**SECURITIES
AND EXCHANGE COMMISSION**





**Washington,
D.C. 20549**





**Form
10-K**











[x]  Annual
Report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934
for the fiscal year ended


December
31, 2004.





[ ]  Transition
Report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934
for the transition period


from ____
to ____.





Commission
file number 0-22635





**RC2
Corporation**


(Exact
name of Registrant as Specified in Its Charter)





Delaware
      (State
      or Other Jurisdiction of Incorporation or Organization)
    36-4088307
      (IRS
      Employer Identification No.)1111
      West 22ndStreet, Suite 320, Oak Brook, Illinois
      (Address
      of principal executive offices)
    60523
      (Zip
      Code)Registrant’s
      telephone number, including area code:  630-573-7200Securities
      registered pursuant to Section 12(b) of the Exchange Act:
      Title
      of each class
      NA
    Name
      of each exchange on which registered
      NASecurities
      registered pursuant to Section 12(g) of the Exchange Act:Common
      Stock, Par Value $0.01 Per Share
      (Title
      of class)





Indicate
by check mark whether the Registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the Registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.  Yes X No __





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of Registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.   [  ]





Indicate
by check mark whether the Registrant is an accelerated filer (as defined in
Exchange Act Rule 12b-2). Yes X No  __





Aggregate
market value of the Registrant’s common stock held by non-affiliates as of June
30, 2004 (the last business day of the Registrant’s most recently completed
second quarter): $535,805,440. Shares of common stock held by any executive
officer or director of the Registrant and any person who beneficially owns 10%
or more of the outstanding common stock have been excluded from this computation
because such persons may be deemed to be affiliates. This determination of
affiliate status is not a conclusive determination for other
purposes.





Number of
shares of the Registrant’s common stock outstanding as of February 25,
2005:  20,480,886














DOCUMENTS
INCORPORATED BY REFERENCE





Portions
of the Proxy Statement for the 2005 Annual Meeting of the Stockholders of the
Registrant are incorporated by reference into Part III of this
report.





As used
in this report, the terms “we,” “us,” “our,” “RC2 Corporation” and the “Company”
mean RC2 Corporation and its subsidiaries, unless the context indicates another
meaning, and the term “common stock” means our common stock, par value $0.01 per
share.





Special
Note Regarding Forward-Looking Statements





Certain
statements contained in this report are considered “forward-looking statements”
within the meaning of the Private Securities Litigation Reform Act of 1995.
These statements may be identified by the use of forward-looking words or
phrases such as “anticipate,” “believe,” “could,” “expect,” “intend,” “may,”
“hope,” “plan,” “potential,” “should,” “estimate,” “predict,” “continue,”
“future,” “will,” “would” or the negative of these terms or other words of
similar meaning. Such forward-looking statements are inherently subject to known
and unknown risks and uncertainties. Our actual results and future developments
could differ materially from the results or developments expressed in, or
implied by, these forward-looking statements. Factors that may cause actual
results to differ materially from those contemplated by such forward-looking
statements include, but are not limited to, those described under the caption
“Risk Factors” in Item 1 of this report. We undertake no obligation to make any
revisions to the forward-looking statements contained in this filing or to
update them to reflect events or circumstances occurring after the date of this
filing.






**Part
I**





**Item
1. Business**





**Overview**





We are a
leading designer, producer and marketer of innovative, high-quality toys,
collectibles, hobby and infant care products that are targeted at consumers of
all ages. Our infant and preschool products are marketed under our Learning
Curve® family of brands which includes The First Years®, Eden® and Lamaze brands
as well as popular and classic licensed properties such as Thomas & Friends,
Bob the Builder, Winnie the Pooh, John Deere and Sesame Street. We market our
collectible and hobby products, including die-cast replicas, under a portfolio
of brands including Racing Champions®, Ertl®, Ertl Collectibles®, American
MuscleTM, Johnny Lightning®, AMT®, Polar Lights®, Press Pass®, JoyRide®, JoyRide
Studios®, Memory LaneTM, and W. Britain®. We reach our target consumers through
multiple channels of distribution supporting more than 25,000 retail outlets
throughout North America, Europe, Australia and Asia Pacific.





Our
die-cast replicas are produced in various sizes such as 1:9, 1:18, 1:24 and 1:64
scales. The “scale” measures the size of the product in proportion to the car,
truck, tractor or other item being replicated, and a larger scale results in a
smaller replica. For example, a 1:24 scale vehicle replica is approximately
eight inches long whereas a 1:64 scale vehicle replica is approximately three
inches long. For additional information regarding the process of die-casting,
see “Production - Die-Casting” on page 9.





**Business
Segments**





The
Company’s reportable segments are North America and International. The North
America segment includes the United States, Canada and Mexico. The International
segment includes non-North America markets. The discussion in this Form 10-K
applies to all segments except where otherwise stated. For additional
information on the Company’s segment reporting, including net sales, operating
income and assets, see Note 5 to our consolidated financial statements included
elsewhere herein.





2







Corporate History




We are a
Delaware corporation that was originally formed in April 1996 as a holding
company to combine the domestic operations of a privately held Illinois
corporation formed in 1989 and the operations of four affiliated foreign
corporations. We were originally named Collectible Champions, Inc. In 1997, we
changed our name to Racing Champions Corporation before our initial public
offering. In 2002, we changed our name to Racing Champions Ertl Corporation to
reflect our integration of the business of The Ertl Company, Inc. In 2003,
following our acquisition of Learning Curve International, Inc., we changed our
name to RC2 Corporation.





Since our
inception in 1989, we have capitalized on the popularity of themed collectibles
and toys. We became well-known in the early 1990s for our officially licensed
collectible die-cast replicas of popular race cars and subsequently expanded our
product offering to include other automotive die-cast replicas. These products
were primarily sold in the chain retailer channel under our Racing Champions
brand.





On April
30, 1996, an investor group led by Willis Stein & Partners, L.P. and some
members of our management consummated a recapitalization transaction in which
our foreign and domestic operations were combined. This transaction was
accounted for using the purchase method and provided us with a stronger platform
to manage our business more effectively.





Following
several years of strong growth, we completed an initial public offering in June
1997. In the offering, we sold approximately 5.4 million shares of common stock
and received net proceeds of $68.7 million. This offering provided us with
additional capital to grow our business through internal initiatives and
acquisitions.





In June
1998, we acquired Wheels Sports Group, Inc. (subsequently renamed RC2 South,
Inc.) for 2.7 million shares of our common stock. This transaction was accounted
for as a pooling of interests. The purchase of Wheels Sports Group built upon
our strength in the racing segment by expanding our product lines to include
collectible sports trading cards, apparel and souvenirs.





In April
1999, we acquired The Ertl Company, Inc. (Ertl) for approximately $94.6 million
in cash. This transaction was accounted for using the purchase method. Ertl is a
producer and marketer of collectibles and toys focused on agricultural and heavy
equipment die-cast vehicle replicas, classic and high performance die-cast
vehicle replicas, custom-imprint die-cast vehicle replicas, preschool toys,
collectible figures and hobby model kits.





On March
4, 2003, with an effective date of February 28, 2003, we acquired Learning Curve
International, Inc. (Learning Curve) and certain of its affiliates
(collectively, LCI) through a merger of a wholly owned subsidiary of RC2 with
and into Learning Curve for approximately $104.4 million in cash (excluding
transaction expenses) and 666,666 shares of our common stock, including $12
million in escrow to secure Learning Curve’s indemnification obligations under
the merger agreement. Additional consideration of up to $6.5 million was
contingent upon LCI product lines reaching certain sales and margin targets in
2003, but this contingent consideration was not payable because the targets were
not met. LCI develops and markets a variety of high-quality, award-winning
traditional children’s toys for every stage from birth through age eight. This
transaction was accounted for under the purchase method of accounting, and
accordingly, the operating results of LCI have been included in our consolidated
statements of earnings since the effective date of the acquisition. The purchase
was funded with a credit facility (see Note 7 to the consolidated financial
statements). The excess of the aggregate purchase price over the fair market
value of net assets acquired of approximately $39.8 million and $49.6 million
has been recorded as goodwill in the accompanying consolidated balance sheets as
of December 31, 2003 and 2004, respectively.








3





Twelve
million dollars of the purchase price for Learning Curve was originally
deposited in an escrow account to secure Learning Curve’s indemnification
obligations under the merger agreement. In the merger agreement, Learning Curve
agreed to indemnify the Company for losses relating to breaches of Learning
Curve’s representations, warranties and covenants in the merger agreement and
for specified liabilities relating to Learning Curve’s historical business. The
Company may make indemnification claims against the escrow account until the
later of March 31, 2005 or the 10 th day
following resolution of any tax audit or similar proceeding subject to potential
indemnification under the merger agreement. The amount in escrow was reduced to
$10 million in May 2003. During the quarter ended December 31, 2003, Learning
Curve settled litigation involving Playwood Toys, Inc. and the settlement amount
of $11.2 million was funded in part through a $10.1 million payment from the
escrow account, which constituted all of the funds then in the escrow account.
The Company was required to return a part of that amount to the escrow account
based on the tax benefits realized by the Company relating to the settlement
amount less other expenses relating to the litigation. On March 30, 2004, the
Company made additional escrow claims of $295,908 relating primarily to alleged
breaches of Learning Curve’s representations and warranties in the merger
agreement. On August 31, 2004, the Company increased its additional escrow
claims to $552,313. The Company and representatives of the former Learning Curve
shareholders entered into a letter agreement, dated December 14, 2004, which
resolved all of the Company’s pending escrow claims and required the Company to
return $2,825,424 to the escrow account which is available for future claims
under the terms of the escrow until the escrow account is closed. Learning Curve
is currently subject to a tax audit which is subject to potential
indemnification under the merger agreement, and as a result, the escrow account
will not close before the 10 th day
following the resolution of this tax audit. In February 2005, the Company
notified the representatives of the former Learning Curve shareholders of the
tax audit and an additional indemnification claim.





On June
7, 2004, we acquired substantially all the assets of Playing Mantis, Inc.
(Playing Mantis) with an effective date of June 1, 2004. Closing consideration
consisted of $17.0 million of cash (excluding transaction expenses) and 91,388
shares of the Company’s common stock. Additional cash consideration of up to
$4.0 million may be earned in the transaction by Playing Mantis based on
achieving net sales and margin targets for 2004 and net sales targets for 2005.
The contingent consideration for 2004 was not payable because the net sales and
margin targets were not met in 2004. Playing Mantis, which was based in
Mishawaka, Indiana prior to the acquisition, designs and markets collectible
vehicle replicas under the Johnny Lightning® and Polar Lights® brands and
collectible figures under the Memory LaneTM brand. Playing Mantis’ products are
primarily sold at mass merchandising, hobby, craft, drug and grocery chains.
This transaction has been accounted for under the purchase method of accounting
and, accordingly, the operating results of Playing Mantis have been included in
our consolidated statements of earnings since the effective date of the
acquisition. The excess of the aggregate purchase price over the fair market
value of net assets acquired of approximately $14.1 million has been recorded as
goodwill in the accompanying consolidated balance sheet at December 31,
2004.





On
September 15, 2004, the Company acquired The First Years Inc. (TFY) for
approximately $156.1 million in cash (excluding transaction expenses). TFY,
based in Avon, Massachusetts, is an international developer and marketer of
infant and toddler care and play products sold under The First Years® brand name
and under various licenses, including Disney's Winnie the Pooh. TFY’s products
are sold at toy, mass merchandising, drug and grocery chains, and at specialty
retailers. This transaction has been accounted for under the purchase method of
accounting and, accordingly, the operating results of TFY have been included in
the accompanying consolidated statements of earnings since the effective date of
the acquisition. The purchase was funded with the Company’s new credit facility
(See Note 7 to the consolidated financial statements). The excess of the
aggregate purchase price over the fair market value of net assets acquired of
approximately $97.6 million has been recorded as goodwill in the accompanying
consolidated balance sheet at December 31, 2004.








4





**Products**





With the
acquisitions of Playing Mantis and TFY, we have revised our product categories
to reflect our three product platforms: collectible products, children’s toys
and infant products. This presentation is consistent with how we view our
business. We provide a diverse offering of highly detailed, authentic replicas
and stylized toys and infant products known for their quality workmanship. Our
products currently retail from $0.96 to $599.99. We have successfully expanded
our product offering and, by offering a wide range of products at varying price
points, we believe our products appeal to a broad range of consumers. The
following chart summarizes our current product categories:





**Category**
    **Key
      Licenses**
    **Key
      Brands**
    **Price
      Range**Collectible
      Products
    Ford
      General
      Motors
      DaimlerChrysler
      NASCAR
      NHRA
      Discovery
      Channel
      Universal
      Studios
      John
      Deere
      Microsoft
    Racing
      Champions
      Ertl
      Collectibles
      American
      Muscle
      Johnny
      Lightning
      Memory
      Lane
      JoyRide
      Studios
      JoyRide
      Press
      Pass
    $0.99
      - $129.99Children’s
      Toys
    HIT
      Entertainment
      John
      Deere
    Thomas
      Wooden Railway
      Take
      Along Thomas
      Thomas
      Interactive Railway
      Bob
      the Builder Project: Build It
      Take
      Along Bob the Builder
      John
      Deere Kids
      Learning
      Curve
    $1.99
      - $599.99Infant
      Products
    Lamaze
      Disney
      Sesame
      Street
    Lamaze
      Infant Development System
      The
      First Years
      Learning
      Curve
    $0.96
      - $199.00




***Collectible
Products.*** Our
collectible products category consists of automotive, high performance and
racing vehicle replicas, agricultural, construction and outdoor sports vehicle
replicas, sports trading cards, apparel and souvenirs, and collectible figures.
Products in this category include:





·
    Racing
      Champions die-cast stock cars, trucks and team transporters representing a
      large number of the vehicles competing in the NASCAR Nextel Cup Series,
      NASCAR Busch Grand National Series and National Hot Rod Association (NHRA)
      Drag Racing Series;





·
    Ertl
      Collectibles die-cast custom imprint cars and trucks, various scales of
      delivery trucks and tractor trailers and vintage and modern tractors, farm
      implements and construction vehicles of major original equipment
      manufacturers (OEMs) such as John Deere and Case New
      Holland;





·
    Johnny
      Lightning and American Muscle collectible die-cast classic, high
      performance, entertainment-related and late model automobiles and
      trucks;





·
    Orange
      County Chopper/American Chopper die-cast collectible replicas of custom
      motorcycles;





·
    Memory
      Lane collectible figures, including figures from the Rudolph the Red-Nosed
      Reindeer television series; and





·
    JoyRide
      Studios collectible figures of characters from popular video
      games.




5





We market
our 1:64 th scale
die-cast replicas to consumers for purchase as either toys or collectibles. Our
larger scaled, highly detailed die-cast replicas are primarily targeted to adult
collectors. Collectors, by their nature, make multiple purchases of die-cast
replicas because of their affinity for classic, high performance and late model
cars, trucks, hot rods and tuners, vintage and modern tractors, farm implements,
construction vehicles and all-terrain vehicles. Tuners are cars that are
extensively modified by enthusiasts for performance and style.  These
collectors value the authenticity of these replicas and the enjoyment of
building their own unique collections. Our model kits are primarily
1:25 th scale
and are purchased by adult hobbyists who enjoy building and collecting a range
of models. We also produce die-cast replicas, sports trading cards, apparel and
souvenirs under licenses from a number of NASCAR and NHRA race teams.





In 2004,
we expanded our collectible products category with the acquisition of Playing
Mantis, the introduction of new product lines and the expansion of our existing
product lines. We acquired the Johnny Lightning die-cast vehicle product line
and the Memory Lane collectible figures product line with the acquisition of
Playing Mantis in June 2004. We also introduced die-cast collectible replicas
from Orange County Choppers as seen on the popular television series American
Chopper. Under the JoyRide Studios product line, we introduced an all new series
of authentic, detailed action figures to coincide with the introduction of the
Xbox video game, Halo 2. Additionally, we expanded our existing product lines
with approximately 240 new product releases during 2004.





In 2005,
we will expand our Johnny Lightning and JoyRide vehicle replica product lines.
For the first time, a series of 1:24 th scale
collectible vehicles will be introduced under the Johnny Lightning product line.
These vehicles will feature die-cast bodies and chassis with opening hoods,
factory paint schemes and customized details. We will also introduce die-cast
replicas under the JoyRide collectible vehicle brand, including replicas of
vehicles seen on the American Hot Rod television series, in RIDES Magazine and
at Formula D drifting events. Formula D drifting events showcase vehicles that
have the ability to drive sideways at high speeds and at extreme angels without
losing control. Additionally, we will introduce die-cast replicas of the Dukes
of Hazzard and Disney’s Herbie The Love Bug vehicles, as well as model kits of
the Star Wars vehicles, in conjunction with the related movie releases in
2005.





***Children’s
Toys.*** This
category includes product lines that are marketed to parents and grandparents of
pre-school age children and infants. Products in this category
include:





·
    Thomas
      Wooden Railway, Take Along Thomas and Thomas Interactive Learning Railway,
      wooden and die-cast engines, vehicles, destinations and playsets marketed
      under our Learning Curve brand; and





·
    John
      Deere farm, construction, ride-on and role-play activity
    toys.





In 2004,
we introduced Thomas Interactive Learning Railway, which challenges children
with different tasks and, upon completion of each task, rewards the child with a
positive message. The Thomas Wooden Railway product line introduced Sights and
Sounds Destinations, which includes interactive and multi-sensory features.
Additionally, new episodes of the Thomas & Friends television series
returned to PBS in the fall of 2004. The John Deere product lines were also
expanded during 2004. The John Deere Full Throttle vehicle line was introduced
and includes a full line of die-cast farming and construction concept machines.
These concept machines are agricultural or construction highly-stylized fantasy
vehicles.





In 2005,
we will launch the Bob the Builder product line marketed under our Learning
Curve brand. The Bob the Builder product line pairs classic construction play
with all new and existing characters and will be offered for sale at retailers
worldwide. The debut of this product line coincides with new episodes of the Bob
the Builder television series which are scheduled to air on PBS and on other
networks around the world in 2005. Additionally, under the John Deere product
lines, we will introduce play sets that will extend the farm play experience, as
well as a battery-powered John Deere Buck ATV. We will also introduce two new
Thomas ride-ons, one foot-to-floor version and one battery-powered
version.





***Infant
Products.*** This
category includes a wide range of infant products including products related to
feeding, care/safety and play. Products in this category include:





·
    Lamaze
      Infant Development System, developmental infant toys geared toward three
      different stages of infant development marketed under our Learning Curve
      brand;





·
    Lamaze
      Play and Grow, developmental infant toys geared towards all ages;
      and





·
    The
      First Years, a full line of feeding, care/safety and play products for
      infants.




6





Upon the
acquisition of TFY in September 2004, we expanded our branded product lines
within the infant products category. The First Years product line offers a wide
range of infant products, including feeding, care/safety and play products sold
under The First Years brand and under various licenses, including Disney's
Winnie the Pooh. Additionally during 2004, we introduced the Grow with Baby
Collection under the Lamaze Infant Development System product line. Each Grow
with Baby product provides developmental features for each of the three stages
of infant development.





In 2005,
we will expand the Lamaze Play and Grow line, as well as incorporate new
features, such as lights and sounds, into some Lamaze products. Under The First
Years brand, we will introduce a full line of Finding Nemo bath accessories, as
well as Sesame Street Beginnings feeding and teething products which feature the
Sesame Street baby characters. We are planning to introduce the Designer Baby
product line which will be sold at selected retailers. The Designer Baby product
line will include infant toys which will coordinate with infant nursery products
that are designed for these selected retailers.





**Licenses**





We market
a significant portion of our products with licenses from other parties. We have
license agreements with automotive and truck manufacturers; agricultural,
construction and outdoor sports vehicle and equipment manufacturers; major race
sanctioning bodies; race team owners, sponsors and drivers; and entertainment,
publishing and media companies. A significant element of our strategy depends on
our ability to identify and obtain licenses for recognizable and respected
brands and properties. Our licenses reinforce our brands and establish our
products’ authenticity, credibility and quality with consumers, and in some
cases, provide for new product development opportunities and expand distribution
channels. Our licenses are generally limited in scope and duration and authorize
the sale of specific licensed products on a nonexclusive basis. As of December
31, 2004, approximately 60% of our licenses required us to make minimum
guaranteed royalty payments whether or not we meet specific sales targets. These
minimum guarantees over the term of the license range up to $6.1 million. Total
minimum guarantee expense in 2004 was $14.2 million. This expense includes
actual amounts earned under the minimum guarantee, as well as expense related to
the Playing Mantis and TFY acquisitions in 2004. We have over 700 license
agreements, with terms generally of one to three years.





We do not
expect renewal of our licenses with Hendrick Motorsports for racing vehicle
replicas, apparel and souvenirs for its NASCAR Nextel Cup drivers, including
Jimmie Johnson. These licenses expire during 2005. In 2005, we expect that our
net sales related to these expiring licenses with Hendrick Motorsports will be
approximately $1.7 million.





**Channels
of Distribution**





Our
products are available through more than 25,000 retail outlets located in North
America, Europe, Australia and Asia Pacific. We market our products through
multiple channels of distribution in order to maximize our sales opportunities
for our broad product offering. Products with lower price points are generally
sold in chain retailer channels while products with more detailed features and
higher prices are typically sold in hobby, collector and independent toy stores
and through wholesalers and OEM dealers. We believe we have a leading position
in multiple distribution channels and that this position enhances our ability to
secure additional licenses, extends the reach of our products to consumers and
mitigates the risk of concentration by channel or customer.





***Chain
Retailers.*** Our
products marketed through this channel are targeted predominately at price
conscious end-users. As a result, the majority of our products marketed through
this channel are designed to span lower price points and generally retail for
less than $30. Customers included in this channel have more than 10 retail
locations and can include a wide range of retailers such as book, farm and
ranch, automotive and craft/hobby stores, as well as the national discount
retailers. Key customers in our chain retailer channel include Wal-Mart, Target,
Toys “R” Us/Babies “R” Us, Tractor Supply Company, Kmart and Michaels Stores,
Inc. Sales in 2004 to chain retailers were 52.3% of our total net
sales.





***Specialty
and Hobby Wholesalers and Retailers.*** We sell
many of the products available at chain retailers as well as higher priced
products with special features to specialty and hobby wholesalers and retailers
which comprised 30.6% of our net sales in 2004. We reach these customers
directly through our internal telesales group and business-to-business website
located at www.myRC2.com and through specialty toy representatives and
collectible and toy trade shows. Key customers in our specialty and hobby
wholesaler and retailer channel include Learning Express, Great Planes Model
Manufacturing Company, Excell Marketing, L.C., Beckett & Associates and
Master Toy & Novelties, Inc.




7





***OEM
Dealers.*** We often
sell licensed products to the licensing OEM’s dealer network. OEM licensing
partners benefit from our OEM dealer sales through the opportunity to receive
royalties from additional product sales through the OEM’s dealer network. We
often provide OEM dealers with a short-term exclusivity period where the OEM
dealers have the opportunity to purchase new products for a short period
(generally 90 to 360 days) before the products become available through other
distribution channels. Key customers in our OEM dealer channel include John
Deere, Case New Holland and Polaris. Sales in 2004 to OEM dealers were 9.9% of
our net sales.





***Corporate
Promotional Accounts.*** We
believe we have the top position in North America in the die-cast vehicle
corporate promotional channel. Corporate promotional products allow a company to
promote its products, reinforce its brands and reward employees and customers.
In this channel, we can cost-effectively accommodate both large-unit orders and
lower-unit orders due to our extensive tooling library, our flexible, dedicated
suppliers and the nature of our operations. This gives us a competitive
advantage over our larger competitors because it allows our product sourcing to
be flexible enough to accommodate small production runs. Key customers in our
corporate promotional channel include Matco Tools and Texaco. Corporate
promotional accounts comprised 4.8% of our net sales in 2004.





***Direct
to Consumers.*** In 2004,
we made certain products available for direct sales to consumers through
track-side event sales concessions, company stores, a business-to-consumer
website located at www.diecastexpress.com and a strategic alliance with the
Bradford Exchange Group, a top direct marketing company. In 2005, we have
discontinued our trackside distribution. Individual products sold directly to
consumers sell at prices similar to those found at retailers, hobby stores and
dealers and constituted 2.4% of our net sales in 2004.





**Trademarks**





We have
registered several trademarks with the U.S. Patent and Trademark Office,
including the trademarks Racing Champions®, Ertl®, Press Pass®, Learning Curve®,
Johnny Lightning®, Polar Lights® and The First Years®. A number of these
trademarks are also registered in foreign countries. We believe our trademarks
hold significant value, and we plan to build additional value through increased
consumer awareness of our many other trade names and trademarks.





**Sales
and Marketing**





Our sales
organization consists of an internal sales force and external sales
representative organizations. Our internal sales force provides direct customer
contact with nearly all of our retail chain and key wholesale accounts. A number
of accounts are designated as “house accounts” and are handled exclusively by
our internal sales staff. Our inside sales and customer service groups use
telephone calls, mailings, faxes and e-mails to directly contact OEM dealers and
smaller volume customers such as collector, hobby, specialty and independent toy
stores.





Our
internal sales force is supplemented by external sales representative
organizations. These external sales representative organizations provide more
frequent customer contact and solicitation of the national, regional and
specialty retailers and supported 30.7% of our net sales in 2004. External sales
representatives generally earn commissions of 1% to 15% of the net sales price
from their accounts. Their commissions are unaffected by the involvement of our
internal sales force with a customer or sale.





At the
end of 2003, we re-launched our business-to-business website under a new name,
www.myRC2.com. This website, targeted at smaller volume accounts, allows
qualified customers to view new product offerings, place orders, check open
order shipping status and review past orders. We believe that www.myRC2.com
leverages our internal sales force, inside sales group and customer service
group by providing customers with greater information access and more convenient
ordering capability.





Our
marketing programs are directed toward adult collectors and children, current
customers and potential new customers that fit the demographic profile of our
target market. Our objectives include increasing awareness of our product
offerings and brand names, as well as executing consumer promotions. We utilize
the following media vehicles in our marketing plans.





·
    *Advertising.*We
      place print advertisements in publications with high circulation and
      targeted penetration in key vertical categories such as parenting, gift,
      hobby, die-cast, NASCAR, trading cards and action figures. We run
      commercials on a selective basis on cable television programs that target
      key consumers.





·
    *Public
      Relations.*We
      have developed a sustained trade and consumer public relations effort to
      build relationships with editors at publications targeted across all of
      our product lines. Ongoing press releases keep editors abreast of new
      product introductions, increase our credibility and market acceptance, and
      encourage the editorial staffs of these publications to give more coverage
      to our products.





