SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                 --------------

                                    FORM 10-K

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

                  For the fiscal year ended December 31, 1998
                                            -----------------

                         Commission File Number 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)

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

      Title of each class             Name of Each Exchange on Which Registered
      -------------------             -----------------------------------------

  None
----------------------------------   -------------------------------------------


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

                          Common Stock, $0.01 par value
--------------------------------------------------------------------------------
                                (Title of Class)


<PAGE>

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


     State  the  aggregate  market  value of the  voting  common  stock  held by
non-affiliates  of the  registrant:  $28,146,250  at March 15, 1999 based on the
last sales price on that date.


     Indicate the number of shares outstanding of each of the registrant's
classes of common stock, as of March 15, 1999:


                 Class                              Number of Shares
                 ------                           ------------------
     Common Stock, $0.01 par value                     10,280,000


     The  following  documents  are  incorporated  by reference  into the Annual
Report on Form 10-K: Portions of the registrant's definitive Proxy Statement for
its 1999 Annual Meeting of Stockholders  are incorporated by reference into Part
III of this Report.




<PAGE>
                                TABLE OF CONTENTS



              Item                                                      Page
              ----                                                      ----

PART I           1. Business.......................................       1

                 2. Properties.....................................       9

                 3. Legal Proceedings..............................       9

                 4. Submission of Matters to a Vote of Security
                     Holders.......................................       9

PART II          5. Market for the Company's Common Equity
                     and Related Stockholder Matters...............      10

                 6. Selected Consolidated Financial Data...........      12

                 7. Management's Discussion and Analysis of
                    Financial Condition and Results of Operations..      13

                7A. Quantitative and Qualitative Disclosure
                     About Market Risk.............................      20

                 8. Financial Statements and Supplementary Data....      20

                 9. Changes in and Disagreements with Accountants
                    on Accounting and Financial Disclosure.........      20

PART III        10. Directors and Executive Officers of the
                     Company.......................................      21

                11. Executive Compensation.........................      21

                12. Security Ownership of Certain Beneficial
                    Owners and Management..........................      21

                13. Certain Relationships and Related Transactions.      21

PART IV         14. Exhibits, Financial Statement Schedules,
                    and Reports on Form 8-K........................      22

SIGNATURES.........................................................      23

EXHIBIT INDEX......................................................      25

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS.........................     F-1


                                        i
<PAGE>
                                     PART I


ITEM 1.   BUSINESS.

GENERAL

     Happy Kids Inc.  ("Happy Kids" or the "Company") 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  (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.

     In 1995, to leverage its customer  relationships,  its popular licenses and
brand names and its reputation for quality products and reliable  delivery,  the
Company  initiated  its  current  sales  strategy  under which  customers  order
specific  quantities  of goods on a  fixed-price  basis  three to nine months in
advance  of a selling  season.  For  1998,  substantially  all of the  Company's
apparel was produced upon receipt of customer orders. Based upon orders received
as of December 31,  1998,  the Company had backlog of $123.5  million,  which it
expects to fill over the  following  three to nine  months.  However,  in recent
months  subsequent  to the  year  ended  December  31,  1998,  the  Company  has
experienced a significant  increase in orders  involving a rapid turnaround from
the date the order is placed to the shipment date.

     Also  in  1995,  the  Company  began  focusing  on  the  development  of  a
diversified  portfolio  of popular,  established  and  well-recognized  licensed
properties and branded private label arrangements. Consequently, the Company has
shifted its product mix to higher  margin  licensed  and private  label  apparel
programs from lower margin house  brands.  As a result of this change in product
mix combined with the implementation of the Company's sales strategy,  net sales
and gross margins increased as follows:

                              Net Sales         Gross Margins
                              ---------         -------------
           1998           $154.6 million             26.4%
           1997           $106.7 million             25.2%
           1996           $ 90.7 million             23.0%
           1995           $ 79.8 million             18.5%

     Additionally,  the  Company has been able to leverage  the  popularity  and
goodwill  associated  with its  licensed  properties  and brand names to promote
sales, rather than undertaking costly marketing initiatives.

     The  Company's  playwear  is designed  by over 50  in-house  designers  and
graphic artists  organized in teams dedicated to each of the Company's  licensed
properties and private label  programs.  Each team works closely with licensors,
customers and contract manufacturers,

                                       1
<PAGE>
utilizing state-of-the-art CAD systems, to design coordinated products featuring
textured  fabrications  and detailed  graphics.  The Company  believes  that its
customers  rely on its  ability to design,  have  manufactured  and deliver on a
timely basis commercially  successful apparel programs.  The Company markets its
playwear  primarily  to  mass-market   retailers,   mid-tier   distributors  and
department stores, including Kmart, Target and WalMart.

     The Company's  products are manufactured to exacting quality  standards and
specifications   by  over  75  unaffiliated,   foreign  and  domestic   contract
manufacturers.  The Company uses  third-party  manufacturers  to  eliminate  the
significant   capital  investment   requirements   associated  with  maintaining
manufacturing facilities. The Company has developed long-standing  relationships
with many of its contract  manufacturers.  The  Company's  ability to design and
have  manufactured  high-quality  playwear is evidenced by the Company's product
return rates of 2.0% and 1.9% in 1998 and 1997, respectively.

     The  Company's  growth  strategy is to continue to leverage the strength of
its diversified  portfolio of licensed  properties,  private label relationships
and the quality of its  playwear  products.  The key  elements of this  strategy
include:

     o   to increase sales to existing accounts by expanding product  categories
         and sizes  incorporating the Company's existing licensed properties and
         private label relationships;

     o   to  expand  the  Company's  customer  base  by  selling  to  additional
         mass-market  retailers,   mid-tier  distributors,   department  stores,
         specialty retailers and sporting goods chains;

     o   to  leverage  newly  acquired  licensed  properties  and  private label
         relationships; and

     o   to  add  new  licenses  and  private   label   relationships  based  on
         established and popular brands.


REORGANIZATION

     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  business  operations in 1979, all under the common  ownership of the
principal shareholders of the Company,  consisting of Messrs. Jack M. Benun, the
Company's Chairman of the Board,  President and Chief Executive Officer, Mark J.
Benun, the Company's Executive Vice President and Secretary, and Isaac Levy, the
Company's  Senior Vice  President.  On April 1, 1998,  immediately  prior to the
effectiveness  of the Company's  initial  public  offering on April 2, 1998 (the
"IPO"),  all of such separate entities became  wholly-owned  subsidiaries of the
Company.   The  Company  issued   4,262,500  shares  of  Common  Stock  to  such
shareholders  in  exchange  for  their  ownership  of  these  separate  business
entities.  All share and per share amounts  throughout  this Form 10-K have been
restated to retroactively reflect such reorganization.


                                       2
<PAGE>
PRODUCTS AND LICENSES

     The Company's  playwear  products are designed and marketed as  coordinated
apparel programs and include knit tops, bottoms, overalls, shortalls,  coveralls
and  swimwear.  The  Company's  products  are  marketed  in a  variety  of  size
categories including newborns,  infants,  toddlers (2T-4T),  boys (4-7 and 8-20)
and girls (4-6x and 7-16).  The  following  is a  description  of the  Company's
current apparel programs:
<TABLE>
<CAPTION>

 EXISTING LICENSED AND BRANDED                                                                   CURRENT SIZE
        APPAREL PROGRAMS           DESCRIPTION         CURRENT DISTRIBUTION CHANNELS             OFFERINGS
--------------------------------------------------------------------------------------------------------------------------

<S>                              <C>                   <C>                                   <C>
AND 1........................... Basketball apparel    Top-line specialty athletic           Toddlers, boys
                                                       retailers, mid-tier athletic
                                                       retailers and full-price
                                                       department stores with athletic
                                                       concept shops

B.U.M. Equipment................ Lifestyle activewear  Mass-market retailers,                Newborns, infants,
                                                       mid-tier distributors                 toddlers, boys, girls

Canyon River Blues for Sears.... Activewear            Sears                                 Infants, toddlers, boys
                                                                                             (4-7), girls (4-6x)

E.N.U.F. Internationale......... Lifestyle activewear  Mid-tier distributors,                Boys, girls
                                                       department stores

First Moments for Kohls......... Infantwear            Kohls                                 Newborns, infants

Lullaby Club for Target......... Infantwear            Target                                Newborns, infants

New Legends for Kids R Us....... Activewear            Kids R Us                             Toddlers, girls

Nickelodeon's Rugrats........... Character-based       Mass-market retailers,                Boys, girls
                                 activewear            mid-tier distributors,
                                                       department stores

Sesame Street for Kmart......... Character-based       Kmart                                 Infants, toddlers, boys
                                 activewear                                                  (4-7), girls (4-6x)

Warner Brothers' Scooby Doo..... Character-based       Mid-tier distributors,                Boys, girls
                                 activewear            mass-market retailers

World Wrestling Federation...... Character-based       Mass-market retailers, mid-tier       Boys
                                 apparel               distributors, department
                                                       stores, specialty retailers

 NEW LICENSED AND BRANDED
     APPAREL PROGRAMS              DESCRIPTION         ANTICIPATED DISTRIBUTION CHANNELS     ANTICIPATED LAUNCH (1)
--------------------------------------------------------------------------------------------------------------------------
Arthur.......................... Character-based       Mid-tier distributors,                Fall 1999
                                 activewear            department stores

Jim Henson's Kermit the Frog
and Friends..................... Character-based       Mass-market retailers, mid-tier       Holiday 1999 (2)
                                 activewear            distributors, department stores

MECCA........................... Activewear            Mid-tier distributors,                Holiday 1999
                                                       department stores

MUDD............................ Sportswear            Mid-tier distributors,                Holiday 1999
                                                       department stores

Teletubbies..................... Character-based       Mass-market retailers, mid-tier       Fall 1999
                                 activewear            distributors, department stores

-------------
(1) Initial sales of such products are expected to occur subsequent to December 31, 1998.
(2) The Company has negotiated a deal with Kmart to launch  such license exclusively with Kmart.
</TABLE>


                                       3
<PAGE>
     The  Company's  current  licensing  arrangements  contain  initial terms of
between eighteen months and five years,  and typically  include multiple renewal
options of between  one and five  years,  subject  to  certain  conditions.  The
present terms of the Company's current license  arrangements will expire between
December  1999  and May  2003.  The  Company's  licenses  generally  require  an
initiation  fee and/or  minimum  annual  royalties  to be recouped  from ongoing
royalty  payment  obligations,  which  currently range from 6.0% to 12.0% of the
Company's  net sales of  products  incorporating  a licensed  property.  Apparel
industry  licenses  typically  are granted with  respect to product  categories,
sizes  and   channels  of   distribution,   and  may  be  either   exclusive  or
non-exclusive.  Virtually  all of the  licenses are  non-assignable  without the
consent of the  licensors and may be terminated by the licensor upon a change of
control of the Company.  The Company's private label relationships are conducted
on a purchase  order basis,  rather than pursuant to contract.  Net sales by the
Company for 1998 attributable to its licensing or private label arrangements for
Nickelodeon's  Rugrats,  B.U.M.  Equipment,  AND 1 and  Sesame  Street for Kmart
accounted  for 20.2%,  14.4%,  14.1% and 17.8% of net sales,  respectively.  Net
sales by the Company for 1997  attributable  to its  licensing or private  label
arrangements  for B.U.M.  Equipment,  Nickelodeon's  Rugrats,  Ocean Pacific and
Sesame  Street  for Kmart  accounted  for 18.9%,  11.3%,  11.1% and 14.3% of net
sales, respectively.  No other licensing or private label arrangements accounted
for more than 10% of the Company's net sales in either 1998 or 1997.


