**FORM 10-Q**

 

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**(MARK ONE)**

 
| **ý**                       | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                  |
|----------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                             |                                                                                                                                                          |
|                             | **For the quarterly period ended  September 30, 2002**                                                                                                        |
|                             |                                                                                                                                                          |
|                             | **or**                                                                                                                                                        |
|                             |                                                                                                                                                          |
| **o**                            | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                 |
|                             |                                                                                                                                                          |
|                             | **For the transition period  from          to          ** |
|                             |                                                                                                                                                          |
| **Commission  File No. 0-22545** |

 

**DSI Toys, Inc.**

(Exact name of Registrant as specified in its charter)

 

| **Texas**                                                                 |   | **74-1673513**                        |
|---------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction  of incorporation or organization)           |   | (I.R.S. Employer  Identification No.) |
|                                                                      |   |                                  |
| **10110 West Sam  Houston Parkway South, #150  Houston, Texas**           |   | **77099**                             |
| (Address of principal executive offices)                                  |   | (Zip Code)                            |
|                                                                      |   |                                  |
| Registrant’s telephone number including area code:**(713) 365-9900** |

 

Indicate by check mark whether the Registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes ý  No o

 

As of November 12, 2002,10,866,365 shares of common stock, par value $.01 per share, of DSI Toys, Inc.were outstanding.

 

 

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**TABLEOF CONTENTS**

 

**PART I- FINANCIALINFORMATION**

 
| Item  1.                         | Financial  Statements                                                                                         |
|----------------------------------|---------------------------------------------------------------------------------------------------------------|
|                             |                                                                                                          |
|                             | Consolidated Balance  Sheet as of September 30, 2002 and December 31, 2001                                    |
|                             |                                                                                                          |
|                             | Consolidated Statement of  Operations for the Three Months and Nine Months Ended September 30, 2002 and  2001 |
|                             |                                                                                                          |
|                             | Consolidated Statement of  Cash Flows for the Nine Months Ended September 30, 2002 and 2001                   |
|                             |                                                                                                          |
|                             | Consolidated  Statement of Shareholders’ Equity                                                          |
|                             |                                                                                                          |
|                             | Notes to  Consolidated Financial Statements                                                                   |
|                             |                                                                                                          |
| Item  2.                         | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                   |
|                             |                                                                                                          |
| Item  3.                         | Quantitative  and Qualitative Disclosure About Market Risk                                                    |
|                             |                                                                                                          |
| Item  4.                         | Controls  and Procedures                                                                                      |
|                             |                                                                                                          |
| **PART II - OTHER  INFORMATION** |
|                             |
| Item 1.                          | Legal  Proceedings                                                                                            |
|                             |                                                                                                          |
| Item 2.                          | Change in Securities  and Use of Proceeds                                                                     |
|                             |                                                                                                          |
| Item 5.                          | Other Information                                                                                             |
|                             |                                                                                                          |
| Item 6.                          | Exhibits and Reports  on Form 8-K                                                                             |
|                             |                                                                                                          |
| Signatures                       |
|                             |                                                                                                          |
| Certifications                   |

** **

**i**

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**PART I - FINANCIAL INFORMATION**

 

**Item 1.          Financial Statements**

 

**DSI Toys,Inc.**

**ConsolidatedBalance Sheet**

 
|                                                                                                                                                                           |   | **September 30  2002** |       | **December 31,  2001** |       |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|------------|------------------------|------------|
|                                                                                                                                                                           |   | **(Unaudited)**        |       |                   |       |
| **ASSETS**                                                                                                                                                                     |   |                   | ** ** |                   | ** ** |
| Current assets:                                                                                                                                                                |   |                   |       |                   |       |
| Cash                                                                                                                                                                           |   | $                      | 1,602,249  |                   | $          | 284,637 |   |
| Accounts receivable, net                                                                                                                                                       |   | 11,414,071             |       | 8,767,550              |       |
| Inventories                                                                                                                                                                    |   | 9,407,746              |       | 6,739,920              |       |
| Prepaid expenses                                                                                                                                                               |   | 3,284,552              |       | 1,981,592              |       |
| Deferred income taxes                                                                                                                                                          |   | —                 |       | 893,000                |       |
| Total current assets                                                                                                                                                           |   | 25,708,618             |       | 18,666,699             |       |
|                                                                                                                                                                           |   |                   |       |                   |       |
| Property and equipment, net                                                                                                                                                    |   | 2,241,095              |       | 1,769,284              |       |
| Deferred income taxes                                                                                                                                                          |   | —                 |       | 1,312,000              |       |
| Goodwill, net                                                                                                                                                                  |   | 9,241,128              |       | 9,241,128              |       |
| Other assets                                                                                                                                                                   |   | 822,602                |       | 323,624                |       |
| Total assets                                                                                                                                                                   |   | $                      | 38,013,443 |                   | $          | 31,312,735 |   |
|                                                                                                                                                                           |   |                   |       |                   |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                  |   |                   | ** ** |                   | ** ** |
| Current liabilities:                                                                                                                                                           |   |                   |       |                   |       |
| Accounts payable and accrued liabilities                                                                                                                                       |   | $                      | 18,661,154 |                   | $          | 6,580,780 |   |
| Current portion of long-term debt                                                                                                                                              |   | 9,702,055              |       | 1,120,650              |       |
| Current portion of long-term debt due to a related  party                                                                                                                      |   | 951,685                |       | 1,751,485              |       |
| Income taxes payable                                                                                                                                                           |   | 168,760                |       | 69,638                 |       |
| Total current liabilities                                                                                                                                                      |   | 29,483,654             |       | 9,522,553              |       |
|                                                                                                                                                                           |   |                   |       |                   |       |
| Long-term debt                                                                                                                                                                 |   | —                 |       | 9,210,390              |       |
| Long-term debt due to a related party                                                                                                                                          |   | 4,797,547              |       | 3,289,552              |       |
| Deferred income taxes                                                                                                                                                          |   | 156,642                |       | 156,642                |       |
| Total liabilities                                                                                                                                                              |   | 34,437,843             |       | 22,179,137             |       |
|                                                                                                                                                                           |   |                   |       |                   |       |
| Shareholders’ equity:                                                                                                                                                     |   |                   |       |                   |       |
| Preferred stock, $.01 par value, 5,000,000 shares  authorized, none issued or outstanding                                                                                      |   | —                 |       | —                 |       |
| Common stock, $.01 par value, 35,000,000 shares  authorized, 10,866,365 and 9,066,365 shares issued and outstanding,  respectively at September 30, 2002 and December 31, 2001 |   | 108,664                |       | 90,664                 |       |
| Additional paid-in capital                                                                                                                                                     |   | 7,855,465              |       | 5,173,465              |       |
| Common stock warrants                                                                                                                                                          |   | 102,500                |       | 2,802,500              |       |
| Accumulated other comprehensive loss                                                                                                                                           |   | (79,374                | )          | (70,928                | )          |
| Accumulated earnings (deficit)                                                                                                                                                 |   | (4,411,655             | )          | 1,137,897              |       |
| Total shareholders’ equity                                                                                                                                                |   | 3,575,600              |       | 9,133,598              |       |
| Total liabilities and shareholders’ equity                                                                                                                                |   | $                      | 38,013,443 |                   | $          | 31,312,735 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

