SECURITIES
      AND EXCHANGE COMMISSION


WASHINGTON,
      D.C.  20549





FORM
      10-Q





(Mark
                One)x
            
            QUARTERLY
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934For
                the quarterly period ended September 30, 2008ORo
            
            TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934For
                the transition period from _________ to
                _________





Commission
                file number:
            0-22635RC2
                Corporation(Exact
                name of Registrant as specified in its charter)Delaware
            
            36-4088307(State
                or other jurisdiction of incorporation or organization)
            
            (IRS
                Employer Identification No.)1111
                West 22nd
                Street, Suite 320, Oak Brook, Illinois  60523(Address
                of principal executive offices)Registrant’s
                telephone number, including area
                code:  630-573-7200





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


Yes
            X
            
            No





Indicate
      by check mark whether the Registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer or a smaller reporting
      company.  See the definitions of "large accelerated filer,"
      "accelerated filer" and "smaller reporting company" in Exchange Act Rule
      12b-2.


Large
                accelerated filer
            [X]
            
            Accelerated
                filer
            [   ]Non-accelerated
                filer
            [   ]
            
            Smaller
                reporting company
            [   ](Do
                not check if a smaller reporting company)





Indicate
      by check mark whether the Registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act.)


Yes
            
            
            No
            X





On
      October 28, 2008, there were outstanding 17,245,074 shares of the Registrant’s
      $0.01 par value common stock.









RC2
      CORPORATION




FORM
      10-Q





SEPTEMBER
      30, 2008





INDEX








PART
                I – FINANCIAL INFORMATION
            PageItem
                1.
            Condensed
                Consolidated Balance Sheets as of September
                30, 2008
              and
                December 31, 2007
            
            3Condensed
                Consolidated Statements of Earnings
                for the Three Months and
              Nine
                Months Ended September 30, 2008 and
                2007
            
            4Condensed
                Consolidated Statements of Cash Flows for the
                Nine Months
              Ended
                September 30, 2008 and 2007
            
            5Notes
                to Condensed Consolidated Financial
                Statements
            
            7Item
                2.
            Management’s
                Discussion and Analysis of Financial
                Condition and
              Results
                of Operations
            
            20Item
                3.
            Quantitative
                and Qualitative Disclosures about Market
                Risk
            
            32Item
                4.
            Controls
                and Procedures
            
            32PART
                II – OTHER INFORMATIONItem
                1.
            Legal
                Proceedings
            
            33Item
                1A.
            Risk
                Factors
            
            34Item
                2.
            Unregistered
                Sales of Equity Securities and Use
                of Proceeds
            
            35Item
                3.
            Defaults
                Upon Senior Securities
            
            35Item
                4.
            Submission
                of Matters to a Vote of Security
                Holders
            
            35Item
                5.
            Other
                Information
            
            35Item
                6.
            Exhibits
            
            35Signatures
            
            37





2


PART
      I – FINANCIAL INFORMATION




Item
      1.  Financial Statements





RC2
      Corporation and Subsidiaries


Condensed
      Consolidated Balance Sheets


(Unaudited
      and in thousands)





September
                30,
              2008
            
            
            December
                31, 2007AssetsCash
                and cash equivalents
            
            $
            61,958
            
            
            $
            57,809Accounts
                receivable, net
            
            
            101,900
            
            
            
            110,317Inventory
            
            
            92,808
            
            
            
            77,034Other
                current assets
            
            
            15,558
            
            
            
            19,207Total
                current assets
            
            
            272,224
            
            
            
            264,367Property
                and equipment, net
            
            
            34,438
            
            
            
            37,293Goodwill
            
            
            246,454
            
            
            
            247,814Intangibles,
                net
            
            
            95,542
            
            
            
            96,675Other
                non-current assets
            
            
            3,165
            
            
            
            4,096Total
                assets
            
            $
            651,823
            
            
            $
            650,245Liabilities
                and stockholders’ equityAccounts
                payable and accrued expenses
            
            $
            78,000
            
            
            $
            99,076Line
                of credit
            
            
            44,350
            
            
            
            95,000Other
                current liabilities
            
            
            2,765
            
            
            
            3,163Total
                current liabilities
            
            
            125,115
            
            
            
            197,239Line
                of credit
            
            
            93,750
            
            
            
            ---Other
                non-current liabilities
            
            
            56,109
            
            
            
            55,628Total
                liabilities
            
            
            274,974
            
            
            
            252,867Stockholders’
                equity
            
            
            376,849
            
            
            
            397,378Total
                liabilities and stockholders’ equity
            
            $
            651,823
            
            
            $
            650,245





See
      accompanying notes to condensed consolidated financial statements.




3


RC2
      Corporation and Subsidiaries


Condensed
      Consolidated Statements of
      Earnings


(Unaudited
      and in thousands, except per share data)




For
                the three months
              ended
                September 30,
            
            
            For
                the nine months
              ended
                September 30,2008
            
            
            2007
            
            
            2008
            
            
            2007Net
                sales, including recall-related itemsof
                $(406) and
              $1,683
                for the threemonths
                ended September 30, 2008
              and
                2007,respectively,
                and $(341) and $4,110 for the nine
              months
                ended September 30, 2008 and 2007, respectively
            
            $
            132,856
            
            
            $
            144,843
            
            
            $
            315,339
            
            
            $
            350,426Cost
                of sales
            
            
            72,114
            
            
            
            78,552
            
            
            
            171,162
            
            
            
            194,227Recall-related
                items
            
            
            (1,357
            )
            
            
            2,408
            
            
            
            (936
            )
            
            
            4,111Gross
                profit
            
            
            62,099
            
            
            
            63,883
            
            
            
            145,113
            
            
            
            152,088Selling,
                general and administrative expenses
            
            
            41,026
            
            
            
            42,680
            
            
            
            112,388
            
            
            
            113,170Recall-related
                items
            
            
            (1,464
            )
            
            
            5,270
            
            
            
            15,185
            
            
            
            7,503Terminated
                acquisition costs
            
            
            1,416
            
            
            
            ---
            
            
            
            1,416
            
            
            
            ---Amortization
                of intangible assets
            
            
            219
            
            
            
            208
            
            
            
            670
            
            
            
            634Operating
                income
            
            
            20,902
            
            
            
            15,725
            
            
            
            15,454
            
            
            
            30,781Interest
                expense, net
            
            
            1,238
            
            
            
            355
            
            
            
            3,053
            
            
            
            507Write-off
                of investment
            
            
            2,057
            
            
            
            ---
            
            
            
            2,057
            
            
            
            ---Other
                expense (income)
            
            
            229
            
            
            
            (411
            )
            
            
            171
            
            
            
            (987
            )Income
                from continuing operations
              before
                income taxes
            
            
            17,378
            
            
            
            15,781
            
            
            
            10,173
            
            
            
            31,261Income
                tax expense
            
            
            6,269
            
            
            
            5,012
            
            
            
            3,476
            
            
            
            10,083Income
                from continuing operations
            
            
            11,109
            
            
            
            10,769
            
            
            
            6,697
            
            
            
            21,178Income
                from discontinued operations, net of tax
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            110Net
                income
            
            $
            11,109
            
            
            $
            10,769
            
            
            $
            6,697
            
            
            $
            21,288Basic
                earnings per common share:Income
                from continuing operations
            
            $
            0.65
            
            
            $
            0.52
            
            
            $
            0.38
            
            
            $
            1.01Income
                from discontinued operations
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            0.01Net
                income
            
            $
            0.65
            
            
            $
            0.52
            
            
            $
            0.38
            
            
            $
            1.02Diluted
                earnings per common share:Income
                from continuing operations
            
            $
            0.64
            
            
            $
            0.52
            
            
            $
            0.38
            
            
            $
            0.99Income
                from discontinued operations
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            0.01Net
                income
            
            $
            0.64
            
            
            $
            0.52
            
            
            $
            0.38
            
            
            $
            1.00Weighted
                average shares outstanding:Basic
            
            
            17,210
            
            
            
            20,523
            
            
            
            17,460
            
            
            
            20,952Diluted
            
            
            17,463
            
            
            
            20,850
            
            
            
            17,715
            
            
            
            21,336





See
      accompanying notes to condensed consolidated financial statements.




4


RC2
      Corporation and Subsidiaries


Condensed
      Consolidated Statements of Cash Flows


(Unaudited
      and in thousands)





For
                the nine months
              ended
                September 30,2008
            
            
            2007Cash
                flows from operating activitiesNet
                income
            
            $
            6,697
            
            
            $
            21,288Income
                from discontinued operations, net of tax
            
            
            ---
            
            
            
            (110
            )Depreciation
                and amortization
            
            
            10,114
            
            
            
            11,191Amortization
                and write-off of deferred financing costs
            
            
            463
            
            
            
            470Write-off
                of investment
            
            
            2,057
            
            
            
            ---Stock-based
                compensation
            
            
            4,034
            
            
            
            3,544Excess
                tax benefit on stock option exercises
            
            
            87
            
            
            
            (1,023
            )Loss
                (gain) on disposition of assets
            
            
            13
            
            
            
            (21
            )Changes
                in operating assets and liabilities
            
            
            (29,834
            )
            
            
            2,506Net
                cash (used in) provided by continuing operations
            
            
            (6,369
            )
            
            
            37,845Net
                cash provided by discontinued operations
            
            
            ---
            
            
            
            110Net
                cash (used in) provided by operating activities
            
            
            (6,369
            )
            
            
            37,955Cash
                flows from investing activitiesPurchase
                of property and equipment
            
            
            (6,747
            )
            
            
            (8,134
            )Proceeds
                from disposition of property and equipment
            
            
            8
            
            
            
            13Purchase
                price of acquisitions, net of cash acquired
            
            
            13
            
            
            
            (6,772
            )Proceeds
                from sale of discontinued operations
            
            
            ---
            
            
            
            110(Increase)
                decrease in other non-current assets
            
            
            (116
            )
            
            
            69Net
                cash used in continuing operations
            
            
            (6,842
            )
            
            
            (14,714
            )Net
                cash used in discontinued operations
            
            
            ---
            
            
            
            ---Net
                cash used in investing activities
            
            
            (6,842
            )
            
            
            (14,714
            )Cash
                flows from financing activitiesBorrowings
                on line of credit
            
            
            43,100
            
            
            
            80,000Payments
                on bank term loans
            
            
            ---
            
            
            
            (22,438
            )Issuance
                of stock upon option exercises
            
            
            956
            
            
            
            1,975Excess
                tax benefit on stock option exercises
            
            
            (87
            )
            
            
            1,023Issuance
                of stock under ESPP
            
            
            128
            
            
            
            134Purchase
                of treasury stock
            
            
            (24,660
            )
            
            
            (68,131
            )Financing
                fees paid
            
            
            (219
            )
            
            
            ---Net
                cash provided by (used in) continuing operations
            
            
            19,218
            
            
            
            (7,437
            )Net
                cash used in discontinued operations
            
            
            ---
            
            
            
            ---Net
                cash provided by (used in) financing activities
            
            
            19,218
            
            
            
            (7,437
            )






5


RC2
      Corporation and Subsidiaries


Condensed
      Consolidated Statements of Cash Flows


(Unaudited
      and in thousands)




For
                the nine months
              ended
                September 30,2008
            
            
            2007Effect
                of exchange rate changes on cash
            
            
            (1,858
            )
            
            
            2,013Net
                increase in cash and cash equivalents
            
            
            4,149
            
            
            
            17,817Cash
                and cash equivalents, beginning of year
            
            
            57,809
            
            
            
            25,365Cash
                and cash equivalents, end of period
            
            $
            61,958
            
            
            $
            43,182Supplemental
                information:Cash
                flows during the period for:Interest
                paid
            
            $
            3,787
            
            
            $
            492Income
                taxes paid
            
            
            5,837
            
            
            
            11,064Income
                tax refunds received
            
            $
            4,168
            
            
            $
            839





See
      accompanying notes to condensed consolidated financial statements.




6


RC2
      Corporation and Subsidiaries


Notes
      to Condensed Consolidated Financial
      Statements





Note
      1 – Basis of Presentation





The
      condensed consolidated financial statements include the accounts of RC2
      Corporation and its subsidiaries (the Company or RC2).  All
      intercompany transactions and balances have been eliminated.





The
      accompanying unaudited condensed consolidated financial statements have been
      prepared by management, and in the opinion of management, contain all
      adjustments, consisting of normal recurring adjustments, necessary to present
      fairly the financial position of the Company as of September 30, 2008, the
      results of operations for the three-month and nine-month periods ended September
      30, 2008 and 2007, and cash flows for the nine-month periods ended September
      30,
      2008 and 2007.





Certain
      information and note disclosures normally included in financial statements
      prepared in accordance with U.S. generally accepted accounting principles have
      been omitted.  It is suggested that these condensed consolidated
      financial statements be read in conjunction with the consolidated financial
      statements and related notes included in the Company’s Form 10-K for the year
      ended December 31, 2007.  The condensed consolidated balance sheet
      information as of December 31, 2007, appearing herein, is derived from the
      consolidated balance sheet in the Form 10-K.





Due
      to
      the seasonality of our business, the results of operations for interim periods
      are not necessarily indicative of the operating results for a full
      year.





Note
      2 – Business Combinations





Mother’s
      Intuition Inc.





On
      November 30, 2007, the Company acquired substantially all of the assets of
      Mother’s Intuition Inc. (MI), a privately-held, start-up developer and marketer
      of women’s prenatal bodycare products based in Mission Viejo,
      California.  Closing consideration consisted of $2.2 million of cash,
      excluding transaction expenses.  An additional $1.5 million in
      purchase price has been deferred and will be paid in three equal installments
      of
      $0.5 million each on December 31, 2008, 2009 and 2010.  This deferred
      purchase price is included in other current liabilities and other non-current
      liabilities in the accompanying condensed consolidated balance sheets at
      September 30, 2008 and December 31, 2007.  Additional cash
      consideration of $10.5 million may be earned in the transaction by MI based
      on
      achieving certain financial targets in each of the three years beginning in
      2008
      through 2010.  This transaction has been accounted for under the
      purchase method of accounting, and accordingly, the operating results of MI
      have
      been included in the accompanying condensed consolidated statements of earnings
      since the effective date of the acquisition.  The excess of the
      aggregate purchase price over the fair market value of net assets acquired
      of
      $3.5 million and $3.4 million at September 30, 2008 and December 31, 2007,
      respectively, has been recorded as goodwill in the accompanying condensed
      consolidated balance sheets.





