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More Downside Ahead for Spin Master Corp.

Spin Master Corp. (TSX:TOY) has been tanking thanks to a large number of defective Hatchimals that caused backlash on social media after Christmas. The company is already struggling to keep up with current demand for the toy, but this hiccup could mean a further correction in the stock price back to more reasonable valuations.

The issue of Hatchimals not hatching and alleged potty-mouthed units will not hurt the stock for the long term, but I believe the short-term impact could be devastating to the stock. The company will have to replace all of the defective units, and this could result in the next few earnings reports to be more modest than expected.

The Hatchimals issue is just a catalyst for the stock correcting itself. The stock is ridiculously overvalued and has run up far beyond what it should have. The stock became speculative as traders piled into the stock on news that Hatchimals was experiencing demand that hasn’t been seen since Tickle Me Elmo.

The problem is that Spin Master wasn’t able to take full advantage of the overwhelmingly high demand, and earnings will actually be quite modest to start 2017. Traders who are piling into the stock at these levels are expecting Spin Master to report ridiculously high earnings, but this is not going to happen in the short term. As a result, traders will start jumping out of the stock because they can’t think past a horizon of a few months, and investors will be left with a falling stock.

I like the business for the long term, though, as the people running the company have a terrific vision. It’s just a matter of improving its operations, and the company will do very well for many years to come.

The stock has terrific growth potential, but the current valuation doesn’t make any sense, especially considering how dangerous it is to own at current levels. There are many short-term thinkers in the stock right now, and you can count on ridiculous volatility to start the year.

The stock currently trades at a 29.8 price-to-earnings multiple with a hefty 7.6 price-to-book multiple, and an absurd 31.5 price-to-cash flow. Although I like the company, there are unrealistic expectations of the company, and, as a result, we could see a short-term correction to the high $20 level over the next few months.

Remember, all of the hype is about one product right now. Hatchimals, while a terrific product, is a single source of failure for the company. There are unrealistic expectations for the next earnings report, and I believe the stock could correct further before the next earnings report is released.

If you want to get a piece of Spin Master, then wait until the stock is cheaper. It will get cheaper considering the huge amount of volatility in the stock. Just be patient and sit on the sidelines until the stock falls to the $30 level, then buy more on the way down. This way, you’ll cut down on risk and avoid the traders that are causing the short-term volatility.

Stay smart. Stay hungry. Stay Foolish.

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Fool Contributor Joey Frenette has no positions in the companies mentioned.

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