**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-K**

 

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

 

| **For the fiscal year ended:December 31, 2002** |   | **Commission  File Number:  0-22545** |
|-------------------------------------------------|--------|---------------------------------------|

** **

| **DSI TOYS, INC.**                                                                |
|-----------------------------------------------------------------------------------|
| (Exact name of Registrant as specified in its charter)                            |
|                                                                              |   |   |
| **Texas**                                                                         |   | **74-1673513** |
| (State or other jurisdiction  of incorporation or organization)                   |   | (I.R.S. Employer  Identification No.) |
|                                                                              |   |   |
| **10110 West Sam  Houston Parkway South,  Suite 150  Houston, Texas**             |   | **77099** |
| (Address of principal executive offices)                                          |   | (Zip Code) |
|                                                                              |   |   |
| Registrant’s telephone number, including area code:  **(713) 365-9900** |
|                                                                              |   |   |
| Securities registered pursuant to Section  12(b) of the Act:                      |

 

| **Title of each class**      |   | **Name of each exchange on which  registered** |
|------------------------------|--------|------------------------------------------------|
| Common Stock, $.01 par value |   | Over the Counter Bulletin Board                |

 

Securities registered pursuant to Section12(g) of the Act:

**None**

 

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

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof Registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K.  o

 

Indicateby check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes o   No  ý

 

Theaggregate market value of the voting common stock held by non-affiliates of theRegistrant as of June 28, 2002 was $1,899,183.

 

Asof  March 14, 2003 there were 10,866,365shares of common stock, $.01 par value, outstanding.

 

 

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**Tableof Contents**

 
| PART I                                                   |
|----------------------------------------------------------|
|                                                     |   |   |
| Item 1.                                                  | Business |
|                                                     |   |   |
| Item 2.                                                  | Properties |
|                                                     |   |   |
| Item 3.                                                  | Legal Proceedings |
|                                                     |   |   |
| Item  4.                                                 | Submission  of Matters to a Vote of Security Holders |
|                                                     |   |   |
| PART II                                                  |
|                                                     |
| Item  5.                                                 | Market  for Registrant’s Common Equity and Related Shareholder Matters |
|                                                     |   |   |
| Item 6.                                                  | Selected  Consolidated Financial Data |
|                                                     |   |   |
| Item  7.                                                 | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
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| Item  7A.                                                | Quantitative  and Qualitative Disclosures about Market Risk |
|                                                     |   |   |
| Item  8.                                                 | Financial  Statements and Supplementary Data |
|                                                     |   |   |
| Item  9.                                                 | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure |
|                                                     |   |   |
| PART III                                                 |
|                                                     |   |   |
| Item  10                                                 | Directors  and Executive Officers of the Registrant |
|                                                     |   |   |
| Item 11                                                  | Executive Compensation |
|                                                     |   |   |
| Item  12.                                                | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters |
|                                                     |   |   |
| Item  13                                                 | Certain  Relationships and Related Transactions |
|                                                     |   |   |
| Item 14                                                  | Controls and  Procedures |
|                                                     |   |   |
| Item 15                                                  | Principal  Accountant Fees and Services |
|                                                     |   |   |
| PART IV                                                  |
|                                                     |   |   |
| Item 16.                                                 | Exhibits, Financial Statement Schedules, and  Reports on Form 8-K |
|                                                     |   |   |
| Signatures                                               |
|                                                     |   |   |
| Index  to Consolidated Financial Statements and Schedule |
|                                                     |   |   |
| Index to Exhibits                                        |

 

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**PARTI**

**ITEM 1.  BUSINESS**

 

**GeneralDevelopment of the Business**

 

Except as otherwiseindicated, references to the “Company” refer to DSI Toys, Inc. and its whollyowned Hong Kong subsidiary, DSI(HK) Limited (“DSI(HK)”).  The terms “fiscal year” and “fiscal” referto the Company’s fiscal year which is the year ending December 31 of thecalendar year mentioned (*e.g*., a reference to fiscal 2002 is areference to the fiscal year ended December 31, 2002).  Effective December 31, 1999, the Companychanged its fiscal year end from January 31 to a calendar year end.

 

The Company designs,develops, markets and distributes high quality, innovative dolls, toys andconsumer electronics products.  Coreproducts include *Tech-Link*® communications products, KAWASAKI® electronicmusical instruments, *GearHead*TM remote control vehicles, *DJ Skribble*®*’s Spinheads*TMmusical figures and toys, a full range of special feature doll brands including*SweetFaith®*, *Pride & Joy®*, *Too Cute Twins*® and *Lovin’TouchTM*life-like dolls,*Baby Knows Her NameTM*talking doll, *ChildhoodVersesTM*nursery rhyme dolls*, Little Darlings®* dolls and CollectiblePlush, including *Kitty, Kitty, Kittens®*and*Puppy, Puppy, Puppies®*.

 

The Company wasincorporated in Texas in 1970.   Itsexecutive offices are located at 10110 West Sam Houston Parkway South, Suite150, Houston, Texas, 77099, telephone (713) 365-9900.  The Company’s website can be reached at http://www.DSIToys.com.

 

**MeritusAcquisition**

 

Effective January 7,2000, the Company acquired by way of merger Meritus Industries, Inc.(“Meritus”), a privately held toy manufacturer, engaged in the manufacturingand marketing of dolls, doll houses, doll accessories, and girls’ toys.  As a result of the merger, the Company addedthe *ForeverGirl Friends*® brand accessories for 11-1/2” fashion dolls, and *LittleDarlings®*brand value-priced action feature dolls to its productofferings, as well as the *Elite Dolls*TM brand,**which was created byMeritus specifically to manufacture and market *Lifetime Play DollsTM*, a lineof exquisite 18” dolls and accessories suitable for playing or collecting.

 

The Company also acquiredthree wholly-owned Hong Kong subsidiaries in the merger with Meritus: MeritusIndustries Limited, RSP Products Limited, and Elite Dolls Limited, each ofwhich were engaged in doll manufacturing operations.  The Company transferred the operations of these entities to DSI(HK) and liquidated the three acquired subsidiaries effective October 22, 2002.

 

**Descriptionof Business Segments and Products**

 

The Company has threemajor product categories which represent the Company’s operating segments:Juvenile Audio Products, Girls’ Toys and Boys’ Toys.  Because these operating segments all have similar economiccharacteristics, the Company has one reportable business segment.  For additional information with respect tothe Company’s business segment reporting, see Note 13 to the ConsolidatedFinancial Statements.

 

*JuvenileAudio Products*

 

The Juvenile AudioProduct category consists of Youth Electronics products and MusicalInstruments.  Products in the YouthElectronics line include walkie-talkies, wrist watch walkie-talkies, audioproducts and novelty electronic products. The category brands include *Tech-Link*® communications products,walkie-talkies and bike alarms, the new *BioScan*TM *Room GuardianTM,*and DJ Skribble*®’sSpinheadsTM*, a new**line of musical toys*.*  The Musical Instrument line also includes the branded line ofKAWASAKI® guitars, drum-pads, saxophones and keyboards.

 

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*Girls’Toys*

 

The Girls’ Toys productcategory includes dolls, interactive plush toys, play sets, accessories, andgirls’ activity toys.  The Girls’ Toysportfolio of brands includes *Baby Knows Her NameTM, Lovin’ TouchTM, ChildhoodVersesTM, Pride & Joy®,*and*Little Darlings®,*along with interactiveplush products and girls’ activity products such as *Twist and Twirl BraiderTM.*

 

*Boys’Toys*

 

The Boys’ Toys productcategory includes radio control and infra-red control vehicles.  The brands in this product category are *GearHead*TMradio control vehicles, including the *Insector*®, and the uniqueultra-articulated *Street SavageTM*and *Crazy Taxi*TM, based on the popular Sega ofAmerica, Inc. arcade and home video game of the same name.

 

*ProductIntroductions*

 

New product introductionsduring 2002 included KAWASAKI® foldable keyboards and drumpads, the *LazerDoodle*TMelectronic drawing toy, the *Somersault Sara*TM interactive electronicdoll, and the *Dual FusionTM*radio control vehicle.

 

The following tabledepicts the Company’s net sales, as a percentage of total net sales, by productcategory for the fiscal years indicated. 

** **
| **Product Category**     |   | **2002** |   | **2001** |   | **2000** |   |
|--------------------------|--------|----------|--------|----------|--------|----------|--------|
| Juvenile  Audio Products |   | 40.3     | %      | 38.8     | %      | 39.5     | %      |
| Girls’  Toys        |   | 40.1     |   | 46.4     |   | 39.8     |   |
| Boys’  Toys         |   | 12.6     |   | 12.6     |   | 18.0     |   |
| Other                    |   | 7.0      |   | 2.2      |   | 2.7      |   |
| Total                    |   | 100.0    | %      | 100.0    | %      | 100.0    | %      |

 

Between 30% and 40% ofthe Company’s products (by dollar volume of net sales) are replaced each yearthrough the introduction of new products. As a result of this turnover, product development is critical to the Company’sbusiness.  The Company develops bothproprietary and non-proprietary products. The Company’s proprietary product lines consist of products that (i) arelicensed from outside inventors and designers, (ii) incorporate trademarkslicensed to the Company, (iii) are designed in-house, or (iv) are manufacturedusing Company-owned tooling, dies and molds based on a proprietary design oridea owned by the Company or the inventor.** **Proprietarytoys accounted for approximately 86%, 80%, and 78% of the Company’s net salesfor fiscal 2002, 2001, and 2000, respectively. The Company’s proprietary products generally yield higher gross marginsto the Company than non-proprietary products.

 

Non-proprietary productsare defined by the Company as toys designed and manufactured by independent toymanufacturers and marketed by the Company, usually on an exclusive basis in theCompany’s primary markets.  The Companyselects its non-proprietary products after an evaluation of several factors,including the quality and pricing of the product, as well as whether theproduct presents an opportunity for the Company to utilize packaging andmarketing to differentiate the product from other toys.  The Company often markets these toys underin-house brands, such as *Tech-Link®*and *My Music Maker*®.  Non-proprietary products accounted forapproximately 14%, 20%, and 22% of the Company’s net sales for fiscal 2002,2001 and 2000, respectively.

 

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**Customers**

 

The Company made sales toover 500 different customers in approximately 40 countries during fiscal 2002.The table below sets forth the Company’s net sales by geographic area as apercentage of total net sales for the specified fiscal years. 

 
| **Geographic Area**    |   | **2002** |   | **2001** |   | **2000** |   |
|------------------------|--------|----------|--------|----------|--------|----------|--------|
| United  States         |   | 81.1     | %      | 82.8     | %      | 81.1     | %      |
| All  Foreign Countries |   | 18.9     |   | 17.2     |   | 18.9     |   |

 

The Company’s principalcustomers are retailers, including mass merchandising discounters such asWal-Mart, Kmart and Target, specialty toy retailers such as Toys “R” Us, KayBee Toy & Hobby and QVC, and deep discount stores such as Family DollarStores, Inc., Consolidated Stores Corporation and Value City Department Stores,Inc.  The Company’s top five customersaccounted for approximately 52.9% of the Company’s net sales in fiscal2002.  During fiscal 2002, Wal-Mart andKmart accounted for 26.8% and 9.5%, respectively, of the Company’s net sales.In fiscal 2001, Wal-Mart and Kmart accounted for 21.1% and 10.4% respectively,of the Company’s annual net sales.  Infiscal 2000, Wal-Mart and Toys “R” Us accounted for 18.1% and 11.5%,respectively, of the Company’s annual net sales.  During fiscal 2002, the Company’s sales to Toys “R” Us, Wal-Mart,Kmart, Target and Kay-Bee Toy & Hobby, the five largest toy retailers inthe United States, decreased as a percentage of the Company’s net sales to44.5% compared to 49.2% of net sales during fiscal 2001 and 46.1% of net salesduring fiscal 2000.  The Company doesnot have long-term contractual arrangements with its customers.

 

**Marketingand Sales**

 

The Company’s sellingstrategy consists of in-house sales personnel and a network of independent,commission-based sales representatives. Significant product presentations aremade by either executive management, in the case of new product presentations,or in-house sales personnel. The independent sales representatives manage theday-to-day account administration.

 

New toys are marketedprimarily by members of the Company’s executive management and sales departmentat the Company’s showrooms in Hong Kong and New York during major,international toy shows in those cities (Hong Kong in January, July andSeptember/October, and New York in February and October).  The Company also maintains a showroom at itsheadquarters in Houston.

 

In international markets,the Company generally sells its products to independent distributors.  These distributors retain their own salesrepresentatives and product showrooms where products are marketed andsold.  The Company also sells directlyto international retailers, principally as a result of contacts made at theCompany’s showrooms.

 

**Advertising**

 

In recent years, theCompany has allocated the majority of its advertising budget to televisionpromotion, retailer-based programs and print advertising.  During 2002, the Company devoted the bulk ofits television advertising to the fall and Christmas season, principally topromote *TooCute Twins®* and *Somersault SaraTM*.* *In addition, during 2002 and 2001 the Company utilized aportion of its advertising budget on print advertising for the *Pride &Joy®* product line as well as participating in retailer basedprograms.** **The Company expects to continueusing promotional programs involving television and consumer magazineadvertising of certain, unique proprietary products, as well as year-roundpublic relations programs, participation in national consumer-based toy testawards programs, internet linkages where appropriate, trade advertising andtraditional retailer-based ad programs including cooperative promotional ads,special offers and retail catalogues.

 

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**Manufacturing**

 

The Company annuallycontracts with approximately 30 independent manufacturers located within a300-mile radius of Hong Kong, principally in the Peoples’ Republic of China(the “PRC”), for the manufacture of its products.  The Company may use more than one manufacturer to produce asingle product.  The manufacturers thataccounted for more than 10% of the Company’s purchases of products duringfiscal 2002 were Wah Lung (19.4%), which manufactured dolls and girls playsets,and Potex Toys Manufacturer, Ltd. (24.4%), which manufactured musical instruments.  Manufacturing commitments are made on apurchase order basis.  The Company doesnot have long-term contractual arrangements with its manufacturers.

 

Decisions related to thechoice of manufacturer for non-proprietary products generally are based onreliability, merchandise quality, price and the manufacturer’s ability to meetthe Company’s or its customers’ delivery requirements.  Proprietary products designed by the Companyare placed with a specific manufacturer whose expertise is in that type oftoy.  The Company currently has itstooling placed in several different manufacturing facilities and generallyreceives delivery 60 to 90 days after issuing its purchase orders to themanufacturer.

 

DSI(HK) monitorsmanufacturing operations, including quality control, production scheduling andorder fulfillment from the manufacturers. DSI(HK) utilizes a quality control and assurance staff of degreedengineers and inspectors.  The principalmaterials used in the production of the Company’s products are plastics,integrated circuits, batteries, corrugated paper (used in packaging and packingmaterial) and textiles.  The Companybelieves that an adequate supply of materials used in the manufacture andpackaging of its products is readily available from existing and alternativesources at reasonable prices.

 

**Distribution**

 

The Company distributesits products either FOB Asia or through direct sales made from inventorymaintained at its U.S. distribution facilities.  For FOB Asia sales, the customer places its order and providesshipping instructions; the toys are then manufactured and shipped directly fromthe factory to the customer or its freight consolidator.

 

In early 2002, theCompany’s primary distribution facility was moved to a public warehouse facilityin Fife, Washington in anticipation of the expiration of the Company’s primaryHouston facility lease in August, 2002. The Company contracted with the facility on a limited basis in 2001 totest its distribution ability and performance. Based on the positive distribution results and the cost savingsachieved, the Company in March, 2002, decided to transfer all domesticdistribution to the Fife facility. Additionally, the Fife geographic location enables the Company toincrease the speed of distribution to customers for faster-sellingtelevision-promoted items.  During thetransition process in 2002, the Company continued to ship from both the oldprimary location and a public over-flow warehouse in Houston.  In 2003, the Company will transition the Houstonpublic warehouse to a defective return center.

 

Historically, basiccontinuous stock toys that are offered by retailers on a year-round basis areshipped to customers from the Company’s domestic inventory.  In addition, certain faster-selling toys areoften shipped directly to major customers for seasonal selling and stocked bythe Company in its domestic facilities for peak season back-up and continuoussupply.  The Company also maintainsinventory which is intended for specific customers for peak holiday seasonsupport, as well as some inventory which is available for smaller retailers andfor opportunistic selling strategies.

 

Most of the Company’slarger customers have instituted electronic data interchange (“EDI”) programsto reduce the retailers’ inventory carrying requirements and place moreinventory risk on the supplier.  Whenselling toys out of its domestic inventory, the Company participates in the EDIprograms of most of its customers who have established EDI programs, includingWal-Mart, Kmart, Toys “R” Us, Target and Kay-Bee Toy & Hobby.  Although these programs require the Companyto bear some inventory risk, the Company believes the programs can be utilizedto monitor store inventory levels, schedule production to meet anticipatedreorders and maintain sufficient inventory levels to serve its customers.

 

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**LicenseAgreements**

 

Various licenseagreements with inventors and other third parties, including Kawasaki MotorsCorp., U.S.A. (“Kawasaki”), permit the Company to utilize the trademark,character or product of the licensor in its product line.  In return, the Company agrees to pay to thelicensor a percentage of net sales (“royalty rate”) of the licensedproduct.  Typically, these royalty ratesrange from 4% to 7% of net sales.  Salesof licensed products such as the *Street SavageTM* R/C vehicle, the *Too CuteTwins®* dolls, and the KAWASAKI® musical instruments accounted forapproximately 75%, 68%, and 59% of the Company’s net sales during fiscal 2002,2001, and 2000, respectively.  Theacquisition of licenses also typically requires the payment of non-refundableadvances and/or guaranteed minimum royalties.

 

The Company initiallyentered into a license agreement with Kawasaki in January of 1994, and thatagreement, together with subsequent amendments, and renewals thereof, hasauthorized the Company to use the KAWASAKI*®* brand name in connection with severaldifferent products, including R/C motorcycles, bicycle accessories,walkie-talkies and a complete line of electronic musical instruments, includingkeyboards, guitars and percussion instruments. The current agreement with Kawasaki was renewed effective as of January1, 2003, and now expires on December 31, 2007.

 

The Company has enteredinto a licensing agreement with Skribbleeno Productions, Inc. for the name,signature, recorded voice, photographic likeness, and sculpted likeness ofScott Ialacci, who is professionally known as DJ Skribble, together with theregistered trademark *DJ Skribble*® for the marketing and sale ofmusical toy products.  Further, theCompany recently executed a license agreement with Sega of America, Inc. forthe use of the intellectual property associated with *Crazy Taxi*TM in the marketingand sale of R/C vehicles.

 

As of December 31, 2002,the aggregate guaranteed royalties payable by the Company under all of itslicenses totaled approximately $250,000 in fiscal 2003 and $835,000 thereafterthrough fiscal 2007.  In prior years,the Company changed its license strategy to reduce its long-term commitments tolicensors in favor of larger advance royalty payments.  The Company believes that this strategybetter matches royalty liabilities with the product life cycles and minimizesthe potential negative impact on future earnings.  The Company does enter into agreements on proven properties, likeKAWASAKI®, guaranteeing significant royalties in future years, where futuresales of the covered products are deemed to be more reliable.

 

The Company believes thatby developing licensed products based principally on popular properties andtrademarks, it can establish a licensed product portfolio that is characterizedby products with a longer life cycle than is typical in the toy industry.  The Company intends to continue to developits licensed product lines by targeting licensing opportunities to take advantageof advertising, publicity and media exposure.

 

**Competition**

 

The toy industry ishighly competitive.  Dun &Bradstreet categorizes over 1,000 companies as toy manufacturers.  Competitive factors include product appeal,new product introductions, space allocation by the major retailers, price andorder fulfillment capability.  TheCompany competes with many companies that have greater financial resources andadvertising budgets than the Company, including Mattel, Inc. and Hasbro, Inc.,the largest U.S. toy companies. The Company also considers The Lego Company,Inc., Playmates Toys, Inc., ToyMax International, Inc., Toy Biz, Inc.,KIDdesigns, Inc., and MGA Entertainment to be among its other competitors.  In addition, due to the low barriers toentry into the toy business, the Company competes with many smaller toycompanies, some of which market single products.

 

**Seasonality**

 

Retail sales of toyproducts are seasonal, with a majority of retail sales occurring during theChristmas holiday period: September through December.  As a result, shipments of toy products to retailers are typicallygreater in each of the third and fourth quarters than in the first and secondquarters combined.  This seasonality isincreasing as the large toy retailers are becoming more efficient in theirinventory control systems.  See “RiskFactors.”

 

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In anticipation of thisseasonal increase in retail sales, the Company significantly increases itsproduction during the second quarter in advance of the peak selling period,with a corresponding build-up of inventory levels.    This results in significant peaks in the second and thirdquarters in the respective levels of inventories and accounts receivable, whichresult in seasonal working capital financing requirements.  See “Seasonal Financing.”

 

**SeasonalFinancing**

 

The Company’s financingof seasonal working capital typically peaks in the third quarter of the year,when accounts receivable are at their highest due to increased sales volume andsales programs, and when inventories are at their highest in anticipation ofexpected second half sales volume.  See“Seasonality.”  The Company financed itsseasonal working capital requirements in 2002 primarily by using internallygenerated cash and borrowings under its line of credit with Dao Heng BankLimited (the “Dao Heng Facility”), a line of credit facility with StandardChartered Bank (the “Standard Chartered Facility”) and its revolving line ofcredit (the “Revolver”) with Sunrock Capital Corp. (“Sunrock”).  Additionally, the Company borrows, asneeded, against customers’ letters of credit with several Hong Kong banks.  The bank is selected based on the most advantageousterms to the Company and as directed by customers. See “Management’s DiscussionAnd Analysis Of Financial Condition And Results Of Operations - Liquidity andCapital Resources.”

 

**Governmentand Industry Regulation**

 

The Company is subject tothe provisions of the Federal Hazardous Substances Act and the Federal ConsumerProduct Safety Act.  Such Acts empowerthe United States Consumer Products Safety Commission (the “CPSC”) to protectthe public from hazardous goods.  TheCPSC has the authority to exclude from the market goods that are found to behazardous and to require a manufacturer to repurchase such goods under certaincircumstances.  The Company sendssamples of all of its marketed products to independent laboratories to test forcompliance with the CPSC’s rules and regulations, as well as with the productstandards of the Toy Industry of America, Inc. (“TIA”).  The Company is not required to comply withthe product standards of the TIA but voluntarily does so.  Similar consumer protection laws exist instate and local jurisdictions within the United States, as well as in certainforeign countries.  The Company designsits products to meet the highest safety standards imposed or recommended bothby government and industry regulatory authorities.

 

**Tariffsand Duties**

** **

In December 1994, theUnited States approved a trade agreement pursuant to which import duties ontoys, games, dolls and other specified items were eliminated, effective January1, 1995, from products manufactured in all Most Favored Nation countries(including the PRC).  Increases inquotas, duties, tariffs or other changes or trade restrictions which may beimposed in the future could have a material adverse effect on the Company’sfinancial condition, operating results or ability to import products.

 

**IntellectualProperty**

 

Most of the Company’sproducts and product lines are marketed and sold under trademarks, trade namesand copyrights, including, without limitation: *Big Bam Boom®, Childhood VersesTM,Elite®, Forever Girlfriends®, GearheadTM, Insector®, Pride & Joy®, Rosie®,Street SavageTM, Sweet Faith®, Tech-Link® and Too Cute Twins®.*** **The Company considers itstrademarks and trade names to be significant assets in that they provideproduct and brand recognition.

 

 The Company customarily seeks trademark orcopyright protection, when applicable, covering its products and productlines.  Several of these trademarks andcopyrights relate to product lines that are significant to the Company’sbusiness and operations.  While theCompany believes that its rights to these properties are adequately protected,there can be no assurance that its rights can be successfully asserted in thefuture or will not be invalidated, circumvented or challenged.  See “Risk Factors.”

 

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**HumanResources**

 

As of December 31, 2002,the Company had a total of 76 employees, 43 of which were based in Houston and33 were employees of DSI(HK) based in Hong Kong.

 

**RiskFactors**

 

This Risk Factors sectionis written to be responsive to the Securities and Exchange Commission’s “PlainEnglish” guidelines.  In this sectionthe words “we,” “ours” and “us” refer only to the Company and its subsidiaryand not any other person.

** **

**Changing Consumer Preferences,Reliance on New Product Introduction. **Consumerpreferences are difficult to predict and the introduction of new products iscritical in the toy industry.  Ourbusiness and operating results depend largely upon the appeal of ourproducts.  A decline in the popularityof our existing products and product lines or the failure of new products andproduct lines to achieve and sustain market acceptance could result in loweroverall revenues and margins, which in turn could have a material adverseeffect on our business, financial condition, and results of operations.  Our continued success in the toy industrywill depend on our ability to redesign, restyle and extend our existing coreproducts and product lines, and to develop, introduce and gain customeracceptance of new products and product lines. As a result of changing consumer preferences, individual productstypically have short life cycles of two years or less.  There can be no assurance that:

 

•                                          anyof our current products or product lines will continue to be popular withconsumers for any significant period of time;

 

•                                          anynew products and product lines introduced by us will achieve an adequate degreeof market acceptance, or that if such acceptance is achieved, it will bemaintained for any significant period of time;

 

•                                          anynew products’ life cycles will be sufficient to permit us to recover development,manufacturing, marketing and other costs of the products.

** **

**Dependence on Limited Number ofCustomers.**  A smallnumber of our customers account for a large share of our net sales.  For fiscal 2002, our five largest customersaccounted for approximately 53% of our net sales. Sales to Wal-Mart, the KmartCorporation (“Kmart”), and QVC, our three largest customers, accounted forapproximately 45% of our net sales during the same period.

 

On January 22, 2002,Kmart filed for Chapter 11 bankruptcy. Kmart was our second largest customer in 2002 and 2001, comprising 9.5%and 10% of sales, respectively.  Kmartrequired normal trade terms from companies desiring to do business with them in2002, and in return offered a second-priority lien or “Trade Creditor Lien” inKmart’s owned merchandise inventory. Due to Kmart’s market share we accepted this lien position and sold toKmart in 2002. Kmart is continuing business and is currently scheduled to exitbankruptcy in April 2003.  Kmart haseither closed, or announced the closing of, approximately 600 stores, whichreduces our distribution outlets with Kmart and could result in reduced salesto Kmart.

 

We expect to continue torely on Kmart and a relatively small number of other customers for asignificant percentage of sales for the foreseeable future.  If some of these customers were to ceasedoing business with us, or to significantly reduce the amount of theirpurchases from us, it could have a material adverse effect on our business,financial condition and results of operations.

** **

**Liquidity.** Weutilize borrowings under the Revolver, the Dao Heng Facility, the StandardChartered Facility and the discounting of customers’ letters of credit withother banks to finance accounts receivable, inventory, and other operating andcapital requirements.  We entered intothe Revolver on February 21, 1999, and amended the Revolver on March 30, 2001,to increase the Company’s credit line from $10 million to $17.5 million. TheRevolver matures March 31, 2004, and contains covenants relating to ourfinancial condition. If we fail to maintain compliance with the financialcovenants contained in the Revolver, the maturity date can or will beaccelerated, among other remedies which may be pursued by the lender.

 

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The Company’s net lossesfor the period ended December 31, 2002, and its overall financial conditionresulted in the Company being out of compliance with certain financialcovenants required under the Revolver. Therefore, the Company’s $7.0 million debt under the Revolver as ofDecember 31, 2002, has been reclassified as a current liability.  As a result, the Company’s currentliabilities exceeded its current assets by $6.5 million as of December 31,2002. If Sunrock were to accelerate the Revolver, which it has the option todo, the $7.0 million debt would become immediately due and payable.

 

Sunrock has recentlycompleted a transaction with Wells Fargo & Company in which Wells Fargopurchased most of  Sunrock’s existingloans.  Sunrock has retained certaincredit facilities, including the Revolver. Based on discussions with Sunrock, the Company’s management believesthat although Sunrock will not amend the Revolver, nor grant a waiver for theCompany’s non-compliance, Sunrock will not accelerate the Revolver at thistime.

 

The Dao Heng Facility andthe Standard Chartered Facility were obtained on December 4, 2001, and April29, 2002, respectively, are subject to periodic review, and may be canceled bythe bank upon notice.  The StandardChartered Facility affords DSI(HK) a credit limit in the aggregate of up to HKD19,000,000 (approximately US $2.4 million as of December 31, 2002) in the formof a line of credit financing facility based on actual shipments of product andopened letters of credit.  The Dao HengFacility affords DSI(HK) a credit limit in the aggregate of up to US$6,000,000.The Company has guaranteed DSI(HK)’s obligations under the Dao Heng CreditFacility and the Standard Chartered Facility. See “Management’s Discussion And Analysis Of Financial Condition AndResults Of Operations - Liquidity and Capital Resources.”

 

The Company purchasesgoods, services and supplies from a number of vendors.  The Company currently is in arrears inmaking its payment obligations to certain of these vendors.

 

To the extent theCompany’s cash reserves and cash flows from operations are insufficient to meetfuture cash requirements, the Company will need to successfully raiseadditional capital through an equity infusion or the issuance of debt.  The Company’s executive management believesthat the Company will be required to either obtain a new revolving loan orobtain necessary additional capital to allow the Company to continue its normaloperations for the foreseeable future. However, there can be no assurance theCompany will meet its projected operating results or be successful either inobtaining additional capital, or obtaining a new revolving loan.

 

The Company has helddiscussions and negotiations with several lenders regarding a credit facilityto replace the Revolver.  Management isnegotiating with one of those institutions regarding a replacement creditfacility that will become effective at the close of the anticipated going privatetransaction, which is discussed in Item 7 below.  Management believesthat the going private transaction will close and that the Company will be ableto continue its operations until that time.

