SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    --------

                                    FORM 10-Q

               QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

                       THE SECURITIES EXCHANGE ACT OF 1934

                For the quarterly period ended September 30, 1998
                           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, 1998:

             Class                                         Number of Shares
             -----                                         ----------------
 Common Stock, $.01 par value                                10,280,000



<PAGE>


                        HAPPY KIDS INC. AND SUBSIDIARIES

                                TABLE OF CONTENTS


                                                                          Page
                                                                          ----

PART I.  CONDENSED CONSOLIDATED FINANCIAL INFORMATION...................    1

     Item 1.  Condensed Consolidated Financial Statements...............    1

              Condensed Consolidated Balance Sheets as of September
                30, 1998 (unaudited) and December 31, 1997..............    2

              Condensed Consolidated Statements of Income for the
                Three and Nine Months Ended September 30, 1998 and
                1997 (audited with respect to the nine months ended
                September 30, 1997).....................................    3

              Condensed Consolidated Statements of Cash Flows for the
                Nine Months Ended September 30, 1998 (unaudited) and 
                1997....................................................    4

              Notes to Condensed Consolidated Financial Statements......    5

     Item 2.  Management's Discussion and Analysis of Financial
                Condition and Results of Operations.....................   10

              Results of Operations.....................................   11

              Liquidity and Capital Resources...........................   13

              Backlog...................................................   14

              Management Information Systems............................   15

              European Monetary Union...................................   16

              Effect of Recently Issued Accounting Standards............   16

PART II. OTHER INFORMATION..............................................   17

     Item 6.  Exhibits and Reports on Form 8-K..........................   17

SIGNATURES..............................................................   18


                                     - i -



<PAGE>














              PART I. CONDENSED CONSOLIDATED FINANCIAL INFORMATION
              ----------------------------------------------------

               Item 1. Condensed Consolidated Financial Statements















                                      - 1 -
<PAGE>


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

                                                               September 30,  December 31,
                                                                  1998          1997
                                                               ------------  -------------
                                                               (unaudited)

                       ASSETS
<S>                                                              <C>           <C>    
CURRENT ASSETS
   Cash ......................................................   $   357       $   374
   Due from factor ...........................................    25,111        24,232
   Accounts receivable - trade (net of allowance of
     $513 at September 30, 1998 and  December 31, 1997) ......       636           316
   Inventories ...............................................    21,331        16,316
   Due from shareholders .....................................      --             347
   Other current assets ......................................     4,352         1,139
                                                                 -------       -------
      Total current assets ...................................    51,787        42,724
FIXED ASSETS - NET ...........................................     1,501         1,476
OTHER ASSETS .................................................       547           752
                                                                 -------       -------
      Total assets ...........................................   $53,835       $44,952
                                                                 =======       =======

        LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
   Due to bank ...............................................   $ 8,315       $24,863
   Current portion - capital lease obligations ...............        37            49
   Accounts payable and accrued liabilities ..................    10,067        11,393
   Due to shareholders .......................................       314          --
                                                                 -------       -------
      Total current liabilities ..............................    18,733        36,305

DEFERRED RENT PAYABLE ........................................       524           584
CAPITAL LEASE OBLIGATIONS ....................................      --              19
DUE TO SHAREHOLDERS ..........................................     5,405         1,400
COMMITMENTS
SHAREHOLDERS' EQUITY:
   Preferred stock - 5,000 shares authorized, $.01
      par value; no shares issued and outstanding ............      --            --
   Common stock - 30,000 shares authorized, $.01 par
      value; 10,280 and  7,750 shares issued and
      outstanding at September 30, 1998 and December
      31, 1997, respectively .................................       103            78
   Additional paid-in capital ................................    23,263         1,119
   Retained earnings .........................................     5,807         5,447
                                                                 -------       -------
      Total shareholders' equity .............................    29,173         6,644
                                                                 -------       -------
      Total liabilities and shareholders' equity .............   $53,835       $44,952
                                                                 =======       =======


            The accompanying notes are an integral part of these statements.