7


The
      purchase price was allocated to the net assets of MI based on their estimated
      fair values on November 30, 2007, as follows:





(in
                thousands)Total
                purchase price, including expenses, net of cash acquired
            
            
            
            
            $
            3,748Less:Current
                assets
            
            $
            168Intangible
                assets
            
            
            180Liabilities
            
            
            (76
            )
            
            
            (272
            )Excess
                purchase price over net assets acquired
            
            
            
            
            
            $
            3,476





The
      unaudited pro forma condensed consolidated results of operations of MI are
      not
      presented due to the immateriality of its results of operations.





Angels
      Landing, Inc.





On
      May
      24, 2007, the Company acquired substantially all of the assets of Angels
      Landing, Inc. (Angels Landing), a privately-held, start-up developer and
      marketer of infant and toddler travel gear under the Compass brand name (the
      Compass Business) based in Kettering, Ohio.  Closing consideration
      consisted of $6.9 million of cash, excluding transaction expenses, and includes
      $0.3 million which may be earned in the transaction by Angels Landing if gross
      sales relating to the Compass Business in 2008 exceed a certain
      target.  This transaction has been accounted for under the purchase
      method of accounting, and accordingly, the operating results of the Compass
      Business have been included in the accompanying condensed consolidated
      statements of earnings since the effective date of the
      acquisition.  The excess of the aggregate purchase price over the fair
      market value of net assets acquired of $4.2 million has been recorded as
      goodwill in the accompanying condensed consolidated balance sheets at September
      30, 2008 and December 31, 2007.





The
      purchase price was allocated to the net assets of the Compass Business based
      on
      their estimated fair values on May 24, 2007, as follows:





(in
                thousands)Total
                purchase price, including expenses, net of cash acquired
            
            
            
            
            $
            6,772Less:Current
                assets
            
            $
            1,351Property
                and equipment
            
            
            817Intangible
                assets
            
            
            890Liabilities
            
            
            (485
            )
            
            
            (2,573
            )Excess
                purchase price over net assets acquired
            
            
            
            
            
            $
            4,199





The
      unaudited pro forma condensed consolidated results of operations for the Compass
      Business are not presented due to the immateriality of its results of
      operations.





Children’s
      Publishing Division of Publications International, Ltd.





On
      June
      23, 2008, the Company announced it signed a definitive purchase agreement to
      acquire the Children’s Publishing Division (CPD) of privately-held Publications
      International, Ltd.  However, on September 30, 2008, the Company
      announced that due to adverse capital markets, it terminated the purchase
      agreement.  Costs of $1.4 million, incurred by the Company related to
      the CPD transaction, are included in terminated acquisition costs on the
      accompanying condensed consolidated statements of earnings for the three months
      and nine months ended September 30, 2008.





8


Note
      3 – Business Segments





The
      Company is a leading designer, producer and marketer of innovative, high-quality
      toys, collectibles, and infant and toddler products.





The
      Company’s reportable segments under Statement of Financial Accounting Standards
      (SFAS) No. 131, “Disclosure About Segments of an Enterprise and Related
      Information,” are North America and International.  The North America
      segment includes the United States, Canada and Mexico.  The
      International segment includes non-North America markets.





Segment
      performance is measured at the operating income level.  Segment assets
      are comprised of all assets, net of applicable reserves and
      allowances.  Certain assets and resources are jointly used between the
      North America and International segments.  Intercompany allocations of
      such uses are not made.





Results
      are not necessarily those that would be achieved if each segment were an
      unaffiliated business enterprise.  Information by segment and a
      reconciliation to reported amounts for the three months and nine months ended
      September 30, 2008 and 2007, are as follows:





Three
                Months Ended
              September
                30,
            
            
            Nine
                Months Ended
              September
                30,(in
                thousands)
            
            2008
            
            
            2007
            
            
            2008
            
            
            2007Net
                sales:North
                America
            
            $
            98,998
            
            
            $
            114,495
            
            
            $
            234,264
            
            
            $
            276,645International
            
            
            34,106
            
            
            
            30,570
            
            
            
            81,761
            
            
            
            74,339Sales
                and transfers between segments
            
            
            (248
            )
            
            
            (222
            )
            
            
            (686
            )
            
            
            (558
            )Combined
                total
            
            $
            132,856
            
            
            $
            144,843
            
            
            $
            315,339
            
            
            $
            350,426Operating
                income:North
                America
            
            $
            14,441
            
            
            $
            11,165
            
            
            $
            6,781
            
            
            $
            20,635International
            
            
            6,409
            
            
            
            4,789
            
            
            
            8,624
            
            
            
            10,364Sales
                and transfers between segments
            
            
            52
            
            
            
            (229
            )
            
            
            49
            
            
            
            (218
            )Combined
                total
            
            $
            20,902
            
            
            $
            15,725
            
            
            $
            15,454
            
            
            $
            30,781





(in
                thousands)
            
            September
                30,
              2008
            
            
            December
                31, 2007Total
                assets:North
                America
            
            $
            508,265
            
            
            $
            513,289International
            
            
            143,558
            
            
            
            136,956Combined
                total
            
            $
            651,823
            
            
            $
            650,245





Under
      the
      enterprise-wide disclosure requirements of SFAS No. 131, the Company reports
      net
      sales by product category and by distribution channel.  During the
      first quarter of 2008, the Company reclassified its product categories and
      distribution channels to be more closely aligned with its strategic direction
      and organization structure.  The presentation is consistent with how
      the Company views its business.  The Company groups its products into
      two product categories: mother, infant and toddler products, and preschool,
      youth and adult products.  The following table presents consolidated
      net sales by product category and by distribution channel for the three months
      and nine months ended September 30, 2008 and 2007:






9


Three
                Months Ended
              September
                30,
            
            
            Nine
                Months Ended
              September
                30,(in
                thousands)
            
            2008
            
            
            2007
            
            
            2008
            
            
            2007Mother,
                infant and toddler products
            
            $
            47,004
            
            
            $
            47,509
            
            
            $
            134,770
            
            
            $
            142,989Preschool,
                youth and adult products
            
            
            85,852
            
            
            
            97,334
            
            
            
            180,569
            
            
            
            207,437Net
                sales
            
            $
            132,856
            
            
            $
            144,843
            
            
            $
            315,339
            
            
            $
            350,426Chain
                retailers
            
            $
            90,580
            
            
            $
            97,972
            
            
            $
            220,552
            
            
            $
            241,135Specialty
                retailers, wholesalers, OEM dealers
              and
                other
            
            
            42,276
            
            
            
            46,871
            
            
            
            94,787
            
            
            
            109,291Net
                sales
            
            $
            132,856
            
            
            $
            144,843
            
            
            $
            315,339
            
            
            $
            350,426





Note
      4 – Goodwill and Intangible Assets





The
      change in carrying value of goodwill by reporting unit for the nine months
      ended
      September 30, 2008, is shown below:





(in
                thousands)
            
            North
                America
            
            
            International
            
            
            TotalBalance
                at January 1, 2008
            
            $
            232,194
            
            
            $
            15,620
            
            
            $
            247,814Compass
                Business fair value allocation
            
            
            (51
            )
            
            
            ---
            
            
            
            (51
            )MI
                fair value allocation
            
            
            28
            
            
            
            ---
            
            
            
            28Other
                adjustments
            
            
            ---
            
            
            
            (1,337
            )
            
            
            (1,337
            )Balance
                at September 30, 2008
            
            $
            232,171
            
            
            $
            14,283
            
            
            $
            246,454





Other
      adjustments made during the nine months ended September 30, 2008, primarily
      relate to currency exchange rate changes.





The
      components of intangible assets, net are as follows:





(in
                thousands)
            
            September
                30,
              2008
            
            
            December
                31, 2007Gross
                amount of amortizable intangible assets:Customer
                relationships
            
            $
            8,582
            
            
            $
            8,582Other
            
            
            4,321
            
            
            
            4,32112,903
            
            
            
            12,903Accumulated
                amortization of amortizable intangible assets:Customer
                relationships
            
            
            881
            
            
            
            706Other
            
            
            3,310
            
            
            
            2,8154,191
            
            
            
            3,521Intangible
                assets not subject to amortization:Licenses
                and trademarks
            
            
            86,830
            
            
            
            87,293Total
                intangible assets, net
            
            $
            95,542
            
            
            $
            96,675





Other
      amortizable intangible assets consist primarily of patents, non-compete
      agreements, trademarks and licenses.  Amortization expense related to
      amortizable intangible assets for the year 2008 is estimated to be approximately
      $0.9 million.




10





Note
      5 – Income Taxes





Effective
      January 1, 2007, the Company adopted FASB Interpretation No. (FIN) 48,
“Accounting for Uncertainty in Income Taxes – an interpretation of FASB
      Statement No. 109.”  This Interpretation clarifies the accounting for
      uncertainty in income taxes recognized in an enterprise’s financial statements
      in accordance with FASB Statement No. 109, “Accounting for Income
      Taxes.”  This Interpretation prescribes a recognition threshold and
      measurement approach for the financial statement recognition and measurement
      of
      a tax position taken or expected to be taken in a tax return.  This
      Interpretation also provides guidance on derecognition, classification, interest
      and penalties, accounting in interim periods, disclosure and
      transition.





The
      uncertain tax positions as of September 30, 2008 and December 31, 2007 totaled
      $3.8 million and $4.2 million, respectively.  At September 30, 2008
      and December 31, 2007, approximately $2.7 million and $3.0 million,
      respectively, of the total gross unrecognized tax benefits represent the amount
      that, if recognized, would affect the effective income tax rate in future
      periods.  The Company and its subsidiaries are subject to U.S. federal
      income tax, as well as income tax of multiple state and foreign
      jurisdictions.  The Company has substantially concluded all U.S.
      federal income tax matters for years through 2004.  Substantially all
      material state and local and foreign income tax matters have been concluded
      for
      years through 2004.  U.S. federal income tax returns for 2005 through
      2007 are currently open for examination.  In the next twelve months,
      the Company expects to reduce the unrecognized tax position reserves by
      approximately $1.6 million, primarily due to the settlement of various state
      and
      international income tax audits and court cases and the closing of various
      statutes.  The Company’s continuing practice is to recognize interest
      and/or penalties related to income tax matters in income tax
      expense.  During the nine months ended September 30, 2008, the Company
      recorded adjustments to interest of $0.1 million and an immaterial amount to
      potential penalties, related to these unrecognized tax benefits.  In
      total, as of September 30, 2008 and December 31, 2007, the Company has recorded
      a liability for interest of $2.1 million and $2.0 million, respectively, and
      $0.4 million and $0.4 million, respectively, for potential
      penalties.





Note
      6 – Debt





In
      2004,
      the Company entered into a credit facility, as amended, comprised of an $85.0
      million term loan and a $100.0 million revolving line of credit.  The
      credit facility also provided for an additional $75.0 million of capacity under
      the revolving line of credit, which was approved by the lenders upon the
      Company’s request in October 2007.  During the first quarter of 2007,
      the term loan was repaid and was no longer available for
      borrowing.  The revolving line of credit was to be available until its
      maturity on September 14, 2008.  However, on September 12, 2008, the
      Company entered into an amendment which extended the maturity date of the credit
      facility to November 14, 2008, and provided that during the period after the
      original maturity date of September 14, 2008, until the extended maturity date
      of November 14, 2008, the Company may use any further proceeds of the revolving
      line of credit solely for general working capital purposes in the ordinary
      course of business.  The amendment also increased the applicable
      margin and the commitment fee on the revolving line of credit. On November
      3,
      2008, this credit facility was replaced with a new senior credit facility (see
      Note 20 – Subsequent Event).





A
      portion
      of the term loan had an interest rate of 3.45%, plus applicable margin, through
      the first three years of the facility.  The remaining term loan and
      revolving line of credit bore interest, at the Company’s option, at a base rate
      or at a LIBOR rate plus applicable margin.  The applicable margin was
      based on the Company’s ratio of consolidated debt to consolidated EBITDA
      (earnings before interest, taxes, depreciation, amortization and non-cash
      expense related to equity awards) and varied between 2.00% and
      3.50%.  At September 30, 2008, the margin in effect was 2.00% for
      LIBOR loans.  The Company was also required to pay a commitment fee of
      0.40% to 0.50% per annum on the average daily unused portion of the revolving
      line of credit.  At September 30, 2008, the commitment fee in effect
      was 0.40% per annum.  The credit facility was secured by working
      capital assets and certain intangible assets.  On September 30, 2008,
      the Company had $138.1 million outstanding on the revolving line of
      credit.





11


In
      conjunction with the amendment to extend the maturity date of its credit
      facility to November 14, 2008, the Company paid a fee of $0.2
      million.  At October 14, 2008, the Company was required to pay an
      additional extension fee of $0.2 million.  These fees are being
      amortized over the extension period.





During
      the first quarter of 2007, the Company expensed $0.2 million of deferred
      financing fees in conjunction with the Company’s voluntary payment of the
      remaining balance of its term loan.  Amortization and write-offs of
      deferred financing fees are included in interest expense, net in the
      accompanying condensed consolidated statements of earnings.





Note
      7 – Commitments and Contingencies





The
      Company leases office and warehouse/distribution space under various
      non-cancelable operating lease arrangements, which expire through November
      30,
      2019.





The
      Company markets a significant portion of its products under licenses from other
      parties.  These licenses are limited in scope and duration and
      authorize the sale of specific licensed products generally on a nonexclusive
      basis.  The Company has license agreements with, among others, various
      entertainment, publishing and media companies, automotive and truck
      manufacturers, and agricultural and construction vehicle and equipment
      manufacturers.  The Company is a party to more than 400 license
      agreements with terms generally of two to three years.  Many of the
      license agreements include minimum guaranteed royalty payments that the Company
      must pay whether or not it meets specified sales targets.  The Company
      believes it either achieved its minimum guarantees or has accrued for the costs
      related to these guarantees for the nine months ended September 30, 2008 and
      2007.





Note
      8 – Legal Proceedings





See
      Note
      14 – Product Recalls for a description of certain putative class action lawsuits
      against the Company with respect to the products subject to the 2007
      recalls.





The
      Company also has certain contingent liabilities resulting from litigation and
      claims incident to the ordinary course of business.  Management believes
      that the probable resolution of such contingencies will not materially affect
      the Company’s financial position or results of operations.





