Buy Consumer Stocks Based on Realistic Growth Trajectories

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

Video game and toy stocks are an attractive investment to make in preparation for a full recovery. While some stocks have meaningful growth potential that will make up for elevated multiples, others are in turnaround mode and over-focused on "what it wants to do" but probably can't do. Since companies are valued based on the future, it is important to discern the difference between corporate goals and trajectories. The trajectory is a safer part to bet on than corporate goals, which can be very unpredictable. Bearing this in mind, I will walk you through some of my thoughts on a toy producer and a game producer.

Mattel (NASDAQ: MAT) is Still a Solid Income Investment

Mattel may be very shareholder-friendly in terms of its capital allocation policy (eg. the company pays a 3.5% dividend yield), but its high multiple of 15.8x past earnings will turn a lot of investors off. In my view, the expensive price tag is justified by the company's top brand name; 1H12, for example, featured excellent momentum across all the brands and markets (particularly Brazil, Mexico, China, the U.K., and India), offsetting large FX headwinds.

Since the company has a strong contract with Disney, it is also a major beneficiary of the media company's multi-billion dollar buyout of Lucasfilm (that is, Star Wars). With a series of new Star Wars movies slated over the next few years, Mattel should get nice demand tailwinds that feed into longer term sustainability. The more brands Mattel can capture, the more it can convince parents into preferentially buying at Mattel over a competitor.

On a more operational level, the company can also benefit from cost cutting and optimizing its geographical sales mix. A year ago, many were even calling the company a likely takeover target for its high generation of free cash flow and potential room for margins expansion. But with excellent returns posted for American Girls, Barbie, Hot Wheels, and new products, there is probably little doubt from management or the board that they can fare just fine independently.

Avoid Electronic Arts (NASDAQ: EA)

If you are interested in exposure from the gaming market, you may be tempted into buying the riskiest stocks under the premise that they will turn around from macro trends. While several video game produces are getting ready for some major launches (like Nintendo, which is releasing the Wii U console around this holiday), a rising tide may leave some boats behind; EA is likely to be one of them for several reasons.

First, the company's brand continues to go nowhere but down. It has released a series of flops ranging from FIFA 13 to NHL 13. Perhaps most importantly, the titles that game reviewers thought would jumpstart demand, like Star Wars: The Old Republic, produced very weak results. It should not be surprising then that the company has attempted to hedge its poor results in core markets by speaking about the future in mobile & online gaming. In my view, these markets have been tremendously over-hyped. Case in point: Zynga (NASDAQ: ZNGA). The company has seen declining user engagement and lost nearly nine tenths of its market cap from poor performance. Management still speaks about creating "great games," but that's what it said months ago as demand came out much worse than the "experts" anticipated. CityVille and CastleVille, which were hailed as "catalysts," failed to keep demand elevated.

So, what you have with EA is a company that has failed in core markets due to poor innovation and a company that is seeking to enter new, faddish markets. It's easy when results are poor to point to a future in smartphones and tablets; but, based on industry and corporate trends, I would not anticipate a recovery any time soon.


TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Mattel. Motley Fool newsletter services recommend Electronic Arts 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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