Wall Street to Toy Makers: Get the Lead Out

Toy makers had little to laugh about on Aug. 2, even as a jumpy Wall Street managed a convincing rally overall. After the market closed on Aug. 1, Mattel issued a recall of nearly one million toys in the U.S. and another half-million in overseas markets. The company found potentially high levels of lead paint in the products, made in China.

Recalls are common among toy makers, but this one affected some marquee brands -- the popular Elmo, Dora the Explorer and Diego characters. It comes at a time when consumers are already leery of Chinese products. Bargain hunters initially pushed Mattel's stock (symbol MAT) higher, but by mid-morning it changed course and the stock closed at $23.18, down 1.7%.

Meanwhile, stock in competitor RC2 (RCRC) sank nearly 20% to close at $28.94 after the company reported disappointing second-quarter earnings and lowered profit projections for the full year. RC2 struggled with its own lead-paint issue in June, when the toymaker recalled various wooden railway toys from its Thomas & Friends line.

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The cost of the recall pushed RC2's earnings to 11 cents a share for the second-quarter. Without the recall, the company would have netted 30 cents a share, still below the 38 cents a share it earned in the same quarter last year and below the 35 cents a share analysts generally expected.

Besides the recall, the company's product line for boys (Thomas, Bob the Builder) is facing stiff competition from competitors including Hasbro's Spiderman and Transformers. Not including the Thomas recall costs, the company said it expects to earn $2.05 to $2.15 a share in 2007, down from a previous forecast of $2.60 to $2.75.

To what extent parents remain loyal to Elmo, Big Bird, Dora and Diego remains to be seen. "'Lead paint and toys' -- those words don't go together very well in headlines," says Gerrick Johnson, an analyst with BMO Capital Markets. He notes that some of the toy industry's high-profile recalls in the past year or so, including RC2's, have turned out to be more expensive than originally thought.

And there are other challenges. Barbie, Mattel's icon-in-chief, is no spring chicken, and the fashion doll segment of the business in general has slowed as kids gravitate to toys such as Webkinz, hugely popular because of its Internet tie-in, which lets the swing-set crowd create its own social network online. Johnson also worries that the company’s American Girl line will lose some cachet as the company makes them more widely available in shopping malls. Traditionally, the historical character doll have been purchased via catalog or online, or at lavish stores in select cities, promoted as destinations in their own right.

How low can Mattel go? Oppenheimer analyst Linda Bolton Weiser, who was lukewarm on Mattel even before the recall, sees a floor under the stock in the $18- to $19-share range.

So are toymakers, Mattel in particular, too dangerous for investors to play with?

Don't panic. The first thing to realize is that for mysterious reasons, summer is often a cruel season for toy stocks. More important, most analysts don't expect the recall to have a lingering effect on industry leader Mattel, whose reputation for safety and quality is top-notch. Mattel figures its recall will cost some $30 million, or about seven cents a share. Analysts are expecting earnings of $1.63 a share this year; $1.76 a share next.

And Mattel is seeing strong sales overseas, and should have no trouble logging annual revenue growth in the mid-single-digits, says T. Rowe Price analyst Ira Carnahan. The company's Equity Income and Mid-Cap Value mutual funds own the stock. What's more, the business generates lots of cash to buy back shares or to pay out as dividends. Mattel's 2.8% dividend yield is a big plus.

So while investing in toy makers isn't child's play, long-term investors can be secure that Barbie and Mattel still have plenty of good years left.