10-K 1 rc2dec312006form10-k.htm RC2 DECEMBER 31, 2006 FORM 10-K RC2 December 31, 2006 Form 10-K

Form 10-K


SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

[ X ]         Annual Report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year
ended December 31, 2006.

[    ]         Transition Report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition 
period from _____ to _____.

Commission file number 0-22635

RC2 Corporation
(Exact name of Registrant as Specified in Its Charter)

Delaware
 
36-4088307
(State or Other Jurisdiction of Incorporation or Organization)
 
(IRS Employer Identification No.)
     
1111 West 22nd Street, Suite 320, Oak Brook, Illinois
 
60523
(Address of principal executive offices)
 
(Zip Code)
     
Registrant’s telephone number, including area code:    630-573-7200
   
     
Securities registered pursuant to Section 12(b) of the Exchange Act:
   
Title of each class
 
Name of each exchange on which registered
Common Stock, Par Value $0.01 Per Share
 
The NASDAQ Stock Market
 
Securities registered pursuant to Section 12(g) of the Exchange Act:  None

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined by Rule 405 of the Securities Act.
Yes    X       No  ___
 
Indicate by check mark if Registrant is not required to file reports pursuant to Section 13 of 15(d) of the Exchange Act.
Yes  ___      No    X  

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes    X       No  ___

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of
the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form
10-K.  [   ]

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Exchange Act Rule 12b-2.
Large accelerated filer [X]               Accelerated filer [   ]                 Non-accelerated filer [   ]

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes  ___      No    X  



Aggregate market value of the Registrant’s common stock held by non-affiliates as of June 30, 2006 (the last business day of the Registrant’s most recently completed second quarter): $771,869,168. Shares of common stock held by any executive officer or director of the Registrant have been excluded from this computation because such persons may be deemed to be affiliates. This determination of affiliate status is not a conclusive determination for other purposes.

Number of shares of the Registrant’s common stock outstanding as of February 21, 2007:  21,110,772

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the 2007 Annual Meeting of the Stockholders of the Registrant are incorporated by reference into Part III of this report.

As used in this report, the terms “we,” “us,” “our,” “RC2 Corporation,” “RC2” and the “Company” mean RC2 Corporation and its subsidiaries, unless the context indicates another meaning, and the term “common stock” means our common stock, par value $0.01 per share.

Special Note Regarding Forward-Looking Statements

Certain statements contained in this report are considered “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements may be identified by the use of forward-looking words or phrases such as “anticipate,” “believe,” “could,” “expect,” “intend,” “may,” “hope,” “plan,” “potential,” “should,” “estimate,” “predict,” “continue,” “future,” “will,” “would” or the negative of these terms or other words of similar meaning. Such forward-looking statements are inherently subject to known and unknown risks and uncertainties. Our actual results and future developments could differ materially from the results or developments expressed in, or implied by, these forward-looking statements. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, but are not limited to, those described under the caption “Risk Factors” in Item 1A of this report. We undertake no obligation to make any revisions to the forward-looking statements contained in this filing or to update them to reflect events or circumstances occurring after the date of this filing.
 
 
Part I

 
Item 1. Business

Overview

We are a leading designer, producer and marketer of innovative, high-quality toys, collectibles, and infant products that are targeted to consumers of all ages. Our leadership position is measured by sales and brand recognition. Our infant, toddler and preschool products are marketed under our Learning Curve® family of brands which includes The First Years® by Learning Curve and Lamaze brands as well as popular and classic licensed properties such as Thomas & Friends, Bob the Builder, Winnie the Pooh, John Deere, Nickelodeon and Sesame Street. We market our youth and adult products primarily under the Johnny Lightning® and Ertl® brands. We reach our target consumers through multiple channels of distribution supporting more than 25,000 retail outlets throughout North America, Europe, Australia and Asia Pacific.

Business Segments

The Company’s reportable segments are North America and International. The North America segment includes the United States, Canada and Mexico. The International segment includes non-North America markets. The discussion in this Form 10-K applies to all segments except where otherwise stated. For additional information on the Company’s segment reporting, including net sales, operating income and assets, see Note 5 to our consolidated financial statements included elsewhere herein.


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Corporate History

We are a Delaware corporation that was originally formed in April 1996 as a holding company to combine the domestic operations of a privately held Illinois corporation formed in 1989 and the operations of four affiliated foreign corporations. We were originally named Collectible Champions, Inc. In 1997, we changed our name to Racing Champions Corporation before our initial public offering. In 2002, we changed our name to Racing Champions Ertl Corporation to reflect our integration of The Ertl Company, Inc. In 2003, following our acquisition of Learning Curve International, Inc. and certain of its affiliates (collectively, LCI), we changed our name to RC2 Corporation. In addition, we changed the name of our main domestic operating subsidiary to RC2 Brands, Inc.

On June 7, 2004, with an effective date of June 1, 2004, the Company acquired substantially all of the assets of Playing Mantis, Inc. (PM) primarily consisting of the Johnny Lightning® brand. Closing consideration consisted of $17.0 million of cash, excluding transaction expenses, and 91,388 shares of the Company’s common stock. This transaction has been accounted for under the purchase method of accounting, and accordingly, the operating results of PM have been included in our consolidated statements of earnings since the effective date of the acquisition.

On September 15, 2004, the Company acquired The First Years Inc. (TFY) for $156.1 million in cash, excluding transaction expenses. TFY is an international developer and marketer of infant and toddler care and play products sold under The First Years® brand name and under various licenses, including Disney’s Winnie the Pooh. This transaction has been accounted for under the purchase method of accounting, and accordingly, the operating results of TFY have been included in the accompanying consolidated statements of earnings since the effective date of the acquisition. The purchase was funded with a credit facility (see Note 8 to the consolidated financial statements).

On November 3, 2006, the Company announced the sale of RC2 South, Inc., its collectible trading card business, and substantially all of the assets relating to its die-cast sports collectibles product line. Closing consideration consisted of $6.9 million of cash, excluding transaction expenses. The sale was effective November 1, 2006 and the results of this sold business are presented as discontinued operations in the accompanying consolidated statements of earnings and consolidated statements of cash flows. The net proceeds of this transaction were used to pay down debt.

During December 2006, the Company made the decision to discontinue its Racing Champions®, JoyRide®, AMT® and certain Ertl® die-cast and model kit automotive collectible product lines. Discontinuing the automotive collectible product lines is consistent with the Company’s strategy to focus on sustainable, organic growth and on allocating resources to its higher growth infant and toddler products and preschool products categories. The Company plans to continue its agricultural collectibles business and continue to invest in its strategic long-term relationship with John Deere. Additionally, the Company plans to continue with its strategy to reposition its Johnny Lightning brand targeting younger consumers.

In January 2007, we changed the name of RC2 Brands, Inc., our main domestic operating subsidiary, to Learning Curve Brands, Inc., to better reflect our strategy of focusing on our Learning Curve family of infant, toddler and preschool brands.

Products

We group our products into three product categories: infant and toddler products; preschool products; and youth and adult products. During the fourth quarter of 2006, the Company reclassified its product categories and channels of distribution to be more closely aligned with its strategic direction and organization structure. This presentation is consistent with how we view our business. We provide a diverse offering of infant and toddler products, stylized toys and highly detailed, authentic replicas known for their quality workmanship. Our products currently retail from $1.79 to $599.99. We have successfully expanded our product offering, and by offering a wide range of products at varying price points, we believe our products appeal to a broad range of consumers.

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The following chart summarizes our current product categories:

         Category
Key Licensed Properties
          Key Brands
Retail Price Range
Infant and toddler products
Lamaze
Learning Curve
$1.79 - $149.99
 
Winnie the Pooh
The First Years by Learning Curve
 
 
Disney Princess
 
 
 
Sesame Street
 
 
 
American Red Cross
   
 
Soothie
   
       
Preschool products
Thomas & Friends
Learning Curve
$4.99 - $599.99
 
Bob the Builder
Take Along by Learning Curve
 
 
John Deere
 
 
 
Nickelodeon
 
 
       
Youth and adult products
John Deere
Johnny Lightning
$2.99 - $175.00
 
Case New Holland
Ertl
 

Infant and toddler products. This category includes a wide range of infant and toddler products related to feeding, care, safety and play. Products in this category include:

·
Learning Curve's Lamaze infant toys with features that encourage developmental and interactive play; and

·
The First Years by Learning Curve, a full line of feeding, care, safety and play products for infants and toddlers, including the Take & Toss® and Soothie product lines.

In 2006, we introduced the Soothie bottles product line under The First Years by Learning Curve brand. These bottles offer the same shaped, medical grade silicone nipple as those used on Soothie pacifiers. Additionally, we expanded the Take & Toss toddler self-feeding system under The First Years by Learning Curve brand. The Take & Toss product line includes sippy and straw cups, plates, bowls and feeding accessories.  In 2006, we added licensed properties such as Thomas & Friends, Bob the Builder, The Wiggles, Barney, Sesame Street, Disney Princess, Winnie the Pooh, Spiderman, Finding Nemo and Cars to our Take & Toss product line. In late 2006, we introduced a line of The First Years by Learning Curve healthcare products associated with the American Red Cross licensed property.

In 2007, we plan to introduce a new look for Lamaze, featuring new colors and patterns. We also plan to launch a new play line featuring the Winnie the Pooh licensed property. Under The First Years by Learning Curve brand, we plan to expand distribution of our new Clean Air Odor Free diaper disposal system which utilizes a carbon filter/fan system to both trap and eliminate odors. We also plan to introduce a portable infant glider and a retractable gate under The First Years by Learning Curve brand. Additionally, we plan to broaden our Take & Toss product line to include feeding sets featuring our most popular licensed properties.

Preschool products. This category includes product lines that are marketed to parents, grandparents, caregivers and giftgivers of preschool-aged children. Products in this category are marketed under our Learning Curve brand and include:

·
Thomas & Friends Wooden Railway, wooden engines, vehicles, destinations and playsets;

·
Bob the Builder Project: Build It characters, vehicles, playsets and role-play toys;

·
Take Along by Learning Curve die-cast vehicles and playsets designed around licensed properties such as Thomas & Friends, Bob the Builder, Big Foot Presents Meteor and the Mighty Monster Trucks, as well as several characters featured on popular Nickelodeon television shows;


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·
Play Town classic wooden figures, vehicles, buildings and playsets;

·
John Deere farm, construction and role-play activity toys; and

·
Ride-ons featuring the John Deere, Thomas & Friends and Bob the Builder licensed properties.

In 2006, we expanded the distribution of our ride-ons. Additionally in 2006, we introduced new radio-controlled vehicles under the Bob the Builder and John Deere licensed properties.

In 2007, we plan to introduce our Play Town from Learning Curve product line which offers characters, vehicles, buildings and playsets for open-ended, classic and creative play for toddlers and preschoolers. We also plan to expand our Take Along by Learning Curve line to include popular Nickelodeon television characters such as Dora the Explorer, Go Diego Go!, The Backyardigans, Blue’s Clues and SpongeBob SquarePants.
 
Youth and adult products. This category includes product lines that are marketed to older boys and adult collectors. Products in this category include:

·
Johnny Lightning toy and radio-controlled vehicles; and

·
Ertl, collectible and toy vintage and modern tractors, farm implements and construction vehicles of major original equipment manufacturers (OEMs) such as John Deere and Case New Holland.

In 2007, we plan to reposition the Johnny Lightning product line featuring a new logo, packaging and product design targeting younger consumers. Under the Johnny Lightning brand, we plan to introduce Lightning Wheels, a line of fantasy vehicles with tires that illuminate.  Additionally, we plan to introduce two new radio-controlled product lines,  V-Bot and Battle Wheels.  The V-Bot product line features a fully funtional radio-controlled vehicle that transforms into a robot.  The Battle Wheels product line features radio-contolled battling action figures on wheels.

Licenses

We market a significant portion of our products with licenses from other parties. We have license agreements with entertainment, publishing and media companies; automotive and truck manufacturers; agricultural and construction vehicle and equipment manufacturers; among others.  A significant element of our strategy depends on our ability to identify and obtain licenses for recognizable and respected brands and properties. Our licenses reinforce our brands and establish our products’ authenticity, credibility and quality with consumers, and in some cases, provide for new product development opportunities and expand distribution channels. Our licenses are limited in scope and duration and authorize the sale of specific licensed products generally on a nonexclusive basis. For the year ended December 31, 2006, net sales of the Company’s products with the licensed properties of Thomas & Friends and John Deere each accounted for more than 10.0% of total net sales. No other licensed property accounted for more than 10.0% of our total net sales for the year ended December 31, 2006. As of December 31, 2006, approximately 69.7% of our licenses required us to make minimum guaranteed royalty payments whether or not we meet specific sales targets. Aggregate future minimum guaranteed royalty payments as of December 31, 2006, are $50.7 million, with the individual license minimum guarantees ranging from $1.00 to $20.9 million. Royalty expense related to licenses with minimum guarantees for the year ended December 31, 2006 was $32.6 million. We are a party to over 500 license agreements, approximately 400 of which are actively used in our current product lines, with terms generally of two to three years. Any termination of or failure to renew our significant licenses, or inability to develop and enter into new licenses, could limit our ability to market our products or develop new products and reduce our net sales and profitability. Over the next two years, license agreements in connection with several of our key licensed properties, including licenses for certain Winnie the Pooh, Disney Princess, Finding Nemo, Bob the Builder, Ford Motor Company and DaimlerChrysler Corporation products, are scheduled to expire. Competition for licenses could require us to pay licensors higher royalties and higher minimum guaranteed payments in order to obtain or retain attractive licenses, which could increase our expenses.