MERCHANDISING

   Design

     The Company's  playwear products are designed by over 50 in-house designers
and  graphic  artists  organized  in teams  dedicated  to each of the  Company's
licensed  properties  and private label  programs.  Each team works closely with
licensors, customers and contract manufacturers,  utilizing state-of-the-art CAD
systems,  to design coordinated  products  featuring  textured  fabrications and
detailed  graphics.  The Company believes that its customers rely on its ability
to  design,  have  manufactured  and  deliver  on a  timely  basis  commercially
successful apparel programs.

     The design process incorporates product design, merchandising, sourcing and
production. The Company's design and merchandising teams continually monitor and
evaluate the children's playwear market for styles and trends in fabrics,  trims
and  accessories,  as well as analyze online sales  information  provided by its
customers. In conjunction with its customers and licensors, the Company's design
teams identify specific design needs and develop product  programs.  The Company
oversees all garment  production,  including  pattern  development and color and
sample approval,  through regular communication with the Company's customers and
contract manufacturers.


                                       4
<PAGE>
   Sales and Marketing

     The Company markets and  distributes its products  through four channels of
distribution, including mass-market retailers, mid-tier distributors, department
stores and specialty  retailers,  including  sporting  goods chains.  All of the
Company's  sales are within the  United  States.  Recently,  the  Company  began
exploring  strategies  to exploit  the  growing  trend of  electronic  commerce,
including  seeking to expand certain of its licenses to permit internet sales as
a channel of  distribution  and engaging a website  design firm.  The  Company's
customers include:

     MASS-
    MARKET         MID-TIER             DEPARTMENT               SPECIALTY
   RETAILERS     DISTRIBUTORS             STORES                 RETAILERS
   ---------     ------------      --------------------          ---------

     Kmart         Kids R Us          Dayton Hudson               Champs

    Target       Price/Costco      Federated Department         FootAction
                                          Stores

    WalMart          Sears              JC Penney               Foot Locker

                     Kohls               Dillards

     In 1995, to leverage its customer  relationships,  its popular licenses and
brand names and its reputation for quality products and reliable  delivery,  the
Company  initiated  its  current  sales  strategy  under which  customers  order
specific  quantities  of goods on a  fixed-price  basis  three to nine months in
advance  of a selling  season.  For  1998,  substantially  all of the  Company's
apparel was produced upon receipt of customer orders. Additionally,  the Company
has been able to  leverage  the  popularity  and  goodwill  associated  with its
licenses  and brand  names to promote  sales,  rather  than  undertaking  costly
marketing initiatives.

     As of December 31, 1998, the Company maintained a sales and marketing staff
of 23 people,  including  its senior  management.  The Company is  organized  in
account teams led by key account sales executives.  Each account sales executive
reports  directly to senior  management  and is  responsible  for the day to day
customer  relationship  management and for  supervising and monitoring the sales
staff.  The Company's  sales staff is  compensated  on a salary plus  commission
basis.

     The Company's  sales and  marketing  staff works closely with the Company's
designers and graphic artists throughout the design and production process.  The
Company's  customers  often  launch a new  product  line  associated  with a new
license or private  label  relationship  in a limited  number of stores.  If the
product is  successful,  the Company's  customers  often market the product line
throughout  their retail chains or in a  significantly  larger number of stores.
The  Company's  design team and sales staff work closely  with its  customers to
monitor, review and analyze product launches.



                                       5
<PAGE>
     The   Company's   customer  base  has  been  and  continues  to  be  highly
concentrated.  Sales of the  Company's  products  to each of Kmart,  Target  and
WalMart  accounted  for  approximately  22.3%,  14.0% and 11.4% of net sales for
1998,  respectively.  Sales of the Company's  products to each of  Price/Costco,
Kmart and Kids R Us accounted for  approximately  17.4%,  14.3% and 11.0% of net
sales for 1997,  respectively.  Based upon  historical  and recent  results  and
existing  relationships with customers,  the Company believes that a substantial
portion of its net sales and gross  profits  will  continue to be derived from a
small number of large  customers.  There can be no assurance  that the Company's
larger  customers  will continue to place orders with the Company or that orders
by such customers will continue at their previous levels.


MANUFACTURING

   Contract Manufacturers

     The Company's  products are manufactured to exacting quality  standards and
specifications   by  over  75  unaffiliated,   foreign  and  domestic   contract
manufacturers.  The Company uses  third-party  manufacturers  to  eliminate  the
significant   capital  investment   requirements   associated  with  maintaining
manufacturing  facilities.  For 1998 and 1997,  foreign  manufacturers  produced
approximately 86.2% and 93.4% of the Company's products,  respectively, with the
remainder of products produced domestically.

     The Company  works with  independent  buying  agents in five  countries  to
assist the Company in  selecting a contract  manufacturer.  The Company and such
buying agents review, among other things,  quality of merchandise produced,  the
ability of such  manufacturer  to meet the  Company's  timing  requirements  for
delivery and price. The Company is not a party to long-term contractual or other
arrangements  with any manufacturer and often uses more than one manufacturer to
produce a coordinated  apparel  program.  The Company believes that it has ready
access  to  numerous  contract  manufacturers  and  that its  existing  contract
manufacturers have the ability to manufacture across several product lines.

     During 1998 and 1997,  various  production  facilities  located in Thailand
accounted  for an  aggregate  of 43.1% and 41.4% of the  Company's  manufactured
products, respectively, and various production facilities in Hong Kong accounted
for an  aggregate  of 29.1% and 30.7% of the  Company's  manufactured  products,
respectively.  No  other  country  accounted  for 10% or  more of the  Company's
manufactured products during 1998 or 1997. In addition, a manufacturing facility
located in Hong Kong accounted for 17.7% of the Company's  manufactured products
during  1998 and  12.6% in 1997.  In  addition,  another  facility  in Hong Kong
accounted for 10.6% of the Company's manufactured products during 1997. No other
single  manufacturer  accounted  for 10% or more of the  Company's  manufactured
products during 1998 or 1997.

     The Company's  products are subject to bilateral textile agreements between
the United States and a number of foreign countries. Such agreements, which have
been negotiated  under the framework  established by the  Arrangement  Regarding
International Trade in Textiles, allow the United States to impose restraints at
any time on the importation of categories of merchandise  that,  under the terms
of the agreements  are not currently  subject to specified  limits.  The Company
does not own the right to import finished  garments into the United States,  but
relies on its

                                       6
<PAGE>
contract  manufacturers  to obtain the  necessary  quotas.  In the past,  to the
extent that  necessary  import quotas have not been  available with respect to a
particular  source of supply,  the Company has been able to find an  alternative
source of supply. Accordingly, the availability of quotas has not had a material
effect  upon  the  Company's   business,   financial  condition  or  results  of
operations.  The Company's  continued ability to source products that it imports
may be adversely  affected by a significant  decrease in available import quotas
as well as any additional bilateral agreements or unilateral trade restrictions.
In addition, a significant portion of the Company's products are manufactured in
Hong Kong. China recently resumed sovereignty over Hong Kong. The Company cannot
predict the effect,  if any, this event will have on its contract  manufacturers
in Hong Kong and there can be no  assurance  that Hong Kong will not  experience
political,  economic  or  social  disruption  as a result of the  resumption  of
Chinese  sovereignty.  In  addition,  there  have been a number of recent  trade
disputes  between China and the United States during which the United States has
threatened to impose tariffs and duties on some products imported from China and
to withdraw China's "most favored nation" trade status.  The loss of such status
for China,  changes in current  tariff  structures or the adoption by the United
States of trade  policies  or  sanctions  adverse to China could have a material
effect on the Company's business, financial condition or results of operations.

     The  principal  raw  materials  used  in the  production  and  sale  of the
Company's  products are yarn, fabric,  trim, buttons and other accessories.  Raw
materials are purchased by the  manufacturers  who deliver finished goods to the
Company.  The Company  believes that an adequate supply of raw materials used in
the  manufacture  of  its  products  is  readily  available  from  existing  and
alternative sources at reasonable prices.

   Quality Control

     The Company has in place comprehensive quality control procedures to ensure
that fabrics,  materials and finished goods meet the Company's  exacting quality
standards.  The Company  utilizes both internal and independent  quality control
representatives  to monitor contract  manufacturers'  production  processes.  In
addition,  certain of the Company's buying agents engage their own personnel who
monitor compliance with the Company's quality control specifications.

     The  Company  oversees  testing  of  yarns  and  trim  for   colorfastness,
washability  and other standards  before sample garments are produced.  Selected
product samples are sent to independent  testing  facilities which test garments
for colorfastness,  washability, size specifications and other standards. Sample
garments are randomly  subjected to similar quality control tests by the Company
for  fit  and  appearance.  Foreign  and  domestic  contract  manufacturers  are
routinely  visited on a spot check basis to ensure compliance with the Company's
quality  standards.  Finished  garments are subject to final  inspection  in the
Company's  warehouse  for general  appearance  and quality  prior to shipment to
customers.  Prior to shipment,  inspection  certificates  are issued to indicate
that the products have been  inspected  and found to be in  conformity  with the
order. Products which are manufactured in foreign countries are tested to ensure
that such products meet United States customs import requirements by the foreign
manufacturers  prior to  shipment,  and the  results of such  tests,  along with
samples of each product style, are sent to the Company.



                                       7
<PAGE>
The Company's ability to design and have manufactured  high-quality  playwear is
evidenced  by the  Company's  product  return rates of 2.0% and 1.9% in 1998 and
1997, respectively.


DISTRIBUTION

     Upon completion of the manufacturing  process,  the Company's  products are
shipped from the  contract  manufacturers  by sea, air or land to the  Company's
domestic warehouse facilities.  The Company utilizes its warehouse facilities in
New Brunswick,  New Jersey,  or its public warehouse  arrangement in Long Beach,
California prior to shipping its products  directly to its customers'  stores or
distribution centers via common carrier.


INDUSTRY AND COMPETITION

     The children's playwear industry is highly competitive and fragmented.  The
Company  competes  with many  companies  engaged in the design,  production  and
distribution of children's  apparel for newborns,  infants,  toddlers,  boys and
girls.  Some of the Company's  competitors have longer  operating  histories and
financial, sales, marketing, design capabilities and other competitive resources
which are  substantially  greater  than those of the  Company.  The Company also
faces  competition  from its existing  customers,  who may  themselves  begin to
produce children's  playwear directly.  In addition,  such customers have in the
past competed,  and may continue in the future to compete, for available branded
programs.  Further,  to the extent that the Company's  customers or  competitors
maintain or initiate private label programs,  such customers or competitors will
compete with the  Company's  licensed and branded  properties.  The Company also
competes with other manufacturers of children's apparel for retail floor space.

