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Good morning. My name is Jody, and I will be your conference operator today. At this time, I would like to welcome everyone to the Spin Master Q3 2018 Financial Results Conference Call. [Operator Instructions]Thank you. Mr. Mark Segal, you may begin your conference.
Thank you, Jody. Good morning, and welcome to Spin Master's financial results conference call for the third quarter ended September 30, 2018. My name is Mark Segal, and I'm the Chief Financial Officer of Spin Master. With me on the call is Ronnen Harary, Co-CEO; and Ben Gadbois, President and Chief Operating Officer.For your convenience, the press release, MD&A and audited consolidated financial statements for the third quarter are available on the Investor Relations section of our website at www.spinmaster.com and on SEDAR.Before we start, 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 the 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 assurance 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 to place undue reliance on these forward-looking statements.Except as may be required by law, Spin Master has no obligation to update or revise any forward-looking statement, 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 6, 2018. Please note that Spin Master reports in U.S. dollars, and all dollar amounts to be expressed today are in U.S. currency.I would now like to turn the conference over to Ronnen Harary.
Thank you, Mark. And good morning, and thanks for your interest in Spin Master. Yesterday, we reported our financial results for the third quarter ended September 30, 2018. I'll begin the call with some brief highlights for the quarter as well as the year ahead before Mark provides you with a more detailed review of our financial results, including our outlook for the balance of the year. Ben will then discuss our operational results.As we said last quarter, we're confident we'll manage the Toys "R" Us disruption in 2018 and believe the industry will level-set itself in 2019. We are channel agnostic, and we will evolve as required to continue to grow and support the changing retail environment. We've always been regarded as highly innovative. A great recent example of our ability to innovate is Hatchimals, whereby we produced the most innovative, sought-after and talked about toy that the industry has seen in many years.Hatchimals is a testament to our culture of innovation and collaboration. It brought together all our internal global design and engineering capabilities as well as our link to the external inventor community. We then extended the line, developed entertainment content and a global licensing and merchandising program. Going forward, we want to go much deeper and build many more franchising -- franchises using the model of Hatchimals as a framework. Our increased internal investments will help us develop the next great franchise for Spin Master.The entertainment group at Spin Master remains the cornerstone of our strategy and enhances our ability to drive consistent revenue and earnings growth through the creation of our own content. Successful entertainment content leads to greater market share for our products, allows us to participate in profitable, incremental revenue streams, driven by licensing, merchandising and broadcast revenues.We see entertainment and physical toys as converging contents, which is a strategic way of thinking that we feel will drive long-term growth for Spin Master. We're increasing our focus on our properties as franchises and think about them both in global terms and by leveraging the property across as many platforms as possible.We're also beginning to access how we leverage our franchise, both existing and potential, in Asia. We will focus initially on China and Japan. And we expect to develop partnerships in these areas, which will allow us to localize quickly with limited setup cost. We are super, super excited about our new entertainment content currently in production and slated for release in 2019.In just a few months, we'll be relaunching Bakugan. We announced our global partnership, and this includes some of the partners we worked successfully with for the initial launch of Bakugan. In addition for the relaunch, Takaratomy will launch Bakugan toys in Japan and the rest of Asia. This is a really good example of the deeper Asian franchise strategy that we spoke about earlier.Cartoon Network will begin airing the show in the U.S. in late December. Toys will be launched soon afterwards in the U.S. and Canada in Q1 '19, and will roll out globally in Q2 '19 onwards. We believe the global relaunch of Bakugan with the highly innovative, reimagined toy that has evolved, but remains true to its roots, represents an exciting opportunity for future growth.In addition to the toy and traditional TV show, we'll be producing complementary short-form content for YouTube and other digital audiences, which will air at the same time as the TV show. In addition, we're developing a global license merchandising program, which will drive other revenue. After nearly 3 years of developments, our new preschool show, Abby Hatcher, will be airing on Nickelodeon in the U.S. and TVO in Canada in early 2019 and global distribution will follow during 2019.This adventure-based comedy series follows our heroine, 7-year-old Abby Hatcher, as she rescues her favorite creatures, Fuzzlies, from whatever trouble they have accidentally landed themselves in. We'll launch the toys in 2020 to allow the property to become established with its audience and to build anticipation for the toy.Licensing, which represents 26% of the toy industry, complements our core business well. At this point, we're under-indexed in the industry in terms of our share of revenue derived from third-party licenses. Even though we're highly focused on producing our own content, as you know, we're always looking for high-quality, new, third-party owned IP. We remain very selective about the licenses or alliance partnerships we choose.Having said this, it is a strategic area for the toy industry, and we want to grow our share through long-term, strategic license partnerships, especially for A-type properties. There are several factors that play into our ability to compete for and win major licenses. Our increased international footprint, we now have over 20 sales and marketing offices around the world, and our strong innovation and marketing expertise are critical elements in our attractiveness to third-party IP holders.Equally important, as I described earlier, is our ability to connect entertainment and toys. The success we've had with our integrated approach to developing franchises through entertainment and product design has been noticed by major entertainment IP holders and makes us an attractive option for licensors. We view licensing as an alliance and collaborative partnership. A great example of a collaborative license partnership is our relationship with Feld Entertainment for the Monster Jam toy license.For over 25 years, Monster Jam has been combining spontaneous entertainment with the ultimate off-road motorsports competition. This is a global tenure partnership, primarily focused on the diecast and radio control segments. The line will be released in January 2019. In addition, we're the global master toy license for DreamWorks, How to Train Your Dragon franchise. And we're excited about the third release in 2019 of this very successful global franchise and have introduced exciting innovative -- innovation into the toy line, which will be released early in the first half of the year.Finally, the acquisition we've completed also makes us a more attractive candidate to global licensors. For example, through the acquisition of Gund, we've gained a unique position with respect to winning licenses. Some licenses are plush specific, and we now have this expertise in-house. Others are channel-specific, and Gund has a broad specialty network. Also, the low-cost tooling for plush allows us to incubate licenses such as Pusheen through Gund's consumer base, so we can assess take-up in the market and to see if these licenses can eventually translates to mass.Before I end, I want to call out the performance of our Games & Puzzles area. We're now the largest puzzle manufacturer in North America, and this business is highly scalable globally. The Games & Puzzle business is multidimensional, includes both basic and promotional items at multiple price points for both adults and kids. This represents both a significant domestic and international future growth opportunity for us.Thanks, again, for your interest in Spin Master. I'll now hand over to Mark Segal, our Chief Financial Officer, to review our financial results in more detail. Mark?
