Form
      10-K





SECURITIES
      AND EXCHANGE COMMISSION


Washington,
      D.C.  20549





[x]       Annual
      Report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934
      for the fiscal year ended
      December 31, 2007.





[x]       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
            
            36-4088307(State
                or Other Jurisdiction of Incorporation or Organization)
            
            (IRS
                Employer Identification No.)1111
                West 22nd
                Street, Suite 320, Oak Brook, Illinois
            
            60523(Address
                of principal executive offices)
            
            (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
            
            Name
                of each exchange on which registeredCommon
                Stock, Par Value $0.01 Per Share
            
            The
                NASDAQ Stock MarketSecurities
                registered pursuant to Section 12(g) of the Exchange
                Act:  None





Indicate
      by check mark if the Registrant is a well-known seasoned issuer, as defined
      by
      Rule 405 of the Securities Act.


Yes
      _  NoX





Indicate
      by check mark if Registrant is not required to file reports pursuant to Section
      13 of 15(d) of the Exchange Act.


Yes
      _
      NoX





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 the 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 a large accelerated filer, an
      accelerated filer, a non-accelerated filer or a smaller reporting
      company.  See the definitions of "large accelerated filer,"
      "accelerated filer" and "smaller reporting company" in Exchange Act Rule
      12b-2.





Large
      accelerated filer
      [X]                                                                                     
Accelerated filer [   ]





Non-accelerated
      filer [  
]                                                                                       
Smaller reporting company [   ]


(Do
      not
      check if a smaller reporting company)





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


Yes
      _
      NoX





Aggregate
      market value of the Registrant’s common stock held by non-affiliates as of June
      29, 2007 (the last business day of the Registrant’s most recently completed
      second quarter): $824,795,547.  Shares of common stock held by any
      executive officer or director of the Registrant 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 26,
      2008:  17,947,286





DOCUMENTS
      INCORPORATED BY REFERENCE




Portions
      of the Proxy Statement for the 2008 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," "RC2" 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 1A 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.






2


Part
      I





Item
      1.  Business





Overview





We
      are a
      leading designer, producer and marketer of innovative, high-quality toys,
      collectibles and infant and toddler products.  Our leadership position
      is measured by sales and brand recognition.  Our infant, toddler and
      preschool products are marketed under our Learning Curve® family of brands,
      which includes The First Years® by Learning Curve and Lamaze brands as well as
      popular and classic licensed properties such as Thomas & Friends, Bob
      the Builder, Winnie thePooh,
      John Deere, Nickelodeon
      and Sesame
      Street.  We market our youth and adult products primarily under
      the Johnny Lightning® and Ertl® brands.  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.





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 4 to our consolidated financial statements included elsewhere
      herein.





Products




North
      America





In
      the
      North America segment, our products are organized into the following categories:
      (i) infant and toddler products; (ii) preschool products; and (iii) youth and
      adult products.





Our
      infant and toddler products category includes a wide range of products related
      to infant and toddler feeding, care, safety and play which are marketed under
      such brands as The First Years by Learning Curve and Lamaze.  Some of
      the key product lines in this category include the SoothieTM bottle
      infant
      feeding system, the Take & Toss® toddler
      self-feeding system, the Lamaze infant development products and the American
      Red
      Cross health and wellness products.  In 2007, we introduced a new look
      for Lamaze, which features new colors and patterns.  We also
      introduced a full line of infant developmental play products featuring Winnie the Pooh licensed
      characters under The First Years by Learning Curve
      brand.  Additionally, in 2007, we acquired the Compass Business, a
      privately-held, start-up developer and marketer of infant and toddler travel
      gear, including infant car and booster seats.  In 2008, we plan
      to introduce the Magna Light Travel SystemTM, a super
      light
      weight stroller with an innovative infant seat, as well as a convertible car
      seat with a removable headrest and a new booster seat that will be taller and
      deeper than our current booster seat.  Additionally, in 2008, we plan
      to introduce a range of new products within our American Red Cross health and
      wellness product line, as well as in our Lamaze and Winnie the Pooh infant
      developmental play product lines.






3




Our
      preschool products category includes such brands as Play TownTM by Learning
      Curve
      and Take AlongTM by Learning
      Curve
      and features products with such licensed properties as Thomas & Friends, Bob
      the Builder, John Deere
      and Nickelodeon.  In 2007, we introduced the Play Town by Learning
      Curve product line which offers characters, vehicles, buildings and playsets
      for
      open ended, classic and creative play for toddlers and preschoolers, and we
      expanded our Take Along by Learning Curve product line to include popular
      Nickelodeon television characters such as Dora the Explorer, Go
      Diego Go!, The Backyardigans, Blues
      Clues and SpongeBob
      SquarePants.  In 2008, we plan to introduce Caring CornersTM,
      a product line
      featuring an interactive dollhouse and a full line of dolls and
      accessories, which will reward positive behaviors like caring, sharing and
      preparing for responsibility, both during play and real life.  We also
      plan to add the licensed characters from Sesame Street into our Take
      Along by Learning Curve product line, as well as introduce a proprietary line
      of
      products that enhance the Take Along world.





The
      youth
      and adult product category includes such brands as Johnny Lightning and
      Ertl.  In 2007, we introduced the radio-controlled combat Battle
      WheelsTM
      product line and the radio-controlled transforming robot and vehicle V-BotTM product
      line,
      both of which are marketed under the Johnny Lightning brand name.  In
      2008, we plan to introduce the Double DutyTM product
      line
      which features the licensed John Deere property and includes transforming
      vehicles and accessories.  We also plan to introduce new products within
      our John Deere toy and collectible product lines marketed under the Ertl
      brand.




International





In
      addition to our business in North America, in 2007 we operated in more than
      50
      other countries, selling a representative range of the infant and toddler,
      preschool and youth and adult product lines.  The geographic
      regions in the International segment include Europe, Australia, Asia
      Pacific, South and Latin America.  Key international brands for 2007
      include Thomas &
Friends Wooden Railway,
      Take Along Thomas, Bob the Builder, The First
      Years by Learning Curve and Lamaze.





The
      strength of the U.S. dollar relative to other currencies can significantly
      affect the net sales and profitability of our international
      operations.  See Item 7A. "Quantitative and Qualitative Disclosures
      About Market Risk."





Licenses





We
      market
      a significant portion of our products with licenses from other
      parties.  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 expanded
      distribution channels.  Our licenses are limited in scope and duration
      and authorize the sale of specific licensed products, generally on a
      nonexclusive basis.





We
      have
      entered into agreements to license such properties from, among others, Disney
      Consumer Products, Inc. (including Disney characters such as Winnie the Pooh), HIT
      Entertainment (relating to its Thomas & Friends and
Bob
      the Builder
      properties),  MTV Networks relating to its Nickelodeon properties
      (including Dora the
      Explorer, Go Diego
      Go!, The
      Backyardigans, Blues
      Clues and SpongeBob
      SquarePants), Sesame Workshop (relating to its Sesame Street properties),
      Lamaze International, Inc., and John Deere Shared Services, Inc.





We
      are a
      party to over 400 license agreements with terms generally of two to three
      years.  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 the year ended December 31, 2007, net sales of
      the Company’s products with the licensed properties of Thomas & Friends and John
      Deere each accounted for more than 10.0% of total net sales.  No other
      licensed property accounted for more than 10.0% of our total net sales for
      the
      year ended December 31, 2007.  Over the next two years, license
      agreements in connection with several of our key licensed properties, including
      licenses for certain Nickelodeon and Bob the
      Builder products, are scheduled to expire. 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.






4




As
      of
      December 31, 2007, approximately 42.0% of our licenses require us to make
      minimum guaranteed royalty payments, whether or not we meet specific sales
      targets.  Aggregate future minimum guaranteed royalty payments as of
      December 31, 2007, are $36.2 million, with the individual license minimum
      guarantees ranging from $1.00 to $20.9 million.  Royalty expense
      related to licenses with minimum guarantees for the year ended December 31,
      2007, was $26.2 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 and higher-priced
      products are typically sold in hobby, collector and independent toy stores,
      and
      through wholesalers and original equipment manufacturers (OEMs).  We
      believe we have a leading position in multiple distribution channels and that
      this position 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
      $30.00.  Customers included in this channel have more than ten retail
      locations and include a wide range of retailers, such as book, farm and
      ranch, craft/hobby and juvenile products stores, as well as the
      national toy and discount retailers.  Key customers in our chain
      retailer channel include Wal-Mart,Target, Toys "R" Us/Babies
      "R" Us, Tractor Supply Company and Kmart.  Sales in 2007 to chain
      retailers were 68.3% of our net sales.





Specialty
      retailers, wholesalers and OEM dealers.  We sell many of the
      products available at chain dealers retailers, as well as higher-priced products
      with special features, to specialty retailers, wholesalers and OEM dealers,
      which comprised 28.6% of our net sales in 2007.  Additionally, 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 in which 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.  We
      reach these customers directly through our internal telesales group, our
      business-to-business website located at www.myRC2.com and through specialty
      sales representatives.  Key customers in our specialty retailers,
      wholesalers and OEM dealers channel include Learning Express, All Aboard Toys,
      Buy Buy Baby, Inc., John Deere and Case New Holland.





Corporate
      promotional and direct to consumers.  We make certain
      products available to corporate promotional accounts and to consumers through
      a
      company store and our website located at
      www.learningcurveshop.com.  Individual products sold directly to
      consumers sell at prices similar to those found at retailers, hobby stores
      and
      OEM dealers.  Sales through this channel constituted 3.1% of our net
      sales in 2007.





Trademarks





We
      have
      registered several trademarks with the U.S. Patent and Trademark Office,
      including the trademarks RC2®, Learning Curve®, The First Years®, Johnny
      Lightning®, Ertl® and Take & Toss®.  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.






5





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 chain retail 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 specialty,
      regional and national retailers and supported 29.5% of our net sales in
      2007.  External sales representatives generally earn commissions of
      1.0% to 10.0% 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.





The
      Company maintains a business-to-business website under the 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 and customer service group
      by
      providing customers with greater information access and more convenient ordering
      capability.





We
      support our product lines with various advertising and marketing
      promotions.  Advertising takes place at varying levels throughout the
      year and peaks during the traditional holiday season.  Advertising
      includes television commercials and print advertisements in magazines and other
      publications.  Marketing includes, but is not limited to, digital
      media, including our websites www.learningcurve.com,
      www.johnnylightning.comand www.ertl.com, in-store displays, merchandising material and
      public relations.  We also work closely with retail chains to plan and
      execute ongoing retailer-driven promotions and advertising.  These
      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.





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 toys, collectibles and infant and
      toddler 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 consumer 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.






6





Far
      east product
      sourcing.  We have operations in Kowloon, Hong Kong and in the
      RC2 Industrial Zone in Dongguan City, China, and employ 290 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, facilitates 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 and certain infant and toddler
      products.  Our China-based product sourcing accounted for 88.2% of our
      product purchases in 2007.  We primarily use six third-party,
      dedicated suppliers who manufacture only our products in six factories, three
      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 three of our third-party,
      dedicated suppliers operate freestanding factory facilities.  Most of
      our third-party, dedicated suppliers have been supplying us for more than ten
      years.  Third-party, dedicated suppliers produced 40.3% of our
      China-based product purchases in 2007.  In order to supplement our
      third-party, dedicated suppliers, we use several 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.  We enter into
      purchase orders with our foreign suppliers and generally do not enter into
      long-term contracts.





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.





Domestic
      production.  The production of certain plastic ride-ons and
      certain infant and toddler products 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.  Tooling
      represents 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.  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.  Additionally, following the June 2007
      recall of certain Thomas &
Friends Wooden Railway products,
      we established additional safeguards
      through our Multi-Check Safety System which includes:





●
            Increased
                scope and frequency of testing both incoming materials and finished
                products, including testing of finished products from every production
                run.


●
            Tougher
                certification program for contract manufacturers and paint suppliers,
                including evidence that toy safety standards and quality control
                procedures are in place and operating effectively.


●
            Mandatory
                paint control procedures for contract manufacturers, including certified
                independent lab test results of every batch of wet paint before the
                paint
                is released for production.


●
            Increased
                random inspections and audits of both manufacturers and their suppliers,
                including semi-annual audits and quarterly random inspections for
                key
                suppliers.


●
            Zero
                tolerance for compromise on RC2 specifications reinforced by mandatory
                vendor compliance seminars and signed agreements.





7


We
      carry
      various product liability insurance policies with coverage in
      aggregate over $75.0 million per occurrence.  Certain policies have
      coverage exclusions including, but not limited to, certain policies that exclude
      claims related to lead.




Logistics.  We
      own a distribution facility in Dyersville, Iowa, lease distribution facilities
      in Rochelle, Illinois, and Australia, and use independent warehouses in
      California, Canada, the United Kingdom, Belgium, Germany and
      Australia.





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 59.2% of our net sales for the three years
      ended December 31, 2007, were generated in the second half of the year, with
      August, September, Octoberand Novemberbeing
      the largest shipping
      months.  As a result, consistent with industry practice, our working
      capital, mainly inventory and accounts receivable, is typically highest during
      the third and fourth quarters and lowest during the first and second
      quarters.





Customers





We
      derive
      a significant portion of our sales from some of the world’s largest
      retailers.  Our top three customers, Wal-Mart, Target and Toys "R"
      Us/Babies "R" Us, combined accounted for 42.6% of our net sales in
      2007.  Other than Wal-Mart, Target and Toy "R" Us/Babies "R" Us, no
      customer accounted for more than 10.0% of our net sales in 2007.  Many
      of our retail customers generally purchase large quantities of our product
      on
      credit, which may cause a concentration of accounts receivable among some of
      our
      largest customers.





Employees





As
      of
      December 31, 2007, we had 832 employees, 43 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.  A collective bargaining agreement covers 103 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.rc2.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.





8


Item
      1A.  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.




Costs
      relating to our 2007 recalls could exceed current estimates and reduce our
      net
      sales and profitability.





In
      June and September 2007, we announced the voluntary recall of certain Thomas
&
      Friends Wooden Railway items.  In December 2007, we announced
      the voluntary recall of certain products under our The First Years
      brand.  Following the announcement of the June recall, a number
      of putative class action lawsuits were filed against us with respect to the
      products subject to the June and September recalls.  In January 2008,
      we reached a settlement in Barrett v. RC2
      Corporationwith the plaintiffs in the various class action lawsuits
      filed in state courts.  The proposed settlement, if approved, would resolve
      the class claims made by the members of the class in Barrett, namely persons in the United
      States who do not opt out of the class and who purchased or owned for purposes
      other than resale our Thomas & Friends Wooden
      Railway products which wererecalled in June 2007
      and
      September 2007.  We recorded charges of $17.6 million, net of tax, or
      $0.84 per diluted share, for the year ended December 31, 2007, related to these
      recalls, based on the latest estimates of retailer inventory returns, consumer
      product replacement costs and shipping costs as of the date of this filing,
      as
      well as the additional replacement costs or refunds, donations, notice charges,
      claims administration and legal fees related to the settlement of the class
      action lawsuits.  Since these charges are based on estimates,
      additional charges may be incurred based on a number of factors, many of which
      are outside of the Company’s control, including the amount of inventory of
      affected products at retailers, the amount of affected products that may be
      returned by customers, the cost of providing replacement products to consumers
      and retailers, and the final resolution of the lawsuits.  Any increase
      in the costs relating to the recalls would further reduce our profitability
      and could reduce our net sales.




The
      2007 recalls could harm our reputation and our relationship with retailers
      and
      licensors.





The
      2007 recalls may harm our reputation and consumer acceptance of the affected
      products or our other products, which may have an adverse effect on our net
      sales.  The recalls may also harm our relationships with our retail
      customers, including the willingness of those customers to purchase and provide
      shelf space for our products and to support retailer driven promotions and
      advertising for our products.




The
      June and September recalls may harm our relationship with the licensor (the
      Licensor) who has granted the licenses under which we market the property
      affected by those recalls (the Licenses).  The Licenses give the
      Licensor the right to terminate, under certain circumstances, if we do not
      comply with a covenant relating to compliance with government and industry
      standards or under certain other conditions and to indemnification for certain
      damages arising out of our sales of products covered by the
      Licenses.  The Licensor has sent a letter demanding that we indemnify
      it for certain costs in connection with the recalls and alleging that we
      have not complied with several provisions in the
      Licenses.  We have responded to the Licensor's letter and are
      attempting to resolve these matters.  Any termination of the Licenses, any
      adverse effect of the June and September recalls on our relationship with the
      Licensor and the terms of the Licenses or our other licenses with the Licensor,
      or any increase in the costs of the recalls for any indemnification or other
      payments to the Licensor, would likely have a material adverse effect on
      our business and prospects and would likely materially reduce our net sales
      and profitability.




At
      December 31, 2007, we have intangible assets not subject to amortization of
      $33.1 million relating to the Licenses.  These intangible assets are
      not subject to amortization because they have indefinite useful
      lives.  As of the date of this report, we have determined that there
      is no impairment of these intangible assets or charge to the indefinite useful
      lives.  However, we will continue to monitor these intangible assets
      for impairment or a change in the indefinite useful lives in light of the status
      of the recalls and related events, including the class action
      litigation.  Termination of the Licenses would result in an impairment
      and a write-off of the full value of these intangible assets.  Any
      impairment or change in the useful lives of the intangible assets would increase
      our expenses and reduce our profitability.






9


Other
        product recalls or claims relating to the use of our products could increase
        our
        costs.
 
 Because
        we sell infant products, toys and collectibles 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, under certain
        circumstances, 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.


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 offerings.  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 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 the year
      ended December 31, 2007, net sales of the Company’s products with the licensed
      properties of Thomas &
Friendsand John Deere each
      accounted for more than 10.0% of the
      Company’s total net sales.  Over the next two years, license
      agreements in connection with several key licensed properties, including
      licenses for certain John Deere, Nickelodeon, Bob
      the Builder and Disney
      infant products, are scheduled to expire.  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.




Increases
      in the cost of 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, increase 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.  For example,
      increase in the price of zinc, a key component in die-cast products, and
      increased costs in China, primarily for labor, reduced our gross margins in
      2006
      and 2007 and may continue to reduce our gross margins in 2008.






10


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 toys, collectibles and infant and
      toddler 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.





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. (Learning
      Curve) and certain of its affiliates (collectively, LCI) effective February
      28,
      2003, Playing Mantis, Inc. (PM) effective June 1, 2004, The First Years Inc.
      (TFY) effective September 15, 2004, Angels Landing, Inc. (Angels Landing)
      effective May 24, 2007, and Mother’s Intuition Inc. (MI) effective November 30,
      2007.  The integration of acquired companies and their operations into
      our operations involves a number of risks, including:





●
            the
                acquired business may experience losses that 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.  All of our borrowing capacity is also subject to
      fluctuations in interest rates.





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





In
      2007,
      approximately 68.3% of our net sales were 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.






11


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 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, 2006 and 2007, our credit
      insurance covered 6.3% and 7.9%, respectively, of our gross accounts
      receivable.  Insurance coverage for future sales is subject to
      reduction or cancellation.





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 significant
      portion of our products in six factories, three 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 88.2% of our
      product purchases in 2007.  Third-party, dedicated suppliers who
      manufacture only our products accounted for 40.3% of our China-based product
      purchases in 2007.  We enter into purchase orders with our foreign
      suppliers and generally do not enter into long-term
      contracts.  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 fire, accident, natural disaster or
      an
      outbreak of a contagious disease 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.





Currency
      exchange rate fluctuations could increase our expenses.





Our
      net
      sales are primarily denominated in U.S. dollars, with 19.4% of our net sales
      in
      2007 denominated in British pounds sterling, Australian dollars, Euros or
      Canadian dollars.  Our purchases of finished goods from Chinese
      manufacturers are primarily denominated in Hong Kong
      dollars.  Expenses for these manufacturers are primarily 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 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 British pounds sterling, 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 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 warehouses 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.






12




Any
      of
      these risks could disrupt the supply of our products or increase our
      expenses.  The cost 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.





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.




Our
      existing credit
      facility matures on September 14, 2008, and we currently anticipate that we
      will
      refinance during the second quarter of 2008.  We may not be able to
      refinance on acceptable terms given the current conditions of credit markets
      in
      the United States.  The terms of any refinancing may be less advantageous
      to us than our existing credit facility, including with respect to the amount
      of
      credit available, interest rates and the terms of restrictive debt
      covenants.  A refinancing on less advantageous terms may adversely affect
      our business and may reduce our profitability.




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.





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 become volatile
      again 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.





13


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.





Various
      restrictions in our charter documents, Delaware law and our credit agreement
      could prevent or delay a change in control of us that 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 a 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 completing 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.





Item
      1B.  Unresolved Staff Comments





Not
      applicable.





14


Item
      2.  Properties





As
      of
      December 31, 2007, our facilities were as follows:





Description
            Square
                Feet
            
            Location
            Lease
                ExpirationCorporate
                headquarters
            27,050
            
            Oak
                Brook, IL
            April
                2013Learning
                Curve Brands, Inc. warehouse
            400,000
            
            Rochelle,
                IL
            November
                2019Learning
                Curve Brands, Inc. officeand
                warehouse
            368,000
            
            Dyersville,
                IA
            OwnedLearning
                Curve Brands, Inc. warehouse
            166,000
            
            Dyersville,
                IA
            OwnedLearning
                Curve Brands, Inc. office
            21,650
            
            Stoughton,
                MA
            August
                2010Learning
                Curve Brands, Inc. office
            2,755
            
            Bentonville,
                AR
            October
                2008Learning
                Curve Brands, Inc. office
            2,300
            
            Walnut
                Creek, CA
            May
                2010Learning
                Curve Brands, Inc. office
            1,263
            
            Kettering,
                OH
            Month-to-monthLearning
                Curve Brands, Inc. storage
            1,250
            
            Stoughton,
                MA
            May
                2008Learning
                Curve Brands, Inc. office
            1,200
            
            Mission
                Viejo, CA
            November
                2008Learning
                Curve Brands, Inc. office
            938
            
            Edina,
                MN
            August
                2009Learning
                Curve Brands, Inc. office
            495
            
            Danbury,
                CT
            June
                2008Learning
                Curve Brands, Inc. office
            108
            
            Kansas
                City, MO
            Month-to-monthRC2
                Industrial Zone quarters
            44,867
            
            Dongguan
                City, China
            March
                2008RC2
                Industrial Zone quarters
            25,478
            
            Dongguan
                City, China
            August
                2008RC2
                Industrial Zone office, warehouseand
                storage
            61,398
            
            Dongguan
                City, China
            March
                2008RC2
                Industrial Zone office
            806
            
            Dongguan
                City, China
            August
                2008RC2
                (H.K.) Limited office
            10,296
            
            Kowloon,
                Hong Kong
            July
                2008Racing
                Champions International Limitedoffice
            8,419
            
            Exeter,
                United Kingdom
            October
                2013Racing
                Champions International Limitedoffice
                and showroom
            2,035
            
            Thatcham,
                United Kingdom
            August
                2011Racing
                Champions International Limitedoffice
            667
            
            Saint
                Germain en Laye, France
            December
                2012Racing
                Champions International Limitedoffice
            603
            
            Laren,
                Holland
            December
                2010Racing
                Champions International Limitedoffice
            172
            
            Barcelona,
                Spain
            February
                2008RC2
                Canada Corporation warehouse (1)
            47,000
            
            Concord,
                Ontario
            May
                2010RC2
                Deutschland GmbH office
            2,570
            
            Marsdof,
                Germany
            December
                2010RC2
                Australia, Pty. Ltd. office and warehouse
            49,127
            
            Mount
                Waverly, Victoria, Australia
            December
                2009




(1)
            As
                of January 1, 2004, the Canadian warehouse was no longer being used
                in our
                operations and has been subsequently sublet.