     The Company believes that the principal  competitive  factors affecting its
business include:

     o   the ability to deliver,  on a timely  basis,  high quality  coordinated
         playwear apparel;

     o   the ability to successfully  obtain licensing  arrangements and private
         label  relationships  based on characters and brands that are appealing
         to children and parents;

     o   the ability to successfully design  coordinated  apparel programs based
         on such licensing arrangements and relationships; and

     o   the ability to produce playwear at competitive prices.


EMPLOYEES

     As of December 31, 1998, the Company employed 172 persons, consisting of 23
in sales and  marketing,  69 in design and graphic arts, 48 in  warehousing  and
distribution and 32 in finance,  administration and management.  Twenty eight of
the Company's 48 employees at its New Brunswick,  New Jersey warehouse  facility
are subject to a collective  bargaining  agreement (the


                                       8
<PAGE>
"Collective  Bargaining  Agreement") between Hawk Industries,  Inc. ("Hawk"),  a
wholly-owned  subsidiary of the Company,  and Journeymen's and Production Allied
Services of America and Canada International Union, Local No. 157 (the "Union").
The initial term of such Collective Bargaining Agreement began on August 1, 1996
and extends to July 31, 1999, and shall continue  thereafter  from year to year,
unless  terminated or modified by written  notice  within  certain time periods.
Pursuant to the Collective Bargaining  Agreement,  the Company must, among other
obligations,  recognize the Union as the exclusive  representative of all of the
employees covered under the Collective  Bargaining  Agreement,  endeavor to seek
all employment,  new or otherwise,  through the Union,  require all employees of
Hawk,  as a condition  to  employment,  to become  members of the Union within a
specified  time period and  maintain  specified  hours of work.  The  Collective
Bargaining  Agreement  also  contains  terms  governing,   among  other  things,
overtime,  holidays,  vacations,  leave of  absence,  rest  periods,  safety and
health, strikes and lockouts, wages, grievance procedures and health and welfare
plans.  The Company has not had any significant work stoppages and considers its
relations with its employees to be good.


ITEM 2.     PROPERTIES.

     The Company  currently  leases all of its office space.  The Company leases
approximately  23,000 square feet for its executive offices and showroom located
at 100 West 33rd Street,  New York,  New York.  Such lease  expires in September
2005 and contains  renewal  options for an additional  three and one half years.
The Company also leases  approximately  130,000 square feet for  warehousing and
distribution at its warehouse facility in New Brunswick,  New Jersey. Such lease
expires in March 2000 and contains  renewal options for two additional five year
terms. The Company also maintains a small showroom in Bentonville, Arkansas. The
Company  believes that its  facilities  are sufficient to meet current needs for
its sales,  marketing,  design,  administrative,  warehousing  and  distribution
requirements.


ITEM 3.     LEGAL PROCEEDINGS.

     The Company is not a party to any material legal proceedings.


ITEM 4.     SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

     Not applicable.





                                       9
<PAGE>
                                   PART II


ITEM 5.     MARKET FOR THE  COMPANY'S  COMMON  EQUITY AND RELATED  STOCKHOLDER
            MATTERS.

     Prior to April 1998, there was no established market for the Company's
Common  Stock.  Since April 2, 1998,  the Common  Stock has traded on the Nasdaq
National Market ("NNM") under the symbol "HKID."

     The  following  table sets forth the high and low bid  information  for the
Common Stock for each of the quarters  since the quarter  ended June 30, 1998 as
reported on the NNM. Such quotations reflect inter-dealer prices, without retail
mark-up, mark-down or commission and may not represent actual transactions.

          QUARTER ENDED              HIGH               LOW
     ----------------------------------------------------------------

     June 30, 1998...........     $  14.75           $  10.50
     (from April 2, 1998)
     September 30, 1998......     $  14.00           $   7.375
     December 31, 1998.......     $  13.625          $   7.125

     As of March 15, 1999,  the  approximate  number of holders of record of the
Common  Stock was 22 and the  approximate  number of  beneficial  holders of the
Common Stock was 839.

     The Board of  Directors  intends to retain any  earnings  of the Company to
support  operations  and to  finance  expansion  and does not intend to pay cash
dividends  on  the  Common  Stock  in  the   foreseeable   future.   Any  future
determination  as to the payment of dividends  will be at the  discretion of the
Board of  Directors,  and will  depend  on the  Company's  financial  condition,
results of operations,  capital requirements and such other factors as the Board
of Directors  deems  relevant.  The Company also  currently is restricted by the
terms of its credit facility from paying cash dividends on its Common Stock.

     The Company and certain of its  subsidiaries  had been  treated for federal
and state  income tax  purposes as S  Corporations  under  Sub-chapter  S of the
Internal  Revenue Code of 1986,  as amended,  since 1988.  As a result of such S
Corporation   status,  the  then  current   shareholders  of  each  such  entity
(consisting  solely of the shareholders of each such entity immediately prior to
the  effectiveness  of the IPO),  rather  than  such  entities,  had been  taxed
directly on earnings for federal and certain state income tax purposes,  whether
or not such earnings were distributed. Immediately prior to the effectiveness of
the IPO, each such entity  terminated  its status as an S Corporation  and since
then has been  subject  to  federal  and  state  income  taxes at  applicable  C
Corporation rates.


                                       10
<PAGE>

     Prior to the  termination  of such S Corporation  status,  each such entity
declared an S Corporation distribution to the shareholders of record on the date
of such  declaration.  Such  shareholders  consisted  solely of Messrs.  Jack M.
Benun,  the  Company's  Chairman  of the Board,  President  and Chief  Executive
Officer,  Mark J. Benun,  the Company's  Executive Vice President and Secretary,
and Isaac Levy, the Company's Senior Vice President with respect to the Company,
and solely of Jack Benun and Mark  Benun with  respect to each such  subsidiary.
Such distribution,  amounting to $7.6 million,  represented substantially all of
the remaining  undistributed  S Corporation  earnings of each such entity and is
evidenced by four-year  5.7%  promissory  notes issued to such  shareholders  in
connection with the termination of S Corporation  status.  Of this amount,  $2.0
million  (distributed evenly to the three shareholders) of the net proceeds from
the Company's  IPO was used to make a partial  payment of amounts due under such
notes.  The  balance  of  such S  Corporation  distributions  will  be  paid  in
accordance  with the terms and provisions of such  promissory  notes and provide
for the timely distribution of amounts necessary to pay personal income taxes of
the  shareholders  due on amounts  earned by the S  Corporations  for the period
January 1, 1998 through the termination of S Corporation  status. In addition to
amounts paid pursuant to the promissory  notes,  $314,000 was distributed to the
aforementioned  shareholders  in 1998 in the form of dividends to fund their tax
liabilities resulting from such S Corporation status.


                                       11
<PAGE>
ITEM 6.     SELECTED CONSOLIDATED FINANCIAL DATA.

     The following table sets forth selected  consolidated  historical financial
data of the Company as of the dates and for the periods indicated.  The selected
balance  sheet data set forth below for the Company as of December  31, 1997 and
1998 and the selected  statement of operations data for each of the years in the
three year period ended December 31, 1998 are derived from the audited financial
statements  included elsewhere herein. The selected balance sheet data set forth
below for the Company as of December  31,  1994,  1995 and 1996 and the selected
statement of operations  data for each of the years ended  December 31, 1994 and
1995 are derived from the audited  financial  statements not included  elsewhere
herein.  The selected  consolidated  financial  information  is qualified in its
entirety by, and should be read in conjunction with, the Consolidated  Financial
Statements  and the Notes and "Item 7.  Management's  Discussion and Analysis of
Financial  Condition and Results of Operations" which are included  elsewhere in
this Annual Report on Form 10-K.

<TABLE>
<CAPTION>
                                                   YEARS ENDED DECEMBER 31,
                                        1994      1995      1996       1997       1998
                                    -------------------------------------------------------
                                        (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                    -------------------------------------------------------
STATEMENT OF OPERATIONS DATA:
<S>                                    <C>       <C>       <C>       <C>        <C>     
  Net sales.........................   $74,520   $79,828   $90,723   $106,673   $154,559
  Gross profit......................    15,276    14,792    20,837     26,925     40,763
  Operating expenses................    12,320    14,816    15,370     18,457     22,449
                                       -------   -------   -------   --------   --------

  Operating income (loss)...........     2,956       (24)    5,467      8,468     18,314
  Interest expense, net.............     1,631     2,375     2,980      3,803      2,077
                                       -------   -------   -------   --------   --------
  Income (loss) before pro forma
   income taxes.....................     1,325    (2,399)    2,487      4,665     16,237
  Pro forma net income(1)...........   $   703   $(1,463)  $ 1,497   $  2,704   $  9,580
                                       =======   =======   =======   ========   ========
  Pro forma basic net income per
   share............................   $  0.09   $ (0.19)  $  0.19   $   0.35   $   1.00
                                       =======   =======   =======   ========   ========

  Pro forma diluted net income per
    share...........................   $  0.09   $ (0.19)  $  0.19   $   0.35   $   0.99
                                       =======   =======   =======   ========   ========

  Pro forma weighted average 
   shares outstanding - basic.......     7,750     7,750     7,750      7,750      9,625
                                       =======   =======   =======   ========   ========
  Pro forma weighted average
   shares outstanding - diluted.....     7,750     7,750     7,750      7,750      9,637
                                       =======   =======   =======   ========   ========


                                        1994      1995      1996       1997       1998
                                    -------------------------------------------------------
BALANCE SHEET DATA:
  Working capital...................   $ 5,942   $ 3,260   $ 5,228   $  6,419   $ 36,295
  Total assets......................    27,570    33,568    33,986     44,952     50,452
  Due to bank.......................    14,435    21,340    19,732     24,863      3,753
  Due to shareholders...............     1,200     1,500     1,560      1,400      5,719
  Capital lease obligations.........        14        52       123         68         27
  Shareholders' equity..............     6,135     3,848     5,573      6,644     32,531
</TABLE>

------------
(1) Prior to April 2, 1998,  the Company had  operated as an S  Corporation  for
federal  and  New  York  state  income  tax  purposes  since  1988.  Two  of the
wholly-owned  subsidiaries are C Corporations and, accordingly,  have been taxed
at the  appropriate  corporate  federal  and state  tax  rates.  The  historical
Consolidated  Financial  Statements  do not include a provision  for federal and
state income taxes for such periods for those  subsidiaries which had elected to
be treated as S  Corporations.  A provision for state income taxes has been made
for those states not recognizing S Corporation  status. Pro forma net income has
been  computed  as if the  Company  had been fully  subject to federal and state
income taxes based on the tax laws in effect during the respective periods.  See
Notes A and K to the Consolidated Financial Statements.


                                       12
<PAGE>
ITEM 7.     MANAGEMENT'S  DISCUSSION  AND ANALYSIS OF FINANCIAL  CONDITION AND
            RESULTS OF OPERATIONS.


OVERVIEW

     Happy Kids 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 (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,  for 1997 and for 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 Annual Report on
Form  10-K  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-K 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


                                       13
<PAGE>

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 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.

     The  following   discussion   should  be  read  in  conjunction   with  the
consolidated  financial  statements and notes appearing  elsewhere in the Annual
Report on Form 10-K.


