois, Former Global President, COO & Director]

Steph, I'll take this one. So just reiterating what Mark just pointed out in our script is, our largest shipments, last year, for Hatchimals were in Q3, and mainly, FOB. And as we just pointed out, our sales were down 69% for the brand in Q3, which was by far the largest Hatchimals quarter last year.So when you look at Q4, we already started -- the brand already started to decline in Q4 last year. So the year-over-year comp quarter-over-quarter will be significantly lesser in Q4.And as far as the qualitative between the, call it, the big egg and little egg. The big egg has seen the larger part of the decline, and Colleggtibles, the small egg, continues to be a good business, but also declining. But furthermore, this year, we launched our new Pixie lines, which is performing well and according to plan, and we're very pleased with it. We're also launching a higher-price point item in Q4, the hedge that you mostly likely have seen it already. And this year, we're launching the week of [ wall ] marketing campaign. But our expectation overall for the brand are more modest than prior year in order to reflect the brand maturity. But we do believe and we do -- in terms of how we innovate our portfolio, there's plenty of new innovation that will come out with the Hatchimals brand, and we remain very confident in the brand. It will just be more at a smaller level than what then -- call it, the toy-phenom level that we've been lucky enough to experience in the last few years.And last but not least, I think it's important to talk about the fact that even outside of Hatchimals, our POS was up 17%, which is truly a testament to our 36-month brand innovation pipeline.So we're continuing to keep Hatchimals fresh, but we're also having others segments of the portfolio where we're relaunching a lot of new innovation that is resonating very well.Does that answer your question, Stephanie?

[Stephanie Marie Schiller Wissink, Equity Analyst and Managing Director]

It does. That's very helpful. My second question was juts on inventory. And Mark, maybe this is one for you. As just looking at the inventory at the end of Q3 versus where your current inventory would stand, kind of, inter-quarter, if we assume that you're able to recapture that order carry over into Q4, are you also managing your own inventory more tightly at the current point versus, maybe, where you were at the end of the quarter? How should we think about your own inventory management throughout the course of Q4?

[Mark L. Segal, CFO & Executive VP]

Yes. So Steph, when we talk about domestic inventory, and we talk about the shift to dom, that effectively is our inventory on our books. So as you saw the end of Q3, inventory was up $67 million, and that reflected all the factors that we discussed already on the call, which I'm not going to repeat. And then we will be managing that at the -- with a high degree of vigor throughout Q4, the goal is at the end of the fourth quarter to be down at the same levels that we would've been at if you compare us to historical levels. So if all goes according to plan, and we ship through what we need to ship through in Q4, you'll see our inventory on our books, which is domestic inventory effectively, getting back down to normal levels in relation to prior years.

[Operator]

Your next question comes from the line Derek Dley of Canaccord Genuity.

[Derek Dley, MD & Consumer Products Analyst]

Just in terms of the shift into Q4, which would be the $40 million in sales that were pushed into Q4. But -- outside of that, should we continue to expect this sort of shift from Q3 into Q4 going forward? Like is this something you would expect to happen in 2020 again?

[Mark L. Segal, CFO & Executive VP]

Yes. I think, Derrek, we are seeing the shifts that we described previously reoccurring in future years. Obviously, there is some degree of variability around this. It's not a precise formula. And to some extent, there are product lines that tend more towards dom versus FOB. This year, we had a strong predomination of domestic lines that actually boosted that percentage.But going forward, they are secular and industry shifts that we see happening, and that, both Ben and I described earlier, that I think are going to continue and will actually make Q4 a larger proportion of our year than it has in the past. Ben, do you want to add something on that?

[Benoit J. Gadbois, Former Global President, COO & Director]

Yes. The only thing to add is that the benefit of domestic orders is that when you look at our portfolio, which is this year, for example, more geared to our Colleggtible and mix management and assortments.If you ship it from Asia, you pretty much have a canned assortment.And when the product sells differently on the shelf, you end up with a lot of the stock out, and sometimes, more inventory into different characters than others, and it creates some retail issues, which ultimately, effects POS.So for us, managing our products line more in the domestic basis, like Mark said, it moves the sales to Q4, but ultimately, it allows us to manage the mix at the retail shelf in the way that we can always replenish the shelf with what is exactly needed at the time within the few days. So -- and we believe that ultimately this will drive POS and it's much better for brand and franchise management and life cycle of our innovation.

[Derek Dley, MD & Consumer Products Analyst]

Okay. And then as it relates to the -- what you call it the congestion in your supply chain relating to the rollout of the new DC, are you predominately through those growing pains as of November?