15


Item
      3.  Legal Proceedings





Following
      the announcement of our recall of certain Thomas & Friends Wooden
      Railway products in June 2007, a number of putative class action lawsuits were
      filed against the Company in various federal and state courts with respect
      to
      the products subject to the June and September recalls of the
      Company's Thomas &
Friends Wooden Railway products.  These lawsuits make
      various
      claims and seek (i) medical monitoring as a result of alleged exposure to lead
      in the products subject to the recalls, (ii) disgorgement of certain profits
      under common law unjust enrichment theories, and/or (iii) various remedies
      under
      claims of product liability, breach of warranty, negligence, unfair and
      deceptive trade practices under state law and violation of the federal Consumer
      Product Safety Act.  On December 19, 2007, the various federal class
      action lawsuits were consolidated in the U.S. District Court for the Northern
      District of Illinois.  On January 22, 2008, we announced that we had
      reached a settlement in Barrett v. RC2
      Corporation filed in the Circuit Court of Cook
      County, Illinoiswith the plaintiffs in the various class action
      lawsuits filed in state courts.  The Circuit Court of Cook County, Illinois
      has granted preliminary approval of the terms of the proposed
      settlement.  If the settlement receives final approval it would
      resolve the claims made by members of the class in Barrett, namely persons in the United
      States who do not opt out of the class and who purchased or owned for
      purposes other than resale the Company's Thomas
&
Friends
      Wooden
      Railway products which were recalled in June 2007 and September
      2007.  The settlement would not include a release of individual claims
      for personal injury against the Company.  On
      February 20, 2008, the U.S. District Court for the Northern District of
      Illinois denied a motion filed by plaintiffs in the federal cases for a
      preliminary injunction seeking to stop the settlement proceedings in the
      state court and granted the Company's motion to stay the federal court
      actions pending the state court's final decision of whether to approve the
      proposed settlement in the Barrett
      case.  Certain plaintiffs in the federal court action also filed a
      motion to intervene in the state court proceeding but, on February 25, 2008,
      they withdrew this motion.  The state court had stayed issuance
      of notice of the proposed settlement to the class in Barrettpending a decision on the federal
      plaintiffs' motion to intervene.  Since this motion was withdrawn, the
      Company will now seek to implement the state court settlement in the Barrettcase.





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, 2007.






16


Part
      II





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





Stock
      Price Information





Our
      common stock trades on the NASDAQ Global Select 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.





2006:
            
            High
            
            
            LowFirst
                Quarter
            
            $
            40.18
            
            
            $
            34.10Second
                Quarter
            
            
            39.75
            
            
            
            34.38Third
                Quarter
            
            
            38.85
            
            
            
            31.28Fourth
                Quarter
            
            $
            45.11
            
            
            $
            33.66





2007:
            
            High
            
            
            LowFirst
                Quarter
            
            $
            44.53
            
            
            $
            38.26Second
                Quarter
            
            
            45.72
            
            
            
            39.86Third
                Quarter
            
            
            41.45
            
            
            
            28.86Fourth
                Quarter
            
            $
            30.95
            
            
            $
            26.30





As
      of
      December 31, 2007, there were approximately 134 holders of record of our common
      stock.  We believe the number of beneficial owners of our common stock
      on that date was substantially greater.







17


Dividend
      Policy





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 expenses of
      our
      business, and therefore, we 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.





Issuer
      Purchases of Equity Securities





Period
            
            Total
                Number of Shares Purchased
            
            
            Average
                Price Paid Per Share
            
            
            Total
                Number of Shares Purchased As Part of Publicly Announced
                Program
            
            
            Maximum
                Dollar Value of Shares That May Yet Be Purchased Under the Program
                (000s)January
                1, 2007 through September 30, 2007
            
            
            2,246,396
            
            
            $
            30.33
            
            
            
            2,246,396
            
            
            $
            81,869October
                1, 2007 – October 31, 2007
            
            
            52,300
            
            
            
            28.68
            
            
            
            52,300
            
            
            
            80,368November
                1, 2007 – November 30, 2007
            
            
            427,608
            
            
            
            29.02
            
            
            
            427,608
            
            
            
            67,957December
                1, 2007 – December 31, 2007
            
            
            207,730
            
            
            
            28.37
            
            
            
            207,730
            
            
            
            62,064Total
                quarter ended December 31, 2007
            
            
            687,638
            
            
            
            28.80
            
            
            
            687,638
            
            
            
            62,064Total
            
            
            2,934,034
            
            
            $
            29.97
            
            
            
            2,934,034
            
            
            $
            62,064





In
      February 2007, the Company’s Board of Directors authorized the adoption of a
      program to repurchase up to $75.0 million of the Company’s common
      stock.  The program was initially authorized for a period of one
      year.  In October 2007, the Board of Directors authorized a $75.0
      million increase to the stock repurchase program and extended the timing of
      this
      program through December 31, 2008.  This program may be extended
      beyond the currently authorized period or may be suspended at any
      time.  Under this program, shares may be repurchased from time to time
      in open market transactions or privately negotiated transactions at the
      Company’s discretion, subject to market conditions and other
      factors.  During the year ended December 31, 2007, the Company
      repurchased 2.9 million shares for $87.9 million under this
      program.






18


Item
      6.  Selected Financial Data





The
      following table presents selected consolidated financial data, which should
      be
      read along with our consolidated financial statements, the notes to those
      statements and "Item 7, Management’s Discussion and Analysis of Financial
      Condition and Results of Operations."  The consolidated statements of
      earnings for the years ended December 31, 2005, 2006 and 2007, and the
      consolidated balance sheet data as of December 31, 2006 and 2007, are derived
      from our audited consolidated financial statements included elsewhere
      herein.  The consolidated statements of earnings for the years ended
      December 31, 2003 and 2004, and the consolidated balance sheet data as of
      December 31, 2003, 2004 and 2005, are derived from our audited consolidated
      financial statements, as adjusted for discontinued operations, that are not
      included herein.





Year
                Ended December 31,2003
            
            
            2004
            
            
            2005
            
            
            2006
            
            
            2007Consolidated
                Statements of Earnings:
            
            (in
                thousands, except per share data)Net
                sales (1)
            
            $
            296,689
            
            
            $
            367,687
            
            
            $
            492,766
            
            
            $
            518,829
            
            
            $
            488,999Cost
                of sales (2)
            
            
            142,918
            
            
            
            186,813
            
            
            
            252,935
            
            
            
            275,754
            
            
            
            270,059Restructuring
                charge related to
              discontinued
                automotive collectibles
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            1,872
            
            
            
            —Recall-related
                costs
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            4,624Gross
                profit
            
            
            153,771
            
            
            
            180,874
            
            
            
            239,831
            
            
            
            241,203
            
            
            
            214,316Selling,
                general and administrative
              expenses
                (2)
            
            
            100,385
            
            
            
            121,785
            
            
            
            150,381
            
            
            
            155,180
            
            
            
            161,560Amortization
                of intangible assets
            
            
            30
            
            
            
            94
            
            
            
            1,385
            
            
            
            1,149
            
            
            
            893Impairment
                of intangible assets
            
            
            327
            
            
            
            4,318
            
            
            
            —
            
            
            
            —
            
            
            
            —Gain
                on sale of W. Britain product line
            
            
            —
            
            
            
            —
            
            
            
            (1,953
            )
            
            
            —
            
            
            
            —Restructuring
                charge related to
              discontinued
                automotive collectibles
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            12,631
            
            
            
            —Recall-related
                costs
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            18,068Operating
                income
            
            
            53,029
            
            
            
            54,677
            
            
            
            90,018
            
            
            
            72,243
            
            
            
            33,795Interest
                expense, net
            
            
            3,477
            
            
            
            4,063
            
            
            
            5,983
            
            
            
            3,465
            
            
            
            1,515Other
                (income) expense
            
            
            (145
            )
            
            
            (508
            )
            
            
            146
            
            
            
            530
            
            
            
            (1,768
            )Income
                from continuing operations
              before
                income taxes
            
            
            49,697
            
            
            
            51,122
            
            
            
            83,889
            
            
            
            68,248
            
            
            
            34,048Income
                tax expense
            
            
            13,904
            
            
            
            18,755
            
            
            
            31,153
            
            
            
            24,478
            
            
            
            12,472Income
                from continuing operations
            
            
            35,793
            
            
            
            32,367
            
            
            
            52,736
            
            
            
            43,770
            
            
            
            21,576Income
                (loss) from discontinued
              operations,
                net of tax
            
            
            2,624
            
            
            
            1,611
            
            
            
            394
            
            
            
            (9,676
            )
            
            
            110Net
                income
            
            $
            38,417
            
            
            $
            33,978
            
            
            $
            53,130
            
            
            $
            34,094
            
            
            $
            21,686Basic
                earnings per common share:Income
                from continuing operations
            
            $
            2.10
            
            
            $
            1.73
            
            
            $
            2.56
            
            
            $
            2.09
            
            
            $
            1.05Income
                (loss) from discontinued
              operations
            
            
            0.15
            
            
            
            0.09
            
            
            
            0.02
            
            
            
            (0.46
            )
            
            
            0.01Net
                income
            
            $
            2.25
            
            
            $
            1.82
            
            
            $
            2.58
            
            
            $
            1.63
            
            
            $
            1.06Diluted
                earnings per common share:Income
                from continuing operations
            
            $
            1.98
            
            
            $
            1.64
            
            
            $
            2.45
            
            
            $
            2.04
            
            
            $
            1.04Income
                (loss) from discontinued
              operations
            
            
            0.14
            
            
            
            0.08
            
            
            
            0.02
            
            
            
            (0.45
            )
            
            
            0.01Net
                income
            
            $
            2.12
            
            
            $
            1.72
            
            
            $
            2.47
            
            
            $
            1.59
            
            
            $
            1.05Weighted
                average shares outstanding:Basic
            
            
            17,060
            
            
            
            18,687
            
            
            
            20,613
            
            
            
            20,884
            
            
            
            20,395Diluted
            
            
            18,105
            
            
            
            19,761
            
            
            
            21,532
            
            
            
            21,377
            
            
            
            20,748





19





As
                of December 31,2003
            
            
            2004
            
            
            2005
            
            
            2006
            
            
            2007Consolidated
                Balance Sheet Data:Working
                capital
            
            $
            70,471
            
            
            $
            112,931
            
            
            $
            113,286
            
            
            $
            129,603
            
            
            $
            67,128Total
                assets
            
            
            381,829
            
            
            
            585,748
            
            
            
            629,736
            
            
            
            614,640
            
            
            
            650,245Total
                debt
            
            
            85,000
            
            
            
            131,250
            
            
            
            82,647
            
            
            
            22,438
            
            
            
            95,000Total
                stockholders’ equity
            
            $
            225,299
            
            
            $
            346,762
            
            
            $
            398,951
            
            
            $
            451,926
            
            
            $
            397,378





(1)  Net
      sales for the year ended December 31, 2007, include $5.6 million in
      recall-related returns and allowances.


(2)  Depreciation
      expense was $11.9 million, $15.3 million, $14.4 million, $14.1 million and
      $13.9
      million for the years ended December 31, 2003, 2004, 2005, 2006 and 2007,
      respectively.





General
      Note:  Results for 2003 include the results of LCI from March 1,
      2003.  Results for 2004 include the results of PM from June 1, 2004,
      and TFY from September 16, 2004.  Results for 2007 include the results
      of Angels Landing from May 24, 2007 and MI from November 30, 2007.  As
      these acquisitions were accounted for using the purchase method of accounting,
      periods prior to the acquisition effective dates do not include any results
      for
      LCI, PM, TFY, Angels Landing or MI.  Discontinued operations include
      the results from our collectible trading card business and die-cast sports
      collectibles product line, which were disposed of in connection with the sale
      of
      RC2 South, Inc. effective November 1, 2006.





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, and infant and toddler products.  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) infant and toddler
      products, (ii) preschool products and (iii) youth and adult
      products.  We market a significant portion of our products with
      licenses from other parties, and we are currently a party to over 400 license
      agreements.





The
      Compass
      Business Acquisition.  On May 24, 2007, we acquired
      substantially all of the assets of Angels Landing, Inc. (Angels Landing), a
      privately-held, start-up developer and marketer of infant and toddler travel
      gear under the Compass brand name (the Compass Business) based in Kettering,
      Ohio.  Closing consideration consisted of $6.9 million of cash,
      excluding transaction expenses, and includes $0.3 million which may be earned
      in
      the transaction by Angels Landing if gross sales relating to the Compass
      Business in 2008 exceed a certain target.  This transaction has been
      accounted for under the purchase method of accounting, and accordingly, the
      operating results of the Compass Business have been included in our consolidated
      statements of earnings since the effective date of the acquisition.





Mother’s
      Intuition Acquisition.  On November 30, 2007, we acquired
      substantially all of the assets of Mother’s Intuition Inc. (MI), a
      privately-held, start-up developer and marketer of women’s prenatal bodycare
      products based in Mission Viejo, California.  Closing consideration
      consisted of $2.2 million of cash, excluding transaction expenses.  An
      additional $1.5 million in purchase price has been deferred and will be paid
      in
      three equal installments of $0.5 million each on December 31, 2008, 2009 and
      2010.  Additional cash consideration of up to $10.5 million may be
      earned in the transaction by MI based on achieving certain financial targets
      in
      each of the three years beginning in 2008 through 2010.  This transaction
      has been accounted for under the purchase method of accounting, and accordingly,
      the operating results of MI have been included in our consolidated statements
      of
      earnings since the effective date of the acquisition.





20


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





Sales.  Our
      sales are primarily derived from the sale of infant and toddler products,
      preschool products and youth and adult 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
      retailers, wholesalers and OEM dealers, and corporate promotional and direct
      to
      consumers.  For the years ended December 31, 2005, 2006 and 2007,
      sales to chain retailers comprised 63.8%, 68.0% and 68.3%, respectively, of
      our
      net sales.





Our
      products are marketed and distributed primarily in North America, Europe,
      Australia and Asia Pacific.  International sales, defined as sales
      outside of North America, constituted 14.5%, 16.7% and 22.1% of our net sales
      for the years ended December 31, 2005, 2006 and 2007,
      respectively.  We expect international sales to continue to increase
      as we expand our geographic reach.  Net sales in our international
      segment increased 24.5% for the year ended December 31, 2007, which includes
      a
      9.5% benefit in changes from currency exchange rates.





We
      derive
      a significant portion of our sales from some of the world’s largest
      retailers.  Our top three customers combined accounted for 40.5%,
      44.2% and 42.6% of our net sales in 2005, 2006 and 2007,
      respectively.  Net sales to each of the Company’s largest customers
      for the years ended December 31, 2005, 2006 and 2007, as a percentage of the
      Company’s total net sales in each of the respective years is as
      follows:





Year
                Ended December 31,2005
            
            
            2006
            
            
            2007Wal-mart
            
            
            13.4
            %
            
            
            16.3
            %
            
            
            15.4
            %Target
            
            
            12.0
            
            
            
            13.1
            
            
            
            14.1Toys
                "R" Us/Babies "R" Us
            
            
            15.1
            %
            
            
            14.8
            %
            
            
            13.1
            %





No
      other
      customers accounted for more than 10.0% of the Company’s net sales in any of the
      years ended December 31, 2005, 2006 or 2007.





We
      provide certain customers the option to take delivery of our products in the
      United States, United Kingdom, Australia, Canada, Belgium 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 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, Belgium or
      Germany.  For the years ended December 31, 2005, 2006 and 2007, direct
      sales from China constituted 10.5%, 14.7% and 15.6%, 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 6.2% to 8.6% of our net sales over the last three
      years.  Returns and allowances for the year ended December 31, 2007,
      include $5.6 million related to the 2007 recalls causing an increase in the
      higher end of the annual range.






21


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 81.7%, 82.5% and 80.9% of our cost of sales in
      2005, 2006 and 2007, respectively.  The remainder of our cost of sales
      primarily includes tooling depreciation, freight-in from suppliers, inventory
      reserves, concept and design expenses, employee compensation, expense related
      to
      stock-based payment arrangements and, in 2007, certain recall-related
      costs.  Our purchases of finished products from Chinese
      manufacturers are primarily denominated in Hong Kong dollars.  Expenses for
      these manufacturers are primarily 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 would increase our expenses and,
      therefore, could adversely affect our profitability.





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.  For example, increases in the price of zinc, a key
      component in die-cast products, and increased costs in China, primarily for
      labor, reduced our gross margins in 2006 and 2007 and may continue to reduce
      our
      gross margins in 2008.





Our
      quarterly gross margins can also be affected by the mix of product that is
      shipped during each quarter.  Our infant and toddler products category
      has higher sales of non-licensed products that carry lower selling prices and
      gross margins than our preschool products and youth and adult products
      categories.  Additionally, individual product lines within each
      category carry gross margins that vary significantly and cause quarterly
      fluctuations, based on the timing of these individual shipments throughout
      the
      year.





Selling,
      general and administrative expenses primarily consist of royalties, employee
      compensation, advertising and marketing expenses, freight-out to customers,
      sales commissions, expense related to stock-based payment arrangements and,
      in
      2007, certain recall-related costs.  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
      2007, aggregate royalties by product ranged from approximately 0.3% to 22.0%
      of
      our net sales price.  Royalty expense was 6.6%, 7.4% and 7.1% of
      our net sales for the years ended December 31, 2005, 2006 and 2007,
      respectively.  Sales commissions ranged from approximately 1.0% to
      10.0% of the net sales price, and are generally paid quarterly to our external
      sales representative organizations.  Sales subject to commissions
      represented 31.1%, 30.2% and 29.5% of our net sales for the years ended December
      31, 2005, 2006 and 2007, respectively.   Sales commission expense
      was 1.3%, 1.2% and 1.2% of our net sales for the years ended December 31, 2005,
      2006 and 2007, respectively.





On
      January 1, 2006, the Company adopted SFAS No. 123R, "Share-Based Payment,"
      using
      the modified prospective method.  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."  For periods ended
      prior to January 1, 2006, pursuant to APB Opinion No. 25, no stock-based
      employee compensation expense was recognized by the Company, and under the
      modified prospective method pursuant to SFAS No. 123R, results for prior periods
      have not been restated.





In
      order
      to support its new product launches and to build consumer awareness of its
      owned
      brands, the Company incurred $9.5 million for investment spending during the
      year ended December 31, 2007, of which $8.3 million has been
      expensed.  The spending is focused on key strategic plan initiatives,
      including on-line, digital and traditional consumer marketing, and building
      and
      launching owned brands.





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 59.2% of our net sales for the three years
      ended December 31, 2007, were generated in the second half of the
      year.  As a result, our working capital, mainly inventory and accounts
      receivable, is typically highest during the third and fourthquarters and lowest during
      the first and second quarters.






22


Results
      of Operations


Year
                Ended December 31,2005
            
            
            2006
            
            
            2007(in
                thousands, except per share data)
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            PercentNet
                sales (1)
            
            $
            492,766
            
            
            
            100.0
            %
            
            $
            518,829
            
            
            
            100.0
            %
            
            $
            488,999
            
            
            
            100.0
            %Cost
                of sales
            
            
            252,935
            
            
            
            51.3
            
            
            
            275,754
            
            
            
            53.1
            
            
            
            270,059
            
            
            
            55.2
            %Restructuring
                charge related to
              discontinued
                automotive collectibles
            
            
            —
            
            
            
            —
            
            
            
            1,872
            
            
            
            0.4
            
            
            
            —
            
            
            
            —Recall-related
                costs
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            4,624
            
            
            
            1.0
            %Gross
                profit
            
            
            239,831
            
            
            
            48.7
            
            
            
            241,203
            
            
            
            46.5
            
            
            
            214,316
            
            
            
            43.8Selling,
                general and
              administrative
                expenses
            
            
            150,381
            
            
            
            30.5
            
            
            
            155,180
            
            
            
            29.9
            
            
            
            161,560
            
            
            
            33.0
            %Amortization
                of intangible assets
            
            
            1,385
            
            
            
            0.3
            
            
            
            1,149
            
            
            
            0.3
            
            
            
            893
            
            
            
            0.2Gain
                on sale of W. Britain
              product
                line
            
            
            (1,953
            )
            
            
            (0.4
            )%
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Restructuring
                charge related to
              discontinued
                automotive collectibles
            
            
            —
            
            
            
            —
            
            
            
            12,631
            
            
            
            2.4
            
            
            
            —
            
            
            
            —Recall-related
                costs
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            18,068
            
            
            
            3.7
            %Operating
                income
            
            
            90,018
            
            
            
            18.3
            
            
            
            72,243
            
            
            
            13.9
            
            
            
            33,795
            
            
            
            6.9Interest
                expense, net
            
            
            5,983
            
            
            
            1.2
            
            
            
            3,465
            
            
            
            0.7
            
            
            
            1,515
            
            
            
            0.3Other
                expense (income)
            
            
            146
            
            
            
            —
            
            
            
            530
            
            
            
            0.1
            
            
            
            (1,768
            )
            
            
            (0.4
            )Income
                from continuing operations
              before
                income taxes
            
            
            83,889
            
            
            
            )17.1
            
            
            
            68,248
            
            
            
            13.1
            
            
            
            34,048
            
            
            
            7.0Income
                tax expense
            
            
            31,153
            
            
            
            6.3
            
            
            
            24,478
            
            
            
            4.7
            
            
            
            12,472
            
            
            
            2.6Income
                from continuing operations
            
            
            52,736
            
            
            
            10.8
            
            
            
            43,770
            
            
            
            8.4
            
            
            
            21,576
            
            
            
            4.4Income
                (loss) from discontinued
              operations, net of tax
            
            
            394
            
            
            
            —
            
            
            
            (9,676
            )
            
            
            (1.9
            )
            
            
            110
            
            
            
            —Net
                income
            
            $
            53,130
            
            
            
            10.8
            %
            
            $
            34,094
            
            
            
            6.5
            %
            
            $
            21,686
            
            
            
            4.4
            %Basic
                earnings per common share:Income
                from continuing operations
            
            $
            2.56
            
            
            
            
            
            
            $
            2.09
            
            
            
            
            
            
            $
            1.05Income
                (loss) from discontinued
              operations
            
            
            0.02
            
            
            
            
            
            
            
            (0.46
            )
            
            
            
            
            
            
            0.01Net
                income
            
            $
            2.58
            
            
            
            
            
            
            $
            1.63
            
            
            
            
            
            
            $
            1.06Diluted
                earnings per common share:Income
                from continuing operations
            
            $
            2.45
            
            
            
            
            
            
            $
            2.04
            
            
            
            
            
            
            $
            1.04Income
                (loss) from discontinued
              operations
            
            
            0.02
            
            
            
            
            
            
            
            (0.45
            )
            
            
            
            
            
            
            0.01Net
                income
            
            $
            2.47
            
            
            
            
            
            
            $
            1.59
            
            
            
            
            
            
            $
            1.05Weighted
                average shares outstanding:Basic
            
            
            20,613
            
            
            
            
            
            
            
            20,884
            
            
            
            
            
            
            
            20,395Diluted
            
            
            21,532
            
            
            
            
            
            
            
            21,377
            
            
            
            
            
            
            
            20,748





(1)  Net
      sales for the year ended December 31, 2007, include $5.6 million in
      recall-related returns and allowances.






