SECURITIES
      AND EXCHANGE COMMISSION


WASHINGTON,
      DC 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, 2007ORo
            TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
                OF 1934For
                the transition period from _______ to _________


Commission
      file
      number:  0-22635





RC2
                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 sections 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.




X


Indicate
      by check mark whether the Registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer.  See definition of
“accelerated filer and large accelerated filer” in Exchange Act Rule
      12b-2.




X




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




X


On
      October 24, 2007, there were outstanding 18,954,649 shares of the Registrant's
      $0.01 par value common stock.











RC2
      CORPORATION





FORM
      10-Q





SEPTEMBER
      30, 2007





INDEX





PART
      I -
      FINANCIAL INFORMATION




PageItem
                1.
            Condensed
                Consolidated Balance Sheets as of
                September 30, 2007
              and
                December 31, 2006
            3Condensed
                Consolidated Statements of Earnings
                for the Three
              Months
                and Nine Months Ended September 30,
                2007 and 2006
            4Condensed
                Consolidated Statements of Cash
                Flows for the
              Nine
                Months Ended September 30, 2007 and
                2006
            5Notes
                to Condensed Consolidated Financial
                Statements
            6Item
                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
            32






PART
      II -
      OTHER INFORMATION







Item
                1.
            Legal
                Proceedings
            33Item
                1A.
            Risk
                Factors
            33Item
                2.
            Unregistered
                Sales of Equity Securities and Use
                of Proceeds
            35Item
                3.
            Defaults
                Upon Senior Securities
            36Item
                4.
            Submission
                of Matters to a Vote of Security
                Holders
            36Item
                5.
            Other
                Information
            36Item
                6.
            Exhibits
            36Signatures
            38






2




PART
      I.   FINANCIAL INFORMATION







**Item
      1.   Financial Statements**





**RC2
      Corporation and Subsidiaries**


**Condensed
      Consolidated Balance Sheets**


**(Unaudited
      and in thousands)**





**September
                30, 2007**
            
            
            **December
                31, 2006****Assets**Cash
                and cash equivalents
            
            $
            43,182
            
            
            $
            25,365Accounts
                receivable, net
            
            
            121,685
            
            
            
            112,937Inventory
            
            
            78,978
            
            
            
            83,650Other
                current assets
            
            
            15,037
            
            
            
            15,016Total
                current assets
            
            
            258,882
            
            
            
            236,968Property
                and equipment, net
            
            
            37,416
            
            
            
            38,991Goodwill
            
            
            244,876
            
            
            
            239,067Intangible
                assets, net
            
            
            95,994
            
            
            
            96,400Other
                non-current assets
            
            
            3,169
            
            
            
            3,214Total
                assets
            
            $
            640,337
            
            
            $
            614,640**Liabilities
                and stockholders’ equity**Accounts
                payable and accrued expenses
            
            $
            86,672
            
            
            $
            84,159Line
                of credit
            
            
            80,000
            
            
            
            ---Current
                maturities of bank term loans
            
            
            ---
            
            
            
            22,438Other
                current liabilities
            
            
            2,946
            
            
            
            768Total
                current liabilities
            
            
            169,618
            
            
            
            107,365Other
                non-current liabilities
            
            
            54,242
            
            
            
            55,349Total
                liabilities
            
            
            223,860
            
            
            
            162,714Stockholders’
                equity
            
            
            416,477
            
            
            
            451,926Total
                liabilities and stockholders' equity
            
            $
            640,337
            
            
            $
            614,640





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,****2007**
            
            
            **2006**
            
            
            **2007**
            
            
            **2006**Net
                sales
            
            $
            145,681
            
            
            $
            156,021
            
            
            $
            350,426
            
            
            $
            364,279Cost
                of sales
            
            
            81,798
            
            
            
            82,574
            
            
            
            198,338
            
            
            
            193,115Gross
                profit
            
            
            63,883
            
            
            
            73,447
            
            
            
            152,088
            
            
            
            171,164Selling,
                general and administrative expenses
            
            
            47,950
            
            
            
            42,425
            
            
            
            120,673
            
            
            
            113,187Amortization
                of intangible assets
            
            
            208
            
            
            
            315
            
            
            
            634
            
            
            
            945Operating
                income
            
            
            15,725
            
            
            
            30,707
            
            
            
            30,781
            
            
            
            57,032Interest
                expense, net
            
            
            355
            
            
            
            944
            
            
            
            507
            
            
            
            2,815Other
                (income) expense
            
            
            (411
            )
            
            
            273
            
            
            
            (987
            )
            
            
            155Income
                from continuing operations
              before
                income taxes
            
            
            15,781
            
            
            
            29,490
            
            
            
            31,261
            
            
            
            54,062Income
                tax expense
            
            
            5,012
            
            
            
            10,758
            
            
            
            10,083
            
            
            
            19,716Income
                from continuing operations
            
            
            10,769
            
            
            
            18,732
            
            
            
            21,178
            
            
            
            34,346Income
                from discontinued operations, net of tax
            
            
            ---
            
            
            
            641
            
            
            
            110
            
            
            
            1,652Net
                income
            
            $
            10,769
            
            
            $
            19,373
            
            
            $
            21,288
            
            
            $
            35,998Basic
                earnings per common share:Income
                from continuing
                operations
            
            $
            0.52
            
            
            $
            0.90
            
            
            $
            1.01
            
            
            $
            1.65Income
                from discontinued
                operations
            
            
            ---
            
            
            
            0.03
            
            
            
            0.01
            
            
            
            0.08Net
                income
            
            $
            0.52
            
            
            $
            0.93
            
            
            $
            1.02
            
            
            $
            1.73Diluted
                earnings per common share:Income
                from continuing operations
            
            $
            0.52
            
            
            $
            0.88
            
            
            $
            0.99
            
            
            $
            1.61Income
                from discontinued operations
            
            
            ---
            
            
            
            0.03
            
            
            
            0.01
            
            
            
            0.08Net
                income per share
            
            $
            0.52
            
            
            $
            0.91
            
            
            $
            1.00
            
            
            $
            1.69Weighted
                average shares outstanding:Basic
            
            
            20,523
            
            
            
            20,917
            
            
            
            20,952
            
            
            
            20,844Diluted
            
            
            20,850
            
            
            
            21,365
            
            
            
            21,336
            
            
            
            21,337




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,****2007**
            
            
            **2006****Cash
                flows from operating activities**Net
                income
            
            $
            21,288
            
            
            $
            35,998Income
                from discontinued operations
            
            
            (110
            )
            
            
            (1,652
            )Depreciation
                and amortization
            
            
            11,191
            
            
            
            11,687Amortization
                and write-off of deferred financing costs
            
            
            470
            
            
            
            376Stock-based
                compensation
            
            
            3,544
            
            
            
            3,064Excess
                tax benefit on stock option exercises
            
            
            (1,023
            )
            
            
            (1,411
            )Gain on disposition of assets
            
            
            (21
            )
            
            
            (6
            )Changes
                in operating assets and liabilities
            
            
            2,506
            
            
            
            (20,655
            )Net
                cash provided by continuing operations
            
            
            37,845
            
            
            
            27,401Net
                cash provided by discontinued operations
            
            
            110
            
            
            
            11Net
                cash provided by operating activities
            
            
            37,955
            
            
            
            27,412**Cash
                flows from investing activities**Purchase
                of property and equipment
            
            
            (8,134
            )
            
            
            (10,914
            )Proceeds
                from disposition of
                property and equipment
            
            
            13
            
            
            
            18Decrease
                (increase) in other
                non-current assets
            
            
            22
            
            
            
            (45
            )Purchase
                of the Compass Business, net of cash acquired
            
            
            (6,772
            )
            
            
            ---Proceeds
                from sale of discontinued operations
            
            
            110
            
            
            
            ---Investments
            
            
            47
            
            
            
            (1,214
            )Net
                cash used in continuing
                operations
            
            
            (14,714
            )
            
            
            (12,155
            )Net
                cash used in discontinued operations
            
            
            ---
            
            
            
            (5
            )Net
                cash used in investing activities
            
            
            (14,714
            )
            
            
            (12,160
            )**Cash
                flows from financing activities**Net
                borrowings from (payments to) bank on lines of credit
            
