<PAGE>

                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549
                                ---------------
                                   FORM 10-Q
(Mark One)
[X]   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
      EXCHANGE ACT OF 1934.

               For the quarterly period ended September 30, 1999

[ ]      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
         SECURITIES EXCHANGE ACT OF 1934

             For the transition period from_________________to_______________

                          Commission File No. 0-23629

                                 Happy Kids Inc.
             ----------------------------------------------------
            (Exact Name of Registrant as Specified in Its Charter)

              New York                                 13-3473638
(State or Other Jurisdiction of            (I.R.S. Employer Identification No.)
 Incorporation or Organization)

          100 West 33rd Street, Suite 1100, New York, New York  10001
             (Address of Principal Executive Offices)  (Zip Code)

                                (212) 695-1151
                        -------------------------------
                        (Registrant's Telephone Number,
                             Including Area Code)

     Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

        Yes:   X                                               No: ___
             -----
     Indicate the number of shares outstanding of each of the Registrant's
classes of common stock, as of October 31, 1999:

            Class                               Number of Shares
            -----                               ----------------
Common Stock, $.01 par value per share             10,375,693
<PAGE>

                       HAPPY KIDS INC. AND SUBSIDIARIES
                               TABLE OF CONTENTS
                               -----------------

<TABLE>
<CAPTION>
                                                                                                               Page
                                                                                                               ----
<S>                                                                                                            <C>
PART I.  FINANCIAL INFORMATION.............................................................................       2

         Item 1.  Financial Statements.....................................................................       2

                  Condensed Consolidated Balance Sheets as of September 30, 1999
                   (unaudited) and December 31, 1998.......................................................       3

                  Condensed Consolidated Statements of Income for the Three and Nine
                   Months Ended September 30, 1999 and 1998 (unaudited)....................................       4

                  Condensed Consolidated Statements of Cash Flows for the Nine
                   Months Ended September 30, 1999 and 1998 (unaudited)....................................       5

                  Notes to Condensed Consolidated Financial Statements.....................................       6

         Item 2.   Management's Discussion and Analysis of Financial Condition
                   and Results of Operations...............................................................      11

         Item 3.  Quantitative and Qualitative Disclosures About Market Risk...............................      18

PART II  OTHER INFORMATION.................................................................................      19

         Item 1.  Legal Proceedings........................................................................      19

         Item 2.  Changes in Securities and Use of Proceeds................................................      20

         Item 3.  Defaults Upon Senior Securities..........................................................      20

         Item 4.  Submission of Matters to Vote of Security Holders........................................      20

         Item 5.  Other Information........................................................................      20

         Item 6.  Exhibits and Reports on Form 8-K.........................................................      25

SIGNATURES.................................................................................................      26

EXHIBIT INDEX..............................................................................................      27

EXHIBITS
</TABLE>

                                      -i-
<PAGE>

                        PART I - FINANCIAL INFORMATION
                        ------------------------------

Item 1.  Financial Statements.

     The information presented herein as of September 30, 1999 and for the
three-month and nine-month periods ended September 30, 1999 and September 30,
1998 is unaudited, but, in the opinion of the Happy Kids Inc.'s ("Happy Kids" or
the "Company") management, the accompanying unaudited condensed consolidated
financial statements contain all adjustments (consisting only of normal
recurring adjustments) which the Company considers necessary for the fair
presentation of the Company's financial position as of September 30, 1999 and
the results of its operations for the three-month and nine-month periods ended
September 30, 1999 and 1998, and its cash flows for the nine-month periods ended
September 30, 1999 and 1998. The financial statements included herein have been
prepared in accordance with generally accepted accounting principles and the
instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain
information and footnote disclosures normally included in financial statements
prepared in accordance with generally accepted accounting principles have been
condensed or omitted. These financial statements should be read in conjunction
with the Company's audited financial statements for the year ended December 31,
1998, which were included as part of the Company's Annual Report on Form 10-K,
as filed with the Securities and Exchange Commission (the "SEC") on March 30,
1999.

     Results for the interim period are not necessarily indicative of results
that may be expected for the entire year.

                                      -2-
<PAGE>

                       HAPPY KIDS INC. AND SUBSIDIARIES
                     CONDENSED CONSOLIDATED BALANCE SHEETS
                    (in thousands, except per share amounts)

<TABLE>
<CAPTION>
                                                          September 30,   December 31,
                                                              1999            1998
                                                          -------------   ------------
              ASSETS                                       (unaudited)
<S>                                                       <C>             <C>
CURRENT ASSETS
  Cash                                                    $           5   $        139
  Due from factor                                                46,283         20,640
  Accounts receivable - trade, net                                1,854            347
  Inventories                                                    21,122         23,579
  Prepaid royalties                                               1,700            762
  Deferred income taxes                                           1,029          1,029
  Other current assets                                            3,900          1,496
                                                          -------------   ------------
     Total current assets                                        75,893         47,992
FIXED ASSETS - NET                                                2,352          1,459
OTHER ASSETS                                                      5,957          1,001
                                                          -------------   ------------

  Total assets                                            $      84,202   $     50,452
                                                          =============   ============

  LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
  Due to bank                                             $      25,723   $      3,753
  Accounts payable and accrued liabilities                       10,303          7,944
                                                          -------------   ------------
     Total current liabilities                                   36,026         11,697

DEFERRED RENT PAYABLE                                               445            505
DUE TO STOCKHOLDERS                                               5,570          5,719
COMMITMENTS
STOCKHOLDERS' EQUITY
  Preferred stock - 5,000 shares authorized, $0.01 par
   value; no shares issued and outstanding                           --             --
  Common stock - 30,000 shares authorized, $.01 par
   value; 10,376 and 10,280 shares issued and
   outstanding at September 30, 1999 and December 31,
   1998, respectively                                               104            103
Additional paid-in capital                                       24,262         23,263
Retained earnings                                                17,795          9,165
                                                          -------------   ------------
     Total stockholders' equity                                  42,161         32,531
                                                          -------------   ------------
     Total liabilities and stockholders' equity           $      84,202   $     50,452
                                                          =============   ============
</TABLE>

       The accompanying notes are an integral part of these statements.

                                      -3-

<PAGE>

                       HAPPY KIDS INC. AND SUBSIDIARIES
                  CONDENSED CONSOLIDATED STATEMENTS OF INCOME
                   (in thousands, except per share amounts)