[Benoit J. Gadbois, Former Global President, COO & Director]

Yes. So what I can say is because as we described we consolidated 4 DCs into 1 this year, and then with the -- and we had plans for an order pattern that was probably more spread out during the quarter. So we've noticed in Q3 that the orders came in later than planned. And then as Mark described, we made the decision to bring in more inventory to mitigate potential tariff issue. So what happened is, all at the same time, we experienced a significant bottleneck in that new DC. And it's a new DC, and while we're still ramping up, we just couldn't handle the ramp-up at the end of September. So it was a bit of perfect storm and we're quite disappointed with ourselves into the performance at the of September. But what we did is we turned around in October, and we had our highest domestic shipment in the history of the company. We're getting ready to beat that again in November. We've added resources and capacity into this warehouse, and we feel confident that we will be able to deliver and it was a very hard learning-lesson for us.

[Operator]

Your next question comes from the line of it Brian Morrison with TD Securities.

[Brian Morrison, Research Analyst]

I think you conveyed the gross product sales shortfall and the inventory increases is essentially timing related. But is there any notable product line that was just proportionally impacted relative to your expectations?

[Benoit J. Gadbois, Former Global President, COO & Director]

Brian. No, there wasn't. It was really more blanket. It was truly -- a lot of it was truly caused by the just the DC not being able to ship products on time, which was, as you know, if anyone of our customer order, they place orders across multiple product categories in our brand. So it was pretty much across the board.

[Brian Morrison, Research Analyst]

Okay. And maybe, just change gears here. Ronnen, you've talked about the opportunity with Toca Boca and Sago Mini. Just from a higher level with the adoption of 5G, I'm wondering what you've done in terms of preparation for its adoption? And maybe, just qualify and quantify the opportunity on your digital front as streaming becomes much more popular?

[Ronnen Harary, Co]

Yes. Thanks, Brian. I didn't think that I'd get any questions today. But you know 5G really opens up a lot of possibilities for us. I think the role out of 5G is going to take a while. It's going to -- it's 36 months to 56 months away. But the greatest thing about Toca Boca and Sago Mini is that the acquisition has given us 2 incredible mobile gaming studios of which to build out games for kids. 1 in Toronto and 1 in Sweden. And both of those studios are located in probably 2 of the best talent hubs for digital gaming on the planet.And we've been very focused on bit of a diverse strategy for, both Toca Boca and Sago Mini. And -- so Toco Boca is focused on games for kids, 5 to 9. And the 5G, what that enables us to do is you'll be seeing in the future, multiplayer games that were developing, similar to Fortnite or Roblox or Minecraft, that give kids the ability to play together, and to not only play together, but to share what they're playing and to share that with a wider audience. So that creates a lot of opportunities for us. And so on the Sago Mini side of things, it's bit of a different approach. And I talked about in my comments, which was around subscription. And so we're seeing a big shift. We were looking at some data the other day, and 22% of U.S. households, all have subscription-based products in their homes and a lot of that's focused in and around kids. So we're going down the road, where we're building out subscription-based products that have monthly reoccurring revenues, life time values of the customers. It's quite different to what our regular business is. And it's still at the early stages, but we are very excited to share more with you guys in 2020 around that rollout and operating that we have around subscription.

[Brian Morrison, Research Analyst]

Hello?

[Ronnen Harary, Co]

Yes, go ahead, Brian, did you have a follow-up?

[Brian Morrison, Research Analyst]

Sorry, it's just a little bit of cutting out there. Yes. No, I appreciate that. That last question I had is with respect to Bakugan and how it's trending. You mentioned with respect to its introduction on Netflix. Maybe you can just share any data on how you've seen the benefits once it was placed upon this channel?

[Benoit J. Gadbois, Former Global President, COO & Director]

Yes, Okay. So I can take this one, Brian. So I'm going to say that overall, with Bakugan, we're continuing to see nice growth and momentum building into the franchise on a global scale. The recent launch in France, U.K., Germany, Australia and Belgium, just to name a few, have been very strong. And in some of these countries, the franchise is already in the Top 5 Boys property, and it continues to build very nicely in all of the other markets. In the U.S.A., as you referenced, the serial launch on Netflix in mid-September, and it really accelerated the growth rate in the franchise, and we've seen very positive results from the additional exposure.Overall, we remain very positive for the Bakugan franchise to keep building globally in Q4 and also in 2020, based on our current market reads and the continued momentum that we're experiencing on everywhere globally.

[Operator]

Your next question comes from the line of Linda Bolton-Weiser with D.A. Davidson.

[Linda Ann Bolton-Weiser]

So not to beat the whole FOB issue to death but just I was wondering if you could shed some light on exactly why Mattel didn't experience the same issue? Is it just simply what you said is that they have much less reliance on FOB already than you? And then secondly, I think, in Hasbro's comments, they actually said they expected this issue to shift some revenue from the fourth quarter to the first quarters as well. So is that something that you're thinking as well because it doesn't sound like that's the case? And then finally, I just was curious, if you could give a break down, very roughly, of the distribution channels that you think picked up the Toys"R"Us void. So do you think it's like 80% of Big 3? Or 50% of Big 3? And then grocery and food, something -- food, drug and mass, can you give some kind of rendition of where you think the distribution went?