            
            80,000
            
            
            
            (8,270
            )Payments
                to bank on term loans
            
            
            (22,438
            )
            
            
            (15,938
            )Issuance of common stock upon option exercises
            
            
            1,975
            
            
            
            2,244Excess
                tax benefit on stock option exercises
            
            
            1,023
            
            
            
            1,411Purchase
                of treasury stock
            
            
            (68,131
            )
            
            
            ---Issuance
                of common stock for ESPP
            
            
            134
            
            
            
            156Financing
                fees paid
            
            
            ---
            
            
            
            (182
            )Net
                cash used in continuing
                operations
            
            
            (7,437
            )
            
            
            (20,579
            )Net
                cash used in discontinued operations
            
            
            ---
            
            
            
            ---Net
                cash used in financing activities
            
            
            (7,437
            )
            
            
            (20,579
            )Effect
                of exchange rate changes on cash
            
            
            2,013
            
            
            
            470Net
                increase (decrease) in cash and cash equivalents
            
            
            17,817
            
            
            
            (4,857
            )Cash
                and cash equivalents, beginning of year
            
            
            25,365
            
            
            
            25,262Cash
                and cash equivalents, end of period
            
            $
            43,182
            
            
            $
            20,405Supplemental
                information:Cash
                flows during the period for:Interest
                paid
            
            $
            492
            
            
            $
            2,931Income
                taxes
                paid
            
            $
            11,064
            
            
            $
            18,317Income tax refunds received
            
            $
            839
            
            
            $
            530


See
      accompanying notes to condensed consolidated financial statements.




5


**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, 2007, the
      results of its operations for the three-month and nine-month periods ended
      September 30, 2007 and 2006, and its cash flows for the nine-month periods
      ended
      September 30, 2007 and 2006.





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, 2006.  The condensed consolidated balance sheet
      information as of December 31, 2006 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 Combination**





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 Kings Mills, 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.  The 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 Company’s condensed consolidated financial
      statements since the effective date of the acquisition.  The excess of
      the aggregate purchase price over the fair market value of net assets acquired
      of $5.0 million has been recorded as goodwill in the accompanying condensed
      consolidated balance sheet at September 30, 2007.





6


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





(in
      thousands)





Total
                purchase price, including expenses, net of cash acquired
            
            
            
            
            $
            6,772Less:Current
                assets
            
            $
            1,398Property,
                plant and equipment
            
            
            838Liabilities
            
            
            (485
            )
            
            
            (1,751
            )Excess
                of purchase price over net assets acquired
            
            
            
            
            
            $
            5,021





The
      allocation of purchase price is subject to final adjustment based on valuations
      and other determinations that will be completed as soon as practical but no
      later than by the end of the second quarter of 2008 including performing
      valuations to finalize the fair value of any acquired identifiable intangible
      assets.  To the extent such assets are amortizable, amortization
      expense will be increased.  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.





**Note
      3 – Business Segments**





The
      Company is a leading designer, producer and marketer of innovative, high-quality
      toys, collectibles and infant products targeted to consumers of all
      ages.





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.





7


Results
      are not necessarily those that would be achieved if each segment was an
      unaffiliated business enterprise.  Information by segment and a
      reconciliation to reported amounts for the three months and nine months ended
      September 30, 2007 and 2006 are as follows:





**Three
                Months Ended September 30,**(in
                thousands)
            
            **2007**
            
            
            **2006****Net
                sales:**North
                America
            
            $
            115,208
            
            
            $
            131,741International
            
            
            30,695
            
            
            
            24,553Sales
                and transfers between segments
            
            
            (222
            )
            
            
            (273
            )Combined
                total
            
            $
            145,681
            
            
            $
            156,021**Operating
                income:**North
                America
            
            $
            11,165
            
            
            $
            25,581International
            
            
            4,789
            
            
            
            5,126Sales
                and transfers between segments
            
            
            (229
            )
            
            
            ---Combined
                total
            
            $
            15,725
            
            
            $
            30,707





(in
                thousands)
            
            **September
                30,**
              **2007**
            
            
            **December
                31,**
              **2006****Total
                assets:**North
                America
            
            $
            516,803
            
            
            $
            517,158International
            
            
            123,534
            
            
            
            97,482Combined
                total
            
            $
            640,337
            
            
            $
            614,640





**Nine
                Months Ended September 30,**(in
                thousands)
            
            **2007**
            
            
            **2006****Net
                sales:**North
                America
            
            $
            276,645
            
            
            $
            304,333International
            
            
            74,339
            
            
            
            60,518Sales
                and transfers between segments
            
            
            (558
            )
            
            
            (572
            )Combined
                total
            
            $
            350,426
            
            
            $
            364,279**Operating
                income:**North
                America
            
            $
            20,635
            
            
            $
            45,177International
            
            
            10,364
            
            
            
            11,855Sales
                and transfers between segments
            
            
            (218
            )
            
            
            ---Combined
                total
            
            $
            30,781
            
            
            $
            57,032





8


Under
      the
      enterprise-wide disclosure requirements of SFAS No. 131, the Company reports
      net
      sales by product category and by distribution channel.  During the
      fourth quarter of 2006, the Company reclassified its product categories and
      distribution channels to be more closely aligned with its strategic direction
      and organization structure.  This presentation is consistent with how
      the Company views its business.  The Company groups its products into
      three product categories: infant and toddler products, preschool products and
      youth and adult products.  The following tables present consolidated
      net sales by product category and by distribution channel for the three months
      and nine months ended September 30, 2007 and 2006:





**Three
                Months Ended September 30,**(in
                thousands)
            
            **2007**
            
            
            **2006**Infant
                and toddler products
            
            $
            47,509
            
            
            $
            44,783Preschool
                products
            
            
            60,954
            
            
            
            73,684Youth
                and adult products
            
            
            37,218
            
            
            
            37,554Net
                sales
            
            $
            145,681
            
            
            $
            156,021Chain
                retailers
            
            $
            98,643
            
            
            $
            108,267Specialty
                retailers, wholesales and OEM dealers
            
            
            42,539
            
            
            
            42,626Corporate
                promotional, direct to consumers and other
            
            
            4,499
            
            
            
            5,128Net
                sales
            
            $
            145,681
            
            
            $
            156,021





**Nine
                Months Ended September 30,**(in
                thousands)
            
            **2007**
            
            
            **2006**Infant
                and toddler products
            
            $
            142,989
            
            
            $
            131,101Preschool
                products
            
            
            132,448
            
            
            
            153,691Youth
                and adult products
            
            
            74,989
            
            
            
            79,487Net
                sales
            
            $
            350,426
            
            
            $
            364,279Chain
                retailers
            
            $
            241,135
            
            
            $
            249,416Specialty
                retailers, wholesalers and OEM dealers
            
            
            98,164
            
            
            
            103,635Corporate
                promotional, direct to consumers and other
            
            
            11,127
            
            
            
            11,228Net
                sales
            
            $
            350,426
            
            
            $
            364,279





9


**Note
      4 – Goodwill and Intangible Assets**





The
      change in carrying value of goodwill by reporting unit for the nine months
      ended
      September 30, 2007 is shown below:





(in
                thousands)
            
            **North
                America**
            
            
            **International**
            
            
            **Total**Balance
                at January 1, 2007
            
            $
            223,836
            
            
            $
            15,231
            
            
            $
            239,067Compass
                Business acquisition
            
            
            5,021
            
            
            
            ---
            
            
            
            5,021Other
                adjustments
            
            
            45
            
            
            
            743
            
            
            
            788Balance
                at September 30, 2007
            
            $
            228,902
            
            
            $
            15,974
            
            
            $
            244,876





Other
      adjustments made during the nine months ended September 30, 2007 primarily
      relate to the adoption of FASB Interpretation (FIN) 48 (see Note 5 - Income
      Taxes) and currency exchange rate changes.