** **

**Dependence on Independent Designers,Licenses and Other Proprietary Rights.**  We are dependent on concepts, technologiesand other intellectual property rights licensed from third parties, such asrights to trademarks, with respect to several of our proprietary products.  For each of these proprietary products andproduct lines, we typically enter into a license agreement with the owner ofthe intellectual property to permit us to use the intellectual property.  These license agreements typically providefor the Company to pay royalties to the licensor based on the net sales of theproduct incorporating the licensed property. For fiscal 2002, net sales of products developed and sold under ourlicense agreements accounted for approximately 75% of our net sales, of whichapproximately 24% of net sales were attributable to sales of productsincorporating the KAWASAKI® trademark. In November 2002, the license agreement with Kawasaki® was renewed,extending the license agreement for an additional 5 years.  The license now expires on December 31,2007.  The failure to procure newlicense agreements, renew existing license agreements (on commerciallyreasonable terms, or at all), or maintain existing license agreements couldhave a material adverse effect on our business, financial condition and resultsof operations.

 

8

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In addition to theforegoing, we are dependent on our intellectual property rights and we cannotgive assurances that we will be able to successfully protect such rights.  We rely on a combination of trade secret, copyright,trademark, patent and other proprietary rights laws to protect our rights tovaluable intellectual property related to our proprietary products.  We also rely on license and other agreementsthat establish ownership rights and maintain confidentiality.  We cannot assure you that such intellectualproperty rights can be successfully asserted in the future or will not beinvalidated, circumvented or challenged. Laws of certain foreign countries in which our products may be sold donot protect intellectual property rights to the same extent as the laws of theU.S.  The failure to protect ourproprietary information and any successful intellectual property challenges orinfringement proceedings against us could have a material adverse effect on ourbusiness, financial condition and results of operations.

 

We do not believe thatany of our products infringe on the proprietary rights of third parties in anymaterial respect.  There can be noassurance, however, that third parties will not claim infringement by us with respectto current or future products.  Any suchclaim, with or without merit, could be time-consuming, result in costlylitigation, cause product shipment delays or require us to enter into royaltyor licensing agreements.  Such royaltyor licensing agreements, if required, may not be available on terms acceptableto us or at all, which could have a material adverse effect on our business,financial condition, and results of operations.

** **

**Inventory Management.**  Most of our larger retail customers utilizean inventory management system to track sales of products and rely on reordersbeing rapidly filled by us and other suppliers rather than maintaining largeproduct inventories.  These types ofsystems put pressure on suppliers like us to promptly fill customer orders andalso shift a significant portion of inventory risk and carrying costs from theretailer to the supplier.  The limitedamount of inventory carried by retailers may serve to reduce or delay retailsales of our products.  In addition, thelogistics of supplying more product within shorter time periods will increasethe risk that we fail to achieve tight and compressed shipping schedules.  These inventory management systems requireus to accurately forecast demand for products. The failure to accurately predict and respond to retail demand couldresult in our overproducing items, which could in turn result in pricemarkdowns and increased inventory carrying costs for us, as well asunderproducing more popular items.

** **

**Returns and Markdowns.**  As is customary in the toy industry, wehistorically have permitted certain customers to return slow-moving items forcredit and have allowed price reductions as to certain products then held byretailers in inventory.  We expect thatwe will continue to make such accommodations in the future.  Any significant increase in the amount ofreturns or markdowns could have a material adverse effect on our business,financial condition and results of operations.

** **

**Seasonality.**  Our business is seasonal and therefore ourannual operating results depend, in large part, on our sales during therelatively brief Christmas holiday season. A substantial portion of our net sales is made to retailers inanticipation of the Christmas holiday season. This seasonality is increasing as large toy retailers become moreefficient in their control of inventory levels through quick responsemanagement techniques.  This seasonalpattern requires significant use of working capital mainly to manufactureinventory during the year, prior to the Christmas holiday season, and requiresaccurate forecasting of demand for products during the Christmas holidayseason.  During fiscal 2002, 72% of theCompany’s net sales were made during the third and fourth fiscal quarters.  Adverse business or economic conditions duringthese periods could adversely affect our results of operations for the fullyear.   In addition, failure toaccurately predict and respond to consumer demand may have a material adverseeffect on our business, financial condition and results of operations.

** **

**International Operations.**  Our sales and manufacturing operationsoutside the United States subject us to risks normally associated withinternational operations.  Variousinternational risks, including the war with Iraq, could negatively impact ourinternational sales and manufacturing operations, which could have a materialadverse effect on our business, financial condition and results ofoperations.  For the year ended December31, 2002, our international net revenues comprised approximately 19% of ourtotal consolidated net revenues.  Weexpect international sales to continue to account for a significant portion ofour total revenues.  In addition, weutilize third-party manufacturers principally located in the PRC.  Our international sales and manufacturingoperations are subject to the risks normally associated with internationaloperations, including:

 

9

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•                                          limitations,including taxes, on the repatriation of earnings;

 

•                                          politicalinstability, civil unrest and economic instability;

 

•                                          greaterdifficulty enforcing intellectual property rights and weaker laws protectingsuch rights;

 

•                                          greaterdifficulty and expense in conducting business abroad;

 

•                                          complicationsin complying with foreign laws and changes in governmental policies;

 

•                                          transportationdelays and interruptions;

 

•                                          currencyconversion risks and currency fluctuations; and

 

•                                          theimposition of tariffs.

 

These risks couldnegatively impact our international sales and manufacturing operations, whichcould have a material adverse effect on our business, financial condition andresults of operations.

 

During fiscal 2002, twomanufacturers accounted for approximately 44% of our purchases ofproducts.  The loss of any of thesemanufacturers, or a substantial interruption of our manufacturing arrangementswith any of these manufacturers, could cause a delay in the production of ourproducts for delivery to our customers and could have a material adverse effecton our business, financial condition and results of operations.  While we believe that our reliance onexternal sources of manufacturing can be shifted, over a period of time, toalternative sources of supply, there can be no assurance that alternate arrangementscould be provided in a timely manner or on terms acceptable to us. Furthermore,the imposition of trade sanctions by the United Sates or the European Unionagainst a class of products imported by us from, or the loss of “permanentnormal trade relations” status by, the PRC could significantly increase ourcost of products imported into the United States or Europe.

** **

**Acquisition Risks.**  We may from time to time evaluate and pursueacquisition opportunities on terms that we consider favorable.  A successful acquisition involves anassessment of the business condition and prospects of the acquisition target,which includes factors beyond our control. This assessment is necessarily inexact, and its accuracy is inherentlyuncertain.  In connection with such anassessment, we perform a review that we believe to be generally consistent withindustry practices.  This review,however, will not reveal all existing or potential problems, nor will it permita buyer to become sufficiently familiar with the acquisition target to assessfully its deficiencies.  There can be noassurance that any such acquisition would be successful or that the operationsof the acquisition target could be successfully integrated with our operations.  Any unsuccessful acquisition could have amaterial adverse effect on our business, financial condition and results ofoperations.

** **

**Product Safety, Liability andRegulation.** Productsthat have been or may be developed or sold by us may expose us to potentialliability from personal injury or property damage claims by end-users of suchproducts. We currently maintain product liability insurance coverage in amountswhich we believe to be sufficient for our business risks.  There can be no assurance that we will beable to maintain such coverage or obtain additional coverage on acceptableterms, or that such insurance will provide adequate coverage against allpotential claims.  Moreover, even if wemaintain adequate insurance, any successful claim could materially andadversely affect our business, financial condition, and results of operations.

 

In addition to theforegoing, the CPSC has the authority under certain federal laws andregulations to protect consumers from hazardous goods.  The CPSC may exclude from the market goodsit determines are hazardous and may require a manufacturer to repurchase suchgoods under certain circumstances.  Somestate, local and foreign governments have similar laws and regulations.  In the event that such laws or regulationschange or in the future we are found to have violated any such law or regulation,the sale of the relevant product could be prohibited, and we could be requiredto repurchase such products.

 

10

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**Competition.** The toy industry is highly competitive.  Many of our competitors have longeroperating histories, broader product lines and greater financial resources andadvertising budgets than us.  Inaddition, the toy industry has nominal barriers to entry.  Competition is based primarily on theability to design and develop new toys, procure licenses for popular products,characters and trademarks, and successfully market products.  Many of our competitors offer similarproducts or alternatives to our products. Our products compete with other products for retail shelf space.  There can be no assurance that shelf spacein retail stores will continue to be available to support our existing productsor any expansion of our current products and product lines.  There can be no assurance that we will beable to continue to compete effectively in this marketplace.

** **

**Control by Current Management.**  As of March 15, 2003, our directors andexecutive officers beneficially owned an aggregate of 7,627,391 shares ofcommon stock (excluding convertible securities and the shares underlying same),which represents approximately 70% of the total issued and outstanding sharesof common stock of the Company.  As aresult, it would be extremely difficult, if not impossible, to obtain majoritysupport for  shareholder proposalsopposed by management and the Board of Directors.

** **

**Possible Volatility of Stock Price.**  The market price of the common stock hasbeen and may continue to be highly volatile and has been and could be subjectto wide fluctuations in response to quarterly variations in operating results,announcements of new products by us or our competitors, changes in financialestimates by securities analysts, or other events or factors.  In the event our operating results are belowthe expectations of public market analysts and investors in one or more futurequarters, it is likely that the price of the common stock would be materiallyadversely affected.  In addition,general market fluctuations may adversely affect the market price of the commonstock.

 

**ExecutiveOfficers of the Registrant**

 

The executive officers ofthe Company as of December 31, 2002, all of whom are appointed annually by theBoard of Directors to serve at the pleasure of the Board, are as follows:

 
| **Name**                   |   | **Age** |   | **Position**                                                                    |   | **Executive Officer  Since** |
|----------------------------|--------|---------|--------|---------------------------------------------------------------------------------|--------|------------------------------|
|                       |   |    |   |                                                                            |   |                         |
| Joseph S. Whitaker         |   | 62      |   | Chief Executive Officer  and President                                          |   | 1999                         |
| Robert L. Weisgarber       |   | 51      |   | Chief Financial Officer                                                         |   | 1999                         |
| Gregory A. Barth(1)        |   | 51      |   | Senior Vice President  of Worldwide Operations, Business Planning and Logistics |   | 2001                         |
| Chan Tit Yu (Alfred  Chan) |   | 55      |   | Managing Director of DSI(HK)                                                    |   | 2002                         |
| William J. Kerner(2)       |   | 48      |   | Vice President,  Research and Development                                       |   | 1999                         |
| Milan Seda(3)              |   | 55      |   | Vice President,  Research and Development                                       |   | N/A                          |
| Robert M. Erickson         |   | 49      |   | Vice President  Marketing                                                       |   | 2002                         |
| Thomas V. Yarnell          |   | 49      |   | Administrative Vice President,  Corporate Secretary and General Counsel         |   | 1989                         |
| C. Shelton Suter           |   | 44      |   | Vice  President/Controller                                                      |   | 2000                         |
| E. Thomas Martin           |   | 59      |   | Chairman of the Board                                                           |   | 1999                         |

 

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(1)                                  GregoryA. Barth’s employment contract terminates on March 31, 2003. Mr. Barth willleave the employment of the Company at that time.

 

(2)                                  WilliamJ. Kerner left the Company’s employment on March 7, 2003.

 

(3)                                  MilanSeda was hired by the Company, but does not begin his employment until April 1,2003.

 

11

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**Joseph S. Whitaker**has served as a director since June 1, 1999, and President and Chief ExecutiveOfficer since December 1, 2001.  Hejoined the Company on June 1, 1999 as Senior Vice President, New BusinessDevelopment.  He also serves as VicePresident of, and owns less than a 1% membership interest in MVII, LLC, aCalifornia limited liability company (“MVII”) controlled by E. Thomas Martin,Chairman of the Board of Directors.  Forthe five years prior to joining the Company, Mr. Whitaker operated a consultingbusiness in La Jolla, California, providing services related to marketing,licensing and product development to the toy industry.

** **

**Robert L. Weisgarber**has served as Chief Financial Officer of the Company since March 1999.  Prior to his employment by the Company, heserved as Executive Vice President and Chief Financial Officer for SteelWorks,Inc., an office products manufacturer in Des Moines, Iowa.  From 1993 to 1995, he was Vice President,Administration for Texberry Container Corporation in Houston, Texas.

** **

**Gregory A. Barth** has served as Senior Vice Presidentof Worldwide Operations, Business Planning and Logistics since April 2001.  Prior to that time, Mr. Barth was Presidentof G.A.B. Sales Consulting from 1997-2001, working for a variety of clientsincluding the Company from April 2000 until being employed by the Company in2001. Mr. Barth’s employment contract terminates on March 31, 2003.  Mr. Barth will leave the employment of theCompany at that time.

 

**Chan Tit Yu (Alfred Chan)**has served as the Managing Director of the Company’s wholly-owned subsidiary,DSI(HK) since January 2002.  From 2000to 2002, he was Director and Chief Operating Officer for Toy Options, Ltd., aUK listed group. He served as Vice President, Product Development andEngineering for PLAYMATES Toys (HK) Ltd. from 1997 to 2000, and was SeniorDirector, Engineering and Quality for TYCO Hong Kong Ltd. from 1996 to 1997.

** **

**William J. Kerner**served as Vice President of Research and Development of the Company December 1999through March 7, 2003.  Prior to that,he was Senior Director of Design for Tyco Toys/Mattel, Inc., MatchBox Divisionfrom 1995 through December 1999, and Director of Product Design, MatchboxDivision at Tyco from 1992 until 1995.

** **

**Milan Seda** will officiallybegin employment with the Company on April 1, 2003.  Prior to joining the Company, from October 1999 he served as thePresident and CEO of Toy Works Centre, Inc., a company that provides design anddevelopment services to toy companies and toy inventors.  From February 1998 through January 2000, Mr.Seda was the President and General Partner of Business By Design, Inc., agraphic and design services company.

** **

**Robert M. Erickson**has been an employee of the Company since September 2000.  Until September 2001, he served as Directorof Marketing – Boys Division.  FromSeptember 2001 through November 2002 he was Director of Marketing, and he nowserves as Vice President of Marketing. Prior to employment with the Company, Mr. Erickson was Director of Marketingfor The Ertl Company, Inc. from February 1995 through April 1999, and Directorof Marketing for Toymax, Inc. from August 1999 until September 2000.

** **

**Thomas V. Yarnell**hasbeen an employee of the Company since February 1989, serving as Administrative VicePresident since October 1989, Corporate Secretary since April 1991, and GeneralCounsel since December 1995.

** **

**C. Shelton Suter**has served as Vice President and Controller of the Company since January2000.  Prior to joining the Company, hewas the Treasurer and Controller of Ansaldo Ross Hill, Inc., in Houston, Texas,from July 1997 through December 1999.

**E. Thomas Martin**has served as the Chairman of the Board of the Company since June 1,1999.  He is the sole Manager andPresident of MVII.  Mr. Martin isPresident of Martin Resorts, Inc., a private California corporation which ownsand operates coastal hotels in California. Mr. Martin was the Chief Executive Officer and a partner in Martin &MacFarlane, Inc. and Martin Media, L.P., national outdoor advertisingcompanies, until their sale to Chancellor Media in September of 1998.  Mr. Martin also manages various real estateventures.  He is the Chairman of theExecutive Committee.

 

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**ITEM 2.  PROPERTIES**

 
| **Location**        |   | **Use**                             |   | **Square  Feet** |   | **Type of  Possession**     |   | **Expiration  Dates** |   |
|---------------------|--------|-------------------------------------|--------|------------------|--------|-----------------------------|--------|-----------------------|--------|
| Houston,   Texas    |   | Executive Office and  Showroom      |   | 16,608           |   | Lease                       |   | 10/31/07              |   |
|                |   |                                |   |             |   |                        |   |                  |   |
| Fife,  Washington   |   | Warehouse and  Distribution Center  |   | 75,000           |   | Service and Rate  Agreement |   | 12/31/06              |   |
|                |   |                                |   |             |   |                        |   |                  |   |
| New York,  New York |   | Showroom                            |   | 5,148            |   | Lease                       |   | 4/30/10               |   |
|                |   |                                |   |             |   |                        |   |                  |   |
| Hong  Kong          |   | Administrative Office  and Showroom |   | 12,877           |   | Lease                       |   | 3/22/06               |   |
|                |   |                                |   |             |   |                        |   |                  |   |
| Hong  Kong          |   | Warehouse                           |   | 2,600            |   | Lease                       |   | 3/07/04               |   |

 

In addition to the abovelisted facilities, the Company currently leases additional public warehousespace in Houston to accommodate inventory needs.  The foregoing properties consist of block, cinder block orconcrete block buildings which the Company believes are in good condition andwell maintained.

 

**ITEM 3.  LEGAL PROCEEDINGS**

 

The Company is involvedin various legal proceedings and claims incident to the normal conduct of itsbusiness.  The Company believes thatsuch legal proceedings and claims, individually and in the aggregate, are notlikely to have a material adverse effect on its financial position or resultsof operations.  The Company maintainsproduct liability and general liability insurance in amounts it believes to bereasonable.

 

The Company is thedefendant in a lawsuit styled Rymax Corp. d/b/a Rymax Marketing Services, Inc,(“Rymax”) v. DSI Toys, Inc. in the Superior Court of New Jersey LawDivision:  Morris County; civil actiondocket number MRSL-3799-02.  In thelawsuit, Rymax claims that the Company failed to pay commissions due to Rymaxand demands judgment for damages in the amount of $45,061.67 plus interest,attorney fees and costs of court.  TheCompany does not believe it owes these damages and may bring a counterclaim againstRymax for an amount exceeding $75,000.00 for goods shipped and sold tothem.  At this time, the Company isattempting to negotiate a settlement of the entire controversy.

 

The Company is thedefendant in a lawsuit styled The Cartoon Network, LP, LLLP (“TCN”) v. DSIToys, Inc. in the State Court of Fulton County, State of Georgia, Civil ActionFile No. 03VS046924C.  In the lawsuit,TCN claims the Company is indebted to TCN for $725,051.70 for televisionadvertisements aired by TCN, together with interest at the rate of 18% perannum until paid. The Company is in negotiations with TCN and believes it hasrecorded an adequate amount for the ultimate settlement.

 

The Company has receiveda demand letter from the Chapter 7 Trustee for bankruptcy cases that arepending in the Southern District of New York involving Play Co. Toys &Entertainment Corp., Toys International.Com, Inc. and Play Co. Toys CanyonCountry, Inc.  The Trustee alleges thata payment received by the Company from Toys International.Com, Inc. in theamount of $93,834.56 was a preferential transfer that is recoverable underBankruptcy Code Sections 547 and 550. The Company has responded to the demand letter that the payment was apayment on an invoice for delivered goods made in the regular course ofbusiness. At this time the Company and the Trustee are in negotiations tosettle the matter in its entirety.

 

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

 

No matters were submittedto a vote of shareholders during the fourth quarter of fiscal 2002.

 

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**PART II**

 

**ITEM5.  MARKET FOR REGISTRANT’S COMMONEQUITY AND RELATED STOCKHOLDER MATTERS**

 

**MarketInformation**

 

The Company’s commonstock is traded on the over-the-counter Bulletin Board electronic quotationsystem under the symbol “DSIT.” Prior to March 27, 2003, the Company’s commonstock was traded on The Nasdaq SmallCap Market.  Prior to August 17, 1998, the Company’s common stock was tradedon The Nasdaq National Market.  Thetable sets forth, for the periods indicated, the reported high and low closesale prices of the Company’s common stock as reported on The Nasdaq SmallCapMarket: 

 
|               |   | **High** |   | **Low** |   |
|--------------------|--------|----------|--------|---------|--------|
| Fiscal  Year 2001: |   |     |   |    |   |
| 1st  Quarter       |   | 1.938    |   | 1.250   |   |
| 2nd  Quarter       |   | 1.620    |   | 1.000   |   |
| 3rd  Quarter       |   | 1.180    |   | 0.950   |   |
| 4th  Quarter       |   | 1.100    |   | 0.750   |   |
|               |   |     |   |    |   |
| Fiscal  Year 2002: |   |     |   |    |   |
| 1st  Quarter       |   | 0.950    |   | 0.460   |   |
| 2nd  Quarter       |   | 0.750    |   | 0.480   |   |
| 3rd  Quarter       |   | 0.650    |   | 0.300   |   |
| 4th  Quarter       |   | 0.550    |   | 0.270   |   |

 

On February 14, 2002, theCompany received notice from The Nasdaq Stock Market, Inc. that the Company’scommon stock had closed below the minimum price of US$1.00 per sharerequirement for continued listing on the Nasdaq SmallCap Market underMarketplace Rule 4310(c)(4) (the “Rule”). The Company was granted a 180 calendar day grace period to comply withthe Rule, but was still not in compliance with the Rule on August 13, 2002, thefinal day of the grace period.  However,at such time the Company was granted an additional 180 calendar day graceperiod to comply with the Rule because it did meet the initial listing criteriafor the Nasdaq SmallCap Market under Marketplace Rule 4310(c)(2)(A). Theadditional grace period expired on February 10, 2003, without the Company beingin compliance with the Rule.  On March18, 2003, the Company received notification that its securities would bedelisted from the Nasdaq SmallCap Market at the opening of business on March27, 2003.  The Company elected not toappeal the delisting determination and its common stock commenced trading onthe over-the-counter Bulletin Board electronic quotation system effective withthe opening of business on March 27, 2003, under the ticker symbol “DSIT.”

 

**Stockholders**

 

According to the recordsof the Company’s transfer agent, as of March 17, 2003, there were 111 holdersof record of the Company’s common stock. The Company believes that a substantially larger number of beneficialowners hold such shares in depository or nominee form.

 

**Dividendsand Distributions**

 

The Company has neverdeclared nor paid cash dividends on its common stock and does not anticipatepaying any cash dividends on its common stock in the near future.  In addition, the Revolver prohibits thepayment of dividends.

 

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**InvestmentWarrant**

 

On March 19, 2001, theCompany issued to MVII an Investment Warrant to acquire 1.8 million shares ofthe Company’s common stock, at a purchase price of $2.7 million.  The Investment Warrant was exercisable inwhole on in part, for a ten-year period beginning June 3, 2002.  The Investment Warrant was subject tocertain anti-dilution adjustments.  Inconnection with the issuance of the Investment Warrant, the Company and MVIIentered into a Registration Rights Agreement, pursuant to which MVII wasgranted certain piggyback registration rights with respect to the shares of thecommon stock underlying the Warrant. Shares of common stock acquired by MVII upon exercise of the Warrant aresubject to the terms of a Shareholders’ and Voting Agreement dated as of April5, 1999, among MVII and certain of the Company’s other shareholders.  Proceeds from the sale of the InvestmentWarrant were used by the Company for current working capital.

 

The Investment Warrantwas issued by the Company to MVII in reliance on the exemption fromregistration set forth in Section 4(2) of the Securities Act of 1933, asamended.  The Company believes theSection 4(2) exemption from registration was available based upon theestablished criteria for effecting a private offering by virtue of the followingfacts, among others:  (i) MVII hadaccess to the type of information that would be included in a registrationstatement, (ii) MVII’s principals have adequate financial means to bear therisk of MVII’s additional investment in the Company and can be described assophisticated, (iii) MVII was the only offeree in the transaction, (iv) MVIIacquired the Investment Warrant for investment and not with a view towarddistribution, (v) the Investment Warrant contains restrictions on resale of theInvestment Warrant and the common stock issued upon exercise of the InvestmentWarrant, and (vi) no underwriters were involved nor were any underwriters’commissions paid in connection with the transactions.

 

On January 31, 2002, atthe request of NASDAQ and with the agreement of MVII, the Company issued anamended and restated Investment Warrant, which amended and restated in itsentirety the Investment Warrant by removing all anti-dilution provisions.  In addition, the Company and MVII enteredinto an Amended and Restated Registration Rights Agreement, which amended andrestated in its entirety the Registration Rights Agreement, by removing all ofthe provisions regarding the anti-dilution provisions of the originalInvestment Warrant.

 

On August 21, 2002, MVIIconverted the pre-paid Investment Warrant into 1.8 million shares of commonstock.  Upon issuance of these shares,MVII directly owned 5,994,238 shares of common stock.

 

15

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**ITEM6.  SELECTED CONSOLIDATED FINANCIAL DATA**

 

The following table setsforth selected consolidated financial data for the Company.  The selected consolidated financial datawere derived from the Company’s consolidated financial statements.  All dollar amounts are stated in thousands,except per share data.

 

The information should beread in conjunction with “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and the financial statements and notesthereto included elsewhere in this report.

 

 
|                                     |   | **December 31,  2002** |   | **December 31,  2001** |   | **December 31,  2000** |   | **December 31,  1999** |   | **January 31,  1999** |   |
|------------------------------------------|--------|------------------------|--------|------------------------|--------|------------------------|--------|------------------------|--------|-----------------------|--------|
| Statement  of Operations Data:           |   |                   |   |                   |   |                   |   |                   |   |                  |   |
|                                     |   |                   |   |                   |   |                   |   |                   |   |                  |   |
| Net sales                                |   | $                      | 49,754 |                   | $      | 67,906                 |   | $                      | 70,438 |                  | $      | 47,560 |   | $ | 52,723 |   |
| Income (loss) before income taxes        |   | (5,736                 | )      | (1,058                 | )      | (1,326                 | )      | 2,150                  |   | (1,337                | )      |
| Net income (loss)                        |   | (8,012                 | )      | (1,449                 | )      | (849                   | )      | 1,281                  |   | (1,004                | )      |
| Basic earnings (loss) per share          |   | $                      | (.82   | )                      | $      | (.16                   | )      | $                      | (.09   | )                     | $      | .17 |   | $ | (.17 | ) |
| Diluted earnings (loss) per share        |   | $                      | (.82   | )                      | $      | (.16                   | )      | $                      | (.09   | )                     | $      | .16 |   | $ | (.17 | ) |
| Balance  Sheet Data:                     |   |                   |   |                   |   |                   |   |                   |   |                  |   |
|                                     |   |                   |   |                   |   |                   |   |                   |   |                  |   |
| Working capital                          |   | $                      | (6,480 | )                      | $      | 9,144                  |   | $                      | 4,536  |                  | $      | 6,326 |   | $ | 391 |   |
| Total assets                             |   | 28,671                 |   | 31,313                 |   | 29,999                 |   | 15,027                 |   | 11,411                |   |
| Long-term debt, including capital leases |   | 4,554                  |   | 12,500                 |   | 10,755                 |   | 2,393                  |   | 2,541                 |   |
| Total liabilities                        |   | 27,566                 |   | 22,179                 |   | 22,072                 |   | 8,038                  |   | 10,549                |   |
| Shareholders’ equity                |   | 1,105                  |   | 9,134                  |   | 7,927                  |   | 6,989                  |   | 861                   |   |

 

**ITEM7.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**General**

 

The following discussionand analysis should be read in conjunction with the financial statements andnotes thereto, and the information included elsewhere herein.

 

The Company designs,develops, markets and distributes high quality, innovative dolls, toys andconsumer electronics products.  Coreproducts include *Tech-Link*® communications products, KAWASAKI® electronicmusical instruments, *GearHead*TM remote control vehicles, *DJ Skribble*®*’s Spinheads*TMmusical figures and toys, a full range of special feature doll brands including*SweetFaith®*, *Pride & Joy®*, *Too Cute Twins*®, *Lovin’TouchTM*life-like dolls,*Baby Knows Her NameTM*talking doll, *ChildhoodVersesTM*nursery rhyme dolls*, Little Darlings®* dolls and CollectiblePlush, including *Kitty, Kitty, Kittens®*and*Puppy, Puppy, Puppies*.

 

The Company has threemajor product categories: Juvenile Audio Products, Girls’ Toys and Boys’ Toys.

 

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*Juvenile Audio Products*- The Juvenile Audio Product category consists of Youth Electronics productsand Musical Instruments.  Products inthe Youth Electronics line include walkie-talkies, wrist watchwalkie-talkies,  audio products andnovelty electronic products.  Thecategory brands include *Tech-Link*® communications products,walkie-talkies and bike alarms, the Company’s new *BioScan*TM *RoomGuardianTM*and DJ Skribble*®’s SpinheadsTM*, a new line of musical toys*.*  The Musical Instrument line includes thebranded line of KAWASAKI® guitars, drum pads, saxophones and keyboards.

* *

*Girls’ Toys* - TheGirls’ Toys product category includes dolls, interactive plush toys, play sets,accessories, and girls’ activity toys. The Girls’ Toys portfolio of brands includes *Baby Knows Her NameTM, Lovin’ TouchTM,Childhood VersesTM, Pride & Joy®,*and*Little Darlings®,*alongwith interactive plush products and girls’ activity products such as*Twist andTwirl BraiderTM.*

* *

*Boys’ Toys -* TheBoys’ Toys product category includes radio control and infra-red controlvehicles.  The brands in this productcategory are *GearHead*TM radio control vehicles, including the *Insector*®,and the unique ultra-articulated *Street SavageTM*and *Crazy Taxi*®, based on thepopular Sega of America, Inc. arcade and home video game of the same name.

* *

*Product Introductions*- New product introductions during 2002 included KAWASAKI® foldable keyboardsand drumpads, the *LazerDoodle*TM electronic drawing toy, the *SomersaultSara*TM interactive electronic doll, and the *Dual FusionTM*radio controlvehicle.

 

**SignificantAccounting Policies**

 

Our significantaccounting policies are more fully described in Note 2 to our consolidatedfinancial statements.  Certain of ouraccounting policies require the application of significant judgment bymanagement in selecting the appropriate assumptions for calculating financialestimates.  By their nature, these judgmentsare subject to an inherent degree of uncertainty.  These judgments are based on our historical experience, termswith current customers, our observance of trends in the industry, informationprovided by our customers and information available from other outside sources,as appropriate.  Our significantaccounting policies include:

* *

*Revenue Recognition –*The Company 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. The Securities and Exchange Commission’s Staff Accounting Bulletin (SAB)No. 101, “Revenue Recognition,” provides guidance on the application ofgenerally accepted accounting principles to selected revenue recognitionissues.  The Company has concluded thatits revenue recognition policy is appropriate and in accordance with generallyaccepted accounting principles and SAB No. 101.

