** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-Q**

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** **
| 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 files number **1-8681**

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** **

**RUSSBERRIE AND COMPANY, INC.**

(Exact name of registrant as specified in its charter)

 

| **New Jersey**                                                      |   | **22-1815337**                           |
|---------------------------------------------------------------------|--------|------------------------------------------|
| (State of or  other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification Number) |

 

| **111 Bauer Drive, Oakland, New Jersey**  |   | **07436**  |
|-------------------------------------------|--------|------------|
| (Address of  principal executive offices) |   | (Zip Code) |

 

**(201) 337-9000**

(Registrant’sTelephone Number, including area code) 

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes x              No o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of accelerated filer and largeaccelerated filer in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o             Acceleratedfiler x          Non-acceleratedfilero

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o             No x

The number of shares outstanding of each of theregistrant’s classes of common stock, as of October 27, 2006 was as follows:

** **

| CLASS                             | ** ** | **OUTSTANDING  At October 27, 2006** |
|-----------------------------------|------------|--------------------------------------|
| Common Stock,  $0.10 stated value |       | 20,913,072                           |

 

 

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**RUSSBERRIE AND COMPANY, INC.**

**INDEX**

 
| **PART I—FINANCIAL INFORMATION** |   |
|---------------------------------------|--------|
|                                  |   |   |   |
| Item 1.                               |   | Financial Statements  (unaudited) |   |
|                                  |   |   |   |
| a)                                    |   | Consolidated  Balance Sheets as of September 30, 2006 and December 31, 2005 |   |
|                                  |   |   |   |
| b)                                    |   | Consolidated  Statements of Operations for the three and nine months ended September 30,  2006 and 2005 |   |
|                                  |   |   |   |
| c)                                    |   | Consolidated  Statements of Cash Flows for the nine months ended September 30, 2006 and  2005 |   |
|                                  |   |   |   |
| d)                                    |   | Notes to  Unaudited Consolidated Financial Statements |   |
|                                  |   |   |   |
| Item 2.                               |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
|                                  |   |   |   |
| Item 3.                               |   | Quantitative  and Qualitative Disclosures About Market Risk |   |
|                                  |   |   |   |
| Item 4.                               |   | Controls and  Procedures |   |
|                                  |   |   |   |
|                                  |   |   |   |
| **PART  II—OTHER INFORMATION**   |   |
|                                  |   |   |   |
| Item 1A.                              |   | Risk  Factors |   |
|                                  |   |   |   |
| Item 6.                               |   | Exhibits |   |
|                                  |   |   |   |
| Signatures                            |   |

 

2

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**PART 1 - FINANCIAL INFORMATION**

**ITEM 1.  FINANCIAL STATEMENTS**

**RUSS BERRIE AND COMPANY, INC. AND SUBSIDIARIES****CONSOLIDATED BALANCE SHEETS****(Dollars in Thousands, except per share data)****(UNAUDITED)**
| ** **                                                                                                                                                     | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                     |       |                         |       |                        |       |
| Current assets                                                                                                                                                 |       |                         |       |                        |       |
| Cash and cash  equivalents                                                                                                                                     |       | $                            | 11,182     |                        | $          | 28,667 |   |
| Accounts  receivable, trade, less allowances of $1,734 in 2006 and $1,943 in 2005                                                                              |       | 56,803                       |       | 53,189                      |       |
| Inventories, net                                                                                                                                               |       | 45,140                       |       | 55,871                      |       |
| Prepaid expenses  and other current assets                                                                                                                     |       | 14,701                       |       | 11,651                      |       |
| Income tax  receivable                                                                                                                                         |       | 2,090                        |       | 2,979                       |       |
| Deferred income  taxes                                                                                                                                         |       | 2,132                        |       | 2,274                       |       |
| **Total  current assets**                                                                                                                                      |       | 132,048                      |       | 154,631                     |       |
| Property, plant  and equipment, net                                                                                                                            |       | 13,547                       |       | 17,856                      |       |
| Goodwill                                                                                                                                                       |       | 89,242                       |       | 89,242                      |       |
| Intangible  assets                                                                                                                                             |       | 61,610                       |       | 61,599                      |       |
| Restricted cash                                                                                                                                                |       | 768                          |       | 750                         |       |
| Other assets                                                                                                                                                   |       | 5,102                        |       | 4,883                       |       |
| **Total  assets**                                                                                                                                              |       | $                            | 302,317    |                        | $          | 328,961 |   |
| ** **                                                                                                                                                     |       |                         |       |                        |       |
| **Liabilities and Shareholders’  Equity**                                                                                                                 | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current liabilities                                                                                                                                            |       |                         | ** ** | ** **                  | ** ** |
| Current portion  of long-term debt                                                                                                                             |       | $                            | 9,000      |                        | $          | 2,600 |   |
| Short-term debt                                                                                                                                                |       | 6,506                        |       | 31,924                      |       |
| Accounts payable                                                                                                                                               |       | 11,882                       |       | 17,764                      |       |
| Accrued expenses                                                                                                                                               |       | 27,690                       |       | 26,629                      |       |
| Accrued income  taxes                                                                                                                                          |       | 2,420                        |       | 4,203                       |       |
| **Total  current liabilities**                                                                                                                                 |       | 57,498                       |       | 83,120                      |       |
| Deferred income  taxes                                                                                                                                         |       | 9,340                        |       | 6,358                       |       |
| Long-term debt,  excluding current portion                                                                                                                     |       | 45,750                       |       | 41,993                      |       |
| Other long-term  liabilities                                                                                                                                   |       | 3,488                        |       | 3,636                       |       |
| **Total  liabilities**                                                                                                                                         |       | 116,076                      |       | 135,107                     |       |
| ** **                                                                                                                                                     |       |                         |       |                        |       |
| Commitments and  contingencies                                                                                                                                 |       |                         |       |                        |       |
| Shareholders’ equity                                                                                                                                      |       |                         |       |                        |       |
| Common stock:  $0.10 per share stated value; authorized 50,000,000 shares; issued 26,549,356  shares at September 30, 2006 and 26,472,256 at December 31, 2005 |       | 2,655                        |       | 2,649                       |       |
| Additional paid  in capital                                                                                                                                    |       | 89,802                       |       | 88,751                      |       |
| Retained  earnings                                                                                                                                             |       | 190,046                      |       | 200,756                     |       |
| Accumulated  other comprehensive income                                                                                                                        |       | 13,888                       |       | 11,848                      |       |
| Treasury stock,  at cost, 5,636,284 shares at September 30, 2006 and December 31, 2005                                                                         |       | (110,150                     | )          | (110,150                    | )          |
| **Total  shareholders’ equity**                                                                                                                           |       | 186,241                      |       | 193,854                     |       |
| **Total liabilities and  shareholders’ equity**                                                                                                           |       | $                            | 302,317    |                        | $          | 328,961 |   |

 

*The accompanying notes are an integral part of theunaudited consolidated financial statements.*

3

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**RUSSBERRIE AND COMPANY, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS(Dollars in Thousands, Except Per Share Data)(UNAUDITED)**
| ** **                                                                          | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net sales                                                                           |       | $                                                        | 78,144     |                                                    | $          | 83,237 |   | $ | 221,193 |   | $ | 215,996 |   |
|                                                                                |       |                                                     |       |                                                    |       |   |   |   |   |
| Cost of sales                                                                       |       | 48,838                                                   |       | 48,643                                                  |       | 134,191 |   | 124,985 |   |
| ** **                                                                          | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Gross  profit**                                                                   |       | 29,306                                                   |       | 34,594                                                  |       | 87,002 |   | 91,011 |   |
|                                                                                |       |                                                     |       |                                                    |       |   |   |   |   |
| Selling, general and  administrative expenses                                       |       | 25,775                                                   |       | 29,936                                                  |       | 84,804 |   | 89,831 |   |
|                                                                                |       |                                                     |       |                                                    |       |   |   |   |   |
| **Operating  income**                                                               |       | 3,531                                                    |       | 4,658                                                   |       | 2,198 |   | 1,180 |   |
|                                                                                |       |                                                     |       |                                                    |       |   |   |   |   |
| Other (expense) income:                                                             |       |                                                     |       |                                                    |       |   |   |   |   |
| Interest  expense, including amortization and write-off of deferred financing costs |       | (1,650                                                   | )          | (1,424                                                  | )          | (9,059 | ) | (13,143 | ) |
| Interest and  investment income                                                     |       | 93                                                       |       | 116                                                     |       | 305 |   | 761 |   |
| Other, net                                                                          |       | (141                                                     | )          | (132                                                    | )          | 165 |   | (654 | ) |
|                                                                                |       | (1,698                                                   | )          | (1,440                                                  | )          | (8,589 | ) | (13,036 | ) |
|                                                                                |       |                                                     |       |                                                    |       |   |   |   |   |
| **Income  (loss) before income tax expense**                                        |       | 1,833                                                    |       | 3,218                                                   |       | (6,391 | ) | (11,856 | ) |
|                                                                                |       |                                                     |       |                                                    |       |   |   |   |   |
| Income tax expense                                                                  |       | 1,577                                                    |       | 11,824                                                  |       | 4,319 |   | 4,637 |   |
|                                                                                |       |                                                     |       |                                                    |       |   |   |   |   |
| **Net income  (loss)**                                                              |       | $                                                        | 256        |                                                    | $          | (8,606 | ) | $ | (10,710 | ) | $ | (16,493 | ) |
|                                                                                |       |                                                     |       |                                                    |       |   |   |   |   |
| **Net income (loss) per share:**                                                    | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                                                               |       | $                                                        | 0.01       |                                                    | $          | (0.41 | ) | $ | (0.51 | ) | $ | (0.79 | ) |
| Diluted                                                                             |       | $                                                        | 0.01       |                                                    | $          | (0.41 | ) | $ | (0.51 | ) | $ | (0.79 | ) |
|                                                                                |       |                                                     |       |                                                    |       |   |   |   |   |
| **Weighted average shares:**                                                        | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                                                               |       | 20,864                                                   |       | 20,824                                                  |       | 20,847 |   | 20,824 |   |
| Diluted                                                                             |       | 20,882                                                   |       | 20,824                                                  |       | 20,847 |   | 20,824 |   |

 

*The accompanying notes are anintegral part of the unaudited consolidated financial statements.*

 

4

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**RUSSBERRIE AND COMPANY, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS(Dollars in Thousands)(UNAUDITED)**
| ** **                                                                                 | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| **Cash flows from operating  activities:**                                                 | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| Net loss                                                                                   |       | $                                                       | (10,710    | ) | $ | (16,493 | ) |
| Adjustments to  reconcile net loss to net cash (used in) provided by operating activities: |       |                                                    |       |   |   |
| Depreciation and  amortization                                                             |       | 4,060                                                   |       | 4,971 |   |
| Amortization and  write-off of deferred financing costs                                    |       | 3,009                                                   |       | 5,855 |   |
| Provision for  accounts receivable                                                         |       | 894                                                     |       | 371 |   |
| Provision for  inventory reserve                                                           |       | 2,728                                                   |       | 667 |   |
| Deferred income  taxes                                                                     |       | 3,016                                                   |       | 5,013 |   |
| Write off on  disposal of fixed assets                                                     |       | 2,988                                                   |       |   |   |
| Other                                                                                      |       | (274                                                    | )          | 405 |   |
| Change in assets  and liabilities:                                                         |       |                                                    |       |   |   |
| Restricted cash                                                                            |       | (18                                                     | )          | 14,848 |   |
| Accounts  receivable                                                                       |       | (4,507                                                  | )          | 947 |   |
| Income tax  receivable                                                                     |       | 889                                                     |       | — |   |
| Inventories                                                                                |       | 8,003                                                   |       | (9,958 | ) |
| Prepaid expenses  and other current assets                                                 |       | (3,017                                                  | )          | (252 | ) |
| Other assets                                                                               |       | 43                                                      |       | 62 |   |
| Accounts payable                                                                           |       | (5,883                                                  | )          | 8,983 |   |
| Accrued expenses                                                                           |       | 499                                                     |       | (6,333 | ) |
| Accrued income  taxes                                                                      |       | (1,783                                                  | )          | 7,486 |   |
| Net cash (used  in) provided by operating activities                                       |       | (63                                                     | )          | 16,572 |   |
|                                                                                       |       |                                                    |       |   |   |
| **Cash flows from investing  activities:**                                                 | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| Proceeds from sale of  property, plant and equipment                                       |       | 90                                                      |       | 8,961 |   |
| Capital expenditures                                                                       |       | (2,840                                                  | )          | (950 | ) |
| Net cash (used  in)/provided by investing activities                                       |       | (2,750                                                  | )          | 8,011 |   |
|                                                                                       |       |                                                    |       |   |   |
| **Cash flows from financing  activities:**                                                 | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| Proceeds from issuance  of common stock                                                    |       | 1,057                                                   |       | — |   |
| Dividends paid to  shareholders                                                            |       | —                                                  |       | (2,082 | ) |
| Issuance of long-term  debt                                                                |       | 59,250                                                  |       | 81,983 |   |
| Repayment of long-term  debt                                                               |       | (81,017                                                 | )          | (142,004 | ) |
| Net borrowings on  revolving credit facility                                               |       | 6,506                                                   |       | — |   |
| Payment of deferred  financing costs                                                       |       | (2,508                                                  | )          | (3,513 | ) |
| Net cash used in  financing activities                                                     |       | (16,712                                                 | )          | (65,616 | ) |
|                                                                                       |       |                                                    |       |   |   |
| Effect of exchange rate  changes on cash and cash equivalents                              |       | 2,040                                                   |       | (2,515 | ) |
| Net decrease in cash  and cash equivalents                                                 |       | (17,485                                                 | )          | (43,548 | ) |
| Cash and cash  equivalents at beginning of period                                          |       | 28,667                                                  |       | 48,099 |   |
| Cash and cash  equivalents at end of period                                                |       | $                                                       | 11,182     |   | $ | 4,551 |   |
|                                                                                       |       |                                                    |       |   |   |
| **Cash paid during the year for:**                                                         | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| Interest expense                                                                           |       | $                                                       | 4,270      |   | $ | 7,437 |   |
| Income taxes                                                                               |       | $                                                       | 2,557      |   | $ | 1,831 |   |

 

*The accompanying notes are anintegral part of the unaudited consolidated financial statements*

5

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**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

**NOTE 1 - INTERIM CONSOLIDATED FINANCIAL STATEMENTS**

Theaccompanying unaudited interim consolidated financial statements have beenprepared by Russ Berrie and Company, Inc. and its subsidiaries (the “Company”)in accordance with accounting principles generally accepted in the UnitedStates of America for interim financial reporting and the instructions to theQuarterly Report on Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included infinancial statements prepared under generally accepted accounting principleshave been condensed or omitted pursuant to such principles andregulations.  The information furnished reflects all adjustments, whichare, in the opinion of management, of a normal recurring nature and necessaryfor a fair presentation of the Company’s consolidated financial position,results of operations and cash flows for the interim periods presented. Results for interim periods are not necessarily an indication of results to beexpected for the year.

TheCompany operates in two segments: (i) the Company’s gift business and (ii) theCompany’s infant and juvenile business, which is comprised of Sassy, Inc.and Kids Line, LLC. This segmentation of the Company’s operations reflects howmanagement currently views the results of operations.  Corporate assets and overhead expenses areincluded in the gift segment.  TheCompany has entered into separate credit facilities with respect to each of itssegments (see Note 5).  As provided forunder the Company’s credit facilities, during the nine months ended September30, 2006, the infant and juvenile segment paid the gift segment $1.5 million asreimbursement of corporate expenses. These payments are subject to restrictions as provided under the creditfacility and are eliminated in consolidation.