Note
      9 – Common Stock





Authorized
      and outstanding shares and the par value of the Company’s voting common stock
      are as follows:





(in
                thousands, except par value)
            Authorized
              Shares
            Par
              Value
            Shares
                Outstanding
              at
                September 30, 2008
            Shares
                Outstanding
              at
                December 31, 2007Voting
                common stock
            28,000
            $0.01
            17,242
            18,320





At
      December 31, 2007, the Company held 4.8 million shares of its common stock
      in
      treasury.  During the nine months ended September 30, 2008 and 2007,
      the Company sold a total of 6,681 shares and 3,921 shares, respectively, out
      of
      treasury to Company employees under the Employee Stock Purchase Plan (ESPP)
      for
      $0.1 million and $0.1 million, respectively.





In
      February 2007, the Company’s Board of Directors authorized the adoption of a
      program to repurchase up to $75.0 million of the Company’s common
      stock.  The program was initially authorized for a period of one
      year. In
      October 2007, the Board of Directors authorized a $75.0 million increase to
      the
      stock repurchase program and extended the timing of this program through
      December 31, 2008.  This program may be extended beyond the currently
      authorized period or may be suspended at any time.  Under this
      program, shares may be repurchased from time to time in open market transactions
      or privately negotiated transactions at the Company’s discretion, subject to
      market conditions and other factors.  Shares repurchased by the
      Company are held as treasury shares.  During the nine months ended
      September 30, 2008, the Company repurchased 1.2 million shares for $24.7 million
      under this program.  Through September 30, 2008, the Company had
      repurchased an aggregate of 4.1 million shares for $112.6 million under the
      $150.0 million stock repurchase authorization.  These repurchases were
      funded with borrowings on the Company’s revolving line of credit and with cash
      flow from operations.





12




Note
      10 – Stock-Based Payment Arrangements





At
      September 30, 2008, the Company has three stock incentive plans, two of which
      are dormant, and an ESPP.  Amounts recognized in the financial
      statements with respect to these stock-based payment arrangements for the three
      months and nine months ended September 30, 2008 and 2007, are as
      follows:





Three
                Months Ended
              September
                30,
            
            
            Nine
                Months Ended
              September
                30,(in
                thousands)
            
            2008
            
            
            2007
            
            
            2008
            
            
            2007Total
                expense recognized for stock-based
              payment
                plans
            
            $
            1,361
            
            
            $
            1,195
            
            
            $
            4,034
            
            
            $
            3,544Amount
                of related income tax benefit recognized
              in
                determining net income
            
            $
            513
            
            
            $
            443
            
            
            $
            1,521
            
            
            $
            1,315





Stock-based
      compensation expense is included in cost of sales and selling, general and
      administrative expenses in the accompanying condensed consolidated statements
      of
      earnings for the three months and nine months ended September 30, 2008 and
      2007.





Restricted
      stock awards or options to purchase stock may be granted under the current
      stock
      incentive plan.  A summary of stock option activity for the Company’s
      stock incentive plans for the nine months ended September 30, 2008, is as
      follows:





Number
                of Shares
            
            
            Weighted
                Average
              Exercise
                Price
            
            
            Weighted
                Average Remaining Contractual
              Life
            
            
            Aggregate
                Intrinsic Value (000)Outstanding,
                beginning of year
            
            
            1,491,390
            
            
            $
            24.27Changes
                during the period:Granted
            
            
            579,500
            
            
            
            20.17Exercised
            
            
            82,118
            
            
            
            11.64Forfeited
            
            
            18,800
            
            
            
            31.53Expired
            
            
            12,030
            
            
            
            33.53Outstanding,
                end of period
            
            
            1,957,942
            
            
            $
            23.46
            
            
            
            6.8
            
            
            $
            5,579Exercisable
                at end of period
            
            
            912,125
            
            
            $
            19.40
            
            
            
            4.8
            
            
            $
            5,544





The
      total
      fair value of options vested during the nine months ended September 30, 2008,
      was $4.2 million.  As of September 30, 2008, there was $12.1 million
      of total unrecognized compensation cost related to nonvested stock-based
      compensation arrangements granted under the Company’s stock incentive plans for
      stock options.  That cost is expected to be recognized over a weighted
      average period of 3.3 years.





13


Restricted
      stock awards require no payment from the grantee.  The related
      compensation cost of each award is calculated using either the market price
      on
      the grant date or the market price on the last day of the reported period and
      is
      expensed equally over the vesting period which is generally over two to three
      years.  A summary of restricted stock awards for the Company’s stock
      incentive plans for the nine months ended September 30, 2008, is as
      follows:





Number
                of
              Shares
            
            
            Weighted
              Average
              Fair
                Value
            
            
            Weighted
              Average
              Remaining
              Contractual
                LifeUnvested
                restricted stock awards, beginning of year
            
            
            35,642
            
            
            $
            38.05Changes
                during the period:Granted
            
            
            34,496
            
            
            
            17.39Vested
            
            
            9,939
            
            
            
            41.75Forfeited
            
            
            2,348
            
            
            
            42.61Unvested
                restricted stock awards, end of period
            
            
            57,851
            
            
            $
            23.52
            
            
            2.0





As
      of
      September 30, 2008, there was $1.0 million of total unrecognized compensation
      cost related to nonvested stock-based compensation arrangements granted under
      the Company’s stock incentive plans for restricted stock awards.  That
      cost is expected to be recognized over a weighted average period of 2.0
      years.





Note
      11 – Related Party Transactions





The
      Company purchased some of its finished goods during the three months and nine
      months ended September 30, 2008 and 2007, from a company in which a relative
      of
      a Company stockholder and former director of the Company has an ownership
      interest.  During the three months and nine months ended September 30,
      2007, the Company also purchased some of its finished goods from another company
      in which relatives of a Company stockholder and former director of the Company
      have ownership interests.





Note
      12 – Employee Benefit Plans





The
      Company maintains a funded, noncontributory defined benefit pension plan (the
      Plan) that covers a select group of the Company’s workforce covered by a
      collective bargaining agreement who were hired prior to January 1,
      2002.  The Plan provides defined retirement benefits based on
      employees’ years of service.





The
      components of net periodic benefit cost for the three months and nine months
      ended September 30, 2008 and 2007, are as follows:





Three
                Months Ended
              September
                30,
            
            
            Nine
                Months Ended
              September
                30,(in
                thousands)
            
            2008
            
            
            2007
            
            
            2008
            
            
            2007Service
                cost
            
            $
            26
            
            
            $
            26
            
            
            $
            76
            
            
            $
            80Interest
                cost
            
            
            213
            
            
            
            205
            
            
            
            640
            
            
            
            615Expected
                return on plan assets
            
            
            (277
            )
            
            
            (253
            )
            
            
            (832
            )
            
            
            (759
            )Amortization
                of prior service costs
            
            
            4
            
            
            
            4
            
            
            
            14
            
            
            
            14Amortization
                of net loss
            
            
            47
            
            
            
            96
            
            
            
            142
            
            
            
            288Net
                periodic benefit cost
            
            $
            13
            
            
            $
            78
            
            
            $
            40
            
            
            $
            238





14


The
      Company did not make any contributions to the Plan during the nine months ended
      September 30, 2008, and currently does not expect to make any additional
      contributions during the remainder of the fiscal 2008 year.





Note
      13 – Discontinued Operations





On
      November 3, 2006, the Company announced the completion of the sale of RC2 South,
      Inc., its collectible trading card business, and substantially all of the assets
      related to its die-cast sports collectibles product line.  The sale of
      the Company’s trading card business and sports collectibles product line is
      consistent with the Company’s strategic focus to achieve sustainable organic
      growth and to concentrate its efforts on its higher growth infant, toddler
      and
      preschool products.  The transaction was effective November 1,
      2006.  The sold business was primarily reported under the North
      America segment.  A gain on the sale of $0.1 million, net of income
      tax, was recognized on this transaction during the second quarter of
      2007.  The gain is presented in income from discontinued operations,
      net of tax, on the accompanying condensed consolidated statement of earnings
      for
      the nine months ended September 30, 2007.  This gain represents the
      final escrow payout which was received during the second quarter of
      2007.





Note
      14 – Product Recalls





On
      June
      13, 2007, the Company announced the voluntary recall of 26 individual wooden
      railway vehicles and set components from the Thomas & Friends Wooden
      Railway product line, after an internal investigation linked apparent excess
      levels of lead with a limited number of paint colors used at a single contract
      manufacturing facility which purchased paint from independent
      suppliers.  On September 26, 2007, the Company announced the voluntary
      recall of five Thomas &
Friends Wooden Railway items,
      in addition to those items recalled in June
      2007.  Additionally, on December 6, 2007, the Company announced the
      voluntary recalls of two styles of The First Years 3-in-1 Flush & Sounds
      Potty training seats due to the discovery of excess levels of lead in the
      surface paint on 5-inch rectangular plaques inserted into the backs of the
      training seats and three styles of The First Years Newborn-to-Toddler Reclining
      Feeding Seat due to malfunctioning restraining straps that may disengage and
      permit the child to slip out of the seat.





Following
      the announcement of the June 2007 recall, a total of 23 putative class action
      lawsuits were filed against the Company in various federal and state courts
      with
      respect to the products subject to the June 2007 and September 2007
      recalls.  These lawsuits make various claims and seek (i) medical
      monitoring as a result of alleged exposure to lead in the products subject
      to
      the recalls, (ii) disgorgement of certain profits under common law unjust
      enrichment theories, and/or (iii) various remedies under claims of product
      liability, breach of warranty, negligence, unfair and deceptive trade practices
      under state law and violation of the federal Consumer Product Safety
      Act.  On December 19, 2007, the various federal class action lawsuits
      were consolidated in the U.S. District Court for the Northern District of
      Illinois.





On
      January 22, 2008, the Company announced that it had reached a settlement in
      Barrett v. RC2
      Corporation filed in the Circuit Court of Cook County, Illinois, with the
      plaintiffs in the various class action lawsuits against the Company in state
      courts which arise from or relate to the Company’s recall of certain Thomas & Friends Wooden
      Railway products.  The Circuit Court of Cook County, Illinois, granted
      preliminary approval of the terms of the proposed settlement.  The
      class in the Barrett
      case is basically defined as all persons in the United States who do not opt
      out
      of the class and who purchased or owned other than for resale the Company’s
Thomas & Friends
      Wooden Railway products which were recalled in June 2007 and September
      2007.  The settlement agreement provides class members with several
      relief options, including cash refunds, replacement products and
      coupons.  Under the settlement agreement, the Company also agreed to
      pay attorney’s fees and costs to plaintiff’s counsel totaling $2.9 million,
      subject to court approval.  The settlement agreement also provides
      that the Company will take certain quality control measures.





15


After
      the
      settlement agreement in the Barrett case was announced,
      plaintiff’s counsel in the pending federal court class actions attempted to stop
      the Company from proceeding with the settlement in Barrett, and on January 28,
      2008, filed a motion for a preliminary injunction in the U.S. District Court
      for
      the Northern District of Illinois seeking to enjoin the Company from proceeding
      with the settlement in the Barrett case.  On
      February 20, 2008, the U.S. District Court for the Northern District of Illinois
      denied the motion for a preliminary injunction filed by plaintiffs in the
      federal cases and granted the Company’s motion to stay the federal court actions
      pending the state court’s final decision in the Barrett case of whether
      to
      approve the proposed settlement in that case.  Certain plaintiffs in
      the federal court action also filed a motion to intervene in the state court
      proceeding, but, on February 25, 2008, they withdrew this motion.  The
      state court had stayed the issuance of notice of the proposed settlement to
      the
      class in Barrett
      pending a decision on the federal plaintiffs’ motion to intervene.





After
      the
      federal court plaintiff’s motion for a preliminary injunction to stop the Barrett settlement was
      denied, the Company then entered into further settlement negotiations with
      the
      plaintiffs in the 18 class actions filed in federal court and the plaintiffs
      in
      the 5 class actions filed in state courts to reach a global settlement in the
      Barrett
      case.  The Company, plaintiffs in the 5 state court class actions and
      plaintiffs in the 18 federal court class actions entered into an amended
      settlement agreement in the Barrett case which included
      the plaintiffs in all 23 class actions filed against the Company.  The
      amended settlement agreement incorporated the relief provided to the class
      in
      the original settlement agreement.  In addition, the Company agreed to
      (i) pay an additional $0.1 million in attorney’s fees (for a total of $3.0
      million) to plaintiff’s counsel, (ii) provide the class with additional relief
      in the form of limited reimbursement for blood testing for lead during specified
      limited time periods with caps on the amount of individual claims and a total
      cap of $0.5 million on all claims, and (iii) specify and further define actions
      it would take to increase quality control measures it had agreed to in the
      initial settlement agreement.  The Company paid the attorney’s fees of
      $3.0 million during the third quarter of 2008.





The
      amended settlement agreement was preliminary approved by the Circuit Court
      of
      Cook County on May 5, 2008.  Notice was then issued to the
      class.  The amended settlement agreement received final approval from
      the Circuit Court of Cook County on August 6, 2008.  Less than 50
      persons opted out of the class.  The amended settlement agreement
      resolves all claims of the class, other than for individual claims for personal
      injuries or for persons opting out of the class, with respect to the June 2007
      and September 2007 recalls of certain Thomas &Friends
      Wooden Railway
      toys.  The claim period ran until October 6, 2008.





With
      the
      final approval of the settlement agreement and the end of the claim period,
      the
      class action lawsuits relating to the June 2007 and September 2007 recalls
      have
      been resolved.  The Company may be subject to individual claims for
      personal injuries or other claims or government inquiries (including the inquiry
      by the Consumer Product Safety Commission (CPSC) described in the next
      paragraph) relating to the 2007 recalls.  No assurances can be given
      as to the outcome of any such claims or government inquiries.





During
      the second quarter of 2008, the Company received an inquiry from the CPSC for
      information regarding the recalls of certain Thomas & Friends Wooden
      Railway toys in June 2007 and September 2007 for the purpose of assessing
      whether the CPSC may impose a fine on the Company.  The Company is in
      the process of responding to this inquiry, and at this time, the CPSC has not
      yet imposed a fine upon the Company.