* *

*Allowance for Doubtful Accounts –*  Accounts receivable are reduced by anallowance for amounts that may become uncollectible in the future.  The Company’s estimate for its allowance isbased on two methods which are combined to determine the total amountreserved.  First, the Company evaluatesspecific accounts where we have information that the customer may have aninability to meet its financial obligations (bankruptcy, etc.).  In these cases, the Company uses its judgement,based on the best available facts and circumstances, and records a specificreserve for that customer against amounts due to reduce the receivable to theamount that is expected to be collected. These specific reserves are reevaluated and adjusted as additionalinformation 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.

 

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*Allowance for Returns and Defectives*– The Companyrecords a provision for estimated sales returns and defectives on sales in thesame period as the related revenue is recorded.  Our sales to customers generally do not give them the right toreturn products or to cancel firm orders. However, as is common in the industry, we sometimes accept returns forstock balancing and negotiate accommodations to customers, which include pricediscounts, credits and returns, when demand for specific product falls belowexpectations.  Additionally, customersare given credit for any defective products they may have received.  The allowance estimates are based onhistorical sales returns and defective rates, analysis of credit memo data andother known factors.  If the data theCompany uses to calculate these estimates does not properly reflect futurereturns and defectives, revenue could be overstated and future operatingresults adversely affected.

* *

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

* *

*Deferred Taxes* –The Company recognizes deferred tax assets and liabilities based on thedifferences between the financial statement carrying amounts and the tax basesof assets and liabilities.  Generallyaccepted accounting 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 the expectedtiming of the reversals of temporary differences.  Deferred tax assets of the Company are primarily the result ofunused net operating loss carry-forwards and foreign tax credits which expireover a range of years.

 

The Company recorded a$4.0 million charge in fiscal year 2002 to establish a valuation allowance forall of its deferred tax assets, including $2.2 million of deferred tax assetsrelated to prior years.  The valuationallowance was determined in accordance with the provisions of Statement ofFinancial Accounting Standards (SFAS) 109, “Accounting for Income Taxes,” whichplaces primary importance on the Company’s cumulative operating results in themost recent periods when assessing the need for a valuation allowance.  In 2001, the Company recorded a valuationallowance of $566,000 related to foreign tax credits expiring in 2002, as itwas determined that it was more likely than not that these credits would not berealized.

* *

*Goodwill* – TheCompany made an acquisition in 2000 that included a significant amount ofgoodwill and other intangible assets. Under generally accepted accounting principles through December 31,2001, these assets were amortized over their useful lives, and were to betested periodically to determine if they were recoverable from future operatingearnings over their useful lives.  Werecorded goodwill amortization expense of $513,396 and $513,360, respectivelyin 2001 and 2000.

 

Effective in 2002,goodwill is no longer amortized but is subject to at least an annual impairmenttest based on its estimated fair value. Other intangible assets meeting certain criteria will continue to beamortized over their useful lives and also subject to an impairment test.  There are many assumptions and estimatesunderlying the determination, including future cash flow and operatingresults.  Management engaged anindependent company to assist in valuing the Company’s goodwill as of December31, 2002 and 2001.  Based on thesereviews, no impairment charge is required.

 

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**Resultsof Operations**

 

The following table setsforth the Company’s results of operations as a percentage of net sales for thefiscal years indicated:

 
|                                          |   | **2002** |   | **2001** |   | **2000** |   |
|-----------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Net  sales                                    |   | 100.0    | %      | 100.0    | %      | 100.0    | %      |
| Cost  of goods sold                           |   | 77.8     |   | 70.7     |   | 71.1     |   |
| Gross  profit                                 |   | 22.2     |   | 29.3     |   | 28.9     |   |
| Selling,  general and administrative expenses |   | 32.1     |   | 29.6     |   | 28.9     |   |
| Operating  income (loss)                      |   | (9.9     | )      | (0.3     | )      | 0.0      |   |
| Interest  expense                             |   | (1.8     | )      | (1.7     | )      | (2.1     | )      |
| Other  income                                 |   | 0.2      |   | 0.4      |   | 0.2      |   |
| Income  (loss) before income taxes            |   | (11.5    | )      | (1.6     | )      | (1.9     | )      |
| Benefit  from (provision for) income taxes    |   | (4.6     | )      | (0.5     | )      | 0.7      |   |
|                                          |   |     |   |     |   |     |   |
| Net  income (loss)                            |   | (16.1    | )%     | (2.1     | )%     | (1.2     | )%     |

 

***Fiscal Year 2002 Compared to Fiscal Year 2001***

 

*Net Sales.*  Net sales during fiscal 2002 decreased $18.1million, or 26.7%, to $49.8 million, from $67.9 million in fiscal 2001.  The decrease is primarily due to thecontinued overall sluggish U.S. retail climate and shifts in consumerpreferences that were not met by the Company’s product line. Additionally,production delays in the third quarter that limited the availability of keyproducts for early shipment resulted in some cancelled orders. Thoughproduction was caught-up quickly, the shorter available retail selling periodand retailer’s concerns about reductions in allocations by consumers forChristmas buying contributed to reduced ordering activity.

 

Net Sales of JuvenileAudio Products in fiscal 2002 decreased $6.3 million, or 23.8%, to $20.1million, from $26.3 million in 2001. The major product groups in this categoryare Youth Electronics (formerly Youth Communications) and Musical Instruments.Youth Electronics provided $7.6 million in 2002 sales, a decrease of $7.0million, or 48.5%, when compared to 2001 sales of $14.6 million.  The Youth Electronics decrease is due tocontinued sales declines in children’s walkie-talkies, reflecting a productshift to role-play and spy related products and continued price pressures, anda decrease in sales of the *e-BrainTM* personal communicator, which wasintroduced in the fall of 2001.  MusicalInstruments increased $800,000, or 7.3%, to $12.5 million in 2002 sales ascompared to $11.7 million in 2001 sales. The increase reflects the introduction in 2002 of new foldinginstruments, the Pro Series lines of keyboards and drum-pads, which waspartially offset by declines in sing-a-long products and other de-emphasizedmusical instruments.

 

Net sales of Girls’ Toysdecreased $11.5 million, or 36.6%, to $20.0 million in fiscal 2002 from $31.5million during fiscal 2001. The decrease reflects reduced sales of the *EliteTM,Little Darlings®*, and *Pride and Joy®* doll lines, interactivedolls such as *Too Cute Twins®, Susie So SmartTM* and *Hush L’l Baby®*, and the *Air NailsSalonTM* girls activity toy. This decrease was partially offset by sales of 2002 productionintroductions, the *Somersault SaraTM* doll and the girlsactivity toy, *Twist and Twirl BraiderTM*.

 

Net sales of Boys’ Toysdecreased $2.4 million, or 27.4%, to $6.2 million during fiscal 2002 from $8.6million in fiscal 2001. Reduced sales of the *Insector®* R/C vehicle, introducedin 2000, and 2001 close-out sales of *Data-DawgTM*, were partially offset by salesof the new 2002 R/C product, *Dual FusionTM*.

 

Net sales of products inother categories increased $2.0 million, or 133.1%, to $3.5 million in fiscal2002 from $1.5 million in 2001.  Theincrease is primarily driven by sales of the new 2002 drawing-toy, LazerDoodle,and was partially offset by decreases in sales of doorbells, preschool productsand other electronic games.

 

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International net salesin fiscal 2002 of $9.4 million decreased $2.3 million, or 19.4%, from 2001 netsales of $11.7 million. The decreased sales reflect the soft overall worldretail market, the effect of exchange rate issues, competition with knock-offsof proprietary products, and political instability in several countries andregions.  Additionally, productiondelays that limited the availability of key products resulted in some canceledorders and lost sales.

* *

*Gross Profit*.Gross profit decreased $8.8 million or 44.4%, to $11.1 million during fiscal2002 from $19.9 million in fiscal 2001. Gross profit as a percentage of net sales decreased to 22.2% duringfiscal 2002 from 29.3% in fiscal 2001. The gross profit dollar decrease reflects reduced sales, in conjunctionwith the lower percentage of net sales during fiscal 2002 over 2001.  The percentage decrease reflects anincreased provision for slow-moving inventory, price pressures due to the slowmoving U.S. economy and increased allowances required to move inventory incustomers stores.

* *

*Selling, General and AdministrativeExpenses*. Selling, general and administrative expensesdecreased $4.1 million to $16.0 million, or 20.6%, from $20.1 million in fiscal2001.  Decreases occurred in nearly allareas in 2002, including a $1.4 million reduction in bad debt expense due tothe 2001 provision for Kmart’s bankruptcy filing.  Additionally, employee expense, travel and entertainment, andgeneral office expense decreased approximately $988,000, $203,000 and $482,000respectively, due in part to the closure of the Company’s New Jersey office inthe fourth quarter of 2001 and management’s focus on reducing general officeexpense.  Professional fees decreasedapproximately $168,000, primarily due to the expiration of a consultingagreement with a director (and former CEO). Sales commissions and advertising expense decreased $240,000 and$155,000 respectively, reflecting the lower sales amounts.  A $112,000 reduction in depreciation expenseas assets became fully depreciated was offset by a $146,000 increase in otherexpenses, including product insurance and losses on assets sales orabandonment. Goodwill amortization decreased $514,000, due to the adoption infiscal 2002 of a new accounting pronouncement that eliminated amortization.

* *

*Interest expense.***** Interest expense decreased $243,000, or21.1%, to $912,000 in fiscal 2002 from $1.2 million in fiscal 2001 as a resultof lower interest rates on the Company’s floating rate debt.

* *

*Income Taxes.***** The Company generated in fiscal 2002 a lossbefore income taxes of $5.7 million compared to a $1.0 million loss beforeincome taxes in fiscal 2001. These losses, combined with a $1.3 million lossbefore income taxes in fiscal 2000, provide negative evidence of the ability torealize the future tax benefits associated with the Company’s deferred taxassets. As a result, the Company recorded a deferred tax asset valuationallowance of $4.0 million in 2002, consisting of $2.2 million generated inprior years and $1.8 million for the fiscal year ended 2002.  Additionally, the Company incurred andrecorded a foreign tax expense of approximately $70,000 in 2002.

* *

*Net Loss.*** **The Company’s net loss for fiscal2002 was $8.0 million compared to a net loss of $1.4 million for fiscal 2001.  The primary driving factor was thesignificant decrease in sales and margin amounts in 2002 compared with 2001,which more than offset gains made in reducing selling, general, andadministrative expense.

*** ***

***Fiscal Year 2001 Compared to Fiscal Year 2000***

* *

*Net Sales*.  Net sales during fiscal 2001 decreased $2.5million, or 3.6%, to $67.9 million from $70.4 million in fiscal 2000. Thedecrease was due primarily to reduced sales of Boys’ Toys and Juvenile Audioproducts, partially offset by sales of Girls’ Toys.

 

Net sales of JuvenileAudio Products decreased $1.5 million, or 5.2%, to $26.3 million during fiscal2001 from $27.8 million during fiscal 2000. The major product groups in this category are Youth Electronics and MusicalInstruments, providing $14.6 million and $11.7 million respectively in 2001sales, compared to $14.2 million and $13.6 million respectively in 2000.  The Youth Electronics product group increasereflects sales of *e-Brain*TM personal communicator, introduced in fall 2001,partially offset by decreases in walkie-talkie sales, due to increasedcompetition in non-branded products. Musical Instruments sales decreased primarily in keyboards, which is aresult of decreased warehouse club business with one non-primary customer.

 

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Net sales of Girls’ Toysincreased $3.5 million, or 12.4%, to $31.5 million in fiscal 2001 from $28.0million in fiscal 2000.  The salesincrease in Girls’ Toys was driven by the television promoted *Too CuteTwinsTM* doll line, the girls activity toy *Air Nails*Salon*TM*and the plush toy *Kitty Kitty Kittens®*, which was partially offset by declinesin sales of dolls in the *Pride & Joy®*, *Elite*® and other generaldoll lines.

 

Net sales of Boys’ Toysdecreased $4.1 million, or 32.4%, to $8.6 million during fiscal 2001 from $12.7million in fiscal 2000.  The decrease isdue primarily to the discontinuation of the *Blockmen®* line of products sold in 2000and decreased sales of the primary 2000 R/C vehicle, *Insector®*, and other boys’items, which was partially offset by sales of the new 2001 R/C vehicle, *StreetSavage***(TM)**.

 

Net sales of products inother categories decreased approximately $460,000, or 0.5%, to $1.5 millionduring fiscal 2001 from $1.9 million in fiscal 2000.  The decrease is attributable to lower sales of games, videophones, doorbells and other discontinued lines, which was partially offset byincreased sales of preschool products.

 

International net salesdecreased $1.6 million, or 12.0%, to $11.7 million during fiscal 2001 from$13.3 million in fiscal 2000.  Thedecrease reflects the strength of the U.S. dollar against foreign currencies,thereby negatively affecting sales distributors potential retail price pointsand margins.  International net saleswere 17.2% of total net sales for fiscal 2001 as compared to 18.9% of total netsales in fiscal 2000.

*** ***

***Gross Profit.***  Gross profit decreased approximately$400,000, or 2.0%, to $19.9 million during fiscal 2001 from $20.3 million infiscal 2000.  Gross profit as a percentageof net sales increased to 29.3% during fiscal 2001 from 28.9% in fiscal2000.  The percentage increase reflectsthe continued focus on sales of proprietary products, such as the *Too CuteTwinsTM* doll, *Air Nails Salon*TM girls’ activity toy, andthe *StreetSavage*TM R/C vehicle, versus lower margin, more volume-drivennon-proprietary products.  Proprietaryproducts, which were 80% of our total net sales in 2001, generate a highermargin percentage.

*** ***

***Selling, General and Administrative Expenses. ***Selling, general andadministrative expenses decreased $200,000 to $20.1 million, or 1.3%, duringfiscal 2001 from $20.3 million in fiscal 2000. The decrease reflects reductions of approximately $945,000 and $846,000in advertising and commission expenses due to lower sales volume.  Additionally, professional fees decreased$356,000, as expenses associated with the 2000 Meritus merger werenon-reoccuring, along with a $120,000 decrease in various operating expenses.  Partially offsetting these decreases was anapproximate $525,000 increase in employee compensation, due to employeeadditions and a significant increase in receivables’ bad debt expense. The $1.7million provision for uncollectible accounts receivable is primarily related tothe January 2002 bankruptcy filing of Kmart Corp.

*** ***

***Interest Expense.*** Interest expensedecreased approximately $319,000, or 21.6%, to $1.2 million in fiscal 2001 from$1.5 million during fiscal 2000.  Thedecrease was due primarily to lower interest borrowing rates in 2001 ascompared to 2000.

*** ***

***Income Taxes.*** In fiscal 2001, the Company generated a lossbefore income taxes of $1.0 million compared to a $1.3 million loss beforeincome taxes during fiscal 2000.  Asignificant contributor to the 2001 loss was a $1.7 million provision foruncollectible accounts receivable.  Theprovision is not included in taxable income for 2001, but will be included intaxable income in a future year when the underlying receivables are written-offagainst the provision.  As a result, theCompany believes its ability to use foreign tax credits expiring in 2002 hasbeen potentially negated, and therefore has recorded a $566,000 valuationallowance for the credits in 2001.

*** ***

***Net Loss. ***TheCompany’s net loss for fiscal 2001 was approximately $1.4 million compared to anet loss of approximately $849,000 for fiscal 2000.  The 2001 net loss was due in significant part to the requiredincrease in the uncollectible receivables provision related to the Kmart bankruptcy.  The $1.7 million provision offset all othergains made in reduction of selling, general and administrative expense bymanagement in response to the reduced 2001 sales volumes from 2000.

 

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**Liquidityand Capital Resources**

 

The Company historicallyhas funded its operations and capital requirements by cash generated fromoperations and borrowings.  TheCompany’s primary capital needs have consisted of acquisitions of inventory,financing accounts receivable and capital expenditures for product development.

 

The Company’s operatingactivities provided net cash of $5.2 million during fiscal 2002, consistingprimarily of decreases in accounts receivable and increases in accountspayable. Net cash used in investing activities during fiscal 2002 wasapproximately $2.1 million and was mostly due to capital expenditures.  Net cash used by financing activities was$1.6 million in 2002, resulting from payments on long-term debt. The Company’sworking capital at December 31, 2002, was ($6.5) million and unrestricted cashwas approximately $1.7 million. See “The Revolver.”

 

The seasonal nature ofthe toy business results in complex working capital needs.  The Company’s working capital needs, whichthe Company generally satisfies through short-term borrowings, are greatest inthe last two fiscal quarters. To manage these working capital requirements, theCompany maintains credit facilities collateralized principally by accountsreceivable and inventory.  The Companycurrently maintains the Revolver, and through DSI(HK), the Dao Heng CreditFacility and the Standard Chartered Facility. The Company has guaranteed DSI(HK)’s obligations under the Dao HengCredit Facility and the Standard Chartered Facility.

 

*TheRevolver*

 

The Company’s net lossesfor the period ended December 31, 2002, and its overall financial conditionresulted in the Company being out of compliance with certain financialcovenants required under the Revolver. Therefore, the Company’s $7.0 million debt under the Revolver as ofDecember 31, 2002, has been reclassified as a current liability.  As a result, the Company’s currentliabilities exceeded its current assets by $6.5 million as of December 31,2002. If Sunrock were to accelerate the Revolver, which it has the option todo, the $7.0 million debt would become immediately due and payable.

 

Sunrock has recentlycompleted a transaction with Wells Fargo & Company in which Wells Fargopurchased most of  Sunrock’s existingloans.  Sunrock has retained certaincredit facilities, including the Revolver. Based on discussions with Sunrock, the Company’s management believesthat although Sunrock will not amend the Revolver, nor grant a waiver for theCompany’s non-compliance, Sunrock will not accelerate the Revolver at thistime.

 

*DaoHeng Facility and Standard Chartered Facility*

 

The Dao Heng Facility andthe Standard Chartered Facility were obtained on December 4, 2001, and April29, 2002, respectively, are subject to periodic review, and may be canceled by thebank upon notice.  The StandardChartered Facility affords DSI(HK) a credit limit in the aggregate of up to HKD19,000,000 (approximately US $2.4 million as of December 31, 2002) in the formof a line of credit financing facility based on actual shipments of product andopened letters of credit.  The Dao HengFacility affords DSI(HK) a credit limit in the aggregate of up to US$6,000,000.The Company has guaranteed DSI(HK)’s obligations under the Dao Heng Credit Facilityand the Standard Chartered Facility.

 

*AdditionalFinancing*

 

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

 

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On January 31, 2002, atthe request of Nasdaq and with the agreement of MVII, the Company issued anamended and restated Investment Warrant, which amended and restated in itsentirety the Investment Warrant by removing all anti-dilution provisions.  In addition, the Company and MVII enteredinto an Amended and Restated Registration Rights Agreement, which amended andrestated in its entirety the Registration Rights Agreement, by removing all ofthe provisions regarding the anti-dilution provisions of the originalInvestment Warrant.

 

On August 21, 2002, MVIIconverted the pre-paid Investment Warrant into 1.8 million shares of commonstock.  Upon issuance of these shares,MVII directly owned 5,994,238 shares of common stock.

 

In connection with theacquisition of Meritus Industries, Inc., in January 2000, the Company borrowed$5 million from MVII, evidenced by a promissory note dated January 7, 2000 (the“MVII Note”).  The Company re-borrowedon March 6, 2002, May 21, 2002, and March 10, 2003 a total of $1.35 million ofthe original principal that the Company had paid on the MVII Note.  The proceeds were used to finance the normalbusiness operations of the Company.

 

On August 19, 2002, theCompany executed a Guarantee in favor of Standard Chartered Bank, guaranteeingthe Standard Chartered Facility on behalf of DSI(HK) up to an amount not toexceed HKD 19,000,000 (approximately US$2.4 million at December 31, 2002).  The Revolver was amended on August 14, 2002,to permit this Guarantee.

 

The Company is obligatedto make future minimum royalty payments under certain of its license agreements.  As of December 31, 2002, the Company wasrequired to make an aggregate of approximately $250,000 in payments ofguaranteed royalties under certain licenses in fiscal 2002 and $835,000thereafter through fiscal 2007. Included in these amounts, are minimum royalties due Kawasaki under aSeptember 11, 2002 amendment to the original license agreement, extending thelicense through 2007.

 

The Company madeapproximately $1.5 million in capital expenditures in fiscal 2002 consistingprimarily of purchases of tools, molds and information technology systems.

 

The Company purchasesgoods, services and supplies from a number of vendors.  The Company currently is in arrears inmaking its payment obligations to certain of these vendors.

 

*GoingConcern*

 

The Company’s viabilityas a going concern is dependent upon successful negotiations with Sunrock, anew lender, or a substantial capital infusion, as well as sustained profitableoperations. The accompanying financial statements do not include anyadjustments that might be necessary if the Company is unable to continue as agoing concern.

 

To the extent theCompany’s cash reserves and cash flows from operations are insufficient to meetfuture cash requirements, the Company will need to successfully raise additionalcapital through an equity infusion or the issuance of debt.  The Company’s executive management believesthat the Company will be required to either obtain a new revolving loan orobtain necessary additional capital to allow the Company to continue its normaloperations for the foreseeable future. However, there can be no assurance theCompany will meet its projected operating results or be successful either inobtaining additional capital, or obtaining a new revolving loan.

 

The Company has helddiscussions and negotiations with several lenders regarding a credit facilityto replace the Revolver.  Management isnegotiating with one of those institutions regarding a replacement creditfacility that will become effective at the close of the anticipated goingprivate transaction, which is discussed immediately below.  Management believes that the going privatetransaction will close and that the Company will be able to continue itsoperations until that time.

 

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*GoingPrivate Transaction*

 

Since the Company’s cashreserves and cash flows from operations no longer meet its cash requirements,the Company has explored various alternatives to raise additional capital.

 

In January 2003, afterother alternatives for the Company had been exhausted, E. Thomas Martin, theChairman of the Company’s Board of Directors, and certain other officers,directors and shareholders of the Company (the “Buyer Group”) began seriousconsideration of a going-private transaction. On January 27, 2003, the Board of Directors invited the Buyer Group tosubmit an offer to the Company for a going-private transaction.  In anticipation of such an offer, and uponconsultation with the Company’s outside legal counsel, the Board of Directorsappointed directors M.D. Davis and Joseph N. Matlock as a special committee ofindependent, disinterested directors for the purpose of considering, evaluatingand negotiating any proposed transaction on behalf of the shareholders who arenot members of the Buyer Group and making a recommendation to the Board ofDirectors. The Board of Directors also authorized the special committee toretain, at the Company’s expense, independent legal and financial advisors.

 

On January 28, 2003, theBuyer Group proposed to the Company a going-private transaction by way of amerger that would result in the purchase of shares of common stock held by theshareholders who are not members of the Buyer Group for $0.44 per share.

 

On January 29, 2003, theCompany issued a press release confirming receipt of the Buyer Group’s proposaland announcing that its Board of Directors had formed a special committee ofindependent, disinterested directors.

 

The special committeeconsidered several investment bankers to serve as independent financialadvisors to the special committee.  OnFebruary 4, 2003, after evaluating, among other factors, each consideredinvestment bank’s expertise, responsiveness, knowledge of the Company, fees andtoy industry experience, the special committee approved the retention of Chaffe& Associates, Inc. (“Chaffe”) as its financial advisor in connection withthe proposal of the Buyer Group.

 

On February 20, 2003, thespecial committee met with representatives of Chaffe and Haynes and Boone, LLP(“Haynes and Boone”), legal counsel for the special committee. The purpose ofthe meeting was to review and consider the $0.44 per share proposal by theBuyer Group and to discuss with the special committee’s financial and legaladvisors a negotiating strategy. Chaffe reviewed with the special committee itsevaluation of the Company and the $0.44 per share proposal based upon Chaffe’sextensive, though not yet complete, investigation of the Company.  The special committee concluded that, basedon then-current information, it would not approve the proposal by the BuyerGroup of $0.44 per share and discussed possible counteroffers to the BuyerGroup’s proposal, including an alternative royalty structure.

 

On February 28, 2003, thespecial committee again met with representatives of Chaffe and Haynes andBoone. At the meeting, Chaffe reviewed with the special committee itsevaluation of the Company and the $0.44 per share proposal in light of Chaffe’sconcluded investigation of the Company. The special committee concluded that, based on then-current information,it would not approve the proposal by the Buyer Group of $0.44 per share anddiscussed possible counteroffers to the Buyer Group’s proposal, including analternative royalty structure.  Legalcounsel for the special committee was then directed to communicate therejection of the Buyer Group’s offer to counsel for the Buyer Group and topropose a counter offer of $0.61 per share.

 

On March 4, 2003, legalcounsel for the Buyer Group informed the special committee that the Buyer Grouphad rejected the special committee’s counter offer of $0.61 per share but hadincreased its offer to $0.47 per share.

 

On March 5, 2003, thespecial committee met with representatives of Chaffe and Haynes and Boone toreview and consider the $0.47 per share counter offer by the Buyer Group andchose to make another counteroffer of $0.50 per share to the Buyer Group.  M.D. Davis communicated the $0.50 per sharecounter offer to the Buyer Group.

 

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On March 5, 2003, theBuyer Group rejected the special committee’s latest counteroffer and reiteratedits offer to purchase the common stock owned by the shareholders who are notmembers of the Buyer Group for $0.47. The same day, the special committee met with representatives of Chaffeand Haynes and Boone.  Representativesof Chaffe delivered an oral opinion (which was subsequently confirmed inwriting) that, on the basis of and subject to the matters discussed with thespecial committee, including final negotiation of the merger agreement, theproposed $0.47 per share cash price was fair, from a financial point of view,to the Company’s shareholders, other than the members of the Buyer Group.  The special committee then unanimouslydetermined that the proposed merger was fair to, advisable and in the bestinterests of the Company and its shareholders, other than the members of theBuyer Group, subject to final negotiation of the merger agreement.  Counsel for the special committee thenadvised counsel for the Buyer Group that the special committee had recommendedacceptance of the Buyer Group’s proposal of $0.47 per share, subject to finalnegotiation of the merger agreement.

 

Between March 5, 2003 andMarch 26, 2003, the special committee, the Buyer Group, the Company andrepresentatives of Carrington, Coleman, Sloman & Blumenthal, LLP, legalcounsel to the Company, and Haynes and Boone negotiated the non-priceterms of the draft merger agreement.

 

On March 26, 2003, the special committee met to reviewthe terms of the merger agreement and the merger. A representative of Chaffemade a presentation to the special committee describing the analysis supportingits opinion that the $0.47 per share cash consideration was fair, from afinancial point of view, to the Company’s shareholders who are not members ofthe Buyer Group.  Based upon the opinionprovided by Chaffe and its own investigation, the special committee unanimouslyvoted to recommend that the Board of Directors approve the merger agreement andthe merger. Later that day, the Board of Directors met, received a presentationfrom Chaffe, and received the recommendation of the special committee.  Based upon the opinion of Chaffe and therecommendation of the special committee, the Board of Directors determined thatthe proposed merger was fair to, advisable and in the best interests of theCompany and its shareholders.  The Boardof Directors unanimously voted to approve the merger agreement and the mergerand recommended that the shareholders of the Company approve the mergeragreement and the merger.

 

On March 27, 2003, themerger agreement was signed.  TheCompany issued a press release announcing the merger agreement.

 

If the shareholders ofthe Company approve the merger, the Company’s shares will be delisted from theover-the-counter Bulletin Board electronic quotation system and its commonstock will be deregistered under the Securities Exchange Act of 1934. TheCompany will continue in business as a privately-held Texas corporation.

 

**RecentAccounting Pronouncements**

 

SFAS No. 141 entitled “*BusinessCombinations*” was issued in June 2001 and became effective July 1,2001.  SFAS No. 141 requires that allbusiness combinations be accounted for using the purchase method of accounting,which requires that acquisitions be recorded at fair value as of the date ofacquisition.  The pooling-of-interestsmethod of accounting allowed under prior standards, which reflected businesscombinations using historical financial information, is now prohibited.

 

In June 2001, the FASBissued SFAS No. 142 entitled “*Goodwill and Other Intangible Assets,”*which became effective on January 1, 2002. Under SFAS No. 142, existing goodwill is no longer amortized, but istested for impairment using a fair value approach.  SFAS No. 142 requires goodwill to be tested for impairment at alevel referred to as a reporting unit, generally one level lower thanreportable segments.  SFAS No. 142required us to perform the first goodwill impairment test on all reportingunits within six months of adoption. The first step is to compare the fair value with the book value of areporting unit.  If the fair value ofthe reporting unit is less than its book value, the second step will be tocalculate the impairment loss, if any. After the initial adoption, we will testgoodwill for impairment on an annual basis and between annual tests if an eventoccurs or circumstances change that would more likely than not reduce the fairvalue of a reporting unit below its carrying amount.  The Company adopted SFAS 142 effective January 1, 2002.  Management engaged an independent company toassist in valuing the Company’s goodwill at December 31, 2002 and 2001.  Based on these reviews, an impairment chargewas not required as of December 31, 2002 and 2001.

 

In June 2001, the FASBissued SFAS No. 143, “*Accounting for Asset Retirement Obligations”. *This Statement addressesfinancial accounting and reporting for obligations associated with theretirement of tangible long-lived assets and the associated asset retirementcosts.  Due to the nature of ourbusiness, this new accounting pronouncement is not expected to have asignificant impact on our reported results of operations and financialcondition.

