SECURITIES
        AND EXCHANGE COMMISSION


Washington,
      D.C.  20549





Form
      10-K





[x]
              Annual
                  Report pursuant to Section 13 or 15(d) of the Securities Exchange
                  Act of
                  1934
                for
                  the
                  fiscal year ended December 31, 2008.[
                ]
              Transition
                  Report
                  pursuant to Section 13 or 15(d) of the Securities Exchange Act
                  of
                  1934
                for
                  the transition period from ______ to
                  ______.













Commission
      file number 0-22635





RC2
      Corporation


(Exact
      name of Registrant as specified in its charter)





Delaware
            
            36-4088307(State
                or other jurisdiction of incorporation or organization)
            
            (IRS
                Employer Identification No.)1111
                West 22nd
                Street, Suite 320, Oak Brook, Illinois
            
            60523(Address
                of principal executive offices)
            
            (Zip
                code)Registrant’s
                telephone number, including area code: 630-573-7200Securities
                registered pursuant to Section 12(b) of the Exchange
                Act:Title
                of each class
            
            Name
                of each exchange on which registeredCommon
                Stock, Par Value $0.01 Per Share
            
            The
                NASDAQ Stock MarketSecurities
                registered pursuant to Section 12(g) of the Exchange Act:
                None





Indicate
      by check mark if the Registrant is a well-known seasoned issuer, as defined
      by
      Rule 405 of the Securities Act.  Yes  _  No X





Indicate
      by check mark if the 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. [X]





Indicate
      by check mark whether the Registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer or a smaller reporting
      company.  See the definitions of “large accelerated filer,”
“accelerated filer,” and “smaller reporting company” in Exchange Act Rule
      12b-2.


Large
                accelerated filer  [  ]
            Accelerated
                filer  [X]Non-accelerated
                filer  [  ]
            Smaller
                reporting company  [  ](Do
                not check if a smaller reporting company)








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


Yes
      _  No X





Aggregate
      market value of the Registrant’s common stock held by non-affiliates as of June
      30, 2008 (the last business day of the Registrant’s most recently completed
      second quarter): $311,111,072.  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 24, 2009:
      17,248,420





DOCUMENTS
      INCORPORATED BY REFERENCE





Portions
      of the Proxy Statement for the 2009 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 and toddler products.  Our leadership
      position is measured by sales and brand recognition.  Our infant,
      toddler and preschool products are marketed under our Learning Curve® family of
      brands, which includes The First Years® and Lamaze brands, as well as popular
      and classic licensed properties such as Thomas & Friends, Bob
      the Builder, Winnie the Pooh, John Deere
      and Sesame
      Street.  We market our 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, Asia Pacific and South
      America.





2


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
      (loss) and net assets, see Note 4 to our consolidated financial
      statements included elsewhere herein.





Products





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





Our
      mother, infant and toddler products category includes a wide range of products
      related to infant and toddler feeding, gear, care and play, which are
      marketed under such brands as The First Years and Lamaze.  Some of the
      key product lines in this category include the Take & Toss® toddler
      self-feeding system, Lamaze infant development products and American
      Red Cross health and wellness products.  In 2008, we introduced The
      First Years True Fit convertible car seat.  During 2008, the True Fit
      convertible car seat received a four-star Ease of Use rating from the National
      Highway Traffic Safety Administration.  Additionally in 2008, we
      introduced a range of new safety products within our American Red Cross
      health and wellness product line including several child-proofing
      essentials.  In 2009, we plan to introduce new products under both The
      First Years and Lamaze brands.





Our
      preschool, youth and adult products category includes our Learning Curve, Johnny
      Lightning and Ertl brands and features products with such licensed properties
      as
Thomas & Friends,
Bob
      the Builder andJohn Deere.  In 2008, we
      introduced Caring Corners®, a product line featuring an interactive dollhouse
      and full line of dolls and accessories, which rewards positive behaviors like
      caring, sharing and preparing for responsibility, both during play and real
      life.  Additionally, in 2008, we launched the Thomas & Friends Talking
      Railway Series which incorporates RFID technology into the wooden
      railway.  This series includes talking railway vehicles and
      destinations.  In 2009, we plan to introduce a new toy product line
      featuring the literacy-powered superhero stars from the popular PBS show Super WHY!  This
      line will feature plush toys, figures, vehicles, play sets and electronic
      learning aids.





International.  In
      addition to our business in North America, in 2008, we operated in more than
      50
      countries, selling a representative range of our mother, infant and toddler
      and preschool, youth and adult product lines.  The geographic regions
      in the International segment include Europe, Australia, Asia Pacific and South
      America.  Key international brands for 2008 include Thomas & Friends Wooden
      Railway, Take Along Thomas, Bob the Builder, The First
      Years and Lamaze.





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





Licenses





We
      market
      a significant portion of our products with licenses from other
      parties.  A significant element of our strategy depends on our ability
      to identify and obtain licenses for recognizable and respected brands and
      properties.  Our licenses reinforce our brands and establish our
      products’ overall appeal with consumers, and in some cases, provide for new
      product development opportunities and expanded distribution
      channels.  Our licenses are generally limited in scope and duration
      and authorize the sale of specific licensed products, generally on a
      nonexclusive basis.





3


We
      have
      entered into agreements to license such properties from, among others, Disney
      Consumer Products, Inc. (including Disney characters such as Winnie the Pooh), HIT
      Entertainment (relating to its Thomas & Friends and
Bob
      the Builder
      properties), The American National Red Cross, Lamaze International, Inc., and
      John Deere Shared Services, Inc.





We
      are a
      party to more than 300 license agreements with terms generally of two to three
      years.  Any termination of or failure to renew our significant
      licenses, or inability to develop and enter into new licenses, could limit
      our
      ability to market our products or develop new products and reduce our net sales
      and profitability.  For the year ended December 31, 2008, net sales of
      the Company’s products with the licensed properties 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, 2008.  Our license agreement with HIT
      Entertainment for the Take Along Thomas & Friends die-cast
      product line will terminate at the end of 2009.  This license agreement
      provides for a six month sell-off period following the license termination
      date.  Our license with HIT Entertainment for the Thomas & Friends Wooden Railway product
      line and our license agreements for our John Deere product lines have been
      renewed for multiple years.




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. As
      of
      December 31, 2008, 40.6% of our licenses require us to make minimum
      guaranteed royalty payments, whether or not we meet specific sales
      targets.  Aggregate future minimum guaranteed royalty payments as of
      December 31, 2008, are $38.5 million, with the individual minimum guarantees
      ranging from $1.00 to $16.7 million.  Royalty expense related to
      licenses with minimum guarantees for the year ended December 31, 2008, was
      $28.2
      million.





Channels
      of Distribution





Our
      products are available through more than 25,000 retail outlets located in North
      America, Europe, Australia, Asia Pacific and South America.  We market
      our products through multiple channels of distribution in order to maximize
      our
      sales opportunities for our broad product offering.  Products with
      lower price points are generally sold in chain retailer channels and
      higher-priced products are typically sold in hobby, collector and independent
      toy stores, and through wholesalers and original equipment manufacturers
      (OEMs).  We believe we have a leading position in multiple
      distribution channels and that this position extends the reach of our products
      to consumers and mitigates the risk of concentration by channel or
      customer.





Chain
      retailers.  Our products marketed through this channel are
      targeted predominately at price conscious end-users.  As a result, the
      majority of our products marketed through this channel are designed to span
      lower price points.  Customers included in this channel have more than
      ten retail locations and include a wide range of retailers, such as book, farm
      and ranch, craft/hobby and juvenile products stores, as well as the national
      toy
      and discount retailers.  Key customers in our chain retailer channel
      include Target, Toys “R” Us/Babies “R” Us, Wal-Mart, Tractor Supply Company and
      Sears/Kmart.  Sales in 2008 to chain retailers were 70.3% of our net
      sales.





Specialty
      retailers, wholesalers, OEM dealers and other.  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 29.7% of our net sales in 2008.  Additionally, we
      often sell licensed products to the licensing OEM’s dealer
      network.  OEM licensing partners benefit from our OEM dealer sales
      through the opportunity to receive royalties from additional product sales
      through the OEM’s dealer network.  We often provide OEM dealers with a
      short-term, exclusivity period in which the OEM dealers have the opportunity
      to
      purchase new products for a short period (generally 90 to 360 days) before
      the
      products become available through other distribution channels.  We
      reach these customers directly through our internal telesales group, our
      business-to-business website located at www.myRC2.com
      and through specialty sales representatives.  We also make certain
      products available to consumers through a company store and our website located
      at www.learningcurveshop.com.  Individual
      products sold directly to consumers sell at prices similar to those found at
      retailers, hobby stores and OEM dealers.  Key customers in our
      specialty retailers, wholesalers, OEM dealers and other channel include Learning
      Express, All Aboard Toys, John Deere and Case New Holland.





4


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®, Take & Toss® and Caring Corners®.  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 chain retail and wholesale
      accounts.  A number of accounts are designated as “house accounts” and
      are handled exclusively by our internal sales staff.  Our inside sales
      and customer service groups use telephone calls, mailings, faxes and e-mails
      to
      directly contact OEM dealers and smaller volume customers, such as collector,
      hobby, specialty and independent toy stores.





Our
      internal sales force is supplemented by external sales representative
      organizations.  These external sales representative organizations
      provide more frequent customer contact and solicitation of the specialty,
      regional and national retailers and supported 30.9% of our net sales in
      2008.  External sales representatives earn commissions of 1.0% to
      10.0% of the net sales price from their accounts.  Their commissions
      are unaffected by the involvement of our internal sales force with a customer
      or
      sale.





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





We
      support our product lines with various advertising and marketing
      promotions.  Advertising takes place at varying levels throughout the
      year and peaks during the traditional holiday season.  Advertising
      includes television commercials and print advertisements in magazines and other
      publications.  Marketing includes, but is not limited to, digital
      media, including our websites www.learningcurve.com,
      www.johnnylightning.com
      and www.ertl.com,
      in-store displays, merchandising material and public relations.  We
      also work closely with retail chains to plan and execute ongoing retailer-driven
      promotions and advertising.  These programs usually involve promotion
      of our products in retail customers’ print circulars, mailings and catalogs, and
      sometimes include placing our products in high-traffic locations within retail
      stores.





Competition





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





5


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 the first to market with many innovative products.





Far
      east product
      sourcing.  We have operations in Kowloon, Hong Kong, and in the
      RC2 and LC Industrial Zones in China, and employ 265 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, graphic art and finance support functions, executes the
      production schedule, provides on-site quality control, facilitates third-party
      safety testing and coordinates the delivery of shipments for export from
      China.





Far
      east
      production.  All of our products are manufactured in China,
      except for certain plastic ride-ons and certain infant and toddler
      products.  Our China-based product sourcing accounted for
      approximately 90.0% of our product purchases in 2008.  We primarily
      use eight third-party, dedicated suppliers who manufacture only our products
      in
      eight factories, three of which are located in the RC2 Industrial Zone and
      two
      of which are located in the LC Industrial Zone.  The RC2 Industrial
      Zone is the name of a factory complex developed in 1997 and located in Dongguan
      City, China, (approximately 50 miles from Hong Kong) where three of our
      third-party, dedicated suppliers operate freestanding factory
      facilities.  The LC Industrial Zone is the name of a factory complex
      developed in 2007 and located in Shaoguan City, China, (approximately 200 miles
      from Hong Kong) where two of our third-party, dedicated suppliers operate
      freestanding factory facilities.  Most of our third-party, dedicated
      suppliers have been supplying us for more than ten
      years.  Third-party, dedicated suppliers produced 42.0% of our
      China-based product purchases in 2008.  In order to supplement our
      third-party, dedicated suppliers, we use several other suppliers in
      China.  All products are manufactured to our specifications using
      molds and tooling that we own.  These suppliers own the manufacturing
      equipment and machinery, purchase raw materials, hire workers and plan
      production.  We purchase fully assembled and packaged finished goods
      in master cartons for distribution to our customers.  We enter into
      purchase orders with our foreign suppliers and generally do not enter into
      long-term contracts.





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





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





Tooling.  To
      create new products, we continuously invest in new tooling.  Tooling
      represents the majority of our capital expenditures.  Depending on the
      size and complexity of the product, the cost of tooling a product generally
      ranges from $3,000 to $250,000.  We own all of our tools and provide
      them to our suppliers during production.  Tools are returned to us
      when a product is no longer in production and are stored for future
      use.





6


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.  Following the 2007 recall of certain
      products, we established additional safeguards through our Multi-Check Safety
      System which includes:





●
            Increased
                scope and frequency of testing for both incoming material and
                finished products, including testing of finished products from every
                production run.●
            Tougher
                certification program for contract manufacturers and paint suppliers,
                including evidence that toy safety standards and quality control
                procedures are in place and operating effectively.●
            Mandatory
                paint control procedures for contract manufacturers, including certified
                independent lab test results of every batch of wet paint before the
                paint
                is released for production.●
            Increased
                random inspections and audits of both manufacturers and their suppliers,
                including semi-annual audits and quarterly random inspections for
                key
                suppliers.●
            Zero
              tolerance for
              compromise on RC2 specifications reinforced by mandatory vendor compliance
              seminars and signed agreements.





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





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





Seasonality





We
      have
      experienced, and expect to continue to experience, substantial fluctuations
      in
      our quarterly net sales and operating results, which is typical of many
      companies in our industry.  Our business is highly seasonal due to
      high consumer demand for our products during the year-end holiday
      season.  Approximately 58.7% of our net sales for the three years
      ended December 31, 2008, were generated in the second half of the year, with
      August, September and October 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 three customers, Target, Toys “R” Us/Babies “R” Us
      and Wal-Mart, combined accounted for 40.1% of our net sales in
      2008.  Other than Target, Toys “R” Us/Babies “R” Us and Wal-Mart, no
      customer accounted for more than 10.0% of our net sales in 2008.  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, 2008, we had 742 employees, 34 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.  Collective bargaining agreements cover 104 of our employees who
      work in the Company's distribution facilities.  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.


7


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.





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.





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.





Our
      license agreement with HIT Entertainment for the Take Along Thomas & Friends die-cast
      product line will terminate at the end of 2009.  This license
      agreement provides for a six month sell-off period following the license
      termination date.  For the year ended December 31, 2008, net sales of
      our products under this license agreement accounted for over ten percent of
      our
      total net sales. We are making plans for new preschool products which we believe
      will replace, in future years, the sales volume related to the Take Along Thomas & Friends die-cast
      product line.





Our
      license agreements have terms generally of two to three years.  Competition
      for licenses could require us to pay licensors higher royalties and higher
      minimum guaranteed payments in order to obtain or retain attractive licenses,
      which could increase our expenses.  In addition, licenses granted to
      other parties, whether or not exclusive, could limit our ability to market
      products, including products we currently market, which could cause our net
      sales and profitability to decline. 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.




Product
        recalls or claims relating to the use of our products could increase our
        costs
        and harm our reputation and our relationship with retailers and
        licensors.
 
