Sizing up the toy market

Child's play is big business.

At the annual American International Toy Fair in New York this week, analysts and retailers are scouring the floor for what could become the must-have holiday item this fall.

It's an industry that's easy for investors to overlook. Plastic toys don't have the same wow factor as a tablet computer or a breakthrough in clean energy.

Behind the fun and games are challenges the industry itself must navigate. US retail sales slipped 2% to USD 21.2 billion last year, according to the NPD Group. Analysts point to weaker spending on toys for non-family members as a factor. Toy companies like Hasbro Inc and Mattel Inc find themselves increasingly competing with online games.

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OPTIONS FOR INCOME INVESTORS

Mattel and Hasbro, the two dominant public toy companies, have a special appeal to investors looking for income.

Toy prices are expected to rise due to a 20% increase in China's minimum wage within Guangdong province which produces many toys in the US market.

Higher costs could hurt companies like Jakks Pacific , which makes toys under brands such as Pokemon, Hello Kitty and The Smurfs, and Japan's Namco Bandai Holdings whose sales lagged Mattel's and Hasbro's during the holidays.

Mattel and Hasbro are each expected to raise prices by 6%, according to Robert Carroll, an analyst at UBS, roughly in line with their competitors. But their sales aren't expected to slip because of their brand names and licenses that include Barbie, Star Wars, and Walt Disney Co's "Cars" and "Toy Story" lines.

"Austerity measures don't translate well to kids. If your wife asks for Tide and you come home with a store brand you're not in that much trouble. But if your 7-year old asks for Barbie and you come home with something else, watch out," he said.

Because of that built-in market, these companies could be considered more like defensive stocks than plays on increased consumer spending like other retailers, he said.

"What makes these companies attractive is that they tend to be fairly resilient and they throw off buckets of cash," he said.

Mattel, for instance, pays a dividend yield of 3.8%. It trades at 15.2 times earnings, slightly above the 14 multiple of the broad Standard & Poor's 500 index. Hasbro offers a dividend yield of 3.9% and trades at a P/E multiple of 12.7.

Both companies are popular among income and value funds. Mattel makes up about 2% of the USD 2.7 billion Principal Equity Income fund. The fund, which yields 2.9%, costs 52 cents per USD 100 invested.

Hasbro is 2.5% of the USD 243 million Ave Maria Rising Dividend Fund. The fund, which yields 1.3%, charges 75 cents per USD 100 invested.

PLAYING THE NEXT TWO YEARS

Mattel seems to be the stronger play among the two companies over the next two years, analysts said.

Its new Monster High line of dolls was a hit with $300 million in retail sales in 2011, and the company will continue to roll out the brand globally. In addition, it is expected to do well with toys due to be released later this year based on movies such as Batman, and Disney's "Brave" and "Cinderella", noted Margaret Whitfield, an analyst at Sterne Agee.

She has a price target of USD 38 for the company, or 17% above its current price of about USD 32.60, and expects the company's dividend to increase this year.

Whitfield cut her rating on Hasbro, Mattel's chief competitor, to neutral from buy on Wednesday. She lowered her price target to USD 41 from USD 46, based on a forward price to earnings multiple of 13. An overhang of retailer inventory and a relatively light year of movie tie-ins for 2013 were behind the cut, she said. Sales in the boys' category are expected to be flat as tie-ins from this summer's "Amazing Spider-Man" movie will be balanced out by a drop in the Transformers line.

Hasbro's apps business hasn't performed as well as Mattel's, she noted. "That's a crowded marketplace and lesser toy companies are jumping in on the bandwagon," she said.

PLAYING THE LONGER-TERM

Toymakers are keeping an eye on Apple Inc , which could be a fruitful long-term investment.

The company's iPhones and iPads are huge hits among the true consumers of the toy market, as many parents of young children can attest. Mattel, for instance, has an Apptivity line that offers Fisher-Price and Mattel products that can connect with an iPhone or iPad.

Mattel's Hot Wheels Aptivity set, which goes on sale in May, allows players to maneuver cars along a track that scrolls across an iPad's screen. Special wheels prevent the car from scratching the tablet's glass.

While the apps business is a small part of the industry, it should continue to grow over time, which may not be a welcome sign for toy manufacturers that specialize in board games. While the app business has higher margins, the lower price points are cutting into profits for both companies, noted USB's Carroll.

"You need to sell two or three apps to offset the profit from the lost board game sale," he said.

LeapFrog Enterprises offers another play that combines technology and tots. Its LeapPad Explorer tablet was named the 2011 Toy of the Year by the Toy Industry Association. It could be a momentum play as well. It is up 170% over the last six months and is just a few cents below its 52-week high of USD 7.69.

Zynga Inc , too, could be another option, though its games like Farmville tend to appeal to teenagers and adults. The company is increasing its research on developing new games which will target the growing mobile market.

It is also showing its ability to retain paying customers, noted Daniel Ernst, an analyst at Hudson Square Research who rates the stock a buy.