** **

**FORM 10-Q**

 

 

 

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

 

**(MARK ONE)**

 

**ý        QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d)**

**            OF THE SECURITIES EXCHANGE ACT OF 1934**

**                For the quarterly period endedMarch 31, 2002**

 

**or**

 

**o        TRANSITION REPORT PURSUANT TO SECTION 13OR 15(D) OF THE SECURITIES**

**            EXCHANGE ACT OF 1934**

**                For the transition periodfrom            to          **

 

**Commission FileNo. 0-22545**

 

 

**DSI Toys, Inc.**

(Exact name of Registrant as specified in itscharter)

 

| **Texas**                                |   | **74-1673513**      |
|------------------------------------------|--------|---------------------|
| (State or other jurisdiction             |   | (I.R.S. Employer    |
| of incorporation or organization)        |   | Identification No.) |
|                                     |   |                |
| **1100 West Sam  Houston Parkway North** |   |                |
| **Houston, Texas**                       |   | **77043**           |
| (Address of principal executive offices) |   | (Zip Code)          |

 

 

Registrant’s telephone number including area code:**(713) 365-9900**

 

 

        Indicate by check markwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes ý   No o

 

 

As of April 30, 2002,9,066,365 shares of common stock, par value $.01 per share, of DSI Toys, Inc.were outstanding.

 

 

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**TABLE OFCONTENTS**

** **

** **

** **

** **

**PART I -FINANCIAL INFORMATION**

 
| Item 1.  |   | Financial Statements                                                                        |   |   |
|----------|--------|---------------------------------------------------------------------------------------------|--------|--------|
|     |   |                                                                                        |   |   |
|     |   | Consolidated Balance Sheet  as of March 31, 2002, and December 31, 2001                     |   |   |
|     |   |                                                                                        |   |   |
|     |   | Consolidated  Statement of Operations for the Three Months Ended March 31, 2002, and 2001   |   |   |
|     |   |                                                                                        |   |   |
|     |   | Consolidated  Statement of Cash Flows for the Three Months Ended March 31, 2002, and 2001   |   |   |
|     |   |                                                                                        |   |   |
|     |   | Consolidated  Statement of Shareholders’ Equity                                        |   |   |
|     |   |                                                                                        |   |   |
|     |   | Notes to  Consolidated Financial Statements                                                 |   |   |
|     |   |                                                                                        |   |   |
|     |   |                                                                                        |   |   |
| Item  2. |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |   |
|     |   |                                                                                        |   |   |
| Item  3. |   | Quantitative  and Qualitative Disclosure About Market Risk                                  |   |   |
|     |   |                                                                                        |   |   |

 

 

**PART II- OTHER INFORMATION**

 
| Item 1.    |   | Legal Proceedings                         |   |   |
|------------|--------|-------------------------------------------|--------|--------|
|       |   |                                      |   |   |
| Item  2.   |   | Change  in Securities and Use of Proceeds |   |   |
|       |   |                                      |   |   |
| Item 5.    |   | Other Information                         |   |   |
|       |   |                                      |   |   |
| Item 6.    |   | Exhibits and Reports  on Form 8-K         |   |   |
|       |   |                                      |   |   |
| Signatures |   |                                      |   |   |
|       |   |                                      |   |   |

** **

**i**

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** **

**PART I — FINANCIAL INFORMATION**

 

## **Item 1**.              FinancialStatements

**DSI Toys, Inc.**

**ConsolidatedBalance Sheet**

 

                                                                                                                                
|                                                                                                  |   | **March 31,**   |       | **December  31,** |   |
|-------------------------------------------------------------------------------------------------------|--------|-----------------|------------|-------------------|--------|
|                                                                                                  |   | **2002**        |       | **2001**          |   |
|                                                                                                  |   | **(Unaudited)** |       |              |   |
| **ASSETS**                                                                                            |   |            |       |              |   |
|                                                                                                  |   |            |       |              |   |
| Current assets:                                                                                       |   |            |       |              |   |
| Cash                                                                                                  |   | $               | 288,834    |              | $      | 284,637 |   |
| Accounts  receivable, net                                                                             |   | 2,744,354       |       | 8,767,550         |   |
| Inventories                                                                                           |   | 5,896,130       |       | 6,739,920         |   |
| Prepaid expenses                                                                                      |   | 2,785,642       |       | 1,981,592         |   |
| Deferred income  taxes                                                                                |   | 1,514,684       |       | 893,000           |   |
| Total current  assets                                                                                 |   | 13,229,644      |       | 18,666,699        |   |
|                                                                                                  |   |            |       |              |   |
| Property and  equipment, net                                                                          |   | 1,702,940       |       | 1,769,284         |   |
| Deferred income  taxes                                                                                |   | 1,312,000       |       | 1,312,000         |   |
| Goodwill, net                                                                                         |   | 9,241,128       |       | 9,241,128         |   |
| Other assets                                                                                          |   | 309,960         |       | 323,624           |   |
|                                                                                                  |   | $               | 25,795,672 |              | $      | 31,312,735 |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                        |   |            |       |              |   |
|                                                                                                  |   |            |       |              |   |
| Current  liabilities:                                                                                 |   |            |       |              |   |
| Accounts payable  and accrued liabilities                                                             |   | $               | 7,156,980  |              | $      | 6,580,780 |   |
| Current portion  of long-term debt                                                                    |   | 401,185         |       | 1,120,650         |   |
| Current portion  of long-term debt due to a related party                                             |   | 1,534,678       |       | 1,751,485         |   |
| Income taxes  payable                                                                                 |   | 69,638          |       | 69,638            |   |
| Total current  liabilities                                                                            |   | 9,162,481       |       | 9,522,553         |   |
|                                                                                                  |   |            |       |              |   |
| Long-term debt                                                                                        |   | 4,730,229       |       | 9,210,390         |   |
| Long-term debt  due to a related party                                                                |   | 3,927,747       |       | 3,289,552         |   |
| Deferred income  taxes                                                                                |   | 156,642         |       | 156,642           |   |
| Total  liabilities                                                                                    |   | 17,977,099      |       | 22,179,137        |   |
| Shareholders’  equity:                                                                           |   |            |       |              |   |
| Preferred stock,  $.01 par value, 5,000,000 shares authorized,  none issued or outstanding            |   |                 |       |                   |   |
| Common stock,  $.01 par value, 35,000,000 shares authorized,  9,066,365 shares issued and outstanding |   | 90,664          |       | 90,664            |   |
|                                                                                                  |
| Additional  paid-in capital                                                                           |   | 5,173,465       |       | 5,173,465         |   |
| Common stock  warrants                                                                                |   | 2,802,500       |       | 2,802,500         |   |
| Accumulated  other comprehensive loss                                                                 |   | (72,539         | )          | (70,928           | )      |
| Retained  earnings (deficit)                                                                          |   | (175,517        | )          | 1,137,897         |   |
| Total  shareholders’ equity                                                                      |   | 7,818,573       |       | 9,133,598         |   |
|                                                                                                  |   | $               | 25,795,672 |              | $      | 31,312,735 |   |