Thanks, Ronnen. We are pleased with our financial performance in what was a challenging quarter for the industry. To show both revenue and adjusted EBITDA growth in Q3 over 2017, which up to this point in time was our record quarter, is very encouraging.Our third quarter revenue increased by 2.3% to $620 million from $606 million in 2017. Foreign exchange decreased overall revenue by $3.9 million. In constant currency terms, revenue increased by 2.9%. Excluding Gund, revenue was flat. Gross product sales decreased by 0.4% for the quarter. In constant currency terms, gross product sales increased by 0.1%. Gund gross product sales in the quarter were approximately $19 million. Excluding Gund, gross product sales unadjusted for foreign exchange declined 3.2% for the quarter. As I mentioned a few months ago, the TRU liquidation in the U.S. was completed in Q2 with the majority of inventory sold through by the end of June. The liquidation did have an impact on our Q3 orders and shipments, especially in July, as most retailers adjusted their traditional second half purchase patterns. For context, in Q3 2017, we shipped just under $69 million to Toys "R" Us in the U.S. and $92 million to Toys "R" Us globally compared to just $13 million in Q3 this year, all of which was outside the U.S.We also estimate approximately $10 million to $15 million of orders shifted from Q3 to Q4 as retailers first delayed setting the shelves until August and to validate where 2018 holiday shopping would occur in the absence of TRU. We have also observed retailers looking to use supply chain velocity as a tool to recapture TRU volume rather than fully expanding shelf space. This includes ordering more on a domestic basis compared to FOB Asia in 5 years. Ben will discuss this in more detail shortly.On a geographic basis, while our global platform drove gross product sales growth of 17.4% in the rest of the world, North America and Europe showed a 1.5% and 5.8% decline in shipments, respectively. The U.K. and France are Europe's 2 largest toy markets. Similar to the U.S., the TRU liquidation in the U.K. and the uncertainty surrounding TRU undershipment trends, created a climate of caution in those markets, which expanded into Q3.This cautionary climate resulted in an overall reduction in orders and shipments in the third quarter. Despite this, certain markets in Europe such as Germany and those in Central Eastern Europe continue to show very strong performance. We expect to see a return to normal purchasing behavior in Europe in 2019 as the cautionary climate dissipates and these markets stabilize. Overall, international gross product sales as a percentage of total gross product sales continued to grow.International gross product sales comprised 33.3% in the third quarter, increasing from 32.5% last year and continuing the steady progress we have made over the last few years. Regarding the bankruptcy of Sears and Kmart, we manage credit very tightly and do not have any material credit exposure. Kmart represented approximately 0.8% of our sales in 2017.Sales allowances as a percentage of gross product sales were 9.7% for the quarter. This is slightly below our annual sales allowance range of 10% to 12%. The decrease is attributable to the timing of promotional and markdown spending and our continued tight focus on the management of allowances in general. Other revenue, which primarily reflects merchandising royalty and television distribution income from products marketed by third parties using our intellectual property as well as app revenue from Toca Boca and Sago Mini, continues to grow and increased by over 46% for the quarter.Our gross margin for the quarter declined by 1%. This margin erosion was mainly attributable to product mix, the amortization of the fair market value increment of $3.7 million on the Gund inventory acquired at the time of purchase and the amortization associated with the delivery of more entertainment episodes compared to last year without their full revenue being reflected yet. The decrease was partially offset by higher other revenue and lower sales allowances. If the Gund inventory fair market value amortization is excluded, gross margin declined only 40 basis points for the quarter.Marketing spending was 5.4% of revenue for the quarter, up from 4.3%. Marketing initiatives for the quarter include traditional and digital media, trade shows and content and merchandising initiatives. From a seasonality perspective, as a reminder, most of our marketing spend has actually occurred in Q4 to drive awareness closer to the consumer purchasing decision.Product development expenses were slightly higher than last year because of the timing of our development programs within our 36-month brand innovation pipeline. Distribution expenses was slightly higher than last year to support the integration of Gund into our supply chain. Selling expenses decreased as a percentage of revenue compared to last year. Third-party licensed products continue to make up a lower proportion of our sales mix accounting for the decrease.Admin expenses, as a percentage of revenue, decreased in Q3 by 1.5% over last year. This decrease is primarily attributable to lower incentive compensation costs, partially offset by higher people costs from our acquisition of Gund and resources to support our international expansion, which has a higher ROI. Total SG&A as a percentage of revenue, excluding share-based comp, decreased 1.1% to 25.7%, driven by lower selling and admin expenses, partially offset by higher marketing, distribution and product development expenses.Net income for the quarter decreased by just under $1 million or 0.9% year-over-year. Adjusted net income, which excludes foreign exchange, share-based compensation and other nonrecurring items, increased by $6 million for the quarter to $117.7 million. Adjusted EBITDA for the quarter increased 5.6% to $179.8 million compared to $170.3 million last year. We are very pleased to show adjusted EBITDA growth for the quarter, despite the many headwinds we faced. Our adjusted EBITDA margin increased by 0.9%, mostly due to the decrease in SG&A.Net working capital as a percentage of LTM revenue increased by 40 basis points to 12.4%. This was primarily due to an increase in other receivables, which is driven by our entertainment tax credit receivables. Unlike traditional trade receivables, these tax credit receivables are collectible on a 12- to 18-month cycle and reflect the year-over-year increase in our entertainment production.Our core working capital, comprising trade receivables, trade payables and inventory, was 3.7% lower as a percentage of LTM revenue, primarily due to improved DSO metrics. In addition, despite the shift in sales to more domestic in Q3 and expected in Q4, we saw a decline in days inventory on hand of 2.5 days. We continue to focus on our information systems and global supply chain infrastructure to drive the lowest possible inventory levels, whilst ensuring we meet our customers' needs.Overall, our cash conversion cycle decreased by 7.5 days in the quarter to 44.5 days. Free cash flow increased by 3.2% compared to last year. The increase in free cash flow is attributable to lower cash flows used in investing activities, partially offset by lower cash flow from operating activities. Our balance sheet remains very strong, and we ended Q3 in a net cash position.Repeatedly, on a year-to-date basis, revenue is up by 9.6% and gross product sales are 5.9% higher than '17. Excluding Gund, revenue