<TABLE>
<CAPTION>
                                                                              For the Three Months            For the Nine Months
                                                                              Ended September 30,             Ended September 30,
                                                                            ------------------------       -------------------------
                                                                              1999           1998             1999           1998
                                                                            -----------  -----------       ------------  -----------
                                                                            (unaudited)  (unaudited)       (unaudited)   (unaudited)
<S>                                                                         <C>          <C>               <C>           <C>
Net sales                                                                   $    65,547  $    46,993       $    148,850  $   114,721
Cost of goods sold                                                               48,426       34,750            109,607       85,302
                                                                            -----------  -----------       ------------  -----------
     Gross profit                                                                17,121       12,243             39,243       29,419
                                                                            -----------  -----------       ------------  -----------
Operating expenses:
     Operating expenses                                                           9,244        5,958             23,176       16,539
                                                                            -----------  -----------       ------------  -----------
     Operating earnings                                                           7,877        6,285             16,067       12,880
                                                                            -----------  -----------       ------------  -----------
Interest expense, net                                                               609          472              1,187        1,790
                                                                            -----------  -----------       ------------  -----------
Income before income taxes                                                        7,268        5,813             14,880       11,090
Provision for income taxes                                                        3,053        2,442              6,250        2,814
                                                                            -----------  -----------       ------------  -----------
     Net income                                                             $     4,215  $     3,371       $      8,630  $     8,276
                                                                            ===========  ===========       ============  ===========
Basic income per common share                                               $      0.41  $      0.33       $       0.83  $      0.88
                                                                            ===========  ===========       ============  ===========
Weighted average common shares outstanding                                       10,376       10,280             10,340        9,406
                                                                            ===========  ===========       ============  ===========
Diluted income per common share                                             $      0.41  $      0.33       $       0.83  $      0.88
                                                                            ===========  ===========       ============  ===========
Weighted average common shares outstanding                                       10,382       10,284             10,365        9,419
                                                                            ===========  ===========       ============  ===========
Pro forma data (unaudited):
     Historical income before provision for income taxes                    $     7,268  $     5,813       $     14,880  $    11,090
     Income taxes                                                                 3,053        2,442              6,250        4,658
                                                                            -----------  -----------       ------------  -----------
          Net income                                                        $     4,215  $     3,371       $      8,630  $     6,432
                                                                            ===========  ===========       ============  ===========
Pro forma basic income per share                                            $      0.41  $      0.33       $       0.83  $      0.68
                                                                            ===========  ===========       ============  ===========
Pro forma weighted average common shares outstanding                             10,376       10,280             10,340        9,406
                                                                            ===========  ===========       ============  ===========
Pro forma diluted income per share                                          $      0.41  $      0.33       $       0.83  $      0.68
                                                                            ===========  ===========       ============  ===========
Pro forma weighted average common shares outstanding                             10,382       10,284             10,365        9,419
                                                                            ===========  ===========       ============  ===========
</TABLE>

        The accompanying notes are an integral part of these statements

                                      -4-

<PAGE>

                       HAPPY KIDS INC. AND SUBSIDIARIES
                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                  (unaudited)
                                (in thousands)

<TABLE>
<CAPTION>
                                                           For the Nine Months
                                                           Ended September 30,
                                                           -------------------
                                                             1999       1998
                                                           ---------  --------
<S>                                                        <C>        <C>
Cash flows from operating activities:
Net income                                                 $   8,630  $  8,276
Adjustments to reconcile net income
     to net cash used in operating activities:
     Depreciation and amortization                               433       226
     Deferred taxes                                                -    (1,024)
     Provision for losses on accounts receivable                   3        45
Changes in operating assets and liabilities, net of assets
acquired:
     Accounts receivable                                      (1,510)     (365)
     Due from factor                                         (25,643)     (879)
     Inventories                                               5,357    (5,015)
     Prepaid royalties                                          (938)   (1,737)
     Other current assets                                     (2,404)     (379)
     Other assets                                               (106)      (30)
     Accounts payable and accrued expenses                     2,299    (1,386)
     Due from shareholders                                         -       347
                                                           ---------  --------
Net cash used in operating activities                        (13,879)   (1,921)
                                                           ---------  --------
Cash flows from investing activities:
     Acquired assets of D. Glasgow                            (6,853)        -
     Acquisition of fixed assets                              (1,223)     (251)
                                                           ---------  --------
Net cash used in investing activities                         (8,076)     (251)

Cash flows from financing activities:
     Net borrowings under line of credit                      21,970   (16,548)
     Payments on capital lease                                     -       (31)
     Issuance of common stock                                      -    22,331
     Payments to stockholders                                   (149)     (169)
     Dividends paid                                                -    (3,428)
                                                           ---------  --------
Net cash provided by financing activities                     21,821     2,155
                                                           ---------  --------
Net decrease in cash                                            (134)      (17)
Cash at beginning of year                                        139       374
                                                           ---------  --------
Cash at end of period                                      $       5  $    357
                                                           =========  ========
</TABLE>

        The accompanying notes are an integral part of these statements

                                      -5-
<PAGE>

                                HAPPY KIDS INC.
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (Unaudited)

Note 1 -- General:

         The Company was incorporated in 1988 in New York under the name O'Boy
Inc. and changed its name to Happy Kids Inc. in December 1997. Historically, the
Company operated as separate business entities, with the first of such entities
commencing operations in 1979, all under the common ownership of the Company's
then-current shareholders. Immediately prior to the effectiveness of the
Company's initial public offering (the "Initial Public Offering"), as described
in Note 2, all of such separate entities became wholly-owned subsidiaries of the
Company (the "Reorganization"). The Company issued 4,262,500 additional shares
of common stock, to its then-current shareholders, in exchange for their
ownership in these separate business entities. All share and per share amounts
throughout this Form 10-Q have been restated to retroactively reflect the
Reorganization.

         The accompanying condensed consolidated financial statements include
the consolidated accounts of the Company and its wholly owned subsidiaries to
reflect the Reorganization as stated above. All significant intercompany
accounts and transactions have been eliminated in consolidation.

Note 2 -- Initial Public Offering:

         On April 2, 1998, the Company consummated its Initial Public Offering
of 2,200,000 shares of its common stock, par value $0.01 per share (the "Common
Stock" or "Shares") at a price of $10.00 per share, all of which shares were
issued and sold by the Company. On April 23, 1998, the Company consummated the
exercise of the underwriters' over-allotment option granted by the Company to
the underwriters in connection with the Initial Public Offering. As a result,
the Company issued and sold an additional 330,000 shares of the Company's Common
Stock at the Initial Public Offering price of $10.00 per share. The net proceeds
to the Company from such sales were approximately $22.3 million.

         Of the total net proceeds received by the Company upon the consummation
of its Initial Public Offering and the exercise of the over-allotment option,
$2.0 million was distributed to certain shareholders of the Company in
connection with the payment of a portion of the S Corporation distribution made
by the Company in connection with the Reorganization (the "S Corporation
Distribution") and the remaining amount was utilized to pay down a portion of
the outstanding balance under the Company's bank credit facility (the "Line of
Credit").

Note 3 -- Income Taxes:

         Prior to the completion of the Initial Public Offering, the Company had
elected to be treated as an S Corporation for Federal income tax reporting
purposes. An S Corporation is generally treated like a partnership and is exempt
from Federal income taxes, with certain exceptions, and shareholders report
their pro rata share of corporate taxable income or loss on their individual tax
returns. A provision for state income taxes was made for those states not
recognizing the Company's S Corporation status. The Company's S Corporation
status terminated on the day prior to the effectiveness of the Company's Initial
Public Offering described in Note 2.

         Subsequent to the termination of the Company's S Corporation status,
the Company used

                                      -6-
<PAGE>

the liability method for both Federal and state income tax purposes. The effect
of such change was reflected in net income for the second quarter of 1998 when
such termination occurred and resulted in an increase in deferred tax assets and
net earnings of approximately $1.0 million.

         The pro forma provision for income taxes represents the income tax
provision that would have been reported had the Company been subject to Federal
and additional state and local income taxes as a C Corporation for all periods
presented.

         Deferred income taxes are determined based on the difference between
the tax basis of an asset or liability and its reported amount in the financial
statements using enacted tax rates for the year in which the differences are
expected to reverse.

         The principal types of differences between assets and liabilities for
financial statement and tax return purposes giving rise to deferred income taxes
are accrued expenses, accumulated depreciation, certain costs capitalized to
inventory and allowance for doubtful accounts. A deferred tax asset has been
recorded for these differences.

Note 4 -- Due to Stockholders:

         In connection with the termination of the Company's S Corporation
status, the Company agreed to distribute an aggregate of $7.6 million to the
Company's pre-Initial Public Offering shareholders, such amounts representing
the Company's total undistributed equity resulting from the S Corporation or
limited liability corporation ("LLC") status of the Company and its related
entities prior to the Reorganization, of which $2.0 million was paid from the
proceeds of the Initial Public Offering. The balance is due pursuant to four-
year 5.7% notes payable to such shareholders. Such notes provide for the timely
distribution of amounts necessary to pay the remaining personal income taxes of
such shareholders or members due on amounts earned by such S Corporations or
LLCs for the period January 1, 1998 through the termination of S Corporation or
LLC status. In addition, existing amounts due to shareholders of $1.4 million
are subject to the same terms as the above promissory notes.