 

 See accompanying notes to consolidatedfinancial statements.

 

1

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** DSI Toys, Inc.**

**Consolidated Statement of Operations**

**(Unaudited)**

 

 
|                                          |   | **Three Months Ended March 31** |       |
|-----------------------------------------------|--------|---------------------------------|------------|
|                                          |   | **2002**                        |       | **2001** |   |
|                                          |   |                            |       |   |   |
| Net  sales                                    |   | $                               | 5,188,860  |   | $ | 6,721,223 |   |
| Cost of goods  sold                           |   | 4,085,708                       |       | 4,929,957 |   |
| Gross profit                                  |   | 1,103,152                       |       | 1,791,266 |   |
| Selling, general  and administrative expenses |   | 3,040,057                       |       | 3,979,454 |   |
| Operating loss                                |   | (1,936,905                      | )          | (2,188,188 | ) |
| Interest expense                              |   | (197,868                        | )          | (267,979 | ) |
| Other income                                  |   | 144,752                         |       | 34,375 |   |
| Loss before  income taxes                     |   | (1,990,021                      | )          | (2,421,792 | ) |
| Benefit from  income taxes                    |   | 676,607                         |       | 871,845 |   |
| Net loss                                      |   | $                               | (1,313,414 | ) | $ | (1,549,947 | ) |
|                                          |   |                            |       |   |   |
| Basic earnings  (loss) per share              |   |                            |       |   |   |
| Loss per share                                |   | $                               | (0.14      | ) | $ | (0.17 | ) |
| Weighted  average shares outstanding          |   | 9,066,365                       |       | 9,066,365 |   |
|                                          |   |                            |       |   |   |
| Diluted earnings  (loss) per share            |   |                            |       |   |   |
| Loss per share                                |   | $                               | (0.14      | ) | $ | (0.17 | ) |
| Weighted average  shares outstanding          |   | 9,066,365                       |       | 9,066,365 |   |

 

See accompanying notes toconsolidated financial statements.

 

2

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** **

**DSI Toys, Inc.**

**Consolidated Statement of Cash Flows**

**(Unaudited)**

 

 
|                                                                                       |   | **Three  Months Ended March 31** |       |
|--------------------------------------------------------------------------------------------|--------|----------------------------------|------------|
|                                                                                       |   | **2002**                         |       | **2001** |   |
| Cash flows from  operating activities:                                                     |   |                             |       |   |   |
| Net loss                                                                                   |   | $                                | (1,313,414 | ) | $ | (1,549,947 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |   |                             |       |   |   |
| Depreciation and  amortization                                                             |   | 214,358                          |       | 355,735 |   |
| Amortization and  write-off of debt discount and issuance costs                            |   | 13,664                           |       | 5,048 |   |
| Amortization of  goodwill                                                                  |   |                             |       | 128,349 |   |
| Provision for  doubtful accounts                                                           |   | 790                              |       | 23,882 |   |
| Deferred income  taxes                                                                     |   | (621,684                         | )          | (866,726 | ) |
| Changes in  assets and liabilities:                                                        |   |                             |       |   |   |
| Accounts  receivable                                                                       |   | 6,022,406                        |       | 4,076,355 |   |
| Inventories                                                                                |   | 843,790                          |       | 397,945 |   |
| Income taxes  payable                                                                      |   |                             |       | (95,298 | )  |
| Prepaid expenses                                                                           |   | (804,050                         | )          | (1,073,387 | ) |
| Accounts payable  and accrued liabilities                                                  |   | 576,200                          |       | (1,239,285 | ) |
| Net cash  provided by operating activities                                                 |   | 4,932,060                        |       | 162,671 |   |
|                                                                                       |   |                             |       |   |   |
| Cash flows from  investing activities:                                                     |   |                             |       |   |   |
| Capital  expenditures                                                                      |   | (148,014                         | )          | (106,049 | ) |
| Increase in  other assets                                                                  |   |                             |       | (159,658 | )  |
| Net cash used in  investing activities                                                     |   | (148,014                         | )          | (265,707 | ) |
|                                                                                       |   |                             |       |   |   |
| Cash flows from  financing activities:                                                     |   |                             |       |   |   |
| Net payments  under revolving lines of credit                                              |   | (719,465                         | )          | (2,243,160 | ) |
| Net payments on  long-term debt                                                            |   | (4,480,161                       | )          | (442,776 | ) |
| Net borrowings  of long-term debt due to a related party                                   |   | 421,388                          |       |   |   |
| Net proceeds  from issuance of warrants                                                    |   |                             |       | 2,700,000 |   |
| Net cash  provided (used) by financing activities                                          |   | (4,778,238                       | )          | 14,064 |   |
|                                                                                       |   |                             |       |   |   |
| Effect of  exchange rate changes on cash                                                   |   | (1,611                           | )          | 14,098 |   |
| Net increase  (decrease) in cash                                                           |   | 4,197                            |       | (74,874 | ) |
| Cash and cash  equivalents, beginning of period                                            |   | 284,637                          |       | 177,682 |   |
| Cash and cash  equivalents, end of period                                                  |   | $                                | 288,834    |   | $ | 102,808 |   |