The
      components of intangible assets, net are as follows:





(in
                thousands)
            
            **September
                30,**
              **2007**
            
            
            **December
                31,**
              **2006****Gross
                amount of amortizable intangible assets:**Customer
                relationships
            
            $
            8,363
            
            
            $
            8,363Other
            
            
            3,471
            
            
            
            3,47111,834
            
            
            
            11,834**Accumulated
                amortization of amortizable intangible assets:**Customer
                relationships
            
            
            637
            
            
            
            485Other
            
            
            2,625
            
            
            
            2,1433,262
            
            
            
            2,628**Intangible
                assets not subject to amortization:**Licenses
                and trademarks
            
            
            87,422
            
            
            
            87,194**Total
                intangible assets, net**
            
            $
            95,994
            
            
            $
            96,400





Other
      amortizable intangible assets consist primarily of patents, non-compete
      agreements and trademarks.  Amortization expense related to
      amortizable intangible assets for the year 2007 is estimated to be $0.8
      million.





10


**Note
      5 – Income Taxes**





Effective
      January 1, 2007, the Company adopted 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.  As a result of the Company’s
      adoption of FIN 48, the Company recognized a $0.7 million increase to reserves
      for uncertain tax positions.  This increase was accounted for as a
      $0.7 million adjustment to the beginning balance of retained earnings which
      is
      included in stockholders’ equity and an increase to goodwill on the accompanying
      condensed consolidated balance sheet of less than $0.1 million.  As of
      the date of the adoption, the Company had approximately $5.0 million of total
      gross unrecognized tax benefits.  Approximately $4.1 million of the
      total gross unrecognized tax benefits represents 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 2003.  Substantially all material state and local and foreign
      income tax matters have been concluded for years through 2003.  U.S.
      federal income tax returns for 2004 through 2006 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.  The Company’s continuing practice is to recognize
      interest and/or penalties related to income tax matters in income tax
      expense.  The Company had $1.7 million accrued for interest and $0.9
      million accrued for penalties as of January 1, 2007.





During
      the nine months ended September 30, 2007, the Company reversed $0.5 million
      of
      interest and penalties recorded at adoption due to the settlement of a tax
      position with a foreign taxing jurisdiction.  The Company also
      reversed $0.2 million of tax reserves due to the expiration of the 2003 statute
      of limitations.  Accompanying the reversal of the tax reserves was the
      reversal of $0.1 million in interest and penalties.





11


**Note
      6 – Debt**





Upon
      the
      closing of the acquisition of The First Years Inc. (TFY) on September 15, 2004,
      the Company entered into a new credit facility, which has subsequently been
      amended, to replace its previous credit facility.  The credit facility
      is comprised of an $85.0 million term loan and a $100.0 million revolving line
      of credit.  The credit facility also provides an additional $75.0
      million of capacity under the revolving line of credit which subsequent to
      September 30, 2007, was approved by the lenders upon the Company’s
      request.  During the first quarter of 2007, the term loan was repaid
      and the term loan is no longer available for borrowing.  The revolving
      line of credit is available until its maturity on September 14,
      2008.   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 bore and revolving line of credit
      bears interest, at the Company’s option, at a base rate or at a LIBOR rate plus
      applicable margin.  The applicable margin is 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 varies between 0.75% and 1.625%.  At September 30, 2007, the
      margin in effect was 0.75% for LIBOR loans.  The Company is also
      required to pay a commitment fee of 0.20% to 0.35% per annum on the average
      daily unused portion of the revolving line of credit.  At September
      30, 2007, the commitment fee in effect was 0.20% per annum.  Under the
      terms of this 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, incur additional debt
      and
      make acquisitions above certain amounts.  The key financial covenants
      include minimum EBITDA and interest coverage and leverage ratios.  The
      credit facility is secured by working capital assets and certain intangible
      assets.  On September 30, 2007, the Company had $80.0 million
      outstanding on the revolving line of credit, and was in compliance with all
      covenants.





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.  Write-offs of deferred financing
      fees are included in interest expense, net in the accompanying condensed
      consolidated statements of earnings.





During
      2005, the Company’s United Kingdom subsidiary entered into a line of credit with
      a bank for $8.0 million that was to expire on September 14, 2008.  The
      line of credit bore interest at 1.15% over the LIBOR rate, and the total amount
      was secured by a guarantee of the Company.  During the first half of
      2006, all borrowings under the line of credit were repaid and the Company
      cancelled the availability thereunder.





**Note
      7 – Commitments and Contingencies**





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





12


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, 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 500 license agreements, approximately 400 of which are actively used in
      the
      Company’s current product lines, 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,
      2007 and 2006.





During
      the first quarter of 2007, the Company entered into a multi-year digital media
      agreement which requires monthly payments beginning June 1, 2007 through May
      31,
      2009.  The aggregate commitment under this agreement is $2.8
      million.





**Note
      8 – Legal Proceedings**





See
      Note
      18 – Recalls of Certain *Thomas & Friends* Wooden Railway Toys for a
      description of certain putative class action lawsuits against the Company with
      respect to the products subject to the 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 financial position or the results of the Company's
      operations.





**Note
      9 - Common Stock**





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





**Authorized**
            **Par**
            **Shares
                Outstanding at**
            **Shares
                Outstanding at****Shares**
            **Value**
            **September
                30, 2007**
            **December
                31, 2006**Voting
                Common Stock
            28,000,000
            $0.01
            19,005,300
            21,052,038





At
      December 31, 2006, the Company held 1,824,221 shares of its common stock in
      treasury. During the nine months ended September 30, 2007 and 2006, the Company
      sold a total of 3,921 shares and 4,782 shares, respectively, out of treasury
      to
      Company employees under the employee stock purchase plan (ESPP) for $0.1 million
      and $0.2 million, respectively.





13


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.  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 will be held as treasury shares.  The program has
      initially been authorized for a period of one year, but may be extended beyond
      that period or may be suspended at any time.  During the nine months
      ended September 30, 2007, the Company repurchased 2,246,396 shares for $68.1
      million under this program.  These repurchases were funded via
      borrowings on the Company’s revolving line of credit.  Subsequent to
      September 30, 2007, the Company’s 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.





**Note
      10 – Stock-Based Payment Arrangements**





Effective
      January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based
      Payment.”  This Statement is a revision of SFAS No. 123, “Accounting
      for Stock-Based Compensation” and supersedes Accounting Principles Board Opinion
      No. 25, “Accounting for Stock Issued to Employees.”  This Statement
      establishes standards for the accounting for transactions in which an entity
      exchanges its equity instruments for goods or services, and also addresses
      transactions in which an entity incurs liabilities in exchange for goods and
      services that are based on the fair value of the entity’s equity instruments or
      that may be settled by the issuance of those instruments.  The Company
      adopted this Statement on a modified prospective basis, and therefore, no
      compensation expense related to stock-based payment arrangements was recognized
      in the financial statements prior to adoption.





At
      September 30, 2007, 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, 2007 and 2006, are as
      follows:





**For
                the three months ended September 30,**(in
                thousands)
            
            **2007**
            
            
            **2006**Total
                expense recognized for stock-based payment plans
            
            $
            1,195
            
            
            $
            1,009Amount
                of related income tax benefit recognized in determining net
                income
            
            $
            443
            
            
            $
            375





**For
                the nine months ended September 30,**(in
                thousands)
            
            **2007**
            
            
            **2006**Total
                expense recognized for stock-based payment plans
            
            $
            3,544
            
            
            $
            3,064Amount
                of related income tax benefit recognized in determining net
                income
            
            $
            1,315
            
            
            $
            1,137





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, 2007 and
      2006.





14


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, 2007 is as
      follows:




**Number
                of**
              **Shares**
            
            
            
            **Weighted
                Average Exercise**
              **Price**
            
            
            **Weighted**
              **Average**
              **Remaining**
              **Contractual**
              **Life**
            
            
            **Aggregate**
              **Intrinsic**
              **Value
                (000)**Outstanding
                at beginning of the year
            
            
            1,412,201
            
            
            $
            20.15Changes
                during the period:Granted
            
            
            257,009
            
            
            
            39.12Exercised
            
            
            155,900
            
            
            
            12.67Cancelled
            
            
            800
            
            
            
            31.27Expired
            
            
            16,320
            
            
            
            9.84Outstanding
                at end of period
            
            
            1,496,190
            
            
            $
            24.30
            
            
            
            6.6
            
            
            $
            10,990Exercisable
                at end of period
            
            
            779,886
            
            
            $
            15.68
            
            
            
            5.1
            
            
            $
            10,271





The
      total
      fair value of options vested during the nine months ended September 30, 2007
      was
      $3.2 million.  As of September 30, 2007, there was $11.7 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 3.4 years.