23


Operating
      Highlights





Net
      sales
      for the year ended December 31, 2007, decreased 5.7%.  Gross margin
      decreased to 43.8% for 2007 from 46.5% for 2006.  Selling, general and
      administrative expenses as a percentage of net sales increased to 33.0% for
      2007
      from 29.9% for 2006.  Operating income decreased to $33.8 million for
      2007 compared to $72.2 million for 2006.  As a percentage of net
      sales, operating income decreased to 6.9% for 2007 from 13.9% for
      2006.




The
      Company recorded charges of $17.6 million, net of tax, or $0.84 per diluted
      share, in the year ended December 31, 2007, related to the 2007
      recalls.  The portion of these charges included in the North
      America and International segments for the year ended December 31, 2007, is
      $14.8 million and $2.8 million, respectively.  These charges are based
      on the latest estimates of retailer inventory returns, consumer product
      replacement costs and shipping costs as of the date of this filing, as well
      as the additional replacement costs or refunds, donations, notice charges,
      claims administration and legal fees related to the settlement of the class
      action lawsuits.  See Part I, Item 1A, “Risk Factors” for additional
      information.





On
      January 1, 2006, the Company adopted SFAS No. 123R, "Share-Based Payment,"
      using
      the modified prospective method.  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."  For periods ended
      prior to January 1, 2006, pursuant to APB Opinion No. 25, no stock-based
      employee compensation expense was recognized by the Company, and under the
      modified prospective method pursuant to SFAS No. 123R, results for the prior
      periods have not been restated.  Results for the year ended December
      31, 2005, do not include compensation expense for stock-based payment
      arrangements.





Effective
      November 1, 2006, the Company sold all of the issued and outstanding capital
      stock of RC2 South, Inc., its collectible trading card business, and
      substantially all of the assets related to its die-cast sports collectibles
      product line.  Closing consideration consisted of $6.9 million of
      cash, excluding transaction expenses.  The sale of the Company’s
      trading card business and sports collectibles product line is consistent with
      the Company’s strategic focus to achieve sustainable organic growth and to
      concentrate its efforts on its higher growth infant and toddler products and
      preschool products categories. The transaction was effective November 1, 2006,
      and the results of this sold business are presented as discontinued operations
      in the accompanying consolidated statements of earnings and consolidated
      statements of cash flows.  A loss of $11.4 million and a gain of
      $0.1 million, both net of income tax, on the sale were recognized on
      this transaction during the years ended December 31, 2006 and 2007,
      respectively.  The operations of the sold business, as well as the
      loss and the gain on the sale, are presented in income (loss) from
      discontinued operations, net of tax, in the accompanying consolidated statements
      of earnings for the years ended December 31, 2006 and 2007.





During
      December 2006, the Company made the decision to discontinue its Racing
      Champions®,
      JoyRide®,
      AMT® and
      certain Ertl®
      die-cast and model kit automotive collectible product lines.  As a
      result of discontinuing certain of these product lines, the Company recorded
      a
      non-cash restructuring charge of $14.5 million, or $9.1 million net of estimated
      income tax benefits, or $0.42 per diluted share, for the year ended December
      31,
      2006, to write-off undepreciated tooling costs and unamortized intangible assets
      and to provide inventory and royalty reserves.




Results
      for 2005 were negatively impacted by a tax charge of $0.5 million incurred
      as a
      result of repatriation of foreign earnings and by additional depreciation
      expense of $0.8 million, or $0.5 million net of income tax benefit, for tooling
      on discontinued product lines.  These negative impacts were offset by
      a gain of $2.0 million, or $1.2 million net of income tax expense, on the sale
      of the W. Britain product line and an income tax benefit of $0.7 million due
      to
      a reduction of income tax accruals stemming from the resolution of specific
      outstanding state and foreign tax issues.  The combined impact of
      these charges positively impacted diluted earnings per share for the year ended
      December 31, 2005, by $0.05 per diluted share.






24


Year
      Ended December 31, 2007, Compared to Year Ended December 31, 2006





Net
      sales.  Net sales decreased $29.8 million, or 5.7%, to $489.0
      million for 2007 from $518.8 million for 2006.  Net sales in our North
      America segment decreased 11.8% and net sales in our international segment
      increased 24.5% which includes a 9.5% benefit in changes from currency exchange
      rates.




Net
      sales
      for the year ended December 31, 2007, excluding $22.2 million in net sales
      of
      discontinued product lines and $5.6 million of recall-related returns and
      allowances, were $472.4 million, a decrease of 1.9% when compared with net
      sales
      for the year ended December 31, 2006, excluding $37.4 million in net sales
      of
      discontinued product lines, of $481.4 million.  Management believes
      that the presentation of these non-GAAP financial measures provides useful
      information to investors because this information may allow investors to better
      evaluate ongoing business performance and certain components of the Company’s
      results.  A reconciliation to the nearest GAAP financial measure
      follows:





(in
                millions)
            
            Net
                Sales2007
                actual
            
            $
            489.0Deduct:
                discontinued product lines
            
            
            22.2Add:
                recall-related returns and allowances
            
            
            5.6As
                adjusted
            
            $
            472.42006
                actual
            
            $
            518.8Deduct:
                discontinued product lines
            
            
            37.4As
                adjusted
            
            $
            481.4





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




Net
      sales
      in our preschool products category decreased 14.2% primarily driven by declines
      in our licensed toy product lines and ride-ons which offset the increases
      generated from new product launches.  Excluding the $4.9 million of
      recall-related returns and allowances, our preschool products category decreased
      12.0%.  Net sales in our youth and adult products category decreased
      5.7% primarily due to lower sales of discontinued products, partially offset
      by
      sales increases attributable to new product launches.  Excluding net
      sales related to the discontinued product lines, net sales in our youth and
      adult products category increased 11.0%.  Net sales in our infant and
      toddler products category increased 5.2% primarily driven by our Take & Toss
      toddler self-feeding system, our Soothie bottle feeding system, our American
      Red
      Cross health and wellness products marketed under our The First Years by
      Learning Curve brand and the newly re-launched Lamaze infant development
      products.  Excluding the $0.7 million of recall-related returns and
      allowances and net sales related to discontinued product lines of $0.3 million,
      net sales in our infant and toddler products category increased
      5.8%.  Information in this paragraph regarding net sales in our infant
      and toddler products category excluding recall-related returns and allowances
      and excluding net sales related to discontinued product lines, in our preschool
      products category excluding recall-related returns and allowances and in our
      youth and adult products category excluding net sales related to discontinued
      product lines constitutes non-GAAP financial information.  Management
      believes that the presentation of these non-GAAP financial measures provides
      useful information to investors because this information may allow investors
      to
      better evaluate ongoing business performance and certain components of the
      Company’s results.






25


A
      reconciliation to the nearest GAAP financial measure follows:





Net
                Sales(in
                millions)
            
            2007
            
            
            2006
            
            
            Difference
            
            
            %
                ChangeInfant
                and toddler products actual
            
            $
            184.9
            
            
            $
            175.7
            
            
            $
            9.2
            
            
            
            5.2
            %Add:
                recall-related returns and allowances
            
            
            0.7
            
            
            
            —
            
            
            
            0.7
            
            
            
            —Deduct:
                discontinued product lines
            
            
            —
            
            
            
            0.3
            
            
            
            (0.3
            )
            
            
            —As
                adjusted
            
            $
            185.6
            
            
            $
            175.4
            
            
            $
            10.2
            
            
            
            5.8
            %Preschool
                products actual
            
            $
            196.8
            
            
            $
            229.3
            
            
            $
            (32.5
            )
            
            
            (14.2
            )%Add:
                recall-related returns and allowances
            
            
            4.9
            
            
            
            —
            
            
            
            4.9
            
            
            
            —As
                adjusted
            
            $
            201.7
            
            
            $
            229.3
            
            
            $
            (27.6
            )
            
            
            (12.0
            )%Youth
                and adult products actual
            
            $
            107.3
            
            
            $
            113.8
            
            
            $
            (6.5
            )
            
            
            (5.7
            )%Deduct:
                discontinued product lines
            
            
            22.2
            
            
            
            37.1
            
            
            
            (14.9
            )
            
            
            (40.2
            )As
                adjusted
            
            $
            85.1
            
            
            $
            76.7
            
            
            $
            8.4
            
            
            
            11.0
            %




Gross
      profit.  Gross profit decreased $26.9 million, or 11.2%, to
      $214.3 million for 2007 from $241.2 million for 2006.  The gross
      profit margin, as a percentage of net sales, decreased to 43.8% for 2007
      compared to 46.5% for 2006.  This decrease was primarily due to a less
      favorable product mix, higher product costs than that experienced in the prior
      year and $10.2 million of recall-related costs.  Gross profit for the
      year ended December 31, 2006, was negatively impacted by the $1.9 million
      restructuring charge related to the discontinuance of the automotive collectible
      product lines.  There were no major changes in the components of cost
      of sales.




Selling,
      general
      and administrative expenses. Selling, general and administrative expenses
      increased $6.4 million, or 4.1%, to $161.6 million for 2007 from $155.2 million
      for 2006.  As a percentage of net sales, selling, general and
      administrative expenses increased to 33.0% for 2007 from 29.9% for
      2006.  Selling, general and administrative expenses for the year ended
      December 31, 2007, include $8.3 million of investment spending to support our
      new product launches and to build consumer awareness of our owned
      brands.





Operating
      income. Operating income decreased to $33.8 million for 2007 from $72.2
      million for 2006.  As a percentage of net sales, operating income
      decreased to 6.9% for 2007 from 13.9% for 2006.  Operating income for
      the year ended December 31, 2007, was negatively impacted by $28.3 million
      of
      recall-related costs and $8.3 million of investment spending to support our
      new
      product launches and to build consumer awareness of our owned
      brands.  Operating income for the year ended December 31, 2006,
      includes a $14.5 million restructuring charge related to the discontinuance
      of
      the automotive collectible product lines.





Net
      interest
      expense. Net interest expense of $1.5 million for 2007 and $3.5 million
      for 2006 relates primarily to bank term loans and lines of
      credit.  The decrease in net interest expense for 2007 was primarily
      due to the decrease in average outstanding debt balances partially offset by
      higher average interest rates and the write-off of $0.2 million of deferred
      financing fees related to the Company’s voluntary payment of the remaining
      balance of its term loan.  The $95.0 million of borrowings under our
      revolving line of credit in 2007 will increase net interest expense in future
      periods.





Income
      tax.  Income tax expense for the years ended December 31, 2006
      and 2007, includes provisions for federal, state and foreign income taxes at
      an
      effective rate of 37.3% and 37.9%, respectively.  However, the tax
      rate, including discrete items, for the years ended December 31, 2006 and 2007,
      is 35.9% and 36.6%, respectively.   Discrete items include
      significant, infrequent, unusual or non-recurring items.






26


Year
      Ended December 31, 2006, Compared to Year Ended December 31, 2005





Net
      sales.
      Net sales increased $26.0 million, or 5.3%, to $518.8 million for 2006 from
      $492.8 million for 2005.  Net sales increased in our infant and
      toddler products and preschool products categories, but these increases were
      partially offset by a decrease in our youth and adult products
      category.




Net
      sales
      in our preschool products category increased 14.7% primarily attributable to
      the
Thomas & Friends,
Bob
      the Builder and
      John Deere ride-on and toy vehicles product lines.  Net sales in our
      infant and toddler products category increased 9.8%, primarily attributable
      to
      The First Years’ Take & Toss toddler self-feeding system, Soothie bottle
      system and Learning Curve’s Lamaze infant toys.  Net sales in our
      youth and adult products category decreased 14.4%, primarily due to continued
      softness in the collectibles market.





Actual
      net sales for 2006, excluding $37.4 million in net sales of sold and
      discontinued product lines, were $481.4 million, an increase of 12.0% when
      compared to 2005 actual net sales, excluding $62.9 million in net sales of
      sold
      and discontinued product lines, of $429.9 million.  Management has
      provided this non-GAAP financial information so that investors can more easily
      compare financial performance of the Company’s current business operations from
      period to period.  A reconciliation to the nearest GAAP financial
      measure follows:





(in
                millions)
            
            Net
                Sales2006
                actual
            
            $
            518.8Deduct:
                sold and discontinued product lines
            
            
            37.4As
                adjusted
            
            $
            481.42005
                actual
            
            $
            492.8Deduct:
                sold and discontinued product lines
            
            
            62.9As
                adjusted
            
            $
            429.9




Gross
      profit. Gross profit increased $1.4 million, or 0.6%, to $241.2 million
      for 2006 from $239.8 million for 2005.  However, the gross profit
      margin, as a percentage of net sales, decreased to 46.5% for 2006 compared
      to
      48.7% for 2005.  This decrease was primarily due to a less favorable
      product and distribution mix, higher product costs, especially in die-cast
      products, and increasing costs in China, primarily for labor, than that
      experienced in 2005.  In addition, the 2006 gross profit was
      negatively impacted by the $1.9 million restructuring charge related to the
      discontinuance of the automotive collectible product lines.  There
      were no major changes in the components of cost of sales.





Selling,
      general
      and administrative expenses.  Selling, general and
      administrative expenses increased $4.8 million, or 3.2%, to $155.2 million
      for
      2006 from $150.4 million for 2005.  As a percentage of net sales,
      selling, general and administrative expenses decreased to 29.9% for 2006 from
      30.5% for 2005.  Selling, general and administrative expenses for the
      year ended December 31, 2006, include $3.9 million of compensation expense
      for
      stock-based payment arrangements.  Results for the year ended December
      31, 2005, do not include compensation expense for stock-based payment
      arrangements.  Pro forma compensation expense for stock-based payment
      arrangements for the year ended December 31, 2005, was $3.3
      million.





Operating
      income.  Operating income decreased to $72.2 million for 2006
      from $90.0 million for 2005.  As a percentage of net sales, operating
      income decreased to 13.9% for 2006 from 18.3% for 2005.  Operating
      income for 2006 includes a $14.5 million restructuring charge related to the
      discontinuance of the automotive collectible product lines.  Operating
      income for 2005 includes a $2.0 million gain on the sale of assets related
      to
      the sale of our W. Britain product line.





Net
      interest
      expense.  Net interest
      expense of $3.5 million for 2006 and $6.0 million for 2005 relates primarily
      to
      bank term loans and lines of credit.  The decrease in net interest
      expense for 2006 was primarily due to a decrease in average outstanding debt
      balances offset slightly by higher interest rates.






27


Income
      tax.  Income tax expense of $24.5 million for 2006 includes
      provisions for federal, state and foreign income taxes at an effective rate
      of
      37.3%.  However, the tax rate, including discrete items, for 2006 is
      35.9%.  Discrete items include significant, infrequent, unusual or
      non-recurring items.  Income tax expense of $31.2 million for 2005
      includes a tax charge of $0.5 million, or $0.02 per diluted share, incurred
      as a
      result of repatriation of foreign earnings and a tax benefit of $0.7 million,
      or
      $0.03 per diluted share, relating to a reduction of income tax accruals stemming
      from the resolution of specific outstanding state and foreign tax
      issues.  Income tax expense for 2005 includes provisions for federal,
      state and foreign income taxes at an effective rate of 37.1%.





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 $63.5 million in 2007, $61.8 million
      in
      2006 and $59.1 million in 2005.





Working
      capital decreased $62.5 million to $67.1 million at December 31, 2007, from
      $129.6 million at December 31, 2006.  Cash and cash equivalents
      increased $32.4 million to $57.8 million at December 31, 2007, from $25.4
      million at December 31, 2006.  Our accounts receivable decreased $2.6
      million to $110.3 million at December 31, 2007, from $112.9 million at December
      31, 2006.  Our inventory level decreased $6.7 million to $77.0 million
      at December 31, 2007, from $83.7 million at December 31,
      2006.  Accounts payable and accrued recall-related costs increased
      $21.7 million to $48.6 million at December 31, 2007, from $26.9 million at
      December 31, 2006.





Net
      cash
      used in investing activities was $20.3 million in 2007, $8.3 million in 2006
      and
      $6.6 million in 2005. The increase in 2007 was primarily attributable to the
      2007 acquisitions of the Compass Business and MI and the 2006 sale of
      discontinued operations.  Capital expenditures, primarily for molds
      and tooling, in 2007 and 2006 were $11.5 million and $14.4 million,
      respectively, and we expect capital expenditures for 2008, principally for
      molds
      and tooling, to be approximately $14.0 million.





Net
      cash
      used in financing activities was $12.3 million in 2007, $54.5 million in 2006
      and $46.5 million in 2005.  Payments of outstanding debt under our
      credit facilities were $22.4 million for the year ended December 31, 2007,
      all
      of which were made on our term loan and resulted in our paying off our
      outstanding term loan debt during the first quarter of 2007.  During
      the year ended December 31, 2007, we purchased $87.9 million of our common
      stock
      which we funded via borrowings on our revolving line of credit.  Borrowings
      on our revolving line of credit were $95.0 million during the year ended
      December 31, 2007.




Upon
      the
      closing of the acquisition of TFY on September 15, 2004, the Company entered
      into a new credit facility, which has subsequently been amended, to replace
      its
      previous credit facility.  The credit facility is comprised of an
      $85.0 million term loan and a $100.0 million revolving line of
      credit.  The credit facility also provides an additional $75.0 million
      of capacity under the revolving line of credit which was approved by the lenders
      upon the Company’s request in October 2007.  During the first quarter
      of 2007, the term loan was repaid and the term loan is no longer available
      for
      borrowing.  The revolving line of credit is available until its
      maturity on September 14, 2008.  A portion of the term loan had an
      interest rate of 3.45% plus applicable margin through the first three years
      of
      the facility.  The remaining term loan bore and revolving line of
      credit bears interest, at the Company’s option, at a base rate or at a LIBOR
      rate plus applicable margin.  The applicable margin is based on the
      Company’s ratio of consolidated debt to consolidated EBITDA (earnings before
      interest, taxes, depreciation, amortization and non-cash expense related to
      equity awards) and varies between 0.75% and 1.625%.  At December 31,
      2007, the margin in effect was 1.00% for LIBOR loans.  The Company is
      also required to pay a commitment fee of 0.20% to 0.35% per annum on the average
      daily unused portion of the revolving line of credit.  At December 31,
      2007, the commitment fee in effect was 0.25% per annum.  Under the
      terms of this credit facility, the Company is required to comply with certain
      financial and non-financial covenants.  Among other restrictions, the
      Company is restricted in its ability to pay dividends, incur additional debt
      and
      make acquisitions above certain amounts.  The key financial covenants
      include minimum EBITDA and interest coverage and leverage ratios.  The
      credit facility is secured by working capital assets and certain intangible
      assets.  On December 31, 2007, the Company had $95.0 million
      outstanding on the revolving line of credit, and was in compliance with all
      covenants.




The
      Company’s Hong Kong subsidiary maintains an on-going credit agreement with a
      bank that provides for a line of credit of up to $1.9
      million.  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, 2006 and 2007,
      there were no outstanding borrowings under this line of credit.





The
      Company’s United Kingdom subsidiary maintains two on-going lines of credit with
      two banks totaling $0.4 million.  The lines of credit bear 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, 2006 and 2007, there
      were no amounts outstanding on these lines of credit.





28


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





The
      following table summarizes our significant contractual commitments at December
      31, 2007:





Payment
                Due by Period(in
                thousands)
              Contractual
                Obligations
            
            Total
            
            
            2008
            
            
            
            2009-2010
            
            
            
            2011-2012
            
            
            2013
                and
              beyondLine
                of credit
            
            $
            95,000
            
            
            $
            95,000
            
            
            $
            —
            
            
            $
            —
            
            
            $
            —Estimated
                future interest payments
              on
                line of credit
            
            
            4,097
            
            
            
            4,097
            
            
            
            —
            
            
            
            —
            
            
            
            —Minimum
                guaranteed royalty payments
            
            
            36,245
            
            
            
            4,147
            
            
            
            15,981
            
            
            
            15,842
            
            
            
            275Operating
                leases
            
            
            25,804
            
            
            
            4,095
            
            
            
            6,413
            
            
            
            4,267
            
            
            
            11,029Unconditional
                purchase obligations
            
            
            65,720
            
            
            
            23,261
            
            
            
            42,459
            
            
            
            —
            
            
            
            —Total
                contractual cash obligations
            
            $
            226,866
            
            
            $
            130,600
            
            
            $
            64,853
            
            
            $
            20,109
            
            
            $
            11,304





Estimated
      future interest payments on our line of credit were based upon the interest
      rates in effect at December 31, 2007.




In
      February 2007, we announced that our Board of Directors authorized the
      adoption of a program to repurchase up to $75.0 million of our common
      stock.  The program was initially authorized for a period of one
      year.  In October 2007, the Board of Directors authorized a $75.0
      million increase to the stock repurchase program and extended the timing of
      this
      program through December 31, 2008.  This program may be extended
      beyond the currently authorized period or may be suspended at any
      time.  Under this program, shares may be repurchased from time to time
      in open market transactions or privately negotiated transactions at our
      discretion, subject to market conditions and other factors.  Shares
      repurchased are held as treasury shares.  During the year ended
      December 31, 2007, we repurchased 2.9 million shares for $87.9 million under
      this program.  These repurchases were funded via borrowings on
      our revolving line of credit.





In
      order
      to support our new product launches and to build consumer awareness of our
      owned
      brands, we incurred $9.5 million for investment spending during the year ended
      December 31, 2007 of which $8.3 million has been expensed.  The
      spending is focused on key strategic plan initiatives including on-line, digital
      and traditional consumer marketing and building and launching owned
      brands.





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 2008.  Our existing credit facility
      matures on September 14, 2008, and we currently anticipate that we will
      refinance during the second quarter of 2008.  Due to seasonal
      increases in demand for our products, our working capital is typically highest
      during the third and fourth quarters, and our debt levels are highest during
      the
      second and third quarters.  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.