Note 5 -- Pro forma Information:

         a.   Pro Forma Results of Income and Pro Forma Income Taxes:

         Pro Forma adjustments in the statement of income for the three-month
and nine-month periods ended June 30, 1998 reflect provisions for income taxes
based upon pro forma pretax income as if the Company had been subject to Federal
and additional state and local income taxes.

         As disclosed in Note 3, the Company has, in the past, elected for
certain of its affiliates to be taxed as S Corporations pursuant to the Internal
Revenue Code. In connection with the Company's Initial Public Offering, the
Company terminated such S elections and partnership

                                      -7-
<PAGE>

status and became subject to Federal and additional state and local income
taxes. The pro forma provision for income taxes represents the income tax
provisions that would have been reported had the Company been subject to Federal
and additional state and local income taxes. The effective pro forma tax rate of
the Company differs from the Federal rate of 34% primarily due to the effects of
state and local income taxes.

         b.   Pro Forma Net Income

         Pro forma net income represents the historical amounts after the pro
forma adjustments discussed above.

Note 6 -- Earnings Per Share:

         A reconciliation between basic and diluted earnings per share from
operations is as follows:

<TABLE>
<CAPTION>
                                            Three Months Ended             Six Months Ended
                                            September 30,                  September 30,
                                            ---------------------------    -----------------------
                                            1999                   1998    1999               1998
                                            ----                   ----    ----               ----
                                                     (in thousands, except per share amounts)
<S>                                         <C>              <C>           <C>            <C>
Net Income................................. $    4,215       $    3,371    $  8,630       $  8,276
Basic EPS:
   Basic common shares.....................     10,376           10,280      10,340          9,406
                                            ==========       ==========    ========       ========
   Basic EPS............................... $     0.41       $     0.33    $   0.83       $   0.88
                                            ==========       ==========    ========       ========
Diluted EPS:
   Basic common shares.....................     10,376           10,280      10,340          9,406
   Diluted common shares...................          6                4          25             13
                                            ----------       ----------    --------       --------
   Total diluted shares....................     10,382           10,284      10,365          9,419
                                            ==========       ==========    ========       ========
   Diluted EPS............................. $     0.41       $     0.33    $   0.83       $   0.88
                                            ==========       ==========    ========       ========
</TABLE>

                                      -8-
<PAGE>

Note 7 -- Accounts Receivable:

         Accounts Receivable consist of the following:

<TABLE>
<CAPTION>
                                                              September 30, 1999        December 31, 1998
                                                             --------------------      -------------------
                                                                             (In thousands)
<S>                                                          <C>                       <C>
Accounts Receivable.................................         $             3,097       $              860
Allowances..........................................                      (1,243)                    (513)
                                                             -------------------       ------------------
                                                             $             1,854       $              347
                                                             ===================       ==================
</TABLE>

Note 8 -- Inventories:

         Inventories consist of the following finished goods:

<TABLE>
<CAPTION>
                                                                       June 30,                 December 31,
                                                                         1999                       1998
                                                               ---------------------      --------------------
                                                                                 (In thousands)
<S>                                                            <C>                        <C>
     Warehouse......................................           $              17,114      $             16,531
     In-transit,overseas and raw materials .........                           4,021                     7,277
     LIFO valuation allowance.......................                             (13)                     (229)
                                                               ---------------------      --------------------
                                                               $              21,122      $             23,579
                                                               =====================      ====================
</TABLE>





         For the nine months ended September 30, 1999, the liquidation of LIFO
inventories decreased the cost of sales and, therefore, increased income before
taxes by $216,000. For the nine months ended September 30, 1998, the liquidation
of LIFO inventories decreased the cost of sales and, therefore, increased income
before taxes by $53,000. For the three months ended September 30, 1999, the
liquidation of LIFO inventories decreased the cost of sales and, therefore,
increased income before taxes by $216,000. There was no liquidation of LIFO
inventories for the three months ended September 30, 1998.

Note 9 -- Acquisition:

         On April 13, 1999, the Company entered into an asset purchase agreement
(the "Purchase Agreement") with D. Glasgow & Sons Inc., a New York corporation
(the "Seller") and Mr. Andrew D. Glasgow, its sole shareholder, to acquire
certain of the assets (the "Assets") of the Seller. The Assets include
intellectual property rights under license agreements to design and

                                      -9-
<PAGE>

manufacture children's apparel bearing logos, trademarks and tradenames of the
National Football League, the National Basketball Association, Major League
Baseball and the National Hockey League, as well as certain Warner Brothers'
properties, including Looney Tunes, and Saban's Power Rangers, among other
licenses. The Company also acquired certain machinery and equipment from the
Seller. The purchase price for the Assets included a cash consideration of $3.7
million and the issuance of 95,693 shares of Common Stock of the Company having
a fair market value of $1.0 million. Such shares of Common Stock are restricted
shares, and the Company has granted certain piggy-back registration rights to
the holder of such restricted stock. The Purchase Agreement also provided for
the Company to purchase the Seller's apparel inventory for an additional cash
payment of approximately $2.9 million.

     In connection with the consummation of the transactions contemplated by the
Purchase Agreement, Mr. Glasgow, formerly the President of the Seller, was
elected as a Director of the Company in April 1999. In addition, Mr. Glasgow was
appointed Vice President of the Company and President of the Company's Glasgow
Division on the terms set forth in a five (5) year Employment Agreement with the
Company. Pursuant to such Employment Agreement, Mr. Glasgow is entitled to an
annual base salary of $250,000 and bonuses commensurate with other executive
officers of the Company, which amounts and payments are within the discretion of
the Compensation Committee of the Board of Directors. In addition, Mr. Glasgow
is entitled to receive, in quarterly payments, subject to annual adjustment, a
percentage of certain divisional profits and certain import sales profits of the
Company's Glasgow Division. Mr. Glasgow's Employment Agreement requires Mr.
Glasgow to maintain the confidentiality of Company information and requires that
during the term of his employment with the Company and thereafter for a period
of two years, he will not compete with the Company in any state or territory of
the United States where the Company does business. Mr. Glasgow's Employment
Agreement also provides that, for a period of two years following the
termination of his employment with the Company, he will not solicit the
Company's licensors, customers or employees.

Note 10 -- Plan of Merger:

     On September 17, 1999, an Agreement and Plan of Merger, (as amended, the
"Merger Agreement"), was entered into by and between the Company and HK Merger
Corp. ("HK"). HK is a New York corporation newly-formed by H.I.G. Capital, LLC
("HIG") and controlled by HIG-HK Investment Inc. ("HIG-HK"), an affiliate of
HIG. HK was formed solely for the purpose of consummating the Merger (as defined
below). Under the terms of the Merger Agreement, HK will be merged with and into
the Company (the "Merger") with the Company continuing as the surviving
corporation. Pursuant to the Merger Agreement, all unaffiliated shareholders of
the Company will receive $12.00 per share in cash. Messrs. Jack M. Benun,
President and Chairman, Mark J. Benun, Vice Chairman and Secretary, and Isaac
Levy, Vice President (collectively, the "Management Shareholders"), who hold
74.69% of the Company's outstanding shares, will receive $7.164 per share in
cash for their holdings of outstanding shares except that such shareholders will
retain shares representing, in the aggregate, 23.61% of the outstanding

                                      -10-
<PAGE>

shares of the surviving corporation. Each holder of an outstanding stock option
in the Company immediately prior to the effective time of the Merger, other than
holders of certain non-vested employee options, will be entitled to receive a
cash payment in settlement for such option. Messrs. Benun, Benun and Levy will
continue in their present roles as senior management of the Company following
the Merger and each of them has executed an employment agreement with the
Company with respect thereto, with each such employment agreement to be
effective upon consummation of the Merger. The employment agreements provide for
annual base salaries and annual bonuses (in cash and common stock of the
Company) based upon the performance of the Company. In connection with the
Merger Agreement, the Management Shareholders have also entered into a Support
Agreement (as defined herein) and a Shareholders Agreement (as defined herein)
with HIG. See "Part II. Other Information, Item. 5. Other Information."