Restricted
      stock awards require no payment from the grantee.  The related
      compensation cost of each award is calculated using 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, 2007 is as
      follows:




**Number
                of**
              **Shares**
            
            
            **Weighted**
              **Average**
              **Grant
                Date**
              **Fair
                Value**
            
            **Weighted**
              **Average**
              **Remaining**
              **C****ontractual**
              **Life**Unvested
                restricted stock awards at beginning of year
            
            
            ---
            
            $
            
            ---Changes
                during the period:Granted
            
            
            39,837
            
            
            
            38.22Vested
            
            
            4,195
            
            
            
            40.57Unvested
                restricted stock awards at end of period
            
            
            35,642
            
            $
            
            37.94
            
            2.3





As
      of
      September 30, 2007, there was $1.2 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 2.3
      years.





15


**Note
      11 – Related Party Transactions**





The
      Company purchased some of its finished goods during the nine months ended
      September 30, 2007 and 2006 from two companies in which relatives of a Company
      stockholder/director 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 the
      employees’ years of service.





The
      components of net periodic benefit cost for the three months and nine months
      ended September 30, 2007 and 2006 are as follows:




**For
                  the three months ended**
                **September
                  30,**(in
                  thousands)
              
              **2007**
              
              
              **2006**Service
                  cost
              
              $
              26
              
              
              $
              27Interest
                  cost
              
              
              205
              
              
              
              197Expected
                  return on plan assets
              
              
              (253
              )
              
              
              (245
              )Amortization
                  of prior service costs
              
              
              4
              
              
              
              5Amortization
                  of net loss
              
              
              96
              
              
              
              110Net
                  periodic benefit cost
              
              $
              78
              
              
              $
              94
 
 **For
                  the nine months ended**
                **September
                  30,**(in
                  thousands)
              
              **2007**
              
              
              **2006**Service
                  cost
              
              $
              80
              
              
              $
              79Interest
                  cost
              
              
              615
              
              
              
              591Expected
                  return on plan assets
              
              
              (759
              )
              
              
              (735
              )Amortization
                  of prior service costs
              
              
              14
              
              
              
              15Amortization
                  of net loss
              
              
              288
              
              
              
              330Net
                  periodic benefit cost
              
              $
              238
              
              
              $
              280


The
      Company made a contribution of $0.6 million  to the pension benefit
      plan during the nine months ended September 30, 2007 and currently does not
      expect to make any additional contributions during the remainder of the fiscal
      2007 year.





16


**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 and toddler
      products and preschool products categories.  The transaction was
      effective November 1, 2006, and the results of this sold business are presented
      as discontinued operations in the accompanying condensed consolidated statements
      of earnings and condensed consolidated statements of cash flows.  The
      sold business was primarily reported under the North America
      segment.





Net
      sales
      and income before income taxes generated by the sold business for the three
      months and nine months ended September 30, 2006, were as follows:





(in
                thousands)
            
            **For
                the three**
              **months
                ended**
              **September
                30,**
              **2006**
            
            
            **For
                the nine**
              **months
                ended**
              **September
                30,**
              **2006**Net
                sales
            
            $
            4,433
            
            
            $
            12,391Income
                before income taxes
            
            $
            1,018
            
            
            $
            2,621





A
      gain on
      the sale of $0.1 million, net of income tax benefit, 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.  For tax purposes, this
      sale generated a pre-tax capital loss and a valuation allowance was established
      during the fourth quarter of 2006 because the Company does not believe
      recoverability of this amount is more likely than not.  The valuation
      allowance was reduced by less than $0.1 million during the second quarter of
      2007 as a result of the gain recorded.





**Note
      14 – 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.





17


**Note
      15 – Earnings Per Share**





The
      Company computes earnings per share in accordance with SFAS No. 128, "Earnings
      Per Share."  Under the provisions of SFAS No. 128, basic earnings per
      share is computed by dividing net income for the period by the weighted average
      number of common shares outstanding during the period.  Diluted net
      income per 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.  Options to purchase 773,921 shares and 548,875
      shares of common stock were outstanding during the three months ended September
      30, 2007 and 2006, respectively, but were not included in the computation of
      diluted earnings per share because the options were
      anti-dilutive.  Options to purchase 507,201 shares and 503,067 shares
      of common stock were outstanding during the nine months ended September 30,
      2007
      and 2006, respectively, but were not included in the computation of diluted
      earnings per share because the options were anti-dilutive.





**Note
      16 – Comprehensive Income**





The
      Company reports comprehensive 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 income for the nine months
      ended September 30, 2007 and 2006 is calculated as follows:





(in
                thousands)
            
            **2007**
            
            
            **2006**Net
                income
            
            $
            21,288
            
            
            $
            35,998Other
                comprehensive income – foreign currencytranslation
                adjustments
            
            
            4,972
            
            
            
            3,577Comprehensive
                income
            
            $
            26,260
            
            
            $
            39,575





**Note
      17 – Reclassifications**





Certain
      prior year amounts have been reclassified to conform to the current year
      presentation.  In addition, see Note 18 - Recalls of Certain
*Thomas & Friends* Wooden Railway Toys relating to the
      reclassification of certain recall-related costs included in the three month
      and
      nine month periods ended September 30, 2007.


**Note
      18 – Recalls of Certain *Thomas & Friends* Wooden Railway
      Toys**





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 an independent
      supplier.  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.





18


The
      Company recorded charges of $5.9 million, net of tax, or $0.28 per diluted
      share
      and $10.0 million, net of tax, or $0.47 per diluted share, in the three months
      and nine months ended September 30, 2007 related to both the June and September
      recalls.  These charges are based on the latest estimates of retailer
      inventory returns and consumer product replacement costs as of the date of
      this
      filing.  The Company expects to incur total recall-related costs in
      the range of $13.0 million to $14.0 million, net of tax, during
      2007.  These costs cover both the June and September recalls and
      include estimates of inventory reserves, higher levels of retailer and consumer
      product returns and associated replacement costs, professional service fees,
      air
      freight, returns and replacement processing, marketing and promotional costs,
      incremental product testing, as well as estimated defense costs for 2007
      relating to the class action lawsuits that have been filed against the Company
      described in the next paragraph.





Following
      the announcement of the June recall, a number of putative class action lawsuits
      have been filed against the Company with respect to the products subject to
      the
      June recall, although in most cases the alleged claims could also encompass
      the
      products subject to the September recall.  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.  The Company intends to vigorously defend against
      these lawsuits, although no assurances can be given as to the outcome of these
      matters.  In view of the inherent difficulty of predicting the outcome
      of litigation, the Company cannot predict the outcome of these lawsuits and
      has
      not established any reserves for any potential liability relating to the
      lawsuits.  As described above, the Company does anticipate incurring
      estimated defense costs for 2007 relating to these lawsuits, but has not
      estimated defense costs for periods after 2007.




In
        connection with finalizing the September 30, 2007 financial statements, the
        Company determined that certain recall-related costs that were presented
        as a
        reduction of sales in the June 30, 2007 financial statements as previously
        filed
        on Form 10-Q on August 7, 2007 and the September 30, 2007 financial statements
        included in the press release issued on October 24, 2007 should have been
        included as a component of cost of sales. Accordingly, a year-to-date
        reclassification has been made in the September 30, 2007 condensed consolidated
        statements of earnings to reflect these costs in cost of sales. This revision
        increased net sales and cost of sales by $2.7 million for the three month
        and
        nine month periods ended September 30, 2007 versus the amounts presented
        in the
        Company’s press release issued on October 24, 2007.


**Note
      19 – Subsequent Events**





During
      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.  Shares of the Company’s common stock 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 that may be repurchased by the
      Company will be held as treasury shares.  This program may be extended
      beyond the currently authorized period or may be suspended at any
      time.





During
      October 2007, the Company increased the size of its revolving line of credit
      to
      $175.0 million by requesting the additional $75.0 million of capacity under
      its
      current revolving line of credit.  The additional capacity was
      approved by the Company’s lenders.  The Company currently has $94.8
      million of remaining borrowing capacity as of the date of this
      filing.





