**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-Q**

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| o      | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                               |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | ** ** | **For the  quarterly period ended June 30, 2006**                                                                                                                                                                                         |
|   | ** ** | **Or**                                                                                                                                                                                                                                    |
| o      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                   |
|   | ** ** | **For the  transition period from                    to                ** |

 

**Commission files number 1-8681**

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**RUSSBERRIE AND COMPANY, INC.**

(Exact name of registrant as specified in its charter)

 

| **New Jersey**                                            |   | **22-1815337**                           |
|-----------------------------------------------------------|--------|------------------------------------------|
| (State of or  other jurisdiction of                       |   | (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 x              No o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer inRule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o             Acceleratedfiler x            Non-accelerated filer   o

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

The number of shares outstanding of each of theregistrant’s classes of common stock, as of July 31, 2006 was as follows:

| CLASS                             | ** ** | **OUTSTANDING   At July 31, 2006** |
|-----------------------------------|------------|------------------------------------|
| Common Stock,  $0.10 stated value |       | 20,853,372                         |

 

 

 

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**RUSS BERRIE AND COMPANY, INC.**

**INDEX**

 

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

 

2

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**PART 1 - FINANCIAL INFORMATION**

**ITEM 1.  FINANCIAL STATEMENTS**

**RUSSBERRIE AND COMPANY, INC. AND SUBSIDIARIES**

 **CONSOLIDATEDBALANCE SHEETS**

 **(Dollars in Thousands, except per share data)(UNAUDITED)**

 

| ** **                                                                                                                                                | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|------------|
| **Assets (Note 5)**                                                                                                                                       | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** ** |
| Current assets                                                                                                                                            |       |                        |       |                            |       |       |
| Cash and cash  equivalents                                                                                                                                |       | $                           | 10,333     |                            | $          | 28,667     |   |   |
| Accounts  receivable, trade, less allowances of $1,948 in 2006 and $1,943 in 2005                                                                         |       | 50,575                      |       | 53,189                          |       |       |
| Inventories, net                                                                                                                                          |       | 50,565                      |       | 55,871                          |       |       |
| Prepaid expenses  and other current assets                                                                                                                |       | 12,091                      |       | 12,152                          |       |       |
| Income tax  receivable                                                                                                                                    |       | 2,532                       |       | 2,979                           |       |       |
| Deferred income  taxes                                                                                                                                    |       | 2,273                       |       | 2,274                           |       |       |
| **Total  current assets**                                                                                                                                 |       | 128,369                     |       | 155,132                         |       |       |
| Property, plant  and equipment, net                                                                                                                       |       | 15,715                      |       | 17,856                          |       |       |
| Goodwill                                                                                                                                                  |       | 89,242                      |       | 89,242                          |       |       |
| Intangible  assets                                                                                                                                        |       | 61,586                      |       | 61,599                          |       |       |
| Restricted cash                                                                                                                                           |       | 771                         |       | 750                             |       |       |
| Other assets                                                                                                                                              |       | 6,370                       |       | 4,883                           |       |       |
| **Total  assets**                                                                                                                                         |       | $                           | 302,053    |                            | $          | 329,462    |   | ** ** |
| **Liabilities  and Shareholders’ Equity**                                                                                                            | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** ** |
| Current liabilities                                                                                                                                       |       |                        |       |                            |       |       |
| Current portion  of long-term debt                                                                                                                        |       | $                           | 9,000      |                            | $          | 2,600      |   |   |
| Short-term debt                                                                                                                                           |       | 10,229                      |       | 31,924                          |       |       |
| Accounts payable                                                                                                                                          |       | 8,759                       |       | 17,764                          |       |       |
| Accrued expenses                                                                                                                                          |       | 26,162                      |       | 27,130                          |       |       |
| Accrued income  taxes                                                                                                                                     |       | 2,402                       |       | 4,203                           |       |       |
| **Total  current liabilities**                                                                                                                            |       | 56,552                      |       | 83,621                          |       |       |
| Deferred income  taxes                                                                                                                                    |       | 9,438                       |       | 6,358                           |       |       |
| Long-term debt,  excluding current portion                                                                                                                |       | 48,000                      |       | 41,993                          |       |       |
| Other long-term  liabilities                                                                                                                              |       | 3,680                       |       | 3,636                           |       |       |
| **Total  liabilities**                                                                                                                                    |       | 117,670                     |       | 135,608                         |       |       |
| Commitments and  contingencies                                                                                                                            |       |                        |       |                            |       |       |
| Shareholders’ equity                                                                                                                                 |       |                        |       |                            |       |       |
| Common stock:  $0.10 per share stated value; authorized 50,000,000 shares; issued 26,489,656  shares at June 30, 2006 and 26,472,256 at December 31, 2005 |       | 2,658                       |       | 2,649                           |       |       |
| Additional paid  in capital                                                                                                                               |       | 89,005                      |       | 88,751                          |       |       |
| Retained  earnings                                                                                                                                        |       | 189,789                     |       | 200,756                         |       |       |
| Accumulated  other comprehensive income                                                                                                                   |       | 13,081                      |       | 11,848                          |       |       |
| Treasury stock,  at cost, 5,636,284 shares at June 30, 2006 and December 31, 2005                                                                         |       | (110,150                    | )          | (110,150                        | )          |       |
| **Total  shareholders’ equity**                                                                                                                      |       | 184,383                     |       | 193,854                         |       |       |
| **Total liabilities and  shareholders’ equity**                                                                                                      |       | $                           | 302,053    |                            | $          | 329,462    |   |   |

 

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

3

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**RUSSBERRIE AND COMPANY, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Dollarsin Thousands, Except Per Share Data)**

**(UNAUDITED)**

 

| ** **                                                                          | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net sales                                                                           |       | $                                                   | 65,689     |                                              | $          | 62,019 |   | $ | 143,049 |   | $ | 132,759 |   |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Cost of sales                                                                       |       | 39,815                                              |       | 36,997                                            |       | 85,353 |   | 76,341 |   |
| ** **                                                                          |       |                                                |       |                                              |       |   |   |   |   |
| **Gross profit**                                                                    |       | 25,874                                              |       | 25,022                                            |       | 57,696 |   | 56,418 |   |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Selling, general  and administrative expenses                                       |       | 27,275                                              |       | 29,182                                            |       | 59,030 |   | 59,867 |   |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| **Operating loss**                                                                  |       | (1,401                                              | )          | (4,160                                            | )          | (1,334 | ) | (3,449 | ) |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Other  (expense)/income:                                                            |       |                                                |       |                                              |       |   |   |   |   |
| Interest expense, including amortization and  write-off of deferred financing costs |       | (1,614                                              | )          | (8,227                                            | )          | (7,409 | ) | (11,719 | ) |
| Interest and investment income                                                      |       | 109                                                 |       | 343                                               |       | 212 |   | 645 |   |
| Other, net                                                                          |       | (60                                                 | )          | (287                                              | )          | 306 |   | (548 | ) |
|                                                                                |       | (1,565                                              | )          | (8,171                                            | )          | (6,891 | ) | (11,622 | ) |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| **Loss before income tax**                                                          |       | (2,966                                              | )          | (12,331                                           | )          | (8,225 | ) | (15,071 | ) |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| Income tax  expense/(benefit)                                                       |       | 3,009                                               |       | (6,169                                            | )          | 2,742 |   | (7,187 | ) |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| **Net (loss)**                                                                      |       | $                                                   | (5,975     | )                                                 | $          | (6,162 | ) | $ | (10,967 | ) | $ | (7,884 | ) |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| **Net  loss per share:**                                                            |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                                                               |       | $                                                   | (0.29      | )                                                 | $          | (0.30 | ) | $ | (0.53 | ) | $ | (0.38 | ) |
| Diluted                                                                             |       | $                                                   | (0.29      | )                                                 | $          | (0.30 | ) | $ | (0.53 | ) | $ | (0.38 | ) |
|                                                                                |       |                                                |       |                                              |       |   |   |   |   |
| **Weighted  average shares:**                                                       |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                                                               |       | 20,840,000                                          |       | 20,824,000                                        |       | 20,838,000 |   | 20,824,000 |   |
| Diluted                                                                             |       | 20,840,000                                          |       | 20,824,000                                        |       | 20,838,000 |   | 20,824,000 |   |

 

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

4

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**RUSSBERRIE AND COMPANY, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Dollars in Thousands)(UNAUDITED)**

 

| ** **                                                                                 | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| **Cash  flows from operating activities:**                                                 | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Net loss                                                                                   |       | $                                                 | (10,967    | ) | $ | (7,884 | ) |
| Adjustments to  reconcile net loss to net cash (used in)/provided by operating activities: |       |                                              |       |   |   |
| Depreciation and amortization                                                              |       | 2,746                                             |       | 3,480 |   |
| Amortization and write-off of deferred financing  costs                                    |       | 2,848                                             |       | 5,711 |   |
| Provision for accounts receivable                                                          |       | 550                                               |       | 167 |   |
| Provision for inventory reserve                                                            |       | 1,377                                             |       | 517 |   |
| Deferred income taxes                                                                      |       | 2,012                                             |       | (2,259 | ) |
| Other                                                                                      |       | (434                                              | )          | 409 |   |
| Change in assets and liabilities:                                                          |       |                                              |       |   |   |
| Restricted cash                                                                            |       | (20                                               | )          | 14,847 |   |
| Accounts receivable                                                                        |       | 2,491                                             |       | 20,355 |   |
| Income tax receivable                                                                      |       | 537                                               |       | — |   |
| Inventories                                                                                |       | 4,541                                             |       | (3,374 | ) |
| Prepaid expenses and other current assets                                                  |       | 603                                               |       | 432 |   |
| Other assets                                                                               |       | (55)                                              |       | 245 |   |
| Accounts payable                                                                           |       | (9,126                                            | )          | (2,975 | ) |
| Accrued expenses                                                                           |       | (1,802                                            | )          | (6,817 | ) |
| Accrued income taxes                                                                       |       | (1,852                                            | )          | 2,358 |   |
| Total adjustments                                                                          |       | 4,416                                             |       | 33,096 |   |
| Net cash (used in)/provided by operating activities                                        |       | (6,551                                            | )          | 25,212 |   |
| **Cash flows from investing activities:**                                                  | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Proceeds from  sale of property, plant and equipment                                       |       | 75                                                |       | 8,914 |   |
| Capital  expenditures                                                                      |       | (324                                              | )          | (614 | ) |
| Net cash (used in)/provided by investing activities                                        |       | (249                                              | )          | 8,300 |   |
| **Cash flows from financing activities:**                                                  | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Proceeds from  issuance of common stock                                                    |       | 262                                               |       | (17 | ) |
| Dividends paid  to shareholders                                                            |       | —                                            |       | (2,082 | ) |
| Issuance of  long-term debt                                                                |       | 59,250                                            |       | 76,800 |   |
| Repayment of  long-term debt                                                               |       | (78,320                                           | )          | (135,000 | ) |
| Net borrowings  on revolving credit facility                                               |       | 9,783                                             |       | - |   |
| Payment of  deferred financing costs                                                       |       | (2,509                                            | )          | (3,113 | ) |
| Net cash used in financing activities                                                      |       | (11,534                                           | )          | (63,412 | ) |
| Effect of exchange rate changes on cash and cash  equivalents                              |       | —                                            |       | (2,701 | ) |
| Net decrease in  cash and cash equivalents                                                 |       | (18,334                                           | )          | (32,601 | ) |
| Cash and cash  equivalents at beginning of period                                          |       | 28,667                                            |       | 48,099 |   |
| Cash and cash  equivalents at end of period                                                |       | $                                                 | 10,333     |   | $ | 15,498 |   |
| **Cash paid during the year for:**                                                         | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Interest expense                                                                           |       | $                                                 | 2,941      |   | $ | 6,008 |   |
| Income taxes                                                                               |       | $                                                 | 2,092      |   | $ | 1,377 |   |

 

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

5

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** **

**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

(Unaudited)

** **

**NOTE 1 - INTERIM CONSOLIDATED FINANCIAL STATEMENTS**

The accompanying unaudited interim consolidatedfinancial statements have been prepared by Russ Berrie and Company, Inc. andits subsidiaries (the “Company”) in accordance with accounting principlesgenerally accepted in the United States of America for interim financialreporting and the instructions to the Quarterly Report on Form 10-Q and Rule10-01 of Regulation S-X.  Accordingly, certain information and footnotedisclosures normally included in financial statements prepared under generallyaccepted accounting principles have been condensed or omitted pursuant to suchprinciples and regulations.  The information furnished reflects alladjustments, which are, in the opinion of management, of a normal recurringnature and necessary for a fair presentation of the Company’s consolidatedfinancial position, results of operations and cash flows for the interimperiods presented.  Results for interim periods are not necessarily anindication of results to be expected for the year.

