Unassociated Document
 


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

 
FORM 10-Q
 

 
(Mark one)
 
x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)     
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2006
 
-OR
 
o      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: 0-28104
 

 
JAKKS Pacific, Inc.
(Exact Name of Registrant as Specified in Its Charter)
 

 
Delaware
      
95-4527222
(State or Other Jurisdiction of Incorporation or Organization)
 
(I.R.S. Employer Identification No.)

22619 Pacific Coast Highway
Malibu, California
      
90265
(Address of Principal Executive Offices)
 
(Zip Code)
 
Registrant’s telephone number, including area code: (310) 456-7799
 

 
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  o
 
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 Rule 12b-2 of the Exchange Act. (Check one):
 
Large Accelerated Filer o
Accelerated Filer x
Non-Accelerated Filer o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes   o     No   x
 

 
The number of shares outstanding of the issuer’s common stock is 27,770,747(as of November 8, 2006).
 



 
JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
INDEX TO QUARTERLY REPORT ON FORM 10-Q
Quarter Ended September 30, 2006
 
ITEMS IN FORM 10-Q
 
     
Page
       
Part I
FINANCIAL INFORMATION
     
 
Item 1.
Financial Statements
 
2
 
Condensed Consolidated Balance Sheets - December 31, 2005 and
September 30, 2006 (unaudited)
 
2
 
Condensed Consolidated Statements of Income for the Three and Nine Months
Ended September 30, 2005 and 2006 (unaudited)
 
3
 
Condensed Consolidated Statements of Cash Flows for the Nine Months
Ended September 30, 2005 and 2006 (unaudited)
 
4
 
Notes to Condensed Consolidated Financial Statements (unaudited)
 
6
Item 2.
Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 
22
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
 
30
Item 4.
Controls and Procedures
 
30
       
Part II
OTHER INFORMATION
   
Item 1.
Legal Proceedings
 
31
Item 1A.
Risk Factors
 
33
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
None
Item 3.
Defaults Upon Senior Securities
 
None
Item 4.
Submission of Matters to a Vote of Security Holders
 
40
Item 5.
Other Information
 
None
Item 6.
Exhibits
 
41
       
Signatures
 
42
Exhibit 31.1
   
Exhibit 31.2
   
Exhibit 32.1
   
Exhibit 32.2
   
 
DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS
 
This report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. For example, statements included in this report regarding our financial position, business strategy and other plans and objectives for future operations, and assumptions and predictions about future product demand, supply, manufacturing, costs, marketing and pricing factors are all forward-looking statements. When we use words like “intend,” “anticipate,” “believe,” “estimate,” “plan” or “expect,” we are making forward-looking statements. We believe that the assumptions and expectations reflected in such forward-looking statements are reasonable, based on information available to us on the date hereof, but we cannot assure you that these assumptions and expectations will prove to have been correct or that we will take any action that we may presently be planning. We are not undertaking to publicly update or revise any forward-looking statement if we obtain new information or upon the occurrence of future events or otherwise.
 

 
JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
 
   
December 31,
2005
 
September 30,
2006
 
   
(*)
 
(Unaudited)
 
ASSETS
           
Current assets
             
Cash and cash equivalents
 
$
240,238
 
$
132,966
 
Accounts receivable, net of allowances for uncollectible accounts of
$2,336 and $1,433, respectively
   
87,199
   
182,818
 
Inventory
   
66,729
   
86,676
 
Prepaid expenses and other current assets
   
17,533
   
32,515
 
Deferred income taxes
   
13,618
   
12,315
 
Total current assets
   
425,317
   
447,290
 
Property and equipment
             
Office furniture and equipment
   
7,619
   
8,619
 
Molds and tooling
   
26,948
   
33,779
 
Leasehold improvements
   
3,522
   
4,471
 
Total
   
38,089
   
46,869
 
Less accumulated depreciation and amortization
   
25,394
   
31,136
 
Property and equipment, net
   
12,695
   
15,733
 
Investment in video game joint venture
   
10,365
   
1,936
 
Goodwill, net
   
269,298
   
315,315
 
Trademarks, net
   
17,768
   
19,068
 
Intangibles and other, net
   
18,512
   
55,187
 
Total assets
 
$
753,955
 
$
854,529
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
             
Current liabilities
             
Accounts payable
 
$
50,533
 
$
85,935
 
Accrued expenses
   
44,415
   
48,122
 
Reserve for sales returns and allowances
   
25,123
   
24,838
 
Income taxes payable
   
3,792
   
4,441
 
Total current liabilities
   
123,863
   
163,336
 
Deferred income taxes
   
6,446
   
7,358
 
Deferred rent liability
   
995
   
889
 
Convertible senior notes
   
98,000
   
98,000
 
Total liabilities
   
229,304
   
269,583
 
Stockholders’ equity
             
Preferred stock, $.001 par value; 5,000,000 shares authorized; nil outstanding
   
   
 
Common stock, $.001 par value; 100,000,000 shares authorized; 26,944,559 and 27,765,597 shares issued and outstanding, respectively
   
27
   
28
 
Additional paid-in capital
   
287,356
   
298,189
 
Retained earnings
   
240,057
   
289,249
 
Accumulated comprehensive loss
   
(2,789
)
 
(2,520
)
Total stockholders’ equity
   
524,651
   
584,946
 
Total liabilities and stockholders’ equity
 
$
753,955
 
$
854,529
 
 

(*)
Derived from audited financial statements
 
2


JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)

   
Three Months Ended
September 30,
(Unaudited)
 
Nine Months Ended
September 30,
(Unaudited)
 
   
2005
 
2006
 
2005
 
2006
 
                       
Net sales
 
$
233,500
 
$
295,789
 
$
495,266
 
$
527,075
 
Cost of sales
   
140,048
   
182,906
   
299,529
   
320,750
 
Gross profit
   
93,452
   
112,883
   
195,737
   
206,325
 
Selling, general and administrative expenses                                                
   
46,234
   
54,679
   
120,229
   
136,914
 
Income from operations
   
47,218
   
58,204
   
75,508
   
69,411
 
Profit (loss) from video game joint venture
   
238
   
(245
)
 
1,541
   
732
 
Other expense
   
(1,401
)
 
   
(1,401
)
 
 
Interest Income
   
1,386
   
1,029
   
3,419
   
3,530
 
Interest Expense
   
(1,135
)
 
(1,133
)
 
(3,402
)
 
(3,400
)
Income before provision for income taxes
   
46,306
   
57,855
   
75,665
   
70,273
 
Provision for income taxes
   
13,553
   
17,356
   
21,186
   
21,083
 
Net income
 
$
32,753
 
$
40,499
 
$
54,479
 
$
49,190
 
Earnings per share - basic
 
$
1.22
 
$
1.46
 
$
2.04
 
$
1.79
 
Earnings per share - diluted
 
$
1.05
 
$
1.26
 
$
1.77
 
$
1.57
 
 
3


JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
 
   
Nine Months Ended
September 30,
(Unaudited)
 
   
2005
 
2006
 
CASH FLOWS FROM OPERATING ACTIVITIES
           
Net income
 
$
54,479
 
$
49,190
 
Adjustments to reconcile net income to net cash provided by operating activities:
             
Depreciation and amortization
   
11,344
   
18,516
 
Share-based compensation expense
   
(813
)
 
4,800
 
Write-off of investment in Chinese joint venture
   
1,401
   
 
Loss on disposal of property and equipment
   
103
   
7
 
Deferred income taxes
   
(4,295
)
 
2,216
 
Change in operating assets and liabilities:
             
Accounts receivable
   
(40,437
)
 
(82,587
)
Inventory
   
(20,418
)
 
(18,241
)
Prepaid expenses and other current assets
   
(1,795
)
 
(14,265
)
Investment in video game joint venture
   
6,207
   
7,950
 
Accounts payable
   
2,856
   
32,969
 
Accrued expenses
   
23,867
   
8,938
 
Reserve for sales returns and allowances
   
4,009
   
(2,498
)
Income taxes payable
   
19,315
   
649
 
Deferred rent liability
   
   
(105
)
Total adjustments
   
1,344
   
(41,651
)
Net cash provided by operating activities
   
55,823
   
7,539
 
CASH FLOWS FROM INVESTING ACTIVITIES
             
Cash paid for net assets acquired, net of cash acquired
   
(20,610
)
 
(109,842
)
Purchase of property and equipment
   
(5,491
)
 
(7,718
)
Sale (purchase) of other assets
   
92
   
(151
)
Net purchase of marketable securities
   
19,047
   
 
Net cash used by investing activities
   
(6,962
)
 
(117,711
)
CASH FLOWS FROM FINANCING ACTIVITIES
             
Net proceeds from stock options exercised
   
2,968
   
1,376
 
Tax benefit from stock options exercised
   
   
1,218
 
Net cash provided by financing activities
   
2,968
   
2,594
 
Foreign currency translation adjustment
   
(320
)
 
306
 
Net increase (decrease) in cash and cash equivalents
   
51,509
   
(107,272
)
Cash and cash equivalents, beginning of period
   
176,544
   
240,238
 
Cash and cash equivalents, end of period
 
$
228,053
 
$
132,966
 
Supplemental disclosure of cash flow information:
             
Cash paid during the period for:
             
Income taxes
 
$
7,792
 
$
17,004
 
Interest
 
$
2,267
 
$
2,266
 
 
Non cash investing and financing activity:
 
In September 2005, two executive officers acquired 215,982 shares of common stock in a cashless option exercise through their surrender of an aggregate of 101,002 shares of restricted stock at a value of $1.7 million. This restricted stock was subsequently retired by the Company.
 
In February 2006, the Company issued 150,000 shares of its common stock valued at approximately $3.4 million in connection with the acquisition of Creative Designs (see Note 9).
 
4

 
During the nine months ended September 30, 2006, two executive officers surrendered 124,000 shares of restricted stock at a value of $2.8 million to acquire an aggregate of 37,910 shares of common stock in a cashless option exercise and to cover their income taxes due on the 2006 vesting of the restricted shares granted them in 2005. This restricted stock was subsequently retired by the Company.
 
5


JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
September 30, 2006
 
Note 1 — Basis of Presentation
 
The accompanying unaudited interim condensed consolidated financial statements included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures are adequate to prevent the information presented from being misleading. These financial statements should be read in conjunction with Management’s Discussion and Analysis of financial condition and results of operations and the financial statements and the notes thereto included in the Company’s Form 10-K, which contains financial information for the three years in the period ended December 31, 2005.
 
The information provided in this report reflects all adjustments (consisting solely of normal recurring items) that are, in the opinion of management, necessary to present fairly the financial position and the results of operations for the periods presented. Interim results are not necessarily indicative of results to be expected for a full year.
 
Certain reclassifications have been made to prior year balances in order to conform to the current year presentation.
 
The condensed consolidated financial statements include the accounts of JAKKS Pacific, Inc. and its wholly-owned subsidiaries.
 
Note 2 — Business Segments, Geographic Data, Sales by Product Group, and Major Customers
 
The Company is a worldwide producer and marketer of children’s toys and related products, principally engaged in the design, development, production and marketing of traditional toys, including boys’ action figures, vehicles and playsets, role-play, dress-up, craft and activity products, writing instruments, compounds, girls’ toys, plush, construction toys, and infant and preschool toys, as well as pet treats, toys and related pet products. The Company’s reportable segments are North America Toys, Pet Products and International.
 
The North America Toys segment, which includes the United States and Canada, and the International segment, which includes sales to non-North American markets, include the design, development, production and marketing of children’s toys and related products, and Pet Products includes the design, development, production and marketing of pet treats, toys and related pet products.
 
Segment performance is measured at the operating income level. All sales are made to external customers, and general corporate expenses have been attributed to the North America Toy segment, which is a dominant segment.
 