19


**Item
      2.  Management's Discussion
      and Analysisof 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, 2007, decreased 6.6% primarily due
      to
      lower sales in our preschool and youth and adult products categories and include
      $0.8 million of recall-related returns and allowances.  Gross margin
      decreased to 43.9% for the three months ended September 30, 2007, from 47.1%
      for
      the three months ended September 30, 2006, primarily due to a less favorable
      product mix and higher product costs than that experienced in the prior year
      and
      $4.1 million of recall-related costs.  Selling, general and
      administrative expenses as a percentage of net sales increased to 32.9% for
      the
      three months ended September 30, 2007, from 27.2% for the three months ended
      September 30, 2006.  Selling, general and administrative expenses for
      the three months ended September 30, 2007, include $5.3 million of
      recall-related costs and $1.4 million of investment spending to launch and
      build
      owned brands.  Operating income decreased to $15.7 million for the
      three months ended September 30, 2007, compared with $30.7 million for the
      three
      months ended September 30, 2006.  Operating income for the three
      months ended September 30, 2007, includes $9.4 million of recall-related
      costs.  As a percentage of net sales, operating income decreased to
      10.8% for the three months ended September 30, 2007, from 19.7% for the three
      months ended September 30, 2006.





Net
      sales
      for the nine months ended September 30, 2007, decreased 3.8% primarily due
      to
      lower sales in our preschool and youth and adult products categories and include
      $4.1 million of recall-related returns and allowances.  Gross margin
      decreased to 43.4% for the nine months ended September 30, 2007, from 47.0%
      for
      the nine months ended September 30, 2006, primarily due to a less favorable
      product mix and higher product costs than that experienced in the prior year
      and
      $8.2 million of recall-related costs.  Selling, general and
      administrative expenses as a percentage of net sales increased to 34.4% for
      the
      nine months ended September 30, 2007, from 31.1% for the nine months ended
      September 30, 2006.  Selling, general and administrative expenses for
      the nine months ended September 30, 2007, include $7.5 million of recall-related
      costs and $2.2 million of investment spending to launch and build owned
      brands.  Operating income decreased to $30.8 million for the nine
      months ended September 30, 2007, compared with $57.0 million for the nine months
      ended September 30, 2006.  Operating income for the nine months ended
      September 30, 2007, includes $15.7 million of recall-related
      costs.  As a percentage of net sales, operating income decreased to
      8.8% for the nine months ended September 30, 2007, from 15.6% for the nine
      months ended September 30, 2006.





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.  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.  The
      Company recorded charges of $5.9 million, net of tax, or $0.28 per diluted
      share, and $10.0 million, net of tax, or $0.47 per diluted share, in the three
      months and nine months ended September 30, 2007, respectively, related to both
      the June and September recalls.  The portion of these charges for the
      three months ended September 30, 2007, included in the North America and
      International segments is $4.9 million and $1.0 million,
      respectively.  The portion of these charges for the nine months ended
      September 30, 2007, included in the North America and International segments
      is
      $8.1 million and $1.9 million, respectively.  These charges are based
      on the latest estimates of retailer inventory returns and consumer product
      replacement costs as of the date of this filing.   The Company
      expects to incur total recall-related costs in the range of $13.0 million to
      $14.0 million, net of tax, during 2007.  These costs cover both the
      June and September recalls and include estimates of inventory reserves, higher
      levels of retailer and consumer product returns and associated replacement
      costs, professional service fees, air freight, returns and replacement
      processing, marketing and promotional costs, incremental product testing, as
      well as estimated defense costs for 2007 relating to the class action lawsuits
      that have been filed against the Company.   The June and
      September recalls may have a material adverse effect on our business and
      reputation, and may reduce our net sales and increase our costs in excess of
      the
      amounts currently anticipated.  See Part II, Item 1A, “Risk Factors”
for additional information.


In
        connection with finalizing the September 30, 2007 financial statements, the
        Company determined that certain recall-related costs that were presented
        as a
        reduction of sales in the June 30, 2007 financial statements as previously
        filed
        on Form 10-Q on August 7, 2007 and the September 30, 2007 financial statements
        included in the press release issued on October 24, 2007 should have been
        included as a component of cost of sales. Accordingly, a year-to-date
        reclassification has been made in the September 30, 2007 condensed consolidated
        statements of earnings to reflect these costs in cost of sales. This revision
        increased net sales and cost of sales by $2.7 million for the three month
        and
        nine month periods ended September 30, 2007 versus the amounts presented
        in the
        Company’s press release issued on October 24, 2007.


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 Kings Mills, 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.  The transaction has been accounted for under the purchase
      method of accounting, and accordingly, the operating results of the Compass
      Business have been included in our condensed consolidated financial statements
      since the effective date of the acquisition.  These results did not
      have a material impact on the three months or nine months ended September 30,
      2007.





21


**Three
      Months Ended September 30, 2007, Compared to Three Months Ended September 30,
      2006**





*Net
      sales.*Net sales for the three months ended September 30,
      2007, decreased $10.3 million, or 6.6%, to $145.7 million from $156.0 million
      for the three months ended September 30, 2006.





Net
      sales
      for the three months ended September 30, 2007, excluding $5.5 million in net
      sales of discontinued product lines and the $0.8 million of recall-related
      returns and allowances, were $141.0 million, a decrease of 3.2% when compared
      with net sales for the three months ended September 30, 2006, excluding $10.4
      million in net sales of discontinued product lines, of $145.6
      million.  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 results.  A reconciliation to
      the nearest GAAP financial measure follows:





(in
                millions)
            
            **Net
                Sales**2007
                actual
            
            $
            145.7Deduct:
                discontinued product lines
            
            
            5.5Add:
                recall-related returns and allowances
            
            
            0.8$
            141.02006
                actual
            
            $
            156.0Deduct:
                discontinued product lines
            
            
            10.4$
            145.6





Net
      sales
      decreases occurred in our preschool products and youth and adult products
      categories, but these decreases were partially offset by an increase in our
      infant and toddler products category.





22


Net
      sales
      in our preschool products category decreased 17.2% primarily due to declines
      in
*Bob the Builder*, John Deere and *Thomas & Friends* toy
      product lines and ride-ons which offset increases generated from Take Along
      by
      Learning Curve’s Nickelodeon and Play TownTM new product
      line
      launches.  In addition, recall-related returns and allowances of $0.8
      million negatively impacted the net sales in the preschool products
      category.  Excluding the $0.8 million of recall-related returns and
      allowances, our preschool products category decreased 16.1%.  Net
      sales in our youth and adult products category decreased 1.1% primarily due
      to
      lower sales of discontinued products partially offset by sales increases
      attributable to the launch of Battle WheelsTM and V-BotTM
      radio control
      products.  Excluding net sales related to the discontinued product
      lines, net sales in our youth and adult products category increased
      16.5%.  Net sales in our infant and toddler products category
      increased 6.1% primarily driven by our SoothieTM bottle
      feeding
      system and our American Red Cross health and wellness products marketed under
      our The First Years® brand.  Information in this paragraph regarding
      net sales in our preschool products category excluding recall-related returns
      and allowances and in our youth and adult products category excluding net sales
      related to discontinued product lines constitutes non-GAAP financial
      information.  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 results.  A
      reconciliation to the nearest GAAP financial measure follows:





**Net
                Sales**(in
                millions)
            
            **2007**
            
            
            **2006**
            
            
            **Difference**
            
            
            **%
                Change**Preschool
                products actual
            
            $
            61.0
            
            
            $
            73.7
            
            
            $
            (12.7
            )
            
            
            (17.2
            )%Add:
                recall-related returns and allowances
            
            
            0.8
            
            
            
            ---
            
            
            
            0.8
            
            
            
            ---$
            61.8
            
            
            $
            73.7
            
            
            $
            (11.9
            )
            
            
            (16.1
            )%Youth
                and adult products actual
            
            $
            37.2
            
            
            $
            37.6
            
            
            $
            (0.4
            )
            
            
            (1.1
            )%Deduct:
                discontinued product lines
            
            
            5.4
            
            
            
            10.3
            
            
            
            (4.9
            )
            
            
            (47.6
            )$
            31.8
            
            
            $
            27.3
            
            
            $
            4.5
            
            
            
            16.5
            %





*Gross
      profit.*Gross profit decreased $9.5 million, or 12.9%, to $63.9
      million for the three months ended September 30, 2007, from $73.4 million for
      the three months ended September 30, 2006.  As a percentage of net
      sales, gross profit margin decreased to 43.9% in the three months ended
      September 30, 2007, compared with 47.1% in the three months ended September
      30,
      2006, primarily due to a less favorable product mix and higher product costs
      than that experienced in the prior year and $4.1 million of recall-related
      costs.  Our quarterly gross margins can be affected by the mix of
      product that is shipped during each quarter.  Our 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.