The Company operates in two segments: (i) the Company’sgift business and (ii) the Company’s infant and juvenile business, which iscomprised of Sassy, Inc. and Kids Line, LLC. This segmentation of theCompany’s operations reflects how the Company’s Chief Executive Officercurrently views the results of operations. There are no inter-segment revenuesto eliminate. Corporate assets and overhead expenses are included in the giftsegment.  The Company has entered intoseparate credit facilities with respect to each of its segments (see Note 5).

The Company’s gift business designs, manufacturesthrough third parties and markets a wide variety of gift products to retailstores throughout the United States and throughout the world via the Company’sinternational wholly-owned subsidiaries. The Company’s infant and juvenilebusinesses design and market products in a number of baby categories including,among others, infant bedding and accessories, bath toys and accessories, developmentaltoys, feeding items and baby comforting products. These products are sold toconsumers, primarily in the United States, through mass merchandisers, toyspecialty, food, drug and independent retailers, apparel stores and militarypost exchanges.

Certain prior year amounts have been reclassified toconform to the 2006 presentation.

This Quarterly Report on Form 10-Q should be read inconjunction with the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2005, as amended on April 20, 2006 and May 1, 2006 (the “200510-K”).

**NOTE 2 - ACCOUNTING FOR STOCK OPTIONS**

The Company currently maintains the 2004 Stock Option,Restricted and Non-Restricted Stock Plan (the “2004 Option Plan”) and theAmended and Restated 2004 Employee Stock Purchase Plan (collectively, the “2004Stock Plans”).  As of December 31, 2005,there were 1,507,844 shares of common stock reserved for issuance under the2004 Stock Plans.  The Company alsocontinues to have options outstanding under the 1999 and 1994 Stock Option andRestricted Stock Plans, the 1999 and 1994 Stock Option Plans and the 1999 and1994 Stock Option Plans for Outside Directors, (collectively, the “PredecessorPlans”).  No awards could be made afterDecember 31, 2003 with respect to the 1999 Predecessor Plans and after December31, 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.)

**StockOption Plans**

The exercise pricefor options issued under the 2004 Option Plan and the Predecessor Plans isequal to the closing price of the Company’s common stock as of the date theoption is granted, except for the options granted in 2000 which were repricedto the closing price of the Company’s stock effective February 29, 2000and at $2.00 above the closing price of the Company’s stock price effectiveFebruary 29, 2000 for the Company’s 1999 Stock Plan for Outside Directors.Generally, stock options under the 2004 Option Plan and the Predecessor Plansvest between one and five years from the grant date unless otherwise stated bythe specific grant. Options generally expire 10 years from the date ofgrant.

Prior to January1, 2006, the Company accounted for stock-based compensation under therecognition and measurement principles of Account Principles Board Opinion (“APB”)No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and relatedinterpretations.  No compensation expenserelated to stock option plans was reflected in the Company’s ConsolidatedStatements of Operations as all options had an exercise price equal to themarket value of the underlying common stock on the date of grant.  Statement of Financial Accounting Standards (“SFAS”)No. 123, “Accounting for Stock Based Compensation” (“SFAS 123”), establishedaccounting and disclosure requirements using a fair-value-based method ofaccounting for stock-based employee compensation plans.  As permitted by SFAS 123, the Company electedto continue to apply the intrinsic-value-based method of 

6

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** **

**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

(Unaudited)

APB 25 describedabove, and adopted only the disclosure requirements of SFAS 123, as amended bySFAS No. 148, “Accounting for Stock-Based Compensation — Transition andDisclosure.”

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 isa replacement of SFAS 123 and supersedes APB 25.  SFAS 123(R) requires companies to recognizean expense for compensation cost related to share-based payment arrangements,including stock options and employee stock purchase plans, based on thegrant-date fair value of the award.  Thisstandard applies to all awards unvested or granted as of the required effectivedate and to awards modified, repurchased, or cancelled after that date.

The Companyadopted the provisions of SFAS 123(R) on January 1, 2006 using the “modifiedprospective” transition method.  The “modifiedprospective” transition method requires compensation cost to be recognizedbeginning with the effective date (a) based on the requirements of SFAS123(R) for all share-based payments granted after the effective date and(b) based on the requirements of SFAS 123 for all awards granted to employeesprior to the effective date of SFAS 123(R) that remain unvested on theeffective date.  In accordance with thismethod, prior periods were not restated to reflect the impact of adopting thenew standard.

Effective December28, 2005, the Company amended all outstanding stock option agreements whichpertained to options with exercise prices in excess of the market price for theCompany’s common stock at the close of business on December 28, 2005 (“UnderwaterOptions”) which, at that time, had remaining vesting requirements. As a 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 were held by non-employee directors,approximately 854,000 were held by officers of the Company and the balance wereheld by other employees of the Company as of June 30, 2006.** **Because these options were pricedabove the then current market price on December 28, 2005, the acceleration ofvesting of these options did not result in any expense being recognized in theCompany’s Consolidated Statements of Operations.  The purpose of the accelerated vesting ofstock options was to enable the Company to avoid recognizing compensationexpense associated with these options in future periods as required by SFAS123(R), estimated at the date of acceleration to be $1.6 million (pre-tax)in 2006 and in subsequent years through 2010 of approximately $3.7 million(pre-tax).

As noted above, prior to January 1, 2006, in accordance with APB 25, nocompensation cost had been recognized for options granted by the Company withan initial exercise price equal to the fair value of the common stock, exceptfor the application of Financial Accounting Interpretation No. 44, “Accountingfor Certain Transactions Involving Stock Compensation”, which resulted in non-cash income of $9,000 and $17,000during the three and six months ended June 30, 2005, respectively, due tooptions granted during 2000 that were repriced as of February 29, 2000 uponapproval of the Board of Directors and the Company’s shareholders.  Had compensation cost for the Company’s stockgrants been determined based upon the fair value recognition provisions of SFAS123 at the grant date, the Company’s pro-forma net loss and loss per share forthe three and six months ended June 30, 2005 would have been as follows:

** **

|                                                                                                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                               | ** ** | **June 30, 2005**      | ** ** | **June 30, 2005**    | ** ** |
| Net loss-as  reported                                                                                    |       | $                                | (6,162,000 | )                              | $          | (7,884,000 | ) |
| Deduction for  stock-based compensation expense determined under fair value method net of  tax-pro forma |       | 239,000                          |       | 357,000                        |       |
| Net loss-pro  forma                                                                                      |       | $                                | (6,401,000 | )                              | $          | (8,241,000 | ) |
| Loss per share (basic) - as reported                                                                     |       | $                                | (0.30      | )                              | $          | (0.38 | ) |
| Loss per share (basic) — pro forma                                                                  |       | $                                | (0.31      | )                              | $          | (0.40 | ) |
| Loss per share (diluted) — as reported                                                              |       | $                                | (0.30      | )                              | $          | (0.38 | ) |
| Loss per share  (diluted) — pro forma                                                               |       | $                                | (0.31      | )                              | $          | (0.40 | ) |

 

7

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** **

**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

(Unaudited)

The fair value ofeach option granted by the Company was estimated on the grant date using theBlack-Scholes option-pricing model with the following assumptions used for thegrants:

 

|                                                                 | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                      | ** ** | **June 30, 2005**      | ** ** | **June 30, 2005**    | ** ** |
| Dividend yield                                                  |       | 2.50                             | %          | 2.50                           | %          |
| Risk-free  interest rate                                        |       | 3.74                             | %          | 3.84                           | %          |
| Volatility                                                      |       | 34.62                            | %          | 33.89                          | %          |
| Expected life  (years)                                          |       | 4.5                              |       | 4.5                            |       |
| Weighted average fair  value of options granted during the year |       | $                                | 4.72       |                           | $          | 4.28 |   |
|                                                                 |            |                                  |            |                                |            |  |  |

 

The followingtable summarizes stock option activity for the six months ended June 30, 2006:

 

| ** **                                   | ** ** | **Options** | ** ** | **Weighted   Average   Exercise   Price** | ** ** | **Weighted   Average   Remaining   Life (in years)** | ** ** | **Aggregate  Intrinsic   Value ** | ** ** |
|----------------------------------------------|------------|-------------|------------|----------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| Outstanding and  vested at December 31, 2005 |       | 1,769,238   |       | $                                                        | 17.16      |                                                                          | 8.49       |                                        | —     |   |
| Exercised                                    |       | 17,400      |       | $                                                        | 13.42      |                                                                          | —     |                                        | —     |   |
| Cancelled                                    |       | 2,216       |       | $                                                        | 33.44      |                                                                          | —     |                                        | —     |   |
| Outstanding and vested  at June 30, 2006     |       | 1,749,622   |       | $                                                        | 17.19      |                                                                          | 8.00       |                                        | $          | 130,000 |   |
|                                              |            |             |            |                                                          |            |                                                                               |            |                                             |            |  |  |

 

In the first half of 2006, no options were granted**.**  The aggregateintrinsic value in the table above represents the total pretax value of thein-the-money options, which value is determined by aggregating the spreadbetween each of the in-the-money options and the exercise prices thereof,assuming that all shareholders exercised their options on June 30, 2006.  This amount will change based on the fairmarket value of the Company’s stock. The Company’s policy is to issue sharesfrom authorized shares to fulfill stock option exercises.

During the first half of 2006, no compensation expensewas recorded because the Company did not grant any options during such periodand all of the options outstanding at the date of adoption of SFAS 123(R) werefully vested**.**

**Employee Stock Purchase Plan**

Under the Amended and Restated 2004 Employee StockPurchase Plan, eligible employees are provided the opportunity to purchase theCompany’s common stock at a discount. Pursuant to this plan, options are granted to participants as of thefirst trading day of each plan year, which is the calendar year, and may beexercised as of the last trading day of each plan year, to purchase from theCompany the number of shares of common stock that may be purchased at therelevant purchase price with the aggregate amount contributed by eachparticipant.  In each plan year, aneligible employee may elect to participate in the plan by filing a payrolldeduction authorization form for up to 10% (in whole percentages) of his or hercompensation.  No employee shall have theright to purchase Company common stock under the Amended and Restated 2004Employee Stock Purchase Plan that has a fair market value in excess of $25,000in any plan year.  The purchase price isthe lesser of 85% of the closing market price of the Company’s common stock oneither the first trading day or the last trading day of the plan year.  If an employee does not elect to exercise hisor her option, the total amount credited to his or her account during that planyear is returned to such employee, and his or her option expires.  As of June 30, 2006, the Amended andRestated 2004 Employee Stock Purchase Plan had 131,722 shares reserved forfuture issuance.

8

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** **

**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

(Unaudited)

The fair value of each option granted under theAmended and Restated 2004 Employee Stock Purchase Plan is estimated on the dateof grant using the Black-Scholes option-pricing model with the followingassumptions:

 

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

 

The Companyestimates expected stock price volatility based on actual historical changes inthe market value of the Company’s stock. The risk-free interest rate is basedon the U.S. Treasury yield with a term that is consistent with the expectedlife of the stock options.  The expectedlife of stock options under the Amended and Restated 2004 Employee StockPurchase Plan is one year, or the equivalent of the annual plan year.  The impact of SFAS 123(R) for the Amended andRestated 2004 Employee Stock Purchase plan for the first half of 2006 wasimmaterial to the Company’s unaudited consolidated financial statements.

**NOTE 3 - WEIGHTED AVERAGE COMMONSHARES**

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

 

|                                                                            | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Weighted average  common shares outstanding                                |       | 20,840,000                                          |       | 20,824,000                                        |       | 20,838,000 |   | 20,824,000 |   |
| Dilutive effect  of common shares issuable under outstanding stock options |       | —                                              |       | —                                            |       | — |   | — |   |
| Weighted average common  shares outstanding assuming dilution              |       | 20,840,000                                          |       | 20,824,000                                        |       | 20,838,000 |   | 20,824,000 |   |

 

The average number of diluted shares outstanding forthe three and six months ended June 30, 2006 and 2005 exclude shares relatingto stock options because there was a net loss and such shares would have beenanti-dilutive.** **Stockoptions to purchase approximately 1.8 million and 0.6 million shares wereoutstanding at June 30, 2006 and 2005, respectively.

