Toy Stories

This is the tale of two toy companies, the nation's number-one and number-two purveyors of playtime fun. The stock of one is on a roll, having outpaced both the overall market and its main competitor this year by a stunning margin. The stock of the other is laboring under last year's lead-paint-related recalls and has an aging marquee product, but it sells for a song.

Both companies just reported second-quarter results that surprised Wall Street analysts in a good way. So which company's stock, if either, should you buy?

That's a tough call. The answer almost depends more on the type of investor you are than on each company's prospects.

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Investors who'd rather ride the momentum of a stock that has proven itself time and again might prefer country's second-largest toymaker, Hasbro (symbol HAS). Its shares, which closed at $40.41 on July 25, have nearly doubled since mid January.

Hasbro is proving that when it comes to the so-called consumer-discretionary sector of the economy, parents may really not exercise all that much discretion. Even when retailers are suffering and families' finances are stretched, there seems to be money for toys. Hasbro shares have appreciated by an average of 40% over the past five recessions, according to analyst Drew Crum, of Stifel Nicolaus. The company managed to generate sales and profit growth during four of those downturns.

The pattern seems to be holding this time, too, although a recession has yet to be officially declared. Analysts had expected Hasbro's second-quarter sales to decline modestly from the year-earlier period. Instead, the company reported that sales jumped 13.4%, driven by toys with movie tie-ins (Transformers, Star Wars, Iron Man and Hulk), as well as by solid sales in such stalwart toy lines as Littlest Pet Shop, Nerf, Playskool and Monopoly.

Analysts have been revising earnings estimates upward, and on average they now expect Hasbro to earn $2.20 per share in 2008 and $2.51 in 2009. The stock sells at 18 times expected '08 earnings and 16 times '09 estimates, a premium to the market and the competition.

Fans say the stock deserves to sell for more. A licensing agreement with Electronic Arts gives Hasbro entree into the lucrative, fast-growing video-game market, where sales are expected to grow at a 35% annualized rate for the next three years. And demographic trends bode well at both ends of the spectrum, with a mini baby boom in 2006 and the number of grandparents (who collectively spend an average $35 billion a year on grandkids) expected to swell to 80 million by 2013.

And Hasbro likes to return capital to shareholders. In the past five years, the company has generated $1.9 billion in free cash flow (money left over after the capital expenditures needed to maintain the business) and returned nearly $1.4 billion to shareholders through dividends and stock buybacks. At its July 25 close, the stock yields 2.1%.

But the manufacturer of Mr. Potato Head and other childhood icons isn't immune to the risks that plague its competitors. Higher commodity prices have raised costs for toys and packaging. Chinese labor costs are rising, too. Hasbro has said it will raise its prices on September 1, its second boost this year. And if the economy deteriorates further, even the most pampered progeny might have to do without if Mom and Dad are struggling to put gas in the minivan and food on the table.

There's no telling if -- or more likely, when -- a setback will send the stock tumbling from its near-record height. Says Stifel Nicolaus's Crum: "I like the product mix, the management team and the licensing agreements better than those of any other company in the space. But in the current environment, the stock may be priced for perfection."

If you have the hair-trigger reflexes of a momentum investor, by all means, enjoy the ride as long as it lasts. But if you're a value-conscious investor, you may prefer to watch for an entry point in the low $30s before playing with Hasbro.

Or, you might consider shares of Mattel (MAT), the top toy company, with expected 2008 sales of about $6 billion. Mattel's shares have been treading water most of the year. They closed at $20.81 on July 25, down 20% from a 52-week peak of $26.

Mattel, of course, must contend with the same economic forces as Hasbro. But Mattel is also still reeling from a slew of lead-paint-related recalls last year, and the cachet of fashion diva Barbie, the Norma Desmond of the toy industry, continues to fade.

Barbie sales account for nearly one-fifth of the company's revenues. The news for the second quarter wasn't good, with Barbie sales down 6%. But Mattel's overall results weren't as bad as expected, thanks to brisk sales of Hot Wheels and Speed Racer brands, as well as the fanfare surrounding the release of the Kit Kittredge movie, based on a popular American Girl doll.

In the second half of the year, Mattel should benefit from more movie tie-ins, including toys based on mega blockbuster Batman: The Dark Knight, as well as Speed Racer and Kung Fu Panda. Two new American Girl boutiques will open, in Boston and Minneapolis. On average, analysts expect the company to earn $1.47 a share this year and $1.70 next year.

And Mattel just got some good news in its legal dispute with MGA Entertainment over the origins of the popular Bratz dolls. A jury recently found that the original drawings, done by a former Mattel employee, are Mattel property. Damages, which by some calculations may amount to as much as $3 to $4 a share for Mattel, could be decided by the end of July.

Yet even after a recent jump, Mattel is selling at just 12 times estimated '09 earnings, while the stock sports a generous 3.6% dividend yield. "The lead scare is behind us, and the yield, valuation and fundamentals from the bottom up make Mattel a great stock to own," says Don Wordell, manager of Ridge Worth Mid-Cap Value fund, which holds a stake in Mattel. If the rest of the market eventually agrees with him, then Mattel is a bargain.