8




·
    *Co-op
      Advertising.*We
      work closely with retail chains to plan and execute ongoing
      retailer-driven promotions and advertising. The programs usually involve
      promotion of our products in retail customers’ print circulars, mailings
      and catalogs, and sometimes include placing our products in high-traffic
      locations within retail stores.





·
    *Internet.*The Internet is an increasingly important part of our marketing plan
      because collectors have quickly adopted the Internet as a preferred way to
      communicate with other enthusiasts about their hobby. Our website,
      www.rc2corp.com, highlights our products, lists product release dates and
      collects market data directly from consumers. We also gather consumer
      information through consumer letters, e-mail, telephone calls, product
      surveys and focus groups.





**Competition**





We
compete with several large domestic and foreign companies, such as Mattel, Inc.
and Hasbro, Inc., with private label products sold by many of our retail
customers and with other producers of collectibles, toys and infant products.
Competition in the distribution of our products is intense, and the principal
methods of competition consist of product appeal, ability to capture shelf or
rack space, timely distribution, price and quality. Competition is also based on
the ability to obtain license agreements for existing and new products to be
sold through specific distribution channels or retail outlets. We believe that
our competitive strengths include our knowledge of the markets we serve, our
ability to bring products to market rapidly and efficiently, our dedicated and
integrated suppliers, our multiple channels of distribution, our well-known
brands supported by respected licenses, our diversified product categories and
our established and loyal customer base. Many of our competitors have longer
operating histories, greater brand recognition and greater financial, technical,
marketing and other resources than we have.





**Production**





We
believe we are an industry leader in bringing new products to market rapidly and
efficiently. Our integrated design and engineering expertise, extensive library
of product designs, molds and tools and dedicated suppliers enable us to be
first to market with many innovative products.





*Far
East Product Sourcing.* We have
operations in Kowloon, Hong Kong and in the RC2 Industrial Zone in Dongguan
City, China and employ 184 people in Hong Kong and China who oversee the
sourcing of the majority of our products. This group assists our suppliers in
sourcing raw materials and packaging, performs engineering and graphic art
functions, executes the production schedule, provides on-site quality control,
facilities third-party safety testing and coordinates the delivery of shipments
for export from China.





*Far
East Production.* All of
our products are manufactured in China, except for certain plastic ride-ons,
certain infant products, sports trading cards and certain apparel and souvenirs.
Our China-based product sourcing accounted for approximately 84.1% of our total
product purchases in 2004. We primarily use six third-party, dedicated suppliers
who manufacture only our products in eight factories, four of which are located
in the RC2 Industrial Zone. The RC2 Industrial Zone is the name of a factory
complex developed in 1997 and located in Dongguan City, China (approximately 50
miles from Hong Kong) where four of our third-party, dedicated suppliers operate
freestanding factory facilities. These six third-party, dedicated suppliers
produced approximately 59.6% of our China-based product purchases in 2004. In
order to supplement our third-party, dedicated suppliers, we use approximately
fifteen other suppliers in China. All products are manufactured to our
specifications using molds and tooling that we own. These suppliers own the
manufacturing equipment and machinery, purchase raw materials, hire workers and
plan production. We purchase fully assembled and packaged finished goods in
master cartons for distribution to our customers. Most of our suppliers have
been supplying us for more than five years. We use only purchase orders and not
long-term contracts with our foreign suppliers.





*Die-Casting.* All of
our die-cast products are manufactured in China. Die-casting for our products
involves the use of custom molds to shape melted zinc alloy into our die-cast
products. Our suppliers purchase zinc alloy and conduct the die-cast
manufacturing process at their facilities.




9





*Domestic
Production.* The
production of certain plastic ride-ons, certain infant products, sports trading
cards and certain apparel and souvenirs is completed primarily by U.S.-based
suppliers. We create the product design and specifications and coordinate the
manufacturing activities. We generally prefer to coordinate the production of
these products through a limited number of suppliers and believe that a number
of alternate suppliers are available.





*Tooling.* To
create new products, we continuously invest in new tooling. These tooling
expenditures represent the majority of our capital expenditures. Depending on
the size and complexity of the product, the cost of tooling a product generally
ranges from $3,000 to $250,000. For many of our products, we eliminate
significant tooling time by utilizing our extensive tooling library of more than
25,000 tools. We own all of our tools and provide them to our suppliers during
production. Tools are returned to us when a product is no longer in production
and are stored for future use.





*Product
Safety.* Our
products are designed, manufactured, packaged and labeled to conform with
all safety requirements under U.S. federal and other applicable laws and
regulations, industry developed voluntary standards and product specific
standards, and are periodically reviewed and approved by independent safety
testing laboratories. We carry product liability insurance coverage with a
limit of over $50 million per occurrence.





*Logistics.* Our
customers purchase our products either in the United States, United Kingdom,
Australia, Canada or Germany or directly from China. We own distribution
facilities in Dyersville, Iowa and Avon, Massachusetts, lease distribution
facilities in Bolingbrook and Rochelle, Illinois, Mishawaka, Indiana, and
Australia, and use independent warehouses in California, Canada, the United
Kingdom and Germany.





**Seasonality**





We have
experienced, and expect to continue to experience, substantial fluctuations in
our quarterly net sales and operating results, which is typical of many
companies in our industry. Our business is highly seasonal due to high consumer
demand for our products during the year-end holiday season. Approximately 63.4%
of our net sales for the three years ended December 31, 2004, were generated in
the second half of the year, with September, October and November being the
largest shipping months. As a result, consistent with industry practices, our
investment in working capital, mainly inventory and accounts receivable, is
highest during the third and fourth quarters and lowest during the first
quarter.





**Customers**





We derive
a significant portion of our sales from some of the world’s largest retailers
and OEM dealers. Our top five customers accounted for 35.3%, 38.0% and 37.9% of
total net sales in 2002, 2003 and 2004, respectively. Toys “R” Us/Babies “R” Us,
our largest customer, accounted for 10.5% of total net sales in 2004. Other than
Toys “R” Us/Babies “R” Us, no customer accounted for more than 10% of our total
net sales in 2004. Other than Wal-Mart, no customer accounted for more than 10%
of our total net sales in 2003. Other than the John Deere dealer network and
Wal-Mart, no customer accounted for more than 10% of total net sales in 2002.
Many of our retail customers generally purchase large quantities of our products
on credit, which may cause a concentration of accounts receivable among some of
our largest customers.





**Employees**





As of
December 31, 2004, we had 742 employees, 41 of whom were employed part-time. We
emphasize the recruiting and training of high-quality personnel, and to the
extent possible, promote people from within RC2 Corporation. A collective
bargaining agreement covers 75 of our employees, all of whom work in the
distribution facility in Dyersville, Iowa. We consider our employee relations to
be good. Our continued success will depend, in part, on our ability to attract,
train and retain qualified personnel at all of our locations.





**Available
Information**





We
maintain our corporate website at www.rc2corp.com and we make available, free of
charge, through this website our annual report on Form 10-K, quarterly reports
on Form 10-Q, current reports on Form 8-K, and amendments to those reports that
we file with or furnish to the Securities and Exchange Commission (the
Commission), as soon as reasonably practicable after we electronically file such
material with, or furnish it to, the Commission. Information on our website is
not part of this report. This report includes all material information about the
Company that is included on the Company’s website and is otherwise required to
be included in this report.




10





**Risk
Factors**





The risks
described below are not the only risks we face. Additional risks that we do not
yet know of or that we currently think are immaterial may also impair our
business operations. If any of the events or circumstances described in the
following risks actually occur, our business, financial condition or results of
operations could be materially adversely affected. In such cases, the trading
price of our common stock could decline.





**Our
net sales and profitability depend on our ability to continue to conceive,
design and market products that appeal to consumers.**





The
introduction of new products is critical in our industry and to our growth
strategy. Our business depends on our ability to continue to conceive, design
and market new products and upon continuing market acceptance of our product
offering. Rapidly changing consumer preferences and trends make it difficult to
predict how long consumer demand for our existing products will continue or what
new products will be successful. Our current products may not continue to be
popular or new products that we introduce may not achieve adequate consumer
acceptance for us to recover development, manufacturing, marketing and other
costs. A decline in consumer demand for our products, our failure to develop new
products on a timely basis in anticipation of changing consumer preferences or
the failure of our new products to achieve and sustain consumer acceptance could
reduce our net sales and profitability.





**Competition
for licenses could increase our licensing costs or limit our ability to market
products.**





We market
a significant portion of our products with licenses from other parties. These
licenses are generally limited in scope and duration and generally authorize the
sale of specific licensed products on a nonexclusive basis. Our license
agreements often require us to make minimum guaranteed royalty payments that may
exceed the amount we are able to generate from actual sales of the licensed
products. Any termination of or failure to renew our significant licenses, or
inability to develop and enter into new licenses, could limit our ability to
market our products or develop new products and reduce our net sales and
profitability. For example, we do not expect renewal of our licenses with
Hendrick Motorsports for racing vehicle replicas, apparel and souvenirs for its
NASCAR Nextel Cup drivers, including Jimmie Johnson. These licenses expire
during 2005. Competition for licenses could require us to pay licensors higher
royalties and higher minimum guaranteed payments in order to obtain or retain
attractive licenses, which could increase our expenses. In addition, licenses
granted to other parties, whether or not exclusive, could limit our ability to
market products, including products we currently market, which could cause our
net sales and profitability to decline.





**Competition
in our markets could reduce our net sales and
profitability.**





We
operate in highly competitive markets. We compete with several large domestic
and foreign companies such as Mattel, Inc. and Hasbro, Inc., with private label
products sold by many of our retail customers and with other producers of
collectibles, toys and infant products. Many of our competitors have longer
operating histories, greater brand recognition and greater financial, technical,
marketing and other resources than we have. In addition, we may face competition
from new participants in our markets because the collectible, toy and infant
product industries have limited barriers to entry. We experience price
competition for our products, competition for shelf space at retailers and
competition for licenses, all of which may increase in the future. If we cannot
compete successfully in the future, our net sales and profitability will likely
decline.





11





**We
may experience difficulties in integrating strategic
acquisitions.**





As part
of our growth strategy, we intend to pursue acquisitions that are consistent
with our mission and enable us to leverage our competitive strengths. We
acquired Learning Curve International, Inc. effective February 28, 2003, Playing
Mantis, Inc. effective June 1, 2004 and The First Years Inc. effective September
15, 2004. The integration of acquired companies and their operations into our
operations involves a number of risks including:





·
    the
      acquired business may experience losses which could adversely affect our
      profitability;





·
    unanticipated
      costs relating to the integration of acquired businesses may increase our
      expenses;





·
    possible
      failure to obtain any necessary consents to the transfer of licenses or
      other agreements of the acquired company;





·
    possible
      failure to maintain customer, licensor and other relationships after the
      closing of the transaction of the acquired
company;





·
    difficulties
      in achieving planned cost-savings and synergies may increase our expenses
      or decrease our net sales;





·
    diversion
      of management’s attention could impair their ability to effectively manage
      our business operations; and





·
    unanticipated
      management or operational problems or liabilities may adversely affect our
      profitability and financial condition.





Additionally,
to finance our strategic acquisitions, we have borrowed funds under our credit
facility and we may borrow additional funds to complete future acquisitions.
This debt leverage could adversely affect our profit margins and limit our
ability to capitalize on future business opportunities. A portion of this debt
is also subject to fluctuations in interest rates.





**Management
has not yet evaluated the internal control over financial reporting of TFY and
its subsequent evaluation of such internal control may find material weaknesses
that may affect the Company’s financial reporting with respect to TFY for the
year ended December 31, 2004.**





In
reliance on guidance from the Commission, management’s evaluation of the
Company’s internal control over financial reporting as of December 31, 2004 in
Item 9A of this report did not include TFY, a material business acquired by the
Company on September 15, 2004. Although effective January 1, 2005, TFY’s
internal controls were fully integrated with the Company’s internal control
framework, management has not yet conducted any testing of TFY’s internal
controls. In connection with management’s evaluation of internal control over
financial reporting as of December 31, 2005, testing of the effectiveness of
TFY’s internal controls will occur which may find material weaknesses or
significant deficiencies that may affect the Company’s financial reporting with
respect to TFY for the year ended December 31, 2004. The Company cannot make any
assurance as to the effectiveness of TFY’s internal controls as of December 31,
2004.





**We
depend on the continuing willingness of chain retailers to purchase and provide
shelf space for our products.**





In 2004,
we sold 52.3% of our products to chain retailers. Our success depends upon the
continuing willingness of these retailers to purchase and provide shelf space
for our products. We do not have long-term contracts with our customers. In
addition, our access to shelf space at retailers may be reduced by store
closings, consolidation among these retailers and competition from other
products. An adverse change in our relationship with or the financial viability
of one or more of our customers could reduce our net sales and
profitability.





**We
may not be able to collect outstanding accounts receivable from our major retail
customers.**





Many of
our retail customers generally purchase large quantities of our products on
credit, which may cause a concentration of accounts receivable among some of our
largest customers. Our profitability may be harmed if one or more of our largest
customers were unable or unwilling to pay these accounts receivable when due or
demand credits or other concessions for products they are unable to sell. We
only maintain credit insurance for some of our major customers and the amount of
this insurance generally does not cover the total amount of the accounts
receivable. At December 31, 2003 and 2004, our credit insurance covered
approximately 10.6% and 8.4%, respectively, of our total gross accounts
receivable. Insurance coverage for future sales is subject to reduction or
cancellation.





12





**We
rely on a limited number of foreign suppliers in China to manufacture a majority
of our products.**





We rely
on six third-party, dedicated suppliers in China to manufacture a majority of
our products in eight factories, four of which are located in close proximity to
each other in the RC2 Industrial Zone manufacturing complex in China. Our
China-based product sourcing accounted for approximately 84.1% of our total
product purchases in 2004. The six third-party, dedicated suppliers who
manufacture only our products accounted for approximately 59.6% of our
China-based product purchases in 2004. We have only purchase orders, not
long-term contracts with our foreign suppliers. Because we rely on these
suppliers for flexible production and have integrated these suppliers with our
development and engineering teams, if these suppliers do not continue to
manufacture our products exclusively, our product sourcing would be adversely
affected. Difficulties encountered by these suppliers such as a fire, accident,
natural disaster or an outbreak of severe acute respiratory syndrome (SARS) at
one or more of their facilities, could halt or disrupt production at the
affected facilities, delay the completion of orders, cause the cancellation of
orders, delay the introduction of new products or cause us to miss a selling
season applicable to some of our products. Any of these risks could increase our
expenses or reduce our net sales.





**Increases
in the cost of the raw materials used to manufacture our products could increase
our cost of sales and reduce our gross margins.**





Since our
products are manufactured by third-party suppliers, we do not directly purchase
the raw materials used to manufacture our products. However, the prices we pay
our suppliers may increase if their raw materials, labor or other costs
increase. We may not be able to pass along such price increases to our
customers. As a result, increases in the cost of raw materials, labor or other
costs associated with the manufacturing of our products could increase our cost
of sales and reduce our gross margins.





**Currency
exchange rate fluctuations could increase our expenses.**





Our net
sales are primarily denominated in U.S. dollars, except for a small amount of
net sales denominated in U.K. pounds, Australian dollars, Euros or Canadian
dollars. Our purchases of finished goods from Chinese manufacturers are
denominated in Hong Kong dollars. Expenses for these manufacturers are
denominated in Chinese Renminbi. As a result, any material increase in the value
of the Hong Kong dollar or the Renminbi relative to the U.S. dollar or the U.K.
pound would increase our expenses and therefore could adversely affect our
profitability. We are also subject to exchange rate risk relating to transfers
of funds denominated in U.K. pounds, Australian dollars, Canadian dollars or
Euros from our foreign subsidiaries to the United States. Historically, we have
not hedged our foreign currency risk.





**Because
we rely on foreign suppliers and we sell products in foreign markets, we are
susceptible to numerous international business risks that could increase our
costs or disrupt the supply of our products.**





Our
international operations subject us to the risks including:





·
    economic
      and political instability;





·
    restrictive
      actions by foreign governments;





·
    greater
      difficulty enforcing intellectual property rights and weaker laws
      protecting intellectual property rights;





·
    changes
      in import duties or import or export
restrictions;





·
    timely
      shipping of product and unloading of product through West Coast ports, as
      well as timely rail/truck delivery to the Company’s warehouse and/or a
      customer’s warehouse;





·
    complications
      in complying with the laws and policies of the United States affecting the
      importation of goods, including duties, quotas and taxes;
    and





·
    complications
      in complying with trade and foreign tax
laws.





Any of
these risks could disrupt the supply of our products or increase our expenses.
The costs of compliance with trade and foreign tax laws increases our expenses
and actual or alleged violations of such laws could result in enforcement
actions or financial penalties that could result in substantial
costs.





13





**Product
liability, product recalls and other claims relating to the use of our products
could increase our costs.**





Because
we sell collectibles, toys and infant products to consumers, we face product
liability risks relating to the use of our products. We also must comply with a
variety of product safety and product testing regulations. If we fail to comply
with these regulations or if we face product liability claims, we may be subject
to damage awards or settlement costs that exceed our insurance coverage and we
may incur significant costs in complying with recall requirements. In addition,
substantially all of our licenses give the licensor the right to terminate if
any products marketed under the license are subject to a product liability
claim, recall or similar violations of product safety regulations or if we
breach covenants relating to the safety of the products or their compliance with
product safety regulations. A termination of a license could adversely affect
our net sales. Even if a product liability claim is without merit, the claim
could harm our reputation and divert management’s attention and resources from
our business.





**Trademark
infringement or other intellectual property claims relating to our products
could increase our costs.**





Our
industry is characterized by frequent litigation regarding trademark and patent
infringement and other intellectual property rights. We are and have been a
defendant in trademark and patent infringement claims and claims of breach of
license from time to time, and we may continue to be subject to such claims in
the future. The defense of intellectual property litigation is both costly and
disruptive of the time and resources of our management even if the claim is
without merit. We also may be required to pay substantial damages or settlement
costs to resolve intellectual property litigation.





**Our
debt covenants may limit our ability to complete acquisitions, incur debt, make
investments, sell assets, merge or complete other significant
transactions.**





Our
credit agreement includes provisions that place limitations on a number of our
activities, including our ability to:





·
    incur
      additional debt;





·
    create
      liens on our assets or make guarantees;





·
    make
      certain investments or loans;





·
    pay
      dividends; or





·
    dispose
      of or sell assets or enter into a merger or similar
      transaction.





These
debt covenants could restrict our ability to pursue opportunities to expand our
business operations.





**Sales
of our products are seasonal, which causes our operating results to vary from
quarter to quarter.**





Sales of
our products are seasonal. Historically, our net sales and profitability have
peaked in the third and fourth quarters due to the holiday season buying
patterns. Seasonal variations in operating results may cause us to increase our
debt levels and interest expense in the second and third quarters and may tend
to depress our stock price during the first and second
quarters.





14





**The
trading price of our common stock has been volatile and investors in our common
stock may experience substantial losses.**





The
trading price of our common stock has been volatile and may continue to be
volatile in the future. The trading price of our common stock could decline or
fluctuate in response to a variety of factors, including:





·
    our
      failure to meet the performance estimates of securities
      analysts;





·
    changes
      in financial estimates of our net sales and operating results or buy/sell
      recommendations by securities analysts;





·
    the
      timing of announcements by us or our competitors concerning significant
      product developments, acquisitions or financial
    performance;





·
    fluctuation
      in our quarterly operating results;





·
    substantial
      sales of our common stock;





·
    general
      stock market conditions; or





·
    other
      economic or external factors.





You may
be unable to sell your stock at or above your purchase price.





**We
may face future securities class action lawsuits that could require us to pay
damages or settlement costs and otherwise harm our
business.**





A
securities class action lawsuit was filed against us in 2000 following a decline
in the trading price of our common stock from $17.00 per share on June 21, 1999
to $6.50 per share on June 28, 1999. We settled this lawsuit in 2002 with a $1.8
million payment, covered by insurance, after incurring legal costs of $1.0
million that were not covered by insurance. Future volatility in the price of
our common stock may result in additional securities class action lawsuits
against us, which may require that we pay substantial damages or settlement
costs in excess of our insurance coverage and incur substantial legal costs, and
which may divert management’s attention and resources from our
business.





**A
limited number of our shareholders can exert significant influence over
us.**





As of
February 25, 2005, our executive officers and directors collectively
beneficially owned 12.5% of the outstanding shares of our common stock. This
share ownership would permit these stockholders, if they chose to act together,
to exert significant influence over the outcome of stockholder votes, including
votes concerning the election of directors, by-law amendments, possible mergers,
corporate control contests and other significant corporate
transactions.





15





**Various
restrictions in our charter documents, Delaware law and our credit agreement
could prevent or delay a change in control of us which is not supported by our
board of directors.**





We are
subject to a number of provisions in our charter documents, Delaware law and our
credit agreement that may discourage, delay or prevent a merger, acquisition or
change of control that a stockholder may consider favorable. These anti-takeover
provisions include:





·
    advance
      notice procedures for nominations of candidates for election as directors
      and for stockholder proposals to be considered at stockholders’
      meetings;





·
    covenants
      in our credit agreement restricting mergers, asset sales and similar
      transactions and a provision in our credit agreement that triggers an
      event of default upon the acquisition by a person or group of persons of
      beneficial ownership of 33 1/3% or more of our outstanding common stock;
      and





·
    the
      Delaware anti-takeover statute contained in Section 203 of the Delaware
      General Corporation Law.





Section
203 of the Delaware General Corporation Law prohibits a merger, consolidation,
asset sale or other similar business combination between RC2 and any stockholder
of 15% or more of our voting stock for a period of three years after the
stockholder acquires 15% or more of our voting stock, unless (1) the transaction
is approved by our board of directors before the stockholder acquires 15% or
more of our voting stock, (2) upon completion of the transaction the stockholder
owns at least 85% of our voting stock outstanding at the commencement of the
transaction, or (3) the transaction is approved by our board of directors and
the holders of 66 2/3% of our voting stock excluding shares of our voting stock
owned by the stockholder.





16





**Item
2. Properties**





As of
December 31, 2004, our facilities were as follows:





**Description**
    **Square Feet**
    **Location**
    **Lease
      Expiration**Corporate
      headquarters
    27,050
    Oak
      Brook, IL
    April
      2013RC2
      Brands, Inc. warehouse (1)
    325,144
    Bolingbrook,
      IL
    August
      2011RC2
      Brands, Inc. warehouse
    400,000
    Rochelle,
      IL
    November
      2019RC2
      Brands, Inc. office (2)
    15,309
    Chicago,
      IL
    May
      2007RC2
      Brands, Inc. office and warehouse
    368,000
    Dyersville,
      IA
    OwnedRC2
      Brands, Inc. warehouse (3)
    166,000
    Dyersville,
      IA
    OwnedRC2
      Brands, Inc. office and warehouse (4)
    37,750
    Mishawaka,
      IN
    June
      2005RC2
      Brands, Inc. office and warehouse (5)
    127,000
    Avon,
      MA
    OwnedRC2
      Brands, Inc. office
    2,755
    Bentonville,
      AK
    October
      2005RC2
      Brands, Inc. office
    106
    Kansas
      City, MO
    May
      2007RC2
      Brands, Inc. office
    288
    Danbury,
      CT
    March
      2005RC2
      Brands, Inc. office (4)
    793
    Lake
      Forest, CA
    February
      2005RC2
      Brands, Inc. showroom
    9,240
    New
      York, NY
    April
      2009RC2
      Brands, Inc. office
    1,670
    New
      York, NY
    December
      2004RC2
      Brands, Inc. company store
    5,500
    Oak
      Brook Terrace, IL
    July
      2010RC2
      South, Inc. office
    6,864
    Charlotte,
      NC
    April
      2007Green’s
      Racing Souvenirs, Inc. office (6)
    814
    South
      Boston, VA
    Month-to-monthHong
      Kong office
    10,296
    Kowloon,
      Hong Kong
    July
      2006RC2
      Industrial Zone office, warehouse,
      quarters
      and storage
    99,186
    Dongguan
      City, China
    March
      2006Racing
      Champions International Limited office
    5,419
    Exeter,
      United Kingdom
    October
      2013Racing
      Champions International Limited office (4)
    1,269
    Glouscester,
      United Kingdom
    March
      2005Racing
      Champions International Limited showroom
    987
    Northhampton,
      United
      Kingdom
    December
      2005RC2
      Canada Corporation office
    2,220
    New
      Market, Ontario
    March
      2007RC2
      Canada Corporation warehouse (7)
    47,000
    Concord,
      Ontario
    May
      2010Learning
      Curve Deutschland GmbH office (8)
    2,067
    Mannheim,
      Germany
    March
      2005RC2
      Australia, Pty. Ltd. office and warehouse (9)
    22,000
    Springvale,
      Victoria, Australia
    November
      2006





(1)
    We
      expect to vacate our facility in Bolingbrook, IL by the end of the first
      quarter of 2005, as we occupied the Rochelle, IL warehouse beginning in
      December 2004. The Bolingbrook lease will be assumed by our Rochelle, IL
      lessor upon our vacating the facility.


(2)
    As
      of April 2004, the Chicago office is no longer being used in our
      operations. The space is currently being offered for
    sublease.


(3)
    38,000
      square feet of the Dyersville, IA warehouse has been sublet and is not
      being used in our operations.


(4)
    This
      facility is currently not being used in our operations. We will allow the
      lease to expire.


(5)
    The
      Avon, MA office and warehouse is being offered for sale. The office will
      be relocating to another facility when the sale is
    complete.


(6)
    As
      of November 30, 2004, the South Boston, VA office has been extended on a
      month-to-month basis.


(7)
    As
      of January 1, 2004, the Canadian warehouse was no longer being used in our
      operations and has been subsequently sublet. Canadian distribution is now
      fulfilled from the Dyersville, IA,
warehouse.


(8)
    In
      January 2005, we entered into a lease agreement for a 2,621 square foot
      office facility in Marsdof, Germany, and the Mannheim, Germany office was
      relocated to this facility at that time. We will allow the Mannheim,
      Germany lease to expire.


(9)
    We
      have entered into a lease agreement for a 49,127 square foot warehouse and
      office facility in Mount Waverly, Victoria, Australia which we occupied
      beginning in January 2005. At that time, we vacated our facility in
      Springvale, Victoria, Australia and the facility is being offered for
      sublease.





17





**Item
3. Legal Proceedings**





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





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





No
matters were submitted to a vote of security holders during the fourth quarter
of the fiscal year ended December 31, 2004.





**Part
II**








**Item
5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer
Purchases of Equity Securities**





Our
common stock trades on the Nasdaq National Market under the symbol “RCRC.” The
following table sets forth the high and low closing sales prices for our common
stock as reported by Nasdaq for the periods indicated.