TheCompany’s gift business designs, manufactures through third parties and marketsa wide variety of gift products to retail stores throughout the United Statesand throughout the world via the Company’s international wholly-ownedsubsidiaries and independent distributors. The Company’s infant and juvenilebusinesses design and market products in a number of baby categories including,among others, infant bedding and accessories, bath toys and accessories,developmental toys, feeding items and baby comforting products. These productsare sold to consumers, primarily in the United States, through massmerchandisers, toy specialty, food, drug and independent retailers, apparelstores and military post exchanges.

Certainprior year amounts have been reclassified to conform to the 2006 presentation.

ThisQuarterly Report on Form 10-Q should be read in conjunction with the Company’sAnnual Report on Form 10-K for the year ended December 31, 2005, asamended on April 20, 2006 and May 1, 2006 (the “2005 10-K”) and the Company’sQuarterly Reports on Form 10-Q for the first and second quarters of 2006.

**NOTE 2 - ACCOUNTING FOR STOCK COMPENSATION**

The Companycurrently maintains the 2004 Stock Option, Restricted and Non-Restricted StockPlan (the “2004 Option Plan”) and the Amended and Restated 2004 Employee StockPurchase Plan (collectively, the “2004 Stock Plans”).  As of September 30, 2006, there were1,688,263 shares of common stock reserved for issuance under the 2004 StockPlans, net of shares previously issued under the 2004 Stock Plans.  The Company also continues to have optionsoutstanding under its 1999 and 1994 Stock Option and Restricted Stock Plans,its 1999 and 1994 Stock Option Plans and its 1999 and 1994 Stock Option Plansfor Outside Directors, (collectively, the “Predecessor Plans”).  No awards could be made after December 31,2003 with respect to the 1999 Predecessor Plans and after December 31, 1998with respect to the 1994 Predecessor Plans. (Refer to Item 12, “Security Ownership of Certain Beneficial Owners andManagement and Related Stockholder Matters - Equity Compensation PlanInformation”, and Note 19, “Stock Plans”, of the 2005 10-K for further detailswith respect to option plans).

 

6

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**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS(Unaudited)**

**Stock Option Plans**

The exercise price foroptions issued under the 2004 Option Plan and the Predecessor Plans isgenerally equal to the closing price of the Company’s common stock as of thedate the option is granted. Generally, stock options under the 2004 Option Planand the Predecessor Plans vest between one and five years from the grant dateunless otherwise stated by the specific grant. Options generally expire10 years from the date of grant.

Prior to January 1, 2006,the Company accounted for stock-based compensation under the recognition andmeasurement principles of Accounting Principles Board Opinion (“APB”) No. 25, “Accountingfor Stock Issued to Employees” (“APB 25”), and related interpretations.  Statement of Financial Accounting Standards (“SFAS”)No. 123, “Accounting for Stock Based Compensation” (“SFAS 123”), establishedaccounting and disclosure requirements using a fair-value-based method ofaccounting for stock-based employee compensation plans.  As permitted by SFAS 123, the Company electedto continue to apply the intrinsic-value-based method of APB 25 describedabove, and adopted the disclosure only requirements of SFAS 123, as amended bySFAS No. 148, “Accounting for Stock-Based Compensation – Transition andDisclosure.”

In December 2004,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123(R), “Share-BasedPayment” (“SFAS 123(R)”), which establishes standards for transactions in whichan entity exchanges its equity instruments for goods or services.  This statement is a replacement of SFAS 123and supersedes APB 25.  SFAS 123(R)requires companies to recognize an expense for compensation cost related toshare-based payment arrangements, including stock options and employee stockpurchase plans, based on the grant-date fair value of the award.  This standard applies to all awards unvestedor granted as of the required effective date and to awards modified,repurchased or cancelled after that date.

The Company adopted theprovisions of SFAS 123(R) on January 1, 2006 using the “modifiedprospective” transition method.  The “modifiedprospective” transition method requires compensation cost to be recognizedbeginning with the effective date (a) based on the requirements of SFAS123(R) for all share-based payments granted after the effective date and(b) based on the requirements of SFAS 123 for all awards granted toemployees prior to the effective date of SFAS 123(R) that remain unvested onthe effective date.  In accordance withthis method, prior periods were not restated to reflect the impact of adoptingthe new standard.

Effective December 28,2005, the Company amended all outstanding stock option agreements thatpertained to options with exercise prices in excess of the market price for theCompany’s common stock at the close of business on December 28, 2005 (“UnderwaterOptions”) which at that time had remaining vesting requirements. As a result ofthese amendments, all Underwater Options, which represented all outstandingoptions (to purchase approximately 1.5 million shares of the Company’s commonstock) that had not yet fully-vested, became fully vested and immediatelyexercisable at the close of business on December 28, 2005.  Of the optionsaccelerated, approximately 90,000 options were held by non-employee directors,approximately 678,000 were held by officers of the Company and the balance wereheld by other employees of the Company as of September 30, 2006.  Because these options were priced above thethen current market price on December 28, 2005, the acceleration of vesting ofthese options did not result in any expense being recognized in the Company’sConsolidated Statements of Operations. The purpose of the accelerated vesting of stock options was to enablethe Company to avoid recognizing compensation expense associated with theseoptions in future periods as required by SFAS 123(R), estimated at the date ofacceleration to be $1.6 million (pre-tax) in 2006 and in subsequent yearsthrough 2010 of approximately $3.7 million (pre-tax).

Asnoted above, prior to January 1, 2006, in accordance with APB 25, nocompensation cost had been recognized for options granted by the Company withan initial exercise price equal to the fair value of the common stock.  Had compensation cost for the Company’s stockgrants been determined based upon the 

 

7

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**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

 

fairvalue recognition provisions of SFAS 123 at the grant date, the Company’spro-forma net loss and net loss per share for the three and nine months endedSeptember 30, 2005 would have been as follows (in thousands, except per sharedata):

** **
| ** **                                                                                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                                                               | ** ** | **September 30, 2005** | ** ** | **September 30, 2005** | ** ** |
| Net loss-as  reported                                                                                    |       | $                                | (8,606     | )                                | $          | (16,493 | ) |
| Deduction for  stock-based compensation expense determined under fair value method net of  tax-pro forma |       | 319                              |       | 676                              |       |
| Net loss-pro  forma                                                                                      |       | $                                | (8,925     | )                                | $          | (17,169 | ) |
| Loss per share (basic) — as reported                                                                |       | $                                | (0.41      | )                                | $          | (0.79 | ) |
| Loss per share (basic) — pro forma                                                                  |       | $                                | (0.43      | )                                | $          | (0.82 | ) |
| Loss per share (diluted) — as reported                                                              |       | $                                | (0.41      | )                                | $          | (0.79 | ) |
| Loss per share  (diluted) — pro forma                                                               |       | $                                | (0.43      | )                                | $          | (0.82 | ) |

 

The fair value of each option granted by the Company was estimated onthe grant date using the Black-Scholes option-pricing model with the followingassumptions used for the grants:

 
| ** **                                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                      | ** ** | **September 30, 2005** | ** ** | **September 30, 2005** | ** ** |
| Dividend yield                                                  |       | 1.50                             | %          | 1.50                             | %          |
| Risk-free  interest rate                                        |       | 4.12                             | %          | 4.96                             | %          |
| Volatility                                                      |       | 36.50                            | %          | 35.45                            | %          |
| Expected life  (years)                                          |       | 3.7                              |       | 3.7                              |       |
| Weighted average fair  value of options granted during the year |       | $                                | 5.48       |                             | $          | 5.68 |   |
|                                                                 |            |                                  |            |                                  |            |  |  |

 

The following table summarizes stock option activity for the ninemonths ended September 30, 2006:

 
| ** **                                    | ** ** | ** **  | ** ** | **Weighted**       | ** ** | **Weighted**                  | ** ** | ** **    | ** ** |
|-----------------------------------------------|------------|-------------|------------|--------------------|------------|-------------------------------|------------|---------------|------------|
| ** **                                    | ** ** | ** **  | ** ** | **Average**        | ** ** | **Average**                   | ** ** | **Aggregate** | ** ** |
| ** **                                    | ** ** | ** **  | ** ** | **Exercise ** | ** ** | **Remaining **           | ** ** | **Intrinsic** | ** ** |
| ** **                                    | ** ** | **Options** | ** ** | **Price**          | ** ** | **Life (in years)** | ** ** | **Value**     | ** ** |
| Outstanding and  vested at December 31, 2005  |       | 1,769,238   |       | $                  | 17.16      |                          | 8.49       |          | —     |   |
| Exercised                                     |       | (77,100     | )          | $                  | 12.37      |                          | —     |          | —     |   |
| Cancelled                                     |       | (181,517    | )          | $                  | 14.27      |                          | —     |          | —     |   |
| Outstanding and vested  at September 30, 2006 |       | 1,510,621   |       | $                  | 17.75      |                          | 8.00       |          | $          | 1,845,750 |   |
|                                               |            |             |            |                    |            |                               |            |               |            |  |  |

 

During the nine months ended September 30, 2006, no options weregranted**.** The aggregate intrinsic value in the table above represents the totalpretax value of the in-the-money options, which value is determined byaggregating the “spread” of each of the in-the-money options (with the “spread”being the difference between the fair market value at September 30, 2006 andthe exercise price of each option) assuming that all shareholders exercisedtheir options on September 30, 2006. This amount will change based on the fair market value of the Company’sstock. The Company’s policy is to issue shares from authorized shares reservedfor such issuance to fulfill stock option exercises.

During the nine months ended September 30, 2006, no compensationexpense was recorded because the Company did not grant any options during suchperiod****and all of the options outstanding atthe date of adoption of SFAS 123(R) were fully vested**. **Compensation expense for futureshare-based payment arrangements will be recorded as required by SFAS 123 (R).

**Employee Stock Purchase Plan**

Under the Amended and Restated 2004 Employee Stock Purchase Plan (the “ESPP”),eligible employees are provided the opportunity to purchase the Company’scommon stock at a discount.  Pursuant tothe

 

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**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

ESPP, options are grantedto participants as of the first trading day of each plan year, which is thecalendar year, and may be exercised as of the last trading day of each planyear, to purchase from the Company the number of shares of common stock thatmay be purchased at the relevant purchase price with the aggregate amountcontributed by each participant.  In eachplan year, an eligible employee may elect to participate in the ESPP by filinga payroll deduction authorization form for up to 10% (in whole percentages) ofhis or her compensation.  No employeeshall have the right to purchase Company common stock under the ESPP that has afair market value in excess of $25,000 in any plan year.  The purchase price is the lesser of 85% ofthe closing market price of the Company’s common stock on either the firsttrading day or the last trading day of the plan year.  If an employee does not elect to exercise hisor her option, the total amount credited to his or her account during that planyear is returned to such employee without interest, and his or her optionexpires.  As of September 30, 2006,the ESPP had 131,722 shares reserved for future issuance.  At the ESPP’s last year end, December 31,2005, there were 158 participants in the ESPP. The impact of SFAS 123(R) on  theESPP for the nine months ended September 30, 2006 was approximately $67,000.

The fair value of each option granted under the ESPP is estimated onthe date of grant using the Black-Scholes option-pricing model with thefollowing assumptions:

|                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **               | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Dividend yield           |       | —                           |       | 1.33                            | %          | — |   | 1.33 | % |
| Risk-free  interest rate |       | 4.38                             | %          | 2.79                            | %          | 4.38 | % | 2.79 | % |
| Volatility               |       | 50.40                            | %          | 41.70                           | %          | 50.40 | % | 41.70 | % |
| Expected life (years)    |       | 1                                |       | 1                               |       | 1 |   | 1 |   |

 

The Company estimatesexpected stock price volatility based on actual historical changes in themarket value of the Company’s stock. The risk-free interest rate is based onthe U.S. Treasury yield with a term that is consistent with the expected lifeof the stock options.  The expected lifeof stock options under the ESPP is one year, or the equivalent of the annualplan year.

**NOTE 3 — WEIGHTED AVERAGE COMMON SHARES**

Theweighted average common shares outstanding included in the computation of basicand diluted net income / loss per share is set forth below (in thousands):
| ** **                                   | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Weighted average  common shares outstanding: |       |                                                     |       |                                                    |       |   |   |   |   |
| Basic                                        |       | 20,864                                                   |       | 20,824                                                  |       | 20,847 |   | 20,824 |   |
| Employee stock options and other             |       | 18                                                       |       | —                                                  |       | — |   | — |   |
| Diluted                                      |       | 20,882                                                   |       | 20,824                                                  |       | 20,847 |   | 20,824 |   |

 

Thecomputation of diluted net income (loss) per common share for the three andnine months ended September 30, 2006 did not include options to purchaseapproximately 1.3 million and 1.5 million shares of common stock, respectively,as the effect of their inclusion would have been anti-dilutive to income (loss)per share.  For the three and nine monthsended September 30, 2005, 0.8 million stock options were not included in thecomputation of diluted net income (loss) per common share as the effect oftheir inclusion would have been anti-dilutive.

 

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**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS(Unaudited)**

**NOTE4 — CONTINGENCY**

Aspreviously disclosed in the 2005 10-K, in December 2004, the Company purchasedall of the outstanding equity interests and warrants in Kids Line, LLC (the “Purchase”),in accordance with the terms and provisions of a Membership Interest PurchaseAgreement (the “Purchase Agreement”).  Atclosing, the Company paid approximately $130.5 million, which represented theportion of the purchase price due at closing plus various transaction costs,which was subsequently adjusted to $130.6 million.  The aggregate purchase price under thePurchase Agreement includes the potential payment of contingent consideration(the “Earnout Consideration”).  TheEarnout Consideration shall equal 11.724% of the Agreed Enterprise Value(described below) of Kids Line as of the last day of the Measurement Period(the three year period ending November 30, 2007), and shall be paid at thetimes described in the Purchase Agreement (approximately the third anniversaryof the closing date).  The AgreedEnterprise Value shall be the product of (i) Kids Line’s EBITDA during thetwelve (12) months ending on the last day of the Measurement Period and (ii)the applicable multiple (ranging from zero to eight) as set forth in thePurchase Agreement.  The Company cannotcurrently determine the amount of the Earnout Consideration that will berequired to be paid pursuant to the Purchase Agreement.  However, based on current projections, theCompany currently anticipates that the Earnout Consideration will be approximately$30 million, although the amount could be more or less depending on the actualperformance of Kids Line for the remaining portion of the MeasurementPeriod.  The amount of the EarnoutConsideration will be charged to goodwill.  The Company currently anticipates that cash flow from operations andanticipated availability under the Infantline Credit Agreement will besufficient to fund the payment of the Earnout Consideration (and that suchpayment will be permitted under the Infantline Credit Agreement), however therecan be no assurance that unforeseen events or changes in the Company’s businesswould not have a material adverse impact on our ability to pay the EarnoutConsideration and therefore on the Company’s liquidity.  As described in Note 5 (Section 1.A and 1.E) below,the Infantline Borrowers (defined below) have agreed, on a joint and severalbasis, to assume sole responsibility to pay the Earnout Consideration in placeof the Company.

**NOTE 5 — DEBT**

In connection with thepurchase of Kids Line in December 2004, the Company and certain of itssubsidiaries entered into a financing agreement (the “Financing Agreement”).The Financing Agreement consisted of a term loan in the original principalamount of $125.0 million which was scheduled to mature on November 14,2007 (the “2004 Term Loan”).  The Company used the proceeds of the 2004Term Loan to substantially finance the Purchase and pay fees and expensesrelated thereto.  The 2004 Term Loan was repaid in full and the FinancingAgreement was terminated in connection with the execution of the 2005 CreditAgreement, discussed below, as of June 28, 2005.   There were no fees paid as a result of theearly termination of the Financing Agreement. However, in conjunction therewith, the Company wrote off the remainingunamortized balance of approximately $4.8 million in deferred financing costs.

