Use these links to rapidly review the documentINDEX TO FORM 10-K PART IV



UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

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FORM 10-K

|(Mark One)                                                    |                                                                                         
|------------------------------------------------------------- | ----------------------------------------------------------------------------------------
|ý                                                             | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934    
|For the Fiscal Year Ended December 31, 2007                  
|Or                                                           
|o                                                             | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|For the transition period
from                             to

Commission file number: 001-33182

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HEELYS, INC.(Exact name of Registrant as specified in its charter)

|Delaware(State of incorporation)                                                                                 |  | 75-2880496(I.R.S. Employer Identification No.)
|---------------------------------------------------------------------------------------------------------------- |  | ----------------------------------------------
|3200 Belmeade Drive, Suite 100
Carrollton, Texas 75006(Address of principal executive offices)        (Zip Code)
|(214) 390-1831(Registrant's telephone number, including area code)                                              

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Securities registered pursuant to Section 12(b) of the Act:

Title of each class

Name of each exchange on which registeredCommon Stock, par value $0.001

The Nasdaq Stock Market LLC


Securities registered pursuant to Section 12(g) of the Act: None

Indicate
by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities
Act. Yes o    No ý

Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the
Act. Yes o    No ý

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

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

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

|Large accelerated filer o |  | Accelerated filer ý |  | Non-accelerated filer o (Do not check if a smaller reporting company) |  | Smaller reporting company o
|------------------------- |  | ------------------- |  | --------------------------------------------------------------------- |  | ---------------------------

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

As of June 29, 2007, the last business day of the registrant's most recently completed second fiscal quarter, the aggregate market value of the registrant's
common stock held by non-affiliates was approximately $206,965,933 (based upon the closing price for the registrant's common stock on The Nasdaq Global Market of $25.86 per share). For the
purpose of the foregoing calculation only, all directors and executive officers of the registrant and owners of more
than 5% of the registrant's common stock are assumed to be affiliates of the registrant. This determination of affiliate status is not necessarily conclusive for any other purpose.

As
of March 11, 2008 there were 27,076,367 shares of the registrant's common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

The
information required by Part III of this Report, to the extent not set forth herein, is incorporated herein by reference from the registrant's definitive proxy statement
relating to the Annual Meeting of Shareholders to be held in 2008, which definitive proxy statement shall be filed with the Securities and Exchange Commission within 120 days after the end of
the fiscal year to which this Report relates.



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INDEX TO FORM 10-K



|PART I   |                                                                                                                      | 
|-------- | -------------------------------------------------------------------------------------------------------------------- | 
|         | Item 1. Business                                                                                                     | 
|         | Item 1A. Risk Factors                                                                                                | 
|         | Item 1B. Unresolved Staff Comments                                                                                   | 
|         | Item 2. Properties                                                                                                   | 
|         | Item 3. Legal Proceedings                                                                                            | 
|         | Item 4. Submission of Matters to a Vote of Security Holders                                                          | 
|PART II  |                                                                                                                      | 
|         | Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities | 
|         | Item 6. Selected Financial Data                                                                                      | 
|         | Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations                        | 
|         | Item 7A. Quantitative and Qualitative Disclosures about Market Risk                                                  | 
|         | Item 8. Consolidated Financial Statements and Supplementary Data                                                     | 
|         | Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                         | 
|         | Item 9A. Controls and Procedures                                                                                     | 
|         | Item 9B. Other Information                                                                                           | 
|PART III |                                                                                                                      | 
|         | Item 10. Directors, Executive Officers and Corporate Governance                                                      | 
|         | Item 11. Executive Compensation                                                                                      | 
|         | Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters              | 
|         | Item 13. Certain Relationships and Related Transactions, and Director Independence                                   | 
|         | Item 14. Principal Accounting Fees and Services                                                                      | 
|PART IV  |                                                                                                                      | 
|         | Item 15. Exhibits and Financial Statement Schedules                                                                  | 
|         | SIGNATURES                                                                                                           | 

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PART I

Item 1.    Business

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, or the "Securities Act," and Section 21E of the Securities Exchange Act of 1934, as amended, or the "Exchange Act," that are based on information currently
available to management as well as management's assumptions and beliefs. When used in this document and in documents incorporated by reference, forward-looking statements include, without limitation,
statements regarding financial forecasts or projections, and our expectations, beliefs, intentions or future strategies that are signified by terminology such as "subject to," "believes,"
"anticipates," "plans," "expects," "intends," "estimates," "may," "will," "should," "can," the negatives thereof, variations thereon, similar expressions, or discussions of strategy. These
forward-looking statements reflect our current views with respect to future events, based on what we believe are reasonable assumptions; however, such statements are subject to certain risks and
uncertainties. In addition to the specific uncertainties discussed elsewhere in this Annual Report on Form 10-K, the risk factors set forth in Part I, "Item 1A. Risk
Factors" in this report may affect our performance and results of operations. Those risks, uncertainties and factors include, but are not limited to the fact that substantially all of our net sales
are generated by one product, continued changes in fashion trends and consumer preferences and general economic conditions, our intellectual property may not restrict competing products that infringe
on our patents from being sold, we are dependent upon independent manufacturers, we may not be able to successfully introduce new product categories and the other factors described in our filings with
the Securities and Exchange Commission. Investors are urged to consider these risks, uncertainties and factors carefully in evaluating the forward-looking statements and are cautioned not to place
undue reliance on such forward-looking statements. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may differ
materially from those in the forward-looking statements. You should not place undue reliance on forward-looking statements. We disclaim any intention or obligation to update or review any
forward-looking statements or information, whether as a result of new information, future events or otherwise.

Throughout this report, references to the "Company," "we," and "our" refer to Heelys, Inc. and its consolidated subsidiaries, unless the context indicates
otherwise.

Overview

We are a designer, marketer and distributor of innovative, action sports-inspired products under the HEELYS brand targeted to the youth market. Our primary
product, HEELYS-wheeled footwear, is patented, dual-purpose footwear that incorporates a stealth, removable wheel in the heel. HEELYS-wheeled footwear allows the user to seamlessly
transition from walking or running to skating by shifting weight to the heel. Users can transform HEELYS-wheeled footwear into street footwear by removing the wheel. We believe our distinctive product
offering and our HEELYS brand is becoming synonymous with an increasingly popular lifestyle activity. We believe that the continued exposure of our HEELYS brand will allow us to selectively introduce
additional product categories in the future by taking advantage of our expertise in product development and sourcing, strong retail relationships and knowledge of our target consumer.

We
were initially incorporated as Heeling, Inc. in Nevada in 2000 and were reincorporated in Delaware in August 2006 and changed our name to Heelys, Inc. Through our
general and limited partner interests, we own 100% of Heeling Sports Limited, a Texas limited partnership, which was formed in May 2000.

We
are subject to the informational requirements of the Exchange Act, and, accordingly, file reports, proxy statements and other information with the Securities and Exchange Commission
(the "SEC"). We maintain a website on the World Wide Web atwww.heelys.com.We make available, free of charge through our website, our Annual Report on
Form 10-K, Quarterly Reports on Form 10-Q,

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Current
Reports on Form 8-K, including exhibits thereto, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as
soon as reasonably practicable after the reports are electronically filed with, or furnished to, the SEC. Our reports that are filed with, or furnished to, the SEC are also available at the SEC's
website atwww.sec.gov, which contains material regarding issuers that file electronically with the SEC. You may also obtain copies of any of our
reports filed with, or furnished to, the SEC, free of charge, at the SEC's public reference room at 100 F Street, N.E., Washington, DC 20549. Information regarding the operation of the Public
Reference Room may be obtained by calling the Securities and Exchange Commission at 1-800-SEC-0330.

Our Business

We currently offer HEELYS-wheeled footwear in a wide variety of styles and colors at domestic retail price points ranging from $49.99 to $89.99 depending upon
performance features, comfort and materials. HEELYS-wheeled footwear is protected by numerous patents and trademarks in the United States and certain other countries. In 2007, approximately 98% of our
net sales was derived from the sale of our HEELYS-wheeled footwear. We also sell branded accessories, such as replacement wheels, helmets and other protective gear. In the third quarter of 2006 we
introduced a limited variety of apparel items in response to demand from certain of our retail customers and in 2007 we introduced a line of non-wheeled footwear to broaden and extend the
HEELYS brand.

We
sell our products through distribution channels that merchandise our products in a manner that we believe enhances and protects our HEELYS brand image. Domestically, our products can
be purchased from full-line sporting goods retailers such as The Sports Authority, Academy, Big 5, Modell's and Hibbett Sports; specialty apparel and footwear retailers, such as The Finish
Line and Journeys; select department stores, such as Mervyn's and Nordstrom; and family footwear stores, such as Famous Footwear and Shoe Carnival. Our products can also be purchased from select
online retailers such as Zappos.com. In 2007, 83.4% of our net sales were derived from retailers in the United States. Internationally, our products are currently sold to independent distributors with
exclusive rights to specified international territories. We recently opened a new sales and marketing office in Belgium to focus on expanding our international opportunities by working more closely
with our distributors, establishing relationships with distributors in new international markets and, in selective markets, selling our products direct to retail customers.

Target Market

The growth and longstanding popularity of skateboarding, inline skating, roller skating and scooter riding in the United States reflect consumers' interest in
wheeled sports activities. For example, skateboarding and inline skating have remained a part of youth culture for more than 40 and 25 years, respectively. Our HEELYS-wheeled footwear, which we
believe has broad patent protection relative to other wheeled sports products, appeals to many of these same consumers. While the market for HEELYS-wheeled footwear has grown significantly since our
first product was introduced in 2000, we believe this market continues to have growth potential.

Our
products appeal to a broad range of young, active consumers around the world who enjoy wheeled sports activities. Our primary market is six to fourteen year-old boys and
girls, an age group in the United States that the U.S. Census Bureau estimated to be 36.0 million people in 2008 and projected to grow to 39.2 million people by 2018. Based on our sales
of more than 5.3 million pairs of HEELYS-wheeled footwear in the United States during 2007, we believe that there remains growth potential in our target market for both HEELYS-wheeled footwear
and future product introductions. In addition, we believe we benefit from greater repeat purchases by our consumers relative to other
wheeled sports products, driven by the natural replacement cycle of children's footwear and the new styles that we offer each season.

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We
believe that our products have become more popular in recent years due to the trend among young people away from traditional team sports and toward individual, action sports. We
believe events such as the X Games, the inclusion of snowboarding medal events in the Winter Olympics and the national recognition of leading boardsport athletes have broadened general awareness and
increased the popularity of the action sports youth lifestyle. The trend towards individual, action sports has influenced the styles and performance features of our products and our marketing
strategies.

Business Strengths

We attribute our success to the following business strengths:



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Future Growth Strategy

We plan to continue growing our net sales and earnings over the next several years through the following strategies:



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Products

Our primary product is HEELYS-wheeled footwear, patented, dual-purpose footwear that incorporates a stealth, removable wheel in the heel.
HEELYS-wheeled footwear allows the user to seamlessly transition from walking or running to skating by shifting weight to the heel. Users can remove the wheel to transform HEELYS-wheeled footwear into
street footwear. HEELYS-wheeled footwear is offered in more than 20 styles, incorporating various comfort and performance features and colors at five retail price points. We traditionally offer
a new line of HEELYS-wheeled footwear twice each year for the spring/summer selling season and the back-to-school and holiday selling seasons.

HEELYS-wheeled
footwear can be classified into the following three categories:

|GRAPHIC |  | Single-Wheel.    Our single-wheel HEELYS-wheeled footwear has one detachable wheel and are available in various sizes for men, women and children. We offer wheels
of various performance capabilities in order to appeal to beginners and advanced users. Single-wheel HEELYS-wheeled footwear represented approximately 88.1% of our net sales in 2007. Suggested domestic retail prices for our single-wheel
HEELYS-wheeled footwear generally range from $49.99 to $79.99.                                                                                                                                                                                                                                                                     
|------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|GRAPHIC |  | Two-Wheel.    Our two-wheel HEELYS-wheeled footwear includes two detachable wheels, are designed for novice users and are offered only in children's sizes. This
category represented approximately 9.8% of our net sales in 2007. The suggested domestic retail price for our two-wheel HEELYS-wheeled footwear is generally $49.99.                                                                                                                                                                                                                                                                                                                                                                                                              
|GRAPHIC |  | Grind-and-Roll.Grind-and-roll HEELYS-wheeled footwear represents our highest performance category and are preferred by enthusiasts seeking a challenging and
exciting action sports experience. This category features a single detachable wheel and a patented, hard nylon plate in the arch, enabling the consumer to slide, or "grind," on hand railings and other similar surfaces. Consumers can use our
grind-and-roll HEELYS-wheeled footwear to perform distinctive maneuvers, similar to those performed by skateboarders and inline skaters. The grind-and-roll category represented approximately 2.1% of our net sales in 2007. The suggested domestic
retail price for our grind-and-roll HEELYS-wheeled footwear is generally $89.99.

In addition to offering our standard styles, we collaborate with certain of our retail customers to develop HEELYS-wheeled footwear styles that these retail
customers have the exclusive rights to sell. This special make-up program enables these customers to differentiate their HEELYS-wheeled footwear product offering and allows us to broaden
our product range. In 2007, special make-up program products represented approximately 34.3% of our net sales.

In
the past, we sold less-expensive wheeled footwear under the "Cruz" brand name exclusively to certain of our independent distributors. The Cruz brand represented
approximately 17.7% and 3.3% of our net sales in 2004 and 2005, respectively. Although we have not sold any Cruz branded footwear since 2005, we may choose to re-launch this product line
or a similar product in the future.

We
also offer a selection of HEELYS branded accessories, including protective gear such as helmets and wrist, elbow and knee guards, heel plugs, wheel bags and replacement wheels, a
limited variety of apparel items and non-wheeled footwear. We plan to take advantage of growing consumer awareness of our brand name and our retail relationships to expand our HEELYS
branded accessories

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offerings.
We began to offer HEELYS branded apparel and additional accessories in the third quarter of 2006 and in 2007 we introduced a line of non-wheeled footwear to further broaden and
extend the HEELYS brand.

Product Design and Development

We intend to continually update and refine our product offerings in response to evolving consumer preferences. For example, we introduced the grind plate for our
grind-and-roll HEELYS-wheeled footwear and the two-wheel HEELYS-wheeled footwear, we introduced specific styles for girls and the "sole saver" heel plug, which
provides a finished look to the footwear by covering the wheel cavity when the wheel is removed and, we introduced and are continuing to refine a line of non-wheeled footwear to broaden
and extend the HEELYS brand. We believe that introducing new products, performance features and designs allows us to achieve premium price points, encourage repeat purchases and create incremental
consumer demand for our products. We monitor changing consumer trends and identify new product opportunities through close, interactive contact with our target consumers, frequent dialogue between our
sales representatives, EMMs and our retail customers and input from our sponsored "team riders," some of whom are paid to use and promote our products.

Our
product design and development process is rigorous and highly collaborative, using input from our sales staff, product development professionals, retail customers, EMMs and
consumers. We focus not only on the performance of our products, but also on production cost and efficiency. Our product development efforts include both incremental improvements to our existing
products and entirely new technologies and product categories. Incremental improvements to our existing products include introducing new styles, improving the materials used in our wheels and
designing lighter shoes with greater durability and enhanced comfort and performance features.

Sales

We carefully control the distribution of our products to protect and enhance our HEELYS brand and maintain our ability to offer our products at premium price
points. We sell our products domestically directly to retail customers and internationally we have traditionally sold our products through independent distributors. We recently opened a new sales and
marketing office in Belgium to focus on expanding our international opportunities.

Currently,
we do not sell our products to mass merchants or directly to consumers.

Domestic Sales

Our products are sold through retail customers, including a variety of full-line sporting goods retailers, specialty apparel and footwear retailers, select
department stores and family footwear stores. Our products are also sold through select online retailers. We attempt to choose retail customers who appeal to our target market and who are able and
willing to merchandise our products in a manner that we believe is consistent with our brand message and positioning. The Sports Authority, Academy, Big 5, Modell's, Hibbett Sports, The Finish Line,
Journeys, Mervyn's, Nordstrom, Famous Footwear, Shoe Carnival, and Zappos.com are examples of our domestic retail customers. In 2005, 2006 and 2007, our domestic net sales were $36.6 million,
$161.3 million and $153.0 million respectively, representing 83.2%, 85.7% and 83.4% of our total net sales, respectively.

We
intend to selectively increase our domestic distribution by expanding the number of stores in which HEELYS-wheeled footwear is sold by existing retail customers and by adding new
retail customers. Due to our limited funding at our inception, we focused our marketing resources on specific regions of the country that we believed embraced wheeled sports and innovative products
such as HEELYS-wheeled footwear. As the exposure of our products and brand name increased and our financial position improved, we expanded our focus to other regions of the country.

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We
are committed to providing the highest levels of service to our retail customers. We maintain a national sales force of 18 independent sales representatives, each of whom is assigned
an exclusive territory and is compensated on a commission basis, and who together are responsible for substantially all of our domestic sales. We believe that our product line represents a significant
percentage of the sales made by these independent sales representatives.

International Sales

As of December 31, 2007, we offered our products internationally through 33 independent distributors, each of which has exclusive rights to a designated
territory. In 2007, our largest international territory was the United Kingdom, which accounted for 8.7% of our total net sales. We select our independent distributors based on their relationships
with appropriate retailers, their ability to effectively represent the HEELYS brand and their execution of our distribution strategy. In order to maintain a consistent brand image throughout the
world, we provide marketing, distribution and product training support to our independent distributors. Each distributor must meet minimum sales goals and is responsible for funding its local
marketing campaigns, maintaining its own inventory and providing sufficient sales, distribution and customer service infrastructure. In 2005, 2006 and 2007, our international net sales were
$7.4 million, $26.9 million and $30.5 million, respectively, representing 16.8%, 14.3% and 16.6% of our total net sales, respectively. In 2004, Japan accounted for 19.4% of our
total net sales. Since 2004, no country other than the United States has accounted for 10% or more of our net sales. We believe that international distribution represents a meaningful growth
opportunity for us that we intend to take advantage of by encouraging our existing distributors to expand their market presence, by establishing relationships with distributors in new international
markets and, in selective markets, selling our products direct to retail customers.

Principal Customers

In 2005, Big 5 Sporting Goods, Journeys and The Sports Authority represented 12.3%, 11.3% and 10.6% of our net sales, respectively. In 2006, Journeys accounted
for 12.7% of our net sales. In 2007, Finish Line represented 13.2% of our net sales. No other retail customer or independent distributor accounted for 10% or more of our net sales in any of these
periods.

Marketing

Our marketing strategy is to position our products and the HEELYS brand to represent a lifestyle that includes excitement, individuality and the unique culture of
action sports. Our brand image was recently summarized as "Free Wheel'n Exhilaration." To promote awareness of our HEELYS brand, we utilize a multi-faceted strategy that includes event marketing
activities, television advertising, point-of-purchase, or "POP," displays and product placement and public relations. While we fund the cost of these activities domestically,
our international independent distributors are solely responsible for these costs in their markets. In January 2008, we hired a Senior Vice President of Marketing to oversee both our marketing and
product development initiatives.

Event Marketing Activities

We employ three EMMs who assist us in reaching consumers in key markets at the grass-roots level and driving foot traffic to our retail customers'
locations. EMMs increase consumer awareness of our products by hosting in-store product clinics and demonstrations, teaching store personnel how to use our products, employing
"guerrilla" marketing methods such as arranging for our sponsored "team riders" to skate in high traffic public areas and using online marketing techniques such as hosting message boards and
contributing to skate-oriented chat rooms. Our EMMs recruit, train, and retain handpicked skaters in the key markets. Certain of the top skaters in each of those key markets are invited to
participate on the Heelys National Pro Team.

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Television Advertising

Television advertisements are an important and highly effective tool for increasing awareness of our brand and products among our target consumers because these
advertisements allow us to show consumers HEELYS-wheeled footwear in action. Advertisements air nationally and in selected regions of the United States during our primary selling seasons on cable
channels such as ABC's Family Channel, Nickelodeon, Cartoon Network, NickToons, and Toon Disney. As part of our regional television advertising strategy, we typically feature the name of a local
retail customer at the end of our television advertisements. This tactic is intended to drive consumers to specific retail customers and allows us to evaluate the effectiveness of our advertising. We
ran our first national cable television advertising campaign in the fourth quarter of 2005. During 2006 and 2007, we utilized both regional and national television advertising campaigns and expect to
continue to follow this approach in the future.

Point-of-Purchase Displays

Many of our retail customers have committed valuable floor space to Heelys branded POP displays. When the opportunity presents itself, we often build custom POP
solutions that best fit both our needs and those of our retail customers. Through the use of these POP displays, we are able to present the HEELYS brand message to consumers in a consistent manner and
increase our shelf space in our retail customers' locations.

Product Placement

Because HEELYS-wheeled footwear is highly differentiated from other wheeled sports products and other footwear, we often receive requests from television shows,
magazines and news organizations to review or highlight our products. Our products have been featured in numerous television and print spots, including television shows such as The Amazing Race, Are You Smarter than a Fifth
GraderandRun's House; magazines and newspapers such as Time,People,The Wall Street Journal, In Style,NewsweekandFootwear News;and the World Book Encyclopediaand McGraw-Hill school textbooks. Strategic partnerships such as Disney's theatrical production of the Little
Mermaid and Disney's Wide World of Sports also provide Heelys an opportunity to uniquely secure "product in-use" opportunities. We believe that product placement activities enable us to
build awareness of our products and our HEELYS brand in a cost-effective manner.

Cooperative Marketing

In partnership with our retailers, we offer cooperative marketing support. In our cooperative marketing initiatives we seek to grab customer attention, drive
sales for our retail customers and promote our brand. Examples of cooperative marketing include company approved POP display materials, television, radio, print, and web based advertising, gift with
purchase promotions, and customized event marketing demonstration. We will continue to collaboratively work with retail partners in an effort to drive the overall brand experience.

Manufacturing and Sourcing

We do not own or operate any manufacturing facilities and we purchase our products as finished goods from independent manufacturers. We do not have any
long-term manufacturing contracts, choosing instead to retain the flexibility to change our manufacturing sources if necessary. We believe that alternate manufacturing sources are
available at comparable costs to those we currently experience.

We
carefully monitor all aspects of the production of our HEELYS-wheeled footwear, including the development and manufacturing of prototypes, initial production runs and final product
manufacturing. We perform an array of inspection procedures at various stages of the production

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process,
including examination and testing of raw materials and components prior to manufacture, work-in-process at various stages of production and finished goods prior to
shipment. Historically, our defective return rate has been less than 1.0% of our net sales.

Prior
to 2008, Boss Technical Services, an independent sourcing agent, helped us identify and develop relationships with manufacturers of our footwear products and provided quality
inspection, testing, logistics and product development and design assistance. We paid for these services on a commission basis. Our Vice PresidentSourcing, who we hired in December 2006,
managed our relationship with Boss Technical Services and upon termination of this relationship effective December 31, 2007, now manages our relationship directly with our manufacturers.

Bu
Kyung Industrial, which is owned by one of the owners of Boss Technical Services, has manufactured HEELYS-wheeled footwear since our inception and until 2006 was responsible for
manufacturing substantially all of our HEELYS-wheeled footwear. Due to rapid growth in demand for our HEELYS-wheeled footwear, in 2006 we began using a number of other manufacturers to supply our
products. As of December 31, 2007, we were using four independent manufacturers. We expect Bu Kyung Industrial to continue to manufacture a significant portion of our footwear products, but we
expect to develop relationships with additional manufacturers in order to secure additional capacity and mitigate the risk associated with using a limited number of manufacturers.

In
January 2008, we opened a representative office in Qingdao, China. This new office will serve multiple sourcing functions including quality control, price negotiation, logistics and
product development. We believe our Qingdao office will help us improve our research and development efforts, enhance communication between us and our distribution and manufacturing partners and give
us more direct control over the manufacturing and sourcing process. This new office is managed by our Vice PresidentSourcing.

Order Fulfillment and Inventory Management

Our products are inspected, bar coded and packaged by our independent manufacturers and transported by container ship typically to Long Beach, California. Our
independent manufacturers mark, label and pre-ticket our products for certain of our larger retail customers. For products sold in the United States, after the products clear U.S. customs,
we use an independent freight forwarder and customs broker to ship them via rail by container either to our distribution center located in Carrollton, Texas, a warehouse in San Pedro, California which
is managed by a third party logistics provider, or directly to our retail customers. In 2007, approximately 75.8% of our products in
the United States were shipped directly to our retail customers. Upon receipt at our warehouse, merchandise is inspected and recorded in our management information systems and packaged for delivery.
We maintain electronic data interchange, or "EDI," connections with many of our larger retail customers in order to automate order tracking and inventory management. Substantially all of our products
destined for international distribution are sent directly by our independent manufacturers to our independent distributors.

To
allow us to better plan our production volume with our manufacturers, we offer our retail customers discount incentives to place advance orders. Historically, we received most of our
orders three to four months in advance of the scheduled delivery dates. In 2008, we expect to see certain of our retail customers being more cautious when placing future orders and shifting toward
shorter lead times. We seek to manage our inventory risk, by monitoring available sell-through data and seeking input on anticipated consumer demand from our retail customers.

Intellectual PropertyPatents and Trademarks

We have both domestic and international patent coverage for the technology incorporated in our HEELYS-wheeled footwear and own more than 75 issued patents and
pending patent applications in

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more
than 25 countries, of which more than 55 are related to wheeled footwear. Our first patent was a method patent that was issued in June 2002 and includes coverage for wheeled footwear, including
HEELYS-wheeled footwear, with a wheel in the heel that allows the user to transition from walking or running to skating by shifting weight to at least one wheel in the heel. We also own a variety of
trademarks, with more than 80 registered and pending trademarks with rights in more than 45 countries.

