Year-to-date, Leisure Goods is the best performing FTSE All-Share sector, primarily due to share price strength at its biggest constituent, photo booths operator Photo-Me International (PHTM). Also at play is risk appetite among investors convinced the prolonged bout of consumer gloom could be lifting, as demonstrated by recent share price rebounds at a number of this tiny and eclectic sector’s micro-cap players.

Often overlooked by investors, the leisure goods sector sports a limited number of firms whose expertise ranges from toy design to the distribution of consumer electronics and bicycles. Unhappily for investors, their fortunes are intimately linked to the stocking patterns of retailers and demand from currently cash-strapped consumers. Sales are lumpy and seasonal so forecasting profits can be tricky. With the squeeze on household disposable income continuing and consumer confidence still fragile, retailers remain reluctant to purchase excess inventory they may have to shift at a discount should demand fail to appear. The market also remains highly promotional, while unseasonable weather will not help firms looking to meet profit targets. All in all, there is scope for purveyors of bicycles, sports products and toys to post further disappointing announcements throughout the rest of 2013.

That said, there is upside potential in certain stocks. Photo-Me International is one example, as it boasts geographical diversity and copious cash reserves which should underpin investment in money-spinning new products. Fantasy miniatures maker Games Workshop (GAW) looks capable of firing the market’s imagination too, as its revenue streams look resilient and international market prospects promising. Elsewhere, risk-tolerant portfolio builders might like to further scrutinise health and well-being services specialist Fitbug (FITB: AIM) ahead of a potential profits breakthrough.

Under pressure

Two of the sector’s better-known businesses are model railways specialist Hornby (HRN) and toy products designer Character (CCT:AIM). Each has form when it comes to profit warnings, with both companies reliant on retailers who remain exceedingly cautious with regards to stock levels. Besides the fact that they sell products which are seasonal - Character in particular has a high dependence on Christmas - they operate in highly promotional, margin-crimping markets. While investors may be bidding shares in the General Retailers sector higher, consumer spending will continue to be impacted by the spectre of inflation and low public confidence, which means forecast risk in the leisure goods sector remains high.

Recent retail statements offer a valuable read-across to leisure goods. Last month’s (17 April) full-year figures from Tesco (TSCO) highlighted an alarming 5% decline in general merchandise sales, which included the supermarket giant’s leisure goods offerings ranging from toys and bikes to car audio products. These are all discretionary items the consumer can do without when times get tough. Terry Duddy, boss of Argos-to-Homebase-owner Home Retail (HOME), reported a continuation of subdued consumer spending amid further pressure on disposable incomes in his firm’s annual results statement last week (1 May). Significantly, the £1.3 billion cap bemoaned the negative impact of poor weather conditions on seasonal sales as well as difficult market conditions in big ticket categories, trends which can have hardly helped leisure goods purveyors either.

The extent to which the market may be overestimating the consumer confidence revival is also demonstrated by the latest GfK consumer confidence barometer (30 Apr), which reveals a one-point fall in the index to -27 for April. Conducted by research giant GfK for the UK on behalf of the European Commission, the barometer saw three of its five key measures decline in April. These included decreases for the index measuring changes in personal finances over the last 12 months, for the forecast for personal finances over the next 12 months as well as the major purchases measure.

Nick Moon, managing director of social research at GfK, says: ‘After three months of stability the next move of the index was always going to be important. A move up would suggest that the index had indeed “paused for breath” after its rise at the end of 2012 and was still heading in the right direction. But instead the fall back, even though by only one point, implies the recovery in confidence has stalled, and real recovery looks a long way away.’

