**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

----

**FORM 10-K**
| (Mark One) |       |                                                                                                     |
|------------|------------|----------------------------------------------------------------------------------------------------------|
| **þ** | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**     |
| ** ** | ** ** | **For the  Fiscal Year Ended December 31, 2006**                                                    |
| ** ** | ** ** | **Or**                                                                                                   |
| **o**      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
| ** ** | ** ** | **For the transition period from**                                                                       | ** ** | **to** |
|            |            |                                                                                                          |  |  |  |

**Commissionfile number: 333-137046**

----

**HEELYS, INC.**

(Exact name of Registrant as specified in its charter)

| **Delaware**             |   | **75-2880496**                       |
|--------------------------|--------|--------------------------------------|
| (State of incorporation) |   | (I.R.S. Employer Identification No.) |

**3200 Belmeade Drive,  Suite 100**

**Carrollton,Texas 75006**

(Address of principalexecutive offices)   (Zip Code)

**(214) 390-1831**

(Registrant’s telephonenumber, including area code)

----

**Securities registered pursuant toSection 12(b) of the Act:**

| **Title  of each class**        |   | **Name  of each exchange on which registered** |
|---------------------------------|--------|------------------------------------------------|
| Common Stock, par  value $0.001 |   | The Nasdaq Stock  Market LLC                   |

**Securities registered pursuant toSection 12(g) of the Act: None**

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

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

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

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K.  o

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

| Large accelerated filer   o | Accelerated filer   o | Non-accelerated filer   x |
|-------------------------------------------------|--------------------------------------|------------------------------------------|

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

As of June 30, 2006,the last business day of the registrant’s most recently completed second fiscalquarter, the registrant’s common stock was not listed on any exchange orover-the-counter market. The registrant’s common stock began trading on TheNasdaq Global Market on December 8, 2006. The aggregate market value ofvoting stock held by non-affiliates of the registrant on December 29,2006, the last business day of the registrant’s most recently completed fiscalyear, was approximately $254,270,998 (based upon the closing price for theregistrant’s common stock on The Nasdaq Global Market of $32.11 per share).

At March 11, 2007, 27,046,866 sharesof the registrant’s common stock were outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

The information required by Part III of thisReport, to the extent not set forth herein, is incorporated herein by referencefrom the registrant’s definitive proxy statement relating to the Annual Meetingof Shareholders to be held in 2007, which definitive proxy statement shall befiled with the Securities and Exchange Commission within 120 days after the endof the fiscal year to which this Report relates.

 

----

**INDEXTO FORM 10-K**
| PART I                                                                                                                |   |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|--------|
| Item 1. Business                                                                                                           |   | 1      |
| Item 1A. Risk Factors                                                                                                      |   | 12     |
| Item 1B. Unresolved Staff Comments                                                                                         |   | 22     |
| Item 2. Properties                                                                                                         |   | 22     |
| Item 3. Legal Proceedings                                                                                                  |   | 23     |
| Item 4. Submission of Matters to a Vote of Security  Holders                                                               |   | 23     |
| PART II                                                                                                               |   |   |
| Item 5. Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |   | 23     |
| Item  6. Selected Financial Data                                                                                           |   | 26     |
| Item 7. Management’s Discussion and Analysis of  Financial Condition and Results of Operations                        |   | 27     |
| Item 7A. Quantitative and Qualitative Disclosures  about Market Risk                                                       |   | 38     |
| Item 8. Consolidated Financial Statements and  Supplementary Data                                                          |   | 38     |
| Item 9. Changes in and Disagreements with Accountants  on Accounting and Financial Disclosure                              |   | 38     |
| Item 9A. Controls and Procedures                                                                                           |   | 38     |
| Item  9B. Other Information                                                                                                |   | 39     |
| PART III                                                                                                              |   |   |
| Item 10. Directors, Executive Officers and Corporate  Governance of the Registrant                                         |   | 39     |
| Item  11. Executive Compensation                                                                                           |   | 39     |
| Item 12. Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters              |   | 39     |
| Item 13. Certain Relationships and Related  Transactions, and Director Independence                                        |   | 39     |
| Item 14. Principal Accounting Fees and Services                                                                            |   | 39     |
| PART IV                                                                                                               |   |   |
| Item 15. Exhibits and Financial Statement Schedules                                                                        |   | 40     |
| SIGNATURES                                                                                                                 |   | 43     |

 

i

----

**PART I**

***Item 1.****                          Business*

*This Annual Report on Form 10-K contains “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933, as amended, or the “Securities Act,” and Section 21E of theSecurities Exchange Act of 1934, as amended, or the “Exchange Act,” and weintend such forward-looking statements to be subject to the safe harborscreated thereby. These statements relate to future events or our financialperformance. When used in this document and in documents incorporated byreference, forward-looking statements include, without limitation, statementsregarding financial forecasts or projections, and our expectations, beliefs,intentions or future strategies that are signified by terminology such as “subjectto,” “believes,” “anticipates,” “plans,” “expects,” “intends,” “estimates,”  “may,” “will,” “should,” “can,” the negativesthereof, variations thereon, similar expressions or by discussions of strategy.All forward-looking statements are based upon our current expectations andvarious assumptions. We believe there is a reasonable basis for ourexpectations and assumptions, but they are inherently uncertain, we may notrealize our expectations and our assumptions may not prove correct. Actualresults could differ materially from those described or implied by suchforward-looking statements. Consequently, forward-looking statements should beregarded solely as our current plans, estimates and beliefs. You should notplace undue reliance on forward-looking statements. We cannot guarantee futureresults, events, performance or achievements. We do not have any obligation anddo not intend to update, republish or revise forward-looking statements toreflect future events or circumstances or to reflect the occurrences of unanticipatedevents.*

*Throughout this report, references to the “Company,” “we,”and “our” refer to Heelys, Inc. and its consolidated subsidiaries, unlessthe context indicates otherwise.*

**Overview**

We are a designer,marketer and distributor of innovative, action sports-inspired products underthe HEELYS brand targeted to the youth market. Our primary product,HEELYS-wheeled footwear, is patented, dual-purpose footwear that incorporates astealth, removable wheel in the heel. HEELYS-wheeled footwear allows the user toseamlessly transition from walking or running to skating by shifting weight tothe heel. Users can transform HEELYS-wheeled footwear into street footwear byremoving the wheel. Our distinctive product offering has driven our growth, andwe believe that our HEELYS brand is becoming synonymous with an increasinglypopular lifestyle activity. We believe that the growing exposure of our HEELYSbrand will allow us to selectively introduce additional product categories inthe future by taking advantage of our expertise in product development andsourcing, strong retail relationships and knowledge of our target consumer.

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

We are subject to theinformational requirements of the Exchange Act, and, accordingly, file reports,proxy statements and other information with the Securities and ExchangeCommission (the “SEC”). We maintain a website on the World Wide Web at *www.heelys.com.* We make available, free ofcharge through our website, our Annual Report on Form 10-K, QuarterlyReports on Form 10-Q, Current Reports on Form 8-K,including exhibits thereto, and any amendments to those reports filed orfurnished pursuant to Section 13(a) or 15(d) of the ExchangeAct, as soon as reasonably practicable after the reports are electronicallyfiled with, or furnished to the SEC. Our reports that are filed with, orfurnished to, the SEC are also available at the SEC’s website at *www.sec.gov*, that contains material regarding issuers that file electronicallywith the SEC*.* You may alsoobtain copies of any of our reports filed with, or furnished to, the SEC, freeof charge, at the SEC’s public reference room at 100 F Street, N.E.,Washington, DC 20549. 

1

----

Informationregarding the operation of the Public Reference Room may be obtained bycalling the Securities and Exchange Commission at 1-800-SEC-0330.

**Our Business**

We currently offerHEELYS-wheeled footwear in a wide variety of styles and colors at domesticretail price points ranging from $59.99 to $99.99 depending upon performancefeatures, comfort and materials. HEELYS-wheeled footwear is protected bynumerous patents and trademarks, enabling us to capture the emerging demand forour unique offering in the United States and other countries where we canenforce our patents. In 2006, approximately 98% of our net sales was derivedfrom the sale of our HEELYS-wheeled footwear. We also sell branded accessories,such as replacement wheels, helmets and other protective gear, and a limitedvariety of apparel items.

We sell our productsthrough distribution channels that merchandise our products in a manner that webelieve enhances and protects our HEELYS brand image. Domestically, ourproducts can be purchased from full-line sporting goods retailers such as TheSports Authority, Modell’s and Dick’s Sporting Goods; specialty apparel andfootwear retailers, such as Journeys and The Finish Line; and select departmentstores, such as Nordstrom and Mervyn’s. Our products can also be purchased fromselect online retailers such as Zappos.com. In 2006, 85.7% of our net saleswere derived from retailers in the United States. Internationally, our productsare sold to independent distributors with exclusive rights to specifiedinternational territories.

**Initial Public Offering of Our Common Stock and Use ofProceeds**

On December 7, 2006,a registration statement (File No. 333-137046) relating to ourinitial public offering of our common stock was declared effective by the SEC. Inthis offering we sold a total of 3,125,000 shares of our common stock andselling stockholders sold 4,263,750 shares of our common stock, which included963,750 shares resulting from the exercise of the underwriters’ over-allotmentoption. All common stock registered under the registration statement were soldat a price to the public of $21.00 per share. We did not receive any proceedsfrom the selling stockholders’ sale of their shares. The offering closed on December 13,2006. Bear, Stearns & Co., Inc., Wachovia Capital Markets, LLC,J.P. Morgan Securities Inc. and CIBC World Markets Corp. acted as managingunderwriters.

The gross proceeds fromthe shares of common stock sold by us were $65.6 million. The net proceeds tous from the offering were approximately $58.8 million, after deducting anaggregate of $4.6 million in underwriting discounts and commissions and $2.2million in other expenses incurred in connection with the offering. We used$8.5 million of these proceeds to repay amounts outstanding under our revolvingcredit facility and $8.5 million for working capital purposes. We intend to usethe remaining proceeds to fund infrastructure improvements, including expandingand upgrading our information technology systems; hire new employees; formarketing and advertising programs; product development; working capital needs;and other general corporate purposes.

**Target Market**

The growth andlongstanding popularity of skateboarding, inline skating, roller skating andscooter riding in the United States reflect consumers’ interest in wheeledsports activities. For example, skateboarding and inline skating have remaineda part of youth culture for more than 40 and 25 years, respectively. OurHEELYS-wheeled footwear, which we believe has broad patent protection relativeto other wheeled sports products, appeals to many of these same consumers.While the market for HEELYS-wheeled footwear has grown significantly since ourfirst product was introduced in 2000, we believe this market continues to havegrowth potential.

Our products appeal to abroad range of young, active consumers around the world who enjoy wheeledsports activities. Our primary market is six to fourteen year-old boys andgirls, an age group in the 

2

----

UnitedStates that the U.S. Census Bureau estimated to be 36.4 million people in2005 and projected to grow to 38.2 million people by 2015. Based on oursales of more than 5.2 million pairs of HEELYS-wheeled footwear in theUnited States during 2006, we believe that our target market offers significantgrowth potential for both HEELYS-wheeled footwear and future product introductions.In addition, we believe we benefit from greater repeat purchases by ourconsumers relative to other wheeled sports products, driven by the naturalreplacement cycle of children’s footwear and the new styles that we offer eachseason.

We believe that our productshave become more popular in recent years due to the trend among young peopleaway from traditional team sports and toward individual, action sports. Forexample, SGMA International, a sporting goods industry trade group, estimatedthat from 1998 to 2005, U.S. participation in basketball, baseball and soccerdeclined 24.6%, 16.7% and 6.4%, respectively, while U.S. participation insnowboarding, skateboarding and surfing increased 33.7%, 58.3% and 90.5%,respectively. We believe events such as the X Games, the inclusion ofsnowboarding medal events in the Winter Olympics and the national recognitionof leading boardsport athletes have broadened general awareness and increasedthe popularity of the action sports youth lifestyle. The trend towards individual,action sports has influenced the styles and performance features of ourproducts and our marketing strategies.

**Business Strengths**

Weattribute our success to the following business strengths:

·       ***Strong Brand Recognition.  ***We believe that our brandawareness is a significant competitive strength. We have positioned the HEELYSbrand to represent a fun, youthful and active image and we believe it nowdefines an emerging lifestyle activity with a following among consumers in ourtarget market. According to data collected by NPD, a retail and apparelindustry research group, HEELYS-wheeled footwear had a 51.0% market share inretail sales dollars and a 37% market share in units sold forskateboard-related footwear brands for the quarter ended December 31, 2006.

·       ***Appealing, High-Quality Products.  ***Westrive to provide high-quality, stylish products. We carefully select ourindependent manufacturers and diligently monitor their manufacturing process toensure the quality of their finished goods. To stimulate demand for ourproducts and encourage repeat purchases by consumers, we endeavor toconsistently offer a line of wheeled footwear that combines style, comfort andhigh-quality components including ABEC-rated bearings, specially formulatedpolyurethane wheels and abrasion-resistant outsoles and upper materials. Wehave generally introduced more than 20 standard styles each year in an attemptto respond to changing consumer tastes and preferences.

·       ***Focus on Innovation withIntellectual Property Protection.  ***Our innovativeHEELYS-wheeled footwear is highly differentiated from other wheeled sportsproducts and athletic footwear. We believe that our patents and pending patentapplications enable us to maintain this differentiation. We own more than 80issued patents and pending patent applications in more than 25 countries, ofwhich more than 55 are related to our HEELYS-wheeled footwear. We also havemore than 75 registered trademarks and pending trademark applications in morethan 30 countries. We believe that our experience introducing HEELYS-wheeledfootwear to the market and our growing brand awareness will allow us tosuccessfully develop and introduce additional products incorporating innovativedesigns and technologies that appeal to our target consumers.

·       ***In-Depth Understanding of Our TargetMarket.  ***We employ a grass-roots marketing model thatenables us to regularly interact with and maintain an in-depth understanding ofour target market. In 2006, our event marketing managers, or “EMMs,”coordinated more than 3,000 in-store clinics and demonstrations, allowing us tocommunicate our brand message in an interactive, fun 

3

----

environment. Inaddition, our EMMs use online marketing techniques such as hosting messageboards and contributing to skate-oriented chat rooms. We also sponsor “teamriders” to showcase HEELYS-wheeled footwear in high-traffic, public areas.Through these multifaceted interactions with our target consumers, wecontinually refine our understanding of their evolving preferences. We intendto use this insight to develop new HEELYS-wheeled footwear models, strengthenand extend our HEELYS brand and offer additional product categories.

·       ***Compelling Value Proposition forRetail Customers.  ***We believe that our differentiatedproduct offering and brand name represent a compelling value proposition forour retail customers. Our products have historically enabled our retailcustomers to achieve high sales volumes at or near our suggested retail prices,rapid inventory turns and attractive margins. These results have allowed us todevelop strong relationships and expand our product offerings with our retailcustomers, and add new retail customers.

·       ***Flexible and Efficient SourcingModel.  ***By outsourcing manufacturing, we eliminate the needto purchase raw materials and limit the amounts we are required to spend onworking capital, capital expenditures and overhead. This enables us to focusour resources on developing new products and brand-enhancing activities. We donot have any long-term manufacturing contracts, choosing instead to retain theflexibility to change our manufacturing sources if necessary. We have developedsystems and procedures that enable us to actively monitor product quality,control product costs and facilitate timely product delivery.

·       ***Senior Management Team with DeepIndustry Experience.  ***Our senior management team, which hasoverseen our company since its inception, has been instrumental in developingour HEELYS brand, establishing strong relationships with retail customers andinternational distributors and directing our growth. Our Chief ExecutiveOfficer has approximately 30 years of experience in the branded footwearand action sports industries and has held senior level positions at theRollerblade division of Benetton Group S.p.A. and L.A. Gear. Our Senior VicePresident—Global Sales has more than 25 years of sales and marketingexperience in the athletic apparel and footwear industries and has heldexecutive level and sales positions at L.A. Gear, Kaepa, Nike, Stride-Rite andWilson Sporting Goods.

**Growth Strategy**

Weplan to continue growing our net sales and earnings through the followingstrategies:

·       ***Increase Awareness and Popularity ofour HEELYS Brand.  ***We plan to increase the awareness andpopularity of our HEELYS brand, which we believe will fuel demand for ourproducts. By conveying our brand message through word-of-mouth, grass-roots andtraditional marketing, we seek to strengthen our understanding of and broadenour target market. We believe that enhanced brand awareness will allow us toexpand sales of our current products and successfully offer new productcategories.

·       ***Broaden Our Relationships withExisting Retail Customers.  ***Many of our retail customers donot initially sell our products in all of their stores, choosing to evaluateconsumer acceptance of our products in a limited number of stores. As thedemand for our products continues to grow and our relationships with our retailcustomers develop, we believe that certain of our retail customers willcontinue to increase the number of stores in which our products are sold andexpand the selection of our products that they offer. Based on the success thatthese retailers have had selling our products, we believe that we will haveopportunities to expand our sales with existing retail customers in the future.In addition, we encourage our independent distributors to pursue similar growthstrategies with their customers.

4

----

·       ***Expand Our Customer Base.  ***Weintend to increase our domestic distribution by selectively adding new retailcustomers. In particular, we believe that there are a number of regions in theUnited States where our products are under-distributed and we intend to addretailers in these regions to increase our distribution. We believe thatinternational distribution also represents a significant growth opportunity forus. We intend to take advantage of this opportunity by encouraging our existingdistributors to expand their market presence and by establishing relationshipswith distributors in new international markets.

·       ***Develop and Selectively Acquire NewProducts and Brands.  ***Our vision is to become anaction-sports lifestyle company, consistently bringing innovative brandedproducts to the global market. We intend to leverage our HEELYS brand and ourreputation for innovation, quality, performance and comfort by expanding ourapparel and accessories product offerings, entering new product categories andincreasing the breadth of HEELYS branded products sold by our existing retailcustomers. In addition to continually updating our HEELYS-wheeled footwearoffering with new colors, materials and textures to keep our style assortmentfresh and developing related products and technologies, we believeopportunities exist to acquire complementary brands and products that appeal toour target market.

**Products**

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

HEELYS-wheeledfootwear can be classified into the following three categories:
| **** | *** *** | ***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 89.1% of our net sales in 2006.  Suggested domestic retail prices for our single-wheel HEELYS-wheeled footwear  generally range from $59.99 to $99.99.                                                                                                                                                                                                                                                                                        |
|------|--------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **** | *** *** | ***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 5.6%  of our net sales in 2006. The suggested domestic retail price for our  two-wheel HEELYS-wheeled footwear is generally $59.99.                                                                                                                                                                                                                                                                                                                                                                                                                            |
| **** | *** *** | ***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 3.3% of our net sales in 2006. The suggested domestic retail  price for our grind-and-roll HEELYS-wheeled footwear is generally $89.99. |

 

5

----

In addition to offering our standard styles, wecollaborate with certain of our retail customers to develop HEELYS-wheeledfootwear styles that these retail customers have the exclusive rights to sell.This special make-up program enables these customers to differentiate theirHEELYS-wheeled footwear product offering and allows us to broaden our productrange. These exclusive products are made to order and shipped directly to ourretail customers, thereby mitigating our inventory risk. In 2006, specialmake-up program products represented approximately 23.5% of our net sales.

In the past, we sold less-expensive wheeled footwearunder the “Cruz” brand name exclusively to certain of our independentdistributors. The Cruz brand represented approximately 17.7% and 3.3% of ournet sales in 2004 and 2005, respectively. Although we have not sold any Cruzbranded footwear since 2005, we may choose to re-launch this product line inthe future.

We also offer a selectionof HEELYS branded accessories, including protective gear such as helmets andwrist, elbow and knee guards, heel plugs, wheel bags and replacement wheels anda limited variety of apparel items. We plan to take advantage of growingconsumer awareness of our brand name and our strong retail relationships toexpand our HEELYS branded accessories offerings. In response to demand fromcertain of our retail customers, we began to offer HEELYS branded apparel andadditional accessories in the third quarter of 2006.

**Product Design andDevelopment**

We continually update and refine our product offeringsin response to evolving consumer preferences. For example, in 2002 weintroduced the grind plate for our grind-and-roll HEELYS-wheeled footwear andthe two-wheel HEELYS-wheeled footwear, and in 2003 we introduced specificstyles for girls and the “sole saver” heel plug, which provides a finished lookto the footwear by covering the wheel cavity when the wheel is removed. Webelieve that introducing new products, performance features and designs allowsus to maintain premium price points, encourages repeat purchases and createsincremental consumer demand for our products. We monitor changing consumertrends and identify new product opportunities through close, interactivecontact with our target consumers, frequent dialogue between our EMMs, andour retail customers and input from our sponsored “team riders” who are paid touse and promote our products.

Our product development efforts include bothincremental improvements to our existing products and entirely new technologiesand product categories. Incremental improvements to our existing productsinclude introducing new styles, improving the materials used in our wheels anddesigning lighter shoes with greater durability and enhanced comfort andperformance features.

Our product design anddevelopment process is rigorous and highly collaborative, using input from oursales staff, product development professionals, retail customers, EMMs andconsumers. We focus not only on the performance of our products, but also onproduction cost and efficiency. Prior to hiring our Vice President—Design andDevelopment in October 2006, we outsourced the aesthetic, non-technicalaspects of our product design, such as color and style, to independent productdesigners.

**Sales**

We carefully control thedistribution of our products to protect and enhance our HEELYS brand andmaintain our ability to offer our products at premium price points. We sell ourproducts domestically directly to retail customers and internationally throughindependent distributors. Currently, we do not sell our products to massmerchants or directly to consumers.

***Domestic Sales***

As of December 31, 2006, our customer base ofretail customers in the United States included more than 800 accounts thatoperated more than 7,400 stores. Based on communications with those customers, 

6

----

we believe that as of December 31,2006, our HEELYS-wheeled footwear was offered for sale in more than 5,000 ofthose stores. These retail customers include a variety of full-line sportinggoods retailers, specialty apparel and footwear retailers and select departmentstores. Our products are also sold through select online retailers. We attemptto choose retail customers who appeal to our target market and who are able andwilling to merchandise our products in a manner that we believe is consistentwith our brand message and positioning. Big 5 Sporting Goods, Dick’s SportingGoods, Modell’s, The Sports Authority, Journeys, The Finish Line, Nordstrom,Mervyn’s and Zappos.com are examples of our domestic retail customers. In 2004,2005 and 2006, our domestic net sales were $13.8 million,$36.6 million and $161.3 million, respectively, representing 64.9%,83.2% and 85.7% of our total net sales, respectively.