1

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**DSI Toys,Inc.**

**ConsolidatedStatement of Operations**

**(Unaudited)**

 
|                                         |   | **Three Months Ended September 30,** |       | **Nine Months Ended September 30,** |   |
|----------------------------------------------|--------|--------------------------------------|------------|-------------------------------------|--------|
|                                         |   | **2002**                             |       | **2001**                            |   | **2002** |   | **2001** |   |
|                                         |   |                                 |       |                                |   |   |   |   |   |
| Net sales                                    |   | $                                    | 20,683,800 |                                | $      | 29,927,783 |   | $ | 34,824,317 |   | $ | 46,065,190 |   |
| Costs of goods sold                          |   | 16,721,603                           |       | 21,203,145                          |   | 27,255,720 |   | 33,622,175 |   |
| Gross profit                                 |   | 3,962,197                            |       | 8,724,638                           |   | 7,568,597 |   | 12,443,015 |   |
| Selling, general and administrative expenses |   | 4,386,867                            |       | 5,192,933                           |   | 10,353,689 |   | 13,169,780 |   |
| Operating income (loss)                      |   | (424,670                             | )          | 3,531,705                           |   | (2,785,092 | ) | (726,765 | ) |
| Interest expense                             |   | (198,773                             | )          | (326,668                            | )      | (649,037 | ) | (864,358 | ) |
| Other income                                 |   | 6,912                                |       | 107,316                             |   | 89,577 |   | 167,106 |   |
| Income (loss) before income taxes            |   | (616,531                             | )          | 3,312,353                           |   | (3,344,552 | ) | (1,424,017 | ) |
| Benefit (expense) from income taxes          |   | (3,132,527                           | )          | (1,331,064                          | )      | (2,205,000 | ) | 374,029 |   |
| Net profit (loss)                            |   | $                                    | (3,749,058 | )                                   | $      | 1,981,289 |   | $ | (5,549,552 | ) | $ | (1,049,988 | ) |
|                                         |   |                                 |       |                                |   |   |   |   |   |
| Basic earnings per share                     |   |                                 |       |                                |   |   |   |   |   |
| Earnings (loss) per share                    |   | $                                    | (0.38      | )                                   | $      | 0.22 |   | $ | (0.59 | ) | $ | (0.12 | ) |
| Weighted average shares outstanding          |   | 9,868,539                            |       | 9,066,365                           |   | 9,335,708 |   | 9,066,365 |   |
|                                         |   |                                 |       |                                |   |   |   |   |   |
| Diluted Earnings per share                   |   |                                 |       |                                |   |   |   |   |   |
| Earnings (loss) per share                    |   | $                                    | (0.38      | )                                   | $      | 0.22 |   | $ | (0.59 | ) | $ | (0.12 | ) |
| Weighted average shares outstanding          |   | 9,868,539                            |       | 9,066,365                           |   | 9,335,708 |   | 9,066,365 |   |

 

See accompanying notes to consolidated financial statements.

 

2

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**DSI Toys,Inc.**

**ConsolidatedStatement of Cash Flows**

**(Unaudited)**

 
|                                                            |   | **Nine months ended September 30,** |       |
|-----------------------------------------------------------------|--------|-------------------------------------|------------|
|                                                            |   | **2002**                            |       | **2001** |   |
| Cash flows from operating activities:                           |   |                                |       |   |   |
| Net loss                                                        |   | $                                   | (5,549,552 | ) | $ | (1,049,988 | ) |
| Adjustments to reconcile net loss to net cash used  by          |   |                                |       |   |   |
| operating activities:                                           |   |                                |       |   |   |
| Depreciation and amortization                                   |   | 743,836                             |       | 997,706 |   |
| Amortization and write-off of debt discount and  issuance costs |   | 38,522                              |       | 34,783 |   |
| Amortization of goodwill                                        |   | —                              |       | 385,047 |   |
| Provision for doubtful accounts, net                            |   | 4,490                               |       | 43,144 |   |
| Loss (gain) on abandonment or sale of equipment                 |   | 26,437                              |       | (23,617 | ) |
| Deferred income taxes                                           |   | 2,205,000                           |       | (369,391 | ) |
| Changes in assets and liabilities:                              |   |                                |       |   |   |
| Restricted cash                                                 |   | —                              |       | (300,000 | ) |
| Accounts receivable                                             |   | (2,651,011                          | )          | (8,651,938 | ) |
| Inventories                                                     |   | (2,667,826                          | )          | (5,981,084 | ) |
| Income taxes payable                                            |   | 99,122                              |       | 74,734 |   |
| Prepaid expenses                                                |   | (1,302,960                          | )          | (402,838 | ) |
| Accounts payable and accrued liabilities                        |   | 12,080,374                          |       | 9,817,872 |   |
| Net cash provided (used) by operating activities                |   | 3,026,432                           |       | (5,425,570 | ) |
|                                                            |   |                                |       |   |   |
| Cash flows from investing activities:                           |   |                                |       |   |   |
| Capital expenditures                                            |   | (1,242,084                          | )          | (535,824 | ) |
| Proceeds from sale of equipment                                 |   | —                              |       | 94,592 |   |
| Decrease (increase) in other assets                             |   | (537,500                            | )          | 5,681 |   |
| Net cash used in investing activities                           |   | (1,779,584                          | )          | (435,551 | ) |
|                                                            |   |                                |       |   |   |
| Cash flows from financing activities:                           |   |                                |       |   |   |
| Net borrowings under revolving lines of credit                  |   | 2,279,425                           |       | 1,673,439 |   |
| Net borrowings (payments) on long-term debt                     |   | (2,908,410                          | )          | 1,999,685 |   |
| Borrowings (payments) of long-term debt due to  related party   |   | 708,195                             |       | (372,790 | ) |
| Net proceeds from issuance of warrants                          |   | —                              |       | 2,700,000 |   |
| Debt and stock issue costs                                      |   | —                              |       | (117,500 | ) |
| Net cash provided by financing activities                       |   | 79,210                              |       | 5,882,834 |   |
|                                                            |   |                                |       |   |   |
| Effect of exchange rate changes on cash                         |   | (8,446                              | )          | (49,006 | ) |
| Net increase (decrease) in cash                                 |   | 1,317,612                           |       | (27,293 | ) |
| Cash and cash equivalents, beginning of period                  |   | 284,637                             |       | 177,682 |   |
| Cash and cash equivalents,  end of period                  |   | $                                   | 1,602,249  |   | $ | 150,389 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

3

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**DSI Toys,Inc.**

**ConsolidatedStatement of Shareholders’ Equity**

(Unaudited)

 
|                                         |   |             |   | **Additional  Paid-in  Capital** |    | **Warrants** |   | **Accumulated  Other  Comprehensive  Loss** |   | **Accumulated  Earnings  (Deficit)** |    | **Totals** |   |
|----------------------------------------------|--------|------------------|--------|----------------------------------|---------|--------------|--------|---------------------------------------------|--------|--------------------------------------|---------|------------|--------|
|                                         |   |             |   |                             |    |         |   |                                        |
|                                         |   | **Common Stock** |   |                             |    |         |   |                                        |
|                                         |   | **Shares**       |   | **Amount**                       |    |         |   |                                        |   |                                 |
| Balance, December 31, 2000                   |   | 9,066,365        |   | $                                | 90,664  |         | $      | 5,173,465                                   |   | $                                    | 102,500 |       | $      | (27,062 | ) | $ | 2,587,415 |   | $ | 7,926,982 |   |
|                                         |   |             |   |                             |    |         |   |                                        |   |                                 |    |       |   |   |   |
| Comprehensive loss:                          |   |             |   |                             |    |         |   |                                        |   |                                 |    |       |   |   |   |
| Net loss                                     |   |             |   |                             |    |         |   |                                        |   |                                 |    | (1,449,518 | )      | (1,449,518 | ) |
| Foreign currency translation adj. net of tax |   |             |   |                             |    |         |   |                                        |   | (43,866                              | )       |       |   | (43,866 | ) |
| Comprehensive loss                           |   |             |   |                             |    |         |   |                                        |   |                                 |    |       |   | (1,493,384 | ) |
| Warrants issued                              |   |             |   |                             |    |         |   | 2,700,000                                   |   |                                 |    |       |   | 2,700,000 |   |
| Balance, December 31, 2001                   |   | 9,066,365        |   | 90,664                           |    | 5,173,465    |   | 2,802,500                                   |   | (70,928                              | )       | 1,137,897  |   | 9,133,598 |   |
|                                         |   |             |   |                             |    |         |   |                                        |   |                                 |    |       |   |   |   |
| Comprehensive loss:                          |   |             |   |                             |    |         |   |                                        |   |                                 |    |       |   |   |   |
| Net loss                                     |   |             |   |                             |    |         |   |                                        |   |                                 |    | (1,313,414 | )      | (1,313,414 | ) |
| Foreign currency translation adj. net of tax |   |             |   |                             |    |         |   |                                        |   | (1,611                               | )       |       |   | (1,611 | ) |
| Comprehensive loss                           |   |             |   |                             |    |         |   |                                        |   |                                 |    |       |   | (1,315,025 | ) |
| Balance, March 31, 2002                      |   | 9,066,365        |   | 90,664                           |    | 5,173,465    |   | 2,802,500                                   |   | (72,539                              | )       | (175,517   | )      | 7,818,573 |   |
|                                         |   |             |   |                             |    |         |   |                                        |   |                                 |    |       |   |   |   |
| Comprehensive loss:                          |   |             |   |                             |    |         |   |                                        |   |                                 |    |       |   |   |   |
| Net loss                                     |   |             |   |                             |    |         |   |                                        |   |                                 |    | (487,080   | )      | (487,080 | ) |
| Foreign currency translation adj. net of tax |   |             |   |                             |    |         |   |                                        |   | 2,853                                |    |       |   | 2,853 |   |
| Comprehensive loss                           |   |             |   |                             |    |         |   |                                        |   |                                 |    |       |   | (484,227 | ) |
| Balance, June 30, 2002                       |   | 9,066,365        |   | 90,664                           |    | 5,173,465    |   | 2,802,500                                   |   | (69,686                              | )       | (662,597   | )      | 7,334,346 |   |
|                                         |   |             |   |                             |    |         |   |                                        |   |                                 |    |       |   |   |   |
| Comprehensive loss:                          |   |             |   |                             |    |         |   |                                        |   |                                 |    |       |   |   |   |
| Net loss                                     |   |             |   |                             |    |         |   |                                        |   |                                 |    | (3,749,058 | )      | (3,749,058 | ) |
| Foreign currency translation adj. net of tax |   |             |   |                             |    |         |   |                                        |   | (9,688                               | )       |       |   | (9,688 | ) |
| Comprehensive loss                           |   |             |   |                             |    |         |   |                                        |   |                                 |    |       |   | (3,758,746 | ) |
| Warrants exercised                           |   | 1,800,000        |   | 18,000                           |    | 2,682,000    |   | (2,700,000                                  | )      |                                 |    |       |   |   |   |
| Balance, September 30, 2002                  |   | 10,866,365       |   | $                                | 108,664 |         | $      | 7,855,465                                   |   | $                                    | 102,500 |       | $      | (79,374 | ) | $ | (4,411,655 | ) | $ | 3,575,600 |   |