is up 7.3%, and gross product sales are up by 3.5%. Europe is up 2.1% year-to-date with very strong sales contributions from some of our key European territories such as Germany and CEE. The Rest of the World is up 26% year-to-date based on strength in Mexico, China and Australia.On a year-to-date basis, our international sales represented 33.6% of total sales compared to 32.1% last year. Adjusted EBITDA increased by 9.7% on a year-to-date basis, nearly 4 percentage points higher than our gross product sales growth of 5.9%. And we also increased our adjusted EBITDA margin by 10 basis points to 22.1%. In terms of significant events in the quarter, on July 10, 2018, we amended our $510 million credit facility to take advantage of the improved pricing environment and to accommodate our growth plans. The maturity date has been extended by 18 months to July 2023.In addition, we changed the settlement method of our incentive compensation in August to settle all future LTIP awards in shares rather than cash. As a result, there will no longer be a mark-to-market adjustment in the P&L for the LTIP. On August 15, the founders closed an offering of just under 2.8 million shares of the company. We did not receive any proceeds from the sale.I will conclude with our outlook for 2018. For the full year 2018, organic gross product sales are expected to be slightly lower than previous guidance. We now expect organic gross product sales growth relative to 2017 to be low single digits compared to mid-single digits previously communicated. Including Gund, we now expect gross product sales growth compared to 2017 to be mid-single digits compared to mid-to-high single digits previously communicated.The revision of our gross product sales growth guidance for 2018 is a result of Toys "R" Us' demise and the effect it has had on the purchasing patterns of our customers. We believe this will place significant pressure on industry supply chains during the latter part of the year. It is important to keep in mind that we've never seen such a large toy retailer disappear so quickly, especially one with sales that had a different seasonal cadence than other toy retailers.For this reason, we want to be cautious in our outlook for the full year 2018. We remain confident that overall, virtually all the lost TRU sales will be recaptured in 2019. Consistent with our prior outlook, we expect adjusted EBITDA margins in 2018 to be slightly higher than those we achieved in '17. We remain extremely focused on cost management and productivity initiatives. As a reminder, for Q4, consistent with prior years, when we talk about the timing of spending and profitability, a significant portion of our annual marketing expenses are incurred in Q4 each year to maximize the impact on consumer purchases and our ROI.This typically causes a misalignment of sales and marketing spending between Q4 and Q3, resulting in adjusted EBITDA margins in Q4 significantly below those in Q3. Looking ahead to 2019, we will provide gross product sales growth, expected seasonality and adjusted EBITDA margin guidance for 2019 when we report our fourth quarter and full year 2018 results in early March.This will allow us to incorporate customers' feedback into our outlook from the critical trade shows that started in LA this past September and continue in Hong Kong, New York and Nuremberg during January and February 2019. As a reminder, I want to repeat our overall guidance regarding sales growth. That over the long term, the growth rate for organic gross product sales is expected to converge towards our long-term growth target of mid-to-high single digits.I'd now like to turn it over to Ben Gadbois. Ben?
Thank you, Mark. We're pleased with our financial and operating results in the third quarter of 2018, which demonstrated the underlying resilience of our products and brands. There were several factors that influenced our performance this quarter, some of which will affect the balance of 2018. Let me walk you through these macro themes that dominated the quarter for Spin Master and the industry.From an industry perspective, the performance of the U.S. toy industry in Q3 2018, according to NPD, was down 7% overall and was heavily correlated to where Toys "R" Us had its strongest hold on the market. NPD data indicates that over 80% of industry purchases made at Toys "R" Us U.S. during the liquidation will be given away by the end of Q3.Research also suggests that the more time passes in relation to the U.S. Toys "R" Us store closings, the more the toy industry performance turns positive. We believe this is an indicator that Q4 performance for the industry should continue to trajectories of improving performance into 2019 and beyond.Building on Mark's comments earlier, I want to talk about what influenced our results in Q3 and what will drive results for Q4. If you recall, TRU liquidation of over 700 stores in the U.S. drove incremental sales through the first half of 2018. In early Q3, most key retailors announced plan for expanded shelf space or increased focus on toys to capture the TRU share.In recent weeks, we saw retailers activating their plans for the holiday period. However, we believe that the amount of retail space added in the U.S. and elsewhere was not nearly enough to fully capture the TRU share. We had expected this expansion to allow for between 80% and 90% of TRU's business to be recaptured. We now believe that number to be around 80% of TRU sales, will be reabsorbed during 2018.We continue to believe that 2019 will be the post-TRU new normal, where close to all TRU volume will be redistributed. In addition to the smaller shelf space expansion, many key toy retailers, driven by caution as to where consumer might shop, set their shelves later in Q3 to begin their holiday effort.Nontraditional toy retailer, who are fighting to capture some of the TRU volume such as department, discount, dollar, value, grocery and convenience stores, are drawing inventory late in October and November for a retail set in November and December. We are seeing retailers focus on their supply chain and inventory velocity as a method of capturing TRU share.Because of existing retail space constraints, which reduced FOB shipment in Q3, we are seeing further acceleration to higher frequency, more just-in-time deliveries, smaller shipment sizes and less retailer inventory. We expect customer supply chains to be under significant pressure to cope with additional replenishment volumes in a compressed time frame after U.S. Thanksgiving and Black Friday on November 22.This is exacerbated by a U.S. economy-wide shortage of trucking and freight capacity challenges, which will likely have an impact on delivery efficiencies in Q4. New retailers in the toy industry have not yet demonstrated their ability to execute a Christmas season, carrying a new or broader range of toys. For these reasons, we are adopting a cautious tone in our outlook for 2018.Looking forward, we see the need for distribution center to be closer to our customer. This drives new requirements for our U.S. supply chain. We shipped more product domestically in Q3 than we have historically, and this trend will continue in Q4 and 2019. We are continuing to invest in refining our supply chain efficiencies as the market evolves and have recently added an East Coast warehouse to better meet demand, shorten delivery time and reduce the trucking mileage to our retailer's distribution center.There has been much discussion about tariffs. Based on what