**NOTE 4 — CONTINGENCY**

As previously disclosed, the Company purchased all ofthe outstanding equity interests and warrants in Kids Line, LLC (the “Purchase”),in accordance with the terms and provisions of a Membership Interest PurchaseAgreement (the “Purchase Agreement”) in December 2004.  At closing, the Company paid approximately$130.5 million, which represented the portion of the purchase price due atclosing plus various transaction costs, which was subsequently adjusted to$130.6 million.  The aggregate purchaseprice under the Purchase Agreement includes the potential payment of contingentconsideration (the “Earnout Consideration”). The Earnout Consideration shall equal 11.724% of the Agreed EnterpriseValue (described below) of Kids Line as of the last day of the MeasurementPeriod (the three year period ending November 30, 2007), and shall be paid atthe times described in the Purchase Agreement (approximately the thirdanniversary of the closing date).  TheAgreed Enterprise Value shall be the product of (i) Kids Line’s EBITDA duringthe twelve (12) months ending on the last day of the Measurement Period and(ii) the applicable multiple (ranging from zero to eight) as set forth in thePurchase Agreement. The amount of the Earnout Consideration will be charged togoodwill when and if it is earned.

9

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** **

**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

(Unaudited)

**NOTE 5 — DEBT**

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

In order to reduceoverall interest expense and gain increased flexibility with respect to thefinancial covenant structure of the Company’s senior financing, on March 14,2006, the 2005 Credit Agreement was terminated and the obligations thereunderwere refinanced (the “LaSalle Refinancing”). In connection with the LaSalle Refinancing, all outstanding obligations under the 2005 Credit Agreement (approximately$76.5 million) were repaid using proceeds from the Infantline Credit Agreement,defined below, which is part of the LaSalle Refinancing.  The Company paid a fee of approximately $1.3million in connection with the early termination of the 2005 Credit Agreement,which was 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 theLaSalle Refinancing.

As part of the LaSalle Refinancing, the Company formeda wholly-owned Delaware subsidiary, Russ Berrie U.S. Gift, Inc. (“Newco”), towhich it assigned (the “Assignment”) substantially all of its assets andliabilities which pertain primarily to its domestic gift business, such thatseparate loan facilities could be made directly available to each of theCompany’s domestic gift business and infant and juvenile business,respectively.  The Assignment transactionreinforces the operation of the Company as two separate segments, and thecredit facilities that have been extended to each segment are separate anddistinct.  There are no cross-defaultprovisions between the new Infantline Credit Agreement and Giftline CreditAgreement, described below.

Long-term debt at June 30, 2006 and December 31, 2005consists of the following:

|                                               | ** ** | **June 30, 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) |       | 57,000,000                  |       | —                          |       |
|                                          |       | 57,000,000                  |       | 44,593,000                      |       |
| Less current  portion                         |       | 9,000,000                   |       | 2,600,000                       |       |
| Long-term debt                                |       | $                           | 48,000,000 |                            | $          | 41,993,000 |   |

 

1.             The LaSalle Refinancing — Effective March 14, 2006

*A.  The Infantline Credit Agreement*

On March 14, 2006(the “Closing Date”), Kids Line, LLC (“KL”) and Sassy, Inc. (“Sassy”, andtogether with KL, the “Infantline Borrowers”) entered into a credit agreementas borrowers, on a joint and several basis, with LaSalle Bank NationalAssociation as administrative agent and arranger (the “Agent”), the lendersfrom time to time party thereto, the Company as loan party representative,Sovereign Bank as syndication agent, and Bank of America, N.A. as documentationagent (the “Infantline Credit Agreement”). Unless otherwise specified herein, capitalized terms used but undefinedin this Note 5 Section 1.A shall have the meanings ascribed to them in theInfantline Credit Agreement.

The commitmentsunder the Infantline Credit Agreement (the “Infantline Commitments”) consist of(a) a $35.0 million revolving credit facility (the “Revolving Loan”), with asubfacility for letters of credit in an amount not to exceed $5.0 million, and(b) a $60.0 million term loan facility (the “Term Loan”).  The Infantline Borrowers drew downapproximately $79.7 million on the Infantline Credit Agreement on the ClosingDate, including the full amount of the Term Loan, which reflects the payoff ofall amounts outstanding under the 2005 Credit Agreement and certain fees andexpenses associated with the LaSalle Refinancing.  As of June 30, 2006, the balance on theRevolving Loan was $8.7 million and the balance on the Term Loan was $57.0million.

10

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** **

**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

(Unaudited)

The principal ofthe Term Loan will be repaid in installments as follows: (a) $0.75 million onthe last day of each calendar month for the period commencing March 2006through and including February 2008, (b) $1.0 million on the last day of eachcalendar month for the period commencing March 2008 through and includingFebruary 2009 and $1.25 million on the last day of each calendar month for theperiod commencing March 2009 through and including February 2011.  A final installment in the aggregate amountof the unpaid principal balance of the Term Loan (in addition to alloutstanding amounts under the Revolving Loan) is due and payable on March 14,2011, in each case subject to customary early termination provisions inaccordance with the terms of the Infantline Credit Agreement.

The InfantlineLoans bear interest at a rate per annum equal to the Base Rate (for Base RateLoans) 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 RateLoans.  The applicable interest ratemargins as of June 30, 2006 were:  2.0%for LIBOR loans and 0.5% for Base Rate Loans. The weighted average interest rates for the outstanding loans as of June30, 2006 were as follows:  

|                      | ** ** | **At June 30, 2006** | ** ** |
|----------------------|------------|----------------------|------------|
| ** **           | ** ** | **LIBOR Loans**      | ** ** | **Base Rate Loans** | ** ** |
| Infantline Revolver  |       | 7.16                 | %          | 8.75 | % |
| Infantline Term Loan |       | 7.18                 | %          | 8.75 | % |

 

Interest is due andpayable (i) with respect to Base Rate Loans, monthly in arrears on the last dayof each calendar month, upon a prepayment and at maturity and (ii) with respectto LIBOR Loans, on the last day of each Interest Period, upon a prepayment (andif the Interest Period is in excess of three months, on the three-monthanniversary of the first day of such Interest Period), and at maturity.

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

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

The Infantline Credit Agreement contains customaryaffirmative and negative covenants, as well as the following financialcovenants (the “Infantline 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. As of June 30, 2006, the Company was in compliance with the financialcovenants contained in the Infantline Credit Agreement.

The Infantline Credit Agreement contains significantlimitations on the ability of the Infantline Borrowers to distribute cash toRuss Berrie and Company, Inc. (“RB”), a corporate holding company, for thepurpose of paying dividends to the shareholders of the Company or for thepurpose of paying RB’s corporate overhead expenses, including a cap (subject tocertain exceptions) of $2.0 million per year on the amount that can be providedto RB to pay corporate overhead expenses.

As aresult of the LaSalle Refinancing, the obligation to pay the EarnoutConsideration pursuant to the Kids Line acquisition (see Note 4) is no longerthe obligation of RB, but the joint and several obligation of the InfantlineBorrowers.  With respect to the EarnoutConsideration, the Infantline Borrowers will be permitted to pay all or aportion of the Earnout Consideration to the extent that, before and aftergiving effect to such payment, (i) Excess

 

11

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** **

**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

(Unaudited)

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.

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

*B.  The Giftline Credit Agreement*

On March 14, 2006as amended on April 11, 2006 (to clarify the application of a financialcovenant) and August 8, 2006, Russ Berrie U.S. Gift, Inc. (“Newco”) and otherspecified wholly-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”).  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.

The GiftlineCredit Agreement contemplates the potential inclusion of additional lenderssubsequent to the initial closing, which as of June 30, 2006 has not occurred,and a simultaneous increase in the commitment, and the facility consists of arevolving credit loan commitment (a) before such commitment is increased, if atall, in an amount equal to the Borrowing Base minus amounts outstanding underthe Canadian Credit Agreement (as defined below) and (b) after such commitmentis increased, if at all, in an amount equal to the lesser of (i) $25.0 millionand (ii) the then-current Borrowing Base, in each case minus amountsoutstanding under the Canadian Credit Agreement (the “Giftline Revolver”), witha subfacility for letters of credit to be issued by the Issuing Bank in anamount not to exceed $8.0 million.   TheBorrowing Base is primarily a function of a percentage of eligible accountsreceivable and eligible inventory and, as of June 30, 2006, the Borrowing Base,inclusive of the Borrowing Base provided under the Canadian Credit Agreement,was approximately $11.2 million.  As ofJune 30, 2006, the balance on the Giftline Revolver was $1.1 million and thebalance on the Canadian Revolving Loan (see Section 1.C below) was $0.4million.

All outstandingamounts under the Giftline Revolver are due and payable on March 14, 2011,subject to earlier termination in accordance with the terms of the GiftlineCredit Agreement.

The GiftlineRevolver bears 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), at the Company’soption, plus a margin of 2.75% for LIBOR Loans and 1.25% for Base RateLoans.  Interest is due and payable inthe same manner as with respect to the Infantline Loans.  As of June 30, 2006, the interest rate forthe outstanding Base Rate loan was 9.50%. and there were no outstanding LiborLoans. 

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

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

12

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** **

**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

(Unaudited)

The Giftline Credit Agreement contains customaryaffirmative and negative covenants substantially similar to those applicable tothe Infantline Credit Agreement.  TheGiftline Credit Agreement contains the following financial covenants (the “GiftlineFinancial Covenants”):  (i) a minimumEBITDA test, (ii) a minimum Excess Revolving Loan Availability requirement of$5.0 million, (iii) an annual capital expenditure limitation and (iv) a minimumFixed Charge Coverage Ratio (for quarters commencing with the quarter endedMarch 31, 2008).  In addition, at anytime after December 31, 2007 in respect of which the Fixed Charge CoverageRatio for the Computation Period ending as of the fiscal quarter end mostrecently preceding such date was less than 1.00:1.00, the aggregate amountsoutstanding under the Giftline Credit Agreement and the Canadian Loan Agreementmay not exceed $10.0 million.  As of June30, 2006, the Company was in compliance with the financial covenants containedin the Giftline Credit Agreement.  OnAugust 8, 2006, the Giftline Credit Agreement was amended to lower thethreshold on the Minimum EBITDA covenant by $1.0 million per fiscal quarter foreach of four consecutive fiscal quarters commencing with the fiscal quarterending September 30, 2006.

The Giftline Credit Agreement contains significantlimitations on the ability of the Giftline Borrowers to distribute cash to RBfor the purpose of paying dividends to the shareholders of the Company or forthe purpose of paying RB’s  corporateoverhead expenses, including a cap (subject to certain exceptions) on theamount that can be provided to RB to pay corporate overhead expenses equal to$4.5 million per year for each of fiscal years 2006 and 2007, and $5.0 millionfor each fiscal year thereafter.

In order to securethe obligations of the Giftline Borrowers, the Giftline Borrowers pledged andhave granted security interests to the Administrative Agent in substantiallyall of their existing and future personal property, and each Giftline Borrowerguaranteed the performance of the other Giftline Borrowers under the GiftlineCredit Agreement.  In addition, RBprovided a limited recourse guaranty of the obligations of the GiftlineBorrowers under the Giftline Credit Agreement. This guarantee is secured by a lien on the assets intended to beassigned 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 ForeignSubsidiaries to the Administrative Agent (the “Giftline Pledge Agreement”).  The Giftline Pledge Agreement containssubstantially similar limitations on the activities of RB as is set forth inthe Infantline Pledge Agreement.

The Company’s ability to maintain compliance with thefinancial covenants under the 2006 Credit Agreements is dependent, particularlyin the case of the Giftline Credit Agreement, upon the successful implementationof the Company’s Profit Improvement Plan (described in Note 8 herein) andcurrent operational plans.  Based onthese plans and management’s current projections, management believes that theCompany will remain in compliance with the financial covenants in the 2006Credit Agreements at least through June 30, 2007.  However, in the event that the Company isunable to successfully implement the key elements of the Profit ImprovementPlan and current operational plans, there can be no assurance that the Companywill remain in compliance with the financial covenants in the 2006 CreditAgreements.