Channels of Distribution

Our products are available through more than 25,000 retail outlets located in North America, Europe, Australia and Asia Pacific. We market our products through multiple channels of distribution in order to maximize our sales opportunities for our broad product offering. Products with lower price points are generally sold in chain retailer channels, and products with higher prices are typically sold in hobby, collector and independent toy stores and through wholesalers and OEM dealers. We believe we have a leading position in multiple distribution channels and that this position extends the reach of our products to consumers and mitigates the risk of concentration by channel or customer.

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Chain retailers. Our products marketed through this channel are targeted predominately at price conscious end-users. As a result, the majority of our products marketed through this channel are designed to span lower price points and generally retail for less than $30.00. Customers included in this channel have more than ten retail locations and can include a wide range of retailers, such as book, farm and ranch, automotive and craft/hobby stores, as well as the national discount retailers. Key customers in our chain retailer channel include Wal-Mart, Toys “R” Us/Babies “R” Us, Target, Kohl’s, Tractor Supply Company and Michaels Stores, Inc. Sales in 2006 to chain retailers were 68.0% of our net sales.

Specialty retailers, wholesalers and OEM dealers. We sell many of the products available at chain retailers as well as higher priced products with special features to specialty retailers, wholesalers and OEM dealers, which comprised 29.2% of our net sales in 2006. Additionally, we often sell licensed products to the licensing OEM’s dealer network. OEM licensing partners benefit from our OEM dealer sales through the opportunity to receive royalties from additional product sales through the OEM’s dealer network. We often provide OEM dealers with a short-term exclusivity period in which the OEM dealers have the opportunity to purchase new products for a short period (generally 90 to 360 days) before the products become available through other distribution channels. We reach these customers directly through our internal telesales group and business-to-business website located at www.myRC2.com and through specialty sales representatives. Key customers in our specialty retailers, wholesalers and OEM dealers channel include Learning Express, All Aboard Toys, Horizon Hobby, John Deere and Case New Holland.

Corporate promotional, direct to consumers and other. We make certain products available to corporate promotional accounts and to consumers through company stores and our websites located at www.diecastexpress.com and www.learningcurveshop.com. Individual products sold directly to consumers sell at prices similar to those found at retailers, hobby stores and OEM dealers. Sales through this channel constituted 2.8% of our net sales in 2006.

Trademarks

We have registered several trademarks with the U.S. Patent and Trademark Office, including the trademarks RC2®, Learning Curve®, The First Years®, Johnny Lightning®, Ertl® and Take & Toss®. A number of these trademarks are also registered in foreign countries. We believe our trademarks hold significant value, and we plan to build additional value through increased consumer awareness of our many other trade names and trademarks. 

Sales and Marketing

Our sales organization consists of an internal sales force and external sales representative organizations. Our internal sales force provides direct customer contact with nearly all of our retail chain and key wholesale accounts. A number of accounts are designated as “house accounts” and are handled exclusively by our internal sales staff. Our inside sales and customer service groups use telephone calls, mailings, faxes and e-mails to directly contact OEM dealers and smaller volume customers such as collector, hobby, specialty and independent toy stores.

Our internal sales force is supplemented by external sales representative organizations. These external sales representative organizations provide more frequent customer contact and solicitation of the national, regional and specialty retailers and supported 30.2% of our net sales in 2006. External sales representatives generally earn commissions of 1.0% to 12.0% of the net sales price from their accounts. Their commissions are unaffected by the involvement of our internal sales force with a customer or sale.

The Company maintains a business-to-business website under the name www.myRC2.com. This website, targeted at smaller volume accounts, allows qualified customers to view new product offerings, place orders, check open order shipping status and review past orders. We believe that www.myRC2.com leverages our internal sales force and customer service group by providing customers with greater information access and more convenient ordering capability.

Our marketing programs are directed toward adult collectors, parents and children, current consumers and potential new consumers who fit the demographic profile of our target market. Our objectives include increasing awareness of our product offerings and brand names, as well as executing consumer promotions. We utilize the following media vehicles in our marketing plans:

·
Advertising. We place print advertisements in publications with high circulation and targeted penetration in key vertical categories such as parenting, gift and hobby. We run commercials on a selective basis on television programs that target key consumers.

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·
Digital Marketing. The Internet and other digital media are an increasingly important part of our marketing plan because consumers have quickly adopted the Internet as a preferred way to communicate with others about their product preferences and purchases. Our websites, www.learningcurve.com, www.johnnylightning.com and www.ertl.com, highlight our products, list product release dates and collect market data directly from consumers. We also gather consumer information through consumer letters, e-mails, telephone calls, product surveys and focus groups.

·
Public Relations. We have developed a sustained trade and consumer public relations effort to build relationships with editors at publications targeted across all of our product lines. Ongoing press releases keep editors abreast of new product introductions, increase our credibility and market acceptance, and encourage the editorial staffs of these publications to give more coverage to our products.

·
Co-op Advertising. We work closely with retail chains to plan and execute ongoing retailer-driven promotions and advertising. The programs usually involve promotion of our products in retail customers’ print circulars, mailings and catalogs, and sometimes include placing our products in high-traffic locations within retail stores.

Competition

We compete with several large domestic and foreign companies, such as Mattel, Inc. and Hasbro, Inc., with private label products sold by many of our retail customers and with other producers of toys, infant products and collectibles. Competition in the distribution of our products is intense, and the principal methods of competition consist of product appeal, ability to capture shelf or rack space, timely distribution, price and quality. Competition is also based on the ability to obtain license agreements for existing and new products to be sold through specific distribution channels or retail outlets. We believe that our competitive strengths include our knowledge of the markets we serve, our ability to bring products to market rapidly and efficiently, our dedicated and integrated suppliers, our multiple channels of distribution, our well-known brands supported by respected licenses, our diversified product categories and our established and loyal consumer base. Many of our competitors have longer operating histories, greater brand recognition and greater financial, technical, marketing and other resources than we have.

Production

We believe we are an industry leader in bringing new products to market rapidly and efficiently. Our integrated design and engineering expertise, extensive library of product designs, molds and tools and dedicated suppliers enable us to be first to market with many innovative products.

Far east product sourcing. We have operations in Kowloon, Hong Kong and in the RC2 Industrial Zone in Dongguan City, China and employ 272 people in Hong Kong and China who oversee the sourcing of the majority of our products. This group assists our suppliers in sourcing raw materials and packaging, performs engineering and graphic art functions, executes the production schedule, provides on-site quality control, facilitates third-party safety testing and coordinates the delivery of shipments for export from China.

Far east production. All of our products are manufactured in China, except for certain plastic ride-ons, certain infant products and certain apparel items. Our China-based product sourcing accounted for 91.8% of our product purchases in 2006. We primarily use seven third-party, dedicated suppliers who manufacture only our products in eight factories, three of which are located in the RC2 Industrial Zone. The RC2 Industrial Zone is the name of a factory complex developed in 1997 and located in Dongguan City, China (approximately 50 miles from Hong Kong) where three of our third-party, dedicated suppliers operate three freestanding factory facilities. Most of our third-party, dedicated suppliers have been supplying us for more than ten years. These seven third-party, dedicated suppliers produced 47.9% of our China-based product purchases in 2006. In order to supplement our third-party, dedicated suppliers, we use several other suppliers in China. All products are manufactured to our specifications using molds and tooling that we own. These suppliers own the manufacturing equipment and machinery, purchase raw materials, hire workers and plan production. We purchase fully assembled and packaged finished goods in master cartons for distribution to our customers. We enter into purchase orders with our foreign suppliers and generally do not enter into long-term contracts.

Die-casting. All of our die-cast products are manufactured in China. Die-casting for our products involves the use of custom molds to shape melted zinc alloy into our die-cast products. Our suppliers purchase zinc alloy and conduct the die-cast manufacturing process at their facilities.


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Domestic production. The production of certain plastic ride-ons, certain infant products, and certain apparel items is completed primarily by U.S.-based suppliers. We create the product design and specifications and coordinate the manufacturing activities. We generally prefer to coordinate the production of these products through a limited number of suppliers and believe that a number of alternate suppliers are available.

Tooling. To create new products, we continuously invest in new tooling. Tooling represents the majority of our capital expenditures. Depending on the size and complexity of the product, the cost of tooling a product generally ranges from $3,000 to $250,000. We own all of our tools and provide them to our suppliers during production. Tools are returned to us when a product is no longer in production and are stored for future use.

Product safety. Our products are designed, manufactured, packaged and labeled to conform with all safety requirements under U.S. federal and other applicable laws and regulations, industry developed voluntary standards and product specific standards, and are periodically reviewed and approved by independent safety testing laboratories. We carry product liability insurance coverage with a limit of over $60.0 million per occurrence.

Logistics. We own a distribution facility in Dyersville, Iowa, lease distribution facilities in Rochelle, Illinois, and Australia, and use independent warehouses in California, Illinois, Canada, the United Kingdom, Belgium, Germany and Australia.

Seasonality

We have experienced, and expect to continue to experience, substantial fluctuations in our quarterly net sales and operating results, which is typical of many companies in our industry. Our business is highly seasonal due to high consumer demand for our products during the year-end holiday season. Approximately 61.6% of our net sales for the three years ended December 31, 2006, were generated in the second half of the year, with September, October and November being the largest shipping months. As a result, consistent with industry practice, our working capital, mainly inventory and accounts receivable, is typically highest during the third and fourth quarters and lowest during the first and second quarters.

Customers

We derive a significant portion of our sales from some of the world’s largest retailers. Our top five customers accounted for 39.3%, 48.7% and 51.8% of our net sales in 2004, 2005 and 2006, respectively. Wal-Mart, our largest customer, accounted for 13.4% and 16.3% of our net sales in 2005 and 2006, respectively. Toys “R” Us/Babies “R” Us accounted for 10.9%, 15.1% and 14.8% of our net sales in 2004, 2005 and 2006, respectively. Target accounted for 12.0% and 13.1% of our net sales in 2005 and 2006, respectively. Other than Toys “R” Us/Babies “R” Us, Wal-Mart and Target, no customer accounted for more than 10.0% of our net sales in 2005 or 2006. Other than Toys “R” Us/Babies “R” Us, no customer accounted for more than 10.0% of our net sales in 2004. Many of our retail customers generally purchase large quantities of our product on credit, which may cause a concentration of accounts receivable among some of our largest customers.

Employees

As of December 31, 2006, we had 821 employees, 44 of whom were employed part-time. We emphasize the recruiting and training of high-quality personnel, and to the extent possible, promote people from within RC2. A collective bargaining agreement covers 116 of our employees, all of whom work in the distribution facility in Dyersville, Iowa. We consider our employee relations to be good. Our continued success will depend, in part, on our ability to attract, train and retain qualified personnel at all of our locations.

Available Information

We maintain our corporate website at www.rc2.com and we make available, free of charge, through this website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports that we file with or furnish to the Securities and Exchange Commission (the Commission), as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Commission. Information on our website is not part of this report. This report includes all material information about the Company that is included on the Company’s website and is otherwise required to be included in this report.


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Item 1A. Risk Factors

The risks described below are not the only risks we face. Additional risks that we do not yet know of or that we currently think are immaterial may also impair our business operations. If any of the events or circumstances described in the following risks actually occur, our business, financial condition or results of operations could be materially adversely affected. In such cases, the trading price of our common stock could decline.

Our net sales and profitability depend on our ability to continue to conceive, design and market products that appeal to consumers.

The introduction of new products is critical in our industry and to our growth strategy. Our business depends on our ability to continue to conceive, design and market new products and upon continuing market acceptance of our product offerings. Rapidly changing consumer preferences and trends make it difficult to predict how long consumer demand for our existing products will continue or what new products will be successful. Our current products may not continue to be popular or new products that we introduce may not achieve adequate consumer acceptance for us to recover development, manufacturing, marketing and other costs. A decline in consumer demand for our products, our failure to develop new products on a timely basis in anticipation of changing consumer preferences or the failure of our new products on a timely basis in anticipation of changing consumer preferences or the failure of our new products to achieve and sustain consumer acceptance could reduce our net sales and profitability.

Competition for licenses could increase our licensing costs or limit our ability to market products.

We market a significant portion of our products with licenses from other parties. These licenses are limited in scope and duration and generally authorize the sale of specific licensed products on a nonexclusive basis. Our license agreements often require us to make minimum guaranteed royalty payments that may exceed the amount we are able to generate from actual sales of the licensed products. Any termination of or failure to renew our significant licenses, or inability to develop and enter into new licenses, could limit our ability to market our products or develop new products and reduce our net sales and profitability. For the year ended December 31, 2006, net sales of the Company’s products with the licensed properties of Thomas & Friends and John Deere each accounted for more than 10.0% of the Company’s total net sales. Over the next two years, license agreements in connection with several key licensed properties, including licenses for certain Winnie the Pooh, Disney Princess, Finding Nemo, Bob the Builder, Ford Motor Company and DaimlerChrysler Corporation products, are scheduled to expire. Competition for licenses could require us to pay licensors higher royalties and higher minimum guaranteed payments in order to obtain or retain attractive licenses, which could increase our expenses. For example, in 2006 we entered into two new license agreements with HIT Entertainment with respect to certain Thomas & Friends product lines which increased royalties and minimum guarantee payments starting in 2007. In addition, licenses granted to other parties, whether or not exclusive, could limit our ability to market products, including products we currently market, which could cause our net sales and profitability to decline. 

Competition in our markets could reduce our net sales and profitability.

We operate in highly competitive markets. We compete with several large domestic and foreign companies such as Mattel, Inc. and Hasbro, Inc., with private label products sold by many of our retail customers and with other producers of infant products, toys and collectibles. Many of our competitors have longer operating histories, greater brand recognition and greater financial, technical, marketing and other resources than we have. In addition, we may face competition from new participants in our markets because the collectible, toy and infant product industries have limited barriers to entry. We experience price competition for our products, competition for shelf space at retailers and competition for licenses, all of which may increase in the future. If we cannot compete successfully in the future, our net sales and profitability will likely decline.