**2003:**
    **High**
    **Low**First
      Quarter
    $15.63
    $10.99Second
      Quarter
    $18.70
    $14.64Third
      Quarter
    $20.32
    $15.26Fourth
      Quarter
    $22.43
    $19.64**2004:**
    **High**
    **Low**First
      Quarter
    $28.18
    $20.75Second
      Quarter
    $35.54
    $25.47Third
      Quarter
    $35.31
    $29.86Fourth
      Quarter
    $34.13
    $27.23





As of
December 31, 2004, there were approximately 140 holders of record of our common
stock. We believe the number of beneficial owners of our common stock on that
date was substantially greater.





We have
not paid any cash dividends on our common stock. We intend to retain any
earnings for use in operations, to repay indebtedness and for expansion of our
business, and therefore, do not anticipate paying any cash dividends in the
foreseeable future. Our credit agreement prohibits the Company from declaring or
paying any dividends on any class or series of our capital stock. This
prohibition will apply as long as any credit is available or outstanding under
the credit agreement that currently has a maturity date of September 14,
2008.








18





**Item
6. Selected Financial Data**





The
following table presents selected consolidated financial data, which should be
read along with our consolidated financial statements and the notes to those
statements and with “Item 7 - Management’s Discussion and Analysis of Financial
Condition and Results of Operations” on page 20. The consolidated statements of
earnings for the years ended December 31, 2002, 2003 and 2004, and the
consolidated balance sheet data as of December 31, 2003 and 2004, are derived
from our audited consolidated financial statements included elsewhere herein.
The consolidated statements of earnings for the years ended December 31, 2000
and 2001, and the consolidated balance sheet data as of December 31, 2000, 2001
and 2002, are derived from our audited consolidated financial statements which
are not included herein. Certain reclassifications provided in our accompanying
consolidated statements of earnings for 2001, 2002, 2003 and 2004 have not been
presented for the year ended December 31, 2000, as this information was not
available.





**Year
      Ended December 31,****2000**
    
    **2001**
    
    **2002**
    
    **2003**
    
    **2004****Consolidated
      Statements of Earnings:**
    
    (In
      thousands, except per share data)Net
      sales
    
    $
    214,806
    
    $
    204,661
    
    $
    214,925
    
    $
    310,946
    
    $
    381,425Cost
      of sales (1)
    
    
    116,328
    
    
    99,481
    
    
    102,763
    
    
    148,908
    
    
    193,497Gross
      profit
    
    
    98,478
    
    
    105,180
    
    
    112,162
    
    
    162,038
    
    
    187,928Selling,
      general and administrative
      expenses
      (1) (2)
    
    
    71,636
    
    
    69,266
    
    
    70,238
    
    
    104,467
    
    
    126,265Impairment
      of intangible assets
    
    
    —
    
    
    —
    
    
    —
    
    
    327
    
    
    4,318Amortization
      of goodwill and
      intangible
      assets
    
    
    3,795
    
    
    3,376
    
    
    —
    
    
    30
    
    
    94Operating
      income
    
    
    23,047
    
    
    32,538
    
    
    41,924
    
    
    57,214
    
    
    57,251Interest
      expense, net
    
    
    11,375
    
    
    6,470
    
    
    1,835
    
    
    3,477
    
    
    4,063Other
      (income) expense
    
    
    662
    
    
    277
    
    
    (603
    )
    
    (145
    )
    
    (508
    )Income
      before income taxes
    
    
    11,010
    
    
    25,791
    
    
    40,692
    
    
    53,882
    
    
    53,696Income
      tax expense
    
    
    5,120
    
    
    10,668
    
    
    15,947
    
    
    15,465
    
    
    19,718Net
      income
    
    $
    5,890
    
    $
    15,123
    
    $
    24,745
    
    $
    38,417
    
    $
    33,978Net
      income per share:Basic
    
    $
    0.40
    
    $
    1.03
    
    $
    1.55
    
    $
    2.25
    
    $
    1.82Diluted
    
    $
    0.39
    
    $
    1.00
    
    $
    1.47
    
    $
    2.12
    
    $
    1.72Weighted
      average shares outstanding:Basic
    
    
    14,827
    
    
    14,663
    
    
    15,981
    
    
    17,060
    
    
    18,687Diluted
    
    
    15,085
    
    
    15,159
    
    
    16,829
    
    
    18,105
    
    
    19,761**As
      of December 31,****2000**
    
    
    **2001**
    
    
    **2002**
    
    
    **2003**
    
    
    **2004****Consolidated
      Balance Sheet Data:**Working
      capital
    
    $
    38,955
    
    $
    26,392
    
    $
    49,540
    
    $
    70,471
    
    $
    112,931Total
      assets
    
    
    251,907
    
    
    235,523
    
    
    236,287
    
    
    381,829
    
    
    585,748Total
      debt
    
    
    97,000
    
    
    62,000
    
    
    8,000
    
    
    85,000
    
    
    131,250Total
      stockholders’ equity
    
    $
    104,196
    
    $
    118,099
    
    $
    170,881
    
    $
    225,299
    
    $
    346,762





(1)
    Depreciation
      expense was approximately $9.6 million, $9.2 million, $9.1 million, $12.0
      million and $15.3 million for the years ended December 31, 2000, 2001,
      2002, 2003 and 2004, respectively.


(2)
    Selling,
      general and administrative expenses for 2000 include a charge of $2.5
      million related to minimum guaranteed royalty payments on NASCAR-related
      licensing agreements, which exceeded royalties earned on product
      sales.





General
Note: Results for 2003 include the results of LCI from March 1, 2003. Results
for 2004 include the results of Playing Mantis from June 1, 2004 and TFY from
September 16, 2004. As these acquisitions were accounted for using the purchase
method, periods prior to the acquisition effective dates do not include any
results for LCI, Playing Mantis or TFY.




19





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





**Overview**





We are a
leading designer, producer and marketer of innovative, high-quality toys,
collectibles, hobby and infant care products that are targeted to consumers of
all ages. We reach our target consumers through multiple channels of
distribution supporting more than 25,000 retail outlets throughout North
America, Europe, Australia and Asia Pacific. Our product categories include (i)
collectible products; (ii) children’s toys; and (iii) infant products. We market
virtually all of our products under licenses from other parties, and we are
currently a party to over 700 license agreements.





***The
First Years Acquisition.*** On
September 15, 2004, we acquired The First Years Inc. (TFY). TFY is an
international developer and marketer of infant and toddler care and play
products sold under The First Years® brand name and under various licenses,
including Disney's Winnie the Pooh. This transaction has been accounted for
under the purchase method of accounting and, accordingly, the operating results
of TFY have been included in our consolidated statements of earnings since the
effective date of the acquisition.





***Playing
Mantis Acquisition.*** On June
7, 2004, we acquired substantially all the assets of Playing Mantis, Inc.
(Playing Mantis) with an effective date of June 1, 2004. Playing Mantis designs
and markets collectible vehicle replicas under the Johnny Lightning® and Polar
Lights® brands and collectible figures under the Memory LaneTM brand. This
transaction has been accounted for under the purchase method of accounting and,
accordingly, the operating results of Playing Mantis have been included in our
consolidated statements of earnings since the effective date of the
acquisition.





***Learning
Curve Acquisition.*** On March
4, 2003, with an effective date of February 28, 2003, we acquired Learning Curve
International, Inc. (Learning Curve) and certain of its affiliates
(collectively, LCI) through the merger of a wholly owned subsidiary of RC2 with
and into Learning Curve. LCI develops and markets a variety of high-quality,
award-winning children’s and infant toys for every stage of childhood from birth
through age eight. This transaction has been accounted for under the purchase
method of accounting and, accordingly, the operating results of LCI have been
included in our consolidated statements of earnings since the effective date of
the acquisition.





***Integration
Initiatives.*** During
2004, we focused on integrating our Playing Mantis and TFY acquisitions. As of
December 31, 2004, Playing Mantis was fully integrated. During 2005, we will
continue to focus our efforts on integrating TFY with numerous initiatives to
achieve synergies and cost savings, including payroll, systems development and
maintenance, corporate and administrative, and sales and marketing expenses. We
expect to realize over $10 million in cost savings in 2005 and we also expect
that the cumulative cost savings realized in the 24 months after the
acquisitions will approximate $13 to $15 million.





***Sales.*** Our
sales are primarily derived from the sale of collectible, toy and infant
products and are recognized upon transfer of title of product to our customers.
We market our products through a variety of distribution channels, including
chain retailers, specialty and hobby wholesalers and retailers, OEM dealers,
corporate promotional accounts and direct to consumers. For the years ended
December 31, 2002, 2003 and 2004, sales to chain retailers comprised 37.5%,
48.8% and 52.3%, respectively, of our net sales.





Our
products are marketed and distributed in North America, Europe, Australia and
Asia Pacific. International sales constituted 8.3%, 14.9% and 13.3% of our net
sales for the years ended December 31, 2002, 2003 and 2004, respectively. We
expect international sales to increase over the next several years as we expand
our geographic reach. Our net sales have not been materially impacted by foreign
currency fluctuations.





We derive
a significant portion of our sales from some of the world’s largest retailers
and OEM dealers. Our top five customers accounted for 35.3%, 38.0% and 37.9% of
our net sales in 2002, 2003 and 2004, respectively. Toys “R” Us/Babies “R” Us,
our largest customer, accounted for 10.5% of total net sales in 2004. Wal-Mart
accounted for 11.7% and 10.8% of total net sales in 2002 and 2003, respectively.
The John Deere dealer network accounted for 14.9% of total net sales in 2002.
Other than Wal-Mart and the John Deere dealer network, no customer accounted for
more than 10% of our total net sales in 2002. In 2003, other than Wal-Mart, no
customer accounted for more than 10% of our total net sales. In 2004, other than
Toys “R” Us/Babies “R” Us, no customer accounted for more than 10% of our total
net sales.




20





We
provide certain customers the option to take delivery of our products either in
the United States, United Kingdom, Australia, Canada or Germany with credit
terms generally ranging from 30 to 90 days or directly in China with payment
made by irrevocable letter of credit or wire transfer. We generally grant price
discounts of 15.0% to 25.0% on direct sales from China resulting in lower gross
margins. However, shipments direct from China lower our distribution and
administrative costs, so we believe that our operating income margin is
comparable for products delivered in China versus products shipped in the United
States, United Kingdom, Australia, Canada or Germany. For the years ended
December 31, 2002, 2003 and 2004, direct sales from China constituted 11.0%,
9.6% and 13.0%, respectively, of our net sales.





We do not
ordinarily sell our products on consignment, and we ordinarily accept returns
only for defective merchandise. In certain instances, where retailers are unable
to resell the quantity of products that they have purchased from us, we may, in
accordance with industry practice, assist retailers in selling such excess
inventory by offering credits and other price concessions, which are typically
evaluated and issued annually. Returns and allowances on an annual basis have
ranged from 3.0% to 5.2% of net sales over the last three years.





***Expenses.*** Our
products are manufactured by third-parties, principally located in China. Cost
of sales primarily consists of purchases of finished products, which accounted
for 80.1%, 80.4% and 84.1% of our cost of sales in 2002, 2003 and 2004,
respectively. The remainder of our cost of sales primarily includes tooling
depreciation, freight-in from suppliers and concept and design expenses.
Substantially all of our purchases of finished products from the Far East are
denominated in Hong Kong dollars, and therefore, subject to currency
fluctuations. Historically, we have not incurred substantial exposure due to
currency fluctuations because the Hong Kong government has maintained a policy
of linking the Hong Kong dollar and U.S. dollar since 1983. A future increase in
the value of the Hong Kong dollar relative to the U.S. dollar may increase our
cost of sales and decrease our gross margins.





Additionally,
if our suppliers experience increased raw materials, labor or other costs and
pass along such cost increases to us through higher prices for finished goods,
our cost of sales would increase, and to the extent we are unable to pass such
price increases along to our customers, our gross margins would
decrease.




Our
quarterly gross margins can also be affected by the mix of product that is
shipped during each quarter. While all of our product categories approximated a
similar gross margin prior to 2004, individual product lines within a category
carried gross margins that varied significantly and caused quarterly
fluctuations, based on the timing of individual shipments throughout the
year. Prior to 2004, our gross margins on an annual basis historically fell
within the general range of 51% to 53%. However, due to the 2004 acquisition of
TFY, which has higher sales of non-licensed products that carry lower selling
prices and gross margins than the Company has had historically, we anticipate
our annual gross margins will now fall in the range of 47% to 51%.


Selling,
general and administrative expenses primarily consist of royalties, employee
compensation, advertising and marketing expenses, freight-out to customers and
sales commissions. Royalties vary by product category and are generally paid on
a quarterly basis. Multiple royalties may be paid to various licensors on a
single product. In 2004, aggregate royalties by product ranged from
approximately 1% to 27% of our net sales price. Royalty expense was
approximately 8.7%, 8.5% and 8.4% of our net sales for the years ended December
31, 2002, 2003 and 2004, respectively. Sales commissions ranged from
approximately 1% to 15% of the net sales price and are paid quarterly to our
external sales representative organizations. Sales subject to commissions
represented 35.2%, 31.2% and 30.7% of our net sales for the years ended December
31, 2002, 2003 and 2004, respectively. Sales commission expense was 1.6% of our
net sales for the years ended December 31, 2002, 2003 and 2004.





***Seasonality.*** We have
experienced, and expect to continue to experience, substantial fluctuations in
our quarterly net sales and operating results, which is typical of many
companies in our industry. Our business is highly seasonal due to high customer
demand for our products during the year-end holiday season. Approximately, 63.4%
of our net sales for the three years ended December 31, 2004, were generated in
the second half of the year. As a result, our investment in working capital,
mainly inventory and accounts receivable, is generally highest during the third
and fourth quarters and lowest during the first quarter.





21





**Results
of Operations**





**Year
      Ended December 31,****2002**
    
    **2003**
    
    **2004****Amount**
    
    **Percent**
    
    **Amount**
    
    **Percent**
    
    **Amount**
    
    **Percent**(In
      thousands, except per share data)Net
      sales
    
    $
    214,925
    
    
    100.0
    %
    $
    310,946
    
    
    100.0
    %
    $
    381,425
    
    
    100.0
    %Cost
      of sales
    
    
    102,763
    
    
    47.8
    
    
    148,908
    
    
    47.9
    
    
    193,497
    
    
    50.7Gross
      profit
    
    
    112,162
    
    
    52.2
    
    
    162,038
    
    
    52.1
    
    
    187,928
    
    
    49.3Selling,
      general and
      administrative
      expenses
    
    
    70,238
    
    
    32.7
    
    
    104,467
    
    
    33.6
    
    
    126,265
    
    
    33.1Impairment
      of
      intangible
      assets
    
    
    —
    
    
    —
    
    
    327
    
    
    0.1
    
    
    4,318
    
    
    1.1Amortization
      of
      intangible
      assets
    
    
    —
    
    
    —
    
    
    30
    
    
    —
    
    
    94
    
    
    —Operating
      income
    
    
    41,924
    
    
    19.5
    
    
    57,214
    
    
    18.4
    
    
    57,251
    
    
    15.1Interest
      expense, net
    
    
    1,835
    
    
    0.9
    
    
    3,477
    
    
    1.1
    
    
    4,063
    
    
    1.1Other
      income
    
    
    (603
    )
    
    (0.3
    )
    
    (145
    )
    
    (0.1
    )
    
    (508
    )
    
    (0.1
    )Income
      before income
      taxes
    
    
    40,692
    
    
    18.9
    
    
    53,882
    
    
    17.4
    
    
    53,696
    
    
    14.1Income
      tax expense
    
    
    15,947
    
    
    7.4
    
    
    15,465
    
    
    5.0
    
    
    19,718
    
    
    5.2Net
      income
    
    $
    24,745
    
    
    11.5
    %
    $
    38,417
    
    
    12.4
    %
    $
    33,978
    
    
    8.9
    %Net
      income per share:Basic
    
    $
    1.55
    
    
    
    
    $
    2.25
    
    
    
    
    $
    1.82Diluted
    
    $
    1.47
    
    
    
    
    $
    2.12
    
    
    
    
    $
    1.72Weighted
      average shares
      outstanding:Basic
    
    
    15,981
    
    
    
    
    
    17,060
    
    
    
    
    
    18,687Diluted
    
    
    16,829
    
    
    
    
    
    18,105
    
    
    
    
    
    19,761





**Operating
Highlights**





Net sales
for the year ended December 31, 2004, increased approximately 22.7% primarily
due to the addition of LCI for the entire year of 2004 compared with only ten
months of 2003, as well as the additions of Playing Mantis and TFY as of the
respective effective dates of closing such acquisitions in 2004. Gross margins
decreased to 49.3% for 2004 from 52.1% for 2003 primarily due to higher product
and freight costs, as well as a less favorable product mix. Selling, general and
administrative expenses as a percentage of net sales decreased to 33.1% for 2004
from 33.6% for 2003. Operating income increased to $57.3 million for 2004 from
$57.2 million for 2003, although, as a percentage of net sales, operating income
decreased to 15.0% for 2004 from 18.4% for 2003.





Results
for 2004 were negatively impacted by the Company’s decision to discontinue
certain low-performing product lines as well as its distribution at NASCAR
trackside sales events. In 2004, the Company recorded a non-cash impairment
charge of approximately $2.7 million, net of estimated income tax benefits, to
write-off intangible license and trademark assets recorded at the time of the
Learning Curve acquisition. In addition, charges to write-off undepreciated
tooling costs and fixed assets and to provide inventory and royalty reserves
related to the discontinued product lines and trackside sales distribution
totaled approximately $2.7 million, net of income tax benefits. The Company also
recorded an adjustment to income tax provision of approximately $598,000 in
2004. The combined impact of these charges on the Company’s diluted earnings per
share was approximately $0.30 for the year ended December 31, 2004. Net income
per diluted share for the year ended December 31, 2003 was positively impacted
by $0.19 per diluted share as a result of a reduction in the income tax
provision.





Results
for 2004 include Playing Mantis from June 1, 2004 and TFY from September 16,
2004. Results for 2003 include LCI from March 1, 2003.





22





**Year
Ended December 31, 2004, Compared to Year Ended December 31,
2003**





***Net
Sales.*** Net
sales increased $70.5 million, or 22.7%, to $381.4 million for 2004 from $310.9
million for 2003. The increase was primarily attributable to the addition of the
Learning Curve business for the entire year of 2004 compared with only ten
months in 2003, as well as the additions of Playing Mantis and TFY as of the
respective effective dates of closing such acquisitions in 2004. Net sales
increases occurred in our children’s toys and infant products categories, but
were partially offset by a decrease in our collectible products
category.





Net sales
in our children’s toys category increased 29.3% primarily due to strong sales in
our Thomas & Friends and John Deere ride-on and toy vehicle product lines.
Net sales in our infant products category increased 218.8% primarily due to the
TFY acquisition and growth from Learning Curve’s Lamaze product line. Net sales
in our collectible products category decreased 5.2% primarily due to the
continued softness in the vehicle replica product lines, including *The
Fast and The Furious* and
NASCAR product lines, slightly offset by the Playing Mantis acquisition and the
positive results from the new American Chopper/Orange County Chopper product
line.





Net sales
for the 2004 year excluding the Playing Mantis and TFY acquisitions increased by
approximately 1.4% versus pro forma consolidated net sales for the year ended
December 31, 2003. The pro forma consolidated net sales for 2003 assume that the
Learning Curve acquisition occurred as of January 1, 2003.





***Gross
profit.*** Gross
profit increased $25.9 million, or 16.0%, to $187.9 million for 2004 from $162.0
million for 2003. The gross profit margin (as a percentage of sales) decreased
to 49.3% for 2004 from 52.1% for 2003 primarily due to increased product and
freight costs, a less favorable product mix, the charges related to the
write-off of undepreciated tooling and to provide for inventory related to the
discontinued product lines and trackside distribution, and the impact of sales
from Playing Mantis and TFY which generally carry lower gross profit margins
than historical RC2 products. There were no major changes in the components of
cost of sales.





***Selling,
general and administrative expenses.*** Selling,
general and administrative expenses increased $21.8 million, or 20.9%, to $126.3
million for 2004 from $104.5 million for 2003. The increase in selling, general
and administrative expenses was primarily driven by the inclusion of the Playing
Mantis and TFY acquisitions which have not yet been fully impacted by
integration cost savings, as well as the establishment of royalty reserves
related to discontinued products. As a percentage of net sales, selling, general
and administrative expenses decreased to 33.1% for 2004 from 33.6% for 2003.





***Operating
income.*** Operating income increased slightly to $57.3 million for 2004 from $57.2 million
for 2003. As a percentage of net sales, operating income decreased to 15.0% for
2004 from 18.4% for 2003.





***Net
interest expense.*** Net
interest expense of $4.1 million for 2004 and $3.5 million for 2003 relates
primarily to bank term loans and lines of credit. The increase in net interest
expense for 2004 was primarily due to $0.5 million of deferred financing fees
related to the March 4, 2003 credit facility which were written-off in
conjunction with the new credit agreement dated September 15, 2004.





***Income
tax.*** Income
tax expense of $19.7 million for 2004 includes an adjustment to the income tax
provision of approximately $0.6 million, or $0.03 per diluted share. Income tax
expense for 2004 includes provisions for federal, state and foreign income taxes
at an effective rate of 36.7%. Income tax expense of $15.5 million for 2003
includes a reduction of approximately $3.4 million, or $0.19 per diluted share,
primarily due to the recognition of foreign net operating losses during the year
and a reduction of income tax provision relating to the completion of an IRS tax
audit for the fiscal years 1998 through 2000. Income tax expense, including the
adjustments mentioned, includes provisions for federal, state and foreign income
taxes at an effective tax rate of 28.7% for 2003.





**Year
Ended December 31, 2003, Compared to Year Ended December 31,
2002**





***Net
Sales.*** Net
sales increased $96.0 million, or 44.7%, to $310.9 million for 2003 from $214.9
million for 2002. This sales increase was attributable to the addition of LCI.
Net sales increases occurred in our children’s toys and infant products
categories, but were partially offset by a decrease in our collectible products
category.




23





Sales in
our children’s toys and infant products categories increased approximately
280.4% and 100.0%, respectively, primarily due to the acquisition of LCI, as
these categories include all of the Learning Curve branded product lines. Sales
in our collectible products category decreased approximately 9.8% primarily due
to significant decreases in racing and custom and classic vehicle replicas, soft
sales at our domestic agricultural OEM dealers, and lower sales of apparel and
souvenirs at trackside events partially offset by the strong performance of our *The
Fast and The Furious* product
line.





On a pro
forma basis, consolidated net sales for the year ended December 31, 2003,
decreased by 6.2% to $327.5 million when compared to the pro forma consolidated
net sales for the year ended December 31, 2002, of $349.3 million. The pro forma
consolidated net sales assume that the LCI acquisition took place at the
beginning of each applicable period.





***Gross
Profit.*** Gross
profit increased $49.8 million, or 44.4%, to $162.0 million for 2003 from $112.2
million for 2002. The gross profit margin (as a percentage of net sales)
remained relatively flat at 52.1% for 2003 compared to 52.2% for 2002. There
were no major changes in the components of cost of sales.





***Selling,
General and Administrative Expenses.*** Selling,
general and administrative expenses increased $34.3 million, or 48.9%, to $104.5
million for 2003 from $70.2 million for 2002. As a percentage of net sales,
selling, general and administrative expenses increased to 33.6% for 2003 from
32.7% for 2002. The increase in selling, general and administrative expenses was
primarily due to the addition of LCI.





***Operating
Income.*** Operating income increased $15.3 million, or 36.5%, to $57.2 million for 2003
from $41.9 million for 2002. As a percentage of net sales, operating income
decreased to 18.4% for 2003 from 19.5% for 2002.





***Net
Interest Expense.*** Net
interest expense of $3.5 million for 2003 and $1.8 million for 2002 related
primarily to bank term loans and lines of credit. The increase in net interest
expense was due to the increase in average outstanding debt balances as a result
of the acquisition of LCI in 2003 and an increase in the Company’s incremental
borrowing rate.





***Income
Tax.*** Income
tax expense of $15.5 million for 2003 includes a reduction of approximately $3.4
million, or $0.19 per diluted share, primarily due to the recognition of foreign
net operating losses during the year and a reduction of income tax provision
relating to the completion of an IRS tax audit for the fiscal years 1998 through
2000. Income tax expense, including the adjustments mentioned, includes
provisions for federal, state and foreign income taxes at an effective tax rate
of 28.7% for 2003 compared to 39.2% for 2002.





**Liquidity
and Capital Resources**





We
generally fund our operations and working capital needs through cash generated
from operations and borrowings under our credit facility. Our operating
activities generated cash of approximately $64.3 million in 2004, $38.0 million
in 2003 and $34.0 million in 2002.





Net cash
used in investing activities was $185.0 million in 2004, $114.1 million in 2003
and $8.9 million in 2002. The increase in 2004 was primarily attributable to the
purchases of Playing Mantis and TFY, as well as an increase in capital
expenditures to $15.1 million in 2004 from $10.8 million in 2003. Capital
expenditures for molds and tooling in 2004 and 2003 were $10.9 million and $8.9
million, respectively, and we expect capital expenditures for 2005, principally
for molds and tooling, to be approximately $16.0 million.





Net cash
generated by financing activities in 2004 and 2003 was $123.2 million and $74.8
million, respectively. Net cash used in financing activities was $25.3 million
in 2002. In 2004, we borrowed $85.0 million on our term loans, repaying $53.8
million by year end. During 2004, we borrowed a total of $112.0 million and made
total payments of $97.0 million on our line of credit. At December 31, 2004, we
had $48.9 million available on our line of credit. Historically, we have used a
significant portion of excess cash to pay down debt.




24





Working
capital increased $42.4 million to $112.9 million at December 31, 2004, from
$70.5 million at December 31, 2003. Cash and cash equivalents increased $3.6
million to $20.1 million at December 31, 2004, from $16.5 million at December
31, 2003. Our accounts receivable increased $21.4 million to $93.6 million at
December 31, 2004, from $72.2 million at December 31, 2003, primarily due to the
acquisitions of Playing Mantis and TFY. Our inventory level increased $17.5
million to $55.0 million at December 31, 2004, from $37.5 million at December
31, 2003, primarily due to the acquisitions of Playing Mantis and TFY.
Upon the closing of the acquisition of TFY on September 15, 2004, the
Company entered into a new credit facility to replace its March 4, 2003 credit
facility (see below). This credit facility is comprised of an $85.0 million term
loan and a $100.0 million revolving line of credit, both of which mature on
September 14, 2008 with scheduled quarterly principal payments ranging from $3.8
million to $6.9 million commencing on December 31, 2004 and continuing
thereafter with a final balloon payment upon maturity. Forty million dollars of
the term loan has an interest rate of 3.45% through the first three years of the
agreement. The remaining term loan and revolving loan bear interest, at the
Company’s option, at a base rate or at a LIBOR rate plus applicable margin. The
applicable margin is based on the Company’s ratio of consolidated debt to
consolidated EBITDA (earnings before interest, taxes, depreciation and
amortization) and varies between 1.00% and 1.75%. At December 31, 2004, the
margin in effect was 1.75% for LIBOR loans. The Company is also required to pay
a commitment fee of 0.30% to 0.45% per annum on the average daily unused portion
of the revolving loan. Under the terms of this credit facility, the Company is
required to comply with certain financial and non-financial covenants. Among
other restrictions, the Company is restricted in its ability to pay dividends,
incur additional debt and make acquisitions above certain amounts. The key
financial covenants include minimum EBITDA and interest coverage and leverage
ratios. The credit facility is secured by working capital assets and certain
intangible assets. On December 31, 2004, the Company had $131.3 million
outstanding on this credit facility and was in compliance with all
covenants.