RESULTS OF OPERATIONS

     Year Ended December 31, 1998 Compared to Year Ended December 31, 1997

     Net Sales.  Net sales increased $47.9 million,  or 44.9%, to $154.6 million
in 1998 from $106.7 million in 1997.  The increase in net sales is  attributable
primarily to increased sales of playwear incorporating the properties covered by
the Company's licenses with Nickelodeon's Rugrats, AND 1, B.U.M. Equipment,  and
increased sales to Kmart resulting from its Sesame Street private label program.
This  increase  was  partially  offset  by lower  sales in two of the  Company's
licenses that are no longer active.

     Gross Profit.  Gross profit increased by $13.8 million,  or 51.4%, to $40.8
million in 1998 from $26.9 million in 1997. Due to improved sales mix, the gross
profit margin  increased to 26.4% in 1998 from 25.2% in 1997.  In addition,  the
1997 gross margin amount  includes  $758,000 in income due to a decrease in LIFO
reserves,  which  accounted for .03% of such gross margin,  while the 1998 gross
margin amount  includes  $181,000 in income due to a decrease in LIFO  reserves,
which had no effect on gross margin for the year.

     Operating Expenses. Operating expenses increased by $4.0 million, or 21.6%,
to $22.4 million in 1998 from $18.5 million in 1997.  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 21.1%, to $13.7 million in 1998 from
     $11.3 million in 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
     8.9% in 1998 from 10.6% in 1997.

          General  and  Administrative  Expenses.   General  and  administrative
     expenses  increased  $1.6 million,  or 22.5%,  to $8.8 million in 1998 from
     $7.2  million in 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
     5.7% in 1998 from  6.7% in 1997 due to the  operating  leverage  associated
     with the higher sales.

                                       14
<PAGE>
     Interest Expense,  net. Interest expense,  net, decreased $1.7 million,  or
45.4%,  to $2.1  million in 1998 from $3.9 million in 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 well as a  decrease  in  interest  rates  and
associated lending fees in 1998. As a percentage of net sales,  interest expense
decreased to 1.3% for 1998, as compared to 3.6% in 1997.

     Income  Before Income Taxes.  Income  before income taxes  increased  $11.6
million,  to $16.2  million in 1998 from $4.7 million in 1997 due to the reasons
described  above.  As a  percentage  of net sales,  income  before  income taxes
increased to 10.5% in 1998 from 4.4% in 1997. In  connection  with the Company's
initial public offering,  effective April 2, 1998, the Company changed from an S
Corporation  to a C  Corporation.  This resulted in an increase in current taxes
offset by a deferred tax asset  recognized  upon conversion to the C Corporation
status.

YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996

     Net Sales.  Net sales increased $16.0 million,  or 17.6%, to $106.7 million
in 1997 from $90.7 million for 1996. The increase in net sales was  attributable
primarily to increased sales of playwear incorporating the properties covered by
the Company's  Rugrats  license with  Nickelodeon  and increased  sales to Kmart
resulting in part from the 1997  commencement of its Sesame Street private label
program.  This  increase  was  partially  offset by a  decrease  in net sales of
products  incorporating  properties covered by one of the Company's former major
licenses,  which license  currently  represents  only a small  percentage of net
sales.

     Gross Profit.  Gross profit  increased by $6.1 million,  or 29.2%, to $26.9
million in 1997 from $20.8 million in 1996. The gross profit margin increased to
25.2%  in 1997  from  23.0%  in 1996.  The  increase  in the  gross  margin  was
attributable to the  implementation of the Company's current sales strategy.  As
part of such  strategy,  initiated in 1995,  orders are  received  three to nine
months in advance  of  shipment  resulting  in  finished  goods  being  produced
according  to customer  order.  Due to the timing of the order cycle and revenue
recognition (sales are recognized when products are shipped),  the Company first
began to fully realize the benefits of such  strategy in mid-1996.  In addition,
during  1997,  there was a decrease in the  Company's  product  return  rates as
compared to 1996.  Gross profit is net of any royalties  associated with the use
of licensed properties.

     Operating Expenses. Operating expenses increased by $3.1 million, or 20.1%,
to $18.5 million in 1997 from $15.4 million in 1996.  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 $2.2 million, or 24.9%, to $11.3 million in 1997 from
     $9.0 million in 1996.  This increase was  attributable  primarily to higher
     sales  salaries and  commissions  for existing  personnel and the hiring of
     additional  sales and design  personnel  during the year, as well as higher
     travel, shipping and freight costs associated with increased sales volumes.
     In addition,  other design costs had increased as a result of the expansion
     of the

                                       15
<PAGE>
     Company's production.  As a percentage of net sales, selling, design
     and shipping expenses increased to 10.6% in 1997 from 10.0% in 1996.

          General  and  Administrative  Expenses.   General  and  administrative
     expenses  increased  $839,000,  or 13.3%, to $7.2 million in 1997 from $6.3
     million in 1996.  This  increase was  primarily the result of higher factor
     commissions   associated  with  increased  sales  volume,   the  hiring  of
     additional  office  personnel and normal annual salary rate increases.  The
     Company  utilized its factoring  arrangement for the entire year in 1997 as
     compared  to only ten  months of the  corresponding  period  in 1996.  As a
     percentage of net sales,  general and administrative  expenses decreased to
     6.7% in 1997 from 7.0% in 1996.

     Interest Expense,  net. Interest expense, net increased $823,000, or 27.6%,
to $3.8 million in 1997 from $3.0 million in 1996.  This increase is a result of
higher sales volume resulting in an increase in borrowings, interest expense and
fees under the line of credit.  As a percentage of net sales,  interest expense,
net increased slightly to 3.6% in 1997, from 3.3% in 1996.

     Income  Before Income Taxes.  Income  before  income taxes  increased  $2.2
million,  or 87.6%, to $4.7 million in 1997 from $2.5 million in 1996 due to the
reasons  described  above.  As a percentage  of net sales,  income before income
taxes increased to 4.3% in 1997 from 2.7% in 1996.


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 IPO 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 IPO. As a result,  the Company  issued and
sold an additional 330,000 shares of the Company's Common Stock at the IPO 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 IPO  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.

     Through the  consummation  of the Company's IPO, the Company's  credit line
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 credit line whereby upon  effectiveness of the IPO and
satisfaction  of certain  conditions,  the Company's  credit line was

                                       16
<PAGE>
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 (7.75% at December 31, 1998). In
addition,  in  connection  with  the  amendment  to the  credit  line,  personal
guarantees of certain of the  Company's  present  shareholders  under the credit
line terminated and the collateral  pledged by such  shareholders were released.
The credit  line is  collateralized  by  substantially  all of the assets of the
Company.  As of December  31, 1998 the Company had $3.8  million of  outstanding
direct borrowings and $13.7 million of contingent liabilities under open letters
of credit.  The Company's  credit facility  expires March 31, 1999. A new credit
line effective April 1, 1999 is currently being  negotiated  between the Company
and its  lender.  There can be no  assurance  that the new  credit  line will be
entered  into,  or if it is entered  into,  that it will be on terms at least as
favorable as the current credit line.

     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 December 31, 1998, the Company's other principal sources of liquidity
included  cash of  $139,000,  amounts due from  factor of $20.6  million and net
accounts  receivable  of  $347,000.  The Company  had  working  capital of $36.3
million and long-term debt of $6.2 million as of December 31, 1998.

     For 1998, operating activities provided cash of $2.5 million primarily as a
result of net income of $11.6  million and a decrease in amounts due from factor
of $2.8  million,  offset in part by a decrease in accounts  payable and accrued
expenses of $3.6 million, and an increase in inventory of $7.3 million. Net cash
used in financing  activities during the same period was $2.4 million consisting
primarily  of  payments of $21.1  million  under the  Company's  credit line and
payments to  shareholders  of $3.1 million offset in part by net the proceeds of
the Company's IPO.

     Historically,  the Company's business has not required  significant capital
expenditures.  The  Company's  capital  expenditures  for  1998 and  1997,  were
$321,000  and  $79,000,  respectively.  The  Company  expects  to incur  capital
expenditures  in 1999 totaling  $1.0 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 12 months.


                                       17
<PAGE>
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
$123.5  million at December 31,  1998,  all of which it expects to ship over the
next three to nine months.  However,  in recent  months  subsequent  to the year
ended December 31, 1998, the Company has  experienced a significant  increase in
orders  involving  a rapid  turnaround  from the date the order is placed to the
shipment date.


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.


PRO FORMA ADJUSTMENTS FOR INCOME TAXES

     The Company has operated as an S Corporation for federal and New York state
income tax purposes  since 1988 up and until the  termination of the Company's S
Corporation  status on April 1, 1998,  immediately prior to the effectiveness of
the Company's  IPO. As a result,  for such tax periods,  the Company's  earnings
were taxed directly to the Company's shareholders. The pro forma adjustments for
income taxes  reflected in Item 6 of this Form 10-K under the caption  "Selected
Consolidated  Financial Data" and in the accompanying  Financial Statements were
calculated  as if the Company  were  subject to tax under the tax laws in effect
for the respective  periods using the criteria  established  under  Statement of
Financial  Accounting  Standards ("SFAS") No. 109 "Accounting for Income Taxes."
The effective tax rate for the years ended December 31, 1998,  1997 and 1996 was
28.3%, 10.1% and 4.8% respectively.  The change in the effective tax rate is the
result of payments made in connection  with a settlement of an Internal  Revenue
Service  examination  in 1996,  and the  utilization of State net operating loss
carryforward claims in 1997 and 1996.


                                       18
<PAGE>
YEAR 2000 COMPLIANCE

     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 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 1998 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.

                                       19
<PAGE>
     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 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURE 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.


ITEM 8.     FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

     The financial  statements  required to be filed pursuant to this Item 8 are
appended to this Annual Report on Form 10-K. A list of the financial  statements
filed herewith is found at "Item 14. Exhibits,  Financial  Statement  Schedules,
and Reports on Form 8-K."


ITEM 9.     CHANGES IN AND  DISAGREEMENTS  WITH  ACCOUNTANTS ON ACCOUNTING AND
            FINANCIAL DISCLOSURE.

     Not applicable.



                                       20
<PAGE>
                                    PART III


ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY.

     The information relating to the Company's directors,  nominees for election
as directors and executive  officers under the headings  "Election of Directors"
and "Executive  Officers" in the Company's  definitive  proxy  statement for the
1999 Annual Meeting of Stockholders is incorporated  herein by reference to such
proxy statement.


ITEM 11.    EXECUTIVE COMPENSATION.

     The discussion under the heading "Executive  Compensation" in the Company's
definitive  proxy  statement  for the 1999  Annual  Meeting of  Stockholders  is
incorporated herein by reference to such proxy statement.


ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

     The discussion under the heading "Security  Ownership of Certain Beneficial
Owners and Management" in the Company's  definitive proxy statement for the 1999
Annual Meeting of Stockholders is incorporated herein by reference to such proxy
statement.


ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

     The  discussion  under  the  heading  "Certain  Relationships  and  Related
Transactions"  in the Company's  definitive  proxy statement for the 1999 Annual
Meeting  of  Stockholders  is  incorporated  herein by  reference  to such proxy
statement.




                                       21
<PAGE>
                                     PART IV


ITEM 14.    EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.

 (a)  (1)  Financial Statements.

           Reference is made to the Index to Financial  Statements and Schedules
           on Page F-1.

      (2)  Financial Statement Schedules.

           Reference is made to the Index to Financial  Statements and Schedules
           on Page F-1.