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We may experience difficulties in integrating strategic acquisitions.

As part of our growth strategy, we intend to pursue acquisitions that are consistent with our mission and enable us to leverage our competitive strengths. We acquired LCI effective February 28, 2003, PM effective June 1, 2004, and TFY effective September 15, 2004. The integration of acquired companies and their operations into our operations involves a number of risks including:

·
the acquired business may experience losses that could adversely affect our profitability;
·
unanticipated costs relating to the integration of acquired businesses may increase our expenses;
·
possible failure to obtain any necessary consents to the transfer of licenses or other agreements of the acquired company;
·
possible failure to maintain customer, licensor and other relationships after the closing of the transaction of the acquired company;
·
difficulties in achieving planned cost-savings and synergies may increase our expenses or decrease our net sales;
·
diversion of management’s attention could impair their ability to effectively manage our business operations; and
·
unanticipated management or operational problems or liabilities may adversely affect our profitability and financial condition.

Additionally, to finance our strategic acquisitions, we have borrowed funds under our credit facility and we may borrow additional funds to complete future acquisitions. This debt leverage could adversely affect our profit margins and limit our ability to capitalize on future business opportunities. A portion of our borrowing capacity is also subject to fluctuations in interest rates.

We depend on the continuing willingness of chain retailers to purchase and provide shelf space for our products.

In 2006, we sold 68.0% of our products to chain retailers. Our success depends upon the continuing willingness of these retailers to purchase and provide shelf space for our products. We do not have long-term contracts with our customers. In addition, our access to shelf space at retailers may be reduced by store closings, consolidation among these retailers and competition from other products. An adverse change in our relationship with or the financial viability of one or more of our customers could reduce our net sales and profitability.

We may not be able to collect outstanding accounts receivable from our major retail customers.

Many of our retail customers generally purchase large quantities of our products on credit, which may cause a concentration of accounts receivable among some of our largest customers. Our profitability may be harmed if one or more of our largest customers were unable or unwilling to pay these accounts receivable when due or demand credits or other concessions for products they are unable to sell. We maintain credit insurance for some of our major customers, and the amount of this insurance generally does not cover the total amount of the accounts receivable. At December 31, 2005 and 2006, our credit insurance covered 7.2% and 6.3%, respectively, of our gross accounts receivable. Insurance coverage for future sales is subject to reduction or cancellation.

We rely on a limited number of foreign suppliers in China to manufacture a majority of our products.

We rely on seven third-party, dedicated suppliers in China to manufacture a majority of our products in eight factories, three of which are located in close proximity to each other in the RC2 Industrial Zone manufacturing complex in China. Our China-based product sourcing accounted for 91.8% of our product purchases in 2006. The seven third-party, dedicated suppliers who manufacture only our products accounted for 47.9% of our China-based product purchases in 2006. We enter into purchase orders with our foreign suppliers and generally do not enter into long-term contracts. Because we rely on these suppliers for flexible production and have integrated these suppliers with our development and engineering teams, if these suppliers do not continue to manufacture our products exclusively, our product sourcing would be adversely affected. Difficulties encountered by these suppliers such as fire, accident, natural disaster or an outbreak of a contagious disease at one or more of their facilities, could halt or disrupt production at the affected facilities, delay the completion of orders, cause the cancellation of orders, delay the introduction of new products or cause us to miss a selling season applicable to some of our products. Any of these risks could increase our expenses or reduce our net sales.

10


Increases in the cost of the raw materials used to manufacture our products could increase our cost of sales and reduce our gross margins.

Since our products are manufactured by third-party suppliers, we do not directly purchase the raw materials used to manufacture our products. However, the prices we pay our suppliers may increase if their raw materials, labor or other costs increase. We may not be able to pass along such price increases to our customers. As a result, increases in the cost of raw materials, labor or other costs associated with the manufacturing of our products could increase our cost of sales and reduce our gross margins. For example, increases in the price of zinc, a key component in die-cast products, and increased costs in China, primarily for labor, reduced our gross margins in 2006 and may continue to reduce our gross margins in 2007.

Currency exchange rate fluctuations could increase our expenses.

Our net sales are primarily denominated in U.S. dollars, with 15.5% of our net sales in 2006 denominated in British pounds sterling, Australian dollars, Euros or Canadian dollars. Our purchases of finished goods from Chinese manufacturers are denominated in Hong Kong dollars. Expenses for these manufacturers are denominated in Chinese Renminbi. As a result, any material increase in the value of the Hong Kong dollar or the Renminbi relative to the U.S. dollar would increase our expenses, and therefore, could adversely affect our profitability. We are also subject to exchange rate risk relating to transfers of funds denominated in British pounds sterling, Australian dollars, Canadian dollars or Euros from our foreign subsidiaries to the United States.  Historically, we have not hedged our foreign currency risk.

Because we rely on foreign suppliers and we sell products in foreign markets, we are susceptible to numerous international business risks that could increase our costs or disrupt the supply of our products.

Our international operations subject us to risks including:

·
economic and political instability;
·
restrictive actions by foreign governments;
·
greater difficulty enforcing intellectual property rights and weaker laws protecting intellectual property rights;
·
changes in import duties or import or export restrictions;
·
timely shipping of product and unloading of product through West Coast ports, as well as timely rail/truck delivery to the Company’s warehouses and/or a customer’s warehouse;
·
complications in complying with the laws and policies of the United States affecting the importation of goods, including duties, quotas and taxes; and
·
complications in complying with trade and foreign tax laws.

Any of these risks could disrupt the supply of our products or increase our expenses. The cost of compliance with trade and foreign tax laws increases our expenses, and actual or alleged violations of such laws could result in enforcement actions or financial penalties that could result in substantial costs.

Product liability, product recalls and other claims relating to the use of our products could increase our costs.

Because we sell infant products, toys and collectibles to consumers, we face product liability risks relating to the use of our products. We also must comply with a variety of product safety and product testing regulations. If we fail to comply with these regulations or if we face product liability claims, we may be subject to damage awards or settlement costs that exceed our insurance coverage, and we may incur significant costs in complying with recall requirements. In addition, substantially all of our licenses give the licensor the right to terminate if any products marketed under the license are subject to a product liability claim, recall or similar violations of product safety regulations or if we breach covenants relating to the safety of the products or their compliance with product safety regulations. A termination of a license could adversely affect our net sales. Even if a product liability claim is without merit, the claim could harm our reputation and divert management’s attention and resources from our business.

Trademark infringement or other intellectual property claims relating to our products could increase our costs.

Our industry is characterized by frequent litigation regarding trademark and patent infringement and other intellectual property rights. We are and have been a defendant in trademark and patent infringement claims and claims of breach of license from time to time, and we may continue to be subject to such claims in the future. The defense of intellectual property litigation is both costly and disruptive of the time and resources of our management even if the claim is without merit. We also may be required to pay substantial damages or settlement costs to resolve intellectual property litigation.

11


Our debt covenants may limit our ability to complete acquisitions, incur debt, make investments, sell assets, merge or complete other significant transactions.

Our credit agreement includes provisions that place limitations on a number of our activities, including our ability to:

·
incur additional debt;
·
create liens on our assets or make guarantees;
·
make certain investments or loans;
·
pay dividends; or
·
dispose of or sell assets or enter into a merger or similar transaction.

Sales of our products are seasonal, which causes our operating results to vary from quarter to quarter.

Sales of our products are seasonal. Historically, our net sales and profitability have peaked in the third and fourth quarters due to the holiday season buying patterns. Seasonal variations in operating results may cause us to increase our debt levels and interest expense in the second and third quarters and may tend to depress our stock price during the first and second quarters.

The trading price of our common stock has been volatile, and investors in our common stock may experience substantial losses.

The trading price of our common stock has been volatile and may become volatile again in the future. The trading price of our common stock could decline or fluctuate in response to a variety of factors, including:

·
our failure to meet the performance estimates of securities analysts;
·
changes in financial estimates of our net sales and operating results or buy/sell recommendations by securities analysts;
·
the timing of announcements by us or our competitors concerning significant product developments, acquisitions or financial performance;
·
fluctuation in our quarterly operating results;
·
substantial sales of our common stock;
·
general stock market conditions; or
·
other economic or external factors.

You may be unable to sell your stock at or above your purchase price.

We may face future securities class action lawsuits that could require us to pay damages or settlement costs and otherwise harm our business.

A securities class action lawsuit was filed against us in 2000 following a decline in the trading price of our common stock from $17.00 per share on June 21, 1999, to $6.50 per share on June 28, 1999. We settled this lawsuit in 2002 with a $1.8 million payment, covered by insurance, after incurring legal costs of $1.0 million that were not covered by insurance. Future volatility in the price of our common stock may result in additional securities class action lawsuits against us, which may require that we pay substantial damages or settlement costs in excess of our insurance coverage and incur substantial legal costs, and which may divert management’s attention and resources from our business.

Various restrictions in our charter documents, Delaware law and our credit agreement could prevent or delay a change in control of us which is not supported by our board of directors.

We are subject to a number of provisions in our charter documents, Delaware law and our credit agreement that may discourage, delay or prevent a merger, acquisition or change of control that a stockholder may consider favorable. These anti-takeover provisions include:

·
advance notice procedures for nominations of candidates for election as directors and for stockholder proposals to be considered at stockholders’ meetings;
·
covenants in our credit agreement restricting mergers, asset sales and similar transactions and a provision in our credit agreement that triggers an event of default upon the acquisition by a person or a group of persons of beneficial ownership of 33 1/3% or more of our outstanding common stock; and
·
the Delaware anti-takeover statute contained in Section 203 of the Delaware General Corporation Law.


12


Section 203 of the Delaware General Corporation Law prohibits a merger, consolidation, asset sale or other similar business combination between RC2 and any stockholder of 15% or more of our voting stock for a period of three years after the stockholder acquires 15% or more of our voting stock, unless (1) the transaction is approved by our board of directors before the stockholder acquires 15% or more of our voting stock, (2) upon completing the transaction the stockholder owns at least 85% of our voting stock outstanding at the commencement of the transaction, or (3) the transaction is approved by our board of directors and the holders of 66 2/3% of our voting stock, excluding shares of our voting stock owned by the stockholder.

Item 1B. Unresolved Staff Comments

Not applicable.

Item 2. Properties

As of December 31, 2006, our facilities were as follows: 

                    Description
Square Feet
          Location
Lease Expiration
Corporate headquarters
27,050
 
Oak Brook, IL
April 2013
Learning Curve Brands, Inc. warehouse
400,000
 
Rochelle, IL
November 2019
Learning Curve Brands, Inc. office and warehouse
368,000
 
Dyersville, IA
Owned
Learning Curve Brands, Inc. warehouse
166,000
 
Dyersville, IA
Owned
Learning Curve Brands, Inc. office
21,650
 
Stoughton, MA
August 2010
Learning Curve Brands, Inc. showroom
9,240
 
New York, NY
April 2009
Learning Curve Brands, Inc. office (1)
6,844
 
Chicago, IL
May 2007
Learning Curve Brands, Inc. company store
5,500
 
Oakbrook Terrace, IL
July 2010
Learning Curve Brands, Inc. office
2,755
 
Bentonville, AR
October 2008
Learning Curve Brands, Inc. office
1,932
 
Huntington Beach, CA
May 2007
Learning Curve Brands, Inc. storage
1,250
 
Stoughton, MA
May 2007
Learning Curve Brands, Inc. office (1)
1,100
 
Bentonville, AR
February 2007
Learning Curve Brands, Inc. office
938
 
Edina, MN
August 2009
Learning Curve Brands, Inc. office
495
 
Danbury, CT
March 2007
Learning Curve Brands, Inc. office
108
 
Kansas City, MO
May 2007
RC2 Industrial Zone quarters
44,867
 
Dongguan City, China
March 2008
RC2 Industrial Zone quarters
25,478
 
Dongguan City, China
August 2008
RC2 Industrial Zone office, warehouse and storage
61,398
 
Dongguan City, China
March 2008
RC2 Industrial Zone office
806
 
Dongguan City, China
August 2008
Hong Kong office
10,296
 
Kowloon, Hong Kong
July 2008
Racing Champions International Limited office
8,419
 
Exeter, United Kingdom
October 2013
Racing Champions International Limited office
and showroom
2,035
 
Thatcham, United Kingdom
August 2011
Racing Champions International Limited office
667
 
Saint Germain en Laye, France
December 2012
Racing Champions International Limited office
603
 
Laren, Holland
December 2010
RC2 Canada Corporation warehouse (2)
47,000
 
Concord, Ontario
May 2010
RC2 Canada Corporation office (1)
2,220
 
New Market, Ontario
January 2007
RC2 Deutschland GmbH office
2,184
 
Marsdof, Germany
December 2007
RC2 Australia, Pty. Ltd. office and warehouse
49,127
 
Mount Waverly, Victoria, Australia
December 2009

 
(1)
This facility is no longer being used in our operations. We will allow the lease to expire.
 
(2)
As of January 1, 2004, the Canadian warehouse was no longer being used in our operations and has been subsequently sublet.


13


Item 3. Legal Proceedings

The Company has certain contingent liabilities resulting from litigation and claims incident to the ordinary course of business. Management believes that the probable resolution of such contingencies will not materially affect the financial position or the results of the Company’s operations.

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 2006.
 

Part II



Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Stock Price Information

Our common stock trades on the NASDAQ Global Select Market under the symbol “RCRC.” The following table sets forth the high and low closing sales prices for our common stock as reported by NASDAQ for the periods indicated.