 

See accompanying notes toconsolidated financial statements.

 

3

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**DSIToys, Inc.**

**Consolidated Statement ofShareholders’ Equity**

(Unaudited)

 
|                                         |   |              |   |        |   |           |   |              |   | **Accumulated**  |      |                  |     |       |      |
|----------------------------------------------|--------|-------------------|--------|-------------|--------|----------------|--------|-------------------|--------|------------------|-----------|-----------------------|----------|------------|-----------|
|                                         |   |              |   |        |   | **Additional** |   |              |   | **Other**        |      |                  |     |       |      |
|                                         |   | **Common  Stock** |   | **Paid-in** |   |           |   | **Comprehensive** |   | **Retained**     |      |                  |     |
|                                         |   | **Shares**        |   | **Amount**  |   | **Capital**    |   | **Warrants**      |   | **Income(Loss)** |      | **Earnings(Deficit)** |     | **Totals** |      |
| Balance, December 31, 2000                   |   | 9,066,365         |   | $           | 90,664 |           | $      | 5,173,465         |   | $                | 102,500   |                  | $        | (27,062    | )         | $ | 2,587,415 |   | $ | 7,926,982 |   |
|                                         |   |              |   |        |   |           |   |              |   |             |      |                  |     |       |      |
| Comprehensive Loss:                          |   |              |   |        |   |           |   |              |   |             |      |                  |     |       |      |
| Net loss                                     |   |              |   |        |   |           |   |              |   |             |      | (1,549,947            | )        | (1,549,947 | )         |
| Foreign currency translation adj. net of tax |   |              |   |        |   |           |   |              |   | 14,098           |      |                  |     | 14,098     |      |
| Comprehensive loss                           |   |              |   |        |   |           |   |              |   |             |      |                  |     | (1,535,849 | )         |
| Warrants issued                              |   |              |   |        |   |           |   | 2,700,000         |   |             |      |                  |     | 2,700,000  |      |
| Balance, December 31, 2001                   |   | 9,066,365         |   | 90,664      |   | 5,173,465      |   | 2,802,500         |   | (70,928          | )         | 1,137,897             |     | 9,133,598  |      |
|                                         |   |              |   |        |   |           |   |              |   |             |      |                  |     |       |      |
| Comprehensive Loss:                          |   |              |   |        |   |           |   |              |   |             |      |                  |     |       |      |
| Net loss                                     |   |              |   |        |   |           |   |              |   |             |      | (1,313,414            | )        | (1,313,414 | )         |
| Foreign currency translation adj. net of tax |   |              |   |        |   |           |   |              |   | (1,611           | )         |                  |     | (1,611     | )         |
| Comprehensive Loss                           |   |              |   |        |   |           |   |              |   |             |      |                  |     | (1,315,025 | )         |
| Balance, March 31, 2002                      |   | 9,066,365         |   | $           | 90,664 |           | $      | 5,173,465         |   | $                | 2,802,500 |                  | ($72,539 | )          | ($175,517 | ) | $ | 7,818,573 |   |
|                                              |        |                   |        |             |        |                |        |                   |        |                  |           |                       |          |            |           |  |  |  |  |  |  |

 

 

See accompanying notes toconsolidated financial statements.

 

4

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# **DSI Toys, Inc.**

**Notesto Consolidated Financial Statements**

**(Unaudited)**

 

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

 

The accompanyingunaudited consolidated financial statements of DSI Toys, Inc. and itswholly-owned subsidiaries (the “Company”) have been prepared in accordance withaccounting principles generally accepted in the United States of America forinterim financial information and with the instructions to Form 10-Q.  Accordingly, they do not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States of America for complete financial statements and should beread in conjunction with the financial statements and notes thereto appearingin the Company’s Annual Report on Form 10-K and Form 10-K/A for the fiscal yearended December  31,2001.

 

In the opinion ofthe Company’s management, all adjustments necessary for a fair presentation ofthe results of operations for all periods reported have been included.  Such adjustments consist only of normalrecurring items.

 

The results ofoperations for the three months ended March 31, 2002, are not necessarilyindicative of the results expected for the full year ending December 31, 2002.

 

#### **2.**                                      SignificantAccounting Policies

#### ** **

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

 

*RevenueRecognition*— TheCompany recognizes revenue when products are shipped and title passes tounaffiliated customers.  In most cases,title transfers to our customers when the product has been presented toshipment forwarders on FOB Asia sales and when the product is picked up fromour distribution facilities on domestic sales.

