**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

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** **
| **ý**                                                                                                                                                                                                                               | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                                                               | ** ** | ** **                                                                                                   |
| **For the quarterly period ended March 31, 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                ** |

 

**Commissionfiles number 1-8681**

 

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**RUSS BERRIEAND COMPANY, INC.**

(Exact name of registrant asspecified in its charter)

 

| **New Jersey**                           | ** ** | **22-1815337**                          |
|------------------------------------------|------------|-----------------------------------------|
| (State of or other jurisdiction of       |       | (I.R.S. Employer Identification Number) |
| incorporation or organization)           | ** ** | ** **                              |
|                                     |       |                                    |
| **111 Bauer Drive, Oakland, New Jersey** | ** ** | **07436**                               |
| (Address of principal executive offices) | ** ** | (Zip Code)                              |

 

**(201) 337-9000**

(Registrant’s Telephone 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 ý      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 ý            Non-acceleratedfiler o

 

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

 

The number of sharesoutstanding of each of the registrant’s classes of common stock, as of May 15,2006 was as follows:

** **

| **CLASS**                        | ** ** | **OUTSTANDING  At May 15, 2006** |   |
|----------------------------------|------------|----------------------------------|--------|
| Common Stock, $0.10 stated value |       | 20,835,972                       |   |

 

 

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**RUSS BERRIEAND COMPANY, INC.**

 

**INDEX**

 
| **PART I –  FINANCIAL INFORMATION** |   |
|------------------------------------------|--------|
|                                     |   |   |   |
| Item 1.                                  |   | Financial Statements (unaudited) |   |
|                                     |   |   |   |
| a)                                       |   | Consolidated Balance Sheets as of  March 31, 2006 and December 31, 2005 |   |
|                                     |   |   |   |
| b)                                       |   | Consolidated Statements of  Operations for the three months ended March 31, 2006 and 2005 |   |
|                                     |   |   |   |
| c)                                       |   | Consolidated Statements of  Cash Flows for the three months ended March 31, 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 BERRIEAND COMPANY, INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

**(Dollars inThousands, except per share data)(UNAUDITED)**

 
| ** **                                                                                                                                                 | ** ** | **March 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **Assets (Note 5)**                                                                                                                                        |       |                         |       |                            |       |
| Current assets                                                                                                                                             |       |                         |       |                            |       |
| Cash and cash equivalents                                                                                                                                  |       | $                            | 11,161     |                            | $          | 28,667 |   |
| Accounts receivable, trade, less allowances  of $2,188 in 2006 and $1,943 in 2005                                                                          |       | 62,007                       |       | 53,444                          |       |
| Inventories, net                                                                                                                                           |       | 50,202                       |       | 56,346                          |       |
| Prepaid expenses and other current assets                                                                                                                  |       | 11,180                       |       | 12,152                          |       |
| Income tax receivable                                                                                                                                      |       | 2,753                        |       | 2,979                           |       |
| Deferred income taxes                                                                                                                                      |       | 2,255                        |       | 2,274                           |       |
| **Total current assets**                                                                                                                                   |       | 139,558                      |       | 155,862                         |       |
| Property, plant and equipment, net                                                                                                                         |       | 16,633                       |       | 17,856                          |       |
| Goodwill                                                                                                                                                   |       | 89,242                       |       | 89,242                          |       |
| Intangible assets                                                                                                                                          |       | 61,592                       |       | 61,599                          |       |
| Restricted cash                                                                                                                                            |       | 741                          |       | 750                             |       |
| Other assets                                                                                                                                               |       | 5,579                        |       | 5,283                           |       |
| **Total assets**                                                                                                                                           |       | $                            | 313,345    |                            | $          | 330,592 |   |
| **Liabilities and Shareholders’ Equity**                                                                                                              |       |                         |       |                            |       |
| Current liabilities                                                                                                                                        |       |                         |       |                            |       |
| Current portion of long-term debt                                                                                                                          |       | $                            | 9,000      |                            | $          | 2,600 |   |
| Short-term debt                                                                                                                                            |       | 16,750                       |       | 31,924                          |       |
| Accounts payable                                                                                                                                           |       | 8,959                        |       | 18,494                          |       |
| Accrued expenses                                                                                                                                           |       | 26,528                       |       | 27,530                          |       |
| Accrued income taxes                                                                                                                                       |       | 3,817                        |       | 4,203                           |       |
| **Total current liabilities**                                                                                                                              |       | 65,054                       |       | 84,751                          |       |
| Deferred income taxes                                                                                                                                      |       | 5,564                        |       | 6,358                           |       |
| Long-term debt, excluding current portion                                                                                                                  |       | 50,250                       |       | 41,993                          |       |
| Other long-term liabilities                                                                                                                                |       | 3,530                        |       | 3,636                           |       |
| **Total liabilities**                                                                                                                                      |       | 124,398                      |       | 136,738                         |       |
| Commitments and contingencies                                                                                                                              |       |                         |       |                            |       |
| Shareholders’ equity                                                                                                                                  |       |                         |       |                            |       |
| Common stock: $0.10 per share stated value;  authorized 50,000,000 shares; issued 26,472,256 shares at March 31, 2006 and  December 31, 2005, respectively |       | 2,649                        |       | 2,649                           |       |
| Additional paid in capital                                                                                                                                 |       | 88,784                       |       | 88,751                          |       |
| Retained earnings                                                                                                                                          |       | 195,764                      |       | 200,756                         |       |
| Accumulated other comprehensive income                                                                                                                     |       | 11,900                       |       | 11,848                          |       |
| Treasury stock, at cost, 5,636,284 shares  at March 31, 2006 and December 31, 2005, respectively                                                           |       | (110,150                     | )          | (110,150                        | )          |
| **Total shareholders’ equity**                                                                                                                        |       | 188,947                      |       | 193,854                         |       |
| **Total liabilities and shareholders’ equity**                                                                                                        |       | $                            | 313,345    |                            | $          | 330,592 |   |

* *

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

 

3

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**RUSS BERRIEAND COMPANY, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Dollars inThousands, Except Per Share Data)**

**(UNAUDITED)**

 
| ** **                                                                          | ** ** | **Three Months Ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Net sales                                                                           |       | $                                                    | 77,359     |   | $ | 70,740 |   |
|                                                                                |       |                                                 |       |   |   |
| Cost of sales                                                                       |       | 45,513                                               |       | 39,344 |   |
|                                                                                |       |                                                 |       |   |   |
| **Gross profit**                                                                    |       | 31,846                                               |       | 31,396 |   |
|                                                                                |       |                                                 |       |   |   |
| Selling, general and administrative  expenses                                       |       | 31,778                                               |       | 30,685 |   |
|                                                                                |       |                                                 |       |   |   |
| **Operating income**                                                                |       | 68                                                   |       | 711 |   |
|                                                                                |       |                                                 |       |   |   |
| Other (expense)/income:                                                             |       |                                                 |       |   |   |
| Interest expense, including amortization  and write-off of deferred financing costs |       | (5,795                                               | )          | (3,492 | ) |
| Interest and investment income                                                      |       | 103                                                  |       | 302 |   |
| Other, net                                                                          |       | 365                                                  |       | (261 | ) |
|                                                                                |       | (5,327                                               | )          | (3,451 | ) |
|                                                                                |       |                                                 |       |   |   |
| **Loss before income tax benefit**                                                  |       | (5,259                                               | )          | (2,740 | ) |
|                                                                                |       |                                                 |       |   |   |
| Income tax benefit                                                                  |       | (267                                                 | )          | (1,018 | ) |
|                                                                                |       |                                                 |       |   |   |
| **Net loss**                                                                        |       | $                                                    | (4,992     | ) | $ | (1,722 | ) |
|                                                                                |       |                                                 |       |   |   |
| **Net loss per share:**                                                             |       |                                                 |       |   |   |
| Basic                                                                               |       | $                                                    | (0.24      | ) | $ | (0.08 | ) |
| Diluted                                                                             |       | $                                                    | (0.24      | ) | $ | (0.08 | ) |
|                                                                                |       |                                                 |       |   |   |
| **Weighted average shares:**                                                        |       |                                                 |       |   |   |
| Basic                                                                               |       | 20,836,000                                           |       | 20,824,000 |   |
| Diluted                                                                             |       | 20,836,000                                           |       | 20,824,000 |   |

 

*The accompanyingnotes are an integral part of the unaudited consolidated financial statements.*

 

4

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**RUSS BERRIEAND COMPANY, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Dollars inThousands)(UNAUDITED)**

 
| ** **                                                                                 | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| **Cash flows from operating activities:**                                                  |       |                                                 |       |   |   |
| Net loss                                                                                   |       | $                                                    | (4,992     | ) | $ | (1,722 | ) |
| Adjustments to reconcile net loss to net  cash (used in)/provided by operating activities: |       |                                                 |       |   |   |
| Depreciation and amortization                                                              |       | 1,395                                                |       | 1,898 |   |
| Amortization and write-off of deferred  financing costs                                    |       | 2,688                                                |       | 416 |   |
| Provision for accounts receivable                                                          |       | 349                                                  |       | 96 |   |
| Provision for inventory reserve                                                            |       | 716                                                  |       | — |   |
| Deferred income taxes                                                                      |       | (775                                                 | )          | — |   |
| Other                                                                                      |       | (310                                                 | )          | 90 |   |
| Change in assets and liabilities:                                                          |       |                                                 |       |   |   |
| Restricted cash                                                                            |       | 9                                                    |       | 4,548 |   |
| Accounts receivable                                                                        |       | (8,929                                               | )          | 11,428 |   |
| Income tax receivable                                                                      |       | 226                                                  |       | — |   |
| Inventories                                                                                |       | 5,428                                                |       | 6,065 |   |
| Prepaid expenses and other current assets                                                  |       | 1,123                                                |       | (139 | ) |
| Other assets                                                                               |       | 38                                                   |       | (129 | ) |
| Accounts payable                                                                           |       | (9,536                                               | )          | (5,515 | ) |
| Accrued expenses                                                                           |       | (1,972                                               | )          | (8,873 | ) |
| Accrued income taxes                                                                       |       | (386                                                 | )          | (1,064 | ) |
| Total adjustments                                                                          |       | (9,936                                               | )          | 8,821 |   |
| Net cash (used in)/provided by operating  activities                                       |       | (14,928                                              | )          | 7,099 |   |
|                                                                                       |       |                                                 |       |   |   |
| **Cash flows from investing activities:**                                                  |       |                                                 |       |   |   |
| Proceeds from sale of property, plant and  equipment                                       |       | 26                                                   |       | 8,761 |   |
| Capital expenditures                                                                       |       | (121                                                 | )          | (320 | ) |
| Other                                                                                      |       | —                                               |       | (31 | ) |
| Net cash (used in)/provided by investing  activities                                       |       | (95                                                  | )          | 8,410 |   |
|                                                                                       |       |                                                 |       |   |   |
| **Cash flows from financing activities:**                                                  |       |                                                 |       |   |   |
| Proceeds from issuance of common stock                                                     |       | 33                                                   |       | — |   |
| Issuance of long-term debt                                                                 |       | 59,250                                               |       | — |   |
| Repayment of long-term debt                                                                |       | (76,516                                              | )          | (20,000 | ) |
| Net borrowing on revolving credit facility                                                 |       | 16,750                                               |       | — |   |
| Payment of deferred financing costs                                                        |       | (2,052                                               | )          | (788 | ) |
| Net cash used in financing activities                                                      |       | (2,535                                               | )          | (20,788 | ) |
|                                                                                       |       |                                                 |       |   |   |
| Effect of exchange rate changes on cash and  cash equivalents                              |       | 52                                                   |       | (1,174 | ) |
| Net decrease in cash and cash equivalents                                                  |       | (17,506                                              | )          | (6,453 | ) |
| Cash and cash equivalents at beginning of  period                                          |       | 28,667                                               |       | 48,099 |   |
| Cash and cash equivalents at end of period                                                 |       | $                                                    | 11,161     |   | $ | 41,646 |   |
|                                                                                       |       |                                                 |       |   |   |
| **Cash paid during the year for:**                                                         |       |                                                 |       |   |   |
| Interest expense                                                                           |       | $                                                    | 1,796      |   | $ | 3,077 |   |
| Income taxes                                                                               |       | $                                                    | 518        |   | $ | 405 |   |

 

*Theaccompanying notes are an integral part of the unaudited consolidated financialstatements*

 

5

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

(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, resultsof operations and cash flows for the interim periods presented.  Resultsfor interim periods are not necessarily an indication of results to be expectedfor the year.

 

TheCompany operates in two segments: (i) the Company’s gift business and (ii) the Company’sinfant and juvenile business, which includes the Company’s July 26, 2002acquisition of Sassy, Inc. and the Company’s December 15, 2004 acquisitionof Kids Line, LLC. This segmentation of the Company’s operations reflects howthe Company’s Chief Executive Officer currently views the results ofoperations. There are no inter-segment revenues to eliminate. Corporate assetsand overhead expenses are included in the gift segment. The Company has enteredinto separate credit facilities with respect to each of its segments (see Note5).