2005:
High 
Low  
First Quarter
$34.64
$28.56
Second Quarter
38.40
31.82
Third Quarter
41.27
33.24
Fourth Quarter
$37.26
$31.90

2006:
 High 
Low  
First Quarter
$40.18
$34.10
Second Quarter
39.75
34.38
Third Quarter
38.85
31.28
Fourth Quarter
$45.11
$33.66

As of December 31, 2006, there were approximately 142 holders of record of our common stock. We believe the number of beneficial owners of our common stock on that date was substantially greater.

Dividend Policy

We have not paid any cash dividends on our common stock. We intend to retain any earnings for use in operations to repay indebtedness and for expenses of our business, and therefore, we do not anticipate paying any cash dividends in the foreseeable future. Our credit agreement prohibits the Company from declaring or paying any dividends on any class or series of our capital stock. This prohibition will apply as long as any credit is available or outstanding under the credit agreement that currently has a maturity date of September 14, 2008.


14


Item 6. Selected Financial Data

The following table presents selected consolidated financial data, which should be read along with our consolidated financial statements, the notes to those statements and “Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The consolidated statements of earnings for the years ended December 31, 2004, 2005 and 2006, and the consolidated balance sheet data as of December 31, 2005 and 2006, are derived from our audited consolidated financial statements included elsewhere herein. The consolidated statements of earnings for the years ended December 31, 2002 and 2003, and the consolidated balance sheet data as of December 31, 2002, 2003 and 2004, are derived from our audited consolidated financial statements, as adjusted for discontinued operations, that are not included herein.

   
Year Ended December 31,
 
   
        2002
 
       2003
 
         2004
 
          2005
 
       2006
 
Consolidated Statements of Earnings:
 
(in thousands, except per share data)
 
Net sales
 
$
198,790
 
$
296,689
 
$
367,687
 
$
492,766
 
$
518,829
 
Cost of sales (1)
   
96,612
   
142,918
   
186,813
   
252,935
   
275,754
 
Restructuring charge related to discontinued
automotive collectibles
   
   
   
   
   
1,872
 
Gross profit
   
102,178
   
153,771
   
180,874
   
239,831
   
241,203
 
Selling, general and administrative expenses (1)
   
64,591
   
100,385
   
121,785
   
150,381
   
155,180
 
Amortization of intangible assets
   
   
30
   
94
   
1,385
   
1,149
 
Impairment of intangible assets
   
   
327
   
4,318
   
 
 
 
Gain on sale of W. Britain product line
   
   
   
   
(1,953
)
 
 
Restructuring charge related to discontinued
automotive collectibles
   
   
   
   
 
 
12,631
 
Operating income
   
37,587
   
53,029
   
54,677
   
90,018
   
72,243
 
Interest expense, net
   
1,836
   
3,477
   
4,063
   
5,983
   
3,465
 
Other (income) expense
   
(603
)
 
(145
)
 
(508
)
 
146
   
530
 
Income from continuing operations
before income taxes
   
36,354
   
49,697
   
51,122
   
83,889
   
68,248
 
Income tax expense
   
14,327
   
13,904
   
18,755
   
31,153
   
24,478
 
Income from continuing operations
   
22,027
   
35,793
   
32,367
   
52,736
   
43,770
 
Income (loss) from discontinued operations,
net of tax
   
2,718
   
2,624
   
1,611
   
394
   
(9,676
)
Net income
 
$
24,745
 
$
38,417
 
$
33,978
 
$
53,130
 
$
34,094
 
Basic earnings per common share:
                               
Income from continuing operations
 
$
1.38
 
$
2.10
 
$
1.73
 
$
2.56
 
$
2.09
 
Income (loss) from discontinued operations
   
0.17
   
0.15
   
0.09
   
0.02
   
(0.46
)
Net income
 
$
1.55
 
$
2.25
 
$
1.82
 
$
2.58
 
$
1.63
 
Diluted earnings per common share:
                               
Income from continuing operations
 
$
1.31
 
$
1.98
 
$
1.64
 
$
2.45
 
$
2.04
 
Income (loss) from discontinued operations
   
0.16
   
0.14
   
0.08
   
0.02
   
(0.45
)
Net income
 
$
1.47
 
$
2.12
 
$
1.72
 
$
2.47
 
$
1.59
 
Weighted average shares outstanding:
                               
Basic
   
15,981
   
17,060
   
18,687
   
20,613
   
20,884
 
Diluted
   
16,829
   
18,105
   
19,761
   
21,532
   
21,377
 

   
As of December 31,
 
   
2002
 
2003
 
2004
 
2005
 
2006
 
Consolidated Balance Sheet Data:
                     
Working capital
 
$
49,540
 
$
70,471
 
$
112,931
 
$
113,286
 
$
129,602
 
Total assets
   
236,287
   
381,829
   
585,748
   
629,736
   
614,640
 
Total debt
   
8,000
   
85,000
   
131,250
   
82,647
   
22,438
 
Total stockholders’ equity
 
$
170,881
 
$
225,299
 
$
346,762
 
$
398,951
 
$
451,926
 

(1) Depreciation expense was $8.9 million, $11.9 million, $15.3 million, $14.4 million and $14.1 million for the years ended December 31, 2002, 2003, 2004, 2005 and 2006, respectively.

General Note: Results for 2003 include the results of LCI from March 1, 2003. Results for 2004 include the results of PM from June 1, 2004, and TFY from September 16, 2004. As these acquisitions were accounted for using the purchase method of accounting, periods prior to the acquisition effective dates do not include any results for LCI, PM or TFY. Discontinued operations include the results from our collectible trading card business and die-cast sports collectibles product line, which were disposed of in connection with the sale of RC2 South, Inc. effective November 1, 2006.

15


Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

We are a leading designer, producer and marketer of innovative, high-quality toys, collectibles, and infant products that are targeted to consumers of all ages. We reach our target consumers through multiple channels of distribution supporting more than 25,000 retail outlets throughout North America, Europe, Australia and Asia Pacific. Our product categories include (i) infant and toddler products, (ii) preschool products and (iii) youth and adult products. We market a significant portion of our products with licenses from other parties, and we are currently a party to over 500 license agreements, approximately 400 of which are actively used in our current product lines.

Sales. Our sales are primarily derived from the sale of infant and toddler products, preschool products and youth and adult products and are recognized upon transfer of title of product to our customers. We market our products through a variety of distribution channels, including chain retailers; specialty retailers, wholesalers and OEM dealers; and corporate promotional, direct to consumer and other. For the years ended December 31, 2004, 2005 and 2006, sales to chain retailers comprised 54.3%, 63.8% and 68.0%, respectively, of our net sales.

Our products are marketed and distributed in North America, Europe, Australia and Asia Pacific. International sales, defined as sales outside of North America, constituted 13.8%, 14.5% and 16.7% of our net sales for the years ended December 31, 2004, 2005 and 2006, respectively. We expect international sales to increase over the next several years as we expand our geographic reach. Our net sales have not been materially impacted by foreign currency fluctuations.

We derive a significant portion of our sales from some of the world’s largest retailers. Our top five customers accounted for 39.3%, 48.7% and 51.8% of our net sales in 2004, 2005 and 2006, respectively. Wal-Mart, our largest customer accounted for 13.4% and 16.3% of our net sales in 2005 and 2006, respectively. Toys “R” Us/Babies “R” Us accounted for 10.9%, 15.1% and 14.8% of our net sales in 2004, 2005 and 2006, respectively. Target accounted for 12.0% and 13.1% of our net sales in 2005 and 2006, respectively. In 2004, other than Toys “R” Us/Babies “R” Us, no customer accounted for more than 10.0% of our net sales. Other than Toys “R” Us/Babies “R” Us, Wal-Mart and Target, no customer accounted for more than 10.0% of our net sales in 2005 or 2006.

We provide certain customers the option to take delivery of our products in the United States, United Kingdom, Australia, Canada, Belgium or Germany with credit terms generally ranging from 30 to 90 days or directly in China with payment made by irrevocable letter of credit or wire transfer. We generally grant price discounts on direct sales from China resulting in lower gross margins. However, shipments direct from China lower our distribution and administrative costs, so we believe that our operating income margin is comparable for products delivered in China versus products shipped in the United States, United Kingdom, Australia, Canada, Belgium or Germany. For the years ended December 31, 2004, 2005 and 2006, direct sales from China constituted 13.5%, 10.5% and 14.7%, respectively, of our net sales.

We do not ordinarily sell our products on consignment, and we ordinarily accept returns only for defective merchandise. In certain instances, where retailers are unable to resell the quantity of products that they have purchased from us, we may, in accordance with industry practice, assist retailers in selling such excess inventory by offering credits and other price concessions, which are typically evaluated and issued annually. Returns and allowances on an annual basis have ranged from 5.2% to 6.4% of our net sales over the last three years.

Expenses. Our products are manufactured by third-parties, principally located in China. Cost of sales primarily consists of purchases of finished products, which accounted for 79.5%, 81.7% and 82.5% of our cost of sales in 2004, 2005 and 2006, respectively. The remainder of our cost of sales primarily includes tooling depreciation, freight-in from suppliers, concept and design expenses, employee compensation and expense related to stock-based payment arrangements. Substantially all of our purchases of finished products from the Far East are denominated in Hong Kong dollars, and therefore, subject to currency fluctuations. Historically, we have not incurred substantial exposure due to currency fluctuations because since 1983 the Hong Kong government has maintained a policy of linking the Hong Kong dollar and the U.S. dollar. A future increase in the value of the Hong Kong dollar relative to the U.S. dollar may increase our cost of sales and decrease our gross margins. 

Additionally, if our suppliers experience increased raw materials, labor or other costs and pass along such cost increases to us through higher prices for finished goods, our cost of sales would increase, and to the extent we are unable to pass such price increases along to our customers, our gross margins would decrease. For example, increases in the price of zinc, a key component in die-cast products, and increased costs in China, primarily for labor, reduced our gross margins in 2006 and may continue to reduce our gross margins in 2007.

16


Our quarterly gross margins can also be affected by the mix of product that is shipped during each quarter. Our infant and toddler products category has higher sales of non-licensed products that carry lower selling prices and gross margins than our preschool products and youth and adult products categories. Additionally, individual product lines within each category carry gross margins that vary significantly and cause quarterly fluctuations, based on the timing of these individual shipments throughout the year.

Selling, general and administrative expenses primarily consist of royalties, employee compensation, advertising and marketing expenses, freight-out to customers, sales commissions and expense related to stock-based payment arrangements. Royalties vary by product category and are generally paid on a quarterly basis. Multiple royalties may be paid to various licensors on a single product. In 2006, aggregate royalties by product ranged from approximately 1.0% to 19.0% of our net sales price. Royalty expense was approximately 8.0%, 6.6% and 7.4% of our net sales for the years ended December 31, 2004, 2005 and 2006, respectively. In 2006, we signed two new license agreements with HIT Entertainment with respect to certain Thomas & Friends product lines. Based on the new agreements, we expect our total pre-tax licensing cost, net of expected price increases and margin improvements, for these Thomas & Friends licenses will increase by approximately $4.0 million in 2007 when compared to 2006. Sales commissions ranged from approximately 1.0% to 12.0% of the net sales price and are generally paid quarterly to our external sales representative organizations. Sales subject to commissions represented 32.1%, 31.1% and 30.2% of our net sales for the years ended December 31, 2004, 2005 and 2006, respectively. Sales commission expense was 1.6%, 1.3% and 1.2% of our net sales for the years ended December 31, 2004, 2005 and 2006, respectively.

On January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based Payment,” using the modified prospective method. This Statement is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” For periods ended prior to January 1, 2006, pursuant to APB Opinion No. 25, no stock-based employee compensation expense was recognized by the Company and, under the modified prospective method pursuant to SFAS No. 123R, results for prior periods have not been restated.

In order to support our new product launches and to build consumer awareness of our owned brands, we are planning new investment spending of approximately $9 million in 2007. We estimate that $5 million to $7 million of this amount will be expensed in 2007. This spending will be focused on key strategic plan initiatives including on-line, digital and traditional consumer marketing and building and launching owned brands.

Seasonality. We have experienced, and expect to continue to experience, substantial fluctuations in our quarterly net sales and operating results, which is typical of many companies in our industry. Our business is highly seasonal due to high consumer demand for our products during the year-end holiday season. Approximately 61.6% of our net sales for the three years ended December 31, 2006, were generated in the second half of the year. As a result, our working capital, mainly inventory and accounts receivable, is typically highest during the third and fourth quarters and lowest during the first and second quarters.