HIT
      Entertainment (the Licensor), the licensor who has granted the licenses under
      which the Company markets the property affected by the June 2007 and September
      2007 recalls (the Licenses), sent a letter demanding that the Company indemnify
      it for certain costs in connection with the recalls and alleging that the
      Company had not complied with several provisions in the Licenses.  On
      July 7, 2008, the Company announced it reached an agreement with the Licensor
      which modifies existing license agreements and provides a release to the Company
      in connection with past indemnification claims related to the recall of certain
      products and other legal matters.





16


The
      agreement provides an extension to the license term on the Thomas & Friends Wooden
      Railway product line, along with an immediate reduction in licensing payments
      on
      this product line, and a shortening of the license term on the Take Along Thomas & Friends die-cast
      product line.  In addition, the Company made a one-time cash
      payment to the Licensor of $15.0 million in exchange for a release from
      indemnification claims.  This cash payment was accrued for during the
      second quarter of 2008, and payment was made in July 2008.  This payment is
      included in recall-related items on the accompanying condensed consolidated
      statement of earnings for the nine months ended September 30, 2008.





The
      Company recorded a benefit of $1.9 million, net of tax, or $0.11 per diluted
      share, for the three months ended September 30, 2008, related to the 2007
      recalls.  The benefit recorded during the three months ended September 30,
      2008, includes a recovery of costs and reductions to prior estimates.  The
      Company recorded charges of $5.9 million, net of tax, or $0.28 per diluted
      share, in the three months ended September 30, 2007, related to the 2007
      recalls.    The Company recorded charges of $9.3 million, net of
      tax, or $0.52 per diluted share, and $10.0 million, net of tax, or $0.47 per
      diluted share, in the nine months ended September 30, 2008 and 2007,
      respectively, related to the 2007 recalls.  The Company has $6.5
      million and $14.6 million of accrued recall-related items included in accounts
      payable and accrued expenses in the accompanying condensed consolidated balance
      sheets at September 30, 2008 and December 31, 2007, respectively. These items
      are based on the latest estimates of retailer inventory returns, consumer
      product replacement costs, shipping costs and fines and penalties as of the
      date
      of this filing, as well as additional replacement costs or refunds,
      donations, notice charges, claims administration and legal fees related to
      the
      settlement of the class action lawsuits.  It is reasonably possible
      that actual costs associated with the recalls and related litigation could
      differ significantly from the estimates recorded.





Note
      15 – Reclassifications





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





Note
      16 – Use of Estimates





The
      preparation of the financial statements in conformity with U.S. generally
      accepted accounting principles requires management to make estimates and
      assumptions that affect the amounts reported in the financial statements and
      accompanying notes.  Actual results could differ from those
      estimates.





Note
      17 – Fair Value





In
      September 2006, the FASB issued SFAS No. 157, “Fair Value
      Measurements.”  This Statement defines fair value, establishes a
      framework for measuring fair value in generally accepted accounting principles
      and expands disclosures about fair value measurements.  This Statement
      applies under other accounting pronouncements that require or permit fair value
      measurement.  However, this Statement does not require any new fair
      value measurements.  This Statement is effective for the financial
      statements issued for fiscal years beginning after November 15, 2007, and
      interim periods within those fiscal years.  In February 2008, the FASB
      issued FASB Staff Position (FSP) No. FAS 157-2, “Effective Date of FASB
      Statement No. 157,” which provides a one year deferral of the effective date of
      SFAS No. 157 for non-financial assets and non-financial liabilities, except
      those that are recognized or disclosed in the financial statements at fair
      value
      at least annually. In accordance with FSP No. FAS 157-2, as of January 1, 2008,
      the Company has only adopted the provisions of SFAS No. 157 with respect to
      its
      financial assets and liabilities that are measured at fair value within the
      financial statements.   Based upon this one year deferral in the
      effective date, the provisions of SFAS No. 157 have not been applied to
      non-financial assets and non-financial liabilities.  The major
      categories of assets and liabilities that are measured at fair value, for which
      the Company has not applied the provisions of SFAS No. 157, are goodwill and
      intangible assets.





17





Note
      18 – Comprehensive (Loss) Income





The
      Company reports comprehensive (loss) income in accordance with SFAS No. 130,
      “Reporting Comprehensive Income.”  SFAS No. 130 requires companies to
      report all changes in equity during a period, except those resulting from
      investment by owners and distributions to owners, in a financial statement
      for
      the period in which they are recognized.  Comprehensive (loss) income
      for the nine months ended September 30, 2008 and 2007, is calculated as
      follows:





(in
                thousands)
            
            2008
            
            
            2007Net
                income
            
            $
            6,697
            
            
            $
            21,288Other
                comprehensive (loss) income – foreign currency
              translation
                adjustments
            
            
            (7,789
            )
            
            
            4,972Comprehensive
                (loss) income
            
            $
            (1,092
            )
            
            $
            26,260





Note
      19 –Earnings Per Common Share





The
      Company computes earnings per common share in accordance with SFAS No. 128,
      “Earnings Per Share.”  Under the provisions of SFAS No. 128, basic
      earnings per common share is computed by dividing net income for the period
      by
      the weighted average number of common shares outstanding during the
      period.  Diluted earnings per common share is computed by dividing net
      income for the period by the weighted average number of common and common
      equivalent shares outstanding during the period.  The following table
      discloses the components of earnings per common share from continuing operations
      as required by SFAS No. 128:





Three
                Months Ended
              September
                30,
            
            
            Nine
                Months Ended
              September
                30,(in
                thousands)
            
            2008
            
            
            2007
            
            
            2008
            
            
            2007Income
                from continuing operations
            
            $
            11,109
            
            
            $
            10,769
            
            
            $
            6,697
            
            
            $
            21,178Weighted
                average common and common
              equivalent
                shares outstanding:Weighted
                average common shares outstanding
            
            
            17,210
            
            
            
            20,523
            
            
            
            17,460
            
            
            
            20,952Add
                effect of diluted securities – assumed
              exercise
                of stock options and vesting of
              restricted
                stock awards
            
            
            253
            
            
            
            327
            
            
            
            255
            
            
            
            384Weighted
                average common and common
              equivalent
                shares outstanding
            
            
            17,463
            
            
            
            20,850
            
            
            
            17,715
            
            
            
            21,336Basic
                earnings per common share from
              continuing
                operations
            
            $
            0.65
            
            
            $
            0.52
            
            
            $
            0.38
            
            
            $
            1.01Diluted
                earnings per common share from
              continuing
                operations
            
            $
            0.64
            
            
            $
            0.52
            
            
            $
            0.38
            
            
            $
            0.99





Options
      to purchase 1,500,863 shares and 773,921 shares of common stock were outstanding
      during the three months ended September 30, 2008 and 2007, respectively, but
      were not included in the computation of diluted earnings per common share
      because the options were anti-dilutive.  Options to purchase 1,381,104
      shares and 507,201 shares of common stock were outstanding during the nine
      months ended September 30, 2008 and 2007, respectively, but were not included
      in
      the computation of diluted earnings per common share because the options were
      anti-dilutive.





18


Note
      20 – Subsequent Event





On
      November 3, 2008 (the Close Date), RC2 entered into a new $145.0 million senior
      credit facility to replace its previous facility.  The credit facility
      is comprised of a $75.0 million term loan and a $70.0 million revolving line
      of
      credit.  The total borrowing capacity available under the credit
      facility is subject to a formula based on the Company’s leverage ratio, as
      defined in the credit agreement.  The term loan and revolving line of
      credit both have a scheduled maturity date of November 1, 2011.  Under
      this credit facility, the term loan and the revolving line of credit bear
      interest, at the Company’s option, at a base rate or at LIBOR, plus applicable
      margins, which are based on the Company’s leverage ratio.  Applicable
      margins vary between 2.25% to 3.25%on LIBOR borrowings
      and 1.25% to 2.25%on base rate
      borrowings.  At the Close Date, the applicable margin in effect was
      3.00% for LIBOR borrowings and 2.00% for base rate
      borrowings.  Principal payments on the term loan commence on March 31,
      2009, at a rate of $3.8 million per calendar quarter, with the remaining
      principal of $33.8 million due on November 1, 2011.  The Company is
      also required to pay a commitment fee which varies between 0.45% to 0.50% per
      annum on the average daily unused portion of the revolving line of credit. 
At the Close Date, the commitment fee in effect was 0.50% per
      annum.





Under
      the
      terms of the credit facility, the Company is required to comply with certain
      financial and non-financial covenants.  Among other restrictions, the
      Company is restricted in its ability to pay dividends, buy back its stock,
      incur
      additional debt and make acquisitions above certain amounts.  The
      credit facility also includes a clean down provision that limits the maximum
      amount of borrowings under the revolving line of credit to $30.0 million for
      a
      period of 60 consecutive days during the first four calendar months of
      2009.  The clean down provision limits decrease to $27.5 million for a
      period of 60 consecutive days during the first four calendar months of 2010
      and
      $25.0 million for a period of 60 consecutive days during the first four
      calendar months of 2011.  The key financial covenants include a
      maximum leverage ratio of 2.5x and a fixed charge ratio (as defined in the
      agreement).  At the Close Date, the Company had $75.0
      million outstanding under its new term loan and $55.0 million
      outstanding under its new revolving line of credit.  The Company
      classified $44.4 million of its outstanding line of credit as short-term at
      September 30, 2008, based upon the payments required under the new credit
      facility.





The
      Company incurred approximately $2.3 million of financing fees in conjunction
      with the execution of the credit agreement.  These financing fees will
      be capitalized and amortized over the term of the credit agreement.





19




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





The
      following is a discussion and analysis of the Company’s financial condition,
      results of operations, liquidity and capital resources.  The
      discussion and analysis should be read in conjunction with the Company’s
      unaudited condensed consolidated financial statements and notes thereto included
      elsewhere herein.




RESULTS
      OF OPERATIONS





Operating
      Highlights





Net
      sales
      for the three months ended September 30, 2008, decreased 8.2% compared to net
      sales for the three months ended September 30, 2007.  Net sales for
      the three months ended September 30, 2008, were impacted by conservative
      ordering by many retailers in the North America segment.  Gross profit
      increased to 46.7% for the three months ended September 30, 2008, from 44.1%
      for
      the three months ended September 30, 2007.  Selling, general and
      administrative expenses, as a percentage of net sales, increased to 30.9% for
      the three months ended September 30, 2008, from 29.5% for the three months
      ended
      September 30, 2007.  Operating income increased to $20.9 million for
      the three months ended September 30, 2008, from $15.7 million for the three
      months ended September 30, 2007.  As a percentage of net sales,
      operating income increased to 15.7% for the three months ended September 30,
      2008, from 10.8% for the three months ended September 30, 2007.





Net
      sales
      for the nine months ended September 30, 2008, decreased 10.0% compared to net
      sales for the nine months ended September 30, 2007.  Gross profit
      increased to 46.0% for the nine months ended September 30, 2008, from 43.4%
      for
      the nine months ended September 30, 2007.  Selling, general and
      administrative expenses, as a percentage of net sales, increased to 35.6% for
      the nine months ended September 30, 2008, from 32.3% for the nine months ended
      September 30, 2007.  Operating income decreased to $15.5 million for
      the nine months ended September 30, 2008, from $30.8 million for the nine months
      ended September 30, 2007.  As a percentage of net sales, operating
      income decreased to 4.9% for the nine months ended September 30, 2008, from
      8.8%
      for the nine months ended September 30, 2007.





The
      Company closely monitors its product line profitability and cost
      controls.  During the second and third quarters of 2008, the Company
      implemented its expected prices increases.  During 2008, the Company
      continued to eliminate individual products with unacceptable levels of
      profit.  The Company expects product cost pressures to continue
      throughout the remainder of 2008 and into 2009.





On
      July
      7, 2008, the Company announced it reached an agreement with HIT Entertainment
      (the Licensor) which modifies existing license agreements and provides a release
      to the Company in connection with past indemnification claims related to the
      recall of certain products and other legal matters.  The agreement
      provides an extension to the license term on the Thomas & Friends Wooden
      Railway product line, along with an immediate reduction in licensing payments
      on
      this product line, and a shortening of the license term on the Take Along Thomas & Friends die-cast
      product line.  In addition, the Company made a one-time cash
      payment to the Licensor of $15.0 million in exchange for a release from
      indemnification claims.  This payment was accrued for during the
      second quarter of 2008, and payment was made in July 2008.  This
      payment is included in recall-related items on the accompanying condensed
      consolidated statement of earnings for the nine months ended September 30,
      2008.  The Company expects the one-time payment and reduced future
      profits from the shortening of license term on the Take Along Thomas & Friends product
      line will over time be offset by the reduction in licensing payments and
      licensing term extension on the Thomas & Friends Wooden
      Railway product line.





On
      June
      23, 2008, the Company announced it signed a definitive purchase agreement to
      acquire the Children’s Publishing Division (CPD) of privately-held Publications
      International, Ltd.  However, on September 30, 2008, the Company
      announced that due to adverse capital markets, it terminated the purchase
      agreement.  Costs of $1.4 million, incurred by the Company related to
      the CPD transaction, are included in terminated acquisition costs on the
      accompanying condensed consolidated statements of earnings for the three months
      and nine months ended September 30, 2008.





20


On
      June
      13, 2007, the Company announced the voluntary recall of 26 individual wooden
      railway vehicles and set components from the Thomas & Friends Wooden
      Railway product line, after an internal investigation linked apparent excess
      levels of lead with a limited number of paint colors used at a single contract
      manufacturing facility which purchased paint from independent
      suppliers.  On September 26, 2007, the Company announced the voluntary
      recall of five Thomas &
Friends Wooden Railway items,
      in addition to those items recalled in June
      2007.  Additionally, on December 6, 2007, the Company announced the
      voluntary recalls of two styles of The First Years 3-in-1 Flush & Sounds
      Potty training seats due to the discovery of excess levels of lead in the
      surface paint on 5-inch rectangular plaques inserted into the backs of the
      training seats and three styles of The First Years Newborn-to-Toddler Reclining
      Feeding Seat due to malfunctioning restraining straps that may disengage and
      permit the child to slip out of the seat.  The Company recorded a
      benefit of $1.9 million, net of tax, or $0.11 per diluted share, in the three
      months ended September 30, 2008, related to the 2007 recalls.  The
      benefit recorded during the threee months ended September 30, 2008, includes
      a
      recovery of costs and reductions to prior estimates. The Company recorded
      charges of $5.9 million, net of tax, or $0.28 per diluted share, in the three
      months ended September 30, 2007, related to the 2007 recalls.  The
      Company recorded charges of $9.3 million, or $0.52 per diluted share, and $10.0
      million, net of tax, or $0.47 per diluted share, in the nine months ended
      September 30, 2008 and 2007, respectively.  The portion of these
      (recoveries) charges, net of tax, included in the North America and
      International segments for the three months and nine months ended September
      30,
      2008 and 2007, is outlined in the table below.