We believe that there are numerous opportunities toexpand our domestic distribution. We intend to increase our domesticdistribution by expanding the number of stores in which HEELYS-wheeled footwearis sold by existing retail customers and by adding new retail customers. Due toour limited funding at our inception, we focused our marketing resources onspecific regions of the country that we believed embraced wheeled sports andinnovative products such as HEELYS-wheeled footwear. As the exposure of ourproducts and brand name increased and our financial position improved, weexpanded our focus to other regions of the country.

We are committed toproviding the highest levels of service to our retail customers. We maintain anational sales force of 19 independent sales representatives, each of whom isassigned an exclusive territory and is compensated on a commission basis, andwho together are responsible for substantially all of our domestic sales. Webelieve that our product line represents a significant percentage of the salesmade by these independent sales representatives. Our Senior Vice President—GlobalSales, who oversees our independent sales representatives, and our independentsales representatives are supported by our twelve-person sales and customerservice department.

***International Sales***

As of December 31,2006, we offered our products internationally through more than 29 independentdistributors, each of which has exclusive rights to a designated territory. In2006, our largest international territories by net sales were the UnitedKingdom, Canada and Ireland. We select our independent distributors based ontheir relationships with appropriate retailers, their ability to effectively representthe HEELYS brand and their execution of our distribution strategy. In order tomaintain a consistent brand image throughout the world, we provide marketing,distribution and product training support to our independent distributors. Eachdistributor must meet minimum sales goals and is responsible for funding itslocal marketing campaigns, maintaining its own inventory and providingsufficient sales, distribution and customer service infrastructure. In 2004,2005 and 2006, our international net sales were $7.5 million,$7.4 million and $26.9 million, respectively, representing 35.1%,16.8% and 14.3% of our total net sales, respectively. In 2004, Japan accountedfor 19.4% of our total net sales.   Since2004, no country other than the United States has accounted for 10% or more ofour net sales. We believe that international distribution represents ameaningful growth opportunity for us that we intend to take advantage of byencouraging our existing distributors to expand their market presence and by establishingrelationships with distributors in new international markets.

***Principal Customers***

In 2004, A.G. Corporationin Japan accounted for 19.4% of our net sales and Big 5 Sporting Goodsrepresented 15.8% of our net sales. In 2005, Big 5 Sporting Goods, Journeys andThe 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. No otherretail customer or independent distributor accounted for 10% or more of our netsales in any of these periods.

7

----

**Marketing**

Our marketing strategy isto position our products and the HEELYS brand to represent a lifestyle thatincludes excitement, individuality and the unique culture of action sports. Topromote awareness of our HEELYS brand, we utilize a multi-faceted strategy thatincludes event marketing activities, television advertising, point-of-purchase,or “POP,” displays and product placement and public relations opportunities.While we fund the cost of these activities domestically, our independentdistributors are solely responsible for these costs in their markets.

***Event Marketing Activities***

We employ a team of sixEMMs that enables us to reach consumers at the grass-roots level and helpdrive foot traffic to our retail customers’ locations. EMMs increaseconsumer awareness of our products by hosting in-store product clinics anddemonstrations, teaching store personnel how to use our products, employing “guerrilla”marketing methods such as arranging for our sponsored “team riders” to skate inhigh traffic public areas and using online marketing techniques such as hostingmessage boards and contributing to skate-oriented chat rooms. EMMs educateretail sales personnel on techniques to maximize sell-through of our productsand to promote product awareness and safety.

***Television Advertising***

Television advertisements arean important and highly effective tool for increasing awareness of our brandand products among our target consumers because these advertisements allow us toshow consumers HEELYS-wheeled footwear in action. Advertisements air inselected regions of the United States during our primary selling seasons oncable channels such as ABC’s Family Channel, Nickelodeon and The CartoonNetwork. As part of our regional television advertising strategy, we featurethe name of a local retail customer at the end of our televisionadvertisements. This tactic is intended to drive consumers to specific retailcustomers and allows us to evaluate the effectiveness of our advertising. Weran our first national cable television advertising campaign in the fourthquarter of 2005. During 2006, we continued utilizing both regional and nationaltelevision advertising campaigns and expect to continue to follow this approachin the future.

***Point-of-Purchase Displays***

Certain of our retailcustomers have committed valuable floor space to POP displays we provide toenhance the presentation of our products. Through the use of these POPdisplays, we are able to present the HEELYS brand message to consumers in aconsistent manner and increase our shelf space in our retail customers’locations. EMMs ensure that our merchandise is effectively featured usingPOP displays.

***Product Placement***

Because HEELYS-wheeledfootwear is highly differentiated from other wheeled sports products and otherfootwear, we often receive requests from television shows, magazines and newsorganizations to review or highlight our products. While we have not paid forproduct placement, our products have been featured in numerous television andprint spots, including television networks such as CNN and CNBC; televisionshows such as *So You Think You Can Dance*,*Good Morning America*, *Radical Sabbatical*, *Livin’ Large*, *CSI: Miami* and *InventThis*; magazines and newspapers such as *Time*, *People*, *The Wall Street Journal*, *In Style*, *Newsweek*and *Sports Illustrated;* and the *World Book Encyclopedia* and McGraw-Hillschool textbooks. HEELYS-wheeled footwear was used in the Miramax film *Spy Kids 2* as well as in the Lionsgate film *Employeeof the Month*; and has been featured in pop artist Usher’smusic videos and television specials. We believe that product placementactivities enable us to build awareness of our products and our HEELYS brand ina cost-effective manner.

8

----

**Manufacturing andSourcing**

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

We carefully monitor all aspects of the production ofour HEELYS-wheeled footwear, including the development and manufacturing ofprototypes, initial production runs and final product manufacturing. We performan array of inspection procedures at various stages of the production 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 toshipment. Historically, our defective return rate has been less than 1.0% ofour net sales. We also conduct on-site visits to our manufacturers’ facilitiesto confirm that they engage in ethical business practices.

Boss Technical Services, our independent sourcingagent, helps us identify and develop relationships with manufacturers of ourfootwear products and provides quality inspection, testing, logistics andproduct development and design assistance. We pay for these services on acommission basis. We also hired a Vice President—Sourcing in December 2006to manage our relationship with Boss Technical Services and our manufacturers.

Bu Kyung Industrial, whichis owned by one of the owners of Boss Technical Services, has manufacturedHEELYS-wheeled footwear since our inception and until 2006 was responsible formanufacturing substantially all of our HEELYS-wheeled footwear. Due to rapidgrowth in demand for our HEELYS-wheeled footwear, in 2006 we began using anumber of other manufacturers to supply our products. We expect Bu KyungIndustrial to continue to manufacture a significant portion of our footwearproducts, but we expect to develop relationships with additional manufacturersin order to secure additional capacity and mitigate the risk associated withusing a limited number of manufacturers.

**Order Fulfillmentand Inventory Management**

Our products are inspected, bar coded and packaged byour independent manufacturers and transported by container ship typically toLong Beach, California. Our independent manufacturers mark, label andpre-ticket our products for certain of our larger retail customers. Forproducts sold in the United States, after the products clear U.S. customs, weuse an independent freight forwarder and customs broker to ship them via railby container either to our distribution center located in Carrollton, Texas, ordirectly to our retail customers. In 2006, approximately 81.2% of our products in the UnitedStates were shipped directly to our retail customers. Upon receipt at ourwarehouse, merchandise is inspected and recorded in our management informationsystems and packaged for delivery. We maintain electronic data interchange, or “EDI,”connections with many of our larger retail customers in order to automate ordertracking and inventory management. Substantially all of our products destinedfor international distribution are sent directly by our independentmanufacturers to our independent distributors.

To allow us to better planour production volume with our manufacturers, we offer our retail customersdiscount incentives to place advance orders. We typically receive most of ourorders, which are not subject to cancellation, three to four months in advanceof the scheduled delivery dates. To manage our inventory risk, we regularlymonitor available sell-through data and seek input on anticipated consumerdemand from our retail customers.

**IntellectualProperty—Patents and Trademarks**

We have both domestic and international patentcoverage for the technology incorporated in our HEELYS-wheeled footwear and ownmore than 80 patents issued or pending in more than 25 countries, of which morethan 55 are related to our HEELYS-wheeled footwear. Our first patent was amethod patent 

9

----

that was issued in June 2002and includes coverage for wheeled footwear, including HEELYS-wheeled footwear,with a wheel in the heel that allows the user to transition from walking orrunning to skating by shifting weight to at least one wheel in the heel. Wealso own a variety of trademarks, with more than 75 registered and pendingtrademarks in more than 30 countries.

We have vigorously enforced and expect to continue tovigorously enforce our intellectual property rights against infringersdomestically and around the world. Despite the challenges inherent in combatinginfringers in international jurisdictions that may not protect intellectualproperty rights to the same extent as the United States, we have cooperatedwith the appropriate authorities and they have conducted successful raids,customs seizures and product confiscations of products that infringe ourintellectual property rights in various countries. We have obtained agreementsfrom importers and retailers to cease and desist all infringing activities and,in some cases have been paid monetary compensation. We have also successfullyasserted our patent rights against manufacturers of infringing products.

We have an exclusiveworldwide license to use intellectual property related to the technology usedin our grind-and-roll HEELYS-wheeled footwear. We pay a royalty of 12.0% of ourcost on certain products, $1.00 per unit on certain styles of footwear and 25%of any sublicensed revenue of any non-footwear products, apparel andaccessories or similar items that absent our license would infringe thetrademarks relating to such products under the license agreement. Provided thatwe make all required royalty payments, at December 31, 2008, title to thisintellectual property automatically transfers to us without any further payment.The licensor has the right to reacquire the intellectual property if we fail tomake the required royalty payments.

**Seasonality**

Similar to other vendorsof footwear products, sales of our products are subject to seasonality. Thereare three major buying seasons in footwear: spring/summer, back-to-school andholiday. Shipments for spring/summer take place during the first quarter andearly weeks of the second quarter, shipments for back-to-school generally occurover the summer and shipments for the holiday season begin in October andfinish in early December. Historically, we have experienced greater revenues inthe second half of the year than those in the first half due to a concentrationof shopping around the back-to-school and holiday seasons. In 2006, due to thegrowth of our business and delays we experienced from our independent manufacturers,we experienced a higher percentage of net sales in the third quarter in comparisonto the total year than we have experienced in the past, as many orders weredelayed from the second quarter to the third quarter, thereby causing thesecond quarter to be lower than normal and the third quarter to be higher thannormal. Our first quarter has typically been our lowest sales quarter. Althoughweather 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 beexpected for any other quarter or for any year.

**Employees**

As of December 31, 2006, we employed a total of41 full-time employees, 36 of whom work in our Carrollton, Texas headquarters.Our full-time employees include 12 in sales and customer service, eight inmarketing, eight in executive and administration, two in informationtechnology, five in finance and six in warehousing operations. We also employtemporary warehouse employees during peak shipment periods. We are not a partyto any labor agreements and none of our employees are represented by a laborunion.

In September 2004, weentered into an agreement with an affiliate of Gevity HR, Inc. aprofessional employer organization, or “PEO,” under which Gevity providespayroll and employee benefit services and acts as a co-employer of our employees.We believe this arrangement allows us to provide our employees with competitivebenefits in a cost-effective manner.

10

----

**Insurance andProduct Liability**

We purchase insurance to cover standard risksassociated with our business, including policies to cover commercial generalliability and other casualty and property risks. Our insurance rates dependupon our safety record as well as trends in the insurance industry. Through ourPEO our employees are also covered by workers’ compensation insurance, the costof which is retrospective and varies depending upon the frequency and severityof claims during the policy year.

We face an inherent risk of exposure to personalinjury or product liability claims if, among other things, use of our productsresults in injury, disability or death. We believe our insurance coverage issufficient for the risks relating to our products. Our coverage involvesretentions with primary and excess liability coverage above the retentionamount.

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

**InformationTechnology Systems**

Our information technology systems are designed toprovide 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 MicrosoftDynamics SL version 6.0 software, with several customizations that enhance thispackage for our purposes. We also maintain an EDI system that provides acomputer link between us and certain of our customers, which enables us tomonitor purchases, inventory and retail sales and also improves our efficiencyin responding to customer needs. Prior to May 1, 2006, when we hired aDirector of Information Technology, we outsourced all of our informationtechnology functions.

We are in the process ofexpanding and upgrading our information technology systems to support recentand expected future growth. Specifically, we plan to add servers and datawarehousing machines and enhance our order management, inventory and EDImodules. We will also evaluate and may implement a new warehouse managementsystem, a new customer-relationship management tool that will integrate withour website for improved customer service and an online and off-site backupsystem with full data recovery and redundancy capability. Although we do nothave an enterprise resource planning system, after making these upgrades, webelieve our information technology systems will be sufficient to meet ouranticipated growth for the foreseeable future.

**Competition**

We compete with companiesthat focus on the young consumer across a number of markets, includingfootwear, sporting goods and recreational products. Many of these companieshave substantially greater financial, distribution and marketing resources thanwe have. Product design, performance, styling, comfort, quality, brandawareness, timeliness of product delivery and pricing are all importantelements of competition in the markets for our products. We believe that thestrength of our HEELYS brand, the intellectual property related to the designof HEELYS-wheeled footwear, the quality of our products and our relationshipswith retailers and distributors allow us to compete effectively in the marketswe serve. In certain international markets where enforcing our intellectualproperty rights is more difficult than in the United States, we compete againstcounterfeit, knockoff and infringing products, which typically are offered atlower prices.

11

----

**Backlog**

We typically receive mostof our orders three to four months prior to the date the products are shippedto customers. Generally, these orders are not subject to cancellation prior tothe date of shipment. At December 31, 2006, our backlog was approximately$53.2 million, compared to approximately $10.7 million atDecember 31, 2005. At December 31, 2005, our backlog wasapproximately $10.7 million, compared to approximately $3.6 millionat December 31, 2004. For a variety of reasons, including the timing ofrelease dates for our product offerings, shipments, order deadlines and receiptof orders, backlog may not be a reliable measure of future sales and may not becomparable from one period to another.

***Item 1A. Risk Factors***

*Beforedeciding to purchase, hold or sell our common stock, you should carefullyconsider the risks described below in addition to the more detailed descriptionof our business and other cautionary statements and risks described elsewhere,and the other information contained, in this Annual Report on Form 10-Kand in our other filings with the SEC, including our subsequent reports onForms 10-Q and 8-K. The risks and uncertainties describedbelow are not the only ones we face. Additional risks and uncertainties notpresently known to us or that we currently deem immaterial may also affect ourbusiness. If any of these known or unknown risks or uncertainties actuallyoccurs with material adverse effects on us, our business, financial conditionand results of operations could be seriously harmed. In that event, the marketprice for our common stock will likely decline, and you may lose all or part ofyour investment. Our business, prospects, financial condition or results ofoperations could be materially and adversely affected by the following:*

***We depend primarilyupon sales from a single product line and the absence of continued demand forour products would have a material adverse effect on our net sales and resultsof operations.***

In 2005 and 2006, wegenerated approximately 95% and 98% of our net sales, respectively, from ourHEELYS-wheeled footwear and we expect to continue to depend upon HEELYS-wheeledfootwear for substantially all of our net sales in the foreseeable future.Because we are dependent on a single line of products, factors such as changesin consumer preferences may have a disproportionately greater impact on us thanif we offered multiple product categories. If consumer interest inHEELYS-wheeled footwear or wheeled sports activity products in generaldeclines, we would likely experience a significant loss of sales and may beforced to liquidate excess inventories at a discount, which would have amaterial adverse impact on our business and operations.

***If we are unable toenforce our patents, trademarks and other intellectual property rights,competitors may be able to sell products that are substantially similar to ourproducts, 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 valuableand integral to our success. The costs associated with obtaining andmaintaining our intellectual property rights and protecting our HEELYS brandare significant. Further, we do not know whether our pending or future patentapplications will result in the issuance of patents. Even if patents are issuedin the future, we cannot predict how the patent claims will be construed andsuch patents may not provide us with the ability to prevent the development,manufacturing or marketing of infringing products. Enforcement of our patentand other intellectual property rights in the future may be met with defenses,counterclaims and countersuits attacking the validity and enforceability of ourpatents and other intellectual property rights.

In addition, we may not be able to detect infringementof our intellectual property rights quickly or at all, and at times in the pastwe have not been, and in the future we may not be, successful combatingcounterfeit, infringing or knockoff products, thereby damaging our competitiveposition. For example, on many occasions, we have identified knockoff productssold by others that we believe may infringe upon our 

12

----

intellectual propertyrights. Historically, knockoff products have been sold mainly in internationalmarkets, but recently we have identified an increasing number of knockoffproducts being sold domestically. Knockoff products often are sold under abrand name that is the same as or substantially similar to the HEELYS name.Knockoff and counterfeit products may continue to emerge, as others seek totrade on the goodwill of the HEELYS name and benefit from the consumer demandfor our products. We may not be able to detect all knockoff and counterfeitproducts and may lose our competitive position in a given geographic marketbefore we become aware of any such infringement. For example, our net sales inAsia decreased from $12.1 million in 2003 to $5.4 million in 2004,which we believe was primarily due to the presence of lower-priced counterfeit,knockoff and infringing products in certain Asian markets.

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

***We may not be ableto obtain and maintain patent, trademark or other intellectual property rightsprotection in some foreign countries, which could result in us being unable toprevent others from using our HEELYS mark, which could have a material adverseeffect on our business.***

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

In some countries where wehave sought patent protection, third parties have challenged the validity,enforceability and scope of our patent rights. For example, the validity of ourJapanese patent was challenged in May 2004, resulting in the Japan PatentOffice issuing an opinion in February 2006 that our Japanese patent isinvalid. We filed a lawsuit with the Intellectual Property High Court in Japanin June 2006, and we filed a Request for Trial for Correction in the JapanPatent Office in September 2006 to attempt to overturn the prior opinion. Theseactions are still proceeding.  Inaddition, a third party filed a cancellation application in July 2004 withthe Taiwan Intellectual Property Office to cancel our issued patent in Taiwan,and this proceeding is still pending. There can be no assurance that we willprevail in these or similar proceedings. Our HEELYS brand, business, financialcondition and results of operations could be adversely affected if we fail to obtainand maintain intellectual property right protection in foreign countries wherewe derive a large amount of our net sales.

13

----

***Because we are aconsumer products company, if we fail to accurately forecast consumer demandand trends in consumer preferences, our HEELYS brand, net sales, customerrelationships and results of operations may be adversely affected.***

Demand for ourproducts, and for consumer products in general, is subject to rapidly changingconsumer demand and trends in consumer preferences. Therefore, our successdepends upon our ability to:

·       identify,anticipate, understand and respond to these trends in a timely manner;

·       expandthe number of styles of HEELYS-wheeled footwear we offer to broaden the appealof our products to a wider range of consumers; and

·       introduceappealing new products and performance features on a timely basis.

We generally must makedecisions regarding product designs several months before our products areavailable for sale, and it can take us up to six months to achieve fullproduction of certain models. Accordingly, at the time we have to makedecisions that determine our inventory levels, we cannot be certain that ourproduct offerings will be well received by consumers, in which case we may beforced to liquidate excess inventories at a discount. Conversely, if weunderestimate consumer demand for our products, we could have inventoryshortages, which would result in lost sales, delays in shipments to retailcustomers and independent distributors, strains on our relationships withretail customers and independent distributors and diminished brand loyalty.Even if we introduce appealing new styles and products on a timely basis, wemay set prices for our products too high to be successful. A decline in demandfor our products, or any failure on our part to satisfy increased demand forour products, could adversely affect our net sales and results of operations.

***We havesignificantly increased our sales and the scope of our operations over the pasttwo years. If we fail to manage our growth effectively, we may experiencedifficulty in filling purchase orders, declines in product quality, increasedcosts or other operating challenges.***

We have:

·       transitionedfrom purchasing almost all of our footwear products from one independentmanufacturer at December 31, 2005 to purchasing from a number ofadditional manufacturers in the second quarter of 2006;

·       increasedthe pairs of HEELYS-wheeled footwear sold from 697,000 pairs in 2004, to1.4 million pairs in 2005 and to 6.2 million pairs in 2006; and

·       increasedthe number of our full-time employees from 19 at June 30, 2004 to 41 at December 31,2006.

We anticipate thatcontinued growth of our operations will be required to satisfy increasingconsumer demand and to avail ourselves of new market opportunities. Theexpanding scope of our business and growth in the number of our employees,customers and independent manufacturers have placed and will continue to placea significant strain on our management, information technology systems andother resources. To properly manage our growth, we need to hire additionalemployees, upgrade our existing financial and reporting systems, improve ourbusiness processes and controls and identify and develop relationships withadditional independent manufacturers. We may also be required to expand ourdistribution facilities or add new facilities. Failure to effectively manageour growth could result in difficulty in distributing our products and fillingpurchase orders, declines in product quality or increased costs, any of whichwould adversely impact our business and results of operations.

14

----

***Because weoutsource all of our manufacturing to a small number of independentmanufacturers, we may face challenges in maintaining a sufficient supply ofproducts to meet demand for our products or experience interruptions in oursupply chain. Any shortfall in the supply of our products may decrease our netsales and have an adverse impact on our customer relationships and results ofoperations.***

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

***Our operations aredependent upon the strength of our relationships with our retail customers andindependent distributors and their success in selling our products, and a smallnumber of retail customers and independent distributors are responsible for asignificant percentage of our net sales.***

Our success is dependentupon the willingness and ability of our retail customers to market and sell ourproducts to consumers, as well as the success of our independent distributorsin developing foreign markets for our products. For the year ended December 31,2005, Big 5 Sporting Goods, Journeys and The Sports Authority wereresponsible for approximately 12.3%, 11.3% and 10.6% of our net sales,respectively. For the year ended December 31, 2006, Journeys accounted forapproximately 12.7% of our net sales. If any of these or our other significantretail customers or independent distributors were to experience financialdifficulties, reduce the quantity of our products it sells or stop selling ourproducts, our financial condition and results of operations could be adverselyaffected.

***We do not havelong-term contracts with any of our retail customers or independentdistributors, and the loss or material reduction in their business with uscould result in reduced sales of our products.***

Our retail customers andindependent distributors generally purchase products from us on a purchaseorder basis and do not have long-term contracts with us. Consequently, withlittle or no notice and without penalty, our retail customers and independentdistributors may terminate their relationship with us or materially reduce thelevel of their purchases of our products. If this were to occur with one or moreretail customers or independent distributors who purchase significantquantities of our products, it may be difficult for us to establish substituterelationships in a timely manner, which could have a material adverse effect onour financial condition and results of operations.