17

Results of Operations
   
Year Ended December 31,
   
         2004
 
        2005
 
        2006
 
   
Amount
 
Percent
 
Amount
 
Percent
 
Amount
 
Percent
 
   
(in thousands, except per share data)
Net sales
 
$
367,687
   
100.0
%
$
492,766
   
100.0
%
$
518,829
   
100.0
%
Cost of sales
   
186,813
   
50.8
   
252,935
   
51.3
   
275,754
   
53.1
 
Restructuring charge related to discontinued
automotive collectibles
   
   
   
   
   
1,872
   
0.4
 
Gross profit
   
180,874
   
49.2
   
239,831
   
48.7
   
241,203
   
46.5
 
Selling, general and
administrative expenses
   
121,785
   
33.1
   
150,381
   
30.5
   
155,180
   
29.9
 
Amortization of intangible assets
   
94
   
   
1,385
   
0.3
   
1,149
   
0.3
 
Impairment of intangible assets
   
4,318
   
1.2
   
   
   
   
 
Gain on sale of W. Britain product line
   
   
   
(1,953
)
 
(0.4
)  
 
 
 
Restructuring charge related to discontinued
automotive collectibles
   
   
   
   
   
12,631
 
 
2.4
 
Operating income
   
54,677
   
14.9
   
90,018
   
18.3
   
72,243
   
13.9
 
Interest expense, net
   
4,063
 
 
1.1
   
5,983
 
 
1.2
   
3,465
 
 
0.7
 
Other (income) expense
   
(508
)
 
(0.1
)
 
146
 
 
   
530
 
 
0.1
 
Income from continuing operations
before income taxes
   
51,122
   
13.9
   
83,889
 
 
17.1
   
68,248
 
 
13.1
 
Income tax expense
   
18,755
   
5.1
   
31,153
 
 
6.3
   
24,478
 
 
4.7
 
Income from continuing operations
   
32,367
   
8.8
   
52,736
 
 
10.8
   
43,770
 
 
8.4
 
Income (loss) from discontinued
operations, net of tax
   
1,611
   
0.4
   
394
 
 
   
(9,676
)
 
(1.9
 
)
Net income
 
$
33,978
   
9.2
%
$
53,130
 
 
10.8
%
$
34,094
 
 
6.5
%
                                       
Basic earnings per common share:
                                     
Income from continuing operations
 
$
1.73
       
$
2.56
 
     
$
2.09
 
     
Income (loss) from discontinued
operations
   
0.09
         
0.02
 
       
(0.46
)
     
Net income
 
$
1.82
       
$
2.58
 
     
$
1.63
 
     
Diluted earnings per common share:
                                     
Income from continuing operations
 
$
1.64
       
$
2.45
 
     
$
2.04
 
     
Income (loss) from discontinued
operations
   
0.08
         
0.02
 
       
(0.45
)
     
Net income
 
$
1.72
       
$
2.47
 
     
$
1.59
 
     
Weighted average shares outstanding:
                                     
Basic
   
18,687
         
20,613
         
20,884
       
Diluted
   
19,761
         
21,532
         
21,377
       

Operating Highlights

Net sales for the year ended December 31, 2006, increased 5.3%. Gross margin decreased to 46.5% for 2006 from 48.7% for 2005. Selling, general and administrative expenses as a percentage of net sales decreased to 29.9% for 2006 from 30.5% for 2005. Operating income decreased to $72.2 million for 2006 compared to $90.0 million for 2005. As a percentage of net sales, operating income decreased to 13.9% for 2006 from 18.3% for 2005.

On January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based Payment,” using the modified prospective method. This Statement is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” For periods ended prior to January 1, 2006, pursuant to APB Opinion No. 25, no stock-based employee compensation expense was recognized by the Company and, under the modified prospective method pursuant to SFAS No. 123R, results for the prior periods have not been restated. Operating income for the year ended December 31, 2006 includes $3.9 million in compensation expense for stock options as a result of the Company’s adoption of SFAS No. 123R which negatively impacted diluted earnings per share from continuing operations by $0.11. Results for the years ended December 31, 2004 and 2005 do not include compensation expense for stock options.

18


Effective November 1, 2006, the Company sold all of the issued and outstanding capital stock of RC2 South, Inc., its collectible trading card business, and substantially all of the assets related to its die-cast sports collectibles product line. Closing consideration consisted of $6.9 million of cash, excluding transaction expenses. The sale of the Company’s trading card business and sports collectibles product line is consistent with the Company's strategic focus to achieve sustainable organic growth and to concentrate its efforts on its higher growth infant and toddler products and preschool products categories. The transaction was effective November 1, 2006 and the results of this sold business are presented as discontinued operations in the accompanying consolidated statements of earnings and consolidated statements of cash flows. A loss on the sale of $11.4 million, net of income tax benefit, was recognized on this sales transaction. The loss is presented in income (loss) from discontinued operations, net of tax, on the accompanying consolidated statement of earnings for the year ended December 31, 2006.

During December 2006, the Company made the decision to discontinue its Racing Champions, JoyRide, AMT and certain Ertl die-cast and model kit automotive collectible product lines. As a result of discontinuing certain of these product lines, the Company recorded a non-cash restructuring charge of $14.5 million, or $9.1 million net of estimated income tax benefits, or $0.42 per diluted share, to write-off undepreciated tooling costs and unamortized intangible assets and to provide inventory and royalty reserves.

Results for 2005 were negatively impacted by a tax charge of $0.5 million incurred as a result of repatriation of foreign earnings and by additional depreciation expense of $0.8 million, or $0.5 million net of income tax benefit, for tooling on discontinued product lines. These negative impacts were offset by a gain of $2.0 million, or $1.2 million net of income tax expense, on the sale of the W. Britain product line and an income tax benefit of $0.7 million due to a reduction of income tax accruals stemming from the resolution of specific outstanding state and foreign tax issues. The combined impact of these charges positively impacted diluted earnings per share for the year ended December 31, 2005, by $0.05 per diluted share.

Results for 2004 were negatively impacted by the Company’s decision to discontinue certain low-performing product lines as well as its distribution at NASCAR trackside sales events. In 2004, the Company recorded a non-cash impairment charge of $4.3 million, or $2.7 million net of income tax benefits, to write-off intangible license and trademark assets recorded at the time of the Learning Curve acquisition. In addition, charges to write-off undepreciated tooling and fixed assets and to provide inventory and royalty reserves related to the discontinued product lines and trackside sales distribution totaled $4.2 million, or $2.7 million net of income tax benefits. The Company also recorded an adjustment to the income tax provision of $0.6 million in 2004. The combined impact of these charges on the Company’s diluted earnings per share was $0.30 for the year ended December 31, 2004. 

Results for 2004 include PM from June 1, 2004, and TFY from September 16, 2004.

Year Ended December 31, 2006, Compared to Year Ended December 31, 2005

Net sales. Net sales increased $26.0 million, or 5.3%, to $518.8 million for 2006 from $492.8 million for 2005. Net sales increased in our infant and toddler products and preschool products categories, but these increases were partially offset by a decrease in our youth and adult products category.

Net sales in our preschool products category increased 14.7% primarily attributable to the Thomas & Friends, Bob the Builder and John Deere ride-on and toy vehicles product lines. Net sales in our infant and toddler products category increased 9.8% primarily attributable to The First Years’ Take & Toss toddler self-feeding system, Soothie bottle system and Learning Curve’s Lamaze infant toys. Net sales in our youth and adult products category decreased 14.4% primarily due to continued softness in the collectibles market.
 
Actual net sales for 2006, excluding $37.4 million in net sales of sold and discontinued product lines, were $481.4 million, an increase of 12.0% when compared to 2005 actual net sales, excluding $62.9 million in net sales of sold and discontinued product lines, of $429.9 million. Management has provided this non-GAAP financial information so that investors can more easily compare financial performance of the Company's current business operations from period to period. A reconciliation to the nearest GAAP financial measure follows:

(in millions)
 
    Net Sales
 
2006 actual
 
$
518.8
 
Deduct: sold and discontinued product lines
   
37.4
 
   
$
481.4
 
         
2005 actual
 
$
492.8
 
Deduct: sold and discontinued product lines
   
62.9
 
   
$
429.9
 
 
Gross profit. Gross profit increased $1.4 million, or 0.6%, to $241.2 million for 2006 from $239.8 million for 2005. However, the gross profit margin, as a percentage of net sales, decreased to 46.5% for 2006 compared to 48.7% for 2005.  This decrease was primarily due to a less favorable product and distribution mix, higher product costs, especially in die-cast products, and increasing costs in China, primarily for labor, than that experienced in 2005.  In addition, the 2006 gross profit was negatively impacted by the $1.9 million restructuring charge related to the discontinuance of the automotive collectible product lines. There were no major changes in the components of cost of sales. 

Selling, general and administrative expenses. Selling, general and administrative expenses increased $4.8 million, or 3.2%, to $155.2 million for 2006 from $150.4 million for 2005. As a percentage of net sales, selling, general and administrative expenses decreased to 29.9% for 2006 from 30.5% for 2005. Selling, general and administrative expenses for the year ended December 31, 2006 include $3.9 million of compensation expense for stock options. Results for the year ended December 31, 2005 do not include compensation expense for stock options.  Pro forma compensation expense for stock options for the year ended December 31, 2005 was $3.3 million. 

19


Operating income. Operating income decreased to $72.2 million for 2006 from $90.0 million for 2005. As a percentage of net sales, operating income decreased to 13.9% for 2006 from 18.3% for 2005. Operating income for 2006 includes a $14.5 million restructuring charge related to the discontinuance of the automotive collectible product lines. Operating income for 2005 includes a $2.0 million gain on the sale of assets related to the sale of our W. Britain product line.  

Net interest expense. Net interest expense of $3.5 million for 2006 and $6.0 million for 2005 relates primarily to bank term loans and lines of credit. The decrease in net interest expense for 2006 was primarily due to a decrease in average outstanding debt balances offset slightly by higher interest rates.

Income tax. Income tax expense of $24.5 million for 2006 includes provisions for federal, state and foreign income taxes at an effective rate of 37.3%. However, the tax rate including discrete items for 2006 is 35.9%. Discrete items include significant, unusual or non-recurring items. Income tax expense of $31.2 million for 2005 includes a tax charge of $0.5 million, or $0.02 per diluted share, incurred as a result of repatriation of foreign earnings and a tax benefit of $0.7 million, or $0.03 per diluted share, relating to a reduction of income tax accruals stemming from the resolution of specific outstanding state and foreign tax issues. Income tax expense for 2005 includes provisions for federal, state and foreign income taxes at an effective rate of 37.1%.

Year Ended December 31, 2005, Compared to Year Ended December 31, 2004

Net sales. Net sales increased $125.1 million, or 34.0%, to $492.8 million for 2005 from $367.7 million for 2004. This sales increase was primarily attributable to the addition of TFY for the full year of 2005 versus only three-and-a-half months in 2004, as well as growth in our preschool products category. Net sales increased in our infant and toddler products and preschool products categories, but these increases were partially offset by a decrease in our youth and adult products category.

Net sales in our infant and toddler products category increased 165.9% primarily due to the addition of TFY. Net sales in our preschool products category increased 20.1% primarily driven by strong performance of Thomas & Friends and John Deere toy vehicles and our ride-on products, as well as sales of our new Bob the Builder product line. Net sales in our youth and adult products category decreased 5.8% primarily due to the continued tough comparisons to both The Fast and The Furious and American Chopper/Orange County Chopper product lines in 2004, the discontinuance of Memory Lane seasonal figures, lower overall NASCAR product sales and the discontinuance of distribution at NASCAR trackside events in 2005.

Gross profit. Gross profit increased $58.9 million, or 32.6%, to $239.8 million for 2005 from $180.9 million for 2004 . The gross profit margin, as a percentage of net sales, decreased to 48.7% for 2005 compared to 49.2% for 2004. Gross profit for 2004 was adversely affected by $3.0 million in non-recurring charges to write-off undepreciated tooling and to provide for inventory related to the discontinued product lines and trackside sales distribution. There were no major changes in the components of cost of sales.

Selling, general and administrative expenses. Selling, general and administrative expenses increased $28.6 million, or 23.5%, to $150.4 million for 2005 from $121.8 million for 2004. As a percentage of net sales, selling, general and administrative expenses decreased to 30.5% for 2005 from 33.1% for 2004. Selling, general and administrative expenses for 2004 include $1.2 million in non-recurring charges. The decrease in selling, general and administrative expenses as a percentage of net sales was primarily due to operating leverage gained from the increased sales from the 2004 acquisitions, integration cost savings and disciplined control over discretionary operating expenses. Results for the years ended December 31, 2004 and 2005 do not include compensation expense for stock options.

Operating income. Operating income increased to $90.0 million for 2005 from $54.7 million for 2004. As a percentage of net sales, operating income increased to 18.3% for 2005 from 14.9% for 2004. Operating income for 2005 includes a $2.0 million gain on the sale of assets related to the sale of our W. Britain product line. Operating income for 2004 includes $8.5 million in non-recurring charges related to the discontinuance of certain product lines and our NASCAR trackside distribution.

Net interest expense. Net interest expense of $6.0 million for 2005 and $4.1 million for 2004 relates primarily to bank term loans and lines of credit. The increase in net interest expense for 2005 was primarily due to the increase in average outstanding debt balances and an increase in the Company’s incremental borrowing rate.

Income tax. Income tax expense of $31.2 million for 2005 includes a tax charge of $0.5 million, or $0.02 per diluted share, incurred as a result of repatriation of foreign earnings and a tax benefit of $0.7 million, or $0.03 per diluted share, relating to a reduction of income tax accruals stemming from the resolution of specific outstanding state and foreign tax issues. Income tax expense for 2005 includes provisions for federal, state and foreign income taxes at an effective rate of 37.1%. Income tax expense of $18.8 million for 2004 includes an adjustment to the income tax provision of $0.06 million, or $0.03 per diluted share. Income tax expense in 2004 includes provisions for federal, state and foreign income taxes at an effective rate of 36.7%.

20


Liquidity and Capital Resources

We generally fund our operations and working capital needs through cash generated from operations and borrowings under our credit facility. Our operating activities generated cash of $61.8 million in 2006, $59.1 million in 2005 and $64.1 million in 2004.

Working capital increased $16.3 million to $129.6 million at December 31, 2006, from $113.3 million at December 31, 2005. Cash and cash equivalents increased $0.1 million to $25.4 million at December 31, 2006, from $25.3 million at December 31, 2005. Our accounts receivable decreased $0.2 million to $112.9 million at December 31, 2006, from $113.1 million at December 31, 2005. Our inventory level increased $12.4 million to $83.7 million at December 31, 2006, from $71.3 million at December 31, 2005.

Net cash used in investing activities was $8.3 million in 2006, $6.6 million in 2005 and $185.0 million in 2004. Capital expenditures for molds and tooling in 2006 and 2005 were $14.4 million and $14.1 million, respectively, and we expect capital expenditures for 2007, principally for molds and tooling, to be approximately $16.0 million.