has been announced so far, there is minimal risk for 2018 at this point for Spin Master. Toys were not named as part of the administration's most recent list of goods that are subject to a tariff. There is an insignificant impact on a very small part of our toy line related to some inputs we use in our kids furniture line and for retail merchandisers.Looking forward to 2019 and beyond, the likelihood of the imposition of tariffs is uncertain. Politically, it could be viewed as taxing kids. If however, tariffs are imposed, we will do our best to mitigate the impact through negotiation with our suppliers and value engineering. But any residual tariffs would likely mean higher cost to the consumer.From our perspective, we do not know, ultimately, what will happen, but keep in mind these 2 important points. The resilience of the toy industry over time. It has grown for a long time as parents tend to sacrifice themselves before their children. And the second, over 25% of our current toy production is in Vietnam, Mexico and India.We are executing plans to grow this to approximately 60% over the next 3 to 4 years. All the above implies that tightly managing distribution and inventory to minimize the year-end inventories overage and keep a clean channel will be critical to starting 2019 successfully. Our Q3 results reflect this as we are in a better position to refill customer inventories.Overall, global POS is up high single digit for year 3 to date and retail inventory is down 14%. We expect to end the year mid-single-digit down from inventory level at retail. We expect this to bode well for the fourth quarter replenishment as the retailers lean into what is selling through but subject, as I discussed above, to potential supply chain constraints.Overall, despite some short-term noise, we feel confident that Spin Master will weather this storm well, and we are starting to see some M&A opportunity arising out of this situation later in 2019 and beyond. I'd now like to briefly review our 4 key growth strategies and provide you with an update on some of our current initiative.Our first growth strategy to continue to innovate the core product portfolio relies on our ability to consistently infuse innovation into our brands and products. Our internal 36-months brand innovation process facilitate the identification of market opportunity that we capitalize on through product development or acquisition. We view this process as integral to sustainable profitability.In the activity and Games & Puzzles segment, gross product sales maintained their strong, positive momentum growth, growing at 29.9%. This was primarily due to the acquisition of Gund and to increased sales of games and puzzle, which include Cardinal, the Cool Maker branded product and Kinetic Sand, offsetting declines in Bunchems and Build-A-Bear.In the Remote Control and Interactive Characters segment, gross product sales in the segment declined 8.9%. Hatchimal Colleggtibles and Luvabella are driving growth. However, sales of the higher price point Hatchimal eggs have declined as have sales for Zoomer and Air Hogs. Looking at Hatchimals, in Q3, Colleggtibles saw a 17% POS increase. From a year-to-date POS perspective, the total Hatchimal brand saw a positive 23% POS lift. The strong POS growth rate suggests that kids are still actively engaged with Hatchimal. At the end of Q3, POS for the larger egg is down, which is in line with expectation as it was always going to be a tough comparable against the huge success we had in 2017.Looking forward, the growth of Colleggtibles strongly suggest that our consumer are interested in our characters, our stories and the world of Hatchtopia. This supports our strategic initiative of increasing the amount of content and stories we are creating and sharing. That new content will reach YouTube consumers globally this quarter, and we will be releasing content steadily in 2019.It also bodes well for all the new product and product line we have coming in 2019 that tie into the world we're creating and the content we're delivering. We are seeing more than ever a huge appetite for innovation in the toy space, and the 2019 interacting -- interactive offering will bring an entirely new level of innovation to the franchise.Gross product sales in the Boy Action and High-Tech Construction segment decreased 16.6% in the quarter. Initial selling of Boxer and sales of Fuggler contributed to growth, but this was more than offset by declines in Meccano and Pirates of the Caribbean license products. This shift was planned well in advance, and there's no inventory or margin impact.In the Pre-School and Girls segment, gross product sales in the segment were down 3.4%. New product launch of Twisty Petz and Party Popteenies drove growth, but this was more than offset by a decline in sales of ZhuZhu Pets, Chubby Puppies and PAW Patrol. Twisty Petz is doing very well, globally. We will build on this growth in 2019.I would now like to take a few minutes to review PAW Patrol with you. As we discussed in August, for the first half of 2019, global PAW Patrol POS was slightly up. However, global PAW POS in Q3 was down, and POS on a global year-to-date basis as a result was marginally down. Excluding the U.S., POS is up 5% year-to-date. In the U.S., including TRU, PAW Patrol POS is down for Q3, mainly driven by the impact of TRU in July.August and September showed a much improved POS performance. On a year-to-date, PAW POS is down slightly less than the decline in the overall toy industry in the U.S., again, for the third quarter. It is very important you understand what is happening behind these POS numbers. In the U.S. and the U.K., the liquidation of TRU during Q2 had a significant effect on PAW Patrol as it was one of TRU's largest inventory position.The liquidation pulled sales into the first half. This had an impact on shipment and sales in Q3, especially in July, as Walmart, Target and other retailers did not reset their stores to capture TRU shares until August. Crucially, POS for Q3 is up 16% for the period since August 1 and is moving in a strong direction with peak seasonality just hitting. In particular, the fresh team is working, and we are closing the POS gap.We have reached PAW Patrol's highest market share ever of over 14% in the preschool category for October, despite the market disruption caused by TRU. PAW Patrol remains the #1 property in preschool and the #8 property overall in the toy industry. Nickelodeon revised their programming strategy with more telecasts. And so far, the new Ultimate Rescue episodes are rating very high.In mid-October, we had the highest impression levels since August 2017 and the highest of any preschool property this year. Our new short-form content on YouTube is driving greater awareness. The Ultimate Rescue Fire Truck is leading with over 15% year-over-year POS growth compared to the Sea Patroller, even though it was launched 1 month later.The new My Size Lookout Tower did not sell at most retailer until late Q3, and we are already seeing strong performance early in Q4. Both Target-exclusive programs are significantly outpacing 2017, driven by strong product and marketing. In key market internationally, we're seeing similar performance.Looking forward, the team and product line for 2019 will be one of the strongest we have created. We are managing PAW Patrol with a 20-year vision. And whilst it is unlikely that PAW Patrol on an overall basis going forward will grow at the same rate it has historically, it is a