Michael Brush - Writer
Nov 2004 

Beset by a host of serious challenges, the toy sector may seem like the last place to put your money.  

Indeed, at the annual Harris Nesbitt "Playtime" Investor Conference in New York City November 8 and 9, the venue for toy makers was virtually empty, while investors overflowed from the hall where video game makers pitched their latest hot products.  

But as any good contrarian thinker knows, the overlooked sectors that get passed up at investing conferences often provide the best hunting grounds for bargains. And that just might be the case with the toy sector right now.  

Before we get to some of the ways you might make money in this group, let's take a look at the big challenges toy makers face. Here is a quick summary.  

The toy industry is in a “multi-year funk.” After three yearsq of little or no growth, retail toy sales slipped by 3% in the first half of 2004, says Sean McGowan, the toy sector analyst at Harris Nesbitt. It’s likely to finish the year flat, he predicts.  

There’s a lot of competition. Part of the problem is that companies in the $50 billion global toy market face challenges everywhere for the attention toy lovers young and old -- from video games and consumer electronics devices, to the cell phone. Reliable standbys like Barbie and LEGO just aren’t selling like they used to.  

Costs are rising. Meanwhile, toy makers are getting hit hard by rising costs. Toys are made of plastic. And as the price of oil goes up, so do the prices of resins used by toy makers. Some companies have hedged away the risk for the near term. But they will get hit next year by higher resin costs which have gone up anywhere from 25% to 40% compared to last year, says McGowan. Freight charges are high, too. That’s bad for any companies that manufacture in China – like most of the toy makers.  

Mega Bloks Inc (MB.TO) chief executive Marc Bertrand told investors at the Harris Nesbitt conference that resin prices for his company are up 30% in a year. And resins represent about 15% of the cost of goods at his company. At RC2 Corp (RCRC), which makes collectible cars and other toys, rising costs nipped 2.5 percentage points off gross margins in the most recent quarter.  

Specialty toy retailers are shutting their doors. Chains like Toys R Us (TOY), KB Toys and FAO (FAOOQ.PK) continue to close stores – as shoppers go for the lower prices and convenience at discounters like Wal-Mart Stores (WMT) and Target (TGT). And hundreds more specialty toy outlets will be shut down in 2005. That will shift even more toy sales to Wal-Mart Stores and Target. These two are notorious for using their weight to push down prices from vendors, or force them to meet tricky “just in time” deadlines.  

Discount retailer chains like Wal-Mart also sell their own private label toys, which sop up scarce shelf space. “You have to be the guy to get the end of the isle,” says John LaForge, a value manager with FA Asset Management, a part of First Albany Corp. “But there’s so much going on, it is just impossible to get mind share. You have to be the next best thing, or you have nothing.”  

Making money in toy stocks 

Despite these obstacles, there are still a few ways to make money in toy stocks. One is to exploit the trading patterns in these stocks – particularly the bigger more liquid names like Hasbro (HAS) and Mattel (MAT). The other way is to ignore the big names like these, and look for pockets of growth among the small-cap players. Here’s a quick look at both of these approaches.  

Play the trading range  

Toy sector stocks are generally strongest from January through May. And they typically peter out during the rest of the year. Why? First of all, they get about two thirds of their sales in the second half of the years. So – as is typical in the market -- investors bid up these names about six months ahead of the good news, driving these stocks higher in the first half of the year. Next, toy stocks are often their weakest in

December as investors inevitably fret about potentially weak holiday sales. This sets the stage for the January-May strength, says McGowan.  

Another factor: Toy makers release hot, new products at the New York Toy Fair in February, generating excitement for these stocks. And here’s a good tip about how to trade the larger, more liquid toy makers like Hasbro and Mattel. They typically sell at a price-earnings ratios of 11 to 20, says McGowan. So astute traders may make money by taking positions as they approach the low end, and selling towards the high end.  

The smaller growth names  

Three toy companies at the Harris Nesbitt conference presented intriguing growth stories that look like they may have good prospects -- based on three different themes. Here’s a quick look.  

Theme Number One: If you can't beat em, join em.  While the toy industry languishes overall, toy maker Radica Games (RADA) posted an awesome 38% sales growth in its most recent quarter. How did it pull off this stunt? Simple. Rather than running from the electronics and digital trends that threaten sales of traditional toys, Radica embraces technology to come up with new ideas.  