23


*Selling,
      general and administrative expenses.*Selling, general and
      administrative expenses increased $5.6 million, or 13.2%, to $48.0 million
      for
      the three months ended September 30, 2007, from $42.4 million for the three
      months ended September 30, 2006.  As a percentage of net sales,
      selling, general and administrative expenses increased to 32.9% for the three
      months ended September 30, 2007, from 27.2% for the three months ended September
      30, 2006.  Selling, general and administrative expenses for the three
      months ended September 30, 2007, include $5.3 million of recall-related costs
      and $1.4 million of investment spending to launch and build owned
      brands.





*Operating
      income.*Operating income decreased to $15.7 million for the
      three months ended September 30, 2007, from $30.7 million for the three months
      ended September 30, 2006.  As a percentage of net sales, operating
      income decreased to 10.8% in the three months ended September 30, 2007, from
      19.7% in the three months ended September 30, 2006.  Operating income
      for the three months ended September 30, 2007, was negatively impacted by $9.4
      million of recall-related costs.





*Net
      interest expense*.  Net interest expense of $0.4 million and $0.9
      million for the three months ended September 30, 2007 and 2006, respectively,
      relates primarily to bank term loans and lines of credit.  The
      favorable change in net interest expense is primarily due to lower average
      outstanding debt balances and a decrease in the Company’s incremental borrowing
      rate.





*Income
      tax.*Income tax expense for the three months ended September 30,
      2007 and 2006, includes provisions for federal, state and foreign income taxes
      at an effective rate of 36.5% and 36.9%, respectively.  However, the
      tax rate, including discrete items, for the three months ended September 30,
      2007 and 2006 is 31.8% and 36.5%, respectively.





**Nine
      Months Ended September 30, 2007, Compared to Nine Months Ended September 30,
      2006**





*Net
      sales.*Net sales for the nine months ended September 30,
      2007, decreased $13.9 million, or 3.8%, to $350.4 million from $364.3 million
      for the nine months ended September 30, 2006.





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 returns
      and allowances, were $338.6 million, an increase of 0.3% when compared with
      net
      sales for the nine months ended September 30, 2006, excluding $26.7 million
      in
      net sales of discontinued product lines, of $337.6
      million.  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 results.  A reconciliation to
      the nearest GAAP financial measure follows:





(in
                millions)
            
            **Net
                Sales**2007
                actual
            
            $
            350.4Deduct:
                discontinued product lines
            
            
            15.9Add:
                recall-related returns and allowances
            
            
            4.1$
            338.62006
                actual
            
            $
            364.3Deduct:
                discontinued product lines
            
            
            26.7$
            337.6





24


Net
      sales
      decreases occurred in our preschool products and youth and adult products
      categories, but these decreases were partially offset by an increase in our
      infant and toddler products category.





Net
      sales
      in our preschool products category decreased 13.9% primarily driven by declines
      in *Bob the Builder*, John Deere and *Thomas & Friends* toy
      product lines and ride-ons which offset the increases generated from Take Along
      by Learning Curve’s Nickelodeon and Play Town new product line
      launches.  In addition, recall-related returns and allowances of $4.1
      million negatively impacted the net sales in the preschool products
      category.  Excluding the $4.1 million of recall-related returns and
      allowances, our preschool products category decreased 11.2%.  Net
      sales in our youth and adult products category decreased 5.7% primarily due
      to
      lower sales of discontinued products, partially offset by sales increases
      attributable to the launch of Battle Wheels and V-Bot radio control
      products.  Excluding net sales related to the discontinued product
      lines, net sales in our youth and adult products category increased
      11.7%.  Net sales in our infant and toddler products category
      increased 9.1% primarily driven by our Take & Toss® toddler self-feeding
      system, our Soothie bottle feeding system, our American Red Cross health and
      wellness products marketed under our The First Years brand and the newly
      re-launched Lamaze infant development products.  Information in this
      paragraph regarding net sales in our preschool products category excluding
      recall-related returns and allowances and in our youth and adult products
      category excluding net sales related to discontinued product lines constitutes
      non-GAAP financial information.  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
      results.  A reconciliation to the nearest GAAP financial measure
      follows:





**Net
                Sales**(in
                millions)
            
            **2007**
            
            
            **2006**
            
            
            **Difference**
            
            
            **%
                Change**Preschool
                products actual
            
            $
            132.4
            
            
            $
            153.7
            
            
            $
            (21.3
            )
            
            
            (13.9
            )%Add:
                recall-related returns and allowances
            
            
            4.1
            
            
            
            ---
            
            
            
            4.1
            
            
            
            ---$
            136.5
            
            
            $
            153.7
            
            
            $
            (17.2
            )
            
            
            (11.2
            )%Youth
                and adult products actual
            
            $
            75.0
            
            
            $
            79.5
            
            
            $
            (4.5
            )
            
            
            (5.7
            )%Deduct:
                discontinued product lines
            
            
            15.8
            
            
            
            26.5
            
            
            
            (10.7
            )
            
            
            (40.4
            )$
            59.2
            
            
            $
            53.0
            
            
            $
            6.2
            
            
            
            11.7
            %





*Gross
      profit.*Gross profit decreased $19.1 million, or 11.2%, to
      $152.1 million for the nine months ended September 30, 2007, from $171.2 million
      for the nine months ended September 30, 2006.  As a percentage of net
      sales, the gross profit margin decreased to 43.4% in the nine months ended
      September 30, 2007, compared with 47.0% in the nine months ended September
      30,
      2006, primarily due to a less favorable product mix and higher product costs
      than that experienced in the prior year and $8.2 million of recall-related
      costs.  There were no major changes in the components of cost of
      sales.





25


*Selling,
      general and administrative expenses.*Selling, general and
      administrative expenses increased $7.5 million, or 6.6%, to $120.7 million
      for
      the nine months ended September 30, 2007, from $113.2 million for the nine
      months ended September 30, 2006.  As a percentage of net sales,
      selling, general and administrative expenses increased to 34.4% for the nine
      months ended September 30, 2007, from 31.1% for the nine months ended September
      30, 2006.  Selling, general and administrative expenses for the nine
      months ended September 30, 2007, include $7.5 million of recall-related costs
      and $2.2 million of investment spending to launch and build owned
      brands.





*Operating
      income.*Operating income decreased to $30.8 million for the nine
      months ended September 30, 2007, from $57.0 million for the nine months ended
      September 30, 2006.  As a percentage of net sales, operating income
      decreased to 8.8% in the nine months ended September 30, 2007, from 15.6% in
      the
      nine months ended September 30, 2006.  Operating income for the nine
      months ended September 30, 2007, was negatively impacted by $15.7 million of
      recall-related costs.





*Net
      interest expense*.  Net interest expense of $0.5 million and $2.8
      million for the nine months ended September 30, 2007 and 2006, respectively,
      relates primarily to bank term loans and lines of credit.  The
      decrease in net interest expense was primarily due to the decrease in average
      outstanding debt balances partially offset by the write-off of $0.2 million
      of
      deferred financing fees related to the Company’s voluntary payment of the
      remaining balance of its term loan.





*Income
      tax.*Income tax expense for the nine months ended September 30,
      2007 and 2006, includes provisions for federal, state and foreign income taxes
      at an effective rate of 36.5% and 36.9%, respectively.  However, the
      tax rate, including discrete items, for the nine months ended September 30,
      2007
      and 2006, is 32.3% and 36.5%, respectively.  Additionally, during the
      nine months ended September 30, 2007, the Company reversed $0.5 million, or
      $0.02 per diluted share, of interest and penalties recorded at the adoption
      of
      FIN 48 due to the settlement of a tax position with a foreign taxing
      jurisdiction.