Net cash used in financing activities in 2006 and 2005 was $54.5 million and $46.5 million, respectively. Net cash provided by financing activities in 2004 was $123.4 million. In 2006, we made payments of $42.3 million on our term loans. During 2006, we borrowed a total of $18.0 million and made total payments of $36.3 million on our lines of credit. At December 31, 2006, we had $99.6 million available on our domestic line of credit. Historically, we have used a significant portion of excess cash to pay down debt.

Upon the closing of the acquisition of TFY on September 15, 2004, the Company entered into a new credit facility, which has subsequently been amended, to replace its previous credit facility. The credit facility is comprised of an $85.0 million term loan and a $100.0 million revolving line of credit. The credit facility also provides an additional $75.0 million of capacity under the revolving line of credit. This additional capacity is currently uncommitted by the lenders and must be approved by the lenders upon the Company’s request for borrowing. Principal payments ranging from $3.8 million to $6.5 million on the term loan are scheduled quarterly beginning December 31, 2004 and continue thereafter until December 31, 2007. The revolving line of credit is available until its maturity on September 14, 2008. A portion of the term loan has an interest rate of 3.45% plus applicable margin through the first three years of the facility. The remaining term loan and revolving line of credit bear interest, at the Company’s option, at a base rate or at a LIBOR rate plus applicable margin. The applicable margin is based on the Company’s ratio of consolidated debt to consolidated EBITDA (earnings before interest, taxes, depreciation, amortization and non-cash expense related to equity awards) and varies between 0.75% and 1.625%. At December 31, 2006, the margin in effect was 0.75% for LIBOR loans. The Company is also required to pay a commitment fee of 0.20% to 0.35% per annum on the average daily unused portion of the revolving line of credit. At December 31, 2006, the commitment fee in effect was 0.20% per annum. Under the terms of this credit facility, the Company is required to comply with certain financial and non-financial covenants. Among other restrictions, the Company is restricted in its ability to pay dividends, incur additional debt and make acquisitions above certain amounts. The key financial covenants include minimum EBITDA and interest coverage and leverage ratios. The credit facility is secured by working capital assets and certain intangible assets. On December 31, 2006, the Company had $22.4 million outstanding on the term loan and no amounts outstanding on the revolving line of credit and was in compliance with all covenants.

In August 2004, the Company completed a public offering of 2,655,000 shares of common stock, and certain selling stockholders sold 220,000 shares of common stock at a price of $31.00 per share. The Company received proceeds of $77.8 million from the offering, net of underwriting discount, and used $74.0 million of the proceeds to repay outstanding debt.

The Company’s Hong Kong subsidiary maintains an on-going credit agreement with a bank that provides for a line of credit of up to $1.9 million. Amounts borrowed under this line of credit bear interest at the bank’s prime rate or prevailing funding cost, whichever is higher, and are cross-guaranteed by the Company. As of December 31, 2005 and 2006, there were no outstanding borrowings under this line of credit.

The Company’s United Kingdom subsidiary maintains a line of credit with a bank for $0.2 million that expires on July 31, 2007. The line of credit bears interest at 1.0% over the bank’s base rate, and the total amount is subject to a letter of guarantee given by the Company. At December 31, 2005 and 2006, there were no amounts outstanding on this line of credit.

During 2005, the Company’s United Kingdom subsidiary entered into an additional line of credit with a bank for $8.0 million that was to expire on September 14, 2008. The line of credit bore interest at 1.15% over the LIBOR rate, and the total amount was secured by a guarantee of the Company. During 2006, all borrowings under the line of credit were repaid and the Company cancelled the availability thereunder.

21


The following table summarizes our significant contractual commitments at December 31, 2006:

   
Payment Due by Period
 
(in thousands)
Contractual Obligations
 
Total
 
  2007
 
     2008-2009
 
      2010-2011
 
2012 and
beyond
 
Long-term debt (including current portion)
 
$
22,438
 
$
22,438
 
$
 
$
 
$
 
Estimated future interest payments
on long-term debt
   
632
   
632
   
   
   
 
Minimum guaranteed royalty payments
   
50,702
   
10,288
   
16,485
   
15,689
   
8,240
 
Operating leases
   
30,249
   
4,644
   
7,626
   
4,835
   
13,144
 
Unconditional purchase obligations
   
83,952
   
21,528
   
42,024
   
20,400
   
 
Total contractual cash obligations
 
$
187,973
 
$
59,530
 
$
66,135
 
$
40,924
 
$
21,384
 

Estimated future interest payments on long-term debt were based upon the interest rates in effect at December 31, 2006.

On February 22, 2007, we announced that our Board of Directors authorized a stock repurchase program to repurchase up to $75 million in shares of our common stock. The program has initially been authorized for a period of one year, but may be extended beyond that period or may be suspended at any time. Repurchases may occur from time to time and are expected be funded by cash flow from operations.

We believe that our cash flows from operations, cash on hand and available borrowings will be sufficient to meet our working capital and capital expenditure requirements and provide us with adequate liquidity to meet anticipated operating needs in 2007. Due to seasonal increases in demand for our products, our working capital is typically highest during the third and fourth quarters and our debt levels are the highest during the second and third quarters. Although operating activities are expected to provide sufficient cash, any significant future product or property acquisitions, including up-front licensing payments, may require additional debt or equity financing.

Off-Balance Sheet Arrangements

The Company did not have any off-balance sheet arrangements during any of the years ended December 31, 2004, 2005 and 2006.

Critical Accounting Policies and Estimates

The Company makes certain estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. The accounting policies described below are those the Company considers critical in preparing its consolidated financial statements. These policies include significant estimates made by management using information available at the time the estimates are made. However, as described below, these estimates could change materially if different information or assumptions were used.

Allowance for doubtful accounts. The allowance for doubtful accounts represents adjustments to customer trade accounts receivable for amounts deemed uncollectible. The allowance for doubtful accounts reduces gross trade receivables to their estimated net realizable value and is disclosed on the face of the accompanying consolidated balance sheets. The Company’s allowance is based on management’s assessment of the business environment, customers’ financial condition, historical trends, customer payment practices, receivable aging and customer disputes. The Company has purchased credit insurance that covers a portion of its receivables from major customers. The Company will continue to proactively review its credit risks and adjust its customer terms to reflect the current environment.

Inventory. Inventory, which consists of finished goods, has been written down for excess quantities and obsolescence, and is stated at the lower of cost or market. Cost is determined by the first-in, first-out method and includes all costs necessary to bring inventory to its existing condition and location. Market represents the lower of replacement cost or estimated net realizable value. Inventory write-downs are recorded for damaged, obsolete, excess and slow-moving inventory. The Company’s management uses estimates to record these write-downs based on its review of inventory by product category, length of time on hand and order bookings. Changes in public and consumer preferences and demand for product or changes in customer buying patterns and inventory management, as well as discontinuance of products or product lines, could impact the inventory valuation.

22


Impairment of long-lived assets, goodwill and other intangible assets. Long-lived assets have been reviewed for impairment based on SFAS No. 144, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of.” This Statement requires that an impairment loss be recognized whenever the carrying value of an asset exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of that asset, excluding future interest costs the entity would recognize as an expense when incurred. Goodwill and other intangible assets have been reviewed for impairment based on SFAS No. 142, “Goodwill and Other Intangible Assets.” Under this Statement, goodwill and other intangible assets that have indefinite useful lives are not amortized, but rather tested at least annually for impairment. The Company’s management reviews for indicators that might suggest an impairment loss could exist. Testing for impairment requires estimates of expected cash flows to be generated from the use of the assets. Various uncertainties, including changes in consumer preferences, deterioration in the political environment or changes in general economic conditions, could impact the expected cash flows to be generated by an asset or group of assets. Intangible assets that have finite useful lives are amortized over their useful lives. The Company adopted SFAS No. 142 on January 1, 2002. Goodwill had been amortized over 40 years on a straight-line basis through December 31, 2001. Approximately $88.7 million of this goodwill is tax deductible over 15 years. 

As of December 31, 2005 and 2006, goodwill, net of accumulated amortization, was $253.6 million and $239.1 million, respectively. The decrease in goodwill at December 31, 2006, was due to the completion of the sale of the RC2 South, Inc. business. The Company completed its annual goodwill impairment tests as of October 1, 2005 and 2006 which resulted in no impairment. The annual impairment tests for intangible assets in 2005 resulted in no impairment to intangibles. However, for the year ended December 31, 2006, an impairment charge for intangible assets in the North America segment of $2.8 million has been included in the restructuring charge related to discontinued automotive collectibles within operating expenses in the accompanying consolidated statement of earnings, as a result of the 2006 annual impairment test for intangible assets. The impairment charge was based upon the Company’s decision to discontinue its automotive collectible product lines.

Income taxes. The Company records current and deferred income tax assets and liabilities. Management considers all available evidence in evaluating the realizability of the deferred tax assets and records valuation allowances against its deferred tax assets as needed. Management believes it is more likely than not that the Company will generate sufficient taxable income in the appropriate carry-forward periods to realize the benefit of its deferred tax assets except for those deferred tax assets for which an allowance has been provided. In determining the required liability, management considers certain tax exposures and all available evidence. However, if the available evidence were to change in the future, an adjustment to the tax-related balances may be required. Estimates for such tax contingencies are classified in other non-current liabilities on the accompanying consolidated balance sheets.

Accrued allowances. The Company ordinarily accepts returns only for defective merchandise. In certain instances, where retailers are unable to resell the quantity of products that they have purchased from the Company, the Company, may, in accordance with industry practice, assist retailers in selling excess inventory by offering credits and other price concessions, which are typically evaluated and issued annually. Other allowances can also be issued for defective merchandise, volume programs and co-op advertising. All allowances are accrued throughout the year, as sales are recorded. The allowances are based on the terms of the various programs in effect; however, management also takes into consideration historical trends and specific customer and product information when making its estimates. For the volume programs, the Company generally sets a volume target for the year with each participating customer and issues the discount if the target is achieved. The allowance for the volume program is accrued throughout the year, and if it becomes clear to management that the target for the participating customer will not be reached, the Company will change the estimate for that customer as required. The Company’s products currently carry a limited warranty which guarantees the product to be free from defects in material and workmanship under normal and intended use for a period of 90 days from the date of consumer purchase. Historical results of product warranty claims have shown that they have had an immaterial impact on the Company. Based upon the historical results, appropriate allowances for product warranty claims are accrued throughout the year.

Accrued royalties. Royalties are accrued based on the provisions in licensing agreements for amounts due on net sales during the period, as well as management estimates for additional royalty exposures. Royalties vary by product category and are generally paid on a quarterly basis. Multiple royalties may be paid to various licensors on a single product. Royalty expense is included in selling, general and administrative expenses on the accompanying consolidated statements of earnings.

Stock-based compensation. On January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based Payments.” The Company elected to use the modified prospective application of SFAS No. 123R for awards issued prior to January 1, 2006. Income from continuing operations before income taxes for the year ended December 31, 2006 includes total expense recognized for stock-based payment plans.

23


The fair value of stock options granted under the stock incentive plans is estimated on the date of grant based on the Black-Scholes option pricing model. The Company calculates the expected volatility factor for those options issued under the stock incentive plan to correspond with the average volatility factor of those companies included in a peer group study. The historical stock price movements of the Company’s common stock have not been considered a good indicator of expected future volatility because the Company’s business has changed significantly as a result of acquisitions completed. However, the Company continues to monitor its actual volatility to assess whether its historical stock price movements over the expected option term are a good indicator of expected future results. 

The Company uses historical data to estimate share option exercise and employee departure behavior used in the Black-Scholes option pricing model. The expected term of share options granted represents the period of time that share options granted are expected to be outstanding. The risk-free rate for the period within the contractual term of the share option is based on the U.S. Treasury yield curve in effect at the time of grant.

Recently Issued Accounting Pronouncements

In June 2006, the FASB issued FASB Interpretation 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109.” This Interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” This Interpretation prescribes a recognition threshold and measurement approach for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006. The Company is currently assessing the impact that this Interpretation will have on the Company’s financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurement. However, this Statement does not require any new fair value measurements. This Statement is effective for the financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is evaluating the effect that this Statement will have on the Company’s financial statements.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

The Company’s exposure to market risk is limited to interest rate risk associated with the Company’s credit facilities and foreign currency exchange rate risk associated with the Company’s foreign operations.

Based on the Company’s interest rate exposure on variable rate borrowings at December 31, 2006, a one percentage point increase in average interest rates on the Company’s borrowings would increase future interest expense by $1,664 per month and a five percentage point increase would increase future interest expense by approximately $8,318 per month. The Company determined these amounts based on approximately $2.0 million of variable rate borrowings at December 31, 2006, multiplied by 1.0% and 5.0%, respectively, and divided by twelve. The Company is currently not using any interest rate collars, hedges or other derivative financial instruments to manage or reduce interest rate risk. As a result, any increase in interest rates on the Company’s variable rate borrowings would increase interest expense and reduce net income.