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

We sell substantially allof our products domestically through our network of 19 independent salesrepresentatives. We rely on these independent sales representatives to providenew customer prospects 

15

----

andmarket our products to our retail customers. Our independent sales representativesdo not sell our products exclusively and may terminate their relationships withus at any time with limited notice. Our ability to maintain and increase ourdomestic sales depends in large part on our success in maintainingrelationships with our independent sales representatives on commerciallyreasonable terms. Any failure to maintain and develop new satisfactoryrelationships with independent sales representatives, or any failure of ourindependent sales representatives to effectively market our products, couldadversely affect our domestic sales.

***Our currentinformation technology systems may be unable to support our growth, and plannedimprovements may be inadequate or may not be successfully implemented on atimely basis, which would adversely affect our ability to operate effectively.***

We expect to upgrade andimplement new information technology systems to facilitate our growth,streamline our financial reporting and improve our internal controls. We haveidentified a number of significant deficiencies related to the security of ourinformation technology systems that may affect the timeliness and accuracy ofrecording transactions and which could become material weaknesses in futureperiods if not remedied. The deficiencies include our need to further enhanceaccess privileges and password settings and provide for more frequentmonitoring of production critical processes. In addition, we may experiencedifficulties in transitioning to new or upgraded systems, including the loss ofdata and diminished productivity as our personnel become familiar with our newsystems. As we grow and our business needs change, we could experiencedifficulties associated with systems transitions. If we experience difficultiesin implementing new or upgraded information technology systems or experiencesystem failures, or if we are unable to successfully modify our informationtechnology systems to respond to changes in our business, our ability tooperate effectively could be adversely affected.

***Our business couldsuffer if our independent manufacturers violate legal requirements or fail toconform to generally accepted ethical standards.***

We expect our independentmanufacturers to comply with applicable legal requirements and generallyaccepted ethical standards for working conditions and other matters. However,we do not control our independent manufacturers or their business practices. Ifany 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 incompliance with local safety regulations or diverge from other applicable legalrequirements or business practices generally accepted as ethical, we would takeappropriate action, which could result in an interruption in our productsupply. In addition, we could suffer negative publicity and damage to ourreputation and the value of our HEELYS brand, which would adversely affect ourbusiness and results of operations.

***If our independentmanufacturers are unable to obtain raw materials, our costs could increase orthe delivery of our products could be delayed, which could adversely affect ournet sales and results of operations.***

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

16

----

***Because ourproducts are manufactured in Asia and a portion of our sales activities occuroutside of the United States, we are subject to international business,political, operational, financial and economic risks that could adverselyaffect our net sales and results of operations.***

Conducting businessinternationally entails numerous risks which could interrupt or otherwiseadversely affect our business, including:

·       increasedtransportation costs;

·       delaysand other logistical problems relating to the transportation of goods shippedby ocean freight;

·       workstoppages, strikes, lockouts or increased security concerns at seaports;

·       tariffs,import and export controls and other barriers, such as quotas and local contentrules;

·       restrictionson the transfer of funds;

·       changingeconomic conditions;

·       changesin governmental policies and regulations;

·       limitationson the level of intellectual property protections;

·       pooror unstable infrastructure of certain foreign countries;

·       tradesanctions, political unrest, terrorism, war, epidemics and pandemics;

·       expropriationand nationalization; and

·       difficultiesin understanding and complying with local laws, regulations and customs inforeign jurisdictions.

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

***We are subject toforeign exchange risk, and if the U.S. dollar significantly weakens compared tothe currency in the markets where our products are produced, our manufacturerscould increase the prices they charge us for our products, which could reduceour profitability.***

We pay for our productsand we pay commissions to our independent sourcing agent in U.S. dollars, andour independent distributors pay us in U.S. dollars. International salesaccounted for approximately 35.1% of our net sales in 2004, 16.8% of our netsales in 2005 and 14.3% of our net sales in 2006. We do not engage in anyforeign currency hedging transactions. If the U.S. dollar strengthens comparedto the currency in the foreign markets where our products are sold, ourproducts will be more expensive in those markets making them less attractive toconsumers. If the U.S. dollar significantly weakens compared to the currency inthe foreign markets where our products are produced, our manufacturers couldincrease the prices they charge us for our products, which could reduce ourprofitability. There can be no assurance that we can effectively mitigate ourforeign exchange risk.

***HEELYS-wheeledfootwear could become subject to import duties in the United States, and if wecannot increase our prices to compensate for such duties, it could reduce ourprofitability.***

HEELYS-wheeled footwear iscurrently classified by U.S. Customs and Border Protection as a skate, and assuch we do not pay import duties to the United States. This customsclassification can be changed at any time and, although we would vigorouslyoppose any proposed change, there can be no assurance that we would prevail. Ifthe classification for HEELYS-wheeled footwear changed and HEELYS-wheeled 

17

----

footwearbecame subject to an import duty, it might be difficult to increase our pricesto compensate for any such duty, which could reduce our profitability.

***Third parties mayclaim that we are infringing their intellectual property rights, and suchclaims may be costly to defend, may require us to pay licensing fees, damagesor other amounts and may prevent or limit the manufacture, marketing or sale ofour products.***

Third parties may successfully claim that we areinfringing their intellectual property rights. While we do not believe that anyof our products infringe valid intellectual property rights of third parties,we may be unaware of the intellectual property rights of others that may coversome of our technology or products. For example, because many patentapplications in the United States are not publicly disclosed immediately afterthey are filed, we could adopt technology without knowledge of a pending patentapplication, which technology would infringe a third-party patent once thatpatent is issued.

Our competitors in boththe United States and foreign countries may have applied for or obtained, ormay in the future apply for or obtain, patents that will prevent, limit orotherwise interfere with our ability to make, market or sell our products.Although we may conduct our own independent review of patents issued to certainthird parties, we cannot assure you that we will be aware of all pre-existingtechnology that may subject us to patent litigation. If we are forced to defendagainst infringement claims, whether or not such claims are resolved in ourfavor, we could encounter expensive and time-consuming litigation which coulddivert the attention of our management and other key personnel from ourbusiness operations. Furthermore, if we are found to be infringing intellectualproperty rights of others, we could be required to pay licensing fees ordamages. In addition, if we are not able to obtain license agreements on termsacceptable to us, or at all, we may be prevented from manufacturing, marketingor selling our products. As a result, our net sales could be significantlyreduced and our cost of sales could be significantly increased, either of whichcould have an adverse effect on our business.

***We are dependent onour management team and other personnel, and the failure to attract and retainsuch individuals could adversely affect our operations.***

Our future success willdepend in large part on our ability to retain Michael G. Staffaroni,Michael W. Hessong, Charles D. Beery and Patrick F. Hamner and toattract and retain other qualified managerial personnel. Our management andother employees can terminate their employment with us at any time, and we donot maintain key person life insurance. Our inability to attract or retainqualified employees, or the loss of any key employee, could harm our businessand results of operations. We recently hired a Vice President—Marketing, a VicePresident—Design and Development and a Vice President—Sourcing. Our failure tosuccessfully integrate any of these individuals into our management team couldadversely affect our business and results of operations.

***We are subject toproduct liability, warranty and recall claims and our insurance coverage maynot cover such claims, which could cause us to incur substantial costs andadversely affect our business.***

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

We attach warning labels to our products and packagingrelating to safe usage and the risk of injury. However, if a product liabilityclaim is brought against us, the content of the warnings, the placement of themor both may be considered inadequate by courts, exposing us to liability. Wecannot be certain that our safety warning labels are adequate. Productliability claims could result in us having to expend 

18

----

significant time andexpense to defend these claims and to pay, if necessary, settlement amounts ordamages, which could adversely affect our financial condition. In addition,claims that use of our products resulted in an injury, disability or deathcould cause our HEELYS brand image and operating performance to suffer bydamaging our reputation and prospects and by diverting the time and attentionof our management, even if we are not at fault.

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

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

***Additional bans onthe use of our HEELYS-wheeled footwear due to public safety and liabilityconcerns could adversely affect our net sales and results of operations.***

Various places of businessand other institutions, such as shopping malls and schools, have imposed banson the use of our HEELYS-wheeled footwear due to public safety and liabilityconcerns. If the number of businesses and other institutions instituting suchbans increases in the future, consumers could find our HEELYS-wheeled footwearless appealing, which could adversely affect our net sales and result ofoperations.

***Expanding ourdistribution to mass merchants could have a material adverse effect on ourgross margin, brand image and results of operations.***

We sell our products tosporting goods retailers, specialty apparel and footwear retailers and selectdepartment stores in an effort to maintain a high-quality image for our HEELYSbrand and premium price points for our products. Although we do not currentlyanticipate distributing to mass merchants, if we choose to do so in the futureit could have a material adverse effect on our gross margin and couldnegatively affect our HEELYS brand image and our reputation with consumers,which could adversely affect our results of operations and financial condition.

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

We have experienced, and expect to continue toexperience, substantial seasonal and quarterly variations in our net sales andnet income. These variations are primarily related to increased sales of ourproducts during the holiday selling season. Our quarterly results of operationsmay also fluctuate significantly as a result of a variety of other factors,including, among other things, the timing of holidays and advertisinginitiatives and changes in our product mix. In addition, variations in weatherconditions may significantly affect our results of operations.

As a result of these seasonaland quarterly fluctuations, we believe that comparisons of our operatingresults between different quarters within a single year are not necessarilymeaningful and that these comparisons cannot be relied upon as indicators ofour future performance. Any seasonal or quarterly fluctuations that we reportin the future may differ from the expectations of market analysts andinvestors. This could cause the price of our common stock to fluctuatesignificantly.

19

----

***As a relativelyyoung 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 companiesthat sell to young consumers in several different product markets, includingfootwear, sporting goods and recreational products. These markets are intenselycompetitive and we expect competition to increase in the future. A number ofour competitors have significantly greater financial, marketing, distributionand manufacturing resources than we do, as well as greater brand awareness inthe markets in which they operate. We also compete with counterfeit, knockoffand infringing products, which are often sold at lower prices. If we fail toremain competitive with respect to the quality, design, price and timelydelivery of products, our business, financial condition and results ofoperations could be materially adversely affected.

***We may havedifficulty identifying and successfully integrating acquisitions into ourbusiness and any acquisitions we make could result in adverse consequences.***

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

We have limitedexperience acquiring other businesses and may not be able to successfullyintegrate any acquired operations with our business or effectively manage thecombined business following an acquisition. We also may not achieve theanticipated benefits of an acquisition due to any of the following factors:

·       unanticipatedcosts associated with making the acquisition and operating the acquiredbusiness;

·       harmto our business relationships with independent manufacturers, retail customersand independent distributors;

·       lossof key employees of the acquired business; or

·       difficultiesassociated with entering product categories or markets in which we have littleor no prior experience.

If we experience any ofthe difficulties noted above, our business and financial condition could beadversely affected.

***The trading price of our common stock may fluctuatesignificantly.***

Volatility in thetrading price of our common stock may prevent you from being able to sell yourshares of our common stock at prices equal to or greater than your purchaseprice. The trading price of our common stock could fluctuate significantly forvarious reasons, including:

·       ouroperating and financial performance and prospects;

·       ourquarterly or annual earnings or those of other companies in our industry;

·       thepublic’s reaction to our press releases, other public announcements and filingswith the SEC;

·       changesin earnings estimates or recommendations by research analysts who track ourcommon stock or the stock of other companies in our industry;

·       strategicactions by us or our competitors;

·       newlaws or regulations or new interpretations of existing laws or regulationsapplicable to our business;

·       changesin accounting standards, policies, guidance, interpretations or principles;

20

----

·       changesin general economic conditions in the United States and global economies orfinancial markets, including such changes resulting from war or incidents ofterrorism; and

·       salesof our common stock by us or members of our management team.

In addition, in recentyears, the stock market has experienced significant price and volumefluctuations. This volatility has had a significant impact on the trading priceof securities issued by many companies, including companies in our industry.The changes frequently occur irrespective of the operating performance of theaffected companies. Hence, the trading price of our common stock couldfluctuate based upon factors that have little or nothing to do with ourbusiness.

***Existing stockholders significantly influence ourcorporate governance.***

As of December 31,2006 our executive officers, key employees, directors and their affiliatesbeneficially owned, in the aggregate, approximately 71% of our outstandingcommon stock. In addition, Capital Southwest Venture Corporation, or “CSVC,”which owns approximately 34.5% of our common stock, has the contractual rightto designate (i) two nominees for director to be included in management’sslate of director nominees, so long as it owns at least 15% of the outstandingshares of our common stock, and (ii) one such nominee so long as it ownsat least 10%, but less than 15%, of the outstanding shares of our common stock.As a result, through its designees, CSVC may significantly influence ourcorporate governance.

***Our Certificate ofIncorporation and By-Laws and Delaware law contain provisions that coulddiscourage a third party from acquiring us and consequently decrease the valueof an investment in our common stock.***

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

·       authorizeour board of directors, without prior stockholder approval, to issue preferredstock with rights, privileges and preferences, including voting rights, seniorto those of our common stock;

·       prohibitstockholder action by written consent, thereby requiring all stockholderactions to be taken at a meeting of our stockholders;

·       establishadvance notice requirements for submitting nominations for election to theboard of directors and for proposing matters that can be acted upon bystockholders at a meeting; and

·       imposerestrictions on mergers and other business combinations between us and anyholder of 15% or more of our outstanding common stock.

These provisions coulddiscourage proxy contests, make it more difficult for our stockholders to electdirectors and take other corporate actions and may discourage, delay or preventa change in control or changes in our management that a stockholder mightconsider favorable. Any delay or prevention of a change in control or change inmanagement that stockholders might otherwise consider to be favorable coulddeprive you of the opportunity to sell your common stock at a price in excessof the prevailing trading price and cause the trading price of our common stockto decline.

21

----

***As a publiccompany, we will be required to meet periodic reporting requirements under SEC rules andregulations. Complying with federal securities laws as a public company isexpensive and we will incur significant time and expense enhancing,documenting, testing and certifying our internal control over financialreporting. Any deficiencies in our financial reporting or internal controlscould adversely affect our business and the trading price of our common stock.***

SEC rules require that, as a publicly tradedcompany, we file periodic reports containing our financial statements within aspecified time following the completion of quarterly and annual periods. Priorto the completion of our initial public offering in December 2006, we werenot required to comply with SEC requirements to have our financial statementscompleted and reviewed or audited within a specified time and, as such, we mayexperience difficulty in meeting the SEC’s reporting requirements. Any failureby us to file our periodic reports with the SEC in a timely manner could harmour reputation and reduce the trading price of our common stock.

As a public company we will incur significant legal,accounting, insurance and other expenses. The Sarbanes-Oxley Act of 2002, aswell as compliance with other SEC and Nasdaq rules, will increase our legal andfinancial compliance costs and make some activities more time-consuming andcostly. Furthermore, SEC rules require that our chief executive officerand chief financial officer periodically certify the existence andeffectiveness of our internal control over financial reporting. Our independentregistered public accounting firm will be required, beginning with our AnnualReport on Form 10-K for our fiscal year ending on December 31,2007, to attest to our assessment of our internal control over financialreporting. This process generally requires significant documentation ofpolicies, procedures and systems, review of that documentation by our internalaccounting staff and our outside auditors and testing of our internal controlover financial reporting by our internal accounting staff and our outsideindependent registered public accounting firm. Documentation and testing of ourinternal controls, which we have not undertaken in the past, will involveconsiderable time and expense, may strain our internal resources and have an adverseimpact on our operating costs.

During the course of ourtesting, we may identify deficiencies which would have to be remediated tosatisfy the SEC rules for certification of our internal control overfinancial reporting. As a consequence, we may have to disclose in periodicreports we file with the SEC significant deficiencies or material weaknesses inour system of internal controls. The existence of a material weakness wouldpreclude management from concluding that our internal control over financial reportingis effective, and would preclude our independent auditors from issuing anunqualified opinion that our internal control over financial reporting iseffective. In addition, disclosures of this type in our SEC reports could causeinvestors to lose confidence in our financial reporting and may negativelyaffect the trading price of our common stock. Moreover, effective internalcontrols are necessary to produce reliable financial reports and to preventfraud. If we have deficiencies in our disclosure controls and procedures orinternal control over financial reporting it may negatively impact ourbusiness, results of operations and reputation.

***Item 1B.****                  UnresolvedStaff Comments*

None.

***Item 2.****                          Properties*

We lease our corporateheadquarters, an approximately 48,400 square-foot facility located inCarrollton, Texas, consisting of approximately 34,500 square feet of warehousespace and approximately 13,900 square feet of office space. Our lease expiresin August 2015, but we have two five-year extension options. We believethat our existing facility is adequate to meet our current requirements.

22

----

***Item 3.****                          LegalProceedings*

Due to the nature of ourproducts, from time to time we have to defend against personal injury andproduct liability claims arising out of personal injuries that allegedly aresuffered using our products. To date, none of these claims has had a materialadverse effect on us. We are also engaged in various claims and legalproceedings relating to intellectual property matters, especially in connectionwith enforcing our intellectual property rights against the various thirdparties importing and selling knockoff products domestically andinternationally. Often, such legal proceedings result in counterclaims againstus that we must defend. We believe that none of our pending legal matters willhave a material adverse effect upon our liquidity, financial condition orresults of operations.

***Item 4.****                          Submissionof Matters to a Vote of Security Holders*

**Annual Meeting ofShareholders**

No matters were submitted by the Company’sshareholders during the fourth quarter of the fiscal year ended December 31,2006.

**PART II**

***Item 5.****                          Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities*

**Market Information**

Ourcommon stock, par value $0.001, has been listed on The Nasdaq Global Marketunder the stock symbol “HLYS” since December 8, 2006. Prior to that timethere was no public market for our stock. The initial public offering price ofour common stock on December 8, 2006 was $21.00 per share. As of March 11,2007, there were 28 holders of record of our common stock. The following tablesets forth the range of high and low market prices for the common stock for theperiod beginning on December 8, 2006 through December 29, 2006, asreported by The Nasdaq Global Market.

| **2006**                                      | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------------------------------------|------------|------------|------------|----------|------------|---------|------------|
| Fourth Quarter (since  December 8, 2006) |       | $38.75     |       | $30.00   |       |

 

**Dividends**

In the past we have notpaid any dividends, nor do we anticipate paying any dividends in theforeseeable future. Instead, we anticipate that all of our earnings, if any, inthe foreseeable future will be used for working capital and to finance thegrowth and development of our business. Any future determination relating todividend policy will be made at the discretion of our board of directors andwill 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 ofsurplus or net profit for the then current and immediately preceding fiscalyears, and other factors that our board of directors may deem relevant. Ourrevolving credit facility prohibits us from paying dividends or making otherdistributions to our stockholders, and future agreements governing ourborrowings, and the terms of any preferred stock we may issue in the future,will also likely contain restrictive covenants prohibiting us from payingdividends.

**Initial PublicOffering of Our Common Stock and Use of Proceeds**

On December 7, 2006, a registration statement(File No. 333-137046) relating to our initial public offering of ourcommon stock was declared effective by the SEC. In this offering we sold atotal of 3,125,000 shares of our common stock and selling stockholders sold4,263,750 shares of our common stock, which included 963,750 shares resultingfrom the exercise of the underwriters’ over-allotment option. All 

23

----

common stock registeredunder the registration statement were sold at a price to the public of $21.00per share. We did not receive any proceeds from the selling stockholders’ saleof their shares. The offering closed on December 13, 2006. Bear, Stearns &Co., Inc., Wachovia Capital Markets, LLC, J.P. Morgan Securities Inc. andCIBC World Markets Corp. acted as managing underwriters.

The gross proceeds fromthe shares of common stock sold by us were $65.6 million. The net proceeds tous from the offering were approximately $58.8 million, after deducting anaggregate of $4.6 million in underwriting discounts and commissions and $2.2million in other expenses incurred in connection with the offering. We used$8.5 million of these proceeds to repay amounts outstanding under our revolvingcredit facility and $8.5 million for working capital purposes. We intend to usethe remaining proceeds to fund infrastructure improvements, including expandingand upgrading our information technology systems; hire new employees; for marketingand advertising programs; product development; working capital needs; and othergeneral corporate purposes.

**Unregistered Sales ofEquity Securities**

During the period coveredby this Annual Report on Form 10-K, we did not sell or issue anyunregistered equity securities.

**Repurchases**

None.

**SecuritiesAuthorized for Issuance under Equity Compensation Plans**

The Company has reserved 2,272,725 shares of commonstock subject to its 2006 Stock Incentive Plan, or the “2006 Plan,” and had45,225 shares remaining available at December 31, 2006 that may be grantedto employees, consultants and nonemployee directors of the Company. The 2006Plan is administered by the compensation committee of the Company’s board ofdirectors, which selects the persons to whom options will be granted,determines the number of shares to be subject to each grant, and prescribes theother terms and conditions of each grant, including the type of considerationto be paid to the Company upon exercise and the vesting schedule. If a changeof control of the Company, as defined by the 2006 Plan, occurs, the vesting ofthe options will accelerate and become fully vested and exercisable.

Our board of directors andstockholders approved our 2006 Plan and we do not have any other equity basedplans.

**Equity CompensationPlan 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))** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **(a)**                                                                                                                                              | ** ** | **(b)**                                                                                                     | ** ** | **(c)**                                                                                                                                                                                                          | ** ** |
| Equity  compensation plans approved by security holders     |       |                                                                                                                                                 | 2,214,427  |                                                                                                        |       |                                                                                                                                                                                                             | $          | 5.79 |   |   |   | 45,225 |   |   |
| Equity  compensation plans not approved by security holders |       |                                                                                                                                                 | —     |                                                                                                        |       |                                                                                                                                                                                                             | $          | — |   |   |   | — |   |   |
| Total                                                       |       |                                                                                                                                                 | 2,214,427  |                                                                                                        |       |                                                                                                                                                                                                             | $          | 5.79 |   |   |   | 45,225 |   |   |

----

The table above sets forth information regarding our2006 Plan as of December 31, 2006.