valuable, evergreen franchise that we will continue to invest in and support with innovative toy and entertainment, including traditional TV, an annual 1-hour TV special every year and new short-form content for YouTube.Our second growth strategy is to significantly increase our international sales. We revised our medium-term goal following our 2017 result to the upper end of our previous target of 35% to 40% of our sales internationally. Our overall international gross product sales growth continued an upward trajectory for the third quarter 2018. Markets such as Germany, Mexico and U.K. have performed well, and our newer markets, such as Australia and Central and Eastern Europe, are continuing to show strong growth.In China, our brands and products are resonating with consumer and sales. While still small, China is exceeding our expectation. During the third quarter, we announced a strategic partnership with Internet giant, Alibaba. The strategic cooperation will be committed to creating a leading digital platform for retail, brand building and data-powered marketing, demonstrating a mutual confidence and recognition of Spin Master global potential in China.China is a key part of our international growth strategy, and Alibaba is a strong partner who shares our commitment to excellence. The strategic cooperation agreement with Alibaba represents a significant milestone in our effort to grow China in the years ahead. In addition, we are working hard to establish our newest direct market in Russia, Greece, Austria and Switzerland for launch in early 2019.Third, we continue to develop evergreen global entertainment properties. I want to highlight for you something that is working particularly well in our entertainment strategy. Our entertainment and brand themes work closely together, integrating the show and the toy line to deliver innovative toy ideas that translates on-screen, on-shelf and at home.PAW Patrol is a great example of the fusion of storytelling and toy design. We are introducing themes each season that are timed to the delivery of our fall product line. This ensures that during our largest selling quarter, the new products on the retailer shelf and the new episodes on air are closely linked in both themes and content. PAW Patrol continues to perform well, and it's rating are consistently at the top of Nielsen ranking.The rating for PAW kids 2 to 5 grew 3%, while total kid 2 to 5 declined 17%. In 2 days, on November 9, Nickelodeon will be airing the first PAW Patrol 1 hour TV special titled Mighty Pups. The Mighty Pups DVD, which was a Walmart exclusive, has been one of the top-selling DVDs in recent history. The DVD will be available more broadly in fall 2019. As I mentioned earlier, we plan on doing at least 1 new PAW Patrol 1 hour TV special every year.Fourth, we intend to grow through strategic acquisition. We have the balance sheet and financial flexibility to do so, and we are actively seeking opportunities with the right strategic fit. To position Gund for future growth, we are working on several integration initiatives, including aligning the business with internal Spin Master processes. We have already completed moving Gund onto SAP and have transitioned the reporting, warehousing, order management and inventory control process.Similar to the work we're doing on Gund, as we seek to continue to drive margin expansion through operating leverage, we are constantly looking at ways to modernize and optimize our global organization. In the near-term, some key initiatives we're looking at include refining our global business unit and center of excellence model, both structurally and geographically, to increase operating leverage and momentum with our innovation process and our brands and franchise.We plan on investing more in R&D, focusing on the R. We plan on enhancing our go-to-market strategy for online channel, also enhancing talent management and leadership development globally and also improving information system and data analysis capabilities to reduce non-value-added activities and improve management decision-making. We look forward to seeing you all in New York Toy Fair in February, and we are very excited to show you our 2019 line, which has some of the great innovative item -- which has some great new innovative item, including our 3 major franchise launches of Bakugan, Monster Jam and How to Train Your Dragon.I want to conclude with a comment about the future. We are confident in our ability to build on the strong and focused platform we have established over the last several years. Overall, we are incredibly proud of the effort and results that our employees have delivered by executing on our growth pillars, despite the short-term headwind created by TRU. We remain very focused on executing our 4 key growth strategies at every level of the business globally, and we'll be using our result-driven, high performance culture to continue to drive value.That concludes our formal remarks. Now Ronnen, Mark and I will be pleased to answer your questions. Operator, please begin the question period.
[Operator Instructions] Your first question comes from the line of Adam Shine of National Bank Financial.
I might as well start with guidance. I mean, thanks for the color there, Mark. It looks -- and not to put words into your mouth, but it looks obviously that, in recent weeks, the realization was that the pull-through or the pull back into Q2 and then perhaps some of the push into Q4 was certainly a bigger effect maybe than previously anticipated. And also, you're alluding to some of the logistical issues beyond just trucking. I don't know if there's any further pockets of surprises along the way. I mean, you did provide a bit more clarity on Hatchimals and PAW Patrol as to the Q3 dynamic. But anything else in terms of some of the shift? And also, I guess for some of us on the call, there's no doubt that we're all watching the uncertainty around Toys "R" Us quite naturally and some concerns that maybe Q4 would see a bit of a weakness. But I guess, the industry tends to perform within the context of a replenishment cycle the last 5 weeks of the year. And perhaps, I guess your optimism regarding that may have changed a little bit or perhaps you're just being a bit more conservative. Can we start there? And I'll follow up with one more.
Yes. So Adam, I think we've given a lot of color on the call this morning. I don't think there's a lot to add other than to just emphasize one point, which is, as you said, from Thanksgiving onwards to Christmas, there's always that replenishment cycle that every year, we don't know how it's going to go. And so there's always that uncertainty, which is why we wanted to adopt a more cautious tone, which I think myself and Ben described in a lot of detail in our prepared remarks. So I don't think there's much to add to that.
Okay. And then in terms of just the cadence as we look out to 2019. Obviously, we will get the guidance in mid-March, and the presumption would be that you do start lapping some pretty easy comps post Q1. Any particular implications for perhaps Q1 in terms of early 2019 as we exit some of the color you've just provided vis-Ã -vis Q4?
Well, yes, it's a little early to start talking about 2019 guidance. I would just point out that we will give guidance formally in March 7 this year -- in 2019, just to highlight the 3 major properties that we are launching earlier in the year, Bakugan in early January and then Monster Jam and then How to Train Your Dragon. Ben?
