The Real 'Toy Story'

Zain is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

For some time, the toy industry has been undergoing a decline in demand due to macro as well as secular reasons. Industry trends remain tepid in both Europe and the US given macroeconomic pressures. Also, a slow but steady shift toward digital forms of entertainment has posed a huge threat to this industry. In these circumstances, it is worthwhile to have a look at some of the toy companies and predict their outlook for the foreseeable future.

Goldman is bearish on this company

Hasbro (NASDAQ: HAS) is an old publicly traded toy company. It is set to release its earnings for the second quarter on Jul 22. The company is expected to post EPS of $0.35. However, Goldman Sachs believes that the company might be well short of its estimates. This is expected to be led by 6% lower-than-anticipated revenue, which will likely spill through to the profit and loss statement due to fixed cost de-leveraging. The lower revenue forecast is driven by ongoing checks that suggest Hasbro is under-performing the broader US toy industry year-to-date (running down in mid-single digits versus a more flattish industry trend).

While it is tough to model toy companies quarter by quarter due to fluctuations in shipments versus retail sales, the magnitude of the gap between Goldman’s forecast and the Street's leaves enough buffer room for the directional view to be correct even if there are some unexpected positive offsets somewhere in the profit and loss statement.

The biggest argument for a sell rating on this stock is that there is an impending inflection from 2014 through 2015 from sales of Transformers and Star Wars toys. Also, the company has announced a restructuring plan, which will help it to save an annual $100 million after 2014. However, there are two counterpoints. Firstly, Hasbro might not be able to achieve full gains from the restructuring due to some re-investments. Moreover, despite accounting for maximum benefits from Transformers and the Star Wars program, the consensus estimates for 2014 and 2015 seem to be highly unattainable.

A company like Hasbro

Mattel (NASDAQ: MAT) has a similar revenue base to Hasbro. Apart from the secular shift toward other forms of entertainment and macro pressures, there are some other problems that it shares with Hasbro. Both toy companies generate more than 50% of their revenue from sales outside of the US. This means that they are well prone to dollar fluctuations. Recent fears of QE tapering from the Fed sent the dollar surging to record highs, which in turn has posed headwinds for both of these companies.

Moreover, toy valuations seem to be a bit stretched. By this I mean, that the stocks are expensive in terms of their trading multiples. Both are currently trading at a 5% to 10% premium to the S&P 500, above their historical relative multiples.

Dividend yields also need to be mentioned. Mattel pays a dividend yield of 3.1%. Hasbro pays a dividend yield of 3.4%. Dividend payouts will limit the magnitude of downside potential in the shares (since shareholders like dividend-paying stocks). However, figures show that there is room for declines in both stocks today.

Neither Hasbro nor Mattel sits in the 3.5% to 4.0% dividend-yield range today that has typically served as a valuation floor for the stocks. (A declining stock price will automatically increase the dividend yields, taking them to 3.5% to 4% bracket.)

Keeping macro factors aside, Mattel has been a solid company with a well-diversified portfolio of brands, something that is not present in Hasbro. With strong momentum in Mattel’s core brands, including Other Girls Brands, Monster High and American Girl Brand, its top line is expected to improve in the ensuing quarter.

Moreover, cost initiatives and some strategic acquisitions (one of them is HIT entertainment, a leader in preschool brands; Mattel acquired HIT in Feb 2012) have made the company an attractive investment in the toy industry.

Another high dividend-yielder in the same space

Unlike its peers, JAKKS Pacific (NASDAQ: JAKK) is down 11% year-to-date (both Hasbro and Mattel have climbed upward.) JAKKS is expected to announce its earnings on the same date as Mattel, i.e. July 17. The company is expected to post a profit per share of $0.05 and revenue of $147.2 million. It is interesting to note that the company recently started making profits. However, the stock pays a dividend yield of 2.7%. Investors seem to be cautious about the sustainability of the company’s dividends.

JAKKS suffers from a lack of demand in some of its key products. Some new major products, such as Monsuno and Winx Club, didn’t have the success the company expected, which led to increasing inventories. Moreover, in the short term, there is only one significant launch, Dreamplay products, which -- if successful -- will impact profits only a few quarters from now. For the time being, the outlook remains bleak for the company.

Final word

Secular and macro reasons for declines in toy demand have surely sent bearish signals to the market. Stretched valuations, foreign-exchange headwinds and flashy estimates from the Street have made life even harder for investors seeking to go long in these stocks. However, new product launches and potential restructurings present some hope for investors in this space. Mattel seems to be the best option in this sector given its well-diversified portfolio of brands, strategic acquisitions and cost-cutting initiatives.

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Zain Abbas has no position in any stocks mentioned. The Motley Fool recommends Hasbro and Mattel. The Motley Fool owns shares of Hasbro. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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