**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, 2006.





[  
       ] 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 22ndStreet, 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 Market




Securities
      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 X No
       ___




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


Yes
       ___      No X





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, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Exchange Act Rule 12b-2.


Large
      accelerated filer
      [X]              
Accelerated filer [  
]                
Non-accelerated filer [   ]





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


Yes
       ___      No  X











Aggregate
      market value of the Registrant’s common stock held by non-affiliates as of
      June 30, 2006 (the last business day of the Registrant’s most recently
      completed second quarter): $771,869,168. 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 21,
      2007:  21,110,772





DOCUMENTS
      INCORPORATED BY REFERENCE





Portions
      of the Proxy Statement for the 2007 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.






**Part
        I**







**Item
      1. Business**





**Overview**





We
      are a
      leading designer, producer and marketer of innovative, high-quality toys,
      collectibles, and infant products that are targeted to consumers of all ages.
      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
      the*  *Pooh* ,
      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 5 to our consolidated financial statements included
      elsewhere herein.








2





**Corporate
      History**





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





On
      June 7, 2004, with an effective date of June 1, 2004, the Company
      acquired substantially all of the assets of Playing Mantis, Inc. (PM) primarily
      consisting of the Johnny Lightning® brand. Closing consideration consisted of
      $17.0 million of cash, excluding transaction expenses, and 91,388 shares of
      the Company’s common stock. This transaction has been accounted for under the
      purchase method of accounting, and accordingly, the operating results of PM
      have
      been included in our consolidated statements of earnings since the effective
      date of the acquisition.





On
      September 15, 2004, the Company acquired The First Years Inc. (TFY) for
      $156.1 million in cash, excluding transaction expenses. TFY is an
      international developer and marketer of infant and toddler care and play
      products sold under The First Years® brand name and under various licenses,
      including Disney’s *Winnie
      the Pooh* .
      This
      transaction has been accounted for under the purchase method of accounting,
      and
      accordingly, the operating results of TFY have been included in the accompanying
      consolidated statements of earnings since the effective date of the acquisition.
      The purchase was funded with a credit facility (see Note 8 to the consolidated
      financial statements).





On
      November 3, 2006, the Company announced the sale of RC2 South, Inc., its
      collectible trading card business, and substantially all of the assets relating
      to its die-cast sports collectibles product line. Closing consideration
      consisted of $6.9 million of cash, excluding transaction expenses. The sale
      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 net proceeds of
      this
      transaction were used to pay down debt.





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 on allocating resources to its higher growth infant and toddler
      products and preschool products categories. The Company plans to continue its
      agricultural collectibles business and continue to invest in its strategic
      long-term relationship with John Deere. Additionally, the Company plans to
      continue with its strategy to reposition its Johnny Lightning brand targeting
      younger consumers.





In
      January 2007, we changed the name of RC2 Brands, Inc., our main domestic
      operating subsidiary, to Learning Curve Brands, Inc., to better reflect our
      strategy of focusing on our Learning Curve family of infant, toddler and
      preschool brands.





**Products**





We
      group
      our products into three product categories: infant and toddler products;
      preschool products; and youth and adult products. During the fourth quarter
      of
      2006, the Company reclassified its product categories and channels of
      distribution to be more closely aligned with its strategic direction and
      organization structure. This presentation is consistent with how we view our
      business. We provide a diverse offering of infant and toddler products, stylized
      toys and highly detailed, authentic replicas known for their quality
      workmanship. Our products currently retail from $1.79 to $599.99. We have
      successfully expanded our product offering, and by offering a wide range of
      products at varying price points, we believe our products appeal to a broad
      range of consumers.





3





The
      following chart summarizes our current product categories:





**Category**
            **Key
                Licensed Properties**
            **Key Brands**
            **Retail
                Price Range**Infant
                and toddler products
            Lamaze
            Learning
                Curve
            $1.79
                - $149.99*Winnie
                the Pooh*
            The
                  First Years by Learning CurveDisney
                Princess*Sesame
                Street*American
                Red CrossSoothiePreschool
                products
            *Thomas
                & Friends*
            Learning
                Curve
            $4.99
                - $599.99*Bob
                the Builder*
            Take
                Along by Learning CurveJohn
                DeereNickelodeonYouth
                and adult products
            John
                Deere
            Johnny
                Lightning
            $2.99
                - $175.00Case
                New Holland
            Ertl





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





**·**
            Learning
                Curve's Lamaze infant toys with features that encourage developmental
                and
                interactive play; and





**·**
            The
                First Years by Learning Curve, a full line of feeding, care, safety
                and
                play products for infants and toddlers, including the Take & Toss®
                and Soothie
                product lines.





In
      2006,
      we introduced the Soothie bottles product line under The First Years by Learning
      Curve brand. These bottles offer the same shaped, medical grade silicone nipple
      as those used on Soothie pacifiers. Additionally, we expanded the Take &
Toss toddler self-feeding system under The First Years by Learning Curve
      brand. The Take & Toss product line includes sippy and straw cups, plates,
      bowls and feeding accessories.  In 2006, we added licensed properties
      such as *Thomas
      & Friends* , *Bob
      the Builder* , *The
      Wiggles* , *Barney* , *Sesame
      Street* ,
      Disney
      Princess, *Winnie
      the Pooh,* *Spiderman,
      Finding Nemo*and *Cars*to our Take & Toss product
      line .
      In late
      2006, we introduced a line of The First Years by Learning Curve healthcare
      products associated with the American Red Cross licensed property.





In
      2007,
      we plan to introduce a new look for Lamaze, featuring new colors and patterns.
      We also plan to launch a new play line featuring the *Winnie
      the Pooh* licensed
      property. Under The First Years by Learning Curve brand, we plan to expand
      distribution of our new Clean Air Odor FreeTM diaper
      disposal
      system which utilizes a carbon filter/fan system to both trap and eliminate
      odors. We also plan to introduce a portable infant glider and a retractable
      gate
      under The First Years by Learning Curve brand. Additionally, we plan to broaden
      our Take & Toss product line to include feeding sets featuring our most
      popular licensed properties.





***Preschool
      products.*** This
      category includes product lines that are marketed to parents, grandparents,
      caregivers and giftgivers of preschool-aged children. Products in this category
      are marketed under our Learning Curve brand and include:





**·**
            *Thomas
                & Friends* Wooden Railway, wooden engines, vehicles, destinations
                and playsets;





**·**
            *Bob
                the Builder Project: Build It*characters, vehicles, playsets and role-play
                toys;





**·**
            Take
                Along by Learning Curve die-cast vehicles and playsets designed
                around licensed properties such as*Thomas
                & Friends*,*Bob
                the Builder*,*Big
                Foot Presents Meteor and the Mighty Monster Trucks*,
                as well as several characters featured on popular Nickelodeon television
                shows;








4





**·**
            Play
                Town classic wooden figures, vehicles, buildings and playsets;





**·**
            John
                Deere farm, construction and role-play activity toys;
                and





**·**
            Ride-ons
                featuring the John Deere,*Thomas
                & Friends*and*Bob
                the Builder*licensed properties.





In
      2006,
      we expanded the distribution of our ride-ons .
      Additionally in 2006, we introduced new radio-controlled vehicles under the *Bob
      the Builder* and John
      Deere licensed properties.





In
      2007,
      we plan to introduce our Play Town from Learning Curve product line which offers
      characters, vehicles, buildings and playsets for open-ended, classic and
      creative play for toddlers and preschoolers. We also plan to expand our Take
      Along by Learning Curve line to include popular Nickelodeon television
      characters such as *Dora
      the Explorer* , *Go
      Diego Go!* , *The
      Backyardigans* , *Blue’s
      Clues* and *SpongeBob
      SquarePants.*




***Youth
      and adult products.*** This
      category includes product lines that are marketed to older boys and adult
      collectors. Products in this category include:





**·**
            Johnny
                Lightning toy and radio-controlled vehicles;
                and





**·**
            Ertl,
                collectible and toy vintage and modern tractors, farm implements
                and
                construction vehicles of major original equipment manufacturers (OEMs)
                such as John Deere and Case New
                Holland.





In
      2007,
      we plan to reposition the Johnny Lightning product line featuring a new logo,
      packaging and product design targeting younger consumers. Under the Johnny
      Lightning brand, we plan to introduce Lightning Wheels, a line of fantasy
      vehicles with tires that illuminate.  Additionally, we plan
      to introduce two new radio-controlled product lines,  V-BotTM and Battle
      WheelsTM. 
The V-Bot
      product line features a fully funtional radio-controlled vehicle that transforms
      into a robot.  The Battle Wheels product line features radio-contolled
      battling action figures on wheels.





**Licenses**





We
      market
      a significant portion of our products with licenses from other parties. We
      have
      license agreements with entertainment, publishing and media companies;
      automotive and truck manufacturers; agricultural and construction vehicle and
      equipment manufacturers; among others. **** A
      significant element of our strategy depends on our ability to identify and
      obtain licenses for recognizable and respected brands and properties. Our
      licenses reinforce our brands and establish our products’ authenticity,
      credibility and quality with consumers, and in some cases, provide for new
      product development opportunities and expand distribution channels. Our licenses
      are limited in scope and duration and authorize the sale of specific licensed
      products generally on a nonexclusive basis. For the year ended December 31,
      2006, 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, 2006. As of December 31, 2006, approximately 69.7% of our
      licenses required 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, 2006, are $50.7 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, 2006 was $32.6 million. We are a party to over 500
      license agreements, approximately 400 of which are actively used in our current
      product lines, 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. Over the next two years,
      license agreements in connection with several of our key licensed properties,
      including licenses for certain *Winnie
      the Pooh* ,
      Disney
      Princess, *Finding
      Nemo, Bob the Builder* ,
      Ford
      Motor Company and DaimlerChrysler Corporation 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.





**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 products with higher prices are
      typically sold in hobby, collector and independent toy stores and through
      wholesalers and OEM dealers. We believe we have a leading position in multiple
      distribution channels and that this position extends the reach of our
      products to consumers and mitigates the risk of concentration by channel or
      customer.





5





***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 can include a wide range of retailers, such as book, farm and
      ranch, automotive and craft/hobby stores, as well as the national discount
      retailers. Key customers in our chain retailer channel include Wal-Mart, Toys
      “R” Us/Babies “R” Us, Target, Kohl’s, Tractor Supply Company and Michaels
      Stores, Inc. Sales in 2006 to chain retailers were 68.0% of our net
      sales.





***Specialty
      retailers, wholesalers and OEM dealers.*** We sell
      many of the products available at chain retailers as well as higher priced
      products with special features to specialty retailers, wholesalers and OEM
      dealers, which comprised 29.2% of our net sales in 2006. 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 and 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, Horizon Hobby, John Deere and Case New Holland.





***Corporate
      promotional, direct to consumers and other.*** We make
      certain products available to corporate promotional accounts and to
      consumers through company stores and our websites located at
      www.diecastexpress.com and 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 2.8% of our net sales in 2006.





**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. ****





**Sales
      and Marketing**





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





Our
      internal sales force is supplemented by external sales representative
      organizations. These external sales representative organizations provide more
      frequent customer contact and solicitation of the national, regional and
      specialty retailers and supported 30.2% of our net sales in 2006. External
      sales
      representatives generally earn commissions of 1.0% to 12.0% 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.





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





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





6








**·**
            *Digital
                Marketing.*The Internet and other digital media are an increasingly important
                part of
                our marketing plan because consumers have quickly adopted the Internet
                as
                a preferred way to communicate with others about their product preferences
                and purchases. Our websites, www.learningcurve.com,
                www.johnnylightning.com and www.ertl.com, highlight our products,
                list
                product release dates and collect market data directly from consumers.
                We
                also gather consumer information through consumer letters, e-mails,
                telephone calls, product surveys and focus
                groups.





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





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





**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, infant products and collectibles.
      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.





***Far
      east product sourcing.*** We have
      operations in Kowloon, Hong Kong and in the RC2 Industrial Zone in Dongguan
      City, China and employ 272 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,
      certain infant products and certain apparel items. Our China-based product
      sourcing accounted for 91.8% of our product purchases in 2006. We primarily
      use
      seven third-party, dedicated suppliers who manufacture only our products in
      eight 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 three freestanding factory
      facilities. Most of our third-party, dedicated suppliers have been supplying
      us
      for more than ten years. These seven third-party, dedicated suppliers produced
      47.9% of our China-based product purchases in 2006. 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.








7





***Domestic
      production.*** The
      production of certain plastic ride-ons, certain infant products, and certain
      apparel items 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, and are periodically reviewed and approved by independent safety
      testing laboratories. We carry product liability insurance coverage with a
      limit
      of over $60.0 million per occurrence.





***Logistics.*** We own a
      distribution facility in Dyersville, Iowa, lease distribution facilities in
      Rochelle, Illinois, and Australia, and use independent warehouses in California,
      Illinois, 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 61.6%
      of our net sales for the three years ended December 31, 2006, were
      generated in the second half of the year, with September, October and November
      being the largest shipping months. As a result, consistent with industry
      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 five customers accounted for 39.3%, 48.7% and 51.8% of our net sales
      in
      2004, 2005 and 2006, respectively. Wal-Mart, our largest customer, accounted
      for
      13.4% and 16.3% of our net sales in 2005 and 2006, respectively. Toys “R”
Us/Babies “R” Us accounted for 10.9%, 15.1% and 14.8% of our net sales in 2004,
      2005 and 2006, respectively. Target accounted for 12.0% and 13.1% of our net
      sales in 2005 and 2006, respectively. Other than Toys “R” Us/Babies “R” Us,
      Wal-Mart and Target, no customer accounted for more than 10.0% of our net sales
      in 2005 or 2006. Other than Toys “R” Us/Babies “R” Us, no customer accounted for
      more than 10.0% of our net sales in 2004. 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, 2006, we had 821 employees, 44 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 116 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.





**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 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, 2006, 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 the Company’s total net sales. Over
      the next two years, license agreements in connection with several key licensed
      properties, including licenses for certain *Winnie
      the Pooh* ,
      Disney
      Princess, *Finding
      Nemo, Bob the Builder* ,
      Ford
      Motor Company and DaimlerChrysler Corporation 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. For example, in 2006 we entered
      into two new license agreements with HIT Entertainment with respect to certain *Thomas
      & Friends* product
      lines which increased royalties and minimum guarantee payments starting in
      2007.
      In addition, licenses granted to other parties, whether or not exclusive, could
      limit our ability to market products, including products we currently market,
      which could cause our net sales and profitability to decline. ****





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





We
      operate in highly competitive markets. We compete with several large domestic
      and foreign companies such as Mattel, Inc. and Hasbro, Inc., with private label
      products sold by many of our retail customers and with other producers of infant
      products, toys and collectibles. 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.








9





**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 LCI effective February 28, 2003, PM effective June 1, 2004,
      and TFY effective September 15, 2004. The integration of acquired companies
      and their operations into our operations involves a number of risks
      including:





**·**
            the
                acquired business may experience losses 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. A portion 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
      2006,
      we sold 68.0% of our products to chain retailers. Our success depends upon
      the
      continuing willingness of these retailers to purchase and provide shelf space
      for our products. We do not have long-term contracts with our customers. In
      addition, our access to shelf space at retailers may be reduced by store
      closings, consolidation among these retailers and competition from other
      products. An adverse change in our relationship with or the financial viability
      of one or more of our customers could reduce our net sales and
      profitability.