                                          - 2 -
</TABLE>



<PAGE>


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


                                              For the Three Months          For the Nine Months
                                               Ended September 30,           Ended September 30,
                                              --------------------          --------------------
                                               1998           1997            1998        1997
                                            ---------      ---------      ---------     ---------
                                           (unaudited)    (unaudited)    (unaudited)

<S>                                         <C>            <C>            <C>           <C>      
Net sales ...............................   $  46,993      $  37,771      $ 114,721     $  77,328
Cost of goods sold ......................      34,750         28,359         85,302        57,908
                                            ---------      ---------      ---------     ---------
    Gross profit ........................      12,243          9,412         29,419        19,420
                                            ---------      ---------      ---------     ---------
Operating expenses:
    Selling, design and shipping ........       3,648          2,832          9,653         7,552
    General and administrative ..........       2,310          2,570          6,886         6,281
                                            ---------      ---------      ---------     ---------
          Total operating expenses ......       5,958          5,402         16,539        13,833
                                            ---------      ---------      ---------     ---------
          Operating earnings ............       6,285          4,010         12,880         5,587
                                            ---------      ---------      ---------     ---------
Interest expense, net ...................         472          1,154          1,790         2,522
                                            ---------      ---------      ---------     ---------
Income  before income taxes .............       5,813          2,856         11,090         3,065
Provision for income taxes:
     Income taxes .......................       2,442            352          3,838           373
     Deferred tax benefit ...............        --             --           (1,024)         --
                                            ---------      ---------      ---------     ---------

          Total income taxes ............       2,442            352          2,814           373
                                            ---------      ---------      ---------     ---------
          Net income ....................   $   3,371      $   2,504      $   8,276     $   2,692
                                            =========      =========      =========     =========
Basic income
    per common share ....................   $    0.33      $    0.32      $    0.88     $    0.35
                                            =========      =========      =========     =========
Weighted average common
    shares outstanding ..................      10,280          7,750          9,406         7,750
                                            =========      =========      =========     =========
Diluted income
    per common share ....................   $    0.33      $    0.32      $    0.88     $    0.35
                                            =========      =========      =========     =========
Weighted average common
    shares outstanding ..................      10,284          7,750          9,419         7,750
                                            =========      =========      =========     =========

Pro forma data (unaudited):
    Historical income  before
          provision for income taxes ....   $   5,813      $   2,856      $  11,090     $   3,065
    Income taxes ........................       2,442          1,199          4,658         1,287
                                            ---------      ---------      ---------     ---------
          Net income ....................   $   3,371      $   1,657      $   6,432     $   1,778
                                            =========      =========      =========     =========
Pro forma basic income per share ........   $    0.33      $    0.21      $    0.68     $    0.23
                                            =========      =========      =========     =========
Pro forma weighted average
    common shares outstanding ...........      10,280          7,750          9,406         7,750
                                            =========      =========      =========     =========
Pro forma diluted income per share ......   $    0.33      $    0.21      $    0.68     $    0.23
                                            =========      =========      =========     =========
Pro forma weighted average
    common shares outstanding ...........      10,284          7,750          9,419         7,750
                                            =========      =========      =========     =========


                 The accompanying notes are an integral part of these statements.


                                                - 3 -
</TABLE>
<PAGE>


<TABLE>
<CAPTION>
                          HAPPY KIDS INC. AND SUBSIDIARIES
                  CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (in thousands)

                                                             For the Nine Months
                                                             Ended September 30,
                                                           -----------------------
                                                              1998           1997
                                                           --------       --------
                                                          (unaudited)

<S>                                                        <C>            <C>     
Cash flows from operating activities:
Net income .........................................       $  8,276       $  2,692
Adjustments to reconcile net income
   to net cash provided by operating activities:
   Depreciation and amortization ...................            226            260
   Deferred taxes ..................................         (1,024)            99
   Provision for losses on accounts receivable .....             45            355
Changes in operating assets and liabilities:
   Accounts receivable .............................           (365)           131
   Due from factor .................................           (879)        (8,207)
   Inventories .....................................         (5,015)           872
   Other current assets ............................         (2,116)           536
   Other assets ....................................            (30)            12
   Accounts payable and accrued expenses ...........         (1,386)        (1,558)
   Due from shareholders ...........................            347            463
                                                           --------       --------

Net cash used in operating activities ..............         (1,921)        (4,345)
                                                           --------       --------

Cash flows from investing activities:
   Acquisition of fixed assets .....................           (251)           (60)
                                                           --------       --------

Cash flows from financing activities:
   Net borrowings under line of credit .............        (16,548)         7,560
   Payments on capital lease .......................            (31)           (43)
   Borrowings from shareholders ....................           (169)          (160)
   Dividends paid ..................................         (3,428)        (3,007)
   Issuance of common stock ........................         22,331           --
                                                           --------       --------

Net cash provided by financing activities ..........          2,155          4,350
                                                           --------       --------

Net decrease in cash ...............................            (17)           (55)

Cash at beginning of year ..........................            374            674
                                                           --------       --------

Cash at end of period ..............................       $    357       $    619
                                                           ========       ========


          The accompanying notes are an integral part of these statements.