     Consummation of the Merger is subject to customary conditions, including
the approval of two-thirds of the Happy Kids' shareholders entitled to vote
thereon and receipt of proceeds from financing. Pursuant to the Support
Agreement, Messrs. Benun, Benun and Levy, as shareholders, have agreed to vote
their shares in favor of the Merger.

     Financing the Merger will require approximately $100.8 million to pay the
merger consideration to the Management Shareholders and unaffiliated
shareholders, to pay for the settlement of the stock options, to refinance
existing indebtedness, to repay certain notes, and to pay estimated fees and
expenses in connection with the Merger and such financing. HIG has received
commitments for debt financing from two Deutsche Bank affiliates, the provision
of which is subject to customary conditions. Such financing commitments will
expire in accordance therein if the Merger is not consummated on or prior to
December 15, 1999. In addition HIG has committed to provide equity capital to
the Company upon consummation of the Merger.

     The Company expects that the Merger will be consummated no later than
December 15, 1999. The Merger Agreement has been approved and adopted by the
Company's Board of Directors upon the recommendation of its special committee of
disinterested directors, namely Messrs. Marvin Azrak and Stephen I. Kahn, and
the opinion of CIBC World Markets Corp. that the price to be received by public
shareholders is fair from a financial point of view to such holders. It is
expected that, in the event the Merger is consummated, the registration of the
Company's Common Stock pursuant to Section 12 of the Securities Exchange Act of
1934, as amended (the "Exchange Act") would be terminated and the Company's
Common Stock would cease to be listed on the Nasdaq National Market.

Item 2.   Management's Discussion and Analysis of Financial Condition and
          Results of Operations.

     General
     -------

     The Company, is a designer and marketer of custom-designed, licensed and
branded

                                      -11-
<PAGE>

children's apparel. The Company produces high-quality, coordinated apparel
programs, including knit tops, bottoms, overalls, shortalls, coveralls and
swimwear, for newborns, infants, toddlers, boys and girls (collectively,
"playwear"). The Company's major licenses include Nickelodeon's Rugrats, AND 1
and B.U.M. Equipment. The Company also designs and delivers private label
branded playwear programs for leading retailers, such as Sesame Street for
Kmart. The Company's strategy is to work closely with its customers to design
and market coordinated playwear programs resulting in gross margins that the
Company believes are higher than those typically generated from sales of non-
licensed or non-private label branded playwear.

     Prior to and including much of 1995, the Company's operating strategy
primarily focused on developing and marketing its own house brands. The Company
manufactured products for inventory under the Company's brands and often
concentrated on enhancing sales volume rather than focusing on a combination of
sales volume and gross margins. The Company believes that the loss it incurred
in 1995 was primarily attributable to these factors. In 1995, to leverage its
strong customer relationships, the Company initiated its current sales strategy
under which the Company's customers order specific quantities of goods on a
fixed-price basis three to nine months in advance of a selling season. As a
result, substantially all of the Company's playwear is produced upon receipt of
customer orders. Also in 1995, the Company elected to concentrate on developing
a diversified portfolio of popular, established and well-recognized licensed
properties and private label relationships and de-emphasized its reliance on
house brands, which have been a declining component of the Company's net sales
in each year since 1995. Since that time, the Company's strategy has been to
work closely with its customers to design and market high-quality coordinated
apparel programs resulting in gross margins that the Company believes are higher
than those typically generated from sales of non-licensed or non-private label
branded playwear. In connection with this strategy and the Company's acquisition
of certain assets from D. Glasgow & Sons Inc. ("Glasgow") in April 1999, the
Company acquired certain intellectual property rights under various license
agreements to design and manufacture children's apparel.

     Statements contained or incorporated by reference in this Form 10-Q that
are not based on historical facts are "forward-looking statements" within the
meaning of Section 21E of the Exchange Act, including, without limitation,
statements regarding the Company's sales strategy, concentration on the
development of a diversified portfolio of licensed properties and private label
relationships and gross margins. Forward-looking statements also may be
identified by the use of forward-looking terminology such as "may", "will",
"expect", "estimate", "anticipate", "continue", or similar terms, variations of
such terms or the negative of those terms. This Form 10-Q contains forward-
looking statements that involve risks and uncertainties, including, but not
limited to, those related to: (i) general economic conditions; (ii) a dependence
on license arrangements; (iii) a dependence on private label relationships; (iv)
a dependence on contract manufacturers; (v) a reliance on key customers; (vi) a
dependence on access to credit facilities; (vii) the risks associated with
significant growth; (viii) competition; (ix) seasonality of sales; (x)
cyclicality and trends in the apparel industry; (xi) import restrictions and
other risks associated with international business; (xii) the Company's ability
to successfully integrate the licenses recently acquired from D. Glasgow & Sons,
Inc. into its current operations; and (xiii) risks

                                      -12-
<PAGE>

relating to the Company's Year 2000 compliance and the Year 2000 compliance of
the Company's contract manufacturers, suppliers, distributors, marketing
partners and certain other parties. The Company's actual results may differ
materially from the results discussed in the forward-looking statements
contained herein.

     Results of Operations
     ---------------------

Three Months Ended September 30, 1999 Compared to Three Months Ended September
30, 1998

     Net Sales. Net sales increased $18.5 million, or 39.5%, to $65.5 million in
the third quarter of 1999 from $47.0 million in the third quarter of 1998. The
increase in net sales is attributable primarily to sales associated with the
Glasgow product lines acquired in April 1999 and increased sales of playwear of
both licensed products and private label programs.

     Gross Profit. Gross profit increased by $4.9 million, or 39.8%, to $17.1
million in the third quarter of 1999 from $12.2 million in the third quarter of
1998. Such increase was due, in part, to gross profit associated with the
Glasgow product lines and to increased sales in certain higher margin licensed
products as well as efficiencies in transportation and handling costs.

     Operating Expenses. Operating expenses increased by $3.3 million, or 55.2%,
to $9.2 million in the third quarter of 1999 from $5.9 million in the third
quarter of 1998. Operating expenses consist entirely of selling, design and
shipping expenses, and general and administrative expenses.

          Selling, Design and Shipping Expenses. Selling, design and shipping
     expenses increased by $2.4 million, or 64.6%, to $6.0 million in the third
     quarter of 1999 from $3.6 million in the third quarter of 1998. This
     increase is attributable primarily to higher sales compensation, shipping
     and freight costs associated with increased sales volumes, travel expense
     and licensing fees. In addition, design and production salaries and
     sampling costs increased as a result of the Company's expanded product
     lines. As a percentage of net sales, selling, design and shipping expenses
     increased to 9.2% in the third quarter of 1999 from 7.8% in the third
     quarter of 1998.

          General and Administrative Expenses. General and administrative
     expenses increased by $930,000, or 40.3%, to $3.2 million in the third
     quarter of 1999 from $2.3 million in the third quarter of 1998. This
     increase is attributable primarily to higher salaries and related payroll
     costs and higher depreciation and goodwill amortization. As a percentage
     of net sales, general and administrative expenses were 4.9% in the third
     quarter of 1999 and 1998.