*C.            Canadian Credit Agreement*

As contemplated bythe 2005 Credit Agreement on June 28, 2005, the Company’s Canadian subsidiary,Amram’s Distributing Ltd. (“Amrams”), executed a separate Credit Agreement(acknowledged by the Company) with the financial institutions party thereto andLaSalle Business Credit, a division of ABN AMRO Bank, N.V., Canada Branch, aCanadian branch of a Netherlands bank, as issuing bank and administrative agent(the “Canadian Credit Agreement”), and related loan documents with respect to amaximum U.S. $10.0 million revolving loan (the “Canadian Revolving Loan”).  RB executed an unsecured Guarantee (the “CanadianGuarantee”) to guarantee the obligations of Amrams under the Canadian CreditAgreement.  In connection with theLaSalle Refinancing, the Canadian Credit Agreement was amended to (i) replacereferences to the LaSalle Credit Agreement with the Giftline Credit Agreement(such that, among other conforming changes, a default under the Giftline CreditAgreement will be a default under the Canadian Credit Agreement), (ii) releaseRB from the Canadian Guaranty and (iii) provide for a maximum U.S. $5.0 million revolving loan.  In connection with the release of the Companyfrom the Canadian Guaranty, Newco executed an unsecured Guarantee (the “NewcoGuarantee”) to guarantee the obligations of Amrams under the Canadian CreditAgreement.  A default under theInfantline Credit Agreement will not constitute a default under the CanadianCredit Agreement**. **Theoutstanding balance under the Canadian Revolving Loan as of June 30, 2006 was$0.4 million which reduces availability under the Giftline Credit Agreement.

The Commitments bearinterest at a rate per annum equal to the sum of the Base Rate (for Base RateLoans) or the LIBOR Rate (for LIBOR Loans) plus an applicable margin.  Asof June 30, 2006, the interest rate for the outstanding Base Rate loan was8.25%. and there were no outstanding Libor Loans.

13

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** **

**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

(Unaudited)

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

Since 1983, theCompany had been a guarantor of the EDA Loan Agreement, pursuant to which theEDA issued the EDA Bonds in the principal amount of $7.0 million to finance theconstruction of the South Brunswick, New Jersey facility now leased by theCompany from the Estate of Mr. Russell Berrie. Mr. Berrie (and after his death, his Estate) was the primary obligorwith respect to the EDA Bonds. In connection therewith, the Company, in 1983,caused the issuance of a letter of credit in an amount of approximately $7.4million to secure the payment obligations with respect to the EDA Bonds and hadgranted a security interest on accounts receivable and inventory of the Companyup to $2.0 million to secure its obligations under its guarantee and theAmended and Restated Letter of Credit Reimbursement Agreement (“L/C RA”)executed in connection therewith.

Consummation ofthe 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 the agreement of the EDA Standby L/C Issuer torefrain for a specified time period from demanding such cash collateral oradditional collateral, the Administrative Agent had agreed to issue, on behalfof the Giftline Borrowers, a letter of credit in an approximate amount of $7.4million (the “Back-Stop L/C”) that could have been drawn upon by the EDAStandby L/C Issuer under specified circumstances, including any draw on the EDAStandby L/C or the failure of the EDA Bonds to be redeemed by August 15,2006.  In consideration for theestablishment of the Back-Stop L/C, the EDA Standby L/C Issuer granted to theAdministrative Agent a 100% participation in all rights of the EDA Standby L/CIssuer under L/C RA, including the EDA Standby L/C.

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

*E.            Earnout Security Documents*

All capitalizedterms used but undefined in this Note 5, Section 1.E “Earnout SecurityDocuments” section shall have the meanings ascribed to them in the “GiftlineCredit Agreement”.

As has beenpreviously reported, the Company was obligated to pay the Earnout Considerationunder the Kids Line Purchase Agreement. Pursuant to the Letter Agreement between the Infantline Borrowers andCalifornia KL Holdings, Inc., and the other parties thereto (the “LetterAgreement”), the Infantline Borrowers have agreed, on a joint and severalbasis, to assume sole responsibility to pay the Earnout Consideration in theplace of the Company.  In connectiontherewith, the Earnout Security Documents have been amended to effect thepartial release of the Company as obligor and the full release of the securityinterests granted thereunder by any Giftline Borrowers.  To secure the obligations of the InfantlineBorrowers to pay the Earnout Consideration, the Infantline Borrowers havegranted a subordinated lien on substantially all of their assets, on a jointand several basis, and RB has granted a subordinated lien on the equityinterests of each of the Infantline Borrowers to the Earnout SellersAgent.  All such security interests andliens are subordinated to the senior indebtedness of the Infantline Borrowersarising under the Infantline Credit Agreement. The Earnout Consideration is not secured by the Giftline Borrowers ortheir assets or equity interests.

14

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** **

**NOTES TO UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

(Unaudited)

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

The Company and certain of its domestic wholly-ownedsubsidiaries party thereto (the “Specified Subsidiaries”), entered into a$105.0 million credit agreement dated as of June 28, 2005, and amended asof August 4 and October 11, 2005 (the “2005 Credit Agreement”), withthe financial institutions parties thereto as Facility A Lenders, the financialinstitutions parties thereto as Facility B Lenders, LaSalle Bank NationalAssociation, in its capacity as “Issuing Bank” thereunder, LaSalle BusinessCredit, LLC (in its individual capacity, “LaSalle”), as administrative agent(in such capacity, the “Administrative Agent”) for the lenders and the IssuingBank, and those lenders, if any, designated therein as the “Documentation Agent”or “Syndication Agent”.  On October 11, 2005, the Company and its lendersamended provisions 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.

The obligations under the 2005 Credit Agreement (the “Commitments”)consisted of Facility A Obligations and Facility B Obligations.  TheFacility A Obligations were comprised of: (a) a $52.0 million revolvingcredit facility (the “Revolving Loan”), with a sub-facility for letters ofcredit to be issued by the Issuing Bank in an amount not to exceed $10.0million; and (b) a $13.0 million term loan facility (“Term Loan A”). The Facility B Obligations consisted of a $40.0 million term loan facility (“TermLoan B”).  Assuming no default or event of default, on the terms andconditions set forth in the 2005 Credit Agreement, and subject to the paymentof applicable fees, the Revolving Loan could have been increased to a maximumof $75.0 million.  As of December 31, 2005, the Company had $31.9million outstanding under the Revolving Loan.

The principal of Term Loan A was due in equal monthlyinstallments of approximately $0.2 million (subject to reduction byprepayments), to be made on the last day of each month (commencingJuly 31, 2005).  A final installment in the aggregate amount of theunpaid principal balance of Term Loan A (in addition to all outstanding amountsunder the Revolving Loan) was due and payable on June 28, 2010, and theprincipal of Term Loan B was due and payable on December 28, 2010, in eachcase subject to earlier termination in accordance with the terms of the 2005Credit Agreement.  Notwithstanding the foregoing, the Company was requiredto repay Term Loan B in full upon a full redemption of the Facility AObligations.

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

In connection with the execution of the 2005 CreditAgreement and the Canadian Credit Agreement, the Company recorded approximately$2.3 million of deferred financing costs which were included in “other assets”at December 31, 2005 and were being amortized over the five-year period ofthe Commitments. The unamortized balance of these deferred financing costs waswritten off in the first quarter of 2006 as a result of the LaSalle Refinancingin March 2006.  The Revolving Loan wassubject to an annual non-use fee (payable monthly, in arrears, and upontermination of the relevant obligations) based on the most recent quarter-endTotal Debt to EBITDA Ratio ranging from 0.375% - 0.50% for unused amounts underthe Revolving Loan, an annual letter of credit fee (payable monthly, inarrears, and upon termination of the relevant obligations) for undrawn amountswith respect to each letter of credit based on the most recent quarter-endTotal Debt to EBITDA Ratio ranging from 1.50% - 2.25% (subject to increase by2.0% at any time an event of default exists), customary letter of creditadministration fees and a letter of credit fronting fee in amounts agreed to bythe Company and the Issuing Bank.  Notwithstanding the foregoing, duringthe Initial Period, the non-use fee was equal to 0.375% and the letter ofcredit fee was equal to 1.75%.

The 2005 Credit Agreement contained the followingfinancial covenants (the “Financial Covenants”):  (i) a minimum FixedCharge Coverage Ratio, (ii) a maximum Total Debt to EBITDA Ratio and(iii) a minimum Excess Revolving Loan Availability requirement of $2.5 million. Excess Revolving Loan Availability at December 31, 2005 was approximately $15.7million.  With respect to dividends, the Company was permitted to pay adividend so long as before and after giving effect to the payment of suchdividends, Excess Revolving Loan Availability would equal or exceed $15.0million and no violation of the Financial Covenants would then exist, or would,on a pro forma basis, result therefrom.  Any such dividends could bedeclared no more frequently than quarterly and were required to take the formof regular cash dividends.  With respect to the Earnout Consideration, theCompany was permitted to pay all or a portion of the Earnout Consideration tothe extent that, before and after giving effect to such payment, Excess RevolvingLoan Availability would equal or exceed $15.0 million and no violation of theFinancial Covenants would then exist, or would, on a pro forma basis, resultthere from.  As of December 31, 2005, the 

15

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** **

**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

(Unaudited)

Company was not in compliance with the “Total Debt toEBITDA 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.

As contemplated by the 2005 Credit Agreement, theCompany’s Canadian subsidiary, Amram’s Distributing Ltd. (“Amrams”), enteredinto on June 30, 2005, as of June 28, 2005, and amended as ofAugust 4 and October 11, 2005, a separate  credit agreement withthe financial institutions party thereto and LaSalle Business Credit, adivision of ABN AMRO Bank, N.V., Canada Branch, a Canadian branch of aNetherlands bank (the “Canadian Credit Agreement”) with respect to a maximumU.S. $10.0 million revolving loan (the “Canadian Revolving Loan”), with asub-facility for letters of credit in an amount not to exceed U.S. $2.0million.  If there was no default or event of default occurring under theCanadian Credit Agreement, upon the terms and conditions set forth therein, andsubject to the payment of applicable fees, the Canadian Revolving Loan couldhave been increased to a maximum commitment of U.S. $15.0 million.  Alloutstanding amounts under the Canadian Revolving Loan were to be due andpayable on June 28, 2010, subject to earlier termination in accordancewith the terms of the Canadian Credit Agreement.

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

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

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

As noted above, the Financing Agreement consisted ofthe 2004 Term Loan in the original principal amount of $125 million and wasscheduled to mature on November 14, 2007.  The 2004 Term Loan boreinterest at an annual rate equal to a base rate (which was subject to a minimumrate of 4.75% per annum) plus a spread of 4.25%, or a LIBOR rate (which wassubject to a minimum rate of 1.75% per annum) plus a spread of 7.0%.  The spreads were adjusted to 5.25% and 8.0%,respectively, pursuant to a March 2005 amendment, subject to further adjustmentdownward if certain EBITDA milestones were met.  Pursuant to the amendment, the Company alsoprepaid $18.25 million of the 2004 Term Loan.

Under the Financing Agreement, as amended, the Companywas required to make prepayments of the 2004 Term Loan in an amount equal to$1.75 million per quarter with the balance due at maturity.  In addition, beginning with the fiscal yearended December 31, 2005, the Company would have been required to makeannual mandatory prepayments of the Term Loan, with specified percentages ofexcess cash flow and the proceeds of certain asset sales, debt issuances,equity issuances, tax refunds, insurance and other extraordinary receipts.

To secure the 2004 Term Loan, Ableco Finance LLC, asagent, had a lien on substantially all of the assets of the Company, andCalifornia KL Holdings, Inc., as agent, had a subordinated lien on theseassets.  The Company also pledged theequity interests of certain of its subsidiaries to the agent and provided anevergreen irrevocable letter of credit in an amount of $10.0 million, which theagent could draw upon if there was an event of default or other eventsspecified under the Financing Agreement occurred.  In addition, theCompany’s domestic subsidiaries provided certain guarantees and securityinterests to the agent in order to secure the Company’s obligations.

The Financing Agreement, as originally executed,contained, among other things, various monthly and quarterly financialcovenants to which the Company and its subsidiaries were subject, including aFunded Debt Ratio, a Fixed Charge Coverage Ratio, a Consolidated EBITDAcovenant, an Infant Line EBITDA covenant and a Minimum Qualified Cash covenant.The amendment referred to above was executed because the Company believed thatit would not be in compliance, as of March 31, 2005, with the ConsolidatedEBITDA Covenant and the Funded Debt Ratio set forth in the Financing Agreementas originally executed, and had substantial concerns over whether the Companywould be in compliance with such covenants for the remainder of 2005.

The Financing Agreement was paid in full using theproceeds from the 2005 Credit Agreement.

16

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** **

**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

(Unaudited)

**NOTE 6 — GOODWILL AND INTANGIBLE ASSETS**

Intangibleassets consist of the following:

 
| ** **                                   | ** ** | **Weighted   Average   Amortization   Period** | ** ** | **June 30,  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                                                    |       | 40,000                  |       | 53,000                      |       |
|                                         |       |                                                          |       | $                       | 61,586,000 |                        | $          | 61,599,000 |   |

 

Other intangible assets as of June 30, 2006 andDecember 31, 2005, include Kids Line and Sassy non-compete agreements which arebeing amortized over four and five years, respectively.  Amortization expense was $13,000 and $0.3million for the first six months of 2006 and 2005, respectively.