 

See accompanyingnotes to consolidated financial statements.

 

**4**

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# **DSI Toys, Inc.**

**Notesto Consolidated Financial Statements**

**(Unaudited)**

 

#### **1.**             Basis of Presentation

 

The accompanying unaudited consolidated financialstatements of DSI Toys, Inc. and its wholly-owned subsidiaries (the “Company”)have been prepared in accordance with accounting principles generally accepted inthe United States of America for interim financial information and with theinstructions to Form 10–Q. Accordingly, they do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States of Americafor complete financial statements and should be read in conjunction with thefinancial statements and notes thereto appearing in the Company’s Annual Reporton Form 10-K and Form 10-K/A for the fiscal year ended December 31, 2001.  

 

In the opinion of the Company’s management, alladjustments necessary for the fair presentation of the results of operationsfor all periods reported have been included. Such adjustments consist only of normal recurring items.

 

The results of operations for the three and ninemonths ended September 30, 2002, are not necessarily indicative of the resultsexpected for the full year ending December 31, 2002.

 

#### **2.**             Significant Accounting Policies

 

Certain of our accounting policies require theapplication of significant judgment by management in selecting the appropriateassumptions for calculating financial estimates.  By their nature, these judgments are subject to an inherentdegree of uncertainty.  These judgmentsare based on our historical experience, terms with current customers, ourobservance of trends in the industry, information provided by our customers andinformation available from other outside sources, as appropriate.  Our significant accounting policies include:

 

*RevenueRecognition*– The Company recognizes revenue when productsare shipped and title passes to unaffiliated customers.  In most cases, title transfers to ourcustomers when the product has been presented to shipment forwarders on FOBAsia sales and when the product is picked up from our distribution facilitieson domestic sales.  

 

*Allowancefor Doubtful Accounts*– Accounts receivable are reduced by an allowance for amounts that maybecome uncollectible in the future.  TheCompany’s estimate for its allowance is based on two methods which are combinedto determine the total amount reserved. First, the Company evaluates specific accounts where we have informationthat the customer may have an inability to meet its financial obligations(bankruptcy, etc.).  In these cases, theCompany uses its judgment, based on the best available facts and circumstances,and records a specific reserve for that customer against amounts due to reducethe receivable to the amount that is expected to be collected.  These specific reserves are reevaluated andadjusted as additional information is received that impacts the amountsreserved.  Second, a reserve isestablished for all other customers based on historical collection andwrite-off experience.  If circumstanceschange, the Company’s estimates of the recoverability of amounts due theCompany could be reduced by a material amount.

 

*Allowancefor Returns and Defectives*– The Company records a provisionfor estimated sales returns and defectives on sales in the same period as therelated revenue is recorded.  Our salesto customers generally do not give them the right to return product or tocancel firm orders.  However, as iscommon in the industry, we sometimes accept returns for stock balancing andnegotiate accommodations to customers, which includes price discounts, creditsand returns when demand for specific products fall below expectations.  Additionally, customers are given credit forany defective products they may have received. The allowance estimates are based on historical sales returns anddefective rates, analysis of credit memo data and other known factors.  If the data the Company uses to calculatethese estimates does not properly reflect future returns and defectives,revenue could be overstated and future operating results adversely affected.

 

5

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*Inventories*– Inventory is valued at the lower of cost or market.  The Company reviews the book value of slow-moving items,discounted product lines and individual products to determine if these itemsare properly valued.  The Companyidentifies these items and assesses the ability to dispose of them at a pricegreater than cost.  If it is determinedthat cost is less than market value, then cost is used for inventoryvaluation.  If market value is less thancost, then the Company establishes a reserve for the amount required to valuethe inventory at market.  If the Companyis not able to achieve its expectations of the net realizable value of theinventory at its current value, the Company would adjust its reserveaccordingly.

 

*DeferredTaxes* – The Company recorded a $3.1 million charge toestablish an additional valuation allowance for its deferred tax assets in thethird quarter of fiscal 2002.  Thevaluation allowance was calculated in accordance with the provisions ofStatement of Financial Accounting Standards (SFAS) 109, “Accounting for IncomeTaxes”, which places primary importance on the Company's cumulative operatingresults in the most recent three-year period when assessing the need for avaluation allowance.

 

The primary factors considered in evaluating therealizability of the deferred tax assets and establishing the valuationallowance were continued operating losses for the Company through September 30,2002, the Company’s projection of future operating results and the number ofyears it will take to recover the tax assets in a difficult market.  This evaluation provides sufficient negativeevidence to establish an additional valuation allowance under the provisions ofSFAS 109.  The Company intends to maintaina full valuation allowance for its deferred tax assets and net operating losscarryforwards until sufficient positive evidence exists to support reversal ofthe allowance.  The establishment ofthis valuation allowance in no way affects the Company’s ability to reducefuture tax expense through utilization of net operating losses and foreignincome tax credits.

 

*Impairmentof assets* - The Company reviews for the impairment oflong-lived assets, including goodwill, whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable.

 

Goodwill has been amortized over 20 years using thestraight-line method in 2001.  In 2002,the Company adopted Statement of Financial Accounting Standards, No. 142,“Goodwill and Other Intangible Assets” (“FAS 142”), which eliminatesamortization of goodwill beginning in January 2002 and requires an annualimpairment assessment based on its estimated fair value, using futurediscounted cash flow and other factors. The initial December 31, 2001, fair value assessment was completed by anindependent company during the first quarter of 2002.  Based on this review an impairment adjustment is not required.Pursuant to FAS 142, the annual impairment assessment on the estimated fair valueof the Company’s goodwill will be performed by an independent company at theend of the fourth quarter of 2002.  

 

#### **3.**                                      AccountsReceivable

 

Accounts receivable consist of the following:

 
|                       |   | **September 30,  2002** |       | **December 31,  2001** |   |
|----------------------------|--------|-------------------------|------------|------------------------|--------|
|                       |   |                    |       |                   |   |
| Trade receivables          |   | $                       | 14,818,890 |                   | $      | 12,717,550 |   |
| Provisions for:            |   |                    |       |                   |   |
| Discounts and markdowns    |   | (1,156,921              | )          | (1,472,706             | )      |
| Return of defective  goods |   | (514,534                | )          | (777,294               | )      |
| Doubtful accounts          |   | (1,733,364              | )          | (1,700,000             | )      |
| Accounts receivable,  net  |   | $                       | 11,414,071 |                   | $      | 8,767,550 |   |

 

6

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**4.****                                      SegmentInformation**

 

Financial information for the nine months endedSeptember 30, 2002 and 2001 is as follows:

 
|                                   |   | **United States** |       | **Hong Kong** |   | **Consolidated** |   |
|----------------------------------------|--------|-------------------|------------|---------------|--------|------------------|--------|
| Nine months ended September 30, 2002:  |   |              |       |          |   |             |   |
| Net sales                              |   | $                 | 11,994,419 |          | $      | 22,829,898       |   | $ | 34,824,317 |   |
| Operating income (loss)                |   | (3,671,277        | )          | 886,185       |   | (2,785,092       | )      |
| Total assets at  September 30, 2002..  |   | 29,095,505        |       | 8,917,938     |   | 38,013,443       |   |
|                                   |   |              |       |          |   |             |   |
| Nine months ended  September 30, 2001: |   |              |       |          |   |             |   |
| Net sales                              |   | $                 | 16,717,170 |          | $      | 29,348,020       |   | $ | 46,065,190 |   |
| Operating income (loss)                |   | (3,056,134        | )          | 2,329,369     |   | (726,765         | )      |
| Total assets at  September 30, 2001    |   | 35,689,159        |       | 9,103,927     |   | 44,793,086       |   |

 

**5.****                                      Liquidity**

 

The Company’s net losses for the nine months endedSeptember 30, 2002, resulted in the Company being out of compliance withcertain financial covenants required under the revolving credit facilitybetween Sunrock Capital Corp. (“Sunrock”) and the Company (the “Revolver”).  Therefore, the Company’s $6.3 milliondebt under the Revolver as of September 30, 2002, has been reclassified as acurrent liability.  As a result, theCompany’s current liabilities exceeded its current assets by $3.8 millionas of September 30, 2002. If Sunrock were to accelerate the Revolver, the$6.3 million debt would become immediately due and payable.