Test of character

Acutely exposed to retailer caution is Hornby, the hobby products play behind the eponymous model railways brand as well as Scalextric slot car toys. The £32.3 million cap’s progress in 2012 was derailed by poor Olympics-related merchandise sales and supply chain issues in China, causing the company to warn on profits (25 Sep) then suspend the interim dividend (9 Nov). However Hornby (28 Mar) soothed sentiment with a more positive market missive (28 Mar). The Margate-based business stated trading into the year-end had been in line with expectations, flagged a broadening of its supplier base and the well-received launch of new products at international toy fairs earlier this year. Shares expects a bullish update on the company’s new ‘Quick Build’ model concept for the Scalextric and Airfix brands alongside next month’s (7 June) full-year figures.

Hornby’s story of brand strength and a broad geographical base is a compelling one, although in the near term fragile consumer confidence is distinctly unhelpful for higher-ticket Hornby and Scalextric product sales. Broker Numis reckons forthcoming finals to March will show a drop from £4.5 million taxable profits to a break-even result, ahead of profits recovery to the tune of £1.8 million for March 2014, giving earnings per share of 3.4p. Based on the 85.1p share price, Hornby trades on a punchy 25 times prospective earnings, a multiple reflecting its depleted profits and one which is unlikely to have value-seekers salivating.

Retailer caution and discounting is a particular concern for Character, the toy designer and distributor languishing at 126p, off of a 52-week high of 159.5p. Sentiment has worsened in the wake of profits warnings last year (27 Jul ’12 and 9 Nov’12), although the shares tempt risk-tolerant investors looking for a recovery play.

As anticipated, last week’s (2 May) half-year figures to 28 February were poor, showing a swing from £5.6 million taxable profits to losses of more than £1.9 million. On the positive side, the £28.3 million cap, whose leading branded ranges include Doctor Who, Peppa Pig, Fireman Sam and Scooby Doo, maintained its interim dividend at 3.3p and said it expected to return to profit in the second half of the fiscal year to August. The company insisted the unveiling of new season’s ranges at toy fairs in London and the Far East had gone well, while international sales, up 25% in the first half, have been building nicely. Based on a forecast 6.6p annual dividend, the shares offer a prospective yield of 5.2%.

Brighter picture

Within the leisure goods sector, there are opportunities to position your portfolio towards strong cash generation, progressive dividend payments and potential forecast upgrades. Photo-Me International is a printing kiosks to photo booths operator with a vending equipment estate spanning 15 countries, primarily the UK, France and Japan. Guided by major shareholder and CEO Serge Crasnianski, Photo-Me generates robust cashflow through an operations division which underpins its steady stream of dividends as well as potential for further special payments. It could be worth pocketing stock ahead of full-year results due this summer, where further forecast upgrades are possible as the £278.5 million cap flags positive momentum in key markets combined with the benefits of new product launches.

Potential earnings catalysts going forwards include the roll-out of higher-margin photo booths designed by Philippe Starck, as well as the delivery of the Leatherhead-based company’s new Revolution-branded laundry machine product to supermarkets in France and Belgium. Balance sheet strength is a further reason to invest in this business, which boasted a £70 million net cash pile at the half year and paid out £11 million in special dividends in March.

Continuing to generate copious amounts of liquidity, additional returns of cash could be on the cards. For the year to April, finnCap forecasts 20% growth in taxable profits to £24 million and a 15% earnings per share advance to 4.6p, ahead of £27 million profits and 5.2p of earnings for 2014. Shares believes those numbers could yet prove conservative, while the broker’s 90p price target implies 17.5% upside versus the 76.6p price at the time of writing.

Marching on

Another resilient potential portfolio pick is Games Workshop, the fantasy miniatures maker whose shares have rebounded from 600p in March to 697.5p. The Nottingham-headquartered company behind the Warhammer brand has a niche and strongly cash-generative business model, which underpins its scope for profitable growth in tough economic times as well as an attractive dividend yield and scope for special payouts. Moreover, Games Workshop boasts growth potential in countries where legions of hobbyists have the financial means to continue spending money on its products amid inclement economic conditions.