In August
2004, the Company completed a public offering of 2,655,000 shares of common
stock and certain selling stockholders sold 220,000 shares of common stock at a
price of $31.00 per share. The Company received proceeds of $77.8 million from
the offering, net of underwriting discount, and used $74.0 million of the
proceeds to repay outstanding debt.





Upon the
closing of the acquisition of LCI on March 4, 2003, with an effective date of
February 28, 2003, the Company entered into a credit facility to replace its
April 2002 credit facility (see below). This credit facility was comprised of a
$60.0 million term loan and an $80.0 million revolving loan, both of which were
to mature on April 30, 2006. Thirty million dollars of the term loan had an
interest rate of 2.61% plus applicable margin through the maturity of the
agreement. The remaining term loan and revolving loan bore interest, at the
Company’s option, at a base rate or at a LIBOR rate plus applicable margin. The
applicable margin was based on the Company’s ratio of consolidated debt to
consolidated EBITDA and varied between 0.75% and 1.75%. The facility was
replaced with the September 2004 credit facility discussed above.





In April
2002, the Company completed a public offering of 1,545,000 shares of common
stock and certain selling stockholders sold 3,975,000 shares of common stock at
a price of $17.25 per share. The Company received proceeds of $25.2 million from
the offering, net of underwriting discount, and used $24.0 million of the
proceeds to repay outstanding debt.





Upon the
closing of the public offering in April 2002, the Company entered into a credit
facility to replace its previous credit facility. The credit facility was a
three-year $50.0 million unsecured revolving loan that bore interest, at the
Company’s option, at a base rate or at a LIBOR rate plus a margin that varied
between 0.75% and 1.40%. The applicable margin was based on the Company’s ratio
of consolidated debt to consolidated EBITDA. The facility was replaced with the
March 2003 credit facility discussed above.





The
Company’s Hong Kong subsidiary has a credit agreement with a bank that provides
for a line of credit of up to $2.0 million, which is renewable annually on
January 1. Amounts borrowed under this line of credit bear interest at the
bank’s prime rate or prevailing funding cost, whichever is higher, and are
cross-guaranteed by the Company. As of December 31, 2003 and 2004, there were no
outstanding borrowings under this line of credit.





The
Company’s United Kingdom subsidiary has a line of credit with a bank for $0.8
million which expires on July 31, 2005. The line of credit bears interest at
1.0% over the bank’s base rate, and the total amount is subject to a letter of
guarantee given by the Company. At December 31, 2003 and 2004, there were no
amounts outstanding on this line of credit.





25





The
following table summarizes our significant contractual commitments at December
31, 2004:

(In
      thousands)
    
    
    
    **Payment
      Due by Period****Contractual
      Obligations**
    
    **Total**
    
    **2005**
    
    **2006-2007**
    
    **2008-2009**
    
    **2010
      and beyond**Long-term
      debt (including current portion)
    
    $
    131,250
    
    $
    16,563
    
    $
    44,066
    
    $
    70,621
    
    $
    —Minimum
      royalty guarantees
    
    
    28,727
    
    
    10,658
    
    
    17,704
    
    
    340
    
    
    25Operating
      leases
    
    
    29,581
    
    
    4,391
    
    
    5,858
    
    
    4,490
    
    
    14,842Purchase
      commitments
    
    
    1,474
    
    
    1,474
    
    
    —
    
    
    —
    
    
    —Total
      contractual cash obligations
    
    $
    191,032
    
    $
    33,086
    
    $
    67,628
    
    $
    75,451
    
    $
    14,867
We believe that our cash flows from operations, cash on hand
and available borrowings will be sufficient to meet our working capital and
capital expenditure requirements and provide us with adequate liquidity to meet
anticipated operating needs in 2005. Working capital financing requirements are
usually highest during the third and fourth quarters due to seasonal increases
in demand for our collectibles, toys and infant products. Although operating
activities are expected to provide sufficient cash, any significant future
product or property acquisitions, including up-front licensing payments, may
require additional debt or equity financing.





**Critical
Accounting Policies and Estimates**





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





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





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




26


******
 ***Impairment
of Long-lived Assets, Goodwill and Other Intangible
Assets.*** Long-lived assets have been reviewed for impairment based on SFAS No. 144,
“Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed Of.” This statement requires that an impairment loss be recognized
whenever the sum of the expected future cash flows (undiscounted and without
interest changes) resulting from the use and ultimate disposal of an asset is
less than the carrying amount of the asset. Goodwill and other intangible assets
have been reviewed for impairment based on SFAS No. 142, “Goodwill and Other
Intangible Assets” (SFAS No. 142). Under SFAS No. 142, goodwill and other
intangible assets that have indefinite useful lives will not be amortized, but
rather will be tested at least annually for impairment. The Company’s management
reviews for indicators that might suggest an impairment loss could exist.
Testing for impairment requires estimates of expected cash flows to be generated
from the use of the assets. Various uncertainties, including changes in consumer
preferences, deterioration in the political environment or changes in general
economic conditions, could impact the expected cash flows to be generated by an
asset or group of assets. Intangible assets that have finite useful lives will
continue to be amortized over their useful lives. The Company adopted SFAS No.
142 on January 1, 2002. Goodwill had been amortized over 40 years on a
straight-line basis through December 31, 2001. Approximately $88.7 million of
this goodwill is tax deductible over 15 years. As of December 31, 2003 and 2004,
goodwill, net of accumulated amortization, was approximately $159.7 million and
$282.4 million, respectively. The increase in goodwill at December 31, 2004, was
primarily due to the acquisitions of Playing Mantis and TFY. The Company has
completed its annual goodwill and intangible impairment tests as of October 1,
2003 and 2004. The goodwill impairment tests completed in October 2003 and 2004
resulted in no goodwill impairment. However, impairment charges for
intangible assets in the North America segment of $0.3 million and $4.3 million
have been included in the accompanying consolidated statements of earnings for
the years ended December 31, 2003 and 2004, respectively. The impairment charges
are based upon the Company’s decision to discontinue certain low-performing
product lines.
  ***I*** ***ncome
Taxes.*** The
Company records current and deferred income tax assets and liabilities.
Management considers all available evidence in evaluating the realizability of
the deferred tax assets and records valuation allowances against its deferred
tax assets as needed. Management believes it is more likely than not that the
Company will generate sufficient taxable income in the appropriate carry-forward
periods to realize the benefit of its deferred tax assets. In determining the
required liability, management considers certain tax exposures and all available
evidence. However, if the available evidence were to change in the future, an
adjustment to the tax-related balances may be required.





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





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





**Recently
Issued Accounting Pronouncements**





In
December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment.” This
statement is a revision of SFAS No. 123, “Accounting for Stock-Based
Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to
Employees.” This statement establishes standards for the accounting for
transactions in which an entity exchanges its equity instruments for goods or
services and also addresses transactions in which an entity incurs liabilities
in exchange for goods or services that are based on the fair value of the
entity’s equity instruments or that may be settled by the issuance of those
instruments. This statement applies to all awards granted after the required
effective date and to awards modified, repurchased, or cancelled after that
date. This statement is effective as of the beginning of the first interim or
annual reporting period that begins after June 15, 2005. The Company will adopt
this statement for the quarter beginning July 1, 2005.





In
December 2004, the FASB issued FASB Staff Position (FSP) 109-2, “Accounting and
Disclosure Guidance for the Foreign Earnings Repatriation Provision within the
American Jobs Creation Act of 2004.” This FSP was issued to provide accounting
and disclosure guidance for the repatriation provision of the American Jobs
Creation Act of 2004 which was signed into law on October 22, 2004. This FSP was
effective upon issuance and the required disclosures have been included in Note
6 - Income Taxes on page F20.




27


****
 **Item
7A. Quantitative and Qualitative Disclosures About Market
Risk**
 
 The
Company’s exposure to market risk is limited to interest rate risk associated
with the Company’s credit agreement and foreign currency exchange rate risk
associated with the Company’s foreign operations.
 
 The
Company’s credit agreement prior to April 2002 required that the Company
maintain an interest rate protection agreement. Effective June 3, 1999, the
Company entered into an interest rate collar transaction covering $35.0 million
of its debt, with a cap based on 30-day LIBOR rates of 8.0% and a floor of
5.09%. The agreement, which had quarterly settlement dates, expired on June 3,
2002.  During 2002, the Company paid approximately $548,000 which is
included in interest expense on the accompanying consolidated statement of
earnings for the year ended December 31, 2002. Additionally, a benefit of
approximately $542,000 was recorded in net interest expense related to the
change in fair value of the Company’s interest rate collar during the year ended
December 31, 2002.


Based on
the Company’s interest rate exposure on variable rate borrowings at December 31,
2004, a one percentage point increase in average interest rates on the Company’s
borrowings would increase future interest expense by approximately $76,042 per
month and a five percentage point increase would increase future interest
expense by approximately $380,208 per month. The Company determined these
amounts based on approximately $91.3 million of variable rate borrowings at
December 31, 2004, multiplied by 1% and 5%, respectively, and divided by 12.
Since the expiration of the collar transaction described in the preceding
paragraph, the Company has not used any interest rate collars, hedges or other
derivative financial instruments to manage or reduce interest rate risk. As a
result, any increase in interest rates on the Company’s variable rate borrowings
would increase interest expense and reduce net income.





The
Company’s net sales are primarily denominated in U.S. dollars, except for a
small amount of net sales denominated in U.K. pounds, Australian dollars, Euros
and Canadian dollars. The Company’s purchases of finished goods from Chinese
manufacturers are primarily denominated in Hong Kong dollars. Expenses for these
manufacturers are primarily denominated in Chinese Renminbi. The Hong Kong
dollar and the Chinese Renminbi are currently pegged to the U.S. dollar. If the
Hong Kong dollar and the Chinese Renminbi ceased to be pegged to the U.S.
dollar, a material increase in the value of the Hong Kong dollar or the Chinese
Renminbi relative to the U.S. dollar or the U.K. pound would increase our
expenses and therefore could adversely affect our profitability. A 10% change in
the exchange rate of the U.S. dollar with respect to the Hong Kong dollar for
the year ended December 31, 2004 would have changed the total dollar amount of
our gross profit by approximately 8%. A 10% change in the exchange rate of the
U.S. dollar with respect to the U.K. pound, the Australian dollar, the Euro or
the Canadian dollar for the year ended December 31, 2004 would not have had a
significant impact on the Company’s earnings. The Company is also subject to
exchange rate risk relating to transfers of funds denominated in U.K. pounds,
Australian dollars, Canadian dollars or Euros from its foreign subsidiaries to
the United States. Historically, the Company has not used hedges or other
derivative financial instruments to manage or reduce exchange rate
risk.





**Item
8. Financial Statements and Supplementary Data**





**Financial
Statements**





Our
consolidated financial statements and notes thereto are filed under this item
beginning on page F1 of this report.




**Quarterly
Results of Operations**
 
 The
following table sets forth our unaudited quarterly results of operations for
2003 and 2004. We have prepared this unaudited information on a basis consistent
with the audited consolidated financial statements contained in this report and
this unaudited information includes all adjustments, consisting only of normal
recurring adjustments, that we consider necessary for a fair presentation of our
results of operations for the quarters presented. You should read this quarterly
financial data along with the Condensed Consolidated Financial Statements and
the related notes to those statements included in our Quarterly Reports on Form
10-Q filed with the Commission. The operating results for any quarter are not
necessarily indicative of the results for any future period.





28




**Fiscal
      Year 2003**(In
      thousands, except per share data)
    
    **Q1**
    
    **Q2**
    
    **Q3**
    
    **Q4**Net
      sales
    
    $
    42,352
    
    $
    70,059
    
    $
    97,711
    
    $
    100,824Cost
      of sales (1)
    
    
    19,802
    
    
    35,841
    
    
    44,373
    
    
    48,892Gross
      profit
    
    
    22,550
    
    
    34,218
    
    
    53,338
    
    
    51,932Selling,
      general and administrative expenses (1)
    
    
    17,641
    
    
    26,774
    
    
    29,065
    
    
    30,987Impairment
      of intangible assets
    
    
    —
    
    
    —
    
    
    —
    
    
    327Amortization
      of intangible assets
    
    
    —
    
    
    —
    
    
    —
    
    
    30Operating
      income
    
    
    4,909
    
    
    7,444
    
    
    24,273
    
    
    20,588Interest
      expense, net
    
    
    360
    
    
    1,061
    
    
    1,072
    
    
    984Other
      expense (income)
    
    
    (140
    )
    
    359
    
    
    (100
    )
    
    (264
    )Income
      before income taxes
    
    
    4,689
    
    
    6,024
    
    
    23,301
    
    
    19,868Income
      tax expense
    
    
    1,782
    
    
    2,289
    
    
    7,138
    
    
    4,256Net
      income
    
    $
    2,907
    
    $
    3,735
    
    $
    16,163
    
    $
    15,612Net
      income per share:Basic
    
    $
    0.17
    
    $
    0.22
    
    $
    0.94
    
    $
    0.90Diluted
    
    $
    0.17
    
    $
    0.21
    
    $
    0.89
    
    $
    0.85Weighted
      average shares outstanding:Basic
    
    
    16,666
    
    
    17,142
    
    
    17,145
    
    
    17,277Diluted
    
    
    17,551
    
    
    18,169
    
    
    18,224
    
    
    18,396





(1)
Depreciation expense was approximately $2.6 million, $3.1 million, $3.2 million
and $3.1 million for Q1, Q2, Q3 and Q4 2003, respectively.





**Fiscal
      Year 2004**(In
      thousands, except per share data)
    
    **Q1**
    
    **Q2**
    
    **Q3**
    
    **Q4**Net
      sales
    
    $
    61,300
    
    $
    69,399
    
    $
    110,289
    
    $
    140,437Cost
      of sales (1)
    
    
    30,291
    
    
    32,661
    
    
    54,283
    
    
    76,262Gross
      profit
    
    
    31,009
    
    
    36,738
    
    
    56,006
    
    
    64,175Selling,
      general and administrative expenses (1)
    
    
    25,582
    
    
    26,559
    
    
    33,497
    
    
    40,627Impairment
      of intangible assets
    
    
    —
    
    
    —
    
    
    —
    
    
    4,318Amortization
      of intangible assets
    
    
    —
    
    
    —
    
    
    —
    
    
    94Operating
      income
    
    
    5,427
    
    
    10,179
    
    
    22,509
    
    
    19,136Interest
      expense, net
    
    
    786
    
    
    668
    
    
    1,011
    
    
    1,598Other
      expense (income)
    
    
    42
    
    
    (127
    )
    
    (345
    )
    
    (78
    )Income
      before income taxes
    
    
    4,599
    
    
    9,638
    
    
    21,843
    
    
    17,616Income
      tax expense
    
    
    1,657
    
    
    3,468
    
    
    7,864
    
    
    6,729Net
      income
    
    $
    2,942
    
    $
    6,170
    
    $
    13,979
    
    $
    10,887Net
      income per share:Basic
    
    $
    0.17
    
    $
    0.35
    
    $
    0.72
    
    $
    0.53Diluted
    
    $
    0.16
    
    $
    0.33
    
    $
    0.68
    
    $
    0.51Weighted
      average shares outstanding:Basic
    
    
    17,420
    
    
    17,540
    
    
    19,348
    
    
    20,413Diluted
    
    
    18,501
    
    
    18,655
    
    
    20,443
    
    
    21,418





(1)
Depreciation expense was approximately $3.0 million, $3.0 million, $3.3 million
and $6.0 million for Q1, Q2, Q3 and Q4 2004, respectively.





29





General
Note: Results for 2003 include the results of LCI from March 1, 2003. Results
for 2004 include the results of Playing Mantis from June 1, 2004 and the results
of TFY from September 16, 2004. As these acquisitions were accounted for using
the purchase method, periods prior to the acquisition effective dates do not
include any results for LCI, Playing Mantis or TFY.





**Item
9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure**





Not
applicable.





**Item
9A. Controls and Procedures**





**Evaluation
of Disclosure Controls and Procedures**





As of the
end of the period covered by this report, the Company carried out an evaluation
under the supervision and with the participation of the Company’s management,
including the Company’s Chief Executive Officer and Chief Financial Officer, of
the Company’s disclosure controls and procedures [as defined in Rules 13a-15(e)
and 15d-15(e) under the Securities Exchange Act of 1934, as amended]. Based on
this evaluation, the Company’s Chief Executive Officer and Chief Financial
Officer concluded that the Company’s disclosure controls and procedures were
effective in timely alerting them to material information relating to the
Company required to be included in the Company’s periodic filings with the
Commission. It should be noted that in designing and evaluating the disclosure
controls and procedures, management recognized that any controls and procedures,
no matter how well designed and operated, can provide only reasonable assurance
of achieving the desired control objectives, and management necessarily was
required to apply its judgment in evaluating the cost-benefit relationship of
possible controls and procedures. The Company has designed its disclosure
controls and procedures to reach a level of reasonable assurance of achieving
the desired control objectives and based on the evaluation described above, the
Company’s Chief Executive Officer and Chief Financial Officer concluded that the
Company’s disclosure controls and procedures were effective at reaching that
level of reasonable assurance.





**Changes
in Internal Control Over Financial Reporting**





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





**Management’s
Report on Internal Control Over Financial Reporting**





Management
of the Company is responsible for establishing and maintaining effective
internal control over financial reporting as defined in Rules 13a-15(f) under
the Securities Exchange Act of 1934, as amended. The Company’s internal control
over financial reporting is designed to provide reasonable assurance to the
Company’s management and board of directors regarding the preparation and fair
presentation of published financial statements. The Company’s internal control
over financial reporting includes those policies and procedures
that:




(i)  pertain
to the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the
Company;





(ii)  provide
reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the Company are
being made only in accordance with authorizations of management and directors of
the Company; and





(iii)  provide
reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use or disposition of the Company’s assets that could have a
material effect on the financial statements.




30


Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Therefore, even those systems determined to be
effective can provide only reasonable assurance with respect to financial
statement preparation and presentation. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.


Management
assessed the effectiveness of the Company’s internal control over financial
reporting as of December 31, 2004. In making this assessment, management used
the criteria set forth by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO) in *Internal
Control-Integrated Framework.* Based on
our assessment, management believes that, as of December 31, 2004, the Company’s
internal control over financial reporting was effective based on those
criteria.





The scope
of management’s assessment of the effectiveness of internal control over
financial reporting includes all of the Company’s consolidated subsidiaries
except for The First Years, Inc. and its subsidiary (TFY), a material business
acquired by the Company on September 15, 2004. The Company’s consolidated net
sales for the year ended December 31, 2004 were approximately $381.4 million, of
which TFY represented approximately $37.3 million. The Company’s consolidated
total assets as of December 31, 2004 were approximately $585.7 million, of which
TFY represented approximately $22.2 million.





KPMG LLP,
the independent registered public accounting firm who audited the Company’s
consolidated financial statements, has issued an attestation report on
management’s assessment of the Company’s internal control over financial
reporting, which appears on page F3 hereof.





**Item
9B. Other Information**





Not
applicable.




**Part
III**








**Item
10. Directors and Executive Officers of the Registrant**





Information
regarding the executive officers and directors of the Company is incorporated
herein by reference to the discussions under “Election of Directors,” “Executive
Officers,” “Section 16(a) Beneficial Ownership Reporting Compliance” and “Audit
Committee Matters-Audit Committee Financial Expert” in the Company’s Proxy
Statement for the 2005 Annual Meeting of Stockholders, which will be filed with
the Commission on or before May 2, 2005. Information regarding the Company’s
Code of Business Ethics is incorporated herein by reference to the discussion
under “Corporate Governance Matters-Code of Business Ethics” in the Company’s
Proxy Statement for the 2005 Annual Meeting of Stockholders.





The Audit
Committee of our Board of Directors is an “audit committee” for purposes of
Section 3(a)(58)(A) of the Securities Exchange Act of 1934. The members of the
Audit Committee are John J. Vosicky (Chairman), John S. Bakalar and Daniel M.
Wright.





**Item
11. Executive Compensation**





Information
regarding executive compensation is incorporated herein by reference to the
discussion under “Executive Compensation” and “Compensation of Directors” in the
Company’s Proxy Statement for the 2005 Annual Meeting of Stockholders, which
will be filed with the Commission on or before May 2, 2005.





31


****
 **Item
12. Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters**
 
 Information
regarding security ownership of certain beneficial owners and management is
incorporated herein by reference to the discussion under “Security Ownership” in
the Company’s Proxy Statement for the 2005 Annual Meeting of Stockholders, which
will be filed with the Commission on or before May 2,
2005.


****


**Equity
Compensation Plan Information**





The
following table summarizes share information, as of December 31, 2004, for the
Company’s equity compensation plans, including the Racing Champions Ertl
Corporation Stock Incentive Plan, the Racing Champions Ertl Corporation Employee
Stock Purchase Plan, the Racing Champions, Inc. 1996 Key Employees Stock Option
Plan and the Wheels Sports Group, Inc. 1996 Omnibus Stock Plan. All of these
plans have been approved by the Company’s stockholders, other than the Wheels
Sports Group, Inc. 1996 Omnibus Stock Plan, which was approved by Wheels Sports
Group’s stockholders and assumed by the Company following its acquisition of
Wheels Sports Group in 1998. Both the Wheels Sports Group, Inc. 1996 Omnibus
Stock Plan and the Racing Champions, Inc. 1996 Key Employee Stock Plan are
dormant, and no future issuances are allowed under those plans.





**Plan
      Category**
    **Number
      of**
      **Common
      Shares to Be**
      **Issued
      Upon Exercise**
      **of
      Outstanding**
      **Options,**
      **Warrants
      and Rights**
    **Weighted-average**
      **Exercise
      Price of**
      **Outstanding
      Options,**
      **Warrants
      and Rights**
    **Number
      of**
      **Common
      Shares**
      **Available
      for Future**
      **Issuance
      Under**
      **Equity**
      **Compensation
      Plans**Equity
      compensation plans approved
      by
      stockholders
    1,549,079
    $11.72
    809,456Equity
      compensation plans not
      approved
      by stockholders
    —
    —
    —Total
    1,549,079
    $11.72
    809,456





**Item
13. Certain Relationships and Related Party Transactions**





Information
regarding certain relationships and related transactions is incorporated herein
by reference to the discussions under “Executive Compensation-Employment
Agreements” and “Certain Relationships and Related Transactions” in the
Company’s Proxy Statement for the 2005 Annual Meeting of Stockholders, which
will be filed with the Commission on or before May 2, 2005.





**Item
14. Principal Accountant Fees and Services**





Information
regarding the fees and services of the independent registered public
accountanting firm is incorporated herein by reference to the discussion under
“Audit Committee Matters-Fees of Independent Registered Public Accounting Firm”
in the Company’s Proxy Statement for the 2005 Annual Meeting of Stockholders,
which will be filed with the Commission on or before May 2, 2005.





32





**Part
IV**





**Item
15. Exhibits and Financial Statement Schedules**





(a) The
following documents are filed as part of this report:





**1.**  **Financial
Statements**





The
following consolidated financial statements of the Company are included in Item
8 of this report:





Reports
of Independent Registered Public Accounting Firm





Consolidated
Balance Sheets as of December 31, 2003 and 2004





Consolidated
Statements of Earnings for the Years Ended December 31, 2002, 2003 and
2004





Consolidated
Statements of Stockholders’ Equity for the Years Ended December 31, 2002, 2003
and 2004





Consolidated
Statements of Cash Flows for the Years Ended December 31, 2002, 2003 and
2004





Notes to
Consolidated Financial Statements





**2.**  **Financial
Statement Schedules**





Report of
Independent Registered Public Accounting Firm





Financial
Statement Schedule for the Years Ended December 31, 2002, 2003 and
2004:





Schedule
      Number
    
    Description
    
    PageII
    
    Valuation
      and Qualifying Accounts
    
    37





All other
schedules for which provision is made in the applicable accounting regulations
of the Commission are not required under the related instructions, are
inapplicable or the required information is shown in the financial statements or
notes thereto, and therefore, have been omitted.





**3.** **Exhibits**





3.1
    Amended
      and Restated Certificate of Incorporation of the Company [incorporated by
      reference to Exhibit 3.1 of the Company’s Quarterly Report on Form 10-Q
      for the quarter ended March 31, 2002 (File No.
  0-22635)].





3.2
    First
      Amendment to Amended and Restated Certificate of Incorporation of the
      Company [incorporated by reference to Exhibit 3.2 of the Company’s
      Quarterly Report on Form 10-Q for the quarter ended March 31, 2002 (File
      No. 0-22635)].





3.3
    Certificate
      of Ownership and Merger changing the Company’s name to Racing Champions
      Ertl Corporation [incorporated by reference to Exhibit 3.3 of the
      Company’s Quarterly Report on Form 10-Q for the quarter ended March 31,
      2002 (File No. 0-22635)].





3.4
    Certificate
      of Ownership and Merger changing the Company’s name to RC2 Corporation
      [incorporated by reference to Exhibit 3.4 of the Company’s Quarterly
      Report on Form 10-Q for the quarter ended March 31, 2003 (File No.
      0-22635)].





3.5
    Amended
      and Restated By-Laws of the Company [incorporated by reference to Exhibit
      3.5 of the Company’s Quarterly Report on Form 10-Q for the quarter ended
      March 31, 2004 (File No. 0-22635)].




33





10.1*
    Employment Agreement, dated as of April 30, 2001, between
      the Company and Robert E. Dods [incorporated byreference
      to Exhibit 10.10 of the Company’s Annual Report on Form 10-K for the year
      ended December 31, 2001(File
      No.
0-22635)].