Results are not necessarily those that would be achieved were each segment an unaffiliated business enterprise. Information by segment and a reconciliation to reported amounts for the three and nine months ended September 30, 2005 and 2006 and as of December 31, 2005 and September 30, 2006 are as follows (in thousands):
 
   
Three Months Ended September 30, 2005
 
   
Traditional
Toys
 
Craft/Activities/
Writing Products
 
Seasonal
Products
 
Pet
Products
 
Total
 
                            
Net Sales
                          
North America Toys
 
$
186,815
 
$
15,880
 
$
1,268
 
$
 
$
203,963
 
Pet Products
   
   
   
   
3,514
   
3,514
 
International
   
23,898
   
2,109
   
16
   
   
26,023
 
   
$
210,713
 
$
17,989
 
$
1,284
 
$
3,514
 
$
233,500
 

6


JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Note 2 — Business Segments, Geographic Data, Sales by Product Group, and Major Customers - (continued)


   
Three Months Ended September 30, 2006
 
   
Traditional
Toys
 
Craft/Activities/
Writing Products
 
Seasonal
Products
 
Pet
Products
 
Total
 
Net Sales
                               
North America Toys
 
$
241,650
 
$
13,103
 
$
8,460
 
$
 
$
263,213
 
Pet Products
   
   
   
   
6,688
   
6,688
 
International
   
24,438
   
1,436
   
14
   
   
25,888
 
   
$
266,088
 
$
14,539
 
$
8,474
 
$
6,688
 
$
295,789
 
 
   
Nine Months Ended September 30, 2005
 
   
Traditional
Toys
 
Craft/Activities/
Writing Products
 
Seasonal
Products
 
Pet
Products
 
Total
 
Net Sales
                          
North America Toys                    
 
$
363,996
 
$
44,633
 
$
15,201
 
$
 
$
423,830
 
Pet Products (see Note 9)
   
   
   
   
4,595
   
4,595
 
International
   
62,234
   
3,343
   
1,264
   
   
66,841
 
   
$
426,230
 
$
47,976
 
$
16,465
 
$
4,595
 
$
495,266
 

   
Nine Months Ended September 30, 2006
 
   
Traditional
Toys
 
Craft/Activities/
Writing Products
 
Seasonal
Products
 
Pet
Products
 
Total
 
Net Sales
                          
North America Toys                    
 
$
399,173
 
$
39,184
 
$
22,018
 
$
 
$
460,375
 
Pet Products (see Note 9)
   
   
   
   
13,114
   
13,114
 
International
   
49,564
   
3,529
   
493
   
   
53,586
 
   
$
448,737
 
$
42,713
 
$
22,511
 
$
13,114
 
$
527,075
 

   
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
   
2005
 
2006
 
2005
 
2006
 
Operating Income
                     
North America Toys                                                                  
 
$
41,245
 
$
51,794
 
$
64,904
 
$
61,221
 
Pet Products
   
711
   
1,316
   
835
   
1,708
 
International
   
5,262
   
5,094
   
9,769
   
6,482
 
   
$
47,218
 
$
58,204
 
$
75,508
 
$
69,411
 

   
December 31,
2005
 
September 30,
2006
 
Assets
 
                  
 
                  
 
North America Toys                                                                     
 
$
677,420
 
$
760,416
 
Pet Products
   
23,432
   
19,321
 
International
   
53,103
   
74,792
 
   
$
753,955
 
$
854,529
 
 
7

 
JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Note 2 — Business Segments, Geographic Data, Sales by Product Group, and Major Customers - (continued)
 
The following tables present information about the Company by geographic area as of December 31, 2005 and September 30, 2006 and for the three and nine months ended September 30, 2005 and 2006 (in thousands):
 
   
December 31,
2005
 
September 30,
2006
Long-lived Assets
     
 
                 
     
 
                 
United States                                                                              
 
$
283,350
 
$
338,665
Hong Kong
   
34,038
   
65,585
   
$
317,388
 
$
404,250

   
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
   
2005
 
2006
 
2005
 
2006
 
Net Sales by Geographic Area
                     
United States                                                                                        
 
$
198,369
 
$
256,600
 
$
412,547
 
$
453,045
 
Europe
   
13,481
   
10,223
   
32,889
   
22,662
 
Canada
   
9,108
   
13,300
   
15,878
   
20,409
 
Hong Kong
   
6,830
   
7,607
   
20,431
   
12,210
 
Other
   
5,712
   
8,059
   
13,521
   
18,749
 
   
$
233,500
 
$
295,789
 
$
495,266
 
$
527,075
 
 
Major Customers
 
Net sales to major customers for the three and nine months ended September 30, 2005 and 2006 were as follows (in thousands, except for percentages):
 
   
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
   
2005
 
2006
 
2005
 
2006
 
   
Amount
 
Percentage of Net Sales
 
Amount
 
Percentage
of Net Sales
 
Amount
 
Percentage
of Net Sales
 
Amount
 
Percentage
of Net Sales
 
        
                
      
                
      
                
      
                
 
Wal-Mart
 
$
75,604
   
32.4
%
$
78,766
   
26.6
%
$
131,545
   
26.6
%
$
126,914
   
24.1
%
Toys ‘R’ Us 
   
34,553
   
14.8
%
 
43,366
   
14.7
   
54,831
   
11.1
%
 
74,361
   
14.1
 
Target
   
21,493
   
9.2
%
 
38,167
   
12.9
   
50,060
   
10.1
%
 
86,406
   
16.4
 
   
$
131,650
   
56.4
%
$
160,299
   
54.2
%
$
236,436
   
47.8
%
$
287,681
   
54.6
%
 
Wal-Mart accounts for a large percentage of the toy industry’s sales at retail which is consistent with the proportion of the Company’s sales to Wal-Mart. No customers, other than those listed above, accounted for more than 10% of the Company’s total net sales in the periods presented.
 
At December 31, 2005 and September 30, 2006, the Company’s three largest customers accounted for approximately 73.0% and 62.1%, respectively, of net accounts receivable. The concentration of the Company’s business with a relatively small number of customers may expose the Company to material adverse effects if one or more of its large customers were to experience financial difficulty. The Company performs ongoing credit evaluations of its top customers and maintains an allowance for potential credit losses.
 
8


JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Note 3 — Inventory
 
Inventory, which includes the ex-factory cost of goods, in-bound freight, duty and warehouse costs, is stated at the lower of cost (first-in, first-out) or market and consists of the following (in thousands):
 
   
December 31,
2005
 
September 30,
2006
 
       
                 
 
Raw materials                                
 
$
2,679
 
$
7,287
 
Finished goods
   
64,050
   
79,389
 
   
$
66,729
 
$
86,676
 
 
Note 4 — Revenue Recognition and Reserve for Sales Returns and Allowances
 
Revenue is recognized upon the shipment of goods to customers or their agents, depending on terms, provided that there are no uncertainties regarding customer acceptance, the sales price is fixed or determinable, and collectibility is reasonably assured and not contingent upon resale.
 
Generally, the Company does not allow for product returns. It provides a negotiated allowance for breakage or defects to its customers, which is recorded when the related revenue is recognized. However, the Company does make occasional exceptions to this policy and consequently accrues a return allowance in gross sales based on historic return amounts and management estimates. The Company also will occasionally grant credits to facilitate markdowns and sales of slow moving merchandise. These credits are recorded as a reduction of gross sales at the time of occurrence.
 
The Company also participates in cooperative advertising arrangements with some customers, whereby it allows a discount from invoiced product amounts in exchange for customer purchased advertising that features the Company’s products. Typically, these discounts range from 1% to 6% of gross sales, and are generally based on product purchases or on specific advertising campaigns. Such amounts are accrued when the related revenue is recognized or when the advertising campaign is initiated. These cooperative advertising arrangements are accounted for as direct selling expenses.
 
The Company’s reserve for sales returns and allowances amounted to $24.8 million as of September 30, 2006, compared to $25.1 million as of December 31, 2005. The slight decrease was due primarily to certain customers taking their allowances throughout the year, instead of waiting until the beginning of the following calendar year. Additionally, there was a decrease in sales of the Company’s electronic products which typically have higher defective rates than the Company’s other products.
 
Note 5 — Convertible Senior Notes
 
In June 2003, the Company sold an aggregate of $98.0 million of 4.625% Convertible Senior Notes due June 15, 2023 and received net proceeds of approximately $94.4 million. The notes are convertible into shares of the Company’s common stock at an initial conversion price of $20.00 per share and they provide for the cash payment of interest at an annual rate of 4.625% of the principal amount at issuance, from the issue date to June 15, 2010, payable on June 15 and December 15 of each year. After June 15, 2010, interest will accrue on the outstanding notes until maturity. At maturity, the Company will redeem the notes at their accreted principal amount, which will be equal to $1,811.95 (181.195%) per $1,000 principal amount at issuance, unless redeemed or converted earlier.
 
9


JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Note 5 — Convertible Senior Notes (continued)
 
The Company may redeem the notes at its option in whole or in part beginning on June 15, 2010, at 100% of their accreted principal amount plus accrued and unpaid interest, if any, payable in cash. Holders of the notes may also require the Company to repurchase all or part of their notes on June 15, 2010, for cash, at a repurchase price of 100% of the principal amount per note plus accrued and unpaid interest, if any. Holders of the notes may also require the Company to repurchase all or part of their notes on June 15, 2013 and June 15, 2018 at a repurchase price of 100% of the accreted principal amount per note plus accrued and unpaid interest, if any, and may be paid in cash, in shares of common stock or a combination of cash and shares of common stock.
 
Note 6 — Income Taxes
 
Provision for income taxes included Federal, state and foreign income taxes at effective tax rates of 28.0% in 2005 and 30.0% in 2006, benefiting from a flat 17.5% tax rate on our income arising in, or derived from, Hong Kong for each of 2005 and 2006. The increase in the effective tax rate in 2006 is due to a greater proportion of taxable income generated in the United States.  As of September 30, 2006, the Company had net deferred tax assets of approximately $5.0 million for which no allowance has been provided since, in the opinion of management, realization of the future benefit is more likely than not.
 
Note 7 — Earnings Per Share
 
The following table is a reconciliation of the weighted average shares used in the computation of basic and diluted earnings per share for the periods presented (in thousands, except per share data):
 
   
Three Months Ended September 30,
 
   
2005
 
2006
 
   
Income
 
Weighted
Average
Shares
 
Per-Share
 
Income
 
Weighted
Average
Shares
 
Per-Share
 
                               
Earnings per share - basic
                             
Income available to common
stockholders
 
$
32,753
   
26,778
 
$
1.22
 
$
40,499
   
27,694
 
$
1.46
 
Effect of dilutive securities
                                     
Convertible senior notes
   
801
   
4,900
         
737
   
4,900
       
Options and warrants
   
   
410
         
   
142
       
Earnings per share - diluted
                                     
Income available to common
stockholders plus assumed exercises
and conversion
 
$
33,554
   
32,088
 
$
1.05
 
$
41,236
   
32,736
 
$
1.26
 
 
10


JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Note 7 — Earnings Per Share (continued)

   
Nine Months Ended September 30,
 
   
2005
 
2006
 
   
Income
 
Weighted
Average
Shares
 
Per-Share
 
Income
 
Weighted
Average
Shares
 
Per-Share
 
                               
Earnings per share - basic
                             
Income available to common
stockholders
 
$
54,479
   
26,673
 
$
2.04
 
$
49,190
   
27,514
 
$
1.79
 
Effect of dilutive securities
                                     
Convertible senior notes
   
2,448
   
4,900
         
2,210
   
4,900
       
Options and warrants
   
   
609
         
   
317
       
Earnings per share - diluted
                                     
Income available to common
stockholders plus assumed exercises
and conversion
 
$
56,927
   
32,182
 
$
1.77
 
$
51,400
   
32,731
 
$
1.57
 
 
Basic earnings per share has been computed using the weighted average number of common shares outstanding. Diluted earnings per share has been computed using the weighted average number of common shares and common share equivalents outstanding (which consist of warrants, options and convertible debt to the extent they are dilutive). Potentially dilutive stock options of 690,444 and 668,894 for the three months ended September 30, 2005 and 2006, respectively, were not included in the computation of diluted earning per share as the average market price of the Company’s common stock did not exceed the weighted average exercise price of such options and to have included them would have been anti-dilutive. Potentially dilutive stock options of 438,195 and 489,940 for the nine months ended September 30, 2005 and 2006, respectively, were not included in the computation of diluted earning per share as the average market price of the Company’s common stock did not exceed the weighted average exercise price of such options and to have included them would have been anti-dilutive.
 
11

 
JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Note 8 — Common Stock and Preferred Stock
 
The Company has 105,000,000 authorized shares of stock consisting of 100,000,000 shares of $.001 par value common stock and 5,000,000 shares of $.001 par value preferred stock.
 
In January 2006, the Company issued an aggregate of 240,000 shares of restricted stock to two of its executive officers, which vest 50% in each of January 2007 and 2008 subject to acceleration based on the Company achieving certain financial performance criteria, and an aggregate of 28,660 shares of restricted stock to its five non-employee directors, which vest in January 2007, at an aggregate value of approximately $5.6 million. During 2006, the Company also issued 321,878 shares of common stock on the exercise of options for a total of $4.2 million, and 124,000 shares of restricted stock previously received by two executive officers were surrendered at a value of $2.8 million to cover their income taxes due on the 2006 vesting of the restricted shares granted them in 2005. This surrendered restricted stock was subsequently retired by the Company. In February 2006, the Company issued 150,000 shares of its common stock valued at approximately $3.4 million in connection with the acquisition of Creative Designs International, Ltd. and a related Hong Kong company, Arbor Toys Company Limited (collectively “Creative Designs”) (see Note 9). In August 2006, the Company granted and issued an aggregate of 200,000 shares of restricted stock to its employees, which vest over a five-year period, at an aggregate value of approximately $3.4 million, which represents the fair market value at the grant date.
 
In January 2005, the Company issued 240,000 shares of restricted stock to two of its executive officers, which vested in the first quarter of 2006, and an aggregate of 5,000 shares of restricted stock to its five non-employee directors, which vested in January 2006, at an aggregate value of approximately $5.1 million. During 2005, the Company also issued 566,546 shares of common stock on the exercise of options for a total of $4.9 million, including 215,982 shares of common stock acquired by two executive officers in a cashless exercise through their surrender of an aggregate of 101,002 shares of restricted stock at a value of $1.7 million. This surrendered restricted stock was subsequently retired by the Company.
 
