Toy fears play into investors' hands

By Michael Brush

It's a parent's worst nightmare: The Big Bird in the nursery is coated with lead paint.

And it's reality for thousands of parents across the country as toy makers and retailers have in recent weeks recalled products made in China because of lead paint and other safety issues.

It's an atmosphere that has investors bailing out of toy maker stocks big time. As a group, they are down almost 9% since Aug. 1, when the bad news really started to ramp up. Investors worry that toy safety concerns will hurt sales during the all-important holiday season, when these companies ring up more than a third of their annual sales.

As troubling as it is for parents, I think investors are worrying too much about the problem. Ultimately it's fixable. China will figure out how to make all of its toys lead-free.

And we know from experience that consumers have a great capacity to either forgive or forget problems and restore a company's reputation. Remember how Martha Stewart was supposed to lose her sway over consumers because of her legal problems?

All this makes stocks like Mattel (MAT, news, msgs), RC2 (RCRC, news, msgs), Hasbro (HAS, news, msgs), Jakks Pacific (JAKK, news, msgs) and Marvel Entertainment (MVL, news, msgs) attractive contrarian investments over the next six months.

Toy stories

Mattel has grabbed most of the attention with three big recalls since Aug. 1. But the toy safety problems actually can be traced back to the middle of June when RC2 yanked 1.5 million Thomas & Friends Wooden Railway toys because of concerns about lead paint. Hasbro followed up in July when it pulled Chinese-made Easy-Bake ovens from the shelves because of defects that may cause burns.

Things really started to melt down for the toy makers after the close on Aug. 1. RC2 announced second-quarter profits dropped 73%, thanks in part to recall costs. RC2 said recall costs could reach 37 cents a share for the year. It now expects to earn $2.05 to $2.15 per share for the year.

Later that day, Mattel dropped the first of its bombs when it recalled 83 toys made by its Fisher-Price unit, including Big Bird, Elmo, Dora the Explorer and Diego. By the end of the month, Mattel had recalled more than 21 million Chinese-made toys worldwide. Barbie accessories like Dream Puppy House and characters based on the movie "Cars" made the list because of lead paint. So did toys like Doggie Day Care, because they contain small magnets that could be harmful if swallowed.

In the most recent recall, Toys "R" Us on Aug. 31 pulled Chinese-made art sets because of excessive levels of lead in some watercolor paints.

An opportunity for outrage

To make matters worse for the toy makers, politicians are getting into the act. Democratic presidential candidate John Edwards said earlier this month that if Mattel "can't ensure the safety of the children's toys it is selling to families, our government must do it for them." A Senate Appropriations subcommittee led by Dick Durbin, D-Ill., grilled Mattel Chief Executive Robert Eckert about what went wrong. The Consumer Product Safety Commission is looking into whether Mattel waited too long to notify the government about recalls.

All of this could hardly come at a worse time for toy makers. It's now "crunchtime" as they focus on getting the right products to the store shelves in time for the holiday season. They don't need any distractions. "The anxiety meter . . . is about as high as it gets right now," Mattel's Eckert told investors in a July 16 conference call before news of the first Mattel recalls broke.

Toy makers generate more than a third of their revenue in the fourth quarter, and more than two-thirds in the second half of the year. The toy scare increases the chances they will make tactical errors in planning for the all-important Christmas shopping season.

Continued: Beaten-down stocks should rebound

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