In order to reduceoverall interest expense and gain increased flexibility with respect to thefinancial covenant structure of the Company’s senior financing, on March 14,2006, the 2005 Credit Agreement (defined below) was terminated and theobligations thereunder were refinanced (the “LaSalle Refinancing”).  In connection with the LaSalle Refinancing, all outstanding obligations under the 2005Credit Agreement (approximately $76.5 million) were repaid using proceeds fromthe Infantline Credit Agreement, defined below, which is part of the LaSalleRefinancing.  The Company paid afee of approximately $1.3 million in connection with the early termination ofthe 2005 Credit Agreement.  In addition,the Company wrote off, in the first quarter of 2006, approximately $2.5 millionin deferred financing costs in connection with the LaSalle Refinancing.

As partof the LaSalle Refinancing, the Company formed a wholly-owned Delawaresubsidiary, Russ Berrie U.S. Gift, Inc. (“Newco”), to which it assigned (the “Assignment”)substantially all of its assets and liabilities which pertain primarily to itsdomestic gift business, such that separate loan facilities could be madedirectly available to each of the Company’s domestic gift business and infantand juvenile business, respectively.  TheAssignment transaction reinforces the operation of the Company as two separatesegments, and the credit facilities that have been extended to each segment areseparate and distinct.  There are nocross-default provisions between the Infantline Credit Agreement and GiftlineCredit Agreement, which are described below.

Long-termdebt at September 30, 2006 and December 31, 2005 consists of the following (inthousands):

 

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**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS(Unaudited)**
| ** **                                    | ** ** | **September 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Term Loan A  (2005 Credit Agreement)          | ** ** | **$**                            | **—** |                            | $          | 4,593 |   |
| Term Loan B  (2005 Credit Agreement)          | ** ** | **—**                       |       | 40,000                          |       |
| Term Loan (2006  Infantline Credit Agreement) |       | 54,750                           |       | —                          |       |
|                                          |       | 54,750                           |       | 44,593                          |       |
| Less current  portion                         |       | 9,000                            |       | 2,600                           |       |
| Long-term debt                                |       | $                                | 45,750     |                            | $          | 41,993 |   |

 

1.             The LaSalle Refinancing – Effective March 14, 2006

*A.  The Infantline Credit Agreement*

On March 14, 2006 (the “ClosingDate”), Kids Line, LLC (“KL”) and Sassy, Inc. (“Sassy”, and together with KL,the “Infantline Borrowers”) entered into a credit agreement as borrowers, on ajoint and several basis, with LaSalle Bank National Association asadministrative agent and arranger (the “Agent”), the lenders from time to timeparty thereto, the Company as loan party representative, Sovereign Bank assyndication agent, and Bank of America, N.A. as documentation agent (the “InfantlineCredit Agreement”).  Unless otherwisespecified herein, capitalized terms used but undefined in this Note 5 Section1.A shall have the meanings ascribed to them in the Infantline CreditAgreement.

The commitments under theInfantline Credit Agreement (the “Infantline Commitments”) consist of (a) a$35.0 million revolving credit facility (the “Revolving Loan”), with asubfacility for letters of credit in an amount not to exceed $5.0 million, and(b) a $60.0 million term loan facility (the “Term Loan”).  The Infantline Borrowers drew down approximately$79.7 million on the Infantline Credit Agreement on the Closing Date, includingthe full amount of the Term Loan, which reflects the payoff of all amountsoutstanding under the 2005 Credit Agreement and certain fees and expensesassociated with the LaSalle Refinancing. As of September 30, 2006, the outstanding balance on the Revolving Loanwas $0.75 million and the outstanding balance on the Term Loan was $54.75million.

The principal of the TermLoan will be repaid in installments as follows: (a) $0.75 million on the lastday of each calendar month for the period commencing March 2006 through andincluding February 2008, (b) $1.0 million on the last day of each calendarmonth for the period commencing March 2008 through and including February 2009and (c) $1.25 million on the last day of each calendar month for the periodcommencing March 2009 through and including February 2011.  A final installment in the aggregate amountof the unpaid principal balance of the Term Loan (in addition to all outstandingamounts under the Revolving Loan) is due and payable on March 14, 2011, in eachcase subject to customary early termination provisions in accordance with theterms of the Infantline Credit Agreement.

The Infantline Loans bearinterest at a rate per annum equal to the Base Rate (for Base Rate Loans) orthe LIBOR Rate (for LIBOR Loans), at the Company’s option, plus an applicablemargin, in accordance with a pricing grid based on the most recent quarter-endTotal Debt to EBITDA Ratio, which applicable margin shall range from 1.75% -2.50% for LIBOR Loans and from 0.25% - 1.00% for Base Rate Loans.  The applicable interest rate margins as ofSeptember 30, 2006 were: 2.0% for LIBOR loans and 0.5% for Base Rate Loans.  The weighted average interest rates for theoutstanding loans as of September 30, 2006 were as follows:  

|                      | ** ** | **At September 30, 2006** | ** ** |
|----------------------|------------|------------------------------------------|------------|
| ** **           | ** ** | **LIBOR Loans**                     | ** ** | **Base Rate Loans** | ** ** |
| Infantline  Revolver |       | n/a                                      |       | 8.75 | % |
| Infantline Term Loan |       | 7.43                                     | %          | 8.75 | % |

 

Interest is due andpayable (i) with respect to Base Rate Loans, monthly in arrears on the last dayof each calendar month, upon a prepayment and at maturity and (ii) with respectto LIBOR Loans, on the last day

 

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**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

of each Interest Period,upon a prepayment (and if the Interest Period is in excess of three months, onthe three-month anniversary of the first day of such Interest Period), and atmaturity.

In connection with theexecution of the Infantline Credit Agreement, the Infantline Borrowers paidaggregate closing fees of $1.4 million and an aggregate agency fee of$25,000.  An aggregate agency fee of$25,000 will be payable on each anniversary of the Closing Date.  The Revolving Loan is subject to an annualnon-use fee (payable monthly, in arrears, and upon termination of the relevantobligations) of 0.50% for unused amounts under the Revolving Loan, an annualletter of credit fee (payable monthly, in arrears, and upon termination of therelevant obligations) for undrawn amounts with respect to each letter of creditbased on the most recent quarter-end Total Debt to EBITDA Ratio ranging from1.75% - 2.50% and other customary letter of credit administration fees.  In addition, if the credit facility isterminated for any reason prior to the first anniversary of the Closing Date,the Infantline Borrowers shall pay an aggregate early termination fee ofapproximately $1.0 million.

The Infantline Borrowersare required to make prepayments of the Term Loan upon the occurrence ofcertain transactions, including most asset sales or debt or equityissuances.   Additionally, commencing inearly 2008 with respect to fiscal year 2007, annual mandatory prepayments ofthe Term Loan shall be required in an amount equal to 50% of Excess Cash Flowfor each fiscal year unless the Total Debt to EBITDA Ratio for such fiscal yearwas equal to or less than 2.00:1.00.

TheInfantline Credit Agreement contains customary affirmative and negativecovenants, as well as the following financial covenants (the “InfantlineFinancial Covenants”):  (i) a minimumEBITDA test, (ii) a minimum Fixed Charge Coverage Ratio, (iii) a maximum TotalDebt to EBITDA Ratio and (iv) an annual capital expenditure limitation.  As of September 30, 2006, the Company was in compliancewith the financial covenants contained in the Infantline Credit Agreement.

The Infantline Credit Agreement contains significantlimitations on the ability of the Infantline Borrowers to distribute cash toRuss Berrie and Company, Inc. (“RB”), which became a  corporate holding company by virtue of theAssignment, for the purpose of paying dividends to the shareholders of theCompany or for the purpose of paying RB’s corporate overhead expenses,including a cap (subject to certain exceptions) of $2.0 million per year on theamount that can be provided to RB to pay corporate overhead expenses.

As a result of the LaSalle Refinancing, the obligationto pay the Earnout Consideration pursuant to the Kids Line acquisition (seeNote 4) is no longer the obligation of RB, but the joint and several obligationof the Infantline Borrowers.  Withrespect to the Earnout Consideration, the Infantline Borrowers will bepermitted to pay all or a portion of the Earnout Consideration to the extentthat, before and after giving effect to such payment, (i) Excess Revolving LoanAvailability will equal or exceed $3.0 million and (ii) no violation of theInfantline Financial Covenants would then exist, or would, on a pro formabasis, result therefrom.

In order to secure theobligations of the Infantline Borrowers, (i) the Infantline Borrowers havepledged and have granted security interests to the Agent in substantially allof their existing and future personal property, (ii) each Infantline Borrowerhas guaranteed the performance of the other Infantline Borrower, (iii) Sassygranted a mortgage for the benefit of the Agent and the lenders on its realproperty located at 2305 Breton Industrial Park Drive, S.E., Kentwood, Michiganand (iv) the Company pledged 100% of the equity interests of each of theInfantline Borrowers to the Agent (the “Infantline Pledge Agreement”).  Pursuant to the Infantline Pledge Agreement,RB has agreed that it will function solely as a holding company and will not,without the prior written consent of the Agent, engage in any business oractivity except for specified activities, including those relating to itsinvestments in its subsidiaries existing on the Closing Date, the maintenanceof its existence and compliance with law, the performance of obligations underspecified contracts and other specified ordinary course activities.

*B.  The Giftline Credit Agreement*

On March 14, 2006 asamended on April 11, 2006 (to clarify the application of a financial covenant)and August 8, 2006, Russ Berrie U.S. Gift, Inc. (“Newco”) and other specifiedwholly-owned domestic subsidiaries of the Company (collectively, the “GiftlineBorrowers”), entered into a credit agreement as borrowers, on a joint andseveral basis, with LaSalle Bank National Association, as issuing bank (the “IssuingBank”), LaSalle Business Credit, LLC as administrative agent (the “AdministrativeAgent”), the 

 

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**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

lenders from time to timeparty thereto, and the Company, as loan party representative (as amended, the “GiftlineCredit Agreement” and, together with the Infantline Credit Agreement, the “2006Credit Agreements”).  Unless otherwisespecified herein, capitalized terms used but undefined in this Note 5 Section1.B shall have the meanings ascribed to them in the Giftline Credit Agreement.

The Giftline CreditAgreement contemplates the potential inclusion of additional lenders subsequentto the initial closing, which as of September 30, 2006 has not occurred, and asimultaneous increase in the commitment. The facility consists of a revolving credit loan commitment (a) beforesuch commitment is increased, if at all, in an amount equal to the BorrowingBase minus amounts outstanding under the Canadian Credit Agreement (as definedbelow) and (b) after such commitment is increased, if at all, in an amountequal to the lesser of (i) $25.0 million and (ii) the then-current BorrowingBase, in each case minus amounts outstanding under the Canadian CreditAgreement (the “Giftline Revolver”), with a subfacility for letters of creditto be issued by the Issuing Bank in an amount not to exceed $8.0 million.   The Borrowing Base is primarily a functionof a percentage of eligible accounts receivable and eligible inventory and, asof September 30, 2006, the Borrowing Base, inclusive of the Borrowing Baseprovided under the Canadian Credit Agreement, was approximately $7.9million.  As of September 30, 2006, theoutstanding balance on the Giftline Revolver was $4.6 million and the balanceon the Canadian Revolving Loan (see Section 1.C below) was $1.1 million.

All outstanding amountsunder the Giftline Revolver are due and payable on March 14, 2011, subject toearlier termination in accordance with the terms of the Giftline CreditAgreement.

The Giftline Revolverbears interest at a rate per annum equal to the sum of the Base Rate (for BaseRate Loans) or the LIBOR Rate (for LIBOR Loans), at the Company’s option, plusa margin of 2.75% for LIBOR Loans and 1.25% for Base Rate Loans.  Interest is due and payable in the samemanner as with respect to the Infantline Loans. As of September 30, 2006, the interest rate was 9.5% for the oneoutstanding Base Rate loan and 8.12% for outstanding LIBOR loans.

In connection with theexecution of the Giftline Credit Agreement, the Infantline Borrowers paid (onbehalf of the Giftline Borrowers) aggregate closing fees of $0.15 million andan aggregate agency fee of $20,000. Aggregate agency fees of $20,000 will be payable by the GiftlineBorrowers on each anniversary of the Closing Date.  The Giftline Revolver is subject to an annualnon-use fee (payable monthly, in arrears, and upon termination of the relevantobligations) of 0.50% for unused amounts under the Giftline Revolver, and otherfees as described with respect to the Giftline Revolver.  If the commitment under the Giftline CreditAgreement is increased, an additional fee equal to 1.0% of the increase will berequired.  In addition, if theTermination Date (which includes customary termination events) occurs prior tothe first anniversary of the Closing Date, the Giftline Borrowers shall pay atermination fee equal to 1.0% of the highest Maximum Revolving Commitment thathad been in effect at any time prior to such termination.

All accounts of theGiftline Borrowers are required to be with the Administrative Agent or itsaffiliates, and cash in such accounts will be swept on a daily basis to paydown outstanding amounts under the Giftline Revolver.

The Giftline Credit Agreement contains customaryaffirmative and negative covenants substantially similar to those applicable tothe Infantline Credit Agreement.  TheGiftline Credit Agreement contains the following financial covenants (the “GiftlineFinancial Covenants”):  (i) a minimumEBITDA test, (ii) a minimum Excess Revolving Loan Availability requirement of$5.0 million, (iii) an annual capital expenditure limitation and (iv) a minimumFixed Charge Coverage Ratio (for quarters commencing with the quarter endedMarch 31, 2008).  In addition, at anytime after December 31, 2007 in respect of which the Fixed Charge CoverageRatio for the Computation Period ending as of the fiscal quarter end mostrecently preceding such date was less than 1.00:1.00, the aggregate amountsoutstanding under the Giftline Credit Agreement and the Canadian Loan Agreementmay not exceed $10.0 million.  On August8, 2006, the Giftline Credit Agreement was amended to lower the threshold onthe Minimum EBITDA covenant by $1.0 million per fiscal quarter for each of fourconsecutive fiscal quarters commencing with the fiscal quarter ending September30, 2006.  As of September 30, 2006, theCompany was in compliance with the financial covenants contained in theGiftline Credit Agreement.

The Giftline Credit Agreement contains significantlimitations on the ability of the Giftline Borrowers to distribute cash to RBfor the purpose of paying dividends to the shareholders of the Company or forthe

 

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**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

purpose of paying RB’s corporate overhead expenses,including a cap (subject to certain exceptions) on the amount that can beprovided to RB to pay corporate overhead expenses equal to $4.5 million peryear for each of fiscal years 2006 and 2007, and $5.0 million for each fiscalyear thereafter.

In order to secure theobligations of the Giftline Borrowers, the Giftline Borrowers pledged and havegranted security interests to the Administrative Agent in substantially all oftheir existing and future personal property, and each Giftline Borrower guaranteedthe performance of the other Giftline Borrowers under the Giftline CreditAgreement.  In addition, RB provided alimited recourse guaranty of the obligations of the Giftline Borrowers underthe Giftline Credit Agreement.  Thisguarantee is secured by a lien on the assets intended to be assigned to Newcopursuant to the Assignment.  RB alsopledged 100% of the equity interests of each of the Giftline Borrowers and 65%of its equity interests in certain of its First Tier Foreign Subsidiaries tothe Administrative Agent (the “Giftline Pledge Agreement”).  The Giftline Pledge Agreement containssubstantially similar limitations on the activities of RB as is set forth inthe Infantline Pledge Agreement.