All issuances of common stock, including those issued pursuant to stock option and warrant exercises, restricted stock grants and acquisitions, are issued from the Company’s authorized but not issued and outstanding shares.
 
Note 9 — Business Combinations
 
The Company acquired the following entities to further enhance its existing product lines, continue diversification into other toy categories and counter-seasonal businesses and expand distribution of its products.
 
On February 9, 2006, the Company acquired substantially all of the assets of Creative Designs. The total initial consideration of $111.2 million consisted of cash paid at closing in the amount of $101.7 million, the issuance of 150,000 shares of the Company’s common stock valued at approximately $3.4 million and the assumption of liabilities in the amount of $6.1 million, and resulted in the recording of goodwill in the amount of $44.5 million. Goodwill represents anticipated synergies to be gained via the combination of Creative Designs with the Company. In addition, the Company agreed to pay an earn-out of up to an aggregate of $20.0 million in cash over the three calendar years following the acquisition based on the achievement of certain financial performance criteria, which will be recorded as goodwill when and if earned. Creative Designs is a leading designer and producer of dress-up and role-play toys. This acquisition expands our product offerings in the girls role-play and dress-up area and brings new product development and marketing talent to us. The Company’s results of operations have included Creative Designs from the date of acquisition.
 
12


JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Note 9 — Business Combinations (continued)
 
The amount of goodwill from the Creative Designs acquisition that is expected to be deductible for Federal and state income tax purposes is approximately $36.5 million. The total purchase price was allocated based on preliminary studies and valuations performed to the estimated fair value of assets acquired and liabilities assumed. This valuation will be completed by December 31, 2006 and the preliminary allocation may change. The preliminary allocation is set forth in the following table (in thousands):
 
Estimated fair value of net assets:
      
Current assets acquired
 
$
15,655
 
Property and equipment, net
   
1,235
 
Other assets
   
103
 
Liabilities assumed
   
(6,081
)
Intangible assets other than goodwill                            
   
49,688
 
Goodwill
   
44,494
 
   
$
105,094
 
 
The following unaudited pro forma information represents the Company’s consolidated results of operations as if the acquisition of Creative Designs had occurred on January 1, 2005 and after giving effect to certain adjustments including the elimination of certain general and administrative expenses and other income and expense items not attributable to ongoing operations, interest expense, and related tax effects. Such pro forma information does not purport to be indicative of operating results that would have been reported had the acquisition of Creative Designs occurred on January 1, 2005 or future operating results (in thousands, except per share data).
 
   
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
   
 2005
 
 2006
 
 2005
 
 2006
 
Net sales
 
$
322,292
 
$
295,789
 
$
616,503
 
$
539,957
 
Net income
 
$
41,572
 
$
40,498
 
$
69,615
 
$
50,857
 
Earnings per share - basic
 
$
1.54
 
$
1.46
 
$
2.57
 
$
1.84
 
Weighted average shares outstanding - basic
   
26,928
   
27,694
   
27,039
   
27,611
 
Earnings per share - diluted
 
$
1.31
 
$
1.26
 
$
2.23
 
$
1.62
 
Weighted average shares and equivalents outstanding - diluted
   
32,238
   
32,736
   
32,341
   
32,760
 
 
In June 2005, the Company purchased substantially all of the operating assets and assumed certain liabilities relating to the Pet Pal line of pet products, including toys, treats and related pet products. The total initial consideration of $11.2 million consisted of cash paid at closing in the amount of $10.6 million and the assumption of liabilities in the amount of $0.6 million. Goodwill of $4.6 million arose from this transaction, which represents the excess of the purchase price over the fair value of assets acquired less the liabilities assumed. In addition, the Company agreed to pay an earn-out of up to an aggregate amount of $25.0 million in cash based on the achievement of certain financial performance criteria, which will be recorded as goodwill when and if earned. For the fiscal year ended May 31, 2006, $1.5 million of the earn-out was earned and recorded as goodwill. This acquisition expands the Company’s product offerings and distribution channels. The Company’s results of operations have included Pet Pal from the date of acquisition. Proforma results of operations are not provided since the amounts are not material to the consolidated results of operations.
 
In June 2004, the Company purchased substantially all of the assets and assumed certain liabilities of Play Along. The total initial consideration of $108.0 million consisted of cash paid at closing in the amount of $70.8 million, the issuance of 749,005 shares of the Company’s common stock valued at $14.9 million and the assumption of liabilities in the amount of $22.3 million, and resulted in the recording of goodwill in the amount of $58.0 million. In addition, the Company agreed to pay an earn-out of up to $10.0 million per year for the four calendar years following the acquisition up to an aggregate amount of $30.0 million based on the achievement of certain financial performance criteria which will be recorded as goodwill when and if earned. For the two years in the period ended December 31, 2005, an aggregate of $16.7 million of the earn-out was earned and recorded as goodwill of which $6.7 million was earned in 2005 and paid in 2006. The annual maximum earn-out for the remaining two years through December 31, 2007 is approximately $6.7 million, or an aggregate of $13.3 million. Play Along designs and produces traditional toys, which it distributes domestically and internationally. This acquisition expands the Company’s product offerings in the pre-school area and brings it new product development and marketing talent. The Company’s results of operations have included Play Along from the date of acquisition.
 
13

 
JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Note 9 — Business Combinations (continued)
 
Approximately $44.8 million of goodwill from the Play Along acquisition is expected to be deductible for Federal and state income tax purposes. The total purchase price, including the earn-out of $16.7 million earned in 2004 and 2005, was allocated based on studies and valuations performed to the estimated fair value of assets acquired and liabilities assumed, as set forth in the following table (in thousands):
 
Estimated fair value of net assets:
      
Current assets acquired
 
$
24,063
 
Property and equipment, net
   
546
 
Other assets
   
3,184
 
Liabilities assumed
   
(22,263
)
Intangible assets other than goodwill                                         
   
22,100
 
Goodwill
   
74,723
 
   
$
102,353
 
 
Note 10 — Joint Ventures
 
The Company owns a fifty percent interest in a joint venture with THQ Inc. (“THQ”), a developer, publisher and distributor of interactive entertainment software for the leading hardware game platforms in the home video game market. The joint venture has entered into a license agreement with an initial license period expiring December 31, 2009, and a renewal for five years at the option of the joint venture, under which it acquired the exclusive worldwide right to publish WWE themed wrestling video games on all hardware platforms. The Company’s investment is accounted for using the cost method due to the financial and operating structure of the venture and its lack of control over the joint venture. The Company’s basis consists primarily of organizational costs, license costs and recoupable advances and is being amortized over the term of the initial license period. The joint venture agreement provides for the Company to have received guaranteed preferred returns through June 30, 2006 at varying rates of the joint venture’s net sales depending on the cumulative unit sales and platform of each particular game. The preferred return was subject to change after June 30, 2006 and was to be set for the distribution period beginning July 1, 2006 and ending December 31, 2009 (the “Next Distribution Period”). The agreement provides that the parties will negotiate in good faith and agree to the preferred return not less than 180 days prior to the start of the Next Distribution Period. It further provides that if the parties are unable to agree on a preferred return, the preferred return will be determined by arbitration. The parties have not reached an agreement with respect to the preferred return for the Next Distribution Period and the Company anticipates that the reset of the preferred return will be determined through arbitration. The preferred return is accrued in the quarter in which the licensed games are sold and the preferred return is earned, but an estimate of $0.4 million has been used for the quarter ended September 30, 2006 pending the outcome of the arbitration. The Company’s joint venture partner retains the financial risk of the joint venture and is responsible for the day-to-day operations, including development, sales and distribution, for which it is entitled to any remaining profits. In addition, THQ is entitled to receive a preferred return based on the Company’s sale of WWE themed TV Games. The preferred return paid to THQ in the nine month periods ended September 30, 2005 and 2006 was $0.8 million and nominal, respectively.
 
In the third quarter of 2005, the Company wrote off its $1.4 million investment in a Chinese joint venture to Other Expense on its determination that no future value would be realized.
 
14

 
JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Note 11 — Goodwill
 
The changes in the carrying amount of goodwill for the nine months ended September 30, 2006 are as follows (in thousands):
 
Balance at beginning of period
 
$
269,298
 
Goodwill acquired during the period (see Note 9)                           
   
44,494
 
Adjustments to goodwill during the period
   
1,523
 
Balance at end of period
 
$
315,315
 
 
Note 12 — Intangible Assets
 
Intangible assets consist primarily of licenses, product lines, customer relationships, debt offering costs from the issuance of the Company’s convertible senior notes and trademarks. Amortized intangible assets are included in the Intangibles and other, net, in the accompanying balance sheets. Trademarks is disclosed separately in the accompanying balance sheets. Intangible assets are as follows (in thousands):
 
       
December 31, 2005
 
September 30, 2006
 
   
Weighted
Useful
Lives
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Net
Amount
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Net
Amount
 
   
(Years)
                               
                                     
Amortized Intangible Assets:
                                   
Acquired order backlog
   
0.5
 
$
 
$
 
$
 
$
1,298
 
$
(1,298
)
$
 
Licenses
   
4.3
   
23,635
   
(12,082
)
 
11,553
   
37,825
   
(19,048
)
 
18,777
 
Product lines
   
3.5
   
17,700
   
(17,700
)
 
   
17,700
   
(17,700
)
 
 
Customer relationships
   
6.1
   
1,846
   
(700
)
 
1,146
   
34,746
   
(3,647
)
 
31,099
 
Non-compete/Employment contracts
   
4.0
   
2,748
   
(1,049
)
 
1,699
   
2,748
   
(1,576
)
 
1,172
 
Debt offering costs
   
20.0
   
3,705
   
(477
)
 
3,228
   
3,705
   
(616
)
 
3,089
 
Total amortized intangible assets
         
49,634
   
(32,008
)
 
17,626
   
98,022
   
(43,885
)
 
54,137
 
Unamortized Intangible Assets:
                                           
Trademarks
   
indefinite
   
17,768
   
N/A
   
17,768
   
19,068
   
N/A
   
19,068
 
         
$
67,402
 
$
(32,008
)
$
35,394
 
$
117,090
 
$
(43,885
)
$
73,205
 
 
Amortization expense related to limited life intangible assets was $2.3 million and $6.8 million, respectively, for the three and nine months ended September 30, 2005 and $3.8 million and $11.9 million, respectively, for the three and nine months ended September 30, 2006.
 
Note 13 — Share-Based Payments
 
Under its 2002 Stock Award and Incentive Plan (“the Plan”), which incorporated its Third Amended and Restated 1995 Stock Option Plan, the Company has reserved 6,025,000 shares of its common stock for issuance upon the exercise of options granted under the Plan, as well as for the awarding of other securities. Under the Plan, employees (including officers), non-employee directors and independent consultants may be granted options to purchase shares of common stock and other securities. The vesting of these options and other securities may vary, but typically vest on a step-up basis over a maximum period of five years. Share-based compensation expense is recognized on a straight-line basis over the requisite service period.
 
15


JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Note 13 — Share-Based Payments (continued)
 
Under the Plan, share-based compensation payments may include the issuance of shares of restricted stock. Beginning in January 2006, the Company’s five non-employee directors are each to receive annual grants of restricted stock at a value of $120,000 (or, for 2006, 5,732 shares per director) which vest after one year. In March 2003, two executive officers of the Company were granted an annual aggregate amount of 240,000 shares of restricted stock which vest over two years subject to acceleration based on the achievement of certain financial performance criteria and may be earned through 2010 based upon the achievement by the Company of certain financial performance criteria and continuing employment. In January 2005 and 2006, respectively, the Company issued 245,000 shares of restricted stock at a value of $5.1 million and 268,660 shares of restricted stock at a value of $5.6 million to two executive officers and five non-employee directors of the Company. In August 2006, the Company granted and issued an aggregate of 200,000 shares of restricted stock to its employees, which vest over a five-year period, at an aggregate value of approximately $3.4 million, which represents the fair market value at the grant date.
 
In December 2004, the Financial Accounting Standards Board (FASB) revised Statement of Financial Accounting Standards No. 123 (FAS 123R), “Share-Based Payment,” which establishes accounting for share-based awards exchanged for employee services and requires companies to expense the estimated fair value of these awards over the requisite employee service period. The accounting provisions of FAS 123R became effective for the Company beginning on January 1, 2006.
 
Under FAS 123R, share-based compensation cost is measured at the grant date, based on the estimated fair value of the award, and is recognized as expense over the employee’s requisite service period. The Company adopted the provisions of FAS 123R using a modified prospective application. The valuation provisions of FAS 123R apply to new awards and to awards that are outstanding on the effective date and subsequently modified or cancelled. Estimated compensation expense for awards outstanding at the effective date will be recognized over the remaining service period using the compensation cost calculated for pro forma disclosure purposes under FASB Statement No. 123, “Accounting for Stock-Based Compensation” (FAS 123).
 