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





Many
      of
      our retail customers generally purchase large quantities of our products on
      credit, which may cause a concentration of accounts receivable among some of
      our
      largest customers. Our profitability may be harmed if one or more of our largest
      customers were unable or unwilling to pay these accounts receivable when due
      or
      demand credits or other concessions for products they are unable to sell. We
      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, 2005 and 2006, our credit insurance covered
      7.2% and 6.3%, 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 seven third-party, dedicated suppliers in China to manufacture a majority
      of
      our products in eight 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 91.8% of our product purchases in
      2006. The seven third-party, dedicated suppliers who manufacture only our
      products accounted for 47.9% of our China-based product purchases in 2006.
      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.





10





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





Since
      our
      products are manufactured by third-party suppliers, we do not directly purchase
      the raw materials used to manufacture our products. However, the prices we
      pay
      our suppliers may increase if their raw materials, labor or other costs
      increase. We may not be able to pass along such price increases to our
      customers. As a result, increases in the cost of raw materials, labor or other
      costs associated with the manufacturing of our products could increase our
      cost
      of sales and reduce our gross margins. 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 may continue to
      reduce our gross margins in 2007.





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





Our
      net
      sales are primarily denominated in U.S. dollars, with 15.5% of our net sales
      in
      2006 denominated in British pounds sterling, Australian dollars, Euros or
      Canadian dollars. Our purchases of finished goods from Chinese manufacturers
      are
      denominated in Hong Kong dollars. Expenses for these manufacturers are
      denominated in Chinese Renminbi. As a result, any material increase in the
      value
      of the Hong Kong dollar or the Renminbi relative to the U.S. dollar 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.





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.





**Product
      liability, product recalls and other 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
      if
      any products marketed under the license are subject to a product liability
      claim, recall or similar violations of product safety regulations or if we
      breach covenants relating to the safety of the products or their compliance
      with
      product safety regulations. A termination of a license could adversely affect
      our net sales. Even if a product liability claim is without merit, the claim
      could harm our reputation and divert management’s attention and resources from
      our business.





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





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





11





**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.





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





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





**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.





**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 which is not supported by
      our
      board of directors.**





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





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


**·**
            covenants
                in our credit agreement restricting mergers, asset sales and similar
                transactions and a provision in our credit agreement that triggers
                an
                event of default upon the acquisition by a person or 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.








12





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.





**Item
      2. Properties**





As
      of
      December 31, 2006, our facilities were as follows: ****





**Description**
            **Square
                Feet**
            **Location**
            **Lease
                Expiration**Corporate
                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. showroom
            9,240
            
            New
                York, NY
            April
                2009Learning
                Curve Brands, Inc. office (1)
            6,844
            
            Chicago,
                IL
            May
                2007Learning
                Curve Brands, Inc. company store
            5,500
            
            Oakbrook
                Terrace, IL
            July
                2010Learning
                Curve Brands, Inc. office
            2,755
            
            Bentonville,
                AR
            October
                2008Learning
                Curve Brands, Inc. office
            1,932
            
            Huntington
                Beach, CA
            May
                2007Learning
                Curve Brands, Inc. storage
            1,250
            
            Stoughton,
                MA
            May
                2007Learning
                Curve Brands, Inc. office (1)
            1,100
            
            Bentonville,
                AR
            February 2007Learning
                Curve Brands, Inc. office
            938
            
            Edina,
                MN
            August
                2009Learning
                Curve Brands, Inc. office
            495
            
            Danbury,
                CT
            March
                2007Learning
                Curve Brands, Inc. office
            108
            
            Kansas
                City, MO
            May
                2007RC2
                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
                2008Hong
                Kong office
            10,296
            
            Kowloon,
                Hong Kong
            July
                2008Racing
                Champions International Limited office
            8,419
            
            Exeter,
                United Kingdom
            October
                2013Racing
                Champions International Limited office
              and
                showroom
            2,035
            
            Thatcham,
                United Kingdom
            August
                2011Racing
                Champions International Limited office
            667
            
            Saint
                Germain en Laye, France
            December
                2012Racing
                Champions International Limited office
            603
            
            Laren,
                Holland
            December
                2010RC2
                Canada Corporation warehouse (2)
            47,000
            
            Concord,
                Ontario
            May
                2010RC2
                Canada Corporation office (1)
            2,220
            
            New
                Market, Ontario
            January
                2007RC2
                Deutschland GmbH office
            2,184
            
            Marsdof,
                Germany
            December
                2007RC2
                Australia, Pty. Ltd. office and warehouse
            49,127
            
            Mount
                Waverly, Victoria, Australia
            December
                2009





(1)
            This
                facility is no longer being used in our operations. We will allow
                the
                lease to expire.


(2)
            As
                of January 1, 2004, the Canadian warehouse was no longer being used
                in our operations and has been subsequently sublet.








13





**Item
      3. Legal Proceedings**





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





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





No
      matters were submitted to a vote of security holders during the fourth quarter
      of the fiscal year ended December 31, 2006.







**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.





**2005:**
            **High**
            **Low**First
                Quarter
            $34.64
            $28.56Second
                Quarter
            38.40
            31.82Third
                Quarter
            41.27
            33.24Fourth
                Quarter
            $37.26
            $31.90





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





As
      of
      December 31, 2006, there were approximately 142 holders of record of our
      common stock. We believe the number of beneficial owners of our common stock
      on
      that date was substantially greater.





**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.








14





**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, 2004, 2005 and 2006, and the consolidated
      balance sheet data as of December 31, 2005 and 2006, are derived from our
      audited consolidated financial statements included elsewhere herein. The
      consolidated statements of earnings for the years ended December 31, 2002
      and 2003, and the consolidated balance sheet data as of December 31, 2002,
      2003 and 2004, are derived from our audited consolidated financial statements,
      as adjusted for discontinued operations, that are not included
      herein.





**Year
                Ended December 31,****2002**
            
            **2003**
            
            **2004**
            
            **2005**
            
            **2006****Consolidated
                Statements of Earnings:**
            
            (in
                thousands, except per share data)Net
                sales
            
            $
            198,790
            
            $
            296,689
            
            $
            367,687
            
            $
            492,766
            
            $
            518,829Cost
                of sales (1)
            
            
            96,612
            
            
            142,918
            
            
            186,813
            
            
            252,935
            
            
            275,754Restructuring
                charge related to discontinued
              automotive
                collectibles
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            1,872Gross
                profit
            
            
            102,178
            
            
            153,771
            
            
            180,874
            
            
            239,831
            
            
            241,203Selling,
                general and administrative expenses (1)
            
            
            64,591
            
            
            100,385
            
            
            121,785
            
            
            150,381
            
            
            155,180Amortization
                of intangible assets
            
            
            —
            
            
            30
            
            
            94
            
            
            1,385
            
            
            1,149Impairment
                of intangible assets
            
            
            —
            
            
            327
            
            
            4,318
            
            
            —
            
            
            —Gain
                on sale of W. Britain product line
            
            
            —
            
            
            —
            
            
            —
            
            
            (1,953
            )
            
            —Restructuring
                charge related to discontinued
              automotive
                collectibles
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            12,631Operating
                income
            
            
            37,587
            
            
            53,029
            
            
            54,677
            
            
            90,018
            
            
            72,243Interest
                expense, net
            
            
            1,836
            
            
            3,477
            
            
            4,063
            
            
            5,983
            
            
            3,465Other
                (income) expense
            
            
            (603
            )
            
            (145
            )
            
            (508
            )
            
            146
            
            
            530Income
                from continuing operations
              before
                income taxes
            
            
            36,354
            
            
            49,697
            
            
            51,122
            
            
            83,889
            
            
            68,248Income
                tax expense
            
            
            14,327
            
            
            13,904
            
            
            18,755
            
            
            31,153
            
            
            24,478Income
                from continuing operations
            
            
            22,027
            
            
            35,793
            
            
            32,367
            
            
            52,736
            
            
            43,770Income
                (loss) from discontinued operations,
              net
                of tax
            
            
            2,718
            
            
            2,624
            
            
            1,611
            
            
            394
            
            
            (9,676
            )Net
                income
            
            $
            24,745
            
            $
            38,417
            
            $
            33,978
            
            $
            53,130
            
            $
            34,094Basic
                earnings per common share:Income
                from continuing operations
            
            $
            1.38
            
            $
            2.10
            
            $
            1.73
            
            $
            2.56
            
            $
            2.09Income
                (loss) from discontinued operations
            
            
            0.17
            
            
            0.15
            
            
            0.09
            
            
            0.02
            
            
            (0.46
            )Net
                income
            
            $
            1.55
            
            $
            2.25
            
            $
            1.82
            
            $
            2.58
            
            $
            1.63Diluted
                earnings per common share:Income
                from continuing operations
            
            $
            1.31
            
            $
            1.98
            
            $
            1.64
            
            $
            2.45
            
            $
            2.04Income
                (loss) from discontinued operations
            
            
            0.16
            
            
            0.14
            
            
            0.08
            
            
            0.02
            
            
            (0.45
            )Net
                income
            
            $
            1.47
            
            $
            2.12
            
            $
            1.72
            
            $
            2.47
            
            $
            1.59Weighted
                average shares outstanding:Basic
            
            
            15,981
            
            
            17,060
            
            
            18,687
            
            
            20,613
            
            
            20,884Diluted
            
            
            16,829
            
            
            18,105
            
            
            19,761
            
            
            21,532
            
            
            21,377





**As
                of December 31,****2002**
            
            **2003**
            
            **2004**
            
            **2005**
            
            **2006****Consolidated
                Balance Sheet Data:**Working
                capital
            
            $
            49,540
            
            $
            70,471
            
            $
            112,931
            
            $
            113,286
            
            $
            129,602Total
                assets
            
            
            236,287
            
            
            381,829
            
            
            585,748
            
            
            629,736
            
            
            614,640Total
                debt
            
            
            8,000
            
            
            85,000
            
            
            131,250
            
            
            82,647
            
            
            22,438Total
                stockholders’ equity
            
            $
            170,881
            
            $
            225,299
            
            $
            346,762
            
            $
            398,951
            
            $
            451,926





(1)
      Depreciation expense was $8.9 million, $11.9 million,
      $15.3 million, $14.4 million and $14.1 million for the years
      ended December 31, 2002, 2003, 2004, 2005 and 2006,
      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. 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 or TFY. 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.





15





**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 products that are targeted to consumers of all ages.
      We
      reach our target consumers through multiple channels of distribution supporting
      more than 25,000 retail outlets throughout North America, Europe, Australia
      and
      Asia Pacific. Our product categories include (i) 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 500 license agreements, approximately 400 of which
      are
      actively used in our current product lines.





***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, direct to consumer
      and
      other. For the years ended December 31, 2004, 2005 and 2006, sales to chain
      retailers comprised 54.3%, 63.8% and 68.0%, respectively, of our net
      sales.





Our
      products are marketed and distributed in North America, Europe, Australia and
      Asia Pacific. International sales, defined as sales outside of North America,
      constituted 13.8%, 14.5% and 16.7% of our net sales for the years ended
      December 31, 2004, 2005 and 2006, respectively. We expect international
      sales to increase over the next several years as we expand our geographic reach.
      Our net sales have not been materially impacted by foreign currency
      fluctuations.





We
      derive
      a significant portion of our sales from some of the world’s largest retailers.
      Our top five customers accounted for 39.3%, 48.7% and 51.8% of our net sales
      in
      2004, 2005 and 2006, respectively. Wal-Mart, our largest customer accounted
      for
      13.4% and 16.3% of our net sales in 2005 and 2006, respectively. Toys “R”
Us/Babies “R” Us accounted for 10.9%, 15.1% and 14.8% of our net sales in 2004,
      2005 and 2006, respectively. Target accounted for 12.0% and 13.1% of our net
      sales in 2005 and 2006, respectively. In 2004, other than Toys “R” Us/Babies “R”
Us, no customer accounted for more than 10.0% of our net sales. Other than
      Toys
“R” Us/Babies “R” Us, Wal-Mart and Target, no customer accounted for more than
      10.0% of our net sales in 2005 or 2006.





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,
      2004, 2005 and 2006, direct sales from China constituted 13.5%, 10.5% and 14.7%,
      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 5.2% to 6.4% of our net sales over the last three
      years.





***Expenses.*** Our
      products are manufactured by third-parties, principally located in China. Cost
      of sales primarily consists of purchases of finished products, which accounted
      for 79.5%, 81.7% and 82.5% of our cost of sales in 2004, 2005 and 2006,
      respectively. The remainder of our cost of sales primarily includes tooling
      depreciation, freight-in from suppliers, concept and design expenses, employee
      compensation and expense related to stock-based payment arrangements.
      Substantially all of our purchases of finished products from the Far East are
      denominated in Hong Kong dollars, and therefore, subject to currency
      fluctuations. Historically, we have not incurred substantial exposure due to
      currency fluctuations because since 1983 the Hong Kong government has maintained
      a policy of linking the Hong Kong dollar and the U.S. dollar. A future increase
      in the value of the Hong Kong dollar relative to the U.S. dollar may increase
      our cost of sales and decrease our gross margins. ****





Additionally,
      if our suppliers experience increased raw materials, labor or other costs and
      pass along such cost increases to us through higher prices for finished goods,
      our cost of sales would increase, and to the extent we are unable to pass such
      price increases along to our customers, our gross margins would decrease. 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 may continue to reduce our gross margins in
      2007.





16





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 and expense related to stock-based payment arrangements.
      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
      2006, aggregate royalties by product ranged from approximately 1.0% to 19.0%
      of
      our net sales price. Royalty expense was approximately 8.0%, 6.6% and 7.4%
      of
      our net sales for the years ended December 31, 2004, 2005 and 2006,
      respectively. In 2006, we signed two new license agreements with HIT
      Entertainment with respect to certain *Thomas
      & Friends* product
      lines. Based on the new agreements, we expect our total pre-tax licensing cost,
      net of expected price increases and margin improvements, for these *Thomas
      & Friends* licenses
      will increase by approximately $4.0 million in 2007 when compared to 2006.
      Sales commissions ranged from approximately 1.0% to 12.0% of the net sales
      price
      and are generally paid quarterly to our external sales representative
      organizations. Sales subject to commissions represented 32.1%, 31.1% and 30.2%
      of our net sales for the years ended December 31, 2004, 2005 and 2006,
      respectively. Sales commission expense was 1.6%, 1.3% and 1.2% of our net sales
      for the years ended December 31, 2004, 2005 and 2006,
      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 our new product launches and to build consumer awareness of our
      owned
      brands, we are planning new investment spending of approximately $9 million
      in 2007. We estimate that $5 million to $7 million of this amount will
      be expensed in 2007. This spending will be 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 61.6%
      of our net sales for the three years ended December 31, 2006, 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 fourth quarters and lowest during the first and second
      quarters.