We
have vigorously enforced and expect to continue to vigorously enforce our intellectual property rights against infringers domestically and around the world. Despite the challenges
inherent in combating infringers in international jurisdictions that may not protect intellectual property rights to the same extent as the United States, we have cooperated with the appropriate
authorities and they have conducted successful raids, customs seizures and product confiscations of products that infringe our intellectual property rights in various countries. We have obtained
agreements from importers and retailers to cease and desist all infringing activities and, in some cases have been paid monetary compensation. We have also successfully asserted our patent rights
against manufacturers of infringing products.

We
have an exclusive worldwide license to use intellectual property related to the technology used in our grind-and-roll HEELYS-wheeled footwear. We pay a royalty
of 12.0% of our cost on certain products, $1.00 per unit on certain styles of footwear and 25% of any sublicensed revenue of any non-footwear products, apparel and accessories or similar
items that
absent our license would infringe the trademarks relating to such products under the license agreement. We are required to make royalty payments through December 31, 2008. If we fail to make
the required royalty payments the licensor has the right to reacquire the intellectual property.

Seasonality

Similar to other vendors of footwear products, sales of our products are subject to seasonality. There are three major buying seasons in footwear: spring/summer,
back-to-school and holiday. Shipments for spring/summer take place during the first quarter and early weeks of the second quarter, shipments for
back-to-school generally begin in May and finish in late August and shipments for the holiday season begin in October and finish in early December. Historically, we have
experienced greater revenues in the second half of the year than those in the first half due to a concentration of shopping around the back-to-school and holiday seasons. In
2006, due to the growth of our business and the delays we experienced from our independent manufacturers, we experienced a higher percentage of net sales in the third quarter in comparison to the
total year than we experienced in the past, as many orders were delayed from the second quarter to the third quarter, thereby causing the second quarter to be lower than normal and the third quarter
to be higher than normal. In 2006, we estimate that approximately $20 million of net sales shifted from the second quarter to the third quarter due to late shipments. During 2007 we did not
experience the same production delays, but instead experienced challenges related primarily to higher than expected inventory positions of product at many of our domestic accounts as weekly unit sales
were lower than internal projections of many of our domestic retail customers, which had a significant adverse effect on our results for the second half of 2007. We believe that this was attributed
to: (1) aggressive sell-through expectations of some of our domestic retailers going into the summer months and (2) retail softness in footwear and apparel. Certain of our major
retailers are reluctant to place significant orders until their current inventory is reduced to their targeted levels. We also saw decreased prices on our products at certain of our retailers in the
fourth quarter of 2007. These factors have led us to work closely with each of our key retail customers to assist them in managing their inventory and sell-through. This process typically
includes providing marketing discretionary funds, rescheduling orders to later dates, accepting cancellations, increasing marketing, promotion and advertising support, and accepting returns. Although

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weather
is a factor in our seasonality, it is difficult to measure its impact. Results for any one quarter are not necessarily indicative of results to be expected for any other quarter or for any
year.

Employees

As of December 31, 2007, we employed a total of 55 full-time employees, 49 of whom worked in our Carrollton, Texas headquarters; and included
15 in sales and customer service, 7 in marketing, 3 in product development, 10 in executive and administration, 3 in information technology,
8 in finance and 9 in warehousing operations. We also employ temporary warehouse employees during peak shipment periods. We are not a party to any labor agreements and none of our employees are
represented by a labor union.

In
September 2004, we entered into an agreement with an affiliate of Gevity HR, Inc. a professional employer organization, or "PEO," under which Gevity provides payroll and
employee benefit services and acts as a co-employer of our employees. We believe this arrangement allows us to provide our employees with competitive benefits in a
cost-effective manner.

Insurance and Product Liability

We purchase insurance to cover standard risks associated with our business, including policies to cover commercial general liability and other casualty and
property risks. Our insurance rates depend upon our safety record as well as trends in the insurance industry. Through our PEO our employees are also covered by workers' compensation insurance, the
cost of which is retrospective and varies depending upon the frequency and severity of claims during the policy year.

We
face an inherent risk of exposure to personal injury or product liability claims if, among other things, use of our products results in injury, disability or death. We believe our
insurance coverage is sufficient for the risks relating to our products. Our coverage involves retentions with primary and excess liability coverage above the retention amount.

We
retain certain property and casualty risks based on our analysis of the risk, the frequency and severity of a loss and the cost of insurance for the risk. We believe that the risk we
have assumed through retention is not significant and payments of retained claims will not have an adverse impact on our performance.

Information Technology Systems

Our information technology systems are designed to provide us with, among other things, comprehensive order processing, production, accounting and management
information for the sourcing, importing, distribution and marketing aspects of our business. We use the Microsoft Dynamics SL version 6.0 software, with several customizations that enhance this
package for our purposes. We also maintain an EDI system that provides a computer link between us and certain of our customers, which enables us to monitor purchases, inventory and retail sales and
also improves our efficiency in responding to customer needs.

During
2007, we added servers and data warehousing machines and enhanced our order management, inventory and EDI modules. We also implemented an online and off-site backup
system with full recovery and redundancy capability. We believe our information technology systems are sufficient to meet our anticipated growth for the foreseeable future.

We
will continue to assess the need to expand and upgrade our information technology systems to support actual or expected future growth. We will evaluate and may implement a new
warehouse management system and a new customer-relationship management tool that will integrate with our website for improved customer service.

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Competition

We compete with companies that focus on the young consumer across a number of markets, including footwear, sporting goods and recreational products. Many of these
companies have substantially greater financial, distribution and marketing resources than we have. Product design, performance, styling, comfort, quality, brand awareness, timeliness of product
delivery and pricing are all important elements of competition in the markets for our products. We believe that the strength of our HEELYS brand, the intellectual property related to the design of
HEELYS-wheeled footwear, the quality of our products and our relationships with retailers and distributors allow us to compete effectively in the markets we serve. In certain international markets,
where enforcing our intellectual property rights is more difficult than in the United States, we compete against counterfeit, knockoff and infringing products, which typically are offered at lower
prices.

Backlog

Historically, we received most of our orders three to four months prior to the date the products were shipped to customers. At December 31, 2007, our
backlog was approximately $7.2 million, compared to approximately $53.2 million at December 31, 2006. Although generally, these orders are not subject to cancellation prior to the
date of shipment, cancellations have and may continue to occur. Due to the inventory challenges we experienced in the second half of 2007, many of our retail customers have not placed significant
future orders with us. In 2008, we expect to see certain of our retail customers being more cautious when placing future orders and shifting toward shorter lead times. For a variety of reasons,
including the timing of release dates for our product offerings, shipments, order deadlines and receipt of orders, backlog may not be a reliable measure of future sales and may not be comparable from
one period to another.

Item 1A.    Risk Factors

Before deciding to purchase, hold or sell our common stock, you should carefully consider the risks described below in addition to the
more detailed description of our business and other cautionary statements and risks described elsewhere, and the other information contained, in this Annual Report on Form 10-K and
in our other filings with the SEC, including our subsequent reports on Forms 10-Q and 8-K. The risks and uncertainties described below are not the only ones we face.
Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business. If any of these known or unknown risks or uncertainties actually occurs
with material adverse effects on us, our business, financial condition and results of operations could be seriously harmed. In that event, the market price for our common stock will likely decline,
and you may lose all or part of your investment. Our business, prospects, financial condition or results of operations could be materially and adversely affected by the
following:

We depend primarily upon sales from a single product line and the absence of continued demand for our products would have a material adverse effect on
our net sales and results of operations.

In 2006 and 2007, we generated approximately 98% of our net sales from our HEELYS-wheeled footwear and we expect to continue to depend upon HEELYS-wheeled
footwear for substantially all of our net sales in the foreseeable future. Because we are dependent on a single line of products, factors such as changes in consumer preferences may have a
disproportionately greater impact on us than if we offered multiple product categories. If consumer interest in HEELYS-wheeled footwear or wheeled sports activity products in general declines, we
would likely experience a significant loss of sales, cancellation of orders from retail customers, loss of retail customers, excess inventories, higher reserves for marketing discretionary fund
assistance, increased reserves for inventory returns, inventory markdowns and discounts to our retail customers, deterioration of our brand image, and lower revenues and gross and operating margins,
as a result of price reductions and may be forced to

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liquidate
excess inventories at a discount, any or all of which would have a material adverse impact on our business and operations. Given the limited history of our HEELYS brand, it is especially
difficult to evaluate whether our products will hold long-term consumer appeal.

Because we are a consumer products company, if we fail to accurately forecast consumer demand and trends in consumer preferences, our HEELYS brand, net
sales, customer relationships and results of operations may be adversely affected.

Demand for our products, and for consumer products in general, is subject to rapidly changing consumer demand and trends in consumer preferences. Therefore, our
success depends upon our ability to:



We
generally must make decisions regarding product designs several months before our products are available for sale, and it can take us up to six months to achieve full production of
certain models. Accordingly, at the time we have to make decisions that determine our inventory levels, we cannot be certain that our product offerings will be well received by consumers, in which
case we may be forced to liquidate excess inventories at a discount. In addition to offering our standard styles, we collaborate with certain of our retail customers to develop HEELYS-wheeled footwear
styles that these retail customers have the exclusive rights to sell. If these retail customers are unable to sell through these footwear styles we may agree to provide marketing discretionary fund
assistance or to accept return of this inventory. Because these styles have been specifically designed for a particular customer we may not be able to sell the returned inventory or may not be able to
sell the returned inventory at or above cost. Conversely, if we underestimate consumer demand for our products, we could have inventory shortages, which would result in lost sales, delays in shipments
to retail customers and independent distributors, strains on our relationships with retail customers and independent distributors and diminished brand loyalty. Even if we introduce appealing new
styles and products on a timely basis, we may set prices for our products too high to be successful. A decline in demand for our products, or any failure on our part to satisfy increased demand for
our products, could adversely affect our net sales and results of operations.

We have experienced significant increases in the scope of our operations, and if we fail to manage our operations or future growth effectively, we may
experience difficulty in filling purchase orders, declines in product quality, increased costs or other operating challenges.

Our sales and operations grew rapidly in 2005 and 2006 and we have:



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The
increased scope of our business and growth in the number of our employees, customers and independent manufacturers have placed and will continue to place a significant strain on our
management, information technology systems and other resources. To properly manage our operations, we may need to hire additional employees, upgrade our existing financial and reporting systems,
improve our business processes and controls and identify and develop relationships with additional
independent manufacturers. We may also be required to expand our distribution facilities or add new facilities. Our former sourcing agent performed quality inspections, testing, logistics and product
development and design assistance. We may fail to adequately perform these functions. Failure to effectively manage our operations or growth could result in difficulty in distributing our products and
filling purchase orders, declines in product quality or increased costs, any of which would adversely impact our business and results of operations.

Our operations are dependent upon the strength of our relationships with our retail customers and independent distributors and their success in selling
our products, and a small number of retail customers and independent distributors are responsible for a significant percentage of our net sales.

Our success is dependent upon the willingness and ability of our retail customers to market and sell our products to consumers, as well as the success of our
independent distributors in developing foreign markets for our products. For the year ended December 31, 2005, Big 5 Sporting Goods, Journeys and The Sports Authority were responsible for
approximately 12.3%, 11.3% and 10.6% of our net sales, respectively. For the year ended December 31, 2006, Journeys accounted for approximately 12.7% of our net sales. For the year ended
December 31, 2007, Finish Line accounted for approximately 13.2% of our net sales. No other retail customer or independent distributor accounted for 10% or more of our net sales in any of these
periods. If any of these or our other significant retail customers or independent distributors were to experience financial difficulties, reduce the quantity of our products it sells, discount the
retail sales price, request markdown assistance or additional marketing assistance, or stop selling our products, our financial condition and results of operations could be adversely affected.

We do not have long-term contracts with any of our retail customers or independent distributors, and the loss or material reduction in their
business with us could result in reduced sales of our products.

Our retail customers and independent distributors generally purchase products from us on a purchase order basis and do not have long-term contracts
with us. Consequently, with little or no notice and without penalty, our retail customers and independent distributors may terminate their relationship with us or materially reduce the level of their
purchases of our products. For example, recently one of our large retail customers determined that it will no longer sell HEELYS-wheeled footwear. This customer accounted for 7.2% of our total net
sales for the year ended December 31, 2007. If this were to occur with more retail customers or independent distributors who purchase significant quantities of our products, it may be difficult
for us to establish substitute relationships in a timely manner, which could have a material adverse effect on our financial condition and results of operations.

Changes in the mix of retail customers to whom we distribute our products could impact our gross margin and brand image, which could have a material
adverse effect on our results of operations.

We sell our products through a mix of retail customers. Although we do not currently anticipate material changes in the mix of our retail customers, any such
changes could adversely affect our gross margin and could negatively affect both our brand image and our reputation with our consumers. A negative change in our gross margin or our brand image and
acceptance could have a material adverse effect on our results of operations and financial condition.

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We are dependent on our management and other personnel, and the failure to attract and retain such individuals could adversely affect our operations.

Our success depends on our ability to attract and retain qualified managerial and other personnel. Our management and other employees can terminate their
employment with us at any time, and we do not maintain key person life insurance. Our inability to attract or retain qualified employees, or the loss of any key employee, could harm our business and
results of operations.

In
February of 2008, Michael G. Staffaroni, our Chief Executive Officer since 2001, and Charles D. Beery, our Senior Vice PresidentGlobal Sales since 2001, resigned. Ralph
T. Parks, former President and Chief Executive Officer of FootAction USA, is serving as our interim Chief Executive Officer. An executive search firm has been retained to identify a permanent chief
executive officer. Our failure to successfully identify a permanent chief executive officer, or our failure to successfully integrate this individual into our organization, could adversely affect our
business and results of operations. Our failure to have a Senior Vice PresidentGlobal Sales may adversely affect our sales and results of operations.

In
January 2008, our Director of IT resigned. We are in the process of identifying a replacement. If we fail to successfully identify a replacement, or are unable to successfully
integrate this person into our organization, our ability to effectively operate our information technology systems and related financial reporting and internal controls could be adversely affected.

We
have recently hired a Senior Vice President of Marketing. Our failure to successfully integrate this individual into our organization could adversely affect our business and results
of operations.

Negative publicity relating to our products could cause our HEELYS brand to suffer and adversely affect our net sales and results of operations.

Various media outlets have reported on injuries suffered by users of our products and have quoted from or referred to medical studies and U.S. Consumer Product
Safety Commission data relating to injury rates of users of wheeled footwear. This negative publicity and any future negative publicity relating to the safety of our products or products similar to
ours could cause our HEELYS brand image to suffer and adversely affect our net sales and operating performance.

Additional bans on the use of our HEELYS-wheeled footwear due to public safety and liability concerns could adversely affect our net sales and results
of operations.

Various places of business and other institutions, such as shopping malls and schools, have imposed bans on the use of our HEELYS-wheeled footwear due to public
safety and liability concerns. If the number of businesses and other institutions instituting such bans increases in the future, consumers could find our HEELYS-wheeled footwear less appealing, which
could adversely affect our net sales and result of operations.

Because of increased inventory at our retail customers, or for other reasons, our net sales may not grow or may decrease and that may have a material
adverse effect on our results of operations and margins.

We recently experienced challenges related primarily to higher than expected inventory positions of our HEELYS-wheeled footwear at many of our retail customers as
weekly unit sales were lower than internal projections of many of our retail customers and certain of our major retail customers have been reluctant to place significant orders for additional product.
These factors have required us to assist certain of our key retail customers in managing their inventory and sell-through, including rescheduling orders to later dates, accepting cancellations,
increasing marketing, promotion and advertising support, accepting returns, and further requiring us to increase substantially our reserve for marketing discretionary fund assistance and returns
reserve. Additionally, as a result of the decrease in

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net
sales during the second half of 2007 and cancelled orders, our inventory position at year end was greater than we have historically seen, and required us to take a write-down on our inventory. The
existence or persistence of any of these factors may cause our net sales to stall or decrease, which could have a material adverse effect on our results of operation, margins and financial condition.

If we are unable to enforce our patents, trademarks and other intellectual property rights, competitors may be able to sell products that are
substantially similar to our products, which could adversely affect our sales and damage our brand image.

We believe our trademarks, trade names, copyrights, trade secrets, issued and pending patents, trade dress and designs are valuable and integral to our success.
The costs associated with obtaining and maintaining our intellectual property rights and protecting our HEELYS brand are significant. Further, we do not know whether our pending or future patent
applications will result in the issuance of patents. Even if patents are issued in the future, we cannot predict how the patent claims will be construed and such patents may not provide us with the
ability to prevent the development, manufacturing or marketing of infringing products. Enforcement of our patents and other intellectual property rights is often met with defenses, counterclaims and
countersuits attacking the validity and enforceability of our patents and other intellectual property rights. The validity and enforceability of our patents may be challenged by third parties for many
different reasons, including for example, prior art, prior disclosure, prior offers to sell, incorrect inventorship, prior invention by another, patent misuse, antitrust violations, laches and
estoppel.

In
addition, we may not be able to detect infringement of our intellectual property rights quickly or at all, and at times in the past we have not been, and in the future we may not be,
successful combating counterfeit, infringing or knockoff products, thereby damaging our competitive position. For example, on many occasions, we have identified knockoff products sold by others that
we believe may infringe upon our intellectual property rights. Historically, knockoff products have been sold mainly in international markets, but recently we have identified an increasing number of
knockoff products being sold domestically. Knockoff products often are sold under a brand name that is the same as or substantially similar to the HEELYS name. Knockoff and counterfeit products may
continue to emerge, as others seek to trade on the goodwill of the HEELYS name and benefit from the consumer demand for our products. We may not be able to detect all knockoff and counterfeit products
and may lose our competitive position in a given geographic market before we become aware of any such infringement.

To
protect our HEELYS brand, we have already spent significant resources and may be required to spend significantly greater resources in the future to monitor and police our intellectual
property rights. If we are unsuccessful in enforcing our intellectual property rights, sales of counterfeit, knockoff or infringing products by others could harm our HEELYS brand and adversely affect
our business, financial condition and results of operations. Even if we successfully enforce our intellectual property rights, the presence in the market of counterfeit, knockoff or infringing
products of poor quality for even a short time period could have a detrimental impact on our HEELYS brand.

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We may not be able to obtain and maintain patent, trademark or other intellectual property rights protection in some foreign countries, which could
result in us being unable to prevent others from using our HEELYS mark, which could have a material adverse effect on our business.

We depend upon the laws of the countries where our products are sold to protect our intellectual property. Intellectual property rights may be unavailable or
limited in some countries because patent laws and standards of patentability vary internationally. Consequently, in certain foreign jurisdictions, we have elected not to apply for patents or trademark
registrations. Further, patent and trademark protection may not be available in every country where our products are sold. While we generally apply for patents and trademarks in most countries where
we intend to sell patented products, we may not accurately predict all of the countries where patent or trademark protection will ultimately be desirable. If we fail to timely file a patent or
trademark application in any such country, we will likely be precluded from doing so at a later date. Failure to adequately pursue and enforce our patent and trademark rights could damage our HEELYS
brand, enable others to compete with us and impair our ability to compete effectively.

In
some countries where we have sought patent protection, third parties have challenged the validity, enforceability and scope of our patent rights. Patent laws, and standards of
patentability and validity, vary from one country to the next. For example, the validity of our Japanese patent claims was challenged in May 2004, resulting in an opinion that our Japanese patent
claims were invalid. In February of 2008, we learned that our appeals of this opinion were unsuccessful, although additional patent applications are still pending in Japan. Conversely, we recently
learned that we had prevailed against a challenge to our patent in Taiwan where a third party filed a cancellation application in July 2004 with the Taiwan Intellectual Property Office to cancel our
issued patent in Taiwan. Patent challenges are commonly filed as counterclaims in patent litigation proceedings. There can be no assurance that we will prevail in similar proceedings. Our HEELYS
brand, business, financial condition and results of operations could be adversely affected if we fail to obtain and maintain intellectual property right protection in foreign countries where we derive
a large amount of our net sales.

Because we outsource all of our manufacturing to a small number of independent manufacturers, we may face challenges in maintaining a sufficient supply
of products to meet demand for our products or experience interruptions in our supply chain. Any shortfall in the supply of our products may decrease our net sales and have an adverse impact on our
customer relationships and results of operations.

All of our products are produced by independent manufacturers with which we do not have long-term contracts. As such, any of them could unilaterally
terminate its relationship with us or increase the prices it charges us at any time. Until May 2006, one independent manufacturer produced almost all of our HEELYS-wheeled footwear. Commencing in May
2006, when demand for our HEELYS-wheeled footwear products outstripped the capacity of this independent manufacturer, we used additional independent manufacturers to produce HEELYS-wheeled footwear.
Although these additional manufacturers have enabled us to increase our monthly production capacity, we may be unable to fill a substantial number of future orders placed by our customers on a timely
basis. To expedite the delivery of past-due customer orders, we typically ship via air freight for which we pay higher shipping rates. During the second and third quarters of 2006 our
inability to deliver customer orders on a timely basis resulted in delayed sales and higher shipping costs which caused us to miss certain internal financial targets. If we cannot procure sufficient
quantities of HEELYS-wheeled footwear to meet customer demand in a timely manner, or if the quality of our products declines, customers may cancel orders, refuse shipments, negotiate for reduced
purchase prices or ask us to pay extraordinary shipping costs, any of which could have a material adverse effect on our customer relationships and operating results. Additionally, if any of our
independent manufacturers fail or refuse to ship any orders for any reason, our business could be adversely affected.

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We rely on our independent sales representatives for our domestic sales, and if our relationships with a material number of these representatives were
terminated, it could result in reduced sales of our products.

We sell substantially all of our products domestically through our network of 18 independent sales representatives. We rely on these independent sales
representatives to provide new customer prospects and market our products to our retail customers. Our independent sales representatives do not sell our products exclusively and may terminate their
relationships with us at any time with limited notice. Our ability to maintain and increase our domestic sales depends in large part on our success in maintaining relationships with our independent
sales representatives on commercially reasonable terms. Any failure to maintain and develop new satisfactory relationships with independent sales representatives, or any failure of our independent
sales representatives to effectively market our products, could adversely affect our domestic sales.

Our new distribution efforts in the European Union involve inherent risks which could result in harm to our business.

We recently opened a new sales and marketing office in Belgium to focus on expanding our international opportunities by working more closely with our
distributors, establishing relationships with distributors in new international markets and, in selective markets, selling our products direct to retail customers. Our ability to meet customer
expectations, manage inventory, complete sales and achieve objectives for operating efficiencies depends upon the proper operation of our new distribution model and the development of additional
distribution capabilities. This new distribution model is subject to a number of risks, including greater difficulties in staffing and managing foreign operations, unexpected changes in regulatory
practices and tariffs, longer collection cycles, seasonality, potential changes in export and tax laws and other risks and uncertainties inherent in doing business outside of the United States. This
new distribution model may also adversely impact our relationship with our independent distributors.

Improvements to our information technology systems may be inadequate, which would adversely affect our ability to operate effectively.

We have upgraded and implemented new information technology systems to facilitate our growth, streamline our financial reporting and improve our internal
controls. As we grow and our business needs change, we could experience difficulties associated with systems transitions. If we experience difficulties in our information technology systems or
experience system failures, or if we are unable to successfully modify our information technology systems to respond to changes in our business, our ability to operate effectively could be adversely
affected.

Our business could suffer if our independent manufacturers violate legal requirements or fail to conform to generally accepted ethical standards.

We expect our independent manufacturers to comply with applicable legal requirements and generally accepted ethical standards for working conditions and other
matters. However, we do not control our independent manufacturers or their business practices. If any of our manufacturers were to use forced or indentured labor or child labor, fail to pay
compensation in accordance with local law, fail to operate in compliance with local safety regulations or diverge from other applicable legal requirements or business practices generally accepted as
ethical, we would take appropriate action, which could result in an interruption in our product supply. In addition, we could suffer negative publicity and damage to our reputation and the value of
our HEELYS brand, which would adversely affect our business and results of operations.

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If our independent manufacturers are unable to obtain raw materials, our costs could increase or the delivery of our products could be delayed, which
could adversely affect our net sales and results of operations.

The production capacity of our independent manufacturers is dependent, in part, upon the availability of raw materials. Our manufacturers may experience shortages
of raw materials, which could result in increased costs to us or delays in deliveries of our products from our manufacturers. As a result, we could experience cancellation of orders, refusal to accept
deliveries or a reduction in our sales prices and profit margins, any of which could harm our net sales and results of operations.

Because our products are manufactured in Asia, we recently opened offices in China and Belgium, and a portion of our sales activities occur outside of
the United States, we are subject to international business, political, operational, financial and economic risks that could adversely affect our net sales and results of operations.

Conducting business internationally entails numerous risks which could interrupt or otherwise adversely affect our business, including:



These
factors and the failure to effectively respond to them could result in, among other things, poor quality in our products, product shortages, delivery delays, decreased net sales
and increased costs.

We are subject to foreign exchange risk, and if the U.S. dollar significantly weakens compared to the currency in the markets where our products are
produced, our manufacturers could increase the prices they charge us for our products, which could reduce our profitability.

We pay for our products and, until 2008 we paid commissions to our independent sourcing agent in U.S. dollars, and our independent distributors pay us in U.S.
dollars. International sales accounted for approximately 16.8% of our net sales in 2005, 14.3% of our net sales in 2006 and 16.6% of our net sales in 2007. We do not engage in any foreign currency
hedging transactions. If the U.S. dollar strengthens compared to the currency in the foreign markets where our products are sold, our products will be more expensive in those markets making them less
attractive to consumers. If the U.S. dollar

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significantly
weakens compared to the currency in the foreign markets where our products are produced, our manufacturers could increase the prices they charge us for our products, which could reduce
our profitability. There can be no assurance that we can effectively mitigate our foreign exchange risk.