 

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. The Company’s infant and juvenile businesses design and marketproducts in a number of baby categories including, among others, infant beddingand accessories, bath toys and accessories, developmental toys, feeding itemsand baby comforting products. These products are sold to consumers, primarilyin the United States, through mass merchandisers, toy specialty, food, drug andindependent retailers, apparel stores and military post exchanges.

 

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

 

ThisQuarterly Report on Form 10-Q for the three months ended March 31, 2006should be read in conjunction with the Company’s Annual Report on Form 10-K forthe year ended December 31, 2005, as amended on April 20, 2006 and May 1,2006 (the “2005 10-K”).

 

**NOTE 2 - ACCOUNTING FOR STOCK OPTIONS**

 

The Company currently maintains the 2004 StockOption, Restricted and Non-Restricted Stock Plan (the “2004 Option Plan”) andthe 2004 Employee Stock Purchase Plan (collectively, the “2004 Stock Plans”).  As of December 31, 2005 there were1,507,844 shares of common stock reserved for issuance under the 2004 StockPlans.  The Company also continues tohave options outstanding under the 1999 and 1994 Stock Option and RestrictedStock Plans, the 1999 and 1994 Stock Option Plans and the 1999 and 1994 StockOption Plans for 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 31,1998 with respect to the 1994 Predecessor Plans.  (Refer to Item 12, “Security Ownership ofCertain Beneficial Owners and Management and Related Stockholder Matters -Equity Compensation Plan Information”, and Note 19, “Stock Plans”, of the 200510-K for further details with respect to option plans.)

 

Theexercise price for options issued under the 2004 Option Plan and thePredecessor Plans is equal to the closing price of the Company’s common stockas of the date the option is granted, except for the options granted in 2000which were repriced to the closing price of the Company’s stock effective February 29,2000 and at $2.00 above the closing price of the Company’s stock priceeffective February 29, 2000 for the Company’s 1999 Stock Plan for OutsideDirectors. Generally, stock options under the 2004 Option Plan and thePredecessor Plans vest between one and five years from the grant date unlessotherwise stated by the specific grant. Options generally expire 10 yearsfrom the date of grant.

 

Historically,the Company accounted for stock-based compensation under the recognition andmeasurement principles of Account Principles Board Opinion (“APB”) No. 25, “Accountingfor Stock Issued to Employees” (“APB 25”), and related interpretations. Nocompensation expense related to stock option plans was reflected in the Company’sConsolidated Statements of Operations as all options had an exercise priceequal to the market value of the underlying common stock on the date of grant. Statementof Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock BasedCompensation” (“SFAS 123”), established accounting and disclosure requirementsusing a fair-value-based method of accounting for stock-based employeecompensation plans. As permitted by SFAS 123, the Company elected to continueto apply the intrinsic-value-based method of APB 25 described above, andadopted only the disclosure requirements of SFAS 123, as amended by SFAS No.148, “Accounting for Stock-Based Compensation – Transition and Disclosure.”

 

InDecember 2004, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), which establishesstandards for transactions in which an entity exchanges its equity instrumentsfor goods or services. This statement is a replacement of SFAS 123 andsupersedes APB 25. SFAS 123(R) requires companies to recognize an expense forcompensation cost related to share-based payment arrangements, including stockoptions and employee stock purchase plans, based on the grant-date fair valueof the award. This standard applies to all awards unvested or granted as of therequired effective date and to awards modified, repurchased, or cancelled afterthat date.

 

TheCompany adopted the provisions of SFAS 123(R) on January 1, 2006 using the“modified prospective” transition method. The “modified prospective” transitionmethod requires compensation cost to be recognized beginning with the effectivedate (a) based on the requirements of SFAS 123(R) for all share-basedpayments 

 

6

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

 

grantedafter the effective date and (b) based on the requirements of SFAS 123 forall awards granted to employees prior to the effective date of SFAS 123(R) thatremain unvested on the effective date. In accordance with this method, priorperiods were not restated to reflect the impact of adopting the new standard.

 

EffectiveDecember 28, 2005, the Company amended all outstanding stock option agreementswhich pertained to options with exercise prices in excess of the market pricefor the Company’s common stock at the close of business on December 28, 2005 (“UnderwaterOptions”) which, at that time, had remaining vesting requirements. As a resultof these amendments, all Underwater Options, which represented all outstandingoptions (to purchase approximately 1.5 million shares of the Company’s commonstock) which had not yet fully-vested, became fully vested and immediately exercisableat the close of business on December 28, 2005.  Of the optionsaccelerated, approximately 120,000 options are held by non-employee directors,approximately 868,000 are held by officers of the Company and the balance areheld by other employees of the Company as of March 31, 2006.  Becausethese options were priced above the then current market price on December 28,2005, the acceleration of vesting of these options did not result in anyexpense being recognized in the Company’s Consolidated Statements of Operations.The purpose of the accelerated vesting of stock options was to enable theCompany to avoid recognizing compensation expense associated with these optionsin 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).

 

As noted above, prior to January 1, 2006, inaccordance with APB 25, no compensation cost had been recognized for optionsgranted by the Company with an initial exercise price equal to the fair valueof the common stock, except for the application of Financial AccountingInterpretation No. 44, “Accounting for Certain Transactions Involving StockCompensation”, which resulted in non-cash income of $8,600 during the threemonths ended March 31, 2005, due to options granted during 2000 that wererepriced as of February 29, 2000 upon approval of the Board of Directors and theCompany’s shareholders. Had compensation cost for the Company’s stock grantsbeen determined based upon the fair value recognition provisions of SFAS 123 atthe grant date, the Company’s pro-forma net loss and loss per share for thethree months ended March 31, 2005 would have been as follows:

 
| ** **                                                                                              | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2005**                                         | ** ** |
| Net loss-as reported                                                                                    |       | $                                                | (1,722,000 | ) |
| Deduction for stock-based compensation  expense determined under fair value method net of tax-pro forma |       | 118,000                                          |       |
| Net loss pro forma                                                                                      |       | (1,840,000                                       | )          |
| Loss per share (basic) - as reported                                                                    |       | (0.08                                            | )          |
| Loss per share (basic) – pro forma                                                                 |       | (0.09                                            | )          |
| Loss per share (diluted) – as reported                                                             |       | (0.08                                            | )          |
| Loss per share (diluted) – pro forma                                                               |       | (0.09                                            | )          |
|                                                                                                         |            |                                                  |            |  |

 

Thefair value of each option granted by the Company was estimated on the grantdate using the Black-Scholes option-pricing model with the followingassumptions used for the grants:

 
| ** **                                                     | ** ** | **Three Months  Ended  March 31,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                                | ** ** |
| Dividend yield                                                 |       | 5.04                                    | %          |
| Risk-free interest rate                                        |       | 4.12                                    | %          |
| Volatility                                                     |       | 29.42                                   | %          |
| Expected life (years)                                          |       | 4.2                                     |       |
| Weighted average fair value of options granted during the year |       | $                                       | 3.93       |   |
|                                                                |            |                                         |            |  |

 

Thefollowing table summarizes stock option activity for the quarter ended March31, 2006:

 
| ** **                                  | ** ** | **Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Life (in years)** | ** ** | **Aggregate  Intrinsic  Value (in  thousands)** | ** ** |
|---------------------------------------------|------------|-------------|------------|----------------------------------------|------------|---------------------------------------------------|------------|-------------------------------------------------|------------|
| Outstanding and vested at December 31, 2005 |       | 1,769,238   |       | $                                      | 17.16      |                                              | 8.49       |                                            | —     |   |
| Expired                                     |       | 2,216       |       | $                                      | 33.44      |                                              | —     |                                            | —     |   |
| Outstanding and vested at March 31, 2006    |       | 1,767,022   |       | $                                      | 17.14      |                                              | 8.49       |                                            | $          | 2,394 |   |
|                                             |            |             |            |                                        |            |                                                   |            |                                                 |            |  |  |

 

Therewere no options granted or exercised in the first quarter of 2006. Theaggregate intrinsic value in the table above represents the total pretax valueof the in-the-money options, which value is determined by aggregating thespread between each of the in-the-money options and the exercise pricesthereof, assuming that all shareholders exercised their options on March 31,2006.

 

7

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

 

Thisamount will change based on the fair market value of the Company’s stock. TheCompany’s policy is to issue shares from authorized shares to fulfill stockoption exercises.

 

During the first quarter of 2006, no compensation expense was recordedbecause the Company did not grant any options during the quarter and all of theoptions outstanding at the date of adoption of SFAS 123(R) were fully vested.

 

**EmployeeStock Purchase Plan**

 

Under the 2004 Employee StockPurchase Plan, eligible employees are provided the opportunity to purchase theCompany’s common stock at a discount. Pursuant to this plan, options aregranted to participants as of the first trading day of each plan year, which isthe calendar 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 each plan year, an eligible employee mayelect to participate in the plan by filing a payroll deduction authorizationform for up to 10% (in whole percentages) of his or her compensation. Noemployee shall have the right to purchase the Company’s common stock under the 2004Employee Stock Purchase Plan which has a fair market value in excess of $25,000in any plan year. The purchase price is the lesser of 85% of the closing marketprice of the Company’s common stock on either the first trading day or the lasttrading day of the plan year. If an employee does not elect to exercise his orher option, the total amount credited to his or her account during that planyear is returned to such employee, and his or her option expires. As of March31, 2006, the 2004 Employee Stock Purchase Plan had 131,722 shares reserved forfuture issuance.

 

Thefair value of each option granted under the 2004 Employee Stock Purchase Planis estimated on the date of grant using the Black-Scholes option-pricing modelwith the following assumptions:

 
| ** **              | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------|------------|--------------------------------------------------|------------|
| ** **              | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Dividend yield          |       | —                                           |       | 1.33 | % |
| Risk-free interest rate |       | 4.38                                             | %          | 2.79 | % |
| Volatility              |       | 50.40                                            | %          | 41.70 | % |
| Expected life (years)   |       | 1                                                |       | 1 |   |

 

TheCompany estimates expected stock price volatility based on actual historicalchanges in the market value of the Company’s stock. The risk-free interest rateis based on the U.S. Treasury yield with a term that is consistent with theexpected life of the stock options. The expected life of stock options underthe 2004 Employee Stock Purchase Plan is one year, or the equivalent of theannual plan year. The impact of SFAS 123(R) for the 2004 Employee StockPurchase plan for the first quarter of 2006 was immaterial to the Company’sunaudited consolidated financial statements.

 

**NOTE 3 - WEIGHTED AVERAGE COMMON SHARES**

 

Areconciliation of weighted average common shares outstanding to weighted averagecommon shares outstanding assuming dilution is as follows:

 
| ** **                                                                 | ** ** | **Three Months Ended March 31,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Weighted average common shares outstanding                                 |       | 20,836,000                                           |       | 20,824,000 |   |
| Dilutive effect of common shares issuable  under outstanding stock options |       | —                                               |       | — |   |
| Weighted average common shares outstanding  assuming dilution              |       | 20,836,000                                           |       | 20,824,000 |   |

 

The average number of diluted shares outstanding for the three monthsended March 31, 2006 and 2005 exclude shares relating to stock options becausethere was a net loss and such shares would have been anti-dilutive. Stockoptions to purchase approximately 1.8 million and 0.6 million shares wereoutstanding at March 31, 2006 and 2005, respecitvely.

 

8

----

 

**NOTES TO UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

 

**N****OTE 4 – CONTINGENCY**

 

Aspreviously disclosed, the Company purchased all of the outstanding equityinterests and warrants in Kids Line, LLC (the “Purchase”), in accordance withthe terms and provisions of a Membership Interest Purchase Agreement (the “PurchaseAgreement”) in December 2004. At closing, the Company paid approximately $130.5million, which represented the portion of the purchase price due at closingplus various transaction costs, which was subsequently adjusted to $130.6million. The aggregate purchase price under the Purchase Agreement includes thepotential 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 ended November 30, 2007), and shall be paid at the timesdescribed in the Purchase Agreement (approximately the third anniversary of theclosing date). The Agreed Enterprise Value shall be the product of (i) KidsLine’s EBITDA during the twelve (12) months ending on the last day of theMeasurement Period and (ii) the applicable multiple (ranging from zero toeight) as set forth in the Purchase Agreement. The amount of the EarnoutConsideration will be charged to goodwill when and if it is earned.

 

**NOTE 5 – DEBT**

 

Inconnection with the purchase of Kids Line in December 2004, the Company andcertain of its subsidiaries entered into a financing agreement (the “FinancingAgreement”). The Financing Agreement consisted of a term loan in the originalprincipal amount of $125.0 million which was scheduled to mature onNovember 14, 2007 (the “2004 Term Loan”).  The Company used theproceeds of the 2004 Term Loan to substantially finance the Purchase and payfees and expenses related thereto.  The 2004 Term Loan was repaid in fulland the Financing Agreement was terminated in connection with the execution ofthe 2005 Credit Agreement, discussed below, as of June 28, 2005. There were no fees paid as a result of the early termination of the FinancingAgreement.  However, in conjunction therewith, the Company wrote off theremaining unamortized balance of approximately $4.8 million in deferredfinancing costs.