 

The Company is in negotiations with Sunrock to amendthe Revolver to bring the Company back into compliance.  The Company’s viability as a going concernis dependent upon successful negotiations with Sunrock or a substantial capitalinfusion. The accompanying financial statements do not include any adjustmentsthat might be necessary if the Company is unable to continue as a goingconcern.

 

To the extent the Company’s cash reserves and cashflows from operations are insufficient to meet future cash requirements, theCompany will need to successfully raise additional capital through additionalequity infusion or the issuance of debt. However, there can be no assurance the Company will meet its projectedoperating results or be successful either in obtaining additional capital, oramending the Revolver.  The Company’sexecutive management believes that the Company will be able to either amend theRevolver or obtain necessary additional capital to allow the Company tocontinue its normal operations for the forseeable future.

 

**6.****                                      WarrantConversion**

 

On August 21, 2002, MVII, LLC (“MVII”), a Californialimited liability company controlled by E. Thomas Martin, converted a prepaid InvestmentWarrant into 1.8 million shares of Common Stock. Upon issuance of these shares,MVII directly owned 5,994,238 shares of Common Stock.

 

## **7.**                                      Recent Accounting Pronouncements

 

In June 2001, SFAS No. 143, “Accounting for AssetRetirement Obligations” was issued. The standard requires that legalobligations associated with the retirement of long-lived intangible assets berecorded at fair value when incurred and will be effective on January 1, 2003.The adoption of this statement is not expected to have a material impact on theCompany’s consolidated financial position, results of operations or cash flows.

## ** **

In April 2002, SFAS No. 145, “Recission of FASBStatements No. 4, 44 and 64, Amendment to FASB No. 13, and TechnicalCorrections” was issued. This statement provides guidance on the classificationof gains and losses from the extinguishment of debt and on the accounting forcertain specified lease transactions. The adoption of this statement is notexpected to have a material impact on the Company’s consolidated financialposition, results of operations or cash flows.

 

7

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In June 2002, SFAS No. 146, “Accounting for CostsAssociated with Exit or Disposal Activities” was issued. This statementprovides guidance on the recognition and measurement of liabilities associatedwith disposal activities and is effective on January 1, 2003. The adoption ofthis statement is not expected to have a material impact on the Company’sconsolidated financial position, results of operations or cash flows.

 

8

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## **Item2.    Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

**Exceptas otherwise indicated, references to the “Company” refer to DSI Toys, Inc. andits  wholly-owned Hong Kong subsidiary,DSI (HK) Limited (“DSI(HK)”). Former wholly-owned subsidiaries MeritusIndustries Limited, RSP Products Limited and Elite Dolls Limited, all of whoseoperations were transferred to DSI(HK) on January 7, 2000, were liquidated, asplanned, effective October 22, 2002. The terms “fiscal year” and “fiscal” referto the Company’s fiscal year, which is the year ending December 31 of thecalendar year mentioned (*e.g*., a reference to fiscal 2001 is areference to the fiscal year ended December 31, 2001).**

 

#### **General**

The following discussion and analysis should be readin conjunction with the financial statements and notes thereto, and theinformation included elsewhere herein.

 

The Company designs, develops, markets and distributeshigh quality, innovative dolls, toys and consumer electronics products.  Core product lines include *Tech-Link*®fun electronic gadgets for kids, Kawasaki®electronic musical instruments, *GearHead®* remote control vehicles, *LazerDoodle*TM,the electronic drawing toy,**and a full range of special feature dollbrands including*Somersault SaraTM, Too Cute TwinsTM, Childhood VersesTM, Pride &Joy®, Little Darlings®,*along with interactive plush productsincluding *KittyKitty Kittens®, Frisky KittensTM, Puppy Puppy Puppies®,*and girls’activity products such as *Twist and Twirl BraiderTM.*

 

The Company has four major product categories: YouthElectronics (formerly Youth Communications), Musical Instruments, Girls’ Toysand Boys’ Toys. 

 

***Youth Electronics***

 

The Youth Electronics product line includeswalkie-talkies, wristwatch walkie-talkies, audio products and noveltyelectronic products.  The categorybrands include *Tech-Link*® and *Micro Link*® communications products,  bike alarms, and the Company’s new *BioScan*TM*RoomGuardianTM.*  

 

*Musical Instruments*

 

The Musical Instrument line includes the branded lineof KAWASAKI® guitars, drum pads, saxophones and keyboards.  The Company successfully completednegotiations and amended its license agreement with Kawasaki Motors Corp.,U.S.A., allowing the Company to continue to utilize the KAWASAKI® trademark, aswell as other marks, on toy musical instruments, and other products,  through December 31, 2007.

* *

*Girls’Toys*

 

The Girls’ Toys product category includes dolls,interactive plush toys, play sets, accessories, and girls’ activity toys.  The Girls’ Toys portfolio of brands includes*SomersaultSaraTM, Too Cute TwinsTM, Childhood VersesTM, Pride & Joy®, Little Darlings®,*alongwith interactive plush products including *Kitty Kitty Kittens®, Frisky KittensTM, Puppy PuppyPuppies®,*and girls’ activity products such as *Twist and Twirl BraiderTM. *

* *

*Boys’ Toys*

 

The Boys’ Toys product category includes radio controland infra-red control vehicles.  Thebrands in this product category are *GearHead*® radio control vehicles,including the bat-like *Dual FusionTM,**Insector*®, and the uniqueultra-articulated *Street SavageTM*. 

 

9

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#### **Results of Operations**

 

The following table sets forth for the periodsindicated certain income and expense items expressed as a percentage of netsales:

 
|                                          |   | **Percent of Net Sales**              |   |
|-----------------------------------------------|--------|---------------------------------------|--------|
|                                          |   | **Three Months Ended  September 30,** |   | **Nine Months Ended  September 30,** |   |
|                                          |   | **2002**                              |   | **2001** |   | **2002** |   | **2001** |   |
| Net sales                                     |   | 100.0                                 | %      | 100.0 | % | 100.0 | % | 100.0 | % |
| Costs of goods sold                           |   | 80.8                                  |   | 70.8 |   | 78.3 |   | 73.0 |   |
| Gross profit                                  |   | 19.2                                  |   | 29.2 |   | 21.7 |   | 27.0 |   |
| Selling, general and  administrative expenses |   | 21.2                                  |   | 17.4 |   | 29.7 |   | 28.6 |   |
| Operating income (loss)                       |   | (2.0                                  | )      | 11.8 |   | (8.0 | ) | (1.6 | ) |
| Interest expense                              |   | (1.0                                  | )      | (1.1 | ) | (1.9 | ) | (1.9 | ) |
| Other income (expense)                        |   | 0.0                                   |   | 0.4 |   | 0.3 |   | 0.4 |   |
| Income (loss) before  income taxes            |   | (3.0                                  | )      | 11.1 |   | (9.6 | ) | (3.1 | ) |
| Benefit (expense) from  income taxes          |   | (15.1                                 | )      | (4.5 | ) | (6.3 | ) | 0.8 |   |
| Net income (loss)                             |   | (18.1                                 | )%     | 6.6 | % | (15.9 | )% | (2.3 | )% |

 

***Three Months EndedSeptember 30, 2002, Compared to the Three Months Ended September 30, 2001***

 

*Netsales.* Net sales for the three months ended September 30,2002, decreased approximately $9.2 million, or 31%, to $20.7 million, from$29.9 million in the third quarter of 2001. All product categories decreased except Musical Instruments, reflectingthe overall sluggish U.S. retail climate, some shifts in consumer preferencesthat were not met by the Company’s product line and  production delays which limited the availability of key productsfor shipment. The production delays were the result of several factors,including the engineering complexity of certain products, longer than expecteddevelopment cycles for key items, and the failure of certain factories to meetproduction run schedules.