HEELYS-wheeled footwear could become subject to import duties in the United States, and if we cannot increase our prices to compensate for such duties,
it could reduce our profitability.

HEELYS-wheeled footwear is currently classified by U.S. Customs and Border Protection as a skate, and as such we do not pay import duties to the United States.
This customs classification can be changed at any time and, although we would vigorously oppose any proposed change, there can be no assurance that we would prevail. If the classification for
HEELYS-wheeled footwear changed and HEELYS-wheeled footwear became subject to an import duty, it might be difficult to increase our prices to compensate for any such duty, which could reduce our
profitability.

Third parties may claim that we are infringing their intellectual property rights, and such claims may be costly to defend, may require us to pay
licensing fees, damages or other amounts and may prevent or limit the manufacture, marketing or sale of our products.

Third parties may successfully claim that we are infringing their intellectual property rights. While we do not believe that any of our products infringe the
valid intellectual property rights of third parties, we may be unaware of the intellectual property rights of others that may cover some of our technology or products. For example, because many patent
applications in the United States are not publicly disclosed immediately after they are filed, we could adopt technology without knowledge of a pending patent application, which technology would
infringe a third-party patent once that patent is issued.

Our
competitors in both the United States and foreign countries may have applied for or obtained, or may in the future apply for or obtain, patents that will prevent, limit or otherwise
interfere with our ability to make, market or sell our products. Although we may conduct our own independent review of patents issued to certain third parties, we cannot assure you that we will be
aware of all pre-existing technology that may subject us to patent litigation. Further, we may adopt a trademark or trade dress that a third party claims infringes their rights in such
trademark or trade dress. If we are forced to defend against infringement claims, whether or not such claims are resolved in our favor, we could encounter expensive and time-consuming
litigation which could divert the attention of our management and other key personnel from our business operations. Furthermore, if we are found to be infringing intellectual property rights of
others, we could be required to pay licensing fees or damages. In addition, if we are not able to obtain license agreements on terms acceptable to us, or at all, we may be prevented from
manufacturing, marketing or selling our products. As a result, our net sales could be significantly reduced and our cost of sales could be significantly increased, either of which could have an
adverse effect on our business.

We are subject to product liability, warranty and recall claims and our insurance coverage may not cover such claims, which could cause us to incur
substantial costs and adversely affect our business.

Due to the inherent risk of injury related to the use of our products, our business exposes us to claims for product liability and warranty claims if our products
actually or allegedly fail to perform as expected, or the use of our products results or is alleged to result in personal injury, disability or death. There can be no assurance that we will be able to
successfully defend or settle the product liability claims and lawsuits to which we are and in the future may be subject.

We
attach warning labels to our products and packaging relating to safe usage and the risk of injury. However, if a product liability claim is brought against us, the content of the
warnings, the placement of them or both may be considered inadequate by courts, exposing us to liability. We cannot

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be
certain that our safety warning labels are adequate. Product liability claims could result in us having to expend significant time and expense to defend these claims and to pay, if necessary,
settlement amounts or damages, which could adversely affect our financial condition. In addition, claims that use of our products resulted in an injury, disability or death could cause our HEELYS
brand image and operating performance to suffer by damaging our reputation and prospects and by diverting the time and attention of our management, even if we are not at fault.

There
can be no assurance that our product liability insurance coverage will be adequate, that our insurers will be financially viable when payment of a claim is required or that we will
be able to obtain such insurance in the future on acceptable terms, if at all.

If
any of our products are or are alleged to be defective, we may be required to recall that product. Any product recall could cause us to incur substantial cost, and irreparably harm
our relationships with our customers, which could adversely affect our business.

Expanding our distribution to mass merchants could have a material adverse effect on our gross margin, brand image and results of operations.

We sell our products to sporting goods retailers, specialty apparel and footwear retailers, select department stores, and family footwear stores in an effort to
maintain a high-quality image for our HEELYS brand and premium price points for our products. Although we do not currently anticipate distributing to mass merchants, if we choose to do so
in the future it could have a material adverse effect on our gross margin and could negatively affect our HEELYS brand image and our reputation with consumers, which could adversely affect our results
of operations and financial condition.

Our operating results are subject to seasonal and quarterly variations in our net sales and net income, which could adversely affect the price of our
common stock.

We have experienced, and expect to continue to experience, substantial seasonal and quarterly variations in our net sales and net income. Our quarterly results of
operations may also fluctuate significantly as a result of a variety of other factors, including, among other things, the amount of inventory carried by our retailers, timing of holidays and
advertising initiatives and changes in our product mix. In addition, variations in weather conditions may significantly affect our results of operations.

As
a result of these seasonal and quarterly fluctuations, we believe that comparisons of our operating results between different quarters within a single year are not necessarily
meaningful and that these comparisons cannot be relied upon as indicators of our future performance. Any seasonal or quarterly fluctuations that we report in the future may differ from the
expectations of market analysts and investors. This could cause the price of our common stock to fluctuate significantly.

As a relatively young consumer products company, we may not be able to compete effectively, which could have a negative impact on our sales and our
business.

We compete with companies that sell to young consumers in several different product markets, including footwear, sporting goods and recreational products. These
markets are intensely competitive and we expect competition to increase in the future. A number of our competitors have significantly
greater financial, marketing, distribution and manufacturing resources than we do, as well as greater brand awareness in the markets in which they operate. We also compete with counterfeit, knockoff
and infringing products, which are often sold at lower prices. If we fail to remain competitive with respect to the quality, design, price and timely delivery of products, our business, financial
condition and results of operations could be materially adversely affected.

21

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If our new product initiatives are not accepted by our customers or if we are unable to maintain our margins, it could materially affect our financial
performance.

We are currently in the process of introducing a new product line of non-wheeled footwear. Non-wheeled footwear are subject to intense competition in the
marketplace. As is typical with new products, market acceptance of these new lines is uncertain and achieving market acceptance may require substantial marketing efforts and expenditures. We also
cannot assure that these new products will have the same or better margins than our current products. The failure of the new product lines to gain market acceptance or our inability to maintain our
current product margins with the new lines could adversely affect our business, financial performance and brand image.

The current uncertainty surrounding the United States economy and adverse trends in retailing could have a material adverse effect on our results of
operations.

As economic conditions in the United States change, trends in discretionary consumer spending may become more unpredictable and discretionary consumer spending
could be reduced due to uncertainties about the future. When discretionary consumer spending is reduced, purchases of our products may decline. We have noticed a higher level of caution from our
retail customers than in past years and this may result in lower than expected orders and increased inventory controls by some of our customers. A recession in the general economy or continued
uncertainties regarding future economic prospects could have a material adverse effect on our results of operations.

We may have difficulty identifying and successfully integrating acquisitions into our business and any acquisitions we make could result in adverse
consequences.

We may make acquisitions of complementary companies and products. The pursuit of acquisitions may divert the attention of management and cause us to incur
significant expenses identifying, investigating and pursuing suitable acquisitions, whether or not they are consummated.

We
have limited experience acquiring other businesses and may not be able to successfully integrate any acquired operations with our business or effectively manage the combined business
following an acquisition. We also may not achieve the anticipated benefits of an acquisition due to any of the following factors:



If
we experience any of the difficulties noted above, our business and financial condition could be adversely affected.

We have experienced volatility in our stock price and it may fluctuate in the future. Therefore, you may be unable to resell shares of our common stock
at or above the price you paid for them.

The market price of our common stock has fluctuated in the past and may fluctuate significantly in the future. For example, during 2007, our common stock traded
at prices as low as $5.75 and as high as $40.09 per share. Such volatility in the trading price of our common stock may prevent you from being able to sell your shares of our common stock at prices
equal to or greater than your purchase price.

22

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Such
fluctuations may be influenced by many factors, many of which are outside of our control, including:



In
addition, in recent years, the stock market has experienced significant price and volume fluctuations. This volatility has had a significant impact on the trading price of securities
issued by many companies, including companies in our industry. The changes frequently occur irrespective of the operating performance of the affected companies. Hence, the trading price of our common
stock could fluctuate based upon factors that have little or nothing to do with our business.

Class action and derivative lawsuits have been filed against us and certain of our officers and directors, which could result in significant costs and a
diversion of our management's efforts.

We and certain of our officers and directors have been sued in class action lawsuits and derivative lawsuits alleging violations of federal securities law in
connection with our initial public offering. While we believe we have meritorious defenses and plan to defend vigorously any such claims made against us, we cannot assure you that these actions will
be resolved without incurring significant costs (including paying the costs relating to such litigation incurred by our officers, directors and underwriters pursuant to various indemnification
obligations) and/or resulting in the diversion of the attention of management and other key employees. The resolution of this pending securities litigation and the defense of any additional litigation
that may arise could result in significant costs and any unfavorable outcome could have a material adverse effect on our business.

We were not in compliance with Nasdaq listing requirements due to the resignation of one of our Directors from our Board of Directors and as a Member of
our Board's Audit Committee.

As a result of the Board of Directors vacancy created in December 2007 by the resignation of one of our Directors and as member of our Board's Audit
Committee, we were not in compliance with Nasdaq's Marketplace Rule 4350(d)(2), which required us to have an audit committee of at least three independent directors as defined by Nasdaq's
rules. Consistent with Nasdaq's Marketplace Rule 4350(d)(4), we had a cure period until June 16, 2008 to fill the vacancy and regain compliance. Effective March 12, 2008, a new
independent director was elected to our Board and also to serve on our Board's Audit Committee, and we regained compliance with Nasdaq's Marketplace Rule 4350(d)(2). If, in the future,
resignation of one or more members of our Audit Committee should occur we may again not be in compliance with the Nasdaq listing requirements and we may not be able to timely identify and elect an
appropriate replacement. Failure to maintain compliance with Nasdaq listing requirements could result in the delisting of our shares from trading on the Nasdaq system,

23

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which
could have a material adverse effect on the trading price, volume and marketability of our common stock.

Existing stockholders significantly influence our corporate governance.

As of December 31, 2007 our executive officers, key employees, directors and their affiliates beneficially owned, in the aggregate, approximately 70% of
our outstanding common stock. In addition, Capital Southwest Venture Corporation, or "CSVC," which owns approximately 34.4% of our common stock, has the contractual right to designate (i) two
nominees for director to be included in management's slate of director nominees, so long as it owns at least 15% of the outstanding shares of our common stock, and (ii) one such nominee so long
as it owns at least 10%, but less than 15%, of the outstanding shares of our common stock. CSVC's parent company is Capital Southwest Corporation ("CSC"). The Chairman of our Board of Directors is the
President and CEO of CSC. In addition, one of our directors is the Vice President of CSC. The Chairman of our Audit Committee serves on the Board of CSC and was designated to our Board by CSVC. As a
result, through its designees, CSVC may significantly influence our corporate governance.

Our Certificate of Incorporation and By-Laws and Delaware law contain provisions that could discourage a third party from acquiring us and
consequently decrease the value of an investment in our common stock.

Our Certificate of Incorporation and By-Laws and Delaware corporate law contain provisions that could delay or prevent a change in control of our
company or changes in our management. Among other things, these provisions:



These
provisions could discourage proxy contests, make it more difficult for our stockholders to elect directors and take other corporate actions and may discourage, delay or prevent a
change in control or changes in our management that a stockholder might consider favorable. Any delay or prevention of a change in control or change in management that stockholders might otherwise
consider to be favorable could deprive you of the opportunity to sell your common stock at a price in excess of the prevailing trading price and cause the trading price of our common stock to decline.

As a public company, we are required to meet periodic reporting requirements under SEC rules and regulations. Complying with federal securities laws as
a public company is expensive and we will incur significant time and expense enhancing, documenting, testing and certifying our internal control over financial reporting. Any deficiencies in our
financial reporting or internal controls could adversely affect our business and the trading price of our common stock.

SEC rules require that, as a publicly traded company, we file periodic reports containing our financial statements within a specified time following the
completion of quarterly and annual periods. Prior to the completion of our initial public offering in December 2006, we were not required to comply with SEC requirements to have our financial
statements completed and reviewed or audited within a specified time. We may experience difficulty in meeting the SEC's reporting requirements. Any

24

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failure
by us to file our periodic reports with the SEC in a timely manner could harm our reputation and reduce the trading price of our common stock.

As
a public company we incur significant legal, accounting, insurance and other expenses. The Sarbanes-Oxley Act of 2002, as well as compliance with other SEC and Nasdaq rules, will
increase our legal and financial compliance costs and make some activities more time-consuming and costly. Furthermore, SEC rules require that our chief executive officer and chief
financial officer periodically certify the existence and effectiveness of our internal control over financial reporting. Our independent registered public accounting firm is required, beginning with
this report, to attest to our assessment of our internal control over financial reporting. This process generally requires significant documentation of policies, procedures and systems, review of that
documentation by our internal accounting staff and our outside auditors and testing of our internal control over financial reporting by our internal accounting staff and our outside independent
registered public accounting firm. Documentation and testing of our internal controls, which we have not undertaken in the past, will involve considerable time and expense, may strain our internal
resources and have an adverse impact on our operating costs.

During
the course of our testing, we may identify deficiencies which would have to be remediated to satisfy the SEC rules for certification of our internal control over financial
reporting. As a consequence, we may have to disclose in periodic reports we file with the SEC significant deficiencies or material weaknesses in our system of internal controls. The existence of a
material weakness would preclude management from concluding that our internal control over financial reporting is effective, and would preclude our independent auditors from issuing an unqualified
opinion that our internal control over financial reporting is effective. In addition, disclosures of this type in our SEC reports could cause investors to lose confidence in our financial reporting
and may negatively affect the trading price of our common stock. Moreover, effective internal controls are necessary to produce reliable financial reports and to prevent fraud. If we have deficiencies
in our disclosure controls and procedures or internal control over financial reporting it may negatively impact our business, results of operations and reputation.

Item 1B.    Unresolved Staff Comments

None.

Item 2.    Properties

We lease our corporate headquarters, an approximately 48,400 square-foot facility located in Carrollton, Texas, consisting of approximately 34,500
square feet of warehouse space and approximately 13,900 square feet of office space. Our lease expires in August 2015, but we have two five-year extension options.

On
October 29, 2007, we signed a lease for office space for our representative office in Qingdao, China. The lease consists of approximately 2,850 square feet of office space. Our
lease expires December 1, 2008, but we have two one-year extension options.

In
2007, we entered into an agreement to add a third-party distribution facility in San Pedro, California. We have also expanded our use of a third-party distribution facility in Belgium
to facilitate European distributions.

We
believe that our existing facilities are adequate to meet our current requirements.

Item 3.    Legal Proceedings

The Company, its former Chief Executive Officer, its Chief Financial Officer, and its directors who signed the Company's registration statement filed with the
Securities and Exchange Commission in connection with our December 7, 2006 initial public offering (the "IPO")along with Capital

25

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Southwest
Corporation, Capital Southwest Venture Corporation and the underwriters for the IPOare defendants in a lawsuit originally filed on August 27, 2007 in the United States
District Court for the Northern District of Texas, Dallas Division, by plaintiff Brian Rines, Individually and On Behalf of All Others Similarly Situated, purportedly on behalf of all persons who
purchased the Company's common stock pursuant to or traceable to the IPO registration statement. The complaint alleges violations of Sections 11 and 15 of the Securities Act of 1933. The
plaintiff seeks an order determining that the action may proceed as a class action, awarding compensatory damages in favor of the plaintiff and the other class members in an unspecified amount, and
reasonable costs and expenses incurred in the action, including counsel fees and expert fees. Four similar lawsuits were also filed in September and October 2007 in the United States District Court
for the Northern District of Texas, Dallas Division, by plaintiffs Vulcan Lee, John Avila, Gerald Markey, and Robert Eiron on behalf of the same plaintiff class, making substantially similar
allegations under Sections 11, 12, and 15 of the Securities Act of 1933, and seeking substantially similar damages. These lawsuits have been transferred to a single judge have been consolidated
into a single action. An amended consolidated complaint was filed on March 11, 2008. Lead plaintiffs and lead counsel have been appointed. The amended complaint alleges that the prospectus used
in connection with our IPO contained misstatements of material fact or omitted to state material facts necessary in order to make the statements made not misleading relating to among other
allegations, safety concerns and injuries associated with our products and their alleged impact on demand, visibility into our sales channel and competition from knockoffs, in violation of Sections
11, 12(a)(2) and 15 of the Securities Act of 1933 and requests substantially similar damages and relief as previously mentioned. While the Company cannot predict the outcome of these matters, the
Company believes that the plaintiffs' claims are without merit, denies the allegations in the complaints, and the Company intends to vigorously defend the lawsuits. If any of these matters were
successfully asserted against the Company, there could be a material adverse effect on the Company's financial position, cash flows or results of operations.

On
October 3, 2007 and October 24, 2007, in the United States District Court for the Northern District of Texas, Dallas Division, Jack Freeman and Brian Mossman,
respectively brought shareholders' derivative actions, for the Company's benefit, as nominal defendant, against the Company's former Chief Executive Officer, the Company's former Director of Research
and Development, the Company's Chief Financial Officer, Senior Vice President and certain members of the Company's board of directors and one of our former directors. The Company is a nominal
defendant, and the complaints do not seek any damages against the Company. The complaints allege violations of Section 14(a) of the Securities Act of 1933 and breaches of fiduciary duty, abuse
of control, gross mismanagement, waste of corporate assets and unjust enrichment on the part of each of the named defendants. The complaints seek unspecified amounts of compensatory damages, voiding
the election of the director defendants, as well as interest and costs, including legal fees from the defendants. The derivative claims have been transferred to a single judge and have been
consolidated into a single derivative claim. An amended consolidated complaint making substantially similar allegations and claims for damages was filed on March 14, 2008.

Due
to the nature of the Company's products, from time to time the Company has to defend against personal injury and product liability claims arising out of personal injuries that
allegedly are suffered using the Company's products. To date, none of these claims has had a material adverse effect on the Company. The Company is also engaged in various claims and legal proceedings
relating to intellectual property matters, especially in connection with enforcing the Company's intellectual property rights against the various third parties importing and selling knockoff products
domestically and internationally. Often, such legal proceedings result in counterclaims against the Company that the Company must defend. The Company believes that none of the pending personal injury,
product liability or intellectual property legal matters will have a material adverse effect upon the Company's financial position, cash flows or results of operations.

26

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

Annual Meeting of Shareholders

No matters were submitted by the Company's shareholders during the fourth quarter of the fiscal year ended December 31, 2007.

PART II

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

Market Information

Our common stock, par value $0.001, has been listed on The Nasdaq Global Market under the stock symbol "HLYS" since December 8, 2006. Prior to that time
there was no public market for our stock. The initial public offering price of our common stock on December 8, 2006 was $21.00 per share. As of March 11, 2008, there were 22 holders of
record of our common stock. The following table sets forth the range of high and low market prices for the common stock for the period beginning on December 8, 2006 through December 31,
2007, as reported by The Nasdaq Global Market.

2007

High

LowFirst Quarter

$
40.09

$
27.25Second Quarter

$
38.68

$
24.42Third Quarter

$
28.38

$
7.65Fourth Quarter

$
10.80

$
5.752006

High

LowFourth Quarter (since December 8, 2006)

$
38.75

$
30.00


27

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Dividends

In the past we have not paid any dividends, nor do we anticipate paying any dividends in the foreseeable future. Instead, we anticipate that all of our earnings,
if any, in the foreseeable future will be used for working capital and to finance the growth and development of our business. Any future determination relating to dividend policy will be made at the
discretion of our board of directors and will depend on a number of factors, including our outstanding indebtedness, earnings, capital requirements, financial condition and future prospects,
applicable Delaware law, which provides that dividends are only payable out of surplus or net profit for the then current and immediately preceding fiscal years, and other factors that our board of
directors may deem relevant. Future agreements governing our borrowings, and the terms of any preferred stock we may issue in the future, will also likely contain restrictive covenants prohibiting us
from paying dividends.

Initial Public Offering of Our Common Stock and Use of Proceeds

On December 13, 2006, we completed the initial public offering of our common stock pursuant to a Registration Statement (File
No. 333-137046) that was declared effective by the Securities and Exchange Commission on December 7, 2006. In that offering we sold a total of 3,125,000 shares of our common
stock and selling stockholders sold 4,263,750 shares of our common stock, which included 963,750 shares resulting from the exercise of the underwriters' over-allotment option. All common
stock registered under that registration statement were sold at a price to the public of $21.00 per share. We did not receive any proceeds from the selling stockholders' sale of their shares.

The
net proceeds to us from the offering were approximately $58.8 million, after deducting underwriting discounts and commissions and other expenses incurred in connection with
the offering. As of December 31, 2007, we had used $8.5 million of these proceeds to repay amounts outstanding under our revolving credit facility and $27.7 million for working
capital purposes ($8.5 million in December 2006 and the remaining $19.2 million during 2007). We intend to use the remaining proceeds to fund infrastructure improvements, including
expanding and upgrading our information technology systems; hiring new employees; marketing and advertising programs; product development; expanding our international operations; cost to comply with
the Sarbanes-Oxley Act of 2002; working capital needs; and other general corporate purposes.

Unregistered Sales of Equity Securities

During the period covered by this Annual Report on Form 10-K, we did not sell or issue any unregistered equity securities.

Repurchases

None.

Securities Authorized for Issuance under Equity Compensation Plans

The Company has reserved 2,272,725 shares of common stock subject to its 2006 Stock Incentive Plan, or the "2006 Plan," and had 35,747 shares remaining available
at December 31, 2007 that may be granted to employees, consultants and nonemployee directors of the Company. The 2006 Plan is administered by the compensation committee of the Company's board
of directors, which selects the persons to whom options will be granted, determines the number of shares to be subject to each grant, and prescribes the other terms and conditions of each grant,
including the type of consideration to be paid to the Company upon exercise and the vesting schedule. If a change of control of the Company, as defined by the 2006 Plan, occurs, the vesting of the
options will accelerate and become fully vested and exercisable.

28

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Our
board of directors and stockholders approved our 2006 Plan and we do not have any other equity based plans.

Equity Compensation Plan Information

|Plan Category                                              |  | Number of securities to be issued upon exercise of outstanding options, warrants and rights |  | Weighted-average exercise price of outstanding options, warrants and rights |      | Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
|---------------------------------------------------------- |  | ------------------------------------------------------------------------------------------- |  | --------------------------------------------------------------------------- | ---- | -------------------------------------------------------------------------------------------------------------------------------------------
|
|Equity compensation plans approved by security holders     |  | 2,190,997                                                                                   |  | $                                                                           | 5.89 |                                                                                                                                            
|Equity compensation plans not approved by security holders |  |                                                                                            |  | $                                                                           |     |                                                                                                                                            
|                                                           |  |                                                                                             |  |                                                                             |      |                                                                                                                                            
|Total                                                      |  | 2,190,997                                                                                   |  | $                                                                           | 5.89 |                                                                                                                                            
|                                                           |  |                                                                                             |  |                                                                             |      |                                                                                                                                            

The
table above sets forth information regarding our 2006 Plan as of December 31, 2007.

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Performance Graph

The graph below compares the cumulative total stockholder return on our common stock for the period from December 8, 2006, the date of our initial public
offering, through December 31, 2007 with the cumulative total return on the NASDAQ 100 and the Dow Jones Footwear Index. Each comparison assumes the investment of $100 on
December 8, 2006 in our common stock and in each of the indices and, in each case, assumes reinvestment of all dividends.

GRAPHIC

30

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Item 6.    Selected Financial Data

The following selected consolidated financial data should be read in conjunction with, and are qualified by reference to, our consolidated financial statements
and related notes and "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing elsewhere in this Annual Report on Form 10-K. The
consolidated statements of operations data for the years ended December 31, 2005, 2006 and 2007, and the consolidated balance sheet data at December 31, 2006 and 2007 are derived from
our consolidated financial statements which have been audited by Deloitte & Touche LLP, an independent registered public accounting firm, and are included elsewhere in this Report. The
consolidated statements of operations data for the years ended December 31, 2003 and 2004, and the consolidated balance sheet data at December 31, 2003, 2004 and 2005 are derived from
our consolidated financial statements not included herein.

|                                            |                            | Year Ended December 31, |                                                  
|------------------------------------------- | -------------------------- | ----------------------- | -------------------------------------------------
|
|
|Consolidated Statements of Operations Data: |                            |                         |                                                  
|Net sales                                   |                            | $                       | 22,215                                           
|Cost of sales                               |                            |                         | 15,583                                           
|                                            |                            |                         |                                                  
|Gross profit                                |                            |                         | 6,632                                            
|Selling, general and administrative expense |                            |                         |                                                  
|                                            | Sales and marketing        |                         |                                                  
|                                            | General and administrative |                         |                                                  
|                                            |                            |                         |                                                  
|                                            |                            |                         | Total selling, general and administrative expense
|                                            |                            |                         |                                                  
|Income from operations                      |                            |                         | 1,709                                            
|Other expense (income), net                 |                            |                         | 33                                               
|                                            |                            |                         |                                                  
|Income before income taxes                  |                            |                         | 1,676                                            
|Income taxes                                |                            |                         | 575                                              
|                                            |                            |                         |                                                  
|Net income                                  |                            | $                       | 1,101                                            
|                                            |                            |                         |                                                  
|Earnings per share:                         |                            |                         |                                                  
|                                            |                            | Basic                   |                                                  
|                                            |                            | Diluted                 |                                                  
|Weighted average shares outstanding:        |                            |                         |                                                  
|                                            |                            | Basic                   |                                                  
|                                            |                            | Diluted                 |                                                  
|Other Data:                                 |                            |                         |                                                  
|Net sales, domestic                         |                            | $                       | 9,458                                            
|Net sales, international                    |                            |                         | 12,757                                           
|Depreciation and amortization               |                            |                         | 548                                              

31

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|
|

|                                  |  | At December 31,
|--------------------------------- |  | ---------------
|
|
|Consolidated Balance Sheet Data:  |  |                
|Cash and cash equivalents         |  | $              
|Working capital                   |  |                
|Total assets                      |  |                
|Total long-term liabilities(2)(3) |  |                
|Total stockholders' equity        |  |                

---

Note:
The numbers in the tables above, except per share data, have been rounded to thousands. All calculations related to the period-to-period comparisons in "Management's
Discussion and Analysis of Financial Condition and Results of Operations" are derived from the tables above, are rounded to millions and could differ immaterially if such calculations were computed
without rounding.