In November 2005, the FASB issued FASB Staff Position No. FAS 123(R)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.” The Company has elected to adopt the alternative transition method provided in this FASB Staff Position for calculating the tax effects of share-based compensation pursuant to FAS 123R. The alternative transition method includes a simplified method to establish the beginning balance of the additional paid-in capital pool (APIC pool) related to the tax effects of employee share-based compensation, which is available to absorb tax deficiencies recognized subsequent to the adoption of FAS 123R.
 
The Company uses the Black-Scholes method of valuation for share-based option awards. In valuing the stock options, the Black-Scholes model incorporates assumptions about stock volatility, expected term of stock options, and risk free interest rate. The valuation is reduced by an estimate of stock option forfeitures.
 
The Company issued no stock options during the nine months ended September 30, 2006. The amount of share-based compensation expense recognized in the three and nine months ended September 30, 2006 is based on options issued prior to January 1, 2006 and restricted stock issued during the three and nine months ended September 30, 2006, and ultimately expected to vest, and it has been reduced for estimated forfeitures. FAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.
 
16


JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Note 13 — Share-Based Payments (continued)
 
Total share-based compensation expense and related tax benefits recognized for the three and nine months ended September 30, 2006 were $ 0.4 million and $0.1 million, respectively, and $1.4 million and $0.5 million, respectively, relating to stock options and $0.7 million and $0.3 million, respectively, and $3.4 million and $1.3 million, respectively, relating to restricted stock. Stock option activity pursuant to the Plan for the nine months ended September 30, 2006 is summarized as follows:
 
   
Plan Stock Options
 
   
Number of
Shares
 
Weighted
Average
Exercise
Price
 
            
Outstanding, December 31, 2005                                                         
   
1,789,106
 
$
16.32
 
Granted
   
   
 
Exercised
   
(321,878
)
$
10.18
 
Forfeited
   
(8,500
)
 
17.23
 
Outstanding, September 30, 2006
   
1,458,728
 
$
17.05
 
 
As of December 31, 2005, the Company had 245,000 shares of restricted stock outstanding, all of which vested during the first quarter of 2006. In January 2006, the Company issued 268,660 shares of restricted stock, 240,000 of which vest over a two-year period subject to acceleration and 28,660 of which vest over a one-year period. In August 2006, the Company issued an aggregate of 200,000 shares of restricted stock to its employees, which vest over a five-year period. All restricted shares granted during 2006 remain unvested as of September 30, 2006.
 
The following characteristics apply to the Plan stock options that are fully vested, or expected to vest, as of September 30, 2006:
 
Number of options outstanding
   
1,458,728
 
Weighted-average exercise price
 
$
17.05
 
Aggregate intrinsic value
 
$
12,042,204
 
Weighted-average contractual term of options outstanding                               
   
3.5 years
 
Number of options currently exercisable
   
886,532
 
Weighted-average exercise of options currently exercisable
 
$
16.01
 
Aggregate intrinsic value of options currently exercisable
 
$
9,136,611
 
Weighted-average contractual term of currently exercisable
   
3.39 years
 
 
At and for the nine months ended September 30, 2005, the Company accounted for the Plan under the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. Prior to the implementation of FAS 123R, stock-based employee compensation expense was not generally reflected in net income, as all options granted under the Plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FAS 123R to stock-based employee compensation for the three and nine months ended September 30, 2005, (in thousands, except per share data):
 
   
Three Months
Ended
September 30,
2005
 
Nine Months
Ended
September 30,
2005
 
           
Net income, as reported
 
$
32,753
 
$
54,479
 
Add (deduct): Stock-based employee compensation expense (credit) included in
reported net income, net of related tax effects
   
(669
)
 
(1,696
)
Deduct: Total stock-based employee compensation expense determined
under fair value method for all awards, net of related tax effects
   
(816
)
 
(2,016
)
Pro forma net income
 
$
31,268
 
$
50,767
 
Earnings per share:
             
Basic - as reported
 
$
1.22
 
$
2.04
 
Basic - pro forma
 
$
1.17
 
$
1.90
 
Diluted - as reported
 
$
1.05
 
$
1.77
 
Diluted - pro forma
 
$
1.00
 
$
1.66
 
 
17


JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Note 13 — Share-Based Payments (continued
 
In 2005, the fair value of each employee option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used: risk-free rate of interest of 4.25%; dividend yield of 0%, with volatility of 55.3%; and expected lives of five years.
 
Note 14 — Comprehensive Income
 
The table below presents the components of the Company’s comprehensive income for the three and nine months ended September 30, 2005 and 2006 (in thousands):
 
   
Three Months
Ended September 30,
 
Nine Months
Ended September 30,
 
   
2005
 
2006
 
2005
 
2006
 
                       
Net income
 
$
32,753
 
$
40,499
 
$
54,479
 
$
49,190
 
Other comprehensive income (loss):
                         
Foreign currency translation adjustment                                             
   
(105
)
 
130
   
(288
)   
269
 
Comprehensive income
 
$
32,648
 
$
40,629
 
$
54,191
 
$
49,459
 
 
Note 15 — Recent Accounting Pronouncement
 
In July 2006, the FASB issued FASB Interpretation No. 48 (FIN 48) “Accounting for Uncertainty in Income Taxes” which prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the derecognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. The accounting provisions of FIN 48 will be effective for the Company beginning January 1, 2007. The Company is in the process of determining the effect, if any, the adoption of FIN 48 will have on its financial statements.
 
18

 
In September 2006, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurement, which provides guidance for applying the definition of fair value to various accounting pronouncements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company will incorporate the guidance in SFAS 157 in our valuation of the CDI acquisition, which valuation will be completed by December 31, 2006.
 
19

 
JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Note 15 — Recent Accounting Pronouncement (continued)
 
In September 2006, the FASB also issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans. SFAS 158 amends SFAS 87, 88, 106, and 132R, and requires employers to recognize the overfunded or underfunded status of defined benefit postretirement plans as an asset or liability in its statement of financial position. SFAS No. 158 is effective as of the end of fiscal years ending after December 15, 2006. SFAS 158 is not applicable to the Company, as it does not have a defined benefit pension plan.
 
In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin 108 ("SAB 108"), Considering the Effect of Prior Year Misstatements when Quantifying Misstatements in the Current Year Financial Statements, that addresses how uncorrected errors in previous years should be considered when quantifying errors in the current year financial statements.  SAB 108 is effective for fiscal years ending November 15, 2006 and, upon adoption, companies are allowed to record the effects as a cumulative-effect adjustment to retained earnings.  The Company will adopt SAB 108 for its fiscal year ending December 31, 2006 and is assessing what impact, if any, the adoption of SAB 108 will have on its financial position and results of operations.
 
Note 16 — Litigation
 
In October 2004, the Company was named as a defendant in a lawsuit commenced by WWE (the “WWE Action”). The complaint also named as defendants, among others, the joint venture with THQ Inc., certain of the Company’s foreign subsidiaries and the Company’s three executive officers. The Complaint was amended, the antitrust claims were dismissed and, on grounds not previously considered by the Court, a motion to dismiss the RICO claim, the only remaining basis for federal jurisdiction, was argued and submitted in September 2006. Discovery remains stayed. In November 2004, several purported class action lawsuits were filed in the United States District Court for the Southern District of New York, alleging damages associated with the facts alleged in the WWE Action (the “Class Action”). They are the subject of a motion to dismiss that has been fully briefed and argument has been scheduled for November 30, 2006. Three shareholder derivative actions have also been filed against the Company, nominally, and against certain of the Company’s Board members (the “Derivative Actions”). The Derivative Actions seek to hold the individual defendants liable for damages allegedly caused to the Company by their actions, and, in one of the Derivative Actions, seeks restitution to the Company of profits, benefits and other compensation obtained by them. These actions are currently stayed or the time to answer has been extended.
 
The Company received notice from WWE alleging breaches of the video game license in connection with sales of WWE video games in Japan and other countries in Asia. The joint venture has responded that WWE acquiesced in the arrangements, and separately released any claim against the joint venture in connection therewith and accordingly there is no breach of the joint venture’s video game license.
 
While the joint venture does not believe that WWE has a valid claim, it tendered a protective “cure” of the alleged breaches with a full reservation of rights. WWE “rejected” that cure and reserved its rights. On October 12, 2006, WWE commenced a lawsuit in Connecticut state court against THQ and THQ/JAKKS Pacific LLC (the “LLC”), involving a claim concerning allegedly improper sales of WWE video games in Japan and other countries in Asia. The lawsuit seeks, among other things, a declaration that WWE is entitled to terminate the video game license and monetary damages. THQ and the LLC have stated that they believe the lawsuit is without merit and intend to defend themselves vigorously. However, because this action is in its preliminary stage, no assurance may be given as to the outcome, nor can an estimate be made of the range of the Company’s potential losses, if any.
 
In connection with the joint venture with THQ (see Note 10), the Company receives its profit through a preferred return based on net sales of the joint venture, which was to be reset as of July 1, 2006. The agreement with THQ provides for the parties to agree on the reset of the preferred return or, if no agreement is reached, for arbitration of the issue. No agreement has been reached and the Company anticipates that the reset of the preferred return will be determined through arbitration. The preferred return is accrued in the quarter in which the licensed games are sold and the preferred return is earned, but an estimate of $0.4 million has been used for the quarter ended September 30, 2006 pending the outcome of the arbitration.
 
20

 
JAKKS PACIFIC, INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited
 
Note 16 — Litigation (continued)
 
The Company is a party to, and certain of its property is the subject of, various other pending claims and legal proceedings that routinely arise in the ordinary course of its business. Other than with respect to the claims in the WWE Action, the Class Action, and the matter of the reset of the preferred return from THQ in connection with the joint venture, with respect to which the Company cannot give assurance as to the outcome, the Company does not believe that any of these claims or proceedings will have a material effect on its business, financial condition or results of operations.
 
21

 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following discussion and analysis of financial condition and results of operations should be read together with our Condensed Consolidated Financial Statements and Notes thereto which appear elsewhere herein.
 
Critical Accounting Policies and Estimates
 
Share-Based Payments. We grant restricted stock and options to purchase our common stock to our employees (including officers) and non-employee directors under our 2002 Stock Award and Incentive Plan (“the Plan”), which incorporated our Third Amended and Restated 1995 Stock Option Plan. The benefits provided under the Plan are share-based payments subject to the provisions of revised Statement of Financial Accounting Standards No. 123 (FAS 123R), “Share-Based Payment.” Effective January 1, 2006, we began to use the fair value method to apply the provisions of FAS 123R with a modified prospective application. The valuation provisions of FAS 123R apply to new awards and to awards that were outstanding on the effective date and subsequently modified or cancelled. Under the modified prospective application, prior periods are not restated for comparative purposes. Share-based compensation expense recognized on a straight-line basis over the requisite service period under FAS 123R for the three and nine months ended September 30, 2006 was $0.4 and $1.4 million, respectively, relating to stock options, and $0.7 and $3.4 million, respectively, relating to restricted stock. At September 30, 2006, total unrecognized estimated compensation expense related to non-vested stock options granted prior to that date was $2.9 million, which is expected to be recognized over a weighted average period of 4.15 years, and $5.7 million related to non-vested restricted stock, which is expected to be recognized over a weighted average period of 2.35 years. Net stock options, after forfeitures and cancellations, granted during the nine months ended September 30, 2005 represented 1.08% of outstanding shares as of the beginning of the fiscal period. Total stock options granted during the nine months ended September 30, 2005 represented 1.35% of outstanding shares as of the end of the fiscal period. There were no stock options granted during the nine months ended September 30, 2006.
 
We estimate the value of share-based awards on the date of grant using the Black-Scholes option-pricing model. Prior to the adoption of FAS 123R, the estimated value of each share-based award was used for the pro forma information required to be disclosed under FAS 123. The determination of the fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends.
 
If factors change and we employ different assumptions in the application of FAS 123R in future periods, the compensation expense that we record under FAS 123R may differ from what we have recorded in the current period. Option-pricing models were developed for use in estimating the value of traded options that have no vesting or hedging restrictions, are fully transferable and do not cause dilution. Because our share-based payments have characteristics significantly different from those of freely traded options, and because changes in the subjective input assumptions can materially affect our estimates of fair values, in our opinion, existing valuation models, including the Black-Scholes and lattice binomial models, may not provide reliable measures of the fair values of our share-based compensation. Consequently, there is a risk that our estimates of the fair values of our share-based compensation awards on the grant dates may differ from the actual values realized upon the exercise, expiration, early termination or forfeiture of those share-based payments in the future. Certain share-based payments, such as employee stock options, may expire worthless or otherwise result in zero intrinsic value as compared to the fair values originally estimated on the grant date and reported in our financial statements. Alternatively, value may be realized from these instruments that is significantly in excess of the fair values originally estimated on the grant date and reported in our financial statements. There is currently no market-based mechanism or other practical application to verify the reliability and accuracy of the estimates stemming from these valuation models, nor is there a means to compare and adjust the estimates to actual values. Although the fair value of employee share-based awards is determined in accordance with FAS 123R and the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107 (SAB 107) using an option-pricing model, that value may not be indicative of the fair value observed in a willing buyer/willing seller market transaction.
 