24

----

**Performance Graph**

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

 

25

----

***Item 6.****                          SelectedFinancial Data*

Thefollowing selected consolidated financial data should be read in conjunctionwith, and are qualified by reference to, our consolidated financial statementsand related notes and “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” appearing elsewhere in this Annual Reporton Form 10-K. The consolidated statements of operations data for theyears ended December 31, 2004, 2005 and 2006, and the consolidated balancesheet data at December 31, 2005 and 2006 are derived from our consolidatedfinancial statements which have been audited by Deloitte & Touche LLP,an independent registered public accounting firm, and are included elsewhere inthis Report. The consolidated statements of operations data for the years endedDecember 31, 2002 and 2003, and the consolidated balance sheet data at December 31,2002, 2003 and 2004 are derived from our consolidated financial statements notincluded herein.
|                                                                      | ** ** | **Year Ended December 31,**                         | ** ** |
|----------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                           | ** ** | **2002**                                                           | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                                           | ** ** | **(in thousands, except per share data)** | ** ** |
| **Consolidated Statements of  Operations Data:**                     |       |                                                               |       |   |   |   |   |   |   |   |   |
| Net sales                                                            |       | $                                                                  | 25,820     |   | $ | 22,215 |   | $ | 21,310 |   | $ | 43,950 |   | $ | 188,208 |   |
| Cost of sales                                                        |       | 17,741                                                             |       | 15,583 |   | 14,529 |   | 28,951 |   | 122,565 |   |
| Gross profit                                                         |       | 8,079                                                              |       | 6,632 |   | 6,781 |   | 14,999 |   | 65,643 |   |
| Selling, general and  administrative expenses                        |       |                                                               |       |   |   |   |   |   |   |   |   |
| Sales and marketing                                                  |       | 3,048                                                              |       | 2,739 |   | 3,191 |   | 5,247 |   | 13,695 |   |
| General and administrative                                           |       | 3,035                                                              |       | 2,184 |   | 2,368 |   | 2,987 |   | 6,397 |   |
| Total selling, general and administrative expenses    |       | 6,083                                                              |       | 4,923 |   | 5,559 |   | 8,234 |   | 20,092 |   |
| Income from operations                                               |       | 1,996                                                              |       | 1,709 |   | 1,222 |   | 6,765 |   | 45,551 |   |
| Other (income)  expense                                              |       | 43                                                                 |       | 33 |   | 1 |   | 131 |   | 589 |   |
| Income before income taxes                                           |       | 1,953                                                              |       | 1,676 |   | 1,221 |   | 6,634 |   | 44,962 |   |
| Income taxes                                                         |       | 667                                                                |       | 575 |   | 418 |   | 2,287 |   | 15,788 |   |
| Net income                                                           |       | $                                                                  | 1,286      |   | $ | 1,101 |   | $ | 803 |   | $ | 4,347 |   | $ | 29,174 |   |
| **Earnings  per share:**                                             |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                                |       | $                                                                  | 0.09       |   | $ | 0.08 |   | $ | 0.06 |   | $ | 0.31 |   | $ | 1.50 |   |
| Diluted                                                              |       | $                                                                  | 0.05       |   | $ | 0.04 |   | $ | 0.03 |   | $ | 0.17 |   | $ | 1.16 |   |
| **Weighted average shares  outstanding:**                            |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                                                |       | 13,989                                                             |       | 13,989 |   | 13,989 |   | 13,989 |   | 19,479 |   |
| Diluted                                                              |       | 25,353                                                             |       | 25,353 |   | 25,353 |   | 25,353 |   | 25,114 |   |
| **Other  Data:**                                                     |       |                                                               |       |   |   |   |   |   |   |   |   |
| Net sales,  domestic                                                 |       | $                                                                  | 13,058     |   | $ | 9,458 |   | $ | 13,835 |   | $ | 36,573 |   | $ | 161,347 |   |
| Net sales,  international                                            |       | 12,762                                                             |       | 12,757 |   | 7,475 |   | 7,377 |   | 26,861 |   |
| Depreciation and  amortization                                       |       | 304                                                                |       | 548 |   | 454 |   | 396 |   | 402 |   |

 

26

----

 
|                                       | ** ** | **At December 31,** | ** ** |
|---------------------------------------|------------|-------------------------------|------------|
| ** **                            | ** ** | **2002**                      | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                            | ** ** | **(in thousands)**       | ** ** |
| **Consolidated  Balance Sheet Data:** |       |                          |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents            |       | $                        | 54         |   | $ | 1,200 | (1) | $  | 1,628 |   | $ | 738 |   | $ | 54,184 |   |
| Working capital                       |       | 4,015                         |       | 3,355 |   | 4,281 |   | 8,101 |   | 92,528 |   |
| Total assets                          |       | 7,881                         |       | 5,549 |   | 6,321 |   | 11,990 |   | 106,338 |   |
| Total long-term  liabilities(2)(3)    |       | 2,526                         |       | 598 |   | 500 |   | — |   | — |   |
| Total stockholders’  equity      |       | 2,677                         |       | 3,778 |   | 4,581 |   | 8,928 |   | 93,770 |   |
|                                       |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Includes$1.1 million of cash on deposit held under a previously outstandingrevolving line of credit.

(2)          Includes current portionof long-term debt.

(3)          Includes $500,000 Series ARedeemable Preferred Stock at December 31, 2002, 2003 and 2004.

Note: The numbers in thetables above, except per share data, have been rounded to thousands. Allcalculations related to the period-to-period comparisons in “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” arederived from the tables above, are rounded to millions and could differimmaterially if such calculations were computed without rounding.

***Item 7.****                          Management’sDiscussion and Analysis of Financial Condition and Results of Operations*

*The following discussion should be read in conjunctionwith our consolidated financial statements and the related notes includedelsewhere in this Annual Report on Form 10-K. This discussioncontains forward-looking statements that involve risks and uncertainties. Ouractual results may differ materially from those anticipated in these forwardlooking statements due to known or unknown risks, uncertainties and other factors,including those discussed in “Risk Factors” included elsewhere in this  Annual Report on Form 10-K. Thoserisk factors expressly qualify all subsequent oral and written forward-lookingstatements attributable to us or persons acting on our behalf. We do not haveany intention or obligation to update forward-looking statements included inthis Annual Report on Form 10-K after the date of this Annual Reporton Form 10-K, except as required by law.*

**Overview**

We are a designer, marketer and distributor of innovative,action sports-inspired products under the HEELYS brand targeted to the youthmarket. Our primary product, HEELYS-wheeled footwear, is patented, dual-purposefootwear that incorporates a stealth, removable wheel in the heel.HEELYS-wheeled footwear allows the user to seamlessly transition from walkingor running to skating by shifting weight to the heel. Users can transformHEELYS-wheeled footwear into street footwear by removing the wheel. In 2006,approximately 98% of our net sales was derived from the sale of ourHEELYS-wheeled footwear. We also sell branded accessories such as replacementwheels, helmets and other protective gear, and a limited variety of apparelitems.

We introduced HEELYS-wheeled footwear in 2000, and forseveral years our domestic sales were concentrated with one large, nationalspecialty retailer. Although we initially focused on driving our domestic salesgrowth, we also established relationships with an independent distributor ineach of Japan, South Korea and Southeast Asia. As a result, the sources of ournet sales were largely concentrated and we were susceptible tocustomer-specific and region-specific factors, including competition fromcounterfeit, knockoff and infringing products in international markets. Thisconcentration caused variability in our results of operations. Since that time,we have diversified our retail customer base in the United States and expandedour international distribution channels to mitigate this concentration.

27

----

Since 2003, ourdomestic net sales have increased rapidly. We believe that this increase hasresulted primarily from the growing acceptance of HEELYS-wheeled footwear byconsumers, increasing recognition of our HEELYS brand name and expandingdistribution of HEELYS-wheeled footwear to existing and new retail customers.We believe that our grass-roots marketing programs, quality products andrelationships with our retail customers have contributed to this growingdemand. Continued growth of our net sales will depend on consumer demand for HEELYS-wheeledfootwear and our ability to satisfy this demand. A number of factors may impactconsumer demand for our products, including:

·       theeffectiveness of our marketing strategies;

·       ourability to effectively distribute our products;

·       ourability to design products that appeal to our target consumers;

·       ourability to protect our intellectual property rights;

·       generaleconomic conditions, particularly changes in consumer discretionary spendingpatterns; and

·       changesin the popularity of and participation rates in wheeled sports activities.

We intend to continue todiversify our product offering with new HEELYS-wheeled footwear models, productcategories and accessories in order to benefit from the increasing recognitionof our HEELYS brand and the growing market for action sports-inspired products.Designing, marketing and distributing new products will require us to devoteadditional resources to product development, marketing and operations. Theseadditional resources may include hiring new employees to support our growth inthese areas and increasing amounts allocated to product advertising andpromotion. Each of these additional resource commitments will increase ourselling, general and administrative expenses. Because the selling price and unitcost of new products may differ from those of our existing products, sales ofthese new products may also impact our gross margin. In addition, we may seekto selectively acquire products and companies that offer products that arecomplementary to ours.

**General**

***Net Sales***

Net sales represent primarily sales of HEELYS-wheeledfootwear, less an estimated reserve for sales returns, allowances anddiscounts. A small portion of our net sales are derived from the sale ofaccessories such as replacement wheels, helmets and other protective gear, anda limited variety of apparel items. Amounts billed to domestic customers forshipping and handling are included in net sales.

We sell our productsthrough distribution channels that merchandise our products in a manner that webelieve enhances and protects our HEELYS brand image. Domestically, ourproducts can be found in full-line sporting goods retailers, specialty appareland footwear retailers and select department stores and online retailers. As ofDecember 31, 2006, our customer base of retail customers in the UnitedStates included more than 800 accounts that operated more than 7,400 stores.Based on communications with these customers, we believe that as of December 31,2006, our HEELYS-wheeled footwear was offered for sale in more than 5,000 ofthese stores. In 2006, 85.7% of our net sales were derived from domestic retailcustomers. Internationally, our products are sold to 29****independentdistributors with exclusive rights to specified territories. Our three largestinternational territories in 2006, by net sales, were the United Kingdom,Canada and Ireland. Sales to our independent distributors are denominated inU.S. dollars.

***Cost of Sales and Gross Profit***

Cost of sales consists primarily of the cost to purchasefinished products from our independent manufacturers. Cost of sales alsoincludes commissions paid to our independent sourcing agent, inbound 

28

----

and outbound freight,warehousing expenses, tooling depreciation, royalty expenses related tolicensed intellectual property and an inventory reserve for shrinkage andwrite-downs.

We source all of our products and accessories frommanufacturers located in China, Indonesia and South Korea. Our product costsare largely driven by the prices we negotiate with our independentmanufacturers. Each season, we negotiate a unit price for each model ofHEELYS-wheeled footwear. Factors that influence these prices include rawmaterials and labor costs and foreign exchange rates. We pay our independentsourcing agent a commission equal to a specified percentage of our per unitcost, with the percentage decreasing when our annual purchases exceed apredetermined unit volume threshold. We believe that our sourcing model allowsus to minimize our capital investment, retain the production flexibility,cost-effectiveness and scalability inherent in the use of independentmanufacturers and focus our resources on developing new products and enhancingour HEELYS brand image.

We have generally avoidedselling our products at close-out prices due to strong demand. Should demandfor our products slow, we may discount our products to reduce our inventory,which may cause our gross profit as a percentage of net sales, or gross margin,to decline. Our gross margin is affected by our sourcing and distributioncosts, our product mix and our ability to avoid excess inventory by accuratelyforecasting demand for our products. The unit prices that we charge ourdomestic retail customers are generally higher than what we charge ourindependent distributors for similar products, because our independentdistributors are responsible for distribution and marketing costs relating toour products. The gross margin for products sold to our domestic retailcustomers and independent distributors are similar, however, due to highershipping costs and standard customer discounts and allowances related todomestic sales.

***Selling, General and Administrative Expenses***

Selling, general and administrative expenses consistof wages and related payroll and employee benefit costs, sales and marketingexpenses, advertising costs, travel and insurance expenses, product developmentcosts, costs to enforce our intellectual property rights, depreciation,amortization, professional fees and facility expenses. Our selling, general andadministrative expenses have increased annually as we have increased ourmarketing expenses and expanded our infrastructure to support our sales growth.In addition, our product liability insurance premiums have increased as our netsales have increased. We expect that our selling, general and administrativeexpenses will continue to increase in future periods as we continue to hireadditional personnel, develop our infrastructure, increase our brandrecognition through marketing, secure and enforce our intellectual propertyrights and incur additional expenses associated with operating as a publiccompany, including compliance with the Sarbanes-Oxley Act of 2002.

As a result of adoptingFinancial Accounting Standards Board, or FASB, No. 123(R), *Share-Based Payment (Revised 2004),* onJanuary 1, 2006, we incurred approximately $375,000, net of tax, innon-cash stock-based compensation expense during 2006. The amount ofcompensation expense recognized will depend upon numerous factors andestimates, including the number and vesting period of option grants, thepublicly traded price of our common stock, the estimated volatility of ourcommon stock price, estimates of the timing and volume of exercises andforfeitures of the options and fluctuations in future interest and income taxrates.

***Income Taxes***

We operate through HeelingSports Limited, a Texas limited partnership, and, accordingly, have notincurred significant amounts of Texas franchise taxes. Texas recently passedlegislation amending its franchise tax law. As a result, effectiveJanuary 1, 2007, we expect our effective tax rate to increase by up to0.5%.

29

----

**Results of Operations**

| ** **                                         | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                         | ** ** | **2004**                                   | ** ** | **2005** | ** ** | **2006** | ** ** |
| Net sales                                          |       | 100.0                                      | %          | 100.0 | % | 100.0 | % |
| Cost of sales                                      |       | 68.2                                       |       | 65.9 |   | 65.1 |   |
| Gross profit                                       |       | 31.8                                       |       | 34.1 |   | 34.9 |   |
| Selling, general  and administrative expenses      |       |                                       |       |   |   |   |   |
| Sales and marketing                                |       | 15.0                                       |       | 11.9 |   | 7.3 |   |
| General and administrative                         |       | 11.1                                       |       | 6.8 |   | 3.4 |   |
| Total selling, general and administrative expenses |       | 26.1                                       |       | 18.7 |   | 10.7 |   |
| Income from operations                             |       | 5.7                                        |       | 15.4 |   | 24.2 |   |
| Other expense  (income)                            |       | —                                     |       | 0.3 |   | 0.3 |   |
| Income before income taxes                         |       | 5.7                                        |       | 15.1 |   | 23.9 |   |
| Income taxes                                       |       | 2.0                                        |       | 5.2 |   | 8.4 |   |
| Net income                                         |       | 3.8                                        | %          | 9.9 | % | 15.5 | % |

 

***Comparison of the Years Ended December 31, 2006and December 31, 2005***

*Netsales.**  *Netsales increased $144.3 million, or 328.2%, to $188.2 million in 2006from $44.0 million in 2005. This increase was primarily the result ofhigher unit sales of our HEELYS-wheeled footwear, which increased by 4.8million pairs, or 338.1%, to 6.2 million pairs in 2006 from 1.4 millionpairs in 2005. In 2006, 85.7% of our net sales were derived from domesticretail customers, compared to 83.2% in 2005. Domestically, our net salesincreased $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 higherunit 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 pairsin 2006 from 1.1 million pairs in 2005. Internationally, our net salesincreased $19.5 million, or 264.1%, to $26.9 million in 2006,compared to $7.4 million in 2005. This increase was primarily the resultof increased sales to distributors in the United Kingdom, Canada and Ireland,partially offset by decreased sales to distributors in Japan andSpain/Portugal.

*Grossprofit.**  *Grossprofit 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 to34.1% in 2005. The increase in gross margin was attributed to a decrease in ourproduct costs of 0.8% of net sales due to product mix and reduced sourcingcommissions; reduced costs of 0.4% of net sales related to efficiencies inoperating our distribution center and reduced royalty expense of 0.2% of netsales related to fewer royalty-based sales. These cost reductions werepartially offset by increased freight costs of 0.7% of net sales, includingextraordinary air freight costs incurred to offset startup production delays atseveral new factories.

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

*Generaland administrative expense.**  *General and administrative expense increased $3.4million to $6.4 million in 2006 from $3.0 million in 2005. Thisincrease was primarily the result of a $1.2 million increase in our productliability insurance premiums which are based on sales volumes, $602,000 inpayroll 

30

----

and related costs due toan increase in the number of employees, $441,000 in stock-based compensationexpense and a $328,000 increase in our provision for doubtful accounts due toincreased sales volume. Although the dollar amount of general andadministrative expense in 2006 increased from the prior period, as a percentageof net sales, general and administrative expense decreased to 3.4% in 2006 from6.8% in 2005.

*Operatingincome.**  *Asa 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.

*Incometaxes.**  *Incometaxes were $15.8 million in 2006, representing an effective income taxrate of 35.1%, compared to $2.3 million in 2005, representing an effectiveincome 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.

**Comparison of theYears Ended December 31, 2005 and 2004**

*Netsales.**  *Netsales increased $22.6 million, or 106.2%, to $44.0 million in 2005from $21.3 million in 2004. This increase was primarily the result ofhigher unit sales of our HEELYS-wheeled footwear, which increased by 714,000pairs, or 102.4%, to 1.4 million pairs in 2005 from 697,000 pairs in 2004.In 2005, 83.2% of our net sales were derived from domestic retail customerscompared to 64.9% in 2004. Domestically, our net sales increased$22.7 million, or 164.4%, to $36.6 million in 2005 from$13.8 million in 2004. This increase was primarily the result of higherunit sales of our HEELYS-wheeled footwear to existing and new retail customers,which increased by 722,000 pairs, or 170.7%, to 1.1 million pairs in 2005from 423,000 pairs in 2004. Internationally, our net sales decreased $98,000,or 1.3%, to $7.4 million in 2005 compared to $7.5 million in 2004.This decrease was primarily the result of lower sales in Japan that we believeoccurred primarily due to competing counterfeit and knockoff products,partially offset by increased sales to independent distributors in Canada, theUnited Kingdom, Ireland and Spain/Portugal.

*Grossprofit.**  *Grossprofit increased $8.2 million to $15.0 million in 2005 from$6.8 million in 2004. Our gross margin improved to 34.1% in 2005 from31.8% in 2004. The increase in gross margin was primarily due to decreases inour product costs of 1.0% of net sales due to product mix and cost reductions,reduced inventory reserve costs of 0.8% of net sales based on actualexperience, reduced costs of 0.3% of net sales related to efficiencies inoperating our distribution center and reduced royalty expense of 0.3% of netsales related to fewer royalty-based sales, all of which were partially offsetby increased freight costs of 0.1% of net sales.

*Salesand marketing expense.**  *Salesand marketing expense increased $2.1 million to $5.2 million in 2005from $3.2 million in 2004. This increase was primarily the result of a$1.3 million increase in sales commissions related to our increaseddomestic net sales, together with a $415,000 increase in advertising expense.Although the dollar amount of sales and marketing expense in 2005 increasedfrom the prior period, as a percentage of net sales, sales and marketingexpense decreased to 11.9% in 2005 from 15.0% in 2004.

*Generaland administrative expense.**  *General and administrative expense increased $619,000to $3.0 million in 2005 from $2.4 million in 2004. This increase wasprimarily the result of $304,000 in increased compensation expense due to anincrease in the number of our employees and amount of bonus payments, and a$110,000 increase in our bad debt expense as we increased our provision fordoubtful accounts due to increased sales volume. Although the dollar amount ofgeneral and administrative expense in 2005 increased from the prior period, asa percentage of net sales, general and administrative expense decreased to 6.8%in 2005 from 11.1% in 2004.

31

----

*Operatingincome.**  *Asa result of the above factors, operating income increased $5.5 million to$6.8 million in 2005 from $1.2 million in 2004. As a percentage ofnet sales, operating income increased to 15.4% in 2005 from 5.7% in 2004.

*Incometaxes.**  *Incometaxes were $2.3 million in 2005, representing an effective income tax rateof 34.5%, compared to $418,000 in 2004, representing an effective income taxrate of 34.2%.

*Net income.**  *As a result of the above factors,net income was $4.3 million in 2005 compared to $803,000 in 2004. As apercentage of net sales, net income increased to 9.9% in 2005 from 3.8% in2004.

**Liquidity andCapital Resources (in thousands)**

Our primary cash need is for working capital, which wegenerally finance with cash flow from operating activities and borrowings underour revolving credit facility. In December 2006, we completed an initialpublic offering of our common stock. The net proceeds to us were approximately$58.8 million, after deducting an aggregate of $4.6 million in underwritingdiscounts and commissions and $2.2 million in other expenses incurred inconnection with the offering. We used $8.5 million of these proceeds to repayamounts outstanding under our revolving credit facility and $8.5 million forworking capital purposes. We intend to use the remaining proceeds to fundinfrastructure improvements, including expanding and upgrading our informationtechnology systems; hire new employees; for marketing and advertising programs;product development; working capital needs; and other general corporatepurposes. These sources of liquidity may be impacted by fluctuations in demandfor our products, investments in our infrastructure and expenditures onmarketing and advertising.

The table belowsets forth, for the periods indicated, our beginning balance of cash and cashequivalents, net cash flows from operating, investing and financing activitiesand our ending balance of cash and cash equivalents:

| ** **                                        | ** ** | **Year Ended  December 31,** | ** ** |
|---------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                        | ** ** | **2004**                               | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                        | ** ** | **(in thousands)**                | ** ** |
| Cash and cash  equivalents at beginning of period |       | $                                      | 61         |   | $ | 1,628 |   | $ | 738 |   |
| Cash provided by (used in) operating activities   |       | 711                                    |       | 21 |   | (2,180 | ) |
| Cash provided by (used in) investing activities   |       | 863                                    |       | (416 | ) | (505 | ) |
| Cash (used in)  provided by financing activities  |       | (7                                     | )          | (495 | ) | 56,131 |   |
| Cash and cash  equivalents at end of period       |       | $                                      | 1,628      |   | $ | 738 |   | $ | 54,184 |   |

Cash flow from operatingactivities consists primarily of net income adjusted for certain non-cashitems, including depreciation and amortization, deferred income taxes,stock-based compensation expense and gains or losses on sales of assets and theeffect of changes in operating assets and liabilities, principally includingaccounts receivable, inventory, accounts payable and accrued expenses.

In 2006, cash used in operating activities was $2.2million compared to cash provided by operating activities of $21,000 in 2005.Cash used in operating activities in 2006 consisted primarily of an increase innet 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 workingcapital was primarily the result of an increase of $35.0 million inaccounts receivable due to increased net sales, an increase in inventory of$4.6 million primarily due to the timing of receipt of our initialinventory for our spring product line and an increase in inventory in transit,an increase in prepaid expenses of $644,000 due to higher liability insurancepremiums resulting from increased net sales, partially offset by an increase inaccounts payable of $1.1 million, accrued expenses of $4.9 million andincome taxes payable of $2.5 million, net of excess tax benefit onstock-based compensation awards,  relatedto our increased income before income taxes.

32

----

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

In 2004, cash provided by operating activities was$711,000 and consisted of net income of $803,000, increased by adjustments fornon-cash items of $399,000, partially offset by an increase of $491,000 in networking capital. The increase in net working capital consisted primarily of anincrease in accounts receivable of $778,000 and a decrease in accounts payableof $130,000, partially offset by a decrease in inventory of $279,000 and anincrease in income taxes payable of $115,000.

