Toy maker RC2 (NASDAQ:RCRC) will report Q2 earnings after today's close on the back of reports that it will take a larger-than-expected $4 million charge for the June recall of Thomas & Friends wooden railway toys. As you may remember, the voluntary recall was issued after an internal investigation found excess levels of lead in some of the paint used in the toys.

After three consecutive earnings surprises, how will the recall affect second-quarter earnings?

What analysts say:

  • Buy, sell, or hold? Eight analysts cover RC2, with six recommending a buy and two recommending a hold.
  • Revenues. On average, they're expecting a 4.1% decrease in quarterly sales growth to $108 million.
  • Earnings. Profits are also predicted to shrink by 19% to $0.35 per share.

What management says:
Although no illnesses have been reported from the recalled products, management has to be concerned about how the company's internal controls missed such a PR disaster-in-waiting. In the children's toys industry, especially, lawsuits from concerned parents can be quick and severe. Indeed, just last month a class action lawsuit was filed against RC2, claiming that the company committed negligence and fraud for distributing the lead-based paint in the Thomas & Company toys. Hopefully, management will speak to the effects of the recall in greater detail in today's call.

With great quarters posted by larger competitors Hasbro (NYSE:HAS), Marvel Entertainment (NYSE:MVL), and Mattel (NYSE:MAT), the pressure is on RC2 to reassure its investors of its vitality, both in the short and long terms.

What management does:
Has the 14% drop in RC2 shares created a buying opportunity for long-term investors? Margins have been strong and consistent for the company in the past, largely thanks to its strong brands and pricing power, but savvy investors should keep their eyes on the company's margins going forward, to see how the well-publicized recall affects long-term profitability. Here are the recent quarters' figures:

12/2005

3/2006

6/2006

9/2006

12/2006

3/2007

Gross Margin

48.8%

48%

47.8%

47.4%

47.2%

46.8%

Oper. Margin

18%

17.7%

17.8%

17.9%

17.8%

17.4%

Net Margin

10.8%

10.6%

10.4%

10.3%

6.6%

6.5%
All data courtesy of Capital IQ, a division of Standard & Poor's. Data reflects trailing-12-month performance for the quarters ended in the named months.

One Fool says:
This is a very important quarterly call for RC2 shareholders. Long-term investors should pay close attention to management's candor and transparency regarding the recall. With a great bullpen of brands like Thomas & Friends and Bob the Builder, a solid balance sheet, and a beaten-down share price, RC2 has the potential to be a great investment. Today's call gives management an excellent opportunity to remind investors why this is the case.

RC2 is a Motley Fool Hidden Gems pick. Hasbro and Marvel Entertainment are Motley Fool Stock Advisor recommendations. You can check out either service absolutely free for 30 days.

Fool contributor Todd Wenning does not own shares of any company mentioned. The Fool's disclosure policy is on the right track.