      (3)  Exhibits.

           Reference is made to the Index to Exhibits on Page 25.

 (b)       Reports on Form 8-K.

           No reports on Form 8-K were filed during the quarter  ended  December
           31, 1998.



                                       22
<PAGE>


                                   SIGNATURES

     Pursuant  to the  requirements  of  Section  13 or 15(d) of the  Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized this 30th day of March,
1999.

                                     Happy Kids Inc.




                                     By: /s/ Jack M. Benun
                                         --------------------------------
                                         Jack M. Benun
                                         President and Chief Executive Officer




                                       23
<PAGE>


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

            Signature                         Title                  Date
---------------------------------  --------------------------  -----------------

/s/ Jack M. Benun                  President, Chief Executive   March 30, 1999
------------------------------
Jack M. Benun                      Officer and Director
                                   (Principal Executive
                                    Officer)

/s/ Stuart Bender                  Chief Financial Officer      March 30, 1999
------------------------------
Stuart Bender                      and Treasurer (Principal
                                   Financial and Accounting
                                   Officer)

/s/ Mark J. Benun                  Executive Vice President,    March 30, 1999
------------------------------
Mark J. Benun                      Secretary and Director

/s/ Isaac Levy                     Senior Vice President and    March 30, 1999
------------------------------
Isaac Levy                         Director

/s/ Marvin Azrak                   Director                     March 30, 1999
------------------------------
Marvin Azrak

                                   Director
------------------------------
Stephen I. Kahn


                                       24
<PAGE>


                                  EXHIBIT INDEX

      EXHIBIT NO.                        DESCRIPTION OF EXHIBIT
      -----------                        ----------------------

      3.1                 Restated Certificate of  Incorporation.  (Incorporated
                          by   reference   to  Exhibit  3.1  to  the   Company's
                          Registration   Statement  on  Form  S-1  (File  Number
                          333-44267) which became effective April 2, 1998.)

      3.2                 Amended  and   Restated   Bylaws.   (Incorporated   by
                          reference to Exhibit 3.2 to the Company's Registration
                          Statement  on Form S-1 (File Number  333-44267)  which
                          became effective April 2, 1998.)

      4.1                 Voting  Agreement,  dated  January  1,  1998,  by  and
                          between  Jack Benun and Mark Benun.  (Incorporated  by
                          reference to Exhibit 4.1 to the Company's Registration
                          Statement  on Form S-1 (File Number  333-44267)  which
                          became effective April 2, 1998.)

      4.2                 Shareholder Agreement,  dated January 1, 1998,  by and
                          among  Jack   Benun,   Mark  Benun   and  Isaac  Levy.
                          (Incorporated  by  reference  to  Exhibit  4.2 to  the
                          Company's  Registration  Statement  on Form S-1  (File
                          Number  333-44267)  which  became  effective  April 2,
                          1998.)

      10.1*               1997 Stock Option Plan.  (Incorporated by reference to
                          Exhibit 10.1 to the Company's  Registration  Statement
                          on Form  S-1  (File  Number  333-44267)  which  became
                          effective April 2, 1998.)

      10.2                Form of Indemnification Agreement  executed by each of
                          the Company's directors and   officers.  (Incorporated
                          by  reference  to   Exhibit  10.2  to  the   Company's
                          Registration  Statement  on  Form  S-1   (File  Number
                          333-44267) which became effective April 2, 1998.)

      10.3                Lease  Agreement,  by and between J&B Corp. and SZS 33
                          Associates   L.P.,   as  amended.   (Incorporated   by
                          reference   to   Exhibit   10.3   to   the   Company's
                          Registration   Statement  on  Form  S-1  (File  Number
                          333-44267) which became effective April 2, 1998.)

      10.4                Lease Agreement, by and between Hawk  Industries, Inc.
                          and  Triangle Fidelco  Industrial Center,  as amended.
                          (Incorporated  by  reference to  Exhibit 10.4  to  the
                          Company's  Registration  Statement on  Form  S-1 (File
                          Number 333-44267) which became effective April 2,
                          1998.)

      10.5                Financing  Agreement  with  the  CIT  Group/Commercial
                          Services,  Inc., as Agent for itself and certain other
                          lenders,  as amended.  (Incorporated  by  reference to
                          Exhibit 10.5 to the Company's  Registration  Statement
                          on Form  S-1  (File  Number  333-44267)  which  became
                          effective April 2, 1998.)

                                       25
<PAGE>
      EXHIBIT NO.                        DESCRIPTION OF EXHIBIT
      -----------                        ----------------------

      10.6                Notification  Factoring  Agreement.  (Incorporated  by
                          reference   to   Exhibit   10.6   to   the   Company's
                          Registration   Statement  on  Form  S-1  (File  Number
                          333-44267) which became effective April 2, 1998.)

      10.7*               Employment  Agreement,  by and between the Company and
                          Jack Benun. (Incorporated by reference to Exhibit 10.7
                          to the  Company's  Registration  Statement on Form S-1
                          (File Number  333-44267)  which became effective April
                          2, 1998.)

      10.8*               Employment  Agreement,  by and between the Company and
                          Mark Benun. (Incorporated by reference to Exhibit 10.8
                          to the  Company's  Registration  Statement on Form S-1
                          (File Number  333-44267)  which became effective April
                          2, 1998.)

      10.9*               Employment  Agreement,  by and between the Company and
                          Isaac Levy. (Incorporated by reference to Exhibit 10.9
                          to the  Company's  Registration  Statement on Form S-1
                          (File Number  333-44267)  which became effective April
                          2, 1998.)

      10.10*              Employment  Agreement,  by and between the Company and
                          Stuart Bender.  (Incorporated  by reference to Exhibit
                          10.10 to the Company's  Registration Statement on Form
                          S-1 (File Number  333-44267)  which  became  effective
                          April 2, 1998.)

      10.11               Model   Form   of   Confidentiality/Non   Solicitation
                          Agreement. (Incorporated by reference to Exhibit 10.11
                          to the  Company's  Registration  Statement on Form S-1
                          (File Number  333-44267)  which became effective April
                          2, 1998.)

      10.12               Securities Purchase Agreement,  dated as of January 1,
                          1998, by and among,  the Company and Jack M. Benun and
                          Mark J. Benun.  (Incorporated  by reference to Exhibit
                          10.12 to the Company's  Registration Statement on Form
                          S-1 (File Number  333-44267)  which  became  effective
                          April 2, 1998.)

      10.13**             License  Agreement by  and between the Company and MTV
                          Networks. (Incorporated by reference to  Exhibit 10.13
                          to the Company's Registration  Statement  on Form  S-1
                          (File Number 333-44267)  which became effective  April
                          2, 1998.)


                                       26
<PAGE>
      EXHIBIT NO.                        DESCRIPTION OF EXHIBIT
      -----------                        ----------------------

      10.14**             License  Agreement  by and  between  the  Company  and
                          B.U.M.   Equipment.   (Incorporated  by  reference  to
                          Exhibit 10.14 to the Company's  Registration Statement
                          on Form  S-1  (File  Number  333-44267)  which  became
                          effective April 2, 1998.)

      10.15**             License Agreement by and between the Company and Ocean
                          Pacific  Apparel Corp.  (Incorporated  by reference to
                          Exhibit 10.15 to the Company's  Registration Statement
                          on Form  S-1  (File  Number  333-44267)  which  became
                          effective April 2, 1998.)

      10.16               Amendment No. 5 to the Company's Financing  Agreement,
                          dated  March 25, 1998,  with the CIT  Group/Commercial
                          Services, Inc., as agent for itself and certain  other
                          lenders, as  previously   amended.   (Incorporated  by
                          reference to  Exhibit 10.1  to the Company's Form 10-Q
                          for the quarter ended March 31, 1998.)

      10.17*+             Change in Control  Severance  Pay  Agreement,  by  and
                          between the Company and Stuart Bender.

      21                  Subsidiaries  of  the  Registrant.   (Incorporated  by
                          reference to Exhibit 21 to the Company's  Registration
                          Statement  on Form S-1 (File Number  333-44267)  which
                          became effective April 2, 1998.)

      27+                 Financial  Data Schedule for the years ended December
                          31, 1998 and 1997.

      -----------------------

      *     A management  contract or compensatory plan or arrangement  required
            to be filed as an exhibit pursuant to Item 14(c) of Form 10-K.

      **    Confidential  treatment  has been  requested for a portion of this
            Exhibit.

      +     Filed herewith.  All other exhibits incorporated by reference.

      (b)   Financial Statement Schedules



                                       27
<PAGE>
                  INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

                                                                      PAGE
                                                                      ----

Report of Independent Certified Public Accountants.................   F-2

Consolidated Balance Sheets
 as of December 31, 1997 and 1998..................................   F-3

Consolidated Statements of Operations for the
years ended December 31, 1996, 1997 and 1998.......................   F-4

Consolidated Statements of Stockholders'
Equity for the years ended December 31, 1996, 1997 and 1998........   F-5

Consolidated Statements of Cash Flows for the years
ended December 1996, 1997 and 1998.................................   F-6

Notes to Consolidated Financial Statements.........................   F-7

Schedule II - Valuation and Qualifying Accounts....................   F-25


                                       F-1
<PAGE>
              REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS




Board of Directors
   HAPPY KIDS INC.


We have audited the accompanying  consolidated balance sheets of Happy Kids Inc.
and Subsidiaries as of December 31, 1997 and 1998, and the related  consolidated
statements of operations,  stockholders'  equity, and cash flows for each of the
three years in the period ended December 31, 1998.  These  financial  statements
are the  responsibility of the Company's  management.  Our  responsibility is to
express an opinion on these financial statements based on our audits.

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

In our opinion,  the financial  statements  referred to above present fairly, in
all material  respects,  the consolidated  financial position of Happy Kids Inc.
and Subsidiaries as of December 31, 1997 and 1998, and the consolidated  results
of their  operations  and their  consolidated  cash  flows for each of the three
years in the period ended  December  31,  1998,  in  conformity  with  generally
accepted accounting principles.

We have also audited  Schedule II of Happy Kids Inc. and  Subsidiaries as of and
for the three years ended  December 31,  1998.  In our  opinion,  this  schedule
presents fairly, in all material  respects,  the information  required to be set
forth therein.