 

Net sales of Youth Electronics products during thethird quarter ended September 30, 2002, decreased approximately $4.0 million,or 59%, to $2.8 million from $6.8 million in the third quarter of 2001.  The significant decrease is due to acategory shift to more role-play and spy related products, as well as pricepressures due to the availability of less expensive family radio service(“FRS”) walkie-talkie products.

 

Net sales of Musical Instrument products was $7.5million during the third quarter of 2002, an increase of $1.5 million or 25%,from the $6.0 million sold during the quarter ended September 30, 2001.  Sales of new folding keyboards and drum-padsintroduced this quarter, combined with the new Pro series line of keyboards anddrum-pads, drove the increase, offsetting decreases in products de-emphasizedin the line, such as musical guitars, sax-a-booms, and sing-a-long products.

 

Net sales of Girls’ Toys declined approximately $6.4million, or 47%, to $7.2 million during the third quarter ended September 30,2002, from $13.6 million in the third quarter of 2001.  The primary contributors to the decreasewere the declining sales of the *Pride and Joy®* and *Elite*® doll lines, *Susie-So-SmartTM*,a 2001 television promoted doll, and the girls activity toy*Air Nails SalonTM,* whichwere**partiallyoffset by sales of the new 2002 television promoted doll *Somersault SaraTM*.  Delays in the availability of *SomersaultSaraTM*due to the complexity of the item and problems with themanufacturer led to lower than expected sales and margins on this item in thethird quarter.

 

Net sales of Boys’ Toys were down approximately $1.5million, or 52%, to $1.4 million in the third quarter ended September 30, 2002,from $2.9 million in the third quarter of 2001.  This decrease is primarily due to slowing sales of the *Insector®*radio-controlled (“R/C”) product, introduced in 2000.

 

10

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Net sales of products in other categories during thethird quarter ended September 30, 2002, increased approximately $1.2 million,or 205%, to $1.8 million from $600,000 in the third quarter of 2001.  The increase reflects the introduction ofthe new electronic drawing toy, *LazerDoodleTM*, which was partially offsetby decreases in preschool products and other electronic games.

 

International net sales for the three months endedSeptember 30, 2002, declined approximately $2.3 million, or 34%, to $4.5million from $6.8 million in the third quarter of 2001.  The decrease is due to the depressedworld-wide economy, manufacturers selling knock-off products, and politicalinstability in several countries and regions.

 

*Grossprofit.* Gross profit decreased $4.7 million, or 54%, to $4.0million from $8.7 million in the third quarter of 2001.  Gross profit as a percentage of net salesdecreased to 19.2% in the third quarter ended September 30, 2002, from 29.2% inthe third quarter of fiscal 2001.  Thegross profit dollar decrease reflects the decline in sales activity, ascompared to last year, while the gross profit as a percentage of net salesdecrease over the same period in 2001 reflects price pressures related to theretail climate, an obsolesence allowance for slow-moving inventory and thedelay in shipping several higher-margin products due to production delays.  To meet the required delivery dates ofcertain key customers, the Company utilized air freight, which is moreexpensive than ocean cargo rates, to deliver goods to the United States.

 

*Selling,general and administrative expenses.* Selling, general andadministrative expenses decreased to $4.4 million in the third quarter endedSeptember 30, 2002, compared with $5.2 million for the third quarter of 2001, adecrease of approximately $800,000. Included are decreases in employee expense, professional fees, salescommissions and facility operating expense, of approximately $350,000,$100,000, $140,000, and $160,000, respectively.  Television and print advertising in total in the third quarter of2002 was consistent with 2001, though more weighted toward television versusprint advertising.  Additionally, in2001 the Company recorded approximately $130,000 in goodwill amortization,which is not recorded in 2002 due to the Company’s adoption of SFAS #142,“Goodwill and Other Intangibles”.  *SeeSignificant Accounting Polici*es.

 

*Interestexpense.* Interest expense during the third quarter endedSeptember 30, 2002, decreased to approximately $200,000 from $325,000 in thethird quarter of 2001 due to lower interest rates in 2002 as compared to thesame period in 2001.

 

*Incometaxes.*Income tax expense of $3.1 million for the threemonths ended September 30, 2002, increased $1.8 million compared to thecorresponding period last year.  Theincrease is due to a charge of $3.1 million to establish an additionalvaluation allowance for deferred tax assets, offset by the tax expense recordedon the operating profit for the three months ended September 30, 2001.  Although management expects that the Companywill generate sufficient taxable income in future years to fully utilize itsnet operating losses and foreign income tax credits, such expectation is not acertainty. 

 

In accordance with SFAS 109, the Company establishedan additional valuation allowance for its net deferred tax assets based on itscumulative operating results in the most recent three-year period, estimatedfuture taxable income and the volatility and seasonality of earning of theindustry in which it operates.  Thisevaluation provides sufficient negative evidence to establish an additionalvaluation allowance.  The Company willcontinue to reserve all of its deferred tax assets and net operating loss carryforwardsuntil sufficient positive evidence exists to support  reversal of the allowance. This valuation allowance in no way affects the Company’s ability toreduce future tax expense through utilization of net operating losses andforeign income tax credits.

 

***NineMonths Ended September 30, 2002, Compared to the Nine Months Ended September30, 2001***

 

*Netsales.* Net sales for the nine months ended September 30,2002, decreased $11.2 million, or 24%, to $34.8 million from $46.0 million inthe comparable period in 2001.  Thedecrease is primarily due to the continued overall sluggish U.S. retail climate, shifts in consumer preferencesthat were not met by the Company’s product line and  production delays which limited the availability of key productsfor shipment.  The production delayswere the result of several factors, including the engineering complexity ofcertain products, longer than expected development cycles for key items and thefailure of certain factories to meet production run schedules.

 

11

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Net sales of Youth Electronics products during thenine months ended September 2002, decreased approximately $4.8 million, or 45%,to $5.7 million from $10.5 million in the first nine months of 2001.  The reduced sales reflects a category shiftto role-play and spy related products, as well as price pressures due to theavailability of less expensive FRS products.

 

Net sales of Musical Instrument products was $11.1million during the first nine months of 2002, an increase of $1.7 million or19%, from the $9.4 million sold during the nine months ending September 30,2001.  This increase reflects the 2002third quarter introduction of new folding musical instruments, plus the new ProSeries lines of keyboards and drum-pads, which was partially offset by declinesin sing-a-long products and other de-emphasized musical instruments.

 

Net sales of Girls’ Toys declined approximately $7.1million, or 35%, to $13.1 million during the first nine months ended September 30,2002, from $20.2 million during the comparable period in 2001.  The decrease reflects reduced sales of the *Elite®*,*Little Darlings®* and *Pride andJoy®* doll lines, and the *Air Nails SalonTM* girls activity toy,partially offset by increased sales of television promoted dolls, including *SomersaultSara*TM.  Sales of *Two CuteTwinsTM*, introduced in 2001, continues to be strong and on par with2001. Delays in the availability of *Somersault SaraTM*due to the complexity ofthe item and problems with the manufacturer led to lower than expected salesand margins on this item in the third quarter.

 

Net sales of Boys’ Toys decreased approximately $2.0million, or 42%, to $2.8 million in the first nine months ended September 30,2002, from $4.8 million in the first nine months of 2001.  The decrease reflects slowing sales of the *Insector®*R/C vehicle, introduced in 2000, and 2001 close-out sales of *Data-Dawg*,which were partially offset by increased sales of *Street SavageTM* and boysmilitary products.

 

Net sales of products in other categories during thefirst nine months ended September 30, 2002, increased $1.0 million, or 81%, to$2.1 million from $1.1 million in the first nine months of 2001.  The increase is primarily driven by sales ofdoorbells and the new drawing-toy, *LazerDoodleTM*, introduced in the thirdquarter of 2002,  partially offset bydecreases in sales of preschool and other electronic games.

 

International net sales for the nine months ended September30, 2002, decreased $2.2 million, or 23%, to $7.4 million, from $9.6 million inthe first nine months of 2001.  Thedecreased sales reflects the soft overall world retail market, the effect ofexchange rate issues, competition with knock-offs of proprietary products, andpolitical instability in several countries and regions.