All of the Company’s goodwill is in the infant andjuvenile segment.  There were no changesto the carrying amount of goodwill during the six months ended June 30, 2006.

**NOTE 7 - DIVIDENDS**

No cash dividends were paid during the three and sixmonths ended June 30, 2006.  Cashdividends of $2.1 million were paid during the three and six months ended June30, 2005.  See Note 5 for a discussion of dividend restrictionsimposed by the Company’s senior bank facilities.

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

In November 2005,the Company continued its prior restructuring of its domestic gift business toreduce expenses, right-size the infrastructure consistent with current 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. Additional restructuringcharges of approximately $1.5 million were incurred in 2005 primarily as aresult of right-sizing the Company’s Eastern Asian and European giftoperations.  As part of therestructuring, the Company also commenced a plan to reduce its facilitiesexpenses by rationalizing certain warehouse and distribution activities in 2006(discussed below).  During the first half of 2006, in accordance with itsNovember 2005 restructuring plan, the Company recorded a $0.4 millionrestructuring charge related to severance costs of employees at its Petaluma,California distribution center which closed in the second quarter of 2006, aswell as $0.3 million due to the reduction of additional sales staff andoperational support positions in the US Gift business.  In addition, in connection with the PIPimplementation, the Company eliminated three executive positions and recorded arestructuring charge of an aggregate of approximately $0.7 million primarilyassociated with severance costs.  TheCompany recorded an additional restructuring charge of $2.2 million in thefirst half of 2006 attributable to the downsizing of its operations in Europeunder its PIP, primarily related to employee severance costs.  See Note 10 of the 2005 10-K for additionalinformation.

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

|                     | ** ** | **Employee**   | ** ** | **Facility**        | ** ** | ** ** | ** ** |
|---------------------|------------|----------------|------------|---------------------|------------|------------|------------|
| ** **          | ** ** | **Separation** | ** ** | **Exit Costs** | ** ** | **Total**  | ** ** |
| Balance @  12/31/05 |       | $              | 1,731,000  |                | $          | 131,000    |       | $ | 1,862,000 |   |
| 2006 Provision      |       | 3,620,000      |       | —              |       | 3,620,000  |       |
| Less Payments       |       | 3,285,000      |       | 21,000              |       | 3,306,000  |       |
| Balance @ 6/30/06   |       | $              | 2,066,000  |                | $          | 110,000    |       | $ | 2,176,000 |   |

 

17

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** **

**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

(Unaudited)

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

The Company operates in twosegments: (i) the Company’s gift business and (ii) the Company’s infant andjuvenile business, which includes Sassy, Inc. and Kids Line,LLC.  This segmentation of the Company’soperations reflects how the Company’s Chief Executive Officer currently viewsthe results of operations.  There are nointer-segment revenues to eliminate. Corporate assets and overhead expenses are included in the gift segment.

The Company’s gift business designs, manufacturesthrough third parties and markets a wide variety of gift products to retailstores throughout the United States and throughout the world via the Company’sinternational wholly-owned subsidiaries. The Company’s infant and juvenilebusinesses design and market products in a number of baby categories including,among others, infant bedding and accessories, bath toys and accessories,developmental toys, feeding items and baby comforting products.  These products are sold to consumers,primarily in the United States, through mass merchandisers, toy specialty,food, drug and independent retailers, apparel stores and military post exchanges.
| ** **                                       | ** ** | **Three Months Ended   June 30,** | ** ** | **Six Months Ended   June 30,** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                              | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                       | ** ** | **(Dollars in thousands)**                  | ** ** |
| **Gift:**                                        | ** ** | ** **                                            | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                        |       | $                                                     | 29,158     |                                                | $          | 28,771 |   | $ | 69,190 |   | $ | 66,676 |   |
| Selling, general and administrative expenses (a) |       | 22,435                                                |       | 24,659                                              |       | 49,436 |   | 50,570 |   |
| Operating loss                                   |       | (11,332                                               | )          | (12,612                                             | )          | (22,414 | ) | (20,288 | ) |
| Other income/(expense)                           |       | (115                                                  | )          | 81                                                  |       | 132 |   | 108 |   |
| Depreciation and amortization                    |       | 1,135                                                 |       | 1,354                                               |       | 2,323 |   | 2,789 |   |
| Loss before income taxes                         |       | $                                                     | (11,448    | )                                                   | $          | (12,531 | ) | $ | (22,282 | ) | $ | (20,180 | ) |
| **Infant  and juvenile:**                        | ** ** | ** **                                            | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                        |       | $                                                     | 36,531     | ** **                                          | $          | 33,248 |   | $ | 73,859 | ** ** | $ | 66,083 | ** ** |
| Selling, general and administrative expenses     |       | 4,840                                                 |       | 4,523                                               |       | 9,594 |   | 9,297 |   |
| Operating income                                 |       | 9,932                                                 |       | 8,452                                               |       | 21,080 |   | 16,839 |   |
| Other expense                                    |       | (1,450                                                | )          | (8,252                                              | )          | (7,023 | ) | (11,730 | ) |
| Depreciation and amortization                    |       | 216                                                   |       | 228                                                 |       | 423 |   | 691 |   |
| Income before income taxes                       |       | $                                                     | 8,482      |                                                | $          | 200 |   | $ | 14,057 |   | $ | 5,109 |   |
| **Consolidated:**                                | ** ** | ** **                                            | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                        |       | $                                                     | 65,689     |                                                | $          | 62,019 |   | $ | 143,049 |   | $ | 132,759 |   |
| Selling, general and administrative expenses     |       | 27,275                                                |       | 29,182                                              |       | 59,030 |   | 59,867 |   |
| Operating loss                                   |       | (1,401                                                | )          | (4,160                                              | )          | (1,334 | ) | (3,449 | ) |
| Other expense                                    |       | (1,565                                                | )          | (8,171                                              | )          | (6,891 | ) | (11,622 | ) |
| Depreciation and amortization                    |       | 1,351                                                 |       | 1,582                                               |       | 2,746 |   | 3,480 |   |
| Loss before  income taxes                        |       | $                                                     | (2,966     | )                                                   | $          | (12,331 | ) | $ | (8,225 | ) | $ | (15,071 | ) |

 

(a)          Included in the giftsegment selling, general and administrative expense in the three and six monthsended June 30, 2006 was $1.0 million and $3.7 million, respectively, of chargesassociated with restructuring activities in the U.S. and European giftdivisions and $1.2 million and $2.5 million, respectively, of consulting costsincurred in connection with the development of the PIP.

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** **

**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

(Unaudited)

Totalassets of each segment were as follows:

|                      | ** ** | **June 30 , 2006**    | ** ** | **December 31, 2005*** | ** ** |
|----------------------|------------|--------------------------------------|------------|----------------------------------|------------|
| ** **           | ** ** | **(Dollars in thousands)** | ** ** |
| Gift                 |       | $                                    | 103,005    |                             | $          | 130,222 |   |
| Infant and  juvenile |       | 199,048                              |       | 199,240                          |       |
| Total                |       | $                                    | 302,053    |                             | $          | 329,462 |   |

----

*                    December31, 2005 balances have been reclassified to conform to the June 30, 2006presentation.

**Concentrationof Risk**

As disclosed in the 2005 10-K, approximately 89% ofpurchases are attributable to manufacturers in the People’s Republic ofChina.  The supplier accounting for thegreatest dollar volume of purchases accounted for approximately 16% and thefive largest suppliers accounted for approximately 40% in the aggregate. The Company utilizes approximately 130 manufacturers in Eastern Asia andbelieves that there are many alternative manufacturers and sources of rawmaterials for the Company’s products.  As a result, the Company does notbelieve there is a concentration of risk associated with any significantmanufacturing relationship.

With respect to customers, Toys “R” Us, Inc. andBabies “R” Us, Inc. in the aggregate accounted for 26.2% and 24.8%,respectively, of the Company’s consolidated net sales during the three and sixmonth periods ended June 30, 2006.

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

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

The Company accounts for its forward exchangecontracts as an economic hedge, with subsequent changes in fair value recordedin the Consolidated Statements of Operations. As of June 30, 2006, netunrealized gains of $0.93 million relating to forward contracts are included inother current assets and as of December 31, 2005, unrealized losses of$0.16 million are included in accrued expenses in the Consolidated BalanceSheets.

The Company has forward contracts to exchange Britishpounds sterling, Canadian dollars and Australian dollars for United Statesdollars with notional amounts of $6.4 million and $3.3 million as of June 30,2006 and December 31, 2005, respectively. The Company has forwardcontracts to exchange United States dollars to Euros with notional amounts of$3.2 million and $6.4 million as of June 30, 2006 and December 31, 2005,respectively. The Company does not anticipate any material adverse impact onits results of operations or financial position from these contracts.

19

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** **

**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

(Unaudited)

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

Comprehensive (Loss)/Income, representing all changesin Shareholders’ Equity during the period other than changes resulting from theissuance or repurchase of the Company’s common stock and payment of dividends,is reconciled to net loss for the three and six months ended June 30, 2006 and2005 as follows:

 

|                                                                               | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                    | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                    | ** ** | **(Dollars in thousands)**                | ** ** |
| Net (loss)                                                                    |       | $                                                   | (5,975     | )                                                 | $          | (6,162 | ) | $ | (10,967 | ) | $ | (7,884 | ) |
| Other  comprehensive income/(loss), net of tax:                               |       |                                                |       |                                              |       |   |   |   |   |
| Foreign currency  translation adjustments                                     |       | 1,181                                               |       | (1,899                                            | )          | 1,232 |   | (3,346 | ) |
| Net unrealized  gain on foreign currency forward exchange contracts and other |       | —                                              |       | 336                                               |       | — |   | 415 |   |
| Other  comprehensive income/(loss)                                            |       | 1,181                                               |       | (1,563                                            | )          | 1,232 |   | (2,931 | ) |
| Comprehensive (loss)                                                          |       | $                                                   | (4,794     | )                                                 | $          | (7,725 | ) | $ | (9,735 | ) | $ | (10,815 | ) |

 

**NOTE 12 — CONTINGENCIES AND COMMITMENTS**

In the ordinary course of its business, the Company isparty to various copyright, patent and trademark infringement, unfaircompetition, breach of contract, customs, employment and other legal actionsincidental to its business, as plaintiff or defendant.  In the opinion of management, the amount ofultimate liability with respect to these actions will not materially adverselyaffect the consolidated results of operations, financial condition or cashflows of the Company.

In connection with the Company’s purchase of Kids LineLLC, the aggregate purchase price includes a potential payment of EarnoutConsideration as more fully described in Note 4.  The amount of Earnout Consideration, if any,is not currently determinable.

The Company enters into various license agreementsrelating to trademarks, copyrights, designs, and products which enable theCompany to market items compatible with its product line.  All license agreements other than theagreement with MAM Babyartikel GmbH (which has a remaining term of five years),are for three year terms with extensions agreed to by both parties.  Some of these license agreements includeprepayments and minimum guarantee royalty payments.  The amount of guaranteed royalty paymentswith respect to all license agreements over the next three years aggregates$2.1 million.  At December 31, 2005, theCompany recorded a pre-tax charge of $2.3 million against these royaltyguarantees.  The Company’s royaltyexpense for the six months ended June 30, 2006 and 2005 was $1.1 million and$1.0 million, respectively.

20

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** **

**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

(Unaudited)

**NOTE 13 — RECENTLY ISSUED ACCOUNTING STANDARDS**

InDecember 2004, the FASB issued SFAS 123(R) which establishes standards fortransactions in which an entity exchanges its equity instruments for goods orservices.  This statement is areplacement of SFAS 123 and supersedes APB 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 theaward.  This standard applies to allawards unvested or granted as of the required effective date and to awardsmodified, repurchased, or cancelled after that date.  SFAS 123(R) became effective for the Companybeginning with the first quarter of 2006 and was adopted by the Company as ofJanuary 1, 2006  See Note 2 for furtherdiscussion of the impact of SFAS 123(R).

In July 2006, theFASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”(FIN 48), effective for fiscal years beginning after December 15, 2006.  FIN 48 requires a two-step approach todetermine how to recognize tax benefits in the financial statements whererecognition and measurement of a tax benefit must be evaluated separately.  A tax benefit will be recognized only if itmeets a “more-likely-than-not” recognition threshold.  For tax positions that meet this threshold,the tax benefit recognized is based on the largest amount of tax benefit thatis greater than 50 percent likely of being realized upon ultimate settlementwith the taxing authority. We are currently evaluating the impact of adoptingFIN48, and have not yet determined the significance of this new rule to ouroverall results of operations, cash flows or financial position.