Off-Balance
      Sheet Arrangements





The
      Company did not have any off-balance sheet arrangements during any of the years
      ended December 31, 2005, 2006 and 2007.






29


Critical
      Accounting Policies and Estimates





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





Allowance
      for
      doubtful accounts.  The allowance for doubtful accounts
      represents adjustments to customer trade accounts receivable for amounts deemed
      uncollectible.  The allowance for doubtful accounts reduces gross
      trade receivables to their estimated net realizable value 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 the lower of cost or market.  Cost
      is determined by the first-in, first-out method and includes all costs necessary
      to bring inventory to its existing condition and location.  Market
      represents the lower of replacement cost or estimated net realizable
      value.  Inventory write-downs are recorded for damaged, obsolete,
      excess and slow-moving inventory.  The Company’s management uses
      estimates to record these write-downs based on its review of inventory by
      product category, length of time on hand and order bookings.  Changes
      in public and consumer preferences and demand for product or changes in customer
      buying patterns and inventory management, as well as discontinuance of products
      or product lines, could impact the inventory valuation.




Impairment
      of
      long-lived assets, goodwill and other intangible
      assets.  Long-lived assets have been reviewed for impairment
      based on SFAS No. 144, "Accounting for the Impairment of Long-Lived Assets
      and
      for Long-Lived Assets to be Disposed Of."  This Statement requires
      that an impairment loss be recognized whenever the carrying value of an asset
      exceeds the sum of the undiscounted cash flows expected to result from the
      use
      and eventual disposition of that asset, excluding future interest costs the
      entity would recognize as an expense when incurred.  Goodwill and
      other intangible assets have been reviewed for impairment based on SFAS No.
      142,
      "Goodwill and Other Intangible Assets."  Under this Statement,
      goodwill and other intangible assets that have indefinite useful lives are
      not
      amortized, but rather tested at least annually for impairment.  The
      Company’s management reviews for indicators that might suggest an impairment
      loss could exist.  Testing for impairment requires estimates of
      expected cash flows to be generated from the use of the
      assets.  Various uncertainties, including changes in consumer
      preferences, deterioration in the political environment or changes in general
      economic conditions, could impact the expected cash flows to be generated by
      an
      asset or group of assets.  Intangible assets that have finite useful
      lives are amortized over their useful lives.  The Company adopted SFAS
      No. 142 on January 1, 2002. Goodwill has been amortized over 40 years on a
      straight-line basis through December 31, 2001.





As
      of
      December 31, 2006 and 2007, goodwill, net of accumulated amortization, was
      $239.1 million and $247.8 million, respectively.  The increase in
      goodwill at December 31, 2007, was due to the acquisition of the Compass
      Business and MI.  The Company completed its annual goodwill impairment
      tests as of October 1, 2006 and 2007, which resulted in no
      impairment.  The annual impairment tests for intangible assets in 2007
      resulted in no impairment to intangibles.  However, for the year ended
      December 31, 2006, an impairment charge for intangible assets in the North
      America segment of $2.8 million has been included in the restructuring charge
      related to discontinued automotive collectibles within operating expenses in
      the
      accompanying consolidated statement of earnings, as a result of the 2006 annual
      impairment test for intangible assets.  The impairment charge was
      based upon the Company’s decision to discontinue its automotive collectible
      product lines.





30


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





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




Product
      recalls. The Company establishes a reserve for product
      recalls on a product-specific basis during the period in which the circumstances
      giving rise to the recall become known and estimatable.  Facts
      underlying the recall, including, among others, estimates of retailer inventory
      returns, consumer replacement costs and shipping costs, are considered when
      establishing a product recall reserve.  In 2007, the Company also
      considered additional replacement costs or refunds, donations, notice charges,
      claims admininstration and legal fees related to the settlement of the class
      action lawsuits (see Item 3).  When facts or circumstances become
      known that would indicate that the recall reserve is either not sufficient
      to
      cover or exceeds the estimated product recall expenses, the reserve is adjusted,
      as appropriate.




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




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





Stock-based
      compensation.  Effective January 1, 2006, the Company adopted
      SFAS No. 123R, "Share-Based Payment."  The Company elected to use the
      modified prospective application of SFAS No. 123R for awards issued prior to
      January 1, 2006.  Income from continuing operations before income tax
      for the years ended December 31, 2006 and 2007, includes total expense
      recognized for all of the Company’s stock-based payment plans.





The
      fair
      value of stock options granted under the stock incentive plans is estimated
      on
      the date of grant based on the Black-Scholes option pricing
      model.  Prior to 2007, the Company calculated the expected volatility
      factor for those options issued under the stock incentive plans to correspond
      with the average volatility factor of those companies included in a peer group
      study.  The historical stock price movements of the Company’s common
      stock had not been considered a good indicator of expected future volatility
      because the Company’s business had changed significantly as a result of
      acquisitions completed.  However, the Company continued to monitor its
      actual volatility to assess whether its historical stock price movements over
      the expected option term were a good indicator of expected future results and
      began using Company specific volatility in 2007.





The
      Company uses historical data to estimate stock option exercise and employee
      departure behavior used in the Black-Scholes option pricing
      model.  The expected term of stock options granted represents the
      period of time that stock options granted are expected to be
      outstanding.  The risk-free rate for the period within the contractual
      term of the stock option is based on the U.S. Treasury yield curve in effect
      at
      the time of grant.





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





31


Recently
      Issued Accounting Pronouncements





In
      September 2006, the FASB issued SFAS No. 157, "Fair Value
      Measurements."  This Statement defines fair value, establishes a
      framework for measuring fair value in generally accepted accounting principles
      and expands disclosures about fair value measurements.  This Statement
      applies under other accounting pronouncements that require or permit fair value
      measurement.  However, this Statement does not require any new fair
      value measurements.  This Statement is effective for the financial
      statements issued for fiscal years beginning after November 15, 2007, and
      interim periods within those fiscal years.  The Company is evaluating
      the effect that this Statement will have on the Company’s financial
      statements.




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





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 facilities and foreign currency exchange rate risk
      associated with the Company’s foreign operations.





Based
      on
      the Company’s interest rate exposure on variable rate borrowings at December 31,
      2007, a one percentage point increase in average interest rates on the Company’s
      borrowings would increase future interest expense by $0.1 million per month
      and
      a five percentage point increase would increase future interest expense by
      approximately $0.4 million per month.  The Company determined these
      amounts based on $95.0 million of variable rate borrowings at December 31,
      2007,
      multiplied by 1.0% and 5.0%, respectively, and divided by twelve.  The
      Company is currently not using any interest rate collars, hedges or other
      derivative financial instruments to manage or reduce interest rate
      risk.  As a result, any increase in interest rates on the Company’s
      variable rate borrowings would increase interest expense and reduce net
      income.





The
      Company’s net sales are primarily denominated in U.S. dollars, with 19.4% of net
      sales in 2007 denominated in British pounds sterling, Australian dollars, Euros
      and Canadian dollars.  The Company’s purchases of finished goods from
      Chinese manufacturers are primarily denominated in Hong Kong
      dollars.  Expenses for these manufacturers are primarily denominated
      in Chinese Renminbi.  The Hong Kong dollar is currently pegged to the
      U.S. dollar.  If the Hong Kong dollar ceased to be pegged to the U.S.
      dollar, a material increase in the value of the Hong Kong dollar relative to
      the
      U.S. dollar would increase our expenses, and therefore, could adversely affect
      our profitability.  A 10.0% change in the exchange rate of the U.S.
      dollar with respect to the Hong Kong dollar for the year ended December 31,
      2007, would have changed the total dollar amount of our gross profit by
      10.2%.  During July 2005, China revalued the Chinese Renminbi,
      abandoning the former method of pegging the Chinese Renminbi to the U.S.
      dollar.  As expenses for the Company’s Chinese manufacturers are
      primarily denominated in Chinese Renminbi, a material increase in the value
      of
      the Chinese Renminbi relative to the U.S. dollar would increase the Company’s
      expenses, and therefore, could adversely affect the Company’s
      profitability.  A 10.0% change in the exchange rate of the U.S. dollar
      with respect to the British pound sterling, the Australian dollar, the Euro
      or
      the Canadian dollar for the year ended December 31, 2007, individually would
      not
      have had a significant impact on the Company’s earnings.  The Company
      is also subject to exchange rate risk relating to transfers of funds denominated
      in British pounds sterling, 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.






32


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 tables set forth our unaudited quarterly results of operations for
      2006 and 2007.  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 the annual period or any future
      period.





Fiscal
                Year 2006(in
                thousands, except per share data)
            
            
            Q1
            
            
            
            Q2
            
            
            
            Q3
            
            
            
            Q4Net
                sales
            
            $
            101,672
            
            
            $
            106,586
            
            
            $
            156,021
            
            
            $
            154,550Cost
                of sales (1)
            
            
            54,395
            
            
            
            56,146
            
            
            
            82,574
            
            
            
            82,639Restructuring
                charge related to discontinued
              automotive
                collectibles
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            1,872Gross
                profit
            
            
            47,277
            
            
            
            50,440
            
            
            
            73,447
            
            
            
            70,039Selling,
                general and administrative expenses(1)
            
            
            34,116
            
            
            
            36,646
            
            
            
            42,425
            
            
            
            41,993Amortization
                of intangible assets
            
            
            315
            
            
            
            315
            
            
            
            315
            
            
            
            204Restructuring
                charge related to discontinued
              automotive
                collectibles
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            12,631Operating
                income
            
            
            12,846
            
            
            
            13,479
            
            
            
            30,707
            
            
            
            15,211Interest
                expense, net
            
            
            1,015
            
            
            
            856
            
            
            
            944
            
            
            
            650Other
                (income) expense
            
            
            (155
            )
            
            
            37
            
            
            
            273
            
            
            
            375Income
                before income taxes
            
            
            11,986
            
            
            
            12,586
            
            
            
            29,490
            
            
            
            14,186Income
                tax expense
            
            
            4,420
            
            
            
            4,538
            
            
            
            10,758
            
            
            
            4,762Income
                from continuing operations
            
            
            7,566
            
            
            
            8,048
            
            
            
            18,732
            
            
            
            9,424(Loss)
                income from discontinued operations,
              net
                of tax
            
            
            (76
            )
            
            
            1,087
            
            
            
            641
            
            
            
            (11,328
            )Net
                income (loss)
            
            $
            7,490
            
            
            $
            9,135
            
            
            $
            19,373
            
            
            $
            (1,904
            )Basic
                earnings per common share:Income
                from continuing operations
            
            $
            0.36
            
            
            $
            0.39
            
            
            $
            0.90
            
            
            $
            0.45Income
                (loss) from discontinued operations
            
            
            —
            
            
            
            0.05
            
            
            
            0.03
            
            
            
            (0.54
            )Net
                income (loss)
            
            $
            0.36
            
            
            $
            0.44
            
            
            $
            0.93
            
            
            $
            (0.09
            )Diluted
                earnings per common share:Income
                from continuing operations
            
            $
            0.35
            
            
            $
            0.38
            
            
            $
            0.88
            
            
            $
            0.44Income
                (loss) from discontinued operations
            
            
            —
            
            
            
            0.05
            
            
            
            0.03
            
            
            
            (0.53
            )Net
                income (loss)
            
            $
            0.35
            
            
            $
            0.43
            
            
            $
            0.91
            
            
            $
            (0.09
            )Weighted
                average shares outstanding:Basic
            
            
            20,750
            
            
            
            20,863
            
            
            
            20,917
            
            
            
            21,004Diluted
            
            
            21,262
            
            
            
            21,347
            
            
            
            21,365
            
            
            
            21,463




(1)  Depreciation
      expense was
      $3.5 million, $3.6 million, $3.6 million and $3.4 million for Q1, Q2, Q3 and
      Q4
      2006, respectively.






33


Fiscal
                Year 2007(in
                thousands, except per share data)
            
            
            Q1
            
            
            
            Q2
            
            
            
            Q3
            
            
            
            Q4Net
                sales (1)
            
            $
            112,593
            
            
            $
            92,990
            
            
            $
            144,843
            
            
            $
            138,573Cost
                of sales (2)
            
            
            62,131
            
            
            
            53,544
            
            
            
            78,552
            
            
            
            75,832Recall-related
                costs
            
            
            —
            
            
            
            1,703
            
            
            
            2,408
            
            
            
            513Gross
                profit
            
            
            50,462
            
            
            
            37,743
            
            
            
            63,883
            
            
            
            62,228Selling,
                general and administrative expenses (2)
            
            
            37,768
            
            
            
            32,722
            
            
            
            42,680
            
            
            
            48,390Amortization
                of intangible assets
            
            
            213
            
            
            
            213
            
            
            
            208
            
            
            
            259Recall-related
                costs
            
            
            —
            
            
            
            2,233
            
            
            
            5,270
            
            
            
            10,565Operating
                income
            
            
            12,481
            
            
            
            2,575
            
            
            
            15,725
            
            
            
            3,014Interest
                expense (income), net
            
            
            302
            
            
            
            (150
            )
            
            
            355
            
            
            
            1,008Other
                income
            
            
            (466
            )
            
            
            (110
            )
            
            
            (411
            )
            
            
            (781
            )Income
                before income taxes
            
            
            12,645
            
            
            
            2,835
            
            
            
            15,781
            
            
            
            2,787Income
                tax expense
            
            
            4,586
            
            
            
            485
            
            
            
            5,012
            
            
            
            2,389Income
                from continuing operations
            
            
            8,059
            
            
            
            2,350
            
            
            
            10,769
            
            
            
            398Income
                from discontinued operations,
              net
                of tax
            
            
            —
            
            
            
            110
            
            
            
            —
            
            
            
            —Net
                income
            
            $
            8,059
            
            
            $
            2,460
            
            
            $
            10,769
            
            
            $
            398Basic
                earnings per common share:Income
                from continuing operations
            
            $
            0.38
            
            
            $
            0.11
            
            
            $
            0.52
            
            
            $
            0.02Income
                from discontinued operations
            
            
            —
            
            
            
            0.01
            
            
            
            —
            
            
            
            —Net
                income
            
            $
            0.38
            
            
            $
            0.12
            
            
            $
            0.52
            
            
            $
            0.02Diluted
                earnings per common share:Income
                from continuing operations
            
            $
            0.37
            
            
            $
            0.11
            
            
            $
            0.52
            
            
            $
            0.02Income
                from discontinued operations
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Net
                income
            
            $
            0.37
            
            
            $
            0.11
            
            
            $
            0.52
            
            
            $
            0.02Weighted
                average shares outstanding:Basic
            
            
            21,116
            
            
            
            21,225
            
            
            
            20,523
            
            
            
            18,743Diluted
            
            
            21,519
            
            
            
            21,611
            
            
            
            20,850
            
            
            
            19,060




(1)  Net
      sales for Q2, Q3, and Q4 2007 include $2.4 million, $1.7 million and $1.5
      million, respectively, of recall-related returns and allowances.


(2)  Depreciation
      expense was $3.6 million, $3.6 million, $3.3 million and $3.4 million for Q1,
      Q2, Q3 and Q4 2007, respectively.






34


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, as of the end of such
      period, the Company’s disclosure controls and procedures were effective in
      recording, processing, summarizing and reporting, on a timely basis, information
      required to be disclosed by the Company in reports that the Company files with
      or submits to the 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) and
      15d-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 U.S. 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.





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, 2007.  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, 2007, the Company’s internal control over financial reporting
      was effective based on those criteria.




KPMG,
      LLP, the independent registered
      public accounting firm that audited the Company's consolidated financial
      statements, has issued an attestation report on the Company's internal control
      over financial reporting, which appears on page F-3 hereof.





Item
      9B. Other Information





Not
      applicable.




35


Part
      III





Item
      10.  Directors, Executive Officers and Corporate
      Governance





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 2008 Annual Meeting of Stockholders, which will be filed
      with
      the Commission on or before April 29, 2008.  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 2008 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 Daniel M. Wright (Chairman), John J. Vosicky,
      Michael J. Merriman, Jr. and Linda A. Huett.





Item
      11.  Executive Compensation





Information
      regarding executive compensation is incorporated herein by reference to the
      discussion under "Executive Compensation" and "Director Compensation" in the
      Company’s Proxy Statement for the 2008 Annual Meeting of Stockholders, which
      will be filed with the Commission on or before April 29, 2008.





The
      information incorporated by reference from the "Report of the Compensation
      Committee" in the Company’s Proxy Statement for the 2008 Annual Meeting of
      Stockholders shall not be deemed "filed" for purposes of Section 18 of the
      Securities Exchange Act of 1934, nor shall it be deemed incorporated by
      reference in any filing under the Securities Act of 1933 or the Securities
      Exchange Act of 1934, except as shall be expressly set forth by specific
      reference in such filing.





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 2008 Annual Meeting of Stockholders, which
      will be filed with the Commission on or before April 29, 2008.





Equity
      Compensation Plan Information





The
      following table summarizes share information, as of December 31, 2007, for
      the
      Company’s equity compensation plans, including the RC2 Corporation 2005 Stock
      Incentive Plan (2005 Plan), the Racing Champions Ertl Corporation Stock
      Incentive Plan, the RC2 Corporation Employee Stock Purchase Plan (ESPP) 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.  The Wheels Sports Group, Inc. 1996 Omnibus
      Stock Plan and the Racing Champions Ertl Corporation Stock Incentive Plan are
      dormant, and no future issuances are allowed under these plans.





Plan
                Category
            Number
                of
              Common
                Shares to Be
              Issued
                Upon Exercise
              of
                Outstanding
              Options
            Weighted
                Average
              Exercise
                Price of
              Outstanding
                Options
            Number
                of
              Common
                Shares
              Available
                for Future
              Issuance
                Under
              Equity
              Compensation
                Plans (1)Equity
                compensation plans
              approved
                by stockholders
            1,491,390
            $24.27
            1,144,499Equity
                compensation plans not
              approved
                by stockholders
            —
            —
            —Total
            1,491,390
            $24.27
            1,144,499





(1)  Number
      of common shares available for future issuance under equity compensation plans
      includes 463,283 shares related to the ESPP and 681,216 shares related to the
      2005 Plan.






36


Item
      13.  Certain Relationships and Related Party Transactions and Director
      Independence





Information
      regarding certain relationships and related transactions is incorporated herein
      by reference to the discussions under "Transactions with Related Persons" in
      the
      Company’s Proxy Statement for the 2008 Annual Meeting of Stockholders, which
      will be filed with the Commission on or before April 29,
      2008.  Information regarding director independence is incorporated by
      reference to the discussions under "Corporate Governance Matters-Director
      Independence" in the Company’s Proxy Statement for the 2008 Annual Meeting of
      Stockholders, which will be filed with the Commission on or before April 29,
      2008.





Item
      14.  Principal Accountant Fees and Services





Information
      regarding the fees and services of the independent registered public accounting
      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 2008 Annual Meeting of Stockholders, which
      will be filed with the Commission on or before April 29, 2008.






37


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, 2006 and 2007





Consolidated
      Statements of Earnings for
      the Years Ended December 31, 2005, 2006 and 2007





Consolidated
      Statements of
      Stockholders’ Equity for the Years Ended December 31, 2005, 2006 and
      2007





Consolidated
      Statements of Cash Flows
      for the Years Ended December 31, 2005, 2006 and 2007





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, 2005, 2006 and 2007:





Schedule
              Number
            
            Description
            
            PageII
            
            Valuation
                and Qualifying Accounts
            
            44





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.





38


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)).10.1*
            Employment
                Agreement, dated as of April 4, 2005, between the Company and Curtis
                W.
                Stoelting (incorporated by reference to Exhibit 10.5 of the Company’s
                Quarterly Report on Form 10-Q for the quarter ended June 30, 2005
                (File
                No. 0-22635)).10.2*
            Employment
                Agreement, dated as of April 4, 2005, between the Company and Peter
                J.
                Henseler (incorporated by reference to Exhibit 10.6 of the Company’s
                Quarterly Report on Form 10-Q for the quarter ended June 30, 2005
                (File
                No. 0-22635)).10.3*
            Employment
                Agreement, dated as of April 4, 2005, between the Company and Jody
                L.
                Taylor (incorporated by reference to Exhibit 10.7 of the Company’s
                Quarterly Report on Form 10-Q for the quarter ended June 30, 2005
                (File
                No. 0-22635)).10.4*
            Employment
                Agreement, dated as of April 4, 2005, between the Company and Helena
                Lo
                (incorporated by reference to Exhibit 10.8 of the Company’s Quarterly
                Report on Form 10-Q for the quarter ended June 30, 2005 (File No.
                0-22635)).10.5*
            Employment
                Agreement, dated as of July 31, 2006, between the Company and Gregory
                J.
                Kilrea (incorporated by reference to Exhibit 10.18 to the Company’s Annual
                Report on Form 10-K for the year ended December 31, 2006 (File No.
                0-22635)).10.6*
            RC2
                Corporation 2005 Stock Incentive Plan (incorporated by reference
                to
                Exhibit 99.1 of the Company’s Current Report on Form 8-K (File No.
                0-22635) filed by the Company with the Securities and Exchange Commission
                on May 10, 2005).10.7*
            Form
                of Grant Agreement for the RC2 Corporation 2005 Stock Incentive Plan
                (incorporated by reference to Exhibit 99.2 of the Company’s Current Report
                on Form 8-K (File No. 0-22635) filed by the Company with the Securities
                and Exchange Commission on May 10, 2005).10.8*
            RC2
                Corporation Incentive Bonus Plan and RC2 Corporation Top Management
                Additional Bonus Plan (incorporated by reference to Exhibit 99.3
                of the
                Company’s Current Report on Form 8-K (File No. 0-22635) filed by the
                Company with the Securities and Exchange Commission on May 10,
                2005).10.9*
            Outside
                Director Compensation Plan (incorporated by reference to Exhibit
                10.4 to
                the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30,
                2005 (File No. 0-22635)).  39
 10.10*
            Amendment
                to Outside Director Compensation Plan effective January 1, 2007
                (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly
                Report on Form 10-Q for the quarter ended March 31, 2007 (File No.
                0-22635).


