RC2 Treading Water

The recall wave that swept over toy retailers last year continues to inundate the affected companes, but the receding waters reveal a less devastated landscape than many observers feared.

Thomas & Friends toy train distributor RC2 (Nasdaq: RCRC  ) , which seemed to start the ripple last year with the first highly publicized recall of a popular children's toy tainted by lead paint, has been one of the hardest-hit toymakers. Shares have fallen nearly by half over the past year, as fears of pulled licenses, high litigation costs from shareholder lawsuits, and undermined ability to get shelf space gripped investors.

RC2 reported second-quarter losses yesterday of $6.4 million, or $0.37 a share, on lower sales of $89.2 million. However, the numbers aren't quite as washed-out as they seem.

First, based on the numbers the major toy companies are reporting, any hesitancy parents displayed about buying toys last year has now evaporated. Mattel (NYSE: MAT  ) , which suffered through no less than three recalls last year (not all related to lead paint), has seen its shares fall, too. But it's made up much of its lost ground, churning out profits even with lackluster sales. Add in the potential to win royalties on, if not ownership of, the wildly popular Bratz line of dolls, and Mattel could see some serious growth potential.

Hasbro's (NYSE: HAS  ) toys stayed untainted by lead-contamination recalls, and the company has been profiting handsomely from its lucrative deal with Marvel (NYSE: MVL  ) . Its toys and games are supported by theatrical debuts and television exposure that drive demand higher. Even JAKKS Pacific (Nasdaq: JAKK  ) , roughly the same size as RC2, had rising sales, though its earnings took a hit from litigation expenses.

This is where RC2's results become less muddy. Its losses include a one-time hit of $15 million, the payment the toymaker made to HIT Entertainment to settle the Thomas affair. At the same time, it extended its licensing agreement with HIT for the wooden trains, accompanied by a reduction in licensing payments. Investors no longer need to worry about RC2 losing the rights to the toy, which represent a large proportion of its sales.

Moreover, the company settled a class action lawsuit regarding the lead paint back in January. And among the retailers it depends on for more than 40% of its sales -- Wal-Mart (NYSE: WMT  ) , Target (NYSE: TGT  ) , and Toys 'R' Us -- RC2 has expanded shelf space, if anything.

If you back out the one-time payment to HIT, you find that RC2 was actually able to turn a profit of $0.21 a share. That's assuredly less than what it earned last year on a comparable basis, but it marks a turning point for the toymaker. RC2 should manage to return to its prior growth track, and continue to play with the big boys.

Toy around with further Foolishness:

RC2 is a Motley Fool Hidden Gems recommendation. Wal-Mart Stores is a Motley Fool Inside Value selection. Marvel Entertainment and Hasbro are Motley Fool Stock Advisor recommendations. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Rich Duprey owns shares of Wal-Mart and JAKKS Pacific but does not have a financial position in any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.

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