 

*Grossprofit.* Gross profit decreased approximately $4.8 million, or39%, to $7.6 million for the first nine months ended September 30, 2002, from$12.4 million in the first nine months of 2001.  Gross profit as a percentage of net sales decreased to 21.7% from27.0% in the first nine months of fiscal 2001. The gross profit dollar decrease resulted from the decrease in sales,while the decrease in gross profit as a percentage of net sales primarilyreflects price pressures related to the retail climate, an obsolescenceallowance charge for slow-moving inventory, and the delay in shipping severalhigher-margin products due to production delays.  To meet the required delivery dates of certain key customers, theCompany utilized air freight, which is more expensive than ocean cargo rates,to deliver goods to the United States.

 

*Selling,general and administrative expenses.* Selling, general andadministrative expenses decreased to $10.3 million in the first nine months of2002, compared with $13.2 million for the first nine months of fiscal 2001, adecrease of $2.9 million, or 21%. The decrease occurred in all areas, drivenprimarily by reductions in employee expense, professional fees, salescommissions, travel and entertainment expense, depreciation and office expenseof approximately $760,00, $225,000, $360,000, $160,000, $135,000 and $375,000,respectively.  Advertising expense in2002 declined $380,000, reflecting less spending in the first two quarters of2002 due to general consumer economic concerns.  Additionally, in 2001 the Company recorded approximately $385,000in goodwill amortization, which is not recorded in 2002 due to the Company’sadoption of SFAS#142, “Goodwill and Other Intangibles.”  *See Significant Accounting Policies*.

 

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*Interestexpense.* Interest expense during the first nine months endedSeptember 30, 2002, decreased to approximately $650,000 from $860,000 in thefirst nine months of 2001 due to lower interest borrowing rates in 2002compared to the same period in 2001.

 

*Incometaxes.*Income tax expense of $2.2 million for the nine monthsended September 30, 2002 increased $2.6 million compared to the correspondingperiod last year.  The increase is dueto a charge of $3.1 million during the quarter ended September 30, 2002 toestablish an additional valuation allowance for deferred tax assets*. Seediscussion of Significant Accounting Policies-Deferred Taxes.*

* *

* ***Liquidity and Capital Resources**

 

The Company historically has funded its operations andcapital requirements by cash generated from operations and borrowings.  The Company’s primary capital needs haveconsisted of acquisitions of inventory, financing accounts receivable andcapital expenditures for product development.

 

The Company’s operating activities provided net cashof $3.0 million during the first nine months of fiscal 2002, resultingprimarily from increases in accounts payable, offset by increases in accountsreceivable, inventories  and prepaidexpenses.  Net cash used in investingactivities during the first nine months of fiscal 2002 was $1.8 million and wasprimarily a result of capital expenditures. Net cash used in financing activities was approximately $80,000 in thefirst nine months of fiscal 2002 as a result of payments of long-term debt,partially offset by borrowings on lines of credit and net borrowings fromrelated parties.   Unrestricted cash was$1.6 million as of September 30, 2002, versus $150,000 as of September 30,2001.

 

The seasonal nature of the toy business results incomplex working capital needs.  TheCompany’s working capital needs, which the Company generally satisfies throughshort-term borrowings, are greatest in the last two fiscal quarters.  To manage these working capitalrequirements, the Company maintains credit facilities collateralizedprincipally by accounts receivable and inventory.  The Company currently maintains a line of credit facility withDao Heng Bank Limited (the “Dao Heng Credit Facility”), a line of creditfacility with Standard Chartered Bank [Hong Kong] (the “Standard CharteredFacility”) and a revolving credit facility with Sunrock Capital Corp. (the“Revolver”). 

 

###### ***The Revolver***. 

 

The Company’s net losses for the nine months endedSeptember 30, 2002, resulted in the Company being out of compliance withcertain financial covenants required under the Revolver.  Therefore, the Company’s $6.3 milliondebt under the Revolver as of September 30, 2002, has been reclassified as acurrent liability.  As a result, theCompany’s current liabilities exceeded its current assets by $3.8 millionas of September 30, 2002. If Sunrock were to accelerate the Revolver, the $6.3 milliondebt would become immediately due and payable.

 

The Company is in negotiations with Sunrock to amendthe Revolver to bring the Company back into compliance. The Company’s viabilityas a going concern is dependent upon successful negotiations with Sunrock or asubstantial capital infusion. The accompanying financial statements do notinclude any adjustments that might be necessary if the Company is unable tocontinue as a going concern.

 

To the extent the Company’s cash reserves and cashflows from operations are insufficient to meet future cash requirements, theCompany will need to successfully raise additional capital through additionalequity infusion or the issuance of debt. However, there can be no assurance the Company will meet its projectedoperating results or be successful either in obtaining additional capital, oramending the Revolver.  The Company’sexecutive management believes that the Company will be able to either amend theRevolver or obtain necessary additional capital to allow the Company tocontinue its normal operations for the forseeable future.

 

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*Additional Financing.*

 

The Standard Chartered Facility was entered into onApril 29, 2002, and affords the Company a credit limit in the aggregate ofup to HKD 19,000,000 (approximately US $2.4 million as of September 30, 2002)in the form of a line of credit financing facility based on actual shipments ofproduct and opened letters of credit. The facility is similar to the Dao Heng facility.

 

On March 19, 2001, the Company issued to MVII, LLC(“MVII”), an Investment Warrant to acquire 1.8 million shares of the Company’sCommon Stock at a purchase price of $2.7 million.  The Investment Warrant was exercisable in whole or in part for aten-year period beginning on June 3, 2002. In connection with the issuance of the Investment Warrant, the Companyand MVII entered into a Registration Rights Agreement, pursuant to which MVIIwas granted certain piggyback registration rights with respect to the shares ofthe Common Stock underlying the Warrant. Shares of Common Stock acquired by MVII upon exercise of the Warrant aresubject to the terms of a Shareholders’ and Voting Agreement dated as of April5, 1999, among MVII and certain of the Company’s other shareholders.  Proceeds from the sale of the InvestmentWarrant were used by the Company for current working capital.

 

On January 31, 2002, at the request of Nasdaq and withthe agreement of MVII, the Company issued an amended and restated InvestmentWarrant, which amended and restated in its entirety the Investment Warrant byremoving all anti-dilution provisions. In addition, the Company and MVII entered into an Amended and RestatedRegistration Rights Agreement, which amended and restated in its entirety theRegistration Rights Agreement, by removing all of the provisions regarding theanti-dilution provisions of the original Investment Warrant. On August 21,2002, MVII converted the pre-paid Investment Warrant into 1.8 million shares ofCommon Stock.  Upon issuance of theseshares, MVII directly owned 5,994,238 shares of Common Stock.

 

In connection with the acquisition of MeritusIndustries, Inc., in January 2000, the Company borrowed $5 million from MVII,evidenced by a promissory note dated January 7, 2000 (the “MVII Note”).  The Company re-borrowed on March 6, 2002 andMay 21, 2002, a total of $1.0 million of the original principal that theCompany had paid on the MVII Note.  Theproceeds were used to finance the normal business operations of theCompany.  

 

On August 19, 2002, the Company executed a Guaranteein favor of Standard Chartered Bank, guaranteeing the Standard CharteredFacility up to an amount not to exceed HKD 19,000,000 (approximately US$2.4million at September 30, 2002).  TheRevolver was amended on August 14, 2002, to permit this Guarantee.

 

The Company is obligated to make future minimumroyalty payments under certain of its license agreements.  As of September 30, 2002, the Company wasrequired to make an aggregate of approximately $150,000 in payments ofguaranteed royalties under certain licenses in fiscal 2002 and $760,000thereafter through fiscal 2007. Included in these amounts, are minimum royalties due Kawasaki under aSeptember 11, 2002 amendment to the original license agreement, extending thelicense through 2007.

 

The Company made approximately $1.2 million in capitalexpenditures in fiscal 2002 consisting primarily of purchases of tools, moldsand information technology systems.  Itis not anticipated that additional 2002 capital expenditures, if any, will besubstantial. 

 

**Recent Accounting Pronouncements**

 

In June 2001, SFAS No. 143, “Accounting for AssetRetirement Obligations” was issued. The standard requires that legalobligations associated with the retirement of long-lived intangible assets berecorded at fair value when incurred and will be effective on January 1, 2003.The adoption of this statement is not expected to have a material impact on theCompany’s consolidated financial position, results of operations or cash flows.