GRANT THORNTON LLP


New York, New York
February 5, 1999


                                       F-2
<PAGE>
                        Happy Kids Inc. and Subsidiaries

                           CONSOLIDATED BALANCE SHEETS
                      (in thousands, except per share data)

                                  December 31,

                      ASSETS                            1997           1998
                                                        ----           ----

CURRENT ASSETS:
   Cash...........................................    $   374        $   139
   Due from factor................................     24,232         20,640
   Accounts receivable - trade (net of
     allowance for doubtful accounts  of $513
     at December 31, 1997 and 1998)...............        316            347
   Inventories....................................     16,316         23,579
   Due from stockholders..........................        347             --
   Prepaid royalties..............................        147            762
   Deferred income taxes..........................         40          1,029
   Other current assets...........................        952          1,496
                                                       ------         ------
      Total current assets........................     42,724         47,992
FIXED ASSETS - NET................................      1,476          1,459
OTHER ASSETS......................................        752          1,001
                                                       ------         ------
      Total assets................................    $44,952        $50,452
                                                       ======         ======

       LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
   Due to bank....................................    $24,863        $ 3,753
   Current portion - capital lease obligations....         49             27
   Accounts payable...............................      9,468          6,017
   Accrued liabilities............................      1,925          1,900
                                                       ------         ------
      Total current liabilities...................     36,305         11,697

DEFERRED RENT PAYABLE.............................        584            505

CAPITAL LEASE OBLIGATIONS.........................         19             --

DUE TO STOCKHOLDERS...............................      1,400          5,719

COMMITMENTS
STOCKHOLDERS' EQUITY:
  Preferred stock - 5,000 shares authorized,
    $.01 par value; no shares issued and
    outstanding...................................         --             --
  Common stock - 30,000 shares authorized,
    $.01 par value; 7,750 and 10,280 shares
    issued and  outstanding at December 31,
    1997 and 1998, respectively...................         78            103
  Additional paid-in capital......................      1,119         23,263
  Retained earnings...............................      5,447          9,165
                                                       ------         ------

      Total stockholders' equity..................      6,644         32,531
                                                      -------         ------

      Total liabilities and stockholders' equity..    $44,952        $50,452
                                                       ======         ======


        The accompanying notes are an integral part of these statements.


                                     F-3
<PAGE>
                        Happy Kids Inc. and Subsidiaries

                      CONSOLIDATED STATEMENTS OF OPERATIONS

                             Year ended December 31,
                      (in thousands, except per share data)

                                                  1996         1997      1998
                                                  ----         ----      ----

Net sales....................................   $ 90,723    $106,673   $154,559
Cost of goods sold...........................     69,886      79,748    113,796
                                                  ------      ------    -------

     Gross profit............................     20,837      26,925     40,763

Operating expenses...........................     15,370      18,457     22,449
                                                  ------      ------    -------

     Operating earnings......................      5,467       8,468     18,314

Interest expense, net........................      2,980       3,803      2,077
                                                  ------      ------    -------

     Income before income taxes..............      2,487       4,665     16,237

Income taxes.................................        119         473      4,603
                                                  ------      ------    -------

     Net income..............................   $  2,368    $  4,192   $ 11,634
                                                  ======      ======    =======

Basic income per share.......................   $   0.31    $   0.54   $   1.21
                                                  ======      ======    =======

Diluted income per share.....................   $   0.31    $   0.54   $   1.21
                                                  ======      ======    =======

Pro forma data (unaudited):
  Historical income before income taxes......   $  2,487    $  4,665   $ 16,237
  Income taxes...............................        990       1,961      6,657
                                                  ------      ------    -------

     Net income..............................   $  1,497    $  2,704   $  9,580
                                                  ======      ======    =======

   Pro forma basic net income per share......   $   0.19    $   0.35   $   1.00
                                                  ======      ======    =======

   Pro forma weighted average shares
    outstanding - basic......................      7,750       7,750      9,625
                                                  ======      ======    =======

   Pro forma diluted net income per share....   $   0.19     $  0.35   $   0.99
                                                  ======      ======    =======

   Pro forma weighted average shares
   outstanding - diluted.....................      7,750       7,750      9,637
                                                  ======      ======    =======







        The accompanying notes are an integral part of these statements.



                                      F-4
<PAGE>
                        Happy Kids Inc. and Subsidiaries

                 CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY

                  Years ended December 31, 1996, 1997 and 1998
                                 (in thousands)



                                                          Additional
                                      Common stock         paid-in      Retained
                                   -----------------
                                   Shares     Amount       capital      earnings
                                   ------     ------       -------      --------

Balance at January 1, 1996......     7,750   $   78        $ 1,041      $ 2,729
Waived payment of interest on
 shareholder's note.............        --       --             78           --
Dividends.......................        --       --             --         (721)
Net income......................        --       --             --        2,368
                                    ------    -----         ------       ------

Balance at December 31, 1996....     7,750       78          1,119        4,376

Dividends.......................        --       --             --       (3,121)
Net income......................        --       --             --        4,192
                                    ------    -----         ------       ------

Balance at December 31, 1997....     7,750       78          1,119        5,447

Net proceeds from initial
 public offering................     2,530       25         22,144           --
Conversion of undistributed
 shareholder equity to loan
 payable........................        --       --             --       (7,550)
Dividends.......................        --       --             --         (366)
Net income......................        --       --             --       11,634
                                    ------    -----         ------       ------

Balance at December 31, 1998....    10,280   $  103        $23,263      $ 9,165
                                    ======    =====         ======       ======








         The accompanying notes are an integral part of this statement.


                                      F-5
<PAGE>
                        Happy Kids Inc. and Subsidiaries

                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                             Year ended December 31,

                                                 1996         1997        1998
                                                ------       ------      -----
Cash flows from operating activities
  Net income.................................  $ 2,368      $ 4,192    $ 11,634
  Adjustments to reconcile net income to net
   cash provided by (used  in) operating
   activities:
     Depreciation and amortization...........      388          336         338
     Provision for losses on accounts
       receivable and other receivables......      212          354         882
     Deferred income taxes...................       (8)         164        (912)
     Noncash interest expense................       78           --          --
     Changes in operating assets and
      liabilities:
       Accounts receivable...................   10,521          741         (31)
       Due from factor.......................  (16,925)      (7,307)      2,815
       Inventories...........................    5,669       (6,829)     (7,263)
       Other current assets..................     (471)         815        (649)
       Prepaid royalties.....................      218           42        (615)
       Other assets..........................     (196)          13        (488)
       Accounts payable and accrued
        liabilities..........................      919        5,083      (3,555)
       Due from stockholders.................      308          469         347
                                                ------       ------      ------
     Net cash provided by (used in)
       operating activities..................    3,081       (1,927)      2,503
                                                ------       ------      ------
Cash flows from investing activities:
  Acquisition of fixed assets................     (378)         (79)       (321)
                                                ------       ------      ------
Cash flows from financing activities:
  Net borrowings (payments) under line of
   credit....................................   (1,608)       5,131     (21,110)
  Payments on capital lease..................      (43)         (56)        (41)
  Borrowings from (payments to) stockholders.       60         (160)       (169)
  Dividends paid.............................     (721)      (3,121)       (366)
  Payments on stockholders' notes payable....       --           --      (3,062)
  Proceeds from initial public offering,
   net.......................................       --          (88)     22,331
                                                ------       ------      ------

     Net cash (used in) provided by
       financing activities..................   (2,312)       1,706      (2,417)
                                                ------       ------      ------

     NET INCREASE (DECREASE) IN CASH.........      391         (300)       (235)

Cash at beginning of year....................      283          674         374
                                                ------       ------      ------

Cash at end of year..........................  $   674      $   374    $    139
                                                ======       ======     =======


        The accompanying notes are an integral part of these statements.


                                       F-6
<PAGE>
                        Happy Kids Inc. and Subsidiaries

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                        December 31, 1996, 1997 and 1998
                    (in thousands, except per share data)



NOTE A - SUMMARY OF ACCOUNTING POLICIES

   Happy Kids Inc. (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  stockholders  of the  Company.  Immediately  prior  to the
   effectiveness  of the Initial Public  Offering as described in Note K, all of
   such separate entities became wholly-owned  subsidiaries of the Company.  The
   Company issued 4,263 shares of common stock,  to the principal  stockholders,
   in exchange for their  ownership in these  separate  business  entities.  All
   share and per share amounts have been restated to  retroactively  reflect the
   reorganization.

   The accompanying  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.

   The Company  operates in one business segment - as a designer and marketer of
   licensed and branded children's  apparel.  The Company's revenues are derived
   from  the sale of  children's  apparel  to mass  market  retailers,  mid-tier
   distributors and department stores in the United States.

   A summary of the significant  accounting policies consistently applied in the
   preparation of the accompanying consolidated financial statements follows:

   1. Revenue Recognition

      Sales are recognized when merchandise is shipped to customers.

   2. Inventories

      Inventories,  consisting  primarily of finished  goods,  are stated at the
      lower of cost or market.  One subsidiary  determines  cost by the last-in,
      first-out ("LIFO") method which represented approximately $808 and $407 of
      total  inventory  at December 31, 1997 and 1998,  respectively.  The other
      subsidiaries determine cost by the first-in, first-out ("FIFO") method.



                                      F-7
<PAGE>
                        Happy Kids Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                        December 31, 1996, 1997 and 1998
                      (in thousands, except per share data)



NOTE A (continued)

   3. Depreciation and Amortization

      The Company  depreciates fixed assets over their estimated useful lives by
      the  straight-line  method.  Leasehold  improvements  are depreciated over
      their expected useful life or the life of the respective leases, whichever
      is shorter.

      The following are the estimated lives of the Company's fixed assets:

               Furniture and fixtures              5 years to 10 years
               Equipment                           5 years to 10 years
               Leasehold improvements              up to 10 years

   4. Cash and Cash Equivalents

      Cash and cash equivalents include cash on hand and demand deposits.

      Supplemental disclosures of cash flow information:

                                                 Year ended December 31,
                                            ----------------------------
                                            1996        1997        1998
                                            ----        ----        ----

       Cash paid during the year for
         Interest......................   $2,711      $2,992      $1,764
         Income taxes..................      280         122       6,149

      Noncash investing and financing activities:

         For the year ended  December 31, 1996, the Company  acquired  equipment
         totaling approximately $49 under capital leases.



                                      F-8
<PAGE>
                        Happy Kids Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                        December 31, 1996, 1997 and 1998
                      (in thousands, except per share data)



NOTE A (continued)

   5. 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 K-3.

      Subsequent to the termination of the Company's S Corporation  status,  the
      Company  used 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 $1,024.

      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.



                                      F-9
<PAGE>
                        Happy Kids Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                        December 31, 1996, 1997 and 1998
                      (in thousands, except per share data)



NOTE A (continued)

   6. Use of Estimates

      In preparing  financial  statements in conformity with generally  accepted
      accounting  principles,  management  is  required  to make  estimates  and
      assumptions that affect the reported amounts of assets and liabilities and
      disclosure  of  contingent  assets  and  liabilities  at the  date  of the
      financial  statements  and  revenues  and  expenses  during the  reporting
      period. Actual results could differ from those estimates.

      The Company  estimates an allowance  for  doubtful  accounts  based on the
      creditworthiness   of  their   customers  as  well  as  general   economic
      conditions.  Consequently,  an adverse  change in those  conditions  could
      affect the Company's estimate. See Note I.

   7. Fair Value of Financial Instruments

      Due to the  short-term  nature of the bank  loans,  the fair  value of the
      Company's  due to  bank  approximates  carrying  value.  Furthermore,  the
      carrying value of all other financial  instruments  potentially subject to
      valuation risk (principally  consisting of cash, accounts receivable,  due
      from factor and accounts payable) also approximates fair value.

   8. Future Effect of Recently Issued Accounting Pronouncements

      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.

   9. Earnings Per Share

      Basic earnings per share is based on the weighted average number of common
      shares  outstanding  without  consideration  of common stock  equivalents.
      Diluted  earnings  per share are based on the weighted  average  number of
      common and common equivalent shares outstanding.