                                         - 4 -
</TABLE>


<PAGE>


                                 HAPPY KIDS INC.

              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
            (Information relating to September 30, 1998 is unaudited)


Note 1 -- Basis of Presentation:

      The  information  presented for the nine-month  period ended September 30,
1998 and for the  three-month  periods  ended  September  30,  1998 and 1997 are
unaudited.  The information  presented for the nine-month period ended September
30,  1997 is audited.  In the  opinion of the Happy Kids Inc.'s (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, 1998 and the results of its
operations for the three-month  and nine-month  periods ended September 30, 1998
and 1997 and its cash flows for the nine- month periods ended September 30, 1998
and 1997.  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, 1997,
which were included as part of the Company's  Registration Statement on Form S-1
(Registration  No.  333-44267)  (the  "Registration  Statement"),   as  declared
effective  by the  Securities  and Exchange  Commission  (the "SEC") on April 2,
1998.

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

      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.



                                      - 5 -


<PAGE>


                                 HAPPY KIDS INC.

              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
            (Information relating to September 30, 1998 is unaudited)


Note 2 -- Initial Public Offering:

      On April 8, 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  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").  See
"Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations -- Liquidity and Capital Resources."



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.

      Prior to the  termination  of the  Company's  S  Corporation  status,  the
Company declared the S Corporation Distribution to the shareholders of record of
the Company on such date. Such shareholders  consisted solely of Jack Benun, the
Company's  Chairman of the Board,  President and Chief Executive  Officer,  Mark
Benun, the Company's  Executive Vice President and Secretary and Isaac Levy, its
Senior Vice President.  Such  distribution  (totaling $7.6 million)  represented
substantially  all  of  the  Company's  remaining  undistributed  S  Corporation
earnings as of the date of termination of S Corporation status, and is evidenced
by four-year 5.7%  promissory  notes issued to such  shareholders  in connection
with the Reorganization.  Of the total S Corporation Distribution,  $2.0 million
of the net proceeds from the Company's  Initial Public Offering was used to make
a partial payment of amounts due under the related promissory notes. The balance
of the S Corporation  Distribution will be paid in accordance with the terms and



                                      - 6 -
<PAGE>


                                 HAPPY KIDS INC.

              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
            (Information relating to September 30, 1998 is unaudited)

provisions of such promissory notes and provides for the timely  distribution of
amounts  necessary to pay  personal  income  taxes of such  shareholders  due on
amounts  earned by the  Company  for the  period  January  1, 1998  through  the
termination of such S Corporation status,  currently estimated to be $314,000 as
of September 30, 1998.

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



Note 4 -- Due to Shareholders:

      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  of  approximately  $314,000.  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  statements  of  income  for the three and
nine-month  periods  ended  September 30, 1998 and 1997 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 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



                                     - 7 -
<PAGE>


                                 HAPPY KIDS INC.

              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
           (Information relating to September 30, 1998 is unaudited)


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:

                                     Three Months Ended      Nine Months Ended
                                        September 30,          September 30,
                                     -------------------     -------------------
                                      1998         1997        1998        1997
                                     -------     -------     -------     -------
                                   (unaudited)  (unaudited) (unaudited)
                                       (In thousands except per share amounts)

Net Income .....................     $ 3,371     $ 2,504     $ 8,276     $ 2,692
Basic EPS:
   Basic common shares .........      10,280       7,750       9,406       7,750
                                     =======     =======     =======     =======
   Basic EPS ...................     $  0.33     $  0.32     $  0.88     $  0.35
                                     =======     =======     =======     =======
Diluted EPS:
   Basic common shares .........      10,280       7,750       9,406       7,750
   Diluted common shares .......           4           0          13           0
                                     -------     -------     -------     -------
   Total diluted shares ........      10,284       7,750       9,419       7,750
                                     =======     =======     =======     =======
   Diluted EPS .................     $  0.33     $  0.32     $  0.88     $  0.35
                                     =======     =======     =======     =======



Note 7 -- Reclassification:

      Certain prior year amounts have been  reclassified  to conform to the 1998
presentation.



                                     - 8 -
<PAGE>


                                 HAPPY KIDS INC.