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

The following discussion should be read in conjunction with our consolidated financial statements and the related notes included elsewhere
in this Annual Report on Form 10-K. This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended, or the "Securities Act," and Section 21E of the Securities Exchange Act of 1934, as amended, or the "Exchange Act," that are based on information currently available to
management as well as management's assumptions and beliefs. When used in this document and in documents incorporated by reference, forward-looking statements include, without limitation, statements
regarding financial forecasts or projections, and our expectations, beliefs, intentions or future strategies that are signified by terminology such as "subject to," "believes," "anticipates," "plans,"
"expects," "intends," "estimates," "may," "will," "should," "can," the negatives thereof, variations thereon, similar expressions, or discussions of strategy. These forward-looking statements reflect
our current views with respect to future events, based on what we believe are reasonable assumptions; however, such statements are subject to certain risks and uncertainties. In addition to the
specific uncertainties discussed elsewhere in this Annual Report on Form 10-K, the risk factors set forth in Part I, "Item 1A. Risk Factors" in this report may affect
our performance and results of operations. Those risks, uncertainties and factors include, but are not limited to the fact that substantially all of our net sales are generated by one product,
continued changes in fashion trends and consumer preferences and general economic conditions, our intellectual property may not restrict competing products that infringe on our patents from being
sold, we are dependent upon independent manufacturers, we may not be able to successfully introduce new product categories and the other factors described in our filings with the Securities and
Exchange Commission. Investors are urged to consider these risks, uncertainties and factors carefully in evaluating the forward-looking statements and are cautioned not to place undue reliance on such
forward-looking statements. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may differ materially from those in the
forward-looking statements. You should not place undue reliance on forward-looking statements. We disclaim any intention or obligation to update or review any forward-looking statements or
information, whether as a result of new information, future events or otherwise.

Throughout this report, references to the "Company," "we," and "our" refer to Heelys, Inc. and its consolidated subsidiaries, unless the context indicates
otherwise.

32

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We are a designer, marketer and distributor of innovative, action sports-inspired products under the HEELYS brand targeted to the youth market. Our primary
product, HEELYS-wheeled footwear, is patented, dual-purpose footwear that incorporates a stealth, removable wheel in the heel. HEELYS-wheeled footwear allows the user to seamlessly
transition from walking or running to skating by shifting weight to the heel. Users can transform HEELYS-wheeled footwear into street footwear by removing the wheel. In 2007, approximately 98% of our
net sales was derived from the sale of our HEELYS-wheeled footwear. We also sell branded accessories, such as replacement wheels, helmets and other protective gear. In the third quarter of 2006 we
introduced a limited variety of
apparel items in response to demand from certain of our retail customers and in 2007 we introduced a line of non-wheeled footwear to broaden and extend the HEELYS brand.

We
introduced HEELYS-wheeled footwear in 2000, and for several years our domestic sales were concentrated with one large, national specialty retailer. Although we initially focused on
driving our domestic sales growth, we also established relationships with an independent distributor in each of Japan, South Korea and Southeast Asia. As a result, the sources of our net sales were
largely concentrated and we were susceptible to customer-specific and region-specific factors, including competition from counterfeit, knockoff and infringing products in international markets. This
concentration caused variability in our results of operations. Since that time, we have diversified our retail customer base in the United States and expanded our international distribution channels
to mitigate this concentration.

Continued
growth of our net sales will depend on consumer demand for HEELYS-wheeled footwear and our ability to satisfy this demand. A number of factors may impact consumer demand for
our products, including:



We
intend to continue to diversify our product offering with new HEELYS-wheeled footwear models, product categories and accessories in order to benefit from the increasing recognition of
our HEELYS brand and the growing market for action sports-inspired products. Designing, marketing and distributing new products will require us to devote additional resources to product development,
marketing and operations. These additional resources may include hiring new employees to support expansion in these areas and increasing amounts allocated to product advertising and promotion. Each of
these additional resource commitments will increase our selling, general and administrative expenses. Because the selling price and unit cost of new products may differ from those of our existing
products, sales of these new products may also impact our gross margin. In addition, we may seek to selectively acquire products and companies that offer products that are complementary to ours.

Recent Developments

We recently experienced challenges related primarily to higher than expected inventory positions of product at many of our domestic accounts as weekly unit sales
were lower than internal projections of many of our domestic retail customers, which had a significant adverse effect on our results for the

33

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second
half of 2007. We believe that this was attributed to: (1) aggressive sell-through expectations of some of our domestic retailers going into the summer months and (2) retail
softness in footwear and apparel. Certain of our major retailers were reluctant to place significant fourth quarter 2007 orders until their current inventory was reduced to their targeted levels. We
also saw decreased prices on our products at certain of our retailers in the fourth quarter of 2007. These factors led us to work closely with each of our key retail customers to assist them in
managing their inventory and sell-through. This included providing marketing discretionary funds, rescheduling orders to later dates, accepting cancellations, increasing marketing,
promotion and advertising support, and accepting returns. As a result, our net sales for the second half of 2007 were negatively impacted by approximately $5.1 million related to an increase in
our reserve for marketing discretionary fund assistance and approximately $3.6 million as a result of an increase in our returns reserve. Of the $3.6 million increase in our returns
reserve, $2.7 million was attributable to negotiated returns from two of our retail customers. Both of these reserves are recorded as reductions to revenue and were related to domestic sales.
Additionally, as a result of the decrease in net sales during the second half of 2007 and cancelled orders, our inventory position at year end was greater than we have historically seen. We performed
an analysis of our inventory position, including open purchase commitments, and determined that certain of our inventory was impaired which resulted in a $1.9 million write-down of our
inventories on hand and a $617,000 loss on purchase commitments related to inventory that was still being held by the manufacturers. These impairment charges are recognized in cost of sales.

In
2008, we expect to see certain of our retail customers being more cautious when placing future orders and shifting toward shorter lead times. This trend will require us to take a more
aggressive inventory position to be able to meet at-once orders. While we will continue to experience some rescheduled orders, cancellations and returns in the normal course of business, we do not
anticipate, at this time, for those to be as significant as those we encountered during the second half of 2007. Additionally, we will continue to provide marketing, promotional and advertising
support to our retail
customers to promote the sell-through of our products. We will actively monitor inventory levels at our retail customers in an effort to manage the balance between supply and demand in the retail
channel.

General

Net Sales

Net sales represent primarily sales of HEELYS-wheeled footwear, less an estimated reserve for sales returns, allowances (including certain allowances for
marketing, promotion and advertising support) and discounts. A small portion of our net sales are derived from the sale of accessories such as replacement wheels, helmets and other protective gear, a
limited variety of apparel items and beginning in 2007, our new line of HEELYS non-wheeled footwear. Amounts billed to domestic customers for shipping and handling are included in net
sales.

We
sell our products through distribution channels that merchandise our products in a manner that we believe enhances and protects our HEELYS brand image. Domestically, our products can
be found in full-line sporting goods retailers, specialty apparel and footwear retailers, select department stores, family footwear stores and online retailers. For 2007, 83.4% of our net
sales were derived from domestic retail customers. Internationally, our products are sold to independent distributors with exclusive rights to specified territories. Sales to our independent
distributors are denominated in U.S. dollars. No country, other than the United States accounted for 10% or more of our net sales for 2007.

Cost of Sales and Gross Profit

Cost of sales consists primarily of the cost to purchase finished products from our independent manufacturers. Cost of sales also includes inbound and outbound
freight, warehousing expenses, tooling depreciation, royalty expenses related to licensed intellectual property, an inventory reserve for shrinkage and write-downs and, until 2008, commissions paid to
our independent sourcing agent.

34

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We source all of our products and accessories from manufacturers located in China, Indonesia and South Korea. Our product costs are largely driven by the prices we negotiate with our
independent manufacturers. Each season, we negotiate a unit price for each model of HEELYS-wheeled footwear. Factors that influence these prices include raw materials and labor costs and foreign
exchange rates. We believe that our sourcing model allows us to minimize our capital investment, retain the production flexibility, cost-effectiveness and scalability inherent in the use
of independent manufacturers and focus our resources on developing new products and enhancing our HEELYS brand image.

Through
December 31, 2007, we paid our independent sourcing agent a commission equal to a specified percentage of our per unit cost, with the percentage decreasing when our annual
purchases exceed a predetermined unit volume threshold. In January 2008, we opened a representative office in Qingdao, China and terminated our consulting agreement with our independent sourcing
agent. This new office will serve multiple sourcing functions including quality control, price negotiation, logistics and product development. We believe our Qingdao office will help us improve our
research and development efforts, enhance communication between us and our distribution and manufacturing partners and give us more direct control over the manufacturing and sourcing process. This new
office will be managed by our Vice PresidentSourcing. Costs related to operating this office will be included in cost of sales.

We
generally avoid selling our products at close-out prices. When demand for our products slows, we discount our products to reduce our inventory, which causes our gross
profit as a percentage of net sales, or gross margin, to decline. Our gross margin is affected by our sourcing and distribution costs, our product mix and our ability to avoid excess inventory by
accurately forecasting demand for our products. The unit prices that we charge our domestic retail customers are generally higher than what we charge our independent distributors for similar products,
because our independent distributors are responsible for distribution and marketing costs relating to our products. The gross margin for products sold to our domestic retail customers and independent
distributors are similar, however, due to higher shipping costs and standard customer discounts and allowances related to domestic sales.

Our
inventories are stated at the lower of cost or market. Inventory quantities are regularly reviewed and provisions for excess or obsolete inventory are recorded primarily based on the
forecast of future demand and market conditions. If we estimate that the net realizable value of our inventory is less than the cost of the inventory recorded on our books, we record a
write-down equal to the difference between the cost of the inventory and the estimated net realizable value. This write-down is recorded to cost of sales. If changes in market
conditions result in
reductions in the estimated net realizable value of our inventory below our previous estimate, we would increase our write-down in the period in which we made such a determination and
record it to cost of sales.

As
result of the decrease in net sales during the second half of 2007 and cancelled orders, our inventory position at year end was greater than we have historically seen. We performed an
analysis of our inventory position, including open purchase commitments, and determined that certain of our inventory was impaired, which resulted in a $1.9 million write-down of
our inventories on hand and a $617,000 loss on purchase commitments related to inventory that was still being held by the manufacturers. These impairment charges are recognized in cost of sales.

Selling, General and Administrative Expenses

Selling, general and administrative expenses consist of wages and related payroll and employee benefit costs, sales and marketing expenses, advertising costs,
travel and insurance expenses, product development costs, costs to enforce our intellectual property rights, depreciation, amortization, professional fees, facility expenses and costs associated with
operating as a public company.

We
adopted SFAS No. 123(R) effective January 1, 2006. SFAS No. 123(R) requires the measurement of compensation cost of stock-based compensation awards based on the
estimated fair value of that award on the date of grant. We recognize this compensation cost using the straight-line

35

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method
over the period during which the employee is required to provide service in exchange for the awardthe requisite service period. No compensation cost is recognized for awards for
which the employee does not render the required service. If the requisite service is not provided, all previously recognized compensation cost is reversed. For all awards granted to-date,
the requisite service period is the same as the vesting period of the award.

Our
selling, general and administrative expenses may continue to increase in future periods as we continue to hire additional personnel, develop our infrastructure, increase our brand
recognition through marketing, increase our product development efforts, secure and enforce our intellectual property rights and incur expenses associated with operating as a public company.



We operate through Heeling Sports Limited, a Texas limited partnership. Texas recently passed legislation amending its franchise tax law. As a result, we are now
subject to the new Texas franchise on gross margin sourced to the State of Texas. In addition, the Company's activities in 2007 caused it to incur tax filing responsibilities in the State of
California. These changes resulted in an increase in our effective tax rate of 1.3%.

Results of Operations

Year Ended December 31,2005

2006

2007Net sales

100.0
%
100.0
%
100.0
%Cost of sales

65.9

65.1

68.4Gross profit

34.1

34.9

31.6Selling, general and administrative expenseSales and marketing

11.9

7.3

8.3General and administrative

6.8

3.4

5.9Total selling, general and administrative expense

18.7

10.7

14.2Income from operations

15.4

24.2

17.4Other expense (income)

0.3

0.3

(2.0
)Income before income taxes

15.1

23.9

19.4Income taxes

5.2

8.4

7.2Net income

9.9
%
15.5
%
12.2
%


Comparison of the Years Ended December 31, 2007 and December 31, 2006

Net sales.Net sales decreased $4.7 million, or 2.5%, to $183.5 million in 2007 from $188.2 million in
2006. This decrease was primarily the result of an increase in our reserve for marketing discretionary fund allowances and returns reserve which are recorded as reductions to revenue. Reserve for
marketing discretionary fund allowances increased $6.0 million to $7.5 million in 2007 from $1.5 million in 2006. This increase was due to the challenges our retail customers
experienced in the second half of 2007. Marketing discretionary funds are provided to our customers to assist them in sell-through of our products. Returns reserve expense increased
$4.0 million to $4.3 million in 2007 from $325,000 in 2006. Of this increase, $2.7 million is for negotiated returns from two of our retail customers. Both the reserve for
marketing discretionary fund allowances and the returns reserve are related to domestic sales. In 2007, 83.4% of our net sales were derived from domestic retail customers, compared to 85.7% in 2006.
Domestically, our net sales decreased $8.4 million, or 5.2%, to $153.0 million in 2007 from $161.3 million in 2006. This decrease was primarily the result of the increase in our
marketing discretionary fund allowances and returns reserve. Unit sales of our HEELYS-wheeled footwear to

36

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existing
and new retail customers, increased by 128,000 pairs, or 2.5%, to 5.3 million pairs in 2007 from 5.2 million pairs in 2006. Internationally, our net sales increased
$3.6 million, or 13.5%, to $30.5 million in 2007, compared to $26.9 million in 2006. This increase was primarily the result of higher unit sales of our HEELYS-wheeled footwear,
which increased by 148,000 pairs, or 15.0%, to 1.1 million pairs in 2007 from 986,000 pairs in 2006. In 2007, our largest international territory was the United Kingdom, which accounted for
8.7% of our total net sales.

Gross profit.Gross profit decreased $7.6 million to $58.1 million in 2007 from $65.6 million in 2006.
Our gross margin was 31.6% in 2007 compared to 34.9% in 2006. The decrease in gross profit was primarily the result of the $6.0 million increase in our reserve for marketing discretionary fund
allowances which increased to $7.5 million in 2007 from $1.5 million in 2006 and the increase in our returns reserve of $4.0 million, which resulted in a $2.2 million net
impact on our gross profit, discussed above. Gross profit was also negatively impacted by the $2.6 million increase in our inventory valuation reserve expense which increased to
$2.8 million in 2007 from $203,000 in 2006. This $2.6 milion increase is mainly due to a $1.9 million impairment charge that was recorded at year-end on certain inventory items
resulting from the increase in our inventory during the second half of 2007 and a $617,000 reserve related to similar inventory items for which we were committed to purchase but for which we had not
taken title to as of December 31, 2007. These increases were partially offset by reduced costs of 1.1% of net sales related to product mix and reduced costs of 0.8% of net sales related to
freight.

Sales and marketing expense.Sales and marketing expense, excluding commissions, payroll and payroll related expenses, and
stock based compensation cost, increased $4.8 million to $8.5 million in 2007 from $3.7 million in 2006. This increase was mainly attributed to a $1.5 million increase in
co-op marketing costs, a $1.5 million increase in consumer advertising mainly as a result of additional and longer advertising campaigns, a $945,000 increase in
point-of-sale marketing efforts and a $447,000 increase in other marketing costs. Sales commissions decreased $4.0 million from $8.6 million to
$4.5 million mainly as a result of decreased commission rates. Payroll and payroll related expenses, including stock-based compensation costs, increased $688,000 to $2.1 million from
$1.5 million resulting from an increase in headcount and continued recognition of stock-based compensation costs.

General and administrative expense.General and administrative expense increased $4.5 million to $10.9 million
in 2007 from $6.4 million in 2006. This increase was the result of $2.3 million in costs directly attributable to our status as a public company after the completion of our initial
public offering in December 2006, a $877,000 increase in legal fees to enforce our intellectual property, a $613,000 increase in stock-based compensation costs, $400,000 of costs incurred in
connection with the proposed (and subsequently withdrawn) secondary offering by certain of our stockholders in the second quarter of 2007, a $302,000 increase in professional and consulting fees
related to product development, and a $259,000 increase in payroll and related employee costs resulting for an increase in headcount. These increases were offset by a $547,000 decrease in liability
insurance related costs, a $200,000 increase in bad debt recoveries and a $103,000 decrease in bad debt expense.

Operating income.As a result of the above factors, operating income decreased $13.5 million to $32.0 million
in 2007 from $45.6 in 2006. As a percentage of net sales, operating income decreased to 17.4% in 2007 from 24.2% in 2006.

Other expenses (income).Other expenses (income) increased $4.1 million to $3.6 million in other income (net of
other expense) in 2007 from $589,000 of other expense (net of other income) in 2006. The increase was mainly attributable to a $3.4 million increase in interest income earned on our cash and
cash equivalents and a decrease of $734,000 in interest expense.

Income taxes.Income taxes were $13.2 million in 2007, representing an effective income tax rate of 37.2%, compared to
$15.8 million in 2006, representing an effective income tax rate of 35.1%. The 2.1% increase in our effective income tax rate was mainly due to an increase in state income taxes

37

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which
resulted in a 1.3% increase in our rate. Our effective income tax rate was also impacted by a $144,000 increase in the tax effect of non-deductible incentive stock option expense and
the $123,000 valuation allowance we established in 2007 on deferred income tax assets related to non-qualified stock-options that may not be realized by the Company in future periods,
which increased our effective tax rate by 0.6% and 0.4%, respectively.

Net income.As a result of the above factors, net income was $22.3 million in 2007 compared to $29.2 million in
2006. As a percentage of net sales, net income decreased to 12.2% in 2007 from 15.5% in 2006.

Comparison of the Years Ended December 31, 2006 and 2005

Net sales.Net sales increased $144.3 million, or 328.2%, to $188.2 million in 2006 from $44.0 million
in 2005. This increase was primarily the result of higher unit sales of our HEELYS-wheeled footwear, which increased by 4.8 million pairs, or 338.1%, to 6.2 million pairs in 2006 from
1.4 million pairs in 2005. In 2006, 85.7% of our net sales were derived from domestic retail customers, compared to 83.2% in 2005. Domestically, our net sales increased $124.8 million,
or 341.2%, to $161.3 million in 2006 from $36.6 million in 2005. This increase was primarily the result of higher unit sales of our HEELYS-wheeled footwear to existing and new retail
customers, which increased by 4.1 million pairs, or 353.7%, to 5.2 million pairs in 2006 from 1.1 million pairs in 2005. Internationally, our net sales increased
$19.5 million, or 264.1%, to $26.9 million in 2006, compared to $7.4 million in 2005. This increase was primarily the result of increased sales to distributors in the United
Kingdom, Canada and Ireland, partially offset by decreased sales to distributors in Japan and Spain/Portugal.

Gross profit.Gross profit increased $50.6 million to $65.6 million in 2006 from $15.0 million in 2005.
Our gross margin was 34.9% in 2006 compared to 34.1% in 2005. The increase in gross margin was attributed to a decrease in our product costs of 0.8% of net sales due to product mix and reduced
sourcing commissions; reduced costs of 0.4% of net sales related to efficiencies in operating our distribution center and reduced royalty expense of 0.2% of net sales related to fewer royalty-based
sales. These cost reductions were partially offset by increased freight costs of 0.7% of net sales, including extraordinary air freight costs incurred to offset startup production delays at several
new factories.

Sales and marketing expense.Sales and marketing expense increased $8.4 million to $13.7 million in 2006 from
$5.2 million in 2005. This increase was primarily the result of a $6.4 million increase in sales commissions related to our increased domestic net sales, together with a $696,000
increase in television advertising, a $561,000 increase in co-op advertising, and $127,000 in stock-based compensation. Although the dollar amount of sales and marketing expense in 2006
increased from the prior period, as a percentage of net sales, sales and marketing expense decreased to 7.3% in 2006 from 11.9% in 2005.

General and administrative expense.General and administrative expense increased $3.4 million to $6.4 million
in 2006 from $3.0 million in 2005. This increase was primarily the result of a $1.2 million increase in our product liability insurance premiums which are based on sales volumes,
$602,000 in payroll and related costs due to an increase in the number of employees, $441,000 in stock-based compensation expense and a $328,000 increase in our provision for doubtful accounts due to
increased sales volume. Although the dollar amount of general and administrative expense in 2006 increased from the prior period, as a percentage of net sales, general and administrative expense
decreased to 3.4% in 2006 from 6.8% in 2005.

Operating income.As a result of the above factors, operating income increased $38.8 million to $45.6 million
in 2006 from $6.8 in 2005. As a percentage of net sales, operating income increased to 24.2% in 2006 from 15.4% in 2005.

38

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Income taxes.Income taxes were $15.8 million in 2006, representing an effective income tax rate of 35.1%, compared to
$2.3 million in 2005, representing an effective income tax rate of 34.5%.

Net income.As a result of the above factors, net income was $29.2 million in 2006 compared to $4.3 million in
2005. As a percentage of net sales, net income increased to 15.5% in 2006 from 9.9% in 2005.

Liquidity and Capital Resources (in thousands)

Our primary cash need is for working capital, which we generally finance with cash flow from operating activities. In December 2006, we completed an initial
public offering of our common stock. The net proceeds to us were approximately $58.8 million, after deducting an aggregate of $4.6 million in underwriting discounts and commissions and
$2.2 million in other expenses incurred in connection with the offering. We used $8.5 million of these proceeds to repay amounts outstanding under our revolving credit facility in 2006
and $27.7 million to pay our estimated quarterly income taxes of $8.5 million and $19.2 million in 2006 and 2007, respectively. We intend to use the remaining proceeds to fund
infrastructure improvements, including expanding and upgrading our information technology systems; hire new employees; marketing and advertising programs; product development; expanding our
international operations; working capital needs; and other general corporate purposes. These sources of liquidity may be impacted by fluctuations in demand for our products, investments in our
infrastructure and expenditures on marketing and advertising.

The
table below sets forth, for the periods indicated, our beginning balance of cash and cash equivalents, net cash flows from operating, investing and financing activities and our
ending balance of cash and cash equivalents:

Year Ended December 31,2005

2006

2007(in thousands)Cash and cash equivalents at beginning of period

$
1,628

$
738

$
54,184Cash provided by (used in) operating activities


21


(2,180
)

46,589Cash used in investing activities


(416
)

(505
)

(1,069
)Cash (used in) provided by financing activities


(495
)

56,131


(933
)Cash and cash equivalents at end of period

$
738

$
54,184

$
98,771


Cash
flow from operating activities consists primarily of net income adjusted for certain non-cash items, including depreciation and amortization, deferred income taxes,
stock-based compensation expense and gains or losses on disposal of assets and the effect of changes in operating assets and liabilities, principally including accounts receivable, inventory, accounts
payable and accrued expenses.

In
2007, cash provided by operating activities was $46.6 million compared to cash used in operating activities of $2.2 million in 2006. Cash provided by operating
activities in 2007 resulted from a decrease in net working capital of $22.3 million, $22.3 of net income and non-cash items of $2.0 million. The decrease in net working
capital was primarily the result of a decrease of $37.7 million in accounts receivable due to timing together with an increase in collections, a $1.5 million increase in accrued expenses
mainly due to a $1.1 million increase in customer prepayments and credits due customers in excess of amounts owed as well as a $848,000 increase in marketing related accrued expenses, and a
$617,000 reserve for loss on purchase commitments of inventory items; offset by a $9.7 million increase in inventory primarily due to decrease in sales, timing of sales and order cancellations,
a $1.1 million reserve for inventory returns, a $1.0 million decrease in accounts payable mainly due to timing, a $5.1 million decrease in income taxes payable due to the decrease
in our taxable income and timing of our estimated tax payments, a $884,000 liability recorded for state income taxes, a $660,000 decrease in accrued bonuses due to timing and overall decrease in bonus
amounts, a $613,000 decrease in commissions payable due to decreased commission rates, and a $477,000 decrease in prepaid and other

39

---



current
assets mainly due to timing. The $2.0 million adjustments for non-cash items was primarily the result of the $1.9 million inventory impairment charge recorded at
year-end and $1.6 million of stock-based compensation expense; offset by a $2.0 million increase in deferred income tax benefits.