                                      F-10
<PAGE>
                        Happy Kids Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                        December 31, 1996, 1997 and 1998
                      (in thousands, except per share data)



NOTE A (continued)

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

                                                       December 31,
                                           ---------------------------------
                                            1996         1997          1998
                                            ----         ----          ----

       Net income......................   $ 2,368      $ 4,192        $11,634
                                           ======       ======         ======

       Basic common shares.............     7,750        7,750          9,625
                                           ======       ======         ======

       Basic earnings per share........   $  0.31      $  0.54        $  1.21
                                           ======       ======         ======

       Basic common shares.............     7,750        7,750          9,625
       Diluted common shares...........        --           --             12
                                           ------       ------         ------

       Total diluted shares............     7,750        7,750          9,637
                                           ======       ======         ======

       Diluted earnings per share......   $  0.31      $  0.54        $  1.21
                                           ======       ======         ======

   10.Reclassification

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




                                      F-11
<PAGE>
                        Happy Kids Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                        December 31, 1996, 1997 and 1998
                      (in thousands, except per share data)



NOTE B - INVENTORIES

   Inventories consist of the following finished goods:

                                                        December 31,
                                                ----------------------------
                                                     1997          1998
                                                     ----          ----

    Warehouse...............................       $ 8,716       $16,531
    In-transit and overseas.................         8,010         5,921
    Raw materials...........................            --         1,356
    LIFO valuation allowance................          (410)         (229)
                                                    ------        ------

                                                   $16,316       $23,579
                                                    ======        ======

   For the years ended December 31, 1996, 1997 and 1998, the liquidation of LIFO
   inventories  decreased cost of sales and, therefore,  increased income before
   taxes by $521, $390 and $181, respectively.


NOTE C - FACTORED ACCOUNTS RECEIVABLE - WITHOUT
            RECOURSE AS TO CREDIT RISK

   The Company has an agreement with a commercial finance company which provides
   for the factoring of trade accounts receivable.  The factoring charge amounts
   to 0.55% of the  receivables  assigned.  Factor  charges  for the years ended
   December  31, 1996,  1997 and 1998 were  approximately  $643,  $735 and $966,
   respectively.  The commercial  finance  company also guarantees the Company's
   letters of credit and issues letters of guarantee to company  suppliers.  The
   commercial  finance company has a first lien on all of the Company's tangible
   assets  as  collateral  for  all  of  its  obligations  under  the  financing
   agreement.  Advances and loans under the agreement bear interest at the prime
   rate.

   The aggregate  amounts of such guarantees and advances are limited by formula
   based upon the uncollected  balance of 85% of eligible factored  receivables,
   and 50% of  eligible  inventory  collateral,  plus 50% of  letters  of credit
   outstanding,  and 25% of open  letters of credit and any  overadvance  amount
   permitted by the lender. At December 31, 1997 and 1998, the maximum amount of
   guarantees and advances  permitted by such formula was approximately  $34,723
   and $35,472, respectively.



                                      F-12
<PAGE>
                        Happy Kids Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                        December 31, 1996, 1997 and 1998
                      (in thousands, except per share data)


NOTE C (continued)

   Accounts  receivable are factored without recourse as to credit risk but with
   recourse for any claims by the customer for  adjustments in the normal course
   of business relating to price errors, shortages, etc. The uncollected balance
   of  receivables   held  by  the  commercial   finance  company   amounted  to
   approximately   $24,232  and   $20,640  at   December   31,  1997  and  1998,
   respectively.

NOTE D - FIXED ASSETS

   Fixed assets are recorded at cost and consist of the following:

                                                       December 31,
                                                    ------------------
                                                     1997        1998
                                                     ----        ----

    Furniture and fixtures......................   $  893      $  945
    Equipment...................................      657         726
    Leasehold improvements......................    1,158       1,358
                                                    -----       -----

                                                    2,708       3,029
    Less accumulated depreciation and
       amortization.............................    1,232       1,570
                                                    -----       -----

                                                   $1,476      $1,459
                                                    =====       =====

NOTE E - DUE TO BANK

   The Company has a financing  agreement  with  several  banks that  expires on
   March 31,  1999,  subject to annual  renewals.  The  agreement  provides  for
   advances and letter of credit  accommodations  ranging  between $42.0 million
   and $49.0 million  subject to borrowing base formulas.  The maximum amount of
   revolving credit advances outstanding at any time cannot 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 borrowings under this line of credit bear interest at the
   prime rate.  Borrowings are collateralized by substantially all of the assets
   of the  Company.  At  December  31, 1997 and 1998,  the Company has  borrowed
   $24,863 and $3,753, respectively, under this line. The agreement provides for
   various  restrictive  financial  covenants,   including  the  requirement  to
   maintain a minimum  tangible net worth level.  The  agreement  prohibits  the
   payment of dividends.


                                      F-13
<PAGE>
                        Happy Kids Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                        December 31, 1996, 1997 and 1998
                      (in thousands, except per share data)



NOTE F - TRANSACTIONS WITH STOCKHOLDERS

   Notes payable to stockholder consist of:

                                                             December 31,
                                                       ----------------------
                                                        1997            1998
                                                       ------          ------

    5.7% due to stockholders..................             --         $5,719
    7% due to stockholder.....................         $1,400             --
                                                        -----          -----

                                                       $1,400         $5,719
                                                        =====          =====

   In connection with the termination of the Company's S Corporation status, the
   Company agreed to distribute an aggregate $7,550 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 $2,000 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.  In  addition,  existing  amounts  due to
   shareholders  of $1,400 as of April 2, 1998 were  converted  to the 5.7% note
   payable to such  stockholder  and are  subject to the same terms as the above
   promissory notes.

   Interest  expense on these notes for the years ended December 31, 1996,  1997
   and  1998  was  approximately  $107,  $98 and  $301,  respectively.  Interest
   totaling $78 for the year ended December 31, 1996, was waived and recorded as
   additional paid-in capital.

   The three principal stockholders have entered into a stockholders'  agreement
   dated January 1, 1998. Such agreement  provides  tag-along  rights to each of
   the parties  thereto in the event that any of the other parties elect to sell
   their common stock under certain  circumstances.  In addition,  each party is
   granted a right of first  refusal  to  purchase  any  shares of common  stock
   offered for sale by any other party to the agreement.

   For the years ended December 31, 1996, 1997 and 1998, the Company contributed
   $127, $180 and $165,  respectively,  to a charitable foundation managed by an
   executive of the Company.


                                      F-14
<PAGE>
                        Happy Kids Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                        December 31, 1996, 1997 and 1998
                      (in thousands, except per share data)



NOTE G - COMMITMENTS AND CONTINGENCIES

   The Company leases showroom,  office and warehouse facilities through May 31,
   2006 at the following minimum annual rentals:

                Year ending December 31,                 Amount
                ------------------------                 ------

                   1999                                 $1,281
                   2000                                  1,043
                   2001                                    947
                   2002                                    947
                   2003                                    947
                   Thereafter                            2,292
                                                         -----

                                                        $7,457
                                                         =====

   Rent  expense  for the  years  ended  December  31,  1996,  1997 and 1998 was
   approximately $1,138, $1,126 and $1,187, respectively.

   At December 31, 1998, the Company is  contingently  liable under open letters
   of credit in the amount of approximately $13,655.

   The Company has entered  into  royalty  agreements  that  provide for royalty
   payments  from 6% to 12% of net  sales  of  licensed  products.  The  Company
   incurred  royalty expense  (included in cost of goods sold) of  approximately
   $3,685,  $4,113 and $7,886 for the years ended  December 31,  1996,  1997 and
   1998,  respectively.  Based on minimum  sales  requirements,  future  minimum
   royalty payments required under these agreements are:

                Year ending December 31,                 Amount
                ------------------------                 ------

                   1999                                $ 3,196
                   2000                                  3,628
                   2001                                  3,055
                   2002                                    418
                   2003                                    273
                                                        ------

                                                       $10,570
                                                        ======


                                      F-15
<PAGE>
                        Happy Kids Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                        December 31, 1996, 1997 and 1998
                      (in thousands, except per share data)



NOTE G (continued)

   Executive Compensation

   Effective  January 1, 1998, the Company  entered into  employment  agreements
   with its  executive  officers  for  initial  terms  expiring  in two years at
   initial aggregate annual base salaries of $1,250.

   In  addition,  the Company has a severance  agreement  with an officer of the
   Company,  which  provides  that,  in the event of a change of  control of the
   Company,  the executive would have the right to receive payments at a rate of
   three times the individual's annual regular  compensation upon termination of
   employment within one year.

   Year 2000

   The  Year  2000  issue  relates  to  limitations  in  computer   systems  and
   applications  that may  prevent  proper  recognition  of the Year  2000.  The
   potential  effect  of the Year 2000  issue on the  Company  and its  business
   partners will not be fully  determinable  until the Year 2000 and thereafter.
   If Year 2000  modifications are not properly  completed either by the Company
   or entities with which the Company conducts business,  the Company's revenues
   and financial condition could be adversely impacted.


NOTE H - EMPLOYEE BENEFIT PLAN

   The  Company  has   established  a  401(k)   Profit   Sharing  Plan  covering
   substantially  all eligible  employees.  The plan allows employees to defer a
   percentage of their annual  earnings  subject to limitation of Section 401(m)
   of the Internal Revenue Code.

   The plan  provides  that the  Company can make  discretionary  contributions.
   These   contributions   are  allocated  to  the  participant   based  on  the
   participant's   compensation  in  proportion  to  the   compensation  of  all
   participants.  The  Company's  contribution  to the plan for the years  ended
   December  31,  1996,  1997  and  1998  was  approximately  $31,  $34 and $45,
   respectively.



                                      F-16
<PAGE>
                        Happy Kids Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                        December 31, 1996, 1997 and 1998
                      (in thousands, except per share data)



NOTE I - CONCENTRATIONS

   During the years ended December 31, 1996, 1997 and 1998,  approximately  40%,
   41% and 43%,  respectively,  of total purchases of the Company were made from
   companies located in one overseas country.  In addition,  for the years ended
   December 31, 1996,  1997 and 1998, 37%, 31% and 29%,  respectively,  of total
   purchases  of the  Company  were  made  from  companies  located  in a second
   overseas  country.  In addition,  the Company relied on two manufacturers for
   18%, 11% and 7%, and 11%,  13% and 18% of the  Company's  production  for the
   years ended  December 31, 1996,  1997 and 1998,  respectively.  The Company's
   import  operations  are subject to constraints  imposed by bilateral  textile
   agreements between the United States and a number of foreign countries. These
   agreements  impose  quotas  on the  amount  and  types of goods  which can be
   imported  into  the  United  States  from  these  countries.   The  Company's
   operations may be adversely affected by political  instability,  resulting in
   the  disruption  of trade  from  foreign  countries  in which  the  Company's
   contractors   and  suppliers  are  located,   the  imposition  of  additional
   regulations relating to imports or duties, taxes, quotas and other charges on
   imports. The Company is unable to predict whether any additional regulations,
   duties,  taxes,  quotas or other charges may be imposed on the importation of
   its products.  The assessment of any of these items could result in increases
   in the cost of such imports and affect sales and profitability.  In addition,
   the failure of  manufacturers  to ship some or all of the Company's orders on
   time could impact the Company's ability to deliver products to its customers.
   The  Company  does  not have  long-term  contracts  with any of its  contract
   manufacturers.  The Company believes that alternate  sources of manufacturing
   are available if the need were to arise,  although any  substantial  delay in
   locating,   or  inability  to  locate,   acceptable   alternate   sources  of
   manufacturing could have a material adverse effect on the Company's business,
   financial condition and results of operations.