 

Inorder to reduce overall interest expense and gain increased flexibility withrespect to the financial covenant structure of the Company’s senior financing,on March 14, 2006, the 2005 Credit Agreement (described below) was terminatedand the obligations thereunder were refinanced (the “LaSalle Refinancing”). Inconnection 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), which is part of the LaSalle Refinancing. TheCompany paid a fee of approximately $1.3 million in connection with the earlytermination of the 2005 Credit Agreement, which was scheduled to mature on June28, 2010. In addition, the Company wrote off, in the first quarter of 2006,approximately $2.5 million in deferred financing costs in connection with theLaSalle Refinancing.

 

Aspart of 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 itsgift business, such that separate loan facilities could be made directlyavailable to each of the Company’s domestic gift business and infant andjuvenile business, respectively. The Assignment transaction reinforces theoperation of the Company as two separate segments, and the credit facilitiesthat have been extended to each segment are separate and distinct. There are nocross-default provisions between the new Infantline Credit Agreement andGiftline Credit Agreement (described below).

 

Long-termdebt at March 31, 2006 and December 31, 2005 consists of the following:

 
| ** **                                    | ** ** | **March 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|-----------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| Term Loan A (2005 Credit Agreement)           |       | $                            | —     |                            | $          | 4,593,000 |   |
| Term Loan B (2005 Credit Agreement)           |       | —                       |       | 40,000,000                      |       |
| Term Loan (2006 Infantline Credit  Agreement) |       | 59,250,000                   |       | —                          |       |
|                                          |       | 59,250,000                   |       | 44,593,000                      |       |
| Less current portion                          |       | 9,000,000                    |       | 2,600,000                       |       |
| Long-term debt                                |       | $                            | 50,250,000 |                            | $          | 41,993,000 |   |

 

9

----

 

**NOTES TO UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

 

1.             The LaSalleRefinancing – Effective March 14, 2006

 

*A. The Infantline Credit Agreement*

 

On March 14, 2006 (the “Closing Date”), Kids Line, LLC (“KL”) andSassy, Inc. (“Sassy”, and together with KL, the “Infantline Borrowers”) enteredinto a credit agreement as borrowers, on a joint and several basis, withLaSalle Bank 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 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 the Infantline Credit Agreement (the “InfantlineCommitments”) consist of (a) a $35.0 million revolving credit facility (the “RevolvingLoan”), with a subfacility 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”). TheInfantline Borrowers drew down approximately $79.7 million on 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 LaSalleRefinancing.

 

The principal of the Term Loan will be repaid in installments asfollows: (a) $0.75 million on the last day of each calendar month for theperiod commencing March 2006 through and including February 2008, (b) $1.0million on the last day of each calendar month for the period commencing March2008 through and including February 2009 and $1.25 million on the last day ofeach calendar month for the period commencing March 2009 through and includingFebruary 2011. A final installment in the aggregate amount of the unpaidprincipal balance of the Term Loan (in addition to all outstanding amountsunder the Revolving Loan) is due and payable on March 14, 2011, in each casesubject to customary early termination provisions in accordance with the termsof the Infantline Credit Agreement.

 

The Infantline Loans bear interest at a rate per annum equal to theBase Rate (for Base Rate Loans) or the LIBOR Rate (for LIBOR Loans), at theCompany’s option, plus an applicable margin, in accordance with a pricing gridbased on the most recent quarter-end Total Debt to EBITDA Ratio, whichapplicable margin shall range from 1.75% - 2.50% for LIBOR Loans and from 0.25%- 1.00% for Base Rate Loans; *provided,however*, that from the closing date under the Infantline CreditAgreement until delivery of the financial statements and compliance certificatewith respect to each of the fiscal year ended December 31, 2005 and the fiscalquarter ending March 31, 2006 (the “Initial Period”), the applicable interestrate margins shall be as follows:  2.25%for LIBOR Loans and 0.75% for Base Rate Loans.

 

Interest is due and payable (i) with respect to Base Rate Loans,monthly in arrears on the last day of each calendar month, upon a prepaymentand at maturity and (ii) with respect to LIBOR Loans, on the last day of eachInterest Period, upon a prepayment (and if the Interest Period is in excess ofthree months, on the three-month anniversary of the first day of such InterestPeriod), and at maturity.

 

In connection with the execution of the Infantline Credit Agreement,the Infantline Borrowers paid aggregate closing fees of $1.4 million and anaggregate agency fee of $25,000. An aggregate agency fee of $25,000 will bepayable on each anniversary of the Closing Date. The Revolving Loan is subjectto an annual non-use fee (payable monthly, in arrears, and upon termination ofthe relevant obligations) of 0.50% for unused amounts under the Revolving Loan,an annual letter of credit fee (payable monthly, in arrears, and upon terminationof the relevant obligations) for undrawn amounts with respect to each letter ofcredit based on the most recent quarter-end Total Debt to EBITDA Ratio rangingfrom 1.75% - 2.50% and other customary letter of credit administration fees. Inaddition, if the credit facility is terminated for any reason prior to thefirst anniversary of the Closing Date, the Infantline Borrowers shall pay anaggregate early termination fee of approximately $1.0 million.

 

The Infantline Borrowers are required to make prepayments of the TermLoan upon the occurrence of certain transactions, including most asset sales ordebt or equity issuances, and, commencing with fiscal year 2007, annualmandatory prepayments of the Term Loan shall be required in an amount equal to50% of Excess Cash Flow for each fiscal year unless the Total Debt to EBITDARatio for such fiscal year was 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 ofMarch 31, 2006, the Company was in compliance with the financial covenantscontained in the Infantline Credit Agreement.

 

10

----

 

**NOTES TO UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

 

The InfantlineCredit Agreement contains significant limitations on the ability of theInfantline Borrowers to distribute cash to Russ Berrie and Company, Inc. (“RB”),a corporate holding company, for the purpose of paying dividends to theshareholders of the Company or for the purpose of paying RB’scorporate overhead expenses, including a cap (subject to certain exceptions) of$2.0 million per year on the amount that can be provided to RB to pay corporateoverhead expenses.

 

As a result ofthe LaSalle Refinancing, the obligation to pay the Earnout Considerationpursuant to the Kids Line acquisition (see Note 4) is no longer the obligationof RB, but the joint and several obligation of 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 the obligations of the Infantline Borrowers, (i) theInfantline Borrowers have pledged and have granted security interests to theAgent in substantially all of their existing and future personal property, (ii)each Infantline Borrower has guaranteed the performance of the other InfantlineBorrower, (iii) Sassy granted a mortgage for the benefit of the Agent and thelenders on its real property located at 2305 Breton Industrial Park Drive,S.E., Kentwood, Michigan and (iv) the Company pledged 100% of the equityinterests of each of the Infantline Borrowers to the Agent (the “InfantlinePledge Agreement”). Pursuant to the Infantline Pledge Agreement, RB has agreedthat it will function solely as a holding company and will not, without theprior written consent of the Agent, engage in any business or activity exceptfor specified activities, including those relating to its investments in itssubsidiaries existing on the Closing Date, the maintenance of its existence andcompliance with law, the performance of obligations under specified contractsand other specified ordinary course activities.

 

TheInfantline Loans bear interest at a rate per annum equal to the sum of the BaseRate (for Base Rate Loans) or the LIBOR Rate (for LIBOR Loans) plus anapplicable margin, in accordance with a pricing grid based on the most recentquarter-end Total Debt to EBITDA Ratio.  The weighted average interestrates for the three months ended March 31, 2006 were as follows:

 
| ** **           | ** ** | **LIBOR loans** | ** ** | **Base rate**** ****loans** | ** ** |
|----------------------|------------|----------------------|------------|---------------------------------------|------------|
| Infantline Revolver  |       | 7.16                 | %          | 8.50                                  | %          |
| Infantline Term Loan |       | 7.28                 | %          | 8.50                                  | %          |

 

Interestis due and payable (i) with respect to Base Rate Loans, monthly in arrearson the last day of each calendar month, upon a prepayment and at maturity and(ii) with respect to LIBOR Loans, on the last day 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.

 

*B. The Giftline Credit Agreement*

 

On March 14, 2006 as amended on April 11, 2006 (to clarify theapplication of a financial covenant), Russ Berrie U.S. Gift, Inc. (“Newco”) andother specified wholly-owned domestic subsidiaries of the Company(collectively, the Giftline Borrowers”), entered into a credit agreement asborrowers, on a joint and several basis, with LaSalle Bank NationalAssociation, as issuing bank (the “Issuing Bank”), LaSalle Business Credit, LLCas administrative agent (the “Administrative Agent”), the lenders from time totime party thereto, and the Company, as loan party representative (as amended,the “Giftline Credit Agreement” and, together with the Infantline CreditAgreement, the “2006 Credit Agreements”). Unless otherwise specified herein,capitalized terms used but undefined in this Note 5 Section 1.B shall have themeanings ascribed to them in the Giftline Credit Agreement.

 

TheGiftline Credit Agreement contemplates the potential inclusion of additionallenders subsequent to the initial closing, which as of May 31, 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 sub facility for letters of credit to be issued by theIssuing Bank in an amount not to exceed $8.0 million. The Borrowing Base isprimarily a function of a percentage of eligible accounts receivable andeligible inventory and, as of March 31, 2006, the Borrowing Base, inclusive ofthe Borrowing Base provided under the Canadian Credit Agreement, wasapproximately $19.1 million. The Giftline Borrowers did not draw down on theGiftline Revolver on the Closing Date and, as of March 31, 2006, there are noamounts outstanding under the Giftline Revolver.

 

11

----

 

**NOTES TO UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

 

All outstanding amounts under the Giftline Revolver are due and payableon March 14, 2011, subject to earlier termination in accordance with the termsof the Giftline Credit Agreement.

 

The Giftline Revolver bears interest at a rate per annum equal to thesum of the Base Rate (for Base Rate Loans) or the LIBOR Rate (for LIBOR Loans),at the Company’s option, plus a margin of 2.75% for LIBOR Loans and 1.25% forBase Rate Loans. Interest is due and payable in the same manner as with respectto the Infantline Loans.

 

In connection with the execution of the Giftline Credit Agreement, theInfantline Borrowers paid (on behalf of the Giftline Borrowers) aggregateclosing fees of $0.15 million and an aggregate agency fee of $20,000. Aggregateagency fees of $20,000 will be payable by the Giftline Borrowers on eachanniversary 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 commitmentunder the Giftline Credit Agreement is increased, an additional fee equal to1.0% of the increase will be required. In addition, if the Termination Date(which includes customary termination events) occurs prior to the firstanniversary of the Closing Date, the Giftline Borrowers shall pay a terminationfee equal to 1.0% of the highest Maximum Revolving Commitment that had been ineffect at any time prior to such termination.

 

All accounts of the Giftline Borrowers are required to be with theAdministrative Agent or its affiliates, and cash in such accounts will be swepton a daily basis to pay down outstanding amounts under the Giftline Revolver.

 

The GiftlineCredit Agreement contains customary affirmative and negative covenantssubstantially similar to those applicable to the Infantline Credit Agreement. Inaddition, the Giftline Credit Agreement contains the following financial covenants(the “Giftline 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 ended March 31, 2008). In addition, at any timeafter December 31, 2007 in respect of which the Fixed Charge Coverage Ratio forthe Computation Period ending as of the fiscal quarter end most recentlypreceding such date was less than 1.00:1.00, the aggregate amountsoutstanding under the Giftline Credit Agreement and the Canadian LoanAgreement may not exceed $10.0 million. As of March 31, 2006, the Company wasin compliance with the financial covenants contained in the Giftline CreditAgreement.

 

The GiftlineCredit Agreement contains significant limitations on the ability of theGiftline Borrowers to distribute cash to RB for the purpose of paying dividendsto the shareholders of the Company or for the purpose of payingthe RB’s corporate overhead expenses, including a cap (subject to certainexceptions) on the amount that can be provided to RB to pay corporate overheadexpenses equal to $4.5 millionper year for each of fiscal years 2006 and 2007, and $5.0 million for each fiscalyear thereafter.

 

In order to secure the obligations of the Giftline Borrowers, theGiftline Borrowers pledged and have granted security interests to theAdministrative Agent in substantially all of their existing and future personalproperty, and each Giftline Borrower guaranteed the performance of the otherGiftline Borrowers under the Giftline Credit Agreement. In addition, RBprovided a limited recourse guaranty of the obligations of the GiftlineBorrowers under the Giftline Credit Agreement. This guarantee is secured by alien on the assets intended to be assigned to Newco pursuant to the Assignment.RB also pledged 100% of the equity interests of each of the Giftline Borrowersand 65% of its equity interests in certain of its First Tier Foreign Subsidiariesto the Administrative Agent (the “Giftline Pledge Agreement”). The GiftlinePledge Agreement contains substantially similar limitations on the activitiesof RB as is set forth in the Infantline Pledge Agreement.

