Technology is rapidly changing the way the world works. If you don’t keep up with those technological changes, you are bound to be left in the dust.
That is exactly what happened to Toys “R” Us, Inc., the toy retailer that filed for bankruptcy in September 2017.
In general, the traditional toy industry has struggled to keep up with changes in consumer technology. While phones, watches, televisions, and even appliances have infused technology and gone “smart,” very few toys have made the same transition. Toys remain largely as they were several years ago, before the era of smartphones, smartwatches, smart TVs, and smart appliances.
As a result, demand for traditional toys isn’t what it used to be. Children aren’t entirely shifting away from traditional toys, but there has been a boom in internet and smart device usage among children which does inevitably erode toy demand.
The average age for a child getting their first smartphone is now 10.3 years, which means all those 10-year-olds who were playing with action figures and princess dolls are now playing on smartphones. Plus, tablet usage among children has soared from 26% to 55% over the past several years, while internet usage has soared from 42% to 64%.
In other words, children aren’t playing with traditional toys as much as they used to. That is a bad thing for toy stocks, which have to battle waning demand and Toys “R” Us liquidation headwinds.
That is why I am avoiding all toy stocks. Here’s a list of 3 toy stocks that I am particularly staying far away from.
Broken Toy Stock 1: Hasbro, Inc. (HAS)
The best-in-class in the toy stock group is Hasbro, Inc. (NASDAQ:HAS). The company has strong partnerships with Walt Disney Co (NYSE:DIS) and Netflix, Inc. (NASDAQ:NFLX) which should accelerate in 2019 alongside a powerful movie lineup. That will help offset weakness from the Toys “R” Us liquidation.
But, Hasbro’s recent fist-quarter numbers show that this recovery will be a tough one.
Sales fell 16% last quarter at Hasbro. Margins were essentially wiped out. Profits turned into losses.
Management wants to talk up strength in the company’s Entertainment & Licensing business, and how that will pave the path for a recovery, but nothing else is going right at Hasbro. And the company is still staring at those waning toy demand headwinds from increased smart device engagement among children.
All in all, while Hasbro is the best toy stock, it is still a toy stock. That means slow revenue growth, mitigated margin expansion, and meager profit growth.
At best, this is a 3-5% revenue growth story going forward (in line with historical standards). Margins may be able to rebound to 18% from this year’s depressed 15.6% base. That combination leads to revenue of just over $6.3 billion in five years, and operating profits of just over $1.1 billion.
Taking out $50 million for net interest expense, 20% for taxes, and dividing by 125 million shares, that equates to just under $7 in earnings per share in five years.
A market-average forward multiple of 16 on those $7 earnings implies a four-year forward price target of $111-$112. Discounted back by 10% per year, that equates to a present value of just over $76, well below today’s current stock price.
Broken Toy Stock 2: Mattel, Inc. (MAT)
While Hasbro may be “OK” in the long-term thanks to a burgeoning Entertainment & Licensing business, fellow toy-maker Mattel, Inc. (NASDAQ:MAT) faces a much more uncertain future.
First, the company has bigger exposure to Toys “R” Us than Hasbro. Toys “R” Us accounts for approximately 15-20% of Mattel’s U.S. sales, versus 14% for Hasbro.
Second, the company doesn’t really have a lifeline to save it from persistently weakening demand. Pretty much everything in the company’s toy portfolio, aside from Barbie, Cars 3, and Enchantimals, is in decline. And the declines aren’t small — we’re talking mid-teens to low-20’s declines.
Clearly, the popularity of Mattel brands is eroding. What is happening here is that as children are dedicating more time to electronics, they are dedicating less time to traditional toys. With less time dedicated to traditional toys, children are also becoming more selective about which toys they want to play with.
Mattel toys aren’t making the cut.
Things won’t get better in the near future, either. Nearly one-fifth of the company’s U.S. sales will be zapped away by the Toys “R” Us liquidation. Meanwhile, Hasbro toys will ramp in popularity over the next several quarters, thanks to a strong movie lineup from Marvel. That could mean less market share for MAT.
All in all, Mattel faces a much more uncertain future than Hasbro. As such, MAT stock doesn’t look investable at these levels.
Broken Toy Stock 3: JAKKS Pacific, Inc. (JAKK)
Toy company JAKKS Pacific, Inc. (NASDAQ:JAKK) falls more in the Mattel boat than the Hasbro boat.
Roughly 10% of the company’s sales in 2016 came from Toys “R” Us. While that is less than Hasbro, JAKKS doesn’t really have a lifeline to save it from lost Toys “R” Us sales.
Indeed, much like MAT, the company’s toys were already losing popularity prior to the Toys “R” Us liquidation. Through the first nine months of 2017, sales were down 12% and gross margins had compressed by more than 500 basis points. The Toys “R” Us liquidation accelerated the company’s operational deterioration, and holiday sales dropped nearly 20% year over year, while gross margins fell by more than 900 basis points.
Looking at the company’s portfolio of brands, there really isn’t much to like. An Amazon.com, Inc. (NASDAQ:AMZN) search of JAKKS Pacific reveals a rather unexciting lineup of traditional toys. Search interest related to JAKKS Pacific also remains weak.
As such, it looks like the company’s recent troubles are here to stay for the long haul. Considering the company is unprofitable and loaded with debt, persistent operational headwinds make this stock a sell, even at these lows.
As of this writing, Luke Lango was long AMZN and DIS.