The Company’s ability to maintain compliance with thefinancial covenants under the 2006 Credit Agreements is dependent, particularlyin the case of the Giftline Credit Agreement, upon the successfulimplementation of the Company’s Profit Improvement Plan (described in Note 8herein) and current operational plans. Based on these plans and management’s current projections, managementbelieves that the Company will remain in compliance with the financialcovenants in the 2006 Credit Agreements at least through September 30,2007.  However, in the event that theCompany is unable to successfully implement the key elements of the ProfitImprovement Plan and current operational plans, there can be no assurance thatthe Company will remain in compliance with the financial covenants in the 2006Credit Agreements.

*C.            Canadian Credit Agreement*

As contemplated by the2005 Credit Agreement on June 28, 2005, the Company’s Canadian subsidiary,Amram’s Distributing Ltd. (“Amrams”), executed a separate Credit Agreement(acknowledged by the Company) with the financial institutions party thereto andLaSalle Business Credit, a division of ABN AMRO Bank, N.V., Canada Branch, aCanadian branch of a Netherlands bank, as issuing bank and administrative agent(the “Canadian Credit Agreement”), and related loan documents with respect to amaximum U.S. $10.0 million revolving loan (the “Canadian Revolving Loan”).  RB executed an unsecured Guarantee (the “CanadianGuarantee”) to guarantee the obligations of Amrams under the Canadian CreditAgreement.  In connection with theLaSalle Refinancing, the Canadian Credit Agreement was amended to (i) replacereferences to the LaSalle Credit Agreement with the Giftline Credit Agreement(such that, among other conforming changes, a default under the Giftline CreditAgreement will be a default under the Canadian Credit Agreement), (ii) releaseRB from the Canadian Guaranty and (iii) provide for a maximum U.S. $5.0 million revolving loan.  In connection with the release of the Companyfrom the Canadian Guaranty, Newco executed an unsecured Guarantee (the “NewcoGuarantee”) to guarantee the obligations of Amrams under the Canadian CreditAgreement.  A default under theInfantline Credit Agreement will not constitute a default under the CanadianCredit Agreement**. **Theoutstanding balance under the Canadian Revolving Loan as of September 30, 2006was U.S. $1.12 million which reduces availability under the Giftline CreditAgreement by a corresponding amount.

The Commitments under theCandian Credit Agreement bear interest at a rate per annum equal to the sum ofthe Base Rate (for Base Rate Loans) or the LIBOR Rate (for LIBOR Loans) plus anapplicable margin.  As of September 30, 2006, the interest rate for theoutstanding Base Rate loan was 8.25%, and there were no Libor Loansoutstanding.

*D.            Economic Development Authority (“EDA”) Loan Agreement*

Since 1983, the Companyhad been a guarantor of the EDA Loan Agreement, pursuant to which the EDAissued the EDA Bonds in the principal amount of $7.0 million to finance theconstruction of the South Brunswick, New Jersey facility now leased by theCompany from the Estate of Mr. Russell Berrie. Mr. Berrie (and after his death, his Estate) was the primary obligorwith respect to the EDA Bonds. In connection therewith, the Company, in 1983,caused the issuance of a letter of credit in an amount of 

 

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**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

approximately $7.4million to secure the payment obligations with respect to the EDA Bonds and hadgranted a security interest on accounts receivable and inventory of the Companyup to $2.0 million to secure its obligations under its guarantee and theAmended and Restated Letter of Credit Reimbursement Agreement (“L/C RA”)executed in connection therewith.

On April 3, 2006, theEstate (with funds provided by Ms. Berrie) redeemed the EDA Bonds.  As a result, the Company’s obligations underthe guarantee discussed above (as well as the L/C RA, all letters of credit andrelated security interests) have been terminated.

*E.            Earnout Security Documents*

All capitalized termsused but undefined in this Note 5, Section 1.E “Earnout Security Documents”section shall have the meanings ascribed to them in the “Giftline CreditAgreement”.

As hasbeen previously reported, the Company was obligated to pay the Earnout Considerationunder the Kids Line Purchase Agreement. Pursuant to the Letter Agreement between the Infantline Borrowers andCalifornia KL Holdings, Inc., and the other parties thereto (the “LetterAgreement”), the Infantline Borrowers have agreed, on a joint and severalbasis, to assume sole responsibility to pay the Earnout Consideration in theplace of the Company.  In connectiontherewith, the Earnout Security Documents have been amended to effect thepartial release of the Company as obligor and the full release of the securityinterests granted thereunder by any Giftline Borrowers.  To secure the obligations of the InfantlineBorrowers to pay the Earnout Consideration, the Infantline Borrowers havegranted a subordinated lien on substantially all of their assets, on a jointand several basis, and RB has granted a subordinated lien on the equityinterests of each of the Infantline Borrowers to the Earnout SellersAgent.  All such security interests andliens are subordinated to the senior indebtedness of the Infantline Borrowersarising under the Infantline Credit Agreement. The Earnout Consideration is not secured by the Giftline Borrowers ortheir assets or equity interests. However, based on current projections, theCompany currently anticipates that the Earnout Consideration will be approximately$30 million, although the amount could be more or less depending on the actualperformance of Kids Line for the remaining portion of the MeasurementPeriod.  The Company currentlyanticipates that cash flow from operations and anticipated availability underthe Infantline Credit Agreement will be sufficient to fund the obligation topay the Earnout Consideration.  Theamount of the Earnout Consideration will be charged to goodwill.

2.             2005 Credit Agreement –Effective June 28, 2005 through March 13, 2006

TheCompany and certain of its domestic wholly-owned subsidiaries party thereto(the “Specified Subsidiaries”), entered into a $105.0 million credit agreementdated as of June 28, 2005, and amended as of August 4 andOctober 11, 2005 (the “2005 Credit Agreement”), with LaSalle Bank NationalAssociation and other lenders. Unless otherwise specified herein, capitalizedterms used but undefined herein shall have the meanings ascribed to them in the2005 Credit Agreement.

Theobligations under the 2005 Credit Agreement (the “Commitments”) consisted ofFacility A Obligations and Facility B Obligations.  The Facility AObligations were comprised of: (a) a $52.0 million revolving creditfacility (the “Revolving Loan”), with a sub-facility for letters of credit tobe issued by the Issuing Bank in an amount not to exceed $10.0 million; and(b) a $13.0 million term loan facility (“Term Loan A”).  The FacilityB Obligations consisted of a $40.0 million term loan facility (“Term Loan B”). As of December 31, 2005, the Company had $31.9 million outstanding underthe Revolving Loan.

Theprincipal of Term Loan A was due in equal monthly installments of approximately$0.2 million (subject to reduction by prepayments), to be made on the last dayof each month (commencing July 31, 2005).  As of December 31, 2005, theinterest rate on the base rate loan was 7.5% and the LIBOR Loan was 5.98%.

Inconnection with the execution of the 2005 Credit Agreement and the Canadian CreditAgreement, the Company recorded approximately $2.3 million of deferredfinancing costs which were included in “other assets” at December 31, 2005and were being amortized over the five-year period of the Commitments. Theunamortized balance of these deferred financing costs was written off in thefirst quarter of 2006 as a result of the LaSalle Refinancing in March 2006.

The2005 Credit Agreement contained certain financial covenants and certainrestrictions on the payment of dividends and the Earnout Consideration.    As of December 31, 2005, the Companywas not in compliance with the “Total Debt to EBITDA Ratio” covenant in the2005 Credit Agreement.  However,

15

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**NOTES TO UNAUDITEDCONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

because the Company completed the LaSalle Refinancingon March 14, 2006, the long-term debt at December 31, 2005 was classified aslong-term.

As contemplated by the 2005 Credit Agreement, theCompany’s Canadian subsidiary, Amram’s Distributing Ltd. (“Amrams”), enteredinto on June 30, 2005, as of June 28, 2005, and amended as ofAugust 4 and October 11, 2005, a separate  credit agreement withthe financial institutions party thereto and LaSalle Business Credit, adivision of ABN AMRO Bank, N.V., Canada Branch, a Canadian branch of aNetherlands bank (the “Canadian Credit Agreement”) with respect to a maximumU.S. $10.0 million revolving loan (the “Canadian Revolving Loan”), with asub-facility for letters of credit in an amount not to exceed U.S. $2.0million.   All outstanding amounts under the Canadian Revolving Loanwere to be due and payable on June 28, 2010, subject to earliertermination in accordance with the terms of the Canadian Credit Agreement.

The Canadian Revolving Loan would bear interest at arate per annum equal to the sum of (x)(i) the Base Rate or the CanadianBase Rate (as defined in the Canadian Credit Agreement), at the option ofAmrams (for Base Rate Loans) or (ii) the LIBOR Rate (for LIBOR Loans) plus(y) an applicable margin, in accordance with a pricing grid based on the mostrecent quarter-end Total Debt to EBITDA Ratio.  The interest rate as ofDecember 31, 2005 was 7.25%.  The Canadian Credit Agreement is describedin further detail in the Quarterly Report on Form 10-Q for the period endedJune 30, 2005.  The Canadian CreditAgreement was amended in connection with the execution of the 2006 CreditAgreements, as described above.

In order to secure its obligations under the CanadianCredit Agreement, Amrams has granted security interests to the administrativeagent thereunder in substantially all of its real and personal property. In addition, the Company has executed an unsecured Guarantee (the “CanadianGuaranty”) to guarantee the obligations of Amrams under the Canadian CreditAgreement, which guaranty was released in connection with the 2006 CreditAgreements.  All amounts outstandingunder the 2005 Credit Agreement were paid in full in connection with theLaSalle Refinancing.

See the 2005 10-K for additional detail regarding the2005 Credit Agreement and a predecessor facility.

**NOTE 6 — GOODWILL AND INTANGIBLE ASSETS**

Intangibleassets consist of the following (in thousands):
| ** **                                   | ** ** | **Weighted  Average  Amortization  Period** | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------|------------|---------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| MAM distribution  agreement and relationship |       | Indefinite life                             |       | $                            | 10,400     |                        | $          | 10,400 |   |
| Sassy trade name                             |       | Indefinite life                             |       | 7,100                        |       | 7,100                       |       |
| Applause trade  name                         |       | Indefinite life                             |       | 7,646                        |       | 7,646                       |       |
| Kids Line  customer relationships            |       | Indefinite life                             |       | 31,100                       |       | 31,100                      |       |
| Kids Line trade  name                        |       | Indefinite life                             |       | 5,300                        |       | 5,300                       |       |
| Other intangible  assets                     |       | 4.7 years                                   |       | 64                           |       | 53                          |       |
|                                         |       |                                        |       | $                            | 61,610     |                        | $          | 61,599 |   |

 

Other intangible assets as of September 30, 2006 andDecember 31, 2005 include Kids Line and Sassy non-compete agreements, which arebeing amortized over four and five years, respectively, and a patent.  Amortization expense was $19,000 and $288,000for the first nine months of 2006 and 2005, respectively.

All of the Company’s goodwill and indefinite lifeintangibles, except for the Applause tradename, are in the infant and juvenilesegment, and resulted from the 2002 and 2004 acquisitions of Sassy, Inc. andKids Line LLC, respectively.  There wereno changes to the carrying amount of goodwill during the nine months endedSeptember 30, 2006.

16

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**NOTES TO UNAUDITEDCONSOLIDATED FINANCIAL STATEMENTS (Unaudited)**

**NOTE 7 — DIVIDENDS**

No cash dividends were paid during the three and ninemonths ended September 30, 2006.  No cashdividends were paid during the three months ended September 30, 2005 and $2.1million of dividends were paid during the nine months ended September 30,2005.  See Note 5 for a discussion of dividend restrictions imposed by the Company’s seniorbank facilities.

**NOTE 8 — RESTRUCTURING AND RELATEDCOSTS**

In November 2005,the Company continued restructuring efforts with respect to its domestic giftbusiness to reduce expenses, right-size the infrastructure consistent withcurrent business levels and re-align domestic gift operations to better meetthe needs of different distribution channels.  During the first ninemonths of 2006, in accordance with its November 2005 restructuring plan, theCompany recorded a $0.7 million restructuring charge related to severance costsof employees at its Petaluma, California distribution center, which closed inthe second quarter of 2006, and the reduction of additional sales staff andoperational support positions in the U.S. Gift business.  In addition, in connection with the PIPimplementation (discussed in detail in Item 2 below), the Company recorded arestructuring charge of an aggregate of approximately $3.4 million in the ninemonths ended September 30, 2006 attributable to the downsizing of itsoperations under its PIP, which was comprised primarily of employee severancecosts.  The Company also incurred a onetime charge of $1.3 million during the three months ended September 30, 2006,in connection with the relocation of its distribution facility in the UnitedKingdom, primarily related to the write-off of fixed assets and movingcosts.  See “Item 2, Management’sDiscussion and Analysis of Financial Condition and Results or Operations —Overview.”

The Companyreassesses the reserve requirements under the restructuring efforts at the endof each reporting period.  A rollforwardof the restructuring accrual is set forth below (in thousands):

|                     | ** ** | **Employee**   | ** ** | **Facility**        | ** ** | ** ** | ** ** |
|---------------------|------------|----------------|------------|---------------------|------------|------------|------------|
| ** **          | ** ** | **Separation** | ** ** | **Exit Costs** | ** ** | **Total**  | ** ** |
| Balance @  12/31/05 |       | $              | 1,731      |                | $          | 131        |       | $ | 1,862 |   |
| 2006 Provision      |       | 4,087          |       | —              |       | 4,087      |       |
| Less Payments       |       | 4,419          |       | 41                  |       | 4,460      |       |
| Balance @ 9/30/06   |       | $              | 1,399      |                | $          | 90         |       | $ | 1,489 |   |

 

**NOTE 9 — SEGMENTS OF THE COMPANY AND RELATED INFORMATION**

The Company operates in twosegments: (i) the Company’s gift business and (ii) the Company’s infant andjuvenile business, which includes Sassy, Inc. and Kids Line,LLC.  This segmentation of the Company’soperations reflects how management currently views the results ofoperations.  There are no inter-segmentrevenues to eliminate.  Corporate assetsand overhead expenses are included in the gift segment.

The Company’s gift business designs, manufacturesthrough third parties and markets a wide variety of gift products to retailstores throughout the United States and throughout the world via the Company’sinternational wholly-owned subsidiaries and independent distributors. TheCompany’s infant and juvenile businesses design and market products in a numberof baby categories including, among others, infant bedding and accessories,bath toys and accessories, developmental toys, feeding items and babycomforting products.  These products aresold to consumers, primarily in the United States, through mass merchandisers,toy, specialty, food, drug and independent retailers, apparel stores andmilitary post exchanges.