 

*Allowancefor Doubtful Accounts*—  Accounts receivable arereduced by an allowance for amounts that may become uncollectible in thefuture.  The Company’s estimate for itsallowance is based on two methods which are combined to determine the totalamount reserved.  First, the companyevaluates specific accounts where we have information that the customer mayhave an inability to meet its financial obligations (bankruptcy, etc.).  In these cases, the company uses itsjudgement, based on the best available facts and circumstances, and records aspecific reserve for that customer against amounts due to reduce the receivableto the amount that is expected to be collected.  These specific reserves are reevaluated and adjusted asadditional information is received that impacts the amounts reserved.  Second, a general reserve is established forall other customers based on historical collection and write-off experience.  If circumstances change, the Company’sestimates of the recoverability of amounts due the Company could be reduced bya material amount.

 

*Allowancefor Returns and Defectives*— The Company records a provision for estimated salesreturns and defectives on sales in the same period as the related revenue isrecorded.  Our sales to customersgenerally do not give them the right to return product or to cancel firmorders.  However, as is common in theindustry, we sometimes accept returns for stock balancing and negotiateaccommodations to customers, which includes price discounts, credits andreturns when demand for specific products fall below expectations.  Additionally, customers are given credit forany defective products they may have received. The allowance estimates are based on historical sales returns anddefective rates, analysis of credit memo data and other known factors.  If the data the Company uses to calculatethese estimates does not properly reflect future returns and defectives, revenuecould be overstated and future operating results adversely affected.

 

 

5

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*Inventories* — Inventory is valued at the lower ofcost or market.  The Company reviews thebook value of slow-moving items, discounted product lines and individual productsto determine if these items are properly valued.  The Company identifies these items and assesses the ability todispose of them at a price greater than cost. If it is determined that cost is less than market value, then cost isused for inventory valuation.  If marketvalue is less than cost, then the Company establishes a reserve for the amountrequired to value the inventory at market. If the Company is not able to achieve its expectations of the netrealizable value of the inventory at its current value, the Company wouldadjust its reserve accordingly.

 

*DeferredTaxes* — TheCompany recognizes deferred tax assets and liabilities based on the differencesbetween the financial statement carrying amounts and the tax bases of assetsand liabilities.  Generally acceptedaccounting principles require that we review deferred tax assets forrecoverability and if needed, establish a valuation allowance for those amountsdeemed unrecoverable.  The reviewconsiders historical taxable income, projected future taxable income, and theexpected timing of the reversals of temporary differences.  Deferred tax assets of the Company areprimarily the result of unused net operating loss carry-forwards and foreigntax credits which expire over a range of years.  In 2001, the Company recorded a valuation allowance of $566,000related to foreign tax credits expiring in 2002, as it was determined that itwas more likely than not that these credits would not be realized.

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

#### **Goodwill has been amortized over 20years using the straight-line method in 2001 and 2000.  In 2002, the Company adopted Statement ofFinancial Accounting Standards, No. 142, “Goodwill and Other IntangibleAssets”, which eliminates amortization of goodwill beginning in January 2002and requires an annual impairment assessment based on its estimated fair value,using future discounted cash flow and other factors.  The initial December 31, 2001 fair value assessment was completedby an independent company during the 1st quarter of 2002.  Based on this review an impairmentadjustment is not required.**

#### ** **

#### **3.             Accounts Receivable**

#### ** **

Accounts receivable consist of the following:
|                      |   | **March 31,** |      | **December 31,** |   |
|---------------------------|--------|---------------|-----------|------------------|--------|
|                      |   | **2002**      |      | **2001**         |   |
| Trade receivables         |   | $             | 5,477,433 |             | $      | 12,717,550 |   |
| Provisions for:           |   |          |      |             |   |
| Discounts and markdowns   |   | (694,281      | )         | (1,472,706       | )      |
| Return of defective goods |   | (351,331      | )         | (777,294         | )      |
| Doubtful accounts         |   | (1,687,467    | )         | (1,700,000       | )      |
| Accounts receivable, net  |   | $             | 2,744,354 |             | $      | 8,767,550 |   |

#### ** **

#### **4.             Segment Information**

 

Financial information forthe three months ended March 31, 2002 and 2001 is as follows:
|                               |   | **United States** |      | **Hong Kong** |   | **Consolidated** |   |
|------------------------------------|--------|-------------------|-----------|---------------|--------|------------------|--------|
| Three months ended March 31, 2002: |   |              |      |          |   |             |   |
| Net sales                          |   | $                 | 2,743,621 |          | $      | 2,445,239        |   | $ | 5,188,860 |   |
| Operating loss                     |   | (1,536,257        | )         | (400,648      | )      | (1,936,905       | )      |
| Total assets at March 31, 2002     |   | 22,563,906        |      | 3,231,766     |   | 25,795,672       |   |
|                               |   |              |      |          |   |             |   |
| Three months ended March 31, 2001: |   |              |      |          |   |             |   |
| Net sales                          |   | $                 | 3,794,537 |          | $      | 2,926,686        |   | $ | 6,721,223 |   |
| Operating loss                     |   | (1,801,958        | )         | (386,230      | )      | (2,188,188       | )      |
| Total assets at March 31, 2001     |   | 24,081,386        |      | 3,061,386     |   | 27,142,772       |   |

 

6

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## **Item2.    Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

**Exceptas otherwise indicated, references to the “Company” refer to DSI Toys, Inc. andits four wholly owned Hong Kong subsidiaries, DSI(HK) Limited, MeritusIndustries Limited, RSP Products Limited and Elite Dolls Limited. The terms“fiscal year” and “fiscal” refer to the Company’s fiscal year, which is theyear ending December 31 of the calendar year mentioned (*e.g*.,a reference to fiscal 2001 is a reference to the fiscal year ended December 31,2001).**

 

#### **General**

 

The followingdiscussion and analysis should be read in conjunction with the financialstatements and notes thereto, and the information included elsewhere herein.