Interims to 2 December (18 Jan) showed a 17% year-on-year profits advance to £11.1 million, well ahead of the £9.5 million expected by broker Peel Hunt. With sales up 10.4% at £67.5 million and operating margins expanding from 10.3% to 15.7% in the core business, high operational gearing enabled profits to comfortably smash forecasts. Significantly, Games Workshop generated sales growth across all regions including the UK, US, Europe and Australia.

Supporters argue the £203 million cap is set fair for further earnings upgrades as it opens hobby centres and independent stockists around the world and profits from a steady stream of new product releases. On the retail side, the company is shutting under-performing hobby centres and relocating to cheaper one-man locations so it can improve profitability and return on capital employed (ROCE). Games Workshop is also seeing good growth in higher-margin trade sales, which is indicative of improving earnings quality.

Ahead of this summer’s numbers for the year to May, Peel Hunt’s Charles Hall forecasts 8% growth in taxable profits to £21 million and EPS of 47.6p. For 2014, pre-tax income is expected to march ahead to £22.5 million for EPS of 49.9p, placing the shares on a relatively undemanding prospective PE ratio of (price/earnings) of 14 times. Based on the Hall’s 45p dividend estimate, the shares offer an attractive yield of 6.5%, which means Games Workshop could appeal to investors seeking growth, income or a combination of the two.

Small fry

Elsewhere, the leisure goods sector is home to much smaller fry enjoying varying fortunes. Casdon (CDY:AIM), the Blackpool-based toy replicas developer, grew sales 34% to £4.5 million in the half to October. Buoyed by growth overseas, the £3 million cap’s taxable profits more than doubled to £692,000.

Shares in consumer electronics company Armour (AMR:AIM) have more than doubled to 4.5p year-to-date. The £4.3 million cap, chaired by the influential Bob Morton, is heavily dependent on retailer demand and its in-car communications and home entertainment products are a discretionary purchase. Nevertheless, the share price has responded to news of an encouraging start to the new financial year assisted by restructuring, new product launches and the targeting of new markets to lessen its reliance on retailers.

Another firm that has enjoyed a share price rebound in 2013 is Tandem (TND:AIM), the £4.5 million cap distributor of cycles under the Claud Butler and Dawes brands. While it is also at the mercy of retailer stocking sentiment, Tandem generated improved taxable profits of £830,000 for 2012, against £820,000 for an 11 month period in 2011. Poor weather year-to-date will not be helping sales of bicycles and accessories so a further profits disappointment cannot be categorically ruled out.

One micro-cap stock exposed to more compelling markets is Fitbug, the provider of online personal health and well-being services which target business-to-business markets. Valued at just £1.8 million on a share price of 1.05p, the company combines activity tracking devices with web technology to help people improve
their lifestyles through realistic changes to daily routines. Management sees significant opportunities to sell its service to health insurers as well as fitness and rewards providers.

Chairman Fergus Kee remains convinced Fitbug is well placed to grow strongly in the vast US health market, where the need to deliver care at lowest costs is the greatest. In particular, Fitbug is a prime play on the buoyant connected health market across the pond, where it has been signing up a number of deals. Latest available forecasts suggest Fitbug could reach break-even this year ahead of a profits breakthrough in 2014, although the loss-making firm is most definitely not one for widows and orphans.

» Conclusions

Leisure Goods

» Summary

Retailer caution on stocking at a time of fragile consumer confidence means the risks to forecasts are high. Our preference on the whole is for cash-generative firms with geographical diversity of earnings and balance sheet strength.

SECTOR PEST ANALYSIS

Political

• US needs to control health care costs

• Era of austerity in the West

• Drive to promote cycling

Economic

• Purchasing power of big retailers

• Cheap imports from Europe

• Rising Far East labour and input costs

Social

• Obesity epidemic in developed economies

• Rising middle classes in developing economies

• Fragile consumer confidence

Technological

• Retail shift toward the internet

• Growth of online communities

• Just-in-time stock management systems