 

25

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In August 2001, the FASBissued SFAS No. 144, “*Accounting for the Impairment or Disposal ofLong-Lived Assets,”* which addresses financial accounting andreporting for the impairment or disposal of long-lived assets.  This statement supersedes SFAS No. 121, “*Accountingfor the Impairment of Long-Lived Assets and for Long-Lived Assets to beDisposed Of,”*and the accounting and reporting provisions of APBOpinion No. 30, “*Reporting the Results of Operations – Reporting the Effects of aDisposal of a Business and Extraordinary, Unusual and Infrequently OccurringEvents and Transactions,”* for the disposal of a segment of abusiness.  This Statement also amendsARB No. 51,  “*Consolidated Financial Statements,”*toeliminate the exception to consolidation for a subsidiary for which control islikely to be temporary.  SFAS No. 144became effective on January 1, 2002, and interim periods within fiscal 2003,with early application encouraged.  Theprovisions of this Statement generally are to be applied prospectively. Thisaccounting pronouncement is not expected to have a significant impact on ourreported results of operations and financial condition.

 

In April 2002, SFAS No.145, “Recision of FASB Statements No. 4, 44 and 64, Amendment of FASB No. 13,and Technical Corrections,” was issued. This statement provides guidance on theclassification of gains and losses from the extinguishment of debt and on theaccounting for certain specified lease transactions. The adoption of thisstatement is not expected to have a material impact on the Company’sconsolidated financial position, results of operations or cash flows.

 

In June 2002, SFAS No.146, “Accounting for Costs Associated with Exit or Disposal Activities,” wasissued. This statement provides guidance on the recognition and measurement ofliabilities associated with disposal activities and is effective on January 1,2003. The adoption of this statement is not expected to have a material impacton the Company’s consolidated financial position, results of operations or cashflows.

 

In December 2002, theFASB issued SFAS No. 148, “*Accounting for Stock-Based Compensation Transitionand Disclosure, An Amendment of FAS No. 123*.”  This statement addresses the acceptabletransitional methods when the fair value method of accounting for stock-basedcompensation covered in SFAS No. 123 is elected.  Additionally, the statement prescribes tabular disclosure ofspecific information in the “*Summary of Significant Accounting Policies*”regardless of the method used and also required interim disclosure of similarinformation.  The Company has adoptedthis statement effective with the fiscal year ending December 31,2002.  The Company has not elected thefair value method, but continues accounting for stock-based compensation by theintrinsic method prescribed by APB Opinion 25.  The disclosure required by SFAS 148 is included in theSummary of Significant Accounting Policies.

 

In November 2002, theFASB issued FASB Interpretation No. 45 (FIN 45), “Guarantor’s Accounting andDisclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others,” which established additional accounting and disclosurerequirements when an enterprise guarantees the indebtedness of others.  The enterprise providing the guarantee isrequired to recognize a liability for the fair value of the obligation assumedand disclose the information in its interim and annual financialstatements.  The Company does notbelieve this will have a significant impact on our disclosures.

 

In January 2003, the FASBissued FASB Interpretation No. 46 (FIN 46), “Consolidation of Variable InterestEntities, an interpretation of ARB No. 51.”  The interpretation defines when and who consolidates a “variableinterest entity,” or “VIE.”  This newconsolidation model applies to entities (i) where the equity investors (ifany) do not have a controlling financial interest, or (ii) whose equityinvestment at risk is insufficient to finance that entity’s activities withoutreceiving additional subordinated financial support from other parties andrequires additional disclosures for all enterprises involved with the VIE.  FIN 46 is effective during 2003 depending onwhen the VIE is created.  The Companydoes not believe this will have a significant impact on our reported results ofoperations and financial condition.

 

**MeritusAcquisition**

 

Effective January 7,2000, the Company acquired Meritus by way of merger.  Pursuant to the terms of the merger, the Company acquired all ofthe issued and outstanding stock of Meritus for 533,208 shares of the Company’scommon stock and $2.57 million in other consideration paid to the shareholdersof Meritus.  Contemporaneously with themerger, the Company satisfied $4.4 million of Meritus’ debt.  The merger was accounted for using thepurchase method; therefore the Company recorded the acquired assets at theirfair market value, generating a significant amount of goodwill.  *(See Note 2to the Consolidated Financial Statements.)*

 

26

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As a result of the merger,the Company added the *Baby Beans*® brand**soft bean bag dolls, *Forever GirlFriends*® brand accessories for 11-1/2” fashion dolls, and *LittleDarlings®* brand value-priced action feature dolls to its productofferings, as well as the *Elite Dolls*TM brand,**which was created byMeritus specifically to manufacture and market “*Lifetime Play DollsTM*,” aline of exquisite 18” dolls and accessories suitable for playing or collecting.

 

**Inflation**

 

The Company does notbelieve that inflation in the United States, Europe or Asia in recent years has had a significant effect on itsresults of operations.

 

**Year2000**

 

The Company did notexperience any Year 2000 issues with its internal operating systems or with itscustomers or vendors.  In addition, theCompany did not experience any loss in revenues due to the Year 2000 issue.

 

**CautionaryStatement**

 

Certain written and oralstatements made or incorporated by reference from time to time by the Companyor its representatives in this Form 10-K, other filings or reports with theSecurities and 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 by forward-lookingstatements, please read carefully the information under Item 1, “RiskFactors”, of this Form 10-K.  Inaddition to the Risk Factors and other important factors detailed herein andfrom time to time in other reports filed by the Company with the Securities andExchange Commission, including Forms 8-K, 10-Q, and 10-K, the followingimportant factors could cause actual results to differ materially from thosesuggested by any forward-looking statements.

* *

*Marketplace Risks*

 

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

 

•                  Changesin public and consumer taste, which may negatively affect the sales of theCompany’s products;

 

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

 

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

* *

*Financing Considerations*

 

•                  Currencyfluctuations, which may affect the Company’s reportable income; significantchanges in interest rates, both domestically and internationally, which maynegatively affect the Company’s cost of financing both its operations andinvestments.

 

27

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•                  Theability of the Company to obtain the financing required for its ongoingoperations, which may negatively affect the ability of the Company’s viabilityas a going concern.

* *

*Other Risks*

 

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

 

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

 

•                  Labordisputes, which may lead to increased costs or disruption of any of theCompany’s operations.

 

The risks included hereinand in Item 1 “Risk Factors” are not exhaustive.  Other sections of this Form 10-K may include additionalfactors which could materially and adversely impact the Company’s business,financial condition, 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.

 

**ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.**

 

None**.**

 

**ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

 

See “Index toConsolidated Financial Statements and Schedules” included on page F-1 forinformation required under this Item 8.

 

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

 

None.

 

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**PART III**

** **

**ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT**

 

Information required byItem 10 relating to the Executive Officers of the Company appears under theheading “Executive Officers of the Registrant” in Part I herein, and is herebyincorporated by reference.  Below is asummary of the directors as of March 15, 2003 and their principal business forthe last five years.

 

The Company’s Board ofDirectors consists of eight positions (there is one vacant position), dividedinto three classes: Class I (two directors), Class II (two directors) and ClassIII (three directors).  The Class IIpositions were elected at the Annual Meeting in 2002.  The Class I and III positions will be due for nomination andelection at the annual meetings of shareholders to be held in 2004 and 2003,respectively.

 

Pursuant to the terms ofa Shareholders’ and Voting Agreement dated April 15, 1999 (the “Voting Agreement”),among the Company, M.D. Davis, Barry Conrad, Joseph Matlock, Douglas Smith andRust Capital, Ltd., a Texas limited partnership, (the “DSI Group”) and MVII,LLC, a California limited liability company (“MVII”), the DSI Group is entitledto nominate two of the directors of the Company, and MVII is entitled tonominate the remaining directors of the Company.  Further, each member of the DSI Group has given MVII anirrevocable proxy to vote his or its respective shares of common stock of theCompany for MVII’s nominees for director, and MVII is obligated under theVoting Agreement to vote its shares of common stock of the Company for thenominees of the DSI Group.

 

In addition, pursuant tothe terms of a Shareholders’ and Voting Agreement dated January 7, 2000 (the“Reiling Voting Agreement”), among the Company, MVII and Susan and WalterReiling (the “Reilings”), the number of directors of the Company was increasedby one for a total of seven directors, and the Reilings were entitled tonominate Mr. Reiling to fill the newly-created director position.  Mr. Reiling was appointed to the Board ofDirectors on February 1, 2000, and was subsequently elected to his current termby the shareholders at the 2000 Annual Meeting of Shareholders.  The Reilings also have given MVII anirrevocable proxy to vote their shares of common stock of the Company forMVII’s nominees for director, and MVII is obligated under the Reiling VotingAgreement to vote its shares of common stock of the Company for the Reilings’nominee.

 

Messrs. Burke andMcSorley were previously nominated by MVII pursuant to the Voting Agreement, inaddition to E. Thomas Martin and Joseph S. Whitaker.  Messrs. Davis and Matlock were previously nominated by the DSI Grouppursuant to the terms of the Voting Agreement.

 

**I.              CLASS I DIRECTORS**

** **

**Robert L. Burke**, 59, has served as adirector of the Company since June 1, 1999. After a successful career in the financial business arena, pursuant towhich Mr. Burke held various positions including as an officer of SecurityPacific Bank, a Registered Representative with Bache & Company (nowPrudential Bache), Sales Manager of Beverly Sales, Inc., Vice President ofCalmark Asset Management, Inc., and President of Continental WesternSecurities, Inc., he returned to school and earned a Masters Degree inEducation in 1993.  From 1993 until hisretirement in 1999, he was an educator with the Lake Oswego School District inLake Oswego, Oregon.  He is the Chairmanof the Audit Committee and a member of the Compensation Committee.

 

**John McSorley**, 57, has served as a directorof the Company since June 1, 1999.  FromMarch 1997 to the present, he has served as President of Double Bogey, LLC, aCalifornia limited liability company based in San Rafael, California, that isengaged in the investment of private capital. From November 1989 to October 1996, Mr. McSorley served as ChiefOperating Officer and General Partner of BayCom Partners LP, a Californialimited partnership engaged in the ownership of radio stations in Californiaand Oregon.  Double Bogey, LLC owns a2.22% membership interest in MVII.  Mr.McSorley is the Chairman of the Compensation Committee and a member of theAudit Committee.

 

29

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**II.            CLASS II DIRECTORS**

** **

**E. Thomas Martin**, 59, has served as theChairman of the Board of the Company since June 1, 1999.  He is the sole Manager and President ofMVII.  Mr. Martin is President of MartinResorts, Inc., a private California corporation which owns and operates coastalhotels in California.  Mr. Martin wasthe Chief Executive Officer and a partner in Martin & MacFarlane, Inc. andMartin Media, L.P., national outdoor advertising companies, until their sale toChancellor Media in September of 1998. Mr. Martin also manages various real estate ventures.  He is the Chairman of the ExecutiveCommittee.

** **

**Joseph S. Whitaker**,62, has served as a director since June 1, 1999, and President and ChiefExecutive Officer since December 1, 2001. He joined the Company on June 1, 1999, as Senior Vice President, NewBusiness Development.  He also serves asVice President of, and owns less than a 1% membership interest in MVII.  For the five years prior to joining theCompany, Mr. Whitaker operated a consulting business in La Jolla, California,providing services related to marketing, licensing and product development tothe toy industry.

 

**III.           CLASS III DIRECTORS**

** **

**M. D. Davis,** 68, has served as a directorof the Company since December 11, 1995. He served as the Chairman of the Board and Chief Executive Officer ofthe Company from December 1995 through June 1, 1999. Mr. Davis is a member ofthe Executive Committee.

** **

**Joseph N. Matlock**,54, has served as a director of the Company since December 11, 1995. Mr.Matlock has served the financial services industry for over 25 years, includingseven years as a chief executive officer and nine years as a director forvarious companies. From January 1996 to March 1998, Mr. Matlock served asExecutive Vice President for Bank of America. In September 1995, he founded Afford America, Inc., which provides homeownership for low-income families, and has served as its President since itsinception.  Mr. Matlock is themanaging  partner of Iliad Partners, alate stage technology investment partnership. Since November 2001, he has been the chief executive officer ofNeuro-Enhancement Centers of America, formerly Ensignia, a medical technologycompany.  He is a member of the AuditCommittee and the Compensation Committee.

** **

**Walter S. Reiling**,68, has served as a director of the Company since February 1, 2000.  Mr. Reiling has 45 years of experience inthe toy industry and founded Meritus Industries, Inc. (“Meritus”), a toycompany, in 1981.  Mr. Reiling served asthe principal manager of Meritus from its formation until its acquisition bythe Company on January 7, 2000.  He is amember of the Executive Committee.

 

**CompensationCommittee Interlocks and Insider Participation**

 

Of the current members ofthe Compensation Committee, Mr. McSorley and Mr. Burke have served on suchcommittee since June 1, 1999, and Mr. Matlock has served on such committeesince January 23, 1996.  At no time wasan officer or employee of the Company a member of the Company’s CompensationCommittee. No member of the Board of Directors of the Company or theCompensation Committee serves as a member of the board of directors orcompensation committee of an entity that has one or more executive officersserving as a member of the Company’s Board of Directors or the Company’sCompensation Committee.

 

**DirectorCompensation**

* *

*Annual Retainer and Other Fees andExpenses.* Directorsare paid an annual retainer of $15,000. The Company also reimburses directors for travel, lodging and relatedexpenses they incur in attending Board of Directors and committee meetings.

* *

*Non-Employee Director Stock Options.*  Under the DSI Toys, Inc. 1997 Stock OptionPlan (the “Stock Option Plan”), which was approved and ratified by shareholderson May 1, 1997, non-employee directors may, from time to time at the discretionof the Compensation Committee, receive a grant of an option to purchase sharesof common stock of the Company.  Theoptions are granted at an exercise price as determined by the CompensationCommittee and are exercisable, as determined by the committee, from time totime over a period of ten years from grant date, unless sooner terminated asdescribed in the Stock Option Plan.

 

30

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*Special Committee*.  Mr. Davis and Mr. Matlock, the members ofthe special committee of the Board of Directors formed for the purpose ofconsidering, evaluating and negotiating the proposed going-private transaction,have executed agreements with the Company pursuant to which they shall eachreceive $200 for each meeting of the special committee requiring more than onehour of attendance in person, plus they each shall receive reimbursement ofreasonable out-of-pocket expenses incurred in connection with their service onthe special committee. Mr. Davis and Mr. Matlock additionally entered intoindemnification agreements with the Company with respect to their service onthe special committee.

** **

**Section 16(a) Beneficial OwnershipReporting Compliance**

 

Section 16(a) of theSecurities Exchange Act of 1934 requires the Company’s directors, certain ofits officers and persons who own more than 10 percent of the Company’s commonstock, to file with the Commission reports of ownership and changes inownership of such stock.  Suchdirectors, officers and greater than 10% shareholders are also required tofurnish the Company with copies of all Section 16(a) forms they file.

 

To the Company’sknowledge, based solely on a review of the copies of such reports furnished tothe Company and written representations from the reporting persons during theyear ended December 31, 2002, all Section 16(a) filing requirements applicableto its directors, officers, and greater than 10% shareholders were compliedwith except as follows:

 

•                  WalterS. Reiling was late filing a Form 4 for February, 2002.  He filed a Form 5 on February 12, 2003.

 

•                  GregoryA. Barth was late filing a Form 4 for November, 2002.  He filed a Form 5 on February 12, 2003.

 

•                  TitYu Chan (aka Alfred Chan) was late filing a Form 3.  He filed a Form 5 on February 12, 2003.

 

•                  GarrySpurlock was late filing a Form 3.  Hefiled a Form 5 on February 12, 2003.

 

**ITEM 11.  EXECUTIVE COMPENSATION**

** **

**Report Of The Compensation CommitteeOn Executive Compensation**

 

The CompensationCommittee (the “Committee”) of the Board of Directors is currently composedentirely of outside, non-employee directors. The Committee reviews and sets the compensation levels of the Company’sChief Executive Officer (“CEO”) and other executive officers, evaluates theperformance of management, considers management succession and related matters,and administers the Stock Option Plan. All decisions by the Committee relating to the compensation of executiveofficers are reviewed by the full Board of Directors.

 

The Committee considersinformation with respect to the reasonableness of compensation paid to seniorofficers of the Company, as well as all employees of the Company and itssubsidiaries in managerial positions. The Committee also takes into account how compensation compares tocompensation paid by competitors in the Company’s industry as well as theperformance of the Company.

 

**CompensationPolicies and Programs**

 

The compensation policiesof the Company, set by management and supported by the Committee, focus onenhancing shareholder value.  Specificpolicies are designed to attract, motivate and retain persons of high qualitywho will have the skill, training and dedication to assist the Company inachieving its corporate goals.  Theexecutive compensation program for fiscal 2002 consisted of two elements: basesalary, and long-term incentive compensation through the granting of stockoptions pursuant to the Stock Option Plan.

* *

*Base Salary*:  Base salary for executive officers isdetermined principally by competitive factors and the marketplace.  The policy of the Committee is generally toset base salary levels for positions at approximately the median levelsdetermined from survey information for positions deemed comparable by theCommittee.

 

31

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*Long-term Incentive Compensation*:  The Company uses stock options as a means offurnishing long-term incentives to officers and other employees of the Companyand its subsidiary.  Under the StockOption Plan, the Company has flexibility in granting directors, officers andemployees options to acquire shares of the Company’s common stock.

 

During fiscal year 2002,no named executive officers listed in the Summary Compensation Table weregranted stock options.

 

**Fiscal2002 Compensation of CEO**

 

The 2002 base salary ofthe CEO and President, Mr. Joseph S. Whitaker, was calculated at the rate of$180,000 per annum.  The base salary isestablished pursuant to an employment agreement between Mr. Whitaker and theCompany that became effective on June 1, 1999, and was amended effectiveDecember 1, 2001.  The employmentagreement expires on November 30, 2004. The compensation provided for in the employment agreement was based uponthe duties and time commitment of the offices assumed by Mr. Whitaker as setforth in the agreement.

 

**TaxDeductibility of Executive Compensation**

 

Section 162(m) of theInternal Revenue Code contains provisions which could limit the deductibilityof certain compensation payments to the Company’s executive officers.  The Company believes that any compensation realizedin connection with the exercise of stock options granted by the Company willcontinue to be deductible as performance-based compensation.  The policy of the Company is to design itscompensation programs generally to preserve the tax deductibility ofcompensation paid to its executive officers. The Committee could determine, however, taking into consideration theburdens of compliance with Section 162(m) and other relevant facts andcircumstances, to pay compensation that is not fully deductible if theCommittee believes such payments are in the Company’s best interests.

 

**Summary**

 

The members of theCommittee believe that linking executive compensation to corporate performanceresults in a better alignment of compensation with corporate goals andshareholder interests.  As performancegoals are met or exceeded, resulting in increased value to shareholders,executive officers are to be rewarded commensurately.  The members of the Committee believe that compensation levelsduring fiscal 2002 adequately reflect the compensation goals and policies ofthe Company.  Certain executivecompensation increases were announced and became effective on January 1, 2002,and by contract, certain other executive compensation increases were announcedand became effective on April 2, 2002. No other executive compensation increases are planned for fiscal 2003.

 
|   |   |   |   |   |   |   | John McSorley, Chairman |
|--------|--------|--------|--------|--------|--------|--------|-------------------------|
|   |   |   |   |   |   |   | Robert L. Burke         |
|   |   |   |   |   |   |   | Joseph N. Matlock       |

 

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**Compensation Of Certain NamedExecutive Officers**

 

The following table setsforth certain summary information concerning the compensation awarded to,earned by or paid to the Chief Executive Officer of the Company and certainother executive officers of the Company as of December 31, 2002, for the yearsindicated.

 
|                             |   |             |   | **Annaul  Compensation** |   | **Long-Term  Compensation** |   |                            |   |
|----------------------------------|--------|------------------|--------|--------------------------|--------|-----------------------------|--------|---------------------------------|--------|
| **Name and  Principal Position** |   | **Fiscal  Year** |   | **Salary**               |   | **Bonus**                   |   | **Other  Annual  Compensation** |   | **Stock  Options  number of  shares)(1)** |   | **All Other  Compensation** |   |
| Joseph Whitaker (2)              |   | 2002             |   | 180,000                  |   |                        |   | 15,000                          | (3)    |   |   | $ | 3,606 | (4) |
| *Chief Executive Officer*        |   | 2001             |   | 108,020                  |   |                        |   | 15,000                          | (3)    |   |   | 3,277 | (4) |
| *and President*                  |   | 2000             |   | 98,184                   |   |                        |   | 15,000                          | (3)    |   |   | 3,301 | (4) |
|                             |   |             |   |                     |   |                        |   |                            |   |   |   |   |   |
| Gregory A. Barth (5)             |   | 2002             |   | 153,375                  |   |                        |   |                            |   |   |   | 3,356 | (7) |
| *Senior Vice*                    |   | 2001             |   | 112,500                  |   |                        |   | 61,755                          | (6)    | 50,000 |   | 3,115 | (7) |
| *President*                      |   | 2000             |   |                     |   |                        |   | 150,767                         | (6)    |   |   |   |   |
|                             |   |             |   |                     |   |                        |   |                            |   |   |   |   |   |
| Robert L. Weisgarber             |   | 2002             |   | 147,138                  |   |                        |   |                            |   |   |   | 3,606 | (8) |
| *Chief Financial Officer*        |   | 2001             |   | 142,800                  |   |                        |   |                            |   |   |   | 2,962 | (8) |
|                             |   | 2000             |   | 133,250                  |   |                        |   |                            |   |   |   | 2,889 | (8) |
|                             |   |             |   |                     |   |                        |   |                            |   |   |   |   |   |
| William J. Kerner(9)             |   | 2002             |   | 133,900                  |   |                        |   |                            |   |   |   | 3,030 | (10) |
| *Vice President*                 |   | 2001             |   | 130,000                  |   |                        |   |                            |   |   |   | 2,853 | (10) |
| *Research & Development*     |   | 2000             |   | 125,000                  |   |                        |   |                            |   |   |   | 23,392 | (10) |
|                             |   |             |   |                     |   |                        |   |                            |   |   |   |   |   |
|                             |   |             |   |                     |   |                        |   |                            |   |   |   |   |   |
| Milan Seda(9)                    |   | 2002             |   |                     |   |                        |   |                            |   |   |   |   |   |
| *Vice President*                 |   | 2001             |   |                     |   |                        |   |                            |   |   |   |   |   |
| *Research &*                 |   | 2000             |   |                     |   |                        |   |                            |   |   |   |   |   |
| *Development*                    |   |             |   |                     |   |                        |   |                            |   |   |   |   |   |
|                             |   |             |   |                     |   |                        |   |                            |   |   |   |   |   |
| Tit Yu Chan(11)                  |   | 2002             |   | 176,818                  | (12)   | 25,674(12)(13)              |   |                            |   |   |   | 647 | (14) |
| *(Alfred Chan)*                  |   | 2001             |   |                     |   |                        |   |                            |   |   |   |   |   |
| *Managing Director*              |   | 2000             |   |                     |   |                        |   |                            |   |   |   |   |   |
|                                  |        |                  |        |                          |        |                             |        |                                 |        |  |  |  |  |  |

 

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(1)                Options representthe right to purchase shares of common stock at a fixed price per share.

 

(2)                Mr. Whitakerbecame President and CEO on December 1, 2001. Previously, since June 1, 1999, he had been Senior Vice President, NewBusiness Development.  In December 2002,Mr. Whitaker agreed not to take a salary increase to which he was entitledpursuant to his employment agreement.

 

(3)                Director’s fees.

 

(4)                Includes Companycontributions or other allocations to (i) a defined contribution plan of$3,000, $2,625 and $2,510 for fiscal 2002, 2001 and 2000, respectively, and(ii) group term life insurance premiums of $606, $652, and $791, for fiscal2002, 2001 and 2000, respectively.

 

(5)                Mr. Barth was aconsultant to the Company from April 2000 until he was hired as an employee inApril 2001.  Mr. Barth’s employmentcontract terminates March 31, 2003.  Mr.Barth will leave the employment of the Company at that time.

 

(6)                Consulting feesand other compensation for consulting work performed by Mr. Barth for theCompany.

 

33

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(7)                Includes Companycontributions or other allocations to (i) a defined contribution plan of $2,750and $1,313 and (ii) group term life insurance premiums of $606 and $491 forfiscal 2002 and 2001, respectively.

 

(8)                Includes Companycontributions or other allocations to (i) a defined contribution plan of$3,000, $2,625, and $2,625 and (ii) group term life insurance premiums of $606,$337, and $264, for fiscal 2002, 2001 and 2000, respectively.

 

(9)                Mr. Kerner’semployment with the Company terminated on March 7, 2003.  Mr. Seda will replace Mr. Kerner effectiveApril 1, 2003.

 

(10)          Includes Companycontributions or other allocations to (i) a defined contribution plan of$2,625, $2,625 and $2,156, (ii) group term life insurance premiums of $405,$228 and $264, for fiscal 2002, 2001 and 2000, respectively; and (iii)reimbursed moving expenses of $20,972 in fiscal 2000.

 

(11)          Mr. Chan was hired bythe Company as managing director of DSI (HK) in January 2002.

 

(12)          Based on average US-HKexchange rate.

 

(13)          Bonus earned in fiscal2002, but actually paid in January 2003.

 

(14)          Company contributions togroup term life insurance.

 

There were no options topurchase common stock granted during the year ended December 31, 2002, to anyof the named executive officers.

 

The following table setsforth certain information with respect to the exercise of options to purchasecommon stock during the year ended December 31, 2002, and the unexercisedoptions held at December 31, 2002 and the value thereof, by each of the namedexecutive officers.

 

**AggregatedOption Exercised In Fiscal 2002and 12/31/02 Option Values**

 
| **Name**              |   | **Shares  Acquired  On Exercise (number  of shares)** |   | **Value  Realized** |   | **Number of  Securities  Underlying Options at  12/31/02  (shares)** |   | **Value of  Exercisable and  Unexercisable In-the-Money  Options  at Fiscal Year End** |   |
|-----------------------|--------|-------------------------------------------------------|--------|---------------------|--------|----------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------|--------|
| **Exercisable**       |   | **Unexercisable**                                     |   | **Exercisable**     |   | **Unexercisable**                                                    |
| Joseph  S. Whitaker   |   | 0                                                     |   | $                   | 0      |                                                                 | 75,000 |                                                                                   | 50,000 |   | $ | 0 |   | $ | 0 |   |
| Gregory  A. Barth     |   | 0                                                     |   | 0                   |   | 10,000                                                               |   | 40,000                                                                                 |   | 0 |   | 0 |   |
| Robert  L. Weisgarber |   | 0                                                     |   | 0                   |   | 30,000                                                               |   | 20,000                                                                                 |   | 0 |   | 0 |   |
| Willliam  J. Kerner   |   | 0                                                     |   | 0                   |   | 6,000                                                                |   | 4,000                                                                                  |   | 0 |   | 0 |   |
| Milan  Seda           |   | 0                                                     |   | 0                   |   | 0                                                                    |   | 0                                                                                      |   | 0 |   | 0 |   |
| Tit  Yu Chan          |   | 0                                                     |   | 0                   |   | 0                                                                    |   | 0                                                                                      |   | 0 |   | 0 |   |
|                       |        |                                                       |        |                     |        |                                                                      |        |                                                                                        |        |  |  |  |  |  |  |  |

 

34

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**EquityCompensation Plan Information**

 
| **Plan Category**                                           |   | **Number of  securities to be  issued upon exercise of  outstanding options,  warrants and rights** |   | **Weighted-average  exercise price of  outstanding options,  warrants and rights** |   | **Number of  securities  remaining available for  future issuance under equity  compensation plans  (excluding securities  reflected in column (a))** |    |
|-------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------|---------|
|                                                        |   | **(a)**                                                                                             |   | **(b)**                                                                            |   | **(c)**                                                                                                                                               |    |
| Equity compensation  plans approved by security holders     |   | 574,000                                                                                             |   | $                                                                                  | 3.53   |                                                                                                                                                  | 551,334 |   |
|                                                        |   |                                                                                                |   |                                                                               |   |                                                                                                                                                  |    |
| Equity compensation  plans not approved by security holders |   | 0                                                                                                   |   | 0                                                                                  |   | 0                                                                                                                                                     |    |
|                                                        |   |                                                                                                |   |                                                                               |   |                                                                                                                                                  |    |
| Total                                                       |   | 574,000                                                                                             |   | $                                                                                  | 3.53   |                                                                                                                                                  | 551,334 |   |

 

**PerformanceGraph**

 

The following graphcompares the cumulative total shareholder return on the common stock of theCompany to the cumulative total return of each of the following indices: theStandard & Poor’s 500 Index (“S & P 500”), the Standard and Poor’s 600Index (“S & P SMALLCAP 600”) and a Peer Group Index since January 31, 1998.

 

 

35

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Comparison of Cumulative Total Returns (1)Among DSI Toys, Inc., Standard & Poor’s 500 Index, STANDARD & POOR’S600 INDEX,And PEER Group Index (2)

 
|                                           |   | **1/31/98** |   | **1/31/99** |   | **12/31/99** |   | **12/31/00** |   | **12/31/01** |   | **12/31/02** |   |
|------------------------------------------------|--------|-------------|--------|-------------|--------|--------------|--------|--------------|--------|--------------|--------|--------------|--------|
| DSI  Toys, Inc.                                |   | $           | 100    |        | $      | 69           |   | $            | 118    |         | $      | 49           |   | $ | 34 |   | $ | 18 |   |
| Peer  Group(2)                                 |   | $           | 100    |        | $      | 118          |   | $            | 61     |         | $      | 23           |   | $ | 79 |   | $ | 72 |   |
| Standard  & Poor’s 500 Index          |   | $           | 100    |        | $      | 132          |   | $            | 154    |         | $      | 140          |   | $ | 123 |   | $ | 96 |   |
| Standard  & Poor’s SmallCap 600 Index |   | $           | 100    |        | $      | 99           |   | $            | 113    |         | $      | 126          |   | $ | 135 |   | $ | 115 |   |

 

----

(1)                Total returnassuming reinvestment of dividends. Assumes $100 invested in 1998, in common stock of the Company, theStandard & Poor’s 500 Index, the Standard & Poor’s 600 Index and aCompany constructed peer group index.