For
                the three months
              ended
                September 30,
            
            
            For
                the nine months
              ended
                September 30,(in
                millions)
            
            2008
            
            
            2007
            
            
            2008
            
            
            2007North
                America
            
            $
            (0.2
            )
            
            $
            4.9
            
            
            $
            6.7
            
            
            $
            8.1International
            
            
            (1.7
            )
            
            
            1.0
            
            
            
            2.6
            
            
            
            1.9Total
                recall-related items,net of tax
            
            $
            (1.9
            )
            
            $
            5.9
            
            
            $
            9.3
            
            
            $
            10.0





The
      Company has $6.5 million and $14.6 million of accrued recall-related items
      included in accounts payable and accrued expenses in the accompanying condensed
      consolidated balance sheets at September 30, 2008 and December 31, 2007,
      respectively. These items are based on the latest estimates of retailer
      inventory returns, consumer product replacement costs, shipping costs and fines
      and penalties as of the date of this filing, as well as additional replacement
      costs or refunds, donations, notice charges, claims administration and legal
      fees related to the settlement of the class action lawsuits.





Three
      Months Ended September 30, 2008, Compared to Three Months Ended September 30,
      2007





Net
      sales.  Net sales for the three months ended September 30,
      2008, decreased $11.9 million, or 8.2%, to $132.9 million from $144.8 million
      for the three months ended September 30, 2007.  Net sales in our North
      America segment decreased 13.5%, and net sales in our international segment
      increased 11.6%, which includes a 2.7% negative impact in changes from currency
      exchange rates.




21




Net
      sales
      for the three months ended September 30, 2008, excluding $0.3 million in net
      sales of discontinued product lines and $0.4 million of recall-related items,
      were $132.2 million, a decrease of 6.2% when compared with net sales for the
      three months ended September 30, 2007, excluding $5.5 million in net sales
      of
      discontinued product lines and $1.7 million of recall-related items, of $141.0
      million.  The information in this paragraph constitutes non-GAAP
      financial information.  Internally, the Company uses this non-GAAP
      financial information for the following purposes: financial and operational
      decision making, evaluating period-to-period results and making comparisons
      of
      the Company’s results with those ot its competitors. 
Management believes that the presentation of these non-GAAP financial
      measures provides useful information to investors because this information
      may
      allow investors to better evaluate ongoing business performance and certain
      components of the Company’s operating results. Because the sales related to
      discontinued product lines and recall-related items have both decreased
      significantly, the Company believes that the presentation of this non-GAAP
      financial information enhances an investor’s ability to make period-to-period
      comparisons of the Company’s operating results.  This information
      should be considered in addition to the results presented in accordance with
      GAAP, and should not be considered a substitute for the GAAP results. A
      reconciliation to the nearest GAAP financial measure follows:





(in
                millions)
            
            Net
                Sales2008
                actual
            
            $
            132.9Deduct:  recall-related
                items
            
            
            0.4Deduct:
                discontinued product lines
            
            
            0.3As
                adjusted
            
            $
            132.22007
                actual
            
            $
            144.8Add:
                recall-related items
            
            
            1.7Deduct:
                discontinued product lines
            
            
            5.5As
                adjusted
            
            $
            141.0





Net
      sales
      decreases occurred in both our mother, infant and toddler products category
      and
      our preschool, youth and adult products category.  Net sales in our
      mother, infant and toddler products category decreased 1.1%, primarily driven
      due to sales declines in our The First Years® infant
      care and
      toy product lines which were partially offset by increases in our Lamaze
      developmental toys product line and infant and toddler gear and feeding product
      lines marketed under our The First Years brand.  Net sales in our
      preschool, youth and adult products category decreased 11.7%, primarily driven
      by declines in our Nickelodeon, Bob the
      Builder, radio-control and Thomas & Friends product
      lines, as well as lower sales of discontinued products, slightly offset by
      increases in our John Deere product line and our new Learning Curve® Caring
      CornersTM
      product line.





Excluding
      net sales related to discontinued product lines and recall-related items, net
      sales in our preschool, youth and adult products category decreased
      9.0%.  Information in this paragraph regarding net sales in our
      preschool, youth and adult products category, excluding net sales related to
      discontinued product lines and recall-related items, constitutes non-GAAP
      financial information.  Internally, the Company uses this non-GAAP
      financial information for the following purposes: financial and operational
      decision making, evaluating period-to-period results and making comparisons
      of
      the Company’s results with those of its competitors. Management
      believes that the presentation of these non-GAAP financial measures provides
      useful information to investors because this information may allow investors
      to
      better evaluate ongoing business performance and certain components of the
      Company’s operating results.  Because the sales related to
      discontinued product lines and recall-related items have both decreased
      significantly, the Company believes that the presentation of this non-GAAP
      financial information enhances an investor’s ability to make period-to-period
      comparisons of the Company’s operating results.  This information
      should be considered in addition to the results presented in accordance with
      GAAP, and should not be considered a substitute for the GAAP
      results.  A reconciliation to the nearest GAAP financial measure
      follows:




22





Net
                Sales(in
                millions)
            
            2008
            
            
            2007
            
            
            Difference
            
            
            %
                ChangePreschool,
                youth and adult products actual
            
            $
            85.9
            
            
            $
            97.3
            
            
            $
            (11.4
            )
            
            
            (11.7
            )%(Deduct)
                Add:  recall-related items
            
            
            (0.4
            )
            
            
            1.7
            
            
            
            (2.1
            )
            
            
            ---Deduct:
                discontinued product lines
            
            
            0.3
            
            
            
            5.4
            
            
            
            (5.1
            )
            
            
            ---As
                adjusted
            
            $
            85.2
            
            
            $
            93.6
            
            
            $
            (8.4
            )
            
            
            (9.0
            )%





Gross
      profit.  Gross profit decreased $1.8 million, or 2.8%, to $62.1
      million for the three months ended September 30, 2008, from $63.9 million for
      the three months ended September 30, 2007.  As a percentage of net
      sales, gross profit increased to 46.7% for the three months ended September
      30,
      2008, from 44.1% for the three months ended September 30, 2007, primarily due
      to
      lower recall-related items. Additionally, higher product and transportation
      costs were mostly offset by current year price increases, cost savings
      initiatives and improved product mix.  Our quarterly gross margins can
      be affected by the mix of product that is shipped during each
      quarter.  Our mother, infant and toddler products category has higher
      sales of non-licensed products that carry lower selling prices and gross margins
      that vary significantly and cause quarterly fluctuations, based on the timing
      of
      these individual shipments throughout the year.  There were no major
      changes in the components of cost of sales.





Selling,
      general
      and administrative expenses.  Selling, general and
      administrative expenses decreased $1.7 million, or 4.0%, to $41.0 million for
      the three months ended September 30, 2008, from $42.7 million for the three
      months ended September 30, 2007.  The decrease in selling, general and
      administrative expenses for the three months ended September 30, 2008, was
      primarily due to lower variable sales costs.  However, as a percentage
      of net sales, selling, general and administrative expenses increased to 30.9%
      for the three months ended September 30, 2008, from 29.5% for the three months
      ended September 30, 2007.





Operating
      income.  Operating income increased to $20.9 million for the
      three months ended September 30, 2008, from $15.7 million for the three months
      ended September 30, 2007.  As a percentage of net sales, operating
      income increased to 15.7% for the three months ended September 30, 2008, from
      10.8% for the three months ended September 30, 2007.  Operating income
      for the three months ended September 30, 2008, includes $3.2 million of
      recall-related items offset somewhat by $1.4 million of terminated acquisition
      costs.  Operating income for the three months ended September 30,
      2007, includes $9.4 million of recall-related items.





Net
      interest
      expense.  Net interest expense of $1.2 million and $0.4 million
      for the three months ended September 30, 2008 and 2007, respectively, relates
      primarily to borrowings under our credit facility.  The increase in
      net interest expense is primarily due to higher average debt
      outstanding.





Income
      tax.  Income tax expense for the three months ended September
      30, 2008 and 2007, include provisions for federal, state and foreign income
      taxes at an effective rate of 34.5% and 36.5%, respectively.  However,
      the tax rate, including discrete items, for the three months ended September
      30,
      2008 and 2007, is 36.1% and 31.8%, respectively.  Discrete items
      include significant, infrequent, unusual or non-recurring items.





Nine
      Months Ended September 30, 2008, Compared to Nine Months Ended September 30,
      2007





Net
      sales.  Net sales for the nine months ended September 30, 2008,
      decreased $35.1 million, or 10.0%, to $315.3 million from $350.4 million for
      the
      nine months ended September 30, 2007.  Net sales in our North America
      segment decreased 15.3%, and net sales in our international segment increased
      10.0%, which includes a 2.9% benefit in changes from currency exchange
      rates.





23


Net
      sales
      for the nine months ended September 30, 2008, excluding $1.6 million in net
      sales of discontinued product lines and $0.3 of recall-related items, were
      $313.4 million, a decrease of 7.4% when compared with net sales for the nine
      months ended September 30, 2007, excluding $15.9 million in net sales of
      discontinued product lines and $4.1 million of recall-related items, of $338.6
      million.  The information in this paragraph constitutes non-GAAP
      financial information.  Internally, the Company uses this non-GAAP
      financial information for the following purposes: financial and operational
      decision making, evaluating period-to-period results and making comparisons
      of
      the Company’s results with those of its competitors.  Management
      believes that the presentation of these non-GAAP financial measures provides
      useful information to investors because this information may allow investors
      to
      better evaluate ongoing business performance and certain components of the
      Company’s operating results. Because the sales related to discontinued product
      lines and recall-related items have both decreased significantly, the
      Company believes that the presentation of this non-GAAP financial information
      enhances an investor’s ability to make period-to-period comparisons of the
      Company’s operating results.  This information should be considered in
      addition to the results presented in accordance with GAAP, and should not be
      considered a substitute for the GAAP results. A reconciliation to the nearest
      GAAP financial measure follows:





(in
                millions)
            
            Net
                Sales2008
                actual
            
            $
            315.3Deduct:
                recall-related items
            
            
            0.3Deduct:
                discontinued product lines
            
            
            1.6As
                adjusted
            
            $
            313.42007
                actual
            
            $
            350.4Add:
                recall-related items
            
            
            4.1Deduct:
                discontinued product lines
            
            
            15.9As
                adjusted
            
            $
            338.6





Net
      sales
      decreases occurred in both our mother, infant and toddler products category
      and
      our preschool, youth and adult products category.  Net sales in our
      mother, infant and toddler products category decreased 5.7% primarily driven
      by
      declines in our The First Years care, toddler feeding and toddler and
      infant toy product lines offset slightly by sales increases in our The
      First Years travel gear and infant feeding product lines.  Net sales
      in our preschool, youth and adult products category decreased 12.9% primarily
      driven by declines in our Nickelodeon, Bob the
      Builder, radio-control and Thomas & Friends product
      lines, as well as lower sales of discontinued products, slightly offset by
      shipments in our John Deere product line and our new Caring CornersTM product
      line.





Excluding
      net sales related to discontinued product lines and recall-related items, net
      sales in our preschool, youth and adult products category decreased
      8.7%.  Information in this paragraph regarding net sales in our
      preschool, youth and adult products category excluding net sales related to
      discontinued product lines and recall-related items constitutes non-GAAP
      financial information.  Internally, the Company uses this non-GAAP
      financial information for the following purposes: financial and operational
      decision making, evaluating period-to-period results and making comparisons
      of
      the Company’s results with those of its competitors.  Management
      believes that the presentation of these non-GAAP financial measures provides
      useful information to investors because this information may allow investors
      to
      better evaluate ongoing business performance and certain components of the
      Company’s operating results.  Because the sales related to
      discontinued product lines and recall-related items have both decreased
      significantly, the Company believes that the presentation of this non-GAAP
      financial information enhances an investor’s ability to make period-to-period
      comparisons of the Company’s operating results.  This information
      should be considered in addition to the results presented in accordance with
      GAAP, and should not be considered a substitute for the GAAP
      results.  A reconciliation to the nearest GAAP financial measure
      follows:




24





Net
                Sales(in
                millions)
            
            2008
            
            
            2007
            
            
            Difference
            
            
            %
                ChangePreschool,
                youth and adult products actual
            
            $
            180.6
            
            
            $
            207.4
            
            
            $
            (26.8
            )
            
            
            (12.9
            )%(Deduct)
                Add:  recall-related items
            
            
            (0.3
            )
            
            
            4.1
            
            
            
            (4.4
            )
            
            
            ---Deduct:
                discontinued product lines
            
            
            1.6
            
            
            
            15.8
            
            
            
            (14.2
            )
            
            
            ---As
                adjusted
            
            $
            178.7
            
            
            $
            195.7
            
            
            $
            (17.0
            )
            
            
            (8.7
            )%





Gross
      profit.  Gross profit decreased $7.0 million, or 4.6%, to
      $145.1 million for the nine months ended September 30, 2008, from $152.1 million
      for the nine months ended September 30, 2007.  However, as a
      percentage of net sales, gross profit increased to 46.0% for the nine months
      ended September 30, 2008, from 43.4% for the nine months ended September 30,
      2007.  Aside from the favorable impact of lower recall-related items,
      this increase was primarily due to improved product mix, cost savings
      initiatives and current year price increases which offset higher
      product and transportation costs.  There were no major changes in the
      components of cost of sales.





Selling,
      general
      and administrative expenses.  Selling, general and
      administrative expenses decreased $0.8 million, or 0.7%, to $112.4 million
      for
      the nine months ended September 30, 2008, from $113.2 million for the nine
      months ended September 30, 2007.  The decrease in selling, general and
      administrative expenses for the nine months ended September 30, 2008, was
      primarily due to lower variable sales costs.  As a percentage of net
      sales, selling, general and administrative expenses increased to 35.6% for
      the
      nine months ended September 30, 2008, from 32.3% for the nine months ended
      September 30, 2007.