10.2*
    Employment Agreement, dated as of April 30, 2001, between
      the Company and Boyd L. Meyer [incorporated byreference
      to Exhibit 10.11 of the Company’s Annual Report on Form 10-K for the year
      ended December 31, 2001(File
      No. 0-22635)].  10.3*
    Employment Agreement, dated as of April 30, 2001, between
      Racing Champions Limited and Peter K.K. Chung[incorporated
      by reference to Exhibit 10.10 of the Company’s Annual Report on Form 10-K
      for the year endedDecember
      31, 2001 (File No. 0-22635)].  10.4*
    Employment Agreement, dated July 29, 2002, between the
      Company and Curtis W. Stoelting [incorporated byreference
      to Exhibit 10.2 of the Company’s Quarterly Report on Form 10-Q for the
      quarter ended September 30, 2002(File
      No. 0-22635)].  10.5*
    Employment Agreement, dated July 29, 2002, between the
      Company and Peter J. Henseler [incorporated by referenceto
      Exhibit 10.1 of the Company’s Quarterly Report on Form 10-Q for the
      quarter ended September 30, 2002 (FileNo.
      0-22635)].


10.6*
    Employment
      Agreement, dated July 29, 2002, between the Company and Jody L. Taylor
      [incorporated by reference toExhibit
      10.3 of the Company’s Quarterly Report on Form 10-Q for the quarter ended
      September 30, 2002 (File No.0-22635)].


10.7*
    Racing
      Champions, Inc. 1996 Key Employees Stock Option Plan [incorporated by
      reference to Exhibit 10.19 of the Company’s
      Registration Statement on Form S-1 (Registration No. 333-22493) filed with
      the Commission onFebruary
      27, 1997].   10.8*
    Racing Champions Corporation Stock Incentive Plan, as
      amended [incorporated by reference to Exhibit 10.5 of theCompany’s
      Quarterly Report on Form 10-Q for the quarter ended September 30, 2002
      (File No. 0-22635)].   10.9*
    Wheels Sports Group, Inc. 1996 Omnibus Stock Plan
      [incorporated by reference to Exhibit 10.6 of the Company’sQuarterly
      Report on Form 10-Q for the quarter ended June 30, 1998 (File No.
      0-22635)].   10.10*
    Racing
      Champions Ertl Corporation Employee Stock Purchase Plan, as amended
      [incorporated by reference to Exhibit 10.4
      of the Company’s Quarterly Report on Form 10-Q for the quarter ended
      September 30, 2002 (File No. 0-22635)].


10.11
    Agreement
      and Plan of Merger, dated February 3, 2003, among the Company, RBVD Sub I
      Inc., Racing Champions Worldwide Limited, Racing Champions Limited and
      Learning Curve International, Inc. [incorporated by reference to Exhibit
      2.1 of the Company’s Current Report on Form 8-K dated March 4, 2003 (File
      No. 0-22635) filed by the Company with the Securities and Exchange
      Commission on March 18, 2003].





10.12
    Credit
      Agreement, dated March 4, 2003, by and among the Company, RC Ertl, Inc.,
      Racing Champions South, Inc., Learning Curve International, Inc., Racing
      Champions Worldwide Limited, Harris Trust and Savings Bank, as lender and
      administrative agent, certain other corporations party thereto and the
      other lenders party thereto [incorporated by reference to Exhibit 99.1 of
      the Company’s Current Report on Form 8-K dated March 4, 2003 (File No.
      0-22635) filed by the Company with the Securities and Exchange Commission
      on March 18, 2003].





34




10.13
    First
      Amendment to Credit Agreement, dated June 27, 2003, among the Company, RC
      Ertl, Inc., Racing Champions South, Inc., Learning Curve International,
      Inc., Racing Champions Worldwide Limited, the lenders party thereto, and
      Harris Trust and Savings Bank, as agent, and certain other corporations
      party thereto [incorporated by reference to Exhibit 10.1 of the Company’s
      Quarterly Report on Form 10-Q for the quarter ended June 30, 2003 (File
      No. 0-22635)].





10.14*
    Employment Agreement, dated as of March 4, 2003, between
      the Company and Richard E. Rothkopf [incorporated byreference
      to Exhibit 10.15 of the Company’s Annual Report on Form 10-K for the year
      ended December 31, 2003(File
      No. 0-22635)].





10.15*
    Employment Agreement, dated as of March 4, 2003, between
      the Company and John Walter Lee II [incorporated byreference
      to Exhibit 10.16 of the Company’s Annual Report on Form 10-K for the year
      ended December 31, 2003(File
      No. 0-22635)].





10.16
    Agreement and Plan of Merger, dated as of June 4, 2004,
      among The First Years Inc., the Company and RBVDAcquisition
      Corp. [incorporated by reference to Exhibit 2.1 of the Company’s Current
      Report on Form 8-Kdated
      June 4, 2004 (File No. 0-22635) filed by the Company with the Securities
      and Exchange Commission onJuly
      12, 2004].





10.17
    Amended and Restated Credit Agreement, dated as of
      September 15, 2004, among the Company, certain of itssubsidiaries,
      Harris Trust and Savings Bank, as lender and agent, and the other lenders
      named therein [incorporated byreference
      to Exhibit 99.1 of the Company’s Current Report on Form 8-K dated
      September 15, 2004 (File No. 0-22635) filed by the Company with the
      Securities and Exchange Commission on September 21,
2004].


10.18*
    Employment Agreement, dated as of June 4, 2004, between
      the Company and Thomas Lowe.  21
    Subsidiaries of the
Company.


23.1
    Consent
      of Independent Registered Public Accounting
Firm.





24
    Power
      of Attorney (included as part of the signature page
    hereof).





31.1
    Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.





31.2
    Certification
      of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act
      of 2002.




32.1**
    Certification
      of Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350 (Section
      906 of the Sarbanes-Oxley Act of
2002).
 
 * Management
contract or compensatory plan or arrangement.





**  This
certification is not “filed” for purposes of Section 18 of the Securities
Exchange Act of 1934, as amended, or


incorporated
by reference into any filing under the Securities Act of 1933, as amended, or
the Securities Exchange Act


of 1934,
as amended.


(b)      
Exhibits


Th e
response to this portion of Item 15 is submitted as a separate section of this
report.




(c)  Financial
Statement Schedules


The
response to this portion of Item 15 is submitted as a separate section of this
report.





35





**SIGNATURES**





Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has duly caused this Form 10-K to be signed on its behalf
by the undersigned, thereunto duly authorized.





**Date:
      March 4, 2005**
    **RC2
      CORPORATION**By
    /s/ Curtis W. StoeltingCurtis
      W. Stoelting, Chief Executive Officer





**POWER
OF ATTORNEY**





Each
person whose signature appears below hereby appoints Curtis W. Stoelting and
Jody L. Taylor, and each of them individually, his true and lawful
attorney-in-fact, with power to act with or without the other and with full
power of substitution and resubstitution, in any and all capacities, to sign any
or all amendments to the Form 10-K and file the same with all exhibits thereto,
and other documents in connection therewith, with the Securities and Exchange
Commission, granting unto said attorneys-in-fact and agents full power and
authority to do and perform each and every act and thing requisite and necessary
to be done in and about the premises, as fully to all intents and purposes as he
might or could do in person, hereby ratifying and confirming all that said
attorneys-in-fact and agents, or their substitutes, may lawfully cause to be
done by virtue hereof.





Pursuant
to the requirements of the Securities Exchange Act of 1934, this Form 10-K has
been signed below by the following persons on behalf of the Registrant and in
the capacities and on the dates indicated.





/s/
      Robert E. Dods
    Chairman
      of the Board and
    March
      4, 2005Robert
      E. Dods
    Director/s/
      Boyd L. Meyer
    Vice
      Chairman and Director
    March
      4, 2005Boyd
      L. Meyer/s/
      Curtis W. Stoelting
    Chief
      Executive Officer and
    March
      4, 2005Curtis
      W. Stoelting
    Director
      (Principal Executive Officer)/s/
      Jody L. Taylor
    Chief
      Financial Officer and Secretary
    March
      4, 2005Jody
      L. Taylor
    (Principal
      Financial and Accounting Officer)/s/
      Peter K.K. Chung
    Director
    March
      4, 2005Peter
      K.K. Chung/s/
      Paul E. Purcell
    Director
    March
      4, 2005Paul
      E. Purcell/s/
      John S. Bakalar
    Director
    March
      4, 2005John
      S. Bakalar/s/
      John J. Vosicky
    Director
    March
      4, 2005John
      J. Vosicky/s/
      Daniel M. Wright
    Director
    March
      4, 2005Daniel
      M. Wright/s/
      Richard E. Rothkopf
    Director
    March
      4, 2005Richard
      E. Rothkopf/s/
      Thomas M. Collinger
    Director
    March
      4, 2005Thomas
      M. Collinger/s/
      Michael J. Merriman, Jr.
    Director
    March
      4, 2005Michael
      J. Merriman, Jr.





36





**REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**











The Board
of Directors and Stockholders


RC2
Corporation:








Under
date of March 4, 2005, we reported on the consolidated balance sheets of RC2
Corporation and subsidiaries as of December 31, 2003 and 2004, and the related
consolidated statements of earnings, stockholders’ equity and cash flows for the
years in the three-year period ended December 31, 2004. In connection with our
audit of the aforementioned consolidated financial statements, we also audited
the related consolidated financial statement schedule of Valuation and
Qualifying Accounts. The financial statement schedule is the responsibility of
the Company’s management. Our responsibility is to express an opinion on the
financial statement schedule based on our audits.





In our
opinion this financial statement schedule, when considered in relation to the
basic consolidated financial statements taken as a whole, presents fairly, in
all material respects, the information set forth therein.







KPMG
LLP


Chicago,
Illinois


March 4,
2005


















**Schedule
      II****Description**
      **Valuation
      and Qualifying Accounts****Description**
    
    **Balance
      at**
      **Beginning
      of**
      **Year**
    
    **Charged
      to**
      **Costs
      and**
      **Expenses**
    
    **Charged
      to**
      **Other**
      **Accounts**
    
    **Deductions**
    
    **Balance
      at**
      **End
      of**
      **Year**Allowance
      for doubtful accounts:Year
      ended December 31, 2002
    
    $
    3,009,120
    
    $
    753,849
    
    
    —
    
    $
    (1,162,393
    )
    $
    2,600,576Year
      ended December 31, 2003
    
    $
    2,600,576
    
    $
    2,077,735
    
    $
    1,825,339
    
    $
    (2,497,203
    )
    $
    4,006,447Year
      ended December 31, 2004
    
    $
    4,006,447
    
    $
    1,083,083
    
    $
    481,182
    
    $
    (2,374,153
    )
    $
    3,196,559








37








**INDEX
TO FINANCIAL STATEMENTS**











**RC2
CORPORATION AND SUBSIDIARIES**








Reports
      of Independent Registered Public Accounting Firm
    F2Consolidated
      Balance Sheets as of December 31, 2003 and 2004
    F4Consolidated
      Statements of Earnings for the Years EndedDecember
      31, 2002, 2003 and 2004
    F5Consolidated
      Statements of Stockholders’ Equity for the Years EndedDecember
      31, 2002, 2003 and 2004
    F6Consolidated
      Statements of Cash Flows for the Years EndedDecember
      31, 2002, 2003 and 2004
    F7Notes
      to Consolidated Financial Statements
    F8





F1





**REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**














The Board
of Directors and Stockholders


RC2
Corporation:











We have
audited the accompanying consolidated financial statements of RC2 Corporation
and subsidiaries as listed in the accompanying index. These consolidated
financial statements are the responsibility of the Company’s management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of RC2 Corporation and
subsidiaries as of December 31, 2003 and 2004, and the results of their
operations and their cash flows for each of the years in the three-year
period ended December 31, 2004, in conformity with U.S. generally accepted
accounting principles.





We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the effectiveness of RC2 Corporation’s internal
control over financial reporting as of December 31, 2004, based on criteria
established in Internal Control-Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO), and our reported
dated March 4, 2005 expressed an unqualified opinion on management’s assessment
of, and the effective operation of, internal control over financial
reporting.










KPMG
LLP


Chicago,
Illinois


March 4,
2005





F2





**REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**





The Board
of Directors and Stockholders


RC2
Corporation:





We have
audited management’s assessment, included in the accompanying Management Report
on Internal Control Over Financial Reporting, that RC2 Corporation
maintained effective internal control over financial reporting as of December
31, 2004, based on criteria established in Internal Control-Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO). RC2 Corporation’s management is responsible for maintaining effective
internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting. Our responsibility
is to express an opinion on management’s assessment and an opinion on the
effectiveness of the Company’s internal control over financial reporting based
on our audit.





We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, evaluating management’s assessment, testing and evaluating
the design and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.





A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company’s internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company’s
assets that could have a material effect on the financial
statements.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.





In our
opinion, management’s assessment that RC2 Corporation maintained effective
internal control over financial reporting as of December 31, 2004, is fairly
stated, in all material respects, based on criteria established in Internal
Control-Integrated Framework issued by the Committee of Sponsoring Organizations
of the Treadway Commission (COSO). Also, in our opinion, RC2
Corporation maintained, in all material respects, effective internal
control over financial reporting as of December 31, 2004, based on the criteria
established in Internal Control-Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO).





The scope
of management's assessment
of the effectiveness of internal control over financial reporting includes all
of the Company's consolidated subsidiaries except for The First Years, Inc. and
its subsidiary (TFY), a material business acquired by the Company on September
15, 2004.  The Company's consolidated net sales for the year ended December
31, 2004 were approximately $381.4 million, of which TFY represented
approximately $37.3 million.  The Company's consolidated total assets as of
December 31, 2004 were approximately $585.7 million, of which TFY represented
approximately $22.2 million.





We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets of RC2
Corporation and subsidiaries as of December 31, 2003 and 2004, and the related
consolidated statements of earnings, stockholders’ equity and cash flows for
each of the years in the three-year period ended December 31, 2004, and our
report dated March 4, 2005 expressed an unqualified opinion on those
consolidated financial statements.














KPMG
LLP


Chicago,
Illinois


March 4,
2005


F3




CONSOLIDATED BALANCE SHEETS







**December
      31,****2003**
    
    **2004****Assets**Current
      assets:Cash
      and cash equivalents
    
    $
    16,547,951
    
    $
    20,123,395Restricted
      cash
    
    
    33,118
    
    
    —Accounts
      receivable, net of allowances for doubtful accounts
      of
      $4,006,447 and $3,196,559
    
    
    72,164,500
    
    
    93,616,367Other
      receivables
    
    
    3,624,233
    
    
    6,565,341Inventory
    
    
    37,463,704
    
    
    55,022,928Assets
      held for sale
    
    
    —
    
    
    4,185,959Deferred
      income taxes and prepaid taxes, net
    
    
    4,336,494
    
    
    8,263,659Prepaid
      expenses
    
    
    4,407,985
    
    
    6,602,609Total
      current assets
    
    
    138,577,985
    
    
    194,380,258Property
      and equipment:Land
    
    
    699,498
    
    
    699,498Buildings
      and improvements
    
    
    5,939,271
    
    
    8,049,231Tooling
    
    
    64,146,444
    
    
    85,253,552Other
      equipment
    
    
    16,178,642
    
    
    19,087,07686,963,855
    
    
    113,089,357Less
      accumulated depreciation
    
    
    (48,410,407
    )
    
    (64,232,922
    )38,553,448
    
    
    48,856,435Goodwill
    
    
    159,720,251
    
    
    282,367,323Intangible
      assets, net
    
    
    44,042,417
    
    
    58,243,316Other
      assets
    
    
    934,619
    
    
    1,901,143Total
      assets
    
    $
    381,828,720
    
    $
    585,748,475**Liabilities
      and stockholders’ equity**Current
      liabilities:Accounts
      payable
    
    $
    13,290,001
    
    $
    16,590,061Taxes
      payable, net
    
    
    2,688,336
    
    
    —Accrued
      expenses
    
    
    9,247,947
    
    
    14,263,873Accrued
      allowances
    
    
    12,099,143
    
    
    18,563,026Accrued
      royalties
    
    
    10,853,721
    
    
    14,623,280Current
      maturities of term notes
    
    
    15,000,000
    
    
    16,562,500Other
      current liabilities
    
    
    4,927,573
    
    
    846,618Total
      current liabilities
    
    
    68,106,721
    
    
    81,449,358Line
      of credit
    
    
    35,000,000
    
    
    50,000,000Term
      notes, less current maturities
    
    
    35,000,000
    
    
    64,687,500Deferred
      income taxes
    
    
    6,105,203
    
    
    31,632,972Other
      long-term liabilities
    
    
    12,317,413
    
    
    11,216,229Total
      liabilities
    
    
    156,529,337
    
    
    238,986,059Commitments
      and contingencies**Stockholders’
      equity**Common
      stock, voting, $0.01 par value, 28,000,000 shares authorized,
      19,193,063
      shares issued and 17,380,598 shares outstanding
      at
      December 31, 2003, and 22,294,833 shares issued and
      20,462,659
      shares outstanding at December 31, 2004
    
    
    191,930
    
    
    222,948Additional
      paid-in capital
    
    
    129,436,178
    
    
    215,014,221Accumulated
      other comprehensive income
    
    
    3,880,567
    
    
    6,543,964Retained
      earnings
    
    
    99,503,301
    
    
    133,481,530233,011,976
    
    
    355,262,663Treasury
      stock, at cost, 1,812,465 shares at December 31, 2003,
      and
      1,832,174 shares at December 31, 2004
    
    
    (7,712,593
    )
    
    (8,500,247
    )Total
      stockholders’ equity
    
    
    225,299,383
    
    
    346,762,416Total
      liabilities and stockholders’ equity
    
    $
    381,828,720
    
    $
    585,748,475


The
accompanying notes are an integral part of these consolidated financial
statements.





F4





**CONSOLIDATED
STATEMENTS OF EARNINGS**








**Year
      Ended December 31,****2002**
    
    **2003**
    
    **2004**Net
      sales
    
    $
    214,925,278
    
    $
    310,945,668
    
    $
    381,424,739Cost
      of sales, related party
    
    
    9,589,712
    
    
    8,255,626
    
    
    7,846,269Cost
      of sales, other
    
    
    93,172,883
    
    
    140,651,980
    
    
    185,650,821Gross
      profit
    
    
    112,162,683
    
    
    162,038,062
    
    
    187,927,649Selling,
      general and administrative expenses
    
    
    70,238,398
    
    
    104,467,274
    
    
    126,264,737Impairment
      of intangible assets
    
    
    —
    
    
    327,000
    
    
    4,318,000Amortization
      of intangible assets
    
    
    —
    
    
    30,000
    
    
    93,750Operating
      income
    
    
    41,924,285
    
    
    57,213,788
    
    
    57,251,162Interest
      expense, net
    
    
    1,835,667
    
    
    3,477,352
    
    
    4,063,290Other
      income
    
    
    (602,931
    )
    
    (145,447
    )
    
    (508,160
    )Income
      before income taxes
    
    
    40,691,549
    
    
    53,881,883
    
    
    53,696,032Income
      tax expense
    
    
    15,946,840
    
    
    15,464,620
    
    
    19,717,803Net
      income
    
    $
    24,744,709
    
    $
    38,417,263
    
    $
    33,978,229Net
      income per share:Basic
    
    $
    1.55
    
    $
    2.25
    
    $
    1.82Diluted
    
    $
    1.47
    
    $
    2.12
    
    $
    1.72Weighted
      average shares outstanding:Basic
    
    
    15,980,958
    
    
    17,059,589
    
    
    18,687,057Diluted
    
    
    16,828,924
    
    
    18,104,969
    
    
    19,761,156





The
accompanying notes are an integral part of these consolidated financial
statements.





F5





**CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY**





**Common
      Stock**
    
    
    
    **Treasury
      Stock****Shares**
    
    **Amount**
    
    **Stock
      Warrants Outstanding**
    
    **Shares**
    
    **Amount**
    
    **Accumulated**
      **Other**
      **Comprehensive**
      **Income
      (Loss)**
    
    **Additional**
      **Paid-in**
      **Capital**
    
    **Retained**
      **Earnings**
    
    **Total**
      **Stockholders’**
      **Equity**
    
    **Comprehensive**
      **Income****BALANCE,
      DECEMBER 31, 2001**
    
    
    14,617,408
    
    $
    164,515
    
    $
    728,740
    
    
    1,834,100
    
    $
    (7,830,255
    )
    $
    (593,837
    )
    $
    89,288,930
    
    $
    36,341,329
    
    $
    118,099,422Net
      income
    
    
    
    
    
    —
    
    
    —
    
    
    
    
    
    —
    
    
    —
    
    
    —
    
    
    24,744,709
    
    
    24,744,709
    
    $
    24,744,709Public
      stock offering
    
    
    1,545,000
    
    
    15,450
    
    
    —
    
    
    
    
    
    —
    
    
    —
    
    
    24,721,460
    
    
    —
    
    
    24,736,910
    
    
    —Stock
      issued upon option exercise
    
    
    31,200
    
    
    312
    
    
    —
    
    
    
    
    
    —
    
    
    —
    
    
    296,678
    
    
    —
    
    
    296,990
    
    
    —Stock
      warrants exercised
    
    
    265,958
    
    
    2,659
    
    
    (651,316
    )
    
    
    
    
    —
    
    
    —
    
    
    4,282,772
    
    
    —
    
    
    3,634,115
    
    
    —Stock
      warrants expired
    
    
    
    
    
    —
    
    
    (77,424
    )
    
    
    
    
    —
    
    
    —
    
    
    77,424
    
    
    —
    
    
    —
    
    
    —Reissue
      treasury stock
    
    
    3,805
    
    
    —
    
    
    —
    
    
    (3,805
    )
    
    20,690
    
    
    —
    
    
    38,383
    
    
    —
    
    
    59,073
    
    
    —Other
      comprehensive income-foreign
      currency
      translation adjustments,
      net
      of tax
    
    
    
    
    
    —
    
    
    —
    
    
    
    
    
    —
    
    
    662,168
    
    
    —
    
    
    —
    
    
    662,168
    
    
    662,168Other
      comprehensive loss-minimum
      pension
      liability adjustments,
      net
      of tax
    
    
    
    
    
    —
    
    
    —
    
    
    
    
    
    —
    
    
    (1,352,840
    )
    
    —
    
    
    —
    
    
    (1,352,840
    )
    
    (1,352,840
    )Comprehensive
      income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    24,054,037**BALANCE,
      DECEMBER 31, 2002**
    
    
    16,463,371
    
    $
    182,936
    
    $
    —
    
    
    1,830,295
    
    $
    (7,809,565
    )
    $
    (1,284,509
    )
    $
    118,705,647
    
    $
    61,086,038
    
    $
    170,880,547Net
      income
    
    
    
    
    
    —
    
    
    —
    
    
    
    
    
    —
    
    
    —
    
    
    —
    
    
    38,417,263
    
    
    38,417,263
    
    $
    38,417,263Stock
      issued upon option exercise
    
    
    232,731
    
    
    2,327
    
    
    —
    
    
    
    
    
    —
    
    
    —
    
    
    1,384,395
    
    
    —
    
    
    1,386,722
    
    
    —Tax
      benefit of stock option exercise
    
    
    
    
    
    —
    
    
    —
    
    
    
    
    
    —
    
    
    —
    
    
    1,407,763
    
    
    —
    
    
    1,407,763
    
    
    —Stock
      issued in acquisition
    
    
    666,666
    
    
    6,667
    
    
    —
    
    
    
    
    
    —
    
    
    —
    
    
    7,803,325
    
    
    —
    
    
    7,809,992
    
    
    —Stock
      issued under ESPP
    
    
    10,580
    
    
    —
    
    
    —
    
    
    (10,580
    )
    
    57,548
    
    
    —
    
    
    83,087
    
    
    —
    
    
    140,635
    
    
    —Reissue
      treasury stock
    
    
    7,250
    
    
    —
    
    
    —
    
    
    (7,250
    )
    
    39,424
    
    
    —
    
    
    51,961
    
    
    —
    
    
    91,385
    
    
    —Other
      comprehensive income-foreign
      currency
      translation adjustments
    
    
    
    
    
    —
    
    
    —
    
    
    
    
    
    —
    
    
    5,319,686
    
    
    —
    
    
    —
    
    
    5,319,686
    
    
    5,319,686Other
      comprehensive loss-
      minimum
      pension liability
      adjustments,
      net of tax
    
    
    
    
    
    —
    
    
    —
    
    
    
    
    
    —
    
    
    (154,610
    )
    
    —
    
    
    —
    
    
    (154,610
    )
    
    (154,610
    )Comprehensive
      income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    43,582,339**BALANCE,
      DECEMBER 31, 2003**
    
    
    17,380,598
    
    $
    191,930
    
    $
    —
    
    
    1,812,465
    
    $
    (7,712,593
    )
    $
    3,880,567
    
    $
    129,436,178
    
    $
    99,503,301
    
    $
    225,299,383Net
      income
    
    
    
    
    
    —
    
    
    —
    
    
    
    
    
    —
    
    
    —
    
    
    —
    
    
    33,978,229
    
    
    33,978,229
    
    $
    33,978,229Public
      stock offering
    
    
    2,655,000
    
    
    26,550
    
    
    —
    
    
    
    
    
    —
    
    
    —
    
    
    77,459,532
    
    
    —
    
    
    77,486,082
    
    
    —Stock
      issued upon option exercise
    
    
    355,382
    
    
    3,554
    
    
    —
    
    
    
    
    
    —
    
    
    —
    
    
    2,068,645
    
    
    —
    
    
    2,072,199
    
    
    —Tax
      benefit of stock option exercise
    
    
    
    
    
    —
    
    
    —
    
    
    
    
    
    —
    
    
    —
    
    
    3,075,619
    
    
    —
    
    
    3,075,619
    
    
    —Stock
      issued in acquisition
    
    
    91,388
    
    
    914
    
    
    —
    
    
    
    
    
    —
    
    
    —
    
    
    2,867,390
    
    
    —
    
    
    2,868,304
    
    
    —Stock
      issued under ESPP
    
    
    6,247
    
    
    —
    
    
    —
    
    
    (6,247
    )
    
    33,984
    
    
    —
    
    
    106,857
    
    
    —
    
    
    140,841
    
    
    —Treasury
      stock acquisition
    
    
    (25,956
    )
    
    —
    
    
    —
    
    
    25,956
    
    
    (821,638
    )
    
    —
    
    
    —
    
    
    —
    
    
    (821,638
    )
    
    —Other
      comprehensive income-foreign
      currency
      translation adjustments
    
    
    
    
    
    —
    
    
    —
    
    
    
    
    
    —
    
    
    3,551,728
    
    
    —
    
    
    —
    
    
    3,551,728
    
    
    3,551,728Other
      comprehensive loss-
      minimum
      pension liability
      adjustments,
      net of tax
    
    
    
    
    
    —
    
    
    —
    
    
    
    
    
    —
    
    
    (888,331
    )
    
    —
    
    
    —
    
    
    (888,331
    )
    
    (888,331
    )Comprehensive
      income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    36,641,626**BALANCE,
      DECEMBER 31, 2004**
    
    
    20,462,659
    
    $
    222,948
    
    $
    —
    
    
    1,832,174
    
    $
    (8,500,247
    )
    $
    6,543,964
    
    $
    215,014,221
    
    $
    133,481,530
    
    $
    346,762,416




The
accompanying notes are an integral part of these consolidated financial
statements.