17

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**NOTES TO UNAUDITEDCONSOLIDATED FINANCIAL STATEMENTS (Unaudited)**
| ** **                                           | ** ** | **Three Months Ended   September 30,** | ** ** | **Nine Months Ended   September 30,** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| **(Dollars in thousands)**                 | ** ** | **2006**                                                   | ** ** | **2005**                                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Gift:**                                            | ** ** | ** **                                                 | ** ** | ** **                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                            |       | $                                                          | 43,412     |                                                      | $          | 50,303 |   | $ | 112,603 |   | $ | 116,977 |   |
| Selling, general and administrative expenses (a) (b) |       | 19,240                                                     |       | 25,432                                                    |       | 68,676 |   | 76,029 |   |
| Operating loss (c)                                   |       | (3,932                                                     | )          | (4,269                                                    | )          | (26,345 | ) | (24,587 | ) |
| Other income                                         |       | 3                                                          |       | 12                                                        |       | 135 |   | 147 |   |
| Depreciation and amortization                        |       | 1,114                                                      |       | 1,270                                                     |       | 3,435 |   | 4,317 |   |
| Loss before income tax expense                       |       | $                                                          | (3,929     | )                                                         | $          | (4,257 | ) | $ | (26,210 | ) | $ | (24,440 | ) |
|                                                 |       |                                                       |       |                                                      |       |   |   |   |   |
| **Infant  and juvenile:**                            | ** ** | ** **                                                 | ** ** | ** **                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                            |       | $                                                          | 34,732     |                                                      | $          | 32,934 |   | $ | 108,590 |   | $ | 99,019 |   |
| Selling,general and administrative expenses (b)      |       | 6,535                                                      |       | 4,504                                                     |       | 16,128 |   | 13,802 |   |
| Operating income                                     |       | 7,463                                                      |       | 8,927                                                     |       | 28,543 |   | 25,767 |   |
| Other expense                                        |       | 1,701                                                      |       | 1,452                                                     |       | 8,724 |   | 13,183 |   |
| Depreciation and amortization                        |       | 200                                                        |       | 209                                                       |       | 624 |   | 696 |   |
| Income before income tax expense                     |       | $                                                          | 5,762      |                                                      | $          | 7,475 |   | $ | 19,819 |   | $ | 12,584 |   |
|                                                 |       |                                                       |       |                                                      |       |   |   |   |   |
| **Consolidated:**                                    | ** ** | ** **                                                 | ** ** | ** **                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                            |       | $                                                          | 78,144     |                                                      | $          | 83,237 |   | $ | 221,193 |   | $ | 215,996 |   |
| Selling, general and administrative expenses         |       | 25,775                                                     |       | 29,936                                                    |       | 84,804 |   | 89,831 |   |
| Operating income                                     |       | 3,531                                                      |       | 4,658                                                     |       | 2,198 |   | 1,180 |   |
| Other expense                                        |       | 1,698                                                      |       | 1,440                                                     |       | 8,589 |   | 13,036 |   |
| Depreciation and amortization                        |       | 1,314                                                      |       | 1,479                                                     |       | 4,059 |   | 5,013 |   |
| Income (loss)  before income tax expense             |       | $                                                          | 1,833      |                                                      | $          | 3,218 |   | $ | (6,391 | ) | $ | (11,856 | ) |

----

(a)             Selling,general and administrative expense for the gift segment includes: (i) for thethree months ended September 30, 2006 and 2005, $0.5 million and $0.9 million,respectively, of restructuring costs (ii) for the nine months ended September30, 2006 and 2005, $4.1 million and $1.3 million, respectively, ofrestructuring costs and (iii) for the three and nine months ended September2006, $1.3 million and $3.8 million, respectively of other special chargesincurred in connection with the development of the 2006 PIP.

(b)            Selling,general and administrative expenses for the three and nine months endedSeptember 30, 2006 for the gift segment were reduced by a $1.5 million infantand juvenile segment reimbursement for corporate overhead costs.  This offset to the gift segment expenses iseliminated in consolidation with the corresponding $1.5 million charge toselling, general & administrative expenses of the infant and juvenilesegment.

(c)             Operatingloss for the gift segment is impacted by charges recorded in cost of sales,including: (i) for the three months ended September 30, 2006 and 2005, $2.4million and $0.2 million, respectively, and (ii) for the nine months endedSeptember 30, 2006 and 2005, $3.0 million and $0.3 million.

 

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**NOTES TO UNAUDITEDCONSOLIDATED FINANCIAL STATEMENTS (Unaudited)**

Total assets of each segment were as follows :

| (Dollars in thousands) | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Gift                             |       | $                            | 107,062    |                        | $          | 129,721 |   |
| Infant and  juvenile             |       | 195,255                      |       | 199,240                     |       |
| Total                            |       | $                            | 302,317    |                        | $          | 328,961 |   |

 

**Concentrationof Risk**

As disclosed in the 2005 10-K, approximately 89% ofthe Company’s purchases are attributable to manufacturers in the People’sRepublic of China.  The supplieraccounting for the greatest dollar volume of purchases accounted forapproximately 16% and the five largest suppliers accounted for approximately40% in the aggregate.  The Company utilizes approximately 130manufacturers in Eastern Asia and believes that there are many alternativemanufacturers and sources of raw materials for the Company’s products.  Asa result, the Company does not believe there is a concentration of riskassociated with any significant manufacturing relationship.  See Item 1A, “Risk Factors”, of the 200510-K.

With respect to customers, Toys “R” Us, Inc. andBabies “R” Us, Inc., in the aggregate, accounted for 19.3% and 23.1%,respectively, of the Company’s consolidated net sales during the three and ninemonth periods ended September 30, 2006, and 18.1% and 21.6%, respectively,during the three and nine months periods ended September 30, 2005.

**NOTE 10 — FOREIGN CURRENCY FORWARD EXCHANGE CONTRACTS**

Certain of the Company’s subsidiaries periodicallyenter into foreign currency forward exchange contracts to hedge inventorypurchases, both anticipated and firm commitments, denominated in the UnitedStates dollar. These contracts reduce foreign currency risk caused by changesin exchange rates and are used to offset the currency impact of these inventorypurchases, generally for periods up to 13 months. At September 30, 2006,the Company’s forward contracts have expiration dates which range from one tosix months.

The Company accounts for its forward exchangecontracts as an economic hedge, with subsequent changes in fair value recordedin the Consolidated Statements of Operations. As of September 30, 2006, netunrealized gains****of $15,000 relating to forwardcontracts are included in other current assets and as of December 31,2005, unrealized losses of $0.16 million are included in accrued expenses inthe Consolidated Balance Sheets.

The Company has forward contracts to exchange Britishpounds sterling, Canadian dollars and Australian dollars for United Statesdollars with notional amounts of $5.1 million and $3.3 million as of September30, 2006 and December 31, 2005, respectively. The Company has forwardcontracts to exchange United States dollars to Euros with notional amounts of$2.3 million and $6.4 million as of September 30, 2006 and December 31,2005, respectively. The Company does not anticipate any material adverse impacton its results of operations or financial position from these contracts.

**NOTE 11 — COMPREHENSIVE INCOME / (LOSS)**

Comprehensive Income / (Loss), representing allchanges in Shareholders’ Equity during the period other than changes resultingfrom the issuance or repurchase of the Company’s common stock and payment ofdividends, is reconciled to net income (loss) for the three and nine monthsended September 30, 2006 and 2005 as follows:

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**NOTES TO UNAUDITEDCONSOLIDATED FINANCIAL STATEMENTS (Unaudited)**
| ** **                                                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(Dollars in thousands)**                                          | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net income  (loss)                                                            |       | $                                                    | 256        |                                                | $          | (8,606 | ) | $ | (10,710 | ) | $ | (16,493 | ) |
| Other  comprehensive income (loss), net of tax:                               |       |                                                 |       |                                                |       |   |   |   |   |
| Foreign currency  translation adjustments                                     |       | 808                                                  |       | 233                                                 |       | 2,040 |   | (3,113 | ) |
| Net unrealized  gain on foreign currency forward exchange contracts and other |       | —                                               |       | (57                                                 | )          | — |   | 358 |   |
| Other  comprehensive income (loss)                                            |       | 808                                                  |       | 176                                                 |       | 2,040 |   | (2,755 | ) |
| Comprehensive income  (loss)                                                  |       | $                                                    | 1,064      |                                                | $          | (8,430 | ) | $ | (8,670 | ) | $ | (19,248 | ) |

 

**NOTE 12 — CONTINGENCIES AND COMMITMENTS**

In the ordinary course of its business, the Company isparty to various copyright, patent and trademark infringement, unfaircompetition, breach of contract, customs, employment and other legal actionsincidental to its business, as plaintiff or defendant.  In the opinion of management, the amount ofultimate liability with respect to such actions that are currently pending willnot materially adversely affect the consolidated results of operations,financial condition or cash flows of the Company.

In connection with the Company’s purchase of Kids LineLLC, the aggregate purchase price includes a payment of Earnout Considerationas more fully described in Note 4.  TheCompany cannot currently determine the amount of the Earnout Consideration thatwill be required to be paid pursuant to the Purchase Agreement.  However, based on current projections, theCompany currently anticipates that the Earnout Consideration will be approximately$30 million, although the amount could be more or less depending on the actualperformance of Kids Line for the remaining portion of the Measurement Period.

The Company enters into various license agreementsrelating to trademarks, copyrights, designs, and products which enable theCompany to market items compatible with its product line.  All license agreements other than theagreement with MAM Babyartikel GmbH (which has a remaining term of five years),are for three year terms with extensions agreed to by both parties.  Several of these license agreements requireprepayments of certain minimum guaranteed royalty amounts.  The amount of minimum guaranteed royaltypayments with respect to all license agreements aggregates $6.6 million, ofwhich $1.7 million remained unpaid at September 30, 2006, substantially all ofwhich is due prior to December 31, 2007. During 2005, the Company recorded a charge to cost of sales of $2.3million against these royalty prepayments for amounts that management believeswill not be realized, and during the three months ended September 30, 2006, theCompany recorded an additional $750,000 charge associated with these minimumguaranteed royalties.

During 2002, RussBerrie (UK) Limited entered into a lease with a related party for warehousingspace with a 20 year term.  During August2006, Russ Berrie (UK) entered into an agreement, which closed on October 31,2006, whereby Russ Berrie (UK) agreed to vacate and cancel its lease prior tothe expiration of the stated term.  RussBerrie (UK) subsequently entered into a new third party lease for appropriatelysmaller space with a term of 10 years. In connection with these transactions, the Company recorded a charge of$1.3 million primarily related to the write off of fixed assets and movingcosts.

20

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**NOTES TO UNAUDITEDCONSOLIDATED FINANCIAL STATEMENTS (Unaudited)**

**NOTE 13 — RECENTLY ISSUED ACCOUNTING STANDARDS**

In July 2006, theFASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”(FIN 48), effective for fiscal years beginning after December 15, 2006.  FIN 48 requires a two-step approach todetermine how to recognize tax benefits in the financial statements whererecognition and measurement of a tax benefit must be evaluated separately.  A tax benefit will be recognized only if itmeets a “more-likely-than-not” recognition threshold.  For tax positions that meet this threshold,the tax benefit recognized is based on the largest amount of tax benefit thatis greater than 50 percent likely of being realized upon ultimate settlementwith the taxing authority.  We are currentlyevaluating the impact of adopting FIN 48, and have not yet determined thesignificance of this new rule to our overall results of operations, cash flowsor financial position.

InSeptember 2006, the SEC staff issued Staff Accounting Bulletin (SAB) Topic 1N(SAB 108), “Financial Statements — Considering the Effects of PriorYear Misstatements when Quantifying Misstatements in Current Year FinancialStatements,” which is effective for calendar year companies as ofDecember 31, 2006. SAB 108 provides guidance on how prior yearmisstatements should be taken into consideration when quantifying misstatementsin current year financial statements for purposes of determining whether thefinancial statements are materially misstated. Under this guidance, companiesshould take into account both the effect of a misstatement on the current yearbalance sheet as well as the impact upon the current year income statement inassessing the materiality of a current year misstatement. Once a current yearmisstatement has been quantified, the guidance in SAB Topic 1M, “FinancialStatements — Materiality,” (SAB 99) should be applied todetermine whether the misstatement is material. The Company is currentlyassessing the potential impact, if any, on the implementation of SAB 108on the Company’s financial statement.

 

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**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

The financial and business analysis below providesinformation that the Company believes is relevant to an assessment andunderstanding of the Company’s consolidated financial condition, changes infinancial condition and results of operations. This financial and businessanalysis should be read in conjunction with the Company’s consolidatedfinancial statements and accompanying Notes to Unaudited Consolidated FinancialStatements set forth in Part I, Financial Information, Item 1, “FinancialStatements” of this Quarterly Report on Form 10-Q and the Company’s AnnualReport on Form 10-K for the year ended December 31, 2005, as amended (the “200510-K”), as well as the Company’s Quarterly Report on Form 10-Q for each of theperiods ended March 31, 2006 and June 30, 2006.

**OVERVIEW**

The Company is a leader in the gift and infant andjuvenile industries. The Company’s gift business designs, manufactures throughthird parties and markets a wide variety of gift products to retail storesthroughout the world. The Company’s infant and juvenile businesses design,manufacture through third parties and market products in a number of babycategories, including infant bedding and accessories, bath toys andaccessories, developmental toys, feeding items and baby comforting products.These products are sold to consumers, primarily in the United States, throughmass merchandisers, toy, specialty, food, drug and independent retailers, apparelstores, military post exchanges and other venues.

The Company’s revenues are primarily derived fromsales of its products in its gift and infant and juvenile businesssegments.  For the three and nine monthperiods ended September 30, 2006, gift segment sales accounted for 55.6% and50.9%, respectively, and infant and juvenile segment sales accounted for 44.4%and 49.1%, respectively, of the Company’s consolidated net sales.

Sales and operating profits in the Company’s giftsegment began to decline during 2003 as a result of several factors including:(i) retailer consolidation and a declining number of independent retailoutlets, which in turn had a negative impact on sales from such outlets;(ii) increased competition from other entities, both wholesalers andretailers, which offered lower pricing and achieved greater customer acceptanceof their products; and (iii) changing buying habits of consumers, markedby a shift from independent retailers to mass market retailers. Commencing inthe third quarter of 2003, the Company began to implement a multi-prongedapproach to address these trends, which consists of:  (i) focusing on categorizing andrationalizing its product range; (ii) segmenting its selling efforts toaddress customer requirements and shifting channels of distribution;(iii) increasing its focus on national accounts, in order to build andstrengthen the Company’s presence in the mass market through the use if itsAPPLAUSE® trademark as the mass market brand platform; (iv) focusing ongrowing its international business and infant and juvenile segments;(v) selectively increasing its use of licensing to differentiate itsproducts from its competitors;  (vi) implementing a three-tiered “good”,“better”, “best” branding strategy within its gift segment to differentiateproducts sold into the mass market, the Company’s traditional specialty retailmarket and the upscale department store market; and (vii) ”right-sizing”its operations in order to reduce overhead expenses through headcount reductionsand the closure of certain domestic showrooms and warehouses.

Despite significant cost reductions achieved by thismulti-pronged approach, through much of 2005, the Company had achieved onlylimited success in reversing the challenges facing its gift business and theindustry in general.  As a result, inNovember 2005, the Company commenced the implementation of a restructuringof its domestic gift business designed to “right size” the infrastructureconsistent with existing business levels and re-align domestic gift operationsto better meet the needs of different distribution channels.  The November 2005 restructuring included theelimination of approximately 90 positions, a reduction in the number of giftproducts sold by the Company, and the closure of the Company’s distributioncenter in Petaluma, California.  Theseactions resulted in (i) a pre-tax restructuring charge in 2005 of approximately$1.4 million, (ii) an inventory write-down of $4.2 million charged to cost ofsales in the fourth quarter of 2005 and (iii) $0.7 million of restructuringcharges during the first half of 2006 related to severance costs.  Severance payments to employees impacted bythe November 2005 restructuring will 

 

22

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continue through the end of 2006, although suchpayments will not impact the Company’s results of operations, as they werereflected in the restructuring charges noted above.

As an expansion of its November 2005restructuring and ongoing analysis, in 2006, the Company commenced thedevelopment and phased implementation of a Profit Improvement Program (“PIP”)with respect to its global gift business. The PIP involves the analysis and re-evaluation of key operationalaspects of the Company’s gift business and has been designed to help enable theCompany to return its gift business to a sustainable level ofprofitability.  The PIP’s focus is thereengineering of the manner in which the gift segment operates and reduction ofthe size of the gift business by focusing on the most profitable products,customers and territories as a means of providing a platform for potentialprofitable growth in the future.  Thescope of the PIP is broad and significant and may cause losses to ourbusiness that we cannot predict, including a loss of gift segment sales.  Implementation of the PIP has and maycontinue to result in the recognition of certain restructuring charges and theincurrence of related severance obligations. The Company may also be required to make certain investments to generatethe efficiencies and focus on profitable operations that the PIP is designed toachieve.   See Item 1A, “Risk Factors”,and “Liquidity and Capital Resources” in the Company’s 2005 10-K for furtherinformation regarding the PIP.