 

(2)                In accordance withthe rules of the Securities and Exchange Commission, the Company has elected toselect a group of peer companies on an industry basis for comparisonpurposes.  The peer group for  fiscal 2002 is composed of 8 industryparticipants: Action Performance Inc.; Equity Marketing, Inc.; Grand ToysInternational Inc.; Jakks Pacific Inc.; Marvel Enterprises Inc. (formerly namedToyBiz, Inc.); Ohio Art Company; Racing Champions Corp. and Radica Games,Ltd.  Cumulative total returncalculations were weighted according to the respective company’s marketcapitalization.

 

**ITEM 12.SECURITY OWNERSHIP OF PRINCIPAL SHAREHOLDERS AND MANAGEMENT**

 

The following table setsforth certain information regarding the beneficial ownership of common stock asof March 26, 2003 by: (i) persons known to management to beneficially own morethan 5% of the Company’s common stock; (ii) each director and nominee fordirector of the Company; (iii) each named executive officer listed in theSummary Compensation Table; and (iv) all directors and executive officers as agroup.  Unless otherwise indicated, thebeneficial owner has sole voting and investment power with respect to allshares listed:

 
| **Name of Beneficial Owner**                                          |                  | **Common  Stock  Beneficially Owned** |                  |
|-----------------------------------------------------------------------|-----------------------|---------------------------------------|-----------------------|
|                                                                  | **Number  of Shares** |                                  | **Percent of  Class** |   |
| Gregory  A. Barth (1)                                                 |                  | 22,000                                | (5)                   |   | * |
| Robert  L. Burke (1)                                                  |                  | 15,000                                | (5)(7)                |   | * |
| Tit  Yu Chan (2)                                                      |                  | 0                                     |                  | 0 |   |
| M.D.  Davis (1)                                                       |                  | 354,951                               | (6)(7)                | 3.19 | % |
| William  J. Kerner (1)                                                |                  | 0                                     |                  | 0 |   |
| E.  Thomas Martin (3)(9)                                              |                  | 6,649,323                             | (8)                   | 58.95 | % |
| Martin  Group (9)                                                     |                  | 7,280,568                             | (10)                  | 65.47 | % |
| Joseph  N. Matlock (1)                                                |                  | 117,000                               | (6)(7)                | 1.05 | % |
| John  McSorley (1)                                                    |                  | 15,000                                | (5)(7)                |   | * |
| MVII,  LLC (3)                                                        |                  | 5,994,238                             | (11)                  | 53.94 | % |
| Walter  S. Reiling (4)                                                |                  | 551,208                               | (7)(12)               | 4.96 | % |
| Walter  S. and Susan Reiling, joint tenants (4)                       |                  | 551,208                               | (7)(12)               | 4.96 | % |
| Milan  Seda (1)                                                       |                  | 0                                     |                  | 0 |   |
| Robert  L. Weisgarber (1)                                             |                  | 30,000                                | (7)                   |   | * |
| Joseph  S. Whitaker (1)                                               |                  | 77,000                                | (5)(7)                |   | * |
| All current directors  and executive officers as a group (18 persons) |                  | 7,871,591                             | (7)                   | 70.83 | % |

 

----

*              Represents less than 1%.

 

36

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(1)                The businessaddress for each named person is 10110 West Sam Houston Parkway South, Suite150, Houston, Texas 77099.

 

(2)                The businessaddress for the named person is Suite 1401, New T&T Centre, Harbour City,Tsimshatsui, Kowloon, Hong Kong.

 

(3)                The businessaddress for each named person is 1432 Higuera Street, P.O. Box 12060, San LuisObispo, California 93406.

 

(4)                The businessaddress for each named person is 15 Woodcrest Drive, Morristown, New Jersey07960.

 

(5)                Excludes sharesowned of record by MVII. Messrs. Burke and McSorley each own a 2.22% membershipinterest in MVII; Mr. Whitaker owns less than a 1% membership interest in MVII.

 

(6)                Excludes sharesowned of record by other members of the Martin Group that are to be voted inaccordance with a Shareholders’ and Voting Agreement dated April 15, 1999 (the“Voting Agreement”), among the Company, MVII, M.D. Davis, Barry Conrad, JosephMatlock, Douglas Smith and Rust Capital, Ltd., a Texas limited partnership,(collectively, the “DSI Group”). Pursuant to the Voting Agreement, the DSI Group is entitled to nominatetwo of the directors of the Company and MVII is entitled to nominate theremaining directors of the Company. Further, each member of the DSI Group hasgiven MVII an irrevocable proxy to vote his or its respective shares of commonstock of the Company for MVII’s nominees for director, and MVII is obligatedunder the Voting Agreement to vote its shares of common stock of the Companyfor the nominees of the DSI Group. For a discussion of the Martin Group, seefootnote number 9 to this table.

 

(7)                Includes shares ofcommon stock not outstanding but subject to options currently exercisable, orexercisable within 60 days, as follows: Mr. Barth - 20,000 shares (options willexpire March 31, 2003); Mr. Burke - 15,000 shares; Mr. Davis - 15,000 shares;Mr. Matlock - 17,000 shares; Mr. McSorley - 15,000 shares; Mr. Reiling - 15,000shares; Mr. Weisgarber - 30,000 shares; Mr. Whitaker - 75,000 shares; and group- 246,200 shares.

 

(8)                Includes 640,085shares owned of record by E. Thomas Martin; 15,000 shares of common stock notoutstanding but subject to options currently exercisable, or exercisable within60 days; 5,994,238 shares owned of record by MVII, but excludes shares owned ofrecord by the other members of the Martin Group.

 

(9)                The Martin Groupis comprised of the DSI Group and Walter and Susan Reiling (the “Reilings”).Pursuant to the Voting Agreement, each member of the DSI Group has given MVIIan irrevocable proxy to vote its respective shares of common stock of theCompany for, among other things, MVII’s nominees for director, and MVII isobligated under the Voting Agreement to vote its shares of common stock of theCompany for the nominees of the DSI Group. Pursuant to a Shareholders’ and Voting Agreement dated January 7, 2000(the “Reiling Voting Agreement”), among the Company, MVII and the Reilings, theReilings have given MVII an irrevocable proxy to vote their shares of commonstock of the Company for, among other things, MVII’s nominees for director, andMVII is obligated under the Reiling Voting Agreement to vote its shares ofcommon stock of the Company for the Reilings’ nominee.

 

(10)          Includes 5,994,238shares owned of record by MVII; 354,951 shares owned of record (including15,000 shares not outstanding but subject to options currently exercisable) byM.D. Davis; 117,000 shares owned of record (including 17,000 shares notoutstanding but subject to options currently exercisable) by Joseph N. Matlock;261,171 shares owned of record (including 2,000 shares not outstanding butsubject to options currently exercisable) by Douglas A. Smith; 2,000 shares notoutstanding but subject to options currently exercisable owned of record byBarry B. Conrad; and 551,208 shares owned of record (including 15,000 sharesnot outstanding but subject to options currently exercisable) by the Reilings.

 

(11)          Excludes shares owned ofrecord by other members of the Martin Group that are to be voted in accordancewith the Voting Agreement and the Reiling Voting Agreement.

 

(12)          Excludes shares owned ofrecord by other members of the Martin Group that are to be voted in accordancewith the Reiling Voting Agreement.

 

37

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**ITEM 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**

 

Information concerningcertain transactions involving the Company and certain directors and executiveofficers of the Company is set forth herein.

 

# **Management - Employment andRelated Agreements**

 

Mr. M.D. Davis, director,entered into a consulting agreement effective as of June 1, 1999, pursuant towhich he ceased to be an employee and officer of the Company and agreed toprovide consulting services to the Company through the period ending June 1,2002. For his services under the consulting agreement, Mr. Davis  received total compensation in the amount of$450,000, which was payable in equal monthly installments of $12,500 ($150,000per annum).

 

The Company entered intoan employment agreement with Mr. Joseph S. Whitaker on June 1, 1999, andamended the agreement effective December 1, 2001.  Pursuant to the amended agreement, Mr. Whitaker shall serve asPresident and Chief Executive Officer of the Company for a term ending November30, 2004, and will be paid an annual salary of $180,000, which salary shall beraised on an annual basis in accordance with the Consumer Price Index, and maybe additionally raised at the discretion of the Board of Directors. Theagreement contains non-disclosure, non-competition and non-solicitationprovisions applicable during the term of employment and for one yearthereafter.

 

The Company entered intoan employment contract with Gregory A. Barth on April 1, 2001.  Pursuant to the agreement, Mr. Barth shallserve as Senior Vice President of Worldwide Operations, Business Planning andLogistics of the Company for a term ending March 31, 2003, and will be paid anannual salary of $150,000.  Theagreement contains non-disclosure, non-competition and non-solicitationprovisions applicable during the term of employment and for one yearthereafter. Mr. Barth’s employment contract terminates on March 31, 2003.  Mr. Barth will leave the employment of theCompany at that time.

 

On January 7, 2000, theCompany acquired Meritus by way of merger. Pursuant to the terms of the merger, the Company acquired all of theissued and outstanding stock of Meritus in exchange for (i) 533,208unregistered shares of the Company’s common stock; (ii) $884,033.82 in cash;and (iii) the Company’s Subordinated Secured Promissory Note for $1,690,000paid to the Reilings who were the sole shareholders of Meritus.  Contemporaneously with the merger, theCompany satisfied approximately $4.4 million of Meritus’ debt.  The Reiling Voting Agreement was enteredinto in connection with the merger.

 

In connection with theMeritus acquisition, the Company borrowed $5,000,000 from MVII. That debt isevidenced by a promissory note dated January 7, 2000 (the “MVII Note”).  The MVII Note bears interest at a rate of primeplus 2%, matures on July 1, 2004, and is subordinated to senior debt of theCompany.  The proceeds from the MVIINote were used primarily to facilitate the Company’s merger with Meritus,including the satisfaction of the Meritus debt discussed above.  On March 6, 2002, May 21, 2002 and March 10,2003, pursuant to the terms of the Revolver and the MVII Note, the Companyreborrowed an aggregate of $1.35 million of the original principal that theCompany had paid on the MVII Note.  Theproceeds were used to finance the normal business operations of the Company.

 

Mr. Davis and Mr. JosephN. Matlock, the members of the special committee of the Board of Directorsformed for the purpose of considering, evaluating and negotiating the proposedgoing-private transaction, have executed agreements with the Company pursuantto which they shall each receive $200 for each meeting of the special committeerequiring more than one hour of attendance in person, plus they each shallreceive reimbursement of reasonable out-of-pocket expenses incurred inconnection with their service on the special committee. Mr. Davis and Mr.Matlock additionally entered into indemnification agreements with the Companywith respect to their service on the special committee.

 

38

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**InvestmentWarrant**

 

On March 19, 2001, theCompany issued to MVII an Investment Warrant to acquire 1.8 million shares ofthe Company’s common stock, at a purchase price of $2.7 million.  The Investment Warrant was exercisable inwhole on in part, for a ten-year period beginning June 3, 2002.  The Investment Warrant was subject tocertain anti-dilution adjustments.  Inconnection with the issuance of the Investment Warrant, the Company and MVIIentered into a Registration Rights Agreement, pursuant to which MVII wasgranted certain piggyback registration rights with respect to the shares of thecommon stock underlying the Warrant. Shares of common stock acquired by MVII upon exercise of the Warrant aresubject to the terms of a Shareholders’ and Voting Agreement dated as of April5, 1999, among MVII and certain of the Company’s other shareholders.  Proceeds from the sale of the InvestmentWarrant were used by the Company for current working capital.

 

The Investment Warrantwas issued by the Company to MVII in reliance on the exemption fromregistration set forth in Section 4(2) of the Securities Act of 1933, asamended.  The Company believes theSection 4(2) exemption from registration was available based upon theestablished criteria for effecting a private offering by virtue of thefollowing facts, among others:  (i) MVIIhad access to the type of information that would be included in a registrationstatement, (ii) MVII’s principals have adequate financial means to bear therisk of MVII’s additional investment in the Company and can be described assophisticated, (iii) MVII was the only offeree in the transaction, (iv) MVIIacquired the Investment Warrant for investment and not with a view towarddistribution, (v) the Investment Warrant contains restrictions on resale of theInvestment Warrant and the common stock issued upon exercise of the InvestmentWarrant, and (vi) no underwriters were involved nor were any underwriters’commissions paid in connection with the transactions.

 

On January 31, 2002, atthe request of NASDAQ and with the agreement of MVII, the Company issued anamended and restated Investment Warrant, which amended and restated in itsentirety the Investment Warrant by removing all anti-dilution provisions.  In addition, the Company and MVII enteredinto an Amended and Restated Registration Rights Agreement, which amended andrestated in its entirety the Registration Rights Agreement, by removing all ofthe provisions regarding the anti-dilution provisions of the originalInvestment Warrant.

 

On August 21, 2002, MVIIconverted the pre-paid Investment Warrant into 1.8 million shares of commonstock.  Upon issuance of these shares,MVII directly owned 5,994,238 shares of common stock.

 

**ITEM 14. CONTROLS AND PROCEDURES**

** **

**Evaluation Of Disclosure Controls And Procedures.**

 

With the participation ofmanagement, the Company’s President and Chief Executive Officer and its ChiefFinancial Officer evaluated the Company’s disclosure controls and procedureswithin 90 days of the filing of this report. Based upon this evaluation, thePresident and Chief Executive Officer and the Chief Financial Officer believethat:

 

•                  theCompany’s disclosure controls and procedures are designed to ensure thatinformation the Company is required to disclose in the reports it files orsubmits under the Securities Exchange Act of 1934 is recorded, processed,summarized and reported within the time periods specified in the Securities andExchange Commission’s rules and forms; and

 

•                  theCompany’s disclosure controls and procedures were effective to ensure thatmaterial information was accumulated and communicated to management, includingthe Company’s principal executive officer and principal financial officer, asappropriate, to allow timely decisions regarding required disclosure.

 

**Changes In Internal Controls.**

 

There were no significantchanges in the Company’s internal controls or in other factors that couldsignificantly affect these internal controls subsequent to their evaluation,nor have there been any corrective actions with regard to significantdeficiencies or material weaknesses.

 

39

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**ITEM 15. PRINCIPAL ACCOUNTANT FEESAND SERVICES**

** **

During 2002, the Company incurred fees fromPricewaterhouseCoopers LLP (“PWC”), the principal independent accountant of theCompany, in the amount of $223,000 relating to the audit of its 2002 financialstatements and reviews of its Forms 10-Q for fiscal year 2002, and $79,000 innon-audit related fees.

 

Fees incurred from PWC during 2002 for non-auditrelated services included $54,000 for federal, state and foreign income taxfilings compliance and related matters, and $25,000 for other services.

 

The audit committee considered whether the provisionof non-audit services is compatible with maintaining the independence of theCompany’s outside auditor, PWC.

 

In the event that the going private transactiondiscussed more fully in Item 7 of this report is not consummated, the auditcommittee of the Company intends to institute a policy that thereafter PWCwould be retained solely to provide audit and audit-related services and thatthe auditors would not be retained to provide information systems consultingservices.  The policy would apply to newengagements and does not affect limited term engagements in effect at the timethe policy was approved.  PWC providedcertain consulting and other non-audit services to the Company in fiscal 2002.

 

In addition, the audit committee of the Companycontinues to monitor legislative and regulatory developments concerning auditorindependence and services that may be provided by independent auditors to anaudit client, including those developments under the Sarbanes-Oxley Act of 2002and related rules issued by the Securities and Exchange Commission.

 

40

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**PART IV**

 

**ITEM 16. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ONFORM 8-K**

** **

(a) 1.       *FinancialStatements*. Reference is made to the Index on page F-1 for a list ofall financial statements filed as part of this report.

 

(a) 2. and (d)          *FinancialStatement Schedules*. Reference is made to the Index on page F-1 fora list of all financial statement schedules filed as part of this report.

 

(a) 3. and (c)          *Exhibits*.Reference is made to the Exhibit Index on page E-1 for a list of all exhibitsfiled as part of this report.

 

(b)           *Reports onForm 8-K*.

 

1.             The Company filed a Form 8-K dated January 28, 2003,(filed on January 30, 2003) for the purpose of reporting the receipt of thegoing-private proposal described more fully in Item 7 of this report.

 

2.             The Company filed a Form 8-K dated March 18, 2003,(filed on March 21, 2003) for the purpose of reporting the receipt of adelisting determination from the Nasdaq SmallCap Market described more fully inItem 5 of this report.

 

3.             The Company filed a Form 8-K dated March 27, 2003,(filed on March 28, 2003) for the purpose of reporting the signing of thedefinitive merger agreement for the going private transaction.

 

41

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**SIGNATURES**

 

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

 
|                         |   | DSI Toys, Inc.                                  |
|------------------------------|--------|-------------------------------------------------|
|                         |   |                                            |
| Dated:  March  28, 2003 | By:    | /s/ JOSEPH S. WHITAKER                          |   |
|                         |   | Joseph S. Whitaker                              |
|                         |   | President, Chief Executive Officer and Director |
|                         |   |                                            |
| Dated:  March  28, 2003 | By:    | /s/ ROBERT L. WEISGARBER                        |   |
|                         |   | Robert L. Weisgarber                            |
|                         |   | Chief Financial Officer                         |
|                              |        |                                                 |  |  |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the Registrant in the capacities and on the datesindicated.

 
| **Signature**         |   | **Title** |   | **Date**       |
|-----------------------|--------|-----------|--------|----------------|
|                  |   |      |   |           |
| /s/ E. THOMAS MARTIN  |   | Chairman  |   | March 28, 2003 |   |
| E. Thomas Martin      |   |      |   |           |
|                  |   |      |   |           |
| /s/ M. D. DAVIS       |   | Director  |   | March 28, 2003 |   |
| M.D. Davis            |   |      |   |           |
|                  |   |      |   |           |
| /s/ JOSEPH N. MATLOCK |   | Director  |   | March 28, 2003 |   |
| Joseph N. Matlock     |   |      |   |           |
|                  |   |      |   |           |
| /s/ ROBERT L. BURKE   |   | Director  |   | March 28, 2003 |   |
| Robert L. Burke       |   |      |   |           |
|                  |   |      |   |           |
| /s/ JOHN MCSORLEY     |   | Director  |   | March 28, 2003 |   |
| John McSorley         |   |      |   |           |
|                  |   |      |   |           |
| /s/ WALTER S. REILING |   | Director  |   | March 28, 2003 |   |
| Walter S. Reiling     |   |      |   |           |

 

42

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**CERTIFICATIONS**

 

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

 

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

 

2.                                       Basedon my knowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual report;

 

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

 

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

 

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

 

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

 

c)                                      Presentedin this annual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation  as of the Evaluation Date;

 

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

 

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

 

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

 

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

 
| Date:  | March 28, 2003 | /s/ Joseph S. Whitaker                |   |
|--------|----------------|---------------------------------------|--------|
|   |           | Joseph S. Whitaker                    |
|   |           | President and Chief Executive Officer |

 

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

 

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

 

2.                                       Basedon my knowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual report;

 

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

 

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

 

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

 

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

 

c)                                      Presentedin this annual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation  as of the Evaluation Date;

 

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

 

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

 

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

 

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

 

 
| Date:  | March 28, 2003 | /s/ Robert L. Weisgarber |   |
|--------|----------------|--------------------------|--------|
|   |           | Robert L. Weisgarber     |
|   |           | Chief Financial Officer  |

 

44

----

 

**DSI TOYS, INC.**

 

**INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES**

 

 
|                                                                                                                  | Financial Statements                                                                      |   |
|-----------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------|--------|
|                                                                                                                  |                                                                                      |   |
|                                                                                                                  | Report of Independent  Accountants                                                        |   |
|                                                                                                                  |                                                                                      |   |
|                                                                                                                  | Consolidated Balance Sheet  at December 31, 2002 and 2001                                 |   |
|                                                                                                                  |                                                                                      |   |
|                                                                                                                  | Consolidated  Statement of Operations for fiscal years 2002, 2001 and 2000                |   |
|                                                                                                                  |                                                                                      |   |
|                                                                                                                  | Consolidated  Statement of Cash Flows for fiscal years 2002, 2001 and 2000                |   |
|                                                                                                                  |                                                                                      |   |
|                                                                                                                  | Consolidated  Statement of Shareholders’ Equity for fiscal years 2002, 2001 and 2000 |   |
|                                                                                                                  |                                                                                      |   |
|                                                                                                                  | Notes to  Consolidated Financial Statements                                               |   |
|                                                                                                                  |                                                                                      |   |
| Schedule                                                                                                              |
|                                                                                                                  |
| II.            Valuation and Qualifying Accounts  and Reserves |
|                                                                                                                       |                                                                                           |        |

 

All other schedules are omitted because they are not applicable or therequired information is shown in the financial statements or notes thereto.

 

F-1

----

 

**Reportof Independent Accountants**

 

To the Board of Directorsand Shareholders of

DSI Toys, Inc.

 

In our opinion, the consolidated financial statementslisted in the accompanying index present fairly, in all material respects, thefinancial position of DSI Toys, Inc. as of December 31, 2002 and 2001, andthe results of their operations and their cash flows for each of the threeyears in the period ended December 31, 2002, in conformity with accountingprinciples generally accepted in the United States of America.  In addition, in our opinion, the financialstatement schedule listed in the accompanying index presents fairly, in allmaterial respects, the information set forth therein when read in conjunctionwith the related consolidated financial statements.  These financial statements and financial statement schedule are theresponsibility of the Company’s management; our responsibility is to express anopinion on these financial statements and financial statement schedule based onour audits.  We conducted our audits ofthese statements in accordance with auditing standards generally accepted inthe United States of America, which require that we plan and perform the auditto obtain reasonable assurance about whether the financial statements are freeof material misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts and disclosuresin the financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

 

The accompanying consolidated financial statementshave been prepared assuming that the Company will continue as a goingconcern.  As discussed in Note 1 to theconsolidated financial statements, the Company has incurred losses fromoperations and is in violation of certain lending covenants resulting in aworking capital deficiency.  Thesefactors raise substantial doubt about the Company’s ability to continue as agoing concern.  Management’s plans inregard to these matters are also described in Note 1.  The consolidated financial statements do not include anyadjustments that might result from the outcome of this uncertainty.

 

As discussed in Notes 2 and 5 to the consolidatedfinancial statements, in accordance with Statement of Financial Accounting StandardsNo. 142 “Goodwill and Other Intangible Assets” beginning in 2002, the Companyno longer amortizes goodwill.

 
|           | PricewaterhouseCoopers  LLP |
|----------------|-----------------------------|
| Houston, Texas |
| March 27, 2003 |

 

F-2

----

 

**DSI Toys, Inc.**

**ConsolidatedBalance Sheet**

 
|                                                                                                                                                                   |   | **December  31,  2002** |       | **December  31,  2001** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|------------|-------------------------|--------|
| **ASSETS**                                                                                                                                                             |   |                    |       |                    |   |
|                                                                                                                                                                   |   |                    |       |                    |   |
| Current Assets:                                                                                                                                                        |   |                    |       |                    |   |
| Cash                                                                                                                                                                   |   | $                       | 1,737,329  |                    | $      | 284,637 |   |
| Accounts  receivable, net                                                                                                                                              |   | 4,861,391               |       | 8,767,550               |   |
| Inventories                                                                                                                                                            |   | 6,588,547               |       | 6,739,920               |   |
| Prepaid expenses  and other current assets                                                                                                                             |   | 3,164,281               |       | 1,981,592               |   |
| Deferred income  taxes                                                                                                                                                 |   |                    |       | 893,000                 |   |
| Total current  assets                                                                                                                                                  |   | 16,351,548              |       | 18,666,699              |   |
|                                                                                                                                                                   |   |                    |       |                    |   |
| Property and  equipment, net                                                                                                                                           |   | 2,192,941               |       | 1,769,284               |   |
| Deferred income  taxes                                                                                                                                                 |   |                    |       | 1,312,000               |   |
| Goodwill, net                                                                                                                                                          |   | 9,241,128               |       | 9,241,128               |   |
| Other assets                                                                                                                                                           |   | 885,085                 |       | 323,624                 |   |
|                                                                                                                                                                   |   | $                       | 28,670,702 |                    | $      | 31,312,735 |   |
|                                                                                                                                                                   |   |                    |       |                    |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                         |   |                    |       |                    |   |
|                                                                                                                                                                   |   |                    |       |                    |   |
| Current  liabilities:                                                                                                                                                  |   |                    |       |                    |   |
| Accounts payable  and accrued liabilities                                                                                                                              |   | $                       | 13,517,790 |                    | $      | 6,580,780 |   |
| Current portion  of long-term debt                                                                                                                                     |   | 8,240,923               |       | 1,120,650               |   |
| Current portion  of long-term debt due to a related party                                                                                                              |   | 960,510                 |       | 1,751,485               |   |
| Income taxes  payable                                                                                                                                                  |   | 112,364                 |       | 69,638                  |   |
| Total current  liabilities                                                                                                                                             |   | 22,831,587              |       | 9,522,553               |   |
| Long-term debt                                                                                                                                                         |   |                    |       | 9,210,390               |   |
| Long-term debt  due to a related party                                                                                                                                 |   | 4,554,042               |       | 3,289,552               |   |
| Deferred income  taxes                                                                                                                                                 |   | 179,902                 |       | 156,642                 |   |
| Total  liabilities                                                                                                                                                     |   | 27,565,531              |       | 22,179,137              |   |
| Commitments and  Contingencies (Notes 1 and 12)                                                                                                                        |   |                    |       |                    |   |
| Shareholders’  equity:                                                                                                                                            |   |                    |       |                    |   |
| Preferred stock,  $.01 par value, 5,000,000  shares authorized, none issued or outstanding                                                                             |   |                    |       |                    |   |
| Common stock,  $.01 par value, 35,000,000 authorized,  10,866,365 and 9,066,365 shares issued and outstanding  respectively at December 31, 2002 and December 31, 2001 |   | 108,664                 |       | 90,664                  |   |
| Additional  paid-in capital                                                                                                                                            |   | 7,855,465               |       | 5,173,465               |   |
| Common stock  warrants                                                                                                                                                 |   | 102,500                 |       | 2,802,500               |   |
| Accumulated  other comprehensive loss                                                                                                                                  |   | (87,129                 | )          | (70,928                 | )      |
| Accumulated  earnings (deficit)                                                                                                                                        |   | (6,874,329              | )          | 1,137,897               |   |
| Total  shareholders’ equity                                                                                                                                       |   | 1,105,171               |       | 9,133,598               |   |
|                                                                                                                                                                   |   | $                       | 28,670,702 |                    | $      | 31,312,735 |   |

 

See accompanying notes toconsolidated financial statements.

 

F-3

----

 

**DSI Toys, Inc.**

**Consolidated Statement of Operations**

 

** **
|                                          |   | **Fiscal  Year** |
|-----------------------------------------------|--------|------------------|
|                                          |   | **2002**         |   | **2001** |   | **2000** |   |
|                                          |   |             |   |   |   |   |   |
| Net sales                                     |   | $                | 49,754,173 |   | $ | 67,906,409 |   | $ | 70,438,531 |   |
| Cost of goods  sold                           |   | 38,683,911       |   | 47,985,126 |   | 50,120,552 |   |
| Gross profit                                  |   | 11,070,262       |   | 19,921,283 |   | 20,317,979 |   |
| Selling, general  and administrative expenses |   | 15,972,473       |   | 20,103,335 |   | 20,367,165 |   |
| Operating loss                                |   | (4,902,211       | ) | (182,052 | ) | (49,186 | ) |
| Interest expense                              |   | (911,792         | ) | (1,155,092 | ) | (1,473,909 | ) |
| Other income                                  |   | 77,483           |   | 278,529 |   | 196,661 |   |
| Loss before  income taxes                     |   | (5,736,520       | ) | (1,058,615 | ) | (1,326,434 | ) |
| Benefit from  (provision for) income taxes    |   | (2,275,706       | ) | (390,903 | ) | 477,448 |   |
| Net loss                                      |   | $                | (8,012,226 | ) | $ | (1,449,518 | ) | $ | (848,986 | ) |
|                                          |   |             |   |   |   |   |   |
| Basic earnings  per share                     |   |             |   |   |   |   |   |
|                                          |   |             |   |   |   |   |   |
| Loss per share                                |   | $                | (0.82 | ) | $ | (0.16 | ) | $ | (0.09 | ) |
|                                          |   |             |   |   |   |   |   |
| Weighted average  shares outstanding          |   | 9,720,463        |   | 9,066,365 |   | 9,053,382 |   |
|                                          |   |             |   |   |   |   |   |
| Diluted earnings  per share                   |   |             |   |   |   |   |   |
|                                          |   |             |   |   |   |   |   |
| Loss per share                                |   | $                | (0.82 | ) | $ | (0.16 | ) | $ | (0.09 | ) |
|                                          |   |             |   |   |   |   |   |
| Weighted average  shares outstanding          |   | 9,720,463        |   | 9,066,365 |   | 9,053,382 |   |

 

 

See accompanying notes toconsolidated financial statements.