 

The Company’s ability tomaintain compliance with the financial covenants under the 2006 CreditAgreements is dependent, particularly in the case of the Giftline CreditAgreement, upon the successful implementation of the Company’s restructuringplan and the Profit Improvement Plan (described in Note 8 herein) and currentoperational plans. Based on these plans and management’s current projections,management believes that the Company will remain in compliance with thefinancial covenants in the 2006 Credit Agreements at least through March 31,2007. However, in the event that the Company is unable to successfullyimplement the key elements of the Profit Improvement Plan, there can be noassurance that the Company will remain in compliance with the financialcovenants in the 2006 Credit Agreements.

 

TheCommitments bear interest at a rate per annum equal to the sum of the Base Rate(for Base Rate Loans) or the LIBOR Rate (for LIBOR Loans) plus an applicablemargin.  Interest rates as of March 31, 2006 were as follows:  

 

12

----

 

**NOTES TO UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

 
| ** **        | ** ** | **LIBOR loans** | ** ** | **Base rate**** ****loans** | ** ** |
|-------------------|------------|----------------------|------------|---------------------------------------|------------|
| Giftline Revolver |       | —               |       | 9.00                                  | %          |

 

Interestis due and payable (i) with respect to Base Rate Loans, monthly in arrearson the last day of each calendar month, upon a prepayment and at maturity and(ii) with respect to LIBOR Loans, on the last day of each Interest Period,upon a prepayment (and if the Interest Period was in excess of three months, onthe three-month anniversary of the first day of such Interest Period), and atmaturity.

 

*C.**            Canadian CreditAgreement*

 

As contemplated by the 2005 Credit Agreement on June 28, 2005, theCompany’s Canadian subsidiary, Amram’s Distributing Ltd. (“Amrams”), executed aseparate Credit Agreement (acknowledged by the Company) with the financialinstitutions party thereto and LaSalle Business Credit, a division of ABN AMROBank, N.V., Canada Branch, a Canadian branch of a Netherlands bank, as issuingbank and administrative agent (the “Canadian Credit Agreement”), and relatedloan documents with respect to a maximum 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 the LaSalle Refinancing, the Canadian CreditAgreement was amended to (i) replace references to the LaSalle Credit Agreementwith the Giftline Credit Agreement (such that, among other conforming changes,a default under the Giftline Credit Agreement will be a default under theCanadian Credit Agreement), (ii) release RB from the Canadian Guaranty and(iii) provide for a maximum U.S. $5.0million revolving loan. In connection with the release of the Company from theCanadian Guaranty, Newco executed an unsecured Guarantee (the “Newco Guarantee”)to guarantee the obligations of Amrams under the Canadian Credit Agreement. Adefault under the Infantline Credit Agreement will not constitute a defaultunder the Canadian Credit Agreement.

 

*D.**            Economic DevelopmentAuthority (“EDA”) Loan Agreement*

 

Since1983, the Company had been a guarantor of the EDA Loan Agreement, pursuant towhich the EDA issued the EDA Bonds in the principal amount of $7.0 million tofinance the construction of the South Brunswick, New Jersey facility now leasedby the Company from the Estate of Mr. Russell Berrie. Mr. Berrie (and after hisdeath, his Estate) was the primary obligor with respect to the EDA Bonds. Inconnection therewith, the Company, in 1983, caused the issuance of a letter ofcredit in an amount of approximately $7.4 million to secure the paymentobligations with respect to the EDA Bonds and had granted a security intereston accounts receivable and inventory of the Company up to $2.0 million tosecure its obligations under its guarantee and the Amended and Restated Letterof Credit Reimbursement Agreement (“L/C RA”) executed in connection therewith.

 

Consummationof the Assignment, however, resulted in a covenant default under the documentsgoverning the EDA Bonds and a default under the L/C RA and, as a result, amongother things, would have permitted the EDA Standby L/C Issuer to demand cashcollateral in respect of the EDA Standby L/C. In consideration for theagreement of the EDA Standby L/C Issuer to refrain for a specified time periodfrom demanding such cash collateral or additional collateral, theAdministrative Agent had agreed to issue, on behalf of the Giftline Borrowers,a letter of credit in an approximate amount of $7.4 million (the “Back-Stop L/C”)that could have been drawn upon by the EDA Standby L/C Issuer under specifiedcircumstances, including any draw on the EDA Standby L/C or the failure of theEDA Bonds to be redeemed by August 15, 2006. In consideration for the establishmentof the Back-Stop L/C, the EDA Standby L/C Issuer granted to the AdministrativeAgent a 100% participation in all rights of the EDA Standby L/C Issuer underL/C RA, including the EDA Standby L/C.

 

OnApril 3, 2006, the Estate (with funds provided by Ms. Berrie) redeemed the EDABonds. As a result, the Company’s obligations under the guarantee discussedabove (as well as the L/C RA, all letters of credit and related securityinterests) are in the process of being terminated.

 

*E.**            Earnout Security Documents*

 

All capitalized terms used but undefined in this Note 5, Section 1.E “EarnoutSecurity Documents” section shall have the meanings ascribed to them in the “GiftlineCredit Agreement”.

 

As has been previously reported, the Company was obligated to pay theEarnout Consideration under the Kids Line Purchase Agreement. Pursuant to theLetter Agreement between the Infantline Borrowers and California KL Holdings,Inc., and the other parties thereto (the “Letter Agreement”), the InfantlineBorrowers have agreed, on a joint and several basis, to assume soleresponsibility to pay the Earnout Consideration in the place of the Company. Inconnection therewith, the Earnout Security Documents have been amended toeffect the partial release of the 

 

13

----

 

**NOTES TO UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

 

Company as obligor and the full release of the security interestsgranted thereunder by any Giftline Borrowers. To secure the obligations of theInfantline Borrowers to pay the Earnout Consideration, the Infantline Borrowershave granted a subordinated lien on substantially all of their assets, on ajoint and several basis, and RB has granted a subordinated lien on the equityinterests of each of the Infantline Borrowers to the Earnout Sellers Agent. Allsuch security interests and liens are subordinated to the senior indebtednessof the Infantline Borrowers arising under the Infantline Credit Agreement. TheEarnout Consideration is not secured by the Giftline Borrowers or their assetsor equity interests.

 

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 the financialinstitutions parties thereto as Facility A Lenders, the financial institutionsparties thereto as Facility B Lenders, LaSalle Bank National Association, inits capacity as “Issuing Bank” thereunder, LaSalle Business Credit, LLC (in itsindividual capacity, “LaSalle”), as administrative agent (in such capacity, the“Administrative Agent”) for the lenders and the Issuing Bank, and thoselenders, if any, designated therein as the “Documentation Agent” or “SyndicationAgent”.  On October 11, 2005, the Company and its lenders amendedprovisions of the 2005 Credit Agreement unrelated to the FinancialCovenants.  Unless otherwise specified herein, capitalized terms used butundefined herein shall have the meanings ascribed to them in the 2005 CreditAgreement.  Amounts available under the 2005 Credit Agreement were usedfor working capital requirements and general corporate purposes.

 

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”). Assuming no default or event of default, on the terms and conditions set forthin the 2005 Credit Agreement, and subject to the payment of applicable fees,the Revolving Loan could have been increased to a maximum of $75.0 million. 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).  A final installment in theaggregate amount of the unpaid principal balance of Term Loan A (in addition toall outstanding amounts under the Revolving Loan) was due and payable onJune 28, 2010, and the principal of Term Loan B was due and payable onDecember 28, 2010, in each case subject to earlier termination inaccordance with the terms of the 2005 Credit Agreement.  Notwithstandingthe foregoing, the Company was required to repay Term Loan B in full upon afull redemption of the Facility A Obligations.

 

Interestwas due and payable (i) with respect to Base Rate Loans, monthly inarrears on the last day of each calendar month, upon a prepayment and atmaturity and (ii) with respect to LIBOR Loans, on the last day of eachInterest Period, upon a prepayment (and if the Interest Period was in excess ofthree months, on the three-month anniversary of the first day of such InterestPeriod), and at maturity.

 

Inconnection with the execution of the 2005 Credit Agreement and the CanadianCredit Agreement, 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. The unamortizedbalance of these deferred financing costs were written off in the first quarterof 2006 as a result of the LaSalle Refinancing in March 2006. The RevolvingLoan was subject to an annual non-use fee (payable monthly, in arrears, andupon termination of the relevant obligations) based on the most recentquarter-end Total Debt to EBITDA Ratio ranging from 0.375% - 0.50% for unusedamounts under the Revolving Loan, an annual letter of credit fee (payablemonthly, in arrears, and upon termination of the relevant obligations) forundrawn amounts with respect to each letter of credit based on the most recentquarter-end Total Debt to EBITDA Ratio ranging from 1.50% - 2.25% (subject toincrease by 2.0% at any time an event of default exists), customary letter ofcredit administration fees and a letter of credit fronting fee in amountsagreed to by the Company and the Issuing Bank.  Notwithstanding theforegoing, during the Initial Period, the non-use fee was equal to 0.375% andthe letter of credit fee was equal to 1.75%.

 

The2005 Credit Agreement contained the following financial covenants (the “FinancialCovenants”):  (i) a minimum Fixed Charge Coverage Ratio, (ii) amaximum Total Debt to EBITDA Ratio and (iii) a minimum Excess RevolvingLoan Availability requirement of $2.5 million.  Excess Revolving LoanAvailability at December 31, 2005 was approximately $15.725 million.  Withrespect to dividends, the Company was permitted to pay a dividend 

 

14

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

 

solong as before and after giving effect to the payment of such dividends, ExcessRevolving Loan Availability would equal or exceed $15.0 million and noviolation of the Financial Covenants would then exist, or would, on a pro formabasis, result therefrom.  Any such dividends could be declared no morefrequently than quarterly and were required to take the form of regular cashdividends.  With respect to the Earnout Consideration, the Company was permittedto pay all or a portion of the Earnout Consideration to the extent that, beforeand after giving effect to such payment, Excess Revolving Loan Availabilitywould equal or exceed $15.0 million and no violation of the Financial Covenantswould then exist, or would, on a pro forma basis, result there from.  Asof December 31, 2005, the Company was not in compliance with the “TotalDebt to EBITDA Ratio” covenant in the 2005 Credit Agreement. However, because the Company completed theLaSalle Refinancing on March 14, 2006, the long-term debt at December 31, 2005was classified as long-term.

 

Ascontemplated by the 2005 Credit Agreement, the Company’s Canadian subsidiary,Amram’s Distributing Ltd. (“Amrams”), entered into on June 30, 2005, as ofJune 28, 2005, and amended as of August 4 and October 11, 2005,a separate credit agreement 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 (the “Canadian Credit Agreement”) withrespect to a maximum U.S. $10.0 million revolving loan (the “Canadian RevolvingLoan”), with a sub-facility for letters of credit in an amount not to exceedU.S. $2.0 million.  If there was no default or event of default occurringunder the Canadian Credit Agreement, upon the terms and conditions set forththerein, and subject to the payment of applicable fees, the Canadian RevolvingLoan could have been increased to a maximum commitment of U.S. $15.0million.  All outstanding amounts under the Canadian Revolving Loan wereto be due and payable on June 28, 2010, subject to earlier termination inaccordance with the terms of the Canadian Credit Agreement.

 

TheCanadian Revolving Loan would bear interest at a rate per annum equal to thesum of (x)(i) the Base Rate or the Canadian Base Rate (as defined in theCanadian Credit Agreement), at the option of Amrams (for Base Rate Loans) or(ii) the LIBOR Rate (for LIBOR Loans) plus (y) an applicable margin, inaccordance with a pricing grid based on the most recent quarter-end Total Debtto EBITDA Ratio.  The interest rate as of December 31, 2005 was7.25%.  The Canadian Credit Agreement is described in further detail inthe Quarterly Report on Form 10-Q for the period ended June 30, 2005. TheCanadian Credit Agreement was amended in connection with the execution of the2006 Credit Agreement, as described above.

 

Inorder to secure its obligations under the Canadian Credit Agreement, Amrams hasgranted security interests to the administrative agent thereunder insubstantially all of its real and personal property.  In addition, theCompany has executed an unsecured Guarantee (the “Canadian Guaranty”) toguarantee the obligations of Amrams under the Canadian Credit Agreement, whichguaranty was released in connection with the 2006 Credit Agreement. All amountsoutstanding under the 2005 Credit Agreement were paid in full in connectionwith the LaSalle Refinancing.