In
2006, cash used in operating activities was $2.2 million compared to cash provided by operating activities of $21,000 in 2005. Cash used in operating activities in 2006
consisted primarily of an increase in net working capital of $31.7 million partially offset by net income of $29.2 million and non-cash items of $384,000. The increase in net
working capital was primarily the result of an increase of $35.0 million in accounts receivable due to increased net sales, an increase in inventory of $4.6 million primarily due to the
timing of receipt of our initial inventory for our spring product line and an increase in inventory in transit, an increase in prepaid expenses of $644,000 due to higher liability insurance premiums
resulting from increased net sales, partially offset by an increase in accounts payable of $1.1 million, accrued expenses of $4.9 million and income taxes payable of $2.5 million,
net of excess tax benefit on stock-based compensation awards, related to our increased income before income taxes.

In
2005, cash provided by operating activities was $21,000 and consisted of net income of $4.3 million, increased by adjustments for non-cash items of $244,000, offset
by an increase of $4.6 million in net working capital. The increase in net working capital consisted primarily of increases in accounts receivable of $5.8 million due to the increase in
net sales for the period, and an increase in inventory of $542,000, partially offset by increases in accrued expenses of $1.2 million and income taxes payable of $209,000.

Investing
activities relate primarily to investments in intangible assets and capital expenditures. Investments in intangible assets are amounts we capitalize related to our patents and
trademarks. Our capital expenditures are primarily related to leasehold improvements, furniture and fixtures and computer equipment.

In
2007, cash used in investing activities was $1.1 million compared to $505,000 in 2006 and $416,000 in 2005. The cash used in investing activities primarily related to purchases
of equipment and legal and other costs capitalized related to securing intellectual property rights. The $564,000 increase in cash used in 2007 was mainly due to the leasehold improvements to our
corporate headquarters to expand our office space and the cost to upgrade our information technology systems.

Financing
activities relate primarily to repayments under promissory notes we executed to finance the payment of certain of our insurance premiums, the exercise of stock options and the
excess tax benefit on stock-based compensation awards. In 2007, cash used in financing activities was $933,000 compared to cash provided by financing activities of $56.1 million in 2006. Cash
used in financing activities in 2007 is primarily the result of the payment of $1.1 million of liabilities incurred in connection with our initial public offering, which we closed in December
2006, and principal payments on our promissory notes of $211,000 offset by $133,000 in cash provided by the exercise of stock options and $207,000 in excess tax benefits on stock-based compensation
awards. The cash provided by financing activities in 2006 was primarily the result of the completion of our initial public offering in December. We sold 3,125,000 shares of common stock at a price of
$21.00 per share for total gross proceeds of $65.6 million. The net proceeds were $61.0 million, after deducting $4.6 million in underwriting discounts and commissions. We
incurred a total of $2.2 million in other direct expenses in connection with this offering of which $1.1 million was paid in 2006, bringing the net cash provided by the offering to
$59.9 million. Cash provided by financing activities in 2006 also included $120,000 in net proceeds from short-term debt, $117,000 excess tax benefit on stock-based compensation
awards and $35,000 proceeds from the exercise of stock options, offset by our repurchase of $4.0 million in shares of our common stock from certain of our stockholders. In 2005, cash used in
financing activities was $500,000 related to our redemption of our Series A Preferred Stock.

40

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We
believe that our cash flow from operating activities, together with the net proceeds from the initial public offering of our common stock, will be sufficient to meet our liquidity
needs and capital expenditure requirements for at least the next 12 months.

Revolving Credit Facility

On August 20, 2004, we entered into a $3.0 million revolving credit facility with a predecessor of JPMorgan Chase Bank, N.A. On August 28,
2006, we amended this revolving credit facility, increasing our maximum amount available to $25.0 million. In December 2006, we repaid all amounts outstanding under this revolving credit
facility with a portion of the proceeds from our initial public offering. There were no outstanding borrowings under our revolving credit facility at December 31, 2006. The maximum amount
available under our revolving credit facility was decreased to $10.0 million on January 1, 2007 and on February 7, 2007, we amended our revolving credit facility to
(a) decrease the maximum amount
available to $2.0 million, (b) eliminate the 0.25% non-usage fee and (c) eliminate certain other terms, including terms requiring us to provide monthly reports
regarding our inventory and accounts receivable. This revolving credit facility expired on June 30, 2007. Borrowings were subject to certain limitations, primarily based upon 85% of eligible
accounts receivable and 50% of eligible inventory not to exceed the amount advanced on eligible accounts receivable. Indebtedness under the revolving credit facility bore interest at a floating rate
of interest based on either the prime rate quoted by JPMorgan Chase Bank, N.A. or an adjusted LIBOR rate. Accounts receivable and inventory were pledged as collateral and the Company was subject to
compliance with certain covenants, including minimum levels of net worth and minimum interest coverage ratios. The Company was not permitted to pay dividends or make distributions.

In
September 2007, we entered into a $2.0 million revolving credit facility with JPMorgan Chase Bank, N.A. which expires June 30, 2009. Indebtedness under this revolving
credit facility bears interest at a floating rate of interest based on either the prime rate quoted by JPMorgan Chase Bank, N.A. or an adjusted LIBOR rate. The credit facility agreement contains
various restrictive covenants including (i) an obligation to maintain a tangible net worth of at least $75 million and (ii) a prohibition on incurring any other indebtedness for
borrowed money. The credit agreement prohibits us from creating or permitting any lien, encumbrances or other security interest on the Company's accounts receivable or inventory. There were no
borrowings under this revolving credit facility as of December 31, 2007.

An
irrevocable standby letter of credit in the amount of $50,000 was outstanding in favor of the landlord for our corporate headquarters. The letter of credit expired on March 1,
2008.

Line of Credit Note

On April 18, 2006, we executed a $5.0 million line of credit note with JPMorgan Chase Bank, N.A. In May 2006, we borrowed $4.0 million under
this note. This line of credit note was repaid in October 2006 and was canceled.

41

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Contractual Obligations and Commercial Commitments

The following table summarizes our significant contractual cash obligations as of December 31, 2007:

|                               |  |   |       | Payments due by period
|------------------------------ |  | - | ----- | ----------------------
|
|
|Debt obligations               |  | $ |      |                       
|Operating lease obligations(1) |  |   | 1,647 |                       
|                               |  |   |       |                       
|Total obligations              |  | $ | 1,647 |                       
|                               |  |   |       |                       

---

LeasesWe lease our corporate headquarters, an approximately 48,400 square-foot facility located in Carrollton,
Texas, consisting of approximately 34,500
square feet of warehouse space and approximately 13,900 square feet of office space. Our lease expires in August 2015, but we have two five-year extension options. The information in the
table above does not include these lease extensions.

On
October 29, 2007, we signed a lease for office space for our representative office in Qingdao, China. This new office will serve multiple sourcing functions including quality
control, price negotiation, logistics and product development. The office space is approximately 2,850 square feet. This lease expires December 1, 2008 but we have two one-year
extension options. The information in the table above does not include these lease extensions.

Third-Party Distribution FacilitiesOn August 1, 2007, we entered into an agreement with a third-party distribution
facility in San Pedro, California. The agreement includes multiple functions including receiving, physical inventory, storage, bar coding, ticketing, unpacking, repacking, sorting, inspecting and
shipping. The dedicated floor space is approximately 16,000 square feet. We pay a fixed storage fee for this dedicated floor space. Additionally, we pay this third-party distributor fees and charges
for services including handling, transactional storage and processing. These fees and charges are activity based and therefore fluctuate and as a result we cannot quantify the related future
obligations. The agreement expires on July 31, 2008, but we have the right to reduce or increase dedicated floor space with 90 days notice for periods of no less than 6 month intervals.
The information in the table above includes the fixed fee for the dedicated floor space but does not include the fluctuating fees and charges. In 2007, we expensed $260,000 related to this third-party
distribution facility. These costs are included in cost of sales.

In
addition to the third-party distribution facilities in San Pedro, California, the Company has expanded its use of a third-party distribution facility in Belgium. The Company pays this
third-party distributor fees and charges for services including handling, processing and packing materials. These fees and charges are activity based and therefore fluctuate and as a result related
future obligations cannot be quantified. This agreement is for one year with automatic one year renewal terms. We expensed $58,000 and $5,000 related to this third-party distribution facility in 2007
and 2006, respectively. There were no costs in 2005. These costs are included in cost of sales.

Royalty AgreementWe pay monthly royalties related to a feature incorporated in our grind-and-roll
HEELYS-wheeled footwear equal to a percentage of the purchase price we pay to our manufacturers, net of the costs of the wheels and any other skating apparatus. Monthly royalties due are based on the
number of grind-and-roll HEELYS-wheeled footwear sold. Because the royalty is calculated in this manner, we cannot quantify the future royalty payments. In 2005, 2006 and 2007 we expensed $179,000,
$299,000 and $278,000 respectively, in royalties. Our payment obligation for these royalties will terminate on December 31, 2008.

42

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Severance Agreement with former CEOOn February 1, 2008, we entered into a Severance and General Release Agreement (the
"Severance Agreement") with our former Chief Executive Officer ("CEO"). Under the Severance Agreement, our former CEO is entitled to receive approximately $470,000, payable in ten semi-monthly
installments of approximately $17,000 beginning six months after the date of the Severance Agreement, followed by one lump sum payment of $300,000 payable in January 2009, up to 14 months of
reimbursements for health and life insurance, and will be paid for any unused vacation or personal days and any unreimbursed expenses.

Purchase CommitmentsAt December 31, 2007, we had open purchase commitments of $2.8 million related to inventories that
were still being held by the manufacturers.

Seasonality

Similar to other vendors of footwear products, sales of our products are subject to seasonality. There are three major buying seasons in footwear: spring/summer,
back-to-school and holiday. Shipments for spring/summer take place during the first quarter and early weeks of the second quarter, shipments for
back-to-school generally begin in May and finish in late August and shipments for the holiday season begin in October and finish in early December. Historically, we have
experienced greater revenues in the second half of the year than those in the first half due to a concentration of shopping around the back-to-school and holiday seasons. In
2006, due to the growth of our business and the delays we experienced from our independent manufacturers, we experienced a higher percentage of net sales in the third quarter in comparison to the
total year than we experienced in the past, as many orders were delayed from the second quarter to the third quarter, thereby causing the second quarter to be lower than normal and the third quarter
to be higher than normal. In 2006, we estimate that approximately $20 million of net sales shifted from the second quarter to the third quarter due to late shipments. During 2007 we did not
experience the same production delays, but instead experienced challenges related primarily to higher than expected inventory positions of product at many of our domestic accounts as weekly unit sales
were lower than internal projections of many of our domestic retail customers, which had a significant adverse effect on our results for the second half of 2007. We believe that this was attributed
to: (1) aggressive sell-through expectations of some of our domestic retailers going into the summer months and (2) retail softness in footwear and apparel. Certain of our major
retailers are reluctant to place significant orders until their current inventory is reduced to their targeted levels. We also saw decreased prices on our products at certain of our retailers in the
fourth quarter of 2007. These factors have led us to work closely with each of our key retail customers to assist them in managing their inventory and
sell-through. This process typically includes providing marketing discretionary funds, rescheduling orders to later dates, accepting cancellations, increasing marketing, promotion and
advertising support, and accepting returns. Although weather is a factor in our seasonality, it is difficult to measure its impact. Results for any one quarter are not necessarily indicative of
results to be expected for any other quarter or for any year.

Backlog

Historically, we received most of our orders three to four months prior to the date the products were shipped to customers. At December 31, 2007, our
backlog was approximately $7.2 million, compared to approximately $53.2 million at December 31, 2006. Although generally, these orders are not subject to cancellation prior to the
date of shipment, cancellations have and may continue to occur. Due to the inventory challenges we experienced in the second half of 2007, many of our retail customers have not placed significant
future orders with us. In 2008, we expect to see certain of our retail customers being more cautious when placing future orders and shifting toward shorter lead times. For a variety of reasons,
including the timing of release dates for our product offerings, shipments, order deadlines and receipt of orders, backlog may not be a reliable measure of future sales and may not be comparable from
one period to another.

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Vulnerability Due to Customer Concentration

In 2005, Big 5 Sporting Goods, Journeys and The Sports Authority represented 12.3%, 11.3% and 10.6% of our net sales, respectively. For 2006, Journeys accounted
for 12.7% of our net sales. For 2007, Finish Line accounted for 13.2% of our net sales. No other retail customer or independent distributor accounted for 10% or more of our net sales in any of these
periods. We anticipate that our net sales may remain concentrated for the foreseeable future. If any of our significant retail customers or independent distributors decreases its purchases of our
products or stops purchasing our products our net sales and results of operations could be adversely affected.

Critical Accounting Policies

Our management's discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have
been prepared in accordance with
accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires management to make estimates and judgments that affect the
reported amounts of assets, liabilities, net sales and expenses and related disclosure at the date of our financial statements. We continually evaluate our estimates and judgments, including those
related to net sales, collectability of accounts receivable, inventory reserve allowances, long-lived assets, income taxes and stock-based compensation. We base our estimates and judgments on
historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis of our judgments about the carrying values of assets
and liabilities that are not readily apparent from other sources. Actual results or changes in the estimates or other judgments of matters inherently uncertain that are included within these
accounting policies could result in a significant change to the information presented in the consolidated financial statements. We believe that the following discussion addresses the critical
accounting policies that are necessary to understand and evaluate our reported consolidated financial results.

Revenue Recognition.Revenues are recognized when merchandise is shipped and the customer takes title and assumes risk of
loss, collection of relevant receivables are probable, persuasive evidence of an arrangement exists and the sales price is fixed or determinable. Title passes upon shipment or upon receipt by the
customer depending on the agreement with the customer. Revenues are stated net of estimated returns and other allowances, including permitted returns of damaged or defective merchandise and marketing
discretionary funds. Other allowances include funds for promotional and marketing activities and a volume-based incentive program. We base our estimates and judgements on historical experience and
other various factors including customer communications, and analysis of relevant market information.

Reserve for Uncollectible Accounts Receivable.We continually make estimates relating to the collectability of our accounts
receivable and maintain a reserve for estimated losses resulting from the failure of our customers to make required payments. In determining the amount of the reserve, we consider our historical level
of credit losses and make judgments about the creditworthiness of significant customers. Because we cannot predict future changes in the financial stability of our customers, actual future losses from
uncollectible accounts may differ from our estimates. If the financial condition of our customers were to deteriorate, resulting in their inability to make payments, a larger reserve might be
required. If we determined that a smaller or larger reserve was appropriate, we would record a benefit or charge to general and administrative expense in the period in which we made such a
determination.

Inventory Write-Downs.Our inventories are stated at the lower of cost or market. Inventory quantities are regularly reviewed
and provisions for excess or obsolete inventory are recorded primarily based on the forecast of future demand and market conditions. If we estimate that the net realizable value of our inventory is
less than the cost of the inventory recorded on our books, we record a

44

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write-down
equal to the difference between the cost of the inventory and the estimated net realizable value. This write-down is recorded to cost of sales. If changes in market
conditions result in reductions in the estimated net realizable value of our inventory below our previous estimate, we would increase our write-down in the period in which we made such a
determination and record it to cost of sales.

Long-Lived Assets.Long-lived assets, including furniture and fixtures, office equipment, plant
equipment, leasehold improvements, computer hardware and software and certain intangible assets, are recorded at cost and this cost is depreciated over the asset's estimated useful life. We
continually evaluate whether events and circumstances have occurred that indicate the remaining estimated useful life of long-lived assets and certain intangible assets may warrant
revision or that the remaining balance may not be recoverable. These factors may include a significant deterioration of operating results, changes in business plans or changes in anticipated cash
flow. When factors indicate that a long-lived asset or certain intangible property should be evaluated for possible impairment, we review the asset or property to assess recoverability
from future operations using the undiscounted pre-tax future net cash flows expected to be generated by that asset or property. Impairments are recognized in earnings to the extent that
the carrying value exceeds fair value.

Income Tax.We estimate what our effective tax rate will be for the full year and record a quarterly income tax expense in
accordance with the anticipated effective annual tax rate. As the year progresses, we continually refine our estimate based upon actual events and income before income taxes by jurisdiction during the
year. This process may result in a change to our expected effective tax rate for the year. When this occurs, we adjust the income tax expense during the quarter in which the change in estimate occurs
so that the year-to-date expense equals the expected annual rate. Tax laws require items to be included in our tax returns at different times than when these items are
reflected in the consolidated financial statements. Some of these differences are permanent, such as expenses that are not deductible in our tax return, and some differences reverse over time, such as
depreciation expense. These timing differences create deferred tax assets and liabilities. We assess the realizability of our deferred tax assets to determine whether a valuation allowance is
required. Based on all available evidence, both positive and negative, and the weight of that evidence to the extent such evidence can be objectively verified, if we determine if it is more likely
than not the deferred tax asset will not be realized a valuation allowance is established.

Uncertain Tax Positions.In July 2006, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation
No. 48,Accounting for Uncertainty in Income Taxes("FIN 48"). FIN 48 clarifies the accounting for uncertainty in income taxes
recognized in an enterprise's financial statements in accordance with FASB Statement No. 109,Accounting for Income Taxes. FIN 48
prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Significant
judgment is required in determining whether the recognition threshold has been met for recording an uncertain tax benefit and in determining the appropriate measurement of the uncertain benefit under
FIN 48.

Stock-Based Compensation.We account for stock-based compensation in accordance with SFAS No. 123(R), which requires
the measurement of compensation cost based on the estimated fair value of the award on the date of grant. We recognize that cost using the straight-line method over the period during which
an employee is required to provide service in exchange for the awardthe requisite service period. No compensation cost is recognized for equity instruments for which employees do not
render the requisite service. We determine the grant-date fair value of employee stock options using the Black-Scholes option-pricing model. The amount of compensation expense recognized
will depend upon numerous factors and estimates, including the number and vesting period of option grants, the publicly traded price of our
common stock, the estimated volatility of our common stock price, estimates of the timing and volume of exercises and forfeitures of the options and fluctuations in future interest and income tax
rates.

45

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In September 2006, the FASB issued Statement No. 157,Fair Value Measurements, ("SFAS 157").
SFAS 157 clarifies the principle that fair value should be based on the assumptions that market participants would use when pricing an asset or liability. Additionally, it establishes a fair
value hierarchy that prioritizes the information used to develop those assumptions. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15,
2007. In February 2008, the FASB issued FASB Staff Position FAS 157-2 to defer SFAS 157's effective date for all nonfinancial assets and liabilities, except those items recognized or disclosed at fair
value on an annual or more frequently recurring basis, until years beginning after November 15, 2008. The Company does not expect SFAS 157 to have a material impact on its financial
position, cash flows or results of operations.

In
February 2007, the FASB issued Statement No. 159,The Fair Value Option for Financial Assets and Financial LiabilitiesIncluding an
amendment of FASB Statement No. 115, ("SFAS 159"). SFAS 159 permits companies to measure many financial instruments and certain other items at fair value
at specified election dates. Unrealized gains and losses on these items will be reported in earnings at each subsequent reporting date. The fair value option may be applied instrument by instrument
(with a few exceptions), is irrevocable and is applied only to entire instruments and not to portions of instruments. SFAS No. 159 is effective for fiscal years beginning after
November 15, 2007. The Company does not expect SFAS No. 159 to have a material impact on its financial position, cash flows or results of operations.

In
December 2007, the FASB issued Statement No. 141(R),Business Combinations, ("SFAS 141(R)"). SFAS 141(R) revises the current
accounting practices for business combinations. Significant changes as a result of issuance of SFAS 141(R) include a revised definition of a business, expensing of acquisition-related
transaction costs, and a change in how acquirers measure consideration, identifiable assets, liabilities assumed and goodwill acquired in a business combination. SFAS 141(R) is effective for
business combinations occurring in fiscal years beginning after December 15, 2008, and may not be retroactively applied. There is no current impact to the Company.

In
December 2007, the FASB issued Statement No. 160,Noncontrolling interests in Consolidated Financial Statementsan amendment of ARB
No. 51, ("SFAS 160"). SFAS 160 requires expanded disclosures in the consolidated financial statements that clearly identify and distinguish
between the interests of the parent's owners and the interests of noncontrolling owners of a subsidiary. SFAS 160 is effective for fiscal years beginning on or after December 15, 2008.
The Company does not expect SFAS 160 to have a material impact on its financial position, cash flows or results of operations.

Item 7A.    Quantitative and Qualitative Disclosures about Market Risk

We had a $2.0 million revolving credit facility with JPMorgan Chase Bank, N.A. that expired on June 30, 2007. As of December 31, 2006 there
were no outstanding borrowings under this facility. To the extent we borrowed under our revolving credit facility, which bore interest at floating rates based either on the prime rate quoted by
JPMorgan Chase Bank, N.A. or an adjusted LIBOR rate, we were exposed to market risk related to changes in interest rates. In September 2007, we entered into a new $2.0 million revolving credit
facility with JPMorgan Chase Bank, N.A. which expires on June 30, 2009 and we have not borrowed under this revolving credit facility. To the extent we borrow under our revolving credit
facility, which bears interest at floating rates based either on the prime rate quoted by JPMorgan Chase Bank, N.A. or an adjusted LIBOR rate, we are exposed to market risk related to changes in
interest rates. If applicable interest rates were to increase by 100 basis points, for every $1.0 million outstanding under our revolving credit facility, our income before income taxes would
be reduced by approximately $10,000 per year. We are not party to any derivative financial instruments.

Our
independent distributors pay us in U.S. dollars. Because our independent manufacturers buy materials and pay for manufacturing expenses in their local currencies, to the extent the
U.S. dollar

46

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weakens
compared to such local currencies, our operating results may be adversely affected. Conversely, to the extent the U.S. dollar strengthens compared to local currencies in foreign markets where
our products are sold, our products may appear more expensive relative to local products.

Item 8.    Consolidated Financial Statements and Supplementary Data

Information with respect to this Item is set forth beginning on page F-1.

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

None.

Item 9A.    Controls and Procedures

Evaluation of Disclosure Controls and Procedures

The term "disclosure controls and procedures" refers to the controls and other procedures of a company that are designed to provide reasonable assurance that
information required to be disclosed by a company in the reports that it files or submits under the Exchange Act, is recorded, processed, summarized and reported within required time periods. We have
established disclosure controls and procedures to ensure that material information relating to Heelys, Inc. and its consolidated subsidiaries is made known to the officers who certify our
financial reports, as well as other members of senior management and the Board of Directors, to allow timely decisions regarding required disclosures. As of the end of the period covered by this
annual report on Form 10-K, we carried out an evaluation under the supervision and with the participation of our management, including our Interim Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 of the Exchange Act. Based upon that
evaluation, our Interim Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective.

Inherent Limitations on Effectiveness of Controls

Our management, including our Interim Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our
internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute,
assurance that the control system's objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered
relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not
occur or that all control issues and instances of fraud, if
any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or
mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls
is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future
conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration
in the degree of compliance with policies or procedures.

Changes in Internal Control over Financial Reporting

There were no changes to our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal
controls over financial reporting

47

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during
the fourth quarter of 2007. We have completed our efforts regarding compliance with Section 404 of the Sarbanes-Oxley Act of 2002 for the year ended December 31, 2007. The results
of our evaluation are discussed below in Management's Report on Internal Control Over Financial Reporting.

Management's Report on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in
Rule 13a-15(f) of the Exchange Act. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in
reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our
management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a
material effect on our financial statements.

We
conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework inInternal ControlIntegrated
Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our evaluation under the framework inInternal
Control- Integrated Framework,our management has concluded that as of December 31, 2007, our internal control over financial reporting is effective.

Our
independent registered public accountants, Deloitte & Touche LLP, audited the consolidated financial statements included in this annual report on
Form 10-K and have issued an attestation report on the effectiveness of our internal control over financial reporting as of December 31, 2007, which is included below.

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REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To
the Board of Directors and Stockholders of
Heelys, Inc.
Carrollton, Texas

We
have audited the internal control over financial reporting of Heelys, Inc. and subsidiaries (the "Company") as of December 31, 2007, based on criteria established in Internal ControlIntegrated
Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's
management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the
accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our
audit.

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

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

Because
of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material
misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to
future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In
our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal ControlIntegrated
Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission.

We
have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement
schedule as of and for the year ended December 31, 2007 of the Company and our report dated March 17, 2008 expressed an unqualified opinion on those consolidated financial statements and
financial statement schedule.

/s/ DELOITTE & TOUCHE LLP

Dallas,
Texas
March 17, 2008

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Item 9B.    Other Information

None.

PART III

Item 10.    Directors, Executive Officers and Corporate Governance of the Registrant

Incorporated by reference from the information in our proxy statement for the 2008 Annual Meeting of Stockholders, which we will file with the SEC within
120 days of the end of the fiscal year to which this Report relates.

Code of Business Conduct and Ethics

We have adopted a code of business conduct and ethics that applies to all of our officers, directors and employees. Our code of business conduct and ethics is
posted on our website atwww.heelys.comand we will send a paper copy to any stockholder who submits a request in writing to our Secretary. If we make
any substantive amendments to this code of conduct or if we grant any waivers from a provision of such code of conduct to any director or executive officer, we will promptly disclose the nature of the
amendment or waiver on our website at the address provided above.

Item 11.    Executive Compensation

Incorporated by reference from the information in our proxy statement for the 2008 Annual Meeting of Stockholders, which we will file with the SEC within
120 days of the end of the fiscal year to which this report relates.

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

Incorporated by reference from the information in our proxy statement for the 2008 Annual Meeting of Stockholders, which we will file with the SEC within
120 days of the end of the fiscal year to which this report relates.

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

Incorporated by reference from the information in our proxy statement for the 2008 Annual Meeting of Stockholders, which we will file with the SEC within
120 days of the end of the fiscal year to which this report relates.

Item 14.    Principal Accounting Fees and Services

Incorporated by reference from the information in our proxy statement for the 2008 Annual Meeting of Stockholders, which we will file with the SEC within
120 days of the end of the fiscal year to which this report relates.