              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
           (Information relating to September 30, 1998 is unaudited)


Note 8 - Inventories:

      Inventories consist of the following finished goods:

                                     September 30,   December 31,
                                         1998            1997
                                     -------------   -------------
                                            (in thousands)
      
      Warehouse..................     $  17,382        $   8,716
      In-transit and overseas....         4,306            8,010
      LIFO valuation allowance....         (357)            (410)
                                      ---------        ---------
                                      $  21,331        $  16,316
                                      =========        =========

      For the nine months ended  September 30, 1998 and 1997, the liquidation of
LIFO inventories  decreased the cost of sales and,  therefore,  increased income
before  taxes by $53,000 and  $679,000,  respectively.  For the  quarters  ended
September 30, 1998 and 1997, there were  liquidations of the LIFO reserves of $0
and $428,000, respectively.



                                     - 9 -


<PAGE>


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


General

      Happy Kids Inc. is a designer  and marketer of  custom-designed,  licensed
and branded 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. The Company's
major  licenses  currently  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 and its major programs  currently include Sesame
Street for Kmart and New Legends for Kids R Us.

      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 six to nine  months in  advance  of a  selling  season.  As a
result, for 1997 and for the first nine months of 1998, substantially all of the
Company's  playwear was 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.

      Statements contained or incorporated by reference in this Quarterly Report
on Form  10-Q  that  are not  based on  historical  facts  are  "forward-looking
statements" within the meaning of Section 21E of the Securities  Exchange Act of
1934,  as amended,  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;  and (xii) risks  relating to the  Company's  Year 2000
compliance and the Year 2000 compliance



                                     - 10 -
<PAGE>


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, 1998 Compared to Three Months Ended
September 30, 1997

      Net Sales. Net sales increased $9.2 million, or 24.4%, to $47.0 million in
the third quarter of 1998 from $37.8  million in the third quarter of 1997.  The
increase in net sales is  attributable  primarily to increased sales of playwear
of both licensed products and private label programs.

      Gross Profit.  Gross profit increased by $2.8 million,  or 30.0%, to $12.2
million in the third  quarter of 1998 from $9.4 million in the third  quarter of
1997.  The gross profit  margin  increased to 26.1% in the third quarter of 1998
from 24.9% in the third  quarter of 1997.  Such  increase  was due, in part,  to
increased  sales  in  certain  higher  margin  licensed   products  as  well  as
efficiencies in transportation  and handling costs. In addition,  the 1997 gross
margin amount  includes  $428,000 in income due to a decrease in LIFO  reserves,
which  accounted for .05% of such gross margin,  while the 1998 gross margin had
no LIFO reserve adjustment.

      Selling,  Design and  Shipping  Expenses.  Selling,  design  and  shipping
expenses  increased by $816,000,  or 28.8%, to $3.6 million in the third quarter
of 1998 from $2.8  million  in the  third  quarter  of 1997.  This  increase  is
attributable  primarily to higher sales  compensation,  warehousing and shipping
costs  associated  with  increased  sales  volumes.  In  addition,   design  and
production  salaries  increased as a result of the  Company's  expanded  product
lines.  As a percentage  of net sales,  selling,  design and  shipping  expenses
increased to 7.8% in the third quarter of 1998 from 7.5% in the third quarter of
1997.

      General and Administrative  Expenses.  General and administrative expenses
decreased $260,000,  or 10.1%, to $2.3 million in the third quarter of 1998 from
$2.6 million in the third quarter of 1997. This decrease is primarily the result
of decreased  officers'  compensation  resulting from the reduction in officers'
salaries and bonuses implemented in the first quarter of 1998, offset, somewhat,
by higher factor commissions  associated with increased sales volume, as well as
higher  professional  fees  and  expenses  incurred  and  related  to Year  2000
remediation.  As a percentage of net sales, general and administrative  expenses
decreased to 4.9% in the third quarter of 1998 from 6.8% in the third quarter of
1997 due to the operating leverage associated with the higher sales.

      Interest Expense,  net.  Interest expense,  net,  decreased  $682,000,  or
59.1%,  to $472,000 in the third  quarter of 1998 from $1.2 million in the third
quarter of 1997.  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.  As a
percentage  of net  sales,  interest  expense  decreased  to 1.0% for the  third
quarter of 1998, as compared to 3.1% for the third quarter of 1997.



                                     - 11 -


<PAGE>


      Income  Before Income Taxes.  Income  before income taxes  increased  $2.9
million,  to $5.8 million in the third  quarter of 1998 from $2.9 million in the
third quarter of 1997 due to the reasons described above. As a percentage of net
sales,  income  before  income taxes  increased to 12.4% in the third quarter of
1998 from 7.6% in the third quarter of 1997.


