RC2 Recalls Profits

There must be a number of executives looking wistfully at last year's profit statement from RC2 (Nasdaq: RCRC  ) and wishing they could have those halcyon days back. The toymaker reported that earnings plunged 44% from a year ago on charges related to the company's product recalls in June and then again in September.

Obviously, the toy recalls were the big news and had a big impact on results. Net sales fell 8% year over year to $143 million, particularly in the preschool and youth categories, which were down 15% from the third quarter of 2006. Not surprising, really, considering toys in those groups suffered from the recalls. Parents would naturally be leery of buying new toys from a company that's had to recall lead-tainted toys not once but twice within a few months. Just ask Mattel (NYSE: MAT  ) , which has had three massive recalls and reported disappointing results.

Equally troubling to my thinking is that the Motley Fool Hidden Gems recommendation is expecting the recalls to have a far greater impact than originally thought. Following the June recall of 1.5 million Thomas and Friends toys, RC2 forecast total recall charges of $7 million to $8 million. Now, with an additional 200,000 toys and accessories being recalled, it is effectively doubling the charges it is expecting to take to as much as $14 million. Either management grossly underestimated the costs the first time around, or the new recalls are way more expensive for RC2.

Earnings took a nasty knock in the form of $5.9 million in charges related to the recalls. Excluding those costs, profits would have been $0.80 a share instead of the $0.52 it reported. While that's fine, as it shows the effects of failing to properly monitor the toys, it is still well below last year's reported earnings of $0.91 per share.

Compare those results to Hasbro (NYSE: HAS  ) , which has generally been able to avoid the stench of lead-based recalls. It has essentially emerged undefeated and saw an 18% increase in revenue and a 34% jump in profits.

This year's results for RC2 have also been boosted by the effects of share buybacks. During the first quarter, RC2 announced a $75 million buyback program, and through September, it has repurchased $72.5 million worth of shares. Buybacks typically indicate a bullish sentiment on management's part about a company's prospects going forward. Typically, but not always. Not when they're used to mask the dilutive effects of stock options, for example, or when they minimize the impact of otherwise disappointing results.

The market seems genuinely pleased with the results -- the stock is up about 3% during midday trading. Perhaps that's investor confidence that the worst is over for the toy maker. Although it has given muted guidance for the full year -- net sales are expected to be flat to slightly down compared to last year -- it doesn't seem to account for the lagging effects the recalls may have on consumer spending habits.

RC2 trades at 12 times forward earnings, similar to Mattel yet at a premium to another untainted toy maker, JAKKS Pacific (Nasdaq: JAKK  ) (at 10 times 2008 earnings). RC2 isn't permanently crippled by the recalls and will rebound, but it seems investors are placing a bit too much emphasis on an early return to stasis that might not be warranted.

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