 

3.             2004 Term Loan – Effective December 14, 2004through June 28, 2005

 

Asnoted above, the Financing Agreement consisted of the 2004 Term Loan in theoriginal principal amount of $125 million and was scheduled to mature onNovember 14, 2007.  The 2004 Term Loan bore interest at anannual rate equal to a base rate (whichwas subject to a minimum rate of 4.75% per annum) plus a spread of4.25%, or a LIBOR rate (which wassubject to a minimum rate of 1.75% per annum) plus a spread of 7.0%. Thespreads were adjusted to 5.25% and 8.0%, respectively, pursuant to a March 2005amendment, subject to further adjustment downward if certain EBITDA milestoneswere met. Pursuant to the amendment, the Company also prepaid $18.25 million ofthe 2004 Term Loan.

 

Underthe Financing Agreement, as amended, the Company was required to makeprepayments of the 2004 Term Loan in an amount equal to $1.75 million perquarter with the balance due at maturity. In addition, beginning with thefiscal year ending December 31, 2005, the Company would have been requiredto make annual mandatory prepayments of the Term Loan, with specifiedpercentages of excess cash flow and the proceeds of certain asset sales, debtissuances, equity issuances, tax refunds, insurance and other extraordinaryreceipts.

 

Tosecure the 2004 Term Loan, Ableco Finance LLC, as agent, had a lien onsubstantially all of the assets of the Company, and California KLHoldings, Inc., as agent, had a subordinated lien on these assets. TheCompany also pledged the equity interests of certain of its subsidiaries to theagent and provided an evergreen irrevocable letter of credit in an amount of$10.0 million, which the agent could draw upon if there was an event of defaultor other events specified under the Financing Agreement occurred.  Inaddition, the Company’s domestic subsidiaries provided certain guarantees andsecurity interests to the agent in order to secure the Company’s obligations.

 

TheFinancing Agreement, as originally executed, contained, among other things,various monthly and quarterly financial covenants to which the Company and itssubsidiaries were subject, including a Funded Debt Ratio, a Fixed 

 

15

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

 

ChargeCoverage Ratio, a Consolidated EBITDA covenant, an Infant Line EBITDA covenantand a Minimum Qualified Cash covenant. The amendment referred to above wasexecuted because the Company believed that it would not be in compliance, as ofMarch 31, 2005, with the Consolidated EBITDA Covenant and the Funded DebtRatio set forth in the Financing Agreement as originally executed, and hadsubstantial concerns over whether the Company would be in compliance with suchcovenants for the remainder of 2005.

 

TheFinancing Agreement was paid in full using the proceeds from the 2005 CreditAgreement.

 

**NOTE 6 – GOODWILL AND INTANGIBLE ASSETS**

 

Intangibleassets consist of the following:

 
| ** **                                  | ** ** | **Weighted  Average  Amortization  Period** | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------|------------|---------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| MAM distribution agreement and relationship |       | Indefinite life                             |       | $                        | 10,400,000 |                        | $          | 10,400,000 |   |
| Sassy trade name                            |       | Indefinite life                             |       | 7,100,000                |       | 7,100,000                   |       |
| Applause trade name                         |       | Indefinite life                             |       | 7,646,000                |       | 7,646,000                   |       |
| Kids Line customer relationships            |       | Indefinite life                             |       | 31,100,000               |       | 31,100,000                  |       |
| Kids Line trade name                        |       | Indefinite life                             |       | 5,300,000                |       | 5,300,000                   |       |
| Other intangible assets                     |       | 0.3 years                                   |       | 46,000                   |       | 53,000                      |       |
|                                        |       |                                        |       | $                        | 61,592,000 |                        | $          | 61,599,000 |   |

 

Otherintangible assets as of March 31, 2006 and December 31, 2005, include Kids Lineand Sassy non-compete agreements which are being amortized over four and fiveyears, respectively. Amortization expense was $7,000 and $0.3 million for thefirst three months of 2006 and 2005, respectively.

 

Allof the Company’s goodwill is in the infant and juvenile segment. There were nochanges to the carrying amount of goodwill for the three months ended March 31,2006.

 

**NOTE 7 - DIVIDENDS**

 

Nocash dividends were paid during the three months ending March 31, 2006 and 2005.See Note 5 for a discussion of dividendrestrictions imposed by the Company’s senior bank facilities.

 

**NOTE 8 – COST ASSOCIATED WITH DISPOSAL ACTIVITY**

 

InNovember 2005, the Company continued its prior restructuring of its domesticgift business 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.  The restructuring includedthe immediate elimination of approximately 50 positions, which resulted in apre-tax restructuring charge of approximately $1.4 million in the fourthquarter of 2005, primarily related to employee severance costs. Additionalrestructuring charges of approximately $1.5 million were incurred in 2005primarily as a result of right-sizing the Company’s Eastern Asian and Europeangift operations. As part of the restructuring, the Company also commenced aplan to reduce its facilities expenses by rationalizing certain warehouse anddistribution activities in 2006.

 

Duringthe first quarter of 2006, in accordance with its November 2005 restructuringplan, the Company recorded a $0.6 million restructuring charge related toseverance costs of employees at its Petaluma, California distribution centerwhich is scheduled for closure in the second quarter of 2006, and reduced salesstaffing in its U.S. gift segment. The Company recorded an additionalrestructuring charge of $2.1 million in the first quarter of 2006 attributableto the downsizing of its operations in Europe under its Profit ImprovementProgram, primarily related to employee severance costs.

 

16

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

 

TheCompany reassesses the reserve requirements under the restructuring efforts atthe end of each reporting period. A rollforward of the restructuring accrual isset forth below:  

 
| ** **         | ** ** | **Employee**   | ** ** | **Facility**        | ** ** | ** ** | ** ** |
|--------------------|------------|----------------|------------|---------------------|------------|------------|------------|
| ** **         | ** ** | **Separation** | ** ** | **Exit Costs** | ** ** | **Total**  | ** ** |
| Balance @ 12/31/05 |       | $              | 1,731,000  |                | $          | 131,000    |       | $ | 1,862,000 |   |
| 2006 Provision     |       | 2,650,000      |       | —              |       | 2,650,000  |       |
| Less Payments      |       | 1,500,000      |       | 8,000               |       | 1,508,000  |       |
| Balance @ 3/31/06  |       | $              | 2,881,000  |                | $          | 123,000    |       | $ | 3,004,000 |   |

 

**NOTE 9 – SEGMENTS OF THE COMPANY AND RELATEDINFORMATION**

 

The Company operates in two segments: (i) theCompany’s gift business and (ii) the Company’s infant and juvenile business, whichincludes the Company’s July 26,2002 acquisition of Sassy, Inc. and the Company’s December 15, 2004acquisition of Kids Line, LLC. This segmentation of the Company’s operationsreflects how the Company’s Chief Executive Officer currently views the resultsof operations. There are no inter-segment revenues to eliminate. Corporateassets and overhead expenses are included in the gift segment.

 

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. The Company’s infant and juvenile businesses design and marketproducts in a number of baby categories including, among others, infant beddingand accessories, bath toys and accessories, developmental toys, feeding itemsand baby comforting products. These products are sold to consumers, primarilyin the United States, through mass merchandisers, toy specialty, food, drug andindependent retailers, apparel stores and military post exchanges. 

 
| ** **                                        | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------------------------------------------|------------|------------------------------------------------------|------------|
| **(Dollars in thousands)**              | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| **Gift:**                                         |       |                                                 |       |   |   |
| Net sales                                         |       | $                                                    | 40,031     |   | $ | 37,905 |   |
| Selling, general and administrative  expenses (a) |       | 27,025                                               |       | 25,911 |   |
| Operating loss                                    |       | (11,081                                              | )          | (7,676 | ) |
| Other income                                      |       | 247                                                  |       | 27 |   |
| Depreciation and amortization                     |       | 1,188                                                |       | 1,435 |   |
| Loss before income taxes                          |       | $                                                    | (10,834    | ) | $ | (7,649 | ) |
|                                              |       |                                                 |       |   |   |
| **Infant and juvenile:**                          |       |                                                 |       |   |   |
| Net sales                                         |       | $                                                    | 37,328     | ** ** | $ | 32,835 | ** ** |
| Selling, general and administrative  expenses     |       | 4,753                                                |       | 4,774 |   |
| Operating income                                  |       | 11,149                                               |       | 8,387 |   |
| Other expense (b)                                 |       | (5,574                                               | )          | (3,478 | ) |
| Depreciation and amortization                     |       | 207                                                  |       | 463 |   |
| Income before income taxes                        |       | $                                                    | 5,575      |   | $ | 4,909 |   |
|                                              |       |                                                 |       |   |   |
| **Consolidated:**                                 |       |                                                 |       |   |   |
| Net sales                                         |       | $                                                    | 77,359     |   | $ | 70,740 |   |
| Selling, general and administrative  expenses     |       | 31,778                                               |       | 30,685 |   |
| Operating income                                  |       | 68                                                   |       | 711 |   |
| Other expense                                     |       | (5,327                                               | )          | (3,451 | ) |
| Depreciation and amortization                     |       | 1,395                                                |       | 1,898 |   |
| Loss before income taxes                          |       | $                                                    | (5,259     | ) | $ | (2,740 | ) |

 

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(a)   Included in the gift segment selling, generaland administrative expense in the first quarter of 2006 was $2.7 million incharges associated with restructuring activities in the U.S. and European giftdivisions and $1.3 million of consulting costs incurred in connection with thedevelopment of the PIP.

 

(b)   Included in the infant and juvenile segmentother expense in the first quarter of 2006 was the write-off of $2.5 million indeferred financing costs and a prepayment penalty of $1.3 million associatedwith the Company’s new debt facility.

 

17

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

 

Totalassets of each segment were as follows:

 
| **(Dollars in thousands)** | ** ** | **March 31, 2006** | ** ** | **December 31, 2005*** | ** ** |
|--------------------------------------|------------|------------------------------|------------|----------------------------------|------------|
| Gift                                 |       | $                            | 113,269    |                             | $          | 131,352 |   |
| Infant and juvenile                  |       | 200,076                      |       | 199,240                          |       |
| Total                                |       | $                            | 313,345    |                             | $          | 330,592 |   |

 

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*December 31, 2005 balances have been reclassifiedto conform to the March 31, 2006 presentation.

 

**Concentration of Risk**

 

Approximately89% of purchases are attributable to manufacturers in the People’s Republic ofChina. The supplier accounting for the greatest dollar volume of purchasesaccounted for approximately 16% and the five largest suppliers accounted forapproximately 40% in the aggregate.  The Company utilizes approximately130 manufacturers in Eastern Asia and believes that there are many alternativemanufacturers for the Company’s products and sources of raw materials.  Asa result, the Company does not believe there is a concentration of riskassociated with any significant relationship.

 

Inaddition, Toys “R” Us, Inc. and Babies “R” Us, Inc. in the aggregate accountedfor 20.8% of the Company’s consolidated net sales during the three month periodended March 31, 2006.

 

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

 

Certainof the Company’s subsidiaries periodically enter into foreign currency forwardexchange contracts to hedge inventory purchases, both anticipated and firmcommitments, denominated in the United States dollar. These contracts reduceforeign currency risk caused by changes in exchange rates and are used tooffset the currency impact of these inventory purchases, generally for periodsup to 13 months. At March 31, 2006, the Company’s forward contracts haveexpiration dates which range from one to seven months.

 

TheCompany accounts for its forward exchange contracts as an economic hedge, withsubsequent changes in fair value recorded in the Consolidated Statements ofOperations. As of March 31, 2006, unrealized gains of $0.13 million relating toforward contracts are included in other current assets and as ofDecember 31, 2005, unrealized losses of $0.16 million are included inaccrued expenses in the Consolidated Balance Sheets.

 

TheCompany has forward contracts to exchange British pounds sterling, Canadiandollars and Australian dollars for United States dollars with notional amountsof $3.6 million and $3.3 million as of March 31, 2006 and December 31,2005, respectively. The Company has forward contracts to exchange United Statesdollars to Euros with notional amounts of $5.0 million and $6.4 million as ofMarch 31, 2006 and December 31, 2005, respectively. The Company does notanticipate any material adverse impact on its results of operations orfinancial position from these contracts.

 

18

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

 

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

 

Comprehensive(Loss)/Income, representing all changes in Shareholders’ Equity during theperiod other than changes resulting from the issuance or repurchase of theCompany’s common stock and payment of dividends, is reconciled to net loss forthe three months ended March 31, 2006 and 2005 as follows:

 
| ** **                                                                    | ** ** | **Three Months Ended March 31,** | ** ** |
|-------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                    | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Net loss                                                                      |       | $                                                    | (4,992,000 | ) | $ | (1,722,000 | ) |
| Other comprehensive income/(loss), net of  tax:                               |       |                                                 |       |   |   |
| Foreign currency translation adjustments                                      |       | 51,000                                               |       | (1,448,000 | ) |
| Net unrealized gain on foreign currency  forward exchange contracts and other |       | —                                               |       | 79,000 |   |
| Other comprehensive income/(loss)                                             |       | 51,000                                               |       | (1,369,000 | ) |
| Comprehensive loss                                                            |       | $                                                    | (4,941,000 | ) | $ | (3,091,000 | ) |

 

**NOTE 12 – LITIGATION AND COMMITMENTS**

 

Inthe ordinary course of its business, the Company is party to various copyright,patent and trademark infringement, unfair competition, breach of contract,customs, employment and other legal actions incidental to its business, asplaintiff or defendant. In the opinion of management, the amount of ultimateliability with respect to these actions will not materially adversely affectthe consolidated results of operations, financial condition or cash flows ofthe Company.