Yes, the only thing to add, Mark -- good morning, Adam -- I think you nailed down the market dynamic perfectly. And I think what's really different this year with the changes of Toys "R" Us is that all of our partners, retailers I think are doing a really good job with their plans on being ready for the holiday season. But what it also means for them is, when we look at the -- when we look at Toys "R" Us closing down nearly -- approximately 700 stores, there is not as much shelf space that was added in the rest of the market as we had previously anticipated, which means that all the retailers are now planning on executing on higher velocity at the shelf space and higher velocity at the replenishment level from their warehouse to their stores and also from our warehouses to their warehouses. And one of the challenge that we always experience in Q4, especially as we get closer to the holiday period, is we're having certain part of the country that are always challenged on -- with the freight industry where some part of the country, the trailer-to-truck ratio is 10:1. And now we're heading into the season with increased pressure on velocity and efficiencies of execution with all the retailers. So that creates us to be more cautious. We have a feeling that somewhere along the way, there might be some execution issue. And then the last point is, there is also a lot of new retailers that are stepping up and trying to take -- either entering the toy space or trying to increase their toy space like Best Buy, Party City, T.J. Maxx, Family Dollar and Kohl's. They are actually doing -- they actually have really nice plans, but they are also new to the dynamics of a toy industry or will be -- will have some learning curves this year. So because of all of these factors, we want to be more cautious than we normally would be.
Okay. Maybe just as a byproduct of that answer, in the context of a lack of shelf space to mitigate the absence of Toys "R" Us, it begs the question, okay, so how much potential shifts that incrementally online? So arguably I guess, you're not just -- you're not necessarily assuming that the gap gets covered immediately by a jump in online sales?
No, I think that's correct, Adam. I mean, the last year, if you look at the industry as a whole in North America, the e-commerce side of the industry was 23%. Prediction this year is it will grow north of 15%. We're expecting that 23% to go to 25%, 27%, but there's also a lot of competitive mix amongst all the traditional retailers and the online retailers with free shipment. And so there's a lot of folks out there who really want to capture the extra market share. So there's a lot of activities and excitement in the market.
Your next question comes from the line of Derek Dley of Canaccord Genuity.
I just wanted to follow up on a comment you made. I noticed that the sales allowance in the quarter as a percentage of your gross product sales dropped quite meaningfully. Should we expect that to increase in Q4? Or was there something going on this quarter?
No, there was nothing specific in this quarter. It was really just the timing of promotional and markdown spending. Not a big change either, Derek, relative to prior years. But as I said to you, in previous -- on previous calls, we expect sales allowances to be in the 10% to 12% range. And you should expect that for our full year '18 numbers.
Okay, that's great, that's helpful. And thank you for all the color on PAW Patrol, but it sounds like you did have a strong rebound in POS in North America in August, September and October. Can you talk a little bit about the traction that you're seeing with PAW Patrol in Europe and the Rest of the World following that sort of liquidation period?
Yes, absolutely, Derek. So PAW Patrol is actually doing incredibly well. And overall, even if I go one level above PAW Patrol, we look at the toy industry globally. Year-to-date the industry, despite all the noise that we're experiencing, has grown 1.5%. And when you look at all of the different countries, most of the headwind have been experienced in the U.S., the U.K. and there's some cautiousness in the French market as well. But a lot of the other markets around the world are doing fairly well. So you have markets like Brazil, Mexico, Russia growing double digit. You have Italy, Germany, Canada and many others growing single digits as well. So the toy industry overall globally is doing fine, and PAW Patrol continues to build incredible momentum in a lot of our European countries like in Germany also with our distributors. So Mark expressed the growth we're seeing in the rest of the world and in many other geographies. So we're having strong years in a lot of these other countries, and PAW Patrol is a large part too of our success factor.
Your next question comes from the line of Brian Morrison of TD Securities.
Ben, you talked about the distribution agreement with Alibaba. I'm not sure I get a sense of the details. Is there anything really unique about this partnership? Do you have -- do you plan to have your full product line available through this channel? I'm trying to get a sense of the materiality of its growth potential.
Yes, Brian. So we're -- as you guys know, we launched recently our -- Spin Master did some product launch in China last year, and we built really good momentum. Into this year, we're expecting to double our sales in China. And when you look at the marketplace, we -- the retailer, traditional retail is very important, but the Chinese consumer are very, very as an e-commerce shoppers and consumers, and Alibaba has by far the largest market share in the Chinese market. And we've launched PAW Patrol with Alibaba. We have a dedicated site on Tmall. We have a dedicated site on Hatchimal, which is doing really well. And through discussion with Alibaba, I think they really like the potential of capturing more of the toy industry sales in the Chinese market with a lot of the brands that are doing well globally. And they identified Spin Master as a company they want to do more with, which is a perfect fit for our strategy in China. So not only Ronnen talk about franchise expansion in Asia, but also our product line expansion. So with Alibaba, what we will do is we will continue to do some partner marketing, making sure that we cooperate more closely to build brands in China with them. And again, their footprint with their consumers in China is definitely phenomenal. So this is something that -- the ecosystem that they have is something that is very, very strong in the Chinese market. So we're actually very excited with that partnership. And it's -- but it is not the full product line, Brian. We will actually be very strategic in which brand and franchise we release over time. It's a calculated approach versus an all for all.
That's helpful. Ronnen, you talk about the relaunch of Bakugan. And after 7 years, perhaps, you can provide some color on some of the key factors you've identified? What you've learned from prior experience? Just to ensure that your content and product really appeal to the target markets successfully. What's going to generate excitement for a prolonged period with this item?