Estimates of share-based compensation expenses do have an impact on our financial statements, but these expenses are based on the aforementioned option valuation model and will never result in the payment of cash by us. For this reason, and because we do not view share-based compensation as related to our operational performance, we exclude estimated share-based compensation expense when evaluating the business performance of our operating segments.
 
22

 
The guidance in FAS 123R and SAB 107 is relatively new, and best practices are not well established. The application of these principles may be subject to further interpretation and refinement over time. There are significant differences among valuation models, and there is a possibility that we will adopt different valuation models in the future. This may result in a lack of consistency in future periods and materially affect the fair value estimate of share-based payments. It may also result in a lack of comparability with other companies that use different models, methods and assumptions.
 
Furthermore, theoretical valuation models and market-based methods are evolving and may result in lower or higher fair value estimates for share-based compensation. The timing, readiness, adoption, general acceptance, reliability and testing of these methods is uncertain. Sophisticated mathematical models may require voluminous historical information, modeling expertise, financial analyses, correlation analyses, integrated software and databases, consulting fees, customization and testing for adequacy of internal controls. Market-based methods are emerging that, if employed by us, may dilute our earnings per share and involve significant transaction fees and ongoing administrative expenses. The uncertainties and costs of these extensive valuation efforts may outweigh the benefits to investors.
 
Recent Developments
 
On February 9, 2006, we acquired substantially all of the assets of Creative Designs International, Ltd. and a related Hong Kong company, Arbor Toys Company Limited (collectively “Creative Designs”). The total initial consideration of $111.2 million consisted of cash paid at closing in the amount of $101.7 million, the issuance of 150,000 shares of our common stock at a value of approximately $3.4 million and the assumption of liabilities in the amount of $6.1 million. In addition, we agreed to pay an earn-out of up to an aggregate of $20.0 million in cash over the three calendar years following the acquisition based on the achievement of certain financial performance criteria, which will be recorded as goodwill when and if earned. Our preliminary valuation of this acquisition indicates that goodwill of $44.5 million arose from this transaction, which represents the excess of the purchase price over the fair value of the net assets acquired. Goodwill represents anticipated synergies to be gained via the combination of Creative Designs with our Company. Creative Designs is a leading designer and producer of dress-up and role-play toys. This acquisition expands our product offerings in the girls category and brings new product development and marketing talent to us. Our results of operations have included Creative Designs from the date of acquisition.
 
In June 2005, we purchased substantially all of the operating assets and assumed certain liabilities relating to the Pet Pal line of pet products, including toys, treats and related pet products. The total initial consideration of $11.2 million consisted of cash paid at closing in the amount of $10.6 million and the assumption of liabilities in the amount of $0.6 million. Goodwill of $4.6 million arose from this transaction, which represents the excess of the purchase price over the fair value of the net assets acquired. In addition, we agreed to pay an earn-out of up to an aggregate amount of $25.0 million in cash based on the achievement of certain financial performance criteria, which will be recorded as goodwill when and if earned. For the earn-out period ended May 31, 2006, $1.5 million of the earn-out was earned and recorded as goodwill. This acquisition expands our product offerings and distribution channels. Our results of operations have included Pet Pal from the date of acquisition.
 
23

 
Results of Operations
 
The following unaudited table sets forth, for the periods indicated, certain statement of income data as a percentage of net sales.
 
   
Three Months
Ended
September 30,
 
 Nine Months
Ended
September 30,
 
   
2005
 
2006
 
 2005
 
2006
 
                    
Net sales
   
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
Cost of sales
   
60.0
   
61.8
   
60.5
   
60.9
 
Gross profit
   
40.0
   
38.2
   
39.5
   
39.1
 
Selling, general and administrative expenses                                          
   
19.8
   
18.5
   
24.2
   
26.0
 
Income from operations
   
20.2
   
19.7
   
15.3
   
13.1
 
Profit (loss) from video game joint venture
   
0.1
   
(0.1
)
 
0.3
   
0.1
 
Other expense
   
(0.6
)
 
   
(0.3
)
 
 
Interest income
   
0.6
   
0.3
   
0.7
   
0.7
 
Interest expense
   
(0.5
)
 
(0.3
)
 
(0.7
)
 
(0.6
)
Income before provision for income taxes
   
19.8
   
19.6
   
15.3
   
13.3
 
Provision for income taxes
   
5.8
   
5.9
   
4.3
   
4.0
 
Net income
   
14.0
%
 
13.7
%
 
11.0
%
 
9.3
%
 
The following unaudited table summarizes, for the periods indicated, certain income statement data by segment.

   
Three Months
Ended
September 30,
 
 Nine Months
Ended
September 30,
 
   
2005
 
2006
 
 2005
 
2006
 
                    
Net Sales
                         
North America Toys
 
$
203,963
 
$
263,213
 
$
423,830
 
$
460,375
 
Pet Products
   
3,514
   
6,688
   
4,595
   
13,114
 
International
   
26,023
   
25,888
   
66,841
   
53,586
 
     
233,500
   
295,789
   
495,266
   
527,075
 
Cost of Sales
                         
North America Toys
   
116,934
   
163,857
   
249,105
   
278,760
 
Pet Products
   
2,580
   
3,135
   
3,402
   
7,476
 
International
   
20,534
   
15,914
   
47,022
   
34,514
 
     
140,048
   
182,906
   
299,529
   
320,750
 
Gross Margin
                         
North America Toys
   
87,029
   
99,356
   
174,725
   
181,614
 
Pet Products
   
934
   
3,553
   
1,193
   
5,638
 
International
   
5,489
   
9,974
   
19,819
   
19,073
 
   
$
93,452
 
$
112,883
 
$
195,737
 
$
206,325
 
 
Comparison of the Three Months Ended September 30, 2006 and 2005
 
Net Sales
 
North America Toys. Net sales of our North America Toys segment were $263.2 million in 2006 compared to $204.0 million in 2005, representing an increase of $59.2 million or 29.0%. The increase in net sales was primarily due to (a) an increase in sales of our (i) Traditional Toy products of $54.8 million, with increases in WWE actions figures and accessories, dolls, Doodle Bear, Speed Stacks and Snugglers, offset in part by decreases in TV Games, wheels products, Care Bears, Cabbage Patch Kids and Sky Dancers and (ii) Seasonal products of $7.2 million, partially offset by (b) decreases in sales of our Crafts and Activities and Writing instruments of $2.8 million. Additionally, our North America Toys net sales included approximately $85.0 million of Creative Designs line of products, which we acquired in February 2006.
 
24

 
Pet Products. Net Sales of our Pet Pal line of products contributed $6.7 million in 2006, compared to $3.5 million in 2005, representing an increase of $3.2 million or 91.4%. The increase is attributable to the growth in sales of this new line of products through our existing distribution channels.
 
International. Net sales of our International segment were comparable at $25.9 million in 2006, compared to $26.0 million in 2005. The slight decrease in net sales is primarily due to decreases in sales of our Crafts and Activities and Writing instruments of $0.6 million, offset in part by increases in sales of our Traditional Toy products of $0.5 million. Additionally, our International net sales included approximately $4.3 million of Creative Designs line of products, which we acquired in February 2006.
 
Cost of Sales
 
North America Toys. Cost of sales of our North America Toys segment was $163.9 million in 2006, compared to $116.9 million in 2005, representing an increase of $47.0 million or 40.2%. The increase primarily consisted of increases in product costs of $43.2 million and royalty expense of $3.3 million, which were in line with the higher volume of sales. Furthermore, royalty expense for the North America Toys segment decreased as a percentage of net sales due to changes in the product mix to more products with lower royalty rates or proprietary products with no royalty rates, from products with higher royalty rates. Product costs as a percentage of sales increased due to the mix of the product sold and sell-through of closeout product. Our depreciation of molds and tools increased by $0.4 million due to new product being developed in this segment.
 
Pet Products. Cost of sales of our Pet Pal line of products was $3.1 million in 2006, compared to $2.6 million in 2005, representing an increase of $0.5 million or 19.2%. The increase primarily consisted of increases in product costs of $0.2 million and royalty expense of $0.2 million, which were in line with the higher volume of sales. Additionally, our depreciation of molds and tools increased by $0.1 million.
 
International. Cost of sales of our International segment was $15.9 million in 2006, compared to $20.5 million in 2005, representing a decrease of $4.6 million or 22.4%. The decrease primarily consisted of decreases in product costs of $3.8 million and royalty expense of $0.8 million, which were in line with the lower volume of sales. Furthermore, royalty expense for the International segment decreased as a percentage of net sales due to changes in the product mix to more products with lower royalty rates or proprietary products with no royalty rates, from products with higher royalty rates. Product costs as a percentage of sales also decreased due to the mix of the product sold. Our depreciation of molds and tools was comparable year-over-year.
 
Selling, General and Administrative Expenses
 
Selling, general and administrative expenses were $54.7 million in 2006 and $46.2 million in 2005, constituting 18.5% and 19.8% of net sales, respectively. The overall increase of $8.5 million in such costs was primarily due to the addition of overhead related to the operations of Creative Designs ($7.9 million), increases in product development ($1.3 million), amortization expense related to intangible assets other than goodwill ($1.5 million) and stock-based compensation ($1.7 million), offset in part by decreases in bonus expense ($1.1 million) and other selling expenses ($2.5 million). Increased grants of restricted stock awards to our non-employee directors and the increase in the price of our common stock in 2006 compared to 2005 resulted in stock-based compensation expense of $1.1 million in 2006, compared to a benefit of $0.6 million in 2005. The decrease in direct selling expenses is primarily due to efficiencies gained by closing two third-party warehouses, offset in part by an increase in advertising and promotional expenses of $0.3 million in 2006 in support of several of our product lines. From time to time, we may increase or decrease our advertising efforts, if we deem it appropriate for particular products.
 
Profit from Video Game Joint Venture
 
We incurred a loss from our video game joint venture in 2006 in the amount of $0.2 million, as compared to a profit of $0.2 million in 2005, due to the release of a new game in 2005, and no new games in 2006. We accrued an estimate for the preferred return of $0.4 million, pending the outcome of the arbitration between us and THQ (see “Legal Proceedings”). The actual preferred return may differ, but, in any case, the difference is not anticipated to have a material impact on our financial position or statement of income.
 
Interest Income.
 
Interest income in 2006 was $1.0 million, as compared to $1.4 million in 2005. The decrease is due lower average cash balances, offset in part by higher interest rates during 2006 compared to 2005.
 
25

 
Interest Expense
 
Interest expense was $1.1 million for both 2006 and 2005 and relates to our convertible senior notes payable.
 
Provision for Income Taxes
 
Provision for income taxes included Federal, state and foreign income taxes at effective tax rates of 29.3% in 2005 and 30.0% in 2006, benefiting from a flat 17.5% tax rate on our income arising in, or derived from, Hong Kong for each of 2005 and 2006. The increase in the effective tax rate in 2006 is due to a greater proportion of taxable income generated in the United States. As of September 30, 2006, we had net deferred tax assets of approximately $5.0 million for which no allowance has been provided since, in the opinion of management, realization of the future benefit is more likely than not.
 
Comparison of the Nine Months Ended September 30, 2006 and 2005
 
Net Sales
 
North America Toys. Net sales of our North America Toys segment were $460.4 million in 2006, compared to $423.8 million in 2005, representing an increase of $36.6 million or 8.6%. The increase in net sales was primarily due to (a) an increase in sales of our (i) Traditional Toy products of $35.2 million, with increases in WWE actions figures and accessories, dolls, Doodle Bear, Speed Stacks, Snugglers and Dragonflyz, offset in part by decreases in TV Games, wheels products, Sky Dancers, Care Bears and Cabbage Patch Kids, and (ii) Seasonal products of $6.8 million, partially offset by (b) decreases in sales of our Crafts and Activities and Writing instruments of $5.4 million. Additionally, our North America Toys net sales included approximately $112.3 million of Creative Designs line of products, which we acquired in February 2006.
 
Pet Products. Net Sales of our Pet Pal line of products, which we acquired in June 2005, were $13.1 million in 2006, compared to $4.6 million in 2005, representing an increase of $8.5 million or 184.8%. The increase is attributable to the growth in sales of this new line of products through our existing distribution channels and having sales for the entire nine months ended September 30, 2006.
 
International. Net sales of our International segment were $53.6 million in 2006, compared to $66.8 million in 2005, representing a decrease of $13.2 million or 19.8%. The decrease in net sales is primarily due to decreases in sales of our Traditional Toy products of $12.6 million and Seasonal products of $0.8 million, offset in part by increases in sales of our Crafts and Activities and Writing instruments of $0.2 million. Additionally, our International net sales included approximately $8.2 million of Creative Designs line of products, which we acquired in February 2006.
 