17


**Results
      of Operations**


**Year
                Ended December 31,****2004**
            
            **2005**
            
            **2006****Amount**
            
            **Percent**
            
            **Amount**
            
            **Percent**
            
            **Amount**
            
            **Percent**(in
                thousands, except per share data)Net
                sales
            
            $
            367,687
            
            
            100.0
            %
            $
            492,766
            
            
            100.0
            %
            $
            518,829
            
            
            100.0
            %Cost
                of sales
            
            
            186,813
            
            
            50.8
            
            
            252,935
            
            
            51.3
            
            
            275,754
            
            
            53.1Restructuring
                charge related to discontinued
              automotive
                collectibles
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            1,872
            
            
            0.4Gross
                profit
            
            
            180,874
            
            
            49.2
            
            
            239,831
            
            
            48.7
            
            
            241,203
            
            
            46.5Selling,
                general and
              administrative
                expenses
            
            
            121,785
            
            
            33.1
            
            
            150,381
            
            
            30.5
            
            
            155,180
            
            
            29.9Amortization
                of intangible assets
            
            
            94
            
            
            —
            
            
            1,385
            
            
            0.3
            
            
            1,149
            
            
            0.3Impairment
                of intangible assets
            
            
            4,318
            
            
            1.2
            
            
            —
            
            
            —
            
            
            —
            
            
            —Gain
                on sale of W. Britain product line
            
            
            —
            
            
            —
            
            
            (1,953
            )
            
            (0.4
            )
            
            —
            
            
            —Restructuring
                charge related to discontinued
              automotive
                collectibles
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            12,631
            
            
            2.4Operating
                income
            
            
            54,677
            
            
            14.9
            
            
            90,018
            
            
            18.3
            
            
            72,243
            
            
            13.9Interest
                expense, net
            
            
            4,063
            
            
            1.1
            
            
            5,983
            
            
            1.2
            
            
            3,465
            
            
            0.7Other
                (income) expense
            
            
            (508
            )
            
            (0.1
            )
            
            146
            
            
            —
            
            
            530
            
            
            0.1Income
                from continuing operations
              before
                income taxes
            
            
            51,122
            
            
            13.9
            
            
            83,889
            
            
            17.1
            
            
            68,248
            
            
            13.1Income
                tax expense
            
            
            18,755
            
            
            5.1
            
            
            31,153
            
            
            6.3
            
            
            24,478
            
            
            4.7Income
                from continuing operations
            
            
            32,367
            
            
            8.8
            
            
            52,736
            
            
            10.8
            
            
            43,770
            
            
            8.4Income
                (loss) from discontinued
              operations,
                net of tax
            
            
            1,611
            
            
            0.4
            
            
            394
            
            
            —
            
            
            (9,676
            )
            
            (1.9
            )Net
                income
            
            $
            33,978
            
            
            9.2
            %
            $
            53,130
            
            
            10.8
            %
            $
            34,094
            
            
            6.5
            %Basic
                earnings per common share:Income
                from continuing operations
            
            $
            1.73
            
            
            
            
            $
            2.56
            
            
            
            
            $
            2.09Income
                (loss) from discontinued
              operations
            
            
            0.09
            
            
            
            
            
            0.02
            
            
            
            
            
            (0.46
            )Net
                income
            
            $
            1.82
            
            
            
            
            $
            2.58
            
            
            
            
            $
            1.63Diluted
                earnings per common share:Income
                from continuing operations
            
            $
            1.64
            
            
            
            
            $
            2.45
            
            
            
            
            $
            2.04Income
                (loss) from discontinued
              operations
            
            
            0.08
            
            
            
            
            
            0.02
            
            
            
            
            
            (0.45
            )Net
                income
            
            $
            1.72
            
            
            
            
            $
            2.47
            
            
            
            
            $
            1.59Weighted
                average shares outstanding:Basic
            
            
            18,687
            
            
            
            
            
            20,613
            
            
            
            
            
            20,884Diluted
            
            
            19,761
            
            
            
            
            
            21,532
            
            
            
            
            
            21,377





**Operating
      Highlights**





Net
      sales
      for the year ended December 31, 2006, increased 5.3%. Gross margin
      decreased to 46.5% for 2006 from 48.7% for 2005. Selling, general and
      administrative expenses as a percentage of net sales decreased to 29.9% for
      2006
      from 30.5% for 2005. Operating income decreased to $72.2 million for 2006
      compared to $90.0 million for 2005. As a percentage of net sales, operating
      income decreased to 13.9% for 2006 from 18.3% for 2005.





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. Operating income for the year
      ended December 31, 2006 includes $3.9 million in compensation expense
      for stock options as a result of the Company’s adoption of SFAS No. 123R
      which negatively impacted diluted earnings per share from continuing operations
      by $0.11. Results for the years ended December 31, 2004 and 2005 do not
      include compensation expense for stock options.





18





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 on the sale of $11.4 million,
      net of income tax benefit, was recognized on this sales transaction. The loss
      is
      presented in income (loss) from discontinued operations, net of tax, on the
      accompanying consolidated statement of earnings for the year ended
      December 31, 2006.





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,
      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.





Results
      for 2004 were negatively impacted by the Company’s decision to discontinue
      certain low-performing product lines as well as its distribution at NASCAR
      trackside sales events. In 2004, the Company recorded a non-cash impairment
      charge of $4.3 million, or $2.7 million net of income tax benefits, to
      write-off intangible license and trademark assets recorded at the time of the
      Learning Curve acquisition. In addition, charges to write-off undepreciated
      tooling and fixed assets and to provide inventory and royalty reserves related
      to the discontinued product lines and trackside sales distribution totaled
      $4.2
      million, or $2.7 million net of income tax benefits. The Company also
      recorded an adjustment to the income tax provision of $0.6 million in 2004.
      The combined impact of these charges on the Company’s diluted earnings per share
      was $0.30 for the year ended December 31, 2004. ****





Results
      for 2004 include PM from June 1, 2004, and TFY from September 16,
      2004.





**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 Sales**2006
                  actual
              
              $
              518.8Deduct:
                  sold and discontinued product lines
              
              
              37.4$
              481.42005
                  actual
              
              $
              492.8Deduct:
                  sold and discontinued product lines
              
              
              62.9$
              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 options. Results for the year ended December 31, 2005 do
      not include compensation expense for stock options.  Pro forma compensation
      expense for stock options for the year ended December 31, 2005 was $3.3
      million.





19





***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.





***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, 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%.





**Year
      Ended December 31, 2005, Compared to Year Ended December 31,
      2004**





***Net
      sales.*** Net
      sales increased $125.1 million, or 34.0%, to $492.8 million for 2005
      from $367.7 million for 2004. This sales increase was primarily
      attributable to the addition of TFY for the full year of 2005 versus only
      three-and-a-half months in 2004, as well as growth in our preschool products
      category. 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 infant and toddler products category increased 165.9% primarily due
      to
      the addition of TFY. Net sales in our preschool products category increased
      20.1% primarily driven by strong performance of *Thomas
      & Friends* and John
      Deere toy vehicles and our ride-on products, as well as sales of our new *Bob
      the Builder* product
      line. Net sales in our youth and adult products category decreased 5.8%
      primarily due to the continued tough comparisons to both *The
      Fast and The Furious* and *American
      Chopper/Orange County Chopper* product
      lines in 2004, the discontinuance of Memory Lane seasonal figures, lower overall
      NASCAR product sales and the discontinuance of distribution at NASCAR trackside
      events in 2005.





***Gross
      profit.*** Gross
      profit increased $58.9 million, or 32.6%, to $239.8 million for 2005
      from $180.9 million for 2004 . The gross profit margin, as a percentage of
      net sales, decreased to 48.7% for 2005 compared to 49.2% for 2004. Gross profit
      for 2004 was adversely affected by $3.0 million in non-recurring charges to
      write-off undepreciated tooling and to provide for inventory related to the
      discontinued product lines and trackside sales distribution. There were no
      major
      changes in the components of cost of sales.





***Selling,
      general and administrative expenses.*** Selling,
      general and administrative expenses increased $28.6 million, or 23.5%, to
      $150.4 million for 2005 from $121.8 million for 2004. As a percentage
      of net sales, selling, general and administrative expenses decreased to 30.5%
      for 2005 from 33.1% for 2004. Selling, general and administrative expenses
      for
      2004 include $1.2 million in non-recurring charges. The decrease in
      selling, general and administrative expenses as a percentage of net sales was
      primarily due to operating leverage gained from the increased sales from the
      2004 acquisitions, integration cost savings and disciplined control over
      discretionary operating expenses. Results for the years ended December 31,
      2004 and 2005 do not include compensation expense for stock options.





***Operating
      income.*** Operating income increased to $90.0 million for 2005 from
      $54.7 million for 2004. As a percentage of net sales, operating income
      increased to 18.3% for 2005 from 14.9% for 2004. 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. Operating income for 2004 includes
      $8.5 million in non-recurring charges related to the discontinuance of
      certain product lines and our NASCAR trackside distribution.





***Net
      interest expense.*** Net
      interest expense of $6.0 million for 2005 and $4.1 million for 2004
      relates primarily to bank term loans and lines of credit. The increase in net
      interest expense for 2005 was primarily due to the increase in average
      outstanding debt balances and an increase in the Company’s incremental borrowing
      rate.





***Income
      tax.*** 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%. Income tax expense of $18.8 million
      for 2004 includes an adjustment to the income tax provision of
      $0.06 million, or $0.03 per diluted share. Income tax expense in 2004
      includes provisions for federal, state and foreign income taxes at an effective
      rate of 36.7%.





20





**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 $61.8 million in 2006, $59.1 million in
      2005 and $64.1 million in 2004.





Working
      capital increased $16.3 million to $129.6 million at December 31,
      2006, from $113.3 million at December 31, 2005. Cash and cash
      equivalents increased $0.1 million to $25.4 million at
      December 31, 2006, from $25.3 million at December 31, 2005. Our
      accounts receivable decreased $0.2 million to $112.9 million at
      December 31, 2006, from $113.1 million at December 31, 2005. Our
      inventory level increased $12.4 million to $83.7 million at
      December 31, 2006, from $71.3 million at December 31,
      2005.





Net
      cash
      used in investing activities was $8.3 million in 2006, $6.6 million in
      2005 and $185.0 million in 2004. Capital expenditures for molds and tooling
      in 2006 and 2005 were $14.4 million and $14.1 million, respectively,
      and we expect capital expenditures for 2007, principally for molds and tooling,
      to be approximately $16.0 million.





Net
      cash
      used in financing activities in 2006 and 2005 was $54.5 million and
      $46.5 million, respectively. Net cash provided by financing activities
      in 2004 was $123.4 million. In 2006, we made payments of $42.3 million
      on our term loans. During 2006, we borrowed a total of $18.0 million and
      made total payments of $36.3 million on our lines of credit. At
      December 31, 2006, we had $99.6 million available on our domestic line
      of credit. Historically, we have used a significant portion of excess cash
      to
      pay down 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. This additional capacity is currently
      uncommitted by the lenders and must be approved by the lenders upon the
      Company’s request for borrowing. Principal payments ranging from
      $3.8 million to $6.5 million on the term loan are scheduled quarterly
      beginning December 31, 2004 and continue thereafter until December 31,
      2007. The revolving line of credit is available until its maturity on September
      14, 2008. A portion of the term loan has an interest rate of 3.45% plus
      applicable margin through the first three years of the facility. The remaining
      term loan and revolving line of credit bear interest, at the Company’s option,
      at a base rate or at a LIBOR rate plus applicable margin. The applicable margin
      is based on the Company’s ratio of consolidated debt to consolidated EBITDA
      (earnings before interest, taxes, depreciation, amortization and non-cash
      expense related to equity awards) and varies between 0.75% and 1.625%. At
      December 31, 2006, the margin in effect was 0.75% for LIBOR loans. The
      Company is also required to pay a commitment fee of 0.20% to 0.35% per annum
      on
      the average daily unused portion of the revolving line of credit. At
      December 31, 2006, the commitment fee in effect was 0.20% per annum. Under
      the terms of this credit facility, the Company is required to comply with
      certain financial and non-financial covenants. Among other restrictions, the
      Company is restricted in its ability to pay dividends, incur additional debt
      and
      make acquisitions above certain amounts. The key financial covenants include
      minimum EBITDA and interest coverage and leverage ratios. The credit facility
      is
      secured by working capital assets and certain intangible assets. On
      December 31, 2006, the Company had $22.4 million outstanding on the
      term loan and no amounts outstanding on the revolving line of credit and
      was in compliance with all covenants.





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





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, 2005 and 2006, there were no outstanding
      borrowings under this line of credit.





The
      Company’s United Kingdom subsidiary maintains a line of credit with a bank for
      $0.2 million that expires on July 31, 2007. The line of credit bears
      interest at 1.0% over the bank’s base rate, and the total amount is subject to a
      letter of guarantee given by the Company. At December 31, 2005 and 2006,
      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.





21





The
      following table summarizes our significant contractual commitments at
      December 31, 2006:





**Payment
                Due by Period**(in
                thousands)
              **Contractual
                Obligations**
            
            **Total**
            
            **2007**
            
            **2008-2009**
            
            **2010-2011**
            
            **2012
                and**
              **beyond**Long-term
                debt (including current portion)
            
            $
            22,438
            
            $
            22,438
            
            $
            —
            
            $
            —
            
            $
            —Estimated
                future interest payments
              on
                long-term debt
            
            
            632
            
            
            632
            
            
            —
            
            
            —
            
            
            —Minimum
                guaranteed royalty payments
            
            
            50,702
            
            
            10,288
            
            
            16,485
            
            
            15,689
            
            
            8,240Operating
                leases
            
            
            30,249
            
            
            4,644
            
            
            7,626
            
            
            4,835
            
            
            13,144Unconditional
                purchase obligations
            
            
            83,952
            
            
            21,528
            
            
            42,024
            
            
            20,400
            
            
            —Total
                contractual cash obligations
            
            $
            187,973
            
            $
            59,530
            
            $
            66,135
            
            $
            40,924
            
            $
            21,384





Estimated
      future interest payments on long-term debt were based upon the interest rates
      in
      effect at December 31, 2006.





On
      February 22, 2007, we announced that our Board of Directors authorized a
      stock repurchase program to repurchase up to $75 million in shares of our common
      stock. The program has initially been authorized for a period of one year,
      but
      may be extended beyond that period or may be suspended at any time. Repurchases
      may occur from time to time and are expected be funded by cash flow from
      operations.





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 2007. 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 the 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, 2004, 2005 and 2006.





**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.





22





***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 had been amortized
      over 40 years on a straight-line basis through December 31, 2001.
      Approximately $88.7 million of this goodwill is tax deductible over 15
      years. ****





As
      of
      December 31, 2005 and 2006, goodwill, net of accumulated amortization, was
      $253.6 million and $239.1 million, respectively. The decrease in
      goodwill at December 31, 2006, was due to the completion of the sale of the
      RC2 South, Inc. business. The Company completed its annual goodwill impairment
      tests as of October 1, 2005 and 2006 which resulted in no impairment. The
      annual impairment tests for intangible assets in 2005 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.





***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. In determining
      the
      required liability, management considers certain tax exposures and all available
      evidence. However, if the available evidence were to change in the future,
      an
      adjustment to the tax-related balances may be required. Estimates for such
      tax
      contingencies are classified in other non-current liabilities on the
      accompanying consolidated balance sheets.





***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. The Company’s products currently carry a limited warranty
      which guarantees the product to be free from defects in material and workmanship
      under normal and intended use for a period of 90 days from the date of consumer
      purchase. Historical results of product warranty claims have shown that they
      have had an immaterial impact on the Company. Based upon the historical results,
      appropriate allowances for product warranty claims are accrued throughout the
      year.





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





***Stock-based
      compensation.*** On
      January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based
      Payments.” The Company elected to use the modified prospective application of
      SFAS No. 123R for awards issued prior to January 1, 2006. Income from
      continuing operations before income taxes for the year ended December 31,
      2006 includes total expense recognized for stock-based payment
      plans.