Brian, first of all, thanks for asking me a question. I feel very -- I get so excited because Mark and Ben get all the action. But no, it's a great question. I think first and foremost, the patience that we've had to wait a full 7 years without relaunching the toy app, 4 years or 5 years to try to capture the revenue, is the first critical part. So there's a rule of thumb if you wait 7 years, there is a fresh new generation of kids that never experienced Bakugan before, never experienced a toy franchise. And so that was the first critical thing. So it's been a full fresh 7 years. And then the other part was working very closely with the broadcasters. So originally, when you watched the first 4 seasons of Bakugan, they are 22 minute episodes. And Cartoon Network came to us early about 2 years ago when we reapproached them about relaunching it. And they said, you know guys, the landscape has changed. Kids are watching things in much more bite sizes. And why don't you rechange the format to do them in 11s rather than 22s? And at first, my philosophy is never change anything if it's not broken. But they are close to the customer, and we listen to what exactly they said. And so we changed the format. And then we did something also slightly differently. The marketplace has changed. Kids want comedy, right. Comedy is really important in shows today. And so when we actually did the writing for Bakugan this time around, we brought in U.S. writers, and we did all the writing in California, and then we sent over the scripts to the animators in Japan. And it was very much a collaborative production. And so now when you see Bakugan in January, you'll see 11-minute shows. They're fast. They're punchy. They're funny. I would probably say that we have actually redefined animation -- or sorry, anime, the art style. It is very different to what other stuff that you see in the marketplace. And it's extremely, extremely progressive with its look and its feel, the music, the tone, the pacing, the comedy, the kids, the -- everything. It is completely up-to-date for this generation of kids and how they are watching and how they're viewing and things like the screens and the drones. But then it's also rooted in the core part of Bakugan, which is the collectibility and the magical wish fulfillment of rolling this ball and having this character grow 100 feet in size and battle it out and competitions and all that type of stuff. So I encourage everybody to watch it. And I'm really, really proud of what the actual -- what the team is -- has brought to the marketplace. A lot of love, a lot of care has been put into it. And then also, as we also know, the marketplace has changed in terms of viewing habits, and Cartoon Network has been very open with us to have things on digital platforms like YouTube and having a lot of short-form content, which is bite size, 3-minute forms and 3-minute lengths and constantly updated. And so that's something that we've planned for. And then also working with a company like Takaratomy, which is great. And not only are we getting the Asian distribution from Takaratomy, and we're getting probably -- but that company in Japan to actually market Bakugan, but we're also getting their insights in terms of innovation, play that we're able to incorporate into the line and make the line even that much more robust for Season 2 and for Season 3.
Your next question comes from the line of Gerrick Johnson of BMO Capital Markets.
I actually have 3 questions. Okay. First one, the guidance reduction. Look, we knew Toys "R" Us is gone and everyone else is going to be cautious for a while. So how much of this reduction is really less Toys "R" Us absorption anticipated and how much perhaps from declines in core lines and how much might be from slower uptake of new products?
Gerrick, so obviously the line and the maturity of every products changes every year. So this is obviously -- we're still early in the season, so it's really hard to comment on that. With that said, where I think we -- Gerrick, when you look at what happened in the industry and you go back to Q2, we saw a really bigger impact on Toys "R" Us into Q3 than we had anticipated. So for example, I'll give you a fun fact. So if you look in the month of July, compare your overall marketplace without Toys "R" Us and then with the liquidation of Toys "R" Us, the average unit price on PAW Patrol in the U.S. market went down by nearly 15% as a result of the pricing effect alone of Toys "R" Us. So I think Toys "R" Us took -- move a lot of the Q3 volume into Q2. I think they took a lot of POS dollars out for the industry to their deep discount. And then I think as we go forward, Gerrick, I think we're very optimistic for all of our product lines. I think we're really excited into what 2019 is bringing, but I think it's too early to comment on what is a big-hit, what's medium and what's a disappointment, because we're just heading into the season.
Okay. So the guidance reduction is purely less absorption than planned to Toys "R" Us?
Yes. It is that, Gerrick. And like what we talked about, it's also cautiousness around the new burden that will be placed on the supply chain -- at all touch point of the supply chain.
Okay, great, got it. And the second question is we hear a lot about retailers taking on more product to fill this gap in Toys "R" Us, but you were 2 months into the season. What's your observation? How are the U.S. consumers adapting? Where are they going? Are they showing up where you thought they would? Is the inventory flow into the right places out there?
Yes, I think, Gerrick, again, it's a great question. I think it's too early to have a verdict on that. But I will tell you that when you look at all of the -- anyone that is in the -- anyone that participate in the holiday season with toys is definitely trying to be more -- actually people are always aggressive every year to get -- to gain market share. But I think when you look at all the retailers, everyone is really positioned to have all the right inventory. I don't think anyone wants to get caught with empty shelves. So I think there's plenty of inventory available for the market right now. The challenge, as we discussed, is that there's not a lot more shelf space. So the inventory is sitting in the back of the stores, is sitting in the warehouse or it's still sitting in our warehouse to be shipped. So I don't think, Gerrick, it has to do with the retailers not being prepared or not positioning themselves properly. I truly, truly think it's just -- it's going to come down to managing the new variable all along supply chain and replenishment and dealing with that new velocity. And I think where the consumers will go, to go back to your question, Gerrick, is I think online will continue to grow aggressively. We see -- we said earlier, the e-commerce will grow expectation of over 15%. And I think the online e-commerce retailers are positioning ourselves to be very aggressive and capture more and more. But with all of that said, all the traditional retailers are also positioning themselves to gain market share. So it's -- I think we'll be able to better answer that after the holidays.
Sure. Fair enough. And my last question. So your sales allowances -- that allowance spend, the shift into fourth quarter closer to the retail sales, I get it. But your marketing spend was up 27% in the third quarter. So why was that up so much? And should we expect another massive increase in fourth quarter because, obviously, we've been talking about moving marketing spend towards the retail sale? So why was it up so much in the third quarter? And should it be up a similar amount in the fourth quarter?
So Gerrick, marketing spend in '18, in general -- not just in this quarter, but in '18 versus '17 is a little bit of an interesting anomaly. And it's not so much that '18 is that much higher. It's actually that '17 was relatively low. And that's because in '17, we had very strong performance; firstly, of Hatchimals, and secondly, to some extent, the PAW Patrol. And we did not have to spend the same amount of marketing dollars in '17 than we would normally do either in '18 or in '16 or in '15 for that matter. So if you look at our spend partners on marketing, they're actually very much in line with historical norms. We'll end the year at around 10% of our sales in marketing spend, which is traditionally where we have also spent. And so the increase over '17, as I said, is more related to '17 than it is to a large increase in '18.
Your next question comes from the line of Steph Wissink of Jefferies.
I've got one for each of you. So hopefully, each of you get a chance to respond. And Ronnen -- the first one, Ronnen, is for you. I just want to understand. I think you're the first company within the industry to really reference this potential capacity bottleneck that could surmise kind of mid-holiday order pressure. So I wanted to just understand around how you're thinking about excess inventory in the channel exiting the holiday? Is this actually a bizarre kind of silver lining that this made less than the potential hangover risk of inventory into 2019? And then Mark, one for you. Just I think you mentioned in your remarks that the return on invested capital on international is cited as high -- was cited as higher. If you can give us just some perspective on how much higher. And then wanting to understand a little bit about your international growth up towards that 40% of your mix. Can you just give us some perspective on the bigger franchise brands like PAW Patrol? How did those index relative to that kind of 33% in the quarter or right around that mid-30s range for the year? And then, Ben, for you. I think you mentioned you're trying to manufacturing exposure, trying to lower that over time. And I just want to make share we had the numbers right. So sounds like it's about 75% of your goods today are produced in China, on its way to closer to 40% over the next couple of years. If you could just kind of frame that for us. I want to make sure we got those numbers correct.