10.11*
            Racing
                Champions Ertl Corporation Stock Incentive Plan, as amended (incorporated
                by reference to Exhibit 10.5 of the Company’s Quarterly Report on Form
                10-Q for the quarter ended September 30, 2002 (File No.
                0-22635)).10.12*
            Wheels
                Sports Group, Inc. 1996 Omnibus Stock Plan (incorporated by reference
                to
                Exhibit 10.6 of the Company’s Quarterly Report on Form 10-Q for the
                quarter ended June 30, 1998 (File No. 0-22635)).10.13*
            RC2
                Corporation Employee Stock Purchase Plan, as amended (incorporated
                by
                reference to Exhibit 99.1 of the Company’s Current Report on Form 8-K
                dated May 4, 2007 (File No. 0-22635) filed by the Company with the
                Securities and Exchange Commission on May 10, 2007).10.14
            Amended
                and Restated Credit Agreement, dated as of September 15, 2004, among
                the
                Company, certain of its subsidiaries, Harris Trust and Savings Bank,
                as
                lender and agent, and other lenders named therein (incorporated by
                reference 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).10.15
            First
                Amendment to Amended and Restated Credit Agreement, dated as of August
                19,
                2005, among the Company, certain of its subsidiaries, Harris Trust
                and
                Savings, as lender and agent, and other lenders named therein
                (incorporated by reference to Exhibit 10.18 to the Company’s Annual Report
                on Form 10-K for the year ended December 31, 2005 (File No.
                0-22635)).10.16
            Second
                Amendment to Amended and Restated Credit Agreement, dated as of November
                18, 2005, among the Company, certain of its subsidiaries, Harris
                Trust and
                Savings Bank, as lender and agent, and other lenders named therein
                (incorporated by reference to Exhibit 10.19 to the Company’s Annual Report
                on Form 10-K for the year ended December 31, 2005 (File No.
                0-22635)).10.17
            Third
                Amendment to Amended and Restated Credit Agreement, dated as of July
                28,
                2006, among the Company, certain of its subsidiaries, Harris, N.A.,
                as
                lender and agent, and other lenders named therein (incorporated by
                reference to Exhibit 10.17 to the Company’s Annual Report on Form 10-K for
                the year ended December 31, 2006 (File No. 0-22635)).10.18
            Fourth
                Amendment and Waiver to Amended and Restated Credit Agreement, dated
                as of
                September 29, 2006, among the Company, certain of its subsidiaries,
                Harris
                N.A., as lender and agent and the other lenders named therein
                (incorporated by reference to Exhibit 10.1 to the Company’s Quarterly
                Report on Form 10-Q for the quarter ended June 30, 2007 (File No.
                0-22635)).10.19
            Fifth
                Amendment to Amended and Restated Credit Agreement, dated as of June
                28,
                2007, among the Company, certain of its subsidiaries, Harris N.A.,
                as
                lender and agent and the other lenders named therein (incorporated
                by
                reference to Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q
                for the quarter ended June 30, 2007 (File No. 0-22635)).10.20
            Sixth
                Amendment to Amended and Restated Credit Agreement, dated as of June
                30,
                2007, among the Company, certain of its subsidiaries, Harris N.A.,
                as
                lender and agent and the other lenders named therein (incorporated
                by
                reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q
                for the quarter ended June 30, 2007 (File No. 0-22635)).  40
 10.21
            Seventh
                Amendment to Amended and Restated Credit Agreement, dated as of October
                22, 2007, among the Company, certain of its subsidiaries, Harris,
                N.A., as
                lender and agent, and other lenders named therein.


10.22
            Eighth
                Amendment to Amended and Restated Credit Agreement, dated as of February
                14, 2008, effective as of December 31, 2007, among the Company, certain
                of
                its subsidiaries, Harris, N.A., as lender and agent, and other lenders
                named therein.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 the Sarbanes–Oxley
                Act of 2002.32.1**
            Certification
                of Chief Executive Officer and Chief Financial Officer pursuant to
                18
                U.S.C. Section 1350 (Section 906 of the Sarbanes-Oxley Act of
                2002).


____________________________





*     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)
              ExhibitsThe
                  response to this portion of Item 15 is submitted as a separate
                  section of
                  this report.(c)
              Financial
                  Statement SchedulesThe
                  response to this portion of Item 15 is submitted as a separate
                  section of
                  this report.




41


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:  February
                29, 2008
            RC2
                CORPORATIONBy
                /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
            February
                29, 2008Robert
                E. Dods
            
            Director/s/
                Boyd L. Meyer
            
            Vice
                Chairman and Director
            February
                29, 2008Boyd
                L. Meyer/s/
                Curtis W. Stoelting
            
            Chief
                Executive Officer and
            February
                29, 2008Curtis
                W. Stoelting
            
            Director
                (Principal Executive Officer)/s/
                Jody L. Taylor
            
            Chief
                Financial Officer and Secretary
            February
                29, 2008Jody
                L. Taylor
            
            (Principal
                Financial and Accounting Officer)/s/
                Peter K.K. Chung
            
            Director
            February
                29, 2008Peter
                K.K. Chung/s/
                Peter J. Henseler
            
            Director
            February
                29, 2008Peter
                J. Henseler/s/
                Linda A. Huett
            
            Director
            February
                29, 2008Linda
                A. Huett   42
  /s/
                Paul E. Purcell
            
            Director
            February
                29, 2008Paul
                E. Purcell/s/
                John S. Bakalar
            
            Director
            February
                29, 2008John
                S. Bakalar/s/
                John J. Vosicky
            
            Director
            February
                29, 2008John
                J. Vosicky/s/
                Daniel M. Wright
            
            Director
            February
                29, 2008Daniel
                M. Wright/s/
                Thomas M. Collinger
            
            Director
            February
                29, 2008Thomas
                M. Collinger/s/
                Michael J. Merriman, Jr.
            
            Director
            February
                29, 2008Michael
                J. Merriman, Jr.






43


REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





The
      Board
      of Directors and Stockholders


RC2
      Corporation:





Under
      date of February 29, 2008, we reported on the consolidated balance sheets of
      RC2
      Corporation and subsidiaries as of December 31, 2006 and 2007, 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,
      2007.  In connection with our audits 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.








/s/
      KPMG
      LLP


Chicago,
      Illinois


February
      29, 2008











Schedule
      II





Description


Valuation
      and Qualifying
      Accounts


(in
      thousands)





Description
            
            Balance
                at
              Beginning
                of
              Year
            
            
            Charged
                (Credited) to
              Costs
                and
              Expenses
            
            
            (Credited)
                Charged to
              Other
              Accounts
            
            
            Deductions
            
            
            Balance
                at
              End
                of
              YearAllowance
                for doubtful accounts:Year
                ended December 31, 2005
            
            $
            3,197
            
            
            $
            966
            
            
            $
            (258
            )
            
            $
            (832
            )
            
            $
            3,073Year
                ended December 31, 2006
            
            
            3,073
            
            
            
            (283
            )
            
            
            (50
            )
            
            
            (989
            )
            
            
            1,751Year
                ended December 31, 2007
            
            $
            1,751
            
            
            $
            1,148
            
            
            $
            (41
            )
            
            $
            (1,132
            )
            
            $
            1,808





44





INDEX
      TO FINANCIAL STATEMENTS







RC2
        CORPORATION AND SUBSIDIARIES
 
 Reports
                  of Independent Registered Public Accounting Firm
              F2Consolidated
                  Balance Sheets as of December 31, 2006 and 2007
              F4Consolidated
                  Statements of Earnings for the Years EndedDecember
                  31, 2005, 2006 and 2007
              F5Consolidated
                  Statements of Stockholders’ Equity for the Years EndedDecember
                  31, 2005, 2006 and 2007
              F6Consolidated
                  Statements of Cash Flows for the Years EndedDecember
                  31, 2005, 2006 and 2007
              F7Notes
                  to Consolidated Financial Statements
              F9




F-1




REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM




The
      Board
      of Directors and Stockholders


RC2
      Corporation:





We
      have
      audited the accompanying consolidated balance sheets of RC2 Corporation and
      subsidiaries as of December 31, 2006 and 2007, 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, 2007.  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, 2006 and 2007, and the results of their
      operations and their cash flows for each of the years in the three-year period
      ended December 31, 2007, in conformity with U.S. generally accepted accounting
      principles.





As
      described in Note 2 to the consolidated financial statements, the Company
      adopted FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes
      – an interpretation of FASB Statement No. 109," effective January 1,
      2007.





We
      have
      also audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), RC2 Corporation’s internal control over
      financial reporting as of December 31, 2007, based on criteria established
      in
Internal Control-Integrated
      Framework issued by the Committee of Sponsoring Organizations of the
      Treadway Commission (COSO), and our report dated February 29, 2008 expressed
      an
      unqualified opinion on the effectiveness of the Company’s internal control over
      financial reporting.







/s/
      KPMG
      LLP


Chicago,
      Illinois


February
      29, 2008






F-2




REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





The
      Board
      of Directors and Stockholders


RC2
      Corporation:





We
      have
      audited RC2 Corporation’s (the Company) internal control over financial
      reporting as of December 31, 2007, 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, included in the accompanying Management’s Report on Internal Control
      over Financial Reporting.  Our responsibility is to express an opinion
      on 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, RC2 Corporation maintained, in all material respects, effective
      internal control over financial reporting as of December 31, 2007, based on
      the
      criteria established in Internal Control-Integrated
      Framework issued by COSO.





We
      have
      also 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, 2006 and 2007, 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, 2007, and our
      report dated February 29, 2008 expressed an unqualified opinion on those
      consolidated financial statements.






/s/
      KPMG
      LLP


Chicago,
      Illinois


February
      29, 2008






F-3




CONSOLIDATED
      BALANCE SHEETS


December
                31,(in
                thousands)
            
            2006
            
            
            2007AssetsCurrent
                assets:Cash
                and cash equivalents
            
            $
            25,365
            
            
            $
            57,809Accounts
                receivable, net of allowances for doubtful accounts
              of
                $1,751 and $1,808
            
            
            112,937
            
            
            
            110,317Other
                receivables
            
            
            3,253
            
            
            
            1,910Inventory
            
            
            83,650
            
            
            
            77,034Deferred
                and prepaid income taxes, net
            
            
            5,884
            
            
            
            11,274Prepaid
                expenses
            
            
            5,879
            
            
            
            6,023Total
                current assets
            
            
            236,968
            
            
            
            264,367Property
                and equipment:Land
            
            
            686
            
            
            
            686Buildings
                and improvements
            
            
            9,287
            
            
            
            9,334Tooling
            
            
            99,098
            
            
            
            108,524Other
                equipment
            
            
            20,574
            
            
            
            22,760129,645
            
            
            
            141,304Less
                accumulated depreciation
            
            
            (90,654
            )
            
            
            (104,011
            )38,991
            
            
            
            37,293Goodwill
            
            
            239,067
            
            
            
            247,814Intangible
                assets, net
            
            
            96,400
            
            
            
            96,675Other
                non-current assets
            
            
            3,214
            
            
            
            4,096Total
                assets
            
            $
            614,640
            
            
            $
            650,245Liabilities
                and stockholders’ equityCurrent
                liabilities:Accounts
                payable
            
            $
            26,941
            
            
            $
            33,985Income
                taxes payable, net
            
            
            3,420
            
            
            
            —Accrued
                expenses
            
            
            16,443
            
            
            
            15,529Accrued
                recall-related costs
            
            
            —
            
            
            
            14,594Accrued
                allowances
            
            
            20,192
            
            
            
            20,610Accrued
                royalties
            
            
            17,163
            
            
            
            14,358Line
                of credit
            
            
            —
            
            
            
            95,000Current
                maturities of bank term loans
            
            
            22,438
            
            
            
            —Other
                current liabilities
            
            
            768
            
            
            
            3,163Total
                current liabilities
            
            
            107,365
            
            
            
            197,239Deferred
                income taxes
            
            
            45,524
            
            
            
            47,586Other
                non-current liabilities
            
            
            9,825
            
            
            
            8,042Total
                liabilities
            
            
            162,714
            
            
            
            252,867Commitments
                and contingenciesStockholders’
                equity:Common
                stock, voting, $0.01 par value, 28,000 share authorized,
              22,876
                shares issued and 21,052 shares outstanding at December
              31,
                2006, and 23,072 shares issued and 18,320 shares outstanding
              at
                December 31, 2007
            
            
            229
            
            
            
            231Additional
                paid-in capital
            
            
            230,776
            
            
            
            239,021Accumulated
                other comprehensive income
            
            
            8,838
            
            
            
            12,918Retained
                earnings
            
            
            220,706
            
            
            
            241,709460,549
            
            
            
            493,879Treasury
                stock, at cost, 1,824 shares at December 31, 2006, and
              4,752
                shares at December 31, 2007
            
            
            (8,623
            )
            
            
            (96,501
            )Total
                stockholders’ equity
            
            
            451,926
            
            
            
            397,378Total
                liabilities and stockholders’ equity
            
            $
            614,640
            
            
            $
            650,245





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






F-4


CONSOLIDATED
      STATEMENTS OF EARNINGS


Year
                Ended December 31,(in
                thousands, except per share data)
            
            2005
            
            
            2006
            
            
            2007Net
                sales, including recall-related returns and allowances
              of  $5,596
                for the year ended December 31, 2007
            
            $
            492,766
            
            
            $
            518,829
            
            
            $
            488,999Cost
                of sales, related parties
            
            
            18,520
            
            
            
            27,599
            
            
            
            15,406Cost
                of sales, other
            
            
            234,415
            
            
            
            248,155
            
            
            
            254,653Restructuring
                charge related to discontinued
              automotive
                collectibles
            
            
            —
            
            
            
            1,872
            
            
            
            —Recall-related
                costs
            
            
            —
            
            
            
            —
            
            
            
            4,624Gross
                profit
            
            
            239,831
            
            
            
            241,203
            
            
            
            214,316Selling,
                general and administrative expenses
            
            
            150,381
            
            
            
            155,180
            
            
            
            161,560Amortization
                of intangible assets
            
            
            1,385
            
            
            
            1,149
            
            
            
            893Gain
                on sale of W. Britain product line
            
            
            (1,953
            )
            
            
            —
            
            
            
            —Restructuring
                charge related to discontinued
              automotive
                collectibles
            
            
            —
            
            
            
            12,631
            
            
            
            —Recall-related
                costs
            
            
            —
            
            
            
            —
            
            
            
            18,068Operating
                income
            
            
            90,018
            
            
            
            72,243
            
            
            
            33,795Interest
                expense, net
            
            
            5,983
            
            
            
            3,465
            
            
            
            1,515Other
                expense (income)
            
            
            146
            
            
            
            530
            
            
            
            (1,768
            )Income
                from continuing operations
              before
                income taxes
            
            
            83,889
            
            
            
            68,248
            
            
            
            34,048Income
                tax expense
            
            
            31,153
            
            
            
            24,478
            
            
            
            12,472Income
                from continuing operations
            
            
            52,736
            
            
            
            43,770
            
            
            
            21,576Income
                (loss) from discontinued operations, net of tax
            
            
            394
            
            
            
            (9,676
            )
            
            
            110Net
                income
            
            $
            53,130
            
            
            $
            34,094
            
            
            $
            21,686Basic
                earnings per common share:Income
                from continuing operations
            
            $
            2.56
            
            
            $
            2.09
            
            
            $
            1.05Income
                (loss) from discontinued operations
            
            
            0.02
            
            
            
            (0.46
            )
            
            
            0.01Net
                income
            
            $
            2.58
            
            
            $
            1.63
            
            
            $
            1.06Diluted
                earnings per common share:Income
                from continuing operations
            
            $
            2.45
            
            
            $
            2.04
            
            
            $
            1.04Income
                (loss) from discontinued operations
            
            
            0.02
            
            
            
            (0.45
            )
            
            
            0.01Net
                income
            
            $
            2.47
            
            
            $
            1.59
            
            
            $
            1.05Weighted
                average shares outstanding:Basic
            
            
            20,613
            
            
            
            20,884
            
            
            
            20,395Diluted
            
            
            21,532
            
            
            
            21,377
            
            
            
            20,748





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






F-5


CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ EQUITY


Common
                Stock
            
            Treasury
                Stock
            
            
            Accumulated
                Other Comprehensive
            
            
            Additional
                Paid-in
            
            Retained
            
            
            Total
                Stockholders’
            
            
            Comprehensive(in
                thousands)
            Shares
            
            
            Amount
            
            Shares
            
            
            Amount
            
            
            Income
                (Loss)
            
            
            Capital
            
            Earnings
            
            
            Equity
            
            
            IncomeBalance,
                December 31, 2004
            20,463
            
            
            $
            223
            
            1,832
            
            
            $
            (8,501
            )
            
            $
            6,544
            
            
            $
            215,014
            
            $
            133,482
            
            
            $
            346,762Net
                income
            —
            
            
            
            —
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            53,130
            
            
            
            53,130
            
            
            $
            53,130Stock
                issued upon option
              exercise
            254
            
            
            
            2
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            1,748
            
            
            —
            
            
            
            1,750
            
            
            
            —Tax
                benefit of stock option
              exercise
            —
            
            
            
            —
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            2,729
            
            
            —
            
            
            
            2,729
            
            
            
            —Stock
                issued under ESPP
            6
            
            
            
            —
            
            (6
            )
            
            
            35
            
            
            
            —
            
            
            
            156
            
            
            —
            
            
            
            191
            
            
            
            —Treasury
                stock acquisition
            (5
            )
            
            
            —
            
            5
            
            
            
            (194
            )
            
            
            —
            
            
            
            —
            
            
            —
            
            
            
            (194
            )
            
            
            —Other
                comprehensive loss:Foreign
                currency translation
              adjustments
            —
            
            
            
            —
            
            —
            
            
            
            —
            
            
            
            (5,032
            )
            
            
            —
            
            
            —
            
            
            
            (5,032
            )
            
            
            (5,032
            )Minimum
                pension liability
              adjustment,
                net of tax
            —
            
            
            
            —
            
            —
            
            
            
            —
            
            
            
            (385
            )
            
            
            —
            
            
            —
            
            
            
            (385
            )
            
            
            (385
            )Comprehensive
                income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            47,713Balance,
                December 31, 2005
            20,718
            
            
            $
            225
            
            1,831
            
            
            $
            (8,660
            )
            
            $
            1,127
            
            
            $
            219,647
            
            $
            186,612
            
            
            $
            398,951Net
                income
            —
            
            
            
            —
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            34,094
            
            
            
            34,094
            
            
            $
            34,094Stock
                issued upon option
              exercise
            327
            
            
            
            4
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            3,614
            
            
            —
            
            
            
            3,618
            
            
            
            —Tax
                benefit of stock option
              exercise
            —
            
            
            
            —
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            3,112
            
            
            —
            
            
            
            3,112
            
            
            
            —Stock
                issued under ESPP
            7
            
            
            
            —
            
            (7
            )
            
            
            37
            
            
            
            —
            
            
            
            175
            
            
            —
            
            
            
            212
            
            
            
            —Stock-based
                compensation
              expense
            —
            
            
            
            —
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            4,228
            
            
            —
            
            
            
            4,228
            
            
            
            —Other
                comprehensive income
              (loss):Foreign
                currency translation
              adjustments
            —
            
            
            
            —
            
            —
            
            
            
            —
            
            
            
            6,933
            
            
            
            —
            
            
            —
            
            
            
            6,933
            
            
            
            6,933Adjustment
                to initially apply
              SFAS
                No. 158, net of tax
            —
            
            
            
            —
            
            —
            
            
            
            —
            
            
            
            (84
            )
            
            
            —
            
            
            —
            
            
            
            (84
            )
            
            
            (84
            )Pension
                liability adjustment,
              net of tax
            —
            
            
            
            —
            
            —
            
            
            
            —
            
            
            
            862
            
            
            
            —
            
            
            —
            
            
            
            862
            
            
            
            862Comprehensive
                income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            41,805Balance,
                December 31, 2006
            21,052
            
            
            $
            229
            
            1,824
            
            
            $
            (8,623
            )
            
            $
            8,838
            
            
            $
            230,776
            
            $
            220,706
            
            
            $
            451,926Net
                income
            —
            
            
            
            —
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            21,686
            
            
            
            21,686
            
            
            
            21,686Stock
                issued upon option
              exercise
            156
            
            
            
            2
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            1,976
            
            
            —
            
            
            
            1,978
            
            
            
            —Tax
                benefit of stock option
              exercise
            —
            
            
            
            —
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            1,463
            
            
            —
            
            
            
            1,463
            
            
            
            —Stock
                issued under ESPP
            6
            
            
            
            —
            
            (6
            )
            
            
            59
            
            
            
            —
            
            
            
            116
            
            
            —
            
            
            
            175Deferred
                compensation from
              restricted
                stock awards
            40
            
            
            
            —
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            495
            
            
            —
            
            
            
            495
            
            
            
            —Stock-based
                compensation
              expense
            —
            
            
            
            —
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            4,195
            
            
            —
            
            
            
            4,195
            
            
            
            —Treasury
                stock acquisition
            (2,934
            )
            
            
            —
            
            2,934
            
            
            
            (87,937
            )
            
            
            —
            
            
            
            —
            
            
            —
            
            
            
            (87,937
            )
            
            
            —FIN
                48 adoption
            —
            
            
            
            —
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            (683
            )
            
            
            (683
            )
            
            
            —Other
                comprehensive income:Foreign
                currency translation
              adjustments
            —
            
            
            
            —
            
            —
            
            
            
            —
            
            
            
            3,029
            
            
            
            —
            
            
            —
            
            
            
            3,029
            
            
            
            3,029Pension
                liability adjustment,
              net of tax
            —
            
            
            
            —
            
            —
            
            
            
            —
            
            
            
            1,051
            
            
            
            —
            
            
            —
            
            
            
            1,051
            
            
            
            1,051Comprehensive
                income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            25,766Balance,
                December 31, 2007
            18,320
            
            
            $
            231
            
            4,752
            
            
            $
            (96,501
            )
            
            $
            12,918
            
            
            $
            239,021
            
            $
            241,709
            
            
            $
            397,378


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




F-6


CONSOLIDATED
      STATEMENTS OF CASH FLOWS


Year
                Ended December 31,(in
              thousands)
            
            2005
            
            
            2006
            
            
            2007Operating
                activitiesNet
                income
            
            $
            53,130
            
            
            $
            34,094
            
            
            $
            21,686(Income)
                loss from discontinued operations
            
            
            (394
            )
            
            
            9,676
            
            
            
            (110
            )Adjustments
                to reconcile net income to net cash provided
              by
                operating activities:Depreciation
            
            
            14,444
            
            
            
            14,087
            
            
            
            13,950Impairment
                of intangible assets
            
            
            —
            
            
            
            2,824
            
            
            
            —Write-off
                of tooling related to discontinued automotive collectibles
            
            
            —
            
            
            
            8,621
            
            
            
            —Provision
                (reduction of allowance) for uncollectible accounts
            
            
            830
            
            
            
            (562
            )
            
            
            981Amortization
                and write-off of deferred financing costs
            
            
            483
            
            
            
            696
            
            
            
            587Amortization
                of intangible assets
            
            
            1,385
            
            
            
            1,149
            
            
            
            893Stock-based
                compensation
            
            
            —
            
            
            
            3,856
            
            
            
            4,705Excess
                tax benefit on stock option exercises
            
            
            —
            
            
            
            (2,414
            )
            
            
            (1,024
            )Gain
                on disposition of assets
            
            
            (2,030
            )
            
            
            (9
            )
            
            
            (20
            )Deferred
                income taxes
            
            
            1,887
            
            
            
            (2,453
            )
            
            
            (360
            )Other
            
            
            15
            
            
            
            27
            
            
            
            —Changes
                in operating assets and liabilities:Accounts
                and other receivables
            
            
            (16,288
            )
            
            
            4,121
            
            
            
            4,138Inventory
            
            
            (18,888
            )
            
            
            (12,496
            )
            