24


The Company’s net sales are primarily denominated in U.S. dollars, with 15.5% of net sales in 2006 denominated in British pounds sterling, Australian dollars, Euros and Canadian dollars. The Company’s purchases of finished goods from Chinese manufacturers are primarily denominated in Hong Kong dollars. Expenses for these manufacturers are primarily denominated in Chinese Renminbi. The Hong Kong dollar is currently pegged to the U.S. dollar. If the Hong Kong dollar ceased to be pegged to the U.S. dollar, a material increase in the value of the Hong Kong dollar relative to the U.S. dollar would increase our expenses and, therefore, could adversely affect our profitability. A 10.0% change in the exchange rate of the U.S. dollar with respect to the Hong Kong dollar for the year ended December 31, 2006, would have changed the total dollar amount of our gross profit by 9.6%. During July 2005, China revalued the Chinese Renminbi, abandoning the former method of pegging the Chinese Renminbi to the U.S. dollar. As expenses for the Company’s Chinese manufacturers are primarily denominated in Chinese Renminbi, a material increase in the value of the Chinese Renminbi relative to the U.S. dollar would increase the Company’s expenses and, therefore, could adversely affect the Company’s profitability. A 10.0% change in the exchange rate of the U.S. dollar with respect to the British pound sterling, the Australian dollar, the Euro or the Canadian dollar for the year ended December 31, 2006, would not have had a significant impact on the Company’s earnings. The Company is also subject to exchange rate risk relating to transfers of funds denominated in British pounds sterling, Australian dollars, Canadian dollars or Euros from its foreign subsidiaries to the United Sates. Historically, the Company has not used hedges or other derivative financial instruments to manage or reduce exchange rate risk.

Item 8. Financial Statements and Supplementary Data

Financial Statements

Our consolidated financial statements and notes thereto are filed under this item beginning on page F1 of this report.


25


Quarterly Results of Operations

The following tables set forth our unaudited quarterly results of operations for 2005 and 2006. We have prepared this unaudited information on a basis consistent with the audited consolidated financial statements contained in this report and this unaudited information includes all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair presentation of our results of operations for the quarters presented. You should read this quarterly financial data along with the Condensed Consolidated Financial Statements and the related notes to those statements included in our Quarterly Reports on Form 10-Q filed with the Commission. The operating results for any quarter are not necessarily indicative of the results for the annual period or any future period.

   
Fiscal Year 2005
 
(in thousands, except per share data)
 
Q1
 
Q2
 
Q3
 
Q4
 
Net sales
 
$
94,704
 
$
104,231
 
$
139,895
 
$
153,936
 
Cost of sales (1)
   
46,561
   
53,894
   
71,280
   
81,200
 
Gross profit
   
48,143
   
50,337
   
68,615
   
72,736
 
Selling, general and administrative expenses (1)
   
34,640
   
34,843
   
38,536
   
42,362
 
Amortization of intangible assets
   
94
   
156
   
845
   
290
 
Gain on sale of W. Britain product line
   
   
   
(1,953
)
 
 
Operating income
   
13,409
   
15,338
   
31,187
   
30,084
 
Interest expense, net
   
1,321
   
1,714
   
1,522
   
1,426
 
Other (income) expense
   
(85
)
 
(266
)
 
4
   
493
 
Income before income taxes
   
12,173
   
13,890
   
29,661
   
28,165
 
Income tax expense
   
4,383
   
4,649
   
11,223
   
10,898
 
Income from continuing operations
   
7,790
   
9,241
   
18,438
   
17,267
 
Income (loss) from discontinued operations,
net of tax
   
38
   
522
   
(178
)
 
12
 
Net income
 
$
7,828
 
$
9,763
 
$
18,260
 
$
17,279
 
Basic earnings per common share:
                         
Income from continuing operations
 
$
0.38
 
$
0.45
 
$
0.89
 
$
0.83
 
Income (loss) from discontinued operations
   
   
0.02
   
(0.01
)
 
 
Net income
 
$
0.38
 
$
0.47
 
$
0.88
 
$
0.83
 
Diluted earnings per common share:
                         
Income from continuing operations
 
$
0.37
 
$
0.43
 
$
0.86
 
$
0.80
 
Income (loss) from discontinued operations
   
   
0.02
   
(0.01
)
 
 
Net income
 
$
0.37
 
$
0.45
 
$
0.85
 
$
0.80
 
Weighted average shares outstanding:
                         
Basic
   
20,496
   
20,593
   
20,656
   
20,703
 
Diluted
   
21,433
   
21,545
   
21,594
   
21,552
 
 
(1)   Depreciation expense was $3.4 million, $3.2 million, $3.7 million and $4.1 million for Q1, Q2, Q3 and Q4 2005, respectively. Q4 2005 depreciation expense includes $0.8 million relating to the write-off of undepreciated tooling for discontinued product lines.

26


   
Fiscal Year 2006
 
(in thousands, except per share data)
 
Q1
 
Q2
 
Q3
 
Q4
 
Net sales
 
$
101,672
 
$
106,586
 
$
156,021
 
$
154,550
 
Cost of sales (1)
   
54,395
   
56,146
   
82,574
   
82,639
 
Restructuring charge related to discontinued
automotive collectibles
   
   
   
   
1,872
 
Gross profit
   
47,277
   
50,440
   
73,447
   
70,039
 
Selling, general and administrative expenses (1)
   
34,116
   
36,646
   
42,425
   
41,993
 
Amortization of intangible assets
   
315
   
315
   
315
   
204
 
Restructuring charge related to discontinued
automotive collectibles
   
   
   
 
 
12,631
 
Operating income
   
12,846
   
13,479
   
30,707
   
15,211
 
Interest expense, net
   
1,015
   
856
   
944
   
650
 
Other (income) expense
   
(155
)
 
37
   
273
   
375
 
Income before income taxes
   
11,986
   
12,586
   
29,490
   
14,186
 
Income tax expense
   
4,420
   
4,538
   
10,758
   
4,762
 
Income from continuing operations
   
7,566
   
8,048
   
18,732
   
9,424
 
(Loss) income from discontinued operations,
net of tax
   
(76
)
 
1,087
   
641
   
(11,328
)
Net income (loss)
 
$
7,490
 
$
9,135
 
$
19,373
 
$
(1,904
)
Basic earnings per common share:
                         
Income from continuing operations
 
$
0.36
 
$
0.39
 
$
0.90
 
$
0.45
 
Income (loss) from discontinued operations
   
   
0.05
   
0.03
   
(0.54
)
Net income (loss)
 
$
0.36
 
$
0.44
 
$
0.93
 
$
(0.09
)
Diluted earnings per common share:
                         
Income from continuing operations
 
$
0.35
 
$
0.38
 
$
0.88
 
$
0.44
 
Income (loss) from discontinued operations
   
   
0.05
   
0.03
   
(0.53
)
Net income (loss)
 
$
0.35
 
$
0.43
 
$
0.91
 
$
(0.09
)
Weighted average shares outstanding:
                         
Basic
   
20,750
   
20,863
   
20,917
   
21,004
 
Diluted
   
21,262
   
21,347
   
21,365
   
21,463
 

(1)  Depreciation expense was $3.5 million, $3.6 million, $3.6 million and $3.4 million for Q1, Q2, Q3 and Q4 2006, respectively.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

Not applicable.

Item 9A. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this report, the Company carried out an evaluation under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended). Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that, as of the end of such period, the Company’s disclosure controls and procedures were effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in reports that the Company files with or submits to the Commission. It should be noted that in designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. The Company has designed its disclosure controls and procedures to reach a level of reasonable assurance of achieving the desired control objectives and based on the evaluation described above, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective at reaching that level of reasonable assurance.


27


Changes in Internal Control Over Financial Reporting

There was no change in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended) during the Company’s most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Management’s Report on Internal Control Over Financial Reporting

Management of the Company is responsible for establishing and maintaining effective internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended). The Company’s internal control over financial reporting is designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation and fair presentation of published financial statements. The Company’s internal control over financial reporting includes those policies and procedures that:

(i)    pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company;

(ii)   provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and

(iii)  provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on our assessment, management believes that, as of December 31, 2006, the Company’s internal control over financial reporting was effective based on those criteria.

KPMG LLP, the independent registered public accounting firm that audited the Company’s consolidated financial statements, has issued an attestation report on management’s assessment of the Company’s internal control over financial reporting, which appears on page F3 hereof.

Item 9B. Other Information

Not applicable.
 

Part III


Item 10. Directors, Executive Officers and Corporate Governance

Information regarding the executive officers and directors of the Company is incorporated herein by reference to the discussions under “Election of Directors,” “Executive Officers,” “Section 16(a) Beneficial Ownership Reporting Compliance” and “Audit Committee Matters-Audit Committee Financial Expert” in the Company’s Proxy Statement for the 2007 Annual Meeting of Stockholders, which will be filed with the Commission on or before April 30, 2007. Information regarding the Company’s Code of Business Ethics is incorporated herein by reference to the discussion under “Corporate Governance Matters-Code of Business Ethics” in the Company’s Proxy Statement for the 2007 Annual Meeting of Stockholders.

The Audit Committee of our Board of Directors is an “audit committee” for purposes of Section 3(a)(58)(A) of the Securities Exchange Act of 1934. The members of the Audit Committee are John J. Vosicky (Chairman), Michael J. Merriman, Jr. and Daniel M. Wright.

28


Item 11. Executive Compensation

Information regarding executive compensation is incorporated herein by reference to the discussion under “Executive Compensation” and “Director Compensation” in the Company’s Proxy Statement for the 2007 Annual Meeting of Stockholders, which will be filed with the Commission on or before April 30, 2007.

The information incorporated by reference from the “Report of the Compensation Committee” in the Company’s Proxy Statement for the 2007 Annual Meeting of Stockholders shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, nor shall it be deemed incorporated by reference in any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except as shall be expressly set forth by specific reference in such filing.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Information regarding security ownership of certain beneficial owners and management is incorporated herein by reference to the discussion under “Security Ownership” in the Company’s Proxy Statement for the 2007 Annual Meeting of Stockholders, which will be filed with the Commission on or before April 30, 2007.

Equity Compensation Plan Information

The following table summarizes share information, as of December 31, 2006, for the Company’s equity compensation plans, including the RC2 Corporation 2005 Stock Incentive Plan, the Racing Champions Ertl Corporation Stock Incentive Plan, the Racing Champions Ertl Corporation Employee Stock Purchase Plan and the Wheels Sports Group, Inc. 1996 Omnibus Stock Plan. All of these plans have been approved by the Company’s stockholders, other than the Wheels Sports Group, Inc. 1996 Omnibus Stock Plan, which was approved by Wheels Sports Group’s stockholders and assumed by the Company following its acquisition of Wheels Sports Group in 1998. The Wheels Sports Group, Inc. 1996 Omnibus Stock Plan and the Racing Champions Ertl Corporation Stock Incentive Plan are dormant, and no future issuances are allowed under these plans.

Plan Category
Number of
Common Shares to Be
Issued Upon Exercise
of Outstanding
Options
Weighted Average
Exercise Price of
Outstanding Options
Number of
Common Shares
Available for Future
Issuance Under
Equity
Compensation Plans
Equity compensation plans
approved by stockholders
1,413,535
$20.16
1,403,019
Equity compensation plans not
approved by stockholders
          —
     —
          —
Total
1,413,535
$20.16
1,403,019

Item 13. Certain Relationships and Related Party Transactions, and Director Independence

Information regarding certain relationships and related transactions is incorporated herein by reference to the discussions under “Transactions with Related Persons” in the Company’s Proxy Statement for the 2007 Annual Meeting of Stockholders, which will be filed with the Commission on or before April 30, 2007. Information regarding director independence is incorporated by reference to the discussions under “Corporate Governance Matters-Director Independence” in the Company’s Proxy Statement for the 2007 Annual Meeting of Stockholders, which will be filed with the Commission on or before April 30, 2007.

Item 14. Principal Accountant Fees and Services

Information regarding the fees and services of the independent registered public accounting firm is incorporated herein by reference to the discussion under “Audit Committee Matters-Fees of Independent Registered Public Accounting Firm” in the Company’s Proxy Statement for the 2007 Annual Meeting of Stockholders, which will be filed with the Commission on or before April 30, 2007.

29

PART IV

Item 15. Exhibits and Financial Statement Schedules

(a)    The following documents are filed as part of this report:

1.    Financial Statements

The following consolidated financial statements of the Company are included in Item 8 of this report:

Reports of Independent Registered Public Accounting Firm

Consolidated Balance Sheets as of December 31, 2005 and 2006

Consolidated Statements of Earnings for the Years Ended December 31, 2004, 2005 and 2006

Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2004, 2005 and 2006

Consolidated Statements of Cash Flows for the Years Ended December 31, 2004, 2005 and 2006

Notes to Consolidated Financial Statements

2.    Financial Statement Schedules

Report of Independent Registered Public Accounting Firm

Financial Statement Schedule for the Years Ended December 31, 2004, 2005 and 2006:

 
Schedule
Number
 
Description
 
Page
 
II
 
Valuation and Qualifying Accounts
 
34

All other schedules for which provision is made in the applicable accounting regulations of the Commission
are not required under the related instructions, are inapplicable or the required information is shown in the
financial statements or notes thereto, and therefore, have been omitted.

3.    Exhibits

3.1   Amended and Restated Certificate of Incorporation of the Company (incorporated by reference to Exhibit 3.1
of the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2002 (File No. 0-22635)).

3.2   First Amendment to Amended and Restated Certificate of Incorporation of the Company (incorporated by
reference to Exhibit 3.2 of the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31,
2002 (File No. 0-22635)).

3.3
Certificate of Ownership and Merger changing the Company’s name to Racing Champions Ertl Corporation
(incorporated by reference to Exhibit 3.3 of the Company’s Quarterly Report on Form 10-Q for the quarter
ended March 31, 2002 (File No. 0-22635)).

3.4
Certificate of Ownership and Merger changing the Company’s name to RC2 Corporation (incorporated by
reference to Exhibit 3.4 of the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31,
2003 (File No. 0-22635)).

3.5
Amended and Restated By-Laws of the Company (incorporated by reference to Exhibit 3.5 of the Company’s
Quarterly Report on Form 10-Q for the quarter ended March 31, 2004 (File No. 0-22635)).