 

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

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

**OVERVIEW**

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

The Company’s revenues are primarily derived fromsales of its products in its gift and infant and juvenile business segments.Sales and operating profits in the Company’s gift segment began to declineduring 2003 as a result of several factors including: (i) retailerconsolidation and a declining number of independent retail outlets, which inturn had a negative impact on sales from such outlets; (ii) increasedcompetition from other entities, both wholesalers and retailers, which offeredlower pricing and achieved 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.

The Company has continued to address the challenges inits gift business through the multi-pronged approach discussed above, which hasenabled the Company to reduce significantly its operating expenses. However,the Company achieved only limited success in reversing the challenges facingits gift business and the industry in general. As a result, inNovember 2005, the Company commenced the implementation of a furtherrestructuring of its domestic gift business designed to “right size” theinfrastructure consistent with existing business levels and re-align domesticgift operations to better meet the needs of different distributionchannels.  The restructuring included theimmediate 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.  As part of the November 2005restructuring, the Company also commenced a plan to reduce its facilitiesexpenses by rationalizing certain warehouse and distribution activities, as furtherdescribed below.  In addition, inconnection with the November 2005 restructuring, the Company conductedanother comprehensive review of its gift product line to identify productcategories and individual items that did not fit into its future sales andmarketing plans.  As a result of productline decisions made in the fourth quarter of 2005, an additional inventorywrite-down of $4.2 million (pre-tax) was recorded in the fourth quarter of2005. The Company is selling substantially all of this inventory through otherthan its normal sales channels.

Management believes that future operating expenseswill be reduced by approximately $15.0 million on an annualized basis as aresult of the restructuring commenced in November 2005. A portion of theseexpense savings related to employee expenses were reflected in the Company’sresults of operations for the fourth quarter of 2005, and the remaining costreductions are expected to be achieved during 2006. Severance payments toemployees impacted by the November 2005 restructuring will continue through theend of 2006, although such payments will not impact the Company’s results ofoperations, as they were reflected in the restructuring charge recorded in thefourth quarter of 2005.

During the first half of2006, in accordance with its November 2005 restructuring plan, the Companyrecorded a $0.4 million restructuring charge related to severance costs ofemployees at its Petaluma, California distribution center which closed in thesecond quarter of 2006, as well as $0.3 million due to the reduction ofadditional sales staffing and operational support positions in the US Giftbusiness.  The Company does not expect toincur additional restructuring costs in association with the November 2005restructuring plan but may incur further restructuring costs as it implementsthe Profit Improvement Program, as described below.

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As an expansion of itsNovember 2005 restructuring and ongoing analysis, in 2006, the Companycommenced the development and phased implementation of a Profit ImprovementProgram (“PIP”) with respect to its global gift business. The Company hadretained the services of an independent advisor to assist in the development ofthe PIP.  During the first half****of 2006, the Company incurred consulting expense ofapproximately $2.5 million in connection with services provided by suchadvisor, which relationship was concluded at the end of June 2006.  The PIP involves an analysis and, in someinstances, re-evaluation of key operational aspects of the Company’s giftbusiness and has been designed to help enable the Company to return its giftbusiness to a sustainable level of profitability.  The PIP involves reengineering the manner inwhich the gift segment operates, and reducing the size of the gift business by focusingon the most profitable products, customers and territories as a means ofproviding a platform for potential profitable growth in the future.  The scope of the PIP is broad and significantand may cause losses to our business that we cannot predict, including aloss of gift segment sales. Implementation of the PIP (significant portions of which are underway inphases) will result in the recognition of certain restructuring charges and theincurrence of related severance obligations. The Company may also be required to make certain investments togenerate the efficiencies and focus on profitable operations that the PIP willbe designed to achieve.   See Item 1Aunder the captions, “Risk Factors” and “Liquidity and Capital Resources” in theCompany’s 2005 10-K.  

As part of the PIP,the Company has evaluated the need to maintain direct sales and distributionefforts in several European countries. To date, the Company has terminated itsdirect sales and distribution operations in France, Germany, Belgium andHolland, and has restructured certain of its sales and related operations inthe U.K.  As a result of these actions,the Company has reduced headcount by an aggregate of 48 positions and hasrecorded a restructuring charge of an aggregate of approximately $2.2 millionin the first half of 2006 primarily related to severance costs.**** Management believesthat future operating expenses, predominantly through reduced employee costs,will be reduced by an aggregate of approximately $4.2 million on an annualizedbasis as a result of these reductions. The Company anticipates that it will establish alternative means ofreaching certain customers in the affected countries, including through the useof independent sales representatives or distributors, although the Company anticipatesthat its aggregate sales from France, Germany, Belgium and Holland may bereduced by approximately $6.0 million on an annualized basis as a result ofthese actions, at least for the near term.**** In addition, in connection with the PIP, theCompany eliminated three executive positions in the US Gift segment andrecorded a restructuring charge of an aggregate of approximately $0.7 millionin the first half of 2006 primarily related to severance costs.**** Management believesthat future operating expenses, predominantly through reduced employee costs,will be reduced by an aggregate of approximately $0.8 million on an annualizedbasis as a result of these reductions.  

As a result of theimplementation of the PIP, in addition to the estimated annual savings of $15.0million under the November 2005 restructuring, the Company expects anadditional annual savings of $5.0 million, the components of which aredescribed in the paragraph immediately preceeding.  Althoughdevelopment of the PIP has been largely completed and certain portionsimplemented as described herein, the estimated completion date of itsimplementation and estimates of the range of charges to be incurred or otherexpenditures required in connection therewith cannot be determined at thistime, as a final determination with respect to which remaining portions, ifany, of the PIP will be implemented has not yet been made.  

Effective December 28, 2005, the Company amended alloutstanding stock option agreements which pertained to options with exerciseprices in excess of the market price for the Company’s Common Stock at theclose of business on December 28, 2005 (“Underwater Options”) which hadremaining vesting requirements. As a result of these amendments, all UnderwaterOptions, which represented all outstanding options (to purchase approximately1.5 million shares of the Company’s common stock) which had not yetfully-vested, became fully vested and immediately exercisable at the close ofbusiness on December 28, 2005.** **Of theoptions accelerated, approximately 120,000 options were held by non-employeedirectors, approximately 854,000 are held by officers of the Company and thebalance were held by other employees of the Company as of June 30, 2006.  Because the Company has accounted forstock-based compensation using the intrinsic value method prescribed in APB 25,and because these options were priced above the then current market price, theacceleration of vesting of these options did not require accounting recognitionin the Company’s financial statements. The options were accelerated to reduce the financial statement expenseimpact in 2006 and beyond of a new accounting standard (SFAS No. 123(R), “ShareBased Payment”) for stock based compensation (described in Note 2 of Notes toUnaudited Consolidated 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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**Prentice Purchase**

As of August 4, 2006, investment entities and accountsmanaged and advised by Prentice Capital Management, L.P. (“Prentice”) agreed topurchase all of the Common Stock of the Company owned by The Russell Berrie Foundation(approximately 8.8 million shares), representing approximately 42% of theoutstanding shares of the Company (the “Prentice Purchase”).  Upon the closing of the Prentice Purchase,the Company’s Board of Directors will be reconstituted to consist of a total ofnine members, including four to be nominated by Prentice, and the Company willprovide to Prentice certain continuing Board representation rights andregistration rights with respect to the purchased shares.  The Company will not receive any of theproceeds from the Prentice Purchase.  

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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 ENDED JUNE 30, 2006AND 2005**

The Company’s consolidated net sales for the threemonths ended June 30, 2006 increased 5.9% to $65.7 million compared to $62.0million for the three months ended June 30, 2005 as a result of sales growth inboth its infant and juvenile and gift business segments.

The Company’s gift segment net sales for the threemonths ended June 30, 2006 increased 1.3% to $29.2 million compared to $28.8million for the three months ended June 30, 2005, primarily as a result ofimproved product content and availabilityduring the 2006 period.  Net sales in the Company’s gift segment werenegatively impacted by foreign exchange rates by approximately $0.1 million forthe three months ended June 30, 2006.  The Company’s infant and juvenilesegment net sales for the three months ended June 30, 2006 increased 9.9% to$36.5 million compared to $33.2 million for the three months ended June 30,2005.  This increase is primarilyattributable to sales growth in the Company’s Kids Line subsidiary.

Consolidated gross profit was 39.4% of consolidatednet sales for the three months ended June 30, 2006 as compared to 40.3% of consolidatednet sales for the three months ended June 30, 2005.  The decline in theconsolidated gross profit percentage is primarily due to competitive pricingpressure and sales channel mix as well as close-out sales related to theelimination of certain product lines in connection with the implementation ofthe PIP in the gift segment.  Gross profit for the Company’s gift segmentwas 38.1% of net sales for such segment for the three months ended June 30,2006 as compared to 41.9% of net sales for the three months ended June 30,2005.  Gross profit for the Company’s infant and juvenile segment was40.4% of net sales for such segment for the three months ended June 30, 2006 ascompared to 39.0% of net sales for the three months ended June 30, 2005.

Consolidated selling, general and administrativeexpense was $27.3 million, or 41.5% of consolidated net sales, for the threemonths ended June 30, 2006 compared to $29.2 million, or 47.1% of consolidatednet sales, for the three months ended June 30, 2005.  Selling, general andadministrative expense in the Company’s gift segment decreased by approximately$2.3 million to $22.4 million in the second quarter of 2006 from $24.7 millionin the prior year period primarily as a result of ongoing expense reductions inthe gift segment related to 2005 and 2006 restructuring activities.**  **Included in thegift segment selling, general and administrative expense in the second quarterof 2006 was $1.0 million in charges associated with the restructuringactivities in the U.S. and European gift divisions and $1.2 million ofconsulting costs incurred in connection with the development of the PIP.  These charges were partially offset by anincrease in selling, general and administrative expense of $0.3 million in theCompany’s infant and juvenile segment, primarily as a result of increased costsassociated with growth at Kids Line.

Consolidated other expense was $1.6 million for thethree months ended June 30, 2006 compared to $8.2 million for the three monthsended June 30, 2005.  This $6.6 milliondecrease is primarily the result of the write-off of deferred financing costsincurred in June 2005 as well as lower interest expense as a result of lowerborrowings and a lower interest rate compared to the second quarter of 2005, partiallyoffset by financing costs in 2006.  Otherexpense in the Company’s gift segment for the three months ended June 30, 2006increased $0.2 million compared to the prior year period primarily as a resultof foreign exchange losses in 2006.

Income tax expense increased $9.2 million to $3.0million of income tax expense for the three months ended June 30, 2006 ascompared to an income tax benefit of $6.2 million for the three months endedJune 30, 2005.  Effective with thequarter ended December 31, 2005, the Company has recorded full valuationallowances against substantially all of its net deferred tax assets, whilecontinuing to record deferred tax expense related to the amortization ofcertain indefinite life intangibles resulting from acquisitions made inprevious years.

As a result of the foregoing, consolidated net lossfor the three months ended June 30, 2006 was $6.0 million, or $0.29 per dilutedshare, compared to consolidated net loss of $6.2 million, or $0.30 per dilutedshare, for the three months ended June 30, 2005.

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** **

**RESULTS OF OPERATIONS— SIX MONTHS ENDED JUNE 30, 2006 AND2005**

The Company’s consolidated net sales for the sixmonths ended June 30, 2006 increased 7.8% to $143.0 million compared to $132.8million for the six months ended June 30, 2005 as a result of sales growth inboth its infant and juvenile and gift business segments.

The Company’s gift segment net sales increased 3.8%for the six months ended June 30, 2006 to $69.2 million compared to $66.7million for the six months ended June 30, 2005, primarily as a result ofimproved content and product availability as well as strong consumer demand forYomiko TM brand of premium plus products within the specialty channel has beenof particular impact on improved results during the 2006 period.  The Company’s increased presence in the masschannels in its Applause TM brand has also positively impacted its first halfsales.  Net sales in the Company’s giftsegment were negatively impacted by foreign exchange rates by approximately$0.4 million for the six months ended June 30, 2006.  The Company’s infantand juvenile segment net sales for the six months ended June 30, 2006 increased11.8% to $73.9 million compared to $66.1 million for the six months ended June30, 2005. This increase is primarily attributable to sales growth in theCompany’s Kids Line subsidiary.