Cost of Sales
 
North America Toys. Cost of sales of our North America Toys segment was $278.8 million in 2006, compared to $249.1 million in 2005, representing an increase of $29.7 million or 11.9%. The increase primarily consisted of an increase in product costs of $30.7 million, which is in line with the higher volume of sales. Furthermore, royalty expense for the North America Toys segment decreased by $2.0 million and as a percentage of net sales due to changes in the product mix to more products with lower royalty rates or proprietary products with no royalty rates, from products with higher royalty rates. Product costs as a percentage of sales increased due to the mix of the product sold and sell-through of closeout product. Our depreciation of molds and tools increased by $0.9 million due to new product being developed in this segment.
 
Pet Products. Cost of sales of our Pet Pal line of products, which we acquired in June 2005, was $7.5 million in 2006, compared to $3.4 million in 2005, representing an increase of $4.1 million or 120.6%. The increase primarily consisted of increases in product costs of $3.2 million, royalty expense of $0.7 million, which were in line with the higher volume of sales. Additionally, our depreciation of molds and tools increased by $0.2 million.
 
International. Cost of sales of our International segment was $34.5 million in 2006, compared to $47.0 million in 2005, representing a decrease of $12.5 million or 26.6%. The decrease primarily consisted of decreases in product costs of $10.6 million and royalty expense of $2.0 million, which were in line with the lower volume of sales. Furthermore, royalty expense for the International segment decreased as a percentage of net sales due to changes in the product mix to more products with lower royalty rates or proprietary products with no royalty rates, from products with higher royalty rates. Product costs as a percentage of sales also decreased due to the mix of the product sold. Our depreciation of molds and tools increased by $0.1 million, which was comparable year-over-year.
 
26

 
Selling, General and Administrative Expenses
 
Selling, general and administrative expenses were $136.9 million in 2006 and $120.2 million in 2005, constituting 26.0% and 24.2% of net sales, respectively. The overall increase of $16.7 million in such costs was primarily due to the addition of overhead related to the operations of Creative Designs ($12.7 million), increases in product development ($2.6 million), amortization expense related to intangible assets other than goodwill ($5.1 million) and stock-based compensation ($5.6 million), offset in part by a decrease in other selling expenses ($10.4 million). Increased grants of restricted stock awards to our non-employee directors and the increase in the price of our common stock in 2006 compared to 2005 resulted in stock-based compensation expense of $4.8 million in 2006, compared to a benefit of $0.8 million in 2005. The decrease in direct selling expenses is primarily due to efficiencies gained by closing two third-party warehouses and decreases in sales commission expense ($1.2 million) and advertising and promotional expenses of $5.6 million in 2006 in support of several of our product lines. From time to time, we may increase or decrease our advertising efforts, if we deem it appropriate for particular products.
 
Profit from Video Game Joint Venture
 
Profit from our video game joint venture in 2006 was $0.7 million with one new game released, as compared to $1.5 million in 2005 with one new game released, with the overall profit decrease attributable to stronger carryover sales of existing titles in 2005, compared to 2006. For the three months ended September 30, 2006, we accrued an estimate for the preferred return of $0.4 million, pending the outcome of the arbitration between us and THQ (see “Legal Proceedings”). The actual preferred return may differ, but, in any case, the difference is not anticipated to have a material impact on our financial position or statement of income.
 
Interest Income
 
Interest income in 2006 was $3.5 million, as compared to $3.4 million in 2005. The moderate increase is due to higher interest rates during 2006 compared to 2005, offset in part by lower average cash balances.
 
Interest Expense
 
Interest expense was $3.4 million for both 2006 and 2005 and relates to our convertible senior notes payable.
 
Provision for Income Taxes
 
Provision for income taxes included Federal, state and foreign income taxes at effective tax rates of 28.0% in 2005 and 30.0% in 2006, benefiting from a flat 17.5% tax rate on our income arising in, or derived from, Hong Kong for each of 2005 and 2006. The increase in the effective tax rate in 2006 is due to a greater proportion of taxable income generated in the United States. As of September 30, 2006, we had net deferred tax assets of approximately $5.0 million for which no allowance has been provided since, in the opinion of management, realization of the future benefit is more likely than not.
 
Seasonality and Backlog
 
The retail toy industry is inherently seasonal. Generally, our sales have been highest during the third and fourth quarters, and collections for those sales have been highest during the succeeding fourth and first fiscal quarters. Sales of writing instrument products are likewise seasonal, with sales highest during the second and third quarters, as are our Go Fly a Kite, Funnoodle and Storm outdoor products, which are largely sold in the first and second quarters. Our working capital needs have been highest during the third and fourth quarters.
 
While we have taken steps to level sales over the entire year, sales are expected to remain heavily influenced by the seasonality of our toy products. The result of these seasonal patterns is that operating results and demand for working capital may vary significantly by quarter. Orders placed with us for shipment are cancelable until the date of shipment. The combination of seasonal demand and the potential for order cancellation makes accurate forecasting of future sales difficult and causes us to believe that backlog may not be an accurate indicator of our future sales. Similarly, financial results for a particular quarter may not be indicative of results for the entire year.
 
27

 
Recent Accounting Pronouncement
 
In July 2006, the FASB issued FASB Interpretation No. 48 (FIN 48) “Accounting for Uncertainty in Income Taxes” which prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on the derecognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. The accounting provisions of FIN 48 will be effective for us beginning January 1, 2007. We are in the process of determining the effect, if any, the adoption of FIN 48 will have on our financial statements.
 
In September 2006, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurement, which provides guidance for applying the definition of fair value to various accounting pronouncements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. We will incorporate the guidance in SFAS 157 in our valuation of the CDI acquisition, which valuation will be completed by December 31, 2006.
 
In September 2006, the FASB also issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans. SFAS 158 amends SFAS 87, 88, 106, and 132R, and requires employers to recognize the overfunded or underfunded status of defined benefit postretirement plans as an asset or liability in its statement of financial position. SFAS No. 158 is effective as of the end of fiscal years ending after December 15, 2006. SFAS 158 is not applicable to us, as we do not have a defined benefit pension plan..
 
In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin 108 ("SAB 108"), Considering the Effect of Prior Year Misstatements when Quantifying Misstatements in the Current Year Financial Statements, that addresses how uncorrected errors in previous years should be considered when quantifying errors in the current year financial statements.  SAB 108 is effective for fiscal years ending November 15, 2006 and, upon adoption, companies are allowed to record the effects as a cumulative-effect adjustment to retained earnings.  We will adopt SAB 108 for our fiscal year ending December 31, 2006 and are assessing what impact, if any, the adoption of SAB 108 will have on our financial position and results of operations.
 
Liquidity and Capital Resources
 
As of September 30, 2006, we had working capital of $284.0 million, compared to $301.5 million as of December 31, 2005. This decrease was primarily attributable to disbursements related to the acquisition of Creative Designs.
 
Operating activities provided net cash of $7.5 million in 2006, as compared to $55.8 million in 2005. Net cash was used primarily to fund our working capital needs, offset in part by contributions from net income and non-cash charges. Our accounts receivable turnover as measured by days sales for the quarter outstanding in accounts receivable was comparable at approximately 56 days as of September 30, 2005 and 2006. Other than open purchase orders issued in the normal course of business, we have no obligations to purchase finished goods from our manufacturers. As of September 30, 2006, we had cash and cash equivalents of $133.0 million.
 
Our investing activities used net cash of $117.7 million in 2006, as compared to $7.0 million in 2005, consisting primarily of cash paid for the purchase of net assets in the Creative Designs acquisition of $101.7 million, the Play Along earn-out of $6.7 million, the Pet Pal earn-out of $1.5 million and the purchase of office furniture and equipment and molds and tooling of $7.7 million used in the manufacture of our products and other assets. In 2005, our investing activities consisted primarily of cash paid for the Play Along earn-out of $10.0 million, the purchase of net assets in the Pet Pal acquisition and the purchase of office furniture and equipment and molds and tooling used in the manufacture of our products, offset in part by the sale of marketable securities. As part of our strategy to develop and market new products, we have entered into various character and product licenses with royalties generally ranging from 1% to 12% payable on net sales of such products. As of September 30, 2006, these agreements required future aggregate minimum guarantees of $40.3 million, exclusive of $25.3 million in advances already paid. Of this $40.3 million future minimum guarantee, $8.4 million is due over the next twelve months.
 
Our financing activities provided net cash of $2.6 million in 2006, consisting of proceeds from the exercise of stock options and the tax benefit from stock option exercises. In 2005, financing activities provided net cash of $3.0 million, consisting of proceeds from the exercise of stock options.
 
In October 2004, the American Jobs Creation Act of 2004 was signed into law and created a one-time incentive for U.S. corporations to repatriate undistributed earnings from their international subsidiaries by providing an 85% dividends-received deduction for certain international earnings. The deduction was available to corporations during the tax year that included October 2004, or in the immediately subsequent tax year. In the fourth quarter of 2005, our Board of Directors approved a plan to repatriate to the U.S. $105.5 million in foreign earnings, which was completed in December 2005. The Federal and state income tax expense related to this repatriation was approximately $4.7 million.
 
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In June 2003, we sold an aggregate of $98.0 million of 4.625% Convertible Senior Notes due June 15, 2023 and received net proceeds of approximately $94.4 million. The notes are convertible into shares of our common stock at an initial conversion price of $20.00 per share. Cash interest is payable at an annual rate of 4.625% of the principal amount at issuance, from the issue date to June 15, 2010, payable on June 15 and December 15 of each year. After June 15, 2010, interest will accrue on the outstanding notes until maturity. At maturity, we will redeem the notes at their accreted principal amount, which will be equal to $1,811.95 (181.195%) per $1,000 principal amount at issuance, unless redeemed or converted earlier.
 
We may redeem the notes at our option in whole or in part beginning on June 15, 2010, at 100% of their accreted principal amount plus accrued and unpaid interest, if any, payable in cash. Holders of the notes may also require us to repurchase all or part of their notes on June 15, 2010, for cash, at a repurchase price of 100% of the principal amount per note plus accrued and unpaid interest, if any. Holders of the notes may also require us to repurchase all or part of their notes on June 15, 2013 and June 15, 2018 at a repurchase price of 100% of the accreted principal amount per note plus accrued and unpaid interest, if any, and may be paid in cash, in shares of common stock or a combination of cash and shares of common stock.
 
On February 9, 2006, we acquired substantially all of the assets of Creative Designs. The total initial consideration of $111.2 million consisted of $101.7 million in cash paid at closing, the issuance 150,000 shares of our common stock valued at approximately $3.4 million and the assumption of liabilities in the amount of $6.1 million, and resulted in the recording of goodwill in the amount of $44.5 million. Goodwill represents anticipated synergies to be gained via the combination of Creative Designs with our Company. In addition, we agreed to pay an earn-out of up to an aggregate amount of $20.0 million in cash over the three calendar years following the acquisition based on the achievement of certain financial performance criteria, which will be recorded as goodwill when and if earned. Creative Designs is a leading designer and producer of dress-up and role-play toys. This acquisition expands our product offerings in the girls role-play and dress-up area and brings new product development and marketing talent to us. Our results of operations have included Creative Designs from the date of acquisition.
 
In June 2005, we purchased substantially all of the operating assets and assumed certain liabilities relating to the Pet Pal line of pet products, including toys, treats and related pet products. The total initial consideration of $11.2 million consisted of cash paid at closing in the amount of $10.6 million and the assumption of liabilities in the amount of $0.6 million. Goodwill of $4.6 million arose from this transaction, which represents the excess of the purchase price over the fair value of the net assets acquired. In addition, we agreed to pay an earn-out of up to an aggregate amount of $25.0 million in cash based on the achievement of certain financial performance criteria, which will be recorded as goodwill when and if earned. For the fiscal year ended May 31, 2006, $1.5 million of the earn-out was earned and recorded as goodwill. This acquisition expands our product offerings and distribution channels. Our results of operations have included Pet Pal from the date of acquisition.
 
In June 2004, we purchased substantially all of the assets and assumed certain liabilities from Play Along. The total initial consideration of $108.0 million consisted of cash paid at closing in the amount of $70.8 million, the issuance of 749,005 shares of our common stock valued at $14.9 million, and the assumption of liabilities in the amount of $22.3 million, and resulted in the recording of goodwill of $58.0 million. In addition, we agreed to pay an earn-out of up to $10.0 million per year for the four calendar years following the acquisition up to an aggregate amount of $30.0 million based on the achievement of certain financial performance criteria which will be recorded as goodwill when and if earned. For the two years in the period ended December 31, 2005, $16.7 million of the earn-out was earned and recorded as goodwill. The annual maximum earn-out for the remaining two years through December 31, 2007 is approximately $6.7 million, or an aggregate of $13.3 million. Play Along designs and produces traditional toys, which it distributes domestically and internationally. This acquisition expands our product offerings in the pre-school area and brings new product development and marketing talent to us. Our results of operations have included Play Along from the date of acquisition.
 
We believe that our cash flow from operations and cash and cash equivalents on hand will be sufficient to meet our working capital and capital expenditure requirements and provide us with adequate liquidity to meet our anticipated operating needs for at least the next 12 months. Although operating activities are expected to provide cash, to the extent we grow significantly in the future, our operating and investing activities may use cash and, consequently, this growth may require us to obtain additional sources of financing. There can be no assurance that any necessary additional financing will be available to us on commercially reasonable terms, if at all. We intend to finance our long-term liquidity requirements out of net cash provided by operations and cash on hand.
 