Okay, that was a mouthful, Steph. So we're -- I'll start with -- I'll answer your inventory -- retail inventory, and I'll talk about the manufacturing sourcing mix. So from an inventory standpoint, we're actually very pleased how we're managing our retail inventory. And I know it's boring, but every quarter we talk about how we measure the beginning inventory at retail, shipment in POS, and then we adjust the go forward based on what we're seeing with ending inventory. And for Q3, our retail inventory on a global basis was down 9% and in the U.S. were down 13%. And all of the projection that we're doing with the guidance that Mark gave will allow us to have our retail inventory down in the high single digit at the end of the year. So we are very, very mindful and cautious with the ending retail inventory. Also, just because we're super excited about 2019 and, as you've heard, we're -- in Q1, we're launching Bakugan, Monster Jam, How to Train Your Dragon, so we really want to be -- make sure that we get our ending retail inventory position right. So we're very, very focused on this. And we expect to be down, okay. So I think that was your first question. And when it comes to the manufacturing mix, as you know, just a few years back, most of our manufacturing was in China in the last 2 years. You nailed the number. We're now down to approximately 75%. And we -- over the last few years, we have made some structural, people and strategic investment into countries like Vietnam, India and Mexico, and those are some of the other counties where -- that are the predominant other countries where the production will continue to move over time. And the strategy is in place. We're actually already executing against it. And they will ultimately reduce that number furthermore to that number that we've talked about, to that 60% plus. Mark?
So thanks. Steph, on the question of ROI for international, I don't want to be too specific about the actual ROI numbers, but I can tell you that the ROI on our international investments are very attractive. And the way you have to look at it from a kind of a modeling perspective, it's -- there's a little bit of a trade-off between the P&L and the balance sheet. So when we go direct in international markets, we're able to now sell in wholesale dollars rather than in third-party distributor dollars. And there's quite a difference between those 2. On the other hand, so we get the margin pick up and by -- and that impacts the P&L positively. However, on the balance sheet side, previously, the distributor used to take inventory risk. Now we put inventory in that block of markets. So we actually have an investment in inventory and receivables. So there's a little bit of a P&L/balance sheet trade-off there. But overall, our international investments are very attractive, and we'll continue to selectively look at markets where it makes sense for us to do that. And in 2019, we're doing -- Russia is our biggest one, and then also Grease, Austria and Switzerland are other markets where we're going direct. In terms of our international growth targets, when we went public, around 28% of our sales were international. We're now up to 33% or just under 34% at the end of Q3. We think we'll be higher than that at the end of the year. And we're continuing now to push for that 40% mark. Previously 35% to 40% was our goal. We now think with our new markets coming on stream in '19 and others in '20 and beyond, we think we'll get to 40% in the next few years.
And the last question then comes from the line of Sabahat Khan of RBC Capital Markets.
So you provided some color earlier on the expectations for Bakugan. I guess when you think about the ramp-up of that platform over the next few years, I guess, without getting into specific numbers, how does a franchise like this perform during its second launch versus a ramp-up of the way, say, PAW Patrol or Bakugan kind of built up over a course of 2 to 4 years? Do you guys have some visibility on that in conversations with the retailers?
I think, first of all, you need to look back to history and look back at previous relaunches of Boys Action properties like Teenage Mutant Ninja Turtles, Beyblade. Those are 2 really -- prime examples are Transformers. And so if treated well in terms of bringing some innovation to the toy line, treated well in terms of the content discretion, upbeat and you have a great platform. And you've obviously, waited for that next generation of kids. I think you have the ingredients there to have a robust relaunch of the product line. And for us, we're taking a long-term view on Bakugan. You have the generation of kids that grew up on it. Now they are advocates of the brand and supporters. And now we're going to have a second generation of kids. And we're going to manage this franchise for the long term. So I mean, it's going to be year-by-year and every year is going to be new innovation and new innovation tied to the TV show and all the rest of it. And so it's going to be a strong launch with a long-term focus on building the franchise. And then again building licensing merchandising, but all the other categories out there and video games and potentially some other content that we can share with you guys in the future.
And so, Ronnen, if I could just add to that. Sabahat, in the context of Steph's earlier question, when we did Bakugan the first time around, most of our sales internationally were actually through third-party distributors, and now they'll be through our own network. So we're excited about our ability to control the marketing, to control the investments in these countries around the world where we now have over 20 sales and marketing offices. And previously in 2007 and '08, when we launched Bakugan the first time, we obviously had a much smaller footprint. So keep that in mind as well.
Okay. And then just a quick one on the other revenue line. Like I guess, would you say that's -- I guess, this quarter it was down quarter-over-quarter, but up year-over-year. How should we think about that line? Is there any relation at all to the direction of your gross product sales or should we think about that completely separately?
So I think you have to think about it a little separately, Sabahat. Because for the most part, we do not actually control that ourselves. In some cases, we do and in some cases we don't. But in the case of PAW Patrol, for example, Nickelodeon actually handles the L&M around the world. And so they are dealing with over 75 different licensees. In the case of Hatchimals, we're dealing with over 75 different licensees. And so to actually predict that in a rational way is somewhat challenging because we're not actually controlling that directly. So I mean, I think there must be some fundamental correlation to the property itself to which the licenses relate. But there isn't a very strong direct relationship that I could point to, to allow you to model that directly.
Operator, I think we're going to have to end the Q&A session at this point.
Certainly, I will turn the call back over to Mark Segal.
Okay. Well, thank you, everybody. I appreciate your interest in the call. It was a long call, and we had a lot of information to get out, which hopefully we did. We look forward to seeing you all in February in New York and to showing you our exciting 2019 product line. Thank you all.
Thank you.
This concludes today's conference call. You may now disconnect.