Operating
      income.  Operating income decreased to $15.5 million for the
      nine months ended September 30, 2008, from $30.8 million for the nine months
      ended September 30, 2007.  As a percentage of net sales, operating
      income decreased to 4.9% for the nine months ended September 30, 2008, from
      8.8%
      for the nine months ended September 30, 2007.  Operating income for
      the nine months ended September 30, 2008, includes recall-related items of
      $13.9
      million and terminated acquisition costs of $1.4 million.  Operating
      income for the nine months ended September 30, 2007, includes recall-related
      items of $15.7 million.





Net
      interest
      expense.  Net interest expense of $3.1 million and $0.5 million
      for the nine months ended September 30, 2008 and 2007, respectively, relates
      primarily to borrowings under our credit facility.  The increase in
      net interest expense is primarily due to higher average debt
      outstanding.





Income
      tax.  Income tax expense for the nine months ended September
      30, 2008 and 2007, includes provisions for federal, state and foreign income
      taxes at an effective rate of 34.5% and 36.5%, respectively.  However,
      the tax rate, including discrete items, for the nine months ended September
      30,
      2008 and 2007, is 34.2% and 32.3%, respectively.  Discrete items
      include significant, infrequent, unusual or non-recurring
      items.  During the nine months ended September 30, 2008, the Company
      recorded adjustments relating to the completion of 2007 statutory audits of
      certain foreign jurisdictions.





Related
      Party Transactions





The
      Company purchased some of its finished goods during the three months and nine
      months ended September 30, 2008 and 2007, from one company in which a relative
      of a Company stockholder and former director of the Company has an ownership
      interest.  Additionally, during the three months and nine months ended
      September 30, 2007, the Company purchased some of its finished goods from
      another company in which relatives of a Company stockholder and former director
      of the Company have ownership interests.




25





LIQUIDITY
      AND CAPITAL RESOURCES





The
      Company’s operations used net cash of $6.4 million for the nine months ended
      September 30, 2008, and provided net cash of $38.0 million for the nine months
      ended September 30, 2007.  Inventory increased $18.5 million during
      the nine months ended September 30, 2008, primarily due to the seasonality
      of
      the Company’s business.  Accounts payable and accrued expenses
      decreased $19.9 million during the nine months ended September 30, 2008,
      primarily due to settlements of recall-related accruals in
      2008.  These increases were partially offset by a decrease in accounts
      receivable of $7.3 million during the nine months ended September 30, 2008,
      primarily due to lower sales volume, as well as the seasonality of the Company’s
      business.





Net
      cash
      used in investing activities was $6.8 million and $14.7 million for the nine
      months ended September 30, 2008 and 2007, respectively. The decrease in
      investing activities was primarily due to lower capital expenditures, as well
      as
      the 2007 purchase of the Compass Business.  Capital expenditures for
      the nine months ended September 30, 2008, were $6.7 million, of which $4.6
      million was for molds and tooling.





Net
      cash
      provided by financing activities was $19.2 million for the nine months ended
      September 30, 2008, and net cash used was $7.4 million for the nine months
      ended
      September 30, 2007.  The increase in cash provided by financing
      activities is primarily due to lower common stock repurchases somewhat offset
      by
      lower net borrowings under the Company's revolving line of credit. 
Borrowings on the Company’s revolving line of credit were $43.1 million during
      the nine months ended September 30, 2008.  During the nine months
      ended September 30, 2008, the Company purchased $24.7 million of its common
      stock, which was funded primarily with cash flows from operations.





Cash
      and
      cash equivalents increased $4.1 million during the nine months ended September
      30, 2008.





In
      2004,
      the Company entered into a credit facility, as amended, comprised of an $85.0
      million term loan and a $100.0 million revolving line of credit.  The
      credit facility also provided for an additional $75.0 million of capacity under
      the revolving line of credit, which was approved by the lenders upon the
      Company’s request in October 2007.  During the first quarter of 2007,
      the term loan was repaid and was no longer available for
      borrowing.  The revolving line of credit was to be available until its
      maturity on September 14, 2008.  However, on September 12, 2008, the
      Company entered into an amendment which extended the maturity date of the credit
      facility to November 14, 2008, and provided that during the period after the
      original maturity date of September 14, 2008, until the extended maturity date
      of November 14, 2008, the Company may use any further proceeds of the revolving
      line of credit solely for general working capital purposes in the ordinary
      course of business.  The amendment also increased the applicable
      margin and the commitment fee on the revolving line of credit.  On
      November 3, 2008, this credit facility was replaced with a new senior credit
      facility as described below.





A
      portion
      of the term loan had an interest rate of 3.45%, plus applicable margin, through
      the first three years of the facility.  The remaining term loan and
      revolving line of credit bore interest, at the Company’s option, at a base rate
      or at a LIBOR rate plus applicable margin.  The applicable margin was
      based on the Company’s ratio of consolidated debt to consolidated EBITDA
      (earnings before interest, taxes, depreciation, amortization and non-cash
      expense related to equity awards) and varied between 2.00% and
      3.50%.  At September 30, 2008, the margin in effect was 2.00% for
      LIBOR loans.  The Company was also required to pay a commitment fee of
      0.40% to 0.50% per annum on the average daily unused portion of the revolving
      line of credit.  At September 30, 2008, the commitment fee in effect
      was 0.40% per annum.  The credit facility was secured by working
      capital assets and certain intangible assets.  On September 30, 2008,
      the Company had $138.1 million outstanding on the revolving line of
      credit.  At September 30, 2008, the Company had $36.9 million
      available on its revolving line of credit.






26


In
      conjunction with the amendment to extend the maturity date of its current credit
      facility to November 14, 2008, the Company paid a fee of $0.2
      million.  At October 14, 2008, the Company was required to pay an
      additional extension fee of $0.2 million.  These fees are being
      amortized over the extension period.





During
      the first quarter of 2007, the Company expensed $0.2 million of deferred
      financing fees in conjunction with the Company’s voluntary payment of the
      remaining balance of its term loan.  Amortization and write-offs of
      deferred financing fees are included in interest expense, net in the
      accompanying condensed consolidated statements of earnings.





On
      November 3, 2008 (the Close Date), RC2 entered into a new $145.0million senior credit
      facility to replace its previous facility.  The credit facility is
      comprised of a $75.0 million term loan and a $70.0 million revolving line of
      credit.  The total borrowing capacity available under the credit
      facility is subject to a formula based on the Company’s leverage ratio, as
      defined in the credit agreement.  The term loan and revolving line of
      credit both have a scheduled maturity date of November 1, 2011.  Under
      this credit facility, the term loan and the revolving line of credit bear
      interest, at the Company’s option, at a base rate or at LIBOR, plus applicable
      margins, which are based on the Company’s leverage ratio.  Applicable
      margins vary between 2.25% to 3.25%on LIBOR borrowings
      and 1.25% to 2.25%on base rate
      borrowings.  At the Close Date, the applicable margin in effect was
      3.00% for LIBOR borrowings and 2.00% for base rate
      borrowings.  Principal payments on the term loan commence on March 31,
      2009, at a rate of $3.8 million per calendar quarter, with the remaining
      principal of $33.8 million due on November 1, 2011.  The Company is
      also required to pay a commitment fee which varies between 0.45% to 0.50% per
      annum on the average daily unused portion of the revolving line of credit. 
At the Close Date, the commitment fee in effect was 0.50% per
      annum.





Under
      the
      terms of the credit facility, the Company is required to comply with certain
      financial and non-financial covenants.  Among other restrictions, the
      Company is restricted in its ability to pay dividends, buy back its stock,
      incur
      additional debt and make acquisitions above certain amounts.  The
      credit facility also includes a clean down provision that limits the maximum
      amount of borrowings under the revolving line of credit to $30.0 million for
      a
      period of 60 consecutive days during the first four calendar months of
      2009.  The clear down provision limits decrease to $27.5 million for a
      period of 60 consecutive days during the first four calendar months of 2010
      and $25.0 million for a period of 60 consecutive days during the first four
      calendar months of 2011.  The key financial covenants include a
      maximum leverage ratio of 2.5x and a fixed charge ratio (as defined in the
      agreement).  At the Close Date, the Company had $75.0 million
      outstanding under its new term loan and $55.0 million outstanding under its
      new revolving line of credit. The Company classified $44.4 million of its
      outstanding line of credit as short-term at September 30, 2008, based upon
      the
      payments required under the new senior credit facility.





The
      Company incurred approximately $2.3 million of financing fees in conjunction
      with the execution of the credit agreement.  These financing fees will
      be capitalized and amortized over the term of the credit agreement.





In
      February 2007, the Company’s Board of Directors authorized the adoption of a
      program to repurchase up to $75.0 million of the Company’s common
      stock.  The program was initially authorized for a period of one
      year.  In October 2007, the Board of Directors authorized a $75.0
      million increase to the stock repurchase program and extended the timing of
      this
      program through December 31, 2008.  This program may be extended
      beyond the currently authorized period or may be suspended at any
      time.  Under this program, shares may be repurchased from time to time
      in open market transactions or privately negotiated transactions at the
      Company’s discretion, subject to market conditions and other
      factors.  Shares repurchased by the Company are held as treasury
      shares.  During the nine months ended September 30, 2008, the Company
      repurchased 1.2 million shares for $24.7 million under this
      program.  Through September 30, 2008, the Company had repurchased an
      aggregate of 4.1 million shares for $112.6 million under the $150.0 million
      stock repurchase authorization.  These repurchases were funded with
      borrowings on the Company’s revolving line of credit and with cash flow from
      operations.  The new senior credit facility limits stock repurchases
      to $5.0 million per year and $15.0 million in aggregate during the life of
      the
      facility, subject to certain financial covenants.





27


The
      Company has met its working capital needs through funds generated from
      operations and available borrowings under its lines of credit.  The
      Company’s working capital requirements fluctuate during the year based on the
      seasonality related to sales.  Due to seasonal increases in demand for
      the Company’s products, working capital financing requirements are usually
      highest during the third and fourth quarters.  The Company expects
      that capital expenditures during 2008, principally for molds and tooling, will
      be approximately $11.0 million.





The
      Company believes that its cash flows from operations, cash on hand and available
      borrowings will be sufficient to meet its working capital and capital
      expenditure requirements and provide the Company with adequate liquidity to
      meet
      anticipated operating needs for 2008.  However, if the Company’s
      capital requirements vary materially from those currently planned, the Company
      may require additional debt or equity financing beyond the available borrowings
      under the new senior credit facility.  In the first quarter of 2009,
      the Company may need additional debt or equity financing to satisfy the clean
      down provision of the new senior credit facility and payments of principal
      under
      the term loan if cash flows from operations are not sufficiant to do so. 
There can be no assurance that financing, if needed, would be available on
      terms
      acceptable to the Company, if at all.





CRITICAL
      ACCOUNTING POLICIES AND ESTIMATES





The
      Company makes certain estimates and assumptions that affect the reported amounts
      of assets and liabilities and the reported amounts of revenues and
      expenses.  The accounting policies described below are those the
      Company considers critical in preparing its consolidated financial
      statements.  These policies include significant estimates made by
      management using information available at the time the estimates are
      made.  However, as described below, these estimates could change
      materially if different information or assumptions were used.





Allowance
      for
      doubtful accounts.  The allowance for doubtful accounts
      represents adjustments to customer trade accounts receivable for amounts deemed
      uncollectible.  The allowance for doubtful accounts reduces gross
      trade receivables to their estimated net realizable value.  The
      Company’s allowance is based on management’s assessment of the business
      environment, customers’ financial condition, historical trends, customer payment
      practices, receivable aging and customer disputes.  The Company has
      purchased credit insurance that covers a portion of its receivables from major
      customers.  The Company will continue to proactively review its credit
      risks and adjust its customer terms to reflect the current
      environment.





Inventory.  Inventory,
      which consists of finished goods, has been written down for excess quantities
      and obsolescence, and is stated at the lower of cost or market.  Cost
      is determined by the first-in, first-out method and includes all costs necessary
      to bring inventory to its existing condition and location.  Market
      represents the lower of replacement cost or estimated net realizable
      value.  Inventory write-downs are recorded for damaged, obsolete,
      excess and slow-moving inventory.  The Company’s management uses
      estimates to record these write-downs based on its review of inventory by
      product category, length of time on hand and order bookings.  Changes
      in public and consumer preferences and demand for product or changes in customer
      buying patterns and inventory management, as well as discontinuance of products
      or product lines, could impact the inventory valuation.





Impairment
      of
      long-lived assets, goodwill and other intangible
      assets.  Long-lived assets have been reviewed for impairment
      based on Statement of Financial Accounting Standards (SFAS) No. 144, “Accounting
      for the Impairment or Disposal of Long-Lived Assets.”  This Statement
      requires that an impairment loss be recognized whenever the carrying value
      of an
      asset exceeds the sum of the undiscounted cash flows expected to result from
      the
      use and eventual disposition of that asset, excluding future interest costs
      the
      entity would recognize as an expense when incurred.  Goodwill and
      other intangible assets have been reviewed for impairment based on SFAS No.
      142,
“Goodwill and Other Intangible Assets.”  Under this Statement,
      goodwill and other intangible assets that have indefinite useful lives are
      not
      amortized, but rather tested at least annually for impairment.  The
      next test for impairment will be as of October 1, 2008, and will be completed
      in
      the fourth quarter of 2008.  The Company’s management reviews for
      indicators that might suggest an impairment loss could exist.  Testing
      for impairment requires estimates of expected cash flows to be generated from
      the use of the assets.  Various uncertainties, including changes in
      consumer preferences, deterioration in the political environment, continued
      adverse conditions in the capital markets or changes in general economic
      conditions, could impact the expected cash flows to be generated by an asset
      or
      group of assets.  Intangible assets that have finite useful lives are
      amortized over their useful lives.




28





Income
      taxes.  The Company records current and deferred income tax
      assets and liabilities.  Management considers all available evidence
      in evaluating the realizability of the deferred tax assets and records valuation
      allowances against its deferred tax assets as needed.  Management
      believes it is more likely than not that the Company will generate sufficient
      taxable income in the appropriate carry-forward periods to realize the benefit
      of its deferred tax assets, except for those deferred tax assets for which
      an
      allowance has been provided.





Effective
      January 1, 2007, the Company adopted FASB Interpretation No. 48, “Accounting for
      Uncertainty in Income Taxes – an interpretation of FASB Statement No.
      109.”  Management considers certain tax exposures and all available
      evidence when evaluating and estimating tax positions and tax benefits, which
      may require periodic adjustments and which may not accurately anticipate actual
      outcomes.  If the available evidence were to change in the future, an
      adjustment to the tax-related balances may be required.  Estimates for
      such tax contingencies are classified in other current liabilities and other
      non-current liabilities in the accompanying condensed consolidated balances
      sheets.