Nine Months Ended September 30, 1998 Compared to Nine Months Ended
September 30, 1997

      Net Sales. Net sales increased $37.4 million,  or 48.4%, to $114.7 million
in the first nine months of 1998 from $77.3  million in the first nine months of
1997. The increase in net sales is attributable  primarily to increased sales of
playwear of both licensed products and private label programs.

      Gross Profit.  Gross profit increased by $10.0 million, or 51.5%, to $29.4
million  in the first nine  months of 1998 from $19.4  million in the first nine
months of 1997.  The gross  profit  margin  increased to 25.6% in the first nine
months of 1998 from 25.1% in the first nine months of 1997.  Such  increase  was
due to increased sales in certain licensed products. In addition, the 1997 gross
margin amount  includes  $679,000 in income due to a decrease in LIFO  reserves,
which  accounted  for .04% of such gross  margin,  while the 1998  gross  margin
amount includes $53,000 in income due to a decrease in LIFO reserves,  which had
no effect on gross margin for that period.

      Selling,  Design and  Shipping  Expenses.  Selling,  design  and  shipping
expenses increased by $2.1 million,  or 27.8%, to $9.7 million in the first nine
months of 1998 from $7.6 million in the first nine months of 1997. This increase
is attributable primarily to higher sales compensation, warehousing and shipping
costs associated with increased sales volumes. In addition, advertising expenses
increased due to cooperative advertising charges from a licensor associated with
a major licensing  program.  Also,  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 decreased to 8.4%
in the first nine months of 1998 from 9.8% in the first nine months of 1997.

      General and Administrative  Expenses.  General and administrative expenses
increased  $605,000,  or 9.6%,  to $6.9 million in the first nine months of 1998
from $6.3 million in the first nine months of 1997.  This  increase is primarily
the result of higher factor commissions  associated with increased sales volume,
as well as higher  professional and data processing  expenses offset somewhat by
reduced  officers'  compensation  implemented in the first quarter of 1998. As a
percentage of net sales,  general and administrative  expenses decreased to 6.0%
in the first nine  months of 1998 from 8.1% in the first nine months of 1997 due
to the operating leverage associated with the higher sales.

      Interest Expense,  net.  Interest expense,  net,  decreased  $732,000,  or
29.0%, to $1.8 million in the first nine months of 1998 from $2.5 million in the
first nine months of 1997.  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. As a
percentage of net sales,  interest expense  decreased to 1.6% for the first nine
months of 1998, as compared to 3.3% for the first nine months of 1997.



                                     - 12 -
<PAGE>


      Income  Before Income Taxes.  Income  before income taxes  increased  $8.0
million,  to $11.1 million in the first nine months of 1998 from $3.1 million in
the  first  nine  months  of  1997  due to the  reasons  described  above.  As a
percentage of net sales,  income  before  income taxes  increased to 9.7% in the
first nine months of 1998 from 4.0% in the first nine months of 1997.



Liquidity and Capital Resources

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

      Through the consummation of the Company's Initial Public Offering on April
8, 1998, the Company's Line of Credit  permitted  borrowings up to $42.0 million
as a revolving  credit line to expire on December  31,  1998,  subject to annual
renewals  (adjusted  seasonally  to $47.0  million  from January 1, 1998 through
April 30,  1998).  The Company  executed an amendment  of its  existing  Line of
Credit  whereby  upon   effectiveness   of  the  Initial  Public   Offering  and
satisfaction of certain conditions,  the Company's Line of Credit was amended to
provide  for a  discretionary  one  year  revolving  Line of  Credit,  renewable
annually,  providing for advances and letter of credit  accommodations up to the
lesser of (a) $49.0 million  through April 30, 1998,  (b) $42.0 million from May
1, 1998  through  December  31,  1998,  (c) $47.0  million  from January 1, 1999
through  March 31,  1999,  or (d) 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 could not
exceed $35.0  million  from January 1, 1998 to April 30, 1998 and $30.0  million
thereafter,  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, 1998). In addition, in
connection  with the  amendment to the Line of Credit,  personal  guarantees  of
certain  of  the  Company's  present  shareholders  under  the  Line  of  Credit
terminated and the collateral pledged by such shareholders were released.

      Prior to such amendment,  the first $5.0 million of borrowings  under this
Line of  Credit  bore  interest  at the  prime  rate plus  4.0%.  The  remaining
borrowings bore interest at the prime rate plus 1.0%. Additionally,  the Company
was  subject to certain  fees  associated  with the Line of Credit.  The Line of
Credit is collateralized  by substantially all of the assets of the Company.  As
of  September  30,  1998 the  Company  had $8.3  million of  outstanding  direct
borrowings  and $16.1  million of contingent  liabilities  under open letters of
credit.