     Interest Expense, net. Interest expense, net increased $137,000, or 29.0%,
to $609,000 in the third quarter of 1999 from $472,000 in the third quarter of
1998 due to increased borrowings associated with the growth of the Company. As a
percentage of net sales, interest expense

                                      -13-
<PAGE>

decreased to 0.9% for the third quarter of 1999 compared to 1.0% in the third
quarter of 1998.

     Income Before Income Taxes. Income before income taxes increased $1.5
million, or 25.0%, to $7.3 million in the third quarter of 1999 from $5.8
million in the third quarter of 1998 due to the reasons described above. As a
percentage of net sales, income before income taxes was 11.1% for the third
quarter of 1999 compared to 12.4% in the third quarter of 1998.

Nine Months Ended September 30, 1999 Compared to Nine Months Ended September 30,
1998

     Net Sales. Net sales increased $34.1 million, or 29.80%, to $148.9 million
for the first nine months of 1999 from $114.7 million for the first nine months
of 1998. The increase in net sales is attributable primarily to sales associated
with the Glasgow product lines acquired in April 1999 and increased sales of
playwear of both licensed products and private label programs.

     Gross Profit. Gross profit increased by $9.8 million, or 33.3%, to $39.2
million for the first nine months of 1999 from $29.4 million for the first nine
months of 1998. Such increase was due, in part, to gross profit associated with
the Glasgow product lines and to increased sales in certain higher margin
licensed products as well as efficiencies in transportation and handling costs.

     Operating Expenses. Operating expenses increased by $6.6 million, or 40.1%,
to $23.2 million for the first nine months of 1999 from $16.5 million for the
first nine months of 1998. Operating expenses consist entirely of selling,
design and shipping expenses, and general and administrative expenses.

          Selling, Design and Shipping Expenses. Selling, design and shipping
     expenses increased by $5.2 million, or 53.7%, to $14.8 million for the
     first nine months of 1999 from $9.7 million for the first nine months of
     1998. This increase is attributable primarily to higher sales compensation,
     advertising and shipping and freight costs associated with increased sales
     volumes travel expense and licensing fees. In addition, design and
     production salaries and sampling costs increased as a result of the
     Company's expanded product lines. As a percentage of net sales, selling,
     design and shipping expenses increased to 10.0% in 1999 from 8.4% in 1998.

          General and Administrative Expenses. General and administrative
     expenses increased by $1.4 million or 21.1%, to $8.3 million for the first
     nine months of 1999 from $6.9 million for the first nine months of 1998.
     This increase is attributable primarily to higher salaries and related
     payroll costs and higher depreciation and goodwill amortization. As a
     percentage of net sales, general and administrative expenses decreased 5.6%
     in 1999 from 6.0% in 1998 due to the operating leverage associated with the
     higher sales.

                                      -14-
<PAGE>

     Interest Expense, net. Interest expense, net decreased $603,000, or 33.7%,
to $1.2 million in 1999 from $1.8 million in 1998. As a percentage of net sales,
interest expense decreased to 0.8% for 1999 compared to 1.6% in 1998. This
decrease is a result of the application of a substantial portion of the proceeds
from the Company's Initial Public Offering to the repayment of the Company's
bank debt in the second quarter of 1998.

     Income Before Income Taxes. Income before income taxes increased $3.8
million, or 34.2%, to $14.9 million in 1999 from $11.1 million in 1998 due to
the reasons described above. As a percentage of net sales, income before income
taxes was 10.0% in 1999 compared to 9.7% in 1998.

     Liquidity and Capital Resources
     -------------------------------

     The Company has financed its cash requirements primarily through operations
and borrowings under its bank line of credit. Historically, the Company's
borrowing requirements have been seasonal, with peak working capital needs
arising during the first and third quarters.

     On April 2, 1998, the Company consummated its Initial Public Offering of
2,200,000 shares of its Common Stock, at a price of $10.00 per share, all of
which shares were issued and sold by the Company. On April 23, 1998, the Company
consummated the exercise of the underwriters' over-allotment option granted by
the Company to the underwriters in connection with the Initial Public Offering.
As a result, the Company issued and sold an additional 330,000 shares of the
Company's Common Stock at the Initial Public Offering price of $10.00 per share.
The net proceeds to the Company from such sales were approximately $22.3
million.

     Of the total net proceeds received by the Company upon the consummation of
its Initial Public Offering and the exercise of the over-allotment option, $2.0
million was distributed to certain shareholders of the Company in connection
with the payment of a portion of the S Corporation distribution and the
remaining amount was utilized to pay down a portion of the outstanding balance
under the Company's credit line.

     On March 31, 1999, the Company executed an amendment of its existing credit
line whereby the Company's credit line was amended to provide for a
discretionary one year revolving line of credit, to expire on March 31, 2000,
renewable annually, providing for advances and letter of credit accommodations
up to the lesser of (a) $50.0 million from April 1, 1999 to March 31, 2000, or
(b) at all times the sum of (i) up to eighty-five percent of eligible accounts
receivables, plus (ii) up to fifty percent of finished goods inventory, plus
(iii) overadvances approved by the lender. The maximum amount of revolving
credit advances outstanding at any time cannot exceed $40.0 million and the
maximum amount of letters of credit outstanding at any time may not exceed $35.0
million. The interest rate on amounts borrowed will be the bank's then
prevailing prime rate (8.25% at September 30, 1999) less 0.5% or at LIBOR plus
2.0%, at the option of the Company. The credit line is collateralized by
substantially all of the assets of the Company. As of September 30, 1999, the
Company had

                                      -15-
<PAGE>

$25.7 million of outstanding direct borrowings and $15.2 million of contingent
liabilities under open letters of credit.

     In addition, the Company's lender has sole discretion to make or withhold
advances under the credit line. There can be no assurance that the lender will
continue to lend under the credit line. If the lender exercises its discretion
to withhold advances, there would be a material adverse effect on the Company's
business, financial condition and results of operations.

     As of September 30, 1999, the Company's other principal sources of
liquidity included cash of $5,000, amounts due from factor of $46.3 million and
net accounts receivable of $1.9 million. The Company had working capital of
$39.9 million and long-term debt of $5.6 million as of September 30, 1999.

     For the nine months ended September 30, 1999, operating activities used
cash of $13.9 million primarily as a result of an increase in amounts due from
factor of $25.6 million, an increase in other current assets and royalties of
$3.3 million, an increase in accounts receivable of $1.5 million, offset in part
by net income of $8.6 million, a decrease in inventory of $5.4 million, and an
increase in accounts payable and accrued expenses of $2.3 million. Net cash used
in investing activities was $8.1 million, primarily in connection with the
acquisition of certain of the assets of D. Glasgow & Sons, Inc. and the
acquisition of fixed assets. Net cash used in financing activities resulted from
borrowings under the line of credit.

     Historically, the Company's business has not required significant capital
expenditures. The Company's capital expenditures for the first nine months of
1999 and 1998, were $1.2 million and $251,000, respectively. The Company expects
to incur total capital expenditures in 1999 of $1.5 million for the purchase of
new computers, software and telecommunications equipment. The Company believes
that cash flow expected to be generated from operations, together with
borrowings under its existing credit line, as amended, will be adequate to
satisfy current and planned operations for at least the next twelve (12) months.

