How to Invest in the Toy Industry (You're Buying Them for Your Kids Anyway)

Did you grow up on Hot Wheels and Barbie? Some classic toy brands are still going strong, while others falter and perhaps begin to make way for new players. Mattel (MAT 0.59%) has teamed up with crowd-sourcing invention company Quirky in search of new ideas, while Hasbro (HAS 4.01%) looks forward to kicking off its relationship with Disney (DIS 1.54%)next year.

Join Sean O'Reilly and Vincent Shen for a trip down memory lane to see how old favorites like Fisher-Price and Barbie are holding up, the hottest new toys, and what investors should keep in mind when looking at this colorful sector.

A full transcript follows the video.

Sean O'Reilly: Dust off your LEGOs, we're talking toys on this consumer goods edition of Industry Focus.

[INTRO]

Greetings Fools! I am Sean O'Reilly, joining you here from beautiful Fool Headquarters in Alexandria, Virginia. I am with the incomparable Vincent Shen. How are you today, sir?

Vincent Shen: "Incomparable," you flatter me. Thank you, Sean.

O'Reilly: Why are you laughing? You are incomparable! We could search the ends of the Earth, and we would not find another Vincent Shen.

Shen: That's true.

O'Reilly: We missed you last week. How was Colorado?

Shen: It was really nice.

O'Reilly: You did a lot of hiking, as I understand it?

Shen: A lot of enjoyment of the outdoors. The air there is very clear. The mountains are unbelievable. Within an hour of my drive toward Boulder, I was ready to move to Colorado.

O'Reilly: Don't leave us! You'd be sorely missed.

Shen: It's just too cold. That's the only issue. Too cold.

O'Reilly: It was cold when you were there?

Shen: Yes. The weather was really nice during the day. It could be 60° or 70°, but at night it would be 30°.

O'Reilly: It drops like a stone.

Shen: It snowed for two days.

O'Reilly: Oh my gosh! Got it.

Well, we are talking about toys this week. What got us started on this, for our listeners that are just joining us, is the news that Mattel is teaming up with Quirky, a crowdsourcing invention website where anybody can submit an idea in order to get feedback and try to come up with the next big toy.

Vince, the first thing I want to know is have you been over to Quirky, and have you submitted your amazing toy ideas?

Shen: I have not submitted my amazing toy idea yet, but I do have multiple sets of blueprints ready to go!

O'Reilly: Anybody can head over to quirky.com/mattel and watch the video about the partnership. Mattel's Chief Operating Officer, Richard Dickson, actually publicly stated that, "This marks a new era for Mattel." I actually don't think that's the case, and I'll get to that in a minute.

"Leveraging Quirky's platform, which allows us to discover new ideas for our toys, this new partnership will enable us to accelerate the speed and scope of invention." That, I do agree with -- the very idea that thousands of people can just submit their ideas and eventually hopefully maybe one of them will become a big idea.

This reminded me ... the first thing I thought of was the Cabbage Patch Kids. Of course I had just been born, but that was like the Furby of the 1980s. People killed to get them, and all that.

Shen: I remember the Cabbage Patch Kids.

O'Reilly: The Tickle Me Elmo of the '80s. But it was actually invented by an art student named Xavier Roberts, who started out just selling these little dolls. The bodies were fabric, and the head was of course some kind of harder plastic. They were just sold at craft shows, and they eventually became so popular they got picked up by these major toy companies.

Shen: They became quite the phenomenon.

O'Reilly: Yes, and then everybody found them under their Christmas tree, brought by Santa. This immediately reminded me of that. What do you think about this? Can this help Mattel at all?

Shen: I think it will. It definitely helps having potentially thousands of people. I think Quirky has over a million members, so having that kind of base to potentially draw ideas from is great. If anything, it will just inspire the company.

O'Reilly: It's a cheap way to get ideas, for sure.

Shen: Exactly, and they're running into issues now with innovation and coming out with new product. The big, big brand is Barbie.

O'Reilly: That's not growing.

Shen: Sales for that have been stagnating or actually decreasing significantly in the past few years.

O'Reilly: Their other doll brand, American Girl, is killing it. It's basically making up for the losses at Barbie. My sister grew up on American Girl dolls. I don't know if you've seen any of these stores. I went with my little cousin, who's like 12. These stores are pandemonium. They're packed, and it's not even Christmas time. It was insane.

Shen: I've never seen one of their retail locations.

O'Reilly: It makes no sense to me.

Shen: I have seen the mail-order catalogues.

O'Reilly: Yes, $200 for a doll? They pay it.

Shen: They're impressive, and the girls love them. It's good that their sales for that line are helping them make up for their weakness in some of their other brands.

O'Reilly: For sure. Of course, none of this is surprising to me. I wanted to do this show because I have a 14-month-old son at home -- William, if you're listening to this in the future, how are you?

He's gotten a plethora of toys; tons of toys from Grandpa and Grandma, and all the aunts and uncles.

Shen: I'm sure.

O'Reilly: Just by chance, he got two of the same talking puppy dogs, that you can program to say his name, like "Hi, Will." Just little things like that. Toys are big business, and it becomes all the more apparent when you become a parent yourself.

