MEGA Brands: A Toy Story
Opposites attract, at least when it comes to magnets.
And interestingly, magnets are also what have been repelling many investors when it comes to shares of MEGA Brands Inc. … while attracting some canny buy recommendations from value-oriented analysts.
MEGA Brands is Canada’s largest toymaker, and the second largest manufacturer of high-quality construction toys worldwide, second only to LEGO. It’s also the second largest company in the U.S. arts and craft market.
Despite this - and despite an impressive growth profile – MEGA Brands shares are off almost 25% from their 52-week high, established in mid-November. And that’s not the first time the stock has slumped.
The breakdown goes back to March 2006, when MEGA Brands announced the recall of 3.8 million of its Magnetix magnetic building sets. This came after one child died and several others were injured after swallowing tiny magnets that had come loose from the toy’s building pieces. At the same time, the U.S. Consumer Product Safety Commission (CPSC) put out a warning about the dangers of magnets on toys being ingested. The move knocked the stock price down from just shy of C$30.00 to around C$21.00.
The stock recovered eventually, and early this year was trading above C$26.00. But recently it was hit with another spate of bad news.
In late April the company announced it was self-insuring for any incidents after Dec. 1, 2006, relating to product manufactured before May 1, 2006. Taking on the risk started the stock sliding, but there was more.
The company, in conjunction with the CPSC, announced a renewed recall of Magnetix building sets. Then in early May, the Chicago Tribune reported that several major retailers and online merchants had pulled the product from their shelves over the previous weekend, amid ongoing concerns over safety issues. The following Monday, the stock opened down 11%.
This flood of negative news has been enough to scare off investors, with the shares now trading at just over C$21.00. But many analysts say that spells opportunity. The thinking of these value-oriented experts is simple: The risks have been overblown, and even if they do become a reality, they’re unlikely to cause more than a short-term hiccup in the company’s longer-term growth story.
Take the renewed recall. Jessy Hayem of Desjardins Securities pointed out in a research resort, the announcement isn’t a new recall, but is “…an extension of [the] previous one issued in March 2006.”
But let’s assume under a pessimistic scenario that MEGA Brands has to toss the whole product line on the scrap heap. If that came to pass, Odlum Brown estimates it would take with it US$0.36 of EPS. Given that the brokerage has forecasted 2007 EPS of $1.80, analyst Stephen Boland said that would leave earnings at US$1.44, or C$1.58. With the shares recently trading at C$21.00, that still gives them an appealing P/E of just over 13.
The self-insurance issue? Here’s what Odlum Brown had to say: “If the company does face additional lawsuits on which it is self-insured, we believe MEGA Brands’ financial capacity is more than adequate.”
And the retailers pulling Magnetix products? It now appears that much of this was due to confusion over packaging. Some product that contained the new redesigned toys were shipped out in older packaging that didn’t have a pre-printed warning label. And as for consumer concerns, U.S. sales of Magnetix products actually grew in 2006.
To understand why there’s still widespread belief in MEGA Brands’ ability to not only overcome these problems but resume its strong growth story, it may help to know a little about the company’s beginnings.
MEGA Brands began life in 1967 as a Canadian marketer of U.S. toys. In 1985, the company began marketing its own line of building blocks, which proved a successful move. The company grabbed significant North American market share, and began expanding internationally. More recently, the company moved into the stationary and crafts market with the acquisition in mid-2005 of Rose Art, now called MEGA Brands America.
The mainstays of its toy division are MEGA Bloks construction toys, and Magnetix building sets. Since launching its construction blocks in 1985, MEGA Brands has rung up 22 consecutive years of profit and sales growth. What’s more, most of that growth was organic, as the company didn’t make its first acquisition until 2005. Today, while LEGO accounts for an estimated 65% of the global construction toy market, MEGA Brands has a 25% share.
This growth can largely be attributed to two factors. Low production costs allow the company to keep its retail prices below its competitors, while still rewarding retailers with above-average margins. Those margins, along with strong turnover, translate into critical and profitable shelf space for MEGA Brands.
As for the future, MEGA Brands plans to leverage its growth abilities in Europe, as well as Latin America and Asia. The company has regularly been able to obtain a 20% market share within three years of entering a country.
Overall, many say the stock offers compelling value given the pullback. Mega Brands also has strong insider ownership, good free cash flow, and high return on equity, which in 2006 was around 23%.
Desjardins Securities has a C$29.50 target, issued when the stock was trading at C$22.67, which would represent a 30% return. Meanwhile, CIBC World Markets analyst Richard Piticco feels that margins will be squeezed somewhat, in part due to excess inventory because of some cancellations of backlogged orders for Magnetix products, and has reduced his target from C$32.00 to C$30.00
Overall, it appears the company is through the worst of it, and it also will be able to financially weather the outcome of outstanding lawsuits, Odlum Brown’s’ Stephen Boland said in a note to clients. “Uncertainty has kept investors away from the stock and we believe it has created an attractive buying opportunity.”