 

The Company designs, develops, markets and distributeshigh quality, innovative dolls, toys and consumer electronics products.  Core products include *Tech-Link*® communicationsproducts, KAWASAKI® electronic musical instruments, *GearHeadTM* remote controlvehicles, *LazerDoodle*TM,the electronic drawing toy,**and a full range of special feature dollbrands including *Sassy SecretsTM, Somersault SaraTM, Too Cute TwinsTM, Childhood VersesTM,Pride & Joy®, Little Darlings®,*along with interactive plushproducts including *Kitty Kitty Kittens®, Frisky KittensTM, Puppy PuppyPuppies®,*and girls’ activity products, *Air Nails SalonTM,*and*Twist andTwirl BraiderTM.*

 

The Company has four major product categories: Youth Communications,Musical Instruments,  Girls Toys andBoys Toys.

 

***YouthCommunications***

 

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

* *

*Musical Instruments*

 

The Musical Instrument line includes the branded lineof KAWASAKI® guitars, drum pads, saxophones and keyboards.

 

*Girls’ Toys*

 

The Girls’ Toys product category includes dolls,interactive plush toys, play sets, accessories, and girls’ activity toys.  The Girls’ Toys portfolio of brands includes*SassySecretsTM, Somersault SaraTM, Too Cute TwinsTM, Childhood VersesTM, Pride &Joy®, Little Darlings®,*along with interactive plush productsincluding *KittyKitty Kittens®, Frisky KittensTM, Puppy Puppy Puppies®,*and girls’activity products, *Air Nails SalonTM,*and*Twist and Twirl BraiderTM.*

 

*Boys’Toys*

 

The Boys’ Toys product category includes radio controland infra-red control vehicles.  Thebrands in this product category are *GearHead*TM radio control vehicles,including the *Insector*®, and the unique ultra-articulated *StreetSavageTM*.  The *GearHead*äbrand also includes *GearHeadTM Jr*. infra-red control vehicles.

 

 

7

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#### **Results of Operations**

The following table setsforth for the periods indicated certain income and expense items expressed as apercentage of net sales:
|                                         |   | **Percent of Net Sales**        |   |
|----------------------------------------------|--------|---------------------------------|--------|
|                                         |   | **Three Months Ended March 31** |   |
|                                         |   | **2002**                        |   | **2001** |   |
| Net sales                                    |   | 100.0                           | %      | 100.0 | % |
| Costs of goods sold                          |   | 78.7                            |   | 73.3 |   |
| Gross profit                                 |   | 21.3                            |   | 26.7 |   |
| Selling, general and administrative expenses |   | 58.6                            |   | 59.2 |   |
| Operating loss                               |   | (37.3                           | )      | (32.5 | ) |
| Interest expense                             |   | (3.8                            | )      | (4.0 | ) |
| Other income                                 |   | 2.8                             |   | 0.5 |   |
| Loss before income taxes                     |   | (38.3                           | )      | (36.0 | ) |
| Benefit from income taxes                    |   | 13.0                            |   | 12.9 |   |
| Net loss                                     |   | (25.3                           | )%     | (23.1 | )% |

 

 

***Three Months Ended March 31, 2002, Compared to theThree Months Ended March 31, 2001***

*Netsales.*  Net sales for the three months ended March31, 2002, decreased $1.5 million or 22.8%, to $5.2  million, from $6.7 million in the first quarter of 2001.  The decrease was due to customers’ focus onminimizing inventory in an uncertain retail climate.

 

Net sales of youth communications products during the first quarterended March 31, 2002, decreased approximately $800,000, or 40.8%, toapproximately $1.1 million from approximately $1.9 million in the first quarterof 2001.  The reduced sales reflects amajor customer’s focus on changing from youth communication SKU’s to productsin a different category.

 

Net sales of musical instrument products was approximately $400,000during the first quarter of 2002, a decrease of approximately $400,000, or 52%,from the approximately $800,000 sold during the quarter ending March 31,2001.  Reduced sales are due tocustomers clearing old merchandise left over from the holiday season whileawaiting styling and packaging changes on 2002 products.

 

Net sales of girls toys increased approximately $200,000, or 8.3%, toapproximately $3.1 million during the first quarter ended March 31, 2002 fromapproximately $2.9 million in the first quarter in 2001.  The increased sales of the first quarter area result primarily of initial sales of the *Sassy Secrets*TM doll and continued sales of*Too CuteTwins*TM (introduced in the 3rd quarter of 2001), offset byreduced sales in the *Elite*® doll line.

 

Net sales of boys toys decreased approximately $500,000 or 60.8% toapproximately $300,000 in the first quarter ended March 31, 2002, from $800,000in the first quarter of 2001.  Thedecreased sales primarily resulted from close-out sales at lower margins of *Data DawgTM*in the first quarter of 2001.

 

Net sales of products in other categories during the first quarterended March 31, 2002, decreased approximately $100,000 or 27.7% toapproximately $200,000 during the first quarter ended March 31, 2002, from$300,000 in the first quarter of 2001. The decrease primarily results from reduced sales of video phones in2002 versus 2001.