According to the Toy Industry Association, yes there is such a thing, the total market for toys across action figures, arts and crafts, dolls, games, and of course Nerf guns -- which we buy lots of at Fool Headquarters here -- totaled $18.1 billion last year, which is up a very respectable 4% over 2013, which was $17.5 billion.

Globally, the United States is less than 25%. It's an $80 billion market, just toys.

Shen: That growth for the U.S. last year is pretty good.

O'Reilly: That's very respectable, yes.

Shen: It's a mature industry.

O'Reilly: Actually, as a complete side note -- this has no bearing on what we're talking about at all -- but Christmas sales were flat, but people were buying more toys the rest of the year.

Shen: Oh, is that the case?

O'Reilly: Yes. It was just a little asterisk on the report I was reading. I was like, "Wow, that's weird."

This is of course dominated by what I call the Coke and Pepsi of the toy industry, which are Mattel and Hasbro. You've got, of course, the sidelines like the building sets like LEGO and youth electronics, which are the fastest-growing categories.

Building sets actually grew 13% over last year and the youth electronics -- we'll get to that in a minute -- grew 11%. It's funny to me how LEGO's blown up. I obviously played with LEGOs when I was a kid, and I'm sure you did too. Now you've got these LEGO stores ...

If I could have bought the same colored brick at the LEGO store when I was a kid, and not have to mismatch when I was building my castles and stuff, that would have been awesome!

Shen: I think LEGO has done really well.

O'Reilly: They are private -- just a disclaimer. You can't invest in LEGO, even though I'd love to!

Shen: Exactly. They've done so well, especially recently. They've had a resurgence of popularity, I feel, because they've done a good job partnering with content.

O'Reilly: Right.

Shen: Star Wars is getting really big, LEGO is absolutely going to have toys for that.

O'Reilly: Huge. Everybody has an Iron Man doll. Licensed toys, in this report -- you think, of course, of Iron Man and Elsa from Frozen and all that stuff -- make up 1/3. It's about 31% of the total industry, and that's a 3% gain over last year.

Of course, the top selling toy property last year was Disney's Frozen. Every little girl had to have an Elsa doll last Christmas.

Shen: Yes, it made for about $530 million of toy sales last year.

O'Reilly: Oh my gosh.

Shen: That is a very impressive showing for Elsa.

O'Reilly: And they're making a Frozen 2. Just for all you parents that are listening, have fun with that!

Did you hear what happened with the director of Frozen?

Shen: No, what happened?

O'Reilly: Of course everybody comes up to her and was like, "We loved Frozen! Thank you so much for making it." It eventually got to the point where she just apologized to the parents for all they're having to do!

Shen: Some parents, I'm sure, have seen that movie probably 20 times.

O'Reilly: Yes. DVDs are being destroyed by just watching so much.

Anyway, back to business. Talk to me about Mattel and Hasbro. How big are these companies? How profitable are they? What are their major brands?

Shen: Mattel, their big brands being the American Girl dolls, they have Barbie, they also have I believe some classics from my childhood, including the cars like Hot Wheels.

Size wise, between Mattel and Hasbro, they're actually very, very similar at about $9.2 billion market cap, but Hasbro has been showing the stronger stock performance lately.

Mattel is trading at about $27, which is about 20 times their 2015 earnings. They've hit some weakness. They recently reported earnings for the first quarter of this year, and for them a win is not losing as much money as Wall Street was expecting.

O'Reilly: Just a decrease in earnings, you mean.

Shen: Yes. They're down, but they weren't down as much as Wall Street was expecting, so that's a win for them. Whereas, Hasbro is actually growing. It's beating on the revenue and earnings lines.

Something else that surprised me for both of these companies, especially Mattel, is the yield that they pay.

O'Reilly: They're paying out dividends?

Shen: They pay a $0.38 quarterly dividend right now. That's a 5.6% yield for Mattel.

O'Reilly: Oh my gosh! What does that say from a capital allocation standpoint? The management is literally saying, "We can't reinvest this profitably, so we're going to do the responsible thing and send the money to shareholders."

Shen: Potentially. The thing is, their payout ratio was about 55% a year or two ago, so very reasonable. But it was recently when they've run into some of their weak earnings, that it's jumped to 100 or more.

O'Reilly: Wow.

Shen: Another big toy that Mattel has coming out, that I think they're really hinging their hopes on, is the Hello Barbie, which is a smart version of the Barbie, that kids can essentially press a button and a microphone will record what they're saying, send it to the cloud, memorize favorite items of theirs, their name, things like that.

Kids can really develop a relationship with this Barbie. Some people are really excited about this. A lot of people on the privacy side, for example, are extremely concerned over what this might mean for privacy of our most vulnerable people, children.

O'Reilly: Yes. I don't think when we read about Big Brother in 8th grade Lit class that they mentioned Barbie at all. That seems to be the case here!

Shen: It's a very unintimidating way to go about it.

O'Reilly: This has had a bunch of backlash, as I understand it.

Shen: Yes, it has, from some parents and other consumer groups who are concerned that these companies are essentially going to be able to build personality profiles for each of these kids who buy this toy. They're not happy about that, of course.