Product
      recalls.  The Company establishes a reserve for product recalls
      on a product-specific basis during the period in which the circumstances giving
      rise to the recall become known and estimatable.  Facts underlying the
      recall, including, among others, estimates of retailer inventory returns,
      consumer replacement costs, shipping costs and fines and penalties are
      considered when establishing a product recall reserve.  The Company
      also considered additional replacement costs or refunds, donations, notice
      charges, claims administration and legal fees related to the settlement of
      the
      class action lawsuits.  When facts or circumstances become known that
      would indicate that the recall reserve is either not sufficient to cover or
      exceeds the estimated product recall expenses, the reserve is adjusted, as
      appropriate.





Accrued
      allowances.  The Company ordinarily accepts returns only for
      defective merchandise.  In certain instances, where retailers are
      unable to resell the quantity of products that they have purchased from the
      Company, the Company may, in accordance with industry practice, assist retailers
      in selling excess inventory by offering credits and other price concessions,
      which are typically evaluated and issued annually.  Other allowances
      can also be issued for defective merchandise, volume programs and co-op
      advertising.  All allowances are accrued throughout the year, as sales
      are recorded.  The allowances are based on the terms of the various
      programs in effect; however, management also takes into consideration historical
      trends and specific customer and product information when making its
      estimates.  For the volume programs, the Company generally sets a
      volume target for the year with each participating customer and issues the
      discount if the target is achieved.  The allowance for the volume
      program is accrued throughout the year, and if it becomes clear to management
      that the target for the participating customer will not be reached, the Company
      will change the estimate for that customer as required.





Accrued
      royalties.  Royalties are accrued based on the provisions in
      licensing agreements for amounts due on net sales during the period, as well
      as
      management estimates for additional royalty exposures.  Royalties vary
      by product category and are generally paid on a quarterly
      basis.  Multiple royalties may be paid to various licensors on a
      single product.  Royalty expense is included in selling, general and
      administrative expenses in the accompanying condensed consolidated statements
      of
      earnings.





Stock-based
      compensation.  Effective January 1, 2006, the Company adopted
      SFAS No. 123R, “Share-Based Payment.”  The Company elected to use the
      modified prospective application of SFAS No. 123R for awards issued prior to
      January 1, 2006.  Income from continuing operations before income
      taxes for the three months and nine months ended September 30, 2008 and 2007,
      includes total expense recognized for all of the Company’s stock-based payment
      plans.




29





The
      fair
      value of stock options granted under the stock incentive plans is estimated
      on
      the date of grant based on the Black-Scholes option pricing
      model.  The Company calculates the expected volatility factor using
      Company-specific volatility as the Company believes that its actual volatility
      is a good indicator of expected future results.  The Company uses
      historical data to estimate stock option exercise and employee departure
      behavior in the Black-Scholes option pricing model.  The expected term
      of stock options granted represents the period of time that stock options
      granted are expected to be outstanding.  The risk-free rate for the
      period within the contractual term of the stock option is based on the U.S.
      Treasury yield curve in effect at the time of grant.





The
      fair
      value of restricted stock awards granted under the stock incentive plan is
      calculated either using the market price on the grant date or the market price
      on the last day of the reported period.





Recently
      Issued Accounting Pronouncements





In
      December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business
      Combinations.”  This Statement will replace SFAS No. 141, “Business
      Combinations.”  This Statement establishes principles and requirements
      for how the acquirer recognizes and measures in its financial statements the
      identifiable assets acquired, the liabilities assumed and any non-controlling
      interest in the acquiree; recognizes and measures the goodwill acquired in
      the
      business combination or a gain from a bargain purchase; and determines what
      information to disclose to enable users of the financial statements to evaluate
      the nature and financial effects of the business combination.  This
      Statement applies prospectively to business combinations for which the
      acquisition date is on or after the beginning of the first annual reporting
      period beginning on or after December 15, 2008.  The Company plans to
      adopt this Statement on January 1, 2009.





In
      September 2006, the FASB issued SFAS No. 157, “Fair Value
      Measurements.”  This Statement defines fair value, establishes a
      framework for measuring fair value in generally accepted accounting principles
      and expands disclosures about fair value measurements.  This Statement
      applies under other accounting pronouncements that require or permit fair value
      measurement.  However, this Statement does not require any new fair
      value measurements.  This Statement is effective for the financial
      statements issued for fiscal years beginning after November 15, 2007, and
      interim periods within those fiscal years.  In February 2008, the FASB
      issued FASB Staff Position No. FAS 157-2, “Effective Date of FASB Statement No.
      157,” which provides a one year deferral of the effective date of SFAS No. 157
      for non-financial assets and non-financial liabilities, except those that are
      recognized or disclosed in the financial statements at fair value at least
      annually.  In accordance with FSP FAS No. 157-2, the Company has only
      adopted the provisions for SFAS No. 157 with respect to its financial assets
      and
      liabilities that are measured at fair value within the financial statements
      as
      of January 1, 2008.  Based upon this one year deferral, the provisions
      of SFAS No. 157 have not been applied to non-financial assets and non-financial
      liabilities. The major categories of assets and liabilities that are measured
      at
      fair value, for which the Company has not applied the provisions of SFAS No.
      157, are goodwill and intangible assets.





30


FORWARD
      LOOKING STATEMENTS





Certain
      statements contained in this report are considered “forward-looking statements”
within the meaning of the Private Securities Litigation Reform Act of
      1995.  These statements may be identified by the use of
      forward-looking words or phrases such as “anticipate,” “believe,” “could,”
“expect,” “intend,” “may,” “planned,” “potential,” “should,” “will,” “would” or
      the negative of those terms or other words of similar meaning.  Such
      forward-looking statements are inherently subject to known and unknown risks
      and
      uncertainties.  The Company’s actual results and future developments
      could differ materially from the results or developments expressed in, or
      implied by, these forward-looking statements.  Factors that may cause
      actual results to differ materially from those contemplated by such
      forward-looking statements include, but are not limited to, the following:
      the
      risk that the charges and expenses the Company expects relating to its recalls
      may increase; the effect of the recalls on the Company’s relationship with the
      licensors and the resolution of any claims or determinations made by such
      licensors including renewal and retention of licenses; the outcome of claims
      against the Company related to the recalls and the possibility of potential
      new
      claims or litigation; risk of future write-downs of goodwill or other intangible
      assets; the effect of the reduced borrowing capacity in the Company's new
      credit facility on the Company's ability to access significant working capital,
      the risk that the Company may not have sufficient cash flows to comply with
      the
      payment terms of the new credit facility and the Company's ability to comply
      with more restrictive covenants in the new credit facility; the effect of the
      modified license terms with the Licensor, including whether the reduction in
      licensing payments and the licensing term extension on the Thomas & Friends Wooden
      Railway product line will be sufficient to offset the one-time $15.0 million
      payment to the Licensor and the reduced future profits from shortening the
      license term on the Take Along Thomas & Friends die-cast
      product line;  the Company may not be able to manufacture, source and
      ship new and continuing products on a timely basis; the Company is dependent
      upon timely shipping of product and unloading of product through West Coast
      ports as well as timely rail/truck delivery to the Company’s warehouse and/or
      customers’ warehouses; increases in the cost of raw materials used to
      manufacture the Company’s products and increases in freight costs could increase
      the Company’s cost of sales and reduce the Company’s gross margins; currency
      exchange rate fluctuations, including in the Chinese Renminbi, the Hong
      Kong dollar, the British pound sterling, the Australian dollar, the Euro or
      the Canadian dollar, could increase the Company’s expenses or reduce the U.S.
      dollar value of the Company's assets denominated in foreign currencies,
      including funds the Company needs to transfer to the U.S.; customers and
      consumers may not accept the Company’s products at prices sufficient for the
      Company to profitably recover development, manufacturing, marketing, royalty
      and
      other costs; the inventory policies of retailers, together with increased
      reliance by retailers on quick response inventory management techniques, may
      increase the risk of underproduction of popular items, overproduction of less
      popular items and failure to achieve tight shipping schedules; competition
      in
      the markets for the Company’s products may increase significantly; the Company
      is dependent upon continuing licensing arrangements with owners of popular
      and
      classic licensed properties such as Thomas & Friends, Bob
      theBuilder, Winnie
      the Pooh, John Deere,
      Nickelodeon and Sesame
      Street, vehicle manufacturers, agricultural equipment manufacturers and
      other licensors; the Company may experience unanticipated negative results
      of
      litigation; the Company relies upon a limited number of independently owned
      factories located in China to manufacture a significant portion of its products;
      the Company is dependent upon the continuing willingness of leading retailers
      to
      purchase and provide shelf space for the Company’s products; and general
      economic conditions in the Company’s markets.  Such uncertainties and
      other risks that may affect the Company’s performance are discussed further in
      Part I, Item 1A, “Risk Factors,” in the Company’s Form 10-K for the year ended
      December 31, 2007.  The Company undertakes no obligation to make any
      revisions to the forward-looking statements contained in this report or to
      update them to reflect events or circumstances occurring after the date of
      this
      report.





31




Item
      3.  Quantitative and QualitativeDisclosures
      about Market Risk





The
      Company’s exposure to market risk is limited to interest rate risk associated
      with the Company’s credit facilities and foreign currency exchange rate risk
      associated with the Company’s foreign operations.




Based
      on
      the Company’s interest rate exposure on variable rate borrowings at September
      30, 2008, a one percentage point increase in average interest rates on the
      Company’s borrowings would increase future interest expense by $0.1 million per
      month and a five percentage point increase would increase future interest
      expense by $0.6 million per month.  The Company determined these
      amounts based on $138.1 million of variable rate borrowings at September 30,
      2008, multiplied by 1.0% and 5.0%, respectively, and divided by
      twelve.  The Company is currently not using any interest rate collars,
      hedges or other derivative financial instruments to manage or reduce interest
      rate risk.  As a result, any increase in interest rates on the
      Company’s variable rate borrowings would increase interest expense and reduce
      net income.





The
      Company’s net sales are primarily denominated in U.S. dollars, with 24.2% of net
      sales for the nine months ended September 30, 2008, denominated in British
      pounds sterling, Australian dollars, Euros and Canadian dollars.  The
      Company’s purchases of finished goods from Chinese manufacturers are primarily
      denominated in Hong Kong dollars.  Expenses for these manufacturers
      are primarily denominated in Chinese Renminbi.  The Hong Kong dollar
      is currently pegged to the U.S. dollar.  If the Hong Kong dollar
      ceased to be pegged to the U.S. dollar, a material increase in the value of
      the
      Hong Kong dollar relative to the U.S. dollar would increase our expenses, and
      therefore, could adversely affect our profitability.  A 10.0% change
      in the exchange rate of the U.S. dollar with respect to the Hong Kong dollar
      and
      the British pound sterling for the nine months ended September 30, 2008, would
      have changed the total dollar amount of our gross profit by 10.9% and 1.1%,
      respectively.  As expenses for the Company’s Chinese manufacturers are
      primarily denominated in Chinese Renminbi, a material increase in the value
      of
      the Chinese Renminbi relative to the U.S. dollar would increase the Company’s
      expenses, and therefore, could adversely affect the Company’s
      profitability.  A 10.0% change in the exchange rate of the U.S. dollar
      with respect to the translation of financial reporting denominated in the
      British pound sterling, the Australian dollar or the Euro for the nine months
      ended September 30, 2008, individually would not have had a significant impact
      on the Company’s earnings.  The Company is also subject to exchange
      rate risk relating to transfers of funds or other transactions denominated
      in British pounds sterling, Australian dollars, Canadian dollars or Euros from
      its foreign subsidiaries to the United States.  The Company is not and
      has not historically used hedges or other derivative financial instruments
      to
      manage or reduce exchange rate risk.





Item
      4.  Controls and Procedures





The
      Company maintains disclosure controls and procedures (as defined in Rules
      13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) designed
      to
      ensure that information required to be disclosed by the Company in the reports
      that it files or submits under the Securities Exchange Act of 1934 is recorded,
      processed, summarized and reported within the time periods specified in the
      SEC’s rules and forms, and that the information required to be disclosed by the
      Company in reports that it files or submits under the Securities Exchange Act
      of
      1934 is accumulated and communicated to its management, including its Chief
      Executive Officer (who currently functions as both the Principal Executive
      Officer and the Principal Financial Officer of the Company), as appropriate
      to
      allow timely decisions regarding required disclosure.  The Company
      carried out an evaluation as of September 30, 2008, under the supervision and
      with the participation of the Company’s management, including its Chief
      Executive Officer, of the effectiveness of the design and operation of the
      Company’s disclosure controls and procedures.  Based on such
      evaluation, the Company’s Chief Executive Officer concluded that the Company’s
      disclosure controls and procedures were effective as of September 30, 2008
      at
      reaching a level of reasonable assurance.  In designing and evaluating
      the disclosure controls and procedures, management recognized that any controls
      and procedures, no matter how well designed and operated, can provide only
      reasonable assurance of achieving the desired control objectives, and management
      necessarily was required to apply its judgment in evaluating the cost-benefit
      relationship of possible controls and procedures.  The Company has
      designed its disclosure controls and procedures to reach a level of reasonable
      assurance of achieving the desired control objectives.





There
      was
      no change in the Company’s internal control over financial reporting (as defined
      in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934,
      as
      amended) during the Company’s most recently completed fiscal quarter that has
      materially affected, or is reasonably likely to materially affect, the Company’s
      internal control over financial reporting.





32


PART
      II.  OTHER INFORMATION





Item
      1.  Legal Proceedings





On
      June
      13, 2007, the Company announced the voluntary recall of 26 individual wooden
      railway vehicles and set components from the Thomas & Friends Wooden
      Railway product line, after an internal investigation linked apparent excess
      levels of lead with a limited number of paint colors used at a single contract
      manufacturing facility which purchased paint from independent
      suppliers.  On September 26, 2007, the Company announced the voluntary
      recall of five Thomas &
Friends Wooden Railway items,
      in addition to those items recalled in June
      2007.