Consolidated gross profit was 40.3% of consolidatednet sales for the six months ended June 30, 2006 as compared to 42.5% ofconsolidated net sales for the six months ended June 30, 2005.  Thedecline in the consolidated gross profit percentage is primarily due tocompetitive pricing pressure and sales channel mix as well as close-out salesrelated to the elimination of certain product lines in connection with theimplementation of the PIP in the gift segment.  Gross profit for the Company’s gift segment was 39.1% of net sales forsuch segment for the six months ended June 30, 2006 as compared to 45.4% of netsales for the six months ended June 30, 2005.  Gross profit for theCompany’s infant and juvenile segment was 41.5% of net sales for such segmentfor the six months ended June 30, 2006 as compared to 39.6% of net sales forthe six months ended June 30, 2005.

Consolidated selling, general and administrativeexpense was $59.0 million, or 41.3% of consolidated net sales, for the sixmonths ended June 30, 2006 compared to $59.9 million, or 45.1% of consolidatednet sales, for the six months ended June 30, 2005.  Selling, general andadministrative expense in the Company’s gift segment decreased by $1.1 millionto $49.4 million in the first half of 2006 from $50.6 million in the prior yearperiod.  Included in the gift segmentselling, general and administrative expense in the first half of 2006 was $3.7million in charges associated with the restructuring activities in the U.S. andEuropean gift divisions and $2.5 million of consulting costs incurred inconnection with the development of the PIP. These charges were offset by ongoing expense reductions in the giftsegment as a result of 2005 and 2006 restructuring activities.  Selling, general and administrative expensein the Company’s infant and juvenile segment increased by $0.3 millionprimarily as a result of increased costs associated with growth at Kids Line.

Consolidated other expense was $6.9 million for thesix months ended June 30, 2006 compared to $11.6 million for the six monthsended June 30, 2005, a decrease of $4.7 million.  This decrease is a result of refinancingcosts incurred in the first half of 2005, partially offset by refinancing costsincurred in the first half of 2006.  The2006 refinancing resulted in lower interest expense as a result of lowerborrowings and lower interest rates, as well as a $2.9 million write-off andamortization of deferred financing costs in 2006 versus a $5.7 millionwrite-off and amortization of deferred financing costs in the same period of2005.

Income tax expense increased $9.9 million to $2.7million of income tax expense for the six months ended June 30, 2006 ascompared to an income tax benefit of $7.2 million for the six months ended June30, 2005.  Effective with the quarterended December 31, 2005, the Company has recorded full valuation allowancesagainst substantially all of its net deferred tax assets, while continuing torecord deferred tax expense related to the amortization of certain indefinitelife intangibles resulting from acquisitions made in previous years.

As a result of the foregoing, consolidated net lossfor the six months ended June 30, 2006 was $11.0 million, or $0.53 per dilutedshare, compared to consolidated net loss of $7.9 million, or $0.38 per dilutedshare, for the six months ended June 30, 2005.

**Liquidity and Capital Resources**

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

As of June 30, 2006, the Company had cash andcash equivalents of $10.3 million compared to $28.7 million atDecember 31, 2005. This reduction****ofapproximately $18.3 million was primarily related to the repayment of debt anda seasonal increase in vendor payments for holiday selling.  The decrease****inaccounts receivable was due 

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primarily to the timing of customer payments, with thesecond quarter traditionally being the weakest quarter of the year for theCompany’s gift business.  The reduction****in inventory reflects the Company’s historical procurementpattern as well as efforts to sell off discontinued lines as a result of the Company’srestructuring activities.  As of June 30,2006 and December 31, 2005, working capital was $71.8 million and$71.1 million, respectively.

Cash and cash equivalents decreased by approximately$18.3 million during the six months ended June 30, 2006 compared to a decreaseof $32.6 million during the six months ended June 30, 2005.  The decrease during the six months ended June30, 2006 was primarily a result of the factors described in the precedingparagraph.  The decrease during the sixmonths ended June 30, 2005 was primarily due to the payment of debt related tothe termination of the Financing Agreement partially offset by proceeds fromthe 2005 Credit Agreement, proceeds from the sale of assets in the UK and HongKong during the first quarter of 2005, the previously recorded US Federal taxrefund received in the second quarter of 2005, and collections of accountsreceivable.** **Netcash used by operating activities was approximately $6.6 million during the sixmonths ended June 30, 2006 compared to net cash provided by operatingactivities of approximately $25.2 million during the six months ended June 30,2005.  The decrease of $31.8 million wasdue primarily to an increase in net loss, the release of restricted cash in the2005 period that was used toward repayment of the 2004 Term Loan and thefactoring of UK receivables in 2006, partially offset by amortization of thedeferred gain on the sale and leaseback of the Canadian facility in 2006 andthe seasonal increase in vendor payments**.** Net cash used in investing activities wasapproximately $0.2 million for the six months ended June 30, 2006 compared tonet cash provided by investing activities of approximately $8.3 million for thesix months ended June 30, 2005.  The reductionof $8.5 million was due primarily to proceeds from the sale of assets in thefirst quarter of 2005.  Net cash used infinancing activities was approximately $11.5 million for the six months endedJune 30, 2006 compared to $63.4 million for the six months ended June 30,2005.  The reduction of $51.9 million wasdue primarily to higher debt repayment in the first quarter of 2005, whichincluded required prepayments of the 2004 Term Loan in the amount of $20.0million and lower borrowings in 2006.

***Kids Line andRelated Financing***

*Overview of Debt at June 30, 2006.*  On March 14, 2006, the Company refinanced itscredit facility and entered into separate Credit Agreements for each of itsoperating segments.  All of the priordebt outstanding on March 14, 2006, together with fees and expenses associatedwith the transaction, was refinanced by drawing down approximately $79.7million under the Infantline Credit Agreement (described below), including thefull amount of the $60.0 million Term Loan and $19.7 million of the InfantlineRevolver.  At June 30, 2006, the Companyhad $65.7 million outstanding under the Infantline Credit Agreement, reflectingrepayments of the Infantline Revolver and the Term Loan in the amounts of $11.0million and $3.0 million, respectively. As of June 30, 2006, the balance on the Giftline revolver was $1.1million and the balance on the Canadian revolver (see Section 1.C below) was$0.4 million.

*Background.*  The Company purchased all of the outstandingequity interests and warrants in Kids Line (the “Purchase”) in accordance withthe terms and provisions of a Membership Interest Purchase Agreement (the “PurchaseAgreement”) executed as of December 15, 2004. At closing, the Company paidapproximately $130.5 million, which represented the portion of the purchaseprice due at closing plus various transaction costs. The aggregate purchaseprice under the Purchase Agreement, however, also includes the potentialpayment of the Earnout Consideration, which is defined as 11.724% of the AgreedEnterprise Value of Kids Line as of the last day of the three year periodending November 30, 2007 (the “Measurement Period”). The EarnoutConsideration shall be paid as provided in the Purchase Agreement(approximately the third anniversary of the Closing Date). The “AgreedEnterprise Value” shall be the product of (i) Kids Line’s EBITDA duringthe twelve (12) months ending on the last day of the Measurement Period and(ii) the applicable multiple (ranging from zero to eight) as set forth inthe Purchase Agreement. The amount of the Earnout Consideration will be chargedto goodwill if and when it is earned. Because the amount payable with respectto the Earnout Consideration, if any, and the Company’s financial condition atthe time any such payment is due are not currently determinable, the Companycannot assure that payment of the Earnout Consideration will not have amaterial impact on the Company’s liquidity.

The Kids Lineacquisition 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 Financing Agreement was subsequentlyreplaced by the 2005 Credit Agreement and the 2005 Canadian Credit Agreement(as defined below), which are described in further detail in Note 5 above andin the Current Report on Form 8-K filed by the Company with the SEC on July 5,2005.

In order to reduce overall interest expense and gainincreased flexibility with respect to the financial covenant structure of theCompany’s senior bank financing, on March 14, 2006, the 2005 Credit Agreementwas terminated and the obligations thereunder were refinanced (the “LaSalleRefinancing”).  For a detaileddescription of the 2006 Credit Agreements, which are defined and summarizedbelow, see Note 5 above and the Company’s Current Report on Form 8-K filed withthe SEC on March 17, 2006.  On March 14,2006, in connection with the LaSalle 

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Refinancing, alloutstanding obligations under the 2005 Credit Agreement (approximately $76.5million) were repaid using proceeds from the 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 Companywrote-off, in the first quarter of 2006, approximately $2.5 million in deferredfinancing costs in connection with the LaSalle Refinancing.

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

*InfantlineCredit Agreement. *On March14, 2006, Kids Line and Sassy (the “Infantline Borrowers”), entered into acredit agreement 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”).  Unless otherwise specified herein,capitalized terms used but undefined in Note 5 Section 1.A shall have themeanings ascribed to them in 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”).  TheInfantline Borrowers drew down approximately $79.7 million under the InfantlineCredit Agreement on the Closing Date, including the full amount of the TermLoan, which reflects the payoff of all amounts outstanding under the 2005Credit Agreement and certain fees and expenses associated with the LaSalleRefinancing.  As of June 30, 2006, thebalance on the Revolving Loan was $8.7 million and the balance on the Term Loanwas $57.0 million.  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 ranges from1.75% - 2.50% for LIBOR Loans and from 0.25% - 1.00% for Base Rate Loans.

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

The InfantlineCredit Agreement contains customary affirmative and negative covenants, as wellas the following financial covenants: (i) a minimum EBITDA test, (ii) a minimum Fixed Charge Coverage Ratio,(iii) a maximum Total Debt to EBITDA Ratio and (iv) an annual capitalexpenditure limitation.  As of June 30,2006, the Company was in compliance with the financial covenants contained inthe Infantline Credit Agreement.

*GiftlineCredit Agreement**. *Also on March 14, 2006 as amendedon April 11, 2006 (to clarify the application of a financial covenant) andAugust 8, 2006, Newco and other specified wholly-owned domestic subsidiaries ofthe Company (collectively, the “Giftline Borrowers”), entered into a creditagreement as borrowers, on a joint and several basis, with LaSalle BankNational Association, as issuing bank (the “Issuing Bank”), LaSalle BusinessCredit, LLC as administrative agent (the “Administrative Agent”), the lendersfrom time to time party thereto, and the Company, as loan party representative(as amended, the “Giftline Credit Agreement” and, together with the InfantlineCredit Agreement, the “2006 Credit Agreements”).  Unless otherwise specified herein,capitalized terms used but undefined in Note 5 Section 1.B shall have themeanings ascribed to them in the Giftline Credit Agreement.

The GiftlineCredit Agreement contemplates the potential inclusion of additional lenderssubsequent to the initial closing, which as of June 30, 2006 has not occurred,and a simultaneous increase in the commitment, and the facility consists of arevolving credit loan commitment (a) before such commitment is increased, if atall, in an amount equal to the Borrowing Base minus amounts outstanding underthe Canadian Credit Agreement (as defined below) and (b) after such commitmentis increased, if at all, in an amount equal to the lesser of (i) $25.0 millionand (ii) the then-current Borrowing Base, in each case minus amountsoutstanding under the Canadian Credit Agreement (the “Giftline Revolver”), witha subfacility for letters of credit to be issued by the Issuing Bank in anamount not to exceed $8.0 million.   TheBorrowing Base is primarily a function of a percentage of eligible accountsreceivable 

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and eligibleinventory and, as of June 30, 2006, the Borrowing Base, inclusive of theBorrowing Base provided under the Canadian Credit Agreement, was approximately$11.2 million**.** The Giftline Borrowers did not draw down on the Giftline Revolver on theClosing Date.  All outstanding amountsunder the Giftline Revolver are due and payable on March 14, 2011, subject toearlier termination in accordance with the terms of the Giftline CreditAgreement.  The balance of the revolverwas $1.1 million at June 30, 2006.  TheGiftline Revolver bears interest at a rate per annum equal to the sum of theBase Rate (for Base Rate Loans) or the LIBOR Rate (for LIBOR Loans), at theCompany’s option, plus a margin of 2.75% for LIBOR Loans and 1.25% for BaseRate Loans.  Interest is due and payablein the same manner as with respect to the Infantline Loans.