   The  Company's  sales are made  principally  to department  stores,  mid-tier
   distributors  and mass  market  retailers  of  children's  apparel.  Sales to
   customers  that  represent  more than 10% of the  Company's  net sales are as
   follows:

     Year ended December 30, 1998                         22%, 14% and 11%
     Year ended December 30, 1997                         17%, 14% and 11%
     Year ended December 30, 1996                         22% and 13%




                                      F-17
<PAGE>
                        Happy Kids Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                        December 31, 1996, 1997 and 1998
                      (in thousands, except per share data)



NOTE J - 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 K-3.





   The components of income tax expense (benefit) are summarized as follows:

                                                Year ended December 31,
                                          ----------------------------------
                                          1996           1997           1998
                                          ----           ----           ----

    Current
      Federal........................     $ 17           $347         $4,304
      State and city.................      109            (38)         1,211
                                           ---            ---          -----

                                           126            309          5,515

    Deferred.........................       (7)           164           (912)
                                           ---            ---          -----

                                          $119           $473         $4,603
                                           ===            ===          =====

   Income tax  expense  for the years  ended  December  31, 1996 and 1997
   and for the period  ended April 2, 1998 does not include  income taxes
   for those  subsidiaries  which are S Corporations  or LLCs.  Reference
   is made to Note A-5.






                                      F-18
<PAGE>
                        Happy Kids Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                        December 31, 1996, 1997 and 1998
                      (in thousands, except per share data)



NOTE J (continued)

   The tax  effect of  temporary  differences  which gave rise to  deferred  tax
   assets and liabilities are as follows:

                                                             December 31,
                                                       -----------------------
                                                        1997             1998
                                                       ------           ------

    Provision for losses on accounts receivable
       and other receivables.....................       $ 33           $  409
    Accrued expenses.............................        280              200
    Depreciation.................................         (1)              (2)
    Costs capitalized to inventory...............         16              636
    Other........................................         --               --
                                                         ---            -----

    Net deferred tax asset.......................       $328           $1,243
                                                         ===            =====

    Current......................................       $ 40           $1,029
    Long-term....................................        288              214

   During the year ended December 31, 1996, the Internal Revenue Service ("IRS")
   completed an examination of the tax returns of Happy Kids, Ltd. for the years
   ended December 31, 1991, 1992 and 1993. As a result of the examination, Happy
   Kids, Ltd.  recorded an additional $235 in Federal and state income taxes and
   $55 in penalties and interest.

   At December 31, 1998, the IRS has cleared the tax returns of Happy Kids, Ltd.
   through December 31, 1996.


NOTE K - STOCKHOLDERS' EQUITY

   1. Stock Option Plan

      The Company's 1997 Stock Option Plan (the "Plan") was adopted by the Board
      of Directors and approved by the  shareholders  of the Company on December
      31,  1997.  A total of 800,000  shares of common  stock are  reserved  for
      issuance  upon  exercise of options  and/or  stock  purchase  rights to be
      granted under the Plan.  Those  eligible to receive stock option grants or
      stock  purchase  rights  under  the Plan  include  employees,  nonemployee
      directors and consultants.


                                      F-19
<PAGE>
                        Happy Kids Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                        December 31, 1996, 1997 and 1998
                      (in thousands, except per share data)


NOTE K (continued)

      Subject to the provisions of the Plan, the  administrator  of the Plan has
      the  discretion to determine the optionees  and/or  grantees,  the type of
      options to be granted  (incentive  stock options  ("ISOs") or nonqualified
      stock options ("NQSOs")),  the vesting provisions, the terms of the option
      grants and such other related  provisions as are consistent with the Plan.
      The  exercise  price of an ISO may not be less than the fair market  value
      per share of the  common  stock on the date of grant or, in the case of an
      optionee  who  beneficially  owns 10% or more of the  outstanding  capital
      stock of the  Company,  not less  than 110% of the fair  market  value per
      share on the date of grant.  The exercise  price of a NQSO may not be less
      than 85% of the fair  market  value per share of the  common  stock on the
      date of grant, or, in the case of any optionee who  beneficially  owns 10%
      or more of the  outstanding  capital  stock of the Company,  not less than
      110% of the fair market value per share on the date of grant. The purchase
      price of shares issued  pursuant to stock purchase  rights may not be less
      than 50% of the fair  market  value of such shares as of the offer date of
      such rights.

      The  options  terminate  not more than ten  years  from the date of grant,
      subject to earlier  termination  on the  optionee's  death,  disability or
      termination of employment  with the Company,  but provide that the term of
      any options granted to a holder of more than 10% of the outstanding shares
      of common stock may be no longer than five years.  The Plan  terminates on
      December 31, 2007.

      The  weighted  average  fair  value at date of grant for  options  granted
      during 1998 was $4.47 per option. The fair value of each option at date of
      grant was estimated using the Black-Scholes  option pricing model with the
      following weighted-average assumptions for grants in 1998:

              Expected stock price volatility       35%
              Expected lives of options             7 years
              Risk-free interest rate               5.7%
              Expected dividend yield                 0%



                                      F-20
<PAGE>
                        Happy Kids Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                        December 31, 1996, 1997 and 1998
                      (in thousands, except per share data)



NOTE K (continued)

   Information regarding these option plans for 1998 is as follows:
<TABLE>
<CAPTION>

                                             Incentive options        Nonqualified options
                                             -----------------        --------------------
                                                       Weighted-               Weighted-
                                                       average                 average
                                                       exercise                exercise
                                           Shares        price       Shares      price
                                           ------        -----       ------      -----
<S>                                          <C>         <C>          <C>         <C>
   Options outstanding at
     beginning of year
      Exercised........................       --          --            --         --
      Granted..........................      100         $10            80        $10
      Canceled or forfeited............       --          --            --         --
                                             ---         ---           ---        ---

   Options outstanding at end of year..      100         $10            80        $10
                                             ===         ===           ===        ===
   

   Exercisable.........................       --                        --
                                             ===                       ===
</TABLE>

   The following table summarizes information about stock options outstanding as
   of December 31, 1998:
<TABLE>
<CAPTION>

                      Number        Weighted-                 Number
                    outstanding      average     Weighted   exercisable   Weighted-
                       as of        remaining     average      as of       average
        Exercise   December 31,    contractual   exercise   December 31,   exercise
         price         1998           life         price      1998          price
        -------    ------------    -----------   --------   ------------  ---------

<S>      <C>           <C>          <C>            <C>          <C>           <C>
         $10           180          9.21 years     $10          --            $10
</TABLE>



                                      F-21
<PAGE>
                        Happy Kids Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                        December 31, 1996, 1997 and 1998
                      (in thousands, except per share data)



NOTE K (continued)

   2. Stock Split

      As of December 31, 1997, the Company  effected a 34,875-for-1  stock split
      of the  Company's  outstanding  common  stock.  A total of 7,750 shares of
      common stock will be issued and outstanding after the split. All share and
      per share  amounts have been restated to  retroactively  reflect the stock
      splits.

   3. Initial Public Offering

      On April 2, 1998, the Company  consummated  its Initial Public Offering of
      2,200  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' overallotment 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 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 $22,331.

      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,
      $2,000  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 (Note F) and the
      remaining  amount was  utilized  to pay down a portion of the  outstanding
      balance under the Company's bank credit facility.



                                      F-22
<PAGE>
                        Happy Kids Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                        December 31, 1996, 1997 and 1998
                      (in thousands, except per share data)



NOTE L - PRO FORMA INFORMATION (UNAUDITED)

   1. Pro Forma Results of Operations and Pro Forma Income Taxes

      Pro forma  adjustments in the statements of operations for the years ended
      December  31,  1996,  1997 and 1998  reflect a provision  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 for the full periods.

      As  disclosed  in  Note  A-5,  the  Company  elected  for  certain  of its
      affiliates  to  be  taxed  as an S  Corporation  or  to  be  treated  as a
      partnership  pursuant to the Internal Revenue Code. In connection with the
      Offering,  the  Company  terminated  its  S  Corporation  and  Partnership
      elections  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 for the
      years ended  December  31,  1996,  1997 and for the period  ended April 2,
      1998.  The  effective  pro forma tax rate of the Company  differs from the
      Federal rate primarily due to the effects of state income taxes.

      The pro forma  provision  for income  taxes,  after  giving  effect to the
      Federal  statutory  rate and an  approximate  state  tax  provision  after
      reflecting the Federal tax benefit, consists of the following:

                                                Year ended December 31,
                                         -----------------------------------
                                         1996            1997           1998
                                         ----            ----           ----

       Federal......................     $661          $1,481          $5,187
       State........................      329             480           1,470
                                          ---           -----           -----

                                         $990          $1,961          $6,657
                                          ===           =====           =====



                                      F-23
<PAGE>
                        Happy Kids Inc. and Subsidiaries

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

                        December 31, 1996, 1997 and 1998
                      (in thousands, except per share data)



NOTE L (continued)

      The  differences  between pro forma tax expense shown in the statements of
      operations  and the pro forma  computed  income tax  expense  based on the
      Federal statutory corporate rate are as follows:

                                                         Year ended December 31,
                                                    ----------------------------
                                                    1996         1997       1998
                                                    ----         ----       ----

       Computed income taxes based on Federal
          statutory rate of 34% in 1996 and
           1997, and 35% in 1998................   $ 845       $1,586     $5,683
       State income taxes, net of Federal
          benefit...............................     217          317        956

       Benefit of utilization of net
       operating losses.........................    (160)          --         --
       Interest waived on debt..................      33           --         --
       Officer's life insurance.................      40           32         --
       Other....................................      15           26         18
                                                    ----        -----      -----

                                                   $ 990       $1,961     $6,657
                                                    ====        =====      =====

   2. Pro Forma Net Income and Net Income Per Common Share

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

      Pro forma net income per share is based on the weighted  average number of
      shares outstanding immediately prior to the closing of the Offering, after
      giving effect to a  34,875-for-1  stock split and the shares issued in the
      Offering.



                                      F-24
<PAGE>
                        Happy Kids Inc. and Subsidiaries

                 SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
                                 (in thousands)


<TABLE>
<CAPTION>
           Column A                     Column B             Column C           Column D      Column E
           --------                     --------             --------           --------      --------

                                                            Additions
                                                            ---------
                                                       (1)         (2)
                                        Balance at    Charged to  Charged to                  Balance at
                                        beginning     costs and      other                      end of
      Description                       of period     expenses     accounts    Deductions(a)    period
      -----------                       ----------    ----------  ----------   -------------  ----------
<S>                                        <C>           <C>         <C>            <C>         <C>   
Year ended December 31, 1996
  Deducted from asset accounts
   Allowance for doubtful accounts         $274          $13         $199           --          $  486


Year ended December 31, 1997
  Deducted from asset accounts
   Allowance for doubtful accounts
     and other receivables                 $486          $31         $323           --          $  840


Year ended December 31, 1998
  Deducted from asset accounts
   Allowance for doubtful accounts
    and other receivables                  $840          $71         $838           --          $1,749


-------------

(a)   Accounts written off as uncollectible.

</TABLE>