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PART IV

Item 15.    Exhibits and Financial Statement Schedules

(a)(1)Financial Statements

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



|Report of Independent Registered Public Accounting Firm                                              |  | F-2
|---------------------------------------------------------------------------------------------------- |  | ---
|Consolidated Balance Sheets as of December 31, 2006 and December 31, 2007                            |  | F-3
|Consolidated Statements of Operations for the Years ended December 31, 2005, 2006 and 2007           |  | F-4
|Consolidated Statements of Stockholders' Equity for the Years ended December 31, 2005, 2006 and 2007 |  | F-5
|Consolidated Statements of Cash Flows for the Years ended December 31, 2005, 2006 and 2007           |  | F-6
|Notes to Consolidated Financial Statements                                                           |  | F-7

(2)Financial Statement Schedule

The
following financial statement schedule is filed herewith:

|Valuation and Qualifying Accounts and Reserves |  | F-26
|---------------------------------------------- |  | ----

(3)Exhibits

(a)
The following exhibits are incorporated by reference or filed herewith. References to the Form S-1 are to the Registrant's Registration Statement on Form S-1
(File No. 333-137046), filed with the Securities and Exchange Commission (SEC) on September 1, 2006. References to Amendment No. 1 to Form S-1 are
to Amendment No. 1 to the Form S-1 filed with the SEC on October 4, 2006. References to Amendment No. 2 to Form S-1 are to Amendment
No. 2 to the Form S-1 filed with the SEC on October 27, 2006. References to Amendment No. 3 to Form S-1 are to Amendment No. 3 to the
Form S-1 filed with the SEC on November 24, 2006.

|Exhibit No. |  | Description                                                                                                                                                                                                                                                                                                 
|----------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|            |  |                                                                                                                                                                                                                                                                                                             
|3.1         |  | Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to the Form S-1).                                                                                                                                                                                                  
|3.2         |  | By-Laws of the Registrant (incorporated by reference to Exhibit 3.1 to Amendment No. 2 to the Form S-1).                                                                                                                                                                                                    
|4.1         |  | Form of Registrant's Common Stock certificate (incorporated by reference to Exhibit 4.1 to Amendment No. 3 to the Form S-1).                                                                                                                                                                                
|10.1        |  | Registration Rights Agreement, dated May 26, 2000, among the Registrant, Samuel B. Ligon and Patricia P. Ligon and Capital Southwest Venture Corporation (incorporated by reference to Exhibit 10.1 to the Form S-1).                                                                                       
|10.2        |  | Manufacturing Agreement, dated March 8, 2001, between Bu Kyung Industrial and Heeling Sports Limited (incorporated by reference to Exhibit 10.2 to the Form S-1).                                                                                                                                           
|10.3        |  | Consulting Agreement, dated September 30, 2006, between Boss Technical Services and Heeling Sports Limited (incorporated by reference to Exhibit 10.3 to Amendment No. 2 to the Form S-1).                                                                                                                  
|10.4        |  | Lease Agreement, dated November 4, 2004, between CP Commercial PropertiesXIX, Inc. and Heeling Sports, Limited, as amended by the First Amendment to Lease Agreement, dated February 27, 2006, for 3200 Belmeade, Suite 100,
Carrollton, Texas (incorporated by reference to Exhibit 10.5 to the Form S-1).

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|10.5  |  | Letter Agreement, dated June 28, 2006, by and between Richard E. Middlekauff and Roger R. Adams, and approved by the Registrant (incorporated by reference to Exhibit 10.9 to the Form S-1).                                                                                                                                                                                                                                                                                
|----- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.6  |  | Amended and Restated Employment Agreement, dated as of November 16, 2006, between Michael W. Hessong and Heeling Sports Limited (incorporated by reference to Exhibit 10.11 to Amendment No. 3 to the Form S-1).*                                                                                                                                                                                                                                                           
|10.7  |  | Employment Agreement, dated as of September 18, 2006, between Patrick F. Hamner and Heeling Sports Limited (incorporated by reference to Exhibit 10.14 to Amendment No. 2 to the Form S-1).*                                                                                                                                                                                                                                                                                
|10.8  |  | Waiver and Agreement, dated as of September 14, 2006, among the Registrant, Roger R. Adams, Richard E. Middlekauff, Robert J. Ward, CYPO, Inc., Heeling Holding Corporation, Heeling Management Corporation, Samuel B. Ligon and Patricia P.
Ligon and Capital Southwest Venture Corporation (incorporated by reference to Exhibit 10.15 to Amendment No. 3 to the Form S-1).                                                                                               
|10.9  |  | 2006 Stock Incentive Plan, as amended by Amendment to Heeling, Inc. 2006 Stock Incentive Plan and form of Stock Option Agreement thereunder (incorporated by reference to Exhibit 10.16 to the Form S-1).*                                                                                                                                                                                                                                                                  
|10.10 |  | Form of Indemnification Agreement entered into by the Registrant with each of its directors and executive officers (incorporated by reference to Exhibit 10.18 to the Form S-1).*                                                                                                                                                                                                                                                                                           
|10.11 |  | Intellectual Property Exclusive License Agreement, dated and effective as of September 23, 2002, between Heeling Sports Limited and Curtis Holdings, LLC; Intellectual Property Purchase Agreement, dated September 23, 2002, between
Heeling Sports Limited and Curtis Holdings, LLC, and Letter Agreement, dated January 5, 2006, between Heeling Sports Limited and Curtis Holdings, LLC (incorporated by reference to Exhibit 10.19 to Amendment No. 1 to the
Form S-1).
|10.12 |  | Investor Rights Agreement, dated as of May 24, 2000, among the Registrant, Roger R. Adams, Richard E. Middlekauff, Robert J. Ward, Cypo, Inc., Heeling Holding Corporation, Heeling Management Corp., Samuel P. Ligon and Patricia P. Ligon and
Capital Southwest Venture Corporation (incorporated by reference to Exhibit 10.20 to Amendment No. 2 to the Form S-1).                                                                                                      
|10.13 |  | Heelys, Inc. Annual Incentive Plan (incorporated by reference to Exhibit 10.1 of the Registrant's Current Report on Form 8-K filed on April 17, 2007) (The Securities and Exchange Commission has granted confidential treatment for a
portion of this document. A complete version of this document has been filed separately with the Securities and Exchange Commission.)*                                                                                               
|10.14 |  | First Amendment to the Employment Agreement, Including Agreement to Arbitrate, Noncompetition Agreement and Nondisclosure Agreement, dated as of April 11, 2007, between Patrick F. Hamner and Heelys, Inc. (incorporated by reference to
Exhibit 10.3 of the Registrant's Current Report on Form 8-K filed on April 17, 2007)*                                                                                                                                             
|10.15 |  | First Amendment to the Amended and Restated Employment Agreement, Including Agreement to Arbitrate, Noncompetition Agreement and Nondisclosure Agreement, dated as of April 11, 2007, between Michael W. Hessong and Heelys, Inc. (incorporated
by reference to Exhibit 10.4 of the Registrant's Current Report on Form 8-K filed on April 17, 2007)*                                                                                                                       

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|10.16 |  | First Amended and Restated Consulting Agreement, dated as of August 1, 2007, between Boss Technical Services and Heeling Sports Limited. (incorporated by reference to Exhibit 10.1 of the Registrant's Current Report on Form 8-K filed on
August 14, 2007)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.17 |  | Employment Agreement, Including Agreement to Arbitrate, Noncompetition Agreement and Nondisclosure Agreement, dated as of April 12 2007, between William D. Albers and Heeling Sports Limited. (incorporated by reference to Exhibit 10.1 of the
Registrant's Current Report on Form 8-K filed on September 5, 2007) (Application for confidential treatment for a portion of this document has been submitted to the Securities and Exchange Commission pursuant to Rule 24b-2 under the
Securities Exchange Act of 1934. The copy of this document filed as an exhibit omits the confidential information subject to the confidentiality request. Omissions are designated by the symbol "**". A complete version of this document has been filed
separately with the Securities and Exchange Commission.)*  
|10.18 |  | Employment Agreement, Including Agreement to Arbitrate, Noncompetition Agreement and Nondisclosure Agreement, dated as of July 5, 2007, between John O'Neil and Heeling Sports Limited. (incorporated by reference to Exhibit 10.2 of the
Registrant's Current Report on Form 8-K filed on September 5, 2007) (Application for confidential treatment for a portion of this document has been submitted to the Securities and Exchange Commission pursuant to Rule 24b-2 under the
Securities Exchange Act of 1934. The copy of this document filed as an exhibit omits the confidential information subject to the confidentiality request. Omissions are designated by the symbol "**". A complete version of this document has been filed
separately with the Securities and Exchange Commission.)*         
|10.19 |  | Employment Agreement, Including Agreement to Arbitrate, Noncompetition Agreement and Nondisclosure Agreement, dated as of August 31, 2007, between James S. Peliotes and Heeling Sports Limited. (incorporated by reference to Exhibit 10.3 of
the Registrant's Current Report on Form 8-K filed on September 5, 2007) (Application for confidential treatment for a portion of this document has been submitted to the Securities and Exchange Commission pursuant to Rule 24b-2 under
the Securities Exchange Act of 1934. The copy of this document filed as an exhibit omits the confidential information subject to the confidentiality request. Omissions are designated by the symbol "**". A complete version of this document has been
filed separately with the Securities and Exchange Commission.)*
|10.20 |  | Credit Agreement dated as of September 19, 2007, between JPMorgan Chase Bank, N.A. and Heeling Sports Limited (incorporated by reference to Exhibit 10.1 of the Registrant's Current Report on Form 8-K filed on September 28,
2007)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|10.21 |  | Line of Credit Note dated as of September 19, 2007, between JPMorgan Chase Bank, N.A. and Heeling Sports Limited (incorporated by reference to Exhibit 10.2 of the Registrant's Current Report on Form 8-K filed on September 28,
2007)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|10.22 |  | Negative Pledge Agreement dated as of September 19, 2007, between JPMorgan Chase Bank, N.A. and Heeling Sports Limited (incorporated by reference to Exhibit 10.3 of the Registrant's Current Report on Form 8-K filed on September 28,
 2007)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|10.23 |  | Severance and General Release Agreement dated as of February 1, 2008, between Michael G. Staffaroni and Heeling Sports Limited (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on Form 8-K filed on
February 4, 2008).*                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|21.1  |  | List of subsidiaries of the Registrant.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|23.1  |  | Consent of Deloitte & Touche LLP, independent registered public accounting firm.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

53

---



|31.1 |  | Certification pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934 by Ralph T. Parks, Interim Chief Executive Officer.
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------
|31.2 |  | Certification pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934 by Michael W. Hessong, Chief Financial Officer.    
|32.1 |  | Certification by Interim Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350.                      

---

54

---





SIGNATURES

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

| |  | HEELYS, INC.
| |  | ------------
| |  | By:         

Date: March 17, 2008

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

|Signature                                       |  | Title                                                                      |  | Date          
|----------------------------------------------- |  | -------------------------------------------------------------------------- |  | --------------
|                                                |  |                                                                            |  |               
|/s/RALPH T. PARKSRalph T. Parks                 |  | Interim Chief Executive Officer and Director (Principal Executive Officer) |  | March 17, 2008
|/s/MICHAEL W. HESSONGMichael W. Hessong         |  | Chief Financial Officer (Principal Financial Officer)                      |  | March 17, 2008
|/s/GARY L. MARTINGary L. Martin                 |  | Chairman of the Board                                                      |  | March 17, 2008
|Roger R. Adams                                  |  | Director                                                                   |  | March 17, 2008
|/s/PATRICK F. HAMNERPatrick F. Hamner           |  | Director                                                                   |  | March 17, 2008
|/s/SAMUEL B. LIGONSamuel B. Ligon               |  | Director                                                                   |  | March 17, 2008
|/s/RICHARD E. MIDDLEKAUFFRichard E. Middlekauff |  | Director                                                                   |  | March 17, 2008
|/s/JEFFREY G. PETERSONJeffrey G. Peterson       |  | Director                                                                   |  | March 17, 2008
|Jerry Edwards                                   |  | Director                                                                   |  | March 17, 2008

55

---





HEELYS, INC.    INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

|                                                                                                     |  | Page    
|---------------------------------------------------------------------------------------------------- |  | --------
|Report of Independent Registered Public Accounting Firm                                              |  | F-2     
|Consolidated Balance Sheets as of December 31, 2006 and 2007                                         |  | F-3     
|Consolidated Statements of Operations for the Years Ended December 31, 2005, 2006 and 2007           |  | F-4     
|Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 2005, 2006 and 2007 |  | F-5     
|Consolidated Statements of Cash Flows for the Years Ended December 31, 2005, 2006 and 2007           |  | F-6     
|Notes to Consolidated Financial Statements                                                           |  | F-7-F-25

F-1

---



REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To
the Board of Directors and Stockholders of
Heelys, Inc.
Carrollton, Texas

We
have audited the accompanying consolidated balance sheets of Heelys, Inc. and subsidiaries (the "Company") as of December 31, 2007 and 2006, and the related consolidated
statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedule
listed in the Index at Item 15. These consolidated financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements and the financial statement schedule based on our audits.

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

In
our opinion, such consolidated financial statements presents fairly, in all material respects, the financial position of Heelys, Inc. and subsidiaries as of December 31,
2007 and 2006, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2007, in conformity with accounting principles generally
accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present
fairly, in all material respects, the information set forth therein.

We
have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of
December 31, 2007, based on the criteria established inInternal ControlIntegrated Frameworkissued by the Committee of Sponsoring
Organizations of the Treadway Commission and our report dated March 17, 2008 expressed an unqualified opinion on the Company's internal control over financial reporting.

/s/ DELOITTE & TOUCHE LLP

Dallas,
Texas
March 17, 2008

F-2

---





HEELYS, INC.        CONSOLIDATED BALANCE SHEETS        AS OF DECEMBER 31, 2006 AND 2007        (In thousands, except share data)

|                                                                                         |                                                                                                                                                                                                     | December 31,             
|---------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------
|
|ASSETS                                                                                   |                                                                                                                                                                                                     |                          
|CURRENT ASSETS:                                                                          |                                                                                                                                                                                                     |                          
|                                                                                         | Cash and cash equivalents                                                                                                                                                                           |                          
|                                                                                         | Accounts receivable, net of allowances of $1,959 and $1,458, respectively                                                                                                                           |                          
|                                                                                         | Inventories                                                                                                                                                                                         |                          
|                                                                                         | Deferred income tax benefits                                                                                                                                                                        |                          
|                                                                                         | Prepaid and other current assets                                                                                                                                                                    |                          
|                                                                                         | Income tax receivable                                                                                                                                                                               |                          
|                                                                                         |                                                                                                                                                                                                     |                          
|                                                                                         |                                                                                                                                                                                                     | Total current assets     
|PROPERTY AND EQUIPMENT, net of accumulated depreciation of $907 and $1,094, respectively |                                                                                                                                                                                                     |                          
|PATENTS AND TRADEMARKS, net of accumulated amortization of $966 and $1,019, respectively |                                                                                                                                                                                                     |                          
|DEFERRED INCOME TAX BENEFITS, net of valuation allowance of $0 and $123, respectively    |                                                                                                                                                                                                     |                          
|                                                                                         |                                                                                                                                                                                                     |                          
|TOTAL ASSETS                                                                             |                                                                                                                                                                                                     | $                        
|                                                                                         |                                                                                                                                                                                                     |                          
|LIABILITIES AND STOCKHOLDERS' EQUITY                                                     |                                                                                                                                                                                                     |                          
|CURRENT LIABILITIES:                                                                     |                                                                                                                                                                                                     |                          
|                                                                                         | Accounts payable                                                                                                                                                                                    |                          
|                                                                                         | Commissions payable                                                                                                                                                                                 |                          
|                                                                                         | Accrued bonus                                                                                                                                                                                       |                          
|                                                                                         | Accrued expenses                                                                                                                                                                                    |                          
|                                                                                         | Income taxes payable                                                                                                                                                                                |                          
|                                                                                         | Debt                                                                                                                                                                                                |                          
|                                                                                         |                                                                                                                                                                                                     |                          
|                                                                                         |                                                                                                                                                                                                     | Total current liabilities
|                                                                                         |                                                                                                                                                                                                     |                          
|COMMITMENTS AND CONTINGENCIES (Note 9)                                                   |                                                                                                                                                                                                     |                          
|STOCKHOLDERS' EQUITY:                                                                    |                                                                                                                                                                                                     |                          
|                                                                                         | Common stock, $0.001 par value, 75,000,000 shares authorized; 27,041,948 shares issued and outstanding as of December 31, 2006 and 27,074,856 shares issued and outstanding as of December 31, 2007 |                          
|                                                                                         | Additional paid-in capital                                                                                                                                                                          |                          
|                                                                                         | Retained earnings                                                                                                                                                                                   |                          
|                                                                                         |                                                                                                                                                                                                     |                          
|                                                                                         | Total stockholders' equity                                                                                                                                                                          |                          
|                                                                                         |                                                                                                                                                                                                     |                          
|TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY                                               |                                                                                                                                                                                                     | $                        
|                                                                                         |                                                                                                                                                                                                     |                          

See
notes to consolidated financial statements.

F-3

---



HEELYS, INC.        CONSOLIDATED STATEMENTS OF OPERATIONS        FOR THE YEARS ENDED DECEMBER 31, 2005, 2006 AND 2007        (In thousands, except per share data)

|                                            |                             | Year Ended December 31,                           |       
|------------------------------------------- | --------------------------- | ------------------------------------------------- | ------
|
|NET SALES                                   |                             | $                                                 | 43,950
|COST OF SALES                               |                             |                                                   | 28,951
|                                            |                             |                                                   |       
|GROSS PROFIT                                |                             |                                                   | 14,999
|SELLING, GENERAL AND ADMINISTRATIVE EXPENSE |                             |                                                   |       
|                                            | Sales and marketing         |                                                   |       
|                                            | General and administrative  |                                                   |       
|                                            |                             |                                                   |       
|                                            |                             | Total selling, general and administrative expense |       
|                                            |                             |                                                   |       
|INCOME FROM OPERATIONS                      |                             |                                                   | 6,765 
|OTHER EXPENSE (INCOME)                      |                             |                                                   |       
|                                            | Interest expense            |                                                   |       
|                                            | Interest income             |                                                   |       
|                                            | Other expense (income), net |                                                   |       
|                                            |                             |                                                   |       
|                                            |                             | Total other expense (income)                      |       
|                                            |                             |                                                   |       
|INCOME BEFORE INCOME TAX EXPENSE            |                             |                                                   | 6,634 
|INCOME TAX EXPENSE                          |                             |                                                   | 2,287 
|                                            |                             |                                                   |       
|NET INCOME                                  |                             | $                                                 | 4,347 
|                                            |                             |                                                   |       
|EARNINGS PER SHARE:                         |                             |                                                   |       
|                                            | Basic                       |                                                   | $     
|                                            | Diluted                     |                                                   | $     
|WEIGHTED AVERAGE SHARES OUTSTANDING:        |                             |                                                   |       
|                                            | Basic                       |                                                   |       
|                                            | Diluted                     |                                                   |       

See
notes to consolidated financial statements.

F-4

---





HEELYS, INC.        CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY        FOR THE YEARS ENDED DECEMBER 31, 2005, 2006 AND 2007        (In thousands)

|                          |                                                                   | Common Stock |        |   |    |    |   |        |       
|------------------------- | ----------------------------------------------------------------- | ------------ | ------ | - | -- | -- | - | ------ | ------
|
|
|BALANCEDecember 31, 2004 |                                                                   | 13,989       |        | $ | 14 |    | $ | 140    |       
|                          | Net income                                                        |              |       |   |    |   |   |        |      
|                          |                                                                   |              |        |   |    |    |   |        |       
|BALANCEDecember 31, 2005 |                                                                   | 13,989       |        |   | 14 |    |   | 140    |       
|                          | Purchase and retirement of treasury stock                         |              | (1,449 | ) |    |   |   |        |      
|                          | Conversion of Series B redeemable preferred stock to common stock |              | 11,364 |   |    | 10 |   |        | 115   
|                          | Initial public offering                                           |              | 3,125  |   |    | 3  |   |        | 58,794
|                          | Stock option exercises                                            |              | 13     |   |    |   |   |        | 53    
|                          | Amortization of stock-based compensation expense                  |              |       |   |    |   |   |        | 576   
|                          | Income tax benefit on stock-based compensation awards             |              |       |   |    |   |   |        | 117   
|                          | Net income                                                        |              |       |   |    |   |   |        |      
|                          |                                                                   |              |        |   |    |    |   |        |       
|BALANCEDecember 31, 2006 |                                                                   | 27,042       |        |   | 27 |    |   | 59,795 |       
|                          | Stock option exercises                                            |              | 33     |   |    |   |   |        | 133   
|                          | Amortization of stock-based compensation expense                  |              |       |   |    |   |   |        | 1,648 
|                          | Income tax benefit on stock-based compensation awards             |              |       |   |    |   |   |        | 207   
|                          | Net income                                                        |              |       |   |    |   |   |        |      
|                          |                                                                   |              |        |   |    |    |   |        |       
|BALANCEDecember 31, 2007 |                                                                   | 27,075       |        | $ | 27 |    | $ | 61,783 |       
|                          |                                                                   |              |        |   |    |    |   |        |       

See notes to consolidated financial statements.

F-5

---



HEELYS, INC.        CONSOLIDATED STATEMENTS OF CASH FLOWS        FOR THE YEARS ENDED DECEMBER 31, 2005, 2006 AND 2007        (In thousands)

|                                                     |                                                                                             | Year Ended December 31,                               |                                 
|---------------------------------------------------- | ------------------------------------------------------------------------------------------- | ----------------------------------------------------- | --------------------------------
|
|OPERATING ACTIVITIES:                                |                                                                                             |                                                       |                                 
|                                                     | Net income                                                                                  |                                                       | $                               
|                                                     | Adjustments to reconcile net income to net cash provided by (used in) operating activities: |                                                       |                                 
|                                                     |                                                                                             | Depreciation and amortization                         |                                 
|                                                     |                                                                                             | Deferred income tax benefits                          |                                 
|                                                     |                                                                                             | Stock-based compensation expense                      |                                 
|                                                     |                                                                                             | Excess tax benefit on stock-based compensation awards |                                 
|                                                     |                                                                                             | Loss on disposal of property and equipment            |                                 
|                                                     |                                                                                             | Inventory impairment charges                          |                                 
|                                                     |                                                                                             | Changes in operating assets and liabilities:          |                                 
|                                                     |                                                                                             |                                                       | Accounts receivable             
|                                                     |                                                                                             |                                                       | Inventory                       
|                                                     |                                                                                             |                                                       | Prepaid and other current assets
|                                                     |                                                                                             |                                                       | Accounts payable                
|                                                     |                                                                                             |                                                       | Commissions payable             
|                                                     |                                                                                             |                                                       | Accrued bonus                   
|                                                     |                                                                                             |                                                       | Accrued expenses                
|                                                     |                                                                                             |                                                       | Income taxes payable/receivable 
|                                                     |                                                                                             |                                                       |                                 
|                                                     |                                                                                             |                                                       |                                 
|                                                     |                                                                                             |                                                       |                                 
|INVESTING ACTIVITIES:                                |                                                                                             |                                                       |                                 
|                                                     | Purchase of equipment                                                                       |                                                       |                                 
|                                                     | Increase in patents and trademarks                                                          |                                                       |                                 
|                                                     |                                                                                             |                                                       |                                 
|                                                     |                                                                                             |                                                       |                                 
|                                                     |                                                                                             |                                                       |                                 
|FINANCING ACTIVITIES:                                |                                                                                             |                                                       |                                 
|                                                     | Purchase of treasury stock                                                                  |                                                       |                                 
|                                                     | Redemption of preferred stock                                                               |                                                       |                                 
|                                                     | Borrowings on revolving credit facility                                                     |                                                       |                                 
|                                                     | Principal payments on revolving credit facility                                             |                                                       |                                 
|                                                     | Proceeds from issuance of short-term debt                                                   |                                                       |                                 
|                                                     | Principal payments on short-term debt                                                       |                                                       |                                 
|                                                     | Proceeds from exercise of stock options                                                     |                                                       |                                 
|                                                     | Excess tax benefit on stock-based compensation awards                                       |                                                       |                                 
|                                                     | Proceeds from initial public offering, net of expenses                                      |                                                       |                                 
|                                                     | Costs related to initial public offering                                                    |                                                       |                                 
|                                                     |                                                                                             |                                                       |                                 
|                                                     |                                                                                             |                                                       |                                 
|                                                     |                                                                                             |                                                       |                                 
|NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS |                                                                                             |                                                       | (890                            
|CASH AND CASH EQUIVALENTS, beginning of period       |                                                                                             |                                                       | 1,628                           
|                                                     |                                                                                             |                                                       |                                 
|CASH AND CASH EQUIVALENTS, end of period             |                                                                                             | $                                                     | 738                             
|                                                     |                                                                                             |                                                       |                                 
|SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:   |                                                                                             |                                                       |                                 
|                                                     | Cash paid during the period for:                                                            |                                                       |                                 
|                                                     |                                                                                             |                                                       |                                 
|                                                     |                                                                                             |                                                       |                                 
|                                                     |                                                                                             |                                                       |                                 
|                                                     |                                                                                             |                                                       |                                 
|SUPPLEMENTAL DISCLOSURE OF NON-CASH INFORMATION:     |                                                                                             |                                                       |                                 
|                                                     | Conversion of Series B redeemable preferred stock into common stock                         |                                                       | $                               
|                                                     |                                                                                             |                                                       |                                 
|                                                     | Accrued costs initial public offering                                                       |                                                       | $                               
|                                                     |                                                                                             |                                                       |                                 
|                                                     | Receivable due from stock option exercises                                                  |                                                       | $                               
|                                                     |                                                                                             |                                                       |                                 

See notes to consolidated financial statements.

