Mattel Takes a Hit on Toy Recall

While some Wall Streeters don't think the move will harm the toymaker's long-term profits, one analyst frets about litigation risk

Shares of Mattel (MAT), the world's leading toy maker, held up fairly well after the company said on Aug. 1 that it was voluntarily recalling about 1.5 million toys made by a long-time supplier in China that were produced using a non-approved paint pigment containing lead, which violates industry and Mattel's own self-imposed standards.

Mattel said it will take a pre-tax charge of $30 million against its second-quarter earnings to cover the financial loss from the recall. On July 16, the company reported a profit of 11 cents a share, compared with eight cents a share in the second quarter of 2006, on a 6.5% rise in global sales.

Mattel's shares were down 2.3% at $23.04 in early afternoon trading Aug. 2.

The recall is on certain Fisher-Price products sold between May and August 2007, including characters popular among pre-schoolers such as Elmo, Big Bird, and Dora the Explorer. Roughly 500,000 of the products have been sold to consumers, while the remaining one million are still in the hands of retailers, equities analyst Margaret Whitfield at Sterne Agee & Leach said in an e-mail to BusinessWeek, after speaking with the company. (Sterne, Agee & Leach has done investment banking with Mattel in te past 12 months and makes a market in its securities.)

The El Segundo (Cal.) company said that after detecting the unsafe lead levels in the last few weeks, it launched a fast-track recall, working with the U.S. Consumer Product Safety Commission and other regulatory agencies around the world. It also said it's helping retailers to identify affected products, remove them from retail store and intercept further shipments and prevent them from being sold.

The news is the latest in a series of reports of unsafe ingredients used by Chinese suppliers in the production of seafood, toothpaste and medicines exported to the U.S. and other countries. Perhaps the most infamous of these concerned contaminated elements found in a wide range of pet food brands, which were linked to a number of animal deaths earlier this year. But toy manufacturers have also come under scrutiny since RC2 Corp.'s (RCRC) well-publicized, voluntary recall in June of 1.5 million wooden railroad toys and set parts from its Thomas & Friends Wooden Railway product line.

The problems have eroded consumer confidence about Chinese imports and prompted a new resolve by the country's commerce officials to regain trust among China's trading partners.

Mattel said it's investigating the reasons for using unauthorized paint but has already restarted production at the supplier and estimates it may take only a week to restock shelves, Whitfield said in her e-mail message. The plant in question has no prior history of violations.

"With annual sales of around $6.0 billion, Mattel ships literally hundreds of millions of individual items, so a recall of one million units is hardly material relative to total sales," Wedbush Morgan Securities analyst Sean McGowan said in a research note.

While the immediate financial impact is probably contained, the company could take further hits down the road as a result of litigation risk, though there have not been any specific reports of affected children, Standard & Poor's said in a research note. The research firm trimmed its 2007 earnings estimate for Mattel to $1.60 from $1.64 a share and cut its 12-month target price to $27 from $29.

Given the seriousness with which Mattel takes safety issues and the importance of consumer perception, the company is likely to treat the matter with the highest urgency and won't settle for the cheapest solution, the Wedbush note said. (Wedbush has no investment banking relationship with the company.)

McGowan said he doesn't expect the recall to cloud investors' views of the company in the long term or to have a recurring impact on Mattel's profits. He maintained his buy rating on the stock and a target price of $32, based on a price-to-earnings multiple of 17 times.

Mattel faces other challenges as well. In an effort to combat the encroachment of computerized toys into its targeted consumer base, the company has recently introduced new product lines such as an MP3 player to be used with its web site and the Radica line of electronic devices.