We are upgrading our recommendation on RC2 Corp. (RCRC) to Neutral from Underperform.

RC2’s fourth-quarter earnings of 43 cents per share was ahead of the Zacks Consensus Estimate of 41 cents. The better-than-expected results were driven by a favorable product mix and higher margins reflecting cost-reduction initiatives. However, the results were flat compared to the prior-year period.

We expect RC2 to further benefit from its aggressive acquisition strategy and the cost cut drives. The company’s focus on core early childhood demographic factors bodes well. It markets its products to new mothers which represent a steady and renewable customer base.

Though RC2’s overall sales and profit are anticipated to be lower in the first half of 2010 compared to the prior-year period due to the transition in its preschool, youth and adult products category, we believe that the company stands to benefit from product launches such as the Dinosaur Train in the second half of the year. We are also positive about the Chuggington franchise.

The recently introduced Chuggington train play product lines have been well received in Hong Kong, London, Nuremberg and New York toy fairs. Additionally, the initial ratings for the Chuggington television show on Playhouse Disney are encouraging. This augurs well for the U.S. Chuggington product sales in 2011.

Importantly, in addition to its Chuggington master toy licensing rights, RC2 holds a 50% interest in the line’s intellectual property rights with Ludorum, a global media company that builds quality children’s entertainment franchises. Therefore, the company stands to benefit from royalty streams from non-toy products Incorporatedluding broadcast fees, apparel and accessories.

However, the loss of the Thomas & Friends license to Fisher-Price will likely prove to be a significant challenge in the near term and curtail sales and profit in the first half of 2010. Additionally, the continuing economic stress will remain a headwind in the near term as the retail environment remains challenging. Hence, we have a Neutral recommendation on the shares of RC2.

Zacks Investment Research

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