            
            8,488Prepaid
                expenses
            
            
            318
            
            
            
            507
            
            
            
            (462
            )Other
                assets
            
            
            —
            
            
            
            —
            
            
            
            (855
            )Accounts
                payable and accrued expenses
            
            
            24,751
            
            
            
            565
            
            
            
            12,112Other
                liabilities
            
            
            (559
            )
            
            
            (74
            )
            
            
            (1,283
            )Net
                cash provided by continuing operations
            
            
            59,084
            
            
            
            62,215
            
            
            
            63,426Net
                cash provided by (used in) discontinued operations
            
            
            52
            
            
            
            (438
            )
            
            
            110Net
                cash provided by operating activities
            
            
            59,136
            
            
            
            61,777
            
            
            
            63,536Investing
                activitiesPurchase
                of property and equipment
            
            
            (14,133
            )
            
            
            (14,396
            )
            
            
            (11,467
            )Proceeds
                from disposition of property and equipment
            
            
            5,546
            
            
            
            24
            
            
            
            13Purchase
                price of acquisitions, net of cash acquired
            
            
            39
            
            
            
            —
            
            
            
            (9,033
            )Proceeds
                from sale of W. Britain product line
            
            
            2,850
            
            
            
            —
            
            
            
            —Proceeds
                from sale of discontinued operations
            
            
            —
            
            
            
            6,819
            
            
            
            110(Increase)
                decrease in other non-current assets
            
            
            (919
            )
            
            
            (1,243
            )
            
            
            82Net
                cash used in continuing operations
            
            
            (6,617
            )
            
            
            (8,796
            )
            
            
            (20,295
            )Net
                cash (used in) provided by discontinued operations
            
            
            (26
            )
            
            
            477
            
            
            
            —Net
                cash used in investing activities
            
            
            (6,643
            )
            
            
            (8,319
            )
            
            
            (20,295
            )








F-7


Financing
                activitiesIssuance
                of stock upon option exercises
            
            
            1,750
            
            
            
            3,618
            
            
            
            1,978Excess
                tax benefit on stock option exercises
            
            
            —
            
            
            
            2,414
            
            
            
            1,024Issuance
                of stock under ESPP
            
            
            191
            
            
            
            212
            
            
            
            175Purchase
                of treasury stock
            
            
            —
            
            
            
            —
            
            
            
            (87,937
            )Payments
                on bank term loans
            
            
            (16,562
            )
            
            
            (42,250
            )
            
            
            (22,438
            )Net
                (payments) borrowings on lines of credit
            
            
            (31,914
            )
            
            
            (18,270
            )
            
            
            95,000Financing
                fees paid
            
            
            —
            
            
            
            (184
            )
            
            
            (118
            )Net
                cash used in continuing operations
            
            
            (46,535
            )
            
            
            (54,460
            )
            
            
            (12,316
            )Net
                cash provided by (used in) discontinued operations
            
            
            —
            
            
            
            —
            
            
            
            —Net
                cash used in financing activities
            
            
            (46,535
            )
            
            
            (54,460
            )
            
            
            (12,316
            )Effect
                of exchange rate changes on cash
            
            
            (819
            )
            
            
            1,105
            
            
            
            1,519Net
                increase in cash and cash equivalents
            
            
            5,139
            
            
            
            103
            
            
            
            32,444Cash
                and cash equivalents, beginning of year
            
            
            20,123
            
            
            
            25,262
            
            
            
            25,365Cash
                and cash equivalents, end of year
            
            $
            25,262
            
            
            $
            25,365
            
            
            $
            57,809Supplemental
                disclosure of cash flow information:Cash
                paid for interest during the period
            
            $
            5,890
            
            
            $
            3,631
            
            
            $
            2,172Cash
                paid for income taxes during the period
            
            
            22,052
            
            
            
            28,367
            
            
            
            18,879Cash
                refunds received from income taxes
            
            
            5,896
            
            
            
            1,078
            
            
            
            1,289Non-cash
                investing and financing activity during the period:Stock
                received in exchange for a receivable
            
            $
            194
            
            
            $
            —
            
            
            $
            —





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






F-8


NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS





FOR
      THE YEARS ENDED DECEMBER 31, 2005, 2006 AND 2007





1.  DESCRIPTION
      OF BUSINESS





Founded
      in 1989, RC2 Corporation and Subsidiaries, (collectively, the Company or RC2),
      is a leading designer, producer and marketer of innovative, high-quality toys,
      collectibles and infant and toddler products.  RC2’s infant, toddler
      and preschool products are marketed under its Learning Curve® family of brands,
      which includes The First Years® by Learning Curve and Lamaze brands, as well as
      popular and classic licensed properties, such as Thomas & Friends, Bob
      the Builder, Winnie the Pooh, John Deere,
      Nickelodeon and Sesame
      Street.  RC2 markets its youth and adult products primarily
      under the Johnny Lightning® and Ertl® brands.  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.  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.





Reclassifications





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





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.





Fair
      Value of Financial Instruments





The
      carrying amounts of cash and cash equivalents, accounts receivable, accounts
      payable and accrued expenses approximate fair value because of the short-term
      nature of these items.  The carrying amounts of the lines of credit
      and the bank term loans approximate their fair value.





Derivative
      Instruments





The
      Company had no derivative instruments during the years ended December 31, 2005,
      2006 and 2007.





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.





F-9


Allowance
      for Doubtful Accounts





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





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 and losses resulting from sales, dispositions 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 LifeBuildings
                and improvements
            2
–
                15 yearsTooling
            3
–
                7 yearsOther
                equipment
            2
                -
                10 years





In
      2005,
      the Company recorded charges of $0.8 million to write-off undepreciated tooling
      related to discontinued product lines primarily in the North America
      segment.  These charges are included in cost of sales, other in the
      accompanying consolidated statement of earnings for the year ended December
      31,
      2005.  In 2006, the Company recorded charges of $8.3 million and $0.3
      million in the North America and International segments, respectively, to
      write-off undepreciated tooling related to the Company’s decision to discontinue
      its automotive collectible product lines.  The charges for 2006 are
      included in the restructuring charge related to discontinued automotive
      collectibles within operating expenses in the accompanying consolidated
      statement of earnings for the year ended December 31, 2006 (see Note 17 -
      Restructuring Charge – Discontinuance of Automotive Collectible Product
      Lines).





F-10


Goodwill
      and Intangible Assets





In
      accordance with the provisions of Statement of Financial Accounting Standards
      (SFAS) No. 142, "Goodwill and Other Intangible Assets," the Company tests
      goodwill and other intangible assets with indefinite useful lives for impairment
      on an annual basis or on an interim basis if an event occurs that might reduce
      the fair value of the reporting unit below its carrying value.  The
      Company conducts testing for impairment during the fourth quarter of its fiscal
      year.  Intangible assets that do not have indefinite lives are
      amortized over their useful lives.





Other
      Non-Current Assets





Other
      non-current assets at December 31, 2006 and 2007, consist primarily of deferred
      financing fees, as well as the Company’s investments in the development of
      intellectual properties (see Note 14 – Other Non-Current Assets).  The
      deferred financing fees are being amortized over the related borrowing
      period.  Amortization and write-offs of deferred financing fees for
      the years ended December 31, 2005, 2006 and 2007, was $0.5 million, $0.7 million
      and $0.6 million, respectively, and is included in interest expense, net in
      the
      accompanying consolidated statements of earnings.





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.





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 royalty agreements may
      be paid to various licensors on a single product.  Royalty expense is
      included in selling, general and administrative expenses in the accompanying
      consolidated statements of earnings.





Foreign
      Currency Translation/Transactions





Foreign
      subsidiary assets and liabilities are recorded in their respective functional
      currencies and translated into U.S. dollars 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.  Unrealized gains and losses resulting from translation for
      the years ended December 31, 2005, 2006 and 2007, have been recorded as
      components of accumulated other comprehensive income in stockholders’
equity.  The net exchange losses resulting from transactions in
      foreign currencies for the years ended December 31, 2005 and 2006 were $0.5
      million and $1.4 million, respectively.  The net exchange gains
      resulting from transactions in foreign currencies for the year ended December
      31, 2007 was $1.0 million.  The net exchange losses and gains are
      included in other expense (income) in the accompanying consolidated statements
      of earnings.





F-11


Comprehensive
      Income





The
      Company reports comprehensive income in accordance with Statement of Financial
      Accounting Standards (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
      distribution 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 pension liability adjustments, net of income tax effects, as part of the
      accompanying consolidated statements of stockholders’ equity.  The
      income tax benefit (expense) related to the components of comprehensive income
      (loss) in 2005, 2006 and 2007 was $0.2 million, $(0.5) million and $(0.6)
      million, respectively.





Revenue
      Recognition





The
      Company recognizes revenue based upon transfer of title of products to
      customers.  Title is transferred to customers FOB shipping
      point.  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.





Shipping
      and Handling Costs





Shipping
      and handling costs, which comprise only those costs incurred to transport
      products to the customer, are included in selling, general and administrative
      expenses in the accompanying consolidated statements of earnings.  For
      the years ended December 31, 2005, 2006 and 2007, shipping and handling costs
      were $19.3 million, $17.3 million and $22.5 million,
      respectively.  Shipping and handling costs for the year ended December
      31, 2007, include costs related to the 2007 recalls of $5.0
      million.





Advertising





The
      Company expenses the production costs of advertising the first time the
      advertising takes place.  Advertising expense, including production
      and placement costs, for the years ended December 31, 2005, 2006 and 2007,
      was
      $3.7 million, $2.8 million and $3.4 million, respectively.





Prepaid
      advertising expenses, such as prepayments on magazine advertisements and artwork
      costs of $0.1 million and $0.2 million, are included in prepaid expenses in
      the
      accompanying consolidated balance sheets at December 31, 2006 and 2007,
      respectively.





In
      order
      to support its new product launches and to build consumer awareness of its
      owned
      brands, the Company incurred $9.5 million for investment spending during the
      year ended December 31, 2007 of which $8.3 million has been
      expensed.  The spending is focused on key strategic plan initiatives
      including on-line, digital and traditional consumer marketing and building
      and
      launching owned brands.





Product
      Recalls





The
      Company establishes a reserve for product recalls on a product-specific basis
      during the period in which the circumstances giving rise to the recall become
      known and estimatable.  Facts underlying the recall, including, among
      others, estimates of retailer inventory returns, consumer replacement costs
      and
      shipping costs, are considered when establishing a product recall reserve. 
In 2007, the Company also considered additional replacement costs or refunds,
      donations, notice charges, claims admininstration and legal fees related to
      the
      settlement of the class action lawsuits (see Note 19 - Subsequent
      Events).  When facts or circumstances become known that would indicate
      that the recall reserve is either not sufficient to cover or exceeds the
      estimated product recall expenses, the reserve is adjusted, as
      appropriate.





F-12


Stock-based
      Compensation





Effective
      January 1, 2006, the Company adopted SFAS No. 123R, "Share-Based
      Payment."  The Company elected to use the modified prospective
      application of SFAS No. 123R for awards issued prior to January 1,
      2006.  Income from continuing operations before income taxes for the
      years ended December 31, 2006 and 2007, includes total expense recognized for
      all of the Company’s stock-based payment plans.





The
      fair
      value of stock options granted under the stock incentive plans is estimated
      on
      the date of grant based on the Black-Scholes option pricing
      model.  Prior to 2007, the Company calculated the expected volatility
      factor for those options issued under the stock incentive plans to correspond
      with the average volatility factor of those companies included in a peer group
      study.  The historical stock price movements of the Company’s common
      stock had not been considered a good indicator of expected future volatility
      because the Company’s business had changed significantly as a result of
      acquisitions completed.  However, the Company continued to monitor its
      actual volatility to assess whether its historical stock price movements over
      the expected option term were a good indicator of expected future results and
      began using Company specific volatility in 2007.





The
      Company uses historical data to estimate stock option exercise and employee
      departure behavior used in the Black-Scholes option pricing
      model.  The expected term of the stock options granted represents the
      period in time that stock options granted are expected to be
      outstanding.  The risk-free rate for the period within the contractual
      term of the stock option is based on the U.S. Treasury yield curve in effect
      at
      the time of grant.





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





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





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





The
      Company collects taxes imposed by governmental authorities, including sales
      taxes, which are generated from revenue-producing transactions between the
      Company and its customers, and remits such taxes directly to these governmental
      authorities.  The Company records these taxes on a net basis,
      therefore having no impact on the Company’s consolidated statements of
      earnings.






F-13


Earnings
      Per Common Share from Continuing Operations





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





Year
                Ended December 31,(in
                thousands, except per share data)
            
            2005
            
            
            2006
            
            
            2007Income
                from continuing operations
            
            $
            52,736
            
            
            $
            43,770
            
            
            $
            21,576Weighted
                average common and common equivalent shares outstanding:Weighted
                average common shares outstanding
            
            
            20,613
            
            
            
            20,884
            
            
            
            20,395Add
                effect of diluted securities – assumed exercise of stock
                options
              and
                vesting of restricted stock awards
            
            
            919
            
            
            
            493
            
            
            
            353Weighted
                average common and common equivalent shares outstanding
            
            
            21,532
            
            
            
            21,377
            
            
            
            20,748Basic
                earnings per common share from continuing operations
            
            $
            2.56
            
            
            $
            2.09
            
            
            $
            1.05Diluted
                earnings per common share from continuing operations
            
            $
            2.45
            
            
            $
            2.04
            
            
            $
            1.04





The
      computation of diluted earnings per common share from continuing operations
      excludes 22,927 shares, 447,975 shares and 571,586 shares in 2005, 2006 and
      2007, respectively, because the options were anti-dilutive.





Concentration
      of Credit Risk





Concentration
      of credit risk is limited to accounts receivable and is subject to the financial
      conditions of certain major customers.  Net sales to each of the
      Company’s largest customers for the years ended December 31, 2005, 2006 and
      2007, as a percentage of the Company’s total net sales in each of the respective
      years, is as follows:





Year
                Ended December 31,2005
            
            
            2006
            
            
            2007Wal-mart
            
            
            13.4
            %
            
            
            16.3
            %
            
            
            15.4
            %Target
            
            
            12.0
            
            
            
            13.1
            
            
            
            14.1Toys
                "R" Us/Babies "R" Us
            
            
            15.1
            %
            
            
            14.8
            %
            
            
            13.1
            %





No
      other
      customers accounted for more than 10.0% of the Company’s net sales in any of the
      years ended December 31, 2005, 2006 or 2007.





F-14


Accounts
      receivable with each of the Company’s largest customers at December 31, 2006 and
      2007, as a percentage of the Company’s total accounts receivable in each of the
      respective years, is as follows:





December
                31,2006
            
            
            2007Target
            
            
            16.0
            %
            
            
            18.8
            %Toys
                "R" Us/Babies "R" Us
            
            
            17.9
            
            
            
            17.6Wal-Mart
            
            
            17.5
            %
            
            
            11.4
            %





No
      other
      customers accounted for more than 10.0% of the Company’s accounts receivable at
      December 31, 2006 or 2007.  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.





Supplier
      Concentration





The
      Company’s purchases from two of its third-party, dedicated suppliers were 14.4%
      and 11.9% in 2005 and 10.3% and 10.0% in 2006, respectively, of its total
      product purchases.  There were no other suppliers accounting for more
      than 10.0% of total product purchases in any of the years ended December 31,
      2005, 2006 or 2007.





Recently
      Issued Accounting Pronouncements





In
      September 2006, the FASB issued SFAS No. 157, "Fair Value
      Measurements."  This Statement defines fair value, establishes a
      framework for measuring fair value in generally accepted accounting principles
      and expands disclosures about fair value measurements.  This Statement
      applies under other accounting pronouncements that require or permit fair value
      measurement.  However, this Statement does not require any new fair
      value measurements.  For fiscal years beginning after November 15,
      2007, and interim periods within those fiscal years, companies will be required
      to implement this Statement for financial assets and liabilities, as well as
      for
      any other assets and liabilities that are carried at fair value on a recurring
      basis in the financial statements.  The Board has provided a one year
      deferral for the implementation of SFAS No. 157 for other non-financial assets
      and liabilities.  The Company is evaluating the effect that this
      Statement will have on the Company’s financial statements.





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




3. 
      BUSINESS COMBINATIONS




Angels
      Landing, Inc.





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





F-15


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





(in
      thousands)


Total
                purchase price, including expenses, net of cash acquired
            
            
            
            
            $
            6,772Less:Current
                assets
            
            $
            1,300Property,
                plant and equipment
            
            
            817Intangible
                assets
            
            
            890Liabilities
            
            
            (485
            )
            
            
            (2,522
            )Excess
                of purchase price over net assets acquired
            
            
            
            
            
            $
            4,250





The
      allocation of purchase price is subject to final adjustment based on valuations
      and other determinations that will be completed as soon as practical but no
      later than by the end of the second quarter of 2008, including completion of
      valuations to finalize the fair value of any acquired identifiable intangible
      assets.  To the extent such assets are amortizable, amortization
      expense will be increased.  The unaudited pro forma consolidated
      results of operations for the Compass Business are not presented due to the
      immateriality of its results of operations.





Mother’s
      Intuition Inc.





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





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





(in
      thousands)


Total
                purchase price, including expenses, net of cash acquired
            
            
            
            
            $
            3,761Less:Current
                assets
            
            $
            198Intangible
                assets
            
            
            180Liabilities
            
            
            (66
            )
            
            
            (312
            )Excess
                of purchase price over net assets acquired
            
            
            
            
            
            $
            3,449





The
      allocation of purchase price is subject to final adjustment based on valuations
      and other determinations that will be completed as soon as practical but no
      later than by the end of the fourth quarter of 2008, including completion of
      valuations to finalize the fair value of any acquired identifiable intangible
      assets.  To the extent such assets are amortizable, amortization
      expense will be increased.  The unaudited pro forma consolidated
      results of operations of MI are not presented due to the immateriality of its
      results of operations.






F-16


4.  BUSINESS
      SEGMENTS





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





The
      Company’s reportable segments under SFAS No. 131, "Disclosure About Segments of
      an Enterprise and Related Information," are North America and
      International.  The North America segment includes the United States,
      Canada and Mexico.  The International segment includes non-North
      America markets.





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





Results
      are not necessarily those that would be achieved if each segment were an
      unaffiliated business enterprise.  Information by segment and a
      reconciliation to reported amounts for the years ended December 31, 2005, 2006
      and 2007, are as follows:





Year
                Ended December 31,(in
                thousands)
            
            2005
            
            
            2006
            
            
            2007Net
                sales:North
                America
            
            $
            422,389
            
            
            $
            432,769
            
            
            $
            381,792International
            
            
            71,688
            
            
            
            86,794
            
            
            
            108,081Sales
                and transfers between segments
            
            
            (1,311
            )
            
            
            (734
            )
            
            
            (874
            )Combined
                total
            
            $
            492,766
            
            
            $
            518,829
            
            
            $
            488,999Operating
                income:North
                America
            
            $
            74,167
            
            
            $
            58,061
            
            
            $
            19,092International
            
            
            15,851
            
            
            
            14,219
            
            
            
            14,811Sales
                and transfers between segments
            
            
            —
            
            
            
            (37
            )
            
            
            (108
            )Combined
                total
            
            $
            90,018
            
            
            $
            72,243
            
            
            $
            33,795Depreciation
                and amortization:North
                America
            
            $
            14,345
            
            
            $
            14,003
            
            
            $
            13,487International
            
            
            1,484
            
            
            
            1,233
            
            
            
            1,356Combined
                total
            
            $
            15,829
            
            
            $
            15,236
            
            
            $
            14,843Capital
                expenditures:North
                America
            
            $
            13,087
            
            
            $
            12,810
            
            
            $
            9,733International
            
            
            1,046
            
            
            
            1,586
            
            
            
            1,734Combined
                total
            
            $
            14,133
            
            
            $
            14,396
            
            
            $
            11,467





December
                31,2006
            
            
            2007Total
                assets:North
                America
            
            $
            517,158
            
            
            $
            513,289International
            
            
            97,482
            
            
            
            136,956Combined
                total
            
            $
            614,640
            
            
            $
            650,245






F-17


Under
      the
      enterprise-wide disclosure requirements of SFAS No. 131, the Company reports
      net
      sales by product category and by distribution channel.  The Company
      groups its products into three product categories: infant and toddler products,
      preschool products and youth and adult products.  Amounts for the
      years ended December 31, 2005, 2006 and 2007, are as shown in the tables
      below:





Year
                Ended December 31,(in
                thousands)
            
            2005
            
            
            2006
            
            
            2007Infant
                and toddler products
            
            $
            160,043
            
            
            $
            175,735
            
            
            $
            184,936Preschool
                products
            
            
            199,857
            
            
            
            229,334
            
            
            
            196,758Youth
                and adult products
            
            
            132,866
            
            
            
            113,760
            
            
            
            107,305Net
                sales
            
            $
            492,766
            
            
            $
            518,829
            
            
            $
            488,999Chain
                retailers
            
            $
            314,217
            
            
            $
            352,555
            
            
            $
            333,775Specialty
                retailers, wholesalers and OEM dealers
            
            
            157,818
            
            
            
            151,410
            
            
            
            139,926Corporate
                promotional and direct to consumers
            
            
            20,731
            
            
            
            14,864
            
            
            
            15,298Net
                sales
            
            $
            492,766
            
            
            $
            518,829
            
            
            $
            488,999





5.  GOODWILL
      AND INTANGIBLE ASSETS





The
      Company completed its annual goodwill impairment tests as of October 1, 2005,
      2006 and 2007, which resulted in no impairment.  The annual impairment
      test for intangible assets in 2005 and 2007 resulted in no impairment to
      intangibles.  However, an impairment charge for intangible assets in
      the North America segment of $2.8 million has been included in the restructuring
      charge related to discontinued automotive collectibles within operating expenses
      in the accompanying consolidated statement of earnings for the year ended
      December 31, 2006, as a result of the Company’s decision to discontinue its
      automotive collectible product lines (see Note 17 - Restructuring Charge –
Discontinuance of Automotive Collectible Product Lines).





The
      carrying value of goodwill by reporting unit for the years ended 2006 and 2007
      is shown below:





(in
                thousands)
            
            North
                America
            
            
            International
            
            
            TotalBalance
                at December 31, 2005
            
            $
            240,130
            
            
            $
            13,441
            
            
            $
            253,571Sale
                of RC2 South, Inc. (Note 16)
            
            
            (15,732
            )
            
            
            —
            
            
            
            (15,732
            )Other
                adjustments
            
            
            (562
            )
            
            
            1,790
            
            
            
            1,228Balance
                at December 31, 2006
            
            
            223,836
            
            
            
            15,231
            
            
            
            239,067Compass
                Business acquisition
            
            
            4,250
            
            
            
            —
            
            
            
            4,250MI
                acquisition
            
            
            3,449
            
            
            
            —
            
            
            
            3,449Other
                adjustments
            
            
            659
            
            
            
            389
            
            
            
            1,048Balance
                at December 31, 2007
            
            $
            232,194
            
            
            $
            15,620
            
            
            $
            247,814





Other
      adjustments made during the year ended December 31, 2006, primarily relate
      to
      currency exchange rate changes and release of certain purchase accounting
      liabilities.  Other adjustments made during the year ended December
      31, 2007, primarily relate to an adjustment to deferred taxes related to fixed
      assets on prior acquisitions and currency exchange rate changes.