 

Inconnection with the Company’s purchase of Kids Line LLC, the aggregate purchaseprice includes a potential payment of Earnout Consideration as more fullydescribed in Note 4. The amount of Earnout Consideration, if any, is notcurrently determinable.

 

TheCompany enters into various license agreements relating to trademarks,copyrights, designs, and products which enable the Company to market itemscompatible 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. Some ofthese license agreements include prepayments and minimum guarantee royaltypayments. The amount of guaranteed royalty payments with respect to all licenseagreements over the next three years aggregates $5.5 million. At December 31,2005, the Company recorded a pre-tax charge of $2.3 million against theseroyalty guarantees. The Company’s royalty expense for the first three months of2006 and 2005 were $0.6 million and $0.4 million, respectively.

 

**NOTE 13 – RECENTLY ISSUED ACCOUNTING STANDARDS**

 

InDecember 2004, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), which establishesstandards for transactions in which an entity exchanges its equity instrumentsfor goods or services. This statement is a revision to SFAS 123 and supersedesAPB 25. SFAS 123(R) requires companies to recognize an expense for compensationcost related to share-based payment arrangements, including stock options andemployee stock purchase plans, based on the grant-date fair value of the award.This standard applies to all awards unvested or granted as of the requiredeffective date and to awards modified, repurchased, or cancelled after thatdate. SFAS 123(R) became effective for the Company beginning with the firstquarter of 2006 and was adopted by the Company as of January 1, 2006  See Note 2 for further discussion of theimpact of SFAS 123(R), as well as the valuation methodology and assumptionsutilized.

 

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**ITEM 2.  MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

Thefinancial and business analysis below provides information which the Companybelieves is relevant to an assessment and understanding of the Company’sconsolidated financial condition, changes in financial condition and results ofoperations. This financial and business analysis should be read in conjunctionwith the Company’s consolidated financial statements and accompanying Notes toUnaudited Consolidated Financial Statements set forth in Part I, FinancialInformation, Item 1, “Financial Statements” of this Quarterly Report onForm 10-Q and the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2005, as amended (the “2005 10-K”).

 

**OVERVIEW**

 

TheCompany is a leader in the gift industry. The Company’s gift business designs,manufactures through third parties and markets a wide variety of gift productsto retail stores throughout the world. The Company’s infant and juvenilebusinesses design, manufacture through third parties and market products in anumber of baby categories, including infant bedding and accessories, bath toysand accessories, developmental toys, feeding items and baby comfortingproducts. These products are sold to consumers, primarily in the United States,through mass merchandisers, toy, specialty, food, drug and independentretailers, apparel stores, military post exchanges and other venues.

 

TheCompany’s revenues are primarily derived from sales of its products, asignificant portion of which are attributable to its gift segment. Sales andoperating profits in the Company’s gift segment began to decline during 2003 asa result of several factors including: (i) retailer consolidation and adeclining number of independent retail outlets, which in turn had a negativeimpact on sales from such outlets; (ii) increased competition from otherentities, both wholesalers and retailers, which offered lower pricing andachieved greater customer acceptance of their products; and (iii) changingbuying habits of consumers, marked by a shift from independent retailers tomass market retailers. Commencing in the third quarter of 2003, the Companybegan to implement a multi-pronged approach to address these trends, whichconsists of: (i) focusing on categorizing and rationalizing its productrange; (ii) segmenting its selling efforts to address customerrequirements and shifting channels of distribution; (iii) increasing itsfocus on national accounts, in order to build and strengthen the Company’spresence in the mass market through the use if its APPLAUSE® trademark as themass market brand platform; (iv) focusing on growing its internationalbusiness and infant and juvenile segments; (v) selectively increasing itsuse of licensing to differentiate its products from its competitors; (vi) implementing a three tiered “good”, “better”, “best” brandingstrategy within its gift segment to differentiate products sold into the massmarket, the Company’s traditional specialty retail market and the upscaledepartment store market; and (vii) ”right-sizing” its operations in orderto reduce overhead expenses through headcount reductions and the closure ofcertain domestic showrooms and warehouses.

 

TheCompany has continued to address the challenges in its gift business throughthe multi-pronged approach discussed above, which has enabled the Company toreduce significantly its operating expenses. However, the Company achieved onlylimited success in reversing the challenges facing its gift business and theindustry in general. As a result, in November 2005, the Company commencedthe implementation of a further restructuring of its domestic gift businessdesigned to “right size” the infrastructure consistent with existing businesslevels and re-align domestic gift operations to better meet the needs ofdifferent distribution channels. The restructuring included the immediateelimination of approximately 50 positions, which resulted in a pre-taxrestructuring charge of approximately $1.4 million in the fourth quarter of2005, primarily related to employee severance costs. As part of theNovember 2005 restructuring, the Company also commenced a plan to reduceits facilities expenses by rationalizing certain warehouse and distributionactivities, as further described below. In addition, in connection with theNovember 2005 restructuring, the Company conducted another comprehensivereview of its gift product line to identify product categories and individualitems that did not fit into its future sales and marketing plans. As a result ofproduct line decisions made in the fourth quarter of 2005, an additionalinventory write-down of $4.2 million (pre-tax) was recorded in the fourthquarter of 2005. The Company is selling substantially all of this inventorythrough other than its normal sales channels. The Company expects to incuradditional restructuring costs as it continues to implement theNovember 2005 restructuring plan and expects to incur furtherrestructuring costs as it implements the Profit Improvement Program currentlyunder development, as described below.

 

Managementbelieves that future operating expenses will be reduced by approximately $15.0million on an annualized basis as a result of the restructuring commenced inNovember 2005. A portion of these expense savings related to employeeexpenses were reflected in the Company’s results of operations for the fourthquarter of 2005, and the remaining cost reductions are expected to be achievedduring 2006. Severance payments to employees impacted by the November 2005restructuring will continue through the end of 2006, although such paymentswill not impact the Company’s results of operations, as they were reflected inthe restructuring charge recorded in the fourth quarter of 2005.

 

20

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Duringthe first quarter of 2006, in accordance with its November 2005 restructuringplan, the Company recorded a $0.6 million restructuring charge related to severancecosts of employees at its Petaluma, California distribution center which isscheduled for closure during the second quarter of 2006 and reduced salesstaffing in its U.S. gift segment.  Inaddition to these restructuring costs, the Company incurred $0.2 millionrelated to moving inventory from the Petaluma, California warehouse facility toCranbury, New Jersey.  The Companyrecorded an additional restructuring charge of $2.1 million in the firstquarter of 2006 attributable to the downsizing of its operations in Europeunder its Profit Improvement Program, primarily related to employee severancecosts.

 

Asan expansion of its November 2005 restructuring and ongoing analysis, in2006, the Company commenced the development and phased implementation of aProfit Improvement Program (“PIP”) with respect to its global gift business.The Company has retained the services of an independent advisor to assist inthe development of the PIP and during the first quarter of 2006, the Company incurredconsulting expense of approximately $1.3 million in connection with serviceprovided by such advisor. The PIP involves an analysis and, in some instances,re-evaluation of key operational aspects of the Company’s gift business andwill, when completed, be designed to help enable the Company to return its giftbusiness to a sustainable level of profitability. The PIP is expected toinvolve reengineering the manner in which the gift segment operates, and willlikely involve reducing the size of the gift business by focusing on the mostprofitable products, customers and territories as a means of providing a platform forpotential profitable growth in the future. The scope of the PIP is intended tobe broad and significant and may cause losses to our business that wecannot predict, including a loss of gift segment sales. Although the Companyhas not yet completed the development of the PIP, its implementation (portionsof which are already underway in phases) will result in the recognition ofcertain restructuring charges and the incurrence of related severanceobligations. The Company may also be required to make certain investmentsto generate the efficiencies and focus on profitable operations that the PIPwill be designed to achieve. Because the PIP is still being developed, theanticipated completion of its implementation and estimates of the total chargesto be incurred as well as any investments or other expenditures required,cannot be determined at this time, although the Company believes that it willhave the resources available to implement the PIP plan. The Company anticipatesthat it will complete the development of the PIP by the beginning of the thirdquarter 2006.

 

Aspart of the PIP, the Company has evaluated the need to maintain directsales and distribution efforts in several European countries. To date, theCompany has determined to terminate its direct sales and distributionoperations in France, Germany, Belgium and Holland, and has restructuredcertain of its sales and related operations in the U.K. As a result of theseactions, the Company has reduced headcount by an aggregate of 48 positions andhas recorded a restructuring charge of an aggregate of approximately $2.1million in the first quarter of 2006 primarily related to severance costs.Management believes that future operating expenses, predominantly throughreduced employee costs, will be reduced by an aggregate of approximately $4.2million on an annualized basis as a result of these reductions. The Companyanticipates that it will establish alternative means of reaching certaincustomers in the affected countries, including through the use of independentsales representatives or distributors, although the Company expects that itsaggregate sales from France, Germany, Belgium and Holland will be reduced byapproximately $6.0 million on an annualized basis as a result of these actions,at least for the near term. See Item 1A under the captions, “Risk Factors” and “–Liquidity and Capital Resources” in the Company’s 2005 10-K.

 

EffectiveDecember 28, 2005, the Company amended all outstanding stock option agreementswhich pertained to options with exercise prices in excess of the market pricefor the Company’s Common Stock at the close of business on December 28, 2005 (“UnderwaterOptions”) which had remaining vesting requirements. As a result of theseamendments, all Underwater Options, which represented all outstanding options(to purchase approximately 1.5 million shares of the Company’s common stock)which had not yet fully-vested, became fully vested and immediately exercisableat the close of business on December 28, 2005.  Of the optionsaccelerated, approximately 120,000 options are held by non-employee directors,approximately 868,000 are held by officers of the Company and the balance areheld by other employees of the Company as of March 31, 2006.  Because theCompany has accounted for stock-based compensation using the intrinsic valuemethod prescribed in APB 25, and because these options were priced above thethen current market price, the acceleration of vesting of these options did notrequire accounting recognition in the Company’s financial statements. Theoptions were accelerated to reduce the financial statement expense impact in2006 and beyond of a new accounting standard (SFAS No. 123(R), “Share BasedPayment”) for stock based compensation (described in Note 2 of Notes to UnauditedConsolidated Financial Statements).  Management determined thataccelerating the vesting of these options prior to the adoption of the newaccounting standard would result in the Company not being required to recognizecompensation expense in 2006 in the amount of approximately $1.6 million(pre-tax) and in subsequent years through 2010 of approximately $3.7 million(pre-tax).

 

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**SEGMENTS**

 

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

 

**RESULTS OF OPERATIONS—THREE MONTHS ENDEDMARCH 31, 2006 AND 2005**

 

TheCompany’s consolidated net sales for the three months ended March 31, 2006increased 9.4% to $77.4 million compared to $70.7 million for the three monthsended March 31, 2005 as a result of sales growth in both its infant andjuvenile and gift business segments.

 

TheCompany’s gift segment net sales for the three months ended March 31, 2006increased 5.6% to $40.0 million compared to $37.9 million for the three monthsended March 31, 2005, primarily as a result of improved product availabilityduring the 2006 period. Net sales in the Company’s gift segment were negativelyimpacted by foreign exchange rates by approximately $0.7 million for the threemonths ended March 31, 2006.  The Company’s infant and juvenile segment’snet sales for the three months ended March 31, 2006 increased 13.7% to $37.3million compared to $32.8 million for the three months ended March 31, 2005.This increase is primarily attributable to sales growth in the Company’s KidsLine subsidiary.

 

Consolidatedgross profit was 41.2% of consolidated net sales for the three months endedMarch 31, 2006 as compared to 44.4% of consolidated net sales for the threemonths ended March 31, 2005.  The decline in the consolidated gross profitpercentage is primarily due to competitive pricing pressure and sales channelmix in the gift segment. Gross profit for the Company’s gift segment was39.8% of net sales for such segment for the three months ended March 31, 2006as compared to 48.1% of net sales for the three months ended March 31,2005.  Gross profit for the Company’s infant and juvenile segment was42.6% of net sales for such segment for the three months ended March 31, 2006as compared to 40.1% of net sales for the three months ended March 31, 2005,principally as the result of a higher gross profit margin at Kids Line.

 

Consolidatedselling, general and administrative expense was $31.8 million, or 41.1% ofconsolidated net sales, for the three months ended March 31, 2006 compared to$30.7 million, or 43.4% of consolidated net sales, for the three months endedMarch 31, 2005.  Selling, general and administrative expense in theCompany’s gift segment increased by $1.1 million to $27.0 million in the firstquarter of 2006 from $25.9 million in the prior year period. Included in thegift segment selling, general and administrative expense in the first quarterof 2006 was $2.7 million in charges associated with the restructuringactivities in the U.S. and European gift divisions and $1.3 million ofconsulting costs incurred in connection with the development of the PIP. Thesecharges were partially offset by ongoing expense reductions in the gift segmentas a result of 2005 and 2006 restructuring activities. Selling, general andadministrative expense in the Company’s infant and juvenile segment wasessentially unchanged from prior year.