 

International net sales for the three months ended March 31, 2002,increased approximately $200,000, or 25.1%, to approximately $1.1million, from approximately $900,000 in the first quarter of 2001.  The increase was due to increased sales toItaly compared to the same period of last year.

 

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*Grossprofit.*  Gross profit decreased approximately$700,000, or 38.4%, to approximately $1.1 million for the first quarter endedMarch 31, 2002, from approximately $1.8 million in the first quarter of2001.  Gross profit as a percentage ofnet sales decreased to 21.3% in the first quarter ended March 31, 2002, from26.6% in the first quarter of fiscal 2001. The gross profit percentage decrease reflects a higher percentage ofsales of closeout products at low margins in the first quarter of 2002 comparedthe same period in 2001.

 

*Selling,general and administrative expenses.*  Selling,general and administrative expenses decreased approximately $900,000 to $3.1 millionin the first quarter ended March 31, 2002, compared with $4.0 million for thefirst quarter of 2001.  The decreaseoccurred in all areas, driven primarily by reductions in employee expense,commissions, advertising, goodwill amortization, depreciation, travel andentertainment, professional fees and general operation expense.

 

*Interestexpense.*  Interest expense during the first quarterended March 31, 2002, decreased to $198,000 from  $268,000 in the first quarter of 2001 as a result of lower borrowinglevels and lower interest rates during the period.

 

#### **Liquidity andCapital Resources**

 

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

 

The Company’s operating activities provided net cash of $4.9 millionduring the first quarter of fiscal 2002, resulting primarily from decreases inaccounts receivable and inventories, offset by increases in accounts payable and prepaid expense.  Net cash used in investing activities duringthe first quarter of fiscal 2002 was $148,000 and was a result of capitalexpenditures.  Net cash used infinancing activities was $4.8 million in the first quarter of fiscal 2002 as aresult of payments of long-term debt. The Company’s working capital as of March 31, 2002, was $4.1 million andunrestricted cash was $289,000, compared to working capital of $3.3 million andunrestricted cash of $102,000 as of March 31, 2001.

 

The seasonal nature of the toy business results in complex workingcapital needs.  The Company’s workingcapital needs, which the Company generally satisfies through short-term borrowings,are greatest in the last two fiscal quarters. To manage these working capital requirements, the Company maintainscredit facilities collateralized principally by accounts receivable andinventory.  The Company currentlymaintains a line of credit facility with Dao Heng Bank Limited (the “Dao HengCredit Facility”) and a revolving credit facility with Sunrock Capital Corp.(the “Revolver”).  As of April 23, 2002,the Company had additional eligible borrowing capacity of $450,000 in theaggregate under the Dao Heng Credit Facility and the Revolver.

 

On March 19, 2001, the Company issued to MVII, LLC (“MVII”), anInvestment Warrant to acquire 1.8 million shares of the Company’s Common Stockat a purchase price of $2.7 million. The Investment Warrant is exercisable in whole or in part for a ten-yearperiod beginning on June 3, 2002.  Asissued, the Investment Warrant was subject to certain anti-dilutionadjustments.  In connection with theissuance of the Investment Warrant, the Company and MVII entered into aRegistration Rights Agreement, pursuant to which MVII was granted certainpiggyback registration rights with respect to the shares of the Common Stockunderlying the Warrant.  Shares ofCommon Stock acquired by MVII upon exercise of the Warrant are subject to theterms of a Shareholders’ and Voting Agreement dated as of April 5, 1999, amongMVII and certain of the Company’s other shareholders.  Proceeds from the sale of the Investment Warrant were used by theCompany for current working capital.

 

On January 31, 2002, at the request of NASDAQ and with the agreement ofMVII, the Company issued an amended and restated Investment Warrant, whichamended and restated in its entirety the Investment Warrant by removing allanti-dilution provisions.  In addition,the Company and MVII entered into an Amended and Restated Registration RightsAgreement, which amended and restated in its entirety the Registration RightsAgreement, by removing all of the provisions regarding the anti-dilutionprovisions of the original Investment Warrant.

 

 

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In connection with the acquisition of Meritus Industries, Inc., inJanuary 2000, the Company borrowed $5 million from MVII, evidenced by apromissory note dated January 7, 2000 (the “MVII Note”).  On March 6, 2002, pursuant to the terms ofthe Revolver and the MVII Note, the Company reborrowed $500,000 of the originalprincipal that the Company had paid on the MVII Note.  The proceeds were used to finance the normal business operationsof the Company.

 

The Company has budgeted approximately $1.3 million for capitalexpenditures for fiscal 2002 consisting primarily of purchases of tools andmolds and information technology systems. Based on projected fiscal 2002 operating results, the Company believescash flows from operations and available borrowings under the Revolver and theDao Heng Credit Facility  will besufficient to meet the Company’s operating cash requirements and fund its anticipatedcapital expenditures.  However, therecan be no assurance the Company will meet its projected operating results.  In connection with any future cash needs oracquisition opportunities, the Company may incur additional debt or issueadditional equity or debt securities depending on market conditions, as well asother factors.

 

The Company is obligated to make future minimum royalty payments undercertain of its license agreements.  Asof March 31, 2002, the Company was required to make an aggregate ofapproximately $150,000 in payments of guaranteed royalties under certainlicenses in fiscal 2002 and $225,000 thereafter through fiscal 2003.