The Company had retained the services of anindependent advisor to assist in the development of the PIP.  During the first half****of2006, the Company incurred consulting expense of approximately $2.5 million inconnection with services provided by such advisor, which relationship wasconcluded at the end of June 2006.

As part of the PIP, the Company has (i)terminated its direct sales and distribution operations in France, Germany,Belgium and Holland, (ii) restructured certain of its sales and relatedoperations in the U.K., (iii) relocated its distribution facility in the U.K.to a lower cost alternative and (iv) eliminated certain executive positions inits domestic gift segment.  As a resultof these actions, the Company reduced headcount by an aggregate of 55 positionsand recorded a restructuring charge of an aggregate of approximately $3.4million in the nine months ended September 30, 2006, primarily related toemployee severance costs.**** The Company also incurred a one-time charge of$1.3 million during the three months ended September 30, 2006 in connectionwith the aforementioned relocation of its United Kingdom distribution facility,primarily related to the write-off of fixed assets and moving costs.  The Company anticipates that it willestablish alternative means of reaching certain customers in the countries whereit has terminated direct sales and distribution efforts, including through theuse of independent sales representatives or distributors.  However, the Company anticipates that itsaggregate sales from France, Germany, Belgium and Holland may be reduced byapproximately $6.0 million on an annualized basis as a result of these actions,at least for the near term.

As a result of the November 2005 restructuring and the2006 PIP, management believes that future expenses will be reduced by approximately $22 million on an annualizedbasis, the full year effect of which is expected to be recognized in fiscal2007.  Although initial implementation ofthe PIP has been largely completed, there are certain additional initiativesthat have been identified by management but which have not commenced pending afinal determination by management of whether their implementation would beappropriate or desirable.  As a result, adescription of further courses of action, the estimated completion date of thePIP’s implementation and estimates of the range of additional charges to beincurred or other expenditures required in connection therewith cannot bedetermined at this time.

**SEGMENTS**

The Company currently operates in two segments: (i) its gift business and (ii) its infant and juvenile business.

**RESULTS OF OPERATIONS—THREE MONTHS ENDED SEPTEMBER 30, 2006AND 2005**

The Company’s consolidated net sales for the threemonths ended September 30, 2006 decreased 6.1% to $78.1 million compared to$83.2 million for the three months ended September 30, 2005 as a result of adecrease in its gift business, partially offset by growth in its infant andjuvenile segment.

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The Company’s gift segment net sales for the threemonths ended September 30, 2006 decreased 13.7% to $43.4 million compared to$50.3 million for the three months ended September 30, 2005, primarily as aresult of significant reductions in sales force personnel and product linerationalizations resulting from implementation of portions of the PIP.  Net sales in the Company’s gift segment werefavorably impacted by foreign exchange rates by approximately $0.9 million forthe three months ended September 30, 2006.  The Company’s infant andjuvenile segment net sales for the three months ended September 30, 2006increased 5.5% to $34.7 million compared to $32.9 million for the three monthsended September 30, 2005.  This increaseis primarily attributable to sales growth in the Company’s Kids Linesubsidiary.

Consolidated gross profit was 37.5% of consolidatednet sales for the three months ended September 30, 2006 as compared to 41.6% ofconsolidated net sales for the three months ended September 30, 2005. Gross profit for the Company’s gift segment was 35.3% of net sales for suchsegment for the three months ended September 30, 2006, as compared to 42.1% ofnet sales for the three months ended September 30, 2005.  The decline in the consolidated gross profitpercentage is primarily due to close-out sales related to the elimination of certaingift segment product lines in connection with the implementation of the PIP, aswell as competitive pricing pressure and sales channel mix.  In addition, the Company recorded aninventory write-down of $1.2 million in connection with its PIP, whichwrite-down was charged to the gift segment cost of sales.  Gross profit for the Company’s infant andjuvenile segment was relatively flat at 40.3% of net sales for the three monthsended September 30, 2006, as compared to 40.8% of net sales for the threemonths ended September 30, 2005.

Consolidated selling, general and administrativeexpense was $25.8 million, or 33.0% of consolidated net sales, for the threemonths ended September 30, 2006, compared to $29.9 million, or 36.0% ofconsolidated net sales, for the three months ended September 30, 2005. Selling, general and administrative expense in the Company’s gift segmentdecreased by approximately $6.2 million to $19.2 million in the third quarterof 2006 from $25.4 million in the prior year period.  This decrease is primarily the result of ongoingexpense reductions in the gift segment due to 2005 and 2006 restructuringactivities.  These decreases werepartially offset by charges of $0.5 million associated with the restructuringactivities in Europe and $1.3 million in connection with the relocation of theCompany’s distribution facility in the U.K in the gift segment, as well as anincrease of $2.0 million in the Company’s infant and juvenile segment. Selling,general and administrative expenses in the 2006 period for the gift segmentinclude a contribution toward corporate overhead from the infant and juvenilesegment of $1.5 million, which amount was charged to the infant andjuvenile segment and credited to the gift segment.

Consolidated other expense was $1.7 million for the threemonths ended September 30, 2006 compared to $1.4 million for the three monthsended September 30, 2005.  This $0.3million increase is primarily the result of higher financing costs in theinfant and juvenile segment in 2006.

Income tax expensefor the three months ended September 30, 2006 was $1.6 million compared to$11.8 million for the three months ended September 30, 2005.  The Company recorded a domestic income taxexpense of approximately $1.0 million for the three months ended September 30,2006 and 2005 primarily related to the deferred tax liability associated withtax amortization of intangible assets relating to the Kids Line, Sassy, andApplause acquisitions.  These deferredtax liabilities are indefinite in nature for accounting purposes, and thereforecannot be offset against the Company’s deferred tax assets.  The Company has recorded full valuationallowances against these deferred tax assets as management believes it is morelikely than not that these net deferred tax assets will not be realized.  The Company recorded approximately $0.6million of foreign tax expense related to profitable operations in Canada, HongKong, and Australia for the three months ended September 30, 2006.  For the three months ended September 30,2005, income tax expense was $11.8 million primarily related to the reversal ofincome tax benefits recorded in the first six months of 2005, and a decision torecord significant valuation allowances against the Company’s deferred taxassets associated with domestic and foreign NOL’s, contribution carryforwards,and foreign tax credit carryforwards, as management believed it was more likelythan not that these deferred tax assets would not be realized.

As a result of the foregoing, consolidated net incomefor the three months ended September 30, 2006 was $0.3 million, or $0.01 perdiluted share, compared to consolidated net loss of $8.6 million, or $0.41 perdiluted share, for the three months ended September 30, 2005.

 

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**RESULTS OF OPERATIONS— NINE MONTHS ENDED SEPTEMBER 30, 2006AND 2005**

The Company’s consolidated net sales for the ninemonths ended September 30, 2006 increased 2.4% to $221.2 million compared to$216.0 million for the nine months ended September 30, 2005 as a result ofsales growth in its infant and juvenile segment.

The Company’s gift segment net sales decreased 3.7%for the nine months ended September 30, 2006 to $112.6 million compared to$117.0 million for the nine months ended September 30, 2005, primarily as aresult of significant reductions in sales force personnel and product linerationalizations as provided in the PIP. Net sales in the Company’s gift segment were favorably impacted byforeign exchange rates by approximately $0.4 million for the nine months endedSeptember 30, 2006.  The Company’s infantand juvenile segment net sales for the nine months ended September 30, 2006increased 9.7% to $108.6 million compared to $99.0 million for the nine monthsended September 30, 2005.  This increaseis primarily attributable to sales growth in the Company’s Kids Linesubsidiary.

Consolidated gross profit was 39.3% of consolidatednet sales for the nine months ended September 30, 2006 as compared to 42.1% ofconsolidated net sales for the nine months ended September 30, 2005. Gross profit for the Company’s gift segment was 37.6% of net sales for suchsegment for the nine months ended September 30, 2006 as compared to 44.0% ofnet sales for the nine months ended September 30, 2005.  The decline inthe consolidated gross profit percentage is primarily due to close-out salesrelated to the elimination of certain product lines in connection with theimplementation of the PIP, as well as competitive pricing pressure and saleschannel mix in the gift segment.  Inaddition, in the third quarter of 2006, the Company recorded an inventorywrite-down of $1.2 million in connection with its PIP.  Gross profit for the Company’s infant andjuvenile segment was 41.1% of net sales for such segment for the nine monthsended September 30, 2006, as compared to 40.0% of net sales for the nine monthsended September 30, 2005.

Consolidated selling, general and administrativeexpense was $84.8 million, or 38.3% of consolidated net sales, for the ninemonths ended September 30, 2006 compared to $89.8 million, or 41.6% of consolidatednet sales, for the nine months ended September 30, 2005.  Selling, generaland administrative expense in the Company’s gift segment decreased by $7.4million to $68.7 million in the first nine months of 2006 from $76.0 million inthe prior year period.  Included in thegift segment selling, general and administrative expense in the first ninemonths of 2006 was $4.1 million in charges associated with the restructuringactivities in the U.S. and European gift divisions, $1.3 million in costsassociated with the relocation of the Company’s distribution facility in theU.K. and $2.5 million of consulting costs incurred in connection with thedevelopment of the PIP.  These chargeswere offset by ongoing expense reductions in the gift segment as a result of2005 and 2006 restructuring activities.

Consolidated other expense was $8.6 million for thenine months ended September 30, 2006 compared to $13.0 million for the ninemonths ended September 30, 2005, a decrease of $4.4 million.  The decrease in 2006 is primarilyattributable to lower interest expense as a result of the LaSalle Refinancingas well as lower overall borrowings. Additionally, during the nine months ended September 30, 2006, theCompany wrote off $2.5 million of deferred financing costs and paid a $1.3million early termination fee related to its refinancing of the 2005 CreditAgreement as compared to $4.8 million written off during the nine months endedSeptember 30, 2005 which resulted from the termination of the FinancingAgreement.

Income tax expensefor the nine months ended September 30, 2006 was $4.3 million compared to $4.6million for the nine months ended September 30, 2005.  The Company recorded a domestic income taxexpense of approximately $3.2 million for the nine months ended September 30,2006 and 2005 primarily related to the deferred tax liability associated withthe tax amortization of intangible assets relating to the Kids Line, Sassy, andApplause acquisitions.  These deferredtax liabilities are indefinite in nature for accounting purposes, and thereforecan not be offset by the Company’s deferred tax assets.  The Company has recorded full valuationallowances against these deferred tax assets as management believes it is morelikely than not that these net deferred tax assets will not be realized.  The Company recorded approximately $1.1million of foreign tax expense related to profitable operations in Canada, HongKong, and Australia for the nine months ended September 30, 2006 versus $0.9million for the nine months ended September 30, 2005.

 

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As a result of the foregoing, consolidated net lossfor the nine months ended September 30, 2006 was $10.7 million, or $0.51 perdiluted share, compared to consolidated net loss of $16.5 million, or $0.79 perdiluted share, for the nine months ended September 30, 2005.

 **Liquidity and Capital Resources**

The Company’s principal sources of liquidity are cashand cash equivalents, funds from operations, and availability under its bankfacilities. The Company believes that it will able to fund its capitalrequirements for 2007 from such sources. In addition, subject to the discussionbelow under “Kids Line and Related Financing” with respect to the EarnoutConsideration and the Company’s continued compliance with the financialcovenants included in its 2006 Credit Agreements (defined below), the Companybelieves that cash flows from operations and future borrowings will besufficient to fund its operating needs for at least the next 12 months.

As of September 30, 2006, the Company had cash andcash equivalents of $11.2 million, compared to $28.7 million atDecember 31, 2005.  This reduction****of approximately $17.5 million was primarily related to therepayment of debt and a decrease in accounts payable, partially offset by areduction in inventory.  As of September30, 2006 and December 31, 2005, working capital was $74.6 million and$71.5 million, respectively.

Cash and cash equivalents decreased by approximately$17.5 million during the nine months ended September 30, 2006, compared to a decreaseof $43.5 million during the nine months ended September 30, 2005.  The decrease during the nine months endedSeptember 30, 2006 was primarily a result of the factors described in thepreceding paragraph.  The decrease duringthe nine months ended September 30, 2005 was primarily due to the payment ofdebt related to the termination of the Financing Agreement partially offset byproceeds from the 2005 Credit Agreement, proceeds from the sale of assets inthe UK and Hong Kong during the first quarter of 2005, the previously recordedUS Federal tax refund received in the second quarter of 2005, and collectionsof accounts receivable.** **Net cash provided by operatingactivities was approximately $2.0 million during the nine months endedSeptember 30, 2006, compared to net cash provided by operating activities ofapproximately $16.6 million during the nine months ended September 30,2005.  The decrease of $14.6 million wasdue primarily to the 2006 payment of debt of approximately $15.3 million, therelease of restricted cash in the 2005 period that was used toward repayment ofthe 2004 term loan, partially offset by amortization of the deferred gain onthe sale and leaseback of the Canadian facility in 2006**.** Net cash used in investing activities wasapproximately $2.8 million for the nine months ended September 30, 2006,compared to net cash provided by investing activities of approximately $8.0million for the nine months ended September 30, 2005.  The reduction of $10.8 million was dueprimarily to proceeds from the sale of assets in the first quarter of2005.  Net cash provided by financingactivities was approximately $16.7 million for the nine months ended September30, 2006, compared to net cash provided by financing activities of $65.6million for the nine months ended September 30, 2005.  The reduction of $48.9 million was dueprimarily to higher debt repayment in the first quarter of 2005, which includedrequired prepayments of the 2004 term loan in the amount of $20.0 million aswell as the Company’s ability to sustain lower borrowings in 2006.

***Kids Line andRelated Financing***

On March 14, 2006, as amended on April 11, 2006 (toclarify the application of a financial covenant) and August 8, 2006, theCompany refinanced its credit facility and entered into separate CreditAgreements for each of its operating segments. All of the prior debt outstanding on March 14, 2006,  together with fees and expenses associatedwith the transaction, was refinanced by drawing down approximately $79.7million under the Infantline Credit Agreement (described below), including thefull amount of the $60.0 million Term Loan and $19.7 million of the InfantlineRevolver.  At September 30, 2006, theCompany had $55.5 million outstanding under the Infantline Credit Agreement,reflecting repayments of the Infantline Revolver and the Term Loan in theamounts of $18.9 million and $5.3 million, respectively.  As of September 30, 2006, the outstanding balanceon the Giftline Revolver was $4.6 million and the balance on the outstandingCanadian Revolver (see Section 1.C below) was $1.1 million.

*Background.*  The Company purchased all of the outstandingequity interests and warrants in Kids Line (the “Purchase”) in accordance withthe terms and provisions of a Membership Interest Purchase Agreement 

 

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(the “Purchase Agreement”) executed as ofDecember 15, 2004. At closing, the Company paid approximately $130.5million, which represented the portion of the purchase price due at closingplus various transaction costs. The aggregate purchase price under the PurchaseAgreement, however, also includes the potential payment of the EarnoutConsideration, which is defined as 11.724% of the Agreed Enterprise Value ofKids Line as of the last day of the three year period ending November 30,2007 (the “Measurement Period”). The Earnout Consideration shall be paid asprovided in the Purchase Agreement (approximately the third anniversary of theClosing Date). The “Agreed Enterprise Value” shall be the product of(i) Kids Line’s EBITDA during the twelve (12) months ending on the lastday of the Measurement Period and (ii) the applicable multiple (rangingfrom zero to eight) as set forth in the Purchase Agreement. The Company cannotcurrently determine the amount of the Earnout Consideration that will berequired to be paid pursuant to the Purchase Agreement.  However, based on current projections, theCompany currently anticipates that the Earnout Consideration will be approximately$30 million, although the amount could be more or less depending on the actualperformance of Kids Line for the remaining portion of the Measurement Period.The amount of the Earnout Consideration will be charged to goodwill if and whenit is earned. The Company currently anticipates that cash flow from operationsand anticipated availability under the Infantline Credit Agreement will besufficient to fund the  payment of theEarnout Consideration (and that such payment will be permitted under theInfantline Credit Agreement),  howeverthere can be no assurance that unforeseen events or changes in our businesswould not have a material adverse impact on our ability to pay the EarnoutConsideration and therefore on our liquidity.