“We create high tech fun for all ages,” says Radica chief executive Patrick Feely. “You overcome a tough market by innovation and by being aggressive and not putting your tail between your legs and sulking.” Virtually all of the company’s revenue comes from electronic games and video game accessories that exploit technology.  

For example, one of Radica’s hottest products is a small sphere programmed with artificial intelligence that’s clever enough to trick you into thinking it can read your mind. Called 20Q, for twenty questions, the game starts when you secretly think of an object. Then you answer twenty queries that allow the device to home in your choice – simple questions like “Is it an animal?”  

Sure enough, 20Q gets the job done, displaying your thought on its readout screen. “Are you sure it can’t hear?” asks one player in a promo video filmed in Times Square . Don’t expect to ever see the promo on TV. The 20Q game sells so fast, there’s no need to run ads. “We can’t keep enough of them on the shelf,” says Feely. The company plans to release several new variations on 20Q to capitalize on the fad.  

Next, in March Radica will begin shipping poker games under the World Poker Tour moniker. It also has popular lines of plug and play TV games, which are more affordable because you don’t have to buy a console. (Though McGowan worries that this space may soon become overcrowded.) Radica is also expanding in Europe . And it is gaining shelf space in retailers that toy makers normally don’t penetrate -- like Brookstone (BKST), Sharper Image (SHRP) and Blockbuster (BBI).  

Profit margins got whacked last quarter when Radica stumbled trying to keep up with its growth. The company had to pay through the nose to ship goods from Asia by air to meet deadlines. That helped reduce gross margins to 31% from 38%. “Next year won’t have the same issues,” said Feely. The company has no debt and strong cash flow. Cash and investments are worth $1.92 per share.  

Theme Number Two: Reach across all age groups.  RC2 hits a broader market than your typical toy maker -- by appealing to adults with collectibles like replicas of John Deere farm equipment, Harley-Davidson motorcycles, or NASCAR cars. At the other end of the spectrum, it appeals to infants with its Thomas & Friends toys, among other lines.  

“We are in the play business not the toy business,” says chief executive Curtis Stoelting. “We are focused on play patterns. People play throughout their lives. We focus on the early and the later years.”

The under-six age group is a good category to serve for a few demographic reasons. First, people are having children later in life. So they have more money to spend on their kids. Next, grandparents are living longer, which means they spend more on toys for toddlers, too.  

RC2 shares got hit in October, 2004 when the company missed sales expectations because of weakness in growth of higher margin products. But several factors may make 2005 a better year. First, the company expects to reap cost savings in the integration of two recent acquisitions, Playing Mantis and The First Years. That should help improve profit margins over the next 18 to 24 months.  

It also plans to get more shelf space at Wal-Mart and Target for John Deere replicas, introduce Bob the Builder toys based on the popular Public Broadcasting System children’s show, and position Thomas & Friends products overseas.  

Theme Number Three: Go for the international growth. Mega Bloks (MB.TO), which makes building blocks, movies, Ninja Turtle and Power Ranger replicas among other toys, should post sales growth of around 11% in 2004. That’s not bad for such a sluggish sector. But this kind of growth might get kicked up even further as the company makes good on plans to expand overseas.  

Toy makers overall get about 40% of their sales from North America , 30% from Europe and 30% from Asia . But Mega Bloks gets around 63% from North America and 37% from overseas. It hopes to tip the balance towards international sales – initially with a sales office that will open soon in Italy . It also plans to expand in Germany and Eastern Europe .  

Here’s another change that may help growth. Next year, Mega Bloks will start making toys based on popular super heroes -- under a new license deal with Marvel Enterprises (MVL). Nothing like a little help from Spider-Man to make your business grow. 

Writer: Michael Brush 

Michael Brush writes a weekly market column for CNBC on MSN Money. Mr. Brush has also covered business and investing for the New York Times, Money magazine and the Economist Group. Mr. Brush studied at Columbia Business School in the Knight-Bagehot Fellowship program. He is the author of Lessons From the Front Line, a book offering insights on investing and the markets based on the experiences of professional money managers.

Michael Brush may hold long or short positions in any of the stocks mentioned in this article and those positions can change at any moment. 

Disclaimer: www.InvestorIdeas.com/About/Disclaimer.asp, 

InvestorIdeas is not affiliated or compensated by the companies mentioned in this article. Michael Brush is a freelance writer.

©Copyright, Michael Brush 2004

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