 Because
        we sell infant and toddler 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.  During 2008, the Consumer Product Safety Improvement Act was
        enacted.  As a result the Consumer Product Safety Commission is
        adopting new regulations for safety and product testing that applies to
        substantially all of our products.  These new regulations significantly tighten the
        regulatory
        requirements governing the manufacture and sale of children's products and
        also
        increase the potential penalties for noncompliance with applicable 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.  Product recalls may harm our reputation and
        consumer acceptance of the affected products or our other products, which
        may
        have an adverse effect on our net sales.  The recalls may also harm
        our relationships with our retail customers, including the willingness of
        those
        customers to purchase and provide shelf space for our products and to support
        retailer driven promotions and advertising for our products. In addition,
        substantially all of our licenses give the licensor the right to terminate,
        under certain circumstances, if any products marketed under the license are
        subject to a product liability claim, recall or similar violations of product
        safety regulations, or if we breach covenants relating to the safety of the
        products or their compliance with product safety regulations. A termination
        of a license could adversely affect our net sales.  Even if a product
        liability claim is without merit, the claim could harm our reputation and
        divert
        management's attention and resources from our business.
   8
 
 During
        2007, we conducted voluntary recalls of certain of our products.  As a
        result of these recalls, we incurred charges related to these recalls, which
        included inventory return costs, consumer product replacement costs, shipping
        costs and fines and penalties, as well as donations, notice charges, claims
        administration and legal fees related to the settlement of the class action
        lawsuits stemming from the recalls, and we expensed as incurred other related
        legal and professional fees.  Additionally, we made a cash payment to
        the licensor of the products that were recalled in connection with obtaining
        a
        release from indemnification claims.  The charges and expenses we have
        incurred relating to our recalls may increase based on the amount of inventory
        of affected products at retailers, the amount of affected products that may
        be
        returned by consumers and the cost of providing replacement products to
        consumers and retailers.  In addition, we may incur additional costs,
        such as settlements with regulatory agencies, or charges for litigation relating
        to the recalls, including the possibility of potential new claims or
        litigation.  Any such additional charges or costs relating to the
        recalls may reduce our net sales and profitability.


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.  In addition,
        the
        trend of children "getting older younger,"
        where children
        are losing interest in traditional toys and games at younger ages, may increase
        the pace of change of consumer preferences that affect the demand for our
        products.  As a result of this trend, at younger and younger ages, our
        toys compete with the offerings of video game suppliers, consumer electronics
        companies and other businesses outside of the traditional toy
        industry.Our current products may not continue to be popular
        or new products that we introduce may not achieve adequate consumer acceptance
        for us to recover development, manufacturing, marketing and other
        costs.  A decline in consumer demand for our products, our failure to
        develop new products on a timely basis in anticipation of changing consumer
        preferences or the failure of our new products to achieve and sustain consumer
        acceptance could reduce our net sales and profitability.
 Uncertainty
          and adverse changes in the general economic conditions may negatively affect
          our
          business.
 
 If
          the recent decline in general economic conditions in the United States
          and other
          global markets in which we operate continues, or if consumers fear that
          economic
          conditions will continue to decline, consumers may reduce expenditures
          for
          products such as our products.  Adverse changes may occur as a result
          of adverse global or regional economic conditions, fluctuating oil prices,
          declining consumer confidence, unemployment, fluctuations in stock markets,
          contraction of credit availability, bankruptcy or liquidity problems with
          our
          customers or other factors affecting economic conditions generally. These
          changes may negatively affect the sales of our products, increase exposure
          to
          losses from bad debts, increase the cost and decrease the availability
          of
          financing, increase the risk of loss on investments, or increase costs
          associated with producing and distributing our
          products.  Additionally, our business is seasonal and, as a result,
          customers’ accounts receivable are generally highest during the fourth quarter,
          which coincides with the recent decline in general economic conditions,
          further
          increasing the exposure to losses from bad debts.
  Currency
            exchange rate fluctuations could increase our expenses.
 
 Our
            net sales are primarily denominated in U.S. dollars, with 23.0% of our
            net sales
            in 2008 denominated in British pounds sterling, Australian dollars, Euro
            dollars
            or Canadian dollars.  Our purchases of finished goods from Chinese
            manufacturers are primarily denominated in Hong Kong
            dollars.  Expenses for these manufacturers are primarily denominated
            in Chinese Renminbi.  As a result, any material increase in the value
            of the Hong Kong dollar or the Renminbi relative to the U.S. dollar would
            increase our expenses, and therefore, could adversely affect our
            profitability.  We are also subject to exchange rate risk relating to
            transfers of funds or other transactions denominated in British pounds
            sterling,
            Australian dollars, Canadian dollars or Euro dollars from our foreign
            subsidiaries to the United States, such as for purchases of inventory
            by certain
            of our foreign subsidiaries, effectively in U.S. dollars.  As a result,
            any material increase in the U.S. dollar relative to our foreign
            subsidiaries' local currencies would increase our expenses, and therefore,
            could adversely affect our profitability.  Historically, we have not hedged
            our foreign currency risk.




Our
      new credit agreement contains more restrictive debt covenants and payment terms
      and reduces our borrowing capacity, all of which may adversely affect our
      business, reduce our profitability and increase the risk of a default under
      the
      credit agreement.




On
      November 3, 2008, we entered into a new $145.0 million senior credit facility
      to
      replace our previous facility.  The credit agreement for the new
      credit facility includes more restrictive debt covenants than the previous
      credit agreement, including more restrictive financial covenants and limits
      on
      our ability to repurchase shares of our common stock.  Moreover, in
      certain circumstances the new credit facility may limit our ability to make
      acquisitions.  The new credit agreement also increases the applicable
      margins for the interest rates on outstanding borrowings under the new credit
      facility, which may increase our interest expense and reduce our
      profitability.





9






The
      new
      credit agreement contains a clean down provision that limits the maximum amount
      of borrowings under the revolving line of credit for a period of 60 consecutive
      days in the first four calendar months of each of 2009, 2010
      and
      2011.  The revolving line of credit borrowing limit under the clean
      down provision for the first four calendar months of 2009 will be $30.0 million
      and will decrease to $27.5 million for 2010 and $25.0 million for
      2011.  We had $20.1 million outstanding under our revolving line of
      credit as of December 31, 2008, and we were in compliance with the clean down
      provision for 2009 as of the date of filing of this report.  We will
      also need to begin making payments of principal at a rate of $3.8 million per
      quarter on the term loan beginning on March 31, 2009.  If we do
      not have sufficient cash flows from operations to reduce the outstanding
      borrowings under the revolving line of credit to comply with the clean down
      provision and to make payments of principal under the term loan, we may need
      to
      seek additional debt or equity financing to avoid a default under the credit
      agreement.  Such financing, if needed, may not be available on terms
      acceptable to us, if at all, or may dilute or otherwise adversely affect the
      interests of our stockholders.





The
      effect of the clean down provision, together with the reduction of borrowing
      capacity from $175.0 million under the previous credit facility to $145.0
      million under the new credit facility, may reduce our access to working capital,
      which may adversely affect our business and our profitability.




Increases
      in the cost of raw materials, labor and other costs 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, an increase in the cost of raw
      materials, labor or other costs associated with the manufacturing of our
      products could increase our cost of sales and reduce our gross
      margins.  For example, an increase in the price of zinc and resins,
      key raw materials in many of our products, and increased costs in China,
      primarily for labor, taxes and currency, reduced our gross margins in 2006,
      2007 and 2008.





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





We
      operate in highly competitive
      markets.  We compete with several large domestic and foreign companies
      such as Mattel, Inc. and Hasbro, Inc., with private label products sold by
      many
      of our retail customers and with other producers of toys, collectibles,
      and infant and toddler products.  Many of our competitors
      have longer operating histories, greater brand recognition, and greater
      financial, technical, marketing and other resources than we have.  In
      addition, we may face competition from new participants in our markets because
      the collectible, toy, and infant and toddler 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.






10




We
      may experience difficulties in integrating strategic
      acquisitions.





As
      part
      of our growth strategy, we intend to pursue acquisitions that are consistent
      with our mission and enable us to leverage our competitive
      strengths.  We acquired Learning Curve International, Inc. (Learning
      Curve) and certain of its affiliates (collectively, LCI) effective February
      28,
      2003, Playing Mantis, Inc. (PM) effective June 1, 2004, The First Years Inc.
      (TFY) effective September 15, 2004, Angels Landing, Inc. (Angels Landing)
      effective May 24, 2007, and Mother's Intuition Inc. (MI) effective November
      30,
      2007.  The integration of acquired companies and their operations into
      our operations involves a number of risks, including:





●
            the
              acquired
              business may experience losses that could adversely affect our
              profitability;●
            unanticipated
              costs
              relating to the integration of acquired businesses may increase our
              expenses;●
            possible
              failure to
              obtain any necessary consents to the transfer of licenses or other
              agreements of the acquired company;●
            possible
              failure to
              maintain customer, licensor and other relationships after the closing
              of
              the transaction of the acquired company;●
            difficulties
              in
              achieving planned cost-savings and synergies may increase our expenses
              or
              decrease our net sales;●
            diversion
                of management's attention could impair their ability to effectively
                manage
                our business operations;●
            we
              may record
              goodwill and nonamortizable intangible assets that are subject to
              impairment testing on a regular basis and potential impairment charges
              and
              we may also incur amortization expenses related to intangible assets;
              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.  Our new credit agreement may limit our ability to make
      acquisitions.  This debt leverage could adversely affect our profit
      margins and limit our ability to capitalize on future business
      opportunities.  All of our borrowing capacity is also subject to
      fluctuations in interest rates.





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





In
      2008,
      approximately 70.3% of our net sales were to chain retailers.  Our
      success depends upon the continuing willingness of these retailers to purchase
      and provide shelf space for our products.  We do not have long-term
      contracts with our customers.  In addition, our access to shelf space
      at retailers may be reduced by store closings, stricter requirements for
      children's products by retailers that we may not be able to meet, consolidation
      among these retailers and competition from other products.  An adverse
      change in our relationship with or the financial viability of one or more of
      our
      customers could reduce our net sales and profitability.







11


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





Many
      of
      our retail customers generally purchase large quantities of our products on
      credit, which may cause a concentration of accounts receivable among some of
      our
      largest customers.  Our profitability or liquidity 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, 2007 and
      2008, our credit insurance covered 7.9% and 9.8%, 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 eight third-party, dedicated suppliers in China to manufacture a significant
      portion of our products in eight factories, three of which are located in close
      proximity to each other in the RC2 Industrial Zone manufacturing complex and
      two
      of which are located in close proximity to each other in the LC Industrial
      Zone,
      both of which are located in China.  Our China-based product sourcing
      accounted for approximately 90.0% of our product purchases in
      2008.  Third-party, dedicated suppliers who manufacture only our
      products accounted for 42.0% of our China-based product purchases in
      2008.  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.




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 our 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.


12





Impairment
      charges could reduce our profitability.





In
      accordance with the provisions of Statement of Financial Accounting Standards
      (SFAS) No. 142, "Goodwill and Other Intangible Assets," we test goodwill and
      our
      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.  We conduct testing
      for impairment during the fourth quarter of our fiscal year.  In the
      fourth quarter of 2008, we recorded goodwill impairment charges of $244.0
      million, which was a 100.0% reduction of our goodwill, and $11.9 million
      for certain of our indefinite lived intangible assets, as a result of our annual
      SFAS No. 142 test.  An amendment to our new credit facility was
      obtained to exclude the effect of these impairment charges on our financial
      covenants.  At December 31, 2008, we had other
      intangible assets of $82.5 million, or approximately 24.5% of our total assets,
      and no remaining goodwill.  Various uncertainties, including changes
      in consumer preferences, deterioration in the political environment, continued
      adverse conditions in the capital markets or changes in general economic
      conditions, could impact the expected cash flows to be generated by an
      intangible asset or group of intangible assets, and may result in an impairment
      of those assets.  Although such an impairment charge would be a
      non-cash expense, any impairment or change in the useful lives of the intangible
      assets could materially increase our expenses and reduce our
      profitability.  If we are required to record an impairment charge, the
      charge could affect our compliance with the debt covenants in our new credit
      facility.  Additionally, should we violate a covenant under our new
      credit facility, the cost of obtaining an amendment or waiver could be
      significant, or the lenders could be unwilling to provide a waiver or agree
      to
      an amendment.





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.





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 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.


13


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





Future
      volatility in the price of our common stock may result in securities class
      action lawsuits against us, which may require that we pay substantial damages
      or
      settlement costs in excess of our insurance coverage and incur substantial
      legal
      costs, and which may divert management's attention and resources from our
      business.





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





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




●
            advance
                notice procedures for nominations of candidates for election as directors
                and for stockholder proposals to be considered at stockholders'
                meetings;●
            covenants
                in our credit agreement restricting mergers, asset sales and similar
                transactions and a provision in our credit agreement that triggers
                an
                event of default upon the acquisition by a person or a group of persons
                of
                beneficial ownership of 33 1/3% or more of our outstanding common
                stock;
                and●
            the
                Delaware anti-takeover statute contained in Section 203 of the Delaware
                General Corporation Law.




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





Item
      1B. Unresolved Staff Comments





Not
      applicable.





14


Item
      2.  Properties





As
      of
      December 31, 2008, our facilities were as follows:





Description
            Square
                Feet
            
            Location
            Lease
                ExpirationCorporate
                headquarters
            27,050
            
            Oak
                Brook, IL
            April
                2013Learning
                Curve Brands, Inc. warehouse
            400,000
            
            Rochelle,
                IL
            November
                2019Learning
                Curve Brands, Inc. office and
              warehouses
            534,000
            
            Dyersville,
                IA
            OwnedLearning
                Curve Brands, Inc. office
            21,650
            
            Stoughton,
                MA
            August
                2010Learning
                Curve Brands, Inc. office
            3,300
            
            Bentonville,
                AR
            October
                2013Learning
                Curve Brands, Inc. office
            2,300
            
            Walnut
                Creek, CA
            May
                2010Learning
                Curve Brands, Inc. office
            1,263
            
            Kettering,
                Ohio
            Month-to-monthLearning
                Curve Brands, Inc. storage
            1,250
            
            Stoughton,
                MA
            June
                2010Learning
                Curve Brands, Inc. office
            938
            
            Edina,
                MN
            August
                2009Learning
                Curve Brands, Inc. office
            659
            
            Mission
                Viejo, CA
            November
                2010Learning
                Curve Brands, Inc. office
            495
            
            Danbury,
                CT
            Month-to-monthLearning
                Curve Brands, Inc. office
            108
            
            Kansas
                City, MO
            Month-to-monthRC2
                (H.K.) Limited RC2 Industrial Zone quarters
            68,230
            
            Dongguan
                City, China
            March
                2010RC2
                (H.K.) Limited RC2 Industrial Zone office, warehouse and
              storage
            66,365
            
            Dongguan
                City, China
            March
                2010RC2
                (H.K.) Limited office
            10,296
            
            Kowloon,
                Hong Kong
            July
                2010Racing
                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
            699
            
            Barcelona,
                Spain
            May
                2013Racing
                Champions International Limited office
            603
            
            Lauren,
                Holland
            December
                2010Racing
                Champions International Limited office
            559
            
            Marcq-En-Baroeul,
                France
            September
                2014RC2
                Canada Corporation warehouse (1)
            47,000
            
            Concord,
                Ontario
            May
                2010RC2
                Deutschland GmbH office
            2,570
            
            Marsdof,
                Germany
            December
                2010RC2
                Australia, Pty. Ltd. office and warehouse
            49,127
            
            Mount
                Waverly, Victoria, Australia
            December
                2009


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





Item
      3.  Legal Proceedings





During
      2008, the Company reached a settlement in the various class action lawsuits
      against the Company which arose from or relate to the Company’s recall of
      certain Thomas &
Friends Wooden Railway products
      in June 2007 and September
      2007.  With the final approval of the settlement agreement and the end
      of the claim period, the class action lawsuits relating to the June 2007 and
      September 2007 recalls have been resolved.  The Company may be subject
      to individual claims for personal injuries or other claims or government
      inquiries (including the inquiry by the Consumer Product Safety Commission
      (CPSC) described in the next paragraph) relating to the 2007
      recalls.  No assurances can be given as to the outcome of any such
      claims or government inquiries.