Following
      the announcement of the June 2007 recall, a total of 23 putative class action
      lawsuits were filed against the Company in various federal and state courts
      with
      respect to the products subject to the June 2007 and September 2007
      recalls.  These lawsuits make various claims and seek (i) medical
      monitoring as a result of alleged exposure to lead in the products subject
      to
      the recalls, (ii) disgorgement of certain profits under common law unjust
      enrichment theories, and/or (iii) various remedies under claims of product
      liability, breach of warranty, negligence, unfair and deceptive trade practices
      under state law and violation of the federal Consumer Product Safety
      Act.  On December 19, 2007, the various federal class action lawsuits
      were consolidated in the U.S. District Court for the Northern District of
      Illinois.





On
      January 22, 2008, the Company announced that it had reached a settlement in
      Barrett v. RC2
      Corporation filed in the Circuit Court of Cook County, Illinois, with the
      plaintiffs in the various class action lawsuits against the Company in state
      courts which arise from or relate to the Company’s recall of certain Thomas & Friends Wooden
      Railway products.  The Circuit Court of Cook County, Illinois, granted
      preliminary approval of the terms of the proposed settlement.  The
      class in the Barrett
      case is basically defined as all persons in the United States who do not opt
      out
      of the class and who purchased or owned other than for resale the Company’s
Thomas & Friends
      Wooden Railway products which were recalled in June 2007 and September
      2007.  The settlement agreement provides class members with several
      relief options, including cash refunds, replacement products and
      coupons.  Under the settlement agreement, the Company also agreed to
      pay attorney’s fees and costs to plaintiff’s counsel totaling $2.9 million,
      subject to court approval.  The settlement agreement also provides
      that the Company will take certain quality control measures.





After
      the
      settlement agreement in the Barrett case was announced,
      plaintiff’s counsel in the pending federal court class actions attempted to stop
      the Company from proceeding with the settlement in Barrett, and on January 28,
      2008, filed a motion for a preliminary injunction in the U.S. District Court
      for
      the Northern District of Illinois seeking to enjoin the Company from proceeding
      with the settlement in the Barrett case.  On
      February 20, 2008, the U.S. District Court for the Northern District of Illinois
      denied the motion for a preliminary injunction filed by plaintiffs in the
      federal cases and granted the Company’s motion to stay the federal court actions
      pending the state court’s final decision in the Barrett case of whether
      to
      approve the proposed settlement in that case.  Certain plaintiffs in
      the federal court action also filed a motion to intervene in the state court
      proceeding, but, on February 25, 2008, they withdrew this motion.  The
      state court had stayed the issuance of notice of the proposed settlement to
      the
      class in Barrett
      pending a decision on the federal plaintiffs’ motion to intervene.





33


After
      the
      federal court plaintiffs’ motion for a preliminary injunction to stop the Barrett settlement was
      denied, the Company then entered into further settlement negotiations with
      the
      plaintiffs in the 18 class actions filed in federal court and the plaintiffs
      in
      the 5 class actions filed in state courts to reach a global settlement in the
      Barrett
      case.  The Company, plaintiffs in the 5 state court class actions and
      plaintiffs in the 18 federal court class actions entered into an amended
      settlement agreement in the Barrett case which included
      the plaintiffs in all 23 class actions filed against the Company.  The
      amended settlement agreement incorporated the relief provided to the class
      in
      the original settlement agreement.  In addition, the Company agreed to
      (i) pay an additional $0.1 million in attorney’s fees (for a total of $3.0
      million) to plaintiff’s counsel, (ii) provide the class with additional relief
      in the form of limited reimbursement for blood testing for lead during specified
      limited time periods with caps on the amount of individual claims and a total
      cap of $0.5 million on all claims, and (iii) specify and further define actions
      it would take to increase quality control measures it had agreed to in the
      initial settlement agreement.  The Company paid the attorney’s fees of
      $3.0 million during the third quarter of 2008.





The
      amended settlement agreement was preliminarily approved by the Circuit Court
      of
      Cook County, on May 5, 2008.  Notice was then issued to the
      class.  The amended settlement agreement received final approval from
      the Circuit Court of Cook County on August 6, 2008.  Less than 50
      persons opted out of the class.  The amended settlement agreement
      resolves all claims of the class, other than for individual claims for personal
      injuries or for persons opting out of the class, with respect to the June 2007
      and September 2007 recalls of certain Thomas &Friends
      Wooden Railway
      toys.  The claim period ran until October 6, 2008.





With
      the
      final approval of the settlement agreement and the end of the claim period,
      the
      class action lawsuits relating to the June 2007 and September 2007 recalls
      have
      been resolved.  The Company may be subject to individual claims for
      personal injuries or other claims or government inquiries (including the inquiry
      by the Consumer Product Safety Commission (CPSC) described in the next
      paragraph) relating to the 2007 recalls.  No assurances can be given
      as to the outcome of any such claims or government inquiries.





During
      the second quarter of 2008, the Company received an inquiry from the CPSC for
      information regarding the recalls of certain Thomas & Friends Wooden
      Railway toys in June 2007 and September 2007 for the purpose of assessing
      whether the CPSC may impose a fine on the Company.  The Company is in
      the process of responding to this inquiry, and at this time, the CPSC has not
      yet imposed a fine upon the Company.





The
      Company also has certain contingent liabilities resulting from litigation and
      claims incident to the ordinary course of business.  Management
      believes that the probable resolution of such contingencies will not materially
      affect the Company’s financial position or results of operations.





Item
      1A.  Risk Factors





Except
      as
      provided below, there have been no material changes from the risk factors
      previously disclosed in Part I, Item 1A, “Risk Factors,” of our Form 10-K for
      the year ended December 31, 2007.  The information presented below
      updates and should be read in conjunction with the risk factors and
      information described in that Form 10-K.




Our
        new credit agreement contains more restrictive debt covenants and payment
        terms
        and reduces our borrowing capacity, all of which may adversely affect our
        business, reduce our profitability and increase the risk of a default under
        the
        credit agreement.
  On
        November 3, 2008, the Company entered into a new $145.0 million senior credit
        facility to replace its previous facility.  The credit agreement for
        the new credit facility includes more restrictive debt covenants than the
        previous credit agreement, including more restrictive financial covenants
        and
        limits on the Company's ability to repurchase shares of its common
        stock.  The new credit agreement also increases the applicable margins
        for the interest rates on outstanding borrowings under the new credit facility,
        which may increase the Company's interest expense and reduce its
        profitability.
 
 The
        new
        credit agreement contains a clean down provision that limits the maximum
        amount
        of borrowings under the revolving line of credit for a period of 60 consecutive
        days in the first four calendar months of each of 2009, 2010 and
        2011.  The limit under the clean down provision for the first four
        calendar months of 2009 will be $30.0 million.  The Company had $55.0
        million outstanding under its revolving line of credit as of November 3,
        2008.  The Company will also need to begin making payments of
        principal at a rate of $3.8 million per quarter on the term loan beginning
        on
        March 31, 2009.  If the Company does not have sufficient cash
        flows from operations to reduce the outstanding borrowings under the revolving
        line of credit to comply with the clean down provision and to make payments
        of
        principal under the term loan, the Company may need to seek additional debt
        or
        equity financing to avoid a default under the credit agreement.  Such
        financing, if needed, may not be available on terms acceptable to the Company,
        if at all, or may dilute or otherwise adversely affect the interests of the
        Company's stockholders.
 
 The
        effect of the clean down provision, together with the reduction of borrowing
        capacity from $175.0 million under the previous credit facility to $145.0
        million under the new credit facility, may reduce the Company's access to
        working capital, which may adversely affect the Company's business and its
        profitability.


34




Item
      2.   Unregistered Salesof Equity
      Securities and Use of Proceeds





(a)
            Not
                applicable.





(b)
            Not
                applicable.





(c)
            Not
                applicable


Item
      3.   Defaults UponSenior Securities





Not
      applicable.





Item
      4.   Submission ofMatters to a Vote of
      Security Holders





Not
      applicable.





Item
      5.   Other Information





Disclosure
      is included in this Form
      10-Q with respect to the following items of Form 8-K for events that occurred
      on
      November 3, 2008:





Item
      1.01.  Entry into a Material Definitive Agreement – On November 3,
      2008, RC2 entered into a new $145 million senior credit facility to replace
      its
      previous credit facility.  The credit facility is set forth in a Credit
      Agreement, dated as of November 3, 2008 (the "Credit Agreement'), among the
      Company, certain of its subsidiaries, Bank of Montreal, as administrative
      agent, BMO Capital Markets as sole lead arranger and sole book runner, and
      other
      lenders named therein. See
      “Item 2.  Management’s Discussion and Analysis of Financial Condition
      and Results of Operations – Liquidity and Capital Resources” for a summary of
      the material terms and conditions of the new credit facility.  The
      description of the new credit facility in this report does not purport to be
      complete and is qualified in its entirety by the terms and conditions of the
      Credit Agreement, a copy of which is attached hereto as Exhibit 10.2 and is
      incorporated herein by reference.





Item
      1.02.  Termination of a Material Definitive Agreement – RC2’s new
      credit facility replaced its prior credit facility represented by the Amended
      and Restated Agreement, dated as of September 15, 2004, as amended, among RC2,
      certain of its subsidiaries, Harris N.A., as lender and agent, and the other
      lends named therein.  See “Item 2. Management’s Discussion and
      Analysis of Financial Condition and Results of Operations – Liquidity and
      Capital Resources” for a summary of the material terms and conditions of the
      prior credit facility.





Item
      2.03.  Creation of a Direct Financial Obligation or an Obligation
      under an Off-Balance Sheet Arrangement of a Registrant – On November 3, 2008, in
      connection with its new credit facility, RC2 has $75.0 million outstanding
      under
      its new term loan and $55.0 million outstanding under its new revolving line
      of
      credit.  See “Item 2.  Management’s Discussion and Analysis
      of Financial Condition and Results of Operations – Liquidity and Capital
      Resources” for a summary of the material terms and conditions of the new credit
      facility.





Item
      6.   Exhibits





2.1
            Asset
                Purchase Agreement dated as of June 20, 2008, among Learning Curve
                Brands,
                Inc., RC2 Australia Pty. Ltd., Racing Champions International Limited,
                Learning Curve Mexico S. de R.L. de C.V., RC2 Limited, RC2 (Asia)
                Limited,
                Publications International, Ltd., PIL, L.L.C., JRS Distribution Co.,
                Publications International Limited Partnership, Publications
                International, Ltd. L.P. and Publications International, Ltd. S de
                R.L. de
                C.V. (incorporated by reference to Exhibit 2.1 of the Company’s Current
                Report on Form 8-K (File No. 0-22635) filed by the Company with the
                Securities and Exchange Commission on June 26, 2008).2.2
            Termination
                Agreement dated as of September 29, 2008, among Learning Curve Brands,
                Inc., RC2 Australia Pty. Ltd., Racing Champions International Limited,
                Learning Curve Mexico S. de R.L. de C.V., RC2 Limited, RC2 (Asia)
                Limited,
                Publications International, Ltd., PIL, L.L.C., JRS Distribution Co.,
                Publications International Limited Partnership, Publications
                International, Ltd., L.P. and Publications International, Ltd. S.
                de R.L.
                de C.V. (incorporated by reference to Exhibit 2.1 of the Company’s Current
                Report on Form 8-K (File No. 0-22635) filed by the Company with the
                Securities and Exchange Commission on October 1, 2008).





35


3.1
              Amended
                  and Restated Certificate of Incorporation of the Company (incorporated
                  by
                  reference to Exhibit 3.1 of the Company’s Quarterly Report on Form 10-Q
                  for the quarter ended March 31, 2002 (File No. 0-22635) filed by
                  the
                  Company with the Securities and Exchange Commission on May 14,
                  2002).3.2
              First
                  Amendment to the Amended and Restated Certificate of Incorporation
                  of the
                  Company (incorporated by reference to Exhibit 3.2 of the Company’s
                  Quarterly Report on Form 10-Q for the quarter ended March 31, 2002
                  (File
                  No. 0-22635) filed by the Company with the Securities and Exchange
                  Commission on May 14, 2002).3.3
              Certificate
                  of Ownership and Merger changing the Company’s name to Racing Champions
                  Ertl Corporation (incorporated by reference to Exhibit 3.3 of the
                  Company’s Quarterly Report on Form 10-Q for the quarter ended March 31,
                  2002 (File No. 0-22635) filed by the Company with the Securities
                  and
                  Exchange Commission on May 14, 2002).3.4
              Certificate
                  of Ownership and Merger changing the Company’s name to RC2 Corporation
                  (incorporated by reference to Exhibit 3.4 of the Company’s Quarterly
                  Report on Form 10-Q for the quarter ended March 31, 2003 (File
                  No.
                  0-22635) filed by the Company with the Securities and Exchange
                  Commission
                  on May 14, 2003).3.5
              Amended
                  and Restated By-Laws of the Company (incorporated by reference
                  to Exhibit
                  3.5 of the Company’s Quarterly Report on Form 10-Q for the quarter ended
                  March 31, 2004 (File No. 0-22635) filed by the Company with the
                  Securities
                  and Exchange Commission on May 10, 2004).10.1
              Tenth
                  Amendment to Amended and Restated Credit Agreement, dated as of
                  September
                  12, 2008, among the Company, certain of its subsidiaries, Harris
                  N.A., as
                  lender and agent, and the other lenders named therein (incorporated
                  by
                  reference to Exhibit 99.1 of the Company’s Current Report on Form 8-K
                  (File No. 0-22635) filed by the Company with the Securities and
                  Exchange
                  Commission on September 16, 2008).10.2
              Credit
                  Agreement, dated as of
                  November 3, 2008, among the Company, certain of its subsidiaries,
                  Bank of
                  Montreal, as administrative agent, BMO Capital Markets as sole
                  lead
                  arranger and sole book runner, and other lenders named
                  therein.31.1
              Certification
                  pursuant to Section 302
                  of the Sarbanes-Oxley Act of 2002.32.1*
              Certification
                  pursuant to 18 U.S.C.
                  Section 1350 (Section 906 of the Sarbanes-Oxley Act of
                  2002).


____________________





*
      This
      certification is not “filed” for purposes of Section 18 of the Securities
      Exchange Act of 1934, as amended, or incorporated by reference into any filing
      under the Securities Act of 1933, as amended, or the Securities Exchange Act
      of
      1934, as amended.




36


SIGNATURES





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





Dated
      this 4th day of November,
      2008.





RC2
                CORPORATIONBy
                /s/ Curtis
                W.
                StoeltingCurtis
                W. Stoelting, Chief Executive Officer
              (Principal
                Executive Officer and Principal Financial
              Officer)







37