23





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. The Company
      calculates the expected volatility factor for those options issued under the
      stock incentive plan to correspond with the average volatility factor of those
      companies included in a peer group study. The historical stock price movements
      of the Company’s common stock have not been considered a good indicator of
      expected future volatility because the Company’s business has changed
      significantly as a result of acquisitions completed. However, the Company
      continues to monitor its actual volatility to assess whether its historical
      stock price movements over the expected option term are a good indicator of
      expected future results.





The
      Company uses historical data to estimate share option exercise and employee
      departure behavior used in the Black-Scholes option pricing model. The expected
      term of 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.





**Recently
      Issued Accounting Pronouncements**





In
      June
      2006, the FASB issued FASB Interpretation 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. This Interpretation is effective for fiscal
      years beginning after December 15, 2006. The Company is currently assessing
      the impact that this Interpretation will have on the Company’s financial
      statements.





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.





**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, 2006, a one percentage point increase in average interest
      rates on the Company’s borrowings would increase future interest expense by
      $1,664 per month and a five percentage point increase would increase future
      interest expense by approximately $8,318 per month. The Company determined
      these
      amounts based on approximately $2.0 million of variable rate borrowings at
      December 31, 2006, 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.








24





The
      Company’s net sales are primarily denominated in U.S. dollars, with 15.5% of net
      sales in 2006 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, 2006, would have changed the total dollar amount of our gross
      profit by 9.6%. 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, 2006, 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
      Sates. Historically, the Company has not used hedges or other derivative
      financial instruments to manage or reduce exchange rate risk.





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





**Financial
      Statements**





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








25





**Quarterly
      Results of Operations**





The
      following tables set forth our unaudited quarterly results of operations for
      2005 and 2006. 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 2005**(in
                thousands, except per share data)
            
            **Q1**
            
            **Q2**
            
            **Q3**
            
            **Q4**Net
                sales
            
            $
            94,704
            
            $
            104,231
            
            $
            139,895
            
            $
            153,936Cost
                of sales (1)
            
            
            46,561
            
            
            53,894
            
            
            71,280
            
            
            81,200Gross
                profit
            
            
            48,143
            
            
            50,337
            
            
            68,615
            
            
            72,736Selling,
                general and administrative expenses (1)
            
            
            34,640
            
            
            34,843
            
            
            38,536
            
            
            42,362Amortization
                of intangible assets
            
            
            94
            
            
            156
            
            
            845
            
            
            290Gain
                on sale of W. Britain product line
            
            
            —
            
            
            —
            
            
            (1,953
            )
            
            —Operating
                income
            
            
            13,409
            
            
            15,338
            
            
            31,187
            
            
            30,084Interest
                expense, net
            
            
            1,321
            
            
            1,714
            
            
            1,522
            
            
            1,426Other
                (income) expense
            
            
            (85
            )
            
            (266
            )
            
            4
            
            
            493Income
                before income taxes
            
            
            12,173
            
            
            13,890
            
            
            29,661
            
            
            28,165Income
                tax expense
            
            
            4,383
            
            
            4,649
            
            
            11,223
            
            
            10,898Income
                from continuing operations
            
            
            7,790
            
            
            9,241
            
            
            18,438
            
            
            17,267Income
                (loss) from discontinued operations,
              net
                of tax
            
            
            38
            
            
            522
            
            
            (178
            )
            
            12Net
                income
            
            $
            7,828
            
            $
            9,763
            
            $
            18,260
            
            $
            17,279Basic
                earnings per common share:Income
                from continuing operations
            
            $
            0.38
            
            $
            0.45
            
            $
            0.89
            
            $
            0.83Income
                (loss) from discontinued operations
            
            
            —
            
            
            0.02
            
            
            (0.01
            )
            
            —Net
                income
            
            $
            0.38
            
            $
            0.47
            
            $
            0.88
            
            $
            0.83Diluted
                earnings per common share:Income
                from continuing operations
            
            $
            0.37
            
            $
            0.43
            
            $
            0.86
            
            $
            0.80Income
                (loss) from discontinued operations
            
            
            —
            
            
            0.02
            
            
            (0.01
            )
            
            —Net
                income
            
            $
            0.37
            
            $
            0.45
            
            $
            0.85
            
            $
            0.80Weighted
                average shares outstanding:Basic
            
            
            20,496
            
            
            20,593
            
            
            20,656
            
            
            20,703Diluted
            
            
            21,433
            
            
            21,545
            
            
            21,594
            
            
            21,552




(1)  
      Depreciation expense was $3.4 million, $3.2 million, $3.7 million
      and $4.1 million for Q1, Q2, Q3 and Q4 2005, respectively. Q4 2005
      depreciation expense includes $0.8 million relating to the write-off of
      undepreciated tooling for discontinued product lines.





26





**Fiscal
                Year 2006**(in
                thousands, except per share data)
            
            **Q1**
            
            **Q2**
            
            **Q3**
            
            **Q4**Net
                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.





**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.








27





**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, 2006. 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, 2006, 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
      management’s assessment of the Company’s internal control over financial
      reporting, which appears on page F3 hereof.





**Item
      9B. Other Information**





Not
      applicable.







**Part
      III**








**Item
      10. Directors, 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 2007 Annual Meeting of Stockholders, which will be filed
      with
      the Commission on or before April 30, 2007. 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 2007 Annual Meeting of
      Stockholders.





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





28





**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 2007 Annual Meeting of Stockholders, which
      will be filed with the Commission on or before April 30, 2007.





The
      information incorporated by reference from the “Report of the Compensation
      Committee” in the Company’s Proxy Statement for the 2007 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 2007 Annual Meeting of Stockholders, which
      will be filed with the Commission on or before April 30, 2007.





**Equity
      Compensation Plan Information**





The
      following table summarizes share information, as of December 31, 2006, for
      the Company’s equity compensation plans, including the RC2 Corporation 2005
      Stock Incentive Plan, the Racing Champions Ertl Corporation Stock Incentive
      Plan, the Racing Champions Ertl Corporation Employee Stock Purchase Plan and
      the
      Wheels Sports Group, Inc. 1996 Omnibus Stock Plan. All of these plans have
      been
      approved by the Company’s stockholders, other than the Wheels Sports Group, Inc.
      1996 Omnibus Stock Plan, which was approved by Wheels Sports Group’s
      stockholders and assumed by the Company following its acquisition of Wheels
      Sports Group in 1998. 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**Equity
                compensation plans
              approved
                by stockholders
            1,413,535
            $20.16
            1,403,019Equity
                compensation plans not
              approved
                by stockholders
            —
            —
            —Total
            1,413,535
            $20.16
            1,403,019





**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 2007 Annual Meeting of Stockholders, which
      will be filed with the Commission on or before April 30, 2007. 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 2007 Annual Meeting of Stockholders, which will be
      filed
      with the Commission on or before April 30, 2007.





**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 2007 Annual Meeting of Stockholders, which
      will be filed with the Commission on or before April 30, 2007.





29


**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, 2005 and 2006





Consolidated
      Statements of Earnings for the Years Ended December 31, 2004, 2005 and
      2006





Consolidated
      Statements of Stockholders’ Equity for the Years Ended December 31, 2004,
      2005 and 2006





Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2004, 2005 and
      2006





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, 2004, 2005 and
      2006:





Schedule
              Number
            
            Description
            
            PageII
            
            Valuation
                and Qualifying Accounts
            
            34





All
      other
      schedules for which provision is made in the applicable accounting regulations
      of the Commission


are
      not
      required under the related instructions, are inapplicable or the required
      information is shown in the


financial
      statements or notes thereto, and therefore, have been omitted.





**3. E** **xhibits**





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)).


30




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 December 13, 2005, between the Company and Richard
      E. Rothkopf


(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 December 16,
      2005).





10.6* Separation
      Agreement and General Release, dated as of December 13, 2005, between the
      Company and John


Walter
      Lee II (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 December 16, 2005).





10.7* 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).





10.8* 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).





10.9* 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).





10.10* 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)).





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* Racing
      Champions Ertl Corporation Employee Stock Purchase Plan, as amended
      (incorporated by


reference
      to Exhibit 10.4 of the Company’s Quarterly Report on Form 10-Q for the quarter
      ended


September 30,
      2002 (File No. 0-22635)).





31





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.





10.18* Employment
      Agreement, dated as of July 31, 2006, between the Company and Gregory J.
      Kilrea .





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) Exhibits


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





(c) Financial
      Statement Schedules


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





32





**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 28, 2007**
            **RC2
                CORPORATION****BY**
            /s/
                Curtis W. StoeltingCurtis
                W. Stoelting, Chief Executive
                Officer





**POWER
      OF ATTORNEY**





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





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





/s/
                Robert E. Dods
            
            Chairman
                of the Board and
            February 28,
                2007Robert
                E. Dods
            
            Director/s/
                Boyd L. Meyer
            
            Vice
                Chairman and Director
            February 28,
                2007Boyd
                L. Meyer/s/
                Curtis W. Stoelting
            
            Chief
                Executive Officer and
            February 28,
                2007Curtis
                W. Stoelting
            
            Director
                (Principal Executive Officer)/s/
                Jody L. Taylor
            
            Chief
                Financial Officer and Secretary
            February 28,
                2007Jody
                L. Taylor
            
            (Principal
                Financial and Accounting Officer)/s/
                Peter K.K. Chung
            
            Director
            February 28,
                2007Peter
                K.K. Chung/s/
                Paul E. Purcell
            
            Director
            February 28,
                2007Paul
                E. Purcell/s/
                John S. Bakalar
            
            Director
            February 28,
                2007John
                S. Bakalar/s/
                John J. Vosicky
            
            Director
            February 28,
                2007John
                J. Vosicky/s/
                Daniel M. Wright
            
            Director
            February 28,
                2007Daniel
                M. Wright/s/
                Thomas M. Collinger
            
            Director
            February 28,
                2007Thomas
                M. Collinger/s/
                Michael J. Merriman, Jr.
            
            Director
            February 28,
                2007Michael
                J. Merriman, Jr.





33





**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**





The
      Board
      of Directors and Stockholders


RC2
      Corporation:





Under
      date of February 28, 2007, we reported on the consolidated balance sheets
      of RC2 Corporation and subsidiaries as of December 31, 2005 and 2006, 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,
      2006. 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 28,
      2007



















**Schedule
      II**





**Description**


**Valuation
      and Qualifying Accounts**


(in
      thousands)





**Description**
            
            **Balance
                at**
              **Beginning**
              **of****Year**
            
            **Charged
                (Credited)**
              **to****Costs
                and**
              **Expenses**
            
            **Charged
                (Credited)**
              **to****Other**
              **Accounts**
            
            **Deductions**
            
            **Balance
                at**
              **End
                of**
              **Year**Allowance
                for doubtful accounts:Year
                ended December 31, 2004
            
            $
            4,007
            
            $
            1,083
            
            $
            481
            
            $
            (2,374
            )
            $
            3,197Year
                ended December 31, 2005
            
            
            3,197
            
            
            966
            
            
            (258
            )
            
            (832
            )
            
            3,073Year
                ended December 31, 2006
            
            $
            3,073
            
            $
            (283
            )
            $
            (50
            )
            $
            (989
            )
            $
            1,751







34





**INDEX
      TO FINANCIAL STATEMENTS**














**RC2
      CORPORATION AND SUBSIDIARIES**





Reports
                  of Independent Registered Public Accounting Firm
              F2Consolidated
                  Balance Sheets as of December 31, 2005 and 2006
              F4Consolidated
                  Statements of Earnings for the Years Ended December 31, 2004, 2005
                  and 2006
              F5Consolidated
                  Statements of Stockholders’ Equity for the Years Ended December 31,
                  2004, 2005 and 2006
              F6Consolidated
                  Statements of Cash Flows for the Years Ended December 31, 2004, 2005
                  and 2006
              F7Notes
                  to Consolidated Financial Statements
              F8





F1





**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**





The
      Board
      of Directors and Stockholders


RC2
      Corporation:





We
      have
      audited the accompanying consolidated balance sheets of RC2 Corporation and
      subsidiaries as of December 31, 2005 and 2006, 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, 2006. 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, 2005 and 2006, and the results of their
      operations and their cash flows for each of the years in the three-year period
      ended December 31, 2006, in conformity with U.S. generally accepted
      accounting principles.





We
      also
      have audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the effectiveness of RC2 Corporation’s internal
      control over financial reporting as of December 31, 2006, 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 28, 2007 expressed an unqualified opinion on management’s
      assessment of, and the effective operation of, internal control over financial
      reporting.





As
      discussed in Note 12 to the financial statements, the Company adopted
*Statement of Financial Accounting Standards* *No. 123R:
      Share-Based Payment* and
      changed its method of accounting for stock based compensation. As discussed
      in
      Note 14 to the financial statements, the Company adopted *Statement
      of Financial Accounting Standards**No. 158: Employers’ Accounting
      for Defined Benefit Pension and Other Postretirement Plans-an amendment of
      Statement of Financial Accounting Standards**No. 87, 88, 106 and
      132(R)* and
      changed its method of accounting for defined benefit pension plans.











/s/
      KPMG
      LLP


Chicago,
      Illinois


February 28,
      2007











F2





**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**





The
      Board
      of Directors and Stockholders


RC2
      Corporation:





We
      have
      audited management’s assessment, included in the accompanying Management Report
      on Internal Control Over Financial Reporting, that RC2 Corporation maintained
      effective internal control over financial reporting as of December 31,
      2006, based on criteria established in Internal Control-Integrated Framework
      issued by the Committee of Sponsoring Organizations of the Treadway Commission
      (COSO). RC2 Corporation’s management is responsible for maintaining effective
      internal control over financial reporting and for its assessment of the
      effectiveness of internal control over financial reporting. Our responsibility
      is to express an opinion on management’s assessment and an opinion on the
      effectiveness of the Company’s internal control over financial reporting based
      on our audit.





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





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





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





In
      our
      opinion, management’s assessment that RC2 Corporation maintained effective
      internal control over financial reporting as of December 31, 2006, is
      fairly stated, in all material respects, based on criteria established in
      Internal Control-Integrated Framework issued by COSO. Also, in our opinion,
      RC2
      Corporation maintained, in all material respects, effective internal control
      over financial reporting as of December 31, 2006, based on the criteria
      established in Internal Control-Integrated Framework issued by
      COSO.





We
      also
      have audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the consolidated balance sheets of RC2
      Corporation and subsidiaries as of December 31, 2005 and 2006, 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, 2006, and
      our report dated February 28, 2007 expressed an unqualified opinion on
      those consolidated financial statements.