30

 
10.1*       Employment Agreement, dated as of April 4, 2005, between the Company and Curtis W. Stoelting (incorporated
by reference to Exhibit 10.5 of the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30,
2005 (File No. 0-22635)).

10.2*       Employment Agreement, dated as of April 4, 2005, between the Company and Peter J. Henseler
(incorporated by reference to Exhibit 10.6 of the Company’s Quarterly Report on Form 10-Q for the quarter
ended June 30, 2005 (File No. 0-22635)).

10.3*       Employment Agreement, dated as of April 4, 2005, between the Company and Jody L. Taylor (incorporated
by reference to Exhibit 10.7 of the Company’s Quarterly Report on Form 10-Q for the quarter ended
June 30, 2005 (File No. 0-22635)).

10.4*       Employment Agreement, dated as of April 4, 2005, between the Company and Helena Lo (incorporated
by reference to Exhibit 10.8 of the Company’s Quarterly Report on Form 10-Q for the quarter ended
June 30, 2005 (File No. 0-22635)).

10.5*       Employment Agreement, dated as of December 13, 2005, between the Company and Richard E. Rothkopf
(incorporated by reference to Exhibit 99.1 of the Company’s Current Report on Form 8-K (File No. 0-22635) filed
by the Company with the Securities and Exchange Commission on December 16, 2005).

10.6*       Separation Agreement and General Release, dated as of December 13, 2005, between the Company and John
Walter Lee II (incorporated by reference to Exhibit 99.2 of the Company’s Current Report on Form 8-K
(File No. 0-22635) filed by the Company with the Securities and Exchange Commission on December 16, 2005).

10.7*       RC2 Corporation 2005 Stock Incentive Plan (incorporated by reference to Exhibit 99.1 of the Company’s
Current Report on Form 8-K (File No. 0-22635) filed by the Company with the Securities and Exchange
Commission on May 10, 2005).

10.8*       Form of Grant Agreement for the RC2 Corporation 2005 Stock Incentive Plan (incorporated by reference
to Exhibit 99.2 of the Company’s Current Report on Form 8-K (File No. 0-22635) filed by the Company
with the Securities and Exchange Commission on May 10, 2005).

10.9*       RC2 Corporation Incentive Bonus Plan and RC2 Corporation Top Management Additional Bonus Plan
(incorporated by reference to Exhibit 99.3 of the Company’s Current Report on Form 8-K (File
No. 0-22635) filed by the Company with the Securities and Exchange Commission on May 10, 2005).

10.10*    Outside Director Compensation Plan (incorporated by reference to Exhibit 10.4 to the Company’s
Quarterly Report on Form 10-Q for the quarter ended June 30, 2005 (File No. 0-22635)).

10.11*     Racing Champions Ertl Corporation Stock Incentive Plan, as amended (incorporated by reference to Exhibit
10.5 of the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002 (File No.
0-22635)).

10.12*    Wheels Sports Group, Inc. 1996 Omnibus Stock Plan (incorporated by reference to Exhibit 10.6 of the
Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 1998 (File No. 0-22635)).

10.13*     Racing Champions Ertl Corporation Employee Stock Purchase Plan, as amended (incorporated by
reference to Exhibit 10.4 of the Company’s Quarterly Report on Form 10-Q for the quarter ended
September 30, 2002 (File No. 0-22635)).

31


10.14       Amended and Restated Credit Agreement, dated as of September 15, 2004, among the Company, certain of
its subsidiaries, Harris Trust and Savings Bank, as lender and agent, and other lenders named therein
(incorporated by reference to Exhibit 99.1 of the Company’s Current Report on Form 8-K dated September
15, 2004 (File No. 0-22635) filed by the Company with the Securities and Exchange Commission on
September 21, 2004).

10.15       First Amendment to Amended and Restated Credit Agreement, dated as of August 19, 2005, among
the Company, certain of its subsidiaries, Harris Trust and Savings, as lender and agent, and other
lenders named therein (incorporated by reference to Exhibit 10.18 to the Company’s Annual Report on
Form 10-K for the year ended December 31, 2005 (File No. 0-22635)).

10.16       Second Amendment to Amended and Restated Credit Agreement, dated as of November 18, 2005,
among the Company, certain of its subsidiaries, Harris Trust and Savings Bank, as lender and agent,
and other lenders named therein (incorporated by reference to Exhibit 10.19 to the Company’s Annual Report
on Form 10-K for the year ended December 31, 2005 (File No. 0-22635)).

10.17       Third Amendment to Amended and Restated Credit Agreement, dated as of July 28, 2006, among the Company,
certain of its subsidiaries, Harris, N.A., as lender and agent, and other lenders named therein.

10.18*     Employment Agreement, dated as of July 31, 2006, between the Company and Gregory J. Kilrea.

21    Subsidiaries of the Company.

23.1
Consent of Independent Registered Public Accounting Firm.

24
Power of Attorney (included as part of the signature page hereof).

31.1
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1**     Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350
(Section 906 of the Sarbanes-Oxley Act of 2002).

____________________________


*         Management contract or compensatory plan or arrangement.

**       This certification is not “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as
    amended, or incorporated by reference into any filing under the Securities Act of 1933, as amended, or the
    Securities Exchange Act of 1934, as amended.

(b)       Exhibits
The response to this portion of Item 15 is submitted as a separate section of this report.

(c)       Financial Statement Schedules
The response to this portion of Item 15 is submitted as a separate section of this report.

32


SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized.

Date: February 28, 2007
RC2 CORPORATION
BY   
 
 /s/ Curtis W. Stoelting
 
Curtis W. Stoelting, Chief Executive Officer

POWER OF ATTORNEY

Each person whose signature appears below hereby appoints Curtis W. Stoelting and Jody L. Taylor, and each of them individually, his true and lawful attorney-in-fact, with power to act with or without the other and with full power of substitution and resubstitution, in any and all capacities, to sign any or all amendments to the Form 10-K and file the same with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or their substitutes, may lawfully cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

/s/ Robert E. Dods
 
Chairman of the Board and
February 28, 2007
Robert E. Dods
 
Director
 
       
/s/ Boyd L. Meyer
 
Vice Chairman and Director
February 28, 2007
Boyd L. Meyer
     
       
/s/ Curtis W. Stoelting
 
Chief Executive Officer and
February 28, 2007
Curtis W. Stoelting
 
Director (Principal Executive Officer)
 
       
/s/ Jody L. Taylor
 
Chief Financial Officer and Secretary
February 28, 2007
Jody L. Taylor
 
(Principal Financial and Accounting Officer)
 
       
/s/ Peter K.K. Chung
 
Director
February 28, 2007
Peter K.K. Chung
     
       
/s/ Paul E. Purcell
 
Director
February 28, 2007
Paul E. Purcell
     
       
/s/ John S. Bakalar
 
Director
February 28, 2007
John S. Bakalar
     
       
/s/ John J. Vosicky
 
Director
February 28, 2007
John J. Vosicky
     
       
/s/ Daniel M. Wright
 
Director
February 28, 2007
Daniel M. Wright
     
       
/s/ Thomas M. Collinger
 
Director
February 28, 2007
Thomas M. Collinger
     
       
/s/ Michael J. Merriman, Jr.
 
Director
February 28, 2007
Michael J. Merriman, Jr.
     

33


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders
RC2 Corporation:

Under date of February 28, 2007, we reported on the consolidated balance sheets of RC2 Corporation and subsidiaries as of December 31, 2005 and 2006, and the related consolidated statements of earnings, stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2006. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedule of Valuation and Qualifying Accounts. The financial statement schedule is the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statement schedule based on our audits.

In our opinion, this financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects, the information set forth therein.




/s/ KPMG LLP
Chicago, Illinois
February 28, 2007


 



Schedule II

Description
Valuation and Qualifying Accounts
(in thousands)

            Description
 
Balance at
Beginning
of Year
 
Charged (Credited)
to Costs and
Expenses
 
Charged (Credited)
 to Other
Accounts
 
Deductions
 
Balance at
End of
Year
 
Allowance for doubtful accounts:
                     
Year ended December 31, 2004
 
$
4,007
 
$
1,083
 
$
481
 
$
(2,374
)
$
3,197
 
Year ended December 31, 2005
 
 
3,197
 
 
966
 
 
(258
)
 
(832
)
 
3,073
 
Year ended December 31, 2006
 
$
3,073
 
$
(283
)
$
(50
)
$
(989
)
$
1,751
 
 

 
34


INDEX TO FINANCIAL STATEMENTS




RC2 CORPORATION AND SUBSIDIARIES


Reports of Independent Registered Public Accounting Firm       
F2
   
Consolidated Balance Sheets as of December 31, 2005 and 2006      
F4
   
Consolidated Statements of Earnings for the Years Ended December 31, 2004, 2005 and 2006   
F5
   
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2004, 2005 and 2006  
F6
   
Consolidated Statements of Cash Flows for the Years Ended December 31, 2004, 2005 and 2006   
F7
   
Notes to Consolidated Financial Statements         
F8
 

F1


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders
RC2 Corporation:

We have audited the accompanying consolidated balance sheets of RC2 Corporation and subsidiaries as of December 31, 2005 and 2006, and the related consolidated statements of earnings, stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of RC2 Corporation and subsidiaries as of December 31, 2005 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of RC2 Corporation’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 28, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

As discussed in Note 12 to the financial statements, the Company adopted Statement of Financial Accounting Standards No. 123R: Share-Based Payment and changed its method of accounting for stock based compensation. As discussed in Note 14 to the financial statements, the Company adopted Statement of Financial Accounting Standards No. 158: Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans-an amendment of Statement of Financial Accounting Standards No. 87, 88, 106 and 132(R) and changed its method of accounting for defined benefit pension plans.



/s/ KPMG LLP
Chicago, Illinois
February 28, 2007



F2


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders
RC2 Corporation:

We have audited management’s assessment, included in the accompanying Management Report on Internal Control Over Financial Reporting, that RC2 Corporation maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). RC2 Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that RC2 Corporation maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by COSO. Also, in our opinion, RC2 Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by COSO.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of RC2 Corporation and subsidiaries as of December 31, 2005 and 2006, and the related consolidated statements of earnings, stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2006, and our report dated February 28, 2007 expressed an unqualified opinion on those consolidated financial statements.


/s/ KPMG LLP
Chicago, Illinois
February 28, 2007

F3

CONSOLIDATED BALANCE SHEETS
(in thousands)
 
December 31,
 
   
2005
 
2006
 
Assets
             
Current assets:
             
Cash and cash equivalents
 
$
25,262
 
$
25,365
 
Accounts receivable, net of allowances for doubtful accounts
of $3,073 and $1,751
   
113,066
   
112,937
 
Other receivables
   
2,284
   
3,253
 
Inventory
   
71,260
   
83,650
 
Deferred income taxes
   
8,717
   
5,884
 
Prepaid expenses
   
6,596
   
5,879
 
Total current assets
   
227,185
   
236,968
 
Property and equipment:
             
Land
   
686
   
686
 
Buildings and improvements
   
8,850
   
9,287
 
Tooling
   
96,416
   
99,098
 
Other equipment
   
17,752
   
20,574
 
     
123,704
   
129,645
 
Less accumulated depreciation
   
(76,665
)
 
(90,654
)
     
47,039
   
38,991
 
Goodwill
   
253,571
   
239,067
 
Intangible assets, net
   
99,611
   
96,400
 
Other non-current assets
   
2,330
   
3,214
 
Total assets
 
$
629,736
 
$
614,640
 
Liabilities and stockholders’ equity
             
Current liabilities:
             
Accounts payable
 
$
25,543
 
$
26,941
 
Taxes payable, net
   
5,575
   
3,420
 
Accrued expenses
   
20,131
   
16,443
 
Accrued allowances
   
21,199
   
20,192
 
Accrued royalties
   
14,874
   
17,163
 
Line of credit
   
3,979
   
 
Current maturities of bank term loans
   
21,250
   
22,438
 
Other current liabilities
   
1,348
   
768
 
Total current liabilities
   
113,899
   
107,365
 
Lines of credit
   
13,980
   
 
Bank term loans, less current maturities
   
43,438
   
 
Deferred income taxes
   
49,313
   
45,524
 
Other non-current liabilities
   
10,155
   
9,825
 
Total liabilities
   
230,785
   
162,714
 
Commitments and contingencies
             
Stockholders’ equity:
             
Common stock, voting, $0.01 par value, 28,000 shares authorized,
22,549 shares issued and 20,718 shares outstanding at December 31, 2005,
and 22,876 shares issued and 21,052 shares outstanding at December 31, 2006
   
225
   
229
 
Additional paid-in capital
   
219,647
   
230,776
 
Accumulated other comprehensive income
   
1,127
   
8,838
 
Retained earnings
   
186,612
   
220,706
 
     
407,611
   
460,549
 
Treasury stock, at cost, 1,831 shares at December 31, 2005, and
1,824 shares at December 31, 2006
   
(8,660
)
 
(8,623
)
Total stockholders’ equity
   
398,951
   
451,926
 
Total liabilities and stockholders’ equity
 
$
629,736
 
$
614,640
 

The accompanying notes are an integral part of these consolidated financial statements.
F4

 
CONSOLIDATED STATEMENTS OF EARNINGS
(in thousands, except per share data)
   
Year Ended December 31,
 
   
2004
 
2005
 
2006
 
Net sales
 
$
367,687
 
$
492,766
 
$
518,829
 
Cost of sales, related parties
   
7,846
   
18,520
   
27,599
 
Cost of sales, other
   
178,967
   
234,415
   
248,155
 
Restructuring charge related to discontinued automotive collectibles
   
   
   
1,872
 
Gross profit
   
180,874
   
239,831
   
241,203
 
Selling, general and administrative expenses
   
121,785
   
150,381