Holiday Toy Stock Roundup: The Good & The Bad

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

If you are looking to get into the toy market ahead of holiday sales reports, I encourage backing a mixture of defensive, or "predictable," winners and takeover plays. Several variables to look for include geographical exposure, proposed expansion, return on invested capital, and free cash flow yields of at least 7%. Below, I review three stocks with this perspective in mind.

Why Mattel (NASDAQ: MAT) Is a Great Defensive Buy

Mattel is just one of those great toy companies that you want to buy for (1) defense, (2) consistency, and (3) expansion opportunities in emerging markets. The company trades reasonably at 15.3x forward earnings but offers a 3.4% in addition to a 9.1% annual EPS growth rate. These variables are enough to provide compelling risk/reward when you factor in the predictability of business. It's not like modeling, say, coal revenue. You know there were X number of buyers last year and this % of GDP growth in geographical regions A, B, and C. So, assuming the distribution stays the same (and it has been increasing), Mattel is on track to yield 13.2% annual returns to shareholders. Not bad for a predictable investment.

Fundamentally, the toy maker is relatively well positioned. An analyst from Goldman Sachs argued that Mattel, by virtue of its resilient brands, was the least vulnerable to toy spending deceleration. In fact, management has been able to increase prices to keep margins elevated, and it expects this to be achievable through growth in Barbie, American Girl, and Monster High in the future. More importantly, the company has a secured foothold in international markets, which has paid dividends in recent quarters. Asia Pacific revenue grew 10%, and it could be catalyzed even more by the introduction of Fisher-Price brands (although this will cut into margins).

Then there's product innovation. The launch of Photo Fashion Barbie, Barbie Holiday Doll, and new doll entertainment DVDs to drive interest. Barbie had strong momentum coming out of the third quarter, and I expect it to do the same going into the fourth quarter.

Avoid Hasbro (NASDAQ: HAS), Buy LeapFrog Enterprises (NYSE: LF)

There are riskier options available that, as financial theory suggests, could generate higher returns. But are they? Hasbro trades at a respective 14.4x and 12.7x past and forward earnings. Analysts forecast just 7.4% annual EPS growth over the next five years. Assuming expectations are met, 2016 EPS will come out to $3.68. At a multiple of 15x, this translates to a future stock value of $55.20. Discounting backwards by 10% yields a present value of $34.27, which indicates the stock is around fair value today.

So, I would thus encourage looking elsewhere. LeapFrog is the right investment to make. It trades at only 10.7x past earnings and a PEG ratio of 0.55x. There is an absence of long-term debt on the balance sheet, which is a bright spot in the relatively highly leveraged toy & game industry. Moreover, analysts forecast 19.5% annual EPS growth over the next five years, which is well above the 11.9% industry average.

Perhaps most excitingly, LeapFrog is an ideal takeover target. With a valuation of just $600 million, the maker of educational toys could be easily bought out by toy producers, like Hasbro and Mattel, that are seeking faster growth and more diversified product portfolios. The greater marketing spend of these larger producers could also generate meaningful revenue synergies in the process. Their substantial free cash flow generation would also make financing a takeover relatively cheap. Given that LeapFrog more than doubled in the last 12 months alone, it is safe to say that Mattel or Hasbro missed an opportunity earlier. With that said, LeapFrog is at an even more compelling multiple today. Let's hope Mattel or Hasbro will seize the moment and drive fantastic return for current LeapFrog shareholders.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Hasbro 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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