      The Company used approximately  $17.1 million of the net proceeds from its
Initial Public Offering consummated on April 8, 1998 and all of the net proceeds
(approximately  $3.1 million)  received in  connection  with the exercise of the
underwriters'  over-allotment option consummated on April 23, 1998 to reduce the
outstanding balance of direct borrowings under the Line of Credit.

     In addition,  the Company's  lender has sole discretion to make or withhold
advances  under the Line of Credit.  There can be no  assurance  that the lender
will continue to lend under the Line

                                     - 13 -


<PAGE>


of Credit.  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.

      On April 8, 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 Line of Credit.

      As of  September  30,  1998,  the  Company's  other  principal  sources of
liquidity  included  cash of $357,000,  amounts due from factor of $25.1 million
and net  accounts  receivable  of $636,000.  The Company had working  capital of
$33.1 million and long-term debt of $5.9 million as of September 30, 1998.

      For the nine months ended  September 30, 1998,  operating  activities used
cash of $1.9 million primarily as a result of a decrease in accounts payable and
accrued  expenses  of $1.4  million,  an  increase in amounts due from factor of
$900,000, an increase in inventory of $5.0 million and increased other assets of
$2.1  million,  offset  by net  income of $8.3  million.  Net cash  provided  by
financing  activities  during  the  same  period  was  $2.2  million  consisting
primarily of the proceeds of the Company's  Initial Public  Offering,  offset by
net  borrowings of $16.6 million under the Company's Line of Credit and payments
to shareholders of $3.4 million.

      Historically,  the Company's business has not required significant capital
expenditures.  The  Company's  capital  expenditures  for the nine months  ended
September  30, 1998 and 1997,  were  $251,000  and  $77,000,  respectively.  The
Company  believes  that cash flow  expected  to be  generated  from  operations,
together with borrowings under its existing Line of Credit, as amended,  will be
adequate  to satisfy  current and  planned  operations  for at least the next 12
months.



Backlog

     The Company's customers order specific quantities of goods on a fixed-price
basis six 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.



                                     - 14 -


<PAGE>


Many of the Company's orders are received  significantly in advance of scheduled
delivery  periods.  Consequently,  the Company had backlog of $105.9  million at
September  30,  1998,  all of which it expects to ship over the next six to nine
months.



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
J.C.  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.  The Company is also able to notify  certain of its  clients'
warehouses, in advance, as to shipments.


      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 second 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 each such entity  indicates that each is, or will be, Year 2000  compliant.
The  Company has  incurred  approximately  $100,000  of  expenses  for Year 2000
remediation  costs in the nine months  ended  September  30, 1998 and  estimates
future  additional  expenditures  for Year  2000  remediation  of  approximately
$50,000.  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.


                                     - 15 -



<PAGE>


European Monetary Union

      On January 1, 1999, eleven of the fifteen member countries of the European
Union are scheduled to set fixed  conversion rates between their existing legacy
currencies and the euro. At such time, 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

      SFAS No. 131,  "Disclosures  about  Segments of an Enterprise  and Related
Information"  ("SFAS  No.  131") was  issued in June  1997.  This  statement  is
effective for the Company's fiscal year ending December 31, 1998. This statement
changes the way public  companies  report  information  about  segments of their
business  in their  annual  financial  statements  and  requires  them to report
selected segment  information in their quarterly  reports.  Adoption of SFAS No.
131 is not  expected  to  have a  material  effect  on the  Company's  financial
statement disclosures.


                                     - 16 -



<PAGE>


                           PART II. OTHER INFORMATION


Item 6.  Exhibits and Reports on Form 8-K

        (a)   Exhibits.

              27    Financial Data Schedule

        (b)   Reports on Form 8-K.

              No reports  on  Form  8-K were filed  during the quarter for which
              this report on Form 10-Q is filed.







                                     - 17 -



<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 6, 1998             By: /s/ Jack Benun
                                         ---------------------
                                         Jack Benun
                                         President and Chief Executive Officer
                                         (Principal Executive Officer)




DATE:   November 6, 1998             By: /s/ Stuart Bender
                                         ---------------------
                                         Stuart Bender
                                         Chief Financial Officer
                                         (Principal Financial and Accounting
                                         Officer)



                                     - 18 -