/s/
      KPMG
      LLP


Chicago,
      Illinois


February 28,
      2007





F3


**CONSOLIDATED
      BALANCE SHEETS**


(in
                thousands)
            
            **December 31,****2005**
            
            **2006****Assets**Current
                assets:Cash
                and cash equivalents
            
            $
            25,262
            
            $
            25,365Accounts
                receivable, net of allowances for doubtful accounts
              of
                $3,073 and $1,751
            
            
            113,066
            
            
            112,937Other
                receivables
            
            
            2,284
            
            
            3,253Inventory
            
            
            71,260
            
            
            83,650Deferred
                income taxes
            
            
            8,717
            
            
            5,884Prepaid
                expenses
            
            
            6,596
            
            
            5,879Total
                current assets
            
            
            227,185
            
            
            236,968Property
                and equipment:Land
            
            
            686
            
            
            686Buildings
                and improvements
            
            
            8,850
            
            
            9,287Tooling
            
            
            96,416
            
            
            99,098Other
                equipment
            
            
            17,752
            
            
            20,574123,704
            
            
            129,645Less
                accumulated depreciation
            
            
            (76,665
            )
            
            (90,654
            )47,039
            
            
            38,991Goodwill
            
            
            253,571
            
            
            239,067Intangible
                assets, net
            
            
            99,611
            
            
            96,400Other
                non-current assets
            
            
            2,330
            
            
            3,214Total
                assets
            
            $
            629,736
            
            $
            614,640**Liabilities
                and stockholders’ equity**Current
                liabilities:Accounts
                payable
            
            $
            25,543
            
            $
            26,941Taxes
                payable, net
            
            
            5,575
            
            
            3,420Accrued
                expenses
            
            
            20,131
            
            
            16,443Accrued
                allowances
            
            
            21,199
            
            
            20,192Accrued
                royalties
            
            
            14,874
            
            
            17,163Line
                of credit
            
            
            3,979
            
            
            —Current
                maturities of bank term loans
            
            
            21,250
            
            
            22,438Other
                current liabilities
            
            
            1,348
            
            
            768Total
                current liabilities
            
            
            113,899
            
            
            107,365Lines
                of credit
            
            
            13,980
            
            
            —Bank
                term loans, less current maturities
            
            
            43,438
            
            
            —Deferred
                income taxes
            
            
            49,313
            
            
            45,524Other
                non-current liabilities
            
            
            10,155
            
            
            9,825Total
                liabilities
            
            
            230,785
            
            
            162,714Commitments
                and contingenciesStockholders’
                equity:Common
                stock, voting, $0.01 par value, 28,000 shares authorized,
              22,549
                shares issued and 20,718 shares outstanding at December 31,
                2005,
              and
                22,876 shares issued and 21,052 shares outstandingat
                December 31, 2006
            
            
            225
            
            
            229Additional
                paid-in capital
            
            
            219,647
            
            
            230,776Accumulated
                other comprehensive income
            
            
            1,127
            
            
            8,838Retained
                earnings
            
            
            186,612
            
            
            220,706407,611
            
            
            460,549Treasury
                stock, at cost, 1,831 shares at December 31, 2005, and
              1,824
                shares at December 31, 2006
            
            
            (8,660
            )
            
            (8,623
            )Total
                stockholders’ equity
            
            
            398,951
            
            
            451,926Total

                liabilities and stockholders’ equity
            
            $
            629,736
            
            $
            614,640





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


F4




**CONSOLIDATED
      STATEMENTS OF EARNINGS**


(in
      thousands, except per share data)


**Year
                Ended December 31,****2004**
            
            **2005**
            
            **2006**Net
                sales
            
            $
            367,687
            
            $
            492,766
            
            $
            518,829Cost
                of sales, related parties
            
            
            7,846
            
            
            18,520
            
            
            27,599Cost
                of sales, other
            
            
            178,967
            
            
            234,415
            
            
            248,155Restructuring
                charge related to discontinued automotive collectibles
            
            
            —
            
            
            —
            
            
            1,872Gross
                profit
            
            
            180,874
            
            
            239,831
            
            
            241,203Selling,
                general and administrative expenses
            
            
            121,785
            
            
            150,381
            
            
            155,180Amortization
                of intangible assets
            
            
            94
            
            
            1,385
            
            
            1,149Impairment
                of intangible assets
            
            
            4,318
            
            
            —
            
            
            —Gain
                on sale of W. Britain product line
            
            
            —
            
            
            (1,953
            )
            
            —Restructuring
                charge related to discontinued automotive collectibles
            
            
            —
            
            
            —
            
            
            12,631Operating
                income
            
            
            54,677
            
            
            90,018
            
            
            72,243Interest
                expense, net
            
            
            4,063
            
            
            5,983
            
            
            3,465Other
                (income) expense
            
            
            (508
            )
            
            146
            
            
            530Income
                from continuing operations before income taxes
            
            
            51,122
            
            
            83,889
            
            
            68,248Income
                tax expense
            
            
            18,755
            
            
            31,153
            
            
            24,478Income
                from continuing operations
            
            
            32,367
            
            
            52,736
            
            
            43,770Income
                (loss) from discontinued operations, net of tax
            
            
            1,611
            
            
            394
            
            
            (9,676
            )Net
                income
            
            $
            33,978
            
            $
            53,130
            
            $
            34,094Basic
                earnings per common share:Income
                from continuing operations
            
            $
            1.73
            
            $
            2.56
            
            $
            2.09Income
                (loss) from discontinued operations
            
            
            0.09
            
            
            0.02
            
            
            (0.46
            )Net
                income
            
            $
            1.82
            
            $
            2.58
            
            $
            1.63Diluted
                earnings per common share:Income
                from continuing operations
            
            $
            1.64
            
            $
            2.45
            
            $
            2.04Income
                (loss) from discontinued operations
            
            
            0.08
            
            
            0.02
            
            
            (0.45
            )Net
                income
            
            $
            1.72
            
            $
            2.47
            
            $
            1.59Weighted
                average shares outstanding:Basic
            
            
            18,687
            
            
            20,613
            
            
            20,884Diluted
            
            
            19,761
            
            
            21,532
            
            
            21,377





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





F5





**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ EQUITY**


(in
      thousands)




**Common
                  Stock**
              
              **Treasury
                  Stock**
              
              **Accumulated**
                **Other**
                **Comprehensive**
              
              **Additional**
                **Paid-in**
              
              **Retained**
              
              **Total**
                **Stockholders’**
              
              **Comprehensive****Shares**
              
              **Amount**
              
              **Shares**
              
              **Amount**
              
              **Income
                  (Loss)**
              
              **Capital**
              
              **Earnings**
              
              **Equity**
              
              **Income****Balance,
                  December 31, 2003**
              
              
              17,381
              
              $
              192
              
              
              1,812
              
              $
              (7,713
              )
              $
              3,880
              
              $
              129,436
              
              $
              99,504
              
              $
              225,299Net
                  income
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              33,978
              
              
              33,978
              
              $
              33,978Public
                  stock offering
              
              
              2,655
              
              
              26
              
              
              —
              
              
              —
              
              
              —
              
              
              77,459
              
              
              —
              
              
              77,485
              
              
              —Stock
                  issued upon option exercise
              
              
              355
              
              
              4
              
              
              —
              
              
              —
              
              
              —
              
              
              2,069
              
              
              —
              
              
              2,073
              
              
              —Tax
                  benefit of stock option exercise
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              3,076
              
              
              —
              
              
              3,076
              
              
              —Stock
                  issued in acquisition
              
              
              92
              
              
              1
              
              
              —
              
              
              —
              
              
              —
              
              
              2,867
              
              
              —
              
              
              2,868
              
              
              —Stock
                  issued under ESPP
              
              
              6
              
              
              —
              
              
              (6
              )
              
              34
              
              
              —
              
              
              107
              
              
              —
              
              
              141
              
              
              —Treasury
                  stock acquisition
              
              
              (26
              )
              
              —
              
              
              26
              
              
              (822
              )
              
              —
              
              
              —
              
              
              —
              
              
              (822
              )
              
              —Other
                  comprehensive income (loss):Foreign
                  currency translation
                adjustments
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              3,552
              
              
              —
              
              
              —
              
              
              3,552
              
              
              3,552Minimum
                  pension liability
                adjustment,
                  net of tax
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              (888
              )
              
              —
              
              
              —
              
              
              (888
              )
              
              (888
              )Comprehensive
                  income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              $
              36,642**Balance,
                  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
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              $
              47,713**Balance,
                  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
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              $
              41,805**Balance,
                  December 31, 2006**
              
              
              21,052
              
              $
              229
              
              
              1,824
              
              $
              (8,623
              )
              $
              8,838
              
              $
              230,776
              
              $
              220,706
              
              $
              451,926




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





F6




**CONSOLIDATED
                STATEMENTS OF CASH FLOWS**
            
            **Year
                Ended December 31,**(in
                thousands)
            
            **2004**
            
            **2005**
            
            **2006****Operating
                activities******Net
                income
            
            $
            33,978
            
            $
            53,130
            
            $
            34,094(Income)
                loss from discontinued operations
            
            
            (1,611
            )
            
            (394
            )
            
            9,676Adjustments
                to reconcile net income to net cash provided by operating
                activities:Depreciation
            
            
            15,272
            
            
            14,444
            
            
            14,087****Impairment
                of intangible assets
            
            
            4,318
            
            
            —
            
            
            2,824Write-off
                of tooling related to discontinued automotive
                collectibles
            
            
            —
            
            
            —
            
            
            8,621Provision
                (reduction of allowance) for uncollectible accounts
            
            
            717
            
            
            830
            
            
            (562
            )Amortization
                and write-off of deferred financing costs
            
            
            829
            
            
            483
            
            
            696Amortization
                of intangible assets
            
            
            94
            
            
            1,385
            
            
            1,149Stock-based
                compensation
            
            
            —
            
            
            —
            
            
            3,856Excess
                tax benefit on stock option exercises
            
            
            —
            
            
            —
            
            
            (2,414
            )Loss
                (gain) on disposition of assets
            
            
            56
            
            
            (2,030
            )
            
            (9
            )Deferred
                income taxes
            
            
            8,386
            
            
            1,887
            
            
            (2,453
            )Other
            
            
            —
            
            
            15
            
            
            27Changes
                in operating assets and liabilities:Accounts
                and other receivables
            
            
            5,277
            
            
            (16,288
            )
            
            4,121Inventory
            
            
            5,157
            
            
            (18,888
            )
            
            (12,496
            )Prepaid
                expenses
            
            
            (80
            )
            
            318
            
            
            507Accounts
                payable and accrued expenses
            
            
            (3,685
            )
            
            24,751
            
            
            565Other
                liabilities
            
            
            (4,631
            )
            
            (559
            )
            
            (74
            )Net
                cash provided by continuing operations
            
            
            64,077
            
            
            59,084
            
            
            62,215Net
                cash provided by (used in) discontinued operations
            
            
            4
            
            
            52
            
            
            (438
            )****Net
                cash provided by operating activities
            
            
            64,081
            
            
            59,136
            
            
            61,777**Investing
                activities**Purchase
                of property and equipment
            
            
            (15,076
            )
            
            (14,133
            )
            
            (14,396
            )Proceeds
                from disposition of property and equipment
            
            
            167
            
            
            5,546
            
            
            24Purchase
                of PM, net of cash acquired
            
            
            (17,238
            )
            
            —
            
            
            —Purchase
                of TFY, net of cash acquired
            
            
            (154,567
            )
            
            39
            
            
            —Proceeds
                from sale of W. Britain product line
            
            
            —
            
            
            2,850
            
            
            —Proceeds
                from sale of discontinued operations
            
            
            —
            
            
            —
            
            
            6,819Investments
            
            
            —
            
            
            (750
            )
            
            (1,214
            )Decrease
                (increase) in other non-current assets
            
            
            1,745
            
            
            (169
            )
            
            (29
            )Net
                cash used in continuing operations
            
            
            (184,969
            )
            
            (6,617
            )
            
            (8,796
            )Net
                cash (used in) provided by discontinued operations
            
            
            (16
            )
            
            (26
            )
            
            477Net
                cash used in investing activities
            
            
            (184,985
            )
            
            (6,643
            )
            
            (8,319
            )**Financing
                activities**Net
                cash proceeds from public stock offering
            
            
            77,485
            
            
            —
            
            
            —Issuance
                of stock upon option exercises
            
            
            1,460
            
            
            1,750
            
            
            3,618Excess
                tax benefit on stock option exercises
            
            
            —
            
            
            —
            
            
            2,414Issuance
                of stock under ESPP
            
            
            141
            
            
            191
            
            
            212Proceeds
                from bank term loans
            
            
            85,000
            
            
            —
            
            
            —Payments
                on bank term loans
            
            
            (53,750
            )
            
            (16,562
            )
            
            (42,250
            )Net
                borrowings (payments) on lines of credit
            
            
            15,000
            
            
            (31,914
            )
            
            (18,270
            )Financing
                fees paid
            
            
            (1,942
            )
            
            —
            
            
            (184
            )Net
                cash provided by (used in) continuing operations
            
            
            123,394
            
            
            (46,535
            )
            
            (54,460
            )Net
                cash provided by (used in) discontinued operations
            
            
            —
            
            
            —
            
            
            —Net
                cash provided by (used in) financing activities
            
            
            123,394
            
            
            (46,535
            )
            
            (54,460
            )Effect
                of exchange rate changes on cash
            
            
            1,052
            
            
            (819
            )
            
            1,105Net
                increase in cash and cash equivalents
            
            
            3,542
            
            
            5,139
            
            
            103Cash
                and cash equivalents, beginning of year
            
            
            16,548
            
            
            20,123
            
            
            25,262****Restricted
                cash
            
            
            33
            
            
            —
            
            
            —Cash
                and cash equivalents, end of year
            
            $
            20,123
            
            $
            25,262
            
            $
            25,365Supplemental
                disclosure of cash flow information:Cash
                paid for interest during the period
            
            $
            3,416
            
            $
            5,890
            
            $
            3,631Cash
                paid for income taxes during the period
            
            
            11,579
            
            
            22,052
            
            
            28,367Cash
                refunds received for income taxes
            
            
            345
            
            
            5,896
            
            
            1,078Non-cash
                investing and financing activity during the period:91,388
                shares of stock issued for the purchase of PM
            
            
            2,868
            
            
            —
            
            
            —Stock
                  received in exchange for option exercises and tax
                  withholdings
            
            
            822
            
            
            —
            
            
            —Stock
                received in exchange for a receivable
            
            $
            —
            
            $
            194
            
            $
            —


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





F7





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**




**FOR
      THE YEARS ENDED DECEMBER 31, 2004, 2005 AND 2006**




**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 products that are targeted to consumers of all ages.
      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.
      RECAPITALIZATION AND ACQUISITIONS**





**Recapitalization**





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





**The
      Ertl Company, Inc.**





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





**Learning
      Curve International, Inc.**





On
      March 4, 2003, with an effective date of February 28, 2003, the
      Company acquired Learning Curve International, Inc. (Learning Curve) and certain
      of its affiliates (collectively, LCI) through the merger of a wholly owned
      subsidiary of RC2 with and into Learning Curve for $104.4 million in cash,
      excluding transaction expenses, and 666,666 shares of the Company’s common
      stock, including $12.0 million in escrow to secure Learning Curve’s
      indemnification obligations under the merger agreement. The purchase was funded
      with the Company’s previous credit facility. During 2006, an agreement was
      reached with the representatives of the former Learning Curve stockholders
      resolving all open escrow claims and disbursing all amounts in escrow other
      than
      $0.3 million which will remain in the escrow to pay certain of the
      Company’s expenses to pursue a pending malpractice litigation claim. For
      additional information relating to the escrow, see Note 10 - Legal
      Proceedings.





**Playing
      Mantis, Inc.**





On
      June 7, 2004, with an effective date of June 1, 2004, the Company
      acquired substantially all of the assets of Playing Mantis, Inc. (PM) primarily
      consisting of the Johnny Lightning® brand. Closing consideration consisted
      of $17.0 million of cash, excluding transaction expenses, and 91,388 shares
      of the Company’s common stock. This transaction has been accounted for under the
      purchase method of accounting, and accordingly, the operating results of PM
      have
      been included in our consolidated statements of earnings since the effective
      date of the acquisition.