F6





**CONSOLIDATED
STATEMENTS OF CASH FLOWS**





**Year
      Ended December 31,****2002**
    
    **2003**
    
    **2004****Operating
      activities**Net
      income
    
    $
    24,744,709
    
    $
    38,417,263
    
    $
    33,978,229Adjustments
      to reconcile net income to net cash
      provided
      by operating activities:Depreciation
    
    
    9,064,997
    
    
    11,950,461
    
    
    15,309,528Impairment
      of intangible assets
    
    
    —
    
    
    327,000
    
    
    4,318,000Provision
      for uncollectible accounts
    
    
    808,064
    
    
    2,089,204
    
    
    767,169Interest
      on deferred financing costs
    
    
    687,849
    
    
    246,129
    
    
    828,771Amortization
      of intangible assets
    
    
    —
    
    
    30,000
    
    
    93,750Loss
      (gain) on disposition of assets
    
    
    (314,241
    )
    
    112,852
    
    
    56,073Deferred
      income taxes
    
    
    3,157,440
    
    
    (6,757,457
    )
    
    8,385,752Changes
      in operating assets and liabilities:Accounts
      and other receivables
    
    
    5,706,990
    
    
    (26,766,961
    )
    
    2,216,593Inventory
    
    
    (5,547,482
    )
    
    7,032,219
    
    
    5,488,130Prepaid
      expenses
    
    
    (1,011,260
    )
    
    1,242,176
    
    
    53,634Accounts
      payable and accrued expenses
    
    
    (3,833,820
    )
    
    170,564
    
    
    (2,574,645
    )Other
      liabilities
    
    
    537,001
    
    
    9,857,813
    
    
    (4,630,769
    )Net
      cash provided by operating activities
    
    
    34,000,247
    
    
    37,951,263
    
    
    64,290,215**Investing
      activities**Purchase
      of property and equipment
    
    
    (9,515,679
    )
    
    (10,752,389
    )
    
    (15,091,603
    )Proceeds
      from disposal of property and equipment
    
    
    457,003
    
    
    33,290
    
    
    166,656Purchase
      of LCI, net of cash acquired
    
    
    —
    
    
    (99,381,955
    )
    
    —Purchase
      of Playing Mantis, net of cash acquired
    
    
    —
    
    
    —
    
    
    (17,238,056
    )Purchase
      of TFY, net of cash acquired
    
    
    —
    
    
    —
    
    
    (154,567,407
    )Decrease
      (increase) in other non-current assets
    
    
    123,615
    
    
    (3,963,090
    )
    
    1,745,373Net
      cash used in investing activities
    
    
    (8,935,061
    )
    
    (114,064,144
    )
    
    (184,985,037
    )**Financing
      activities**Net
      cash proceeds from public stock offering
    
    
    24,736,910
    
    
    —
    
    
    77,486,082Issuance
      of stock upon option exercises
    
    
    296,990
    
    
    1,386,722
    
    
    2,072,199Issuance
      of stock under employee stock purchase plan
    
    
    —
    
    
    140,635
    
    
    140,841Proceeds
      from bank term loans
    
    
    —
    
    
    60,000,000
    
    
    85,000,000Payment
      on bank term loans
    
    
    (62,000,000
    )
    
    (10,000,000
    )
    
    (53,750,000
    )Net
      borrowings on line of credit
    
    
    8,000,000
    
    
    27,000,000
    
    
    15,000,000Proceeds
      from stock warrants exercised
    
    
    3,634,115
    
    
    —
    
    
    —Purchase
      of stock to be held in treasury
    
    
    —
    
    
    —
    
    
    (821,638
    )Proceeds
      from reissuance of treasury stock
    
    
    59,073
    
    
    91,385
    
    
    —Payment
      of note payable
    
    
    —
    
    
    (2,861,816
    )
    
    —Financing
      fees paid
    
    
    —
    
    
    (935,297
    )
    
    (1,942,193
    )Net
      cash provided by (used in) financing activities
    
    
    (25,272,912
    )
    
    74,821,629
    
    
    123,185,291Effect
      of exchange rate changes on cash
    
    
    802,334
    
    
    768,163
    
    
    1,051,857Net
      increase (decrease) in cash and cash equivalents
    
    
    594,608
    
    
    (523,089
    )
    
    3,542,326Cash
      and cash equivalents, beginning of year
    
    
    16,509,550
    
    
    17,104,158
    
    
    16,547,951Restricted
      cash
    
    
    —
    
    
    (33,118
    )
    
    33,118Cash
      and cash equivalents, end of year
    
    $
    17,104,158
    
    $
    16,547,951
    
    $
    20,123,395Supplemental
      disclosure of cash flow information:Cash
      paid for interest during the period
    
    $
    1,712,592
    
    $
    3,439,022
    
    $
    3,416,225Cash
      paid for income taxes during the period
    
    $
    14,845,702
    
    $
    8,754,396
    
    $
    11,986,769Cash
      refund received for income taxes
    
    $
    335,935
    
    $
    777,527
    
    $
    344,861Non-cash
      write-off of pension liability against goodwill,
      net
      of income taxes
    
    $
    1,055,695
    
    
    —
    
    
    —Non-cash
      investing and financing activity during the period:
      666,666
      shares of stock issued for the purchase of LCI
    
    
    —
    
    $
    7,809,992
    
    
    —91,388
      shares of stock issued for the purchase of Playing Mantis
    
    
    —
    
    
    —
    
    $
    2,868,304





The
accompanying notes are an integral part of these consolidated financial
statements.





F7





**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**





**FOR
THE YEARS ENDED DECEMBER 31, 2002, 2003 AND 2004**







**1.
DESCRIPTION OF BUSINESS**





Founded
in 1989, RC2 Corporation and Subsidiaries, (collectively, the Company), is a
leading designer, producer and marketer of innovative, high-quality toys,
collectibles, hobby and infant care products targeted to consumers of all ages.
RC2’s infant and preschool products are marketed under its Learning Curve®
family of brands which includes The First Years®, Eden®, and Lamaze brands as
well as popular and classic licensed properties such as Thomas and Friends, Bob
the Builder, Winnie the Pooh, John Deere and Sesame Street. RC2 markets its
collectible and hobby products under a portfolio of brands including Racing
Champions®, Ertl®, Ertl Collectibles®, American MuscleTM, Johnny Lightning®,
AMT®, Polar Lights®,
Press Pass®,  JoyRide®, JoyRide Studios®, Memory LaneTM, and W. Britain®.
RC2 reaches its target consumers through multiple channels of distribution
supporting more than 25,000 retail outlets throughout North America, Europe,
Australia and Asia Pacific.





**2.
RECAPITALIZATION AND ACQUISITIONS**





**Recapitalization**





Purchase
price in excess of the book value of the net assets acquired in connection with
the Company’s recapitalization (Recapitalization) in 1996 of $88.7 million,
which is deductible for tax purposes over 15 years, has been recorded as
goodwill and through December 31, 2001, was being amortized on a straight-line
basis over a 40-year period.





**RC2
Corporation and The Ertl Company, Inc.**





On April
13, 1999, the Company purchased all of the outstanding shares of The Ertl
Company, Inc. (subsequently renamed RC2 Brands, Inc.) and certain of its
affiliates. The purchase was funded with a drawdown on a previous credit
facility. The excess of the aggregate purchase price over the fair market value
of net assets acquired of approximately $31.1 million was being amortized on a
straight-line basis over 40 years through December 31, 2001.





**RC2
Corporation and Learning Curve International, Inc.**





On March
4, 2003, with an effective date of February 28, 2003, the Company acquired LCI
through the merger of a wholly owned subsidiary of RC2 with and into Learning
Curve for approximately $104.4 million in cash (excluding transaction expenses)
and 666,666 shares of the Company’s common stock, including $12.0 million in
escrow to secure Learning Curve’s indemnification obligations under the merger
agreement. Additional consideration of up to $6.5 million was contingent upon
LCI product lines reaching certain sales and margin targets in 2003. The
contingent consideration was not payable because the targets were not met in
2003. LCI develops and markets a variety of high-quality, award-winning
children’s and infant toys for every stage of childhood from birth through age
eight. This transaction has been accounted for under the purchase method of
accounting and, accordingly, the operating results of LCI have been included in
our consolidated statements of earnings since the effective date of the
acquisition. The purchase was funded with a credit facility (See Note 7 - “Debt”
on page F22). Additionally, the Company purchased the remaining minority
interest of several of the LCI affiliates subsequent to February 28, 2003. As a
result, all subsidiaries of the Company are wholly owned. Minority interest
income of $9,570 has been included in selling, general and administrative
expenses in our accompanying consolidated statements of earnings for those
periods prior to the remaining minority interest purchases. The excess of the
aggregate purchase price over the fair market value of net assets acquired of
approximately $39.8 million and $49.6 million has been recorded as goodwill in
the accompanying consolidated balance sheets at December 31, 2003 and 2004,
respectively.








F8





During
the quarter ended September 30, 2004, the Company became aware that a long-term
deferred tax liability of approximately $11.5 million should have been recorded
during the quarter ended December 31, 2003 with a corresponding increase in
goodwill related to the LCI licenses that were determined through actuarial
valuation to have a capitalizable fair value of  approximately
$40 million. This adjustment did not have any impact on the Company’s
consolidated statement of earnings for the year ended December 31, 2004 nor
would it have had an impact on the consolidated statement of earnings for the
year ended December 31, 2003, had it been recorded at that time. This adjustment
also did not have a material impact on the Company’s consolidated balance sheet
or impact the Company’s compliance with debt covenants at December 31, 2004 nor
would it have if it had been recorded at December 31, 2003. The $11.5 million
deferred tax liability adjustment is presented in the liabilities line in the
purchase price allocation table below.





The
purchase price was allocated to the net assets of LCI based on their estimated
relative fair values on February 28, 2003, and as of the dates of the remaining
minority interest purchases, including the long-term deferred tax liability
discussed above, as follows:





(In
thousands)


Total
      purchase price, including expenses
    
    
    
    
    $
    116,965Less:Current
      assets
    
    $
    51,678Property,
      plant and equipment
    
    
    5,871Intangible
      assets
    
    
    39,627Other
      long-term assets
    
    
    4,353Liabilities
    
    
    (34,180
    )
    
    (67,349
    )Excess
      of purchase price over net assets acquired
    
    
    
    
    $
    49,616





Twelve
million dollars of the purchase price for Learning Curve was originally
deposited in an escrow account to secure Learning Curve’s indemnification
obligations under the merger agreement. In the merger agreement, Learning Curve
agreed to indemnify the Company for losses relating to breaches of Learning
Curve’s representations, warranties and covenants in the merger agreement and
for specified liabilities relating to Learning Curve’s historical business. The
Company may make indemnification claims against the escrow account until the
later of March 31, 2005 or the 10 th day
following resolution of any tax audit or similar proceeding subject to potential
indemnification under the merger agreement. The amount in escrow was reduced to
$10 million in May 2003. During the quarter ended December 31, 2003, Learning
Curve settled litigation involving Playwood Toys, Inc. and the settlement amount
of $11.2 million was funded in part through a $10.1 million payment from the
escrow account, which constituted all of the funds then in the escrow account.
The Company was required to return a part of that amount to the escrow account
based on the tax benefits realized by the Company relating to the settlement
amount less other expenses relating to the litigation. On March 30, 2004, the
Company made additional escrow claims of $295,908 relating primarily to alleged
breaches of Learning Curve’s representations and warranties in the merger
agreement. On August 31, 2004, the Company increased its additional escrow
claims to $552,313. The Company and representatives of the former Learning Curve
shareholders entered into a letter agreement dated December 14, 2004, which
resolved all of the Company’s pending escrow claims and required the Company to
return $2,825,424 to the escrow account which is available for future claims
under the terms of the escrow until the escrow account is closed. Learning Curve
is currently subject to a tax audit which is subject to potential
indemnification under the merger agreement, and as a result, the escrow account
will not close before the 10 th day
following the resolution of this tax audit. In February 2005, the Company
notified the representatives of the former Learning Curve shareholders of the
tax audit and an additional indemnification claim.








F9





**RC2
Corporation and Playing Mantis, Inc.**





On June
7, 2004, the Company acquired substantially all the assets of Playing Mantis,
Inc. (Playing Mantis) with an effective date of June 1, 2004. Closing
consideration consisted of $17.0 million of cash (excluding transaction
expenses) and 91,388 shares of the Company’s common stock. Additional cash
consideration of up to $4.0 million may be earned in the transaction by Playing
Mantis based on achieving net sales and margin targets for 2004 and net sales
targets for 2005. The contingent consideration for 2004 was not payable because
the net sales and margin targets were not met in 2004. Playing Mantis, based in
Mishawaka, Indiana prior to the acquisition, designs and markets collectible
vehicle replicas under the Johnny Lightning® and Polar Lights® brands and
collectible figures under the Memory LaneTM brand. Playing Mantis’ products are
primarily sold at mass merchandising, hobby, craft, drug and grocery chains.
This transaction has been accounted for under the purchase method of accounting
and, accordingly, the operating results of Playing Mantis have been included in
our consolidated statements of earnings since the effective date of the
acquisition. The excess of the aggregate purchase price over the fair market
value of net assets acquired of approximately $14.1 million has been recorded as
goodwill in the accompanying consolidated balance sheet at December 31,
2004.





The
purchase price was allocated to the net assets of Playing Mantis based on their
estimated relative fair values on June 1, 2004 as follows:





(In
thousands)


Total
      purchase price, including expenses, net of cash acquired
    
    
    
    
    $
    20,106Less:Current
      assets
    
    $
    4,569Property,
      plant and equipment
    
    
    4,966Liabilities
    
    
    (3,549
    )
    
    (5,986
    )Excess
      of purchase price over net assets acquired
    
    
    
    
    $
    14,120





The
allocation of the purchase price is subject to final determination based on
valuations and other determinations that will be completed as soon as practical
but no later than by the end of the second quarter of 2005 including performing
valuations to determine the fair value of any acquired identifiable intangible
assets. To the extent such assets are amortizable, amortization expense will be
increased.





**RC2
Corporation and The First Years Inc.**





On
September 15, 2004, the Company acquired The First Years Inc. (TFY) for
approximately $156.1 million in cash (excluding transaction expenses). TFY,
based in Avon, Massachusetts, is an international developer and marketer of
infant and toddler care and play products sold under The First Years® brand name
and under various licenses, including Disney's Winnie the Pooh. TFY’s products
are sold at toy, mass merchandising, drug and grocery chains, and at specialty
retailers. This transaction has been accounted for under the purchase method of
accounting and, accordingly, the operating results of TFY have been included in
the accompanying consolidated statements of earnings since the effective date of
the acquisition. The purchase was funded with the Company’s new credit facility
(See Note 7 - “Debt” on page F22). The excess of the aggregate purchase price
over the fair market value of net assets acquired of approximately $97.6 million
has been recorded as goodwill in the accompanying consolidated balance sheet at
December 31, 2004.








F10





The
purchase price was allocated to the net assets of TFY based on their estimated
relative fair values on September 15, 2004 as follows:





(In
thousands)


Total
      purchase price, including expenses, net of cash acquired
    
    
    
    
    $
    154,567Less:Current
      assets
    
    $
    46,908Property,
      plant and equipment
    
    
    10,026Intangible
      assets
    
    
    18,250Other
      long-term assets
    
    
    60Liabilities
    
    
    (18,242
    )
    
    (57,002
    )Excess
      of purchase price over net assets acquired
    
    
    
    
    $
    97,565





The
allocation of purchase price is subject to final determination based on
valuations and other determinations that will be completed as soon as practical
but no later than by the end of the third quarter of 2005 including performing
valuations to finalize the fair value of any acquired identifiable intangible
assets. To the extent such assets are amortizable, amortization expense will be
increased.





The
following table presents the unaudited pro forma consolidated results of
operations for the years ended December 31, 2003 and 2004. The unaudited pro
forma consolidated results of operations for the year ended December 31, 2003
assume that the TFY and LCI acquisitions occurred as of January 1, 2003. The
unaudited pro forma consolidated results of operations for the year ended
December 31, 2004 assume that the TFY acquisition occurred as of January 1, 2003
(LCI was acquired effective February 28, 2003 and is therefore already included
in the results of operations for the year ended December 31, 2004). The
unaudited pro forma consolidated results of operations for the years ended
December 31, 2003 and 2004 exclude Playing Mantis for the periods prior to the
acquisition due to the immateriality of the results of operations of Playing
Mantis.





(In
      thousands, except per share data)
    
    **2003**
    
    **2004**Net
      sales
    
    $
    463,087
    
    $
    482,482Net
      income
    
    $
    41,469
    
    $
    37,255Net
      income per share:Basic
    
    $
    2.41
    
    $
    1.99Diluted
    
    $
    2.28
    
    $
    1.89





Pro forma
data does not purport to be indicative of the results that would have been
obtained had these acquisitions actually occurred at January 1, 2003 and is not
intended to be a projection of future results.





**3.
SIGNIFICANT ACCOUNTING POLICIES**





**Principles
of Consolidation**





The
consolidated financial statements include the accounts of RC2 Corporation and
its wholly owned subsidiaries. All intercompany transactions and balances have
been eliminated.





**Foreign
Currency Translation/Transactions**





Foreign
subsidiary assets and liabilities are reported in the local currency and
translated at the rates of exchange at the balance sheet date while income
statement accounts and cash flows are translated at the average exchange rates
in effect during the period. Exchange gains and losses resulting from
translation for the years ended December 31, 2002, 2003 and 2004, have been
recorded as a component of accumulated other comprehensive income in
stockholders’ equity. The net exchange losses resulting from transactions in
foreign currencies for the years ended December 31, 2002 and 2003 were $316,788
and $403,750, respectively. The net exchange gains resulting from transactions
in foreign currencies for the year ended December 31, 2004 were $29,916. These
net exchange gains and losses are included in other income on the accompanying
consolidated statements of earnings.





F11





**Revenue
Recognition**





The
Company recognizes revenue based upon transfer of title of products to
customers. The Company provides for estimated credits and other concessions at
the time the sale is recorded, and these credits and other concessions are
recorded as a reduction of gross sales. The Company’s revenue recognition policy
is the same for each channel of distribution.





The
Company ordinarily accepts returns only for defective merchandise. In certain
instances, where retailers are unable to resell the quantity of products that
they have purchased from the Company, the Company may, in accordance with
industry practice, assist retailers in selling excess inventory by offering
credits and other price concessions, which are typically evaluated and issued
annually. Other allowances can also be issued for defective merchandise, volume
programs and co-op advertising. All allowances are accrued throughout the year,
as sales are recorded. Certain Learning Curve branded product carry a lifetime
product warranty and certain TFY branded products carry a satisfaction
guarantee. Historical results of these product warranties have shown that they
have had an immaterial impact on the Company. Based upon the historical results,
appropriate allowances for product warranty claims are accrued throughout the
year.





**Shipping
and Handling Costs**





Shipping
and handling costs are included in selling, general and administrative expenses
in the accompanying consolidated statements of earnings. For the years ended
December 31, 2002, 2003 and 2004, shipping and handling costs were $7.3 million,
$11.0 million and $13.9 million, respectively.





**Cash
and cash equivalents**





The
Company considers all highly liquid investments with original maturities of 90
days or less to be cash equivalents. Such investments are stated at cost, which
approximates fair value.





The
Company had restricted cash of $33,118 at December 31, 2003, relating to
guarantees required for payroll expenses in Australia and rental payments for
our facility in Germany. The Company did not have restricted cash at December
31, 2004.





**Use
of Estimates**





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





**Inventory**





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





F12





**Property
and Equipment**





Property
and equipment are recorded at cost. Depreciation is computed using the
straight-line method for financial statement purposes at rates adequate to
depreciate the cost of applicable assets over their expected useful lives.
Accelerated methods are used for income tax purposes. Repairs and maintenance
are charged to expense as incurred. Gains or losses resulting from sales or
retirements are recorded as incurred, at which time related costs and
accumulated depreciation are removed from the accounts. The estimated useful
lives used in computing depreciation for financial statement purposes are as
follows:





**Asset
      Descriptions**
    **Estimated
      Useful Life**Buildings
      and improvements
    2-15
      yearsTooling
    2-7
      yearsOther
      equipment
    2-10
      years





Tooling
impairments, related to discontinued product lines primarily in the North
America segment, in the total of $2.5 million were recorded in 2004 and are
included in cost of sales, other in the accompanying consolidated statement
of earnings for the year ended Decmeber 21, 2004.





**Goodwill
and Intangible Assets**





Intangible
assets were $44.0 million and $58.2 million at December 31, 2003 and 2004,
respectively, and are recorded at fair market value at date of acquisition less
accumulated amortization. At December 31, 2003, intangible assets consist of a
pension asset of $0.2 million and licenses and trademarks of $43.8 million. At
December 31, 2004 intangible assets consist of a pension asset of $0.2 million,
a non-compete agreement related to the TFY acquisition of $0.6 million, and
licenses and trademarks of $57.4 million.





There are
two intangible assets with defined lives. One was amortized in full as of
December 31, 2003. The other intangible asset, which relates to the non-compete
agreement, is being amortized over its defined life of two years. All other
remaining intangible assets have been assigned indefinite lives. No amortization
expense was recorded in 2002. Amortization expense for the years ended December
31, 2003 and 2004 was $30,000 and $93,750, respectively. Amortization expense of
$375,000 is projected for the year ending December 31, 2005, pending the
completion of the valuations to determine the fair value of any acquired
identifiable intangible assets from the current year acquisitions.





On June
30, 2001, the Financial Accounting Standards Board (FASB) issued Statement No.
142, “Goodwill and Other Intangible Assets” (SFAS No. 142). Under SFAS No. 142,
goodwill and other intangible assets that have indefinite useful lives are not
amortized, but rather will be tested at least annually for impairment. 
Intangible assets that have finite useful lives continue to be amortized over
their useful lives. The Company adopted SFAS No. 142 on January 1, 2002.
Goodwill had been amortized over 40 years on a straight-line basis through
December 31, 2001. As of December 31, 2002, goodwill, net of accumulated
amortization, was approximately $119.2 million. During 2002, the Company wrote
off approximately $1.1 million of pension obligations (net of income tax of $0.7
million) and adjusted goodwill. As of December 31, 2003, goodwill, net of
accumulated amortization, was approximately $159.7 million, with the increase
primarily due to the acquisition of LCI. As of December 31, 2004, goodwill, net
of accumulated amortization, was approximately $282.4 million, with the increase
primarily due to the acquisitions of Playing Mantis and TFY. The Company has
completed its transitional impairment test as of January 1, 2002, and its annual
goodwill impairment tests as of October 1, 2002, 2003 and 2004, and impairment
tests for intangible assets as of October 1, 2003 and 2004. The goodwill
impairment tests completed in October 2002, 2003 and 2004 resulted in no
goodwill impairment. However, impairment charges for intangible assets in
the North America segment of $0.3 million and $4.3 million have been included in
the accompanying consolidated statements of earnings for the years ended
December 31, 2003 and 2004, respectively. The impairment charges are based upon
the Company’s decision to discontinue certain low-performing product
lines.





F13





The
change in carrying value of goodwill by reporting unit for the years ended 2004
and 2003 is shown below.





(in
      thousands)
    
    **North**
      **America**
    
    **International**
    
    **Total**Balance
      at year end 2002
    
    $
    107,686
    
    $
    11,536
    
    $
    119,222Ertl
      acquisition
    
    
    (445
    )
    
    —
    
    
    (445
    )LCI
      acquisition
    
    
    38,308
    
    
    1,470
    
    
    39,778Impact
      of currency exchange rate changes
    
    
    —
    
    
    1,165
    
    
    1,165Balance
      at year end 2003
    
    
    145,549
    
    
    14,171
    
    
    159,720LCI
      acquisition
    
    
    10,128
    
    
    (290
    )
    
    9,838Playing
      Mantis acquisition
    
    
    14,120
    
    
    —
    
    
    14,120TFY
      acquisition
    
    
    97,565
    
    
    —
    
    
    97,565Impact
      of currency exchange rate changes
    
    
    —
    
    
    1,124
    
    
    1,124Balance
      at year end 2004
    
    $
    267,362
    
    $
    15,005
    
    $
    282,367





**Other
Assets**





Other
assets at December 31, 2003, consist of deferred financing fees relating to the
March 4, 2003, credit facility and refundable deposits for leased equipment.
Other assets at December 31, 2004, consist primarily of deferred financing fees
relating to the September 15, 2004, credit facility. The deferred financing fees
are being amortized over the term of the debt agreement. Amortization
of deferred financing fees for the years ended December 31, 2003 and 2004,
was approximately $0.2 million and $0.8 million, respectively, and is included
in interest expense in the accompanying consolidated statements of earnings.
Interest expense for the year ended December 31, 2004 includes $0.5 million
relating to the write-off of fees associated with the March 4, 2003 credit
facility.





**Allowance
for Doubtful Accounts**





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





**Accrued
Allowances**





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





**Accrued
Royalties**





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




F14





**Concentration
of Credit Risk**





Concentration
of credit risk is limited to trade accounts receivable and is subject to the
financial conditions of certain major customers. There was one customer
accounting for approximately 11.7% and 10.8% of net sales for the years ended
December 31, 2002 and 2003, respectively, an additional customer accounting for
approximately 14.9% of net sales for the year ended December 31, 2002 and one
additional customer accounting for approximately 10.5% of net sales for the year
ended December 31, 2004. Additionally, one customer accounted for approximately
21.5%, 15.0% and 14.5% of accounts receivable at December 31, 2002, 2003 and
2004, respectively, a second customer accounted for approximately 10.2% of
accounts receivable at December 31, 2002, a third customer accounted for
approximately 13.0% and 13.7% of accounts receivable at December 31, 2003 and
2004, and a fourth customer accounted for approximately 16.2% and 13.1% of
accounts receivable at December 31, 2003 and 2004. The Company does not require
collateral or other security to support customers’ receivables. The Company
conducts periodic reviews of its customers’ financial condition and vendor
payment practices to minimize collection risks on trade accounts receivable. The
Company has purchased credit insurance, which covers a portion of its
receivables from major customers.





