The World's Largest Toy Market Will Change In 2014

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 |  Includes: ATVI, DIS, MAT
by: Lutz Muller

How Will the U.S. Toy Space Change This Year?

A look at current trends and a peek at the future

We all know that the toy market is going to change this coming year. The question is only which direction this change is going to take? Pessimists point to the decline in toy sales over the past 10 years, the impact of smart phones and tablets, the impoverishment of the middle class, and the declining toy space at retail. They predict that all this is going to spell doom for our industry.

The Glass Half Full

All of this is very true, but there is another way to look at the picture. Yes, the toy market has been either flat or declining since 2003. However, this is measured in dollars, and the picture is quite different if you consider the market in units. In unit terms, it is estimated that the U.S. toy market grew somewhere between half a percent and a percent every year over the last 10 years - pretty much in line with population growth. The difference between the two trends is due to the migration of manufacturing to the Far East, where production costs were (and still are) much lower than in the U.S. This resulted in lower retail prices, hence, eroding toy dollar sales. However, this is about to come to an end. My friends in China tell me that their production costs last year rose by about 10 percent, and this is going to be passed on to the consumer in the form of price increases. This, in turn, will result in increasing overall sales over the next decade.

The question that is often asked is whether a yearly price increase in the 5 to 10 percent range could, in fact, stop sales growth. This is somewhat unlikely for one simple reason: Half of the toys sold this year did not exist last year. Increases will be loaded into those items where there is no way to compare prices. Advertising and promotions will do the rest.

Also, the statistical data underpinning toy market estimates do not take into account a major factor - Skylanders (NASDAQ:ATVI) and Disney (NYSE:DIS) Infinity. The NPD Group, which puts out these market statistics, considers these two products video games, not toys. However, the majority of the sales dollars spent on both ranges is now on the physical toys and not on the game or the console. Had these two product ranges been included in the toy category, there has already been an uptick in 2012, when the Skylanders were first released, and again last year.

Smart Phones in the Toy Space

The impact of smart phones and tablets on the toy market is real, but difficult to measure. Since spending is a zero-sum game, there is no question that the acquisition of a $200 smart phone will take money away from other discretionary purchases such as toys, movies, outings and other things people can do without. How consumer interest levels were impacted by the advent of the iPhone and the iPad is best illustrated by this chart.

There is one area where smart phones and tablets are going head-to-head with toys: - board games. It is estimated that the board game category has lost about 1.5% of sales each year to video games over the past couple of years, and this trend is likely to continue.

Yes, toy space is shrinking. The chart below shows the toy space Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) devoted to toys during the same week in the past seven years:

Click to enlarge

What this chart does not show is Toys "R" Us' overall toy space because of the transformation of its regular stores into side-by-side stores, which devote much more space to the Babies "R" Us Section at the expense of toys. The toy space goes from 60 percent of the regular store to 40 percent for the side-by-side model.

The leading retailers do not cut toy space because they do not like toys; they do it because they sell less of them through their brick-and-mortar stores due to a shift to online transactions. In addition, toy stores are being hammered by competition such as Amazon (NASDAQ:AMZN) and dollar stores.

The chart below shows the latest market share estimate for U.S. toy retailers:

Click to enlarge

While the outlook today is probably better than it has been over the past few years, this does not mean that there will not be fundamental changes. There is first the move from brick-and-mortar store sales to the Internet, as best demonstrated by Amazon's sharp increase in market share. This will have a major impact on both the retailers themselves as well as the major companies making the toys. First, you will need less brick-and-mortar space, and this, in turn, will lead to further reductions in the space allocated to toys. More importantly, as toy sales move from the shelves to online, the promotional and advertising strategies of the toy companies will have to change. The impact of a toy box on the shelf will be replaced by an image on the screen. The toy company will no longer be face-to-face with the consumer, but rather will talk to him or her via an intermediary - the Internet.

Another major change that will undoubtedly gain steam next year is the move to hybrids, combining physical toys and video games - the Skylanders and the Infinitys of this world. There will be more of them, and it is only a matter of time until we see such hybrids in the doll and board game categories. Just like the Skylanders have already begun to disrupt the action figure category, and Infinity the preschool space, these new entrants will profoundly upset the existing order.

The Future of Licensed Toys

Toy licensing is another area where you will likely see changes. Today, 30 percent of all toy dollar sales are in licensed products, and 25 percent in units, and this is driven mainly by movies and TV series. The problem with this is that the young audience for both movies and TV is declining. In addition, the leverage blockbuster movies exert over toy sales appears to be declining - particularly for movies with several sequels. There is also the dawning recognition that licenses basically mean that you let another party - the one that owns the license - control a part of your business. Licenses can be granted and licenses can be taken away, which means that the licensees do not build a long-term asset for their business. Licenses will not go away, but will slowly diminish as a percentage of the total toy space - a trend that is expected to become apparent this year. In parallel, the leading toy manufacturers will probably put more muscle behind the building of their own brands - Mattel's (NASDAQ:MAT) Monsters High and Ever After High are cases in point.

While these developments are significant, they do not herald a basic change in the ongoing love affair between the American public and toys. Parents will continue to look for the best toys they can afford to give to their little ones come their birthday or Christmas, or other holidays.

In summary, the odds are that we shall see solid growth in the U.S. toy market this year.

This article was first published by The Toy Book on February 16, 2014.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.