F8





**The
      First Years Inc.**





On
      September 15, 2004, the Company acquired The First Years Inc. (TFY) for
      approximately $156.1 million in cash, excluding transaction expenses. TFY
      is an international developer and marketer of infant and toddler care and play
      products sold under The First Years® brand name and under various licenses,
      including Disney’s *Winnie
      the Pooh* .
      This
      transaction has been accounted for under the purchase method of accounting,
      and
      accordingly, the operating results of TFY have been included in the accompanying
      consolidated statements of earnings since the effective date of the acquisition.
      The purchase was funded with a credit facility (see Note 8 - Debt).





**3.
      SIGNIFICANT ACCOUNTING POLICIES**





**Principles
      of Consolidation**





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





**Foreign
      Currency Translation/Transactions**





Foreign
      subsidiary assets and liabilities are recorded in local 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, 2004, 2005 and
      2006, have been recorded as components of accumulated other comprehensive income
      in stockholders’ equity. The net exchange gains resulting from transactions in
      foreign currencies for the year ended December 31, 2004, was less than
      $0.1 million. 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. These net exchange losses
      and gains are included in other (income) expense on the accompanying
      consolidated statements of earnings.





**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. The Company’s products currently carry a limited warranty
      which guarantees the product to be free from defects in material and workmanship
      under normal and intended use for a period of 90 days from the date of consumer
      purchase. Historical results of product warranty claims have shown that they
      have had an immaterial impact on the Company. Based upon the historical results,
      appropriate allowances for product warranty claims are accrued throughout the
      year.





**Shipping
      and Handling Costs**





Shipping
      and handling costs, 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, 2004, 2005 and 2006, shipping and handling costs were
      $13.7 million, $19.3 million and $17.3 million,
      respectively. ****





**Cash
      and Cash Equivalents**





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





F9





**Use
      of Estimates**





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





**Inventory**





Inventory
      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 Life**Buildings
                and improvements
            2
                -
                15 yearsTooling
            2
                -
                7 yearsOther
                equipment
            2
                -
                10 years





In
      2004
      and 2005, the Company recorded charges of $2.5 million and
      $0.8 million, respectively, 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 statements
      of earnings for the years ended December 31, 2004 and 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 in 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 18 - Restructuring Charge -
      Discontinuance of Automotive Collectible Product Lines).





**Other
      Non-Current Assets**





Other
      non-current assets at December 31, 2005 and 2006, consist primarily of
      deferred financing fees, as well as the Company’s investment in the development
      of an intellectual property (see Note 15 - Investment). The deferred financing
      fees are being amortized over the related borrowing capacity. Amortization
      of
      deferred financing fees for the years ended December 31, 2004, 2005 and
      2006, was $0.8 million, $0.5 million and $0.7 million, respectively,
      and is included in interest expense in the accompanying consolidated statements
      of earnings.





**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.








F10





**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. The Company’s products currently carry a limited warranty
      which guarantees the product to be free from defects in material and workmanship
      under normal and intended use for a period of 90 days from the date of consumer
      purchase. Historical results of product warranty claims have shown that they
      have had an immaterial impact on the Company. Based upon the historical results,
      appropriate allowances for product warranty claims are accrued throughout the
      year.





**Accrued
      Royalties**





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





**Concentration
      of Credit Risk**





Concentration
      of credit risk is limited to trade accounts receivable and is subject to the
      financial conditions of certain major customers. Wal-Mart, our largest customer,
      accounted for 13.4% and 16.3% of our net sales in 2005 and 2006, respectively.
      Toys “R” Us/Babies “R” Us accounted for 10.9%, 15.1% and 14.8% of our net sales
      in 2004, 2005 and 2006, respectively. Target accounted for 12.0% and 13.1%
      of
      our net sales in 2005 and 2006, respectively. Other than Wal-Mart, Toys “R”
Us/Babies “R” Us and Target, no customer accounted for more than 10.0% of our
      net sales in each period for the three years ended December 31, 2006.
      Additionally, Toys “R” Us/Babies “R” Us accounted for approximately 18.3% and
      17.9% of accounts receivable at December 31, 2005 and 2006, respectively,
      Wal-Mart accounted for approximately 12.1% and 17.5% of accounts receivable
      at
      December 31, 2005 and 2006, respectively, and Target accounted for
      approximately 16.6% and 16.0% of accounts receivable at December 31, 2005
      and 2006, respectively. Other than Toys “R” Us/Babies “R” Us, Wal-Mart and
      Target, no customer accounted for more than 10.0% of accounts receivable at
      December 31, 2005 or 2006. The Company does not require collateral or other
      security to support customers’ receivables. The Company conducts periodic
      reviews of its customers’ financial condition and vendor payment practices to
      minimize collection risks on trade accounts receivable. The Company has
      purchased credit insurance, which covers a portion of its receivables from
      some
      of its major customers. ****





**Supplier
      Concentration**





The
      Company’s purchases from two of its third-party, dedicated suppliers were 16.6%
      and 14.8% in 2004, 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 each period for
      the
      three years ended December 31, 2006. ****





**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,
      2004, 2005 and 2006.








F11





**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, 2004, 2005 and 2006, was
      approximately $2.2 million, $3.7 million and $2.8 million,
      respectively. ****





Prepaid
      advertising expenses, such as prepayments on magazine advertisements and artwork
      costs of $0.1 million, are included in prepaid expenses on the accompanying
      consolidated balance sheets at December 31, 2005 and 2006.





**Income
      and Other Taxes**





The
      Company accounts for income taxes under Statement of Financial Accounting
      Standards (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. In determining the required liability, management considers certain
      tax exposures and all available evidence. Estimates for such tax contingencies
      are classified in other non-current liabilities on 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.





**Stock-Based
      Compensation**





Effective
      January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based
      Payments.” The Company elected to use the modified prospective application of
      SFAS No. 123R for awards issued prior to January 1, 2006. Income from
      continuing operations before income taxes for the year ended December 31,
      2006 includes total expense recognized for 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. The Company
      calculates the expected volatility factor for those options issued under the
      stock incentive plan to correspond with the average volatility factor of those
      companies included in a peer group study. The historical stock price movements
      of the Company’s common stock have not been considered a good indicator of
      expected future volatility because the Company’s business has changed
      significantly as a result of acquisitions completed. However, the Company
      continues to monitor its actual volatility to assess whether its histroical
      stock price movements over the expected option term are a good indicator of
      expected future results.





The
      Company uses historical data to estimate share option exercise and employee
      departure behavior used in the Black-Scholes option pricing model. The expected
      term of 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.








F12





**Earnings
      Per Share from Continuing Operations**





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





**Year
                Ended December 31,**(in
                thousands)
            
            **2004**
            
            **2005**
            
            **2006**Income
                from continuing operations
            
            $
            32,367
            
            $
            52,736
            
            $
            43,770Weighted
                average common and common equivalent
              shares
                outstanding:Weighted
                average common shares outstanding
            
            
            18,687
            
            
            20,613
            
            
            20,884Add
                effect of diluted securities -
              assumed
                exercise of stock options
            
            
            1,074
            
            
            919
            
            
            493Weighted
                average common and common equivalent
              shares
                outstanding
            
            
            19,761
            
            
            21,532
            
            
            21,377Basic
                earnings per common share from continuing operations
            
            $
            1.73
            
            $
            2.56
            
            $
            2.09Diluted
                earnings per common share from continuing operations
            
            $
            1.64
            
            $
            2.45
            
            $
            2.04





The
      computation of diluted earnings per share from continuing operations excludes
      73,110 shares, 22,927 shares and 447,975 shares in 2004, 2005 and 2006,
      respectively, because the options were anti-dilutive.





**Comprehensive
      Income**





The
      Company reports comprehensive income in accordance with SFAS No. 130,
“Reporting Comprehensive Income.” SFAS No. 130 requires companies to report
      all changes in equity during a period, except those resulting from investment
      by
      owners and distributions to owners, in a financial statement for the period
      in
      which they are recognized. The Company has chosen to disclose comprehensive
      income, which encompasses net income, foreign currency translation adjustments
      and 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
      2004, 2005 and 2006 was $0.5 million, $0.2 million and
      $(0.5) million, respectively. ****





**Recently
      Issued Accounting Pronouncements**





In
      June
      2006, the FASB issued FASB Interpretation 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. This Interpretation is effective for fiscal
      years beginning after December 15, 2006. The Company is currently assessing
      the impact that this Interpretation will have on the Company’s financial
      statements.





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.





**Reclassifications**





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





F13





**4.
      INSURANCE RECOVERY**





During
      2004, the Company received an insurance recovery of approximately
      $0.3 million relating to the lost margin on product destroyed during a fire
      at the Company’s third-party warehouse in the United Kingdom in October 2003.
      The insurance recovery is included in the Company’s cost of sales, other in the
      accompanying consolidated statement of earnings for the year ended
      December 31, 2004.





**5.
      BUSINESS SEGMENTS**





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





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, 2004, 2005 and 2006 are
      as follows:





**Year
                Ended December 31,**(in
                thousands)
            
            **2004**
            
            **2005**
            
            **2006**Net
                sales:North
                America
            
            $
            317,969
            
            $
            422,389
            
            $
            432,769International
            
            
            50,759
            
            
            71,688
            
            
            86,794Sales
                and transfers between segments
            
            
            (1,041
            )
            
            (1,311
            )
            
            (734
            )Combined
                total
            
            $
            367,687
            
            $
            492,766
            
            $
            518,829Operating
                income:North
                America
            
            $
            47,022
            
            $
            73,656
            
            $
            57,513International
            
            
            7,655
            
            
            16,362
            
            
            14,767Sales
                and transfers between segments
            
            
            —
            
            
            —
            
            
            (37
            )Combined
                total
            
            $
            54,677
            
            $
            90,018
            
            $
            72,243Depreciation
                and amortization:North
                America
            
            $
            13,517
            
            $
            14,345
            
            $
            14,003International
            
            
            1,849
            
            
            1,484
            
            
            1,233Combined
                total
            
            $
            15,366
            
            $
            15,829
            
            $
            15,236Capital
                expenditures:North
                America
            
            $
            14,216
            
            $
            13,087
            
            $
            12,810International
            
            
            860
            
            
            1,046
            
            
            1,586Combined
                total
            
            $
            15,076
            
            $
            14,133
            
            $
            14,396





**December 31,****2005**
            
            **2006**Total
                assets:North
                America
            
            $
            558,452
            
            $
            517,158International
            
            
            71,284
            
            
            97,482Combined
                total
            
            $
            629,736
            
            $
            614,640








F14





Under
      the
      enterprise-wide disclosure requirements of SFAS No. 131, the Company
      reports net sales by product category and by distribution channel. During the
      fourth quarter of 2006, the Company reclassified its product categories and
      distribution channels to be more closely aligned with its strategic direction
      and organization structure. This presentation is consistent with how the Company
      views its business. The Company groups its products into three product
      categories: infant and toddler products, preschool products and youth and adult
      products. Amounts for the years ended December 31, 2004, 2005 and 2006, are
      as shown in the tables below.





**Year
                Ended December 31,**(in
                thousands)
            
            **2004**
            
            **2005**
            
            **2006**Infant
                and toddler products
            
            $
            60,181
            
            $
            160,043
            
            $
            175,735Preschool
                products
            
            
            166,406
            
            
            199,857
            
            
            229,334Youth
                and adult products
            
            
            141,100
            
            
            132,866
            
            
            113,760Net
                sales
            
            $
            367,687
            
            $
            492,766
            
            $
            518,829Chain
                retailers
            
            $
            199,602
            
            $
            314,217
            
            $
            352,555Specialty
                retailers, wholesalers and OEM dealers
            
            
            140,711
            
            
            157,818
            
            
            151,410Corporate
                promotional, direct to consumers and other
            
            
            27,374
            
            
            20,731
            
            
            14,864Net
                sales
            
            $
            367,687
            
            $
            492,766
            
            $
            518,829





**6.
      GOODWILL AND INTANGIBLE ASSETS**





In
      accordance with the provisions of 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 completed its annual goodwill impairment tests
      as of October 1, 2004, 2005 and 2006, which resulted in no impairment. The
      annual impairment test for intangible assets in 2005 resulted in no impairment
      to intangibles. However, an impairment charge for intangible assets in the
      North
      America segment of $4.3 million has been included in the accompanying
      consolidated statement of earnings for the year ended December 31, 2004, as
      a result of the 2004 annual impairment test of intangible assets. The impairment
      charge is comprised of a license agreement and trademark/brand names related
      to
      discontinued products lines and represents a full write-down of these assets.
      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 18 - Restructuring Charge -
      Discontinuance of Automotive Collectible Product Lines).





The
      change in carrying value of goodwill by reporting unit for the years ended
      2005
      and 2006 is shown below:





(in
                thousands)
            
            **North
                America**
            
            **International**
            
            **Total**Balance
                at December 31, 2004
            
            $
            267,362
            
            $
            15,005
            
            $
            282,367PM
                fair value allocation
            
            
            (3,086
            )
            
            —
            
            
            (3,086
            )TFY
                fair value allocation
            
            
            (24,146
            )
            
            —
            
            
            (24,146
            )Other
                adjustments
            
            
            —
            
            
            (1,564
            )
            
            (1,564
            )Balance
                at December 31, 2005
            
            
            240,130
            
            
            13,441
            
            
            253,571Sale
                of RC2 South, Inc. (Note 17)
            
            
            (15,732
            )
            
            —
            
            
            (15,732
            )Other
                adjustments
            
            
            (562
            )
            
            1,790
            
            
            1,228Balance
                at December 31, 2006
            
            $
            223,836
            
            $
            15,231
            
            $
            239,067





Other
      adjustments made during the year ended December 31, 2005 primarily relate
      to currency exchange rate changes. Other adjustments made during the year ended
      December 31, 2006 primarily relate to currency exchange rate changes and
      release of certain purchase accounting liabilities.








F15





The
      components of net intangible assets are as follows:





(in
                thousands)
            
            **2005**
            
            **2006**Gross
                amount of amortizable intangible assets:Customer
                relationships
            
            $
            8,704
            
            $
            8,363Other
            
            
            2,962
            
            
            3,471$
            11,666
            
            $
            11,834Accumulated
                amortization of amortizable intangible assets:Customer
                relationships
            
            $
            275
            
            $
            485Other
            
            
            1,204
            
            
            2,143$
            1,479
            
            $
            2,628Intangible
                assets not subject to amortization:Licenses
                and trademarks
            
            $
            89,272
            
            $
            87,194Other
            
            
            152
            
            
            —$
            89,424
            
            $
            87,194Total
                intangible assets, net
            
            $
            99,611
            
            $
            96,400





Other
      amortizable intangible assets consist primarily of patents, non-compete
      agreements and trademarks and have estimated useful lives ranging from two
      to
      five 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 operational performance of our largest customers.