 

Consolidatedother expense was $5.3 million for the three months ended March 31, 2006 comparedto $3.5 million for the three months ended March 31, 2005, an increase of $1.8million. Other income in the Company’s gift segment for the three months endedMarch 31, 2006 increased $0.2 million compared to the prior year primarily as aresult of foreign exchange gains in 2006. Other expense in the Company’s infantand juvenile segment increased by $2.1 million compared to prior year. Includedin the infant and juvenile other expense in the first quarter of 2006 was thewrite-off of $2.5 million in deferred financing costs and a prepayment penaltyof $1.3 million associated with the termination of the 2005 Credit Agreement. Thiswas partially offset by lower interest expense as a result of lower borrowingsand a lower interest rate compared to the first quarter of 2005.

 

Theincome tax benefit for the three months ended March 31, 2006 was $0.3 millionas compared to an income tax benefit of $1.0 million for the first three monthsof 2005. The consolidated benefit for income taxes as a percent of income beforetaxes for the three months ended March 31, 2006 was 5.0% compared to a 37.2%benefit for the three months ended March 31, 2005.  The decrease in theeffective tax rate was primarily the result of the Company not providing a taxbenefit on the losses of its European subsidiaries in the first quarter of2006, as it determined that it is more likely than not that these benefits willnot be realized.

 

Asa result of the foregoing, consolidated net loss for the three months endedMarch 31, 2006 was $5.0 million or $0.24 per diluted share compared toconsolidated net loss of $1.7 million or $0.08 per diluted share for the threemonths ended March 31, 2005, representing a decrease of $3.3 million and adecrease of $0.16 per diluted share.

 

**Liquidity and Capital Resources**

 

TheCompany’s principal sources of liquidity are cash and cash equivalents, fundsfrom operations, and availability under its bank facilities. The Companybelieves that it will able to fund its capital requirements for 2006 from suchsources. In addition, subject to the discussion below under “Kids Line andRelated Financing” with respect to the Earnout Consideration and the Company’scontinued compliance with the financial covenants included in its 2006 

 

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CreditAgreements (defined below), the Company believes that cash flows fromoperations and future borrowings will be sufficient to fund its operating needsfor at least the next 12 months.

 

Asof March 31, 2006, the Company had cash and cash equivalents of $11.2million compared to $28.7 million at December 31, 2005. This reduction of$17.5 million was primarily related to the payment of debt, reduced accountspayable and increased accounts receivable, partially offset by lower inventorylevels. The increase in accounts receivable was due primarily to the timing ofcustomer payments. The reduction in inventory reflects the Company’s historicalprocurement pattern. As of March 31, 2006 and December 31, 2005,working capital was $74.5 million and $71.1 million, respectively. Thisincrease of $2.6 million was primarily the result of increased accountsreceivable, reduced accounts payable and lower cash and cash equivalents,partially offset by lower inventory levels.

 

Cashand cash equivalents decreased by $17.5 million during the three months endingMarch 31, 2006 compared to a decrease of $6.5 million during the three monthsending March 31, 2005. The decrease during the three months ending March31, 2006 was primarily a result of the factors described in the precedingparagraph. The decrease during the three months ending March 31, 2005 wasprimarily due to the payment of long-term debt. Net cash used by operating activities was approximately $14.9 millionduring the three months ending March 31, 2006 compared to net cash provided byoperating activities of approximately $7.1 million during the three monthsended March 31, 2005. The decrease of $22.0 million was due primarily to ahigher net loss in the first quarter of 2006 compared to 2005, and an increasein accounts receivable during the first quarter 2006 compared to a reduction inaccounts receivable during the first quarter 2005. Net cash used in investingactivities was approximately $0.1 million for the three months ended March 31,2006 compared to net cash provided of approximately $8.4 million for the threemonths ending March 31, 2005. The reduction of $8.5 million was due primarilyto proceeds from the sale of assets in the first quarter of 2005. Net cash usedin financing activities was approximately $2.5 million for the three monthsending March 31, 2006 compared to $20.8 million for the three months endedMarch 31, 2005. The reduction of $18.3 million was due primarily to higher debtrepayment in the first quarter of 2005, which included required prepayments ofthe 2004 Term Loan (defined below) in the amount of $20.0 million.

 

Duringthe three months ending March 31, 2006, the Company paid approximately $0.5million for income taxes. The Company currently expects that its cash flows willexceed any income tax payments during 2006.

 

***Kids Line and Related Financing***

 

*Overview of Debt at March 31, 2006.*On March 14, 2006, the Company refinanced itscredit facility and entered into separate Credit Agreements for each of itsoperating segments. All of the prior debt outstanding on March 14, 2006,together with fees and expenses associated with the transaction, was refinancedby drawing down approximately $79.7 million under the Infantline CreditAgreement (described below), including the full amount of the $60.0 millionTerm Loan and $19.7 million of the Infantline Revolver. At March 31, 2006, theCompany had $76.0 million outstanding under the new facility, reflectingrepayments of the Infantline Revolver and the Term Loan in the amounts of $2.92million and $0.75 million, respectively.

 

*Background.*TheCompany purchased all of the outstanding equity interests and warrants in KidsLine (the “Purchase”) in accordance with the terms and provisions of aMembership Interest Purchase Agreement (the “Purchase Agreement”) executed asof December 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 amount of theEarnout Consideration will be charged to goodwill if and when it is earned.Because the amount payable with respect to the Earnout Consideration, if any,and the Company’s financial condition at the time any such payment is due arenot currently determinable, the Company cannot assure that payment of theEarnout Consideration will not have a material impact on the Company’sliquidity.

 

TheKids Line acquisition was financed with the proceeds of a term loan (the “FinancingAgreement”), which is described in further detail in the Current Report on Form8-K filed by the Company with the SEC on December 22, 2004. The FinancingAgreement was subsequently replaced by the 2005 Credit Agreement and the 2005Canadian Credit Agreement (as defined below), which are described in furtherdetail in Note 5 above and in the Current Report on Form 8-K filed by the Companywith the SEC on July 5, 2005.

 

In order toreduce overall interest expense and gain increased flexibility with respect tothe financial covenant structure of the Company’s senior bank financing, onMarch 14, 2006, the 2005 Credit Agreement was terminated and the obligationsthereunder were refinanced (the “LaSalle Refinancing”). 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 theLaSalle 

 

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Refinancing, all outstanding obligations under the 2005Credit Agreement (approximately $76.3 million) were repaid using proceeds fromthe Infantline Credit Agreement (defined below). The Company paida fee of approximately $1.3 million in connection with the early termination ofthe 2005 Credit Agreement, which had been scheduled to mature on June 28, 2010.In addition, the Company wrote-off, in the first quarter of 2006, approximately$2.5 million in deferred financing costs in connection with the LaSalleRefinancing.

 

As part of the LaSalle Refinancing, the Company formed a wholly-ownedDelaware subsidiary, Russ Berrie U.S. Gift, Inc. (“Newco”), to which itassigned (the “Assignment”) substantially all of its assets and liabilitieswhich pertain primarily to its domestic gift business, such that separate loanfacilities could be made directly available to each of the Company’s domesticgift business and infant and 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 no cross-default provisions between the newInfantline Credit Agreement and Giftline Credit Agreement (described below).

 

*Infantline Credit Agreement.*On March 14,2006, Kids Line and Sassy (the “Infantline Borrowers”), entered into a creditagreement as borrowers, on a joint and several basis, with LaSalle BankNational Association as administrative agent and arranger (the “Agent”), thelenders 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”). 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”). The Infantline Borrowers drew downapproximately $79.7 million under the Infantline Credit Agreement on theClosing Date, including the full amount of the Term Loan, which reflects thepayoff of all amounts outstanding under the 2005 Credit Agreement and certainfees and expenses associated with the LaSalle Refinancing. The Infantline loansbear interest at a rate per annum equal to the Base Rate (for Base Rate Loans)or the LIBOR Rate (for LIBOR Loans), at the Company’s option, plus anapplicable margin, in accordance with a pricing grid based on the most recentquarter-end Total Debt to EBITDA Ratio, which applicable margin shall rangefrom 1.75% - 2.50% for LIBOR Loans and from 0.25% - 1.00% for Base Rate Loans.

 

The principal of the Term Loan under the Infantline Credit Agreementmust be repaid in installments as follows: (a) $0.75 million on the last day ofeach calendar month for the period commencing March 2006 through and includingFebruary 2008, (b) $1.0 million on the last day of each calendar month for theperiod commencing March 2008 through and including February 2009, (c) $1.25million on the last day of each calendar month for the period commencing March2009 through and including February 2011. A final installment in the aggregateamount of the unpaid principal balance of the Term Loan (in addition to alloutstanding amounts under the Revolving Loan) is due and payable on March 14,2011, in each case subject to earlier termination in accordance with the termsof the Infantline Credit Agreement.

 

The Infantline Credit Agreement contains customary affirmative andnegative covenants, as well as the following financial covenants:  (i) a minimum EBITDA test, (ii) a minimumFixed Charge Coverage Ratio, (iii) a maximum Total Debt to EBITDA Ratio and(iv) an annual capital expenditure limitation.

 

*Giftline Credit Agreement**.*Also on March 14, 2006 (as amended on April 11, 2006 toclarify the application of a financial covenant), 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 lenders from time to time party thereto, and the Company, as loanparty representative (as amended, the “Giftline Credit Agreement” and, togetherwith the Infantline Credit Agreement, the “2006 Credit Agreements”). TheGiftline Credit Agreement contemplates the potential inclusion of additionallenders subsequent to the initial closing, and a simultaneous increase in thecommitment, and the facility consists of a revolving credit loan commitment (a)before such commitment is increased, if at all, in an amount equal to theBorrowing Base minus amounts outstanding under the Canadian Credit Agreement(as defined below) and (b) after such commitment is increased, if at all, in anamount equal to the lesser of (i) $25.0 million and (ii) the then-currentBorrowing Base, in each case minus amounts outstanding under the CanadianCredit Agreement (the “Giftline Revolver”), with a subfacility for letters ofcredit to be issued by the Issuing Bank in an amount not to exceed $8.0 million.The Borrowing Base is primarily a function of a percentage of eligible accountsreceivable and eligible inventory and, as of March 31, 2006, the Borrowing Base,inclusive of the Borrowing Baseprovided under the Canadian Credit Agreement, was approximately $19.1million**.**The Giftline Borrowers did not drawdown on the Giftline Revolver on the Closing Date. The Giftline Revolver willbear 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.

 

The Giftline Credit Agreement contains the following financialcovenants:  (i) a minimum EBITDA test,(ii) a minimum Excess Revolving Loan Availability requirement of $5.0 million,(iii) an annual capital expenditure limitation and (iv) a minimum Fixed ChargeCoverage Ratio (for quarters commencing with the quarter ending 

 

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March 31, 2008). In addition, at any time after December 31, 2007 inrespect of which the Fixed Charge Coverage Ratio for the Computation Periodending as of the Fiscal Quarter end most recently preceding such date was lessthan 1.00:1.00, the aggregate amounts outstanding under the Giftline Agreementand the Canadian Loan Agreement may not exceed $10.0 million.

 

As contemplated by the 2005 Credit Agreement, on June 28, 2005, theCompany’s Canadian subsidiary, Amram’s Distributing Ltd. (“Amrams”), executed aseparate Credit Agreement (acknowledged by the Company) with the financialinstitutions party thereto and LaSalle Business Credit, a division of ABN AMROBank, N.V., Canada Branch, a Canadian branch of a Netherlands bank, as issuingbank and administrative agent (the “Canadian Credit Agreement”), and relatedloan documents with respect to a maximum U.S. $10.0 million revolving loan (the“Canadian Revolving Loan”). Russ Berrie and Company, Inc. (“RB”), a corporateholding company, executed an unsecured Guarantee (the “Canadian Guarantee”) toguarantee the obligations of Amrams under the Canadian Credit Agreement. Inconnection with the LaSalle Refinancing, on March 14, 2006, the Canadian CreditAgreement was amended to (i) replace references to the 2005 Credit Agreementwith the Giftline Credit Agreement (such that, among other conforming changes,a default under the Giftline Credit Agreement will be a default under theCanadian Credit Agreement), (ii) release the Company from the Canadian Guarantyand (iii) provide for a maximum U.S. $5.0million revolving loan. In connection with the release of the Company from theCanadian Guaranty, Newco executed an unsecured Guarantee (the “Newco Guarantee”)to guarantee the obligations of Amrams under the Canadian Credit Agreement. Adefault under the Infantline Credit Agreement will not constitute a defaultunder the Canadian Credit Agreement.

