Buy This "No Lose" Toy Stock

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

It's that time of the year. Parents are making their yearly return to the toy aisle, which will be a make or break moment for not only retailers but also brands like Mattel, Hasbro, and LeapFrog. All three of these companies differ in risk/reward, but they are all either cheap or shareholder-friendly. I encourage buying into takeover targets and backing those with stable economic moats.

A "No Lose" Situation

And there it goes. In just around 3 years of being listed on the NASDAQ, Mattel (NASDAQ: MAT) has just about doubled in value. During the last 12 months alone, Mattel is up 21.5%. The good news? It's still an undervalued defensive investment. Management remains very shareholder friendly and offers a dividend yield of 3.5%. The stock trades at a respective 14.7x and 12.8x past and forward earnings--with a forecast for 9.1% annual EPS growth over the next 5 years, the long-term value is substantial. Caris & Co. just recently issued an equivalent of a "buy" on the stock with a price target of $45, a 30% premium to the prevailing market assessment.

My one concern is that investors have made the company out to be a free cash flow machine. It's not really so good from this perspective. Aside from how FCF has gone nowhere over the last few years and is actually down considerably from the $800 million territory before 2004, current FCF is at only a 5.6% yield against the market cap. But I am still optimistic about the long-term trajectory. Focus on core brands, the launch of new ones every 1-3 years, and expansion into international marketing strategies is a "no lose" strategy. Mattel's brands have resonated through many years, and I see strong appeal going into emerging markets. A Goldman Sachs analyst recently argued that Mattel is better positioned to weather decelerating trends in toy spending than Hasbro (NASDAQ: HAS) is. Performance has been generally above expectations during the past 5 quarters.

Better yet, earnings momentum is improving. Gross margin hit 53.7% in 3Q12, which represented nearly a 600 bps expansion. ROE is substantially above peers, and gaining traction of Fisher-Price should drive even stronger returns.

Strategic Opportunities To Build Momentum

As I mentioned earlier, Hasbro is expected to suffer more than its larger competitor from decelerating toy spending. It has already substantially underperformed with a return of -2.4% over the last 5 years. It trades at a respective 14x and 12.3x past and forward earnings with a generous 4% dividend yield. Analysts, however, rate the stock closer to a "sell" than a "buy."

FCF has gone up and down but nowhere over the last 8 years. It started at around $420 million in 2004 and ended around there in 3Q12 (ttm). However, that still represents a 9.2% yield against the market capitalization.  This company has brought you Furby, Transformer toys, Star Wars toys, Monopoly, My Little Pony, Play-Doh, and so many more popular brands. It carries great appeal but has lost appeal in the market. Management should pursue strategic options going forward to unlock value--this can include either selling the business or buying businesses. If it decides to take the latter path, a good target would be Leap Frog Enterprises (NYSE: LF).

LeapFrog is an attractive target for several reasons. First, it trades incredibly cheaply at 8.8x past earnings. Second, it is in the midst of a major turnaround. Free cash flow was in the negative territory in 2011 and, while it has peaked to around $65 million in mid-2012 (a 13.2% yield), operations have since trended downwards again. Hasbro has the brand appeal and retail connections to help generate substantial revenue synergies. Third, LeapFrog has a very clean balance sheet. There is no debt, and the PEG ratio of 0.45x provides strong growth to easily finance any interest costs from a takeover. With such an acquisition, Hasbro (or even Mattel) could LeapFrog some of its earnings woes.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Hasbro, LeapFrog Enterprises, and Mattel. Motley Fool newsletter services recommend Hasbro, LeapFrog Enterprises, 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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