     Backlog
     -------

     The Company's customers order specific quantities of goods on a fixed-price
basis three to nine months in advance of a selling season. Such customer orders
are placed in backlog upon their receipt and acceptance by the Company. Customer
orders are generally cancelable on notice to the Company without penalty.
Although the Company has not had significant cancellations in the past, no
assurance can be given that it will not experience a significant level of
cancellations in the future or that its backlog at any point in time will be
converted to sales. Many of the Company's orders are received significantly in
advance of scheduled delivery periods. Consequently, the Company had backlog of
$91.5 million at September 30, 1999, all of which it expects to ship over the
next three to nine months. However, in recent months the Company has experienced
a significant increase in orders involving a rapid turnaround from the date the
order is placed to the shipment date.

                                      -16-
<PAGE>

     Variability of Results; Seasonality; Cyclicality
     ------------------------------------------------

     Sales of children's apparel are seasonal. Consequently, the Company's
operating results have varied substantially from quarter to quarter, and the
Company expects that they will continue to do so. Generally, the Company has
experienced significantly higher net sales in the first and third quarters as
compared to the second and fourth quarters, although this may change from time
to time. The seasonality of the Company's business also affects borrowings under
the Company's lines of credit and its level of backlog, which fluctuate in
response to demand for the Company's products. Therefore, the results of any
interim period are not necessarily indicative of the results that may be
achieved for an entire year. In addition, the apparel industry is a cyclical
industry heavily dependent upon the overall level of consumer spending, with
purchases of apparel and related goods tending to decline during recessionary
periods when disposable income is low. A difficult retail environment could
result in downward price pressure which could adversely impact the Company's
gross profit margins.

     Management Information Systems
     ------------------------------

     General

     The Company believes that advanced information processing is essential to
maintaining its competitive position. The Company participates in the electronic
data interchange program maintained by many of its larger customers, including
JC Penney, Kids R Us, Sears, Target and WalMart. This program allows the Company
to receive customer orders, provide advanced shipping notices, monitor store
inventory and track orders on-line from the time such orders are placed through
delivery.

     Year 2000 Compliance

     In 1998, the Company established an oversight committee to review all of
the Company's computer systems and programs, as well as the computer systems of
the third parties upon whose data or functionality the Company relies in any
material respect, and to assess their ability to process transactions in the
Year 2000 and beyond. The Company, through such oversight committee, currently
is upgrading its management information systems, which it expects to complete
during the fourth quarter of 1999, to ensure proper processing of transactions
relating to Year 2000 and beyond. The Company continues to evaluate appropriate
courses of corrective actions, including replacement of certain systems.
Although the Company does not expect the costs associated with ensuring Year
2000 compliance to have a material affect on its financial position or results
of operations, if the computer systems used by the Company, or any of its
suppliers or vendors fail or experience significant difficulties related to the
Year 2000, the Company could experience delays in manufacturing, delays in
shipping, an inability to monitor customer orders or to manage inventory, or may
experience related risks that could materially adversely affect the Company's
financial position or its results of operations. The Company has identified and
been in contact with its major customers, its bank and its factor. The reply
from

                                      -17-
<PAGE>

each such entity indicates that each is, or will be, Year 2000 compliant. The
Company has incurred approximately $250,000 of expenses for Year 2000
remediation costs in 1999 and estimates future additional expenditures for Year
2000 remediation of approximately $100,000. All costs associated with Year 2000
compliance are being funded with cash flow generated from operations and are
being expensed as incurred. The Company has not developed a contingency plan
with respect to Year 2000 issues should they arise.

     European Monetary Union
     -----------------------

     On January 1, 1999, eleven of the fifteen member countries of the European
Union set fixed conversion rates between their existing legacy currencies and
the euro. As such, these participating countries have agreed to adopt the euro
as their common legal currency. The eleven participating countries will issue
sovereign debt exclusively in euro and will redenominate outstanding sovereign
debt. The legacy currencies will continue to be used as legal tender through
January 1, 2002, at which point the legacy currencies will be canceled and euro
bills and coins will be used for cash transactions in the participating
countries.

     The Company does not denominate its agreements or transactions with foreign
entities in foreign currencies. The Company currently does not believe that the
euro conversion will have a material impact on the Company's financial condition
or results of operations.

     Effect of Recently Issued Accounting Standards
     ----------------------------------------------

     In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133 ("SFAS No. 133"), "Accounting for Derivative Instruments and Hedging
Activities," which is effective for the Company's fiscal year ending December
31, 2000. SFAS No. 133 will require the Company to recognize all derivatives on
the balance sheet at fair value. Adoption of SFAS No. 133 is not expected to
have a material effect on the Company's financial statements.

Item 3.   Quantitative and Qualitative Disclosures About Market Risk.

     Interest Rate Exposure
     ----------------------

     The Company is subject to market risk from exposure to changes in interest
rates relating primarily to the Company's short-term debt obligations. The
Company primarily enters into such short-term debt obligations to support
general corporate purposes, including capital expenditures and working capital
needs. All of the Company's debt is short-term with variable rates. To manage
its exposure to changes in interest rates, the Company's policy is to manage
such interest rate exposure through the use of short-term borrowings, which are
negotiated with their lenders on an annual basis. The Company does not expect
changes in interest rates to have a material adverse effect on income or cash
flows in fiscal 1999, although there can be no assurance that interest rates
will not significantly change.

                                      -18-
<PAGE>

                          PART II - OTHER INFORMATION
                          ---------------------------

Item 1.   Legal Proceedings.

     Persons purporting to be public shareholders of the Company brought three
separate actions, as purported class actions on behalf of all public
shareholders, in July 1999 following the Company's press release of July 12,
1999 announcing that HIG had proposed a "going private" transaction for the
Company and to purchase the shares of all public shareholders for $11.50 per
share in a "cash out" merger. These actions challenge the proposed transaction,
if and when approved by the Company's Board of Directors, as a violation of the
Board's fiduciary duties to the Company's public shareholders. The defendants
named in one or more of those actions were the Company, Messrs. Jack and Mark
Benun, Isaac Levy, Andrew Glasgow (another director of the Company) and the
Special Committee, as well as HIG which is named as a joint tortfeasor. Although
the original complaints in these actions have different allegations, they
collectively allege that the earlier proposed offering price of $11.50 per share
to public shareholders of the Company was inadequate, was supposedly arrived by
an arbitrary method (not specified), was not arrived as a result of
disinterested arms' length bargaining with the benefit of advice from
disinterested professionals and that the price for such shares was arrived at
without adequately "shopping" the Company or its businesses, that certain of the
directors allegedly possess non-public information about the "true value" of the
Company that they have not disclosed to the public shareholders, and that the
Board of Directors had otherwise failed to take some unspecified steps required
to obtain the best possible price for the public shareholders. Plaintiffs sought
relief enjoining the earlier proposed transaction or alternatively damages in
some unspecified amount from defendants. The allegations made by the plaintiffs
in the three lawsuits are detailed in the complaints on file with the Clerk of
the Court in the following actions now pending in the Supreme Court of the State
of New York for the County of New York: Glenn Whipple v. Happy Kids Inc. et al.,
Civil Action No. 99-603371; Arthur Kaplan v. Happy Kids Inc. et al., Civil
Action No. 99-114421; and John Tsepelas v. Happy Kids Inc. et al., Civil Action
No. 99-115078.

     Defendants agree to the consolidation of the three actions and to accept
service of any consolidated amended complaint that plaintiff's counsel might
choose to file after the Company's announcement that its Board of Directors had
approved a "going private" transaction.

     The board-approved transaction was publicly announced on September 17,
1999. Plaintiff's counsel have not yet filed any consolidated amended complaint
and the Company does not know whether such a complaint will be filed or the
nature of the claims that may be asserted in such a complaint.

     Defendants believe that they would have meritorious defenses to any claims
that might be made by plaintiff's counsel in any consolidated amended complaint
and intended to vigorously defend against them.