 

The Company believes that the lower interest rates that were extendedto the Company’s subsidiaries in connection with the LaSalle Refinancing willenable the Company to reduce its aggregate interest expense, on a comparablebasis, by approximately $2.0 million per year. However, because the 2006 CreditAgreements are extended directly to RB’s domestic subsidiaries, RB is dependentupon its operating subsidiaries to provide the cash necessary to enable theCompany to fund its corporate overhead and other expenses.

 

The 2006 Credit Agreementsrestrict the ability of the Company’s domestic subsidiaries to distributecash to RB for the purpose of paying dividends to the shareholders of theCompany or for thepurpose of satisfying the Company’s corporate overhead expenses. Subject tocertain exceptions, the aggregate maximum amount that can be distributed by theCompany’s domestic subsidiaries to RB to enable RB to pay corporate overheadexpenses is $6.5 million for each of 2006 and 2007, and $7.0 million annuallythereafter, with only $2.0 million of this amount permitted to be distributedby the Infantline Borrowers on an annualized basis. The Company believes that the amounts permitted to be distributed to itby its subsidiaries will be sufficient to fund its corporate overhead expenses,although there can be no assurance that such expenses will not exceed currentestimates. There are no restrictions in the 2006 Credit Agreements onthe ability of the Company’s foreign subsidiaries to distribute cash to theCompany.

 

As a result ofthe LaSalle Refinancing, the obligation to pay the Earnout Consideration is nolonger the obligation of RB, but the joint and several obligations of theInfantline Borrowers. With respect to the Earnout Consideration, the InfantlineBorrowers will be permitted to pay all or a portion of the EarnoutConsideration to the extent that, before and after giving effect to suchpayment, (i) Excess Revolving Loan Availability will equal or exceed $3.0million and (ii) no violation of the Infantline Financial Covenants would thenexist, or would, on a pro forma basis, result therefrom.

 

The Company’s ability tomaintain compliance with the financial covenants under the 2006 CreditAgreements is dependent, particularly in the case of the Giftline CreditAgreement, upon the successful implementation of the PIP described under “Overview”above and current operational plans. Based on these plans and management’scurrent projections, the Company anticipates that it will remain in compliancewith the financial covenants in the 2006 Credit Agreements at least throughMarch 31, 2007. However, in the event that the Company is unable tosuccessfully implement the key elements of the PIP, there can be no assurancethat the Company will remain in compliance with such financial covenants,particularly the financial covenants in the Giftline Credit Agreement.

 

**Other Events and Circumstances Pertaining to Liquidity**

 

Althoughthe Company has not yet completed the development of the PIP, theimplementation of the PIP (portions of which are already underway in phases)will result in the recognition of certain significant restructuring charges andthe incurrence of related severance obligations. See “Overview” above for amore detailed description of the PIP and the restructuring activitiesundertaken in 2005 and 2006.

 

TheCompany enters into foreign currency forward exchange contracts, principally tomanage the economic currency risks associated with the purchase of inventory byits European, Canadian and Australian subsidiaries in the gift segment and bySassy Inc. in the infant and juvenile segment.

 

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TheCompany is dependent upon information technology systems in many aspects of itsbusiness. In 2002, the Company commenced a global implementation of anEnterprise Resource Planning (“ERP”) system for its gift businesses. During2003 and continuing into 2004, certain of the Company’s international giftsubsidiaries began to phase-in aspects of the new ERP system. In late 2005, theCompany began to explore alternative global information technology systems forits gift business that could provide greater efficiencies, lower costs andgreater reporting capabilities than those provided by the current ERP system. Asa result of this review, all remaining international implementations wereplaced on hold pending a decision on whether or not to replace the current ERPsystem. The Company expects to make a decision on whether to replace itscurrent ERP system in the first half of 2006.

 

InMarch 1990, the Board of Directors authorized the Company to repurchase anaggregate of up to 7.0 million shares of common stock. As of December 31, 2005,5.6 million shares have been repurchased since the beginning of the Company’sstock repurchase program. The Company did not repurchase any shares pursuant tothis program or otherwise during fiscal 2005 or through the first quarterending March 31, 2006. The 2006 Credit Agreements impose certain limitations onthe ability of the Company to repurchase shares.

 

TheCompany is subject to legal proceedings and claims arising in the ordinarycourse of its business that the Company believes will not have a materialadverse impact on the Company’s consolidated financial condition, results ofoperations or cash flows.

 

Consistentwith its past practices and in the normal course of its business, the Companyregularly reviews acquisition opportunities of varying sizes. The Company mayconsider the use of debt or equity financing to fund potentialacquisitions.  The 2006 Credit Agreements impose restrictions on theCompany that could limit its ability to respond to market conditions or to takeadvantage of acquisitions or other business opportunities.

 

**Contractual Obligations**

 

Thefollowing table summaries the Company’s significant known contractualobligations as of March 31, 2006 and the future periods in which suchobligations are expected to be settled in cash (dollars in thousands):

 
| ** **                    | ** ** | **Total** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** |
|-------------------------------|------------|-----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|
| Operating Lease Obligations   |       | $         | 62,780     |     | $          | 6,194    |       | $        | 7,223      |     | $          | 6,541    |       | $              | 6,017      |   | $ | 5,338 |   | $ | 31,467 |   |
| Purchase Obligations(1)       |       | $         | 28,948     |     | $          | 28,948   |       | $        | —     |     | $          | —   |       | $              | —     |   | $ | — |   | $ | — |   |
| Debt Repayment Obligations(2) |       | $         | 76,000     |     | $          | 23,500   |       | $        | 9,000      |     | $          | 11,500   |       | $              | 14,500     |   | $ | 15,000 |   | $ | 2,500 |   |
| Royalty Obligations           |       | $         | 3,139      |     | $          | 1,724    |       | $        | 1,345      |     | $          | 70       |       | $              | —     |   | $ | — |   | $ | — |   |
| Total Contractual Obligations |       | $         | 170,867    |     | $          | 60,366   |       | $        | 17,568     |     | $          | 18,111   |       | $              | 20,517     |   | $ | 20,338 |   | $ | 33,967 |   |

 

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(1)    The Company’s purchase obligations consist ofpurchase orders for inventory.

 

(2)    Reflects repayment obligations under the 2006Credit Agreements effective on March 14, 2006. See Note 5 of Notes to UnauditedConsolidated Financial Statements for a description of the 2006 CreditAgreements, including provisions that create, increase and/or accelerateobligations thereunder.

 

**Off Balance Sheet Arrangements**

 

Asof March 31, 2006, there have been no material changes in the informationprovided under the caption “Off Balance Sheet Arrangements” of Item 7 of the2005 10-K.

 

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**CRITICAL ACCOUNTING POLICIES**

 

TheSEC has issued disclosure advice regarding “critical accounting policies”,defined as accounting policies that management believes are both most importantto the portrayal of the Company’s financial condition and results and requireapplication of management’s most difficult, subjective or complex judgments,often as a result of the need to make estimates about the effects of mattersthat are inherently uncertain.

 

Managementis required to make certain estimates and assumptions during the preparation ofits consolidated financial statements that affect the reported amounts ofassets, liabilities, revenue and expenses, and related disclosure of contingentassets and liabilities. Estimates and assumptions are reviewed periodically,and revisions made as determined to be necessary 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-based compensation under the recognition andmeasurement principles of APB 25 and related 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 accordancewith the disclosure provision of SFAS 123, previously issued financialstatements included pro forma disclosures of the effect on net income and netincome per share as if the Company had applied the fair value recognitionprovisions of SFAS 123, “Accounting for Stock-Based Compensation”, toshare-based compensation.

 

TheCompany adopted the provisions of SFAS 123(R) on January 1, 2006 using the“modified prospective” transition method. The “modified prospective” transitionmethod requires compensation cost to be recognized beginning with the effectivedate (a) based on the requirements of SFAS 123(R) for all share-basedpayments granted after the effective date and (b) based on therequirements of SFAS 123 for all awards granted to employees prior to theeffective date of SFAS 123(R) that remain unvested on the effective date. Inaccordance with this method, prior periods were not restated to reflect theimpact of adopting the new standard.

 

SeeNote 2 of Notes to Unaudited Consolidated Financial Statements for furtherdiscussion of the impact of the Company’s adoption of SFAS 123(R), as well asthe valuation methodology and assumptions utilized.

 

Alsosee Note 2 of Notes to Consolidated Financial Statements of the 2005 10-K for asummary of the significant accounting policies used in the preparation of theCompany’s consolidated financial statements.

 

**Recently Issued Accounting Standards**

 

SeeNote 13 of the Notes to Unaudited Consolidated Financial Statements for adescription of recently issued accounting standards including the respectivedates of adoption and effects on results of operations and financial condition.

 

**Forward-Looking Statements**

 

This Quarterly Report onForm 10-Q contains certain forward-looking statements.  Additionalwritten and oral forward-looking statements may be made by the Company fromtime to time in Securities and Exchange Commission (SEC) filings andotherwise.  The Private Securities Litigation Reform Act of 1995 providesa safe-harbor for forward-looking statements.  These statements may beidentified by the use of forward-looking words or phrases including, but notlimited to, “anticipate”, “project”, “believe”, “expect”, “intend”, “may”, “planned”,“potential”, “should”, “will” or “would”.  The Company cautions readersthat results predicted by forward-looking statements, including, withoutlimitation, those relating to the Company’s future business prospects,revenues, working capital, liquidity, capital needs, interest costs and incomeare subject to certain risks and uncertainties that could cause actual resultsto differ materially from those indicated in the forward-lookingstatements.  Specific risks and uncertainties include, but are not limitedto, those set forth under Item 1A, “Risk Factors”, of the 2005 10-K. TheCompany undertakes no obligation to publicly update any forward-lookingstatement, whether as a result of new information, future events or otherwise.

 

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

 

Asof March 31, 2006, there have been no material changes in the Company’smarket risks associated with marketable securities and foreign currencyexchange rates, as described in Item 7A of the Company’s 2005 10-K. The marketrisk associated with long-term debt has changed as a result of the terminationof the 2005 Credit Agreement and the execution of the 2006 Credit Agreements,as is more fully described in Note 5 of Notes to Unaudited ConsolidatedFinancial Statements. The interest applicable to the 2006 Credit Agreements isbased upon (i) the LIBOR Rate and (ii) the Base Rate (each as defined in the2006 Credit Agreements), plus an applicable margin. At March 31, 2006, asensitivity analysis to measure potential changes in applicable interest rateindicates that a one percentage point increase in interest rates would increasethe Company’s interest expense by approximately $0.8 million annually, basedupon the current level of debt at March 31, 2006. See Note 5 of Notes toUnaudited Consolidated Financial Statements for a description of the interestrates applicable to the loans under the 2006 Credit Agreements.

 

**ITEM 4.  CONTROLS ANDPROCEDURES**

 

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in our reportsfiled or submitted pursuant to the Securities Exchange Act of 1934 is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission’s rules and forms, and that informationrequired to be disclosed in our Exchange Act reports is accumulated andcommunicated to our management, including our Chief Executive Officer and ChiefFinancial Officer, to allow timely decisions regarding required disclosure.

 

Under the supervision and with the participation ofmanagement, including our Chief Executive Officer and Chief Financial Officer,we carried out an evaluation of the effectiveness of the design and operationof our disclosure controls and procedures pursuant to Exchange Act Rule13a-15(e) and 13d-15(e) as of March 31, 2006. Based upon our evaluation, ourChief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures were not effective as of such date due tothe fact that the material weakness described in the 2005 Form 10-K had notbeen remediated as of March 31, 2006, although steps have been taken towardremediation during the first quarter of 2006.

 

**Changes in Internal Control Over Financial Reporting**

 

Therewere no changes in our internal controls over financial reporting identified inconnection with the evaluation required by paragraph (d) of Exchange Act Rules13a-15 or 15d-15 that occurred during our last fiscal quarter 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.                                                        |
|--------|--------|---------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                    |
|   |   | 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 havebeen omitted.**

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized. 

 
|   | RUSS  BERRIE AND COMPANY, INC.                                                                                                                                                 |                                        |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------|
|   |                            (Registrant) |
|   |                                                                                                                                                                           |
|   |                                                                                                                                                                           |                                        |
|   | By                                                                                                                                                                             | /s/  John D. Wille                          |   |
| Date:  | May  31, 2006                                                                                                                                                             |                                        |   | John  D. Wille |
|   |                                                                                                                                                                           | Vice  President and Chief Financial Officer |
|        |                                                                                                                                                                                |                                             |  |  |  |  |

** **

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**EXHIBIT INDEX**

 

31.1  Certification of CEO required by Section 302 of the Sarbanes Oxley Act of2002.

 

31.2  Certification of CFO required by Section 302 of the Sarbanes Oxley Act of2002.

 

32.1  Certification of CEO required by Section 906 of the Sarbanes Oxley Act of2002.

 

32.2  Certification of CFO required by Section 906 of the Sarbanes Oxley Act of2002.

 

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