Investing activities relate primarily to changes incash invested with our commercial lender, investments in intangible assets andcapital expenditures. Investments in intangible assets are amounts wecapitalize related to the acquisition and enforcement of our patents andtrademarks. Our capital expenditures are primarily related to leaseholdimprovements, furniture and fixtures, computer equipment, warehouse equipmentand product molds and designs.

In 2006, cash used in investing activities was$505,000 compared to $416,000 in 2005. The cash used in investing activitiesprimarily related to purchases of equipment and legal and other costscapitalized related to securing intellectual property rights. In 2005, cashused in investing activities was $416,000, consisting primarily of $236,000 forcapital expenditures and $180,000 for legal and other costs capitalized relatedto securing intellectual property rights. In 2004, cash provided by investingactivities was $863,000, consisting primarily of $1.1 million from thewithdrawal of cash on deposit with our commercial lender, partially offset by$209,000 for legal and other costs capitalized related to securing intellectualproperty rights and $84,000 in capital expenditures.

Financing activities relate primarily to netborrowings and repayments under our revolving credit facility and promissorynotes, redemptions of our preferred stock and the exercise of stock options. Weborrow funds under our revolving credit facility primarily to fund seasonalincreases in our inventory and selling, general and administrative expenses. Werepay amounts outstanding on our revolving credit facility with cash generatedfrom the sale of our inventory and the collection of accounts receivable. Wealso borrow funds from commercial finance companies to finance the payment ofinsurance premiums.

In 2006, cash provided by financing activities was$56.1 million compared to $495,000 used in 2005. The cash provided byfinancing activities in 2006 is primarily the result of the completion of ourinitial public offering in December. We sold 3,125,000 shares of common stockat a price of $21.00 per share for total gross proceeds of $65.6 million. Thenet proceeds were $61.0 million, after deducting $4.6 million in underwritingdiscounts and commissions. We incurred a total of $2.2 million in other directexpenses in connection with this offering of which $1.1 million was paid in2006, bringing the net cash provided by the offering to $59.9 million. Cashprovided by financing activities in 2006 also included $120,000 in net proceedsfrom short-term debt, $117,000 excess tax benefit on stock-based compensationawards and $35,000 proceeds from the exercise of stock options, offset by ourrepurchase of $4.0 million in shares of our common stock from certain ofour stockholders. In 2005, cash used in financing activities was $500,000related to our redemption of our Series A Preferred Stock. In 2004, cashused in financing activities was $7,000 related to the net repayment of ourpromissory notes.

We believe that our cashflow from operating activities and borrowings available to us under ourrevolving credit facility, together with the net proceeds from the initialpublic offering for our common stock, will be adequate to meet our liquidityneeds and capital expenditure requirements for at least the next12 months.

33

----

*Revolving CreditFacility*

On August 20, 2004,we entered into a $3.0 million revolving credit facility with apredecessor of JPMorgan Chase Bank, N.A. On August 28, 2006, we amendedthis revolving credit facility, increasing our maximum amount available to$25.0 million. In December 2006, we repaid all amounts outstandingunder this revolving credit facility with a portion of the proceeds from ourinitial public offering. The maximum amount available under our revolvingcredit facility was decreased to $10.0 million on January 1, 2007 andon 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 otherterms, including terms requiring us to provide monthly reports regarding ourinventory and accounts receivable. This revolving credit facility expires onJune 30, 2007. Borrowings are subject to certain limitations, primarilybased upon 85% of eligible accounts receivable and 50% of eligible inventory.Accounts receivable, inventory and general intangibles other than our patentsand trademarks are pledged as collateral for our revolving credit facility andwe are subject to compliance with certain covenants, including maintaining a minimumlevel of net worth of at least $7.0 million as of the end of each fiscalquarter and a minimum interest coverage ratio of 2.5 to 1.0. Our revolvingcredit facility also prohibits us from, among other things, incurringindebtedness for borrowed money, guaranteeing the obligations of another personor entity, creating or permitting any liens on our assets, paying dividends ormaking other distributions to our stockholders. Currently, we are in compliancewith these covenants. Indebtedness under our revolving credit facility bearsinterest at a floating rate of interest based on either the prime rate quotedby JPMorgan Chase Bank, N.A. or an adjusted LIBOR rate. At December 31,2006, the applicable interest rate under our revolving credit facility was 8.0%per annum. An irrevocable standby letter of credit in the amount of $50,000 isoutstanding under our revolving credit facility in favor of the landlord forour corporate headquarters. The landlord may draw upon this letter of credit ifwe are in default under the lease. The letter of credit expires onMarch 1, 2008.

*Line of Credit Note*

On April 18, 2006, weexecuted 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 ofcredit note was repaid in October 2006 and was canceled.

**ContractualObligations and Commercial Commitments**

Thefollowing table summarizes our significant contractual cash obligations as ofDecember 31, 2006:
|                                 | ** ** | ** **              | ** ** | **Payments due by period** | ** ** |
|---------------------------------|------------|-------------------------|------------|-------------------------------------------|------------|
| ** **                      | ** ** | **Total**               | ** ** | **Less than  1 year**           | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **More than  5 years** | ** ** |
| ** **                      | ** ** | **(in thousands)** | ** ** |
| Debt obligations                |       | $                       | 211        |                                      |       | $ | 211 |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Operating lease  obligations(1) |       | 1,741                   |       |                                      | 189        |   |   |   | 575 |   |   |   | 419 |   |   |   | 558 |   |   |
| Total obligations               |       | $                       | 1,952      |                                      |       | $ | 400 |   |   |   | $ | 575 |   |   |   | $ | 419 |   |   |   | $ | 558 |   |   |

----

(1)          Our office leaseprovides that if we are in default of the lease, we must pay certain damages tothe landlord, and the landlord may elect to require us to continue to pay rentthrough the end of the lease term or to pay the present value of the excess, ifany, of the aggregate rent otherwise payable through the end of the lease overthe aggregate fair market value of the premises for the lease period.

We lease our corporate headquarters, an approximately48,400 square-foot facility located in Carrollton, Texas, consisting ofapproximately 34,500 square feet of warehouse space and approximately 13,900square feet of office space. Our lease expires in August 2015, but we havetwo five-year extension 

34

----

options. The informationin the table above does not include these lease extensions. We believe that ourexisting facility is adequate to meet our current requirements.

We pay monthly royaltiesrelated to a feature incorporated in our grind-and-roll HEELYS-wheeled footwearequal to a percentage of the purchase price we pay to our manufacturers, net ofthe costs of the wheels and any other skating apparatus. Because the royalty iscalculated in this manner, we cannot quantify the future royalty payments. In2004, 2005 and 2006, we expensed $143,000, $179,000, and $299,000,respectively, in royalties. Our payment obligation for these royalties willterminate on December 31, 2008.

**Seasonality**

Similar to other vendorsof footwear products, sales of our products are subject to seasonality. Thereare three major buying seasons in footwear: spring/summer, back-to-school andholiday. Shipments for spring/summer take place during the first quarter andearly weeks of the second quarter, shipments for back-to-school generally occurover the summer and shipments for the holiday season begin in October andfinish in early December. Historically, we have experienced greater revenues inthe second half of the year than those in the first half due to a concentrationof shopping around the back-to-school and holiday seasons.  In 2006, due to the growth of our businessand the delays we experienced in our manufacturing to meet this growth, weexperienced a higher percentage of net sales in the third quarter in comparisonto the total year than we experienced in the past as many orders were delayedfrom the second quarter to the third quarter, thereby causing the secondquarter to be lower than normal and the third quarter to be higher than normal.Our first quarter has typically been our lowest sales quarter. Although weatheris a factor in our seasonality, it is difficult to measure its impact. Resultsfor any one quarter are not necessarily indicative of results to be expectedfor any other quarter or for any year.

**Backlog**

We typically receive mostof our orders three to four months prior to the date the products are shippedto customers. Generally, these orders are not subject to cancellation prior tothe date of shipment. At December 31, 2006, our backlog was approximately$53.2 million, compared to approximately $10.7 million atDecember 31, 2005. At December 31, 2005, our backlog wasapproximately $10.7 million, compared to approximately $3.6 millionat December 31, 2004. For a variety of reasons, including the timing ofrelease dates for our product offerings, shipments, order deadlines and receiptof orders, backlog may not be a reliable measure of future sales and may not becomparable from one period to another.

**Vulnerability Dueto Customer Concentration**

In 2004, A.G. CorporationJapan accounted for 19.4% of our net sales and Big 5 Sporting Goods represented15.8% of our net sales. In 2005, Big 5 Sporting Goods, Journeys and The SportsAuthority represented 12.3%, 11.3% and 10.6% of our net sales, respectively.For 2006, Journeys accounted for 12.7% of our net sales. No other retailcustomer or independent distributor accounted for 10% or more of our net salesin any of these periods. We anticipate that our net sales may remain concentratedfor the foreseeable future. If any of our significant retail customers orindependent distributors decreases its purchases of our products or stopspurchasing our products our net sales and results of operations could beadversely affected.

**Critical AccountingPolicies**

Our consolidated financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States, which require us to make estimates and judgments that affect thereported amounts of assets, liabilities, net sales and expenses and relateddisclosure at the date of our 

35

----

financial statements. Wecontinually evaluate our estimates and judgments, including those related tonet sales, intangible assets and stock compensation. We base our estimates andjudgments on historical experience and on various other factors that we believeto be reasonable under the circumstances, the results of which form the basisof our judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results or changes in theestimates or other judgments of matters inherently uncertain that are includedwithin these accounting policies could result in a significant change to theinformation presented in the consolidated financial statements. We believe thatthe following discussion addresses the critical accounting policies that arenecessary to understand and evaluate our reported consolidated financialresults.

*RevenueRecognition.**  *Revenuesare recognized when merchandise is shipped and the customer takes title andassumes risk of loss, collection of relevant receivables are probable,persuasive evidence of an arrangement exists and the sales price is fixed ordeterminable. Title passes upon shipment or upon receipt by the customerdepending on the agreement with the customer. Revenues are stated net ofestimated returns and other allowances, including permitted returns of damagedor defective merchandise and markdowns. Other allowances include funds forpromotional and marketing activities and a volume-based incentive program.

*Reservefor Uncollectible Accounts Receivable.**  *We continually make estimatesrelating to the collectability of our accounts receivable and maintain areserve for estimated losses resulting from the failure of our customers tomake required payments. In determining the amount of the reserve, we considerour historical level of credit losses and make judgments about thecreditworthiness of significant customers. Because we cannot predict futurechanges in the financial stability of our customers, actual future losses fromuncollectible accounts may differ from our estimates. If the financialcondition of our customers were to deteriorate, resulting in their inability tomake payments, a larger reserve might be required. If we determined that asmaller or larger reserve was appropriate, we would record a benefit or chargeto general and administrative expense in the period in which we made such adetermination.

*InventoryWrite-Downs.**  *Wealso continually make estimates relating to the net realizable value of ourinventories, based on our assumptions about future demand and marketconditions. If we estimate that the net realizable value of our inventory isless than the cost of the inventory recorded on our books, we record awrite-down equal to this difference. This write-down is recorded as a charge tocost of sales.

*Long-LivedAssets.**  *Long-livedassets, including furniture and fixtures, office equipment, plant equipment,leasehold improvements, computer hardware and software and certain intangibleassets, are recorded at cost and this cost is depreciated over the asset’sestimated useful life. We continually evaluate whether events and circumstanceshave occurred that indicate the remaining estimated useful life of long-livedassets and certain intangible assets may warrant revision or that the remainingbalance may not be recoverable. These factors may include a significantdeterioration of operating results, changes in business plans or changes inanticipated cash flow. When factors indicate that a long-lived asset or certainintangible property should be evaluated for possible impairment, we review theasset or property to assess recoverability from future operations using theundiscounted pre-tax future net cash flows expected to be generated by thatasset or property. Impairments are recognized in earnings to the extent thatthe carrying value exceeds fair value.

*IncomeTax.**  *Weestimate what our effective tax rate will be for the full year and record aquarterly income tax expense in accordance with the anticipated effectiveannual tax rate. As the year progresses, we continually refine our estimatebased upon actual events and income before income taxes by jurisdiction duringthe year. This process may result in a change to our expected effective taxrate for the year. When this occurs, we adjust the income tax expense duringthe quarter in which the change in estimate occurs so that the year-to-dateexpense equals the expected annual rate. Texas recently passed legislation 

36

----

overhauling its franchisetax law. As a result, effective January 1, 2007, we expect our effectivetax rate to increase by up to 0.5%.

*Stock-Based Compensation.**  *The Company accounts forstock-based compensation in accordance with SFAS No. 123(R), whichrequires the measurement of compensation cost based on the estimated fair valueof the award on the date of grant. That cost is recognized using the straight-linemethod over the period during which an employee is required to provide servicein exchange for the award—the requisite service period. No compensation cost isrecognized for equity instruments for which employees do not render therequisite service. The Company determines the grant-date fair value of employeestock options using the Black-Scholes option-pricing model. The amount ofcompensation expense recognized will depend upon numerous factors andestimates, including the number and vesting period of option grants, thepublicly traded price of our common stock, the estimated volatility of ourcommon stock price, estimates of the timing and volume of exercises andforfeitures of the options and fluctuations in future interest and income taxrates.

**Recent AccountingPronouncements**

In February 2006, the FASB issued StatementNo. 155, *Accounting for Certain HybridFinancial Instruments*, or “SFAS 155,” an amendment of FASB Statements No. 133 and 140.SFAS 155 establishes, among other things, the accounting for certainderivatives embedded in other financial instruments. This combination isreferred to as a hybrid financial instrument. SFAS 155 is effective forall financial instruments acquired, issued or subject to a remeasurement (newbasis) event occurring after the beginning of an entity’s first fiscal yearthat begins after September 15, 2006. We do not believe our adoption ofSFAS 155 will have a significant impact on our financial position, cashflow or results of operations.

In March 2006, the FASB issued StatementNo. 156, *Accounting for Servicing ofFinancial Assets*, or “SFAS 156,” an amendment of FASBStatements No. 140. SFAS 156 requires an entity to recognize aservicing asset or liability each time it undertakes an obligation to service afinancial asset by entering into a servicing contract in certain situations.SFAS 156 also requires all separately recognized servicing assets andservicing liabilities to be initially measured at fair value, if practicable,and to choose the subsequent measurement method. SFAS 156 is effective forus as of January 1, 2007. Early adoption is permitted as of the beginningof our fiscal year provided we have not yet issued financial statements,including interim financial statements, for any period of that fiscal year. Wedo not believe our adoption of SFAS 156 will have a significant impact onour financial position, cash flow or results of operations.

In July 2006, the FASB issued InterpretationNo. 48, *Accounting for Uncertainty inIncome Taxes*, or “FIN 48,” an interpretation of FASB StatementNo. 109. FIN 48 requires the use of a two-step approach forrecognizing and measuring tax benefits taken or expected to be taken in a taxreturn and disclosures regarding uncertainties in income tax positions. We arerequired to adopt FIN 48 effective January 1, 2007. The cumulativeeffect of initially adopting FIN 48 will be recorded as an adjustment toopening retained earnings in the year of adoption and will be presentedseparately. Only tax positions that meet the more likely than not recognitionthreshold at the effective date may be recognized upon adoption of FIN 48.We are currently evaluating the impact FIN 48 will have on our futureresults of operations and financial position.

In September 2006, the FASB issued StatementNo. 157, *Fair Value Measurements*,or “SFAS No. 157.” SFAS 157 clarifies the principle that fair valueshould be based on the assumptions that market participants would use whenpricing an asset or liability. Additionally, it establishes a fair valuehierarchy that prioritizes the information used to develop those assumptions.SFAS 157 is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007. We have not yet determined the impactthat the implementation of SFAS 157 will have on our results of operationsor financial condition.

37

----

In September 2006, the FASB issued StatementNo. 158, *Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans*, or “SFAS No. 158,” anamendment of FASB Statements No. 87, 88, 106 and 132(R). SFAS 158requires employers to recognize the underfunded or overfunded status of adefined benefit postretirement plan as an asset or liability in the employer’sstatement of financial position and to recognize changes in the funded statusin the year in which the changes occur through accumulated other comprehensiveincome. Additionally, SFAS 158 requires employers to measure the fundedstatus of a plan as of the date of the employer’s year-end statement of financialposition. The new reporting requirements and related new footnote disclosurerules of SFAS 158 are effective for fiscal years ending afterDecember 15, 2006. The new measurement date requirement applies for fiscalyears ending after December 15, 2008. The adoption of SFAS 158 will nothave a significant impact on our financial position, cash flow or results ofoperations.

In September 2006,the SEC issued Staff Accounting Bulletin No. 108, *Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements*, or “SAB 108.” SAB 108addresses quantifying the financial statement effects of misstatements,specifically, how the effects of prior year uncorrected errors must beconsidered in quantifying misstatements in the current year financialstatements. SAB 108 does not amend or change the SEC Staff’s previouspositions in Staff Accounting Bulletin No. 99, *Materiality*,regarding qualitative considerations in assessing the materiality ofmisstatements. SAB 108 is effective for fiscal years beginning afterNovember 15, 2006. We do not expect the adoption of SAB 108 to have amaterial impact on our consolidated financial position, results of operationsor cash flows.

***Item 7A.****                  Quantitativeand Qualitative Disclosures about Market Risk*

We have a $2.0 million revolving credit facilitywith JPMorgan Chase Bank, N.A. that will expire on June 30, 2007. As ofDecember 31, 2005 and 2006, there were no outstanding borrowings underthis facility. To the extent we borrow under our revolving credit facility,which bears interest at floating rates based either on the prime rate quoted byJPMorgan Chase Bank, N.A. or an adjusted LIBOR rate, we are exposed to marketrisk related to changes in interest rates. If applicable interest rates were toincrease by 100 basis points, for every $1.0 million outstanding under ourrevolving credit facility, our income before income taxes would be reduced byapproximately $10,000 per year. We are not party to any derivative financialinstruments.

We pay our independentsourcing agent and our independent distributors pay us in U.S. dollars. Becauseour independent manufacturers buy materials and pay for manufacturing expensesin their local currencies, to the extent the U.S. dollar weakens compared tosuch local currencies, our operating results may be adversely affected.Conversely, to the extent the U.S. dollar strengthens compared to localcurrencies in foreign markets where our products are sold, our products mayappear more expensive relative to local products.

***Item 8.****                          FinancialStatements and Supplementary Data*

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

***Item 9.****                          Changesin and Disagreements with Accountants on Accounting and Financial Disclosure*

None.

***Item 9A.****                  Controlsand Procedures*

This Annual Report on Form 10-K does notinclude a report of management’s assessment regarding internal control overfinancial reporting or an attestation report of our registered publicaccounting firm due to a transition period established by rules of the SECfor newly public companies.

38

----

As of December 31,2006, our management, including our Chief Executive Officer and Chief FinancialOfficer, performed an evaluation of the effectiveness of our disclosurecontrols and procedures, as such term is defined in Rule 13a-15(e) ofthe Securities Exchange Act of 1934. Based on this evaluation, our management,including our Chief Executive Officer and Chief Financial Officer, concludedthat as of December 31, 2006, our disclosure controls and procedures wereeffective as of December 31, 2006.

There has been no changein our internal control over financial reporting that occurred during thequarter ended December 31, 2006 that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

***Item 9B.      Other Information***

None.

**PART III**

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

Incorporated by referencefrom the information in our proxy statement for the 2007 Annual Meeting ofStockholders, which we will file with the SEC within 120 days of the endof the fiscal year to which this Report relates.

**Code of BusinessConduct and Ethics**

We have adopted a code ofbusiness conduct and ethics that applies to all of our officers, directors andemployees. Our code of business conduct and ethics is posted on our website at *www.heelys.com* and we will send a paper copy to anystockholder who submits a request in writing to our Secretary. If we make anysubstantive amendments to this code of conduct or if we grant any waivers froma provision of such code of conduct to any director or executive officer, wewill promptly disclose the nature of the amendment or waiver on our website atthe address provided above.

***Item 11.****                   ExecutiveCompensation*

Incorporated by referencefrom the information in our proxy statement for the 2007 Annual Meeting ofStockholders, which we will file with the SEC within 120 days of the endof the fiscal year to which this report relates.

***Item 12.****                   SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters*

Incorporated by referencefrom the information in our proxy statement for the 2007 Annual Meeting ofStockholders, which we will file with the SEC within 120 days of the endof the fiscal year to which this report relates.

***Item 13.****                   CertainRelationships and Related Transactions, and Director Independence*

Incorporated by referencefrom the information in our proxy statement for the 2007 Annual Meeting ofStockholders, which we will file with the SEC within 120 days of the endof the fiscal year to which this report relates.

***Item 14.****                   PrincipalAccounting Fees and Services*

Incorporated by reference from the information in ourproxy statement for the 2007 Annual Meeting of Stockholders, which we will filewith the SEC within 120 days of the end of the fiscal year to which thisreport relates.