#### ** **

#### **Seasonality**

 

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

 

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

** **

**Seasonal Financing**

** **

**TheCompany’s financing of seasonal working capital typically peaks in the thirdquarter of the year, when accounts receivable are at their highest due toincreased sales volume and sales programs, and when inventories are at theirhighest in anticipation of expected second half sales volume.  See “Seasonality.”  The Company finances its seasonal working capital requirements byusing internally generated cash and borrowings under the Dao Heng CreditFacility and the Revolver with Sunrock.**

 

**CautionaryStatement**

 

Certain written and oral statements made orincorporated by reference from time to time by the Company or itsrepresentatives in this Form 10-Q, other filings or reports with the Securitiesand Exchange Commission, press releases, conferences, or otherwise, are“forward-looking statements” within the meaning of the Private SecuritiesLitigation Reform Act of 1995.  TheCompany is including this Cautionary Statement to make applicable and takeadvantage of the safe harbor provisions of the Private Securities LitigationReform Act of 1995 for any such forward-looking statements.  Forward-looking statements can be identifiedby the use of terminology such as “believe,” “anticipate,” “expect,”“estimate,” “may,” “will,” “should,” “project,” “continue,” “plans,” “aims,”“intends,” “likely,” or other words or phrases of similar terminology.  Management cautions you that forward-lookingstatements involve risks and uncertainties which may cause actual results todiffer materially from the forward-looking statements.  For a discussion of some of the factors thatmay cause actual results to differ materially from those suggested byforward-looking statements, please read carefully the information underItem 1, “Risk Factors”, in the Company’s 2000 Annual Report on Form10-K.  In addition to the Risk Factorsand other important factors detailed herein and from time to time in otherreports filed by the Company with the Securities and Exchange Commission,including Forms 8-K, 10-Q, and 10-K, the following important factors couldcause actual results to differ materially from those suggested by anyforward-looking statements.

 

 

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*Marketplace Risks*

•                        Increased competitive pressure, both domestically andinternationally, which may negatively affect the sales of the Company’sproducts;

•                        Changes in public and consumer taste, which maynegatively affect the sales of the Company’s products;

•                        Significant changes in the play patterns of children,whereby they are increasingly attracted to more developmentally advancedproducts at younger ages, which may affect brand loyalty and the perceivedvalue of and demand for the Company’s products; and

•                        Possible weaknesses in economic conditions, bothdomestically and internationally, which may negatively affect the sales of theCompany’s products and the costs associated with manufacturing and distributingthese products.

*FinancingConsiderations*

•                        Currency fluctuations, which may affect the Company’sreportable income; significant changes in interest rates, both domestically andinternationally, which may negatively affect the Company’s cost of financingboth its operations and investments.

*OtherRisks*

•                        Changes in laws or regulations, both domestically andinternationally, including those affecting consumer products or traderestrictions, which may lead to increased costs or interruption in normalbusiness operations of the Company;

•                        Future litigation or governmentalproceedings, which may lead to increased costs or interruption in normalbusiness operations of the Company; and

•                        Labor disputes, which may lead toincreased costs or disruption of any of the Company’s operations.

•                        Failure to demonstrate compliance withNasdaq Marketplace Rules could cause the Company’s securities to bedelisted.  *See Part II, Item 5.*

**Therisks included herein are not exhaustive. Other sections of this Form 10-Q may include additional factorswhich could materially and adversely impact the Company’s business, financialcondition, and results of operations. Moreover, the Company operates in a very competitive and rapidlychanging environment.  New risk factorsemerge from time to time and it is not possible for management to predict allsuch risk factors on the Company’s business, financial condition or results ofoperations or the extent to which any factor, or combination of factors, maycause actual results to differ materially from those contained in anyforward-looking statements.  Given theserisks and uncertainties, investors should not place undue reliance onforward-looking statements as a prediction of actual results.**

** **

## **Item3.  Quantitative and QualitativeDisclosure About Market Risk**

 

                TheCompany does not hold any investments in market risk sensitiveinstruments.  Accordingly, the Company believesthat it is not subject to any material risks arising from changes in interestrates, foreign currency exchange rates, commodity prices, equity prices orother market changes that affect market risk instruments.

 

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**PART II - OTHER INFORMATION**

#### ** **

## **Item 1.  Legal Proceedings**

 

                TheCompany is involved in various legal proceedings and claims incident to thenormal conduct of its business.  TheCompany believes that such legal proceedings and claims, individually and inthe aggregate, are not likely to have a material adverse effect on itsfinancial position or results of operations. The Company maintains product liability and general liability insurancein amounts it believes to be reasonable.

 

## **Item2.  Changes in Securities and Use ofProceeds**

 

On March 19, 2001, the Company issued to MVII an Investment Warrant toacquire 1.8 million shares of the Company’s Common Stock at a purchase price of$2.7 million.  The Investment Warrant isexercisable in whole or in part for a ten-year period beginning on June 3,2002.  As issued, the Investment Warrantwas subject to certain anti-dilution adjustments.  In connection with the issuance of the Investment Warrant, theCompany and MVII entered into a Registration Rights Agreement, pursuant towhich MVII was granted certain piggyback registration rights with respect tothe shares of the Common Stock underlying the Warrant.  Shares of Common Stock acquired by MVII uponexercise of the Warrant are subject to the terms of a Shareholders’ and VotingAgreement dated as of April 5, 1999, among MVII and certain of the Company’sother shareholders.  Proceeds from thesale of the Investment Warrant were used by the Company for current workingcapital.