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

As contemplated bythe 2005 Credit Agreement, on June 28, 2005, the Company’s Canadian subsidiary,Amram’s Distributing Ltd. (“Amrams”), executed a separate Credit Agreement(acknowledged by the Company) with the financial institutions party thereto andLaSalle Business Credit, a division of ABN AMRO Bank, N.V., Canada Branch, aCanadian branch of a Netherlands bank, as issuing bank and administrative agent(the “Canadian Credit Agreement”), and related loan documents with respect to amaximum U.S. $10.0 million revolving loan (the “Canadian Revolving Loan”).  Russ Berrie and Company, Inc. (“RB”), acorporate holding company, executed an unsecured Guarantee (the “CanadianGuarantee”) to guarantee the obligations of Amrams under the Canadian CreditAgreement.  In connection with the LaSalleRefinancing, on March 14, 2006, the Canadian Credit Agreement was amended to(i) replace references to the 2005 Credit Agreement with the Giftline CreditAgreement (such that, among other conforming changes, a default under theGiftline Credit Agreement will be a default under the Canadian CreditAgreement), (ii) release the Company from the Canadian Guaranty and (iii)provide for a maximum U.S. $5.0million revolving loan.  In connectionwith the release of the Company from the Canadian Guaranty, Newco executed anunsecured Guarantee (the “Newco Guarantee”) to guarantee the obligations ofAmrams under the Canadian Credit Agreement. A default under the Infantline Credit Agreement will not constitute adefault under the Canadian Credit Agreement. The outstanding balance under the Canadian Revolving Loan as of June 30,2006 was $0.4 million which reduces availability under the Giftline CreditAgreement.

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

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

As a result of the LaSalle Refinancing, the obligationto pay the Earnout Consideration pursuant to the Kids Line acquisition (seeNote 4), is no longer the obligation of RB, but the joint and severalobligations of the Infantline Borrowers. With respect to the Earnout Consideration, the Infantline Borrowers willbe permitted 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.

 

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The Company’s ability to maintain compliance with thefinancial covenants under the 2006 Credit Agreements is dependent, particularlyin the case of the Giftline Credit Agreement, upon the successfulimplementation of the PIP described under “Overview” above and currentoperational plans.  Based on these plansand management’s current projections, management believes that the Company willremain in compliance with the financial covenants in the 2006 Credit Agreementsat least through June 30, 2007.  However,in the event that the Company is unable to successfully implement the keyelements of the PIP and current operational plans, there can be no assurancethat the Company will remain in compliance with such financial covenants, particularlythe covenants in the Giftline Credit Agreement.

**Other Events and CircumstancesPertaining to Liquidity**

The full implementation of the PIP, certain portionsof which may be delayed based upon future operational decisions, may result inthe recognition of certain significant restructuring charges and the incurrenceof related severance obligations.  Inaddition to the $15.0 million anticipated cost savings as a result of theNovember 2005 restructuring, the PIP initiatives that have been implemented areexpected to result in additional savings of approximately $5.0 millionannually.  See “Overview” above for amore detailed description of the PIP and the restructuring activitiesundertaken in 2005 and 2006.

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

The Company is dependent upon information technologysystems in many aspects of its business. In 2002, the Company commenced aglobal implementation of an Enterprise Resource Planning (“ERP”) system for itsgift businesses.  During 2003 andcontinuing into 2004, certain of the Company’s international gift subsidiariesbegan to phase-in aspects of the new ERP system.  In late 2005, the Company began to explorealternative global information technology systems for its gift business thatcould provide greater efficiencies, lower costs and greater reportingcapabilities than those provided by the current ERP system.  As a result of this review, all remaining internationalimplementations were placed on hold pending a decision on whether or not toreplace the current ERP system.  TheCompany expects to make a decision on whether to replace its current ERP systemin the second half of 2006.

In March 1990, the Board of Directors authorizedthe Company to repurchase an aggregate of up to 7.0 million shares of commonstock. As of December 31, 2005, 5.6 million shares have been repurchased sincethe beginning of the Company’s stock repurchase program. The Company did notrepurchase any shares pursuant to this program or otherwise during fiscal 2005or through the first half of 2006.  The2006 Credit Agreements impose certain limitations on the ability of the Companyto repurchase shares.

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

Consistent with its past practices and in the normalcourse of its business, the Company regularly reviews acquisition opportunitiesof varying sizes. The Company may consider the use of debt or equity financingto fund potential acquisitions.  The 2006 Credit Agreements impose restrictionson the Company that could limit its ability to respond to market conditions orto take advantage of acquisitions or other business opportunities.

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**Contractual Obligations**

The following table summaries the Company’ssignificant known contractual obligations as of June 30, 2006 and the futureperiods in which such obligations are expected to be settled in cash (dollarsin thousands):
| ** **                     | ** ** | **Total** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** |
|--------------------------------|------------|-----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|
| Operating Lease  Obligations   |       | $         | 62,211     |     | $          | 4,090    |       | $        | 7,385      |     | $          | 6,678    |       | $              | 6,138      |   | $ | 5,453 |   | $ | 32,467 |   |
| Purchase  Obligations(1)       |       | $         | 34,018     |     | $          | 34,018   |       | $        | —     |     | $          | —   |       | $              | —     |   | $ | — |   | $ | — |   |
| Debt Repayment  Obligations(2) |       | $         | 67,229     |     | $          | 14,729   |       | $        | 9,000      |     | $          | 11,500   |       | $              | 14,500     |   | $ | 15,000 |   | $ | 2,500 |   |
| Royalty  Obligations           |       | $         | 2,101      |     | $          | 736      |       | $        | 1,295      |     | $          | 70       |       | $              | —     |   | $ | — |   | $ | — |   |
| Total Contractual  Obligations |       | $         | 165,559    |     | $          | 53,573   |       | $        | 17,680     |     | $          | 18,248   |       | $              | 20,638     |   | $ | 20,453 |   | $ | 34,967 |   |

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(1)             TheCompany’s purchase obligations consist of purchase orders for inventory.

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

 

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** **

**Off Balance Sheet Arrangements**

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

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** **

**CRITICAL ACCOUNTING POLICIES**

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

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

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

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

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

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

**Recently Issued Accounting Standards**

InDecember 2004, the FASB issued SFAS 123(R) which establishes standards fortransactions in which an entity exchanges its equity instruments for goods orservices.  This statement is areplacement of SFAS 123 and supersedes APB 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 theaward.  This standard applies to allawards unvested or granted as of the required effective date and to awardsmodified, repurchased, or cancelled after that date.  SFAS 123(R) became effective for the Companybeginning with the first quarter of 2006 and was adopted by the Company as ofJanuary 1, 2006  See Note 2 for furtherdiscussion of the impact of SFAS 123(R), as well as the valuation methodologyand assumptions utilized.

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

**Forward-Looking Statements**

This Quarterly Report on Form 10-Q contains certainforward-looking statements.  Additional written and oral forward-lookingstatements may be made by the Company from time to time in Securities andExchange Commission (SEC) filings and otherwise.  The Private SecuritiesLitigation Reform Act of 1995 provides a safe-harbor for forward-lookingstatements.  These statements may be identified by the use offorward-looking words or phrases including, but not limited to, “anticipate”, “project”,“believe”, “expect”, “intend”, “may”, “planned”, “potential”, “should”, “will”or “would”.  The Company cautions readers that results predicted byforward-looking statements, including, without limitation, those relating tothe Company’s future business prospects, revenues, working capital, liquidity,capital needs, interest costs and income are subject to certain risks anduncertainties that 

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could cause actual results to differ materially fromthose indicated in the forward-looking statements.   Specific risks and uncertainties include, butare not limited to, those set forth under Item 1A, “Risk Factors”, of the 200510-K.  The Company undertakes noobligation to publicly update any forward-looking statement, whether as aresult of new information, future events or otherwise.

**ITEM3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES****ABOUT MARKET RISK**

As of June 30, 2006, there have been no materialchanges in the Company’s market risks associated with marketable securities andforeign currency exchange rates, as described in Item 7A of the 2005 10-K.  The market risk associated with long-termdebt has changed as a result of the termination of the 2005 Credit Agreementand the execution of the 2006 Credit Agreements, as is more fully described inNote 5 of Notes to Unaudited Consolidated Financial Statements.  The interest applicable to the 2006 CreditAgreements is based upon (i) the LIBOR Rate and (ii) the Base Rate (each asdefined in the 2006 Credit Agreements), plus an applicable margin.  At June 30, 2006, a sensitivity analysis to measurepotential changes in applicable interest rates indicates that a one percentagepoint increase in interest rates would increase the Company’s interest expenseby approximately $0.7 million annually, based upon the level of debt at June30, 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.

**ITEM4.  CONTROLS AND PROCEDURES**

We maintain disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-15(e) or 15d-15(e))that are designed to ensure that information required to be disclosed in ourreports filed or submitted pursuant to the Securities Exchange Act of 1934 isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms, and thatinformation required to be disclosed in our Exchange Act reports is accumulatedand communicated to our management, including our Chief Executive Officer andChief Financial Officer, to allow timely decisions regarding requireddisclosure.

Under the supervision andwith the participation of management, including our Chief Executive Officer andChief Financial Officer, we carried out an evaluation of the effectiveness ofthe design and operation of our disclosure controls and procedures pursuant toParagraph (b) OF Exchange Act Rules 13a-15 and 15d-15 as of June 30, 2006.  Based upon our evaluation, our ChiefExecutive Officer and Chief Financial Officer have concluded that ourdisclosure controls and procedures were not effective as of such date due tothe fact that the material weakness described in the 2005 10-K had not beenfully remediated as of June 30, 2006.

The Company believes it willbe able to improve its internal controls and remedy the material weaknesstherein.  Specifically, management iscommitted to hiring a sufficient number of technically-qualified employees toensure that all significant accounting issues, both routine and non-routine,are identified, researched and properly addressed.    Although the Company has taken steps toimplement its remediation plan, it has not been fully implemented as of the endof the second quarter of 2006.  As aresult, the Company will not be able to conclude that the material weakness hasbeen successfully remediated until the test of such controls demonstrates thatsuch controls have operated effectively for a sufficient period of time.

**Changes in Internal Control Over Financial Reporting**

Except as discussed above, there were no changes inour internal controls over financial reporting identified in connection withthe evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15that occurred during the fiscal quarter ended June 30, 2006 that havematerially affected, or are reasonably likely to materially affect, ourinternal control 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 thisQuarterly Report on Form 10-Q.

** **
| 3.2(0) |   | Amendment to  Revised Bylaws of the Company, adopted June 29, 2006, incorporated herein by  reference to the Company’s Current Report on Form 8-K, filed on July 6, 2005                                                                                                                                                                                                                                                                                                                                                    |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 10.104 |   | Agreement dated  March 22, 2006 between the Company and John D Wille, incorporated herein by  reference to the Company’s Current Report on Form 8-K, filed April 4, 2006.                                                                                                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 4.18   |   | Second Amendment to Credit Agreement, dated as of August 8,  2006, among Russ Berrie and Company, Inc., as the Loan Party Representative  and Russ Berrie U.S. Gift, Inc., Russ Berrie & Co. (West), Inc., Russ  Berrie and Company Properties, Inc., RussPlus, Inc., and Russ Berrie and  Company Investments, Inc. as the Borrowers, those financial institutions  party thereto, as Lenders, LaSalle Business Credit, LLC, as Administrative  Agent and Arranger, and LaSalle Bank National Association, as Issuing Bank. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 31.1   |   | Certification of  CEO required by Section 302 of the Sarbanes Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 31.2   |   | Certification of  CFO required by Section 302 of the Sarbanes Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 32.1   |   | Certification of  CEO required by Section 906 of the Sarbanes Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 32.2   |   | Certification of  CFO required by Section 906 of the Sarbanes Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                            |

 

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

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** **

**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized. 
|        |   |           |   | RUSS BERRIE AND COMPANY, INC. |
|--------|--------|----------------|--------|-------------------------------|
|   |   |           |   | (Registrant)                  |
|   |   |           |   |                          |   |
|   |   |           |   | By                            | /s/ JAMES J. O’REARDON, JR. |
| Date:  |   | August 9, 2006 |   |                          | James J. O’Reardon, Jr. |
|   |   |           |   |                          | Vice President and Chief Financial Officer |
|   |   |           |   |                          |   |

 

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**EXHIBIT INDEX**

 
| 4.18   |   | Second Amendment to Credit Agreement, dated as of August 8,  2006, among Russ Berrie and Company, Inc., as the Loan Party Representative  and Russ Berrie U.S. Gift, Inc., Russ Berrie & Co. (West), Inc., Russ  Berrie and Company Properties, Inc., RussPlus, Inc., and Russ Berrie and  Company Investments, Inc. as the Borrowers, those financial institutions  party thereto, as Lenders, LaSalle Business Credit, LLC, as Administrative  Agent and Arranger, and LaSalle Bank National Association, as Issuing Bank. |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 31.1   |   | Certification of  CEO required by Section 302 of the Sarbanes Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 31.2   |   | Certification of  CFO required by Section 302 of the Sarbanes Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 32.1   |   | Certification of  CEO required by Section 906 of the Sarbanes Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 32.2   |   | Certification of  CFO required by Section 906 of the Sarbanes Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                            |

 

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