                                      -19-
<PAGE>

Item 2.   Changes in Securities and Use of Proceeds.

          (a)  Not applicable.

          (b)  Not applicable.

          (c)  Changes in Securities
               ---------------------

          On April 13, 1999, the Company issued 95,693 shares of restricted
Common Stock having a fair market value of $1.0 million to Mr. Andrew D.
Glasgow. See "Part II. Other Information, Item 5. Other Information."

     The Company did not employ an underwriter in connection with the issuance
or sale of the securities described above. The Company claims that the issuance
or sale of the foregoing securities was exempt from registration under Section
4(2) of the Securities Act of 1933, as amended (the "Act"), as a transaction not
involving any public offering and such securities having been acquired for
investment and not with a view to distribution. An appropriate legend was
affixed to the stock certificate issued in connection with the issuance of the
above-referenced securities. Mr. Glasgow had adequate access to information
about the Company.

     (d)  Not applicable.

Item 3.   Defaults Upon Senior Securities.

     (a)  None.

     (b)  None.

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

     The Company expects to hold a special meeting of the shareholders to
consider and vote upon a proposal to approve and adopt the Merger Agreement no
later than December 15, 1999.

Item 5.   Other Information.

     Asset Purchase
     --------------

     On April 13, 1999, the Company entered into an asset purchase agreement
(the "Purchase Agreement") with D. Glasgow & Sons Inc., a New York corporation
(the "Seller") and Mr. Andrew D. Glasgow, its sole shareholder, to acquire
certain of the assets (the "Assets") of the Seller. The Assets included
intellectual property rights under license agreements to design and manufacture
children's apparel bearing logos, trademarks and tradenames of the National
Football League, the National Basketball Association, Major League Baseball and
the National

                                      -20-
<PAGE>

Hockey League, as well as certain Warner Brothers' properties, including Looney
Tunes, and Saban's Power Rangers, among other licenses. The Company also
acquired certain machinery and equipment from the Seller. The purchase price for
the Assets included a cash consideration of $3.7 million and the issuance of
95,693 shares of Common Stock of the Company having a fair market value of $1.0
million. Such shares of Common Stock are restricted shares, and the Company has
granted certain piggy-back registration rights to the holder of such restricted
stock. The Purchase Agreement also provided for the Company to purchase the
Seller's apparel inventory for an additional cash payment of approximately $2.9
million.

     Management Change and Addition to the Board of Directors
     --------------------------------------------------------

     In connection with the consummation of the transactions contemplated by the
Purchase Agreement, Mr. Glasgow, formerly the President of the Seller, was
elected as a Director of the Company in April 1999. In addition, Mr. Glasgow was
appointed Vice President of the Company and President of the Company's Glasgow
Division on the terms set forth in a five (5) year Employment Agreement with the
Company. Pursuant to such Employment Agreement, Mr. Glasgow is entitled to an
annual base salary of $250,000 and bonuses commensurate with other executive
officers of the Company, which amounts and payments are within the discretion of
the Compensation Committee of the Board of Directors. In addition, Mr. Glasgow
is entitled to receive, in quarterly payments, subject to annual adjustment, a
percentage of certain divisional profits and certain import sales profits of the
Company's Glasgow Division. Mr. Glasgow's Employment Agreement requires Mr.
Glasgow to maintain the confidentiality of Company information and requires that
during the term of his employment with the Company and thereafter for a period
of two years, he will not compete with the Company in any state or territory of
the United States where the Company does business. Mr. Glasgow's Employment
Agreement also provides that, for a period of two years following the
termination of his employment with the Company, he will not solicit the
Company's licensors, customers or employees.

     Merger Transaction
     ------------------

     General
     -------

     See general discussion of Merger in "Part 1. Financial Information, Item 1.
Financial Statements - Note 10.--Plan of Merger."

     Merger Agreement
     ----------------

     An Agreement and Plan of Merger, dated as of September 17, 1999 (as
amended, the "Merger Agreement"), has been entered into by and between the
Company and HK Merger Corp. ("HK"). HK is a New York corporation newly-formed by
H.I.G. Capital, LLC ("HIG") and controlled by HIG-HK Investment Inc. ("HIG-HK"),
an affiliate of HIG. HK was formed solely for the purpose of consummating the
Merger. As of the date hereof, HK has not owned any

                                      -21-
<PAGE>

assets and HK will have no assets or material liabilities or obligations as of
the Effective Time (as defined herein). HK's ability to consummate the Merger is
                                        ----------------------------------------
dependent upon, and its obligations to do so is conditioned upon, HK having
---------------------------------------------------------------------------
received the proceeds of certain financing arranged by HIG. The commitment
----------------------------------------------------------
letters for certain financing arranged by HIG terminate on December 15, 1999.

          Under the terms of the Merger Agreement, each share of Common Stock
held by unaffiliated shareholders of the Company will be converted into the
right to receive $12.00 per share in cash without interest (the "Cash Merger
Price"). Messrs. Jack M. Benun, President, Chief Executive Officer and Chairman,
Mark J. Benun, Executive Vice President, Secretary and Director, and Isaac Levy,
Senior Vice President and Director, of the Company (the "Management
Shareholders"), respectively, who collectively hold 74.69% of the Company's
outstanding Shares, will receive $7.164 per share in cash (the "Management Cash
Price") for 6,874,652 Shares held by them for aggregate cash consideration of
$49.25 million. The remaining Shares held by the Management Shareholders (an
aggregate of 875,348 Shares) will be converted into shares of common stock, par
value $.01 per share, of the Surviving Corporation (the "Surviving Corporation
Stock") representing a 23.61% equity interest in the Surviving Corporation. Each
share of common stock, par value $.01 per share, of HK will be converted into
one share of Surviving Corporation Stock. H.I.G. has committed, through the
purchase of common stock of HK, to contribute $20.3 million in equity capital to
the Surviving Corporation. The Surviving Corporation will pay the Company's
four-year 5.7% promissory notes in an aggregate principal amount of
approximately $5.57 million, issued to the Management Shareholders in connection
with the termination of the Company's S Corporation status. The Company has also
executed certain employment agreements effective upon consummation of the Merger
by and between itself and each of the Management Shareholders.

     Immediately prior to the Effective Time (as defined below) of the Merger,
each holder of a Company stock option to purchase the Common Stock will be
entitled to receive a cash payment equal to the product of (i) the total number
of Shares exercisable pursuant to the holder's stock option (except for non-
employee holders of a stock option, in which case this number will be the total
number of Shares subject to such option regardless of whether or not such stock
option is fully exercisable as of closing) and (ii) the excess of the Merger
Consideration over the exercise price per Share subject to such stock option.
The surrender of a stock option for payment will release all of such holder's
rights in the stock option. All non-exercisable stock options will be assumed by
the Surviving Corporation.

     Termination
     -----------

     The Merger Agreement may be terminated at any time prior to the Effective
Time upon the occurrence of certain events or if the Merger is not consummated
by February 15, 2000. Under certain circumstances, if the Merger is terminated,
the Company shall be entitled to reimbursement from HK of all reasonable out-of-
pocket expenses and fees incurred by the Company prior to the termination of the
Merger Agreement in connection with the transactions

                                      -22-
<PAGE>

contemplated thereby. In the event that the Merger Agreement is terminated under
certain other circumstances, the Company may be obligated to pay to HK a fee of
$4.0 million, without additional reimbursement for fees and expenses.

     The foregoing discussion of the Merger Agreement is qualified in its
entirety by reference to the Merger Agreement filed with this Form 10-Q as
Exhibit 2. and incorporated herein by reference.