 

In April 2002, SFAS No. 145, “Recission of FASBStatements No. 4, 44 and 64, Amendment of FASB No. 13, and TechnicalCorrections” was issued. This statement provides guidance on the classificationof gains and losses from the extinguishment of debt

 

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and on the accounting for certain specified lease transactions. Theadoption of this statement is not expected to have a material impact on theCompany’s consolidated financial position, results of operations or cash flows.

 

In June 2002, SFAS No. 146, “Accounting for CostsAssociated with Exit or Disposal Activities “ was issued. This statementprovides guidance on the recognition and measurement of liabilities associatedwith disposal activities and is effective on January 1, 2003. The adoption ofthis statement is not expected to have a material impact on the Company’sconsolidated financial position, results of operations or cash flows.

 

**Seasonality**

 

Retail sales of toy products are seasonal, with amajority of retail sales occurring during the Christmas holiday period:September through December.  As aresult, shipments of toy products to retailers are typically greater in each ofthe third and fourth quarters than in the first and second quarterscombined.  This seasonality is increasingas the large toy retailers are becoming more efficient in their inventorycontrol systems. 

 

In anticipation of this seasonal increase in retailsales, the Company significantly increases its production in advance of thepeak selling period during the second quarter, with a corresponding build-up ofinventory levels.    This results insignificant peaks in the second and third quarters in the respective levels ofinventories and accounts receivable, which result in seasonal working capitalfinancing requirements.  See *“SeasonalFinancing.”*  

 

**Seasonal Financing**

 

The Company’s financing of seasonal working capitaltypically peaks in the third quarter of the year, when accounts receivable areat their highest due to increased sales volume and sales programs, and wheninventories are at their highest in anticipation of expected second half salesvolume.  See *“Seasonality.”*  The Company has previously financed itsseasonal working capital requirements by using internally generated cash andborrowings under the Dao Heng Credit Facility, the Standard Chartered Facilityand the Revolver. 

 

**Cautionary Statement**

 

Certain written and oral statements made orincorporated by reference from time to time by the Company or itsrepresentatives in this Form 10-Q, other filings or reports with the Securitiesand Exchange Commission, press releases, conferences, or otherwise, are“forward-looking statements” within the meaning of the Private SecuritiesLitigation Reform Act of 1995.  TheCompany is including this Cautionary Statement to make applicable and takeadvantage of the safe harbor provisions of the Private Securities LitigationReform Act of 1995 for any such forward-looking statements.  Forward-looking statements can be identifiedby the use of terminology such as “believe,” “anticipate,” “expect,”“estimate,” “may,” “will,” “should,” “project,” “continue,” “plans,” “aims,”“intends,” “likely,” or other words or phrases of similar terminology.  Management cautions you that forward-lookingstatements involve risks and uncertainties which may cause actual results todiffer materially from the forward-looking statements.  For a discussion of some of the factors thatmay cause actual results to differ materially from those suggested byforward-looking statements, please read carefully the information underItem 1, “Risk Factors”, in the Company’s 2001 Annual Report on Form 10-K,and any amendments thereto.  In additionto the Risk Factors and other important factors detailed herein and from timeto time in other reports filed by the Company with the Securities and ExchangeCommission, including Forms 8-K, 10-Q, and 10-K, and any amendments thereto,the following important factors could cause actual results to differ materiallyfrom those suggested by any forward-looking statements.

 

*Marketplace Risks*

 

•                       Increasedcompetitive pressure, both domestically and internationally, which maynegatively affect the sales of the Company’s products.

 

•                       Changesin public and consumer taste, which may negatively affect the sales of the Company’sproducts.

 

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•                       Significantchanges in the play patterns of children, whereby they are increasinglyattracted to more developmentally advanced products at younger ages, which mayaffect brand loyalty and the perceived value of and demand for the Company’sproducts.

 

•                       Possibleweaknesses in economic conditions, both domestically and internationally, whichmay negatively affect the sales of the Company’s products and the costsassociated with manufacturing and distributing these products.

* *

*FinancingConsiderations*

 

•                       Currencyfluctuations, which may affect the Company’s reportable income.

 

•                       Significantchanges in interest rates, both domestically and internationally, which maynegatively affect the Company’s cost of financing both its operations andinvestments.

 

•                       Failureto amend the Revolver to bring the Company back into compliance with thefinancial covenants contained therein could cause Sunrock Capital Corp. toaccelerate the debt, which would affect the Company’s viability as a goingconcern.

* *

•                       Tothe extent the Company’s cash reserves and cash flows from operations areinsufficient to meet future cash requirements, the Company will need tosuccessfully raise additional capital.  There can be no assurance the Company will meet its projected operatingresults or be successful either in obtaining additional capital or amending theRevolver.

* *

*OtherRisks*

 

•                       Changesin laws or regulations, both domestically and internationally, including thoseaffecting consumer products or trade restrictions, which may lead to increasedcosts or interruption in normal business operations of the Company.

 

•                       Futurelitigation or governmental proceedings, which may lead to increased costs orinterruption in normal business operations of the Company.

 

•                       Labordisputes, which may lead to increased costs or disruption of any of theCompany’s operations.  The work stoppageby the International Longshore and Warehouse Union on the west coast has had,and will have an impact on the delivery of the Company’s products to the UnitedStates.  *See Part II, Item 5.*

 

•                       Failureto demonstrate compliance with Nasdaq Marketplace Rules, which could cause theCompany’s securities to be delisted.  *See Part II,Item 5.*

 

The risks included hereinare not exhaustive.  Other sections ofthis Form 10–Q may include additional factors which could materiallyand adversely impact the Company’s business, financial condition, and resultsof operations.  Moreover, the Companyoperates in a very competitive and rapidly changing environment.  New risk factors emerge from time to timeand it is not possible for management to predict all such risk factors on theCompany’s business, financial condition or results of operations or the extentto which any factor, or combination of factors, may cause actual results todiffer materially from those contained in any forward-looking statements.  Given these risks and uncertainties,investors should not place undue reliance on forward-looking statements as a predictionof actual results.

 

## **Item 3.  Quantitative and QualitativeDisclosure About Market Risk**

 

The Company does nothold any investments in market risk sensitive instruments.  Accordingly, the Company believes that it isnot subject to any material risks arising from changes in interest rates,foreign currency exchange rates, commodity prices, equity prices or othermarket changes that affect market risk instruments.

 

**Item4.  Controlsand Procedures**

 

With the participation of management, the Company’s Presidentand Chief Executive Officer and its Chief Financial Officer evaluated theCompany’s disclosure controls and procedures within 90 days of the filing ofthis

 

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quarterly report.  Based uponthis evaluation, the President and Chief Executive Officer and the ChiefFinancial Officer concluded that the Company’s disclosure controls andprocedures are effective in timely alerting them to material informationrelating to the Company (including its consolidated subsidiaries) required tobe included in the reports that the Company files with the Securities andExchange Commission.

 

There were no significant changes in the Company’sinternal controls or, to the knowledge of the Company’s management, in other factorsthat could significantly affect these controls subsequent to the evaluationdate.

 

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**PART II - OTHERINFORMATION**

 

## **Item 1.    Legal Proceedings**

 

The Company is involved in various legal proceedingsand claims incident to the normal conduct of its business.  The Companybelieves that such legal proceedings and claims, individually and in theaggregate, are not likely to have a material adverse effect on its financialposition or results of operations.  TheCompany maintains product liability and general liability insurance in amountsit believes to be reasonable.

 

## **Item 2.    Changesin Securities and Use of Proceeds**

 

On March 19, 2001, the Company issued to MVII anInvestment Warrant to acquire 1.8 million shares of the Company’s Common Stockat a purchase price of $2.7 million. The Investment Warrant was exercisable in whole or in part for aten-year period beginning on June 3, 2002. In connection with the issuance ofthe Investment Warrant, the Company and MVII entered into a Registration RightsAgreement, pursuant to which MVII was granted certain piggyback registrationrights with respect to the shares of the Common Stock underlying theWarrant.  Shares of Common Stockacquired by MVII upon exercise of the Warrant are subject to the terms of aShareholders’ and Voting Agreement dated as of April 5, 1999, among MVII andcertain of the Company’s other shareholders. Proceeds from the sale of the Investment Warrant were used by theCompany for current working capital.

 

On January 31, 2002, at the request of Nasdaq and withthe agreement of MVII, the Company issued an amended and restated InvestmentWarrant, which amended and restated in its entirety the Investment Warrant byremoving all anti-dilution provisions. In addition, the Company and MVII entered into an Amended and RestatedRegistration Rights Agreement, which amended and restated in its entirety theRegistration Rights Agreement, by removing all of the provisions regarding theanti-dilution provisions of the original Investment Warrant. 