During
      2008, the Company received an inquiry from the CPSC for information regarding
      the recalls of certain Thomas
& Friends Wooden Railway toys
      in June 2007 and September 2007 for the
      purpose of asserting whether the CPSC may impose a fine on the
      Company.  The Company is in the process of responding to this inquiry,
      and at this time, the CPSC has not yet imposed a fine upon the
      Company.





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.


15





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, 2008.





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.





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





2008:
            
            High
            
            
            LowFirst
                Quarter
            
            $
            26.89
            
            
            $
            18.55Second
                Quarter
            
            
            22.01
            
            
            
            17.30Third
                Quarter
            
            
            26.83
            
            
            
            16.35Fourth
                Quarter
            
            $
            19.60
            
            
            $
            6.45





As
      of
      December 31, 2008, there were approximately 136 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
      November 1, 2011.





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
      operations for the years ended December 31, 2006, 2007 and 2008, and the
      consolidated balance sheet data as of December 31, 2007 and 2008, are derived
      from our audited consolidated financial statements included elsewhere
      herein.  The consolidated statements of operations for the years ended
      December 31, 2004 and 2005, and the consolidated balance sheet data as of
      December 31, 2004, 2005 and 2006, are derived from our audited consolidated
      financial statements, as adjusted for discontinued operations, that are not
      included herein.


16





Year
                Ended December 31,2004
            2005
            
            2006
            2007
            
            2008Consolidated
                Statement of Operations:
            (in
                thousands, except per share data)Net
                sales (1)
            $
            367,687
            
            $
            492,766
            
            $
            518,829
            
            $
            488,999
            
            $
            437,029Cost
                of sales (2)
            
            186,813
            
            
            252,935
            
            
            275,754
            
            
            270,059
            
            
            246,301Restructuring
                charge related to
              discontinued
                automotive collectibles
            
            —
            
            
            —
            
            
            1,872
            
            
            —
            
            
            —Recall-related
                items
            
            —
            
            
            —
            
            
            —
            
            
            4,624
            
            
            (1,114)Gross
                profit
            
            180,874
            
            
            239,831
            
            
            241,203
            
            
            214,316
            
            
            191,842Selling,
                general andadministrative
                expenses (2)
            
            121,785
            
            
            150,381
            
            
            155,180
            
            
            161,560
            
            
            155,903Amortization
                of intangible assets
            
            94
            
            
            1,385
            
            
            1,149
            
            
            893
            
            
            889Impairment
                of goodwill andother
                intangible assets
            
            4,318
            
            
            —
            
            
            —
            
            
            —
            
            
            255,853Gain
                on sale of W. Britain product line
            
            —
            
            
            (1,953
            )
            
            —
            
            
            —
            
            
            —Restructuring
                charge related to
              discontinued
                automotive collectibles
            
            —
            
            
            —
            
            
            12,631
            
            
            —
            
            
            —Recall-related
                items
            
            —
            
            
            —
            
            
            —
            
            
            18,068
            
            
            15,782Terminated
                acquisition costs
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            1,399Operating
                income (loss)
            
            54,677
            
            
            90,018
            
            
            72,243
            
            
            33,795
            
            
            (237,984)Interest
                expense
            
            4,437
            
            
            6,634
            
            
            4,375
            
            
            2,712
            
            
            6,584Interest
              income
            
            (374
            )
            
            (651
            )
            
            (910
            )
            
            (1,197
            )
            
            (1,579)Write-off
                of investment
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            2,057Other
                (income) expense
            
            (508
            )
            
            146
            
            
            530
            
            
            (1,768
            )
            
            (3,553)Income
                (loss) from continuing
              operations
                before income taxes
            
            51,122
            
            
            83,889
            
            
            68,248
            
            
            34,048
            
            
            (241,493)Income
                tax expense (benefit)
            
            18,755
            
            
            31,153
            
            
            24,478
            
            
            12,472
            
            
            (35,741)Income
                (loss) from continuingoperations
            
            32,367
            
            
            52,736
            
            
            43,770
            
            
            21,576
            
            
            (205,752)Income
                (loss) from discontinuedoperations,
                net of tax
            
            1,611
            
            
            394
            
            
            (9,676
            )
            
            110
            
            
            —Net
                income (loss)
            $
            33,978
            
            $
            53,130
            
            $
            34,094
            
            $
            21,686
            
            $
            (205,752)Basic
                earnings (loss) per common share:Income
                (loss) from continuing operations
            $
            1.73
            
            $
            2.56
            
            $
            2.09
            
            $
            1.05
            
            $
            (11.82)Income
                (loss) from discontinued operations
            
            0.09
            
            
            0.02
            
            
            (0.46
            )
            
            0.01
            
            
            —Net
                income (loss)
            $
            1.82
            
            $
            2.58
            
            $
            1.63
            
            $
            1.06
            
            $
            (11.82)Diluted
                earnings (loss) per common share:Income
                (loss) from continuing operations
            $
            1.64
            
            $
            2.45
            
            $
            2.04
            
            $
            1.04
            
            $
            (11.82)Income
                (loss) from discontinuedoperations
            
            0.08
            
            
            0.02
            
            
            (0.45
            )
            
            0.01
            
            
            —Net
                income (loss)
            $
            1.72
            
            $
            2.47
            
            $
            1.59
            
            $
            1.05
            
            $
            (11.82)Weighted
                average shares outstanding:Basic
            
            18,687
            
            
            20,613
            
            
            20,884
            
            
            20,395
            
            
            17,406Diluted
            
            19,761
            
            
            21,532
            
            
            21,377
            
            
            20,748
            
            
            17,406As
                of December 31,Consolidated
                Balance Sheet Data:
            2004
            
            2005
            2006
            
            2007
            2008Working
                capital
            $
            112,931
            
            $
            113,286
            
            $
            129,603
            
            $
            67,128
            
            $
            125,799Total
                assets
            
            585,748
            
            
            629,736
            
            
            614,640
            
            
            650,245
            
            
            336,650Total
                debt
            
            131,250
            
            
            82,647
            
            
            22,438
            
            
            95,000
            
            
            95,120Total
                stockholders’ equity
            $
            346,762
            
            $
            398,951
            
            $
            451,926
            
            $
            397,378
            
            $
            148,689


(1)  Net
      sales for the years ended December 31, 2007 and 2008, include $(5.6) million
      and
      $0.3 million, respectively, in recall-related items.


(2)  Depreciation
      expense was $15.3 million, $14.4 million, $14.1 million, $13.9 million and
      $15.4
      million for the years ended December 31, 2004, 2005, 2006, 2007 and 2008,
      respectively.


17


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





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





Overview





We
      are a
      leading designer, producer and marketer of innovative, high-quality toys,
      collectibles, and infant and toddler products.  We reach our target
      consumers through multiple channels of distribution supporting more than 25,000
      retail outlets throughout North America, Europe, Australia, Asia Pacific and
      South America.  Our product categories include (i) mother, infant and
      toddler products and (ii) preschool, youth and adult products.  We
      market a significant portion of our products with licenses from other parties,
      and we are currently a party to more than 300 license agreements.





Sales.Our
      sales are primarily derived from the sale of mother, infant and toddler products
      and preschool, 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.  For the years ended December
      31, 2006, 2007 and 2008, sales to chain retailers comprised 68.0%, 68.3% and
      70.3%, respectively, of our net sales.





Our
      products are marketed and distributed primarily in North America, Europe,
      Australia, Asia Pacific and South America.  International sales,
      defined as sales outside of North America, constituted 16.7%, 22.1% and 25.3%,
      or our net sales for the years ended December 31, 2006, 2007 and 2008,
      respectively.  We expect international sales to continue to increase
      in local currencies as we expand our geographic reach.  Net sales
      in our international segment increased 2.2% for the year ended December 31,
      2008, which includes a negative impact of 4.7% related to changes from currency
      exchange rates.  We expect unfavorable foreign currency rates to have
      a negative impact on sales, especially in the first half of 2009.





We
      derive
      a significant portion of our sales from some of the world’s largest
      retailers.  Our top three customers, Target, Toys "R" Us/Babies "R" Us
      and Wal-Mart, combined accounted for 44.2%, 42.6% and 40.1% of our net
      sales in 2006, 2007 and 2008, respectively.  Over the last three
      years, each of these three customers accounted for between 12.1% and 16.3%
      of our net sales. No
      other
      customers accounted for more than 10.0% of the Company’s net sales in any of the
      years ended December 31, 2006, 2007 or 2008.





18


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, 2006, 2007 and 2008, direct
      sales from China constituted 14.7%, 15.6% and 14.1%, respectively, of our net
      sales.





We
      do not
      ordinarily sell our products on consignment, and we ordinarily accept returns
      only for defective merchandise.  In certain instances, where retailers
      are unable to resell the quantity of products that they have purchased from
      us,
      we may, in accordance with industry practice, assist retailers in selling such
      excess inventory by offering credits and other price concessions, which are
      typically evaluated and issued annually.  Returns and allowances on an
      annual basis have ranged from 6.2% to 8.6% of our net sales over the last three
      years.  Returns and allowances for the years ended December 31, 2007
      and 2008, include $5.6 million and $(0.3) million, respectively, of items
      related to the 2007 recalls, causing returns and allowances to be at the higher
      end of the annual range in 2007.





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 82.5%, 82.3% and 80.0% of our cost of sales in
      2006, 2007 and 2008, respectively.  The remainder of our cost of sales
      primarily includes tooling depreciation, freight-in from suppliers, inventory
      reserves, concept and design expenses, employee compensation, expense related
      to
      stock-based payment arrangements and, in 2007 and 2008, certain recall-related
      items.  Our purchases of finished products from Chinese manufacturers
      are primarily denominated in Hong Kong dollars.  Expenses for these
      manufacturers are primarily denominated in Chinese Renminbi.  As a
      result, any material increase in the value of the Hong Kong dollar or the
      Renminbi relative to the U.S. dollar would increase our expenses, and therefore,
      could adversely affect our profitability.  Additionally, as certain of our
      foreign subsidiaries purchase inventory, effectively in U.S. dollars, any
      material increase in the U.S. dollar relative to our foregn subsidiaries' local
      currencies would increase our expenses, and therefore, could adversely affect
      out profitability.





Additionally,
      if our suppliers experience increased raw materials, labor or other costs,
      and
      pass along such cost increases to us through higher prices for finished goods,
      our cost of sales would increase, and to the extent we are unable to pass such
      price increases along to our customers, our gross margins would
      decrease.  For example, increases in the price of zinc, a key
      component in die-cast products, and increased costs in China, primarily for
      labor, taxes and currency, reduced our gross margins in 2006, 2007 and
      2008.





Our
      quarterly gross margins can also be affected by the mix of product that is
      shipped during each quarter.  Our mother, infant and toddler products
      category has higher sales of non-licensed products that carry lower selling
      prices and gross margins than our preschool, youth and adult products
      category.  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, freight-out to customers, sales
      commissions, expense related to stock-based compensation arrangements and,
      in
      2007 and 2008, certain recall-related items.  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 2008, aggregate royalties by product ranged from
      approximately 0.3% to 17.0% of our net sales price.  Royalty expense
      was 7.4%, 7.1% and 7.1% of our net sales for the years ended December 31, 2006,
      2007 and 2008, respectively.  Sales commissions range from 1.0%
      to 10.0% of the net sales price, and are generally paid quarterly to our
      external sales representative organizations.  Sales subject to
      commissions represented 30.2%, 29.5% and 30.9% of our net sales for the years
      ended December 31, 2006, 2007 and 2008, respectively.  Sales
      commission expense was 1.2%, 1.2% and 1.1% of our net sales for the years ended
      December 31, 2006, 2007 and 2008, respectively.





19


In
      the
      fourth quarter of 2008, the Company implemented an operating cost reduction
      plan.  Under this plan, the Company reduced approximately 15.0% of its
      full-time, white-collar workforce.  In addition, the Company has
      enacted plans to reduce non-payroll operating expenses in 2009.  In
      connection with this plan and other personnel changes, the Company incurred
      severance and other non-cash charges of $1.5 million, net of tax, in the fourth
      quarter of 2008.





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 58.7% of our net sales for the three years
      ended December 31, 2008, 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.