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




(in
              thousands)2007
            
            $
            8172008
            
            
            7172009
            
            
            4062010
            
            
            2042011
            
            $
            204





**7.
      INCOME TAXES**





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





**Year
                Ended December 31,**(in
                thousands)
            
            **2004**
            
            **2005**
            
            **2006**Income
                before income taxes:United
                States
            
            $
            44,499
            
            $
            69,773
            
            $
            58,061Foreign
            
            
            6,623
            
            
            14,116
            
            
            10,187$
            51,122
            
            $
            83,889
            
            $
            68,248





Income
      (loss) from discontinued operations, before income taxes, of $2.6 million,
      $0.6 million and $(8.7) million for the years ended December 31,
      2004, 2005 and 2006, respectively, has been excluded from the above
      figures.





F16


The
      significant components of income tax expense (benefit) are as
      follows:


**Year
                Ended December 31,**(in
                thousands)
            
            **2004**
            
            **2005**
            
            **2006**CurrentFederal
            
            $
            7,167
            
            $
            24,493
            
            $
            20,928State
            
            
            1,362
            
            
            1,141
            
            
            2,407Foreign
            
            
            1,518
            
            
            3,544
            
            
            3,60110,047
            
            
            29,178
            
            
            26,936DeferredFederal
            
            
            8,448
            
            
            335
            
            
            (1,608
            )State
            
            
            388
            
            
            1,366
            
            
            (154
            )Foreign
            
            
            (128
            )
            
            274
            
            
            (696
            )8,708
            
            
            1,975
            
            
            (2,458
            )Income
                tax expense
            
            $
            18,755
            
            $
            31,153
            
            $
            24,478


Income
      tax expense related to discontinued operations of $1.0 million,
      $0.2 million and $1.0 million for the years ended December 31,
      2004, 2005 and 2006, respectively, has been excluded from the above
      figures.





A
      reconciliation of the U.S. statutory federal tax rate and actual effective
      income tax rate, including discrete items (significant, unusual or
      non-recurring), is as follows:




**Year
                Ended December 31,****2004**
            
            **2005**
            
            **2006**U.S.
                statutory rate
            
            
            35.0
            %
            
            35.0
            %
            
            35.0
            %State
                taxes, net of federal benefit
            
            
            2.2
            
            
            1.9
            
            
            2.0Foreign
            
            
            (1.2
            )
            
            —
            
            
            (0.4
            )Foreign
                dividend impact
            
            
            —
            
            
            0.6
            
            
            —Other
            
            
            0.7
            
            
            (0.4
            )
            
            (0.7
            )Effective
                rate
            
            
            36.7
            %
            
            37.1
            %
            
            35.9
            %





The
      effective tax rate including the impact of discontinued operations is 36.7%,
      37.1% and 42.8% for the years ended December 31, 2004, 2005 and 2006,
      respectively.




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


**December 31,**(in
                thousands)
            
            **2005**
            
            **2006**Deferred
                tax assets attributable toCapital
                loss carry-forward
            
            $
            —
            
            $
            5,834Stock
                options
            
            
            —
            
            
            1,151Bad
                debt allowance
            
            
            881
            
            
            437Inventory
            
            
            2,500
            
            
            3,333Sales
                allowance
            
            
            4,391
            
            
            3,217Net
                operating loss carry-forwards
            
            
            193
            
            
            471Accrued
                expenses
            
            
            1,501
            
            
            1,118Purchase
                accounting
            
            
            950
            
            
            757Other
            
            
            1,746
            
            
            2,194Total
                deferred tax assets before valuation allowance
            
            
            12,162
            
            
            18,512Valuation
                allowance related to the capital loss carry-forward
            
            
            —
            
            
            (5,834
            )Net
                deferred tax assets
            
            
            12,162
            
            
            12,678Deferred
                tax liabilities attributable toGoodwill
                and intangible assets
            
            
            (48,196
            )
            
            (49,389
            )Property
                and equipment
            
            
            (3,716
            )
            
            (1,585
            )Other
            
            
            (846
            )
            
            (1,344
            )Total
                deferred tax liabilities
            
            
            (52,758
            )
            
            (52,318
            )Net
                deferred tax liability
            
            $
            (40,596
            )
            $
            (39,640
            )


F17





Taxes
      payable at December 31, 2005 and 2006, were $5.6 million and
      $3.4 million, respectively. Taxes in the amount of $15.0 million were
      charged to goodwill related to the 2004 acquisitions of PM and TFY
      during the year ended December 31, 2005.





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% 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
      17- Discontinued Operations). For tax purposes, this sale generated a pre-tax
      capital loss of $15.7 million. A valuation allowance of $5.8 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.





**8.
      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. This additional capacity is currently
      uncommitted by the lenders and must be approved by the lenders upon the
      Company’s request for borrowing. Principal payments ranging from
      $3.8 million to $6.5 million on the term loan are scheduled quarterly
      beginning December 31, 2004 and continue thereafter until December 31,
      2007. The revolving line of credit is available until its maturity on September
      14, 2008. A portion of the term loan has an interest rate of 3.45% plus
      applicable margin through the first three years of the facility. The remaining
      term loan and revolving line of credit bear interest, at the Company’s option,
      at a base rate or at a LIBOR rate plus applicable margin. The applicable margin
      is based on the Company’s ratio of consolidated debt to consolidated EBITDA
      (earnings before interest, taxes, depreciation, amortization and non-cash
      expense related to equity awards) and varies between 0.75% and 1.625%. At
      December 31, 2006, the margin in effect was 0.75% for LIBOR loans. The
      Company is also required to pay a commitment fee of 0.20% to 0.35% per annum
      on
      the average daily unused portion of the revolving line of credit. At
      December 31, 2006, the commitment fee in effect was 0.20% per annum. Under
      the terms of this credit facility, the Company is required to comply with
      certain financial and non-financial covenants. Among other restrictions, the
      Company is restricted in its ability to pay dividends, incur additional debt
      and
      make acquisitions above certain amounts. The key financial covenants include
      minimum EBITDA and interest coverage and leverage ratios. The credit facility
      is
      secured by working capital assets and certain intangible assets. On
      December 31, 2006, the Company had $22.4 million outstanding on the
      term loan and no amounts outstanding on the revolving line of credit and
      was in compliance with all covenants.





In
      connection with its current credit facility, the Company incurred
      $1.9 million in financing fees. Also, during 2006, the Company incurred an
      additional $0.2 million in financing fees on an amendment 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. During 2004, the Company expensed $0.5 million of deferred
      financing fees related to the Company’s previous credit facility. Additionally,
      in conjunction with the Company’s voluntary payment on a portion of its term
      loan in 2006, the Company expensed $0.2 million of deferred financing
      fees.





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





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, 2005 and 2006, there were no outstanding
      borrowings under this line of credit.





F18





The
      Company’s United Kingdom subsidiary maintains a line of credit with a bank for
      $0.2 million that renews annually on July 31. The line of credit bears
      interest at 1.0% over the bank’s base rate, and the total amount is subject to a
      letter of guarantee given by the Company. At December 31, 2005 and 2006,
      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,**(in
                thousands)
            
            **2005**
            
            **2006**Term
                loans payable to banks, bearing interest at 4.70% and 5.64%
              as
                of December 31, 2005, and 4.20% and 6.10% as of
              December 31,
                2006, with quarterly principal payments of $3,750
              beginning
                December 31, 2004, through September 30, 2005,
              quarterly
                principal payments of $5,313 from December 31, 2005,
              through
                September 30, 2007, principal payment of $6,500 at December 31,
                2007
            
            $
            64,688
            
            $
            22,438U.S.
                revolving line of credit, bearing interest at 5.58% as of
                December 31, 2005;
              matures
                on September 14, 2008
            
            
            10,000
            
            
            —U.K.
                revolving line of credit, bearing interest at 5.77% and 3.65% as
                of
                December 31,
              2005;
                availability thereunder cancelled during 2006
            
            
            7,959
            
            
            —Less
                current maturities
            
            
            (25,230
            )
            
            (22,438
            )$
            57,417
            
            $
            —





**9.
      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 a party to over 500 licenses, approximately 400 of which are actively
      used in the Company’s current product lines, with various entertainment,
      publishing and media companies, automotive and truck manufacturers, agricultural
      and construction vehicle and equipment manufacturers, among others. 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)2007
            
            $
            10,2882008
            
            
            8,6022009
            
            
            7,8832010
            
            
            7,8122011
            
            
            7,877Thereafter
            
            
            8,240Total
            
            $
            50,702





Royalty
      expense for licenses, including guaranteed minimums, was $29.5 million,
      $32.3 million and $38.4 million for 2004, 2005 and 2006,
      respectively.








F19





Rental
      expense for office and warehouse space and equipment under cancelable and
      noncancelable operating leases amounted to approximately $4.0 million,
      $4.7 million and $4.7 million for the years ended December 31,
      2004, 2005 and 2006, 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, 2006, are as
      follows:





**Year
                Ending December 31,**(in
                thousands)2007
            
            $
            4,6442008
            
            
            3,9822009
            
            
            3,6442010
            
            
            2,6942011
            
            
            2,141Thereafter
            
            
            13,144Total
            
            $
            30,249





Unconditional
        purchase obligations include agreements for purchases of product, tooling
        and
        services such as advertising, and hardware and software maintenance agreements.
        Payments made and allowances given in connection with these cancelable and
        noncancelable long-term unconditional purchase obligations amounted to
        approximately $0.6 million, $4.0 million and $25.7 million for
        the years ended December 31, 2004, 2005 and 2006, respectively.
 Commitments
        for future minimum payments with terms extending beyond one year at
        December 31, 2006, for noncancelable unconditional purchase obligations are
        as follows:





**Year
                Ending December 31,**(in
                thousands)2007
            
            $
            21,5282008
            
            
            21,1832009
            
            
            20,8412010
            
            
            20,4002011
                and thereafter
            
            
            —Total
            
            $
            83,952





In
      2004,
      the Company received approximately $1.2 million in the form of a grant and
      tax credits from state and local governments in exchange for agreeing to certain
      covenants, including a minimum capital investment and job creation goals
      relating to its Rochelle, Illinois, distribution facility. The Company must
      employ a minimum of 50 employees in Rochelle from March 15, 2006 to
      December 31, 2008, to remain compliant with the terms of the award. Should
      the Company be unable to meet these minimum requirements, the Company may be
      required to forfeit or return a portion of benefits received.





Additionally
      in 2004, the Company received a $0.3 million forgivable loan and a
      three-year interest free $0.1 million loan from the state of Iowa to assist
      in the expansion of the Dyersville, Iowa, distribution facility in exchange
      for
      agreeing to certain covenants, including minimum job creation goals and wage
      obligations. The Company must employ a minimum of 92 employees at a specified
      rate and retain these employees for at least 90 days past the project completion
      date to remain compliant with the terms of the promissory note. Should the
      Company be unable to meet these requirements, the Company may be required to
      forfeit or return a portion of the benefits received. The total of
      $0.4 million is presented in other non-current liabilities in the
      accompanying consolidated balance sheets at December 31, 2005 and
      2006. ****





F20





**10.
      LEGAL PROCEEDINGS**





During
      the quarter ended December 31, 2003, Learning Curve settled the action
      brought by Playwood Toys, Inc. in the U.S. District Court for the Northern
      District of Illinois alleging that Learning Curve and certain of its officers
      and employees misappropriated one or more trade secrets relating to a toy wooden
      railroad track manufactured and sold by Learning Curve as Clickety Clack TrackTM.
      Pursuant to the settlement agreement, the Company, on behalf of Learning Curve,
      made a payment of $11.2 million to the plaintiff. The Company was entitled
      to indemnification for the settlement amount, less realizable tax benefits,
      pursuant to the merger agreement for the Company’s acquisition of Learning
      Curve, and the Company received $10.1 million from an escrow account as of
      December 31, 2003, to fund part of the settlement payment. On
      March 30, 2004, the Company made additional escrow claims of
      $0.3 million relating primarily to alleged breaches of Learning Curve’s
      representations and warranties in the merger agreement. On August 31, 2004,
      the Company increased its additional escrow claims to $0.5 million. The
      Company and representatives of the former Learning Curve shareholders entered
      into a letter agreement, dated December 14, 2004, which resolved all of the
      Company’s pending escrow claims as of the date of the letter agreement, and the
      Company returned $2.8 million to the escrow account. The escrow amount was
      approximately $2.9 million at December 31, 2005. In February and April
      2005, the Company had notified the representatives of the former Learning Curve
      shareholders of certain claims relating to a tax audit and other matters. During
      2006, an agreement was reached with the representatives of the former Learning
      Curve shareholders resolving all open escrow claims and disbursing all amounts
      in escrow other than approximately $0.3 million which will remain in escrow
      to pay certain of the Company’s expenses to pursue a pending malpractice
      litigation claim.





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





**11.
      CAPITAL STOCK**





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





**Authorized**
              **Shares**
            **Par**
              **Value**
            **Shares
                Outstanding at**
              **December 31,
                2005**
            **Shares
                Outstanding at**
              **December 31,
                2006**Voting
                common stock
            28,000,000
            $0.01
            20,717,954
            21,052,038





During
      the year ended December 31, 2005, the Company sold 6,436 shares out of
      treasury to Company employees under the employee stock purchase plan (ESPP)
      for
      $0.2 million. During the fourth quarter of 2005, the Company received 5,092
      shares in lieu of payment on a receivable. These shares were placed into
      treasury for $0.2 million. During the year ended December 31, 2006,
      the Company sold a total of 6,609 shares out of treasury to Company employees
      under the ESPP for $0.2 million. At December 31, 2006, the Company
      held 1,824,221 shares of its common stock in treasury.





**12.
      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.








F21





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





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





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





Prior
      to
      January 1, 2006, the Company accounted for stock-based compensation
      arrangements with employees in accordance with the provisions of ABP Opinion
      No. 25 and complied with the disclosure provisions of SFAS No. 123. If
      compensation costs for stock options issued, 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
      share would have been reduced to the following pro forma amounts:





**Year
                Ended December 31,**(in
                thousands, except per share data)
            
            **2004**
            
            **2005**Net
                income as reported
            
            $
            33,978
            
            $
            53,130Deduct:
                total stock-based employee compensation
              expense
                determined under fair value based method
              for
                all awards, net of related income tax benefit
            
            
            (1,877
            )
            
            (2,061
            )Pro
                forma net income
            
            $
            32,101
            
            $
            51,069Basic
                earnings per common share:As
                reported
            
            $
            1.82
            
            $
            2.58Pro
                forma
            
            $
            1.72
            
            $
            2.48Diluted
                earnings per common share:As
                reported
            
            $
            1.72
            
            $
            2.47Pro
                forma
            
            $
            1.62
            
            $
            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% 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 will terminate on July 1, 2007,
      unless sooner terminated by the Board of Directors.





The
      fair
      value of each option for shares issued under the ESPP during the years ended
      December 31, 2004, 2005 and 2006 is estimated on the date of grant based on
      the Black-Scholes option pricing model with the following assumptions:





**2004**
            **2005**
            **2006**Weighted
                average expected life
            3
                months
            3
                months
            3
                monthsWeighted
                average risk-free rate of return
            1.2%
            2.9%
            4.7%Weighted
                average expected volatility
            77.7%
            30.1%
            25.9%Weighted
                average dividend yield
            None
            None
            None





The
      weighted average fair value of those options granted in 2004, 2005 and 2006
      was
      $8.43, $7.08 and $4.99, respectively.