**Related
      Party Transactions**





The
      Company purchased some of its finished goods during the nine months ended
      September 30, 2007 and 2006 from two companies in which relatives of a Company
      stockholder/director have ownership interests.





LIQUIDITY
      AND CAPITAL RESOURCES





The
      Company’s operations provided net cash of $38.0 million during the nine months
      ended September 30, 2007.  Inventory decreased $7.0 million during the
      nine months ended September 30, 2007 and was the primary source of cash from
      operations.  Accounts receivable increased $5.6 million during the
      nine months ended September 30, 2007.  Capital expenditures for the
      nine months ended September 30, 2007, were $8.1 million, of which $6.0 million
      was for molds and tooling.  Payments of outstanding debt under the
      Company’s credit facilities were $22.4 million for the nine months ended
      September 30, 2007, all of which were made on the Company’s term loan and
      resulted in the Company paying off its outstanding term loan debt during the
      first quarter of 2007.  Borrowings on the Company’s revolving line of
      credit were $80.0 million during the nine months ended September 30,
      2007.  The Company also used $6.8 million of cash to purchase the
      Compass Business during the second quarter of 2007.  Cash and cash
      equivalents increased by $17.8 million during the nine months ended September
      30, 2007.





26


Upon
      the
      closing of the acquisition of The First Years Inc. (TFY) on September 15, 2004,
      the Company entered into a new credit facility, which has subsequently been
      amended, to replace its previous credit facility.  The credit facility
      is comprised of an $85.0 million term loan and a $100.0 million revolving line
      of credit.  The credit facility also provides an additional $75.0
      million of capacity under the revolving line of credit which subsequent to
      September 30, 2007, was approved by the lenders upon the Company’s
      request.  During the first quarter of 2007, the term loan was repaid
      and the term loan is no longer available for borrowing.  The revolving
      line of credit is available until its maturity on September 14,
      2008.  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 bore and revolving line of credit bears interest, at the
      Company’s option, at a base rate or at a LIBOR rate plus applicable
      margin.  The applicable margin is 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
      varies between 0.75% and 1.625%.  At September 30, 2007, the margin in
      effect was 0.75% for LIBOR loans.  The Company is also required to pay
      a commitment fee of 0.20% to 0.35% per annum on the average daily unused portion
      of the revolving line of credit.  At September 30, 2007, the
      commitment fee in effect was 0.20% per annum.  Under the terms of this
      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, incur additional debt and make
      acquisitions above certain amounts.  The key financial covenants
      include minimum EBITDA and interest coverage and leverage ratios.  The
      credit facility is secured by working capital assets and certain intangible
      assets.  On September 30, 2007, the Company had $80.0 million
      outstanding on the revolving line of credit, and was in compliance with all
      covenants.  At September 30, 2007, the Company had $19.8 million
      available on its revolving line of credit.





During
      the nine months ended September 30, 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.  Write-offs of deferred
      financing fees are included in interest expense, net in the accompanying
      condensed consolidated statements of earnings.





During
      2005, the Company’s United Kingdom subsidiary entered into a line of credit with
      a bank for $8.0 million that was to expire on September 14, 2008.  The
      line of credit bore interest at 1.15% over the LIBOR rate, and the total amount
      was secured by a guarantee of the Company.  During the first half of
      2006, all borrowings under the line of credit were repaid and the Company
      cancelled the availability thereunder.





On
      February 22, 2007, the Company announced that its Board of Directors authorized
      a stock repurchase program to repurchase up to $75.0 million of the Company’s
      common stock.  The program has initially been authorized for a period
      of one year, but may be extended beyond that period or may be suspended at
      any
      time.  Repurchases may occur from time to time and are expected to be
      funded by cash flow from operations as well as borrowings on the Company’s
      revolving line of credit.  During the nine months ended September 30,
      2007, the Company repurchased 2.2 million shares for $68.1 million under this
      program. These repurchases were funded via borrowings on the Company’s revolving
      line of credit.  Subsequent to September 30, 2007, the Company’s 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.





27


In
      order
      to support its new product launches and to build consumer awareness of its
      owned
      brands, the Company is planning new investment spending of approximately $9.0
      million in 2007.  The Company estimates that approximately $7.0
      million of this amount will be expensed in 2007.  During the nine
      months ended September 30, 2007, the Company spent $3.7 million, of which $2.2
      million has been expensed.  This spending will be focused on key
      strategic plan initiatives including on-line, digital and traditional consumer
      marketing and building and launching owned brands.





The
      Company has met its working capital needs through funds generated from
      operations and available borrowings under our 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 2007, principally for molds and tooling, will
      be approximately $13.0 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 2007.  However, if the Company’s
      capital requirements vary materially from those currently planned, the Company
      may require additional debt or equity financing.  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 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
      is recognized at the time title is transferred to the Company.  Title
      is transferred to the Company FOB shipping point.  Inventory, which
      consists of finished goods, has been written down for excess quantities and
      obsolescence, and is stated at 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 could impact the inventory
      valuation.




28




*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 of Long-Lived Assets and for Long-Lived Assets to be Disposed
      Of."  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 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 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.





*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 FIN 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 our 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 on the accompanying
      condensed consolidated balance sheets.





29


*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 for 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.  In addition
      to regular allowances for defective merchandise which are recorded throughout
      the year, as sales are recorded, based on historical results, the Company may
      also establish an allowance for returns relating to a specific product or
      issue.  In connection with both the June and September recalls, the
      Company has established an allowance for returns of the affected products in
      the
      three months and nine months ended September 30, 2007 based on the latest
      estimates of retailer inventory returns as well as consumer product replacement
      costs as of the date of this filing.





*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 on the accompanying condensed consolidated
      statements of earnings.





*Stock-based
      compensation.*  On January 1, 2006, the Company adopted SFAS No.
      123R, “Share-Based Payments.”  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, 2007 and 2006, includes total
      expense recognized for all of the Company’s stock-based payment
      plans.





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.  Prior to 2007, the Company calculated the expected volatility
      factor for those options issued under the stock incentive plan to correspond
      with the average volatility factor of those companies included in a peer group
      study.  The historical stock price movements of the Company’s common
      stock had not been considered a good indicator of expected future volatility
      because the Company’s business had changed significantly as a result of
      acquisitions completed.  However, the Company continued to monitor its
      actual volatility to assess whether its historical stock price movements over
      the expected option term were a good indicator of expected future result and
      began using Company specific volatility in 2007.





The
      Company uses historical data to estimate share option exercise and employee
      departure behavior used in the Black-Scholes option pricing
      model.  The expected term of the share options granted represents the
      period in time that share options granted are expected to be
      outstanding.  The risk-free rate for the period within the contractual
      term of the share 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 at the date of grant using the market price on the grant date or
      the
      market price on the last day of the reported period.




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 the its June and September recalls may increase based on the amount
      of inventory of affected products at retailers, the amount of affected products
      that may be returned by consumers and the cost of providing replacement products
      to consumers and retailers; the outcome of the class action lawsuits that have
      been filed against the Company related to the recalls and the possibility of
      potential new claims or litigation; 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, particularly in the
      Chinese Renminbi or the Hong Kong dollar, could increase the Company’s expenses;
      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 the Builder, 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 vehicle replicas and certain other
      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, 2006 and Part II, Item 1A, “Risk Factors,” below
      in this report.  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 Qualitative Disclosuresabout Market Risk**





The
      Company's exposure to market risk is limited to interest rate risk associated
      with the Company’s credit facility 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, 2007, 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 $0.3 million per month.  The Company determined these
      amounts based on $80.0 million of variable rate borrowings at September 30,
      2007, 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
      approximately 19.0% of the Company’s net sales during the nine months ended
      September 30, 2007, denominated in British pounds sterling, Australian dollars,
      Euros or Canadian dollars.  The Company’s purchases of finished goods
      from Chinese manufacturers are denominated in Hong Kong dollars.  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.  During July 2005, China revalued the Chinese Renminbi,
      abandoning the former method of pegging the Chinese Renminbi to the U.S.
      dollar.  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.  The Company is also subject to exchange rate risk
      relating to transfers of funds denominated in British pounds sterling,
      Australian dollars, Canadian dollars or Euros from the Company’s foreign
      subsidiaries to the United States.  Historically, the Company has not
      hedged its foreign currency risk.