39

----

**PART IV**

***Item 15.****                   Exhibitsand Financial Statement Schedules*

(a)(1)               *Financial Statements*

The following documents are filed as a part of thisreport:
| Report of Independent  Registered Public Accounting Firm                                                                                                   |   | F-2 |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----|
| Consolidated Balance  Sheets as of December 31, 2005 and December 31, 2006                                                                       |   | F-3 |
| Consolidated Statements  of Operations for the Years ended December 31, 2004, 2005 and 2006                                                           |   | F-4 |
| Consolidated Statements  of Stockholders’ Equity for the Years ended December 31, 2004, 2005 and  2006        |   | F-5 |
| Consolidated Statements  of Cash Flows for the Years ended December 31, 2004, 2005 and 2006                                                           |   | F-6 |
| Notes to Consolidated Financial Statements                                                                                                                 |   | F-7 |

 

(2)          *FinancialStatement Schedule*

Thefollowing financial statement schedule is filed herewith:
| Valuation and Qualifying  Accounts and Reserves |   | F-22 |
|-------------------------------------------------|--------|------|

 

(3)          *Exhibits*

(a) Thefollowing exhibits are incorporated by reference or filed herewith. Referencesto the Form S-1 are to the Registrant’s Registration Statement onForm S-1 (File No. 333-137046), filed with the Securitiesand Exchange Commission (SEC) on September 1, 2006. References toAmendment No. 1 to Form S-1 are to Amendment No. 1 to theForm S-1 filed with the SEC on October 4, 2006. References toAmendment No. 2 to Form S-1 are to Amendment No. 2 to theForm S-1 filed with the SEC on October 27, 2006. References toAmendment No. 3 to Form S-1 are to Amendment No. 3 to theForm 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).                                 |

40

----

 
| 10.4  |   | Credit Agreement, dated  August 20, 2004, as amended by an Amendment to Credit Agreement, dated  June 15, 2006, and an Amendment to Credit Agreement, dated  August 25, 2006, between Heeling Sports Limited and JPMorgan Chase Bank,  N.A. (incorporated by reference to Exhibit 10.4 to the Form S-1),  and Amendment to Credit Agreement, dated February 7, 2007 by and between  JPMorgan Chase Bank, N.A. and Heeling Sports Limited (incorporated by  reference to Exhibit 10.1 of the Current Report on Form 8-K filed  on February 13, 2007). |
|-------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.5  |   | 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).                                                                                                                                                                                                                                    |
| 10.6  |   | Stock Purchase  Agreement, dated as of April 28, 2006, by and between the Registrant and  Richard E. Middlekauff (incorporated by reference to Exhibit 10.7  to the Form S-1).                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.7  |   | Stock Purchase  Agreement, dated as of May 19, 2006, by and between the Registrant and  Roger R. Adams (incorporated by reference to Exhibit 10.8 to the  Form S-1).                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.8  |   | 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).                                                                                                                                                                                                                                                                                                                                                                          |
| 10.9  |   | Amended and Restated  Employment Agreement, dated as of September 18, 2006, between  Michael G. Staffaroni and Heeling Sports Limited (incorporated by  reference to Exhibit 10.10 to Amendment No. 2 to the Form S-1).*                                                                                                                                                                                                                                                                                                                                                 |
| 10.10 |   | 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).*                                                                                                                                                                                                                                                                                                                                                     |
| 10.11 |   | Amended and Restated  Employment Agreement, dated as of September 18, 2006, between  Charles D. Beery and Heeling Sports Limited (incorporated by reference  to Exhibit 10.12 to Amendment No. 2 to the Form S-1).*                                                                                                                                                                                                                                                                                                                                                      |
| 10.12 |   | Amended and Restated  Employment Agreement, dated as of November 16, 2006, between Roger R.  Adams and Heeling Sports Limited (incorporated by reference to  Exhibit 10.13 to Amendment No. 3 to the Form S-1).*                                                                                                                                                                                                                                                                                                                                                              |
| 10.13 |   | 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).*                                                                                                                                                                                                                                                                                                                                                                          |
| 10.14 |   | 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).                                                                                                                                                             |
| 10.15 |   | 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).*                                                                                                                                                                                                                                                                                                                                                                      |

41

----

 
| 10.16 |   | Heeling Sports Limited  2006 Bonus Plan (incorporated by reference to Exhibit 10.17 to the  Form S-1).*                                                                                                                                                                                                                                                                                                                                                                                                                |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.17 |   | 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).*                                                                                                                                                                                                                                                                                                                              |
| 10.18 |   | 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). |
| 10.19 |   | 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).                                                                                                                             |
| 10.20 |   | Stockholders Agreement,  dated as of May 24, 2000, between Roger R. Adams and Robert J.  Ward (incorporated by reference to Exhibit 10.21 to Amendment No. 2  to the Form S-1).                                                                                                                                                                                                                                                                                                                    |
| 10.21 |   | Agreement, dated  November 17, 2006, between Roger R. Adams and Robert J. Ward  (incorporated by reference to Exhibit 10.22 to Amendment No. 3 to  the Form S-1).                                                                                                                                                                                                                                                                                                                                       |
| 21.1  |   | List of subsidiaries of  the Registrant (incorporated by reference to Exhibit 21.1 to the  Form S-1).                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 23.1  |   | Consent of  Deloitte & Touche LLP, independent registered public accounting  firm.                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 31.1  |   | Certification pursuant  to Rule 13a-14(a) under the Securities Exchange Act of 1934 by Michael G.  Staffaroni, 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 Chief  Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section  1350.                                                                                                                                                                                                                                                                                                                                                                                                                       |

----

*                    Managementcontract or a compensatory plan or arrangement required to be filed as anExhibit pursuant to Item 15(b) of Form 10-K.

42

----

**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

|        | * *   | HEELYS, INC. |
|--------|------------|--------------|
|        |       | By:          |   | /s/ MICHAEL G.  STAFFARONI |
|   | ** ** | ** **   |   | **Michael G. Staffaroni** |
|   | * *   | * *     |   | *Chief Executive Officer* |

 

Date: March 15, 2007

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities and on the dates indicated. 

| Signature                                    | ** ** | **Title**                           | ** ** | **Date**             |
|----------------------------------------------|------------|-------------------------------------|------------|----------------------|
| /s/   MICHAEL  G. STAFFARONI  |       | Chief  Executive Officer, President |       | March 15,  2007 |
| and Director                                 |
| Michael G.  Staffaroni                       |       | (Principal  Executive Officer)      |       |                 |
| /s/   MICHAEL  W. HESSONG     |       | Chief  Financial Officer            |       | March 15, 2007  |
| Michael W.  Hessong                          |       | (Principal  Financial Officer)      |       |                 |
| /s/   PATRICK  F. HAMNER      |       | Chairman  of the Board              |       | March 15, 2007  |
| Patrick F. Hamner                            |       |                                |       |                 |
| /s/     SAMUEL B. LIGON       |       | Director                            |       | March 15, 2007  |
| Samuel B. Ligon                              |       |                                |       |                 |
| /s/   RICHARD  E. MIDDLEKAUFF |       | Director                            |       | March 15, 2007  |
| Richard E.  Middlekauff                      |       |                                |       |                 |
| /s/   JAMES  T. KINDLEY       |       | Director                            |       | March 15, 2007  |
| James T. Kindley                             |       |                                |       |                 |
| /s/   ROGER R. ADAMS          |       | Director                            |       | March 15, 2007  |
| Roger R. Adams                               |       |                                |       |                 |
| /s/   WILLIAM  R. THOMAS      |       | Director                            |       | March 15, 2007  |
| William R. Thomas                            |       |                                |       |                 |

 

43

----

**HEELYS, INC.INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

|                                                                                                                 | ** ** | **Page** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| Report of Independent Registered Public Accounting  Firm                                                        |       | F-2      |       |
| Consolidated Balance Sheets as of December 31,  2005 and 2006                                              |       | F-3      |       |
| Consolidated Statements of Operations for the Years  Ended December 31, 2004, 2005 and 2006                |       | F-4      |       |
| Consolidated Statements of Stockholders’ Equity for  the Years Ended December 31, 2004, 2005 and 2006 |       | F-5      |       |
| Consolidated Statements of Cash Flows for the Years  Ended December 31, 2004, 2005 and 2006                |       | F-6      |       |
| Notes to Consolidated Financial Statements                                                                      |       | F-7-F-21 |       |

 

F-1

----

**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and Stockholders ofHeelys, Inc.Carrollton, TX

We have audited the accompanying consolidated balancesheets of Heelys, Inc. and subsidiaries (the “Company”) as of December 31,2006 and 2005, and the related consolidated statements of operations,stockholders’ equity, and cash flows for each of the three years in the periodended December 31, 2006. Our audits also included the financial statementschedule listed in the Index at Item 15. These financial statements andfinancial statement schedule are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on the financialstatements and financial statement schedule based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor were we engaged toperform, an audit of its internal control over financial reporting. Our auditsincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statementspresent fairly, in all material respects, the financial position of Heelys, Inc.and subsidiaries as of December 31, 2006 and 2005, and the results oftheir operations and their cash flows for each of the three years in the periodended December 31, 2006, in conformity with accounting principlesgenerally accepted in the United States of America. Also, in our opinion, suchfinancial statement schedule, when considered in relation to the basicconsolidated financial statements taken as a whole, present fairly in allmaterial respects the information set forth therein.

/s/ Deloitte & Touche LLP

Dallas, TexasMarch 14, 2007

F-2

----

**HEELYS, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSAS OF DECEMBER 31, 2005 AND 2006(In thousands,except share data)**

| ** **                                                                                                                                                                                                      | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                      | ** ** | **2005**              | ** ** | **2006** | ** ** |
| **ASSETS**                                                                                                                                                                                                      |       |                  |       |   |   |
| CURRENT ASSETS:                                                                                                                                                                                                 |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                       |       | $                     | 738        |   | $ | 54,184 |   |
| Accounts receivable, net  of allowances of $704 and $1,959, respectively                                                                                                                                        |       | 8,286                 |       | 43,256 |   |
| Inventories                                                                                                                                                                                                     |       | 1,479                 |       | 6,057 |   |
| Deferred income tax  benefits                                                                                                                                                                                   |       | 235                   |       | 637 |   |
| Prepaid and other current  assets                                                                                                                                                                               |       | 300                   |       | 962 |   |
| Total current assets                                                                                                                                                                                            |       | 11,038                |       | 105,096 |   |
| PROPERTY AND EQUIPMENT,  net of accumulated depreciation of $760 and $907, respectively                                                                                                                         |       | 240                   |       | 393 |   |
| PATENTS AND TRADEMARKS,  net of accumulated amortization of $779 and $966, respectively                                                                                                                         |       | 534                   |       | 478 |   |
| DEFERRED INCOME TAX  BENEFITS                                                                                                                                                                                   |       | 178                   |       | 371 |   |
| TOTAL ASSETS                                                                                                                                                                                                    |       | $                     | 11,990     |   | $ | 106,338 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                  |       |                  |       |   |   |
| CURRENT LIABILITIES:                                                                                                                                                                                            |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                                                |       | $                     | 218        |   | $ | 1,304 |   |
| Commissions payable                                                                                                                                                                                             |       | 153                   |       | 626 |   |
| Accrued bonus                                                                                                                                                                                                   |       | 612                   |       | 824 |   |
| Accrued expenses                                                                                                                                                                                                |       | 1,508                 |       | 6,737 |   |
| Income taxes payable                                                                                                                                                                                            |       | 350                   |       | 2,866 |   |
| Debt                                                                                                                                                                                                            |       | 96                    |       | 211 |   |
| Total current liabilities                                                                                                                                                                                       |       | 2,937                 |       | 12,568 |   |
| COMMITMENTS AND  CONTINGENCIES (Note 9)                                                                                                                                                                         |       |                  |       |   |   |
| SERIES B CONVERTIBLE,  REDEEMABLE PREFERRED STOCK, $0.001 par value, 454,545 shares issued and  outstanding as of December 2005(1)                                                                         |       | 125                   |       | — |   |
| Total mezzanine financing                                                                                                                                                                                       |       | 125                   |       | — |   |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                                      |       |                  |       |   |   |
| Common stock, $0.001 par  value, 75,000,000 shares authorized; 13,988,875 shares issued and outstanding  as of December 31 2005 and 27,041,948 shares issued and outstanding as  of December 31, 2006 |       | 14                    |       | 27 |   |
| Additional paid-in  capital                                                                                                                                                                                     |       | 140                   |       | 59,795 |   |
| Retained earnings                                                                                                                                                                                               |       | 8,774                 |       | 33,948 |   |
| Total stockholders’  equity                                                                                                                                                                                |       | 8,928                 |       | 93,770 |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                 |       | $                     | 11,990     |   | $ | 106,338 |   |

----

(1)           Does not give effect to the 25-for-one stocksplit effected in October 2006 as discussed in Note 11.

See notes to consolidated financial statements.

F-3

----

**HEELYS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONSFOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006(In thousands, except per share data)**

| ** **                                        | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                        | ** ** | **2004**                                   | ** ** | **2005** | ** ** | **2006** | ** ** |
| NET SALES                                         |       | $                                          | 21,310     |   | $ | 43,950 |   | $ | 188,208 |   |
| COST OF SALES                                     |       | 14,529                                     |       | 28,951 |   | 122,565 |   |
| GROSS PROFIT                                      |       | 6,781                                      |       | 14,999 |   | 65,643 |   |
| SELLING, GENERAL AND  ADMINISTRATIVE EXPENSE      |       |                                       |       |   |   |   |   |
| Sales and marketing                               |       | 3,191                                      |       | 5,247 |   | 13,695 |   |
| General and administrative                        |       | 2,368                                      |       | 2,987 |   | 6,397 |   |
| Total selling, general and administrative expense |       | 5,559                                      |       | 8,234 |   | 20,092 |   |
| INCOME FROM  OPERATIONS                           |       | 1,222                                      |       | 6,765 |   | 45,551 |   |
| OTHER (INCOME) EXPENSE                            |       |                                       |       |   |   |   |   |
| Interest expense                                  |       | 11                                         |       | 51 |   | 744 |   |
| Interest income                                   |       | (3                                         | )          | (15 | ) | (221 | ) |
| Other (income) expense                            |       | (7                                         | )          | 95 |   | 66 |   |
| Total other expense                               |       | 1                                          |       | 131 |   | 589 |   |
| INCOME BEFORE INCOME TAXES                        |       | 1,221                                      |       | 6,634 |   | 44,962 |   |
| INCOME TAXES                                      |       | 418                                        |       | 2,287 |   | 15,788 |   |
| NET INCOME                                        |       | $                                          | 803        |   | $ | 4,347 |   | $ | 29,174 |   |
| EARNINGS PER  SHARE:                              |       |                                       |       |   |   |   |   |
| Basic                                             |       | $                                          | 0.06       |   | $ | 0.31 |   | $ | 1.50 |   |
| Diluted                                           |       | $                                          | 0.03       |   | $ | 0.17 |   | $ | 1.16 |   |
| WEIGHTED AVERAGE SHARES OUTSTANDING:              |       |                                       |       |   |   |   |   |
| Basic                                             |       | 13,989                                     |       | 13,989 |   | 19,479 |   |
| Diluted                                           |       | 25,353                                     |       | 25,353 |   | 25,114 |   |

** **

See notes to consolidated financial statements.

F-4

----

**HEELYS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITYFOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006(In thousands)**

| ** **                                                              | ** ** | **Common Stock** | ** ** | ** ** | ** ** | ** **                       | ** ** | ** **             | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------|------------|------------|------------|----------------------------------|------------|------------------------|------------|
| ** **                                                              | ** ** | **Shares**            | ** ** | **Amount** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Retained  Earnings** | ** ** | **Total  Stockholders’  Equity** | ** ** |
| BALANCE—December 31,  2003                                    |       | 13,989                |       |       | $          | 14                               |       |                   |       | $ | 140 |   |   | $ | 3,624 |   |   | $ | 3,778 |   |   |
| Net income                                                              |       | —                |       |       | —     |                             |       |                   | —     |   |   | 803 |   |   | 803 |   |   |
| BALANCE—December 31, 2004                                     |       | 13,989                |       |       | 14         |                             |       |                   | 140        |   |   | 4,427 |   |   | 4,581 |   |   |
| Net income                                                              |       | —                |       |       | —     |                             |       |                   | —     |   |   | 4,347 |   |   | 4,347 |   |   |
| BALANCE—December 31, 2005                                     |       | 13,989                |       |       | 14         |                             |       |                   | 140        |   |   | 8,774 |   |   | 8,928 |   |   |
| Purchase and retirement of treasury stock                               |       | (1,449                | )          |       | —     |                             |       |                   | —     |   |   | (4,000 | ) |   | (4,000 | ) |   |
| Conversion of Series B redeemable preferred  stock to common stock |       | 11,364                |       |       | 10         |                             |       |                   | 115        |   |   | — |   |   | 125 |   |   |
| Initial public offering                                                 |       | 3,125                 |       |       | 3          |                             |       |                   | 58,794     |   |   | — |   |   | 58,797 |   |   |
| Stock option exercises                                                  |       | 13                    |       |       | —     |                             |       |                   | 53         |   |   | — |   |   | 53 |   |   |
| Amortization of stock-based compensation expense                        |       | —                |       |       | —     |                             |       |                   | 576        |   |   | — |   |   | 576 |   |   |
| Income tax benefit on stock-based compensation  awards                  |       | —                |       |       | —     |                             |       |                   | 117        |   |   | — |   |   | 117 |   |   |
| Net income                                                              |       | —                |       |       | —     |                             |       |                   | —     |   |   | 29,174 |   |   | 29,174 |   |   |
| BALANCE—December 31,  2006                                    |       | 27,042                |       |       | $          | 27                               |       |                   |       | $ | 59,795 |   |   | $ | 33,948 |   |   | $ | 93,770 |   |   |

 

See notes to consolidated financial statements.

F-5

----

**HEELYS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSFOR THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006(In thousands)**
|                                                                                              | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2004**                                   | ** ** | **2005** | ** ** | **2006** | ** ** |
| **OPERATING ACTIVITIES:**                                                                    |       |                                       |       |   |   |   |   |
| Net income                                                                                   |       | $                                          | 803        |   | $ | 4,347 |   | $ | 29,174 |   |
| Adjustments to reconcile  net income to net cash provided by (used in) operating activities: |       |                                       |       |   |   |   |   |
| Depreciation and  amortization                                                               |       | 454                                        |       | 396 |   | 402 |   |
| Deferred income  tax benefits                                                                |       | (55                                        | )          | (161 | ) | (595 | ) |
| Stock-based  compensation expense                                                            |       | —                                     |       | — |   | 576 |   |
| Excess tax benefit  on stock-based compensation awards                                       |       | —                                     |       | — |   | (117 | ) |
| Loss on sale of  equipment                                                                   |       | —                                     |       | 9 |   | 1 |   |
| Changes in operating  assets and liabilities:                                                |       |                                       |       |   |   |   |   |
| Accounts  receivable                                                                         |       | (778                                       | )          | (5,767 | ) | (34,970 | ) |
| Inventory                                                                                    |       | 279                                        |       | (542 | ) | (4,578 | ) |
| Prepaid and other  current assets                                                            |       | 32                                         |       | (77 | ) | (644 | ) |
| Accounts payable                                                                             |       | (130                                       | )          | (9 | ) | 1,086 |   |
| Commissions  payable                                                                         |       | (56                                        | )          | 106 |   | 473 |   |
| Accrued bonus                                                                                |       | (9                                         | )          | 338 |   | 212 |   |
| Accrued expenses                                                                             |       | 56                                         |       | 1,172 |   | 4,167 |   |
| Income taxes  payable                                                                        |       | 115                                        |       | 209 |   | 2,633 |   |
| Net cash provided  by (used in) operating activities                                         |       | 711                                        |       | 21 |   | (2,180 | ) |
| **INVESTING ACTIVITIES:**                                                                    |       |                                       |       |   |   |   |   |
| Change in cash on  deposit held under line of credit                                         |       | 1,139                                      |       | — |   | — |   |
| Purchase of  equipment                                                                       |       | (84                                        | )          | (236 | ) | (310 | ) |
| Increase in  patents and trademarks                                                          |       | (209                                       | )          | (180 | ) | (195 | ) |
| Proceeds from sale  of equipment                                                             |       | 17                                         |       | — |   | — |   |
| Net cash provided  by (used in) investing activities                                         |       | 863                                        |       | (416 | ) | (505 | ) |
| **FINANCING ACTIVITIES:**                                                                    |       |                                       |       |   |   |   |   |
| Purchase of  treasury stock                                                                  |       | —                                     |       | — |   | (4,000 | ) |
| Redemption of  preferred stock                                                               |       | —                                     |       | (500 | ) | — |   |
| Borrowings on  revolving credit facility                                                     |       | —                                     |       | — |   | 23,829 |   |
| Principal payments  on revolving credit facility                                             |       | —                                     |       | — |   | (23,829 | ) |
| Proceeds from  issuance of short-term debt                                                   |       | 497                                        |       | 508 |   | 4,958 |   |
| Principal payments  on short-term debt                                                       |       | (504                                       | )          | (503 | ) | (4,838 | ) |
| Proceeds from  exercise of stock options                                                     |       | —                                     |       | — |   | 35 |   |
| Excess tax benefit  on stock-based compensation awards                                       |       | —                                     |       | — |   | 117 |   |
| Proceeds from  initial public offering, net of expenses                                      |       | —                                     |       | — |   | 59,859 |   |
| Net cash (used in)  provided by financing activities                                         |       | (7                                         | )          | (495 | ) | 56,131 |   |
| **NET  INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS**                                    |       | 1,567                                      |       | (890 | ) | 53,446 |   |
| **CASH AND  CASH EQUIVALENTS, beginning of period**                                          |       | 61                                         |       | 1,628 |   | 738 |   |
| **CASH AND  CASH EQUIVALENTS, end of period**                                                |       | $                                          | 1,628      |   | $ | 738 |   | $ | 54,184 |   |
| **SUPPLEMENTAL DISCLOSURES OF CASH FLOW  INFORMATION:**                                      |       |                                       |       |   |   |   |   |
| Cash paid during the  period for:                                                            |       |                                       |       |   |   |   |   |
| Interest                                                                                     |       | $                                          | 8          |   | $ | 48 |   | $ | 771 |   |
| Income taxes                                                                                 |       | $                                          | 357        |   | $ | 2,238 |   | $ | 13,750 |   |
| **SUPPLEMENTAL DISCLOSURE OF NON-CASH INFORMATION:**                                         |       |                                       |       |   |   |   |   |
| Conversion of  Series B redeemable preferred stock into common stock                    |       | $                                          | —     |   | $ | — |   | $ | 125 |   |
| Accrued costs  initial public offering                                                       |       | $                                          | —     |   | $ | — |   | $ | 1,062 |   |
| Receivable due  from stock option exercises                                                  |       | $                                          | —     |   | $ | — |   | $ | 18 |   |

 

See notes to consolidated financial statements.

F-6

----

**HEELYS, INC.AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1.**                 COMPANYBACKGROUND

Heelys, Inc. and subsidiaries (the “Company” or “Heelys”)is a designer, marketer and distributor of innovative, action sports-inspiredproducts under the HEELYS brand targeted to the youth market. The primaryproduct, HEELYS-wheeled footwear, is patented, dual-purpose footwear thatincorporates a stealth, removable wheel in the heel. HEELYS are distributedprimarily through retail stores in the United States and internationalwholesale distributors.

The Company initiallyincorporated as Heeling, Inc. in Nevada in 2000. The Company wasreincorporated 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 formedin May 2000.

**2.**                 SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES

***ConsolidatedFinancial Statements******—Consolidated***financialstatements include the accounts of Heelys, Inc. and its subsidiaries. Allintercompany balances and transactions are eliminated in consolidation.

***Use of Estimates******—The*** preparationof the consolidated financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect reported amounts ofcertain assets and liabilities and disclosure of contingent assets andliabilities at the date of the consolidated financial statements and thereported amounts of revenues and expenses for the period. Management’ssignificant estimates are as follows: allowances for doubtful accounts,inventory reserves, long-lived assets, income taxes, sales return allowance,legal reserves and the value of common stock options for the purpose ofdetermining stock-based compensation. Actual results could differ from theseestimates and are reported in the period they become known.