**Supplier
Concentration**





The
Company’s purchases in 2002 from three of its third-party, dedicated suppliers
were 24.9%, 18.0% and 11.6%, respectively, of its total product purchases. The
Company’s purchases in 2003 from two of its third-party, dedicated suppliers
were 15.2% and 13.2%, respectively, of its total product purchases. The
Company’s purchases in 2004 from two of its third-party, dedicated suppliers
were 16.1% and 14.3%, respectively, of its total product purchases. There were
no other suppliers accounting for more than 10.0% of total product purchases
during the years ended December 31, 2002, 2003 and 2004.





**Fair
Value of Financial Instruments**





The
carrying amounts of cash and cash equivalents, receivables, accounts payable and
accrued expenses approximate fair value because of the short-term nature of the
items. The carrying amount of the line of credit and the term notes approximates
their fair value.





**Derivative
Instruments**





The
Company accounted for its interest rate collar under Statement of Financial
Accounting Standards (SFAS) No. 133, “Accounting for Derivative Instruments and
Hedging Activities.” Under SFAS No. 133, the Company had recorded the interest
rate collar on the consolidated balance sheets at its fair value. Changes in
fair value were recorded in interest expense in the consolidated statements of
earnings. The interest rate collar expired in June 2002 and the related fair
value was written off to interest expense at expiration.





**Advertising**





The
Company expenses the production costs of advertising the first time the
advertising takes place. Advertising expense for the years ended December 31,
2002, 2003 and 2004, was approximately $2.6 million, $1.9 million and $2.3
million, respectively.





Prepaid
advertising expenses, such as prepayments on magazine advertisements and artwork
costs of $148,032 and $271,064 are included in prepaid expenses on the
accompanying consolidated balance sheets at December 31, 2003 and 2004,
respectively.





**Income
Taxes**





The
Company accounts for income taxes under SFAS No. 109, “Accounting for Income
Taxes.” Under the asset and liability method of SFAS No. 109, deferred income
taxes are recognized for the expected future tax consequences of temporary
differences between financial statement carrying amounts and the tax bases of
existing assets and liabilities and net operating loss and tax credit
carry-forwards using enacted tax rates expected to apply to taxable income in
the years in which those temporary differences are expected to be recovered or
settled. Management considers all available evidence in evaluating the
realizability of the deferred tax assets and records valuation allowances
against its deferred tax assets as needed. Management believes it is more likely
than not that the Company will generate sufficient taxable income in the
appropriate carry-forward periods to realize the benefit of its deferred tax
assets. In determining the required liability, management considers certain tax
exposures and all available evidence.




F15





**Accounting
for Stock-Based Compensation**





The
Company accounts for stock-based compensation arrangements with employees in
accordance with the provisions of Accounting Principles Board (APB) Opinion No.
25, “Accounting for Stock Issued to Employees,” and complies with the disclosure
provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” Under APB
No. 25, compensation expense is based on the difference, if any, on the
measurement date, between the estimated fair value of the Company’s stock and
the exercise price of options to purchase that stock. The compensation expense
is amortized on a straight-line basis over the vesting period of the options. To
date, no compensation expense has been recorded related to stock-based
compensation agreements with employees.





If
compensation costs for stock options issued, including options issued for shares
under the employee stock purchase plan (ESPP), had been determined based on the
fair value at their grant date consistent with SFAS No. 123, the Company’s net
income and net income per share would have been reduced to the following pro
forma amounts:





**Year
      Ended December 31,**(In
      thousands, except per share data)
    
    **2002**
    
    **2003**
    
    **2004**Net
      income as reported
    
    $
    24,745
    
    $
    38,417
    
    $
    33,978Deduct:
      total stock-based employee compensation
      expense
      determined under fair value based
      method
      for all awards, net of related tax effects
    
    
    (797
    )
    
    (958
    )
    
    (1,877
    )Pro
      forma net income
    
    $
    23,948
    
    $
    37,459
    
    $
    32,101Basic
      net income per shareAs
      reported
    
    $
    1.55
    
    $
    2.25
    
    $
    1.82Pro
      forma
    
    $
    1.50
    
    $
    2.20
    
    $
    1.72Diluted
      net income per shareAs
      reported
    
    $
    1.47
    
    $
    2.12
    
    $
    1.72Pro
      forma
    
    $
    1.42
    
    $
    2.07
    
    $
    1.62





The fair
value of each stock option, excluding options issued for shares under the ESPP,
is estimated on the date of grant based on the Black-Scholes option pricing
model that assumes among other things, no dividend yield, risk-free rates of
return from 3.53% to 5.74%, volatility factors of 76.84% to 87.76% and expected
life of 7 to 10 years. The weighted-average fair value of options granted under
the Company’s stock option plan for the years ended December 31, 2002, 2003 and
2004, was $15.61, $11.64 and $19.40 per share, respectively.





The fair
value of each option for shares issued under the ESPP was estimated using the
Black-Scholes model with the following assumptions: risk-free rates of return
from 0.93% to 1.72%, volatility factors of 75.99% to 85.34% and expected life of
three months. The weighted-average fair value of those purchase rights granted
in 2002, 2003 and 2004 were $4.70, $4.86 and $8.43, respectively.





The pro
forma disclosure is not likely to be indicative of pro forma results that may be
expected in future years because of the fact that options vest over several
years. Compensation expense is recognized as the options vest and additional
awards may be granted.





F16





**Net
Income Per Share**





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





**For
      the Year Ended December 31, 2002**(In
      thousands, except per share data)
    
    **Net**
      **Income**
    
    **Weighted**
      **Average**
      **Shares**
    
    **Per**
      **Share**
      **Amount**Basic
      net income per share:
      Net
      income
    
    $
    24,745
    
    
    15,981
    
    $
    1.55Plus
      effect of dilutive securities:
      Stock
      options and warrants
    
    
    —
    
    
    848
    
    
    —Diluted
      net income per share:
      Net
      income plus assumed conversions
    
    $
    24,745
    
    
    16,829
    
    $
    1.47





Options
to purchase 5,000 shares of common stock at $18.72 per share were outstanding
during 2002, but were not included in the computation of diluted earnings per
share because the options’ exercise price was greater than the average market
price of the common shares.





**For
      the Year Ended December 31, 2003**(In
      thousands, except per share data)
    
    **Net**
      **Income**
    
    **Weighted**
      **Average**
      **Shares**
    
    **Per**
      **Share**
      **Amount**Basic
      net income per share:
      Net
      income
    
    $
    38,417
    
    
    17,060
    
    $
    2.25Plus
      effect of dilutive securities:
      Stock
      options
    
    
    —
    
    
    1,045
    
    
    —Diluted
      net income per share:
      Net
      income plus assumed conversions
    
    $
    38,417
    
    
    18,105
    
    $
    2.12





Options
to purchase 5,000 shares of common stock at $18.72 per share were outstanding
during 2003, but were not included in the computation of diluted earnings per
share because the options’ exercise price was greater than the average market
price of the common shares.





**For
      the Year Ended December 31, 2004**(In
      thousands, except per share data)
    
    **Net**
      **Income**
    
    **Weighted**
      **Average**
      **Shares**
    
    **Per**
      **Share**
      **Amount**Basic
      net income per share:
      Net
      income
    
    $
    33,978
    
    
    18,687
    
    $
    1.82Plus
      effect of dilutive securities:
      Stock
      options
    
    
    —
    
    
    1,074
    
    
    —Diluted
      net income per share:
      Net
      income plus assumed conversions
    
    $
    33,978
    
    
    19,761
    
    $
    1.72





Options
to purchase 73,110 shares of common stock at prices between $29.94 and $34.66
per share were outstanding during 2004, but were not included in the computation
of diluted earnings per share because the options’ exercise price was greater
than the average market price of the common shares.








F17





**Comprehensive
Income**





The
Company reports comprehensive income in accordance with SFAS No. 130, “Reporting
Comprehensive Income.” SFAS No. 130 requires companies to report all changes in
equity during a period, except those resulting from investment by owners and
distributions to owners, in a financial statement for the period in which they
are recognized. The Company has chosen to disclose comprehensive income, which
encompasses net income, foreign currency translation adjustments and minimum
pension liability, as part of the consolidated statements of stockholders’
equity. The income tax benefit related to the components of comprehensive income
in 2002, 2003 and 2004 was $(417,106), $(960,816) and $(393,559),
respectively.





**Recently
Issued Accounting Pronouncements**





In
December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment.” This
statement is a revision of SFAS No. 123, “Accounting for Stock-Based
Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to
Employees.” This statement establishes standards for the accounting for
transactions in which an entity exchanges its equity instruments for goods or
services and also addresses transactions in which an entity incurs liabilities
in exchange for goods or services that are based on the fair value of the
entity’s equity instruments or that may be settled by the issuance of those
instruments. This statement applies to all awards granted after the required
effective date and to awards modified, repurchased, or cancelled after that
date. This statement is effective as of the beginning of the first interim or
annual reporting period that begins after June 15, 2005. The Company will adopt
this statement for the quarter beginning July 1, 2005.  We believe the best
indication of the approximate impact on net income of adopting the provisions of
this revised statement may be determined by reviewing the table under the
heading "Accounting for Stock-Based Compensation."  We plan to use the
prospective method and accordingly will not be restating prior periods upon
adoption of SFAS No. 123R.





In
December 2004, the FASB issued FASB Staff Position (FSP) 109-2, “Accounting and
Disclosure Guidance for the Foreign Earnings Repatriation Provision within the
American Jobs Creation Act of 2004.” This FSP was issued to provide accounting
and disclosure guidance for the repatriation provision of the American Jobs
Creation Act of 2004 which was signed into law on October 22, 2004. This FSP was
effective upon issuance and the required disclosures have been included in Note
6 - Income Taxes on page F20.





**Reclassifications**





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





**4.
INSURANCE RECOVERY**





During
2004, the Company received an insurance recovery of approximately $303,000
relating to the lost margin on product destroyed during a fire at the Company’s
third-party warehouse in the United Kingdom in October 2003. The insurance
recovery is included in the Company’s cost of sales, other in the accompanying
consolidated statement of earnings for the year ended December 31,
2004.





**5.
BUSINESS SEGMENTS**





The
Company is a leading designer, producer and marketer of innovative, high-quality
toys, collectibles, hobby and infant care products targeted to consumers of all
ages. The Company has historically reported its results by geographic area in
accordance with the enterprise wide disclosure requirements of SFAS No. 131,
“Disclosure About Segments of an Enterprise and Related
Information.”





The
Company’s reportable segments are North America and International. The North
America segment includes the United States, Canada and Mexico. The International
segment includes non-North America markets.





Segment
performance is measured at the operating income level. Segment assets are
comprised of all assets, net of applicable reserves and
allowances.





F18





Results
are not necessarily those that would be achieved if each segment were an
unaffiliated business enterprise. Information by segment and a reconciliation to
reported amounts for the years ended December 31, 2002, 2003 and 2004 are as
follows:




**Year
      Ended December 31,**(In
      thousands)
    
    **2002**
    
    **2003**
    
    **2004**Net
      sales:North
      America
    
    $
    197,923
    
    $
    276,893
    
    $
    331,707International
    
    
    17,795
    
    
    46,479
    
    
    50,759Sales
      and transfers between segments
    
    
    (793
    )
    
    (12,426
    )
    
    (1,041
    )Combined
      total
    
    $
    214,925
    
    $
    310,946
    
    $
    381,425Operating
      income:North
      America
    
    $
    38,760
    
    $
    50,959
    
    $
    49,595International
    
    
    3,164
    
    
    6,255
    
    
    7,656Combined
      total
    
    $
    41,924
    
    $
    57,214
    
    $
    57,251Depreciation
      and amortization:North
      America
    
    $
    8,158
    
    $
    10,497
    
    $
    13,554International
    
    
    907
    
    
    1,483
    
    
    1,849Combined
      total
    
    $
    9,065
    
    $
    11,980
    
    $
    15,403Capital
      expenditures:North
      America
    
    $
    8,672
    
    $
    7,478
    
    $
    14,232International
    
    
    844
    
    
    3,274
    
    
    860Combined
      total
    
    $
    9,516
    
    $
    10,752
    
    $
    15,092**December
      31,****2003**
    
    
    **2004**Total
      assets:North
      America
    
    
    
    
    $
    328,116
    
    $
    525,526International
    
    
    
    
    
    53,713
    
    
    60,222Combined
      total
    
    
    
    
    $
    381,829
    
    $
    585,748





Under the
enterprise-wide disclosure requirements of SFAS No. 131, the Company reports net
sales by each group of product categories and by distribution channel. With the
acquisitions of Playing Mantis and TFY, the Company has revised its product
categories to reflect the Company’s three product platforms: collectible
products, children’s toys and infant products. The presentation is consistent
with how the Company views its business. Amounts for the years ended December
31, 2002, 2003 and 2004, are as shown in the tables below.





**Year
      Ended December 31,**(In
      thousands)
    
    **2002**
    
    **2003**
    
    **2004**Collectible
      products
    
    $
    181,086
    
    $
    163,355
    
    $
    154,838Children’s
      toys
    
    
    33,839
    
    
    128,715
    
    
    166,406Infant
      products
    
    
    —
    
    
    18,876
    
    
    60,181Net
      sales
    
    $
    214,925
    
    $
    310,946
    
    $
    381,425Chain
      retailers
    
    $
    80,607
    
    $
    151,883
    
    $
    199,637Specialty
      and hobby wholesalers and retailers
    
    
    60,363
    
    
    91,721
    
    
    116,519OEM
      dealers
    
    
    41,043
    
    
    38,613
    
    
    37,810Corporate
      promotional
    
    
    19,869
    
    
    17,842
    
    
    18,216Direct
      to consumers
    
    
    13,043
    
    
    10,887
    
    
    9,243Net
      sales
    
    $
    214,925
    
    $
    310,946
    
    $
    381,425








F19





**6.
INCOME TAXES**





For
financial reporting purposes, income before income taxes includes the following
components:





**Year
      Ended December 31,**(In
      thousands)
    
    **2002**
    
    **2003**
    
    **2004**Income
      before income taxes:United
      States
    
    $
    37,517
    
    $
    47,755
    
    $
    47,072Foreign
    
    
    3,175
    
    
    6,127
    
    
    6,624$
    40,692
    
    $
    53,882
    
    $
    53,696





The
significant components of income tax expense are as follows:





**Year
      Ended December 31,**(In
      thousands)
    
    **2002**
    
    **2003**
    
    **2004**CurrentFederal
    
    $
    10,592
    
    $
    11,492
    
    $
    8,862State
    
    
    568
    
    
    1,629
    
    
    950Foreign
    
    
    926
    
    
    468
    
    
    1,52012,086
    
    
    13,589
    
    
    11,332DeferredFederal
    
    
    3,378
    
    
    2,122
    
    
    8,278State
    
    
    483
    
    
    (664
    )
    
    236Foreign
    
    
    —
    
    
    418
    
    
    (128
    )3,861
    
    
    1,876
    
    
    8,386Income
      tax expense
    
    $
    15,947
    
    $
    15,465
    
    $
    19,718





During
2003, the Company recorded a reduction in the income tax provision of
approximately $1.6 million primarily related to the recognition of foreign net
operating losses and a reduction of approximately $1.8 million related to the
reduction in income tax provision and accruals based on the completion of IRS
audits for the fiscal years 1998 through 2000.





A
reconciliation of the statutory federal tax rate and actual effective income tax
rate is as follows:





**Year
      Ended December 31,****2002**
    
    **2003**
    
    **2004**Statutory
      rate
    
    
    35.0
    %
    
    35.0
    %
    
    35.0
    %State
      taxes, net of federal benefit
    
    
    1.7
    
    
    0.7
    
    
    2.1Foreign
    
    
    (1.0
    )
    
    (2.5
    )
    
    (1.1
    )Other
    
    
    3.5
    
    
    (4.5
    )
    
    0.7Effective
      rate
    
    
    39.2
    %
    
    28.7
    %
    
    36.7
    %




F20





The
significant components of deferred tax assets and liabilities are as
follows:





**December
      31,**(In
      thousands)
    
    **2003**
    
    **2004**Deferred
      tax assetsBad
      debt allowance
    
    $
    1,315
    
    $
    961Inventory
      allowance
    
    
    2,624
    
    
    2,587Sales
      allowance
    
    
    2,232
    
    
    2,936Foreign
      net operating loss carry-forwards
    
    
    1,163
    
    
    783Accrued
      pension
    
    
    1,197
    
    
    1,304Accrued
      legal
    
    
    367
    
    
    317State
      net operating loss carry-forwards
    
    
    315
    
    
    195Accrued
      royalties
    
    
    337
    
    
    228Purchase
      accounting
    
    
    1,895
    
    
    1,857Other
    
    
    1,837
    
    
    393Total
      deferred tax assets
    
    
    13,282
    
    
    11,561Deferred
      tax liabilitiesIntangible
      assets
    
    
    (10,735
    )
    
    (30,205
    )Property
      and equipment
    
    
    (3,837
    )
    
    (4,809
    )Other
    
    
    (479
    )
    
    (1,012
    )Total
      deferred tax liabilities
    
    
    (15,051
    )
    
    (36,026
    )Net
      deferred tax liability
    
    $
    (1,769
    )
    $
    (24,465
    )





Current
deferred income taxes are presented with net prepaid taxes in the accompanying
consolidated balance sheets. Net prepaid (payable) taxes at December 31, 2003
and 2004, were $(2,688,336) and $1,095,350, respectively. Taxes in the amount of
$3.9 million and $2.6 million were charged to goodwill in conjunction with the
acquisitions of LCI, Playing Mantis and TFY during the years ended December 31,
2003 and 2004, respectively.





During
the quarter ended September 30, 2004, the Company became aware that a long-term
deferred tax liability of approximately $11.5 million should have been recorded
during the quarter ended December 31, 2003 with a corresponding increase in
goodwill related to the LCI licenses that were determined through actuarial
valuation to have a capitalizable fair value of  approximately
$40 million. This adjustment did not have any impact on the Company’s
consolidated statement of earnings for the year ended December 31, 2004 nor
would it have had an impact on the consolidated statement of earnings for the
year ended December 31, 2003, had it been recorded at that time. This adjustment
also did not have a material impact on the Company’s consolidated balance sheet
or impact the Company’s compliance with debt covenants at December 31, 2004 nor
would it have if it had been recorded at December 31, 2003.





Pursuant
to The American Jobs Creation Act of 2004 (the Act) enacted on October 22, 2004,
the Company is in the process of evaluating those provisions relating to the
repatriation of certain foreign earnings and their impact on the Company. The
Act provides for a special one time tax deduction of 85 percent of certain
foreign earnings that are repatriated, as defined in the Act. The Company may
elect to apply this provision in 2005. The Company has started its evaluation of
the effects of the repatriation provision, but does not expect to complete the
evaluation until after the Treasury Department provides additional clarifying
language on key elements of the provision. Once such additional clarifying
language is provided, the Company expects to be able to complete its evaluation
within a reasonable time. The range of possible amounts the Company is
considering repatriating is between zero and $5.5 million. The related range of
income tax effects of such repatriation is between zero and $0.7
million.





F21





**7.
DEBT**





Upon the
closing of the acquisition of TFY on September 15, 2004, the Company entered
into a new credit facility to replace its March 4, 2003 credit facility (see
below). This credit facility is comprised of an $85.0 million term loan and a
$100.0 million revolving line of credit, both of which mature on September 14,
2008 with scheduled quarterly principal payments ranging from $3.8 million to
$6.9 million commencing on December 31, 2004 and continuing thereafter with a
final balloon payment upon maturity. Forty million dollars of the term loan has
an interest rate of 3.45% through the first three years of the agreement. The
remaining term loan and revolving loan bear interest, at the Company’s option,
at a base rate or at a LIBOR rate plus applicable margin. The applicable margin
is based on the Company’s ratio of consolidated debt to consolidated EBITDA
(earnings before interest, taxes, depreciation and amortization) and varies
between 1.00% and 1.75%. At December 31, 2004, the margin in effect was 1.75%
for LIBOR loans. The Company is also required to pay a commitment fee of 0.30%
to 0.45% per annum on the average daily unused portion of the revolving loan.
Under the terms of this credit facility, the Company is required to comply with
certain financial and non-financial covenants. Among other restrictions, the
Company is restricted in its ability to pay dividends, incur additional debt and
make acquisitions above certain amounts. The key financial covenants include
minimum EBITDA and interest coverage and leverage ratios. The credit facility is
secured by working capital assets and certain intangible assets. On December 31,
2004, the Company had $131.3 million outstanding on this credit facility and was
in compliance with all covenants.





In
conjunction with the new credit facility, the Company expensed approximately
$0.5 million of deferred financing fees related to the Company’s March 2003
credit facility in interest expense in the accompanying consolidated statement
of earnings for the year ended December 31, 2004. In addition, the Company
incurred approximately $1.9 million in financing fees on the new credit facility
which is included in other assets in the accompanying consolidated balance sheet
at December 31, 2004 and is being charged to interest expense through September
2008.





In August
2004, the Company completed a public offering of 2,655,000 shares of common
stock and certain selling stockholders sold 220,000 shares of common stock at a
price of $31.00 per share. The Company received proceeds of $77.8 million from
the offering, net of underwriting discount, and used $74.0 million of the
proceeds to repay outstanding debt.





Upon the
closing of the acquisition of LCI on March 4, 2003, with an effective date of
February 28, 2003, the Company entered into a credit facility to replace its
April 2002 credit facility (see below). This credit facility was comprised of a
$60.0 million term loan and an $80.0 million revolving loan, both of which were
to mature on April 30, 2006. Thirty million dollars of the term loan had an
interest rate of 2.61% plus applicable margin through the maturity of the
agreement. The remaining term loan and revolving loan bore interest, at the
Company’s option, at a base rate or at a LIBOR rate plus applicable margin. The
applicable margin was based on the Company’s ratio of consolidated debt to
consolidated EBITDA and varied between 0.75% and 1.75%. The facility was
replaced with the September 2004 credit facility discussed above.





In April
2002, the Company completed a public offering of 1,545,000 shares of common
stock and certain selling stockholders sold 3,975,000 shares of common stock at
a price of $17.25 per share. The Company received proceeds of $25.2 million from
the offering, net of underwriting discount, and used $24.0 million of the
proceeds to repay outstanding debt.





In April
2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44,
and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” During
the second quarter of 2002, the Company elected early adoption of this
Statement, and accordingly, included approximately $545,000 of deferred
financing fees related to the Company’s previous credit facility in interest
expense in the accompanying consolidated statement of earnings for the year
ended December 31, 2002. In addition, in connection with the refinancing of the
Company’s credit facility, the Company incurred approximately $284,000 in
financing fees on the new credit facility, which was also included in interest
expense during the year ended December 31, 2002.





Upon the
closing of the public offering in April 2002, the Company entered into a credit
facility to replace its previous credit facility. The credit facility was a
three-year $50.0 million unsecured revolving loan that bore interest, at the
Company’s option, at a base rate or at a LIBOR rate plus a margin that varied
between 0.75% and 1.40%. The applicable margin was based on the Company’s ratio
of consolidated debt to consolidated EBITDA. The facility was replaced with the
March 2003 credit facility discussed above.





F22





The
Company’s credit agreement prior to April 2002 required that the Company
maintain an interest rate protection agreement. Effective June 3, 1999, the
Company entered into an interest rate collar transaction covering $35.0 million
of its debt, with a cap based on 30-day LIBOR rates of 8.0% and a floor of
5.09%. The agreement, which had quarterly settlement dates, was effective
through June 3, 2002.  The Company paid $0.5 million on the agreement,
which is included in interest expense on the accompanying consolidated statement
of earnings for the year ended December 31, 2002.





Effective
January 1, 2001, the Company adopted SFAS No. 133, “Accounting for Derivative
Instruments and Hedging Activities.” As a result of the adoption of this
statement, income of approximately $542,000 was recorded in interest expense
related to the change in fair value of the interest rate collar during the year
ended December 31, 2002.





The
Company’s Hong Kong subsidiary has a credit agreement with a bank that provides
for a line of credit of up to $2.0 million, which is renewable annually on
January 1. Amounts borrowed under this line of credit bear interest at the
bank’s prime rate or prevailing funding cost, whichever is higher, and are
cross-guaranteed by the Company. As of December 31, 2003 and 2004, there were no
outstanding borrowings under this line of credit.





The
Company’s United Kingdom subsidiary has a line of credit with a bank for $0.8
million which expires on July 31, 2005. The line of credit bears interest at
1.0% over the bank’s base rate, and the total amount is subject to a letter of
guarantee given by the Company. At December 31, 2003 and 2004, there were no
amounts outstanding on this line of credit.





Long-term
debt consists of the following:





**December
      31,**(In
      thousands)
    
    **2003**
    
    **2004**Term
      loan payable to banks, bearing interest at
      3.45%
      and 4.22% as of December 31, 2004, with quarterly
      principal
      payments of $3,750 beginning December 31, 2004
      through
      September 30, 2005, quarterly principal payments of $5,313
      from
      December 31, 2005 through September 30, 2007, quarterly
      principal
      payments of $6,875 from December 31, 2007 through
      June
      30, 2008
    
    $
    —
    
    $
    81,250Term
      loan payable to banks, bearing interest at
      4.36%
      and 2.92% as of December 31, 2003
    
    
    50,000
    
    
    —Revolving
      line of credit, bearing interest at
      4.16%
      as of December 31, 2004; matures on September 14, 2008
    
    
    —
    
    
    50,000Revolving
      line of credit, bearing interest at
      2.92%
      as of December 31, 2003
    
    
    35,000
    
    
    —Less
      current maturities
    
    
    (15,000
    )
    
    (16,563
    )$
    70,000
    
    $
    114,687





**8.
COMMITMENTS AND CONTINGENCIES**





The
Company markets a significant portion of its products with licenses from other
parties. These licenses are generally limited in scope and duration and
authorize the sales of specific licensed products on a nonexclusive basis. The
Company has over 700 licenses with various vehicle and equipment manufacturers,
race team owners, drivers, sponsors, agents and entertainment and media
companies, generally for terms of one to three years. Many of the licenses
include minimum guaranteed royalty payments that the Company must pay whether or
not it meets specified sales targets. Aggregate future minimum guaranteed
royalty payments are as follows:





**Year
      Ending December 31,**(In
      thousands)2005
    
    $
    10,6582006
    
    
    9,4432007
    
    
    8,2612008
    
    
    3102009
    
    
    30Thereafter
    
    
    25Total
    
    $
    28,727




F23





Royalties
expensed under licenses, including guaranteed minimums, were $18.7 million,
$26.3 million and $32.0 million for 2002, 2003 and 2004,
respectively.