F22





During
      the first quarter of 2005, the Company evaluated the method that it had
      historically used to calculate the volatility factors used in valuing options
      issued under the ESPP. The Company had been using historical Company results
      to
      compute the volatility factors used in valuing options issued under the ESPP.
      The Company changed the method used to calculate the volatility factor for
      those
      options issued under the ESPP to that of the volatility of the Company’s common
      stock during the most recent three-month period, as it more accurately projects
      the expected volatility over the three-month ESPP period being valued.





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.





**Stock
      Incentive Plans**





The
      Company maintains 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 vest 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. This plan
      became dormant in 2005 upon the approval of the 2005 Stock Incentive Plan,
      as
      discussed below. No future issuances are authorized from this plan.





The
      Company also maintains 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 to executives or key
      employees of the Company. 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.





The
      fair
      value of stock options granted under the stock incentive plans during the years
      ended December 31, 2004, 2005 and 2006 is estimated on the date of grant
      based on the Black-Scholes option pricing model with the following
      assumptions:





**2004**
            **2005**
            **2006**Weighted
                average expected life
            7
                years
            7
                years
            7
                yearsWeighted
                average risk-free rate of return
            3.7%
            4.2%
            4.6%Weighted
                average expected volatility
            79.2%
            54.6%
            54.5%Weighted
                average dividend yield
            None
            None
            None





During
      the first quarter of 2005, the Company evaluated the method that it had
      historically used to calculate the volatility factors used in valuing stock
      options issued. The Company had been using historical Company results to compute
      the volatility factors used in valuing the stock options issued. As the
      Company’s business has changed significantly as a result of the acquisitions
      completed, the historical stock price movements have not been considered a
      good
      indicator of expected future results. Therefore, the Company changed the method
      used to calculate the expected volatility factor for those options issued under
      the stock incentive plan to correspond with the average volatility factor of
      those companies included in a peer group study. However, the Company continues
      to monitor its actual volatility to assess whether its histroical stock price
      movements over the expected option term are a good indicator of expected future
      results.





The
      Company uses historical data to estimate share option exercise and employee
      departure behavior used in the Black-Scholes option pricing model. The expected
      term of 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.





F23





A
      summary
      of stock option activity for the Company’s stock incentive plans for the years
      ended December 31, 2004, 2005 and 2006, is as follows:





**Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            **Aggregate
                Intrinsic**
              **Value**
              **(in
                000s)**
            
            **Weighted**
              **Average**
              **Remaining**
              **Contractual**
              **Life**
            
            **Shares**
              **Available**
              **for Future**
              **Grants**Outstanding
                as of December 31, 2003
            
            
            1,575,274
            
            $
            7.22
            
            
            
            
            
            
            
            
            655,470**2004**Granted
            
            
            346,135
            
            
            26.18Exercised
            
            
            355,382
            
            
            5.83Cancelled
            
            
            18,175
            
            
            13.18Outstanding
                as of December 31, 2004
            
            
            1,547,852
            
            $
            11.71
            
            
            
            
            
            
            
            
            321,135**2005**Granted
            
            
            288,242
            
            
            31.65Exercised
            
            
            253,951
            
            
            6.89Cancelled
            
            
            19,301
            
            
            13.93Outstanding
                as of December 31, 2005
            
            
            1,562,842
            
            $
            16.14
            
            
            
            
            
            
            
            
            1,173,849**2006**Granted
            
            
            259,124
            
            
            35.71Exercised
            
            
            327,475
            
            
            11.05Cancelled/Expired
            
            
            82,290
            
            
            29.23Outstanding
                as of December 31, 2006
            
            
            1,412,201
            
            $
            20.15
            
            $
            33,677
            
            
            6.4
            
            
            934,225Exercisable
                as of December 31, 2006
            
            
            776,670
            
            $
            12.28
            
            $
            24,636
            
            
            5.0





The
      following table summarizes information about stock options outstanding at
      December 31, 2006:





**Options
                Outstanding**
            
            **Options
                Exercisable****Range
                of**
              **Exercise
                Price**
            **Number**
              **Outstanding**
            **Weighted**
              **Average**
              **Remaining**
              **Contractual
                Life**
            **Weighted**
              **Average**
              **Exercise
                Price**
            
            **Number**
              **Exercisable**
            **Weighted**
              **Average**
              **Exercise
                Price**$ 
                1.41 to $  9.84
            462,169
            4.2
            $ 
                6.03
            
            462,169
            $ 
                6.03$10.94
                to $15.10
            213,715
            5.1
            13.16
            
            143,415
            12.94$24.78
                to $29.94
            232,956
            7.1
            25.46
            
            87,156
            24.88$31.27
                to $37.19
            503,361
            8.6
            $33.63
            
            83,930
            $32.45





The
      weighted average fair value of options granted under the Company’s stock
      incentive plans for the years ended December 31, 2004, 2005 and 2006 was
      $19.40, $18.89 and $21.48 per share, respectively. The total intrinsic value
      of
      options exercised during the years ended December 31, 2004, 2005 and 2006
      was $8.0 million, $6.9 million and $9.3 million,
      respectively.





As
      of
      December 31, 2006, there was $9.4 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 3.3 years. The total fair value
      of
      options vested during the year ended December 31, 2006 was
      $3.8 million.





**13.
      RELATED PARTY TRANSACTIONS**





The
      Company purchased approximately $7.8 million, $13.4 million and
      $17.9 million of product during 2004, 2005 and 2006, respectively, from a
      company in which a relative of a Company stockholder/director has ownership
      interests. Accounts payable to this company were $0.5 million and
      $1.0 million as of December 31, 2005 and 2006, respectively.
      Additionally, in 2005, the Company began purchasing product from a second
      company in which the same individual has a partial ownership interest. The
      Company purchased $5.1 million and $9.7 million in 2005 and 2006,
      respectively, from this second company. Accounts payable to this second company
      at December 31, 2005 and 2006, were $0.1 million and
      $0.5 million, respectively.








F24





**14.
      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% of pre-tax gross wages,
      limited to a maximum annual amount as set periodically by the IRS. The Company
      makes matching contributions of 100% on the first 4% of employees’ annual wages
      and 50% on the next 6% of an employee’s annual wages. For the years ended
      December 31, 2004, 2005 and 2006, the Company contributions were
      $0.5 million, $1.1 million and $1.3 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% 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.


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.


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 incremental effect
      of applying SFAS No. 158 on individual line items in the consolidated
      balance sheet at December 31, 2006 is as follows:





(in
                thousands)
            
            **Before
                Application**
              **of
                SFAS No. 158**
            
            **Adjustments**
            
            **After
                Application**
              **of
                SFAS No. 158**Intangible
                assets, net
            
            $
            96,533
            
            $
            (133
            )
            $
            96,400Total
                assets
            
            
            614,773
            
            
            (133
            )
            
            614,640Deferred
                income taxes
            
            
            45,573
            
            
            (49
            )
            
            45,524Total
                liabilities
            
            
            162,763
            
            
            (49
            )
            
            162,714Accumulated
                other comprehensive income
            
            
            8,922
            
            
            (84
            )
            
            8,838Total
                stockholders’ equity
            
            
            452,010
            
            
            (84
            )
            
            451,926Total
                liabilities and stockholders’ equity
            
            $
            614,773
            
            $
            (133
            )
            $
            614,640







F25





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





**December 31,**(in
                thousands)
            
            **2004**
            
            **2005**
            
            **2006****Change
                in benefit obligation**Benefit
                obligation at beginning of year
            
            $
            11,674
            
            $
            13,583
            
            $
            14,599Service
                cost
            
            
            111
            
            
            108
            
            
            105Interest
                cost
            
            
            688
            
            
            768
            
            
            789Actuarial
                loss (gain)
            
            
            1,499
            
            
            558
            
            
            (509
            )Benefits
                paid and plan expenses
            
            
            (389
            )
            
            (418
            )
            
            (462
            )Benefit
                obligation at end of year
            
            $
            13,583
            
            $
            14,599
            
            $
            14,522**Change
                in plan assets**Fair
                value of assets at beginning of year
            
            $
            8,877
            
            $
            10,587
            
            $
            11,464Actual
                return on plan assets
            
            
            902
            
            
            606
            
            
            1,402Employer
                contributions
            
            
            1,197
            
            
            689
            
            
            —Benefits
                paid and plan expenses
            
            
            (389
            )
            
            (418
            )
            
            (462
            )Fair
                value of assets at end of year
            
            $
            10,587
            
            $
            11,464
            
            $
            12,404**Funded
                status at end of year**
            
            $
            (2,996
            )
            $
            (3,135
            )
            $
            (2,118
            )


**Amounts
                  Recognized in the Consolidated Balance Sheets**Intangible
                  assets
              
              $
              171
              
              $
              152
              
              $
              —Other
                  non-current liabilities
              
              
              2,996
              
              
              3,135
              
              
              2,118Accumulated
                  other comprehensive income
              
              $
              5,594
              
              $
              6,152
              
              $
              4,914**Amounts
                  Recognized in Accumulated Other Comprehensive
                  Income**Prior
                  service cost
              
              $
              —
              
              $
              —
              
              $
              133Actuarial
                  loss
              
              
              5,594
              
              
              6,152
              
              
              4,781Accumulated
                  other comprehensive income
              
              $
              5,594
              
              $
              6,152
              
              $
              4,914


**December 31,**(in
                thousands)
            
            **2004**
            
            **2005**
            
            **2006****Information
                for Pension Plans with an Accumulated Benefit Obligation in Excess
                of Plan
                Assets**Projected
                benefit obligation
            
            $
            13,583
            
            $
            14,599
            
            $
            14,522Accumulated
                benefit obligation
            
            
            13,583
            
            
            14,599
            
            
            14,522Fair
                value of plan assets
            
            $
            10,587
            
            $
            11,464
            
            $
            12,404








F26





**Components
      of Net Periodic Benefit Cost**


**Year
                Ended December 31,**(in
                thousands)
            
            **2004**
            
            **2005**
            
            **2006**Service
                cost
            
            $
            111
            
            $
            108
            
            $
            105Interest
                cost
            
            
            688
            
            
            768
            
            
            789Expected
                return on plan assets
            
            
            (866
            )
            
            (978
            )
            
            (981
            )Amortization
                of prior service cost
            
            
            19
            
            
            19
            
            
            19Amortization
                of net loss
            
            
            181
            
            
            372
            
            
            441Net
                periodic benefit cost
            
            $
            133
            
            $
            289
            
            $
            373





**Estimated
                Items That Will Be Amortized from Accumulated Other Comprehensive
                Income**
              **into
                Net Periodic Benefit Cost during 2007**Prior
                service cost
            
            
            
            
            
            
            
            $
            19Actuarial
                loss
            
            
            
            
            
            
            
            
            385Expected
                recognition of expense
            
            
            
            
            
            
            
            $
            404





**Estimated
                Future Benefit Payments**2007
            
            $
            4872008
            
            
            5242009
            
            
            5752010
            
            
            5972011
            
            
            6322012
                to 2016
            
            $
            3,993





**Assumptions**





**2004**
            **2005**
            **2006****Weighted
                Average Assumptions Used**
              **to
                Determine Benefit Obligations**
              **at
                December 31**Discount
                rate
            5.75%
            5.50%
            5.75%Rate
                of compensation increase
            N/A
            N/A
            N/A





**Weighted
                Average Assumptions Used**
              **to
                Determine Net Periodic Benefit Cost**
              **for
                the Years Ended December 31**Discount
                rate
            6.00%
            5.75%
            5.50%Expected
                return on plan assets
            8.50%
            8.50%
            8.50%Rate
                of compensation increase
            N/A
            N/A
            N/A




F27





**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 markets principle that assets with
      higher volatility generate a greater return over the long run. Current market
      factors such as inflation and interest rates are evaluated before long-term
      capital market assumptions are determined. The long-term portfolio return is
      established via a building-block approach with proper consideration of
      diversification and rebalancing. Peer data and historical returns are reviewed
      to check for reasonableness and appropriateness.





**Projected
      Annual Returns**





Based
      on
      the current target allocation of assets, the expected return model estimates
      a
      long-term average (50 th percentile) rate of return (nominal) of 8.52% 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
                Returns****Time
                Period**
            
            **75th**
            
            **50th**
            
            **25****th**1
                year
            
            
            (0.10
            )%
            
            8.52
            %
            
            17.87
            %5
                years
            
            
            4.58
            
            
            8.52
            
            
            12.6010
                years
            
            
            5.72
            
            
            8.52
            
            
            11.3920
                years
            
            
            6.53
            %
            
            8.52
            %
            
            10.54
            %





**Plan
      Assets**





The
      allocation of assets between major asset categories as of December 31, 2005
      and 2006, as well as the target allocation, are as follows:





**Percentage
                of Plan Assets**
              **at
                December 31,****Asset
                Category**
            
            **Target**
              **Allocation**
            
            **2005**
            
            **2006**Large
                cap domestic equity securities
            
            
            45
            %
            
            40
            %
            
            48
            %Mid
                cap domestic equity securities
            
            
            5
            
            
            5
            
            
            —Small
                cap domestic equity securities
            
            
            5
            
            
            4
            
            
            4International
                equity securities
            
            
            10
            
            
            9
            
            
            18Fixed
                income securities
            
            
            35
            
            
            42
            
            
            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**





There
      are
      no minimum required contributions to the Plan for fiscal year 2007. 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.





F28





**15.
      INVESTMENT**





An
      investment of $0.7 million and $2.1 million is included in other
      non-current assets on the accompanying consolidated balance sheets at
      December 31, 2005 and 2006, respectively, 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 has 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.




**16.
      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 on the accompanying consolidated statement
      of earnings for the year ended December 31, 2005.





**17.
      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, 2004, 2005 and 2006 were as follows:




**Year
                Ended December 31,**(in
                thousands)
            
            **2004**
            
            **2005**
            
            **2006**Net
                sales
            
            $
            13,738
            
            $
            11,679
            
            $
            14,101Income
                before income taxes
            
            $
            2,574
            
            $
            634
            
            $
            2,701





A
      loss on
      the sale of $11.4 million, net of income tax benefit, was recognized on
      this transaction. The loss is presented in income (loss) from discontinued
      operations, net of tax, on the accompanying consolidated statement of earnings
      for the year ended December 31, 2006. For tax purposes, this sale
      generated a pre-tax capital loss of $15.7 million. A valuation allowance of
      $5.8 million has been established because the Company does not believe
      recoverability of this amount is more likely than not.




Total
      assets of the sold business of $18.7 million are included in the accompanying
      consolidated balance sheet at December 31, 2005.  Current assets,
      consisting primarily of accounts receivable and inventory, were $1.9 million
      and
      goodwill was $15.7 million.





**18.
      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 restructuring charge related to discontinued automotive
      collectibles on the accompanying consolidated statement of earnings for the
      year
      ended December 31, 2006:





(in
                thousands)
            
            **North
                America**
            
            **International**
            
            **Total**Write-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
                of minimum guaranteed royalties
            
            
            1,186
            
            
            —
            
            
            1,186Total
            
            $
            13,542
            
            $
            961
            
            $
            14,503




**19.  SUBSEQUENT
        EVENT**
 
 In
        February 2007, the Company's Board of Directors authorized the adoption of
        a program to repurchase up to $75.0 million in shares of the Company's common
        stock.  Shares may be repurchased from time to time in open market
        transactions or privately negotiated transactions at the Company's discretion,
        subject to market conditions and other factors.  Shares repurchased by the
        Company will be held as treasury shares.  The program has
        initially been authorized for a period of one year, but may be extended beyond
        that period or may be suspended at any time.




F29