F-18


The
      components of net intangible assets are as follows:





December
                31,(in
                thousands)
            
            2006
            
            
            2007Gross
                amount of amortizable intangible assets:Customer
                relationships
            
            $
            8,363
            
            
            $
            8,582Other
            
            
            3,471
            
            
            
            4,32111,834
            
            
            
            12,903Accumulated
                amortization of amortizable intangible assets:Customer
                relationships
            
            
            485
            
            
            
            706Other
            
            
            2,143
            
            
            
            2,8152,628
            
            
            
            3,521Intangible
                assets not subject to amortization:Licenses
                and trademarks
            
            
            87,194
            
            
            
            87,293Total
                intangible assets, net
            
            $
            96,400
            
            
            $
            96,675





Other
      amortizable intangible assets consist primarily of patents, non-compete
      agreements and trademarks and have estimated useful lives ranging from two
      to
      eight years.  Customer relationships have useful lives ranging from
      eight to fifty years, depending on the type of customer.  We have
      determined that our relationships with our largest customers, Wal-Mart, Toys
      "R"
      Us/Babies "R" Us, Target and Kmart, have useful lives of fifty years because
      we
      have longstanding, continuous relationships with these
      customers.  Furthermore, in determining these useful lives, we
      considered such factors as competition, demand for our products and the
      likelihood of the customer changing suppliers, as well as the financial and
      operating performance of our largest customers.





Estimated
      amortization expense for the years ending December 31, is as
      follows:





(in
                thousands)2008
            $    8892009
            5782010
            3722011
            3322012
            $    319





6.  INCOME
      TAXES





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





Year
                Ended December 31,(in
                thousands)
            
            2005
            
            
            2006
            
            
            2007Income
                from continuing operations before income taxes:United
                States
            
            $
            69,773
            
            
            $
            58,061
            
            
            $
            20,186Foreign
            
            
            14,116
            
            
            
            10,187
            
            
            
            13,862$
            83,889
            
            
            $
            68,248
            
            
            $
            34,048





Income
      (loss) from discontinued operations, before income taxes, of $0.6 million,
      $(8.7) million and $0.1 million for the years ended December 31, 2005, 2006
      and
      2007, respectively, have been excluded from the above figures.





F-19


The
      significant components of income tax expense are as follows:





Year
                Ended December 31,(in
                thousands)
            
            2005
            
            
            2006
            
            
            2007CurrentFederal
            
            $
            24,493
            
            
            $
            20,928
            
            
            $
            6,667State
            
            
            1,141
            
            
            
            2,407
            
            
            
            546Foreign
            
            
            3,544
            
            
            
            3,601
            
            
            
            5,61829,178
            
            
            
            26,936
            
            
            
            12,831DeferredFederal
            
            
            335
            
            
            
            (1,608
            )
            
            
            (157
            )State
            
            
            1,366
            
            
            
            (154
            )
            
            
            (96
            )Foreign
            
            
            274
            
            
            
            (696
            )
            
            
            (106
            )1,975
            
            
            
            (2,458
            )
            
            
            (359
            )Income
                tax expense
            
            $
            31,153
            
            
            $
            24,478
            
            
            $
            12,472





Income
      tax expense related to discontinued operations of $0.2 million and $1.0 million
      for the years ended December 31, 2005 and 2006, respectively, has been excluded
      from the above figures.  There is no income tax expense related to
      discontinued operations for the year ended December 31, 2007.





Income
      tax expense for the years ended December 31, 2005, 2006 and 2007 includes
      provisions for federal, state and foreign income taxes at an effective rate
      of
      37.1%, 37.3% and 37.9%, respectively.  However, the tax rate, including
      discrete items, for the years ended December 31, 2005, 2006 and 2007 is 37.1%,
      35.9% and 36.6%, respectively.  A reconciliation of the U.S. statutory
      federal tax rate and actual effective income tax rate, including discrete items,
      is as follows:





Year
                Ended December 31,2005
            
            
            2006
            
            
            2007U.S.
                statutory rate
            
            
            35.0
            %
            
            
            35.0
            %
            
            
            35.0
            %State
                taxes, net of federal benefit
            
            
            1.9
            
            
            
            2.0
            
            
            
            2.0Foreign
            
            
            (0.6
            )
            
            
            (1.1
            )
            
            
            (1.8
            )Foreign
                dividend impact
            
            
            0.6
            
            
            —
            
            
            
            —Other
            
            
            0.2
            
            
            
            —
            
            
            
            1.4Effective
                rate
            
            
            37.1
            %)
            
            
            35.9
            %)
            
            
            36.6
            %)





Included
      in other in the above table are permanent tax adjustments, tax return to accrual
      adjustments, changes to tax reserves and the impact of statutory tax rate
      changes in various jurisdictions.  Also included is the impact of rate
      changes on the Company's deferred tax assets and liabilities.




The
      effective tax rate including the impact of discontinued operations is 37.1%,
      42.8% and 36.5% for the years ended December 31, 2005, 2006 and 2007,
      respectively.





F-20


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





December
                31,(in
                thousands)
            
            2006
            
            
            2007Deferred
                tax assets attributable toCapital
                loss carry-forward
            
            $
            5,834
            
            
            $
            5,887Stock
                options
            
            
            1,151
            
            
            
            3,151Bad
                debt allowance
            
            
            437
            
            
            
            393Inventory
            
            
            3,333
            
            
            
            4,307Sales
                allowances
            
            
            3,217
            
            
            
            3,131Net
                operating loss carry-forwards
            
            
            471
            
            
            
            671Accrued
                expenses
            
            
            1,118
            
            
            
            2,483Purchase
                accounting
            
            
            757
            
            
            
            682Other
            
            
            2,194
            
            
            
            884Total
                deferred tax assets before valuation allowance
            
            
            18,512
            
            
            
            21,589Valuation
                allowance related to the capital loss carry-forward
            
            
            (5,834
            )
            
            
            (5,887
            )Net
                deferred tax assets
            
            
            12,678
            
            
            
            15,702Deferred
                tax liabilities attributable toGoodwill
                and intangible assets
            
            
            (49,389
            )
            
            
            (52,647
            )Property
                and equipment
            
            
            (1,585
            )
            
            
            (3,079
            )Other
            
            
            (1,344
            )
            
            
            (856
            )Total
                deferred tax liabilities
            
            
            (52,318
            )
            
            
            (56,582
            )Net
                deferred tax liability
            
            $
            (39,640
            )
            
            $
            (40,880
            )





No
      provision has been made for U.S. federal or non-U.S. deferred income taxes
      on
      $44.0 million of accumulated and undistributed earnings of foreign subsidiaries
      at December 31, 2007, since it is the present intention of management to
      reinvest the undistributed earnings indefinitely in those foreign
      operations.  The determination of the amount of unrecognized U.S.
      federal or non-U.S. deferred income tax liabilities for unremitted earnings
      is
      not practicable.





Net
      (payable) prepaid income taxes at December 31, 2006 and 2007 were $(3.4) million
      and $3.1 million, respectively.





The
      American Jobs Creation Act of 2004 (the Act) enacted on October 22, 2004,
      provided a special one-time incentive for U.S. multinational corporations to
      repatriate accumulated income earned abroad by providing an 85.0% exclusion
      from
      taxable income for certain dividends from controlled foreign
      corporations.  In order to benefit from this incentive, the Company
      had to reinvest the qualifying dividends in the U.S. under a domestic
      reinvestment plan approved by the Chief Executive Officer and Board of
      Directors.  On December 23, 2005, after approval by the Company’s
      Chief Executive Officer and Board of Directors, $8.0 million was distributed
      from one of the Company’s United Kingdom subsidiaries and the Company recorded
      $0.5 million of federal and state tax expense in connection with this one-time
      repatriation.  The repatriated funds were used for domestic
      expenditures relating to the compensation of U.S. employees.





On
      November 3, 2006, the Company announced the completion of the sale of RC2 South,
      Inc., its collectible trading card business, and substantially all of the assets
      related to its die-cast sports collectibles product line (see Note 16 -
      Discontinued Operations).  For tax purposes, this sale generated a
      pre-tax capital loss of $15.6 million.  A valuation allowance of $5.9
      million has been established because the Company does not believe recoverability
      of this amount is more likely than not.  This capital loss
      carry-forward will expire in 2011.






F-21


Effective
      January 1, 2007, the Company adopted FIN 48, "Accounting for Uncertainty in
      Income Taxes – an interpretation of FASB Statement No. 109."  This
      Interpretation clarifies the accounting for uncertainty in income taxes
      recognized in an enterprise’s financial statements in accordance with FASB
      Statement No. 109, "Accounting for Income Taxes."  This Interpretation
      prescribes a recognition threshold and measurement approach for the financial
      statement recognition and measurement of a tax position taken or expected to
      be
      taken in a tax return.  This Interpretation also provides guidance on
      derecognition, classification, interest and penalties, accounting in interim
      periods, disclosure and transition.  As a result of the Company’s
      adoption of FIN 48, the Company recognized a $0.7 million increase to reserves
      for uncertain tax positions.  This increase was accounted for as a
      $0.7 million adjustment to the beginning balance of retained
      earnings.  As of the date of adoption, the Company had approximately
      $5.0 million of total gross unrecognized tax benefits.





The
      uncertain tax positions as of December 31, 2007 totaled $4.2
      million.  The following table summarizes the activity related to the
      unrecognized tax benefits:





(in
                thousands)
            
            December
                31, 2007Unrecognized
                tax benefits as of December 31, 2006
            
            $
            4,953Increases
                in positions taken in a prior period
            
            
            546Decreases
                in positions taken in a prior period
            
            
            (727
            )Increases
                in positions taken in a current period
            
            
            97Decreases
                in positions taken in a current period
            
            
            —Decreases
                due to settlements
            
            
            (204
            )Decreases
                due to lapse of statute of limitations
            
            
            (442
            )Unrecognized
                tax benefits as of December 31, 2007
            
            $
            4,223





Approximately
      $3.0 million of the total gross unrecognized tax benefits represents the amount
      that, if recognized, would affect the effective income tax rate in future
      periods.  The Company and its subsidiaries are subject to U.S. federal
      income tax as well as income tax of multiple state and foreign
      jurisdictions.  The Company has substantially concluded all U.S.
      federal income tax matters for years through 2003.  Substantially all
      material state and local and foreign income tax matters have been concluded
      for
      years through 2003.  U.S. federal income tax returns for 2004 through
      2006 are currently open for examination.  In the next twelve months,
      the Company expects to reduce the unrecognized tax position reserves by
      approximately $1.4 million primarily due to the settlement of various state
      and
      international income tax audits and court cases and the closing of various
      statutes.  The Company’s continuing practice is to recognize interest
      and/or penalties related to income tax matters in income tax
      expense.  The Company recorded adjustments to interest and potential
      penalties of $0.3 million and $(0.5) million, respectively, related to these
      unrecognized tax benefits during 2007, and in total, as of December 31, 2007,
      the Company has recorded a liability for interest and potential penalties of
      $2.0 million and $0.4 million, respectively.





7.  DEBT





Upon
      the
      closing of the acquisition of TFY on September 15, 2004, the Company entered
      into a new credit facility, which has subsequently been amended, to replace
      its
      previous credit facility.  The credit facility is comprised of an
      $85.0 million term loan and a $100.0 million revolving line of
      credit.  The credit facility also provides an additional $75.0 million
      of capacity under the revolving line of credit which was approved by the lenders
      upon the Company’s request in October 2007.  During the first quarter
      of 2007, the term loan was repaid and the term loan is no longer available
      for
      borrowing.  The revolving line of credit is available until its
      maturity on September 14, 2008.  A portion of the term loan had an
      interest rate of 3.45% plus applicable margin through the first three years
      of
      the facility.  The remaining term loan bore and revolving line of
      credit bears interest, at the Company’s option, at a base rate or at a LIBOR
      rate plus applicable margin.  The applicable margin is based on the
      Company’s ratio of consolidated debt to consolidated EBITDA (earnings before
      interest, taxes, depreciation, amortization and non-cash expense related to
      equity awards) and varies between 0.75% and 1.625%.  At December 31,
      2007, the margin in effect was 1.00% for LIBOR loans.  The Company is
      also required to pay a commitment fee of 0.20% to 0.35% per annum on the average
      daily unused portion of the revolving line of credit.  At December 31,
      2007, the commitment fee in effect was 0.25% per annum.  Under the
      terms of this credit facility, the Company is required to comply with certain
      financial and non-financial covenants.  Among other restrictions, the
      Company is restricted in its ability to pay dividends, incur additional debt
      and
      make acquisitions above certain amounts.  The key financial covenants
      include minimum EBITDA and interest coverage and leverage ratios.  The
      credit facility is secured by working capital assets and certain intangible
      assets.  On December 31, 2007, the Company had $95.0 million
      outstanding on the revolving line of credit and was in compliance with all
      covenants.





F-22


In
      connection with its current credit facility, the Company incurred $1.9 million
      in financing fees.  The Company also incurred additional financing
      fees of $0.2 million and $0.1 million in 2006 and 2007, respectively, related
      to
      amendments to its current credit facility.  Financing fees are
      included in other non-current assets in the accompanying consolidated balance
      sheets and are being charged to interest expense in the accompanying
      consolidated statements of earnings through the period in which the revolving
      line of credit is available, which is currently September 2008.  In
      conjunction with the Company’s voluntary payment on a portion of its term loan,
      the Company expensed $0.2 million of deferred financing fees in each of the
      years ended December 31, 2006 and 2007.





The
      Company’s Hong Kong subsidiary maintains an on-going credit agreement with a
      bank that provides for a line of credit of up to $1.9
      million.  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, 2006 and 2007,
      there were no outstanding borrowings under this line of credit.





The
      Company’s United Kingdom subsidiary maintains two on-going lines of credit with
      two banks totaling $0.4 million.  The lines of credit bear 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, 2006 and 2007, there
      were no amounts outstanding on this line of credit.





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





Non-current
      debt consists of the following:





December
                31,2006
            
            
            2007Term
                loans payable to banks, bearing interest at 4.20% and 6.10% as
                of
              December
                31, 2006, repaid and no longer available for borrowing
            
            $
            22,438
            
            
            $
            —U.S.
                revolving line of credit, bearing interest in the range of
                approximately
              5.86%
                to 6.51% as of December 31, 2007; matures on September 14,
                2008
            
            
            —
            
            
            
            95,000Less
                current maturities
            
            
            (22,438
            )
            
            
            (95,000
            )$
            —
            
            
            $
            —





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 sale of specific licensed products on a nonexclusive
      basis.  The Company is party to over 400 licenses with, among others,
      various entertainment, publishing and media companies, automotive and truck
      manufacturers, and agricultural and construction vehicle and equipment
      manufacturers.  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)2008
            
            $
            4,1472009
            
            
            8,0682010
            
            
            7,9132011
            
            
            7,8772012
            
            
            7,965Thereafter
            
            
            275Total
            
            $
            36,245





Royalty
      expense for licenses, including guaranteed minimums, was $32.3 million, $38.4
      million and $34.7 million for 2005, 2006 and 2007, respectively.





F-23


Rental
      expense for office and warehouse space and other equipment under cancelable
      and
      noncancelable operating leases amounted to $4.7 million in each of the years
      ended December 31, 2005, 2006 and 2007, respectively.  Certain
      operating leases provide for scheduled increases in rental payments during
      the
      term of the lease or for no rent during part of the term of the
      lease.  For these leases, the Company recognizes total rent expense on
      a straight-line basis over the minimum lease term.  Commitments for
      future minimum lease payments for noncancelable operating leases with terms
      extending beyond one year at December 31, 2007, are as follows:





Year
                Ending December 31,(in
                thousands)2008
            
            $
            4,0952009
            
            
            3,6872010
            
            
            2,7262011
            
            
            2,1712012
            
            
            2,096Thereafter
            
            
            11,029Total
            
            $
            25,804





Unconditional
      purchase obligations include agreements for purchases of product, tooling and
      services such as advertising, and hardware and software
      agreements.  Payments made and allowances given in connection with
      these cancelable and noncancelable long-term unconditional purchase obligations
      amounted to $4.0 million, $25.7 million and $28.6 million for the years ended
      December 31, 2005, 2006 and 2007, respectively.





Commitments
      for future minimum payments with terms extending beyond one year at December
      31,
      2007, for noncancelable unconditional purchase obligations are as
      follows:





Year
                Ending December 31,(in
                thousands)2008
            
            $
            23,2612009
            
            
            22,0472010
            
            
            20,4122011
            
            
            —2012
                and thereafter
            
            
            —Total
            
            $
            65,720





9.  LEGAL
      PROCEEDINGS




See
      Note
      18 - Product Recalls and Note 19 - Subsequent Events for a description of
      certain putative class action lawsuits against the Company with respect to
      the
      products subject to the 2007 recalls and a notice received from a licensor
      relating to the recalls.





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






F-24


10.  COMMON
      STOCK





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





(in thousands, except par value)
            Authorized
              Shares
            Par
              Value
            Shares
                Outstanding at
              December
                31, 2006
            Shares
                Outstanding at
              December
                31, 2007Voting
                common stock
            28,000
            $0.01
            21,052
            18,320





During
      the years ended December 31, 2006 and 2007, the Company sold a total of 6,609
      shares and 5,570 shares, respectively, out of treasury to Company employees
      under the Employee Stock Purchase Plan (ESPP) for $0.2 million in each of the
      years then ended.  At December 31, 2007, the Company held 4.8 million
      shares of its common stock in treasury.





In
      February 2007, the Company’s Board of Directors authorized the adoption of a
      program to repurchase up to $75.0 million of the Company’s common
      stock.  The program was initially authorized for a period of one
      year.  In October 2007, the Board of Directors authorized a $75.0
      million increase to the stock repurchase program and extended the timing of
      this
      program through December 31, 2008.  This program may be extended
      beyond the currently authorized period or may be suspended at any
      time.  Under this program, shares may be repurchased from time to time
      in open market transactions or privately negotiated transactions at the
      Company’s discretion, subject to market conditions and other
      factors.  Shares repurchased by the Company are held as treasury
      shares.  During the year ended December 31, 2007, the Company
      repurchased 2.9 million shares for $87.9 million under this
      program.  These repurchases were funded via borrowings on the
      Company’s revolving line of credit.





11.  STOCK-BASED
      PAYMENT ARRANGEMENTS





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





At
      December 31, 2007, the Company has three stock incentive plans, two of which
      are
      dormant, and an ESPP which are described below.  Amounts recognized in
      the financials statements with respect to these stock-based payment arrangements
      for the years ended December 31, 2006 and 2007, are as follows:





Year
                Ended December 31,(in
                thousands)
            
            2006
            
            
            2007Total
                expense recognized for stock-based payment plans
            
            $
            3,856
            
            
            $
            4,705Amount
                of related income tax benefit recognized in determining net
                income
            
            $
            1,430
            
            
            $
            1,774





Stock-based
      compensation expense is included in cost of sales, other and selling, general
      and administrative expenses in the accompanying consolidated statements of
      earnings for the years ended December 31, 2006 and 2007.





F-25


Prior
      to
      January 1, 2006, the Company accounted for stock-based compensation arrangements
      with employees in accordance with the provisions of APB Opinion No. 25 and
      complied with the disclosure provisions of SFAS No. 123.  If
      compensation costs for stock-based payment plans, including options for shares
      issued under the ESPP, had been determined based on the fair value at their
      grant date consistent with SFAS No. 123, the Company’s net income and earnings
      per common share would have been reduced to the following pro forma
      amounts:





(in
                thousands, except per share data)
            
            Year
                Ended December 31, 2005Net
                income as reported
            
            $
            53,130Deduct:
                total stock-based employee compensation expense
              determined
                under fair value based method for all awards,
              net
                of related income tax benefit
            
            
            (2,061
            )Pro
                forma net income
            
            $
            51,069Basic
                earnings per common share:As
                reported
            
            $
            2.58Pro
                forma
            
            $
            2.48Diluted
                earnings per common share:As reported
            
            $
            2.47Pro forma
            
            $
            2.37





Employee
      Stock Purchase Plan





The
      Company has an ESPP to provide its employees 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.  The price for each share of
      common stock purchased equals 90.0% of the last quoted sales price of a share
      of
      the Company’s common stock as reported by NASDAQ 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 was to
      initially terminate on July 1, 2007.  However, in May 2007, the Board
      of Directors approved an extension of the plan for an additional five years
      and
      it is now scheduled to terminate on July 1, 2012.





The
      fair
      value of each option for shares issued under the ESPP during the years ended
      December 31, 2005, 2006 and 2007, is estimated on the date of grant based on
      the
      Black-Scholes option pricing model with the following assumptions:





2005
            2006
            2007Weighted
                average expected life
            3
                months
            3
                months
            3
                monthsWeighted
                average risk-free rate of return
            2.9%
            4.7%
            4.8%Weighted
                average expected volatility
            30.1%
            25.9%
            42.0%Weighted
                average dividend yield
            None
            None
            None





The
      weighted average fair value of those options granted in 2005, 2006 and 2007,
      was
      $7.08, $4.99 and $9.07, respectively.





The
      Company calculates the volatility factor used in valuing options issued under
      the ESPP based on the volatility of the Company’s common stock during the most
      recent three-month period.  The expected term of share options granted
      represents the period of time that share options granted are expected to be
      outstanding.  The risk-free rate for the period within the contractual
      term of the share option is based on the U.S. Treasury yield curve in effect
      at
      the time of grant.





F-26


Stock
      Incentive Plans





The
      Company maintained a stock incentive plan, under which options could be granted
      to purchase up to 2,300,000 shares of common stock to executives or key
      employees of the Company.  Some of the options that were granted
      vested immediately, and the rest vested over a five-year
      period.  These options expire on the tenth anniversary of the date of
      grant or 90 days after the date of termination of the employee’s employment with
      the Company.  Under this plan, cancelled options revert back into the
      plan.  This plan became dormant in 2005 upon approval of the 2005
      Stock Incentive Plan, as discussed below.  No future issuances are
      authorized from this plan.





The
      Company also maintained an omnibus stock plan, under which the Company had
      400,000 shares of its common stock reserved for issuance.  This plan
      is dormant, and no future issuances are authorized from this plan.





During
      2005, a new stock incentive plan was approved by the Company’s
      stockholders.  Under this plan, restricted stock awards or options to
      purchase stock may be granted for up to 1,200,000 shares of common
      stock.  Options granted may vest immediately or over a five-year
      period.  These options expire on the tenth anniversary of the date of
      grant or 90 days after the date of termination of the employee’s employment with
      the Company.  Under this plan, cancelled options revert back into the
      plan and are available for future issuance.  Restricted stock awards
      generally vest over a two to three year period.