Rental
expense for office and warehouse space and equipment under cancelable and
noncancelable operating leases amounted to approximately $2.3 million, $3.6
million and $4.2 million for the years ended December 31, 2002, 2003 and 2004,
respectively. Certain operating leases provide for scheduled increases in rental
payments during the term of the lease or for no rent during a part of the term
of the lease. For these leases, the Company generally recognizes total rent
expense on a straight-line basis over the minimum lease term. Commitments for
future minimum lease payments with terms extending beyond one year at December
31, 2004, for noncancelable operating leases are as follows:





**Year
      Ending December 31,**(In
      thousands)2005
    
    $
    4,3912006
    
    
    3,3192007
    
    
    2,5392008
    
    
    2,2792009
    
    
    2,211Thereafter
    
    
    14,842Total
    
    $
    29,581





During
the second quarter of 2004, the Company entered into a 15 year lease agreement
for a 400,000 square foot distribution facility located in Rochelle, Illinois.
Following the execution of this lease, the Company received approximately $1.2
million in the form of a grant and tax credits from the state and local
governments in exchange for agreeing to certain covenants, including a minimum
capital investment and job creation goals. The Company must employ a minimum of
50 employees in Rochelle from March 15, 2006 to December 31, 2008 to remain
compliant with the terms of the award. Should the Company be unable to meet
these minimum requirements, the Company may be required to forfeit or return a
portion of benefits received.





Additionally
in 2004, the Company received approval for a $300,000 forgivable loan and a
3-year interest free $100,000 loan from the state of Iowa to assist in the
expansion of the Dyersville, Iowa distribution facility in exchange for agreeing
to certain covenants, including minimum job creation goals and wage obligations.
The Company must employ a minimum of 92 employees at a specified rate and retain
these employees for at least ninety days past the project completion date to
remain compliant with the terms of the promissory note. Should the Company be
unable to meet these requirements, the Company may be required to forfeit or
return a portion of the benefits received. The Company received the total amount
of $400,000 in December 2004 and it is presented in other long-term liabilities
in the accompanying consolidated balance sheet at December 31,
2004.





In
conjunction with the acquisition of TFY, the Company acquired purchase
commitments with certain vendors relating to product and product components
which are kept on hand to shorten lead times. In the event the product is
discontinued, the Company would be required to reimburse the vendor for the cost
of the products and product components on hand. At December 31, 2004, the total
commitment to these vendors was approximately $1.5 million.




F24





**9.
LEGAL PROCEEDINGS**





During
the quarter ended December 31, 2003, Learning Curve settled the action brought
by Playwood Toys, Inc. in the U.S. District Court for the Northern District of
Illinois alleging that Learning Curve and certain of its officers and employees
misappropriated one or more trade secrets relating to a toy wooden railroad
track manufactured and sold by Learning Curve as Clickety Clack TrackTM. Pursuant
to the settlement agreement, the Company, on behalf of Learning Curve, made a
payment of $11.2 million to the plaintiff. The Company is entitled to
indemnification for the settlement amount, less realizable tax benefits,
pursuant to the merger agreement for the Company’s acquisition of Learning
Curve, and the Company received $10.1 million from an escrow account as of
December 31, 2003, to fund part of the settlement payment. On March 30, 2004,
the Company made additional escrow claims of $295,908 relating primarily to
alleged breaches of Learning Curve’s representations and warranties in the
merger agreement. On August 31, 2004, the Company increased its additional
escrow claims to $552,313. The Company and representatives of the former
Learning Curve shareholders entered into a letter agreement, dated December 14,
2004, which resolved all of the Company’s pending escrow claims and required the
Company to return $2,825,424 to the escrow account, which is available for
future claims under the terms of the escrow until the escrow account is closed.
Learning Curve is currently subject to a tax audit which is subject to potential
indemnification under the merger agreement, and as a result the escrow account
will not close before the 10 th day
following the resolution of this tax audit. In February 2005, the Company
notified the representatives of the former Learning Curve shareholders of the
tax audit and an additional indemnification claim.





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





**10.
CAPITAL STOCK**





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





**Authorized**
      **Shares**
    **Par**
      **Value**
    **Shares
      Outstanding at**
      **December
      31, 2003**
    **Shares
      Outstanding at**
      **December
      31, 2004**Voting
      Common Stock
    28,000,000
    $0.01
    17,380,598
    20,462,659





In August
2004, the Company completed a public offering of 2,655,000 shares of common
stock and certain selling stockholders sold 220,000 shares of common stock at a
price of $31.00 per share. The Company received proceeds of $77.8 million from
the offering, net of underwriting discount, and used $74.0 million of the
proceeds to repay outstanding debt. Additionally, the Company incurred $0.3
million of costs associated with the offering and these costs have been
reflected as a reduction of stockholders’ equity on the Company’s consolidated
balance sheet at December 31, 2004.





At
December 31, 2004, the Company held 1,832,174 shares of its common stock in
treasury. During the year ended December 31, 2004, the Company sold a total of
6,247 shares out of treasury to Company employees under the ESPP for $140,841.
During the year ended December 31, 2003, the Company sold a total of 10,580
shares out of treasury to Company employees under the ESPP for $140,635. In
March of 2003, the Company sold 6,500 shares out of treasury to three of the
Company’s executive officers for $79,677 and issued 750 shares to key employees
as compensation for an underlying value of $11,708. In conjunction with the
public offering discussed above, in August 2004 certain selling stockholders
surrendered a total of 25,956 shares of the Company’s common stock to the
Company as payment for the exercise price of certain options exercised as well
as to fund withholding taxes. These shares were placed into treasury for
$821,638. There were no stock repurchases during 2003.





As
discussed in Note 2, the Company issued 91,388 shares of the Company’s common
stock in June 2004 in connection with its acquisition of Playing Mantis. The
Company also issued 666,666 shares of the Company’s common stock in March 2003
in connection with its acquisition of LCI.








F25





**11.
STOCK OPTION PLAN**





The
Company has an employee stock option plan for its key employees. The employee
stock option plan is administered by the Board of Directors. The Company has
reserved 415,041 shares of common stock for issuance under the plan. On April
30, 1996 and June 1, 1996, the Company granted 311,281 and 20,752 options,
respectively, to purchase shares of common stock at an exercise price equal to
fair market value as determined by the Board of Directors in connection with the
Recapitalization. These options vested in equal installments over a five-year
period. The options will expire on the earlier of the 10 th anniversary of the date of grant or 30 days after the date of termination of the
employees’ employment with the Company. This plan is dormant, and no future
issuances are authorized from this plan.





The
Company maintains a stock incentive plan, under which the Board of Directors may
grant options to purchase up to 2,300,000 shares of common stock to executives
or key employees of the Company at an exercise price equal to fair value. Some
of the options that have been granted vested immediately, and the rest vest over
a five-year period. These options expire on the 10 th anniversary of the date of grant or 90 days after the date of termination of the
employees’ employment with the Company. Under this plan, cancelled options
revert back into the plan and are available for future issuance.





The
Company also maintains an omnibus stock plan, under which the Company has
400,000 shares of its common stock reserved for issuance. In 1997, 254,940
options to purchase shares of the Company’s common stock were granted under this
plan. This plan is dormant, and no future issuances are authorized from this
plan.





Stock
option activity for the Company’s stock option plans for the years ended
December 31, 2002, 2003 and 2004, is as follows:




**Shares**
    **Price**
    **Weighted**
      **Average**
      **Exercise**
      **Price**
    **Shares**
      **Available**
      **for
      Future**
      **Grants**Outstanding
      as of December 31, 2001
    1,666,820
    
    $
      6.17
    52,020**2002**Granted
    5,000
    $18.72
    $18.72Exercised
    31,200
    $
      0.13 - $11.57
    $ 
      4.26Canceled
    47,365
    $
      1.41 - $14.00
    $ 
      8.54Outstanding
      as of December 31, 2002
    1,593,255
    
    $ 
      6.17
    870,220**2003**Granted
    218,750
    $13.39
      - $15.10
    $13.64Exercised
    232,731
    $ 
      0.13 - $15.00
    $
       5.96Canceled
    4,000
    $14.05
    $14.05Outstanding
      as of December 31, 2003
    1,575,274
    
    $ 
      7.22
    655,470**2004**Granted
    346,135
    $24.78
      - $34.66
    $26.18Exercised
    355,382
    $ 
      0.13 - $18.72
    $ 
      5.83Canceled
    18,175
    $11.57
      - $14.05
    $13.18Outstanding
      as of December 31, 2004
    1,547,852
    
    $11.71
    327,510Exercisable
      as of December 31, 2004
    812,112
    
    $
       7.60


The
following table summarizes information about stock options outstanding at
December 31, 2004:





**Options
      Outstanding**
    
    **Options
      Exercisable****Range
      of**
      **Exercise
      Price**
    
    **Number**
      **Outstanding**
    
    **Weighted
      Average**
      **Remaining**
      **Contractual
      Life**
    
    **Weighted**
      **Average**
      **Exercise
      Price**
    
    **Number**
      **Exercisable**
    
    **Weighted**
      **Average**
      **Exercise
      Price**$ 
       0.13 to $ 1.56
    
    
    314,470
    
    
    4.9
    
    $
    1.24
    
    
    241,470
    
    $
    1.16$ 
      5.00 to $12.00
    
    
    630,167
    
    
    5.9
    
    $
    8.17
    
    
    449,267
    
    $
    8.25$13.39
      to $18.72
    
    
    257,080
    
    
    7.0
    
    $
    13.72
    
    
    92,680
    
    $
    13.75$24.78
      to $34.66
    
    
    346,135
    
    
    9.2
    
    $
    26.18
    
    
    28,695
    
    $
    31.72








F26





**12.
EMPLOYEE STOCK PURCHASE PLAN**





On
October 1, 2002, the Company implemented the Racing Champions Ertl Corporation
Employee Stock Purchase Plan to provide employees of the Company with an
opportunity to purchase common stock of the Company through accumulated payroll
deductions. The plan allows eligible employees to purchase shares of the
Company’s common stock through quarterly offering periods commencing on each
January 1, April 1, July 1 and October 1 with the first offering period
commencing on October 1, 2002. The option price for each share of common stock
purchased will equal 90% of the last quoted sales price of a share of the
Company’s common stock as reported by the Nasdaq National Market on the first
day of the quarterly offering period or the last day of the quarterly offering
period, whichever is lower. The Company has reserved 500,000 shares of common
stock held in treasury for issuance under the plan. The plan will terminate on
July 1, 2007, unless sooner terminated by the Board of Directors. In 2004, the
Company sold 6,247 shares out of treasury to Company employees under the ESPP
for $140,841. In 2003, the Company sold 10,580 shares out of treasury to Company
employees under the ESPP for $140,635. In January 2005, 1,227 shares were issued
out of treasury relating to purchase rights granted on October 1,
2004.





**13.
RELATED PARTY TRANSACTIONS**





The
Company purchased approximately $9.6 million, $8.3 million and $7.8 million of
product during 2002, 2003 and 2004, respectively, from a company controlled by a
relative of one of the Company’s stockholders/directors. Accounts payable to
this company were $0.2 million and $0.3 million as of December 31, 2003 and
2004, respectively.





The
Company’s German subsidiary had sales transactions in 2003 and 2004 with a
distributor that is owned by the former managing director of the Company’s
German subsidiary. These sales transactions for the years ended December 31,
2003 and 2004 were approximately $160,000 and $130,000, respectively. This
former managing director’s employment with the Company ended on August 31, 2004,
and the relationship with this distributor was terminated as of December 31,
2004.





Rothkopf
Enterprises, Inc., owned by a director of the Company, rented office space from
the Company through April 30, 2004, for a monthly rental payment of $400. All
rental payments were paid through that date.





At
December 31, 2003, advances (including accrued interest) in the amount of
$232,259 were due from three employees. A reserve of $67,771 was recorded on the
advance from one employee. Interest on these advances range from 4% to the prime
rate and the principal portion was due through December 31, 2006. As of December
31, 2004, all of these amounts were settled.





The
Company leases office and warehouse space located in Mishawaka, Indiana from a
company that is owned by the founder of Playing Mantis who is now an Executive
Vice President of the Company. The term of the lease is one year and will expire
on June 4, 2005. The monthly rental payment per the lease agreement is $15,025.
All rental payments have been paid through December 31, 2004.





The
Company paid consulting fees of $37,723 during the year ended December 31, 2004,
to a not-for-profit organization for which one of the Company’s
stockholders/Executive Vice Presidents holds the positions of president,
co-founder and board member. The Company also made a charitable contribution of
$50,000 to this same organization during the year ended December 31, 2004.





**14.
EMPLOYEE BENEFIT PLANS**





The
Company is self-insured on medical benefits offered to employees up to a limit
of $50,000 per employee or $1.0 million in aggregate. Claims are expensed when
incurred, and a provision is provided based on a monthly average of claims
activity. The Company holds excess loss coverage for those amounts that exceed
the self-insured limits.





The
Company has a 401(k) savings plan. Employees meeting certain eligibility
requirements, as defined, may contribute up to 100% of pre-tax gross wages,
limited to a maximum annual amount as set periodically by the IRS. The Company
makes matching contributions of 50% of the employees’ contributions up to 5% of
employee wages. For the years ended December 31, 2002, 2003 and 2004, the
Company contributions were approximately $0.3 million, $0.4 million and $0.6
million, respectively.





F27





Upon the
acquisition of LCI in March 2003, the Company continued the Learning Curve
International Retirement Plan through September 30, 2003. Under this plan,
employees could contribute from 1% to 20% of their annual compensation, limited
to a maximum annual amount as set periodically by the IRS. The Company matched
employee contributions at 25% of the employees’ contributions up to 6.25% of
employee wages, but not to exceed $2,500 annually. As of October 1, 2003, this
plan merged with the RC2 Corporation plan. For the year ended December 31, 2003,
the Company’s contributions under the Learning Curve plan were approximately
$0.1 million.





Upon the
acquisition of TFY in September 2004, the Company continued The First Years Inc.
and Affiliates 401(k) Plan through November 30, 2004. Under this plan, employees
could contribute up to 50% of pre-tax gross wages, limited to a maximum annual
amount as set periodically by the IRS. The Company matched employee
contributions at 25% of the employee’s contributions up to 5% of employee wages.
As of December 1, 2004, this plan merged with the RC2 Corporation plan. In
January 2005, the Company made contributions under The First Years plan related
to the 2004 plan year of approximately $0.1 million.





Upon the
acquisition of TFY in September 2004, the Company also continued The First Years
Inc. and Affiliates Pension Plan through December 31, 2004. This Plan is a
special type of qualified retirement plan commonly referred to as a money
purchase pension plan. The Company made annual contributions at 7% of employees’
total compensation plus 5.7% of employee’s compensation in excess of the Social
Security taxable wage base. As of January 1, 2005, this Plan will become dormant
and the Plan will be amended to reflect future Company contributions at a rate
of 0%. In February 2005, the Company made contributions under The First Years
pension plan related to the 2004 plan year of approximately $0.9 million.





RC2
Corporation maintains a funded noncontributory defined benefit pension plan that
covers a select group of the Company’s workforce. The plan provides defined
retirement benefits based on employees’ years of service. The Company uses a
December 31 measurement date for this plan.





**Reconciliation
of Beginning and End of Year Fair Value of Plan Assets and
Obligations**





(In
      thousands)
    
    **2002**
    
    **2003**
    
    **2004****Change
      in benefit obligation**Benefit
      obligation at beginning of year
    
    $
    9,150
    
    $
    10,329
    
    $
    11,674Service
      cost
    
    
    131
    
    
    122
    
    
    111Interest
      cost
    
    
    637
    
    
    668
    
    
    688Actuarial
      loss
    
    
    759
    
    
    926
    
    
    1,499Benefits
      paid and plan expenses
    
    
    (348
    )
    
    (371
    )
    
    (389
    )Benefit
      obligation at end of year
    
    $
    10,329
    
    $
    11,674
    
    $
    13,583**Change
      in plan assets**Fair
      value of assets at beginning of year
    
    $
    7,601
    
    $
    7,148
    
    $
    8,877Actual
      return on plan assets
    
    
    (680
    )
    
    1,411
    
    
    902Employer
      contributions
    
    
    575
    
    
    689
    
    
    1,197Benefits
      paid
    
    
    (348
    )
    
    (371
    )
    
    (389
    )Fair
      value of assets at end of year
    
    $
    7,148
    
    $
    8,877
    
    $
    10,587**Reconciliation
      of funded status**Funded
      status
    
    $
    (3,181
    )
    $
    (2,797
    )
    $
    (2,996
    )Unrecognized
      net actuarial loss
    
    
    4,069
    
    
    4,312
    
    
    5,594Unrecognized
      prior service cost
    
    
    208
    
    
    189
    
    
    171Prepaid
      benefit cost
    
    $
    1,096
    
    $
    1,704
    
    $
    2,769




F28





**Amounts
Recognized in the Consolidated Balance Sheets**





(In
      thousands)
    
    **2002**
    
    **2003**
    
    **2004**Accrued
      benefit cost
    
    $
    (3,181
    )
    $
    (2,797
    )
    $
    (2,996
    )Intangible
      assets
    
    
    208
    
    
    189
    
    
    171Accumulated
      other comprehensive income
    
    
    4,069
    
    
    4,312
    
    
    5,594Net
      amount recognized
    
    $
    1,096
    
    $
    1,704
    
    $
    2,769Accumulated
      benefit obligation
    
    $
    10,329
    
    $
    11,674
    
    $
    13,583Fair
      value of plan assets
    
    
    7,148
    
    
    8,877
    
    
    10,587Unfunded
      accumulated benefit obligation
    
    $
    3,181
    
    $
    2,797
    
    $
    2,996





**Components
of Net Periodic Benefit Cost**





**Year
      Ended December 31,**(In
      thousands)
    
    **2002**
    
    **2003**
    
    **2004**Service
      cost
    
    $
    131
    
    $
    122
    
    $
    111Interest
      cost
    
    
    637
    
    
    668
    
    
    688Expected
      return on plan assets
    
    
    (772
    )
    
    (804
    )
    
    (866
    )Amortization
      of prior service cost
    
    
    19
    
    
    19
    
    
    19Amortization
      of net loss
    
    
    —
    
    
    76
    
    
    181Net
      periodic benefit cost
    
    $
    15
    
    $
    81
    
    $
    133





**Additional
      information**Increase
      in minimum liability included
      in
      other comprehensive income
    
    $
    2,211
    
    $
    243
    
    $
    1,282





**Estimated
      Future Benefit Payments**2005
    
    $
    422,5512006
    
    
    453,7982007
    
    
    475,2152008
    
    
    515,8102009
    
    
    563,7232010
      to 2015
    
    
    3,443,195





**Assumptions**





**2002**
    
    **2003**
    
    **2004****Weighted-average
      Assumptions Used**
      **to
      Determine Benefit Obligations**
      **at
      December 31**Discount
      rate
    
    
    6.50
    %
    
    6.00
    %
    
    5.75
    %Rate
      of compensation increase
    
    
    N/A
    
    
    N/A
    
    
    N/A**Weighted-average
      Assumptions Used**
      **to
      Determine Net Periodic Benefit Cost**
      **for
      the Years Ended December 31**Discount
      rate
    
    
    7.00
    %
    
    6.50
    %
    
    6.00
    %Expected
      return on plan assets
    
    
    8.50
    %
    
    8.50
    %
    
    8.50
    %Rate
      of compensation increase
    
    
    N/A
    
    
    N/A
    
    
    N/A








F29





**Expected
Return on Plan Assets**





RC2
Corporation employs a building-block approach in determining the long-term rate
of return for plan assets. Historical markets are studied and long-term
historical relationships between equities and fixed income are preserved
consistent with the widely-accepted capital markets principle that assets with
higher volatility generate a greater return over the long run. Current market
factors such as inflation and interest rates are evaluated before long-term
capital market assumptions are determined. The long-term portfolio return is
established via a building block approach with proper consideration of
diversification and rebalancing. Peer data and historical returns are reviewed
to check for reasonableness and appropriateness.





**Projected
Annual Returns**





**Percentile
      Returns****Time
      Period**
    **75th**
    **50th**
    **25th**1
      year
    0.13%
    8.57%
    17.71%5
      years
    4.71%
    8.57%
    12.56%10
      years
    5.82%
    8.57%
    11.38%20
      years
    6.62%
    8.57%
    10.55%





**Plan
Assets**





The
allocation of assets between major asset categories as of December 31, 2003, and
December 31, 2004, as well as the target allocation, are as
follows:





**Percentage
      of Plan Assets**
      **at
      December 31,****Asset
      Category**
    
    **Target**
      **Allocation**
    
    **2003**
    
    **2004**Large
      cap domestic equity securities
    
    
    40
    %
    
    41
    %
    
    46
    %Small
      cap domestic equity securities
    
    
    10
    
    
    7
    
    
    7International
      equity securities
    
    
    10
    
    
    8
    
    
    12Fixed
      income securities
    
    
    40
    
    
    44
    
    
    35Total
    
    
    100
    %
    
    100
    %
    
    100
    %





**Explanation
of Investment Strategies and Policies**





RC2
Corporation employs a total return investment approach whereby a mix of equities
and fixed income investments are used to maximize the long-term return of plan
assets for a prudent level of risk. The intent of this strategy is to minimize
plan expenses by outperforming plan liabilities over the long run. Risk
tolerance is established through careful consideration of plan liabilities, plan
funded status and corporate financial condition.





The
investment portfolio contains a diversified blend of equity and fixed income
investments. Furthermore, equity investments are diversified across U.S. and
non-U.S. stocks as well as growth, value and small and large capitalizations.
Derivatives may be used to gain market exposure in an efficient and timely
manner; however, derivatives may not be used to leverage the portfolio beyond
the market value of the underlying investments. Investment risk is measured and
monitored on an ongoing basis through annual liability measurements, periodic
asset/liability studies and quarterly investment portfolio reviews.





**Employer
Contributions**





RC2
expects to make approximately $1.2 million in contributions to the pension
benefit plan for the 2005 fiscal year.





**15.
ASSETS HELD FOR SALE**





Assets
held for sale in the amount of $4.2 million represent the land and building
located in Avon, Massachusetts of $4.1 million and other equipment related to
the trackside operation of $0.1 million. The warehouse and office space acquired
with the TFY acquisition and located in Avon, Massachusetts will be relocated
and the building is expected to be sold during 2005. Additionally, the rigs
associated with the trackside business were sold subsequent to
year-end.





F30




**CORPORATE
DIRECTORY**





Robert
      E. Dods
      Chairman
      and Director
      RC2
      Corporation
    Richard
      F. Schaub, Jr.
      Senior
      Vice President -
      Sales
      & Consumer Teams
      RC2
      Brands, Inc.
    Helena
      Lo
      Managing
      Director
      RC2
      (H.K.) LimitedBoyd
      L. Meyer
      Vice
      Chairman and Director
      RC2
      Corporation
    Steven
      J. Coble
      Vice
      President - National Accounts
      RC2
      Brands, Inc.
    Rose
      Lam
      Senior
      Vice President - Marketing and
      Customer
      Service
      RC2
      (H.K.) LimitedPeter
      K.K. Chung
      Director
      RC2
      Corporation
    Robert
      L. Jacobsen
      Vice
      President -
      Corporate
      and Promotional Sales
      RC2
      Brands, Inc.
    Kelvin
      Ng
      Senior
      Vice President -
      Engineering
      and Product Development
      RC2
      (H.K.) LimitedCurtis
      W. Stoelting
      Chief
      Executive Officer and Director
      RC2
      Corporation
    Jeff
      Jones
      Vice
      President - Product Development
      RC2
      Brands, Inc.
    Damien
      Weight
      Managing
      Director - Finance & Operations
      Racing
      Champions International LimitedPeter
      J. Henseler
      President
      RC2
      Corporation
    Thomas
      E. Knaggs
      Vice
      President - Business Development
      RC2
      Brands, Inc.
    Clive
      Wooster
      Managing
      Director - Sales & Marketing
      Racing
      Champions International LimitedJody
      L. Taylor
      Chief
      Financial Officer and Secretary
      RC2
      Corporation
    Eric
      L. Meyer
      Vice
      President - Sales and Marketing
      RC2
      Brands, Inc.
    John
      S. Bakalar
      Director,
      RC2 Corporation
      Former
      President and Chief Operating Officer,
      Rand
      McNally CorporationRichard
      E. Rothkopf
      Executive
      Vice President and Director
      RC2
      Corporation
    Patrick
      A. Meyer
      Vice
      President - Licensing and Sales
      RC2
      Brands, Inc.
    Thomas
      M. Collinger
      Director,
      RC2 Corporation
      Associate
      Professor, The Medill Graduate
      School
      of Northwestern UniversityJohn
      W. Lee II
      Executive
      Vice President
      RC2
      Corporation
    Gregory
      R. Miller
      Vice
      President - Marketing
      RC2
      Brands, Inc.
    Michael
      J. Merriman, Jr.
      Director,
      RC2 Corporation
      Former
      Chief Executive Officer,
      Royal
      Appliance Manufacturing CompanyThomas
      Lowe
      Executive
      Vice President
      RC2
      Corporation
    Scott
      A. Sampson
      Vice
      President - Logistics and Distribution
      RC2
      Brands, Inc
    Paul
      E. Purcell
      Director,
      RC2 Corporation
      President
      and Chief Executive Officer,
      Robert
      W. Baird & Co. IncorporatedM.
      Kevin Camp
      Senior
      Vice President -
      Motorsports
      Licensing
      RC2
      Brands, Inc.
    Donald
      Toht
      Vice
      President - Design
      RC2
      Brands, Inc.
    John
      J. Vosicky
      Director,
      RC2 Corporation
      Chief
      Financial Officer, BFG Technologies Inc.Gregory
      J. Kilrea
      Senior
      Vice President -
      Planning
      and Corporate Development
      RC2
      Brands, Inc.
    Robert
      J. Bove
      Managing
      Director
      RC2
      South, Inc.
    Daniel
      M. Wright
      Director,
      RC2 Corporation
      Former
      Partner, Arthur Andersen LLPDoris
      M. Koopman
      Senior
      Vice President - Operations
      RC2
      Brands, Inc.
    Edward
      Eidam
      Vice
      President - Information Systems
      RC2
      South, Inc.










**CORPORATE
INFORMATION**





Corporate
      Office:
      RC2
      Corporation
      1111
      West 22ndStreet, Suite 320
      Oak
      Brook, IL 60523
      630-573-7200
      Telephone
      630-573-7575
      Fax
    Corporate
      Counsel:
      Reinhart
      Boerner Van Deuren s.c.
      1000
      North Water Street
      Milwaukee,
      WI 53202
    Transfer
      Agent:
      EquiServe
      Boston
      Equiserve Division
      150
      Royall Street
      Canton,
      MA 02021Independent
      Registered Public Accountants:
      KPMG
      LLP
      303
      East Wacker Drive
      Chicago,
      IL 60601
    For
      additional information about
      RC2
      Corporation and its products,
      please
      visit our website: www.rc2corp.com