F-6

---



HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. COMPANY BACKGROUND

Heelys, Inc. and subsidiaries (the "Company" or "Heelys") designs, markets and distributes innovative, action sports-inspired products under the HEELYS
brand targeted to the youth market. The primary product, HEELYS-wheeled footwear, is patented, dual-purpose footwear that incorporates a stealth, removable wheel in the heel. HEELYS are
distributed primarily through retail stores in the United States and international wholesale distributors.

The
Company initially incorporated as Heeling, Inc. in Nevada in 2000. The Company was reincorporated in Delaware in August 2006 and changed its name to Heelys, Inc.
Through its general and limited partner interests, Heelys, Inc. owns 100% of Heeling Sports Limited, a Texas limited partnership, which was formed in May 2000.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Consolidated Financial StatementsThe consolidated financial statements include the accounts of
Heelys, Inc. and its subsidiaries. All intercompany balances and transactions are eliminated in consolidation.

Use of EstimatesThe preparation of the consolidated financial statements in conformity with accounting principles generally
accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts of certain assets and liabilities and disclosure of contingent assets and
liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses for the period. Management's significant estimates are as follows: allowances for
estimated customer returns, marketing discretionary funds; doubtful accounts; assessment of lower of cost or market on inventory; useful lives assigned to long-lived assets; income taxes
including deferred taxes and uncertain tax positions; sales return allowances; legal reserves for current pending claims and estimated incurred-but-not-reported
claims; and the value of common stock options for the purpose of determining stock-based compensation cost. Actual results could differ from these estimates and the differences could be material.
Differences are reported in the period they become known.

Segment ReportingThe Company operates in one segment although it sells different types of products in both the domestic and
international markets. The gross margin in these markets is consistent and comparable. The Company does not create separate statements of operations for these products or markets.

Cash EquivalentsCash equivalents consist of highly liquid investments with original maturity dates of three months or less
when purchased.

Concentration of RiskThe Company maintains substantially all of its cash and cash equivalents in one financial institution in
amounts that typically exceed federally insured limits. The Company has not experienced any losses in such accounts and believes it is not exposed to significant credit risk.

The
Company considers its concentration risk related to accounts receivable to be mitigated by the Company's credit policy, the significance of outstanding balances owed by each of
individual customer at any point in time and the geographic dispersion of these customers.

The
Company outsources all of its manufacturing to a small number of independent manufacturers. Establishing replacement sources could require significant additional time and expense.

F-7

---



HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Accounts ReceivableAccounts receivable are stated net of allowances for estimated customer returns, marketing discretionary
funds and doubtful accounts of $1,959,000 and $1,458,000 at December 31, 2006 and 2007, respectively.

InventoriesInventories are stated at the lower of cost or market. Inventories are valued on a first-in
first-out ("FIFO") basis. Inventory costs include inbound freight. Inventory quantities are regularly reviewed and provisions for excess or obsolete inventory are recorded primarily based
on the forecast of future demand and market conditions. Ongoing estimates are made relating to the net realizable value of inventories. If the estimated net realizable value of inventory is less than
the cost recorded a write-down, equal to the difference between the cost of the inventory and the estimated net realizable value, is recorded. If changes in market conditions result in
reductions in the estimated net realizable value of inventory below previous estimates, an increase in the write-down is recorded in the period in which such a determination was made. At
December 31, 2007, the Company recorded a $1.9 million write-down of inventories and a $617,000 loss on purchase commitments related to inventory that was still being held by the
manufacturers. Write-downs are recorded to cost of sales. All other purchasing and distribution costs associated with ending inventories are expensed. Inventories include $54,000 and $1,100,000 of
estimated inventories to be returned at December 31, 2006 and 2007, respectively.

Property and EquipmentProperty and equipment, such as leasehold improvements, furniture and fixtures, equipment and product
molds and designs, are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are provided using the straight-line method over the estimated useful
life of the asset. Leasehold improvements are amortized over their estimated useful lives or the lease term, whichever is shorter.

Patents and TrademarksThese intangibles are stated at cost less accumulated amortization. Amortization is provided using the
straight-line method over the estimated useful lives of five years.

Long-Lived AssetsThe Company reviews its long-lived assets and certain intangible assets for
impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets held and used is generally measured by a
comparison of the carrying amount of an asset to undiscounted pretax future net cash flows expected to be generated by that asset. An impairment loss is recognized if the estimated undiscounted future
cash flows are less than the carrying value of the related assets. There were no impairments identified in the periods reported.

Accrued ExpensesAccrued expenses include amounts accrued by the Company for expenses incurred but not yet realized. Such
expenses may include marketing costs, professional fees, property taxes, liability insurance premiums, interest expense, royalties and amounts received from customers or credits due to customers in
excess of amounts they owe to the Company.

Income TaxesThe Company accounts for income taxes using the asset and liability method. This approach requires the
recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of other assets and liabilities. The
Company evaluates its ability to realize the tax benefits associated with deferred tax assets and a valuation allowance is required to be established unless management determines that it is more
likely than not that the Company will ultimately realize the tax benefit associated with a deferred tax asset.

F-8

---



HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Recognition of RevenuesRevenues are recognized when merchandise is shipped, title passes to the customer, the customer
assumes risk of loss, the collection of relevant receivables is probable, persuasive evidence of an arrangement exists and the sales price is fixed or determinable. Title passes upon shipment or upon
receipt by the customer depending on the agreement with the customer. The Company records reductions to revenue for estimated returns, including permitted returns of damaged or defective merchandise,
and for all other allowances, in accordance with Emerging Issues Task Force Issue 01-09,Accounting for Consideration Given by a Vendor to a Customer or a Reseller
of the Vendor's Product, at the time of revenue recognition. Accordingly, the Company provided total allowances of $733,000, $3,416,000 and $12,596,000 during 2005, 2006 and
2007, respectively.

Advertising CostsAdvertising production costs are expensed the first time the advertisement is run. Media (TV and print)
placement costs are expensed in the month the advertising appears. Through cooperative advertising programs, the Company reimburses its retail customers for certain of their costs of advertising the
Company's products. The Company records these costs in selling and administrative expense at the point in time when it is obligated to its customers for the costs, which is when the related revenues
are recognized. This obligation may arise prior to the related advertisement being run. Total advertising and promotion expenses were $1,743,000, $3,167,000 and $7,890,000 during 2005, 2006 and 2007,
respectively. Prepaid advertising and promotion expenses recorded in prepaid and deferred expenses totaled $87,000 and $131,000 at December 31, 2006 and 2007, respectively.

Shipping and Handling CostsShipping and handling costs are expensed as incurred and included in costs of sales. Shipping and
handling costs included in cost of sales were $1,100,000, $5,389,000 and $4,384,000 during 2005, 2006 and 2007, respectively. Shipping and handling costs billed to domestic customers are included in
net sales in accordance with Emerging Issues Task Force Issue 00-10,Accounting for Shipping and Handling Fees and Costs, and were $201,000,
$800,000 and $533,000 during, 2005, 2006 and 2007, respectively.

InsuranceThe Company's insurance retention is $25,000 per claim for claims incurred through May 31, 2006, and is
$50,000 per claim for claims after May 31, 2006. An estimated liability is provided for current pending claims and estimated incurred-but-not-reported claims
due to this retention risk. A liability for unpaid claims in the amount of $150,000 and $167,000 as of December 31, 2006 and 2007, respectively, is reflected in the balance sheet as an accrued
expense.

Earnings per ShareBasic earnings per common share is calculated by dividing net income available to common stockholders for
the period by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects the effects of potentially dilutive

F-9

---



HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

securities
that could share in the earnings of the Company. A reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings per share is as follows (in
thousands):

Year Ended December 31,2005

2006

2007Numeratornet income available to common stockholders

$
4,347

$
29,174

$
22,317Denominator:Weighted average common stock outstanding for basic earnings per share


13,989


19,479


27,060Effect of dilutive securities:Preferred stock


11,364


5,061


Stock options





574


1,154Adjusted weighted average common stock and assumed conversions for diluted earnings per share


25,353


25,114


28,214


Stock
options to purchase 57,500 and 216,250 shares of common stock at December 31, 2006 and December 31, 2007, respectively, were not included in the computation of
diluted earnings per share because the effect of their inclusion would be anti-dilutive.

Fair Value of Financial InstrumentsThe carrying value of financial instruments, including cash equivalents, accounts
receivable, accounts payable and accrued expenses, approximate fair value due to their short maturities.

Other Comprehensive IncomeThe Company has no components of comprehensive income other than net income.

Recent Accounting PronouncementsIn September 2006, the FASB issued Statement No. 157,Fair
Value Measurements, ("SFAS 157"). SFAS 157 clarifies the principle that fair value should be based on the assumptions that market participants would use when
pricing an asset or liability. Additionally, it establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. SFAS 157 is effective for financial
statements issued for fiscal years beginning after November 15, 2007. In February 2008, the FASB issued FASB Staff Position FAS 157-2 to defer SFAS 157's effective date for all nonfinancial
assets and liabilities, except those items recognized or disclosed
at fair value on an annual or more frequently recurring basis, until years beginning after November 15, 2008. The Company does not expect SFAS 157 to have a material impact on its
financial position, cash flows or results of operations.

In
February 2007, the FASB issued Statement No. 159,The Fair Value Option for Financial Assets and Financial LiabilitiesIncluding an
amendment of FASB Statement No. 115, ("SFAS 159"). SFAS 159 permits companies to measure many financial instruments and certain other items at fair value
at specified election dates. Unrealized gains and losses on these items will be reported in earnings at each subsequent reporting date. The fair value option may be applied instrument by instrument
(with a few exceptions), is irrevocable and is applied only to entire instruments and not to portions of instruments. SFAS 159 is effective for fiscal years beginning after November 15,
2007. The Company does not expect SFAS 159 to have a material impact on its financial position, cash flows or results of operations.

F-10

---



HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

3. INITIAL PUBLIC OFFERING AND USE OF PROCEEDS

On December 13, 2006, the Company completed the initial public offering of its common stock pursuant to a Registration Statement (File
No. 333-137046) that was declared effective by the Securities and Exchange Commission on December 7, 2006. In that offering the Company sold a total of 3,125,000 shares of
common stock and selling stockholders sold 4,263,750 shares of common stock, which included 963,750 shares resulting from the exercise of the underwriters' over-allotment option. All
common stock registered under that registration statement were sold at a price to the public of $21.00 per share. The Company did not receive any proceeds from the selling stockholders' sale of their
shares.

The
net proceeds to the Company from the offering were approximately $58.8 million, after deducting underwriting discounts and commissions and other expenses incurred in
connection with the offering. As of December 31, 2007, the Company had used $8.5 million of these proceeds to repay amounts outstanding under our revolving credit facility and
$27.7 million for working capital purposes ($8.5 million in December 2006 and the remaining $19.2 million during 2007). The Company intends to use the remaining proceeds to fund
infrastructure improvements, including expanding and upgrading its
information technology systems; hiring new employees; marketing and advertising programs; product development; expanding international operations; cost to comply with the Sarbanes-Oxley Act of 2002;
working capital needs; and other general corporate purposes.

4. SIGNIFICANT CUSTOMERS

Customers of the Company consist principally of domestic retail stores and international independent distributors. The customers, individually or considered as a
group under common ownership, which accounted for greater than 10% of accounts receivable or 10% of net sales during the periods reflected were as follows:

Accounts Receivable December 31,

Net Sales
Years Ended December 31,2006

2007

2005

2006

2007Customer A

13
%

%
11
%
13
%
9
%Customer B

5





4

13Customer C

6

11

12

5

3Customer D

4

12

1

1

5Customer E

15

7

11

9

9Customer F



23





1Customer G



19





1


F-11

---



HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

5. PROPERTY AND EQUIPMENT

Property and equipment included the following (in thousands):

December 31,Estimated useful lives2006

2007Leasehold improvements

1-10 years

$
49

$
439Furniture and fixtures

7 years


71


160Computer equipment (including software)

5 years


256


478Equipment

5 years


107


123Product molds and designs

2 years


817


817Total




1,300


2,017Less accumulated depreciation and amortization




(907
)

(1,094
)Property and equipmentnet



$
393

$
923


Depreciation
expense related to property and equipment was $134,000, $151,000 and $228,000 in 2005, 2006 and 2007, respectively.

6. PATENTS AND TRADEMARKS

Patents and trademarks included the following (in thousands):

December 31,2006

2007Patents

$
1,258

$
1,176Trademarks


161


177Other


25


25Total patents and trademarks


1,444


1,378Less accumulated amortization


(966
)

(1,019
)Patents and trademarksnet

$
478

$
359


Amortization
expense related to patents and trademarks was $262,000, $251,000 and $394,000 in 2005, 2006 and 2007, respectively. The amortization amounts include write-offs
of $27,000, $13,000 and $244,000 in 2005, 2006 and 2007, respectively, for patents and trademarks that were
evaluated as having no future benefits. Amortization expense from 2008 through 2012 is expected to be $113,000, $82,000, $67,000, $43,000 and $15,000, respectively.

In
September 2002, the Company entered into an Intellectual Property Exclusive License Agreement (the "License Agreement"), which granted the Company an exclusive worldwide license to
use various marks, trademarks, URLs, patents and patent applications related to the technology used in the Company's grind-and-roll HEELYS-wheeled footwear (collectively, the
"Intellectual Property"). In January 2006, the Company converted the License Agreement into an Intellectual Property Purchase Agreement (the "Purchase Agreement"). Upon the conversion, the Company
paid a non-compete fee of $25,000, which is included in other intangible assets and is being amortized over five years, and became subject to a minimum royalty payment of $10,000 per month
through January 2007.

F-12

---



HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

6. PATENTS AND TRADEMARKS (Continued)

At December 31, 2002, the Company capitalized, as patents in progress, an escrow deposit of $100,000 required under the License Agreement that converted to
the purchase price of the Intellectual Property upon execution of the Purchase Agreement. The Company has also capitalized $102,000 in brokerage and legal fees related to these agreements as patents
in progress at December 31, 2004. Upon the initial distribution of products incorporating the Intellectual Property in 2003, the Company began to amortize these patents in progress over their
estimated useful life.

Royalty
payments of 12% of the Company's cost of certain products, $1.00 per footwear unit for certain styles and 25% of any sublicense revenue of any non-footwear products,
apparel, accessories, or similar products that would infringe the trademarks for such products absent the Company's agreements with respect to such trademarks are expensed as incurred under the
License Agreement. This royalty expense was $179,000, $299,000 and $278,000 in 2005, 2006 and 2007, respectively. The licensor has the option to reacquire the Intellectual Property for certain fixed
prices if the minimum royalty payments are not made throughout the term of the Purchase Agreement.

7. ACCRUED EXPENSES

Accrued expenses consisted of the following (in thousands):

December 31,2006

2007Marketing costs

$
672

$
1,520Customer prepayments and credits due customers in excess of amounts owed


3,266


4,411Liability insurance


785


172Professional fees


229


654Costs initial public offering


1,062


Loss on purchase commitment





617Other


723


415Total accrued expenses

$
6,737

$
7,789


Accrued
expenses at December 31, 2006 included $1.1 million of costs incurred in connection with the Company's initial public offering which closed on December 13,
2006. These costs were offset against the proceeds of the initial public offering resulting in a decrease in the amount of additional paid-in capital recognized. Theses expenses were paid
in 2007.

Accrued
expenses at December 31, 2007 included a $617,000 loss on purchase commitments related to inventory that was still being held by the manufacturers. This loss on purchase
commitments is included in cost of sales.

8. DEBT

Revolving Credit FacilityIn August 2004, the Company entered into a $3,000,000 revolving credit
facility with a predecessor of JPMorgan Chase Bank, N.A. In August 2006, the Company amended this revolving credit facility, increasing the maximum amount available to $25.0 million. In
December 2006, all amounts outstanding under this revolving credit facility were repaid with a portion of the proceeds from the Company's initial public offering. There were no outstanding borrowings
under this revolving credit facility at December 31, 2006. The maximum amount available under this revolving credit facility decreased to $10.0 million on January 1, 2007. On
February 7, 2007, the Company amended the

F-13

---



HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

8. DEBT (Continued)

revolving
credit facility to (a) decrease the maximum amount available to $2.0 million, (b) eliminate the 0.25% non-usage fee and (c) eliminate other terms,
including terms requiring the Company to provide monthly reports regarding the Company's inventory and accounts receivable. The revolving credit facility expired on June 30, 2007. Borrowings
were subject to certain limitations, primarily based upon 85% of eligible accounts receivable and 50% of eligible inventory not to exceed the amount advanced on eligible accounts receivable.
Indebtedness under the revolving credit facility bore interest at a floating rate of interest based on either the prime rate quoted by JPMorgan Chase Bank, N.A. or an adjusted LIBOR rate. Accounts
receivable and inventory were pledged as collateral and the Company was subject to compliance with certain covenants, including minimum levels of net worth and minimum interest coverage ratios. The
Company was not permitted to pay dividends or make distributions.

In
September 2007, the Company entered into a $2,000,000 revolving credit facility with JPMorgan Chase Bank, N.A. which expires June 30, 2009. Indebtedness under this revolving
credit facility bears interest at a floating rate of interest based on either the prime rate quoted by JPMorgan Chase Bank, N.A. or an adjusted LIBOR rate. This revolving credit facility contains
various restrictive covenants including (i) an obligation for the Company to maintain a tangible net worth of at least $75 million and (ii) a prohibition on the Company incurring
any other indebtedness for borrowed money. The Company is also prohibited from creating or permitting any lien, encumbrances or other security interest on the Company's accounts receivable or
inventory. There were no borrowings under this revolving credit facility as of December 31, 2007.

An
irrevocable standby letter of credit in the amount of $50,000 was outstanding in favor of the landlord for the Company's corporate headquarters. The landlord could draw upon this
letter of credit if the Company was in default under the lease. The letter of credit expired on March 1, 2008.

Line of Credit NoteIn April 2006, the Company executed a $5.0 million line of credit note that
matured in April 2007, but was required to be repaid upon consummation of the Company's initial public offering. This note was secured by the same collateral as the revolving credit facility. The
Company borrowed $4.0 million under this note to repurchase 1,448,625 shares of the common stock owned by two stockholders. The note was repaid in October 2006 and canceled.

Other DebtOther debt at December 31, 2006 and 2007 consisted of the following (in thousands):

December 31,2006

2007Promissory note, bearing interest at 6.29%, due February 2007


211


Total


211


Less current portion


(211
)

Long-term portion

$


$



Promissory NotesDuring 2006, the Company signed an agreement with a commercial finance company to
finance the payment of its commercial general liability and umbrella premiums. The agreement provided for an initial payment of a portion of the premium, with the remaining principal balance plus
interest to be paid in monthly installments. Interest accrued at 6.29% on the unpaid balance of $211,000 at December 31, 2006. Prepaid premiums from the insurance policies financed were pledged
as collateral under the promissory notes. This promissory note was paid-in-full during the first quarter of 2007.

F-14

---



HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

9. COMMITMENTS AND CONTINGENCIES

LeasesEffective February 1, 2005, the Company entered into a new operating lease whereby the
Company leases office space for 10 years with renewal options. On February 27, 2006, the Company signed an amendment to its lease for additional warehouse space for the duration of the
lease term. On October 29, 2007, the Company signed a new operating lease for office space in Qingdao, China. This lease expires December 1, 2008 but includes two one-year extension
options. The information in the table below does not include lease extensions.

Third-Party Distribution FacilitiesOn August 1, 2007, the Company entered into an agreement with a third-party
distribution facility in San Pedro, California. The Company pays a fixed storage fee for approximately 16,000 square feet of dedicated floor space. Additionally, the Company pays this third-party
distributor fees and charges for services including handling, transactional storage and processing. These fees and charges are activity based and therefore fluctuate and as a result related future
obligations cannot be quantified. The agreement expires on July 31, 2008, but the Company has the right to reduce or increase dedicated floor space with 90 days notice for periods of no less
than 6 month intervals. The information in the table below includes the fixed fee for the dedicated floor space but does not include the fluctuating fees and charges. The Company expensed $260,000
related to this third-party distribution facility in 2007. These costs are included in cost of sales.

Future
minimum rental payments under these agreements are as follows (in thousands):

Years Ending December 31,2008

$
2952009


1902010


1972011


2092012


209Thereafter


547$
1,647


Rent
expense was $162,000, $227,000 and $353,000 for 2005, 2006 and 2007, respectively.

Third-Party Distribution FacilitiesIn addition to the third-party distribution facility in San Pedro, California, the Company
has expanded its use of a third-party distribution facility in Belgium. The Company pays this third-party distributor fees and charges for services including handling, processing and packing
materials. These fees and charges are activity based and therefore fluctuate and as a result related future obligations cannot be quantified. This agreement is for one year term with automatic one
year renewal terms. The Company expensed $58,000 and $5,000 related to this third-party distribution facility in 2007 and 2006, respectively. There were no costs in 2005. These costs are included in
cost of sales.

Employment ArrangementAll of the personnel of the Company are contractually employees of a Professional Employer Organization
("PEO"). The PEO incurs payroll, payroll tax and payroll-related benefit costs. The Company reimburses these costs plus an administrative fee. With respect to these payroll-related benefits, the
personnel of the Company are pooled with other employees of the PEO.

Royalty AgreementThe Company pays monthly royalties related to a feature incorporated in its
grind-and-roll HEELYS-wheeled footwear equal to a percentage of the purchase price that is paid to the manufacturers, net of the costs of the wheels and any other skating
apparatus. Monthly royalties due are based on the number of grind-and-roll HEELYS-wheeled footwear sold. Because the royalty is

F-15

---



HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

9. COMMITMENTS AND CONTINGENCIES (Continued)

calculated
in this manner, the Company cannot quantify the future royalty payments. Royalty expense was $179,000, $299,000 and $278,000 for 2005, 2006 and 2007, respectively. The Company's payment
obligation for these royalties will terminate on December 31, 2008.

Severance Agreement with former CEOOn February 1, 2008, the Company entered into a Severance and General Release
Agreement (the "Severance Agreement") with its former Chief Executive Officer ("CEO"). Under the Severance Agreement, the Company's former CEO is entitled to receive approximately $470,000, payable in
ten semi-monthly installments of approximately $17,000 beginning six months after the date of the Severance Agreement, followed by one lump sum payment of $300,000 payable in
January 2009, up to 14 months of reimbursements for health and life insurance, and will be paid for any unused vacation or personal days and any unreimbursed expenses.

Purchase CommitmentsAt December 31, 2007, the Company had open purchase commitments of $2.8 million related to
inventories that were still being held by the manufacturers.

Legal ProceedingsThe Company, its former Chief Executive Officer, its Chief Financial Officer, and its directors who signed
the Company's registration statement filed with the Securities and Exchange Commission in connection with our December 7, 2006 initial public offering (the "IPO")along with Capital
Southwest Corporation, Capital Southwest Venture Corporation and the underwriters for the IPOare defendants in a lawsuit originally filed on August 27, 2007 in the United States
District Court for the Northern District of Texas, Dallas Division, by plaintiff Brian Rines, Individually and On Behalf of All Others Similarly Situated, purportedly on behalf of all persons who
purchased the Company's common stock pursuant to or traceable to the IPO registration statement. The complaint alleges violations of Sections 11 and 15 of the Securities Act of 1933. The
plaintiff seeks an order determining that the action may proceed as a class action, awarding compensatory damages in favor of the plaintiff and the other class members in an unspecified amount, and
reasonable costs and expenses incurred in the action, including counsel fees and expert fees. Four similar lawsuits were also filed in September and October 2007 in the United States District Court
for the Northern District of Texas, Dallas Division, by plaintiffs Vulcan Lee, John Avila, Gerald Markey, and Robert Eiron on behalf of the same plaintiff class, making substantially similar
allegations under Sections 11, 12, and 15 of the Securities Act of 1933, and seeking substantially similar damages. These lawsuits have been transferred to a single judge have been consolidated
into a single action. An amended consolidated complaint was filed on March 11, 2008. Lead plaintiffs and lead counsel have been appointed. The amended complaint alleges that the prospectus used
in connection with the IPO contained misstatements of material fact or omitted to state material facts necessary in order to make the statements made not misleading relating to among other
allegations, safety concerns and injuries associated with the Company's products and their alleged impact on demand, visibility into the Company's sales channel and competition from knockoffs, in
violation of Sections 11, 12(a)(2) and
15 of the Securities Act of 1933 and requests substantially similar damages and relief as previously requested. While the Company cannot predict the outcome of these matters, the Company believes that
the plaintiffs' claims are without merit, denies the allegations in the complaints, and the Company intends to vigorously defend the lawsuits. If any of these matters were successfully asserted
against the Company, there could be a material adverse effect on the Company's financial position, cash flows or results of operations.

F-16

---



HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

9. COMMITMENTS AND CONTINGENCIES (Continued)

On October 3, 2007 and October 24, 2007, in the United States District Court for the Northern District of Texas, Dallas Division, Jack Freeman and
Brian Mossman, respectively brought shareholders' derivative actions, for the Company's benefit, as nominal defendant, against the Company's former Chief Executive Officer, the Company's former
Director of Research and Development, the Company's Chief Financial Officer, Senior Vice President and certain members of the Company's board of directors and one of our former directors. The Company
is a nominal defendant, and the complaints do not seek any damages against the Company. The complaints allege violations of Section 14(a) of the Securities Act of 1933 and breaches of fiduciary
duty, abuse of control, gross mismanagement, waste of corporate assets and unjust enrichment on the part of each of the named defendants. The complaints
seek unspecified amounts of compensatory damages, voiding the election of the director defendants, as well as interest and costs, including legal fees from the defendants. The derivative claims have
been transferred to a single judge and have been consolidated into a single derivative claim. An amended consolidated complaint making substantially similar allegations and claims for damages was
filed March 14, 2008.