 

On August 21, 2002, MVII converted the pre-paidInvestment Warrant into 1.8 million shares of Common Stock.  Upon issuance of these shares, MVII directlyowned 5,994,238 shares of Common Stock.

 

## **Item 5.    Other Information**

 

On February 14, 2002, the Company received notice fromThe Nasdaq Stock Market, Inc. that the Company’s common stock had closed belowthe minimum of $1.00 per share requirement for continued inclusion on theNasdaq SmallCap Market under Marketplace Rule 4310(c)(4) (the “Rule”).  Although the Company was not in compliancewith the Rule on August 13, 2002, the Company met the initial listing criteriafor the Nasdaq SmallCap Market under Marketplace Rule 4310(c)(2)(A), and thuson August 14, 2002, the Company was granted an additional 180 calendar daygrace period to demonstrate compliance with the Rule.  Upon the expiration of the grace period, the Company will receivenotification that its securities will be de-listed if it is not in compliancewith the Rule during such additional 180 day period.  If this occurs, the Company may appeal the de-listingdetermination to a  Nasdaq ListingQualifications Panel.

 

On August 5, 2002, the Company completed itsrelocation to its new corporate headquarters located at 10110 West Sam HoustonParkway, South, Suite 150, Houston, TX 77099, pursuant to a 67 month leasecommencing April 1, 2002. The Company’s lease on its previous office/warehouselocation terminated on August 31, 2002.

 

Due to the lack of a labor agreement between theInternational Longshore and Warehouse Union and the Pacific MaritimeAssociation, there was a work stoppage on the docks of the west coast fromSeptember 27, 2002, through October 8, 2002. The work stoppage has delayed, and will continue to delay, the deliveryof the Company’s products to the United States.  This delay in delivery will have an adverse effect on theCompany’s sales for 2002.  Most of theimpact will be realized in the fourth quarter of 2002, and at this time themagnitude of the effect cannot be ascertained.

 

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## **Item 6.    Exhibitsand Reports on Form 8-K**

 

(a)   Exhibits

The information required by this Item 6 (a) is setforth in the Index to Exhibits accompanying this quarterly report and isincorporated herein by reference.

 

(b)   Reports onForm 8-K

There were no reports on Form 8-K filed by the Companyin the third quarter ending September 30, 2002.

 

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**SIGNATURES**

 

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

 

 
|                            | DSI Toys, Inc. |
|---------------------------------|----------------|
|                            |           |
| Dated:   November 14, 2002 | By:            | /s/  Joseph  S. Whitaker |   |
|                            |           | Joseph S. Whitaker |
|                            |           | President and   Chief Executive Officer |
|                            |           |   |
|                            |           |   |
| Dated:   November 14, 2002 | By:            | /s/  Robert  L. Weisgarber |   |
|                            |           | Robert L. Weisgarber |
|                            |           | Chief Financial Officer |
|                            |           | (Principal Financial and Accounting Officer) |

 

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**CERTIFICATIONS**

 

I, Joseph S. Whitaker,President and Chief Executive Officer, certify that:

 

1.             I have reviewed thisquarterly report on Form 10-Q of DSI Toys, Inc. (“registrant”);

 

2.                                       Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterly report;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

 

4.                                       Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)                                      designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

b)                                     evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)                                      presentedin this quarterly report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation  as of the Evaluation Date;

 

5.                                       Theregistrant’s other certifying officers and I have disclosed, based on our most recentevaluation, to the registrants auditors and the audit committee of registrant’sboard of directors (or persons performing the equivalent function):

 

a)                                      allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and have identified for theregistrant’s auditors any material weaknesses in internal controls; and

 

b)                                     anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officers and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

 
| Date:  November 14, 2002 | /s/  Joseph S. Whitaker |                                   |
|-------------------------------|------------------------------|----------------------------------------|
|                          |                         | Joseph S. Whitaker                     |
|                          |                         | President and Chief  Executive Officer |
|                               |                              |                                        |  |

 

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I, Robert L. Weisgarber,Chief Financial Officer certify that:

 

1.                                       Ihave reviewed this quarterly report on Form 10-Q of DSI Toys, Inc.(“registrant”);

 

2.                                       Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterlyreport;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

 

4.                                       Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)                                      designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

b)                                     evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)                                      presentedin this quarterly report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation  as of the Evaluation Date;

 

5.                                       Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrants auditors and the audit committee of registrant’sboard of directors (or persons performing the equivalent function):

 

a)                                      allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and have identified for theregistrant’s auditors any material weaknesses in internal controls; and

 

b)                                     anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officers and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

 
| Date:  November 14, 2002 | /s/  Robert L. Weisgarber |                    |
|-------------------------------|--------------------------------|-------------------------|
|                          |                           | Robert L. Weisgarber    |
|                          |                           | Chief Financial Officer |
|                               |                                |                         |  |

 

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**Index to Exhibits**

 

3.1                                 Amendedand Restated Articles of Incorporation of the Company.(1)

 

3.1.1                        Amendmentto Amended and Restated Articles of Incorporation of the Company (filed asExhibit 3.1.1 to the Company’s Form 10-Q for the quarterly period ended April30, 1999), incorporated herein by reference.

 

3.2                                 Amendedand Restated Bylaws of the Company.(1)

 

3.3                                 Amendmentto Amended and Restated Bylaws of the Company.(1)

 

4.1                                 Amendedand Restated Investment Warrant by and between the Company and MVII, LLC, datedJanuary 31, 2002 (filed as Exhibit 4.8 to the Company’s Form 10-K for thefiscal year ended December 31, 2001), incorporated herein by reference.

 

4.2                                 Amendedand Restated Registration Rights Agreement by and between the Company and MVII,LLC dated January 31, 2002 (filed as Exhibit 4.9 to the Company’s Form 10-K forthe fiscal year ended December 31, 2001), incorporated herein by reference.

 

10.1                           Memorandumof Re-borrowing of Principal by and between the Company and MVII, LLC datedMarch 6, 2002 (filed as Exhibit 10.63 to the Company’s Form 10-K for the fiscalyear ended December 31, 2001), incorporated herein by reference.

 

10.2                           AmendmentNo. 7 dated March 20, 2002, to Loan and Security Agreement by and betweenSunrock Capital Corp. and the Company (filed as Exhibit 10.64 to the Company’sForm 10-K for the fiscal year ended December 31, 2001), incorporated herein byreference.

 

10.3                           UnconditionalGuaranty Agreement dated March 20, 2002, by the Company and Dao Heng BankLimited (filed as Exhibit 10.65 to the Company’s Form 10-K for the fiscal yearended December 31, 2001), incorporated herein by reference.

 

10.4                           AmendmentNo. 8 dated March 29, 2002, to Loan and Security Agreement by and betweenSunrock Capital Corp. and the Company (filed as Exhibit 10.66 to the Company’sForm 10-K for the fiscal year ended December 31, 2001), incorporated herein byreference.

 

10.5                           BankingFacility Agreement by and between Standard Chartered Bank and the Company datedApril 29, 2002 (filed as Exhibit 10.5 to the Company’s Form 10-Q for the periodending June 30, 2002), incorporated herein by reference.

 

10.6                           Memorandumof Reborrowing of Principal by and between the Company and MVII, LLC dated May21, 2002  (filed as Exhibit 10.6 to theCompany’s Form 10-Q for the period ending June 30, 2002), incorporated hereinby reference.

 

10.7                           AmendmentNo. 9 dated June 12, 2002, to Loan and Security Agreement by and betweenSunrock Capital Corp. and the Company (filed as Exhibit 10.7 to the Company’sForm 10-Q for the period ending June 30, 2002), incorporated herein byreference.

 

10.8*                    Amendment No.10 dated August 14, 2002, to Loan and Security Agreement by and betweenSunrock  Capital Corp. and the Company.

 

10.9*                    GuaranteeAgreement dated August 19, 2002, by and between Standard Chartered Bank and theCompany.

 

99.1*                    Certificationof the Chief Executive Officer pursuant to Section 1350 of Chapter 63, Title 18of the United States Code for the period ending September 30, 2002.

 

99.2*                    Certificationof the Chief Financial Officer pursuant to Section 1350 of Chapter 63, Title 18of the United States Code for the period ending September 30, 2002.

 

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(1)                                  Filedas a part of the Registrant’s Registration Statement on Form S-1 (No.333-23961) and incorporated herein by reference.

 

*                                         Filedherewith.

 

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