20


Results
      of Operations





Year
                Ended December 31,2006
            
            
            2007
            
            
            2008(in
                thousands, except per share data)
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            PercentNet
                sales (1)
            
            $
            518,829
            
            
            
            100.0
            %
            
            $
            488,999
            
            
            
            100.0
            %
            
            $
            437,029
            
            
            
            100.0
            %Cost
                of sales
            
            
            275,754
            
            
            
            53.1
            
            
            
            270,059
            
            
            
            55.2
            
            
            
            246,301
            
            
            
            56.4Restructuring
                charge related to
              discontinued
                automotive
              collectibles
            
            
            1,872
            
            
            
            0.4
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Recall-related
                items
            
            
            —
            
            
            
            —
            
            
            
            4,624
            
            
            
            1.0
            
            
            
            (1,114
            )
            
            
            (0.3
            )%Gross
                profit
            
            
            241,203
            
            
            
            46.5
            
            
            
            214,316
            
            
            
            43.8
            
            
            
            191,842
            
            
            
            43.9Selling,
                general and
              administrative
                expenses
            
            
            155,180
            
            
            
            29.9
            
            
            
            161,560
            
            
            
            33.0
            
            
            
            155,903
            
            
            
            35.7Amortization
                of intangible assets
            
            
            1,149
            
            
            
            0.3
            
            
            
            893
            
            
            
            0.2
            
            
            
            889
            
            
            
            0.2Impairment
                of goodwill and other
              intangible
                assets
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            255,853
            
            
            
            58.6Restructuring
                charge related
              todiscontinued
              automotivecollectibles
            
            
            12,631
            
            
            
            2.4
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Recall-related
                items
            
            
            —
            
            
            
            —
            
            
            
            18,068
            
            
            
            3.7
            
            
            
            15,782
            
            
            
            3.6Terminated
                acquisition costs
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            1,399
            
            
            
            0.3Operating
                income (loss)
            
            
            72,243
            
            
            
            13.9
            
            
            
            33,795
            
            
            
            6.9
            
            
            
            (237,984
            )
            
            
            (54.5
            )%Interest
                expense
            
            
            4,375
            
            
            
            0.9
            
            
            
            2,712
            
            
            
            0.5
            
            
            
            6,584
            
            
            
            1.5Interest
              income
            
            
            (910
            )
            
            
            (0.2
            )
            
            
            (1,197
            )
            
            
            (0.2
            )
            
            
            (1,579
            )
            
            
            (0.4
            )Write-off
                of investment
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            2,057
            
            
            
            0.5Other
                expense (income)
            
            
            530
            
            
            
            0.1
            
            
            
            (1,768
            )
            
            
            (0.4
            )
            
            
            (3,553
            )
            
            
            (0.8
            )Income
                (loss) from continuing
              operations
                before income taxes
            
            
            68,248
            
            
            
            13.1
            
            
            
            34,048
            
            
            
            7.0
            
            
            
            (241,493
            )
            
            
            (55.3
            )%Income
                tax expense (benefit)
            
            
            24,478
            
            
            
            4.7
            
            
            
            12,472
            
            
            
            2.6
            
            
            
            (35,741
            )
            
            
            (8.2
            )Income
                (loss) from continuing
              operations
            
            
            43,770
            
            
            
            8.4
            
            
            
            21,576
            
            
            
            4.4
            
            
            
            (205,752
            )
            
            
            (47.1
            )%(Loss)
                income from discontinued
              operations,
                net of tax
            
            
            (9,676
            )
            
            
            (1.9
            )
            
            
            110
            
            
            
            —
            
            
            
            —
            
            
            
            —Net
                income (loss)
            
            $
            34,094
            
            
            
            6.5
            %
            
            $
            21,686
            
            
            
            4.4
            %
            
            $
            (205,752
            )
            
            
            (47.1
            )%Basic
                earnings (loss) per common share:Income
                (loss) from continuing
              operations
            
            $
            2.09
            
            
            
            
            
            
            $
            1.05
            
            
            
            
            
            
            $
            (11.82
            )(Loss)
                income from discontinued
              operations
            
            
            (0.46
            )
            
            
            
            
            
            
            0.01
            
            
            
            
            
            
            
            —Net
                income (loss)
            
            $
            1.63
            
            
            
            
            
            
            $
            1.06
            
            
            
            
            
            
            $
            (11.82
            )Diluted
                earnings (loss) per common share:Income
                (loss) from continuing
              operations
            
            $
            2.04
            
            
            
            
            
            
            $
            1.04
            
            
            
            
            
            
            $
            (11.82
            )(Loss)
                income from discontinued
              operations
            
            
            (0.45
            )
            
            
            
            
            
            
            0.01
            
            
            
            
            
            
            
            —Net
                income (loss)
            
            $
            1.59
            
            
            
            
            
            
            $
            1.05
            
            
            
            
            
            
            $
            (11.82
            )Weighted
                average shares outstanding:Basic
            
            
            20,884
            
            
            
            
            
            
            
            20,395
            
            
            
            
            
            
            
            17,406Diluted
            
            
            21,377
            
            
            
            
            
            
            
            20,748
            
            
            
            
            
            
            
            17,406


(1)
      Net
      sales for the years ended December 31, 2007 and 2008, include $(5.6) million
      and
      $0.3 million, respectively, in recall-related items.


21


Operating
      Highlights





Net
      sales
      for the year ended December 31, 2008, decreased 10.6%.  Gross margin
      increased slightly to 43.9% for 2008 from 43.8% for 2007.  Selling,
      general and administrative expenses, as a percentage of net sales, increased
      to
      35.7% in 2008 from 33.0% in 2007.  The Company recorded an operating
      loss of $238.0 million in 2008 as compared to operating income of $33.8 million
      for 2007.





The
      Company recorded charges in 2008 for a non-cash impairment of goodwill and
      other intangible assets of $215.8 million, net of tax, a non-cash write-off
      of tooling of $1.7 million, net of tax, severance and other non-cash related
      charges of $1.5 million, net of tax, recall-related items of $10.1 million,
      net
      of tax, terminated acquisition costs of $1.0 million, net of tax, and a non-cash
      write-off of an investment of $1.4 million, net of tax.  The results
      for 2008 were negatively impacted by $13.28 per diluted share for these
      charges.  The portion of these charges, net of tax, included in
      the North America and International segments for the year ended December 31,
      2008, is $216.4 million and $15.1 million, respectively.





The
      results for 2007 were negatively impacted by $17.6 million, net of tax, or
      $0.84
      per diluted share, of items related to the 2007 recalls.  The portion
      of these charges, net of tax, included in the North America and
      International segments for the year ended December 31, 2007, is $14.8 million
      and $2.8 million, respectively.





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 was consistent with
      the Company’s strategic focus to achieve sustainable organic growth and to
      concentrate its efforts on its higher growth mother, infant and toddler products
      and preschool products.  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 operations and
      consolidated statements of cash flows.  A loss of $11.4 million and a
      gain of $0.1 million, both net of tax, on the sale were recognized on this
      transaction during the years ended December 31, 2006 and 2007,
      respectively.  The operations of the sold business, as well as the
      loss and the gain on the sale, are presented in (loss) income from discontinued
      operations, net of tax, on the accompanying consolidated statements of
      operations for the years ended December 31, 2006 and 2007.





During
      2006, the Company made the decision to discontinue its Racing Champions,
      JoyRide, AMT and certain Ertl die-cast 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 tax benefits, or $0.42 per diluted share, for the
      year
      ended December 31, 2006, to write-off undepreciated tooling costs and
      unamortized intangible assets and to provide inventory and royalty
      reserves.





Year
      Ended December 31, 2008, Compared to Year Ended December 31, 2007





Net
      sales.
      Net sales decreased $52.0 million, or 10.6%, to $437.0 million for 2008 from
      $489.0 million for 2007.  Net sales in our North America segment
      decreased 14.3% and net sales in our international segment increased 2.2%,
      which
      was negatively impacted by 4.7% in changes from currency exchange
      rates.





22


Net
      sales
      for the year ended December 31, 2008, excluding $2.3 million in net sales of
      discontinued product lines and $(0.3) million of recall-related items, were
      $434.4 million, a decrease of 8.0% when compared with net sales for the year
      ended December 31, 2007, excluding $22.2 million in net sales of discontinued
      product lines and $5.6 million of recall-related items, of $472.4
      million.  Information in this paragraph regarding net sales, excluding
      recall-related items and excluding discontinued product lines, constitutes
      non-GAAP financial information.  See discussion of “Non-GAAP Financial
      Information” below.  A reconciliation to the nearest GAAP
      financial measure follows:





(in
                millions)
            
            Net
                Sales2008
                actual
            
            $
            437.0Add:
                recall-related items
            
            
            (0.3
            )Deduct:
                discontinued product lines
            
            
            2.3As
                adjusted
            
            $
            434.42007
                actual
            
            $
            489.0Add:
                recall-related items
            
            
            5.6Deduct:
                discontinued product lines
            
            
            22.2As
                adjusted
            
            $
            472.4





Net
      sales
      decreases occurred in both our mother, infant and toddler products category
      and
      our preschool, youth and adult products category.





Net
      sales
      in our preschool, youth and adult products category decreased 15.0% primarily
      driven by declines in our licensed toy product lines and ride-ons and lower
      sales of discontinued product lines, which offset the increase generated from
      our new Caring Corners product line.  Excluding net sales of discontinued
      product lines and recall-related items, net sales in our preschool, youth
      and adult products category decreased 10.8%.  Net sales in our mother,
      infant and toddler products category decreased 3.5%, primarily driven by
      decreases in our infant and toddler toys and care product lines, somewhat offset
      by increases in our infant feeding and infant and toddler gear product
      lines.  Information in this paragraph regarding net sales in our
      preschool, youth and adult products category excluding recall-related items
      and
      excluding discontinued product lines constitutes non-GAAP financial
      information.  See discussion of “Non-GAAP Financial
      Information” below.





A
      reconciliation to the nearest GAAP financial measure follows:





Net
                Sales(in
              millions)
            
            2008
            
            
            2007
            
            
            Difference
            
            
            %
                ChangePreschool,
                youth and adult products actual
            
            $
            258.5
            
            
            $
            304.1
            
            
            $
            (45.6
            )
            
            
            (15.0
            )%Add:
                recall-related items
            
            
            (0.3
            )
            
            
            4.9
            
            
            
            (5.2
            )
            
            
            (106.1
            )Deduct:
                discontinued product lines
            
            
            2.3
            
            
            
            22.2
            
            
            
            (19.9
            )
            
            
            (89.6
            )%As
                adjusted
            
            $
            255.9
            
            
            $
            286.8
            
            
            $
            (30.9
            )
            
            
            (10.8
            )%





Gross
      profit.  Gross profit decreased $22.5 million, or 10.5%, to
      $191.8 million for 2008 from $214.3 million for 2007.  The gross
      profit margin, as a percentage of net sales, increased slightly to 43.9% for
      2008 compared to 43.8% for 2007.  Gross profit for the year ended
      December 31, 2008, includes $2.7 million for a write-off of tooling and $0.2
      million of severance charges, partially offset by recall-related
      recoveries of $1.5 million.  Gross profit for the year ended December
      31, 2007, includes $10.2 million of recall-related items.  Excluding
      these non-recurring charges, gross profit margin was adversely affected by
      a
      less favorable product mix and higher product costs, which were partially offset
      by cost improvement initiatives and price increases.  There were no
      major changes in the components of cost of sales.





Selling,
      general
      and administrative expenses.Selling, general and
      administrative expenses decreased $5.7 million, or 3.5%, to $155.9 million
      for
      2008 from $161.6 million for 2007.  The decrease in selling, general
      and administrative expenses is primarily due to lower marketing and variable
      sales costs, partially offset by $2.0 million of severance and other related
      charges.  As a percentage of net sales, selling, general and
      administrative expenses increased to 35.7% for 2008 from 33.0% for 2007
      resulting from reduced sales leverage, as a portion of these costs are fixed
      in
      nature.


23


Operating
      income
      (loss). The Company reported an operating loss of $238.0 million, or
      54.5% of net sales, for 2008, as compared to operating income of $33.8 million,
      or 6.9% of net sales, for 2007.  Operating loss for the year ended
      December 31, 2008 includes an impairment of goodwill and other intangible assets
      of $255.9 million, recall-related items of $14.3 million, a $2.7 million
      write-off of tooling, $2.2 million of severance and other related charges,
      a
      $2.1 million write-off of investment and $1.4 million of terminated acquisition
      costs.  Operating income for the year ended December 31, 2007, was
      negatively impacted by $28.3 million of recall-related items and $8.3 million
      of
      investment spending to support our new product launches and to build consumer
      awareness of our owned brands.





Interest
      expense. Interest expense of $6.6 million for 2008 and $2.7 million
      for 2007 relates primarily to the bank term loan and line of
      credit.  The increase in interest expense for 2008 was primarily
      due to the increase in average outstanding debt balances.





Income
      tax. Income tax expense (benefit) for the years ended December 31, 2007
      and 2008, includes provisions for federal, state and foreign income taxes at
      an
      effective rate of 36.6% and a benefit of 14.8%, respectively, including
      discrete items.  Discrete items include significant, infrequent,
      unusual or non-recurring items.  The decrease in the effective tax rate
      primarliy resulted from the goodwill impairment, the majority of which
      was non-tax deductible.





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





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





Net
      sales
      for the year ended December 31, 2007, excluding $22.2 million in net sales
      of
      discontinued product lines and $5.6 million of recall-related items, were $472.4
      million, a decrease of 1.9% when compared with net sales for the year ended
      December 31, 2006, excluding $37.4 million in net sales of discontinued product
      lines, of $481.4 million.  Information in this paragraph regarding net
      sales, excluding recall-related items and excluding discontinued product lines,
      constitutes non-GAAP financial information.  See discussion of
“Non-GAAP Financial Information” below.  A reconciliation to the
      nearest GAAP financial measure follows:





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





Net
      sales
      decreases occurred in our preschool, youth and adult products category, but
      this
      decrease was partially offset by an increase in our mother, infant and toddler
      products category.





24


Net
      sales
      in our preschool, youth and adult products category decreased 11.4%, primarily
      driven by declines in our licensed toy product lines and ride-ons and lower
      sales of discontinued product lines, which offset the increases generated from
      new product launches.  Excluding net sales of discontinued product
      lines and recall-related items, net sales in our preschool, youth and adult
      products category decreased 6.3%.  Net sales in our mother, infant and
      toddler products category increased 5.2%, primarily driven by our Take &
Toss toddler self-feeding system, our SoothieTM bottle
      feeding
      system, our American Red Cross health and wellness products marketed under
      our
      The First Years by Learning Curve brand and the newly re-launched Lamaze infant
      development products.  Excluding recall-related items and net sales
      related to discontinued product lines, net sales in our mother, infant and
      toddler products category increased 5.8%.  Information in this
      paragraph regarding net sales in our mother, infant and toddler products
      category excluding recall-related items and excluding discontinued product
      lines
      and in our preschool, youth and adult products category excluding recall-related
      items and excluding discontinued product lines constitutes non-GAAP financial
      information.  See discussion of “Non-GAAP Financial
      Information” below.





A
      reconciliation to the nearest GAAP financial measure follows:





Net
                Sales(in
              millions)
            
            2007
            
            
            2006
            
            
            Difference
            
            
            %
                ChangeMother,
                infant and toddler products actual
            
            $
            184.9
            
            
            $
            175.7
            
            
            $
            9.2
            
            
            
            5.2
            %Add:
                recall related items
            
            
            0.7
            
            
            
            —
            
            
            
            0.7
            
            
            
            —Deduct:
                discontinued product lines
            
            
            —
            
            
            
            0.3
            
            
            
            (0.3
            )
            
            
            —As
                adjusted
            
            $
            185.6
            
            
            $
            175.4
            
            
            $
            10.2
            
            
            
            5.8
            %Preschool,
                youth and adult products actual
            
            $
            304.1
            
            
            $
            343.1
            
            
            $
            (39.0
            )
            
            
            (11.4
            )%Add:
                recall-related items
            
            
            4.9
            
            
            
            —
            
            
            
            4.9
            
            
            
            —Deduct:
                discontinued product lines
            
            
            22.2
            
            
            
            37.1
            
            
            
            (14.9
            )
            
            
            (40.2
            )%As
                adjusted
            
            $
            286.8
            
            
            $
            306.0
            
            
            $
            (19.2
            )
            
            
            (6.3
            )%





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





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





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





25


Interest
      expense. Interest expense of $2.7 million for 2007 and $4.4 million
      for 2006 relates primarily to bank term loans and lines of
      credit.  The decrease in interest expense for 2007 was primarily due
      to the decrease in average outstanding debt balances partially offset by higher
      average interest rates and the write-off of $0.2 million of deferred financing
      fees related to the Company’s voluntary payment of the remaining balance of its
      term loan.