 

F-4

----

 

**DSI Toys, Inc**

###### **ConsolidatedStatement of Cash Flows**

 

 
|                                                                                    |   | **Fiscal  Year** |       |
|-----------------------------------------------------------------------------------------|--------|------------------|------------|
|                                                                                    |   | **2002**         |       | **2001** |   | **2000** |   |
| Cash flows from  operating activities:                                                  |   |             |       |   |   |   |   |
| Net loss                                                                                |   | $                | (8,012,226 | ) | $ | (1,449,518 | ) | $ | (848,986 | ) |
| Adjustments to  reconcile net loss to net cash provided (used) by operating activities: |   |             |       |   |   |   |   |
| Depreciation                                                                            |   | 1,071,983        |       | 1,334,392 |   | 1,551,632 |   |
| Amortization and  write-off of debt discount and issuance costs                         |   | 48,539           |       | 42,583 |   | 24,927 |   |
| Amortization of  goodwill                                                               |   |             |       | 513,396 |   | 513,360 |   |
| Provision for  bad debts                                                                |   | 303,872          |       | 1,717,931 |   | 222,021 |   |
| Loss (gain) on  sale or abandonment of equipment                                        |   | 24,474           |       | (25,957 | ) | 32,173 |   |
| Deferred income  taxes                                                                  |   | 2,228,260        |       | (72,207 | ) | (893,491 | ) |
| Changes in  assets and liabilities, excluding acquisitions:                             |   |             |       |   |   |   |   |
| Restricted cash                                                                         |   |             |       | 150,000 |   |   |   |
| Accounts  receivable                                                                    |   | 3,602,287        |       | (3,962,598 | ) | (2,413,654 | ) |
| Inventories                                                                             |   | 151,373          |       | (52,725 | ) | (954,186 | ) |
| Income taxes  payable                                                                   |   | 42,726           |       | (42,687 | ) | (316,402 | ) |
| Prepaid expenses                                                                        |   | (1,182,689       | )          | (240,647 | ) | (507,859 | ) |
| Accounts payable  and accrued liabilities                                               |   | 6,937,010        |       | (1,320,510 | ) | 1,039,373 |   |
| Net cash  provided (used) by operating activities                                       |   | 5,215,609        |       | (3,408,547 | ) | (2,551,092 | ) |
|                                                                                    |   |             |       |   |   |   |   |
| Cash flows from  investing activities:                                                  |   |             |       |   |   |   |   |
| Cash used for  acquisition of Meritus                                                   |   |             |       |   |   | (884,033 | ) |
| Capital  expenditures                                                                   |   | (1,529,837       | )          | (766,921 | ) | (1,249,944 | ) |
| Proceeds from  sale of equipment                                                        |   | 9,723            |       | 104,286 |   |   |   |
| Decrease  (increase) in other assets                                                    |   | (610,000         | )          | 137,120 |   | 273,087 |   |
| Net cash used by  investing activities                                                  |   | (2,130,114       | )          | (525,515 | ) | (1,860,890 | ) |
|                                                                                    |   |             |       |   |   |   |   |
| Cash flows from  financing activity:                                                    |   |             |       |   |   |   |   |
| Net borrowings  (repayments) under revolving lines of credit                            |   | (406,309         | )          | (613,604 | ) | 4,046,472 |   |
| Net borrowings  (repayments) on debt                                                    |   | (2,195,392       | )          | 2,790,465 |   | 400,684 |   |
| Net borrowings  (repayments) on long-term debt due to related parties                   |   | 473,515          |       | (674,478 | ) | 4,025,515 |   |
| Net borrowings  of other short-term debt                                                |   | 511,584          |       |   |   |   |   |
| Payments of assumed  Meritus debt                                                       |   |             |       |   |   | (4,382,541 | ) |
| Net proceeds  from issuance of warrants                                                 |   |             |       | 2,700,000 |   |   |   |
| Debt and stock  issue costs                                                             |   |             |       | (117,500 | ) | 35,000 |   |
| Net cash  provided (used) by financing activities                                       |   | (1,616,602       | )          | 4,084,883 |   | 4,125,130 |   |
| Effect of  exchange rate changes on cash                                                |   | (16,201          | )          | (43,866 | ) | (14,436 | ) |
| Net increase  (decrease) in cash                                                        |   | 1,452,692        |       | 106,955 |   | (301,288 | ) |
| Cash and cash  equivalents, beginning of year                                           |   | 284,637          |       | 177,682 |   | 478,970 |   |
| Cash and cash  equivalents, end of year                                                 |   | $                | 1,737,329  |   | $ | 284,637 |   | $ | 177,682 |   |

 

See accompanying notes toconsolidated financial statements.

 

F-5

----

 

**DSI Toys, Inc.**

**Consolidated Statement of Shareholders’ Equity**

 

 
|                                                                           |   | **Common  Stock** |   | **Additional  Paid-in  Capital** |    | **Warrants** |               | **Accumulated  Other  Comprehensive** |          | **Accumulated  Earning** |      | **Treasury** |      |      |   |
|--------------------------------------------------------------------------------|--------|-------------------|--------|----------------------------------|---------|--------------|--------------------|---------------------------------------|---------------|--------------------------|-----------|--------------|-----------|-----------|--------|
|                                                                           |   | **Shares**        |   | **Amount**                       |    |         | **Income  (Loss)** |                                  | **(Defecit)** |                     | **Stock** |         | **Total** |      |
| Balance, December 31, 1999                                                     |   | 8,719,000         |   | $                                | 87,190  |         | $                  | 4,934,919                             |          | $                        | 102,500   |         | $         | (12,626   | )      | $ | 3,436,401 |   | $ | (1,559,395 | ) | $ | 6,988,989 |   |
| Comprehensive loss:                                                            |   |              |   |                             |    |         |               |                                  |          |                     |      |         |      |      |   |   |   |
| Net Loss                                                                       |   |              |   |                             |    |         |               |                                  |          |                     |      | (848,986     | )         |      |   | (848,986 | ) |
| Foreign Currency translation adjustments net of tax                            |   |              |   |                             |    |         |               |                                  |          | (14,436                  | )         |         |      |      |   | (14,436 | ) |
| Comprehensive Loss                                                             |   |              |   |                             |    |         |               |                                  |          |                     |      |         |      |      |   | (863,422 | ) |
| Issuance of 347,365 common shares and 185,843 common shares from the  treasury |   | 347,365           |   | 3,474                            |    | 238,546      |               |                                  |          |                     |      |         |      | 1,559,395 |   | 1,801,415 |   |
| Balance, December 31, 2000                                                     |   | 9,066,365         |   | 90,664                           |    | 5,173,465    |               | 102,500                               |          | (27,062                  | )         | 2,587,415    |      |      |   | 7,926,982 |   |
| Comprehensive loss:                                                            |   |              |   |                             |    |         |               |                                  |          |                     |      |         |      |      |   |   |   |
| Net Loss                                                                       |   |              |   |                             |    |         |               |                                  |          |                     |      | (1,449,518   | )         |      |   | (1,449,518 | ) |
| Foreign Currency translation adjustments net of tax                            |   |              |   |                             |    |         |               |                                  |          | (43,866                  | )         |         |      |      |   | (43,866 | ) |
| Comprehensive Loss                                                             |   |              |   |                             |    |         |               |                                  |          |                     |      |         |      |      |   | (1,493,384 | ) |
| Warrants Issued                                                                |   |              |   |                             |    |         |               | 2,700,000                             |          |                     |      |         |      |      |   | 2,700,000 |   |
| Balance, December 31, 2001                                                     |   | 9,066,365         |   | 90,664                           |    | 5,173,465    |               | 2,802,500                             |          | (70,928                  | )         | 1,137,897    |      |      |   | 9,133,598 |   |
| Comprehensive loss:                                                            |   |              |   |                             |    |         |               |                                  |          |                     |      |         |      |      |   |   |   |
| Net Loss                                                                       |   |              |   |                             |    |         |               |                                  |          |                     |      | (8,012,226   | )         |      |   | (8,012,226 | ) |
| Foreign Currency translation adjustments net of tax                            |   |              |   |                             |    |         |               |                                  |          | (16,201                  | )         |         |      |      |   | (16,201 | ) |
| Comprehensive Loss                                                             |   |              |   |                             |    |         |               |                                  |          |                     |      |         |      |      |   | (8,028,427 | ) |
| Warrants Exercised                                                             |   | 1,800,000         |   | 18,000                           |    | 2,682,000    |               | (2,700,000                            | )             |                     |      |         |      |      |   |   |   |
| Balance, December 31, 2002                                                     |   | 10,866,365        |   | $                                | 108,664 |         | $                  | 7,855,465                             |          | $                        | 102,500   |         | $         | (87,129   | )      | $ | (6,874,329 | ) |   |   | $ | 1,105,171 |   |
|                                                                                |        |                   |        |                                  |         |              |                    |                                       |               |                          |           |              |           |           |        |  |  |  |  |  |  |  |  |  |

 

See accompanying notes toconsolidated financial statements.

 

F-6

----

 

**DSI TOYS, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**NOTE 1 - Organization:**

 

DSI Toys, Inc. (the “Company”) was incorporated underthe laws of the State of Texas in November 1970.  The Company markets and distributes a variety of toys andchildren’s consumer electronics both within the United States and internationally,primarily to retailers.  The Company’sproducts are manufactured primarily in the People’s Republic of China.

 

Effective May 1, 1997, the Company’s Articles ofIncorporation were amended to (i) authorize the issuance of 5,000,000 shares of$.01 par value preferred stock, (ii) change the par value of common stock to$.01 and (iii) reduce the authorized shares of common stock to 20,000,000shares.

 

On June 3, 1997, the Company completed its initialpublic offering (the “Offering”) of 2,500,000 shares of common stock, whichprovided the Company net proceeds of $17.7 million.  All of the net proceeds were used to repay debt of theCompany.  In connection with theOffering, the Company issued warrants to purchase 250,000 shares of commonstock to the lead underwriters.  Suchwarrants are exercisable at $10.80 per share and expired on May 28, 2002.

 

Effective May 28, 1999, the Company’s Articles ofIncorporation were amended to increase the authorized shares of common stock to35,000,000 shares.

 

Effective June 1, 1999, the Company consummatedtransactions with MVII, LLC (“MVII”) pursuant to a Stock Purchase and SaleAgreement dated April 15, 1999.  As aresult of those transactions, MVII made a total investment of $12 million inthe Company’s common stock, $5 million of which was paid directly to theCompany for the purchase of 2,458,491 shares of common stock.

 

On August 21, 2002, MVII converted a prepaidInvestment Warrant in exchange for 1.8 million shares of common stock.  The Investment Warrant was issued March 19,2001, for a cash purchase price of $2.7 million.  Proceeds from the sale of the Investment Warrant were used by theCompany for current working capital.

* *

*Liquidityand Going Concern*

 

The Company’s viability as a going concern isdependent upon successful negotiations with Sunrock, a new lender, or asubstantial capital infusion, as well as sustained profitable operations. Theaccompanying financial statements do not include any adjustments that might benecessary if the Company is unable to continue as a going concern.

 

To the extent the Company’s cash reserves and cashflows from operations are insufficient to meet future cash requirements, theCompany will need to successfully raise additional capital through an equityinfusion or the issuance of debt.  TheCompany’s executive management believes that the Company will be required toeither obtain a new revolving loan or obtain necessary additional capital toallow the Company to continue its normal operations for the foreseeable future.However, there can be no assurance the Company will meet its projectedoperating results or be successful either in obtaining additional capital, orobtaining a new revolving loan.

 

Since the Company’s cash reserves and cash flows fromoperations no longer meet its cash requirements, the Company has exploredvarious alternatives to raise additional capital.

 

The Company has held discussions and negotiations withseveral lenders regarding a credit facility to replace the Revolver.  Management is negotiating with one of thoseinstitutions regarding a replacement credit facility that will become effectiveat the close of the anticipated going private transaction, which is discussedin greater detail below.  Managementbelieves that the going private transaction will close and that the Companywill be able to continue its operations until that time.

 

F-7

----

 

*Delisting*

 

On February 14, 2002, the Company received notice fromThe Nasdaq Stock Market, Inc. that the Company’s common stock had closed belowthe minimum price of US$1.00 per share requirement for continued listing on theNasdaq SmallCap Market under Marketplace Rule 4310(c)(4) (the “Rule”).  The Company was granted a 180 calendar daygrace period to comply with the Rule, but was still not in compliance with theRule on August 13, 2002, the final day of the grace period.  However, at such time the Company wasgranted an additional 180 calendar day grace period to comply with the Rulebecause it did meet the initial listing criteria for the Nasdaq SmallCap Marketunder Marketplace Rule 4310(c)(2)(A). The additional grace period expired onFebruary 10, 2003, without the Company being in compliance with the Rule.  On March 18, 2003, the Company receivednotification that its securities would be delisted from the Nasdaq SmallCapMarket at the opening of business on March 27, 2003.  The Company elected not to appeal the delisting determination andits common stock commenced trading on the over-the-counter Bulletin Boardelectronic quotation system effective with the opening of business on March 27,2003, under the ticker symbol “DSIT.”

### * *

*GoingPrivate Transaction*

 

Since the Company’s cash reserves and cash flows fromoperations no longer meet its cash requirements, the Company has exploredvarious alternatives to raise additional capital.

 

In January 2003, after other alternatives for theCompany had been exhausted, E. Thomas Martin, the Chairman of the Company’sBoard of Directors, and certain other officers, directors and shareholders ofthe Company (the “Buyer Group”) began serious consideration of a going-privatetransaction.  On January 27, 2003, theBoard of Directors invited the Buyer Group to submit an offer to the Companyfor a going-private transaction.

 

On January 28, 2003, the Buyer Group proposed to theCompany a going-private transaction by way of a merger that would result in thepurchase of shares of common stock held by the shareholders who are not membersof the Buyer Group for $0.44 per share.

 

The Board of Directors appointed a special committeeto review the proposed transaction.

 

Based on a series of negotiations between the specialcommittee and representatives of the Buyer Group, the purchase price wasincreased to $0.47 per share.

 

On March 26, 2003, the Board of Directors unanimouslyvoted to approve the merger agreement and recommended that the shareholdersapprove the merger agreement and the merger.

 

On March 27, 2003, the merger agreement was signed andthe Company issued a press release announcing the merger agreement.

 

If the shareholders of the Company approve the merger,the Company’s shares will be delisted from the over-the-counter Bulletin Boardelectronic quotation system and its common stock will be deregistered under theSecurities Exchange Act of 1934. The Company will continue in business as aprivately-held Texas corporation.

 

F-8

----

 

**NOTE 2 -Summary of Significant Accounting Policies:**

 

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

 

*Basisof presentation*

 

The accompanying consolidated financial statementsinclude the accounts of wholly-owned subsidiary DSI(HK) Limited. Allsignificant intercompany transactions have been eliminated inconsolidation.  The Company’s fiscalyear is the year ending December 31 of the calendar year mentioned.

 

*Cashequivalents*

 

The Company considers investments with originalmaturity dates of three months or less from the date of purchase to be cashequivalents.  Restricted cash, held as acompensating balance under a revolving loan supported by letters of credit isnot considered a cash equivalent.

* *

*RevenueRecognition*

 

The Company recognizes revenue when products areshipped and title passes to unaffiliated customers.  In most cases, title transfers to our customers when the producthas been presented to shipment forwarders on FOB Asia sales and when theproduct is picked up from our distribution facilities on domestic sales.

* *

*Allowancefor Doubtful Accounts*

 

Accounts receivable are reduced by an allowance foramounts that may become uncollectible in the future.  The Company’s estimate for its allowance is based on two methodswhich are combined to determine the total amount reserved.  First, the Company evaluates specificaccounts where we have information that the customer may have an inability tomeet its financial obligations (bankruptcy, etc.).  In these cases, the Company uses its judgment, based on the bestavailable facts and circumstances, and records a specific reserve for thatcustomer against amounts due to reduce the receivable to the amount that isexpected to be collected.  Thesespecific reserves are reevaluated and adjusted as additional information isreceived that impacts the amounts reserved. Second, a reserve is established for all other customers based onhistorical collection and write-off experience.  If circumstances change, the Company’s estimates of therecoverability of amounts due the Company could be reduced by a materialamount.

* *

*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 products 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,revenue could be overstated and future operating results adversely affected.

 

F-9

----

 

*Inventories*

 

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

* *

*Propertyand equipment*

 

Property and equipment are recorded at cost.  Maintenance and repairs are charged tooperations, and replacements or betterments are capitalized.  Property or equipment sold, retired, orotherwise disposed of is removed from the accounts, and any gains or lossesthereon are included in operations during the period of disposal.  Depreciation is recorded over the estimateduseful lives of the related assets using the straight-line method.

* *

*Debtissuance costs and debt discount*

 

Debt issuance costs and debt discount are amortizedover the term of the related debt on a straight-line basis.

* *

*Advertising*

 

The cost of producing media advertising is capitalizedas incurred and expensed in the period in which the advertisement is firstshown.  During interim periods, mediacommunications costs are accrued in relation to sales when the advertising isclearly implicit in the related sales arrangement.  All media communication costs are expensed however in the fiscalyear incurred.  All other advertisingcosts are expensed in the period incurred. Television advertising expense totaled $3,015,000, $2,500,000 and$3,621,000 during fiscal 2002, 2001 and 2000, respectively.  Prepaid television advertising productioncosts of $65,000, $130,000 and $101,000 respectively are included in prepaidexpenses at December 31, 2002, 2001 and 2000. The Company entered into advertising barter transactions in which theCompany recorded $321,000, $730,000 and $529,000 in advertising expenses infiscal 2002, 2001 and 2000, respectively. In addition, prepaid expenses at December 31, 2000, included $200,000 inbartered, prepaid 2001 print advertising. There is no bartered prepaid advertising expense at December 31, 2002and 2001.  Management believes theseamounts approximate fair value.

* *

*Incometaxes*

 

The Company accounts for deferred income taxes usingthe liability method, which provides for the recognition of deferred tax assetsand liabilities based upon temporary differences between the tax basis ofassets and liabilities and their carrying value for financial reportingpurposes.  Deferred tax expense orbenefit is the result of changes in deferred tax assets and liabilities duringthe period.  In estimating future taxconsequences, all expected future events are considered other than enactmentsof changes in the tax law or rates. U.S. deferred income taxes are provided on the undistributed earnings ofthe wholly-owned subsidiaries.

 

The Company recorded a $4.0 million charge in fiscalyear 2002 to establish a valuation allowance for all of its deferred taxassets, including $2.2 million of deferred tax assets generated in prioryears.  The valuation allowance wasdetermined in accordance with the provisions of Statement of FinancialAccounting Standards (SFAS) 109, “Accounting for Income Taxes,” which placesprimary importance on the Company’s cumulative operating results in the mostrecent periods when assessing the need for a valuation allowance. The primaryfactors considered in evaluating the realizability of the deferred tax assetsand establishing the valuation allowance were continued operating losses forthe Company through December 31, 2002, the Company’s projection of futureoperating results and the number of years it will take to recover the taxassets in a difficult market.  Thisevaluation provides sufficient negative evidence to establish an additionalvaluation allowance under the provisions of SFAS 109.  The Company intends to maintain a full valuation allowance forits deferred tax assets and net operating loss carryforwards until sufficientpositive evidence exists to support reversal of the allowance.  The establishment of this valuationallowance in no way affects the Company’s ability to reduce future tax expensethrough utilization of

 

F-10

----

 

net operating losses and foreign income tax credits.  However, currently there can be noassurances that the net operating losses will be utilized.

 

*Foreigncurrency translations*

 

The Company’s foreign subsidiary uses the localcurrency as the functional currency. Accordingly, assets and liabilities of the Company’s foreign subsidiaryare translated using the exchange rate in effect at the balance sheet date,while income and expenses are translated using average rates.  Translation adjustments are reported as aseparate component of shareholders’ equity.

 

*Fairvalue of financial instruments*

 

The Company’s financial instruments recorded on thebalance sheet include cash and cash equivalents, accounts receivable, accountspayable and debt.  Due to their shortmaturity, the fair value of cash and cash equivalents, accounts receivable andaccounts payable approximates carrying value. The fair value of the Company’s debt approximates the carrying amount ofthe debt as it is at variable market rates.

* *

*Concentrationof credit risk and export sales*

 

Financial instruments which potentially subject theCompany to concentrations of credit risk consist primarily of tradereceivables.  The Company sells itsproducts principally to retail discount stores and toy stores.  Five customers comprise a significantportion of the Company’s sales (53% in 2002), and therefore, receivables fromone or all of these customers may, at any point in time, comprise a largeportion of the Company’s total receivables, providing an increasedconcentration of credit risk.  Additionally,the customer base is primarily located in the United States, though overall theCompany’s customer base is large and geographically dispersed across theglobe.  The Company performs ongoingcredit evaluations of its customers to minimize credit risk, and for themajority of its FOB Asia sales, the Company obtains letters of credit from itscustomers supporting the accounts receivable. (See Note 12).

* *

*Useof estimates*

 

The preparation of financial statements in accordancewith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the period. Because of the inherent uncertainties in their process, actual resultscould differ from such estimates. Management believes that the estimates are reasonable.

 

*Impairmentof assets*

 

The Company reviews for the impairment of long-livedassets, including goodwill, whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable.

 

Goodwill has been amortized over 20 years using thestraight-line method in 2001 and 2000. In 2002, the Company adopted, Statement of Financial AccountingStandards, No. 142, “Goodwill and Other Intangible Assets,” (“FAS142”), whicheliminates amortization of goodwill beginning in January 2002 and requires an annualimpairment test based on its estimated fair value, using future discounted cashflow and other factors.

 

The Company engaged an independent company to assistin the fair value assessment as of December 31, 2002 and 2001.  Based on these assessments, an impairmentvaluation is not required.

* *

*Earningsper share*

 

                The Companyreports both basic earnings per share, which is based on the weighted averagenumber of common shares outstanding, and diluted earnings per share, which isbased on the weighted average number of common shares and all dilutivepotential common shares outstanding.

 

F-11

----

 

Stock options and warrants are the only potentiallydilutive shares the Company has outstanding at December 31, 2002. The 574,000shares, 729,500 shares and 866,500 shares, respectively of common stock optionsand warrants outstanding were not included in the diluted earnings per sharecalculation during fiscal 2002, 2001, and 2000, because the options andwarrants would be anti-dilutive.

* *

*Stock-basedcompensation plans*

 

The Company applies Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) andrelated interpretations in accounting for its plans and the disclosure-onlyprovisions of Statement of Financial Accounting Standards No. 123, “Accountingfor Stock-Based Compensation” (“SFAS 123”), and SFAS No. 148, “Accounting forStock-Based Compensation – Transition and Disclosure, An Amendment of FAS 123,”in disclosures regarding the plan.

 

The Company applies the intrinsic method proscribed byAPB 25 and related interpretations in accounting for its stock optionplan.  Accordingly, no compensation costhas been recognized by the Company for this plan.  The following table illustrates the effect on net loss and lossper share calculated as if compensation cost for the 1997 Plan was determinedbased upon the fair value at the grant date for awards under the planconsistent with the methodology prescribed under SFAS 123 for fiscal years2002, 2001 and 2000:

 
|                                                                                                                                  |   | **2002** |       | **2001** |   | **2000**   |   |
|---------------------------------------------------------------------------------------------------------------------------------------|--------|----------|------------|----------|--------|------------|--------|
| Net loss, as  reported                                                                                                                |   | $        | (8,012,226 | )        | $      | (1,449,518 | )      | $ | (848,986 | ) |
| Deduct: Total stock-based employee compensation  expense determined under fair value based method for all awards, net of tax  effects |   | (138,425 | )          | (319,900 | )      | (240,426   | )      |
| Pro forma net  loss                                                                                                                   |   | $        | (8,150,651 | )        | $      | (1,769,418 | )      | $ | (1,089,412 | ) |
| Loss per share:                                                                                                                       |   |     |       |     |   |       |   |
| Basic – as  reported                                                                                                             |   | $        | (0.82      | )        | $      | (0.16      | )      | $ | (0.09 | ) |
| Basic – pro  forma                                                                                                               |   | $        | (0.84      | )        | $      | (0.20      | )      | $ | (0.12 | ) |
|                                                                                                                                  |   |     |       |     |   |       |   |
| Diluted – as  reported                                                                                                           |   | $        | (0.82      | )        | $      | (0.16      | )      | $ | (0.09 | ) |
| Diluted – pro  forma                                                                                                             |   | $        | (0.84      | )        | $      | (0.20      | )      | $ | (0.12 | ) |

 

*RecentAccounting*Pronouncements

 

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

 

In April 2002, SFAS No. 145, “Recision of FASBStatements No. 4, 44 and 64, Amendment of FASB No. 13, and TechnicalCorrections,” was issued. This statement provides guidance on theclassification of gains and losses from the extinguishment of debt and on theaccounting for certain specified lease transactions. The adoption of thisstatement is not expected to have a material impact on the Company’sconsolidated financial position, results of operations or cash flows.

 

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

 

F-12

----

 

In December 2002, the FASB issued SFAS No. 148,“Accounting for Stock-Based Compensation — Transition and Disclosure, AnAmendment of FAS No. 123.”  Thisstatement addresses the acceptable transitional methods when the fair valuemethod of accounting for stock-based compensation covered in SFAS No. 123is elected.  Additionally, the statementprescribes tabular disclosure of specific information in the “*Summary ofSignificant Accounting Policies*” regardless of the method used andalso required interim disclosure of similar information.  The Company has adopted this statementeffective with the fiscal year ending December 31, 2002.  The Company has not elected the fair valuemethod, but continues accounting for stock-based compensation by the intrinsicmethod prescribed by APB Opinion 25. The disclosure required by SFAS 148 is included in the Summary ofSignificant Accounting Policies.

 

In November 2002, the FASB issued FASB InterpretationNo. 45 (FIN 45), “Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others,” whichestablished additional accounting and disclosure requirements when anenterprise guarantees the indebtedness of others.  The enterprise providing the guarantee is required to recognize aliability for the fair value of the obligation assumed and disclose theinformation in its interim and annual financial statements.  The Company does not believe this will havea significant impact on our disclosures.

 

In January 2003, the FASB issued FASB InterpretationNo. 46 (FIN 46), “Consolidation of Variable Interest Entities, aninterpretation of ARB No. 51.”  Theinterpretation defines when and who consolidates a “variable interest entity,”or “VIE.”  This new consolidation modelapplies to entities (i) where the equity investors (if any) do not have acontrolling financial interest, or (ii) whose equity investment at risk isinsufficient to finance that entity’s activities without receiving additionalsubordinated financial support from other parties and requires additionaldisclosures for all enterprises involved with the VIE.  FIN 46 is effective during 2003 depending onwhen the VIE is created.  The Companydoes not believe this will have a significant impact on our reported results ofoperations and financial condition.

 

**NOTE 3 - Accounts Receivable:**

 

Accounts receivable consist of the following:

 
|                       |   | **December  31, 2002** |      | **December  31, 2001** |   |
|----------------------------|--------|------------------------|-----------|------------------------|--------|
| Trade  receivables         |   | $                      | 9,205,491 |                   | $      | 12,717,550 |   |
| Provisions for:            |   |                   |      |                   |   |
| Discounts and  markdowns   |   | (1,905,000             | )         | (1,472,706             | )      |
| Return of  defective goods |   | (395,000               | )         | (777,294               | )      |
| Doubtful  accounts         |   | (2,044,100             | )         | (1,700,000             | )      |
| Accounts  receivable, net  |   | $                      | 4,861,391 |                   | $      | 8,767,550 |   |

 

The 2002 provision for doubtful accounts includesamounts related to trade receivables for several companies filing forbankruptcy during 2002 and early 2003. Among these companies are Ames Department Stores, Inc. and FAO, Inc.,for which amounts were included in the 2002 expense for bad debts.  Additionally, the 2002 provision includes a$1,600,000 amount for Kmart Corp. that was charged to bad debt expense in 2001.

 

F-13

----

 

**NOTE 4 -Property and Equipment:**

 

Property and equipment consist of the following:

 
|                               |   | **Estimated  useful   lives** |   | **December  31,  2002** |      | **December  31,  2001** |   |
|------------------------------------|--------|-------------------------------|--------|-------------------------|-----------|-------------------------|--------|
| Molds                              |   | 3 years                       |   | $                       | 6,359,125 |                    | $      | 5,509,743 |   |
| Equipment,  furniture and fixtures |   | 3-7 years                     |   | 1,834,427               |      | 1,826,150               |   |
| Leasehold  improvements            |   | 10 years or lease term        |   | 653,773                 |      | 1,221,473               |   |
| Automobiles                        |   | 3-5 years                     |   | —                  |      | 31,678                  |   |
|                               |   |                          |   | 8,847,325               |      | 8,589,044               |   |
| Less:  accumulated depreciation    |   |                          |   | (6,654,384              | )         | (6,819,760              | )      |
|                               |   |                          |   | $                       | 2,192,941 |                    | $      | 1,769,284 |   |

 

**Note 5 -Goodwill:**

 

Under SFAS No. 142, goodwill and intangible assetswith indefinite lives are no longer amortized but are reviewed annually (ormore frequently if indicators arise) for impairment.  According to SFAS No. 142, companies are required to identifytheir reporting units and determine the aggregate carrying values and fairvalues of all such reporting units.  Tothe extent the carrying value of a reporting unit exceeds its relative fairvalue, a second step of the SFAS NO. 142 impairment test is required.  This second step requires the comparison ofthe implied fair value of the reporting unit goodwill to its related carryingvalue, both of which must be measured by the company at the same point in timeeach year.  Any initial loss resultingfrom a goodwill impairment test must be recorded as a change in accountingprinciple.  The Company engaged anindependent company to assist in valuing the Company’s goodwill in accordancewith SFAS No. 142 for the years ended December 31, 2002 and 2001.  Based on these reviews, an impairment chargeis not required.