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
 
Market risk represents the risk of loss that may impact our financial position, results of operations or cash flows due to adverse changes in financial and commodity market prices and rates. We are exposed to market risk in the areas of changes in United States and international borrowing rates and changes in foreign currency exchange rates. In addition, we are exposed to market risk in certain geographic areas that have experienced or remain vulnerable to an economic downturn, such as China. We purchase substantially all of our inventory from companies in China, and, therefore, we are subject to the risk that such suppliers will be unable to provide inventory at competitive prices. While we believe that, if such an event were to occur we would be able to find alternative sources of inventory at competitive prices, we cannot assure you that we would be able to do so. These exposures are directly related to our normal operating and funding activities. Historically, we have not used derivative instruments or engaged in hedging activities to minimize our market risk.
 
Interest Rate Risk
 
In June 2003, we issued convertible senior notes payable of $98.0 million with a fixed interest rate of 4.625% per annum, which remain outstanding as of September 30, 2006. Accordingly, we are not generally subject to any direct risk of loss arising from changes in interest rates.
 
Foreign Currency Risk
 
We have wholly-owned subsidiaries in Hong Kong and China. Sales made by the Hong Kong subsidiaries are denominated in U.S. dollars. However, purchases of inventory are typically denominated in Hong Kong dollars and local operating expenses are denominated in the local currency of the subsidiary, thereby creating exposure to changes in exchange rates. Changes in the local currency/U.S. dollar exchange rates may positively or negatively affect our operating results. We do not believe that near-term changes in these exchange rates, if any, will result in a material effect on our future earnings, fair values or cash flows, and therefore, we have chosen not to enter into foreign currency hedging transactions. We cannot assure you that this approach will be successful, especially in the event of a significant and sudden change in the value of the Hong Kong dollar or Chinese Yuan relative to the U.S. dollar.
 
Item 4. Controls and Procedures
 
(a) Evaluation of disclosure controls and procedures.
 
Our Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e)) as of the end of the period covered by this Report, have concluded that as of that date, our disclosure controls and procedures were effective.
 
(b) Changes in internal control over financial reporting.
 
There were no changes in our internal control over financial reporting identified in connection with the evaluation required by Exchange Act Rules 13a-15(d) that occurred during the period covered by this Report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
 
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PART II
OTHER INFORMATION
 
Item 1. Legal Proceedings
 
On October 19, 2004, we were named as defendants in a lawsuit commenced by WWE in the U.S. District Court for the Southern District of New York concerning our toy licenses with WWE and the video game license between WWE and the joint venture company operated by THQ and us, encaptioned World Wrestling Entertainment, Inc. v. JAKKS Pacific, Inc., et al., 1:04-CV-08223-KMK (the “WWE Action”). The complaint also named as defendants THQ, the joint venture, certain of our foreign subsidiaries, Jack Friedman (our Chairman and Chief Executive Officer), Stephen Berman (our Chief Operating Officer, President and Secretary and a member of our Board of Directors), Joel Bennett (our Chief Financial Officer), Stanley Shenker and Associates, Inc., Bell Licensing, LLC, Stanley Shenker and James Bell.
 
WWE sought treble, punitive and other damages (including disgorgement of profits) in an undisclosed amount and a declaration that the video game license with the joint venture, which is scheduled to expire in 2009 (subject to joint venture’s right to extend that license for an additional five years), and an amendment to our toy licenses with WWE, which are scheduled to expire in 2009, are void and unenforceable. This action alleged violations by the defendants of the Racketeer Influenced and Corrupt Organization Act (“RICO”) and the anti-bribery provisions of the Robinson-Patman Act, and various claims under state law.
 
On February 16, 2005, we filed a motion to dismiss the WWE Action. On March 30, 2005, the day before WWE’s opposition to our motion was due, WWE filed an Amended Complaint seeking, among other things, to add the Chief Executive Officer of THQ as a defendant and to add a claim under the Sherman Act. The Court allowed the filing of the Amended Complaint and ordered a two-stage resolution of the viability of the Complaint, with motions to dismiss the federal jurisdiction claims based on certain threshold issues to proceed and all other matters to be deferred for consideration if the Complaint survived scrutiny with respect to the threshold issues. The Court also stayed discovery pending the determination of the motions to dismiss.
 
The motions to dismiss the Amended Complaint based on these threshold issues were fully briefed and argued and, on March 31, 2006, the Court granted the part of our motion seeking dismissal of the Robinson-Patman Act and Sherman Act claims and denied the part of our motion seeking to dismiss the RICO claims on the basis of the threshold issue that was briefed (the “March 31 Order”).
 
On April 7, 2006, we sought certification to appeal from the portion of the March 31 Order denying our motion to dismiss the RICO claim on the one ground that was briefed. Shortly thereafter, WWE filed a motion for reargument with respect to the portion of the March 31 Order that dismissed the Sherman Act claim and, alternatively, sought judgment with respect to the Sherman Act claim so that it could pursue an immediate appeal. At a court conference on April 26, 2006 the Court deferred the requests for judgment and for certification and set up briefing schedules with respect to our motion to dismiss the RICO claim, which claim is presently the sole remaining basis for federal jurisdiction, on grounds that were not the subject of the first round of briefing, and our motion to dismiss the action based on the Release that WWE executed. The Court also established a briefing schedule for WWE’s motion for reargument of the dismissal of the Sherman Act claim. These motions were argued and submitted in September 2006. Discovery remains stayed.
 
In November 2004, several purported class action lawsuits were filed in the United States District Court for the Southern District of New York: (1) Garcia v. Jakks Pacific, Inc. et al., Civil Action No. 04-8807 (filed on November 5, 2004), (2) Jonco Investors, LLC v. Jakks Pacific, Inc. et al., Civil Action No. 04-9021 (filed on November 16, 2004), (3) Kahn v. Jakks Pacific, Inc. et al., Civil Action No. 04-8910 (filed on November 10, 2004), (4) Quantum Equities L.L.C. v. Jakks Pacific, Inc. et al., Civil Action No. 04-8877 (filed on November 9, 2004), and (5) Irvine v. Jakks Pacific, Inc. et al., Civil Action No. 04-9078 (filed on November 16, 2004) (the “Class Actions”). The complaints in the Class Actions allege that defendants issued positive statements concerning increasing sales of our WWE licensed products which were false and misleading because the WWE licenses had allegedly been obtained through a pattern of commercial bribery, our relationship with the WWE was being negatively impacted by the WWE’s contentions and there was an increased risk that the WWE would either seek modification or nullification of the licensing agreements with us. Plaintiffs also allege that we misleadingly failed to disclose the alleged fact that the WWE licenses were obtained through an unlawful bribery scheme. The plaintiffs in the Class Actions are described as purchasers of our common stock, who purchased from as early as October 26, 1999 to as late as October 19, 2004. The Class Actions seek compensatory and other damages in an undisclosed amount, alleging violations of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 promulgated thereunder by each of the defendants (namely the Company and Messrs. Friedman, Berman and Bennett), and violations of Section 20(a) of the Exchange Act by Messrs. Friedman, Berman and Bennett. On January 25, 2005, the Court consolidated the Class Actions under the caption In re JAKKS Pacific, Inc. Shareholders Class Action Litigation, Civil Action No. 04-8807. On May 11, 2005, the Court appointed co-lead counsels and provided until July 11, 2005 for an amended complaint to be filed; and a briefing schedule thereafter with respect to a motion to dismiss. The motion to dismiss has been fully briefed and argument has been scheduled for November 30, 2006.
 
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We believe that the claims in the WWE Action and the Class Actions are without merit and we intend to defend vigorously against them. However, because these Actions are in their preliminary stages, we cannot assure you as to the outcome of the Actions, nor can we estimate the range of our potential losses.
 
On December 2, 2004, a shareholder derivative action was filed in the Southern District of New York by Freeport Partner, LLC against us, nominally, and against Messrs. Friedman, Berman and Bennett, Freeport Partners v. Friedman, et al., Civil Action No. 04-9441 (the “Derivative Action”). The Derivative Action seeks to hold the individual defendants liable for damages allegedly caused to us by their actions and in particular to hold them liable on a contribution theory with respect to any liability we incur in connection with the Class Actions. On or about February 10, 2005, a second shareholder derivative action was filed in the Southern District of New York by David Oppenheim against us, nominally, and against Messrs. Friedman, Berman, Bennett, Blatte, Glick, Miller and Skala, Civil Action 05-2046 (the “Second Derivative Action”). The Second Derivative Action seeks to hold the individual defendants liable for damages allegedly caused to us by their actions as a result of alleged breaches of their fiduciary duties. On or about March 16, 2005, a third shareholder derivative action was filed. It is captioned Warr v. Friedman, Berman, Bennett, Blatte, Glick, Miller, Skala, and Jakks (as a nominal defendant), and it was filed in the Superior Court of California, Los Angeles County (the “Third Derivative Action”). The Third Derivative Action seeks to hold the individual defendants liable for (1) damages allegedly caused to us by their alleged breaches of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets and unjust enrichment; and (2) restitution to us of profits, benefits and other compensation obtained by them. Stays/and or extensions of time to answer are in place with respect to the derivative actions.
 
On March 1, 2005, we delivered a Notice of Breach of Settlement Agreement and Demand for Indemnification to WWE (the “Notification”). The Notification asserted that WWE’s filing of the WWE Action violated A Covenant Not to Sue contained in a January 15, 2004 Settlement Agreement and General Release (“General Release”) entered into between WWE and us and, therefore, that we were demanding indemnification, pursuant to the Indemnification provision contained in the General Release, for all losses that the WWE’s actions have caused or will cause to us and our officers, including but not limited to any losses sustained by us in connection with the Class Actions. On March 4, 2005, in a letter from its outside counsel, WWE asserted that the General Release does not cover the claims in the WWE Action.
 
On March 30, 2006, WWE’s counsel wrote a letter alleging breaches by the joint venture of the video game agreement relating to the manner of distribution and the payment of royalties to WWE with respect to sales of the WWE video games in Japan. WWE has demanded that the alleged breaches be cured within the time periods provided in the video game license, while reserving all of its rights, including its alleged right of termination of the video game license.
 
On April 28, 2006 the joint venture responded, asserting, among other things, that WWE had acquiesced in the manner of distribution in Japan and the payment of royalties with respect to such sales and, in addition, had separately released the joint venture from any claims with respect to such matter, including the payment of royalties with respect to such sales, and that there is therefore no basis for an allegation of a breach of the license agreement.
 
While the joint venture does not believe that WWE has a valid claim, it tendered a protective “cure” of the alleged breaches with a full reservation of rights. WWE “rejected” that cure and reserved its rights. On October 12, 2006, WWE commenced a lawsuit in Connecticut state court against THQ and THQ/JAKKS Pacific LLC (the “LLC”), involving a claim set forth above concerning allegedly improper sales of WWE video games in Japan and other countries in Asia. The lawsuit seeks, among other things, a declaration that WWE is entitled to terminate the video game license and monetary damages. THQ and the LLC have stated that they believe the lawsuit is without merit and intend to defend themselves vigorously. However, because this action is in its preliminary stage, we cannot assure you as to the outcome, nor can we estimate the range of our potential losses, if any.
 
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Our agreement with THQ provides for payment of a preferred return to us in connection with our joint venture (see Note 10, Joint Ventures). The preferred return is subject to change after June 30, 2006 and is to be set for the distribution period beginning July 1, 2006 and ending December 31, 2009 (the “Next Distribution Period”). The agreement provides that the parties will negotiate in good faith and agree to the preferred return not less than 180 days prior to the start of the Next Distribution Period. It further provides that if the parties are unable to agree on a preferred return, the preferred return will be determined by arbitration. The parties have not reached an agreement with respect to the preferred return for the Next Distribution Period and we anticipate that the reset of the preferred return will be determined through arbitration. With respect to the matter of the change in the preferred return, we cannot assure you of the outcome.
 
We are a party to, and certain of our property is the subject of, various other pending claims and legal proceedings that routinely arise in the ordinary course of our business, but we do not believe that any of these claims or proceedings will have a material effect on our business, financial condition or results of operations.
 
Item 1A. Risk Factors
 
From time to time, including in this Quarterly Report on Form 10-Q, we publish forward-looking statements, as disclosed in our Disclosure Regarding Forward-Looking Statements beginning immediately following the Table of Contents of this Report. We note that a variety of factors could cause our actual results and experience to differ materially from the anticipated results or other expectations expressed or anticipated in our forward-looking statements. The factors listed below are illustrative of the risks and uncertainties that may arise and that may be detailed from time to time in our public announcements and our filings with the Securities and Exchange Commission, such as on Forms 8-K, 10-Q and 10-K. We undertake no obligation to make any revisions to the forward-looking statements contained in this Report to reflect events or circumstances occurring after the date of the filing of this report.
 
The outcome of litigation in which we or our videogame joint venture with THQ have been named as defendants is unpredictable and a materially adverse decision in any such matter could have a material adverse affect on our financial position and results of operations.
 