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





Non-GAAP
      Financial
      Information





This
      section includes non-GAAP financial information consisting of net sales
      excluding recall-related items and excluding discontinued product
      lines.  Internally, we use this non-GAAP financial information for the
      following purposes: financial and operational decision making, evaluating
      period-to-period results and making comparisons of our results with those of
      our
      competitors.  Management believes that the presentation of these
      non-GAAP financial measures provides useful information to investors because
      this information may allow investors to better evaluate ongoing business
      performance and certain components of the Company’s results.  Because
      the sales related to discontinued product lines have decreased significantly
      as
      the Company sells off the remaining inventory and recall-related items have
      decreased significantly, the Company believes that the presentation of this
      non-GAAP financial information enhances an investor’s ability to make
      period-to-period comparisons of the Company’s operating results.  This
      information should be considered in addition to the results presented in
      accordance with GAAP, and should not be considered a substitute for the GAAP
      results.





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 $17.5 million in 2008, $63.5 million
      in
      2007 and $61.8 million in 2006.





Working
      capital increased $58.7 million to $125.8 million at December 31, 2008, from
      $67.1 million at December 31, 2007.  Cash and cash equivalents
      decreased $25.7 million to $32.1 million at December 31, 2008, from $57.8
      million at December 31, 2007.  Our accounts receivable decreased $18.7
      million to $91.6 million at December 31, 2008, from $110.3 million at December
      31, 2007, primarily due to lower sales in the fourth quarter of 2008 and the
      impact of changes in foreign currency exchange rates.  Our inventory
      level decreased $3.0 million to $74.0 million at December 31, 2008, from $77.0
      million at December 31, 2007, primarily due to the impact of changes in foreign
      currency exchange rates and lower inventory purchases as a result of lower
      anticipated sales volume.  Accounts payable and accrued
      recall-related costs decreased $16.7 million to $31.9 million at December 31,
      2008, from $48.6 million at December 31, 2007, primarily due to lower inventory
      purchases and lower recall-related items, and our short-term debt decreased
      $80.0 million to $15.0 million at December 31, 2008, from $95.0 million at
      December 31, 2007.





Net
      cash
      used in investing activities was $9.5 million in 2008, $20.3 million in 2007
      and
      $8.3 million in 2006. The decrease in 2008 was primarily attributable to the
      2007 acquisitions of Angel’s Landing, Inc. and Mother’s Intuition
      Inc.  Capital expenditures, primarily for molds and tooling, in 2008
      and 2007 were $9.4 million and $11.5 million, respectively, and we expect
      capital expenditures for 2009, principally for molds and tooling, to be in
      the range of $10.0 million to $11.0 million.





Net
      cash
      used in financing activities was $26.0 million in 2008, $12.3 million in 2007
      and $54.5 million in 2006.  Payments of outstanding debt under our
      credit facility were $173.0 million for the year ended December 31, 2008, all
      of
      which were made on our line of credit, and $22.4 million for the year ended
      December 31, 2007, all of which were made on our term
      loan.  Borrowings under our credit facility were $75.0 million on our
      term loan and $98.1 million on our line of credit during the year ended
      December 31, 2008, and $95.0 million on our line of credit during the year
      ended December 31, 2007.  During the year ended December 31, 2008, we
      purchased $24.7 million of our common stock, which we funded primarily with
      cash
      from operations.


26


On
      November 3, 2008, the Company entered into a new credit facility to replace
      its
      previous credit facility.  The credit facility is comprised of a $75.0
      million term loan and a $70.0 million revolving line of credit.  The
      total borrowing capacity available under the credit facility is subject to
      a
      formula based on the Company’s leverage ratio, as defined in the credit
      agreement.  The term loan and the revolving line of credit both have a
      scheduled maturity date of November 1, 2011.  Under this credit
      facility, the term loan and the revolving line of credit bear interest, at
      the
      Company’s option, at a base rate or at LIBOR, plus applicable margins, which are
      based on the Company’s leverage ratio.  Applicable margins vary
      between 2.25% to 3.25% on LIBOR borrowings and 1.25% and 2.25% on base rate
      borrowings.  At December 31, 2008, the applicable margins in effect
      were 3.00% for LIBOR borrowings and 2.00% for base rate
      borrowings.  Principal payments on the term loan commence on March 31,
      2009, at a rate of $3.8 million per calendar quarter, with the remaining
      principal of $33.8 million due on November 1, 2011.  The Company is
      also required to pay a commitment fee which varies between 0.45% to 0.50% per
      annum on the average daily unused portion of the revolving line of
      credit.  At December 31, 2008, the commitment fee in effect was 0.50%
      per annum.





Under
      the
      terms of the new 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, buy back its stock,
      incur
      additional debt and make acquisitions above certain amounts.  The
      credit facility also includes a clean down provision that limits the maximum
      amount of borrowings under the revolving line of credit to $30.0 million for
      a
      period of 60 consecutive days during the first four calendar months of
      2009.  The clean down provision limits decrease to $27.5 million for a
      period of 60 consecutive days during the first four calendar months of 2010
      and
      $25.0 million for a period of 60 consecutive days during the first four calendar
      months of 2011.  On December 31, 2008, the Company had $95.1 million
      outstanding on this credit facility and was in compliance with all
      covenants.  As of the date of the filing of this report, the Company
      has met its clean down provision requirement for the year 2009.





In
      conjunction with this new credit facility, the Company incurred approximately
      $2.4 million in financing fees which are included in other non-current assets
      in
      the accompanying consolidated balance sheet at December 31, 2008, and are being
      charged to interest expense under the effective interest rate method in the
      accompanying consolidated statements of operations through the term of the
      credit agreement, which is currently November 1, 2011.





Prior
      to
      November 3, 2008, the Company had a credit facility, as amended, which was
      comprised of an $85.0 million term loan and a $100.0 million revolving line
      of
      credit.  The credit facility also provided for an additional $75.0
      million of capacity under the revolving line of credit, which was approved
      by
      the lenders upon the Company’s request in October 2007.  During the
      first quarter of 2007, the term loan was repaid and was no longer available
      for
      borrowing.  The revolving line of credit was to be available until its
      maturity on September 14, 2008.  A portion of the term loan had an
      interest rate of 3.45%, plus applicable margin, through the first three years
      of
      the facility.  The remaining term loan and revolving line of credit
      bore interest, at the Company’s option, at a base rate or at a LIBOR rate plus
      applicable margin.  The applicable margin was based on the Company’s
      ratio of consolidated debt to consolidated EBITDA (earnings before interest,
      taxes, depreciation, amortization and non-cash expense related to equity awards)
      and varied between 0.75% and 1.625%.  The Company was 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.  On September 12, 2008, the
      Company entered into an amendment which extended the maturity date of this
      credit facility to November 14, 2008 and revised the applicable margin to vary
      from 2.00% to 3.50% and the commitment fee to vary from 0.40% to 0.50% per
      annum.  This credit facility was replaced by the November 3, 2008, credit
      facility discussed above.





27


The
      Company’s Hong Kong subsidiary maintains credit facilities with two banks
      providing for documentary and letter of credits of up to approximately $5.0
      million and overdraft protection of up to $0.2 million.  Amounts
      borrowed are due on demand, but are generally available for 90 days, 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,
      2008, there was $0.5 million outstanding under these credit
      facilities.  No amounts were outstanding under these credit facilities
      at December 31, 2007.





The
      following table summarizes our significant contractual commitments at December
      31, 2008:





Payment
                Due by Period(in
                thousands)
              Contractual
                Obligations
            
            Total
            
            
            2009
            
            
            
            2010-2011
            
            
            
            2012-2013
            
            
            2014
                and
              beyondLong-term
                debt (including current portion)
            
            $
            95,120
            
            
            $
            15,000
            
            
            $
            80,120
            
            
            $
            —
            
            
            $
            —Estimated
                future interest payments
              on
                long-term debt (1)
            
            
            10,082
            
            
            
            4,239
            
            
            
            5,843
            
            
            
            —
            
            
            
            —Minimum
                guaranteed royalty payments
            
            
            38,528
            
            
            
            8,728
            
            
            
            17,150
            
            
            
            12,650
            
            
            
            —Operating
                leases
            
            
            22,765
            
            
            
            4,320
            
            
            
            5,319
            
            
            
            3,887
            
            
            
            9,239Unconditional
                purchase obligations
            
            
            30,565
            
            
            
            16,133
            
            
            
            14,432
            
            
            
            —
            
            
            
            —Total
                contractual cash obligations
            
            $
            197,060
            
            
            $
            48,420
            
            
            $
            122,864
            
            
            $
            16,537
            
            
            $
            9,239





(1)
      Estimated future interest payments on our long-term debt were based upon the
      interest rates in effect at December 31, 2008 and the balance outstanding on
      the
      line of credit at December 31, 2008.





In
      February 2007, we announced that our Board of Directors authorized the adoption
      of a program to repurchase up to $75.0 million of our common
      stock.  The program was initially authorized for a period of one
      year.  In October 2007, the Board of Directors authorized a $75.0
      million increase to the stock repurchase program and extended the timing of
      this
      program through December 31, 2008.  Under this program, shares could
      be repurchased from time to time in open market transactions or privately
      negotiated transactions at our discretion, subject to market conditions and
      other factors.  Shares repurchased are held as treasury
      shares.  During the year ended December 31, 2008, the Company
      repurchased 1.2 million shares for $24.7 million under this
      program.  Through December 31, 2008, the Company had repurchased an
      aggregate of 4.1 million shares for $112.6 million under the $150.0 million
      stock repurchase authorization.  These repurchases were funded with
      borrowings on the Company’s previous credit facility and with 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 2009.  Due to seasonal increases in
      demand for our products, our working capital is typically highest during the
      third and fourth quarters, and our debt levels are highest during the second
      and
      third quarters.  Although operating activities are expected to provide
      sufficient cash, any significant future product or property acquisitions,
      including up-front licensing payments, may require additional debt or equity
      financing.





Off-Balance
      Sheet Arrangements





The
      Company did not have any off-balance sheet arrangements during any of the years
      ended December 31, 2006, 2007 and 2008.





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 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.





28


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.  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 primarily of finished goods, has been written down for
      excess quantities and obsolescence, and is stated at the lower of cost or
      market.  Cost reasonably approximates 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, sales
      projections and order bookings.  Changes in public and consumer
      preferences and demand for product or changes in customer buying patterns and
      inventory management, as well as discontinuance of products or product lines,
      could impact the inventory valuation.





Impairment
      of
      long-lived assets, goodwill and other intangible
      assets.  Long-lived assets have been reviewed for impairment
      based on Statement of Financial Accounting Standards (SFAS) No. 144, “Accounting
      for the Impairment or Disposal of Long-Lived Assets.”  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
      next test for impairment will be as of October 1, 2009, and will be completed
      in
      the fourth quarter of 2009.  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, continued
      adverse conditions in the capital markets 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.  In the fourth quarter of 2008, the
      Company recorded an impairment charge, writing-off its entire balance of
      goodwill (see Note 5-Goodwill and Intangible Assets).




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





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


29


Product
      recalls.  The Company establishes a reserve for product recalls
      on a product-specific basis during the period in which the circumstances giving
      rise to the recall become known and estimable.  Facts underlying the
      recall, including, among others, estimates of retailer inventory returns,
      consumer replacement costs, shipping costs and fines and penalties are
      considered when establishing a product recall reserve.  In 2007 and
      2008, the Company also considered additional replacement costs or refunds,
      donations, notice charges, claims administration, licensor indemnification
      claims and plaintiffs' legal fees related to settlement of the class
      action lawsuits.    The Company's legal costs to defend
      recall-related matters are expensed as incurred.  When facts or
      circumstances become known that would indicate that the recall reserve is either
      not sufficient to cover or exceeds the estimated product recall expenses, the
      reserve is adjusted, as appropriate.





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





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





Stock-based
      compensation.  Effective January 1, 2006, the Company adopted
      SFAS No. 123R, “Share-Based Payment.”  The Company elected to use the
      modified prospective application of SFAS No. 123R for awards issued prior to
      January 1, 2006.




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 using
      Company-specific volatility as the Company believes that its actual volatility
      is a good indicator of expected future results.  The Company uses
      historical data to estimate stock option exercise and employee departure
      behavior in the Black-Scholes option pricing model.  The expected term
      of stock options granted represents the period of time that stock options
      granted are expected to be outstanding.  The risk-free rate for the
      period within the contractual term of the stock option is based on the U.S.
      Treasury yield curve in effect at the time of grant.





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





Recently
      Issued Accounting Pronouncements





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


30


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 the fiscal years beginning after November 15, 2007, and
      interim periods within those fiscal years.  In February 2008, the FASB
      issued FASB Staff Position (FSP) No. FAS 157-2, “Effective Date of FASB
      Statement No. 157,” which provides a one year deferral of the effective date of
      SFAS No. 157 for non-financial assets and non-financial liabilities, except
      those that are recognized or disclosed in the financial statements at fair
      value
      at least annually.  In accordance with FSP FAS No. 157-2, the Company
      has only adopted the provisions for SFAS No. 157 with respect to its financial
      assets and liabilities that are measured at fair value within the financial
      statements as of January 1, 2008.  Based upon this one year deferral,
      the provisions of SFAS No. 157 have not been applied to non-financial assets
      and
      non-financial liabilities.  The major category of assets and
      liabilities that are measured at fair value, for which the Company has not
      applied the provisions of SFAS No. 157, is intangible assets.





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 facility 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,
      2008, a one percentage point increase in average interest rates on the Company’s
      borrowings would increase future interest expense by $0.1 million per month
      and
      a five percentage point increase would increase future interest expense by
      approximately $0.4 million per month.  The Company determined these
      amounts based on $95.1 million of variable rate borrowings at December 31,
      2008,
      multiplied by 1.0% and 5.0%, respectively, and divided by twelve.  The
      Company is currently not using any interest rate collars, hedges or other
      derivative financial instruments to manage or reduce interest rate
      risk.  As a result, any increase in interest rates on the Company’s
      variable rate borrowings would increase interest expense and reduce net
      income.





The
      Company’s net sales are primarily denominated in U.S. dollars, with 23.0% of net
      sales in 2008 denominated in British pounds sterling, Australian dollars, Euro
      dollars 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.  During 2005, China revalued the Chinese
      Renminbi, abandoning the former method of pegging the Chinese Renminbi to the
      U.S. dollar.  As a result, any 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.  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,
      2008, would have changed the total dollar amount of our gross profit by
      10.8%.  A 10.0% change in the exchange rate of the U.S. dollar with
      respect to the translation of financial reporting denominated in the British
      pound sterling, the Australian dollar or the Euro dollar for the year ended
      December 31, 2008, individually would have not had a significant impact on
      the
      Company’s earnings.  The Company is also subject to exchange rate risk
      relating to transfers of funds or other transactions denominated in British
      pounds sterling, Australian dollars, Canadian dollars or Euro dollars from
      its
      foreign subsidiaries to the United States, such as for purchases of inventory
      by
      certain of our foreign subsidiaries, effectively in U.S. dollars.  A
      10.0% change in the exchange rate of the U.S. dollar with respect to the British
      pound sterling and the Australian dollar for the year ended December 31, 2008,
      would have changed the total dollar amount of out gross profit by 1.4% and
      0.6%,
      respectively.  The Company is not currently using and has not
      historically used hedges or other derivative financial instruments to manage
      or
      reduce exchange rate risk.





31


Item
      8.  Financial Statements and Supplementary Data





Financial
      Statements





Our
      consolidated financial statements and notes thereto are filed under this item
      beginning on page F-1 of this report.