The Kids Lineacquisition was financed with the proceeds of a term loan under a financingagreement (the “Financing Agreement”), which is described in further detail inthe Current Report on Form 8-K filed by the Company with the SEC on December22, 2004.  The Financing Agreement wassubsequently replaced by the 2005 Credit Agreement and the 2005 Canadian CreditAgreement (as defined below), which are described in further detail in Note 5above and in the Current Report on Form 8-K filed by the Company with the SECon July 5, 2005.

In order to reduce overall interest expense and gainincreased flexibility with respect to the financial covenant structure of theCompany’s senior bank financing, on March 14, 2006, the 2005 Credit Agreementwas terminated and the obligations thereunder were refinanced (the “LaSalleRefinancing”).  For a detaileddescription of the 2006 Credit Agreements, which are defined and summarizedbelow, see Note 5 above and the Company’s Current Report on Form 8-K filed withthe SEC on March 17, 2006.  On March 14,2006, in connection with the LaSalle Refinancing, all outstanding obligations under the 2005 Credit Agreement(approximately $76.5 million) were repaid using proceeds from the InfantlineCredit Agreement (defined below).  TheCompany paid a fee of approximately $1.3 million in connection with the earlytermination of the 2005 Credit Agreement, which had been scheduled to mature onJune 28, 2010.  In addition, the Companywrote-off, in the first quarter of 2006, approximately $2.5 million in deferredfinancing costs in connection with the LaSalle Refinancing.

As part of theLaSalle Refinancing, the Company formed a wholly-owned Delaware subsidiary,Russ Berrie U.S. Gift, Inc. (“Newco”), to which it assigned (the “Assignment”)substantially all of its assets and liabilities which pertain primarily to itsdomestic gift business, such that separate loan facilities could be madedirectly available to each of the Company’s domestic gift business and infantand juvenile business, respectively.  TheAssignment transaction reinforces the operation of the Company as two separatesegments, and the credit facilities that have been extended to each segment areseparate and distinct.  There are nocross-default provisions between the Infantline Credit Agreement and GiftlineCredit Agreement (described below).

*InfantlineCredit Agreement. *OnMarch 14, 2006, Kids Line and Sassy (the “Infantline Borrowers”), entered intoa credit agreement as borrowers, on a joint and several basis, with LaSalleBank National Association as administrative agent and arranger (the “Agent”),the lenders from time to time party thereto, the Company as loan partyrepresentative, Sovereign Bank as syndication agent, and Bank of America, N.A.as documentation agent (the “Infantline Credit Agreement”).  Unless otherwise specified herein,capitalized terms used but undefined in Note 5 Section 1.A this section shallhave the meanings ascribed to them in the Infantline Credit Agreement.

 

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The commitmentsunder the Infantline Credit Agreement consist of (a) a $35.0 million revolvingcredit facility (the “Revolving Loan”), with a subfacility for letters ofcredit in an amount not to exceed $5.0 million, and (b) a $60.0 million termloan facility (the “Term Loan”).  TheInfantline Borrowers drew down approximately $79.7 million under the InfantlineCredit Agreement on the Closing Date, including the full amount of the TermLoan, which reflects the payoff of all amounts outstanding under the 2005Credit Agreement and certain fees and expenses associated with the LaSalle Refinancing.  As of September 30, 2006, the outstandingbalance on the Revolving Loan was $0.75 million and the outstanding balance onthe Term Loan was $54.8 million.  TheInfantline loans bear interest at a rate per annum equal to the Base Rate (forBase Rate Loans) or the LIBOR Rate (for LIBOR Loans), at the Company’s option,plus an applicable margin, in accordance with a pricing grid based on the mostrecent quarter-end Total Debt to EBITDA Ratio, which applicable margin rangesfrom 1.75% - 2.50% for LIBOR Loans and from 0.25% - 1.00% for Base Rate Loans.

The principal ofthe Term Loan under the Infantline Credit Agreement must be repaid ininstallments as follows: (a) $0.75 million on the last day of each calendarmonth for the period commencing March 2006 through and including February 2008,(b) $1.0 million on the last day of each calendar month for the periodcommencing March 2008 through and including February 2009, (c) $1.25 million onthe last day of each calendar month for the period commencing March 2009through and including February 2011.  Afinal installment in the aggregate amount of the unpaid principal balance ofthe Term Loan (in addition to all outstanding amounts under the Revolving Loan)is due and payable on March 14, 2011, in each case subject to earliertermination in accordance with the terms of the Infantline Credit Agreement.

The InfantlineCredit Agreement contains customary affirmative and negative covenants, as wellas the following financial covenants: (i) a minimum EBITDA test, (ii) a minimum Fixed Charge Coverage Ratio,(iii) a maximum Total Debt to EBITDA Ratio and (iv) an annual capitalexpenditure limitation.  As of September30, 2006, the Company was in compliance with the financial covenants containedin the Infantline Credit Agreement.

*GiftlineCredit Agreement**. *Also on March 14, 2006 as amendedon April 11, 2006 (to clarify the application of a financial covenant) andAugust 8, 2006, Newco and other specified wholly-owned domestic subsidiaries ofthe Company (collectively, the (discussed below) “Giftline Borrowers”), enteredinto a credit agreement as borrowers, on a joint and several basis, withLaSalle Bank National Association, as issuing bank (the “Issuing Bank”),LaSalle Business Credit, LLC as administrative agent (the “Administrative Agent”),the lenders from time to time party thereto, and the Company, as loan partyrepresentative (as amended, the “Giftline Credit Agreement” and, together withthe Infantline Credit Agreement, the “2006 Credit Agreements”).  Unless otherwise specified herein,capitalized terms used but undefined in this section shall have the meaningsascribed to them in the Giftline Credit Agreement.

The GiftlineCredit Agreement contemplates the potential inclusion of additional lenderssubsequent to the initial closing, which as of September 30, 2006 has notoccurred, and a simultaneous increase in the commitment, and the facilityconsists of a revolving credit loan commitment (a) before such commitment isincreased, if at all, in an amount equal to the Borrowing Base minus amountsoutstanding under the Canadian Credit Agreement (as defined below) and (b)after such commitment is increased, if at all, in an amount equal to the lesserof (i) $25.0 million and (ii) the then-current Borrowing Base, in each caseminus amounts outstanding under the Canadian Credit Agreement (the “GiftlineRevolver”), with a subfacility for letters of credit to be issued by theIssuing Bank in an amount not to exceed $8.0 million.   The Borrowing Base is primarily a functionof a percentage of eligible accounts receivable and eligible inventory and, asof September 30, 2006, the Borrowing Base, inclusive of the Borrowing Baseprovided under the Canadian Credit Agreement, was approximately $7.9 million**.**  The Giftline Borrowersdid not draw down on the Giftline Revolver on the Closing Date.  All outstanding amounts under the GiftlineRevolver are due and payable on March 14, 2011, subject to earlier terminationin accordance with the terms of the Giftline Credit Agreement.  The balance of the Giftline Revolver was $4.6million at September 30, 2006.  TheGiftline Revolver bears interest at a rate per annum equal to the sum of theBase Rate (for Base Rate Loans) or the LIBOR Rate (for LIBOR Loans), at theCompany’s option, plus a margin of 2.75% for LIBOR Loans and 1.25% for BaseRate Loans.  Interest is due and payablein the same manner as with respect to the Infantline Loans.

 

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The GiftlineCredit Agreement contains customary affirmative and negative covenantssubstantially similar to those applicable to the Infantline CreditAgreement.  The Giftline Credit Agreementcontains the following financial covenants: (i) a minimum EBITDA test, (ii) a minimum Excess Revolving LoanAvailability requirement of $5.0 million, (iii) an annual capital expenditurelimitation and (iv) a minimum Fixed Charge Coverage Ratio (for quarterscommencing with the quarter ending March 31, 2008).  In addition, at any time after December 31,2007 in respect of which the Fixed Charge Coverage Ratio for the ComputationPeriod ending as of the Fiscal Quarter end most recently preceding such datewas less than 1.00:1.00, the aggregate amounts outstanding under the GiftlineCredit  Agreement and the Canadian LoanAgreement may not exceed $10.0 million. As of September 30, 2006, the Company was in compliance with thefinancial covenants contained in the Giftline Credit Agreement.  On August 8, 2006, the Giftline CreditAgreement was amended to lower the threshold on the Minimum EBITDA covenant by$1.0 million per fiscal quarter for each of four consecutive fiscal quarterscommencing with the fiscal quarter ended September 30, 2006.

As contemplated bythe 2005 Credit Agreement, on June 28, 2005, the Company’s Canadian subsidiary,Amram’s Distributing Ltd. (“Amrams”), executed a separate Credit Agreement(acknowledged by the Company) with the financial institutions party thereto andLaSalle Business Credit, a division of ABN AMRO Bank, N.V., Canada Branch, aCanadian branch of a Netherlands bank, as issuing bank and administrative agent(the “Canadian Credit Agreement”), and related loan documents with respect to amaximum U.S. $10.0 million revolving loan (the “Canadian Revolving Loan”).  Russ Berrie and Company, Inc. (“RB”), acorporate holding company, executed an unsecured Guarantee (the “CanadianGuarantee”) to guarantee the obligations of Amrams under the Canadian CreditAgreement.  In connection with theLaSalle Refinancing, on March 14, 2006, the Canadian Credit Agreement wasamended to (i) replace references to the 2005 Credit Agreement with theGiftline Credit Agreement (such that, among other conforming changes, a defaultunder the Giftline Credit Agreement will be a default under the Canadian CreditAgreement), (ii) release the Company from the Canadian Guaranty and (iii)provide for a maximum U.S. $5.0million revolving loan.  In connectionwith the release of the Company from the Canadian Guaranty, Newco executed anunsecured Guarantee (the “Newco Guarantee”) to guarantee the obligations ofAmrams under the Canadian Credit Agreement. A default under the Infantline Credit Agreement will not constitute adefault under the Canadian Credit Agreement. The outstanding balance under the Canadian Revolving Loan as ofSeptember 30, 2006 was $1.12 million which reduces availability under theGiftline Credit Agreement by a corresponding amount.

The Companybelieves that the lower interest rates that were extended to the Company’ssubsidiaries in connection with the LaSalle Refinancing will enable the Companyto reduce its aggregate interest expense, on a comparable basis, byapproximately $2.0 million per year. However, because the 2006 Credit Agreements are extended directly to RB’sdomestic subsidiaries, RB is dependent upon its operating subsidiaries toprovide the cash necessary to enable the Company to fund its corporate overheadand other expenses.

The 2006 Credit Agreements restrict the ability of theCompany’s domestic subsidiaries to distribute cash to RB for the purpose ofpaying dividends to the shareholders of the Company or for the purpose ofsatisfying the Company’s corporate overhead expenses.  Subject to certain exceptions, the aggregatemaximum amount that can be distributed by the Company’s domestic subsidiariesto RB to enable RB to pay corporate overhead expenses is $6.5 million for eachof 2006 and 2007, and $7.0 million annually thereafter, with only $2.0 millionof this amount permitted to be distributed by the Infantline Borrowers on anannualized basis.  The Company believesthat the amounts permitted to be distributed to it by its subsidiaries will besufficient to fund its corporate overhead expenses, although there can be noassurance that such expenses will not exceed current estimates.  See the Company’s Current Report on Form 8-Kfiled on March 17, 2006.  There are norestrictions in the 2006 Credit Agreements on the ability of the Company’sforeign subsidiaries to distribute cash to the Company.

As a result of the LaSalle Refinancing, the obligationto pay the Earnout Consideration pursuant to the Kids Line acquisition is nolonger the obligation of RB, but the joint and several obligations of theInfantline Borrowers.  With respect tothe Earnout Consideration, the Infantline Borrowers will be permitted to payall or a portion of the Earnout Consideration to the extent that, before andafter giving effect to such 

 

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payment, (i) Excess Revolving Loan Availability willequal or exceed $3.0 million and (ii) no violation of the Infantline FinancialCovenants would then exist, or would, on a pro forma basis, result therefrom.

The Company’s ability to maintain compliance with thefinancial covenants under the 2006 Credit Agreements is dependent, particularlyin the case of the Giftline Credit Agreement, upon the successfulimplementation of the PIP described under “Overview” above and currentoperational plans.  Based on these plansand management’s current projections, management believes that the Company willremain in compliance with the financial covenants in the 2006 Credit Agreementsat least through September 30, 2007. However, in the event that the Company is unable to successfullyimplement the key elements of the PIP and current operational plans, there canbe no assurance that the Company will remain in compliance with such financialcovenants, particularly the financial covenants in the Giftline CreditAgreement.

**Other Events and CircumstancesPertaining to Liquidity**

In the event thatadditional initiatives related to the PIP are determined to be implemented,certain significant restructuring charges may be recognized and relatedseverance obligations incurred.  As thedetermination to implement any or all such initiatives has not yet been made,estimates of the range of any additional charges or other related expenditurescannot be determined at this time.  Inaddition to the $15.0 million anticipated cost savings as a result of theNovember 2005 restructuring, the PIP initiatives that have been implemented todate are expected to result in additional savings of approximately $7.0 millionannually.  See “Overview” above for amore detailed description of the PIP and the restructuring activitiesundertaken in 2005 and 2006.

The Company enters into foreign currency forwardexchange contracts, principally to manage the economic currency risksassociated with the purchase of inventory by its European, Canadian andAustralian subsidiaries in the gift segment and by Sassy Inc. in the infant andjuvenile segment.

The Company is dependent upon information technologysystems in many aspects of its business. In 2002, the Company commenced aglobal implementation of an Enterprise Resource Planning (“ERP”) system for itsgift businesses.  During 2003 andcontinuing into 2004, certain of the Company’s international gift subsidiariesbegan to phase-in aspects of the new ERP system.  In late 2005, the Company began to explorealternative global information technology systems for its gift business thatcould provide greater efficiencies, lower costs and greater reportingcapabilities than those provided by the current ERP system.  As a result of this review, all remaininginternational implementations were placed on hold pending a decision on whetheror not to replace the current ERP system. The Company expects to make a decision on whether to replace its currentERP system during fiscal 2007.

Effective December 28, 2005, the Company amended alloutstanding stock option agreements such that all options with exercise pricesin excess of the market price for the Company’s common stock at the close of businesson December 28, 2005 became fully vested and immediately exercisable at theclose of business on December 28, 2005.  Because these options were pricedabove the then current market price on December 28, 2005, the acceleration ofvesting of these options did not result in the recognition of any compensationexpense, although such action enabled the Company to avoid future compensationexpense which would have been required by SFAS 123(R) (described in Note 2 ofNotes to Unaudited Consolidated Financial Statements) of approximately$1.6 million (pre-tax) in 2006 and $3.7 million (pre-tax) in subsequentyears through 2010.

In March 1990, the Board of Directors authorizedthe Company to repurchase an aggregate of up to 7.0 million shares of commonstock. As of December 31, 2005, 5.6 million shares have been repurchased sincethe beginning of the Company’s stock repurchase program. The Company did notrepurchase any shares pursuant to this program or otherwise during fiscal 2005or through the first nine months of 2006. The 2006 Credit Agreements impose certain limitations on the ability ofthe Company to repurchase shares.