Due
to the nature of the Company's products, from time to time the Company has to defend against personal injury and product liability claims arising out of personal injuries that
allegedly are suffered using the Company's products. To date, none of these claims has had a material adverse effect on the Company. The Company is also engaged in various claims and legal proceedings
relating to intellectual property matters, especially in connection with enforcing the Company's intellectual property rights against the various third parties importing and selling knockoff products
domestically and internationally. Often, such legal proceedings result in counterclaims against the Company that the Company must defend. The Company believes that none of the pending personal injury,
product liability or intellectual property legal matters will have a material adverse effect upon the Company's financial position, cash flows or results of operations.

10. INCOME TAXES

Components of income taxes were as follows (in thousands):

December 31,2005

2006

2007Current tax expense

$
2,447

$
16,383

$
15,206Deferred tax benefit


(160
)

(595
)

(1,969
)$
2,287

$
15,788

$
13,237


A
reconciliation of income tax computed at the U.S. federal statutory income tax rate of 34% for 2005, 35% for 2006 and 2007 to the provision for income taxes is as follows (in
thousands):

December 31,2005

2006

2007Tax at statutory rate

$
2,256

$
15,758

$
12,444Non-deductible incentive stock option expense





62


206State income taxes net of federal benefit








458Change in valuation allowance








123Other


31


(32
)

6Income taxes

$
2,287

$
15,788

$
13,237


F-17

---



HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

10. INCOME TAXES (Continued)

In
addition, the Company had an effective state income tax rate of 1.3% related to Texas and California for 2007. There were no state income taxes for 2006.

Deferred
income taxes reflect the tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amount used for
income tax purposes. The tax effects of significant items included in the Company's net deferred tax benefits at December 31, 2006 and 2007 were as follows (in thousands):

December 31,2006

2007Current tax assets (liabilities):Allowances for receivables not currently deductible

$
686

$
2,161Allowances for inventory not currently deductible


65


292Prepaid expenses currently deductible


(272
)

(447
)Accrued expenses not currently deductible


158


81State income taxes





295Current deferred tax assets


637


2,382Long-term tax assets:Accumulated depreciation and amortization


241


218Stock-based compensation


130


500Long-term deferred tax assets


371


718Less valuation allowance





(123
)Net long-term deferred tax assets


371


595Total deferred tax assets

$
1,008

$
2,977


The
Company assesses the realization of its deferred tax assets to determine whether an income tax valuation allowance is required. Based on all available evidence, both positive and
negative, and the weight of that evidence to the extent such evidence can be objectively verified, the Company determined it is more likely than not the deferred tax assets will be realized. During
the year ended December 31, 2007, a valuation allowance of $123,000 was established for deferred income taxes related to non-qualified stock options that may not be realized by the
Company in future periods.

In
July 2006, the FASB issued Interpretation No. 48,Accounting for Uncertainty in Income Taxes, an interpretation of FASB
Statement No. 109, ("FIN 48"). The Company adopted the provisions of FIN 48 effective January 1, 2007. The Company recorded an increase in current state taxes payable of
$23,000 during 2007 based on the principles of FIN 48. The Company recognized penalties of $2,000 and interest of $1,000 related to state taxes payable. The Company's policy is to record
penalties related to tax liabilities as general and administrative expenses and to record interest related to tax liabilities as interest expense. The Company did not have any known unrecognized tax
benefits as of December 31, 2007.

The
Company's tax returns for tax years 2004 through 2007 are subject to examination by the taxing authorities. There are no income tax examinations currently in process.

F-18

---



HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

11. STOCKHOLDERS' EQUITY

Common StockDuring May 2000, the Company issued 11,363,875 shares of its common stock to the initial
common stockholders for $125,000, or $0.011 per share, the estimated fair value of the shares at the date of issuance, in exchange for patent applications and trademarks, which were recorded as
patents and trademarks. The Company had the right of first refusal on any disposition of common stock by the stockholders, but this right terminated on the Company's initial public offering.

In
April 2006, the Company purchased 724,325 shares of Company common stock owned by one of the Company's directors for a purchase price of $2.0 million or $2.76 per share. In May
2006, the Company purchased 724,300 shares of Company common stock owned by the Company's founder for a purchase price of $2.0 million, or $2.76 per share. The excess of the purchase cost over
the par value has been charged to retained earnings.

In
October 2006, the Company effected a 25-for-one stock split. All common share and per common share amounts in these consolidated financial statements have been
retroactively adjusted (unless otherwise stated) for all periods presented to give effect to the stock split.

On
December 13, 2006, the Company closed an initial public offering of its common stock consisting of 7,388,750 shares of common stock. Of these shares, 3,125,000 were newly
issued shares sold by the Company and 4,263,750 were existing shares sold by the selling stockholders, including 963,750 shares pursuant to an exercise by the underwriters of their
over-allotment option. The public offering price was $21.00 per share. The gross proceeds for shares of common stock sold by the Company was $65.6 million. The net proceeds to the
Company were $61.0 million, after deducting an aggregate of $4.6 million in underwriting discounts and commissions. The Company incurred other direct expenses of $2.2 million in
connection with the offering. As of December 31, 2006, the Company had paid $1.1 million of these other direct expenses. Unpaid other direct expenses in the amount of $1.1 million
is included in accrued expenses at December 31, 2006. The Company did not receive any of the proceeds from the sale of shares by selling stockholders or on any exercise of the underwriters'
over-allotment option.

12. REDEEMABLE CONVERTIBLE PREFERRED SHARES

Preferred StockThe Company had authorized an aggregate 3,000,000 shares of $0.001 par value
Series A and B Preferred Stock. In May 2000, the Company sold preferred stock and debentures pursuant to an investment agreement between the preferred stockholders and the Company (the
"Investment Agreement"). The Company sold 1,818,182 shares of Series A Preferred Stock for $500,000, and 454,545 shares of Series B Preferred Stock for $125,000, or in each case $0.275
per share, the estimated fair value of the shares at the date of purchase (not giving effect to the 25-for-one stock split effected in October 2006).

The
Company was subject to compliance with certain covenants included in the Investment Agreement, including restricting the Company from paying any dividends or distributions and
issuing additional shares, except for those restricted common shares issued in February 2001. Concurrent with the execution of the Investment Agreement, the preferred stockholders and the Company
executed a registration rights agreement. After May 2001, the Series B Preferred Stockholders could request a demand registration upon a greater than 50% vote. This demand registration would
cause the Company to perform all conversions, redemptions and payments associated with a qualified public offering.

F-19

---



HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

12. REDEEMABLE CONVERTIBLE PREFERRED SHARES (Continued)

Also,
concurrent with the execution of the Investment Agreement, the common and preferred stockholders executed an investor rights agreement. Under that agreement, a preferred
stockholder was entitled to designate two members of the five-member Board of Directors, and the initial common stockholders were entitled to designate two members of the Board of
Directors. The initial common stockholders and a preferred stockholder were entitled to designate one mutually acceptable member of the Board of Directors.

The
Series A Preferred Stock was nonconvertible and redeemable. The Company could redeem the shares at any time with 30-days' notice, and the shares were mandatorily
redeemable upon the completion of a qualified public offering. The stockholders could require the Company to redeem the shares beginning May 31, 2007. The redemption price and liquidation
preference were $0.275 per share, plus all accrued and unpaid dividends. A cumulative dividend at the rate of $0.022 per annum was to accrue from May 31, 2005 through May 31, 2007 and
was payable quarterly in cash.
The dividend rate was to increase to $0.033 per annum on May 31, 2007. The Series A Preferred Stock was redeemed by the Company on May 31, 2005 for $500,000. Dividends had not
begun accumulating; therefore the shares were redeemed for the original purchase price of $500,000.

The
Series B Preferred Stock was convertible and redeemable. One share of Series B Preferred Stock was convertible into one share of common stock at the option of the
stockholder at $0.275 per share (not giving effect to the 25-for-one stock split effected in October 2006). All shares of Series B Preferred Stock would have
automatically been converted into shares of common stock if the Company completed a qualified public offering, completed a sale of substantially all of its assets or were to have undergone a change in
control or a merger. The stockholders could have required the Company to redeem the shares beginning May 31, 2007. The redemption price was the greater of estimated fair value per share or
$0.275 per share (liquidation preference) (not giving effect to the 25-for-one stock split effected in October 2006). No dividends were to be accrued or paid on the
Series B Preferred Stock. In June 2006, all outstanding shares of the Series B Preferred Stock were converted into common stock, prior to giving effect to the
25-for-one stock split effected in October 2006.

13. STOCK-BASED COMPENSATION

In June 2006, the Company adopted the 2006 Stock Incentive Plan (the "2006 Plan"). Awards are generally granted with an exercise price equal to the market price
of the Company's stock at the date of grant, generally vest based over four years of continuous service and have a 10-year contractual life.

The
Company has reserved 2,272,725 shares of common stock subject to the 2006 Plan and as of December 31, 2007 had 35,747 shares remaining available that may be granted to
employees, consultants and nonemployee directors of the Company in the future. The 2006 Plan is administered by the compensation committee of the Company's board of directors, which selects the
persons to whom options will be granted, determines the number of shares to be subject to each grant, and prescribes the other terms and conditions of each grant, including the type of consideration
to be paid to the Company upon exercise and the vesting schedule. If a change of control of the Company, as defined by the 2006 Plan, occurs, all of the options issued and outstanding under the 2006
Plan will accelerate and become fully vested and exercisable.

In
June 2006, the Company granted 711,800 incentive and 1,330,700 nonqualified stock options at an exercise price of $4.05 per share, which was the fair value of the underlying common
stock at the

F-20

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HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

13. STOCK-BASED COMPENSATION (Continued)

grant
date. The options granted in June 2006 are subject to a 48-month vesting period with a contractual term of ten years.

In
December 2006, the Company granted 87,856 incentive and 99,644 nonqualified stock options at a weighted average exercise price of $24.56 per share. Exercise price was equal to the
fair value of the underlying common stock at the grant date. The options granted in December 2006 vest and become exercisable in four equal cumulative installments on each successive anniversary date
of the grant and have a contractual term of ten years.

In
March 2007, the Company granted 22,592 incentive and 2,408 nonqualified stock options at an exercise price of $31.76 per share, which was the fair value of the underlying common stock
at the grant date. The options granted in March 2007 vest and become exercisable in four equal cumulative installments on each successive anniversary date of the grant and have a contractual term of
ten years.

In
August 2007, the Company granted 15,000 incentive stock options at an exercise price of $9.23 per share, which was the fair value of the underlying common stock at the grant date. The
options granted in August 2007 vest and become exercisable in four equal cumulative installments on each successive anniversary date of the grant and have a contractual term of ten years.

For
the June 2006 grants the Company determined the fair value of its common stock and engaged an independent third party appraiser to perform a contemporaneous valuation of the
Company's common stock as of June 23, 2006, the date of grant of the June 2006 options. Utilizing the methodologies and procedures set forth in the AICPA Practice Aid for the Valuation of
Privately-Held Company Equity Securities Issued as Compensation, the independent appraiser determined the value of the Company's common stock based upon a number of significant factors,
assumptions and methodologies. These factors included recent sales and negotiations for sales of the Company's common stock, the timing of such transactions, the Company's discounted value of
estimated future cash flows, valuations of comparable companies and transactions and the Company's expected value as a public company. The independent appraiser correlated the value indications
derived from the various methodologies to a single value by "weighting" each value indication, applied a lack of marketability discount and further decreased the value per share by the dilution to the
value that would be realized by a Company stockholder by virtue of the June 2006 option issuances. Between June 23, 2006 and the date of the Company's initial public offering, several events
occurred that the Company believed contributed to the increase in the fair value of the Company's common stock. These events included, among others, the Company's increased earnings and the Company's
ability to exceed internally projected sales targets after July 2006.

For
the December 2006, March 2007 and August 2007 grants the Company determined the fair value of its common stock based on the closing market trading price of its common stock at the
date of grant.

The
Company accounts for stock-based compensation in accordance with FASB issued Statement No. 123(R),Share Based Payment, which
requires the measurement of compensation cost based on the estimated fair value of the award on the date of grant. The Company recognizes this cost using the straight-line method over the
period during which an employee is required to provide service in exchange for the awardthe requisite service period. No compensation cost is recognized for equity instruments for which
employees do not render the requisite service. The Company determines the grant-date fair value of employee stock options using the Black-Scholes option-pricing model.

F-21

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HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

13. STOCK-BASED COMPENSATION (Continued)

Accordingly,
the Company computed the fair value of the options granted in 2006 and 2007, using the Black-Scholes option pricing model and the following assumptions:

Assumptions

June 2006

December 2006

March 2007

August 2007Expected volatility

44.27
%
42.94
%
41.74
%
44.78
%Dividend yield







Risk-free interest rate

5.21
%
4.45
%
4.46
%
4.36
%Expected life (years)

6.02

6.25

6.25

6.25


The
Company estimated the volatility of its common stock at the date of grant based on the historical volatility of comparable public companies.

The
risk-free interest rate for periods within the contractual life of the options is based on the U.S. Treasury yield curve in effect at the time of the grant.

Expected
life was calculated using the simplified method as prescribed by the Securities and Exchange Commission's Staff Accounting Bulletin No. 107. This decision was based on
the lack of relevant historical data.

The
following summarizes stock option transactions for the year ended December 31, 2007:

|Options                          |  | Shares    |  | Weighted Average Exercise Price |       | Weighted Average Remaining Contractual Life (Years) |     | Aggregate Intrinsic Value(1)
|-------------------------------- |  | --------- |  | ------------------------------- | ----- | --------------------------------------------------- | --- | ----------------------------
|Outstanding at December 31, 2006 |  | 2,214,427 |  | $                               | 5.79  |                                                     | 9.5 |                             
|Granted                          |  | 40,000    |  |                                 | 23.31 |                                                     |     |                             
|Exercised                        |  | 32,908    |  |                                 | 4.05  |                                                     |     |                             
|Forfeited or expired             |  | 30,522    |  |                                 | 22.92 |                                                     |     |                             
|                                 |  |           |  |                                 |       |                                                     |     |                             
|Outstanding at December 31, 2007 |  | 2,190,997 |  | $                               | 5.89  |                                                     | 8.5 |                             
|                                 |  |           |  |                                 |       |                                                     |     |                             
|Exercisable at December 31, 2007 |  | 760,989   |  | $                               | 5.22  |                                                     | 8.5 |                             
|                                 |  |           |  |                                 |       |                                                     |     |                             
|Vested at December 31, 2007      |  | 760,989   |  | $                               | 5.22  |                                                     | 8.5 |                             
|                                 |  |           |  |                                 |       |                                                     |     |                             
|Unvested at December 31, 2007    |  | 1,430,008 |  | $                               | 6.25  |                                                     | 8.6 |                             
|                                 |  |           |  |                                 |       |                                                     |     |                             

---

The
weighted average fair value of options granted during the years ended December 31, 2006 and 2007 was approximately $2.88 and $11.30, respectively. There were no stock options
granted prior to June 2006.

The
total fair value of shares that vested during 2006 and 2007 was $520,000 and $1,558,000, respectively.

Stock-based
compensation cost was $576,000 and $1,648,000 for the year ended December 31, 2006 and December 31, 2007, respectively. The portion of stock-based compensation
cost included in cost of

F-22

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HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

13. STOCK-BASED COMPENSATION (Continued)

sales,
sales and marketing, and general and administrative expenses in the accompanying consolidated statement of operations during 2006 was $8,000, $128,000 and $440,000, respectively. The portion of
stock-based compensation cost included in cost of sales, sales and marketing, and general and administrative expenses in the accompanying consolidated statement of operations during 2007 was $227,000,
$368,000 and $1,053,000, respectively.

The
remaining unrecognized compensation cost related to unvested awards at December 31, 2007 is $4,350,000 and the weighted-average period of time over which this cost will be
recognized is 2.7 years.

The
Company has not capitalized any stock-based compensation costs at December 31, 2007. There have been no modifications to stock option awards during 2007.

All
unvested options at December 31, 2007 are expected to vest, except for approximately 233,000 options that forfeited subsequent to year end. The weighted average exercise price
of these forfeited options is $6.78; weighted average remaining contractual term of 8.6 years; aggregate intrinsic value of $570,000; and unrecognized compensation cost of $777,000.

Tax
benefits resulting from stock-based compensation deductions in excess of amounts reported for financial reporting purposes was $117,000 and $207,000 for 2006 and 2007, respectively.
This amount is treated as a financing cash flow.

14. OTHER EMPLOYEE BENEFIT PLANS

401(k) PlanEffective January 2002, the Company sponsored a 401(k) Retirement Plan (the "401(k) Plan")
through its PEO. All employees who are 21 years of age or older are eligible to enroll in the 401(k) Plan. Prior to December 31, 2007 the Company only made discretionary contributions to
the 401(k) plan.

For
the 2007 plan year it was determined that the 401(k) Plan was top heavy and as a result the Company was required to make a contribution for 2007 of 3% of eligible wages for all
eligible non-key employees who were employed by the Company on the last day of the 2007 plan year, regardless of whether any such employee elected to contribute to the 401(k) Plan during
the 2007 plan year.

Effective
January 1, 2008 the Company amended its 401(k) Plan to include a Safe Harbor Match Contribution. The Company will make a matching contribution equal to 100% of an
employee's deferral contributions which do not exceed 3% of the employee's compensation, plus 50% of an employee's deferral contributions that exceed 3%, but do not exceed 5%.

The
Company expensed contributions of $73,000, $105,000 and $34,000 during 2005, 2006 and 2007, respectively, related to discretionary contributions. The Company expensed contributions
of $67,000 during 2007 related to nondiscretionary contributions.

15. RELATED-PARTY TRANSACTIONS

The Company's patent attorney is also a stockholder of the Company. The Company capitalized and expensed a total of $190,000, $498,000 and $842,000 included in
patents and trademarks and general and administrative expenses, during 2005, 2006 and 2007, respectively, for costs incurred. Additionally, this patent attorney's law firm provides general corporate
legal counsel to the Company. The Company expensed a total of $24,000, $135,000 and $338,000 for these services during 2005, 2006

F-23

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HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

15. RELATED-PARTY TRANSACTIONS (Continued)

and
2007, respectively. This expense is included in general and administrative expense. In connection with the Company's initial public offering this law firm provided legal counsel to the Company. A
total of $761,000 was incurred for these legal services and has been offset against the proceeds of the initial public offering. The Company owed $523,000 and $218,000 to this law firm as of
December 31, 2006 and 2007, respectively.

In
April 2006, the Company purchased 724,325 shares of Company common stock owned by one of the Company's directors for a purchase price of $2,000,006, or approximately $2.76 per share.

In
May 2006, the Company purchased 724,300 shares of Company common stock owned by the Company's founder for a purchase price of $1,999,937, or approximately $2.76 per share.
Simultaneously with this sale and purchase, the Company's founder sold to one of the Company's directors and executive officers 362,150 shares of Company common stock owned by the founder for a
purchase price of $999,969, or approximately $2.76 per share.

16. SUBSEQUENT EVENTS

On February 1, 2008, the Company entered into a Severance and General Release Agreement (the "Severance Agreement") with its former Chief Executive Officer
("CEO"). Under the Severance Agreement, the former CEO is entitled to receive approximately $470,000, payable in ten semi-monthly installments of approximately $17,000 beginning six months
after the date of the Severance Agreement, followed by one lump sum payment of $300,000 payable in January 2009, up to 14 months of reimbursements for health and life insurance, and will be
paid for any unused vacation or personal days and any unreimbursed expenses. The Agreement provides for (i) mutual releases, (ii) the continuation of certain obligations of the former
CEO to the Company under the former CEO's employment agreement with the Company, and (iii) modifies the non-compete provision contained in such employment agreement to decrease from
one-year to six-months the terms of the former CEO's non-compete relating to competitive business activities other than those based on wheeled footwear products.
The former CEO also agreed to perform certain consulting services for the Company for one year with no additional compensation. During the term of such consulting relationship, options granted to the
former CEO will continue to vest. Remaining unrecognized compensation cost related to the options granted was approximately $405,000 at December 31, 2007.

On
March 13, 2008, the Company entered into a confidential Settlement Agreement (the "Settlement Agreement") effective March 11, 2008 with
Elan-Polo, Inc. ("Elan-Polo") to settle the pending patent and trademark lawsuitHeeling Sports Limited v. Wal-Mart
Stores, Inc., and Elan-Polo, Inc., Civil Action No. 3:07-CV-1695 in the United States District Court for the Northern
District of Texas, Dallas Division. Elan-Polo agreed, among other things, to pay the Company an aggregate of $1,400,000, as follows: $750,000 upon execution of the Settlement Agreement, $250,000 in
April of 2008 and February of 2009 and $150,000 in February 2010 and to indemnify, defend and hold harmless the Company against certain claims, losses and expenses. The Company and Elan-Polo also
entered into a Technology License Agreement (the "License Agreement"), pursuant to which Elan-Polo was granted a limited license to manufacture and sell a certain style of shoe skates to certain
approved retailers located in the United States and Canada. Pursuant to the License Agreement, Elan-Polo agreed to pay royalties to the Company at a royalty rate determined in accordance with the
License Agreement. The License Agreement remains in effect until March 10, 2011.

F-24

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HEELYS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

17. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

The following table sets forth certain financial information for the periods indicated. The data is prepared on the same basis as the audited consolidated
financial statements. All recurring, necessary adjustments are reflected in the data below.

|                                             |                            | Three months ended                                 |       
|-------------------------------------------- | -------------------------- | -------------------------------------------------- | ------
|
|
|Consolidated Statements of Operations Data:  |                            |                                                    |       
|Net sales                                    |                            | $                                                  | 13,669
|Cost of sales                                |                            |                                                    | 8,749 
|                                             |                            |                                                    |       
|Gross profit (loss)                          |                            |                                                    | 4,920 
|Selling, general and administrative expenses |                            |                                                    |       
|                                             | Sales and marketing        |                                                    |       
|                                             | General and administrative |                                                    |       
|                                             |                            |                                                    |       
|                                             |                            | Total selling, general and administrative expenses |       
|                                             |                            |                                                    |       
|Income (loss) from operations                |                            |                                                    | 2,608 
|Other expense (income), net                  |                            |                                                    | 1     
|                                             |                            |                                                    |       
|Income (loss) before income tax expense      |                            |                                                    | 2,607 
|Income tax expense (benefit)                 |                            |                                                    | 912   
|                                             |                            |                                                    |       
|Net income (loss)                            |                            | $                                                  | 1,695 
|                                             |                            |                                                    |       
|Earnings (loss) per share:                   |                            |                                                    |       
|                                             | Basic                      |                                                    | $     
|                                             | Diluted                    |                                                    | $     
|Weighted average shares outstanding:         |                            |                                                    |       
|                                             | Basic                      |                                                    |       
|                                             | Diluted                    |                                                    |       
|Other Data:                                  |                            |                                                    |       
|Net sales, domestic                          |                            | $                                                  | 12,034
|Net sales, international                     |                            |                                                    | 1,635 
|Depreciation and amortization                |                            |                                                    | 93    

F-25

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HEELYS, INC.        Valuation and Qualifying Accounts and Reserves        (In thousands)

For the years ended December 31, 2005, 2006 and 2007:

|Description                                                                     |  | Balance at Beginning of Period |       | Charged to Costs and Expenses |   | Deductions |  | Balance at End of Period |       
|------------------------------------------------------------------------------- |  | ------------------------------ | ----- | ----------------------------- | - | ---------- |  | ------------------------ | ------
|Year ended December 31, 2005                                                    |  |                                |       |                               |   |            |  |                          |       
|Allowance for doubtful accounts                                                 |  | $                              | 32    |                               | $ | 104        |  | $                        | (6    
|Reserve for estimated returns                                                   |  |                                | 108   |                               |   | 347        |  |                          | (242  
|Reserve for cooperative advertising and marketing discretionary fund allowances |  |                                | 184   |                               |   | 518        |  |                          | (341  
|Reserve for inventory valuation                                                 |  |                                | 29    |                               |   | 100        |  |                          | (91   
|Year ended December 31, 2006                                                    |  |                                |       |                               |   |            |  |                          |       
|Allowance for doubtful accounts                                                 |  | $                              | 130   |                               | $ | 435        |  | $                        | (155  
|Reserve for estimated returns                                                   |  |                                | 213   |                               |   | 1,898      |  |                          | (979  
|Reserve for cooperative advertising and marketing discretionary fund allowances |  |                                | 361   |                               |   | 2,033      |  |                          | (1,977
|Reserve for inventory valuation                                                 |  |                                | 38    |                               |   | 203        |  |                          | (199  
|Year ended December 31, 2007                                                    |  |                                |       |                               |   |            |  |                          |       
|Allowance for doubtful accounts                                                 |  | $                              | 410   |                               | $ | 333        |  | $                        | (554  
|Reserve for estimated returns                                                   |  |                                | 1,132 |                               |   | 5,117      |  |                          | (3,265
|Reserve for cooperative advertising and marketing discretionary fund allowances |  |                                | 417   |                               |   | 8,391      |  |                          | (5,016
|Reserve for inventory valuation                                                 |  |                                | 42    |                               |   | 1,809      |  |                          | (1,851

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F-26

---