At the same time the company is trying to defend their actions, saying the information is going to be private and it won't be used to subliminally market to these children, telling them to buy more Barbie products, or make their parents buy them for them.

O'Reilly: This really isn't any different than what Facebook does, though.

Shen: Exactly. In the end, for adults, if you use Google or Facebook or anything along those lines, it does way more.

O'Reilly: They know everything about us.

Shen: But you have to keep in mind, these are children.

O'Reilly: Right.

Shen: That's where the real hot-button issue is. I've seen videos. I highly recommend that anyone listening to this ...

O'Reilly: This is all over YouTube.

Shen: Go on YouTube, search "Hello Barbie" and look at the recent demonstration they had at a toy expo. It's pretty impressive. She can hold a pretty good conversation.

O'Reilly: Oh my gosh! Bringing it back around to Hasbro, they seem to be on the upswing. They seem to have a lot of these deals with the Disneys and the Jurassic Parks and everything.

Shen: Yes, Hasbro is benefiting big time from some of the trends that are happening to the toy industry, one being a lot of its partnership with content, be it TV shows or movies.

Last year Hasbro put up big numbers because they had I think three or four Marvel movies come out. This year they're already starting to see a boost from Jurassic World. They have Star Wars coming at the end of the year. They had Transformers last year. These content partnerships for these toys are really, really important, the licensing.

O'Reilly: Correct me if I'm wrong; Marvel's got a movie scheduled for the next ... five years?

Shen: Exactly.

O'Reilly: They're making another Star Wars trilogy, so there's that. I have to think that Hasbro is pretty well set until the end of the decade.

Shen: Exactly. It's a really nice schedule for them, where they know they're going to see strong demand with each release from these movies.

In 2016, the icing on the cake is that Mattel's licensing with Disney shifts over to Hasbro. They were able to win that deal. Starting in 2016 they will get exclusive rights to produce Disney Princess toys.

O'Reilly: Do you know -- and it's totally fine if you don't, I'm just curious -- do you know if Mattel had to pay Disney and Hasbro just outbid them or anything? How did they win that?

Shen: I would not be surprised. I'm not actually certain. I imagine it's something along those lines.

O'Reilly: I know Disney doesn't make their own toys. It's easier for them to just let people make the plastic, and they just get a check.

Shen: They get some compensation for that. Yes, I'm sure. It's not a small amount, either.

Like we said, just for Mattel Disney Princess dolls contributed about $500 million of revenue for the company in 2014. That's something that they will be missing, and Hasbro will be happily taking over.

O'Reilly: Right. That dividend seems to be the only reason to give them a look.

Despite the success of Mattel's American Girl dolls and Hasbro's obvious advantage partnering up with Disney, and all these movies that are coming out, all is not right in Toyland with companies like LeapFrog (LF.DL).

Shen: Ah, yes. LeapFrog is a smaller player focused on the other big trend that we're seeing in the toy space, which is trying to integrate technology. For Mattel and Hasbro, they've been better off sticking to the basics with their dolls and such.

O'Reilly: These toys are over half a century old. It's worked for a while.

Shen: Yes. How long have action figures and dolls been around? Forever.

O'Reilly: Right.

Shen: Mattel and Hasbro had previously tried to integrate more technology into their toys. It didn't really work out well for them. They're sticking to the basics, and that's generally working pretty well, especially for Hasbro.

But then you have smaller companies like LeapFrog, which I think is around a $150 million market cap, maybe?

O'Reilly: Very, very small, yes.

Shen: They originally started out as more of an educational focus, basically convincing parents by saying, "Some of these products, being electronics, are a little more expensive, but don't you want the best for your children?"

They would really market to schools and teachers, knowing that if teachers use them in their classrooms, that's the perfect marketing scheme for kids. If the kids want it, then the parents will get it for them.

"Scheme" is a strong word, because in the end it did prove to be helpful. They invested in a lot of research to say, "LeapFrog is helping with a lot of reading, early childhood development, and things along those lines."

But they've moved away from that. They are also a very niche product, and one of their big competitors has been taking quite a bit of market share away from them. They've seen struggles.

O'Reilly: Got it. Bring it back around. This is The Motley Fool; what would you say is the investing takeaway here?

Shen: The issue is that Mattel's prospects are a little on the bleaker side, whereas with Hasbro people are bullish, and you can see that in the stock. It's trading near its 52-week high. It's trading at about 23 times 2015 earnings, so not anything absurd.

O'Reilly: Not cheap, but it's not absurd.

Shen: Exactly. If you are looking for maybe some of the more innovative products, you would look toward some of the smaller companies, like an earlier LeapFrog for example.

O'Reilly: It seems highly speculative.

Shen: Exactly. It's definitely a little bit riskier. Otherwise, this is a mature industry. There are always going to be toys. I think that on the longer-term investing horizon that we try and take here at The Motley Fool, Hasbro definitely has stronger prospects overall.

O'Reilly: Awesome. Very good. Thank you for your thoughts, Vince.

Shen: Thank you, Sean.

O'Reilly: Have a good one.

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