[Mark L. Segal, CFO & Executive VP]

Linda, I'm going to try to answer them all. So when you look at our changes from FOB to domestic and you compare us to some of our key competitors, if you actually studied the Q3, Q4 that they've had historically, they have already been much more skewed towards Q4, where we were once a company that had the highest probably FOB percentage in Q3. So what you are actually seeing now is you're seeing our company evolve as we mature and how we manage our brands and franchise towards more of that model as well. Okay. So I think this is -- so I think that's what you're seeing. As far as order from Q4 to Q1, I can say that we are not seeing any order cancellation so far. And what we're actually seeing is, we've obviously seen some shift from Q3 to Q4 as we described, but we're not seeing any order cancellation that would be material. And then from a distribution channel, I think, which was your last question was, who's kind of gaining and picking up. There's something that I haven't heard anyone talk about yet in this earnings season is that last year, what actually happened in Q3 is, although, Toys"R"Us was gone, there was a significant race on the retailer standpoint to, either enter or gain market share in the toy industry and that also created a bit of an inflation in Q3 for the industry, and we're not seeing that this year, which also is a factor that, I think, impacts the industry in the U.S. this year. So as far as who is gaining is, we -- so far we do continue to see the Big 3, the Walmart, Target and Amazon, continuing to grow and continuing to pick share up.

[Operator]

Our last question comes from the line of Adam Shine with National Bank Financial.

[Adam Shine, MD, Head of Montreal Research & Research Analyst]

Maybe one for you, Ben, and the next one for Mark. Ben, you touched earlier on lessons learned. I think this year, some of the supply chain dynamic, and then last year, just in terms of how much of a void was not ultimately filled in the absence of Toys"R"Us.As we look into 2020, are there more lessons to be learned? Or is there a, big sigh, relief that, frankly, that you've gone to school, it's a new paradigm and you've adjusted to the reality, and there's no greater shocks to the system next year.

[Benoit J. Gadbois, Former Global President, COO & Director]

Yes, Adam. So I'm going to start by saying that overall, I think, what we've accomplished this years, we've undertook significant amount of restructuring in our business this year, where we've consolidated and closed down our Gund offices, we've consolidated and closed our Swimway office, we have consolidating -- consolidated our Games business into -- and we opened up our new Long Island City office. We opened an office and a DC in Russia, we opened a DC in Hungary and we have significantly accelerated our Asia diversification plan to be below 50% to protect the company going forward based on these tariff threats.So I think we undertook a lot this year, including the consolidation, last but not least, of these 4 DCs into 1, and we did not anticipate this, I guess, call it, the perfect storm to hit the DC in a matter of a few weeks. So we don't expect that to repeat next year.We don't have any -- we're not opening any new DCs next year, and we're not -- we don't plan on any further consolidation of offices. And I also believe that we've made tremendous amount of progress this year in our supply chain diversification in Asia and so we opened a lot of different vendors in Vietnam and India and Mexico.So I think the team did a pretty good job, and we have a stumble for a few weeks in the DC. And just as a fun fact, Adam, is, our throughput in the DC now, as we speak, is approximately 250% what it is on a daily basis than what was in September.So we definitely reacted to the issue and are dealing with it.

[Adam Shine, MD, Head of Montreal Research & Research Analyst]

Okay. Then just one for Mark in regards to maybe more cleanup and visibility around guidance.With respect to sales allowance, the conversations previously have really been around maybe upper end of a 10% to 12% historical range. Do we still stick to that? Or is there any concern of further slippage to the upside?

[Mark L. Segal, CFO & Executive VP]

So you're correct, Adam. 10% to 12% has always been the range that we've talked about. I would say, for the purpose of modeling and think about going forward, I would say towards the high end of that range. And then particularly -- and actually geographic mix issue because in Europe, as our business grows, Europe is a higher-price, higher-allowances structure. And purely mathematically, that's going to push our average allowance rates up. But there isn't any fundamental change to the way that we actually handle sales allowances in the business. But certainly, as our European business grows at a higher-allowance structure, higher-price structure, that allowance rate will tend towards the higher end of that range.

[Adam Shine, MD, Head of Montreal Research & Research Analyst]

Okay. And that's something that we should also think about, just by virtue of that European dynamic continuing, obviously, post-2019 as well?

[Mark L. Segal, CFO & Executive VP]

Yes, correct.

[Benoit J. Gadbois, Former Global President, COO & Director]

Thanks, Adam.

[Mark L. Segal, CFO & Executive VP]

Thanks, everyone. Much appreciated. We appreciate your time, and we look forward to talking to you, again, in March with our Q4 and full year results.

[Benoit J. Gadbois, Former Global President, COO & Director]

And in New York.

[Mark L. Segal, CFO & Executive VP]

And in New York. That's right.

[Benoit J. Gadbois, Former Global President, COO & Director]

Thank you, everyone.

[Mark L. Segal, CFO & Executive VP]

Thank you. Bye.

[Operator]

This concludes today's conference call. You may now disconnect