We and our video game joint venture with THQ are both defendants in litigation matters, as described under “Legal Proceedings” in our periodic reports filed pursuant to the Securities Exchange Act of 1934, including the lawsuits commenced by WWE and the purported securities class action and derivative action claims stemming from one of the WWE lawsuits (see “Legal Proceedings”). These claims may divert financial and management resources that would otherwise be used to benefit our operations. Although we believe that we have meritorious defenses to the claims made in each and all of the litigation matters to which we have been named a party, and intend to contest each lawsuit vigorously, no assurances can be given that the results of these matters will be favorable to us. A materially adverse resolution of any of these lawsuits could have a material adverse affect on our financial position and results of operations.
 
Our inability to redesign, restyle and extend our existing core products and product lines as consumer preferences evolve, and to develop, introduce and gain customer acceptance of new products and product lines, may materially and adversely impact our business, financial condition and results of operations.
 
Our business and operating results depend largely upon the appeal of our products. Our continued success in the toy industry will depend on our ability to redesign, restyle and extend our existing core products and product lines as consumer preferences evolve, and to develop, introduce and gain customer acceptance of new products and product lines. Several trends in recent years have presented challenges for the toy industry, including:
 
 
·
The phenomenon of children outgrowing toys at younger ages, particularly in favor of interactive and high technology products;
 
 
·
Increasing use of technology;
 
 
·
Shorter life cycles for individual products; and
 
 
·
Higher consumer expectations for product quality, functionality and value.
 
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We cannot assure you that:
 
 
·
our current products will continue to be popular with consumers;
 
 
·
the product lines or products that we introduce will achieve any significant degree of market acceptance; or
 
 
·
the life cycles of our products will be sufficient to permit us to recover licensing, design, manufacturing, marketing and other costs associated with those products.
 
Our failure to achieve any or all of the foregoing benchmarks may cause the infrastructure of our operations to fail, thereby adversely affecting our business, financial condition and results of operations.
 
The failure of our character-related and theme-related products to become and/or remain popular with children may materially and adversely impact our business, financial condition and results of operations.
 
The success of many of our character-related and theme-related products depends on the popularity of characters in movies, television programs, live wrestling exhibitions, auto racing events and other media. We cannot assure you that:
 
 
·
media associated with our character-related and theme-related product lines will be released at the times we expect or will be successful;
 
 
·
the success of media associated with our existing character-related and theme-related product lines will result in substantial promotional value to our products;
 
 
·
we will be successful in renewing licenses upon expiration on terms that are favorable to us; or
 
 
·
we will be successful in obtaining licenses to produce new character-related and theme-related products in the future.
 
Our failure to achieve any or all of the foregoing benchmarks may cause the infrastructure of our operations to fail, thereby adversely affecting our business, financial condition and results of operations.
 
There are risks associated with our license agreements.
 
 
·
Our current licenses require us to pay minimum royalties
 
Sales of products under trademarks or trade or brand names licensed from others account for substantially all of our net sales. Product licenses allow us to capitalize on characters, designs, concepts and inventions owned by others or developed by toy inventors and designers. Our license agreements generally require us to make specified minimum royalty payments, even if we fail to sell a sufficient number of units to cover these amounts. In addition, under certain of our license agreements, if we fail to achieve certain prescribed sales targets, we may be unable to retain or renew these licenses.
 
 
·
Some of our licenses are restricted as to use
 
Under many of our license agreements, including WWE and Nickelodeon, the licensors have the right to review and approve our use of their licensed products, designs or materials before we may make any sales. If a licensor refuses to permit our use of any licensed property in the way we propose, or if their review process is delayed, our development or sale of new products could be impeded.
 
 
·
New licenses are difficult and expensive to obtain
 
Our continued success will depend substantially on our ability to obtain additional licenses. Intensive competition exists for desirable licenses in our industry. We cannot assure you that we will be able to secure or renew significant licenses on terms acceptable to us. In addition, as we add licenses, the need to fund additional royalty advances and guaranteed minimum royalty payments may strain our cash resources.
 
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·
A limited number of licensors account for a large portion of our net sales
 
We derive a significant portion of our net sales from a limited number of licensors. If one or more of these licensors were to terminate or fail to renew our license or not grant us new licenses, our business, financial condition and results of operations could be adversely affected.
 
The toy industry is highly competitive and our inability to compete effectively may materially and adversely impact our business, financial condition and results of operations.
 
The toy industry is highly competitive. Globally, certain of our competitors have financial and strategic advantages over us, including:
 
 
·
greater financial resources;
 
 
·
larger sales, marketing and product development departments;
 
 
·
stronger name recognition;
 
 
·
longer operating histories; and
 
 
·
greater economies of scale.
 
In addition, the toy industry has no significant barriers to entry. Competition is based primarily on the ability to design and develop new toys, to procure licenses for popular characters and trademarks and to successfully market products. Many of our competitors offer similar products or alternatives to our products. Our competitors have obtained and are likely to continue to obtain licenses that overlap our licenses with respect to products, geographic areas and markets. We cannot assure you that we will be able to obtain adequate shelf space in retail stores to support our existing products or to expand our products and product lines or that we will be able to continue to compete effectively against current and future competitors.
 
An adverse outcome in the litigation commenced against us and against our video game joint venture with THQ by WWE, or a decline in the popularity of WWE, could adversely impact our interest in that joint venture.
 
The joint venture with THQ depends entirely on a single license, which gives the venture exclusive worldwide rights to produce and market video games based on World Wrestling Entertainment characters and themes. An adverse outcome against us, THQ or the joint venture in the lawsuit commenced by WWE, or an adverse outcome against THQ or the joint venture in the lawsuit commenced by WWE against THQ and the joint venture (see the first Risk Factor, above, and “Legal Proceedings”), would adversely impact our rights under the joint venture’s single license, which would adversely effect the joint venture’s and our business, financial condition and results of operation.
 
Furthermore, the popularity of professional wrestling, in general, and World Wrestling Entertainment, in particular, is subject to changing consumer tastes and demands. The relative popularity of professional wrestling has fluctuated significantly in recent years. A decline in the popularity of World Wrestling Entertainment could adversely affect the joint venture’s and our business, financial condition and results of operations.
 
The termination of THQ’s manufacturing licenses and the inability of the joint venture to otherwise obtain these licenses from other manufacturers would materially adversely affect the joint venture’s and our business, financial condition and results of operations.
 
The joint venture relies on hardware manufacturers and THQ’s non-exclusive licenses with them for the right to publish titles for their platforms and for the manufacture of the joint venture’s titles. If THQ’s manufacturing licenses were to terminate and the joint venture could not otherwise obtain these licenses from other manufacturers, the joint venture would be unable to publish additional titles for these manufacturers’ platforms, which would materially adversely affect the joint venture’s and our business, financial condition and results of operations.
 
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The failure of the joint venture or THQ to perform as anticipated could have a material adverse affect on our financial position and results of operations.
 
The joint venture’s failure to timely develop titles for new platforms that achieve significant market acceptance, to maintain net sales that are commensurate with product development costs or to maintain compatibility between its personal computer CD-ROM titles and the related hardware and operating systems would adversely affect the joint venture’s and our business, financial condition and results of operations.
 
Furthermore, THQ controls the day-to-day operations of the joint venture and all of its product development and production operations. Accordingly, the joint venture relies exclusively on THQ to manage these operations effectively. THQ’s failure to effectively manage the joint venture would have a material adverse effect on the joint venture’s and our business and results of operations. We are also dependent upon THQ’s ability to manage cash flows of the joint venture. If THQ is required to retain cash for operations, or because of statutory or contractual restrictions, we may not receive cash payments for our share of profits, on a timely basis, or at all.
 
The amount of preferred return that we now receive from the joint venture is subject to change, which could adversely affect our results of operations.
 
The joint venture agreement provides for us to have received guaranteed preferred returns through June 30, 2006 at varying rates of the joint venture’s net sales depending on the cumulative unit sales and platform of each particular game. The preferred return was subject to change after June 30, 2006 and was to be set for the distribution period beginning July 1, 2006 and ending December 31, 2009 (the “Next Distribution Period”). The agreement provides that the parties will negotiate in good faith and agree to the preferred return not less than 180 days prior to the start of the Next Distribution Period. It further provides that if the parties are unable to agree on a preferred return, the preferred return will be determined by arbitration. The parties have not reached an agreement with respect to the preferred return for the Next Distribution Period and we anticipate that the reset of the preferred return will be determined through arbitration. The preferred return is accrued in the quarter in which the licensed games are sold and the preferred return is earned, but an estimate of $0.4 million has been used for the quarter ended September 30, 2006 pending the outcome of the arbitration.
 
Any adverse change to the preferred return for the next distribution period as well as the ongoing performance of the joint venture may result in our experiencing reduced net income, which would adversely affect our results of operations.
 
We may not be able to sustain or manage our rapid growth, which may prevent us from continuing to increase our net revenues.
 
We have experienced rapid growth in our product lines resulting in higher net sales over the last six years, which was achieved through acquisitions of businesses, products and licenses. For example, revenues associated with companies we acquired since 2003 were approximately $125.0 million, $67.1 million and $168.9 million, for the nine months ended September 30, 2006 and for the years ended December 31, 2005 and 2004, respectively, representing 23.7%, 10.1% and 29.4% of our total revenues for those periods. As a result, comparing our period-to-period operating results may not be meaningful and results of operations from prior periods may not be indicative of future results. We cannot assure you that we will continue to experience growth in, or maintain our present level of, net sales.
 
Our growth strategy calls for us to continuously develop and diversify our toy business by acquiring other companies, entering into additional license agreements, refining our product lines and expanding into international markets, which will place additional demands on our management, operational capacity and financial resources and systems. The increased demand on management may necessitate our recruitment and retention of qualified management personnel. We cannot assure you that we will be able to recruit and retain qualified personnel or expand and manage our operations effectively and profitably. To effectively manage future growth, we must continue to expand our operational, financial and management information systems and to train, motivate and manage our work force. There can be no assurance that our operational, financial and management information systems will be adequate to support our future operations. Failure to expand our operational, financial and management information systems or to train, motivate or manage employees could have a material adverse effect on our business, financial condition and results of operations.
 
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In addition, implementation of our growth strategy is subject to risks beyond our control, including competition, market acceptance of new products, changes in economic conditions, our ability to obtain or renew licenses on commercially reasonable terms and our ability to finance increased levels of accounts receivable and inventory necessary to support our sales growth, if any. Accordingly, we cannot assure you that our growth strategy will continue to be implemented successfully.
 
If we are unable to acquire and integrate companies and new product lines successfully, we will be unable to implement a significant component of our growth strategy.
 
Our growth strategy depends in part upon our ability to acquire companies and new product lines. Revenues associated with our acquisitions since 2003 represented approximately 23.7%, 10.1% and 29.4% of our total revenues for the nine months ended September 30, 2006 and the years ended December 31, 2005 and 2004, respectively. Future acquisitions will succeed only if we can effectively assess characteristics of potential target companies and product lines, such as:
 
 
·
attractiveness of products;
 
 
·
suitability of distribution channels;
 
 
·
management ability;
 
 
·
financial condition and results of operations; and
 
 
·
the degree to which acquired operations can be integrated with our operations.
 
We cannot assure you that we can identify attractive acquisition candidates or negotiate acceptable acquisition terms, and our failure to do so may adversely affect our results of operations and our ability to sustain growth. Our acquisition strategy involves a number of risks, each of which could adversely affect our operating results, including:
 
 
·
difficulties in integrating acquired businesses or product lines, assimilating new facilities and personnel and harmonizing diverse business strategies and methods of operation;
 
 
·
diversion of management attention from operation of our existing business;
 
 
·
loss of key personnel from acquired companies; and
 
 
·
failure of an acquired business to achieve targeted financial results.
 
A limited number of customers account for a large portion of our net sales, so that if one or more of our major customers were to experience difficulties in fulfilling their obligations to us, cease doing business with us, significantly reduce the amount of their purchases from us or return substantial amounts of our products, it could have a material adverse effect on our business, financial condition and results of operations.
 
Our three largest customers accounted for 54.6% and 59.1% of our net sales for the nine months ended September 30, 2006 and the year ended December 31, 2005, respectively. Except for outstanding purchase orders for specific products, we do not have written contracts with or commitments from any of our customers. A substantial reduction in or termination of orders from any of our largest customers could adversely affect our business, financial condition and results of operations. In addition, pressure by large customers seeking price reductions, financial incentives, changes in other terms of sale or for us to bear the risks and the cost of carrying inventory also could adversely affect our business, financial condition and results of operations. If one or more of our major customers were to experience difficulties in fulfilling their obligations to us, cease doing business with us, significantly reduce the amount of their purchases from us or return substantial amounts of our products, it could have a material adverse effect on our business, financial condition and results of operations. In addition, the bankruptcy or other lack of success of one or more of our significant retailers could negatively impact our revenues and bad debt expense.
 
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We depend on our key personnel and any loss or interruption of either of their servi