The Company is subject to legal proceedings and claimsarising in the ordinary course of its business that the Company believes willnot have a material adverse impact on the Company’s consolidated financialcondition, results of operations or cash flows.

Consistent with its past practices and in the normalcourse of its business, the Company regularly reviews acquisition opportunitiesof varying sizes. The Company may consider the use of debt or equity financing 

 

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to fund potential acquisitions.  The 2006 CreditAgreements impose restrictions on the Company that could limit its ability torespond to market conditions or to take advantage of acquisitions or otherbusiness opportunities.

**Contractual Obligations**

The following table summarizes the Company’ssignificant known contractual obligations as of September 30, 2006 and thefuture periods in which such obligations are expected to be settled in cash(dollars in thousands):
| ** **                     | ** ** | **Total** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** |
|--------------------------------|------------|-----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|
| Operating Lease  Obligations   |       | $         | 42,107     |     | $          | 1,723    |       | $        | 6,550      |     | $          | 5,946    |       | $              | 5,381      |   | $ | 4,678 |   | $ | 17,829 |   |
| Purchase  Obligations(1)       |       | $         | 39,570     |     | $          | 39,570   |       | $        | —     |     | $          | —   |       | $              | —     |   | $ | — |   | $ | — |   |
| Debt Repayment  Obligations(2) |       | $         | 61,256     |     | $          | 8,756    |       | $        | 9,000      |     | $          | 11,500   |       | $              | 14,500     |   | $ | 15,000 |   | $ | 2,500 |   |
| Royalty  Obligations           |       | $         | 1,678      |     | $          | 313      |       | $        | 1,295      |     | $          | 70       |       | $              | —     |   | $ | — |   | $ | — |   |
| Total Contractual  Obligations |       | $         | 144,611    |     | $          | 50,362   |       | $        | 16,845     |     | $          | 17,516   |       | $              | 19,881     |   | $ | 19,678 |   | $ | 20,329 |   |

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(1)   The Company’s purchase obligationsconsist of purchase orders for inventory.

(2)             Reflects repaymentobligations under the 2006 Credit Agreements. See Note 5 of Notes to Unaudited Consolidated Financial Statements for adescription of the 2006 Credit Agreements, including provisions that create,increase and/or accelerate obligations thereunder.

**Off Balance Sheet Arrangements**

As of September 30, 2006, there have been no materialchanges in the information provided under the caption “Off Balance SheetArrangements” of Item 7 of the 2005 10-K, other than the termination if the EDAObligations described in Note 5 to Notes to Unaudited Consolidated FinancialStatements.

**CRITICAL ACCOUNTING POLICIES**

The SEC has issued disclosure advice regarding “criticalaccounting policies”, defined as accounting policies that management believesare both most important to the portrayal of the Company’s financial conditionand results and require application of management’s most difficult, subjectiveor complex judgments, often as a result of the need to make estimates about theeffects of matters that are inherently uncertain.

Management is required to make certain estimates andassumptions during the preparation of its consolidated financial statements thataffect the reported amounts of assets, liabilities, revenue and expenses, andrelated disclosure of contingent assets and liabilities. Estimates andassumptions are reviewed periodically, and revisions made as determined to benecessary by management.  There have beenno material changes to the Company’s significant accounting estimates andassumptions or the judgments affecting the application of such estimates andassumptions during the period covered by this report from those described inthe Company’s 2005 10-K, except as described below.

Historically, the Company accounted for stock-basedcompensation under the recognition and measurement principles of APB 25 andrelated interpretations.  Accordingly, nocompensation expense was reflected in the Company’s Consolidated Statements ofOperations as all options granted had an exercise price equal to the fairmarket value of the underlying common stock on the date of grant.  In accordance with the disclosure provisionsof SFAS 123, previously issued financial statements included pro formadisclosures of the effect on net income and net income per share as if theCompany had applied the fair value recognition provisions of SFAS 123, “Accountingfor Stock-Based Compensation”, to share-based compensation.

The Companyadopted the provisions of SFAS 123(R) on January 1, 2006 using the “modifiedprospective” transition method.  The “modifiedprospective” transition method requires compensation cost to be

 

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recognizedbeginning with the effective date (a) based on the requirements of SFAS123(R) for all share-based payments granted after the effective date and(b) based on the requirements of SFAS 123 for all awards granted toemployees prior to the effective date of SFAS 123(R) that remain unvested onthe effective date.  In accordance withthis method, prior periods were not restated to reflect the impact of adoptingthe new standard.

See Note 2 of Notes to Unaudited ConsolidatedFinancial Statements for further discussion of the impact of the Company’sadoption of SFAS 123(R), as well as the valuation methodology and assumptionsutilized.

Also see Note 2 of Notes to Consolidated FinancialStatements of the 2005 10-K for a summary of the significant accountingpolicies used in the preparation of the Company’s consolidated financialstatements.

**Recently Issued Accounting Standards**

In July 2006, theFASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”(FIN 48), effective for fiscal years beginning after December 15, 2006.  FIN 48 requires a two-step approach todetermine how to recognize tax benefits in the financial statements whererecognition and measurement of a tax benefit must be evaluated separately.  A tax benefit will be recognized only if itmeets a “more-likely-than-not” recognition threshold.  For tax positions that meet this threshold,the tax benefit recognized is based on the largest amount of tax benefit thatis greater than 50 percent likely of being realized upon ultimate settlementwith the taxing authority.  We arecurrently evaluating the impact of adopting FIN 48, and have not yet determinedthe significance of this new rule to our overall results of operations, cashflows or financial position.

InSeptember 2006, the SEC staff issued Staff Accounting Bulletin (SAB) Topic 1N(SAB 108), “Financial Statements — Considering the Effects of PriorYear Misstatements when Quantifying Misstatements in Current Year FinancialStatements,” which is effective for calendar year companies as ofDecember 31, 2006. SAB 108 provides guidance on how prior yearmisstatements should be taken into consideration when quantifying misstatementsin current year financial statements for purposes of determining whether thefinancial statements are materially misstated. Under this guidance, companiesshould take into account both the effect of a misstatement on the current yearbalance sheet as well as the impact upon the current year income statement inassessing the materiality of a current year misstatement. Once a current yearmisstatement has been quantified, the guidance in SAB Topic 1M, “FinancialStatements — Materiality,” (SAB 99) should be applied todetermine whether the misstatement is material. The Company is currentlyassessing the potential impact, if any on the implementation of SAB 108 onthe Company’s financial statements.

**Forward-Looking Statements**

This Quarterly Report on Form 10-Q containscertain forward-looking statements.  Additional written and oralforward-looking statements may be made by the Company from time to time inSecurities and Exchange Commission (SEC) filings and otherwise.  ThePrivate Securities Litigation Reform Act of 1995 provides a safe-harbor forforward-looking statements.  These statements may be identified by the useof forward-looking words or phrases including, but not limited to, “anticipate”,“project”, “believe”, “expect”, “intend”, “may”, “planned”, “potential”, “should”,“will” or “would”.  The Company cautions readers that results predicted byforward-looking statements, including, without limitation, those relating tothe Company’s future business prospects, revenues, operating results, workingcapital, liquidity, capital needs, interest costs and income are subject tocertain risks and uncertainties that could cause actual results to differmaterially from those indicated in the forward-looking statements.   Specific risks and uncertainties include, butare not limited to, those set forth under Item 1A, “Risk Factors”, of the 200510-K.  The Company undertakes noobligation to publicly update any forward-looking statement, whether as aresult of new information, future events or otherwise.

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**ITEM 3.  QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

As of September 30, 2006, there have been no materialchanges in the Company’s market risks associated with marketable securities andforeign currency exchange rates, as described in Item 7A of the 2005 10-K. Themarket risk associated with long-term debt has changed as a result of thetermination of the 2005 Credit Agreement and the execution of the 2006 CreditAgreements, as is more fully described in Note 5 of Notes to UnauditedConsolidated Financial Statements.  Theinterest applicable to the 2006 Credit Agreements is based upon (i) the LIBORRate and (ii) the Base Rate (each as defined in the 2006 Credit Agreements),plus an applicable margin.  At September30, 2006, a sensitivity analysis to measure potential changes in applicableinterest rates indicates that a one percentage point increase in interest rateswould increase the Company’s interest expense by approximately $0.6 millionannually, based upon the level of debt at September 30, 2006.  See Note 5 of Notes to Unaudited ConsolidatedFinancial Statements for a description of the interest rates applicable to theloans under the 2006 Credit Agreements.

**ITEM4.  CONTROLS AND PROCEDURES**

We maintain disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-15(e) or15d-15(e)) that are designed to ensure that information required to bedisclosed in our reports filed or submitted pursuant to the Securities ExchangeAct of 1934 is recorded, processed, summarized and reported within the timeperiods specified in the Securities and Exchange Commission’s rules and forms,and that information required to be disclosed in our Exchange Act reports isaccumulated and communicated to our management, including our Chief ExecutiveOfficer and Chief Financial Officer, to allow timely decisions regardingrequired disclosure.

Under the supervision andwith the participation of management, including our Chief Executive Officer andChief Financial Officer, we carried out an evaluation of the effectiveness ofthe design and operation of our disclosure controls and procedures pursuant toParagraph (b) of Exchange Act Rules 13a-15 and 15d-15 as of September 30,2006.  Based upon our evaluation, ourChief Executive Officer and Chief Financial Officer have concluded that ourdisclosure controls and procedures are effective as of September 30, 2006.

As previously reported inour Annual Report on Form 10-K for the year ended December 31, 2005 andsubsequent Forms 10-Q, the Company did not maintain sufficient personnelresources with the requisite technical accounting and financial reportingexpertise to: affect a timely financial closing process; sufficiently addressnon- routine and or complex accounting issues that arise from time to time inthe course of the Company’s operations; and effectively prepare timely accountreconciliations and analysis.  This lackof sufficient personnel resources with the requisite technical accounting andfinancial reporting expertise resulted in: material errors in theclassification of long-term debt and income tax expense; errors in equityaccounts, inter-company accounts, depreciation expense, inventory, and foreigncurrency transactions; and material omissions of disclosures in the Company’spreliminary 2005 consolidated financial statements.  The foregoing led management to conclude asof December 31, 2005 that the Company’s disclosure controls and procedures werenot effective and resulted in management concluding that a material weaknessexisted.  The Company’s management, whichincludes the Chief Executive Officer and the Chief Financial Officer, havededicated resources to assess the issues that gave rise to the aforementionedmaterial weakness.  As of the date ofthis filing, the remediation initiatives management has implemented include:

·                  Reorganizing the reporting structure andresponsibilities of the employees within the Finance Department;

·                  Hiring additional qualified staff membersincluding a senior level individual with the required technical and financialreporting expertise;

·                  Implementing changes in the senior levelmanagement of the Finance Department;

·                  Implementing time lines and strengtheninternal reviews of reporting packages from the Company’s operating units; and

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·                  Improving the timeliness of reporting tomanagement and in meeting external reporting requirements in a timely manner.

As of the date of thisfiling, the remediation of this material weakness has been completed.  We have implemented all the remediationinitiatives outlined above, which we believe are sufficient to eliminate thematerial weakness in internal control over financial reporting as discussedabove.

**Changes in Internal Control OverFinancial Reporting**

Except as discussed above, there were no changes inour internal controls over financial reporting identified in connection withthe evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15that occurred during the fiscal quarter ended September 30, 2006 that havematerially affected, or are reasonably likely to materially affect, our internalcontrol over financial reporting.

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**PART II- OTHER INFORMATION**

**ITEM 1A. RISK FACTORS**

Therehave been no material changes to the risk factors set forth in Part I, Item 1A,“Risk Factors”, of the Company’s 2005 10-K.

**ITEM 6.  EXHIBITS** 
|        |   | Exhibits to this Quarterly Report on Form 10-Q. |
|--------|--------|-------------------------------------------------|
|   |   |                                            |   |   |
|   |   | 3.2 (q)                                         |   | Amended and Restated By-Laws of the Company adopted  October 5, 2006. |
|   |   |                                            |   |   |
|   |   | 10.104                                          |   | Investor Rights Agreement, dated as of August 10,  2006, among the Company and the investors listed on the signature pages  thereto. (incorporated by reference to the Current Report on Form 8-K filed  August 14, 2006.) |
|   |   |                                            |   |   |
|   |   | 10.105                                          |   | Lease Agreement, dated August 8, 2006, between  Erachange Limited and Russ Berrie (UK) Limited. |
|   |   |                                            |   |   |
|   |   | 10.106                                          |   | Agreement For the Sale and Purchase of Liberty House  Bulls Copse Road Hounsdown Business Park Totton Southampton, SO40 9RB dated October 31,  2006, between Hounsdown, Inc., Russ Berrie (UK) Limited and Garmin (Europe)  Limited. |
|   |   |                                            |   |   |
|   |   | 31.1                                            |   | Certification of CEO required by Section 302 of  the Sarbanes Oxley Act of 2002. |
|   |   |                                            |   |   |
|   |   | 31.2                                            |   | Certification of CFO required by Section 302 of  the Sarbanes Oxley Act of 2002. |
|   |   |                                            |   |   |
|   |   | 32.1                                            |   | Certification of CEO required by Section 906 of  the Sarbanes Oxley Act of 2002. |
|   |   |                                            |   |   |
|   |   | 32.2                                            |   | Certification of CFO required by Section 906 of  the Sarbanes Oxley Act of 2002. |

 

**Items 1, 2, 3, 4 and 5 are not applicable and have beenomitted.**

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**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized. 

|                        |   |   | RUSS BERRIE AND COMPANY, INC. |
|------------------------|--------|--------|-------------------------------|
|                   |   |   | (Registrant)                  |
|                   |   |   |                          |   |
|                   |   |   |                          |   |
|                   |   |   | By                            | /s/ JAMES J. O’REARDON, JR. |
| Date: November 9, 2006 |   |   |                          | James J. O’Reardon, Jr. |
|                   |   |   |                          | Vice President and Chief Financial Officer |
|                   |   |   |                          |   |

 

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**EXHIBITINDEX**

 

| 3.2 (q) | Amended and Restated By-Laws of the Company adopted  October 5, 2006                                                                                                                                                                     |
|---------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |                                                                                                                                                                                                                                     |
| 10.104  | Investor Rights Agreement, dated as of August 10,  2006, among the Company and the investors listed on the signature pages  thereto. (Incorporated by reference to the Current Report on Form 8-K filed  August 14, 2006.)               |
|    |                                                                                                                                                                                                                                     |
| 10.105  | Lease Agreement, dated August 8, 2006, between Erachange  Limited and Russ Berrie (UK) Limited.                                                                                                                                          |
|    |                                                                                                                                                                                                                                     |
| 10.106  | Agreement For the Sale and Purchase of Liberty House  Bulls Copse Road Hounsdown Business Park Totton Southampton, SO40 9RB dated October 31,  2006, between Hounsdown, Inc., Russ Berrie (UK) Limited and Garmin (Europe) Limited. |
|    |                                                                                                                                                                                                                                     |
| 31.1    | Certification of CEO required by Section 302 of  the Sarbanes Oxley Act of 2002.                                                                                                                                                    |
|    |                                                                                                                                                                                                                                     |
| 31.2    | Certification of CFO required by Section 302 of  the Sarbanes Oxley Act of 2002.                                                                                                                                                    |
|    |                                                                                                                                                                                                                                     |
| 32.1    | Certification of CEO required by Section 906 of  the Sarbanes Oxley Act of 2002.                                                                                                                                                    |
|    |                                                                                                                                                                                                                                     |
| 32.2    | Certification of CFO required by Section 906 of  the Sarbanes Oxley Act of 2002.                                                                                                                                                    |

 

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