Quarterly
      Results of Operations





The
      following tables set forth our unaudited quarterly results of operations for
      2007 and 2008.  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 2007(in
                thousands, except per share data)
            
            
            Q1
            
            
            
            Q2
            
            
            
            Q3
            
            
            
            Q4Net
                sales (1)
            
            $
            112,593
            
            
            $
            92,990
            
            
            $
            144,843
            
            
            $
            138,573Cost
                of sales (2)
            
            
            62,131
            
            
            
            53,544
            
            
            
            78,552
            
            
            
            75,832Recall-related
                items
            
            
            —
            
            
            
            1,703
            
            
            
            2,408
            
            
            
            513Gross
                profit
            
            
            50,462
            
            
            
            37,743
            
            
            
            63,883
            
            
            
            62,228Selling,
                general and administrative expenses (2)
            
            
            37,768
            
            
            
            32,722
            
            
            
            42,680
            
            
            
            48,390Amortization
                of intangible assets
            
            
            213
            
            
            
            213
            
            
            
            208
            
            
            
            259Recall-related
                items
            
            
            —
            
            
            
            2,233
            
            
            
            5,270
            
            
            
            10,565Operating
                income
            
            
            12,481
            
            
            
            2,575
            
            
            
            15,725
            
            
            
            3,014Interest
                expense
            
            
            560
            
            
            
            175
            
            
            
            576
            
            
            
            1,401Interest
              income
            
            
            (258
            )
            
            
            (325
            )
            
            
            (221
            )
            
            
            (393
            )Other
                income
            
            
            (466
            )
            
            
            (110
            )
            
            
            (411
            )
            
            
            (781
            )Income
                before income taxes
            
            
            12,645
            
            
            
            2,835
            
            
            
            15,781
            
            
            
            2,787Income
                tax expense
            
            
            4,586
            
            
            
            485
            
            
            
            5,012
            
            
            
            2,389Income
                from continuing operations
            
            
            8,059
            
            
            
            2,350
            
            
            
            10,769
            
            
            
            398Income
                from discontinued operations, net of tax
            
            
            —
            
            
            
            110
            
            
            
            —
            
            
            
            —Net
                income
            
            $
            8,059
            
            
            $
            2,460
            
            
            $
            10,769
            
            
            $
            398Basic
                earnings per common share:Income
                from continuing operations
            
            $
            0.38
            
            
            $
            0.11
            
            
            $
            0.52
            
            
            $
            0.02Income
                from discontinued operations
            
            
            —
            
            
            
            0.01
            
            
            
            —
            
            
            
            —Net
                income
            
            $
            0.38
            
            
            $
            0.12
            
            
            $
            0.52
            
            
            $
            0.02Diluted
                earnings per common share:Income
                from continuing operations
            
            $
            0.37
            
            
            $
            0.11
            
            
            $
            0.52
            
            
            $
            0.02Income
                from discontinued operations
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            —Net
                income
            
            $
            0.37
            
            
            $
            0.11
            
            
            $
            0.52
            
            
            $
            0.02Weighted
                average shares outstanding:Basic
            
            
            21,116
            
            
            
            21,225
            
            
            
            20,523
            
            
            
            18,743Diluted
            
            
            21,519
            
            
            
            21,611
            
            
            
            20,850
            
            
            
            19,060


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


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


32





Fiscal
                Year 2008(in
                thousands, except per share data)
            
            
            Q1
            
            
            
            Q2
            
            
            
            Q3
            
            
            
            Q4Net
                sales (1)
            
            $
            93,290
            
            
            $
            89,193
            
            
            $
            132,856
            
            
            $
            121,690Cost
                of sales (2)
            
            
            50,748
            
            
            
            48,300
            
            
            
            72,114
            
            
            
            75,139Recall-related
                items
            
            
            20
            
            
            
            401
            
            
            
            (1,357
            )
            
            
            (178
            )Gross
                profit
            
            
            42,522
            
            
            
            40,492
            
            
            
            62,099
            
            
            
            46,729Selling,
                general and administrative expenses (2)
            
            
            36,453
            
            
            
            34,909
            
            
            
            41,026
            
            
            
            43,515Amortization
                of intangible assets
            
            
            225
            
            
            
            226
            
            
            
            219
            
            
            
            219Impairment
                of goodwill and other intangibleassets
            
            
            —
            
            
            
            —
            
            
            
            —
            
            
            
            255,853Recall-related
                items
            
            
            1,420
            
            
            
            15,229
            
            
            
            (1,464
            )
            
            
            597Terminated
                acquisition costs
            
            
            —
            
            
            
            —
            
            
            
            1,416
            
            
            
            (17
            )Operating
                income (loss)
            
            
            4,424
            
            
            
            (9,872
            )
            
            
            20,902
            
            
            
            (253,438
            )Interest
                expense
            
            
            1,464
            
            
            
            1,200
            
            
            
            1,714
            
            
            
            2,206Interest
              income
            
            
            (389
            )
            
            
            (460
            )
            
            
            (476
            )
            
            
            (254
            )Write-off
                of investment
            
            
            —
            
            
            
            —
            
            
            
            2,057
            
            
            
            —Other
                (income) expense
            
            
            (448
            )
            
            
            390
            
            
            
            229
            
            
            
            (3,724
            )Income
                (loss) before income taxes
            
            
            3,797
            
            
            
            (11,002
            )
            
            
            17,378
            
            
            
            (251,666
            )Income
                tax expense (benefit)
            
            
            1,796
            
            
            
            (4,589
            )
            
            
            6,269
            
            
            
            (39,217
            )Net
                income (loss)
            
            $
            2,001
            
            
            $
            (6,413
            )
            
            $
            11,109
            
            
            $
            (212,449
            )Earnings
                (loss) per common share:Basic
            
            $
            0.11
            
            
            $
            (0.37
            )
            
            $
            0.65
            
            
            $
            (12.32
            )Diluted
            
            $
            0.11
            
            
            $
            (0.37
            )
            
            $
            0.64
            
            
            $
            (12.32
            )Weighted
                average shares outstanding:Basic
            
            
            17,912
            
            
            
            17,260
            
            
            
            17,210
            
            
            
            17,245Diluted
            
            
            18,180
            
            
            
            17,260
            
            
            
            17,463
            
            
            
            17,245


(1)  Net
      sales for Q1, Q2 and Q3 2008 include $(32) thousand, $(33) thousand and $406
      thousand, respectively, of recall-related items.


(2)  Depreciation
      expense was $3.1 million, $3.1 million, $3.2 million and $6.0 million for Q1,
      Q2, Q3 and Q4 2008, respectively.





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





Not
      applicable.





33


Item
      9A.  Controls and Procedures





Evaluation
      of Disclosure Controls and Procedures





The
      Company maintains disclosure controls and procedures (as defined in Rules
      13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) designed
      to ensure that information required to be disclosed by the Company in the
      reports that it files or submits under the Securities Exchange Act of 1934
      is
      recorded, processed, summarized and reported within the time periods specified
      in the SEC’s rules and forms, and that the information required to be disclosed
      by the Company in reports that it files or submits under the Securities Exchange
      Act of 1934 is accumulated and communicated to its management, including its
      Chief Executive Officer and Chief Financial Officer, as appropriate to allow
      timely decisions regarding required disclosure.  The Company carried
      out an evaluation as of December 31, 2008, under the supervision and with the
      participation of the Company’s management, including its Chief Executive Officer
      and Chief Financial Officer, of the effectiveness of the design and operation
      of
      the Company’s disclosure controls and procedures.  Based on such
      evaluation, the Company’s Chief Executive Officer and Chief Financial Officer
      concluded that the Company’s disclosure controls and procedures were effective
      as of December 31, 2008 at reaching a level of reasonable
      assurance.  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.





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 of 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 the changes in conditions, or
      that the degree of compliance with the policies or procedures may
      deteriorate.


34


Management
      assessed the effectiveness of the Company’s internal control over financial
      reporting as of December 31, 2008.  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, 2008, the Company’s internal control over financial reporting
      was effective based on those criteria.





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





Item
      9B.  Other Information





On
      February 25, 2009, the Company's Board of Directors adopted an amendment to
      the
      RC2 Corporation 2005 Stock Incentive Plan (the 2005 Stock Incentive
      Plan).  The amendment to the 2005 Stock Incentive Plan authorizes
      the grant of stock settled stock appreciation rights under the 2005 Stock
      Incentive Plan.  A copy of the 2005 Stock Incentive Plan, as amended,
      and the form of stock appreciation right grant agreement are attached
      hereto as exhibits and are incorporated by reference.





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 Experts” in the Company’s Proxy
      Statement for the 2009 Annual Meeting of Stockholders, which will be filed
      with
      the Commission on or before April 30, 2009.  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 2009 Annual Meeting of
      Stockholders.





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





Item
      11.  Executive Compensation





Information
      regarding executive compensation is incorporated herein by reference to the
      discussion under “Executive Compensation” and “Director Compensation” in the
      Company’s Proxy Statement for the 2009 Annual Meeting of Stockholders, which
      will be filed with the Commission on or before April 30, 2009.





The
      information incorporated by reference from the “Report of the Compensation
      Committee” in the Company’s Proxy Statement for the 2009 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 2009 Annual Meeting of Stockholders, which
      will be filed with the Commission on or before April 30, 2009.





35


Equity
      Compensation Plan Information





The
      following table summarizes share information, as of December 31, 2008, for
      the
      Company’s equity compensation plans, including the RC2 Corporation 2005 Sock
      Incentive Plan (2005 Plan), the Racing Champions Ertl Corporation Stock
      Incentive Plan, the RC2 Corporation Employee Stock Purchase Plan (ESPP) and
      the
      Wheels Sports Group, Inc. 1996 Omnibus Stock Plan.  All of these plans
      have been approved by the Company’s stockholders, other than the Wheels Sports
      Group, Inc. 1996 Omnibus Stock Plan, which was approved by Wheels Sports Group’s
      stockholders and assumed by the Company following its acquisition of Wheels
      Sports Group in 1998.  The Wheels Sports Group, Inc. 1996 Omnibus
      Stock Plan and the Racing Champions Ertl Corporation Stock Incentive Plan are
      dormant, and no future issuances are allowed under these plans.


Plan
                Category
            
            Number
                of Common
              Shares
                to Be Issued
              Upon
                Exercise of
              Outstanding
              Options
            
            
            Weighted
              Average
              Exercise
                Price of Outstanding
              Options
            
            
            Number
                of Common
              Shares
                Available for
              Future
                Issuance Under Equity Compensation
              Plans
                (1)Equity
                compensation plans approvedby
                stockholders
            
            
            1,921,142
            
            
            $
            22.80
            
            
            
            1,525,561Equity
                compensation plans not approvedby
                stockholders
            
            
            —
            
            
            
            —
            
            
            
            —Total
            
            
            1,921,142
            
            
            $
            22.80
            
            
            
            1,525,561





(1)  Number
      of common shares available for future issuance under equity compensation plans
      includes 451,706 shares related to the ESPP and 1,073,855 shares related to
      the
      2005 Plan.





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 2009 Annual Meeting of Stockholders, which
      will be filed with the Commission on or before April 30,
      2009.  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 2009 Annual Meeting of
      Stockholders, which will be filed with the Commission on or before April 30,
      2009.





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 2009 Annual Meeting of Stockholders, which
      will be filed with the Commission on or before April 30, 2009.






36





Part
                IV


Item
        15.  Exhibits and Financial Statement Schedules
  (a)
              The
                following
                documents are filed as part of this report:1.
              Financial
                StatementsThe
                following
                consolidated financial statements of the Company are included in
                Item 8 of
                this report:Reports
                of
                Independent Registered Public Accounting FirmConsolidated
                Balance
                Sheets as of December 31, 2007 and 2008Consolidated
                Statements of Operations for the Years Ended December 31, 2006, 2007
                and
                2008Consolidated
                Statements of Stockholders’ Equity for the Years Ended December 31, 2006,
                2007 and 2008Consolidated
                Statements of Cash Flows for the Years Ended December 31, 2006, 2007
                and
                2008Notes
                to
                Consolidated Financial Statements2.
              Financial
                Statement
                SchedulesReport
                of
                Independent Registered Public Accounting FirmFinancial
                Statement
                Schedule for the Years Ended December 31, 2006, 2007 and
                2008:


Schedule
              Number
            
            Description
            
            PageII
            
            Valuation
                and Qualifying Accounts
            
            42






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.
            Exhibits2.1
            Asset Purchase Agreement, dated
                as of June
                20, 2008, among Learning Curve Brands, Inc., RC2Australia Pty. Ltd., Racing Champions International
                Limited,
                Learning Curve Mexico S. de R.L. de C.V., RC2 Limited, RC2 (Asia)
                Limited,
                Publications International, Ltd., PIL, L.L.C., JRS Distribution Co.,
                Publications International Limited Partnership, Publications
                International, Ltd. L.P. and Publications International, Ltd. S.
                de R.L.
                de C.V. (incorporated by reference to Exhibit 2.1 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 June 26,
                2008).






37




2.2
            Termination
              Agreement, dated as of September 29, 2008, among Learning Curve Brands,
              Inc., RC2Australia
              Pty. Ltd., Racing Champions International Limited, Learning Curve Mexico
              S. de R.L. de C.V.,RC2
              Limited, RC2 (Asia) Limited, Publications International, Ltd., PIL,
              L.L.C., JRS Distribution Co.,Publications
              International Limited Partnership, Publications International, Ltd.
              L.P.
              and PublicationsInternational,
              Ltd. S. de R.L. de C.V. (incorporated by reference to Exhibit 2.1 of
              the
              Company’s CurrentReport
              on Form 8-K (File No. 0-22635) filed by the Company with the Securities
              and ExchangeCommission
              on October 1, 2008).3.1
            Amended
                and Restated Certificate of Incorporation of the Company (incorporated
                by
                reference toExhibit
                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 (incorporatedby
                reference to Exhibit 3.2 of the Company’s Quarterly Report on Form 10-Q
                for the quarter endedMarch
                31, 2002 (File No. 0-22635)).3.3
            Certificate
                of Ownership and Merger changing the Company’s name to Racing Champions
                ErtlCorporation
                (incorporated by reference to Exhibit 3.3 of the Company’s Quarterly
                Report on Form10-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
                (incorporatedby
                reference to Exhibit 3.4 of the Company’s Quarterly Report on Form 10-Q
                for the quarter endedMarch
                31, 2003 (File No. 0-22635)).3.5
            Amended
                and Restated By-Laws of the Company (incorporated by reference to
                Exhibit
                3.5 of the Company’s
                Quarterly Report on Form 10-Q for the quarter ended March 31, 2004
                (File
                No. 0-22635)).10.1*
            Employment
                Agreement, dated April 1, 2008, between the Company and Curtis W.
                Stoelting(incorporated
                by reference to Exhibit 10.1 of the Company’s Quarterly Report on Form
                10-Q for thequarter
                ended March 31, 2008 (File No. 0-22635)).10.2*
            Employment
                Agreement, dated April 1, 2008, between the Company and Peter J.
                Henseler(incorporated
                by reference to Exhibit 10.2 of the Company’s Quarterly Report on Form
                10-Q for thequarter
                ended March 31, 2008 (File No. 0-22635)).10.3*
            Employment
                Agreement, dated November 5, 2008, between the Company and Peter
                A.
                Nicholson,(incorporated
                by reference to Exhibit 99.1 of the Company’s Current Report on Form 8-K
                datedNovember
                5, 2008 (File No. 0-22635) filed by the Company with the Securities
                and
                ExchangeCommission
                on November 10, 2008).10.4*
            Employment
                Agreement, dated April 1, 2008, between the Company and Helena Lo
                (incorporated byreference
                to Exhibit 10.4 of the Company’s Quarterly Report on Form 10-Q for the
                quarter endedMarch
                31, 2008 (File No. 0-22635)).10.5*
            Employment
                Agreement, dated April 1, 2008, between the Company and Gregory J.
                Kilrea
                (incorporatedby
                reference to Exhibit 10.5 of the Company’s Quarterly Report on Form 10-Q
                for the quarter endedMarch
                31, 2008 (File No. 0-22635)).10.6*
            Employment
                Agreement, dated April 1, 2008, between the Company and Jody L. Taylor
                (incorporated byreference
                to Exhibit 10.3 of the Company’s Quarterly Report on Form 10-Q for the
                quarter ended March31,
                2008 (File No. 0-22635)).10.7*
            Employment
              Agreement, dated November 5, 2008, between the Company and Jody L.
              Taylor.