 

The changes in the carrying amount of goodwill foreach of the Company’s reportable business segments for the year ended December31, 2002 were as follows:

 
|                                   |   | **United  States** |      | **Hong Kong** |   | **Total** |   |
|----------------------------------------|--------|--------------------|-----------|---------------|--------|-----------|--------|
| Balances as of  January 1, 2002        |   | $                  | 9,241,128 |          | $      | —    |   | $ | 9,241,128 |   |
| Changes to  Goodwill during the period |   |               |      |          |   |      |   |
| Balances as of  December 31, 2002      |   | $                  | 9,241,128 |          | $      | —    |   | $ | 9,241,128 |   |

 

The following table shows what the Company’s net lossand loss per share would have been in 2001 and 2000 if goodwill had not beenamortized during those periods, compared to the net income and loss per sharerecorded for 2002: 

 
|                                  |   | **2002** |       | **2001** |   | **2000**   |   |
|---------------------------------------|--------|----------|------------|----------|--------|------------|--------|
|                                  |   |     |       |     |   |       |   |
| Reported net  loss                    |   | $        | (8,012,226 | )        | $      | (1,499,518 | )      | $ | (848,986 | ) |
| Add back:  Goodwill amortization |   | —   |       | 513,396  |   | 513,360    |   |
| Adjusted net  loss                    |   | $        | (8,012,226 | )        | $      | (986,122   | )      | $ | (335,626 | ) |
|                                  |   |     |       |     |   |       |   |
| Basic Earnings  per Share:            |   |     |       |     |   |       |   |
| Reported net  loss                    |   | $        | (0.82      | )        | $      | (0.16      | )      | $ | (0.09 | ) |
| Goodwill  amortization                |   | —   |       | 0.05     |   | 0.05       |   |
| Adjusted net  loss                    |   | $        | (0.82      | )        | $      | (0.11      | )      | $ | (0.04 | ) |
|                                  |   |     |       |     |   |       |   |
| Diluted Earnings  per Share:          |   |     |       |     |   |       |   |
| Reported net  loss                    |   | $        | (0.82      | )        | $      | (0.16      | )      | $ | (0.09 | ) |
| Goodwill  amortization                |   | —   |       | 0.05     |   | 0.05       |   |
| Adjusted net  loss                    |   | $        | (0.82      | )        | $      | (0.11      | )      | $ | (0.04 | ) |

 

F-14

----

 

**NOTE 6 -Accounts Payable and Accrued Liabilities:**

 

Accounts payable and accrued liabilities consist ofthe following:

 
|                                  |   | **December  31, 2002** |       | **December  31, 2001** |   |
|---------------------------------------|--------|------------------------|------------|------------------------|--------|
| Trade payables                        |   | $                      | 10,317,404 |                   | $      | 3,447,888 |   |
| Accrued  royalties                    |   | 1,638,290              |       | 1,512,586              |   |
| Accrued  compensation and commissions |   | 621,431                |       | 679,540                |   |
| Other                                 |   | 940,665                |       | 940,766                |   |
|                                  |   | $                      | 13,517,790 |                   | $      | 6,580,780 |   |

 

**NOTE 7 - Notes Payable:**

** **

Indebtedness consists of the following:

 
|                                                                                                                                                                                                                                                                                                                                       |   | **December  31, 2002** |      | **December  31, 2001** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|-----------|------------------------|--------|
| Primary Debt                                                                                                                                                                                                                                                                                                                               |   |                   |      |                   |   |
| Bank revolving  line of credit for $17.5 million with a commercial bank, collateralized by  all of the Company’s U.S. accounts receivable, intangibles, equipment,  fixtures, and inventory, and 65% of the common stock of DSI(HK) Limited,  principal due on March 31, 2004; interest at prime plus .75% (5% at December  31, 2002) |   | $                      | 7,014,998 |                   | $      | 9,210,390 |   |
| Revolving bank  loan drawn against a $6 million line of credit, collateralized by customers’  letters of credit, fluctuating interest rate (4.25% at December 31, 2002)                                                                                                                                                               |   | 709,566                |      | – –          |   |
| Bank installment  loan, bearing interest at 4.5%; payable in 12 monthly payments of HKD340,652  (approximately US$43,700 at December 31, 2002), including principal and  interest, with final payment due December 3, 2003.                                                                                                                |   | 511,585                |      | – –          |   |
| Short-term loans  from 3 banks discounted and collateralized by specific customer’s letters of  credit; interest ranging from 4.75% to 5.15%.                                                                                                                                                                                         |   |                   |      | 1,080,235              |   |
| Other                                                                                                                                                                                                                                                                                                                                      |   | 4,774                  |      | 40,415                 |   |
|                                                                                                                                                                                                                                                                                                                                       |   | 8,240,923              |      | 10,331,040             |   |
| Less: current  portion                                                                                                                                                                                                                                                                                                                     |   | 8,240,923              |      | 1,120,650              |   |
|                                                                                                                                                                                                                                                                                                                                       |   | $                      | —    |                   | $      | 9,210,390 |   |

 

The bank revolving credit facility (the “Revolver”)includes a $17.5 million revolving line of credit commitment, subject toavailability under a borrowing base calculated by reference to the level ofeligible accounts receivable and inventory, as defined in the agreement.  The Revolver matures on  March 31, 2004.  Interest on borrowings outstanding under the Revolver is payablemonthly in arrears at an annual rate equal to prime plus .75%.  In addition, an unused line fee at an annualrate equal to .50% applied to the amount by which $17.5 million exceeds the averagedaily principal balance during the month and a collateral management fee of$2,500 is payable monthly.

 

F-15

----

 

The Revolver contains certain restrictive covenantsand conditions among which are prohibition on payment of dividends, limitationson further indebtedness, restrictions on dispositions and acquisition ofassets, limitations on advances to third parties and compliance with minimumnet worth and net income amounts and designation as the “Senior Indebtedness”as relates to the related party debt described below.

 

The Company’s net losses for the year ended December31, 2002, resulted in the Company being out of compliance with certainfinancial covenants required under the Revolver.  Therefore, the Company’s $7.0 million debt under the Revolver asof December 31, 2002, has been reclassified as a current liability.  As a result, the Company’s currentliabilities exceeded its current assets by $6.5 million as of December 31,2002. If the Revolver, at the lender’s option, were to be accelerated, the $7.0million debt would become immediately due and payable.

 

The Company in the past has been successful innegotiating the Revolver amendments to bring the Company back intocompliance.  Primary operations for thelender of the Revolver, Sunrock Capital Corp. were sold in February 2003,limiting the willingness of Sunrock to amend any remaining lendingagreements.  As a result, the Company isin discussions with several banks to replace the Revolver with a new similarloan.  The Company’s viability as agoing concern is dependent upon successful negotiations with Sunrock, a newlender, or a substantial capital infusion, as well as sustained profitableoperations. The accompanying financial statements do not include anyadjustments that might be necessary if the Company is unable to continue as agoing concern.

 

To the extent the Company’s cash reserves and cashflows from operations are insufficient to meet future cash requirements, theCompany will need to successfully raise additional capital through additionalequity infusion or the issuance of debt. The Company’s executive management believes that the Company will berequired to either obtain a new revolving loan or obtain necessary additionalcapital to allow the Company to continue its normal operations for theforeseeable future. However, there can be no assurance the Company will meetits projected operating results or be successful either in obtaining additionalcapital, or obtaining a new revolving loan.

 

In addition to the above, the Company has available anadditional HKD $19,000,000 (approximately US $2.4 million) line of credit bankfacility (the “Standard Chartered Facility”). The facility is in the form of a credit financing facility based on actualshipments of product and opened letters of credit and bears interest at the3-month LIBOR rate plus 2%.  Thisfacility expires June 20, 2003.

 

The Company’s revolving bank loan drawn against a $6million line of credit and the Standard Chartered Facility are subject toperiodic review and may be canceled by the respective bank upon notice.

 
|                                                                                                                                                                                                                                                                                                                                            |   | **December  31, 2002** |      | **December  31, 2001** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|-----------|------------------------|--------|
| Related Party Debt                                                                                                                                                                                                                                                                                                                              |   |                   |      |                   |   |
| Promissory Note  of $1,690,000 to Walter S. and Susan Reiling,  collateralized by a $868,000 Letter of Credit, subordinated to  other debt, payable in quarterly installments of $108,500 through January 7,  2005; including interest at 10.0375%.                                                                                        |   | $                      | 864,552   |                   | $      | 1,191,037 |   |
|                                                                                                                                                                                                                                                                                                                                            |   |                   |      |                   |   |
| Promissory Note  of $5,000,000 to MVII, Inc., subordinated to the  Revolver, payable in monthly installments of $50,000 through  July 2004 plus interest at prime plus 2% (6.25% at December 31, 2002).  Additionally, under certain conditions as  stipulated by the Revolver a $300,000 payment may be made on March 31 each  year. |   | 4,650,000              |      | 3,850,000              |   |
|                                                                                                                                                                                                                                                                                                                                            |   | 5,514,552              |      | 5,041,037              |   |
| Less:  current portion                                                                                                                                                                                                                                                                                                                     |   | 960,510                |      | 1,751,485              |   |
|                                                                                                                                                                                                                                                                                                                                            |   | $                      | 4,554,042 |                   | $      | 3,289,552 |   |

 

F-16

----

 

The $868,000 Letter of Credit collateralizing the$1,690,000 promissory note, is provided for the benefit of the Company byMVII.  Expenses associated with theletter of credit are reimbursed to MVII by the Company.  Payment to MVII on the $5,000,000 promissorynote is subject to the terms of a subordination agreement between MVII and theRevolver bank, which places restrictions on payment to MVII, based on theborrowing capacity available to the Company under the Revolver.

 

The Company’s ability to meet its maturing debt andother cash requirements is dependent on the continuation of sufficient lendingarrangements, additional cash infusions, and/or cash from operations.  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.  However, there can be noassurance the Company will meet its projected operating results.

** **

**NOTE 8 -Income Taxes:**

 

The components of income (loss) before provision for(benefit from) income taxes by fiscal year were as follows:

 
|     |   | **2002** |       | **2001**  |   | **2000**   |   |
|----------|--------|----------|------------|-----------|--------|------------|--------|
| Domestic |   | $        | (5,715,771 | )         | $      | (3,908,923 | )      | $ | (4,167,128 | ) |
| Foreign  |   | (20,749  | )          | 2,850,308 |   | 2,840,694  |   |
|     |   | $        | 5,736,520  |      | $      | (1,058,615 | )      | $ | (1,326,434 | ) |

 

The provision for income taxes (benefit) by fiscalyear is as follows:

 
|      |   | **2002**  |      | **2001** |   | **2000** |   |
|-----------|--------|-----------|-----------|----------|--------|----------|--------|
| Current:  |   | $         | —    |     | $      | —   |   | $ | — |   |
| Federal   |   |      |      |     |   |     |   |
| Foreign   |   | 34,244    |      | 363,992  |   | 324,473  |   |
|      |   | 34,244    |      | 363,992  |   | 324,473  |   |
| Deferred: |   |      |      |     |   |     |   |
| Federal   |   | 2,205,000 |      | (40,000  | )      | (949,000 | )      |
| Foreign   |   | 36,462    |      | 66,911   |   | 147,079  |   |
|      |   | 2,241,462 |      | 26,911   |   | (801,921 | )      |
|      |   | $         | 2,275,706 |     | $      | 390,903  |   | $ | (477,448 | ) |

 

The difference between income taxes (benefit) at thestatutory federal and the effective income tax rates by fiscal year is asfollows:

 
|                                        |   | **2002**  |       | **2001** |   | **2000** |   |
|---------------------------------------------|--------|-----------|------------|----------|--------|----------|--------|
| Taxes (benefit)  computed at statutory rate |   | $         | (1,950,417 | )        | $      | (359,929 | )      | $ | (450,987 | ) |
| U.S. Permanent  items                       |   | 18,600    |       | 191,002  |   | 190,256  |   |
| Split Dollar  Life Insurance                |   | —    |       | —   |   | (592,577 | )      |
| Valuation  allowance                        |   | 4,031,000 |       | 566,474  |   | 371,654  |   |
| Other, net                                  |   | 176,523   |       | (6,644   | )      | 4,206    |   |
|                                        |   | $         | 2,275,706  |     | $      | 390,903  |   | $ | (477,448 | ) |

 

F-17

----

 

Deferred tax assets (liabilities) are comprised of thefollowing:

 
|                                          |   | **December  31,  2002** |      | **December  31,  2001** |   |
|-----------------------------------------------|--------|-------------------------|-----------|-------------------------|--------|
| Net operating  loss carry forward             |   | $                       | 1,152,000 |                    | $      | 610,000 |   |
| Allowance for  doubtful accounts              |   | 638,000                 |      | 578,000                 |   |
| Inventory  valuation adjustments              |   | 33,000                  |      | 29,000                  |   |
| Depreciation                                  |   | 178,000                 |      | 259,000                 |   |
| Accruals for  inventory returns and markdowns |   | 400,000                 |      | 133,000                 |   |
| Foreign and  alternative minimum tax credits  |   | 1,596,000               |      | 1,753,000               |   |
| Other                                         |   | 34,000                  |      | 57,000                  |   |
| Gross deferred  tax assets                    |   | 4,031,000               |      | 3,419,000               |   |
| Less valuation  allowance                     |   | (4,031,000              | )         | (566,000                | )      |
| Net deferred tax  assets                      |   | 0                       |      | 2,853,000               |   |
| Unremitted  earnings of foreign subsidiary    |   | 0                       |      | (648,000                | )      |
| Depreciation                                  |   | (179,902                | )         | (156,642                | )      |
| Other                                         |   | (109,861                | )         | (99,118                 | )      |
| Gross deferred  tax liabilities               |   | (289,763                | )         | (903,760                | )      |
| Net deferred tax  assets (liabilities)        |   | $                       | (289,763  | )                       | $      | 1,949,240 |   |

 

The Internal Revenue Service regulations restrict theutilization of U.S. net operating loss carryforwards and other tax attributessuch as foreign tax credits for any company in which an “ownership change” asdefined in Section 382 of the Internal Revenue Code has occurred.  In June of 1999, the Company had a Section382 change in ownership.  As a result,the Company’s U.S. net operating losses and tax credits generated before thisownership change are subject to limitation of approximately $1,230,000 peryear.  For the current fiscal year, thislimitation did not impact the Company’s utilization of U.S. net operatinglosses and foreign tax credits.

 

At December 31, 2002, the Company has approximately$1,514,000 in foreign tax credit carryforwards which expire between December31, 2002 through December 31, 2007.  TheCompany also has approximately $82,000 in alternative minimum tax creditcarryforwards which do not expire.  TheCompany has federal net operating loss carryforwards (NOL) of approximately$3,389,000 which expire in 2021.  TheCompany’s state net operating loss carryforward is not significant.  The benefit from utilization of netoperating loss carryforwards could be subject to further limitations ifsignificant ownership changes occur in the Company.  The Company’s ability to realize the entire benefit of its deferredtax asset requires that the Company achieve certain future earnings levelsprior to the expiration of its foreign tax credit and NOL carryforwards.

* *

*DeferredTaxes* - TheCompany recorded a $4.0 million charge in fiscal year 2002 to establish avaluation allowance for all of its deferred tax assets, including $2.2 millionof deferred tax assets generated in prior years.  The valuation allowance was calculated in accordance with theprovisions of Statement of Financial Accounting Standards (SFAS) 109, “Accountingfor Income Taxes,” which places primary importance on the Company’s cumulativeoperating results in the most recent periods when assessing the need for avaluation allowance.

 

The primary factors considered in evaluating therealizability of the deferred tax assets and establishing the valuationallowance were continued operating losses for the Company through December 31,2002, the Company’s projection of future operating results and the number ofyears it will take to recover the tax assets in a difficult market.  This evaluation provides sufficient negativeevidence to establish an additional valuation allowance under the provision ofSFAS 109.  The company intends tomaintain a full valuation allowance for its deferred tax assets and net operatingloss carryforwards until sufficient positive evidence exists to supportreversal of the allowance.  Theestablishment of this valuation allowance in no way affects the Company’sability to reduce future tax expense through utilization of net operating lossesand foreign income tax credits.

 

F-18

----

 

**NOTE 9 -Employee Benefit Plan:**

** **

The Company maintains a 401(k) Plan (the “Plan”) forthe benefit of its U.S. employees.  TheCompany may, at its discretion, provide funds to match employee contributionsto the Plan.  The Company contributedapproximately $51,000, $63,000 and $54,000 in fiscal 2002, 2001 and 2000,respectively, as employer matching contributions to employee contributions.

 

**NOTE 10 - The Stock Option Plan andWarrants:**

 

The Company has reserved 388,888 common shares forissuance upon exercise of a warrant issued to a bank.  The warrant expires on December 11, 2005.  Upon completion of the going privatetransaction, such warrant will be exercisable at a purchase price of $0.47 pershare.

 

In connection with the Offering, the Company issuedwarrants to purchase 250,000 shares of common stock.  Such warrants are exercisable at $10.80 per share and expired May28, 2002.

 

On August 21, 2002, MVII converted a prepaidInvestment Warrant in exchange for 1.8 million shares of common stock.  The Investment Warrant was issued March 19,2002, for a cash purchase price of $2.7 million.  Proceeds from the sale of the Investment warrant were used by theCompany for current working capital.

 

In May 1997, the Board of Directors adopted the DSIToys, Inc. 1997 Stock Option Plan (the “1997 Plan”) whereby certain employeesmay be granted stock options, appreciation rights or awards related to theCompany’s common stock.  Additionally,the Company may grant nonstatutory stock options (as defined in the 1997 Plan)to nonemployee board members.  The Boardof Directors authorized 600,000 shares to be available for grant pursuant tothe 1997 Plan.  Options expire no laterthan ten years from the date of grant.

 

Additional awards may be granted under the 1997 Planin the form of cash, stock or stock appreciation rights.  The stock appreciation right awards mayconsist of the right to receive payment in cash or common stock.  Any award may be subject to certainconditions, including continuous service with the Company or achievement ofbusiness objectives.

 

In May 1999, the 1997 Plan was amended to authorize900,000 shares to be available for grant.

 

In May 2000, the 1997 Plan was amended to authorize1,200,000 shares to be available for grant.

 

A summary of the option activity under the 1997 Plan,as amended, follows:

 
|                                      |   | **Number of  Outstanding Options** |   | **Weighted  Average  Option Price** |   |
|-------------------------------------------|--------|------------------------------------|--------|-------------------------------------|--------|
| Options  outstanding at December 31, 1999 |   | 746,500                            |   | $                                   | 3.63   |   |
| Granted                                   |   | 142,500                            |   | 3.19                                |   |
| Surrendered                               |   | (22,500                            | )      | 5.40                                |   |
| Options  outstanding at December 31, 2000 |   | 866,500                            |   | 3.51                                |   |
| Granted                                   |   | 103,000                            |   | 3.13                                |   |
| Surrendered                               |   | (240,000                           | )      | 3.29                                |   |
| Options  outstanding at December 31, 2001 |   | 729,500                            |   | 3.55                                |   |
| Granted                                   |   | 10,000                             |   | 3.13                                |   |
| Surrendered                               |   | (165,500                           | )      | 3.61                                |   |
| Options  outstanding at December 31, 2002 |   | 574,000                            |   | $                                   | 3.53   |   |

 

The weighted average fair value at date of grant foroptions granted during fiscal 2002, 2001 and 2000 was $3.13, $3.13 and $3.19respectively.  Vesting periods foroptions granted range from immediate to seven years from the date of grant inincrements between 5% and 90% per year.

 

F-19

----

 

Options outstanding at December 31, 2002, are asfollows:

 
| **Option Price** |         | **Number of  Outstanding  Options** |    | **Weighted  Average  Exercise  Price** |   | **Weighted  Average  Remaining  Contractual Life** |   | **Number of  Exercisable  Options** |   | **Weighted  Average  Exercise  Price** |   |
|------------------|--------------|-------------------------------------|---------|----------------------------------------|--------|----------------------------------------------------|--------|-------------------------------------|--------|----------------------------------------|--------|
| $                | 3.125 - 3.49 |                                | 528,500 |                                   | $      | 3.14                                               |   | 7                                   |   | 265,100                                |   | $ | 3.13 |   |
| 8.00             |         | 45,500                              |    | $                                      | 8.00   |                                               | 5      |                                | 21,125 |                                   | $      | 8.00 |   |
|             |         | 574,000                             |    |                                   |   |                                               |   | 286,225                             |   |                                   |   |
|                  |              |                                     |         |                                        |        |                                                    |        |                                     |        |                                        |        |  |  |  |

 

The Company applies the intrinsic method prescribed byAPB 25 and related interpretations in accounting for its stock optionplan.  Accordingly, no compensation costhas been recognized by the Company for this plan.  The following unaudited pro forma data is calculated as ifcompensation cost for the 1997 Plan was determined based upon the fair value atthe grant date for awards under the plan consistent with the methodologyprescribed under SFAS 123 for fiscal years 2002, 2001 and 2000:

 
|                                                                                                                                  |   | **2002** |       | **2001** |   | **2000**   |   |
|---------------------------------------------------------------------------------------------------------------------------------------|--------|----------|------------|----------|--------|------------|--------|
| Net loss, as  reported                                                                                                                |   | $        | (8,012,226 | )        | $      | (1,449,518 | )      | $ | (848,986 | ) |
| Deduct: Total stock-based employee compensation  expense determined under fair value based method for all awards, net of tax  effects |   | (138,425 | )          | (319,900 | )      | (240,426   | )      |
| Pro forma net  loss                                                                                                                   |   | $        | (8,150,651 | )        | $      | (1,769,418 | )      | $ | (1,089,412 | ) |
|                                                                                                                                  |   |     |       |     |   |       |   |
| Loss per share:                                                                                                                       |   |     |       |     |   |       |   |
| Basic – as  reported                                                                                                             |   | $        | (0.82      | )        | $      | (0.16      | )      | $ | (0.09 | ) |
| Basic – pro  forma                                                                                                               |   | $        | (0.84      | )        | $      | (0.20      | )      | $ | (0.12 | ) |
|                                                                                                                                  |   |     |       |     |   |       |   |
| Diluted – as  reported                                                                                                           |   | $        | (0.82      | )        | $      | (0.16      | )      | $ | (0.09 | ) |
| Diluted – pro  forma                                                                                                             |   | $        | (0.84      | )        | $      | (0.20      | )      | $ | (0.12 | ) |

 

The fair value of each option granted is estimated onthe date of grant using the Black-Scholes options-repricing model with thefollowing weighted average assumptions used for grants in fiscal 2002, 2001 and2000: expected volatility of 80%, risk-free interest rate of 3.92% to 6.37%, nodividend yield and an expected life of seven years.

** **

**NOTE 11 - Related Party Transactions:**

 

The Company leased its office and warehouse in Houstonduring part of 2002 and in prior years from an entity owned by the previoussole shareholder of the Company.  Rentexpense on these leases was approximately $253,000, $367,000 and $325,000respectively for fiscal 2002, 2001, and 2000. Management believes that the rental rates approximate fair market value.

 

On June 11, 1999, the Company entered into aconsulting agreement with a director (and former CEO), for a term of threeyears.  Compensation for the three yearterm was $450,000 payable in equal monthly installments of $12,500.  The final payment covered by the agreementwas paid in May, 2002.

 

On January 7, 2000, the Company borrowed $5,000,000from MVII, LLC (a California limited liability company controlled by theChairman, and including certain other directors) evidenced by a PromissoryNote.  The Note, which bears interest ata rate of prime plus 2% per annum, requires monthly interest payments from thedate of the Note and principal payments subject to subordination terms of theRevolver (see Note 7).

 

F-20

----

 

Also on January 7, 2000, as discussed in Note 17, theCompany merged with Meritus Industries, Inc. Pursuant to the merger terms, one of Meritus’ primary shareholders wassubsequently elected to the Board of Directors.  In addition to the stock received in the transaction, theshareholder received $1.1 million in cash and a note receivable for $1.7 million. The note, bearing interest at 10.0375% per annum, requires quarterlyprincipal and interest payments beginning April 1, 2000.

 

On March 6, 2002 and May 21, 2002, pursuant to theterms of the Revolver and the MVII Note, the Company reborrowed an aggregate of$1,350,000 of the original principal that the Company had paid on the MVIINote.  Additionally, subsequent toDecember 31, 2002, on March 10, 2003, the Company reborrowed an additional$350,000.  The proceeds were used tofinance normal business operations of the Company.

 

Additional related party transactions are described inNotes 1, 11, 16 and 17.

 

**NOTE 12 - Commitments andContingencies:**

 

In the normal course of business, the Company isinvolved in product and intellectual property issues which sometimes result inlitigation.  It is the opinion ofmanagement that the ultimate resolution of such matters will not have amaterial adverse effect on the Company’s financial position, results ofoperations or cash flows, taken as a whole.

 

The Company and its subsidiary do not maintain anyoff-balance sheet debt or similar financing arrangements nor has either entityformed any special purpose entities for the purpose of maintaining off-balancesheet debt.

 

The Company leases its facilities under variousoperating leases which expire from 2001 to 2010.  Rent expense, including amounts paid to a related party, forfiscal 2002, 2001, and 2000 amounted to $1,024,188, $966,971 and $1,008,183respectively.  Aggregate minimum rentalcommitments under non-cancelable leases are as follows for the specified fiscalyears:

 
| 2003                  |   | $       | 1,086,628 |   |
|-----------------------|--------|---------|-----------|--------|
| 2004                  |   | 980,991 |      |
| 2005                  |   | 975,854 |      |
| 2006                  |   | 801,725 |      |
| 2007                  |   | 320,507 |      |
| Thereafter thru  2010 |   | 390,404 |      |
|                  |   | $       | 4,556,109 |   |

 

In August 2002, the Company leased and relocated itsprimary executive offices, showroom and consumer service operations toapproximately 17,000 square feet of office space at 10110 West Sam HoustonParkway, South, Houston, Texas, 77099. The lease requires monthly lease payments of $14,532, plus additionalannually adjustable monthly amounts for taxes, insurance, and operatingexpense.  The lease expires in September2007.

 

Additionally, the Company leased approximately 75,000square feet of warehouse space in Fife, Washington from a third party logisticscompany to serve as the Company’s primary domestic warehouse and distributioncenter.  The lease expires December 31,2006, and requires monthly payments of $31,500.  The lease is cancelable by either party with nine months notice.

 

Royalty expense under licensing agreements aggregatedapproximately $2,527,000, $3,310,000 and $2,989,000, in fiscal 2002, 2001 and2000, respectively.  At December 31,2002, minimum guaranteed royalties payable under these agreements of  $250,000 in fiscal 2003 and $835,000 through2007 are included in accrued royalties payable and prepaid expenses and otherassets.

 

The Company has employment agreements with executivesat December 31, 2002 that aggregate $403,000, are adjusted annually by the CPIchange, and expire in the next 3-23 months.

 

F-21

----

 

In fiscal 2000, the Company terminated its obligationsfor current and future insurance premium payments on certain life insurancepolicies.  In prior years, the Companypaid premiums for the policies owned by the Tommy and JoBeth Moss Joint LifeInsurance Trust, (the “Trust”), and was entitled to repayment of the advancedpremiums, plus related cumulative interest, upon the death of JoBeth Moss.  The Company agreed to forgo the cumulativeamounts due the Company in exchange for the Trust extinguishing the futureobligations for insurance premium payments.

 

**NOTE 13 - Segment Information:**

 

The Company designs, develops, markets and distributesa variety of toys and children’s consumer electronics.  These product lines are grouped into threemajor categories which represent the Company’s operating segments, as follows:

 

                Juvenile AudioProducts, comprised of Youth Electronics, including walkie-talkies, pre-schoolaudio products, and pre-teen audio products, and Musical Instruments, includingelectronic keyboards, drumpads and other musical toys; Girls’ Toys, includingdolls, play sets and accessories; and Boys’ Toys, including radio controlvehicles, action figures and western and military action toys.

 

These operating segments all have similar economiccharacteristics: the marketing of children’s products.  Based on these similarities, the Company’sproducts can be aggregated into one reportable segment for purposes of thisdisclosure.

 

The Company sells its products through (i) the HongKong operation, where products are shipped directly from contract manufacturersto the Company’s customers, and (ii) the United States operation, whereproducts are shipped from the Company’s warehouses in Houston, TX and Fife, WAto its customers.

 

Financial information for fiscal 2002, 2001, and 2000for the U.S. and Hong Kong operations is as follows:

 
|                             |   | **United  States** |       | **Hong Kong** |   | **Consolidated** |   |
|----------------------------------|--------|--------------------|------------|---------------|--------|------------------|--------|
| **Fiscal 2002:**                 |   |               |       |          |   |             |   |
| Net sales                        |   | $                  | 22,438,750 |          | $      | 27,315,423       |   | $ | 49,754,173 |   |
| Operating income  (loss)         |   | (5,410,345         | )          | 508,134       |   | (4,902,211       | )      |
| Depreciation  expense            |   | 296,592            |       | 775,391       |   | 1,071,983        |   |
| Capital  expenditures            |   | 585,400            |       | 944,437       |   | 1,529,837        |   |
| Total assets at  fiscal year end |   | $                  | 24,022,605 |          | $      | 4,648,097        |   | $ | 28,670,702 |   |
| **Fiscal 2001:**                 |   |               |       |          |   |             |   |
| Net sales                        |   | $                  | 31,859,743 |          | $      | 36,046,666       |   | $ | 67,906,409 |   |
| Operating income  (loss)         |   | (632,616           | )          | 450,564       |   | (182,052         | )      |
| Depreciation  expense            |   | 469,033            |       | 865,359       |   | 1,334,392        |   |
| Capital  expenditures            |   | 121,657            |       | 645,264       |   | 766,921          |   |
| Total assets at  fiscal year end |   | $                  | 27,622,660 |          | $      | 3,690,075        |   | $ | 31,312,735 |   |
| **Fiscal 2000:**                 |   |               |       |          |   |             |   |
| Net sales                        |   | $                  | 27,147,848 |          | $      | 43,290,683       |   | $ | 70,438,531 |   |
| Operating income  (loss)         |   | (682,572           | )          | 633,386       |   | (49,186          | )      |
| Depreciation  expense            |   | 733,186            |       | 818,446       |   | 1,551,632        |   |
| Capital  expenditures            |   | 237,752            |       | 1,012,192     |   | 1,249,944        |   |
| Total assets at  fiscal year end |   | $                  | 26,528,128 |          | $      | 3,471,012        |   | $ | 29,999,140 |   |

 

F-22

----

 

Sales to major customers that exceeded 10% of theCompany’s total net sales consist of the following for the specified fiscalyears:

 
|                  |   | **2002** |   | **2001** |   | **2000** |   |
|-----------------------|--------|----------|--------|----------|--------|----------|--------|
| Wal-Mart              |   | 27       | %      | 21       | %      | 18       | %      |
| Kmart                 |   |     |   | 10       | %      |     |   |
| Toys “R” Us |   |     |   |     |   | 12       | %      |

 

Approximately 19% of the Company’s sales were exportsto countries other than the United States during fiscal 2002, and 17% and 19%during fiscal 2001 and 2000, respectively.