The
      fair
      value of stock options granted under the stock incentive plans during the years
      ended December 31, 2005, 2006 and 2007, is estimated on the date of grant based
      on the Black-Scholes option pricing model with the following
      assumptions:





2005
            2006
            2007Weighted
                average expected life
            7
                years
            7
                years
            7
                yearsWeighted
                average risk-free rate of return
            4.2%
            4.6%
            4.7%Weighted
                average expected volatility
            54.6%
            54.5%
            48.4%Weight
                average dividend yield
            None
            None
            None





The
      fair
      value of stock options granted under the stock incentive plans is estimated
      on
      the date of grant based on the Black-Scholes option pricing
      model.  Prior to 2007, the Company calculated the expected volatility
      factor for those options issued under the stock incentive plans to correspond
      with the average volatility factor of those companies included in a peer group
      study.  The historical stock price movements of the Company’s common
      stock had not been considered a good indicator of expected future volatility
      because the Company’s business had changed significantly as a result of
      acquisitions completed.  However, the Company continued to monitor its
      actual volatility to assess whether its historical stock price movements over
      the expected option term were a good indicator of expected future results and
      began using Company specific volatility in 2007.





The
      Company uses historical data to estimate stock option exercise and employee
      departure behavior used in the Black-Scholes option pricing
      model.  The expected term of stock options granted represents the
      period of time that stock options granted are expected to be
      outstanding.  The risk-free rate for the period within the contractual
      term of the stock option is based on the U.S. Treasury yield curve in effect
      at
      the time of grant.





F-27


A
      summary
      of stock option activity for the Company’s stock incentive plans for the years
      ended December 31, 2005, 2006 and 2007, is as follows:





Shares
            
            
            Weighted
              Average
              Exercise
              Price
            
            Aggregate
              Intrinsic
              Value
              (in
                000s)
            
            Weighted
              Average
              Remaining
              Contractual
              Life
            
            Shares
              Available
              for
                Future
              GrantsOutstanding
                as of December 31, 2004
            
            
            1,547,852
            
            
            $
            11.71
            
            
            
            
            
            
            321,1352005Granted
            
            
            288,242
            
            
            
            31.65Exercised
            
            
            253,951
            
            
            
            6.89Cancelled
            
            
            19,301
            
            
            
            13.93Outstanding
                as of December 31, 2005
            
            
            1,562,842
            
            
            $
            16.14
            
            
            
            
            
            
            1,173,8492006Granted
            
            
            259,124
            
            
            
            35.71Exercised
            
            
            327,475
            
            
            
            11.05Cancelled
            
            
            82,290
            
            
            
            29.23Outstanding
                as of December 31, 2006
            
            
            1,412,201
            
            
            $
            20.15
            
            
            
            
            
            
            934,2252007Granted
            
            
            257,009
            
            
            $
            39.12Exercised
            
            
            156,100
            
            
            
            12.67Cancelled
            
            
            5,400
            
            
            
            33.90Expired
            
            
            16,320
            
            
            
            9.84Outstanding
                as of December 31, 2007
            
            
            1,491,390
            
            
            $
            24.27
            
            $11,254
            
            6.3
            
            
            681,216Exercisable
                as of December 31, 2007
            
            
            783,686
            
            
            $
            15.78
            
            $10,500
            
            4.9





The
      following table summarizes information about stock options outstanding at
      December 31, 2007:





Range
                of Exercise Price
            Number
                Outstanding
            Weighted
                Average Remaining Contractual Life
            Weighted
                Average Exercise Price
            Number
                Exercisable
            Weighted
                Average Exercise Price$  1.41
                - $10.94
            380,439
            3.3
            $  6.15
            380,439
            $  6.15$13.39
                - $24.78
            342,952
            5.6
            19.58
            231,202
            18.73$28.87
                - $35.72
            505,398
            7.6
            33.41
            162,244
            32.84$36.52
                - $43.06
            262,601
            9.1
            $39.06
            9,801
            $38.17





The
      weighted average fair value of options granted under the Company’s stock
      incentive plans for the years ended December 31, 2005, 2006 and 2007, was
      $18.89, $21.48 and $21.54 per share, respectively.  The total
      intrinsic value of options exercised during the years ended December 31, 2005,
      2006 and 2007, was $6.9 million, $9.3 million and $4.4 million,
      respectively.





As
      of
      December 31, 2007, there was $10.6 million of total unrecognized compensation
      cost related to nonvested stock-based compensation arrangements granted under
      the Company’s stock incentive plans.  That cost is expected to be
      recognized over a weighted average period of 3.2 years.  The total
      fair value of options vested during the year ended December 31, 2007, was $3.3
      million.






F-28


Restricted
      stock awards require no payment from the grantee.  The related
      compensation cost of each award is calculated using either the market price
      on
      the grant date or the market price on the last day of the reported period and
      is
      expensed equally over the vesting period.  A summary of restricted
      stock awards for the Company’s stock incentive plan for the year ended December
      31, 2007, is as follows:





Number
                of Shares
            
            
            Weighted
                Average Grant Date Fair Value
            
            Weighted
                Average
              Remaining
              Contractual
                LifeUnvested
                restricted stock awards as of December 31, 2006
            
            
            —
            
            
            $
            —2007Granted
            
            
            39,837
            
            
            
            38.32Vested
            
            
            4,195
            
            
            
            40.57Unvested
                restricted stock awards as of December 31, 2007
            
            
            35,642
            
            
            $
            38.05
            
            2.1





As
      of
      December 31, 2007, there was $1.0 million of total unrecognized compensation
      cost related to nonvested stock-based compensation arrangements granted under
      the Company’s stock incentive plan for restricted stock awards.  That
      cost is expected to be recognized over a weighted average period of 2.1
      years.





12.  RELATED
      PARTY TRANSACTIONS





The
      Company purchased $18.5 million, $27.6 million and $15.4 million of product
      during 2005, 2006 and 2007, respectively, from two companies in which relatives
      of a Company stockholder/director have ownership interests.  Accounts
      payable to these companies were $1.5 million and $2.0 million as of December
      31,
      2006 and 2007, respectively.





13.  EMPLOYEE
      BENEFIT PLANS





The
      Company is self-insured on medical benefits offered to employees up to a limit
      of $0.1 million per employee or $2.0 million in aggregate per coverage
      year.  Claims are expensed when incurred, and a provision is recorded
      for claims incurred but not yet paid 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 100.0% of pre-tax
      gross wages, limited to a maximum annual amount as set periodically by the
      IRS.  The Company makes matching contributions of 100.0% on the first
      4.0% of employees’ annual wages and 50.0% on the next 6.0% of an employee’s
      annual wages.  For the years ended December 31, 2005, 2006 and 2007,
      the Company contributions were $1.1 million, $1.3 million and $1.2 million,
      respectively.  Additionally, there were 401(k) plans associated with
      prior acquisitions to which contributions were made.  All of these
      previous 401(k) plans were merged with the current Company 401(k) savings
      plan.





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 7.0%
      of an employee’s total compensation, plus 5.7% of an employee’s compensation in
      excess of the Social Security taxable wage base.  As of January 1,
      2005, this plan became dormant, and the plan was 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 $0.9 million.





On
      December 31, 2006, the Company adopted SFAS No. 158, "Employers’ Accounting for
      Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB
      Statements No. 87, 88, 106 and 132(R)."  This Statement requires an
      employer to recognize the overfunded or underfunded status of a defined benefit
      postretirement plan as an asset or liability in its balance sheet and to
      recognize changes in that funded status in the year in which the changes occur
      through accumulated other comprehensive income (loss).  This Statement
      also requires an employer to measure the funded status of a plan as of the
      date
      of its year-end statement of financial position.





The
      Company maintains a funded, noncontributory defined benefit pension plan (the
      Plan) that covers a select group of the Company’s workforce covered by a
      collective bargaining agreement who were hired prior to January 1,
      2002.  The Plan provides defined retirement benefits based on
      employees’ years of service.  The Company uses a December 31
      measurement date for this Plan.





F-29


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





December
                31,(in
                thousands)
            
            2005
            
            
            2006
            
            
            2007Change
                in benefit obligationBenefit
                obligation at beginning of year
            
            $
            13,583
            
            
            $
            14,599
            
            
            $
            14,522Service
                cost
            
            
            108
            
            
            
            105
            
            
            
            107Interest
                cost
            
            
            768
            
            
            
            789
            
            
            
            820Actuarial
                loss (gain)
            
            
            558
            
            
            
            (509
            )
            
            
            (1,518
            )Benefits
                paid and plan expenses
            
            
            (418
            )
            
            
            (462
            )
            
            
            (516
            )Benefit
                obligation at end of year
            
            $
            14,599
            
            
            $
            14,522
            
            
            $
            13,415Change
                in plan assetsFair
                value of assets at beginning of year
            
            $
            10,587
            
            
            $
            11,464
            
            
            $
            12,404Actual
                return on plan assets
            
            
            606
            
            
            
            1,402
            
            
            
            778Employer
                contributions
            
            
            689
            
            
            
            —
            
            
            
            615Benefits
                paid and plan expenses
            
            
            (418
            )
            
            
            (462
            )
            
            
            (516
            )Fair
                value of assets at end of year
            
            $
            11,464
            
            
            $
            12,404
            
            
            $
            13,281Funded
                Status at end of year
            
            $
            (3,135
            )
            
            $
            (2,118
            )
            
            $
            (134
            )





Amounts
                Recognized in the Consolidated Balance SheetsIntangible
                assets
            
            $
            152
            
            
            $
            —
            
            
            $
            —Other
                non-current liabilities
            
            
            3,135
            
            
            
            2,118
            
            
            
            134Accumulated
                other comprehensive income
            
            $
            6,152
            
            
            $
            4,914
            
            
            $
            3,228Amounts
                Recognized in Accumulated Other Comprehensive IncomePrior
                service cost
            
            $
            —
            
            
            $
            133
            
            
            $
            114Actuarial
                loss
            
            
            6,152
            
            
            
            4,781
            
            
            
            3,114Accumulated
                other comprehensive income
            
            $
            6,152
            
            
            $
            4,914
            
            
            $
            3,228





December
                31,(in
                thousands)
            
            2005
            
            
            2006
            
            
            2007Information
                for Pension Plans with an Accumulated Benefit Obligation in Excess
                of Plan
                AssetsProjected
                benefit obligation
            
            $
            14,599
            
            
            $
            14,522
            
            
            $
            13,415Accumulated
                benefit obligation
            
            
            14,599
            
            
            
            14,522
            
            
            
            13,415Fair
                value of plan assets
            
            $
            11,464
            
            
            $
            12,404
            
            
            $
            13,281






F-30


Components
      of Net Periodic Benefit Cost


Year
                Ended December 31,(in
                thousands)
            
            2005
            
            
            2006
            
            
            2007Service
                cost
            
            $
            108
            
            
            $
            105
            
            
            $
            107Interest
                cost
            
            
            768
            
            
            
            789
            
            
            
            820Expected
                return on plan assets
            
            
            (978
            )
            
            
            (981
            )
            
            
            (1,012
            )Amortization
                of prior service cost
            
            
            19
            
            
            
            19
            
            
            
            19Amortization
                of net loss
            
            
            372
            
            
            
            441
            
            
            
            384Net
                periodic benefit cost
            
            $
            289
            
            
            $
            373
            
            
            $
            318





Other
                Changes in Plan Assets and Projected Benefit Obligation
                Recognized
              in
                Other Comprehensive IncomeNet
                actuarial gain
            
            $
            (1,284
            )Amortization
                of net actuarial gain
            
            
            (384
            )Amortization
                of prior service cost
            
            
            (19
            )Total
                recognized in other comprehensive income
            
            $
            (1,687
            )





Total
                recognized in net periodic pension cost
              and
                other comprehensive income
            
            $
            (1,369
            )





Estimated
                Items That Will Be Amortized from Accumulated Other Comprehensive
                Income
              into
                Net Periodic Benefit Cost During 2008Prior
                service cost
            
            $
            19Actuarial
                loss
            
            
            185Expected
                recognition of expense
            
            $
            204





Reconciliation
                of Funded StatusFunded
                status
            
            $
            (3,135
            )
            
            $
            (2,118
            )
            
            $
            (134
            )Unrecognized
                net actuarial loss
            
            
            6,152
            
            
            
            4,781
            
            
            
            3,114Unrecognized
                prior service cost
            
            
            152
            
            
            
            133
            
            
            
            114Prepaid
                benefit cost
            
            $
            3,169
            
            
            $
            2,796
            
            
            $
            3,094




Estimated
                Future Benefit Payments2008
            
            $
            5482009
            
            
            5702010
            
            
            5942011
            
            
            6332012
            
            
            6662013
                to 2017
            
            $
            4,261






F-31


Assumptions





2005
            
            
            2006
            
            
            2007Weighted
                Average Assumptions Used
              to
                Determine Benefit Obligations
              at
                December 31Discount
                rate
            
            
            5.50
            %
            
            
            5.75
            %
            
            
            6.50
            %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 31Discount
                rate
            
            
            5.75
            %
            
            
            5.50
            %
            
            
            5.75
            %Expected
                return on plan assets
            
            
            8.50
            %
            
            
            8.50
            %
            
            
            8.50
            %Rate
                of compensation increase
            
            
            N/A
            
            
            
            N/A
            
            
            
            N/A





Expected
      Return on Plan Assets





The
      Company 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 securities are
      preserved consistent with the widely-accepted capital market 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





Based
      on
      the current target allocation of assets, the expected return model estimates
      a
      long-term average (50th
      percentile) rate of return (nominal) of 8.65% per year for the
      Plan.  The model incorporates real return assumptions for each asset
      class adjusting for variations in volatility, correlation and
      inflation.  The following table sets out the projected annual
      returns.





Percentile
                ReturnsTime
                Period
            
            75th
            
            
            50th
            
            
            25th1
                year
            
            
            0.16
            %
            
            
            8.65
            %
            
            
            17.86
            %5
                years
            
            
            4.77
            
            
            
            8.65
            
            
            
            12.6710
                years
            
            
            5.89
            
            
            
            8.65
            
            
            
            11.4820
                years
            
            
            6.69
            %
            
            
            8.65
            %
            
            
            10.64
            %







F-32


Plan
      Assets





The
      allocation of assets between major asset categories as of December 31, 2006
      and
      2007, as well as the target allocation, are as follows:





Percentage
                of Plan Assets
              at
                December 31,Asset
                Category
            
            Target
              Allocation
            
            
            2006
            
            
            2007Large
                cap domestic equity securities
            
            
            50
            %
            
            
            48
            %
            
            
            49
            %Small
                cap domestic equity securities
            
            
            5
            
            
            
            4
            
            
            
            4International
                equity securities
            
            
            15
            
            
            
            18
            
            
            
            17Fixed
                income securities
            
            
            30
            
            
            
            30
            
            
            
            30Total
            
            
            100
            %
            
            
            100
            %
            
            
            100
            %





Explanation
      of Investment Strategies and Policies





The
      Company 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





During
      the year ended December 31, 2007, the Company made contributions of $0.6 million
      to the Plan.  There are no minimum required contributions to the Plan
      for fiscal year 2008.  However, the Company may make contributions to
      the Plan at its discretion.  The Company is not expecting a reversion
      of Plan assets to the employer during the next year.





14.  OTHER
      NON-CURRENT ASSETS





An
      investment of $2.1 million is included in other non-current assets in the
      accompanying consolidated balance sheets at December 31, 2006 and 2007 and
      represents the amount the Company has invested in the development of an
      intellectual property.  The investment balance was accounted for under
      the equity method through November 30, 2006.  Beginning December 1,
      2006, at which time the Company no longer had the ability to exercise
      significant influence over the operating and financial policies of the
      development of the intellectual property, the investment is accounted for under
      the cost method.  During 2007, the Company made an additional
      investment in the development of an intellectual property.





15.  SALE
      OF PRODUCT LINE





During
      the third quarter of 2005, the Company completed the sale of its W. Britain
      product line of collectible pewter toy soldiers and accessories for $2.9 million
      in cash.  The sale resulted in a gain of $2.0 million, which is
      included in operating income in the accompanying consolidated statement of
      earnings for the year ended December 31, 2005.






F-33


16.  DISCONTINUED
      OPERATIONS





On
      November 3, 2006, the Company announced the completion of the sale of RC2 South,
      Inc., its collectible trading card business, and substantially all of the assets
      related to its die-cast sports collectibles product line.  Closing
      consideration consisted of $6.9 million of cash, excluding transaction
      expenses.  The sale of the Company’s trading card business and sports
      collectibles product line is consistent with the Company’s strategic focus to
      achieve sustainable organic growth and to concentrate its efforts on its higher
      growth infant and toddler products and preschool products
      categories.  The transaction was effective November 1, 2006, and the
      results of this sold business are presented as discontinued operations in the
      accompanying consolidated statements of earnings and consolidated statements
      of
      cash flows.  The sold business was primarily reported under the North
      America segment.





Net
      sales
      and income before income taxes generated by the sold business for the years
      ended December 31, 2005 and 2006, were as follows:





Year
                Ended December 31,(in
                thousands)
            
            2005
            
            
            2006Net
                sales
            
            $
            11,679
            
            
            $
            14,101Income
                before income taxes
            
            $
            634
            
            
            $
            2,701





A
      loss of
      $11.4 million and a gain of $0.1 million, net of income tax benefit, were
      recognized on this transaction during the years ended December 31, 2006 and
      2007, respectively.  The operations of the sold business, as well as the
      loss and the gain on the sale, are presented in income (loss) from
      discontinued operations, net of tax, in the accompanying consolidated statements
      of earnings.  For tax purposes, this sale generated a pre-tax capital
      loss of $15.6 million.  A valuation allowance of $5.9 million has been
      established because the Company does not believe recoverability of this amount
      is more likely than not.





17.  RESTRUCTURING
      CHARGE – DISCONTINUANCE OF AUTOMOTIVE COLLECTIBLE PRODUCT


LINES





During
      December 2006, the Company made the decision to discontinue its Racing
      Champions®,
      JoyRide®,
      AMT® and
      certain Ertl®
      die-cast and model kit automotive collectible product
      lines.  Discontinuing the automotive collectible product lines is
      consistent with the Company’s strategy to focus on sustainable organic growth
      and to allocate resources to its higher growth infant and toddler products
      and
      preschool products categories.  As a result of discontinuing these
      product lines, the Company has recorded the following charges which are
      presented in the restructuring charge related to discontinued automotive
      collectibles in the accompanying consolidated statement of earnings for the
      year
      ended December 31, 2006:





(in
                thousands)
            
            North
                America
            
            
            International
            
            
            TotalWrite-down
                of inventory
            
            $
            1,260
            
            
            $
            612
            
            
            $
            1,872Write-off
                of tooling
            
            
            8,272
            
            
            
            349
            
            
            
            8,621Write-off
                of customer relationships
            
            
            341
            
            
            
            —
            
            
            
            341Write-off
                of other intangibles
            
            
            2,483
            
            
            
            —
            
            
            
            2,483Accrual
                for minimum guaranteed royalties
            
            
            1,186
            
            
            
            —
            
            
            
            1,186Total
            
            $
            13,542
            
            
            $
            961
            
            
            $
            14,503






F-34


18.  PRODUCT
      RECALLS





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





Following
      the announcement of the June recall, a number of putative class action lawsuits
      were filed against the Company in various federal and state courts with respect
      to the products subject to the June and September recalls.  These
      lawsuits make various claims and seek (i) medical monitoring as a result of
      alleged exposure to lead in the products subject to the recalls, (ii)
      disgorgement of certain profits under common law unjust enrichment theories,
      and/or (iii) various remedies under claims of product liability, breach of
      warranty, negligence, unfair and deceptive trade practices under state law
      and
      violation of the federal Consumer Product Safety Act.  On December 19,
      2007, the various federal class action lawsuits were consolidated in the U.S.
      District Court for the Northern District of Illinois.  On January 22, 2008,
      the Company announced that it had reached a settlement in Barrett v. RC2 Corporationwith the plaintiffs
      in the various class action lawsuits filed in state courts (see Note 19 –
Subsequent Events).





The
      Company recorded charges of $17.6 million, net of tax, or $0.84 per diluted
      share, in the year ended December 31, 2007, related to the 2007
      recalls.  These charges are based on the latest estimates of retailer
      inventory returns, consumer product replacement costs and shipping costs as
      of
      the date of this filing, as well as the additional replacement costs or refunds,
      donations, notice charges, claims administration and legal fees related to
      the
      settlement of the class action lawsuits.  It is reasonably
      possible that actual costs associated with the recalls and related litigation
      could differ significantly from the estimates recorded.





19.  SUBSEQUENT
      EVENTS





On
      January 22, 2008, the Company announced that it had reached a settlement in
      Barrett v.RC2 Corporationfiled in the
      Circuit Court of Cook County, Illinois with the plaintiffs in the various class
      action lawsuits against the Company in state courts which arise from or
      relate to the Company's recall of certain Thomas & FriendsWooden Railway
      products.  The Circuit Court of Cook County, Illinois has granted
      preliminary approval of the terms of the proposed settlement.  If the
      settlement receives final approval it would resolve all class claims made by
      members of the class in Barrett. 
The class is basically defined as
      all persons in the United States who do
      not opt out of the class and who purchased or owned other than for resale the
      Company's Thomas
&
Friends
      Wooden
      Railway products which were recalled in June 2007 and September
      2007.  The settlement would not include a release of individual claims
      for personal injury against the Company.  On February 20, 2008, the
      U.S. District Court for the Northern District of Illinois denied a motion filed
      by plaintiffs in the federal cases for a preliminary injunction seeking
      to stop the settlement proceedings in the state court and granted the
      Company's motion to stay the federal court actions pending the state
      court's final decision of whether to approve the proposed settlement in the
      Barrett case.  Certain
      plaintiffs in the federal court action also filed a motion to intervene in
      the
      state court proceeding but, on February 25, 2008, they withdrew this
      motion.  The state court had stayed issuance of notice of the
      proposed settlement to the class in Barrettpending a decision on the federal
      plaintiffs' motion to intervene. 
Since this motion was withdrawn, the Company will now seek to implement the
      state court settlement in the Barrettcase.  In connection with this settlement,
      the Company recorded a
      charge of $7.0 million, or $4.5 million, net of tax, to cover estimated
      additional replacement costs or refunds, donations, notice charges, claims
      administration and legal fees in the year ended December 31,
      2007.  This charge is included in the total $17.6 million, net of
      tax, of recall-related costs recorded in the year ended December 31,
      2007.




The
        licensor (the Licensor) who has granted the licenses under which the Company
        markets the property affected by the June and September recalls (the Licenses)
        has sent a letter demanding that the Company indemnify it for certain costs
        in
        connection with the recalls and alleging that the Company has not complied
        with
        several provisions in the Licenses.  The Company has responded to the
        Licensor's letter and is attempting to resolve these
        matters.







F-35