Mattel's recall rebound

NEW YORK (CNNMoney.com) -- Mattel Inc., the world's largest toy maker, is nursing a black-eye after a series of high-profile recalls this summer. But some industry experts think the worst is over for the company and that the stock is now a bargain for long-term investors.

Mattel was heavily criticized for allowing Chinese made toys with unacceptably high levels of lead paint to enter U.S. stores. The company's CEO, Robert Eckert, was called to testify before a Senate subcommittee in September, where he officially apologized and reiterated the company's commitment to safety.

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The controversy then took an unexpected turn when Mattel (Charts, Fortune 500) announced that a significant portion of the toys were recalled because of a design flaw and not substandard manufacturing. Ultimately, Mattel apologized to the Chinese for its earlier criticisms.

During the height of the recall flap, Mattel's stock plunged as much as 25 percent from its year-to-date high. However, the stock has rallied nearly 10 percent since hitting a 2007 low in September. The stock is still a long way off from its highs and it has underperformed its top two peers - Hasbro (Charts) and JAKKS Pacific (Charts) - this year. But the recent bump is viewed by one fund manager as a good sign.

"People are starting to see a bottom," says Ben Mackovak of Rivanna Capital LLC, a Charlottesville, Va.-based fund holding 154,000 shares of Mattel. "They're realizing Mattel is not going out of business."

Investors should learn more about the impact of the recalls when Mattel reports its third quarter earnings on Monday. According to analysts surveyed by Thomson First Call, Mattel is expected to report revenue of $1.91 billion for the quarter, up about 7 percent from a year ago and earnings per share of 70 cents, an increase of 8 percent.

So despite the unflattering press related to the recall, is now the time to add Mattel to your portfolio?

This summer's woes generated the kind of buzz that public relations departments dread, but will it have a lasting effect on Mattel's performance?

In a research report released this week, Michael Savner, an analyst with Bank of America, estimates the cost of the recalls at approximately $24 million, an amount that he dubbed as not "significant."

At the same time, Savner maintained a "neutral" rating on the stock, citing "the risk of additional negative headlines and lack of visibility into the performance of toy sales during the holiday season given recent recalls."

But some experts stress the importance of taking a longer view. Rivanna Capital's Mackovak said parents will obviously be concerned about their kids' safety, but he doubted that the recalls will cause people to never buy a Mattel toy again. In other words, this too shall pass.

Another analyst pointed out that Mattel has significantly improved its testing processes in recent weeks. This is a key issue and an important part of Mattel's recovery, according to Wedbush Morgan analyst Sean McGowan.

"Mattel's problem was a testing problem - and they should have been testing more," McGowan said. "But they are testing everything now and I don't expect to see any more problems."

For the toy industry, the importance of the holiday season cannot be underestimated. Mattel is expected to generate nearly half of this year's profits during October, November and December.

But so far this year, no clear front runner among the A-list of "must-have" toys has emerged.

Last year, Mattel had a big hit with its T.M.X. Elmo doll, an "extreme" version of the traditional plush toy, which sold out during the pre-holiday shopping frenzy.

Despite the short shelf life of most "must-have" toys, the Elmo trend is still going strong, so the fuzzy, red creature, or some new member of the "T.M.X. friends," could be a hit again this year.

Mattel introduced new multimedia products this spring in support of its classic Barbie brand, which has struggled recently in domestic markets. BarbieGirls.com, which allows girls to play and interact online, and the latest "Barbie of the Island" direct-to-home DVD, could be significant drivers for holiday sales.

Another of Mattel's featured products this holiday season is the Fisher-Price Smart Cycle, a "physical learning arcade system," according to the company's website. The Smart Cycle picks up on the popularity of video game related toys and could be a hit with parents because of its educational slant.

The lack of a clear-cut "must-have" toy does not appear to have those in the business worried.

"A fad toy creates buzz around the toy industry as a whole and might get people into the stores," according to Chris Byrne, contributing editor for Toy Wishes magazine. But the absence of a "cultural phenomena" toy, like last year's T.M.X. Elmo, is not necessarily a problem.

Mattel has a number of classic brands, like Hot Wheels and Barbie, "that aren't talked about but should do a decent volume," according to Byrne. In fact, one of Mattel's strengths is its wide and easily recognizable portfolio of products.

As Byrne put it, "Mattel has a lot of stuff that kids want."

Despite the recall concerns and a cloudy holiday outlook, some analysts have become more optimistic about Mattel's outlook. Two months ago, only one of the ten analysts following the company rated it a "buy." Now three analysts designate it a "buy," as analysts from Piper Jaffray and Oppenheimer have upgraded the stock in the past two months.

The optimism seems warranted. For one, according to estimates from Thomson First Call, the company is expected to report revenues of $6.33 billion in 2008, up 4.5 percent from this year. Earnings per share are projected to increase by more than 8 percent from 2007.

Meanwhile, Hasbro is expected to report a sales decrease of 2.5 percent from this year and an earnings decrease of 2 percent, according to estimates from Thomson/First Call. Mattel is also expected to post stronger growth than Hasbro in 2009.

Yet, Mattel's stock is trading at 13 times next year's earnings estimates, a discount to Hasbro, which trades at 15 times 2008 earnings forecasts. So Mattel might be a bargain.

Mattel is trading at a bit of a premium to JAKKS Pacific, which is valued at 11 times 2008 earnings projections. But the company is expected to report higher revenue and profit growth than JAKKS Pacific for the next two years, as well.

For Mattel, 2007 was clearly "the year of the recall," said Wedbush Morgan's McGowan. But Mattel is poised to put it in the past. And once investors realize that the company's prospects look brighter than those of its competitors, Mattel should be back on track.