***Segment Reporting******—The*** Companyoperates in one segment although it sells different types of products in boththe domestic and international markets. The gross margin in these markets isconsistent and comparable. The Company does not create separate statements ofoperations for these products or markets.

***Cash Equivalents******—Cash*** equivalentsconsist of highly liquid investments with original maturity dates of threemonths or less when purchased.

***Concentration ofRisk******—The*** Company’scash and cash equivalents are maintained in one financial institution inamounts that typically exceed federally insured limits. The Company has notexperienced any losses in such accounts and believes it is not exposed tosignificant credit risk.

***Accounts Receivable******—Accounts***receivableare stated net of allowances for estimated customer returns, markdowns anddoubtful accounts of $704,000 and $1,959,000 at December 31, 2005 and 2006,respectively.

***Inventories******—Inventories***are stated at the lower of cost or market. Inventories are valued on a first-infirst-out (“FIFO”) basis. Inventory costs include inbound freight. All otherpurchasing and distribution costs associated with ending inventories areexpensed.

***Property andEquipment******—Property*** andequipment, such as leasehold improvements, furniture and fixtures, equipmentand product molds and designs, are stated at cost less accumulated depreciationand 

F-7

----

amortization. Depreciationand amortization are provided using the straight-line method over the lesser ofthe lease term or the estimated useful lives of the assets.

***Patents andTrademarks******—These*** intangiblesare stated at cost less accumulated amortization. Amortization is providedusing the straight-line method over the estimated useful lives of five years.These assets are amortized beginning when products incorporating theseintangibles are initially distributed or the patent or trademark application isgranted, whichever is earlier.

***Long-Lived Assets******—The***Companyreviews its long-lived assets and certain intangible assets for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. Recoverability of assets held and used isgenerally measured by a comparison of the carrying amount of an asset toundiscounted pretax future net cash flows expected to be generated by thatasset. An impairment loss is recognized if the estimated undiscounted futurecash flows are less than the carrying value of the related assets. There wereno impairments identified in the periods reported.

***Accrued Expenses******—Accrued***expensesinclude amounts accrued by the Company for expenses incurred but not yetrealized. Such expenses may include marketing, professional fees, propertytaxes, liability insurance premiums, interest expense, royalties, inventoryreceived but not invoiced and amounts received from customers or credits due tocustomers in excess of invoices they owe to the Company.

***Deferred IncomeTaxes******—Deferred***incometaxes are provided using the asset and liability method for temporarydifferences between the tax basis of an asset or liability and its reportedamount in the consolidated financial statements.

***Recognition ofRevenues******—Revenues*** arerecognized when merchandise is shipped, title passes to the customer, thecustomer assumes risk of loss, the collection of relevant receivables isprobable, persuasive evidence of an arrangement exists and the sales price isfixed or determinable. Title passes upon shipment or upon receipt by thecustomer depending on the agreement with the customer. The Company recordsreductions to revenue for estimated returns, including permitted returns ofdamaged or defective merchandise, and for all other allowances and markdowns,in accordance with Emerging Issues Task Force Issue 01-09, *Accounting for Consideration Given by a Vendor to a Customer or aReseller of the Vendor’s Product*, at the time of revenue recognition.Accordingly, the Company provided total allowances of $329,000, $733,000 and$3.4 million during 2004, 2005 and 2006, respectively.

***Advertising Costs******—Advertising***productioncosts are expensed the first time the advertisement is run. Media (TV andprint) placement costs are expensed in the month the advertising appears.Through cooperative advertising programs, the Company reimburses its retailcustomers for certain of their costs of advertising the Company’s products. TheCompany records these costs in selling and administrative expense at the pointin time when it is obligated to its customers for the costs, which is when therelated revenues are recognized. This obligation may arise prior to the relatedadvertisement being run. Total advertising and promotion expenses were$1.1 million, $1.6 million and $3.2 million during 2004, 2005and 2006, respectively. Prepaid advertising and promotion expenses recorded asappropriate in prepaid and deferred expenses totaled $62,000 and $87,000****at December 31, 2005 and 2006,respectively.

***Shipping andHandling Costs******—Shipping***andhandling costs are expensed as incurred and included in costs of sales. Shippingand handling costs were $589,000, $1.1 million and $5.4 million during 2004,2005 and 2006, respectively.

***Insurance******—The*** Company’sinsurance 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 estimatedliability is provided for current pending claims and estimated incurred-but-not-reportedclaims due to this retention risk. A liability for unpaid claims in the amountof $75,000 and $150,000 as of December 31, 2005 and 2006, respectively, isreflected in the balance sheet as an accrued expense.

F-8

----

***Net Income per Share******—Basic***netincome per common share is calculated by dividing net income for the period bythe weighted-average number of common shares outstanding during the period.Diluted net income per share reflects the effects of potentially dilutivesecurities, which consists of preferred stock and stock options. Areconciliation of the numerator and denominator used in the calculation ofbasic and diluted net income per share is as follows (in thousands):

| ** **                                                                                     | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2004**                                   | ** ** | **2005** | ** ** | **2006** | ** ** |
| Numerator—net  income applicable to common stockholders                                   |       | $                                          | 803        |   | $ | 4,347 |   | $ | 29,174 |   |
| Denominator:                                                                                   |       |                                       |       |   |   |   |   |
| Weighted average common stock outstanding for basic  earnings per share                        |       | 13,989                                     |       | 13,989 |   | 19,479 |   |
| Effect of  dilutive securities:                                                                |       |                                       |       |   |   |   |   |
| Stock options                                                                                  |       | —                                     |       | — |   | 574 |   |
| Preferred stock                                                                                |       | 11,364                                     |       | 11,364 |   | 5,061 |   |
| Adjusted weighted  average common stock and assumed conversions for diluted earnings per share |       | 25,353                                     |       | 25,353 |   | 25,114 |   |
|                                                                                                |            |                                            |            |  |  |  |  |  |  |  |

 

Potentially dilutive securities that are not includedin the diluted net income per share calculation because they would beantidilutive were employee stock options of 57,500 as of December 31, 2006.

***Fair Value ofFinancial Instruments******—Management***estimatesthat, as of December 31, 2005 and 2006, the fair value of cash and cashequivalents, receivables, accounts payable and accrued expenses are carried atamounts that reasonably approximate their fair value.

***Other ComprehensiveIncome******—The*** Companyhas no components of comprehensive income other than net income.

***Recent AccountingPronouncements******—In*** February 2006,the FASB issued Statement No. 155, *Accountingfor Certain Hybrid Financial Instruments,* an amendment of FASBStatements No. 133 and 140, (“SFAS 155”). SFAS 155 establishes,among other things, the accounting for certain derivatives embedded in otherfinancial instruments. This combination is referred to as a hybrid financialinstrument. SFAS 155 is effective for all financial instruments acquired,issued or subject to a remeasurement (new basis) event occurring after thebeginning of an entity’s first fiscal year that begins after September 15,2006. The Company does not believe the adoption of SFAS 155 will have asignificant impact on the Company’s financial position, cash flows or resultsof operations.

In March 2006, the FASB issued Statement No. 156,*Accounting for Servicing of FinancialAssets,* an amendment of FASB Statements No. 140, (“SFAS 156”).SFAS 156 requires an entity to recognize a servicing asset or liabilityeach time it undertakes an obligation to service a financial asset by enteringinto a servicing contract in certain situations. SFAS 156 also requiresall separately recognized servicing assets and servicing liabilities to beinitially measured at fair value, if practicable, and to choose the subsequentmeasurement method. SFAS 156 is effective for the Company as of thebeginning of its fiscal year that begins after September 15, 2006. Earlieradoption is permitted as of the beginning of the Company’s fiscal year,provided it has not yet issued financial statements, including interim financialstatements, for any period of that fiscal year. The Company does not believethe adoption of SFAS 156 will have a significant impact on the Company’sfinancial position, cash flows or results of operations.

In July 2006, the FASB issued Interpretation No. 48,*Accounting for Uncertainty in Income Taxes*, an interpretation of FASB StatementNo. 109, (“FIN 48”). FIN 48 requires the use of atwo-step approach for recognizing and measuring tax benefits taken or expectedto be taken in a tax return and disclosures regarding uncertainties in incometax positions. The Company is required to adopt FIN 48 effective 

F-9

----

January 1, 2007. Thecumulative effect of initially adopting FIN 48 will be recorded as anadjustment to opening retained earnings in the year of adoption and will bepresented separately. Only tax positions that meet the more likely than notrecognition threshold at the effective date may be recognized upon adoption ofFIN 48. The Company is currently evaluating the impact FIN 48 will have onits future results of operations and financial position.

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 theassumptions that market participants would use when pricing an asset orliability. Additionally, it establishes a fair value hierarchy that prioritizesthe information used to develop those assumptions. SFAS 157 is effectivefor financial statements issued for fiscal years beginning after November 15,2007. The Company has not yet determined the impact that the implementation ofSFAS 157 will have on its results of operations or financial condition.

In September 2006, the FASB issued Statement No. 158,*Employers’ Accounting for Defined Benefit Pensionand Other Postretirement Plans*, an amendment of FASB Statements No. 87,88, 106 and 132(R), (“SFAS 158”). SFAS 158 requires employers torecognize the underfunded or overfunded status of a defined benefitpostretirement plan as an asset or liability in the employer’s statement offinancial position and to recognize changes in the funded status in the year inwhich the changes occur through accumulated other comprehensive income.Additionally, SFAS 158 requires employers to measure the funded status ofa plan as of the date of the employer’s year-end statement of financialposition. The new reporting requirements and related new footnote disclosure rules ofSFAS 158 are effective for fiscal years ending after December 15,2006. The new measurement date requirement applies for fiscal years endingafter December 15, 2008. The adoption of SFAS 158 will not have asignificant impact on the Company’s financial position, cash flows or resultsof operations.

In September 2006, the SEC issued StaffAccounting Bulletin No. 108, *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements*, (“SAB 108”). SAB 108 addressesquantifying the financial statement effects of misstatements, specifically, howthe effects of prior year uncorrected errors must be considered in quantifyingmisstatements in the current year financial statements. SAB 108 does notamend or change the SEC Staff’s previous positions in Staff Accounting BulletinNo. 99, *Materiality*, regarding qualitativeconsiderations in assessing the materiality of misstatements. SAB 108 iseffective for fiscal years beginning after November 15, 2006. The Companydoes not expect the adoption of SAB 108 to have a material impact on itsconsolidated financial position, results of operations or cash flows.

**3.**                 INITIALPUBLIC OFFERING AND USE OF PROCEEDS

On December 13, 2006,the Company completed an initial public offering of its common stock. TheCompany sold a total of 3,125,000 shares of the Company’s common stock andselling stockholders sold 4,263,750 shares of the Company’s common stock, whichincluded 963,750 shares resulting from the exercise of the underwriters’over-allotment option. All common stock registered under the registrationstatement were sold at a price to the public of $21.00 per share. The Companydid not receive any proceeds from the selling stockholders’ sale of theirshares. 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, afterdeducting an aggregate of $4.6 million in underwriting discounts andcommissions. The Company incurred other direct expenses of $2.2 million inconnection with the offering. As of December 31, 2006 the Company had paid$1.1 million of these other direct expenses. Unpaid other direct expenses inthe amount of $1.1 million is included in accrued expenses at December 31,2006.

F-10

----

The Company used $8.5million of the proceeds to repay amounts outstanding under the revolving creditfacility and $8.5 million was used for working capital purposes.  The Company intends to use the remainingproceeds to fund infrastructure improvements, including expanding and upgradingthe Company’s information technology systems; hire new employees; for marketingand advertising programs; product development; working capital needs; and othergeneral corporate purposes.

**4.**                 SIGNIFICANTCUSTOMERS

Customersof the Company consist principally of domestic retail stores and internationalindependent distributors. The customers, individually or considered as a groupunder common ownership, which accounted for greater than 10% of accountsreceivable or 10% of net sales during the periods reflected were as follows:

| ** ** | ** ** | **Accounts Receivable** | ** ** | **Net Sales**                          | ** ** |
|------------|------------|------------------------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **December 31,**        | ** ** | **Years Ended December 31,** | ** ** |
| ** ** | ** ** | **2005**                     | ** ** | **2006**                                    | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
| Customer A |       |                         | 2          | %                                           |       |   | 13 | % |   |   | 7 | % |   |   | 11 | % |   |   | 13 | % |   |
| Customer B |       |                         | —     |                                        |       |   | — |   |   |   | 19 |   |   |   | 3 |   |   |   | — |   |   |
| Customer C |       |                         | 24         |                                        |       |   | 6 |   |   |   | 16 |   |   |   | 12 |   |   |   | 5 |   |   |
| Customer D |       |                         | 16         |                                        |       |   | 7 |   |   |   | 6 |   |   |   | 8 |   |   |   | 4 |   |   |
| Customer E |       |                         | 14         |                                        |       |   | 15 |   |   |   | 5 |   |   |   | 11 |   |   |   | 9 |   |   |

 

**5.**                 PROPERTYAND EQUIPMENT

Propertyand equipment included the following (in thousands):
| ** **                                      | ** ** | **Lesser of terms of  lease or estimated  useful lives** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|-----------------------|------------|
| **2005**                                        | ** ** | **2006**                                                                               |
| Leasehold improvements                          |       |                                                                                   | 1-10 years |                  |       | $ | 45 |   | $ | 49 |   |
| Furniture and fixtures                          |       |                                                                                   | 7 years    |                  |       | 56 |   | 71 |   |
| Computer equipment                              |       |                                                                                   | 5 years    |                  |       | 163 |   | 256 |   |
| Equipment                                       |       |                                                                                   | 5 years    |                  |       | 61 |   | 107 |   |
| Product molds and  designs                      |       |                                                                                   | 2 years    |                  |       | 675 |   | 817 |   |
| Total                                           |       |                                                                                   |       |                  |       | 1,000 |   | 1,300 |   |
| Less accumulated  depreciation and amortization |       |                                                                                   |       |                  |       | (760 | ) | (907 | ) |
| Property and equipment—net                 |       |                                                                                   |       |                  |       | $ | 240 |   | $ | 393 |   |

 

Depreciation expenserelated to property and equipment was $159,000, $134,000, and $151,000 in 2004,2005 and 2006, respectively.

F-11

----

**6.**                 PATENTSAND TRADEMARKS

Patentsand trademarks included the following (in thousands):
| ** **                      | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **2005**              | ** ** | **2006** | ** ** |
| Patents                         |       | $                     | 834        |   | $ | 857 |   |
| Trademarks                      |       | 101                   |       | 120 |   |
| Other                           |       | —                |       | 25 |   |
| Total patents and  trademarks   |       | 935                   |       | 1,002 |   |
| Less accumulated  amortization: |       |                  |       |   |   |
| Patents                         |       | 597                   |       | 707 |   |
| Trademarks                      |       | 68                    |       | 85 |   |
| Other                           |       | —                |       | 5 |   |
| Total accumulated  amortization |       | (665                  | )          | (797 | ) |
| Patents in progress             |       | 250                   |       | 249 |   |
| Trademarks in progress          |       | 14                    |       | 24 |   |
| Patents and trademarks—net |       | $                     | 534        |   | $ | 478 |   |

 

Amortization expenserelated to patents and trademarks was $295,000, $262,000 and $251,000****in 2004, 2005 and 2006, respectively. Theamortization amounts include write-offs of $37,000, $27,000 and $13,000 in2004, 2005 and 2006, respectively, for patents that were evaluated as having nofuture benefits. Amortization expense from 2007 through 2011 is expected to be$175,000, $105,000, $66,000, $38,000 and $13,000, respectively.

In September 2002,the Company entered into an Intellectual Property Exclusive License Agreement(the “License Agreement”), which granted the Company an exclusive worldwidelicense to use various marks, trademarks, URLs, patents and patent applicationsrelated to the technology used in the Company’s grind-and-roll HEELYS-wheeledfootwear (collectively, the “Intellectual Property”). In January 2006, theCompany converted the License Agreement into an Intellectual Property PurchaseAgreement (the “Purchase Agreement”). Upon the conversion, the Company paid anon-compete fee of $25,000, which is included in other intangible assets and isbeing amortized over five years, and became subject to a minimum royaltypayment of $10,000 per month through January 2007.

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

Royalty payments of 12% ofthe Company’s cost of certain products, $1.00 per footwear unit for certainstyles and 25% of any sublicense revenue of any non-footwear products, apparel,accessories, or similar products that would infringe the trademarks for suchproducts absent the Company’s agreements with respect to such trademarks areexpensed as incurred under the License Agreement. This royalty expense was$143,000, $179,000 and $299,000 in 2004, 2005 and 2006, respectively.

The Company iscontingently obligated to maintain and/or prosecute, if considered necessary,the Intellectual Property under both the License Agreement and the PurchaseAgreement until the total payments under the License Agreement and PurchaseAgreement exceed $650,000. The licensor has the 

F-12

----

optionto reacquire the Intellectual Property for certain fixed prices if the minimumroyalty payments are not made throughout the term of the Purchase Agreement.

**7.**                 ACCRUEDEXPENSES

Accruedexpenses consisted of the following (in thousands):
| ** **                           | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **2005**              | ** ** | **2006** | ** ** |
| Inventory received but  not invoiced |       | $                     | 51         |   | $ | — |   |
| Marketing costs                      |       | 650                   |       | 672 |   |
| Customer prepayments                 |       | 339                   |       | 3,266 |   |
| Liability insurance                  |       | 81                    |       | 785 |   |
| Professional fees                    |       | 175                   |       | 229 |   |
| Costs initial public  offering       |       | —                |       | 1,062 |   |
| Other                                |       | 212                   |       | 723 |   |
| Total accrued expenses               |       | $                     | 1,508      |   | $ | 6,737 |   |

 

Included in accruedexpenses are $1.1 million of costs incurred in connection with the Company’sinitial public offering which closed on December 13, 2006. These costshave been offset against the proceeds of the initial public offering resultingin a decrease in the amount of additional paid-in capital recognized.

**8.**                 DEBT

***Revolving Credit Facility******—At***December 31,2005, the Company had an aggregate $3,000,000 revolving credit facility (the “FinancingAgreement”). Borrowings were subject to certain limitations, primarily basedupon 85% of eligible accounts receivable and 50% of eligible inventory. The 50%of eligible inventory calculation was limited to $1,500,000. During 2005, theCompany had total borrowings of $7,500,000 and total payments of $7,500,000related to this facility. There were no outstanding borrowings at December 31,2005. In August 2006, the Company amended the Financing Agreement,increasing the maximum amount available to $25.0 million. This maximum amountdecreased to $10.0 million on January 1, 2007.  On February 7, 2007, the Company amendedthe Financing Agreement to (a) decrease the maximum amount available to$2.0 million, (b) eliminate the 0.25% non-usage fee and (c) eliminateother terms, including terms requiring the Company to provide monthly reportsregarding the Company’s inventory and accounts receivable. The facility willexpire in June 2007. Borrowings are subject to certain limitations,primarily based upon 85% of eligible accounts receivable and 50% of eligibleinventory not to exceed the amount advanced on eligible accounts receivable.Indebtedness under the Financing Agreement bears interest at a floating rate ofinterest based on either the prime rate quoted by JPMorgan Chase Bank, N.A. oran adjusted LIBOR rate. At December 20, 2006, the applicable interest rateunder the Financing Agreement was 8.0% per annum. During 2006, the Company hadtotal borrowings of $23.8 million and total payments of $23.8 million relatedto this facility. There were no outstanding borrowings at December 31,2006.

Accounts receivable andinventory are pledged as collateral under the Financing Agreement. The Companyis subject to compliance with certain covenants under the Financing Agreement, includingminimum levels of net worth and minimum interest coverage ratios. The Companyis not permitted under the Financing Agreement to pay dividends or makedistributions.

***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 publicoffering. This note was secured by the same collateral as the revolving creditfacility. The Company 

F-13

----

borrowed $4.0 millionunder this note to repurchase 1,448,625 shares of the common stock owned by twostockholders. The note was repaid in October 2006 and canceled.

***Other Debt******—Other***debtat December 31, 2005 and 2006 consisted of the following (in thousands):
| ** **                                                          | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                          | ** ** | **2005**              | ** ** | **2006** | ** ** |
| Promissory note, bearing  interest at 5.55%, due March 2006    |       | $                     | 96         |   | $ | — |   |
| Promissory note, bearing  interest at 6.29%, due February 2007 |       | —                |       | 211 |   |
| Total                                                               |       | 96                    |       | 211 |   |
| Less current portion                                                |       | (96                   | )          | (211 | ) |
| Long-term portion                                                   |       | $                     | —     |   | $ | — |   |

 

***Promissory Notes******—******During*** 2005and 2006, the Company signed agreements with commercial finance companies tofinance the payment of its commercial general liability and umbrella premiums.Each agreement provided for an initial payment of a portion of the premium,with the remaining principal balance plus interest to be paid in monthlyinstallments. Interest accrued at 5.55% on the unpaid balance of $96,000 at December 31,2005. Interest accrued at 6.29% on the unpaid balance of $211,000 at December 31,2006. Prepaid premiums from the insurance policies financed are pledged ascollateral under the promissory notes.

**9.**                 COMMITMENTSAND CONTINGENCIES

***Leases******—During***2004and January 2005, the Company sublet its warehouse and office facilities,pursuant to a month-to-month operating sublease, from a related party (seeNote 13). Effective February 1, 2005, the Company entered into a newoperating lease whereby the Company leases office space for 10 years withrenewal options. On February 27, 2006, the Company signed an amendment toits lease for additional warehouse space for the duration of the lease term. TheCompany also leases certain equipment under a cancelable operating lease.

Futureminimum rental payments under the lease are as follows (in thousands):
| **Years Ending  December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------|------------|------------|------------|------------|------------|
| 2007                                     |       | $          | 189        |       |
| 2008                                     |       | 189        |       |
| 2009                                     |       | 189        |       |
| 2010                                     |       | 197        |       |
| 2011                                     |       | 209        |       |
| Thereafter                               |       | 768        |       |
|                                     |       | $          | 1,741      |       |

 

Rent expense was $129,000,$162,000 and $227,000 for 2004, 2005 and 2006, respectively.

***EmploymentArrangement******—All*****of the personnel of the Company are contractually employeesof a Professional Employer Organization (“PEO”). The PEO incurs payroll,payroll tax and payroll-related benefit costs. The Company reimburses thesecosts plus an administrative fee. With respect to these payroll-relatedbenefits, the personnel of the Company are pooled with other employees of thePEO.