** **

**NOTE 14- Supplemental Cash Flow Information:**

 

Additional cash flow information by fiscal year is asfollows:

 
|                                             |   | **2002** |    | **2001** |   | **2000**    |     |
|--------------------------------------------------|--------|----------|---------|----------|--------|-------------|----------|
|                                             |   |     |    |     |   |        |     |
| Cash paid  (received) for:                       |   |     |    |     |   |        |     |
| Interest                                         |   | $        | 935,363 |     | $      | 1,107,486   |     | $ | 1,104,296 |   |
| Income taxes                                     |   | $        | 396,386 |     | $      | 385,926     |     | $ | 753,199 |   |
| Noncash  activities included in the following:   |   |     |    |     |   |        |     |
| Accounts  receivable write-offs (recoveries)     |   | $        | (36,890 | )        | $      | 438,089     |     | $ | (11,769 | ) |
| Acquisition of  Meritus:                         |   |     |    |     |   |        |     |
| Property, plant  and equipment acquired          |   |     |    |     |   | $           | (748,730 | ) |
| Accounts  receivable and other assets acquired   |   |     |    |     |   | (838,563    | )        |
| Liabilities  assumed                             |   |     |    |     |   | 7,475,172   |     |
| Note payable  issued to the Sellers              |   |     |    |     |   | 1,690,000   |     |
| Common stock  issues (including treasury shares) |   |     |    |     |   | 1,801,415   |     |
| Goodwill  resulting from Meritus acquisition     |   |     |    |     |   | (10,263,327 | )        |
| Net cash paid  for Meritus acquisition           |   |     |    |     |   | $           | (884,033 | ) |

 

F-23

----

 

**NOTE 15 - Quarterly FinancialInformation (unaudited):**

 
|                      |   | **Fiscal  Quarter Ended** |      |
|---------------------------|--------|---------------------------|-----------|
|                      |   | **3/31/02**               |      | **6/30/02** |   | **9/30/02** |   | **12/31/02** |   |
| Net sales                 |   | $                         | 5,188,860 |   | $ | 8,951,657 |   | $ | 20,683,800 |   | $ | 14,929,856 |   |
| Operating loss            |   | (1,936,905                | )         | (423,516 | ) | (424,670 | ) | (2,117,120 | ) |
| Loss before  income taxes |   | (1,990,021                | )         | (738,000 | ) | (616,531 | ) | (2,391,968 | ) |
| Net loss                  |   | (1,313,414                | )         | (487,080 | ) | (3,749,058 | ) | (2,462,674 | ) |
| Basic loss per  share     |   | $                         | (0.14     | ) | $ | (0.05 | ) | $ | (0.38 | ) | $ | (0.23 | ) |
| Diluted loss per  share   |   | $                         | (0.14     | ) | $ | (0.05 | ) | $ | (0.38 | ) | $ | (0.23 | ) |

 
|                               |   | **Fiscal  Quarter Ended** |      |
|------------------------------------|--------|---------------------------|-----------|
|                               |   | **3/31/01**               |      | **6/30/01** |   | **9/30/01** |   | **12/31/01** |   |
| Net sales                          |   | $                         | 6,721,223 |   | $ | 9,416,184 |   | $ | 29,927,783 |   | $ | 21,841,219 |   |
| Operating income  (loss)           |   | (2,188,188                | )         | (2,070,282 | ) | 3,531,705 |   | 544,713 |   |
| Income (loss)  before income taxes |   | (2,421,792                | )         | (2,314,578 | ) | 3,312,353 |   | 365,402 |   |
| Net income  (loss)                 |   | (1,549,947                | )         | (1,481,330 | ) | 1,981,289 |   | (399,530 | ) |
| Basic earnings  (loss) per share   |   | $                         | (0.17     | ) | $ | (0.16 | ) | $ | 0.22 |   | $ | (0.04 | ) |
| Diluted earnings  (loss) per share |   | $                         | (0.17     | ) | $ | (0.16 | ) | $ | 0.22 |   | $ | (0.04 | ) |

 
|                               |   | **Fiscal  Quarter Ended** |      |
|------------------------------------|--------|---------------------------|-----------|
|                               |   | **3/31/00**               |      | **6/30/00** |   | **9/30/00** |   | **12/31/00** |   |
| Net sales                          |   | $                         | 6,914,462 |   | $ | 13,582,505 |   | $ | 29,915,591 |   | $ | 20,025,973 |   |
| Operating income  (loss)           |   | (1,735,467                | )         | 362,744 |   | 2,598,974 |   | (1,275,437 | ) |
| Income (loss)  before income taxes |   | (1,995,260                | )         | 3,287 |   | 2,312,891 |   | (1,647,352 | ) |
| Net income  (loss)                 |   | (1,276,913                | )         | 2,049 |   | 1,480,251 |   | (1,054,373 | ) |
| Basic earnings  (loss) per share   |   | $                         | (0.14     | ) | $ | 0.00 |   | $ | 0.16 |   | $ | (0.12 | ) |
| Diluted earnings  (loss) per share |   | $                         | (0.14     | ) | $ | 0.00 |   | $ | 0.16 |   | $ | (0.12 | ) |

#### ** **

#### **NOTE 16- Subsequent Events**

 

The Company is the defendant in a lawsuit styled RymaxCorp. d/b/a Rymax Marketing Services, Inc, (“Rymax”) v. DSI Toys, Inc. in theSuperior Court of New Jersey Law Division: Morris County; civil action docket number MRSL-3799-02.  In the lawsuit, Rymax claims that theCompany failed to pay commissions due to Rymax and demands judgment for damagesin the amount of $45,061.67 plus interest, attorney fees and costs ofcourt.  The Company does not believe itowes these damages and may bring a counterclaim against Rymax for an amountexceeding $75,000.00 for goods shipped and sold to them.  At this time, the Company is attempting tonegotiate a settlement of the entire controversy.

 

F-24

----

 

The Company is the defendant in a lawsuit styled TheCartoon Network, LP, LLLP (“TCN”) v. DSI Toys, Inc. in the State Court ofFulton County, State of Georgia, Civil Action File No. 03VS046924C.  In the lawsuit, TCN claims the Company isindebted to TCN for $725,051.70 for television advertisements aired by TCN, togetherwith interest at the rate of 18% per annum until paid. The Company is innegotiations with TCN and believes it has recorded an adequate amount for theultimate settlement.

 

The Company has received a demand letter from theChapter 7 Trustee for bankruptcy cases that are pending in the SouthernDistrict of New York involving Play Co. Toys & Entertainment Corp., ToysInternational.Com, Inc. and Play Co. Toys Canyon Country, Inc.  The Trustee alleges that a payment receivedby the Company from Toys International.Com, Inc. in the amount of $93,834.56was a preferential transfer that is recoverable under Bankruptcy Code Sections547 and 550.  The Company has respondedto the demand letter that the payment was a payment on an invoice for deliveredgoods made in the regular course of business. At this time the Company and theTrustee are in negotiations to settle the matter in its entirety.

 

F-25

----

 

**NOTE 17- Business Combination**

 

On January 7, 2000, the Company acquired by way of amerger all of the issued and outstanding stock of Meritus Industries, Inc.(“Meritus”) in exchange for (i) 600,000 unregistered shares of the Company’scommon stock, less 66,792 shares of the Company’s common stock, which shareswere initially held by the Company and payable to Walter and Susan Reiling (the“Reilings”) upon satisfaction of certain post-closing conditions as set forthin the Closing and Holdback Agreement between the parties; (ii) $884,034 incash; and (iii) the Company’s Subordinated Secured Promissory Note for$1,690,000 paid to the Reilings, who were the sole shareholders of Meritus. Atthe end of the holdback period (June 7, 2000), the post-closing conditions werenot satisfied and none of the held back (66,792) shares was paid to theReilings.  The market value of theshares issued was $1,081,415 and was satisfied by the issuance of 347,365shares of new stock and 185,843 shares in treasury stock.  Contemporaneously with the merger, theCompany satisfied approximately $4.4 million of Meritus’ debt.

 

The acquisition was accounted for utilizing thepurchase method; therefore the Company recorded the acquired assets at theirestimated fair market value.  Goodwillgenerated by the transaction has been amortized over 20 years using thestraight-line method in 2001 and 2000. In 2002, and thereafter the market value of the goodwill will beevaluated annually and an impairment charge recorded if appropriate inaccordance with Statement of Financial Accounting Standards No. 142, “Goodwilland Other Intangible Assets.”

 

Commensurate with the merger, the Company borrowed$5,000,000 from MVII, LLC, a California limited liability company controlled byE. Thomas Martin (“MVII”), evidenced by a promissory note dated January 7,2000.  The proceeds from the note wereused for the payment of the Meritus debt discussed above.

 

F-26

----

 

**DSIToys, Inc. and Subsidiary**

**Valuationand Qualifying Accounts and Reserves (Schedule II)**

**(Inthousands)**

 
| **Description**                 |   | **Balance at    December  31, 1999** |   | **Deductions** |   | **Charged to  costs and  expenses** |   | **Balance at  December  31, 2000** |   | **Charged to  costs and  expenses** |   | **Deductions** |   | **Balance at  December  31, 2001** |   | **Charged to  costs and  expenses** |   | **Deductions** |   | **Balance at  December  31, 2002** |   |
|---------------------------------|--------|--------------------------------------|--------|----------------|--------|-------------------------------------|--------|------------------------------------|--------|-------------------------------------|--------|----------------|--------|------------------------------------|--------|-------------------------------------|--------|----------------|--------|------------------------------------|--------|
| Reserves  deducted from assets: |   |                                 |   |           |   |                                |   |                               |   |                                |   |           |   |                               |   |                                |   |           |   |                               |   |
|                            |   |                                 |   |           |   |                                |   |                               |   |                                |   |           |   |                               |   |                                |   |           |   |                               |   |
| Trade  receivables              |   | 186                                  |   | 12             |   | 222                                 |   | 420                                |   | 1,718                               |   | (438           | )      | 1,700                              |   | 304                                 |   | 40             |   | 2,044                              |   |
|                            |   |                                 |   |           |   |                                |   |                               |   |                                |   |           |   |                               |   |                                |   |           |   |                               |   |
| Discounts and  markdowns        |   | 729                                  |   | (398           | )      | 1,339                               |   | 1,670                              |   | 1,558                               |   | (1,755         | )      | 1,473                              |   | 2,176                               |   | (1,744         | )      | 1,905                              |   |
|                            |   |                                 |   |           |   |                                |   |                               |   |                                |   |           |   |                               |   |                                |   |           |   |                               |   |
| Return of  defective goods      |   | 1,082                                |   | (1,889         | )      | 1,837                               |   | 1,030                              |   | 1,012                               |   | (1,265         | )      | 777                                |   | 1,115                               |   | (1,497         | )      | 395                                |   |
|                            |   |                                 |   |           |   |                                |   |                               |   |                                |   |           |   |                               |   |                                |   |           |   |                               |   |
| Inventory                       |   | 100                                  |   | (129           | )      | 379                                 |   | 350                                |   | 412                                 |   | (392           | )      | 370                                |   | 1,150                               |   | (370           | )      | 1,150                              |   |
|                            |   | 2,097                                |   | (2,404         | )      | 3,777                               |   | 3,470                              |   | 4,700                               |   | (3,850         | )      | 4,320                              |   | 4,745                               |   | (3,571         | )      | 5,494                              |   |

 

S-1

----

 

**EXHIBITINDEX**

 
| 2.1    |   | Articles/Certificate of Merger of Meritus  Industries, Inc. into the Company, dated January 7, 2000 (filed as Exhibit  2.2 to the Company’s Form 8-K dated January 7, 2000), incorporated herein by  reference.                  |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                  |
| 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)            |
|   |   |                                                                                                                                                                                                                                  |
| 3.2    |   | Amended and Restated Bylaws of the Company.(1)                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                  |
| 3.3    |   | Amendment to Amended and Restated Bylaws of the  Company.(1)                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                  |
| 4.1    |   | Form of Common Stock Certificate.(1)                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                  |
| 4.2    |   | Form of Warrant Agreement among the Company and  Representatives to purchase 250,000 shares of common stock.(1)                                                                                                                       |
|   |   |                                                                                                                                                                                                                                  |
| 4.3    |   | Common Stock Purchase Warrant No. A-1 dated December  11, 1995, issued to Hibernia Corporation to purchase 388,888 shares of common  stock.(1)                                                                                        |
|   |   |                                                                                                                                                                                                                                  |
| 4.4    |   | Registration Rights Agreement by and between the  Company and Hibernia Corporation.(1)                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                  |
| 4.5    |   | Registration Rights Agreement by and between the  Registrant and Tommy Moss.(1)                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                  |
| 4.6    |   | Form of Investment Warrant by and between the  Company and MVII, LLC, dated March 19, 2001(filed as Exhibit 4.6 to the  Company’s Form 10-K for the fiscal year ended December 31, 2000),  incorporated herein by reference.     |
|   |   |                                                                                                                                                                                                                                  |
| 4.7    |   | Registration Rights Agreement by and between the  Company and MVII, LLC, dated March 19, 2001 (filed as Exhibit 4.7 to the  Company’s Form 10-K for the fiscal year ended December 31, 2000),  incorporated herein by reference. |
|   |   |                                                                                                                                                                                                                                  |
| 4.8    |   | Amended and Restated Investment Warrant by and  between the Company and MVII, LLC, dated January 31, 2002.(2)                                                                                                                         |
|   |   |                                                                                                                                                                                                                                  |
| 4.9    |   | Amended and Restated Registration Rights Agreement  by and between the Company and MVII, LLC dated January 31, 2002.(2)                                                                                                               |
|   |   |                                                                                                                                                                                                                                  |
| 10.1   |   | 1997 Stock Option Plan.(1)                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                  |
| 10.2   |   | Agreement for Sale of Stock between Rosie  Acquisition, L.L.C. and DSI Acquisition, Inc. and Diversified Specialists,  Inc. and Tommy Moss, dated December 11, 1995.(1)                                                               |
|   |   |                                                                                                                                                                                                                                  |
| 10.3   |   | Employment Agreement dated December 11, 1995 by and between  the Company and M. D. Davis.(1)                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                  |
| 10.4   |   | Employment Agreement dated December 11, 1995 by and  between the Company and Richard R. Neitz.(1)                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                  |
| 10.5   |   | Employment Agreement dated December 11, 1995 by and  between the Company and Yau Wing Kong.(1)                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                  |
| 10.6   |   | Employment Agreement dated December 11, 1995 by and  between the Company and Dale Y. Chen.(1)                                                                                                                                         |

 

E-1

----

 
| 10.7   |   | Employment Agreement dated December 11, 1995 by and  between the Company and Thomas V. Yarnell.(1)                                                                                                                                                                                                                           |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.8   |   | Employment Agreement dated March 16, 1997 by and  between the Company and J. Russell Denson.(1)                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.9   |   | Letter Loan Agreement between the Company and Bank  One, Texas, N.A. dated December 11, 1995, evidencing a revolving line of  credit and a term note (the “Bank One Letter Loan Agreement”).(1)                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.10  |   | First Amendment to Bank One Letter Loan Agreement,  dated January 31, 1996.(1)                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.11  |   | Second Amendment to Bank One Letter Loan Agreement,  dated August 1, 1996.(1)                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.12  |   | Third Amendment to Bank One Letter Loan Agreement,  dated November 14, 1996.(1)                                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.13  |   | Fourth Amendment to Bank One Letter Loan Agreement,  dated January 31, 1997.(1)                                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.14  |   | Fifth Amendment to Bank One Letter Loan Agreement,  dated January 31, 1997.(1)                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.15  |   | Line of Credit Facility with State Street Bank and  Trust Company, Hong Kong Branch, dated April 1, 1997, evidencing a $5,000,000  line of credit.(1)                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.16  |   | Underwriting Agreement dated May 28, 1997 among the  Company, the Tommy Moss Living Trust, Hibernia Corporation and Tucker Anthony  Incorporated and Sutro & Co. Incorporated (filed as Exhibit 10.1 to the  Company’s Form 10-Q for the quarterly period ended April 30, 1997),  incorporated herein by reference. |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.17  |   | Warrant Agreement dated May 28, 1997 by and among  the Company, Tucker Anthony Incorporated and Sutro & Co. Incorporated  (filed as Exhibit 10.2 to the Company’s Form 10-Q for the quarterly period  ended April 30, 1997), incorporated herein by reference.                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.18  |   | Renewal and Modification of Line of Credit Facility  with State Street Bank and Trust Company, Hong Kong Branch, dated June 6,  1997, evidencing an $8,000,000 line of credit (filed as Exhibit 10.1 to the  Company’s Form 10-Q for the quarterly period ended July 31, 1997), incorporated  herein by reference.      |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.19  |   | Debenture by DSI(HK) Limited to State Street Bank  and Trust Company, Hong Kong Branch, dated July 29, 1997 (filed as Exhibit  10.2 to the Company’s Form 10-Q for the quarterly period ended July 31,  1997), incorporated herein by reference.                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.20  |   | Amended and Restated Bank One Letter Loan Agreement,  dated October 22, 1997 (filed as Exhibit 10.1 to the Company’s Form 10-Q for  the quarterly period ended October 31, 1997), incorporated herein by  reference.                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.21  |   | First Amendment to Amended and Restated Bank One  Letter Loan Agreement, dated January 31, 1998 (filed as Exhibit 10.21 to the  Company’s Form 10-K for the annual period ended January 31, 1998),  incorporated herein by reference.                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.22  |   | Second Amendment to Amended and Restated Bank One  Letter Loan Agreement, dated September 30, 1998 (filed as Exhibit 10.22 to  the Company’s Form 10-Q for the quarterly period ended October 31, 1998),  incorporated herein by reference.                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.23  |   | Employment Agreement dated August 20, 1998 by and  between the Company and Howard G. Peretz.(3)                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                         |
| 10.24  |   | Loan and Security Agreement by and between the  Company and Sunrock Capital Corp. dated February 2, 1999.(3)                                                                                                                                                                                                                 |

 

E-2

----

 
| 10.25  |   | Stock Pledge Agreement by and between the Company  and Sunrock Capital Corp. dated February 2, 1999.(3)                                                                                                                                                                                                                                        |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.26  |   | Assignment of Deposit Account by and between the  Company and Sunrock  Capital Corp.  dated February 2, 1999.(3)                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.27  |   | Trademark Security Agreement by and between the  Company and Sunrock Capital Corp. dated February 2, 1999.(3)                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.28  |   | Patent Collateral Assignment by and between the  Company and Sunrock Capital Corp. dated February 2, 1999.(3)                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.29  |   | Stock Purchase and Sale Agreement dated April 15,  1999 by and between the Company and MVII, LLC (filed as Exhibit 2 to the  Company’s Schedule 14D-9 filed by the Company on April 22, 1999),  incorporated herein by reference.                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.30  |   | Stock Purchase and Sale Agreement, dated April 15,  1999, between the Company and MVII, LLC (filed as Exhibit 99.2 to the  Schedule 14D-9 filed by the Company on April 22, 1999), incorporated herein  by reference.                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.31  |   | Shareholders’ and Voting Agreement dated April 15,  1999, by and among the Company, MVII, LLC, certain management shareholders of  the Company and a limited partnership controlled by a management shareholder  (filed as Exhibit 99.4 to the Schedule 14D-9 filed by the Company on April  22, 1999), incorporated herein by reference. |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.32  |   | Registration Rights Agreement dated April 15, 1999,  by and among the Company, MVII, LLC, certain management shareholders of the  company and a limited partnership controlled by a management shareholder  (filed as Exhibit 99.5 to the Schedule 14D-9 filed by the Company on April  22, 1999), incorporated herein by reference.           |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.33  |   | Irrevocable Proxy dated April 15, 1999, between  MVII, LLC and Conrad.(4)                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.34  |   | Irrevocable Proxy dated April 15, 1999, between  MVII, LLC and Davis.(4)                                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.35  |   | Irrevocable Proxy dated April 15, 1999, between  MVII, LLC and Matlock.(4)                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.36  |   | Irrevocable Proxy dated April 15, 1999, between  MVII, LLC and Rust Capital.(4)                                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.37  |   | Irrevocable Proxy dated April 15, 1999, between  MVII, LLC and Smith.(4)                                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.38  |   | Consulting Agreement dated June 1, 1999, between the  Company and Davis.(4)                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.39  |   | Amendment dated May 5, 1999, to Loan and Security  Agreement, dated as of February 2, 1999, by and between Sunrock Capital Corp.  and the Company.(4)                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.40  |   | Amendment No. 1 dated June 30, 1999, to Loan and  Security Agreement, by and between Sunrock Capital Corp. and the Company.(5)                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.41  |   | Employment Agreement dated June 17, 1999 by and  between the Company and Michael J. Lyden.(5)                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.42  |   | Employment Agreement dated June 1, 1999, by and  between the Company and Joseph S. Whitaker.(5)                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                           |
| 10.43  |   | Amendment to 1997 Stock Option Plan dated May 24,  1999.(5)                                                                                                                                                                                                                                                                                    |

 

E-3

----

 
| 10.44  |   | Restated Employment Agreement dated December 31,  1999, by and between DSI(HK) Limited and Yau Wing Kong (filed as Exhibit  10/44 to the Company’s Form 10-K for the 11 month period ended December 31,  1999), and incorporated herein by reference.              |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                    |
| 10.45  |   | Agreement and Plan of Merger between Meritus  Industries, Inc. et al. and the Company, dated October 7, 1999 (filed as  Exhibit 10.45 to the Company’s Form 10-Q for the quarterly period ended  October 31, 1999), incorporated herein by reference.              |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.46  |   | Closing and Holdback Agreement dated January 7,  2000, by and between the Company and Meritus Industries, Inc., et al. (filed  as Exhibit 2.3 to the Company’s Form 8-K dated January 7, 2000), incorporated  herein by reference.                                 |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.47  |   | Shareholders’ and Voting Agreement dated January 7,  2000, by and among the Company, MVII, LLC and Walter S. and Susan Reiling  (filed as Exhibit 10.1 to the Company’s Form 8-K dated January 7, 2000),  incorporated herein by reference.                   |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.48  |   | Limited Irrevocable Proxy dated January 7, 2000,  between MVII, LLC and Walter S. and Susan Reiling (filed as Exhibit 10.2 to  the Company’s Form 8-K dated January 7, 2000), incorporated herein by  reference.                                                   |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.49  |   | Registration Rights Agreement dated January 7, 2000,  by and between the Company and Walter S. and Susan Reiling (filed as Exhibit  10.3 to the Company’s Form 8-K dated January 7, 2000), incorporated herein by  reference.                                      |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.50  |   | Subordinated Secured Promissory Note dated January  7, 2000, from the Company to Walter S. and Susan Reiling (filed as Exhibit  10.4 to the Company’s Form 8-K dated January 7, 2000), incorporated herein by  reference.                                          |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.51  |   | Promissory Note dated January 7, 2000, from the  Company to MVII, LLC (filed as Exhibit 10.5 to the Company’s Form 8-K dated  January 7, 2000), incorporated herein by reference.                                                                                  |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.52  |   | Amendment No. 2 dated January 7, 2000, to Loan and  Security Agreement, by and between Sunrock Capital Corp. and the Company  (filed as Exhibit 10.6 to the Company’s Form 8-K dated January 7, 2000),  incorporated herein by reference.                          |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.53  |   | Employment Agreement dated January 7, 2000, by and  between the Company and Beth Reiling (filed as Exhibit 10.7 to the Company’s  Form 8-K dated January 7, 2000), incorporated herein by reference.                                                               |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.54  |   | Employment Agreement dated January 7, 2000, by and  between the Company and Joseph Reiling (filed as Exhibit 10.8 to the  Company’s Form 8-K dated January 7, 2000), incorporated herein by reference.                                                             |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.55  |   | Amendment No. 2 to DSI Toys, Inc. 1997 Stock Option  Plan (filed as Exhibit 10.11 to the Company’s Form 10-Q for the quarterly  period ended June 30, 2000), incorporated herein by reference.                                                                     |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.56  |   | Amendment No. 3 dated July 14, 2000, to Loan and  Security Agreement, by and between Sunrock Capital Corp. and the Company  (filed as Exhibit 10.12 to the Company’s Form 10-Q for the period ended June  30, 2000), incorporated herein by reference.             |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.57  |   | Amendment No. 4 dated March 30, 2001, to Loan and  Security Agreement, by and between Sunrock Capital Corp. and the Company  (filed as Exhibit 10.57 to the Company’s Form 10-K for the annual period  ended December 31, 2000), incorporated herein by reference. |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.58  |   | Employment Agreement dated April 1, 2001, but  executed April 23, 2001, by and between the Company and Gregory A. Barth  (filed as Exhibit 10.2 to the Company’s Form 10-Q for the quarterly period  ended March 31, 2001), incorporated herein by reference.      |

 

E-4

----

 
| 10.59  |   | Amendment No. 5 to Loan and Security Agreement,  dated August 13, 2001, by and between Sunrock Capital Corp. and the Company  (filed as Exhibit 10.3 to the Company’s Form 10-Q for the quarterly period  ended June 30, 2001), incorporated herein by reference.  |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                    |
| 10.60  |   | Amendment No. 6 to Loan and Security Agreement,  dated August 13, 2001, by and between Sunrock Capital Corp. and the Company  (filed as Exhibit 10.4 to the Company’s Form 10-Q for the quarterly period  ended June 30, 2001), incorporated herein by reference.  |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.61  |   | First Amendment to Employment Agreement by and  between the Company and Joseph S. Whitaker, dated December 1, 2001.(2)                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.62  |   | Line of Credit Facility with Dao Heng Bank Limited  evidencing a $6,000,000 line of credit, dated December 4, 2001.(2)                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.63  |   | Memorandum of Re-borrowing of Principal by and  between the Company and MVII, LLC, dated March 6, 2002.(2)                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.64  |   | Amendment No. 7 dated March 20, 2002, to Loan and  Security Agreement by and between Sunrock Capital Corp. and the Company.(2)                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.65  |   | Unconditional Guaranty Agreement dated March 20,  2002, by the Company and Dao Heng Bank Limited.(2).                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.66  |   | Amendment No. 8 dated March 29, 2002, to Loan and  Security Agreement by and between Sunrock Capital Corp. and the Company.(2)                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.67  |   | Banking Facility Agreement by and between Standard  Chartered Bank and the Company dated April 29, 2002 (filed as Exhibit 10.5 to  the Company’s Form 10-Q for the period ending June 30, 2002), incorporated  herein by reference.                                |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.68  |   | Memorandum of Reborrowing of Principal by and  between the Company and MVII, LLC dated May 21, 2002  (filed as Exhibit 10.6 to the Company’s  Form 10-Q for the period ending June 30, 2002), incorporated herein by  reference.                              |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.69  |   | Amendment No. 9 dated June 12, 2002, to Loan and  Security Agreement by and between Sunrock Capital Corp. and the Company  (filed as Exhibit 10.7 to the Company’s Form 10-Q for the period ending June  30, 2002), incorporated herein by reference.              |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.70  |   | Amendment No. 10 dated August 14, 2002, to Loan and  Security Agreement by and between Sunrock Capital Corp. and the Company  (filed as Exhibit 10.8 to the Company’s Form 10-Q for the period ending  September 30, 2002), incorporated herein by reference).     |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.71  |   | Guarantee Agreement dated August 19, 2002, by and  between Standard Chartered Bank and the Company (filed as Exhibit 10.71 to  the Company’s Form 10-Q for the period ending September 30, 2002),  incorporated herein by reference).                              |
|   |   |                                                                                                                                                                                                                                                                    |
| 10.72* |   | Memorandum of Reborrowing of Principal by and  between the Company and MVII, LLC dated March 10, 2003.                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                    |
| 99.1   |   | DSI Toys, Inc. Audit Committee of the Board of  Directors, Charter, adopted by the Board of Directors on May 23, 2000 (filed  as Exhibit 99.1 to the Company’s Form 10-Q for the period ended June 30,  2000), incorporated herein by reference.                   |
|   |   |                                                                                                                                                                                                                                                                    |
| 99.2   |   | Amendment No. 1 to the Audit Committee of the Board  of Directors Charter, adopted by the Board of Directors on March 31, 2001  (filed as Exhibit 99.2 to the Company’s Form 10-K for the fiscal year ended  December 31, 2000), incorporated herein by reference. |

 

E-5

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| 99.3*  |   | Certification of the Chief Executive Officer  pursuant to Section 1350 of Chapter 63, Title 18 of the United States Code  for the fiscal year ending December 31, 2002. |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                    |
| 99.4*  |   | Certification of the Chief Financial Officer  pursuant to Section 1350 of Chapter 63, Title 18 of the United States Code  for the fiscal year ending December 31, 2002. |

 

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

 

(2)                                  Filedas the indicated numbered exhibit to the Company’s Form 10-K for the annualperiod ended December 31, 2001, and incorporated herein by reference.

 

(3)                                  Filedas the indicated numbered exhibit to the Company’s Form 10-K for the annual periodended January 31, 1999, and incorporated herein by reference.

 

(4)                                  Filedas the indicated numbered exhibit to the Company’s Form 10-Q for the quarterlyperiod ended April 30, 1999, and incorporated herein by reference.

 

(5)                                  Filedas the indicated numbered exhibit to the Company’s Form 10-Q for the quarterlyperiod ended July 31, 1999, and incorporated herein by reference.

 

*                                         Filedherewith

 

E-6

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