(Bloomberg) -- When two British inventors approached fledgling toy company Spin Master Corp. with an air-powered plane, co-founder Ronnen Harary didn’t know it had already been rejected by his much larger competitors. All he knew was that it was a blast to fly.
“It was probably a good 45 minutes until the inventors told us to stop because they were afraid it was going to break,” said Harary, remembering the day in 1996 when he and Chief Creative Officer Ben Varadi first got their hands on the prototype for what would become Air Hogs, one of the company’s top-selling toys.
More than two decades later, Air Hogs is still winning accolades, including a 2017 Toy of the Year award for a new Star Wars-branded version. Spin Master, meanwhile, has grown into a C$5.3 billion ($4.1 billion) toy powerhouse, returning about 170 percent since its initial public offering in July 2015, versus 18 percent for Canada’s main stock index, and making Harary, 47 and co-founder Anton Rabie, 46, billionaires on paper.
The Air Hogs narrative highlights how Spin Master has managed to stay one step ahead of the turmoil that’s plaguing the toy industry. But it’s getting tougher. The demise of Toys “R” Us Inc.’s U.S. operations has some analysts saying the sector is unlikely to ever completely recover, and Spin Master’s shares have slid this year alongside those of Hasbro Inc. and Mattel Inc. Meantime, the company’s rapid growth puts pressure on it to take bigger risks and hit more “home runs,” said BMO toy analyst Gerrick Johnson.
So far, the Toronto-based company has proved it’s capable of home runs. Hits such as Air Hogs, along with strategic acquisitions like its purchase of the 120-year-old U.S. stuffed toy company Gund, its stable of outside inventors, its entertainment division and rapid international growth have all contributed to its success. But Harary attributes it to something simpler: Everyone loves a surprise.
Hatchimals, for example, peck their way out of eggs and learn to walk, talk and play games. Bakugan balls pop open to reveal action figures when rolled across the ground.
“I know it sounds very simplistic, but for a child, or even for an adult, it’s those unexpected surprises,” Harary said. “There’s something very magical about that moment, that instant.”
Spin Master’s revenues have been on a steady upward trajectory, growing to an estimated $1.7 billion this year, from $418 million in 2012. A big chunk of that growth can be attributed to the success of Hatchimals. The toys sold out in several locations in Christmas 2016, and they were the biggest single contributor to the 6 percent increase in global plush sales in 2017, according to NPD Group Inc., a U.S. market research firm.
This success has prompted some serious envy in the industry. BMO’s Johnson polled more than two dozen executives at the New York Toy Fair in February, asking them which toy company they most admired, other than their own. Spin Master dominated, with a 53 percent vote. Hasbro took second place, with 18 percent.
“They have an incredible ability to find and discover and execute on new ideas for new products,” Johnson said.
This has been true from the beginning. Spin Master’s first product, the Earth Buddy, turned a simple idea—a nylon stocking full of sawdust and grass seeds that would grow to look like hair—into a winner.
Harary’s grandmother had brought him a similar, non-proprietary product from Israel in 1994 and he saw an opportunity to make it work in Canada. With the help of people hired from a homeless shelter in Toronto, Spin Master manufactured 5,000 in time for Mother’s Day. Within two months, it had secured an order for half a million from Kmart. The product is now a case study for business students at Harary and Rabie’s alma mater, Western University in London, Ontario.
“We were so in the moment,” Harary said. “I wish I would have thought about it more.”
Many years and toys later, the pressure is on to keep rewarding investors, said BMO’s Johnson.
“What tends to happen as you get bigger and bigger is you feel the need to find bigger hits and bigger home runs and take more swings for the fences,” he said.
Unearthing toys that will endure is not easy, though the company’s Paw Patrol, a cartoon about a pack of search-and-rescue dogs, will likely be one. It was the top-ranked TV show by Nielsen Holdings Plc in 2017 for kids aged 2- to 5-years-old and inspired several successful toys, including the 2018 preschool toy of the year and vehicle of the year. Giant Paw Patrol characters even featured in last year’s Macy’s Thanksgiving Day Parade in New York.
“Paw Patrol is a brand that’ll live forever, but I think the challenge for Spin Master is replicating that success,” Johnson said. “They’ve produced a lot of great items over the years, but not a lot of enduring brands.”
Spin Master may also find it increasingly difficult to bring innovative new products to market now that Toys “R” Us is shutting down in the U.S., said Johnson. The Canadian stores were sold to Fairfax Financial Holdings Ltd. for C$300 million.
About 15 percent of Spin Master’s gross product sales came from Toys “R” Us over the last three years, and Johnson recently downgraded the stock to the equivalent of a hold, from buy, over the uncertainty caused by the retailer’s bankruptcy. The company has six buys and three holds, according to ratings compiled by Bloomberg.
“Over the long term, the industry growth rate’s going to slow, relative to what it has been recently, because there’s going to be less innovation,” Johnson said. “Walmart’s going to stick with Barbie Dolls and Disney Princess; they’re going to stick with Hot Wheels and Matchbox.”
Harary isn’t particularly worried about losing Toys “R” Us. He believes such other bricks-and-mortar retailers as Walmart Inc., Target Corp., Kohl’s Corp. and Party City Holdco Inc. will step in to fill the demand that hasn’t already been gobbled up by Amazon.com Inc.
“Kids still want toys,” he said. “There’s still the same amount of birthday parties, and Christmas still comes every year.”
Meanwhile, Spin Master has other growth levers it can pull. Harary said the company is “very focused on” its entertainment unit, with a goal of producing a new TV show every year. These can then be turned into new toys, or leveraged for licensing deals for everything from backpacks to party supplies.
The company is also pursuing growth through acquisitions. Its $79.1 million purchase of Gund closed April 1 and Harary plans to expand the brand into international markets—another plank of Spin Master’s strategy. Its sales outside North America grew to 35 percent of total gross product sales in 2017, and it has a medium-term goal of increasing that to 40 percent.
Spin Master has also maintained a strong relationship with its outside inventors since Harary and Varadi flew the first Air Hogs prototype. Varadi and his team are “constantly on the road meeting with inventors” and probably evaluate “a couple thousand ideas a year” before narrowing it down to 10 or 15, Harary said.
“We have a philosophy here. If we’re paying inventors a lot of money, that means we’re doing well,” Harary said. "We made one mission statement, which has held true to today: We’re open to ideas, wherever they come from."
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