     Shareholders Agreement
     ----------------------

     The Shareholders Agreement dated as of September 17, 1999, (the
"Shareholders Agreement") by and among the Company, HIG-HK, the Management
Investors (as defined therein) and the New Shareholders (as defined therein)
provides that from and after the Effective Time each party thereto shall vote
his or its shares of Surviving Corporation Common Stock (and any other voting
securities of the Surviving Corporation over which he or it has voting control)
and shall take all other necessary or desirable action within his or its control
to insure that (a) the authorized number of directors of the Surviving
Corporation shall be the number determined by the Investor, (b) each of the five
representatives designated by HIG-HK (the "Investment Directors") and each of
the four representatives designated by the Management Shareholders (the
"Management Directors") shall be elected to the Board of Directors of the
Surviving Corporation, (c) no Investment Director shall be removed, except upon
the written request of HIG-HK, (d) no Management Director shall be removed,
except upon the written request of a majority of the Management Directors (other
than the director to be removed), (e) any Management Director who ceases to be
an employee of the Surviving Corporation shall be removed as a director, unless
such director was terminated "without cause" or resigned for "good reason" and
such director holds a minimum of five percent (5%) of the outstanding Surviving
Corporation Common Stock, and (f) in the event that any Investment Director or
Management Director ceases to serve as a member of the Board of Directors during
his term of office, the resulting vacancy shall be filled by a representative
designated by the vote of a majority of the shares controlled by HIG-HK (the
"Investor Shares") or a majority of the shares controlled by the Management
Shareholders (the "Executive Shares"), as applicable, provided that if a
Management Director ceases to serve as a result of his termination with "cause"
or resignation without "good reason" then the resulting vacancy shall be filled
by the vote of a majority of the Investor Shares.

     In addition, the terms of the Shareholders Agreement prohibit each holder
of Executive Shares from selling, transferring, assigning, pledging or otherwise
disposing of ("transferring") any interest in his shares without the prior
written consent of HIG-HK, except under certain circumstances.

     Upon termination of the employment of any member of the Management
Shareholders or his resignation (other than termination without cause or
resignation with good reason) all shares of Surviving Corporation Common Stock
issued or issuable to him shall be subject to repurchase by HIG-HK (including
any shares of Surviving Corporation Common Stock held by his

                                      -23-
<PAGE>

transferees), at a price per share equal to $7.164 per share, except that in the
event of his death or disability, such shares may be transferred to the
remaining members of the Management Shareholders provided that if such shares
are not transferred within 60 days of the death or disability of the holder,
such shares shall be subject to repurchase by HIG-HK. All shares eligible for
repurchase by HIG-HK that are not repurchased shall be subject to repurchase by
the Surviving Corporation.

     Prior to consummation of an initial public offering, if the Surviving
Corporation (the "Board of Directors") Board of Directors determines to sell all
or substantially all of the Surviving Corporation's assets or outstanding
capital stock (a "Sale"), the holders of Executive Shares will be given the
opportunity to participate in the sale process, to the extent such participation
does not materially impede the process, and will have the opportunity to make an
offer to the Board of Directors to purchase such assets or capital stock if they
so desire. If the Board of Directors and the holders of a majority of the
outstanding shares of Surviving Corporation Common Stock approve a Sale to an
independent third party or group of independent third parties, then all parties
to the Shareholders Agreement will consent to and raise no objection to such
Sale, will waive all dissenter's rights, appraisal rights or similar rights in
connection with such Sale (if the sale is structured as a merger or
consolidation) and will agree to sell all of their respective shares and rights
to acquire shares in a sale of stock on the terms and conditions approved by the
Board and a majority of the outstanding shares of Surviving Corporation Common
Stock.

     The foregoing discussion of the Shareholders Agreement is qualified in its
entirety by reference to the Shareholders Agreement filed with this Form 10-Q as
Exhibit 4. and incorporated herein by reference.

     Support Agreement
     -----------------

     The Management Shareholders have entered into the Support Agreement with
HK, dated September 17, 1999 (the "Support Agreement"), pursuant to which they
have each agreed to vote their respective shares of Common Stock (including
shares issuable upon exercise of Options prior to the Effective Time) in favor
of the Merger Agreement and the transactions contemplated thereby at a special
meeting or any adjournment thereof. The obligations of the Management
Shareholders to vote in favor of the Merger Agreement and the related proxy
granted under the Support Agreement terminate upon the consummation of the
transactions contemplated by the Merger Agreement or termination of the Merger
Agreement in accordance with its terms. However, if the Merger Agreement is
terminated for any reason that results in the payment of a termination fee by
the Company to HK, then pursuant to the terms of the Support Agreement, the
Management Shareholders will be jointly and severally liable to HK for a
management termination fee of $1.5 million. If, within twelve months following
any termination for which a management termination fee has been paid by the
Management Shareholders, any member of the Management Shareholders sells all or
any portion of Common Stock held by him to any person other than HK or an
affiliate of HK, then the Management Shareholders shall be

                                      -24-
<PAGE>

jointly and severally liable to HK for the payment of a fee equal to the product
of (i) 90% multiplied by (ii) the aggregate number of shares of Common Stock
sold by members of the Management Shareholders in such transaction multiplied by
(iii) the excess of (a) the price per share to be received plus any other
consideration to be received by members of the Management Shareholders over (b)
$7.164. As of September 17, 1999, the parties to the Support Agreement owned
7,750,000 shares of Common Stock, or 74.69% of the outstanding Common Stock.

     The foregoing discussion of the Support Agreement is qualified in its
entirety by reference to the Support Agreement filed with this Form 10-Q as
Exhibit 10. and incorporated herein by reference.

Item 6.   Exhibits and Reports on Form 8-K.

(a)  Exhibits.

     2.   Agreement and Plan of Merger, dated as of September 17, 1999, by and
          between HK Merger Corp. and Happy Kids Inc., as amended.

     4.   Shareholders Agreement, dated as of September 17, 1999, by and among
          Happy Kids Inc., HIG-HK Investment, Inc., each of the persons listed
          in Schedule I thereto and each other person set forth from time to
          time in Schedule I thereto.

     10.  Support Agreement, dated as of September 17, 1999, among HK Merger
          Corp., and the persons listed on Schedule A thereto.

     27.  Financial Data Schedule.

(b)  Reports on Form 8-K.

     On October 4, 1999, the Company filed a Current Report on Form 8-K in
     connection with the execution of the Merger Agreement with HIG and other
     related documents. Such filing was further amended on October 5, 1999 by
     filing Amendment No. 1 to the Form 8-K.

                                      -25-
<PAGE>

                                  SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.



                                        HAPPY KIDS INC.



DATE:     November 15, 1999             By:  /s/ Jack M. Benun
                                           -----------------------------------
                                           Jack M. Benun
                                           President and Chief Executive Officer
                                           (Principal Executive Officer)

DATE:     November 15, 1999             By:  /s/ Stuart Bender
                                           -----------------------------------
                                           Stuart Bender
                                           Chief Financial Officer
                                           (Principal Financial and Accounting
                                            Officer)

                                      -26-
<PAGE>


                                 EXHIBIT INDEX
                                 -------------


Exhibit No.     Document Description
-----------     ------------------------------
     2.         Agreement and Plan of Merger, dated as of September 17, 1999, by
                and between HK Merger Corp. and Happy Kids Inc., as amended.

     4.         Shareholders Agreement, dated as of September 17, 1999, by and
                among Happy Kids Inc., HIG-HK Investment, Inc., each of the
                persons listed in Schedule I thereto and each other person set
                forth from time to time in Schedule I thereto.

     10.        Support Agreement, dated as of September 17, 1999, among HK
                Merger Corp., and the persons listed on Schedule A thereto.

     27.        Financial Data Schedule.


                                      -27-