***Legal Proceedings******—The***Companyis involved in certain legal proceedings arising in the ordinary course ofbusiness, none of which the Company’s management believes will have a materialadverse effect on the Company’s financial position, cash flows or results ofoperations.

F-14

----

**10.**          INCOMETAXES

Componentsof income taxes were as follows (in thousands):

| ** **           | ** ** | **December 31,** | ** ** |
|----------------------|------------|-----------------------|------------|
| ** **           | ** ** | **2004**              | ** ** | **2005** | ** ** | **2006** | ** ** |
| Current tax  expense |       | $                     | 473        |   | $ | 2,447 |   | $ | 16,383 |   |
| Deferred             |       | (55                   | )          | (160 | ) | (595 | ) |
|                 |       | $                     | 418        |   | $ | 2,287 |   | $ | 15,788 |   |

 

Areconciliation of income tax computed at the U.S. federal statutory income taxrate of 34% for 2004 and 2005 and 35% for 2006 to the provision for incometaxes is as follows (in thousands):

| ** **                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2004**              | ** ** | **2005** | ** ** | **2006** | ** ** |
| Tax at statutory  rate                    |       | $                     | 415        |   | $ | 2,256 |   | $ | 15,758 |   |
| Expenses not  deductible for tax purposes |       | 3                     |       | 4 |   | 68 |   |
| Other                                     |       | —                |       | 27 |   | (38 | ) |
| Income taxes                              |       | $                     | 418        |   | $ | 2,287 |   | $ | 15,788 |   |

 

Deferred income taxesreflect the tax effects of temporary differences between the carrying amount ofassets and liabilities for financial reporting purposes and the amount used forincome tax purposes. The tax effects of significant items included in theCompany’s net deferred tax benefits at December 31, 2005 and 2006 were asfollows (in thousands):

| ** **                                           | ** ** | **December 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **2005**              | ** ** | **2006** | ** ** |
| Current tax assets  (liabilities):                   |       |                  |       |   |   |
| Allowances for  receivables not currently deductible |       | $                     | 240        |   | $ | 686 |   |
| Allowances for  inventory not currently deductible   |       | 43                    |       | 65 |   |
| Prepaid expenses  currently deductible               |       | (79                   | )          | (272 | ) |
| Accrued expenses  not currently deductible           |       | 31                    |       | 158 |   |
| Net current  deferred tax benefits                   |       | 235                   |       | 637 |   |
| Long-term tax assets:                                |       |                  |       |   |   |
| Accumulated  depreciation and amortization           |       | 178                   |       | 241 |   |
| Stock-based  compensation                            |       | —                |       | 130 |   |
| Net long-term  deferred tax benefits                 |       | 178                   |       | 371 |   |
| Total deferred tax  benefits                         |       | $                     | 413        |   | $ | 1,008 |   |

 

The Company assesses therealization of its deferred tax assets to determine whether an income taxvaluation allowance is required. Based on all available evidence, both positiveand negative, and the weight of that evidence to the extent such evidence canbe objectively verified, the Company determined it is more likely than not thedeferred tax assets will be realized.

**11.**          STOCKHOLDERS’EQUITY

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

F-15

----

In April 2006, the Company purchased724,325 shares of Company common stock owned by one of the Company’sdirectors 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 theCompany’s founder for a purchase price of $2.0 million, or $2.76 per share.  The excess of the purchase cost over the parvalue has been charged to retained earnings.

In October 2006, the Company effected a 25-for-onestock split. All common share and per common share amounts in theseconsolidated financial statements have been retroactively adjusted (unlessotherwise stated) for all periods presented to give effect to the stocksplit. The Series B Preferred stock shares issued and outstanding asof December 31, 2005, as reported in the consolidated balance sheet, doesnot give effect to the 25-for-one stock split.

On December 13, 2006, the Company closed aninitial public offering of its common stock consisting of 7,388,750 shares ofcommon stock. Of these shares, 3,125,000 were newly issued shares sold by theCompany and 4,263,750 were existing shares sold by the selling stockholders,including 963,750 shares pursuant to an exercise by the underwriters of theirover-allotment option. The public offering price was $21.00 per share. Thegross 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 anaggregate of $4.6 million in underwriting discounts and commissions. TheCompany incurred other direct expenses of $2.2 million in connection with theoffering. As of December 31, 2006, the Company had paid $1.1 million ofthese other direct expenses. Unpaid other direct expenses in the amount of $1.1million is included in accrued expenses at December 31, 2006. The Companydid not receive any of the proceeds from the sale of shares by sellingstockholders or on any exercise of the underwriters’ over-allotment option.

***Long-Term IncentivePlan—******An*** aggregateof 2,625,000 shares of common stock was reserved for issuance pursuant to the2001 Long-Term Incentive Plan (the “2001 Plan”), adopted in February 2001.Under the terms of the 2001 Plan, incentive and nonqualified options topurchase common stock and restricted stock awards were permitted to be grantedto employees, consultants and nonemployee directors of the Company at thediscretion of the compensation committee of the Company’s board of directors,subject to certain restrictions.

Under the 2001 Plan, theCompany sold 2,625,000 shares of restricted common stock to employees, officersand a consultant of the Company, during February 2001, in exchange for$28,875 or $0.011 per share, the estimated fair value at the time of grant.Forfeiture and restriction provisions of the shares lapsed evenly at thefollowing three anniversaries of the date of grant. As of December 31,2004 all restrictions had lapsed.

**12.**          REDEEMABLECONVERTIBLE PREFERRED SHARES

***Preferred Stock******—The***Companyhad authorized an aggregate 3,000,000 shares of $0.001 par value Series Aand B Preferred Stock. In May 2000, the Company sold preferred stock anddebentures pursuant to an investment agreement between the preferredstockholders and the Company (the “Investment Agreement”). The Company sold1,818,182 shares of Series A Preferred Stock for $500,000, and 454,545shares of Series B Preferred Stock for $125,000, or in each case $0.275per share, the estimated fair value of the shares at the date of purchase (notgiving effect to the 25-for-one stock split effected in October 2006).

The Company was subject to compliance with certaincovenants included in the Investment Agreement, including restricting theCompany from paying any dividends or distributions and issuing additionalshares, except for those restricted common shares issued in February 2001.Concurrent with the execution of the Investment Agreement, the preferredstockholders and the Company executed a registration rights agreement. After May 2001,the Series B Preferred Stockholders could request a 

F-16

----

demand registration upon agreater than 50% vote. This demand registration would cause the Company toperform all conversions, redemptions and payments associated with a qualifiedpublic offering.

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

The Series A Preferred Stock was nonconvertibleand redeemable. The Company could redeem the shares at any time with 30-days’notice, and the shares were mandatorily redeemable upon the completion of aqualified public offering. The stockholders could require the Company to redeemthe shares beginning May 31, 2007. The redemption price and liquidationpreference were $0.275 per share, plus all accrued and unpaid dividends. Acumulative 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 dividendrate was to increase to $0.033 per annum on May 31, 2007. The Series APreferred Stock was redeemed by the Company on May 31, 2005 for $500,000.Dividends had not begun accumulating; therefore the shares were redeemed forthe original purchase price of $500,000.

The Series BPreferred Stock was convertible and redeemable. One share of Series BPreferred Stock was convertible into one share of common stock at the option ofthe stockholder at $0.275 per share (not giving effect to the 25-for-onestock split effected in October 2006). All shares of Series BPreferred Stock would have automatically been converted into shares of commonstock if the Company completed a qualified public offering, completed a sale ofsubstantially all of its assets or were to have undergone a change in controlor a merger. The stockholders could have required the Company to redeem theshares beginning May 31, 2007. The redemption price was the greater ofestimated 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 Stockwere converted into common stock, prior to giving effect to the 25-for-onestock split effected in October 2006.

**13.**          RELATED-PARTYTRANSACTIONS

During 2004 and January 2005, the Company subletits warehouse and office facilities from a related company (see Note 9). Adirector and minority owner of the lessor is a stockholder and director of theCompany. The Company expensed $141,000 and $14,000 during 2004 and 2005,respectively, for rent, warehouse management and labor and reimbursement ofutilities provided by this related company.

The Company’s patent attorney is also a stockholder ofthe Company. The Company capitalized and expensed a total of $242,000, $190,000and $498,000 included in patents and trademarks and general and administrativeexpenses, during 2004, 2005 and 2006, respectively, for costs incurred. Additionally,this patent attorney’s law firm provides general corporate legal counsel to theCompany. The Company expensed a total of $0, $24,000 and $135,000****for these services during 2004,2005 and 2006, respectively. This expense is included in general andadministrative expense. In connection with the Company’s initial publicoffering 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 theproceeds of the initial public offering. The Company owed $61,000 and $523,000to this law firm as of December 31, 2005 and 2006, respectively.

In April 2006, the Company purchased724,325 shares of Company common stock owned by one of the Company’sdirectors for a purchase price of $2,000,006, or approximately $2.76 per share.

F-17

----

In May 2006, theCompany purchased 724,300 shares of Company common stock owned by theCompany’s founder for a purchase price of $1,999,937, or approximately $2.76per share. Simultaneously with this sale and purchase, the Company’s founderalso sold to the Company’s Chairman of the Board 362,150 shares of Companycommon stock owned by the founder for a purchase price of $999,969, orapproximately $2.76 per share.

**14.**          OTHEREMPLOYEE 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 areimmediately eligible to enroll in the 401(k) Plan. The Company makesdiscretionary nonelective contributions to the 401(k) plan. The Companyexpensed contributions of $36,000, $73,000 and $105,000****during 2004, 2005 and 2006, respectively,related to discretionary contributions.

**15.**          STOCK-BASEDCOMPENSATION

In June 2006, the Company adopted the 2006 StockIncentive Plan (the “2006 Plan”). The 2006 Plan replaced the 2001 Plan (seeNote 11). Awards are generally granted with an exercise price equal to themarket price of the Company’s stock at the date of grant, generally vest basedover four years of continuous service and have a 10-year contractuallife.

The Company has reserved 2,272,725 shares of commonstock subject to the 2006 Plan and as of December 31, 2006 had 45,225shares remaining available that may be granted to employees, consultants andnonemployee directors of the Company in the future. The 2006 Plan isadministered by the compensation committee of the Company’s board of directors,which selects the persons to whom options will be granted, determines thenumber of shares to be subject to each grant, and prescribes the other termsand conditions of each grant, including the type of consideration to be paid tothe Company upon exercise and the vesting schedule. If a change of control ofthe Company, as defined by the 2006 Plan, occurs, all of the options issued andoutstanding under the 2006 Plan will accelerate and become fully vested andexercisable.

In June 2006, the Company granted 711,800incentive and 1,330,700 nonqualified stock options at an exercise price of$4.05 per share, which was the fair value at the grant date. The optionsgranted in June 2006 are subject to a 48-month vesting period with acontractual term of ten years.

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

The Company accounts for stock-based compensation inaccordance with SFAS No. 123(R), which requires the measurement ofcompensation cost based on the estimated fair value of the award on the date ofgrant. That cost is recognized using the straight-line method over the periodduring which an employee is required to provide service in exchange for theaward—the requisite service period. No compensation cost is recognized forequity instruments for which employees do not render the requisite service. TheCompany determines the grant-date fair value of employee stock options usingthe Black-Scholes option-pricing model.

*FairValue June 2006 Grants—*For the June 2006grants the Company determined the fair value of its common stock and engaged anindependent third party appraiser to perform a contemporaneous valuation of theCompany’s common stock as of June 23, 2006, the date of grant of the June 2006options. Utilizing the methodologies and procedures set forth in the AICPAPractice Aid for the Valuation of Privately-Held Company Equity SecuritiesIssued as Compensation, the independent appraiser determined the value of 

F-18

----

the Company’s common stockbased upon a number of significant factors, assumptions and methodologies.These factors included recent sales and negotiations for sales of the Company’scommon stock, the timing of such transactions, the Company’s discounted valueof estimated future cash flows, valuations of comparable companies andtransactions and the Company’s expected value as a public company. Theindependent appraiser correlated the value indications derived from the variousmethodologies to a single value by “weighting” each value indication, applied alack of marketability discount and further decreased the value per share by thedilution to the value that would be realized by a Company stockholder by virtueof the June 2006 option issuances. Between June 23, 2006 and the dateof the Company’s initial public offering, several events occurred that theCompany believed contributed to the increase in the fair value of the Company’scommon stock. These events included, among others, the Company’s increasedearnings and the Company’s ability to exceed internally projected sales targetsafter July 2006.

The Company estimated the volatility of its commonstock at the date of grant based on the historical volatility of comparablepublic companies.

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

Expected life was calculated using the simplifiedmethod as prescribed by the Securities and Exchange Commission’s StaffAccounting Bulletin No. 107. This decision was based on the lack of relevanthistorical data.

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

| Expected  volatility     |   | 44.27  | %      |
|--------------------------|--------|--------|--------|
| Dividend yield           |   | — |   |
| Risk-free  interest rate |   | 5.21   | %      |
| Expected life (years)    |   | 6.02   |   |

 

*Fair Value December 2006 Grants—*TheCompany computed the fair value of the options granted in December 2006,using the Black-Scholes option pricing model and the following assumptions:

| Expected  volatility     |   | 42.94  | %      |
|--------------------------|--------|--------|--------|
| Dividend yield           |   | — |   |
| Risk-free  interest rate |   | 4.45   | %      |
| Expected life (years)    |   | 6.25   |   |

 

The Company estimated the volatility of its commonstock at the date of grant based on the historical volatility of comparablepublic companies.

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

Expected life was calculated using the simplifiedmethod as prescribed by the Securities and Exchange Commission’s StaffAccounting Bulletin No. 107. This decision was based on the lack ofrelevant historical data.

F-19

----

Thefollowing summarizes stock option transactions for the year ended December 31,2006:

| **Options**                            | ** ** | ** ** | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Weighted Average  Remaining  Contractual  Life (Years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|------------------------------------------------|------------|----------------------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at  December 31, 2005 |       | —     |       |       | $          | —                                         |       |                                                                 |       | —                          |       |   | $ | — |   |
| Granted                                |       | 2,230,000  |       |       | 5.77       |                                           |       |                                                                 | —     |                            |       | — |   |
| Exercised                              |       | 13,073     |       |       | 4.05       |                                           |       |                                                                 | —     |                            |       | 361,000 |   |
| Forfeited or  expired                  |       | 2,500      |       |       | 4.05       |                                           |       |                                                                 | —     |                            |       | — |   |
| Outstanding at  December 31, 2006 |       | 2,214,427  |       |       | $          | 5.79                                           |       |                                                                 |       | 9.5                             |       |   | $ | 58,320,000 |   |
| Exercisable at  December 31, 2006 |       | 241,927    |       |       | $          | 4.05                                           |       |                                                                 |       | 9.5                             |       |   | $ | 6,788,000 |   |
| Vested at  December 31, 2006      |       | 241,927    |       |       | $          | 4.05                                           |       |                                                                 |       | 9.5                             |       |   | $ | 6,788,000 |   |
| Unvested at  December 31, 2006    |       | 1,972,500  |       |       | $          | 6.00                                           |       |                                                                 |       | 9.5                             |       |   | $ | 51,531,000 |   |

 

The total fair value of shares that vested during December 31,2006 was $520,000.

Stock-based compensation cost was $576,000 for theyear ended December 31, 2006. The portion of stock-based compensation costincluded in cost of sales, sales and marketing, and general and administrativeexpenses in the accompanying consolidated statement of operations was $8,000,$128,000 and $440,000, respectively.

The remaining unrecognized compensation cost relatedto unvested awards at December 31, 2006 is $5,842,000 and theweighted-average period of time over which this cost will be recognized is 3.7years.

The Company has not capitalized any stock-basedcompensation costs at December 31, 2006. There have been no modificationsto stock option awards during 2006.

All unvested options at December 31, 2006 areexpected to vest.

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

F-20

----

**16.   QUARTERLYFINANCIAL INFORMATION (UNAUDITED)**

Thefollowing table sets forth certain financial information for the periodsindicated. The data is prepared on the same basis as the audited consolidatedfinancial statements. All recurring, necessary adjustments are reflected in thedata below.
|                                                    | ** ** | **Three months ended** | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|
| ** **                                         | ** ** | **3/31/05**                      | ** ** | **6/30/05** | ** ** | **9/30/05** | ** ** | **12/31/05** | ** ** | **3/31/06** | ** ** | **6/30/06** | ** ** | **9/30/06** | ** ** | **12/31/06** | ** ** |
| ** **                                         | ** ** | **(in thousands)**          | ** ** |
| **Consolidated Statements of  Operations Data:**   |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net sales                                          |       | $                                | 5,432      |   | $ | 10,656 |   | $ | 12,964 |   | $ | 14,898 |   | $ | 13,669 |   | $ | 30,927 |   | $ | 72,511 |   | $ | 71,101 |   |
| Cost of sales                                      |       | 3,472                            |       | 7,003 |   | 8,668 |   | 9,808 |   | 8,749 |   | 20,237 |   | 47,584 |   | 45,995 |   |
| Gross profit                                       |       | 1,960                            |       | 3,653 |   | 4,296 |   | 5,090 |   | 4,920 |   | 10,690 |   | 24,927 |   | 25,106 |   |
| Selling, general and administrative  expenses      |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing                                |       | 624                              |       | 1,082 |   | 1,556 |   | 1,986 |   | 1,381 |   | 2,954 |   | 4,639 |   | 4,721 |   |
| General and administrative                         |       | 575                              |       | 855 |   | 703 |   | 853 |   | 931 |   | 1,220 |   | 1,883 |   | 2,363 |   |
| Total selling, general and administrative expenses |       | 1,199                            |       | 1,937 |   | 2,259 |   | 2,839 |   | 2,312 |   | 4,174 |   | 6,522 |   | 7,084 |   |
| Income from operations                             |       | 761                              |       | 1,716 |   | 2,037 |   | 2,251 |   | 2,608 |   | 6,516 |   | 18,405 |   | 18,022 |   |
| Other expense (income)                             |       | (4                               | )          | 2 |   | 78 |   | 55 |   | 1 |   | 77 |   | 324 |   | 187 |   |
| Income before income taxes                         |       | 765                              |       | 1,714 |   | 1,959 |   | 2,196 |   | 2,607 |   | 6,439 |   | 18,081 |   | 17,835 |   |
| Income taxes                                       |       | 264                              |       | 591 |   | 675 |   | 757 |   | 912 |   | 2,254 |   | 6,294 |   | 6,328 |   |
| Net income                                         |       | $                                | 501        |   | $ | 1,123 |   | $ | 1,284 |   | $ | 1,439 |   | $ | 1,695 |   | $ | 4,185 |   | $ | 11,787 |   | $ | 11,507 |   |
| **Earnings  per share:**                           |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                              |       | $                                | 0.04       |   | $ | 0.08 |   | $ | 0.09 |   | $ | 0.10 |   | $ | 0.12 |   | $ | 0.27 |   | $ | 0.49 |   | $ | 0.47 |   |
| Diluted                                            |       | $                                | 0.02       |   | $ | 0.04 |   | $ | 0.05 |   | $ | 0.06 |   | $ | 0.07 |   | $ | 0.17 |   | $ | 0.48 |   | $ | 0.44 |   |
| **Weighted  average shares outstanding:**          | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                              |       | 13,989                           |       | 13,989 |   | 13,989 |   | 13,989 |   | 13,989 |   | 15,435 |   | 23,904 |   | 24,720 |   |
| Diluted                                            |       | 25,353                           |       | 25,353 |   | 25,353 |   | 25,353 |   | 25,353 |   | 24,501 |   | 24,752 |   | 25,952 |   |
| **Other  Data:**                                   |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net sales, domestic                                |       | $                                | 4,336      |   | $ | 8,391 |   | $ | 10,796 |   | $ | 13,050 |   | $ | 12,034 |   | $ | 27,201 |   | $ | 61,387 |   | $ | 60,725 |   |
| Net sales, international                           |       | 1,096                            |       | 2,265 |   | 2,168 |   | 1,848 |   | 1,635 |   | 3,726 |   | 11,124 |   | 10,376 |   |
| Depreciation and  amortization                     |       | 92                               |       | 94 |   | 90 |   | 120 |   | 93 |   | 95 |   | 102 |   | 112 |   |

 

F-21

----

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

Forthe years ended December 31, 2004, 2005 and 2006:
| Description                          | ** ** | ** ** | ** ** | **Balance at  Beginning  of Period** | ** ** | **Charged to  Costs and  Expenses** | ** ** | **Deductions** | ** ** | **Balance at  End of  Period** | ** ** |
|--------------------------------------|------------|------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|----------------|------------|------------------------------------------|------------|
| *Year ended December 31,  2004* |       |       |       |                                           |       |                                          |       |           |       |                                     |       |   |   |   |   |   |   |
| Allowance for doubtful accounts      |       |       | $          | 38                                             |       |                                          |       | $              | (2         | )                                        |       |   | $ | (4 | ) |   |   | $ | 32 |   |   |
| Reserve for estimated returns        |       |       | 117        |                                           |       |                                          | 157        |           |       |                                     | (166       | ) |   |   | 108 |   |   |
| Reserve for cooperative advertising  |       |       | 124        |                                           |       |                                          | 260        |           |       |                                     | (200       | ) |   |   | 184 |   |   |
| *Year  ended December 31, 2005* |       |       |       |                                           |       |                                          |       |           |       |                                     |       |   |   |   |   |   |   |
| Allowance for doubtful accounts      |       |       | 32         |                                           |       |                                          | 104        |           |       |                                     | (6         | ) |   |   | 130 |   |   |
| Reserve for estimated returns        |       |       | 108        |                                           |       |                                          | 347        |           |       |                                     | (242       | ) |   |   | 213 |   |   |
| Reserve for cooperative advertising  |       |       | 184        |                                           |       |                                          | 518        |           |       |                                     | (341       | ) |   |   | 361 |   |   |
| *Year  ended December 31, 2006* |       |       |       |                                           |       |                                          |       |           |       |                                     |       |   |   |   |   |   |   |
| Allowance for doubtful accounts      |       |       | 130        |                                           |       |                                          | 435        |           |       |                                     | (155       | ) |   |   | 410 |   |   |
| Reserve for estimated returns        |       |       | 213        |                                           |       |                                          | 1,898      |           |       |                                     | (979       | ) |   |   | 1,132 |   |   |
| Reserve for  cooperative advertising |       |       | $          | 361                                            |       |                                          |       | $              | 2,033      |                                     |       |   | $ | (1,977 | ) |   |   | $ | 417 |   |   |

 

 

F-22

----