 

On January 31, 2002, at the request of NASDAQ and with the agreement ofMVII, the Company issued an amended and restated Investment Warrant, whichamended and restated in its entirety the Investment Warrant by removing allanti-dilution provisions.  In addition,the Company and MVII entered into an Amended and Restated Registration RightsAgreement, which amended and restated in its entirety the Registration RightsAgreement, by removing all of the provisions regarding the anti-dilutionprovisions of the original Investment Warrant. *See“Management’s Discussion and Analysis of Financial Condition and Results ofOperations — Liquidity and Capital Resources.”*

 

## **Item 5.  Other Information**

 

On February 14, 2002, the Company received notice fromThe Nasdaq Stock Market, Inc. that the Company’s common stock had closed belowthe minimum of $1.00 per share requirement for continued inclusion on theNasdaq SmallCap Market under Marketplace Rule 4310(c)(4) (the “Rule”).  If, prior to August 13, 2002, the Company’scommon stock closes at $1.00 or more for a minimum of 10 consecutive tradingdays, the Company will receive notification that it is in compliance with theRule.  If compliance is not demonstratedby August 13, 2002, but the Company meets the initial listing criteria for theNasdaq SmallCap Market under Marketplace Rule 4310(c)(2)(A), the Company willbe granted an additional 180 calendar day grace period to demonstratecompliance.  Otherwise, the Company willreceive notification that its securities will be de-listed.  If this occurs, the Company may appeal thede-listing determination to a  NasdaqListing Qualifications Panel.

 

The Company has signed a lease for approximately17,000 square feet of office space at 10110 West Sam Houston Parkway, South,Houston, TX  77099, to replace the leaseon its current corporate offices which expires August 31, 2002.  The Company is scheduled to move in to thenew space during the first half of August 2002.

 

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

 

a)              Exhibits

The information required by this Item 6 (a) is set forth in the Indexto Exhibits accompanying this quarterly report and is incorporated herein byreference.

 

b)             Reportson Form 8-K

The Company filed a Form 8-K dated January 22, 2002, (filed on February5, 2002) to announce the establishment of a special reserve due to K-mart Corp.filing for Chapter 11 bankruptcy protection.

 

 

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**SIGNATURES**

 

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                      |   | DSI Toys, Inc.                                |
|---------------------------|--------|-----------------------------------------------|
|                      |   |                                          |
|                      |   |                                          |
| Dated:  May 13, 2002 |   | /s/ JOSEPH S. WHITAKER                        |
|                      |   | Joseph S. Whitaker                            |
|                      |   | President and  Chief Executive Officer   |
|                      |   |                                          |
|                      |   |                                          |
|                      |   |                                          |
| Dated:  May 13, 2002 | By:    | /s/ ROBERT L.  WEISGARBER                     |
|                      |   | Robert L. Weisgarber                          |
|                      |   | Chief Financial Officer                       |
|                      |   | (Principal Financial  and Accounting Officer) |

 

 

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**Index to Exhibits**

 
| 3.1    |   | Amended and  Restated Articles of Incorporation of the Company. (1)                                                                                                                                                                                                   |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                  |
| 3.1.1  |   | Amendment to  Amended and Restated Articles of Incorporation of the Company (filed as  Exhibit 3.1.1 to the Company’s Form 10-Q for the quarterly period ended April  30, 1999), incorporated herein by reference.                                               |
|   |   |                                                                                                                                                                                                                                                                  |
| 3.2    |   | Amended and Restated  Bylaws of the Company. (1)                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                  |
| 3.3    |   | Amendment to  Amended and Restated Bylaws of the Company. (1)                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                  |
| 4.1    |   | Amended and  Restated Investment Warrant by and between the Company and MVII, LLC, dated  January 31, 2002 (filed as Exhibit 4.8 to the Company’s Form 10-K for the  fiscal year ended December 31, 2001), incorporated herein by reference.                     |
|   |   |                                                                                                                                                                                                                                                                  |
| 4.2    |   | Amended and  Restated Registration Rights Agreement by and between the Company and MVII,  LLC dated January 31, 2002 (filed as Exhibit 4.9 to the Company’s Form 10-K  for the fiscal year ended December 31, 2001), incorporated herein by  reference.          |
|   |   |                                                                                                                                                                                                                                                                  |
| 10.1   |   | Memorandum of  Re-borrowing of Principal by and between the Company and MVII, LLC dated  March 6, 2002 (filed as Exhibit 10.63 to the Company’s Form 10-K for the  fiscal year ended December 31, 2001), incorporated herein by reference.                       |
|   |   |                                                                                                                                                                                                                                                                  |
| 10.2   |   | Amendment No. 7  dated March 20, 2002, to Loan and Security Agreement by and between Sunrock  Capital Corp. and the Company (filed as Exhibit 10.64 to the Company’s Form  10-K for the fiscal year ended December 31, 2001), incorporated herein by  reference. |
|   |   |                                                                                                                                                                                                                                                                  |
| 10.3   |   | Unconditional  Guaranty Agreement dated March 20, 2002, by the Company and Dao Heng Bank  Limited (filed as Exhibit 10.65 to the Company’s Form 10-K for the fiscal  year ended December 31, 2001), incorporated herein by reference.                            |
|   |   |                                                                                                                                                                                                                                                                  |
| 10.4   |   | Amendment No. 8  dated March 29, 2002, to Loan and Security Agreement by and between Sunrock  Capital Corp. and the Company (filed as Exhibit 10.66 to the Company’s Form  10-K for the fiscal year ended December 31, 2001), incorporated herein by  reference. |

 

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(1) Filed as apart of the Registrant’s Registration Statement on Form S-1 (No. 333-23961) andincorporated herein by reference.

 

 

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