How to Play the Toy & Game Market

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

Toys and video games have both been overly depressed in recent years due to an uncertain consumer market. However, the potential for large gains is now very real. Investors who are willing to buy now can outperform the market through zeroing in on stocks that have strong fundamentals, but have been beaten down from tough times. Ultimately, firms are valuable based on their future performance; accordingly, my recommendations below look to the future.

Activision (NASDAQ: ATVI) & Electronic Arts (NASDAQ: EA): Two Very Different Situations

Whereas Activision has seen free cash flow explode over the last few years, EA has headed into negative territory and is in the midst of trying to engineer a turnaround. At only 10.5x forward earnings, Activision is highly compelling given forecasts of 10.9% annual EPS growth over the next 5 years. To put this under context, consider that the low PE multiple over the past 5 years has been 13.4x, while FCF for the TTM ending 2012 has ballooned from $384.4 million in 2008 to $1 billion. Although there was somewhat of a decline from last year, business is good.

By contrast, EA has lost more than half of its 52-week high valuation and continues to be on a roller coaster, even after the general positive August stock reversal. Several factors give rise to Activision being more undervalued than EA today.

Activision has been successful in releasing a string of good titles. Starcraft, for example, has dissipated much of the concern over World of Warcraft churn. Second quarter performance was also solid, with management trumping EPS estimates by the double-digits. Call of Duty and Transformers also promise offsetting streams of subscription revenue. Furthermore, the top-line grew 50.8% from solid momentum in Retail and Digital Online revenues during the second quarter.

On the other hand, EA has failed to offset weak returns in the console gaming market with its sports franchise. It is precisely this inability to make up for weakness in one segment that makes EA an entirely different story than Activision. Especially under the context of it trying to turnaround the business, the ability to deliver results quickly is critical. If operations fail to "deliver", the company's financial woes will become even worse as creditors raise interest rates and thereby limit expansion opportunities. It also particularly disappointing that around a third of the business' total assets come from intangible goodwill. Accordingly, I recommend avoiding the stock and buying Activision as a way to go bullish on the video game market.

Mattel (NASDAQ: MAT): Like Activision, But With Barbies

Mattel has been one of my favorite stocks for some time now. Over the last 12 months, the stock has risen by 34.4% while paying off a 3.5% dividend yield to shareholder. What more could you ask for?

Compelling multiples of course. Mattel trades fairly reasonably at a respective 16.2x and 13.2x past and forward earnings. What really catches my attention, however, is the low bar that has been set by the Street. Analysts only forecast 8.4% annual EPS growth over the next 5 years, despite this being only slightly more than 100 bps greater than what was achieved in the preceding 5 years. Should Mattel be able to best forecasts, multiples are likely to expand.

Additionally, the company has seen attractive growth across all key geographies. Shipments rose for the quarter, and, most importantly, Mattel is gaining share in the infant/preschool doll and vehicle category. This will help it secure a market to sell products as consumers age into the kid years. Especially in the context of a full recovery, the upside looks compelling.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Activision Blizzard and Mattel. Motley Fool newsletter services recommend Activision Blizzard and Mattel. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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