**Item
      4. Controls and
      Procedures**





As
      of the
      end of the period covered by this report, the Company carried out an evaluation,
      under the supervision and with the participation of the Company's management,
      including the Company's Chief Executive Officer and Chief Financial Officer,
      of
      the Company's disclosure controls and procedures (as defined in
      Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
      amended).  Based on this evaluation, the Company's Chief Executive
      Officer and Chief Financial Officer concluded that, as of the end of such
      period, the Company's disclosure controls and procedures were effective in
      recording, processing, summarizing and reporting, on a timely basis, information
      required to be disclosed by the Company in reports that the Company files with
      or submits to the Securities and Exchange Commission.  It should be
      noted that 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 and based on the evaluation described above, the Company's
      Chief Executive Officer and Chief Financial Officer concluded that the Company's
      disclosure controls and procedures were effective at reaching that level of
      reasonable assurance.





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 an independent
      supplier.  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 recall, a number of putative class action lawsuits
      have been filed against the Company with respect to the products subject to
      the
      June recall, although in most cases the alleged claims could also encompass
      the
      products subject to the September recall.  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 violating the federal Consumer
      Products Safety Act.  The Company intends to vigorously defend against
      these lawsuits, although no assurances can be given as to the outcome of these
      matters.





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 financial position or the results of the Company's
      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, 2006.  The information presented below
      updates and should be read in conjunction with the risk factors and information
      disclosed in that Form 10-K.





33


**The
      recalls relating to certain *Thomas & Friends* Wooden Railway
      products could increase our costs in excess of current estimates and could harm
      our reputation or otherwise reduce our net sales and
      profitability.**





The
      Company recorded charges of $5.9 million, net of tax, or $0.28 per diluted
      share, and $10.0 million, net of tax, or $0.47 per diluted share in the three
      months and nine months ended September 30, 2007, respectively, related to both
      the June and September recalls, based on the latest estimates of retailer
      inventory returns and consumer product replacement costs as of the date of
      this
      filing.  The Company expects to incur total recall-related costs in
      the range of $13.0 million to $14.0 million, net of tax, during
      2007.  These costs cover both the June and September recalls and
      include estimates of inventory reserves, higher levels of retailer and consumer
      product returns and associated replacement costs, professional service fees,
      air
      freight, returns and replacement processing, marketing and promotional costs,
      incremental product testing, as well as estimated defense costs for 2007
      relating to the class action lawsuits that have been filed against the Company.
      Since these current and expected future charges are based on estimates, they
      may
      increase based on a number of factors, many of which are outside of the
      Company’s control, including the amount of inventory of affected products at
      retailers, the amount of affected products that may be returned by consumers
      and
      the cost of providing replacement products to consumers and
      retailers.  Any increase in the costs relating to the June and
      September recalls would further reduce our net sales and
      profitability.  In addition, addressing the June and September recalls
      and issues relating to the June and September recalls will likely divert
      management’s attention and resources from our business.





The
      June
      and September recalls may also harm our reputation and consumer acceptance
      of
      the affected products or our other products, which may have an adverse effect
      on
      our net sales.  The June and September recalls may harm our
      relationships with our retail customers, including the willingness of those
      customers to purchase and provide shelf space for our products and to support
      retailer driven promotions and advertising for our products.  The June
      and September recalls may also harm our relationship with the licensor (the
      Licensor) who has granted the license under which we market the products
      affected by the June and September recalls (the License).  The
      License, like most of our other licenses, gives the Licensor the right to
      terminate if we breach covenants relating to compliance with safety
      regulations.  Any termination of the License, or any adverse effect of
      the June and September recalls on our relationship with the Licensor and the
      terms of our other licenses with the Licensor, may have a material adverse
      effect on our business and prospects and could reduce our
      profitability.





At
      September 30, 2007, we have intangible assets not subject to amortization of
      $33.3 million relating to the License.  These intangible assets are
      not subject to amortization because they have indefinite useful
      lives.  As of the date of this report, we have determined that there
      is no impairment of these intangible assets or change to the indefinite useful
      lives.  However, we will continue to monitor these intangible assets
      for impairment or a change in the indefinite useful lives in light of the status
      of the recalls and related events, including the class action
      litigation.  Any impairment or change in the useful lives of the
      intangible assets would increase our expenses and reduce our
      profitability.





34


**We
      face class action lawsuits relating to the June and September recalls that
      could
      require us to pay damages or settlement costs or otherwise harm our
      business.**





Following
      the announcement of the June recall, a number of putative class action lawsuits
      have been filed against the Company with respect to the products subject to
      the
      June recall, although in most cases the alleged claims could also encompass
      the
      products subject to the September recall.  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 violating the federal Consumer
      Products Safety Act.  We are not currently able to estimate any amount
      of damages that we may be required to pay in connection with these
      lawsuits.  These lawsuits, which may be expected to continue for
      years, are currently in a very early stage and the Company has very little
      information as to the course they may take.  In view of the inherent
      difficulty of predicting the outcome of litigation, we cannot predict the
      outcome of these lawsuits and have not established any reserves for any
      potential liability relating to the lawsuits.  As described above, we
      do anticipate incurring estimated defense costs for 2007 relating to these
      lawsuits, but have not estimated defense costs for periods after
      2007.  Any unfavorable outcomes in these lawsuits, resulting in the
      payment of substantial damages, could have a material adverse effect on our
      business and prospects and could reduce our profitability.  Our
      defense costs may also exceed our estimates, which may result in an increase
      in
      the costs relating to the recalls.  In addition, addressing these
      lawsuits will likely divert management’s attention and resources from our
      business.




**Item
      2.     Unregistered Sales of
      Equity Securitiesand Use of Proceeds.**




(a)      Not
      applicable.




(b)      Not applicable.




(c)      Issuer Purchases of Equity
      Securities





Period
            
            
            Total
                Number of
              Shares
                Purchased
            
            
            
            Average
              Price
                Paid
              Per
                Share
            
            
            
            Total
                Number of
              Shares
                Purchased As
              Part
                of Publicly
              Announced
                Program
            
            
            
            Maximum
              Dollar
                Value of
              Shares
                that May
              Yet
                be
              Purchased
              Under
                the
              Program
                (000s)July
                1, 2007 – July 31, 2007
            
            
            ---
            
            
            $
            ---
            
            
            
            ---
            
            
            $
            ---August
                1, 2007 – August 31, 2007
            
            
            1,407,938
            
            
            
            30.38
            
            
            
            1,407,938
            
            
            
            32,092September
                1, 2007 – September 30, 2007
            
            
            834,958
            
            
            
            30.21
            
            
            
            834,958
            
            
            
            6,869Total
            
            
            2,242,896
            
            
            $
            30.31
            
            
            
            2,242,896
            
            
            $
            6,869





35


On
      February 22, 2007, the Company
      announced that its Board of Directors authorized a stock repurchase program
      to
      repurchase up to $75.0 million of the Company’s common stock.  During
      the nine months ended September 30, 2007, the Company repurchased 2.2 million
      shares for $68.1 million under this program.  The program may be
      extended beyond that period or may be suspended at any
      time.  Repurchases may occur from time to time and are expected to be
      funded by cash flow from operations as well as borrowings on the Company’s
      revolving line of credit.  Subsequent to September 30, 2007, the
      Company’s 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.





**Item
      3.    Defaults Upon Senior
      Securities.**





Not
      applicable.





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





Not
      applicable.





**Item
      5.   Other
      Information.**





Not
      applicable.





**Item
      6.   Exhibits.**





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).


36





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).31.1
            
            Certification
                of Chief Executive
                Officer pursuant to Section 302 of the Sarbanes-Oxley Act of
                2002.31.2
            
            Certification
                of Chief Financial
                Officer pursuant to Section 302 of the Sarbanes-Oxley Act of
                2002.32.1*
            
            Certification
                of Chief Executive
                Officer and Chief Financial Officer 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.





37


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 7th day of November
      2007.





RC2
      CORPORATION





By  /s/
      Curtis W.
      Stoelting


Curtis
      W.
      Stoelting, Chief Executive Officer






By  /s/
      Jody L.
      Taylor


Jody
      L.
      Taylor, Chief Financial Officer and Secretary








38