38


10.8*
            RC2
              Corporation 2005
              Stock Incentive Plan, as amended.10.9*
            Form
                of
                Non Statutory Stock Option Grant Agreement for the RC2 Corporation
                2005
                Stock IncentivePlan
                (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).10.10*
            Form
              of Stock
              Appreciation Right Grant Agreement for RC2 Corporation 2008 Stock
              Incentive Plan.10.11*
            RC2
                Corporation 2008 Incentive Bonus Plan (incorporated by reference
                to
                Exhibit 99.2 of the Company’sCurrent
                Report on Form 8-K (File No. 0-22635) filed by the Company with the
                Securities and ExchangeCommission
                on May 12, 2008).10.12*
            Outside
                Director Compensation Plan (incorporated by reference to Exhibit
                10.4 to
                the Company’sQuarterly
                Report on Form 10-Q for the quarter ended June 30, 2005 (File No.
                0-22635)).10.13*
            Amendment
                to Outside Director Compensation Plan effective January 1, 2007
                (incorporated by referenceto
                Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the
                quarter ended March 31, 2007(File
                No. 0-22635)).10.14*
            Racing
                Champions Ertl Corporation Stock Incentive Plan, as amended (incorporated
                by reference toExhibit
                10.5 of the Company’s Quarterly Report on Form 10-Q for the quarter ended
                September 30, 2002(File
                No. 0-22635)).10.15*
            Wheels
                Sports Group, Inc. 1996 Omnibus Stock Plan (incorporated by reference
                to
                Exhibit 99.1 of theCompany’s
                Quarterly Report on Form 10-Q for the quarter ended June 30, 1998
                (File
                No. 0-22635)).10.16*
            RC2
                Corporation Employee Stock Purchase Plan, as amended (incorporated
                by
                reference to Exhibit 99.1of
                the Company’s Current Report on Form 8-K dated May 4, 2007 (File No.
                0-22635) filed by theCompany
                with the Securities and Exchange Commission on May 10,
                2007).10.17
            Credit
                Agreement, dated as of November 3, 2008, among the Company, certain
                of its
                subsidiaries,Bank
                of Montreal, as administrative agent, BMO Capital Markets as sole
                lead
                arranger and sole book runner, and other lenders named therein
                (incorporated by reference to Exhibit 10.2 to the Company’s Quarterly
                Report on Form 10-Q for the quarter ended September 30, 2008 (File
                No.
                0-22635)).10.18
            First
                Amendment to Credit Agreement, dated as of February 12, 2009, among
                the Company, certainof
                its subsidiaries, Bank of Montreal, as administrative agent, and
                the other
                lenders named therein(incorporated
                by reference to Exhibit 99.1 to the Company’s Current Report on Form 8-K
                datedFebruary
                12, 2009 (File No. 0-22635)).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).







39


________________________




*
            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.





40


SIGNATURES





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





Date:
                March 2, 2009
            RC2
                CORPORATIONBy
                /s/ Curtis W. StoeltingCurtis
                W. Stoelting, Chief Executive
                Officer





POWER
      OF ATTORNEY





Each
      person whose signature appears below hereby appoints Curtis W. Stoelting and
      Peter A. Nicholson, 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 and Exchange Act of 1934, this Form 10-K
      has been signed below by the following persons on behalf of the Registrant
      and
      in the capabilities and on the dates indicated.





/s/
                Robert E. Dods
            
            Chairman
                of the Board and Director
            March
                2, 2009Robert
                E. Dods/s/
                Curtis W. Stoelting
            
            Chief
                Executive Officer and
            March
                2, 2009Curtis
                W. Stoelting
            
            Director
                (Principal Executive Officer)/s/
                Peter A. Nicholson
            
            Chief
                Financial Officer
            March
                2, 2009Peter
                A. Nicholson
            
            (Principal
                Financial and Accounting Officer)/s/
                Peter J. Henseler
            
            Director
            March
                2, 2009Peter
                J. Henseler/s/
                Linda A. Huett
            
            Director
            March
                2, 2009Linda
                A. Huett/s/
                Paul E. Purcell
            
            Director
            March
                2, 2009Paul
                E. Purcell/s/
                John S. Bakalar
            
            Director
            March
                2, 2009John
                S. Bakalar/s/
                John J. Vosicky
            
            Director
            March
                2, 2009John
                J. Vosicky/s/
                Daniel M. Wright
            
            Director
            March
                2, 2009Daniel
                M. Wright/s/
                Thomas M. Collinger
            
            Director
            March
                2, 2009Thomas
                M. Collinger/s/
                Michael J. Merriman, Jr.
            
            Director
            March
                2, 2009Michael
                J. Merriman, Jr.




41




REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM




The
      Board
      of Directors and Stockholders


RC2
      Corporation:





Under
      date of March 3, 2009, we reported on the consolidated balance sheets of RC2
      Corporation and subsidiaries as of December 31, 2007 and 2008, and the related
      consolidated statements of operations, stockholders’ equity and cash flows for
      each of the years in the three-year period ended December 31,
      2008.  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


March
      3,
      2009








Schedule
                IIDescriptionValuation
                and Qualifying
                Accounts(in
                thousands)Description
            
            Balance
                at Beginning of Year
            
            
            (Credited)
                Charged to Costs and Expenses
            
            
            (Credited)
                Charged to Other Accounts
            
            
            Deductions
            
            
            Balance
              at
                End of
              YearAllowance
                for doubtful accounts:Year
                ended December 31, 2006
            
            $
            3,073
            
            
            $
            (283
            )
            
            $
            (50
            )
            
            $
            (989
            )
            
            $
            1,751Year
                ended December 31, 2007
            
            
            1,751
            
            
            
            1,148
            
            
            
            41
            
            
            
            (1,132
            )
            
            
            1,808Year
                ended December 31, 2008
            
            $
            1,808
            
            
            $
            1,415
            
            
            $
            (223
            )
            
            $
            (1,207
            )
            
            $
            1,793





42


INDEX
      TO FINANCIAL STATEMENTS








RC2
      CORPORATION AND SUBSIDIARIES







Reports
              of
              Independent Registered Public Accounting Firm
            F-2Consolidated
              Balance
              Sheets as of December 31, 2007 and 2008
            F-3Consolidated
              Statements of Operations for the Years Ended December 31, 2006, 2007
              and
              2008
            F-4Consolidated
              Statements of Stockholders’ Equity for the Years Ended December 31, 2006,
              2007 and 2008
            F-5Consolidated
              Statements of Cash Flows for the Years Ended December 31, 2006, 2007
              and
              2008
            F-6Notes
              to
              Consolidated Financial Statements
            F-7







F-1


REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





The
      Board
      of Directors and Stockholders


RC2
      Corporation:





We
      have
      audited the accompanying consolidated balance sheets of RC2 Corporation and
      subsidiaries as of December 31, 2007 and 2008, and the related consolidated
      statements of operations, stockholders’ equity and cash flows for each of the
      years in the three-year period ended December 31, 2008.  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 principals 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, 2007 and 2008, and the results of their
      operations and their cash flows for each of the years in the three-year period
      ended December 31, 2008, in conformity with U.S. generally accepted accounting
      principles.




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





We
      have
      also audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), RC2 Corporation’s internal control over
      financial reporting as of December 31, 2008, 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 March 3, 2009, expressed an
      unqualified opinion on the effectiveness of the Company’s internal control over
      financial reporting.








/s/
      KPMG
      LLP


Chicago,
      Illinois


March
      3,
      2009


F-2


REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM




The
      Board
      of Directors and Stockholders


RC2
      Corporation:





We
      have
      audited RC2 Corporation’s (the Company) internal control over financial
      reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated
      Framework issued by the Committee of Sponsoring Organizations of the
      Treadway Commission (COSO).  RC2 Corporation’s management is
      responsible for maintaining effective internal control over financial reporting
      and for its assessment of the effectiveness of internal control over financial
      reporting, included in the accompanying Management’s Report on Internal Control
      over Financial Reporting.  Our responsibility is to express an opinion
      on the Company’s internal control over financial reporting based on our
      audit.





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





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





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





In
      our
      opinion, RC2 Corporation maintained, in all material respects, effective
      internal control over financial reporting as of December 31, 2008, based on
      the
      criteria established in Internal Control-Integrated
      Framework issued by COSO.





We
      have
      also audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the consolidated balance sheets of RC2
      Corporation and subsidiaries as of December 31, 2007 and 2008, and the related
      consolidated statements of operations, stockholders’ equity and cash flows for
      each of the years in the three-year period ended December 31, 2008, and our
      report dated March 3, 2009, expressed an unqualified opinion on those
      consolidated financial statements.








/s/
      KPMG
      LLP


Chicago,
      Illinois


March
      3,
      2009


F-3


CONSOLIDATED
      BALANCE SHEETS


December
                31,(in
                thousands)
            
            2007
            
            
            2008AssetsCurrent
                assets:Cash
                and cash equivalents
            
            $
            57,809
            
            
            $
            32,095Accounts
                receivable, net of allowances for doubtful accounts of $1,808 and
                $1,793
            
            
            110,317
            
            
            
            91,647Other
                receivables
            
            
            1,910
            
            
            
            1,764Inventory
            
            
            77,034
            
            
            
            73,989Deferred
                and prepaid taxes, net
            
            
            11,274
            
            
            
            11,898Prepaid
                expenses
            
            
            6,023
            
            
            
            5,900Total
                current assets
            
            
            264,367
            
            
            
            217,293Property
                and equipment:Land
            
            
            686
            
            
            
            686Buildings
                and improvements
            
            
            9,334
            
            
            
            9,517Tooling
            
            
            108,524
            
            
            
            109,545Other
                equipment
            
            
            22,760
            
            
            
            24,122141,304
            
            
            
            143,870Less
                accumulated depreciation
            
            
            (104,011
            )
            
            
            (112,969
            )37,293
            
            
            
            30,901Goodwill
            
            
            247,814
            
            
            
            —Intangible
                assets, net
            
            
            96,675
            
            
            
            82,504Other
                non-current assets
            
            
            4,096
            
            
            
            5,952Total
                assets
            
            $
            650,245
            
            
            $
            336,650Liabilities
                and stockholders’ equityCurrent
                liabilities:Accounts
                payable
            
            $
            33,985
            
            
            $
            25,873Accrued
                expenses
            
            
            15,529
            
            
            
            13,529Accrued
                recall-related costs
            
            
            14,594
            
            
            
            6,036Accrued
                allowances
            
            
            20,610
            
            
            
            17,648Accrued
                royalties
            
            
            14,358
            
            
            
            10,900Line
                of credit
            
            
            95,000
            
            
            
            —Current
                maturities of bank term loan
            
            
            —
            
            
            
            15,000Other
                current liabilities
            
            
            3,163
            
            
            
            2,508Total
                current liabilities
            
            
            197,239
            
            
            
            91,494Line
                of credit
            
            
            —
            
            
            
            20,120Bank
                term loan
            
            
            —
            
            
            
            60,000Deferred
                income taxes
            
            
            47,586
            
            
            
            5,470Other
                non-current liabilities
            
            
            8,042
            
            
            
            10,877Total
                liabilities
            
            
            252,867
            
            
            
            187,961Commitments
                and contingenciesStockholders’
                equity:Common
                stock, voting, $0.01 par value, 28,000 shares authorized, 23,072
                shares
              issued
                and 18,320 shares outstanding at December 31, 2007, and 23,186
                shares
              issued
                and 17,245 shares outstanding at December 31, 2008
            
            
            231
            
            
            
            232Additional
                paid-in capital
            
            
            239,021
            
            
            
            246,284Accumulated
                other comprehensive income (loss)
            
            
            12,918
            
            
            
            (13,949
            )Retained
                earnings
            
            
            241,709
            
            
            
            37,232493,879
            
            
            
            269,799Treasury
                stock, at cost, 4,752 shares at December 31, 2007, and 5,941
                shares
              at
                December 31, 2008
            
            
            (96,501
            )
            
            
            (121,110
            )Total
                stockholders’ equity
            
            
            397,378
            
            
            
            148,689Total
                liabilities and stockholders’ equity
            
            $
            650,245
            
            
            $
            336,650


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


F-4


CONSOLIDATED
      STATEMENTS OF OPERATIONS





Year
                Ended December 31,(in
                thousands, except per share data)
            
            2006
            
            
            2007
            
            
            2008Net
                sales, including recall-related items of $(5,596) and $341
              for
                the years ended December 31, 2007 and 2008, respectively
            
            $
            518,829
            
            
            $
            488,999
            
            
            $
            437,029Cost
                of sales, related parties
            
            
            27,599
            
            
            
            15,406
            
            
            
            4,761Cost
                of sales, other
            
            
            248,155
            
            
            
            254,653
            
            
            
            241,540Restructuring
                charge related to discontinued automotive collectibles
            
            
            1,872
            
            
            
            —
            
            
            
            —Recall-related
                items
            
            
            —
            
            
            
            4,624
            
            
            
            (1,114
            )Gross
                profit
            
            
            241,203
            
            
            
            214,316
            
            
            
            191,842Selling,
                general and administrative expenses
            
            
            155,180
            
            
            
            161,560
            
            
            
            155,903Amortization
                of intangibles
            
            
            1,149
            
            
            
            893
            
            
            
            889Impairment
                of goodwill and other intangible assets
            
            
            —
            
            
            
            —
            
            
            
            255,853Restructuring
                charge related to discontinued automotive collectibles
            
            
            12,631
            
            
            
            —
            
            
            
            —Recall-related
                items
            
            
            —
            
            
            
            18,068
            
            
            
            15,782Terminated
                acquisition costs
            
            
            —
            
            
            
            —
            
            
            
            1,399Operating
                income (loss)
            
            
            72,243
            
            
            
            33,795
            
            
            
            (237,984
            )Interest
                expense
            
            
            4,375
            
            
            
            2,712
            
            
            
            6,584Interest
              income
            
            
            (910
            )
            
