Toyota's (NYSE:TM) massive recall has placed the issue of product recalls and their impact on a company's fortunes squarely in the spotlight. In the majority of cases, an unexpected product recall can have a devastating impact on a public company's stock price, at least in the short term, as investors factor in the worst-case scenario of a recall's effects on the firm's future prospects. (Catch up on this week's top financial news in Water Cooler Finance: Auto Hope, Bubbling Oil And Obamanomics.)
In Pictures: 8 Signs Of A Doomed Stock
Sink or Swim?
Negative effects of a product recall include direct costs such as fixing the problem that caused the recall, litigation costs arising from class-action lawsuits, loss of market capitalization due to the stock's decline and loss of revenue if production and sales of the faulty product are halted until the problem is resolved. Other longer-term, indirect effects include loss of market share and the negative impact on corporate reputation and goodwill.
In some cases, however, a product recall barely has a discernible impact on a company. How then can an investor decide whether a stock will sink on the news of a recall, or absorb the impact and keep on simming? These five questions can help you assess the impact of a recall on a company's fortunes.
1. Is the recall perceived to be a symptom of a deeper underlying problem?
In January, Toyota's American Depositary Receipts plummeted 22% after the company expanded its recall to an additional 2.3 million vehicles and said it would suspend output at five North American plants. The stock plunge wiped out about $32 billion in market value over a one-month period, one of the biggest impacts of a product recall on a stock in recent memory.
Why? Because over the decades, Toyota had built an unblemished reputation for the quality and reliability for its vehicles. But with as many as 6.5 million Toyota vehicles recalled between November and January, the scale of the recall led investors to question whether it was a symptom of a hidden quality problem at the company.
While only time will tell whether Toyota has been unfairly penalized by investors, there is little denying that the company's reputation for quality has been severely dented. (To learn more, see The Cost Of An Auto Recall.)
2. Will the recall have a material impact on the company's finances?
In 2006, Canadian toymaker Mega Bloks (TSE:C.MB) recalled and scrapped more than seven million units of its Magnetix products following the death of a child and injuries suffered by a number of children after they swallowed magnets that detached from the toy.
Mega Bloks had acquired the Magnetix line when it purchased Rose Art Industries, and had taken on a huge debt load to finance the purchase. Magnetix's subsequent losses and huge debt load caused the stock to plunge 66% in the fourth quarter of 2007. It never recovered from that debacle and currently trades 98% below its 2006 peak.
In contrast, the world's largest toymaker, Mattel (Nasdaq:MAT), managed to weather the spate of toy recalls that it had to deal with in 2007. The recalls were caused by dangerous levels of lead paint in some toys and tiny magnets that could be deadly if swallowed in others. Mattel survived because the financial impact of the recalls on the company, while significant, was proportionately much smaller than the recall impact on Mega Bloks, which was a fraction of Mattel's size.
3. Is the recall specific to the company?
In December, the U.S. Consumer Product Safety Commission recalled more than 50 million Roman shades and roll-up blinds - one of the largest recalls in the agency's 35-year history - following reports that the cords posed a strangulation hazard to children. While retailers including Wal-Mart (NYSE:WMT), JC Penney (NYSE:JCP) and Williams-Sonoma (NYSE:WSM) participated in the voluntary recall, it had no lasting impact on their stock prices because of the industry-wide nature of the recall and the minimal contribution the recalled products had on the affected companies' businesses.
4. Have damage control efforts been prompt and effective?
Toyota's executive management is widely acknowledged to have erred by being tardy in owning up to the sudden acceleration problem with its vehicles. Although the company won kudos for its efforts to fix the technical problems once they were identified, its efforts in the sphere of damage control were not as effective.
A company faced with a product recall can sometimes mitigate much of the fallout by fessing up to the problem promptly and taking measures to prevent its recurrence.
6. Are product recalls par for the course for the industry?
Some sectors, such as the automobile industry and meat packers, seem to be more prone to product recalls than others. Investors may view product recalls from such companies as a business risk that cannot be altogether avoided, leading them to adopt a more tolerant attitude toward such recalls.
The Bottom Line
A product recall can decimate a stock in most cases, and have hardly any impact in others. This recall checklist will enable you to get a better idea of whether a stock will recoil or recover following a product recall - and that can help you respond appropriately with your investing choices. (For more, check out A Year In Product Recalls.)