            
            (1,197
            )
            
            
            (1,579
            )Write-off
                of investment
            
            
            —
            
            
            
            —
            
            
            
            2,057Other
                expense (income)
            
            
            530
            
            
            
            (1,768
            )
            
            
            (3,553
            )Income
                (loss) from continuing operations before income taxes
            
            
            68,248
            
            
            
            34,048
            
            
            
            (241,493
            )Income
                tax expense (benefit)
            
            
            24,478
            
            
            
            12,472
            
            
            
            (35,741
            )Income
                (loss) from continuing operations
            
            
            43,770
            
            
            
            21,576
            
            
            
            (205,752
            )(Loss)
                income from discontinued operations, net of tax
            
            
            (9,676
            )
            
            
            110
            
            
            
            —Net
                income (loss)
            
            $
            34,094
            
            
            $
            21,686
            
            
            $
            (205,752
            )Basic
                earnings (loss) per common share:Income
                (loss) from continuing operations
            
            $
            2.09
            
            
            $
            1.05
            
            
            $
            (11.82
            )(Loss)
                income from discontinued operations
            
            
            (0.46
            )
            
            
            0.01
            
            
            
            —Net
                income (loss)
            
            $
            1.63
            
            
            $
            1.06
            
            
            $
            (11.82
            )Diluted
                earnings (loss) per common share:Income
                (loss) from continuing operations
            
            $
            2.04
            
            
            $
            1.04
            
            
            $
            (11.82
            )(Loss)
                income from discontinued operations
            
            
            (0.45
            )
            
            
            0.01
            
            
            
            —Net
                income (loss)
            
            $
            1.59
            
            
            $
            1.05
            
            
            $
            (11.82
            )Weighted
                average shares outstanding:Basic
            
            
            20,884
            
            
            
            20,395
            
            
            
            17,406Diluted
            
            
            21,377
            
            
            
            20,748
            
            
            
            17,406


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


F-5


CONSOLIDATED
      STATEMENTS OF
      STOCKHOLDERS’ EQUITY


Common
                Stock
            
            Treasury
                Stock
            
            Accumulated
                Other Comprehensive
            
            Additional
                Paid-in
            
            Retained
            
            
            Total
                Stockholders’
            
            
            Comprehensive(in
                thousands)
            
            Shares
            
            
            Amount
            
            Shares
            
            
            Amount
            
            Income
                (Loss)
            
            Capital
            
            Earnings
            
            
            Equity
            
            
            Income
                (Loss)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
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            41,805Balance,
                December 31, 2006
            
            
            21,052
            
            
            $
            229
            
            
            1,824
            
            
            $
            (8,623
            )
            $
            8,838
            
            $
            230,776
            
            $
            220,706
            
            
            $
            451,926Net
                income
            
            
            —
            
            
            
            —
            
            
            —
            
            
            
            —
            
            
            —
            
            
            —
            
            
            21,686
            
            
            
            21,686
            
            
            $
            21,686Stock
                issued upon option exercise
            
            
            156
            
            
            
            2
            
            
            —
            
            
            
            —
            
            
            —
            
            
            1,976
            
            
            —
            
            
            
            1,978
            
            
            
            —Tax
                benefit of stock option exercise
            
            
            —
            
            
            
            —
            
            
            —
            
            
            
            —
            
            
            —
            
            
            1,463
            
            
            —
            
            
            
            1,463
            
            
            
            —Stock
                issued under ESPP
            
            
            6
            
            
            
            —
            
            
            (6
            )
            
            
            59
            
            
            —
            
            
            116
            
            
            —
            
            
            
            175
            
            
            
            —Deferred
                compensation from
              restricted
                stock awards
            
            
            40
            
            
            
            —
            
            
            —
            
            
            
            —
            
            
            —
            
            
            495
            
            
            —
            
            
            
            495Stock-based
                compensation expense
            
            
            —
            
            
            
            —
            
            
            —
            
            
            
            —
            
            
            —
            
            
            4,195
            
            
            —
            
            
            
            4,195
            
            
            
            —Treasury
                stock acquisition
            
            
            (2,934
            )
            
            
            —
            
            
            2,934
            
            
            
            (87,937
            )
            
            —
            
            
            —
            
            
            —
            
            
            
            (87,937
            )FIN
                48 adoption
            
            
            —
            
            
            
            —
            
            
            —
            
            
            
            —
            
            
            —
            
            
            —
            
            
            (683
            )
            
            
            (683
            )Other
                comprehensive income:Foreign
                currency translation adjustments
            
            
            —
            
            
            
            —
            
            
            —
            
            
            
            —
            
            
            3,029
            
            
            —
            
            
            —
            
            
            
            3,029
            
            
            
            3,029Pension
                liability adjustment, net of tax
            
            
            —
            
            
            
            —
            
            
            —
            
            
            
            —
            
            
            1,051
            
            
            —
            
            
            —
            
            
            
            1,051
            
            
            
            1,051Comprehensive
                income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            25,766Balance,
                December 31, 2007
            
            
            18,320
            
            
            $
            231
            
            
            4,752
            
            
            $
            (96,501
            )
            $
            12,918
            
            $
            239,021
            
            $
            241,709
            
            
            $
            397,378Net
                loss
            
            
            —
            
            
            
            —
            
            
            —
            
            
            
            —
            
            
            —
            
            
            —
            
            
            (205,752
            )
            
            
            (205,752
            )
            
            $
            (205,752
            )Stock
                issued upon option exercise
            
            
            82
            
            
            
            1
            
            
            —
            
            
            
            —
            
            
            —
            
            
            955
            
            
            —
            
            
            
            956
            
            
            
            —Tax
                benefit of stock option exercise
            
            
            —
            
            
            
            —
            
            
            —
            
            
            
            —
            
            
            —
            
            
            193
            
            
            —
            
            
            
            193
            
            
            
            —Stock
                issued under ESPP
            
            
            9
            
            
            
            —
            
            
            (9
            )
            
            
            51
            
            
            —
            
            
            125
            
            
            —
            
            
            
            176
            
            
            
            —Deferred
                compensation from
              restricted
                stock awards
            
            
            32
            
            
            
            —
            
            
            —
            
            
            
            —
            
            
            —
            
            
            589
            
            
            —
            
            
            
            589
            
            
            
            —Tax
                expense of restricted stock issuance
            
            
            —
            
            
            
            —
            
            
            —
            
            
            
            —
            
            
            —
            
            
            (88
            )
            
            —
            
            
            
            (88
            )Stock-based
                compensation expense
            
            
            —
            
            
            
            —
            
            
            —
            
            
            
            —
            
            
            —
            
            
            5,489
            
            
            —
            
            
            
            5,489
            
            
            
            —Treasury
                stock acquisition
            
            
            (1,198
            )
            
            
            —
            
            
            1,198
            
            
            
            (24,660
            )
            
            —
            
            
            —
            
            
            —
            
            
            
            (24,660
            )
            
            
            —Previous
                years’foreign
                currency translation
              net loss recorded as income tax expense
            
            
            —
            
            
            
            —
            
            
            —
            
            
            
            —
            
            
            (1,275
            )
            
            —
            
            
            1,275
            
            
            
            —
            
            
            
            —Other
                comprehensive loss:Foreign
                currency translation adjustments
            
            
            —
            
            
            
            —
            
            
            —
            
            
            
            —
            
            
            (23,084
            )
            
            —
            
            
            —
            
            
            
            (23,084
            )
            
            
            (23,084
            )Pension
                liability adjustment, net of tax
            
            
            —
            
            
            
            —
            
            
            —
            
            
            
            —
            
            
            (2,508
            )
            
            —
            
            
            —
            
            
            
            (2,508
            )
            
            
            (2,508
            )Comprehensive
                loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            (231,344
            )Balance,
              December 31, 2008
            
            
            17,245
            
            
            $
            232
            
            
            5,941
            
            
            $
            (121,110
            )
            $
            (13,949
            )
            $
            246,284
            
            $
            37,232
            
            
            $
            148,689


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


F-6


CONSOLIDATED
      STATEMENTS OF CASH FLOWS





Year
                Ended December 31,(in
                thousands)
            
            2006
            
            
            2007
            
            
            2008Operating
                activitiesNet
                income (loss)
            
            $
            34,094
            
            
            $
            21,686
            
            
            $
            (205,752
            )Loss
                (income) from discontinued operations
            
            
            9,676
            
            
            
            (110
            )
            
            
            —Adjustments
                to reconcile net income to net cash provided
              by
                operating activities:Depreciation
            
            
            14,087
            
            
            
            13,950
            
            
            
            15,390Impairment
                of goodwill and other intangible assets
            
            
            2,824
            
            
            
            —
            
            
            
            255,853Restructuring
                charge for write-off of tooling related to
              discontinuance
                of certain product lines
            
            
            8,621
            
            
            
            —
            
            
            
            —Write-off
                of investment
            
            
            —
            
            
            
            —
            
            
            
            2,057(Reduction
                of allowance) provision for uncollectible accounts
            
            
            (562
            )
            
            
            981
            
            
            
            654Amortization
                and write-off of deferred financing costs
            
            
            696
            
            
            
            587
            
            
            
            944Amortization
                of intangible assets
            
            
            1,149
            
            
            
            893
            
            
            
            889Stock-based
                compensation
            
            
            3,856
            
            
            
            4,705
            
            
            
            6,078Excess
                tax benefit on stock option exercises
            
            
            (2,414
            )
            
            
            (1,024
            )
            
            
            (182
            )Deferred
                income taxes
            
            
            (2,453
            )
            
            
            (360
            )
            
            
            (41,809
            )Other
            
            
            18
            
            
            
            (20
            )
            
            
            (51
            )Changes
                in operating assets and liabilities:Accounts
                and other receivables
            
            
            4,121
            
            
            
            4,138
            
            
            
            13,952Inventory
            
            
            (12,496
            )
            
            
            8,488
            
            
            
            (4,960
            )Prepaid
                expenses
            
            
            507
            
            
            
            (462
            )
            
            
            (503
            )Other
                assets
            
            
            —
            
            
            
            (855
            )
            
            
            (2,607
            )Accounts
                payable and accrued expenses
            
            
            565
            
            
            
            12,112
            
            
            
            (20,926
            )Other
                liabilities
            
            
            (74
            )
            
            
            (1,283
            )
            
            
            (1,490
            )Net
                cash provided by continuing operations
            
            
            62,215
            
            
            
            63,426
            
            
            
            17,537Net
                cash (used in) provided by discontinued operations
            
            
            (438
            )
            
            
            110
            
            
            
            —Net
                cash provided by operating activities
            
            
            61,777
            
            
            
            63,536
            
            
            
            17,537Investing
                activitiesPurchase
                of property and equipment
            
            
            (14,396
            )
            
            
            (11,467
            )
            
            
            (9,422
            )Proceeds
                from disposition of property and equipment
            
            
            24
            
            
            
            13
            
            
            
            72Purchase
                price of acquisitions, net of cash acquired
            
            
            —
            
            
            
            (9,033
            )
            
            
            13Proceeds
                from sale of discontinued operations
            
            
            6,819
            
            
            
            110
            
            
            
            —(Increase)
                decrease in other non-current assets
            
            
            (1,243
            )
            
            
            82
            
            
            
            (141
            )Net
                cash used in continuing operations
            
            
            (8,796
            )
            
            
            (20,295
            )
            
            
            (9,478
            )Net
                cash provided by discontinued operations
            
            
            477
            
            
            
            —
            
            
            
            —Net
                cash used in investing activities
            
            
            (8,319
            )
            
            
            (20,295
            )
            
            
            (9,478
            )


F-7


CONSOLIDATED
      STATEMENTS OF CASH FLOWS – continued





Year
                Ended December 31,2006
            
            
            2007
            
            
            2008Financing
                activitiesIssuance
                of stock upon option exercises
            
            
            3,618
            
            
            
            1,978
            
            
            
            956Excess
                tax benefit on stock option exercises
            
            
            2,414
            
            
            
            1,024
            
            
            
            182Issuance
                of stock under ESPP
            
            
            212
            
            
            
            175
            
            
            
            176Purchase
                of treasury stock
            
            
            —
            
            
            
            (87,937
            )
            
            
            (24,660
            )Borrowings
                on bank term loan
            
            
            —
            
            
            
            —
            
            
            
            75,000Payments
                on bank term loans
            
            
            (42,250
            )
            
            
            (22,438
            )
            
            
            —Net
                (payments) borrowings on lines of credit
            
            
            (18,270
            )
            
            
            95,000
            
            
            
            (74,880
            )Financing
                fees paid
            
            
            (184
            )
            
            
            (118
            )
            
            
            (2,792
            )Net
                cash used in continuing operations
            
            
            (54,460
            )
            
            
            (12,316
            )
            
            
            (26,018
            )Net
                cash provided by (used in) discontinued operations
            
            
            —
            
            
            
            —
            
            
            
            —Net
                cash used in financing activities
            
            
            (54,460
            )
            
            
            (12,316
            )
            
            
            (26,018
            )Effect
                of exchange rate changes on cash
            
            
            1,105
            
            
            
            1,519
            
            
            
            (7,755
            )Net
                increase (decrease) in cash and cash equivalents
            
            
            103
            
            
            
            32,444
            
            
            
            (25,714
            )Cash
                and cash equivalents, beginning of year
            
            
            25,262
            
            
            
            25,365
            
            
            
            57,809Cash
                and cash equivalents, end of year
            
            $
            25,365
            
            
            $
            57,809
            
            
            $
            32,095Supplemental
                disclosure of cash flow information:Cash
                paid for interest during the period
            
            $
            3,631
            
            
            $
            2,172
            
            
            $
            5,393Cash
                paid for income taxes during the period
            
            
            28,367
            
            
            
            18,879
            
            
            
            7,621Cash
                refunds received from income taxes
            
            $
            1,078
            
            
            $
            1,289
            
            
            $
            4,851


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


F-8


NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS





FOR
      THE YEARS ENDED DECEMBER 31, 2006, 2007 AND 2008





1.  DESCRIPTON
      OF BUSINESS





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





2.  SIGNIFICANT
      ACCOUNTING POLICIES





Principles
      of Consolidation





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





Reclassifications





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





Use
      of Estimates





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





Fair
      Value of Financial Instruments





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





Derivative
      Instruments





The
      Company had no derivative instruments during the years ended December 31, 2006,
      2007 and 2008.





Cash
      and cash equivalents





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





F-9


Allowance
      for Doubtful Accounts





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





Inventory





Inventory
      is recognized at the time title is transferred to the Company.  Title
      is transferred to the Company FOB shipping point.  Inventory, which
      consists primarily of finished goods, has been written down for excess
      quantities and obsolescence, and is stated at lower of cost or
      market.  Cost reasonably approximates 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, sales projectons 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 in computing
      depreciation for financial statement purposes are as follows:





Asset
                Descriptions
            Estimated
                Useful LifeBuildings
                and improvements
            Lesser
                of lease term or 15 yearsTooling
            3
                -
                7 yearsOther
                equipment
            2
                -
                10 years





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
      collectibles product lines.  The charges for 2006 are included in the
      restructuring charge related to discontinued automotive collectibles within
      operating expenses in the accompanying consolidated statement of operations
      for
      the year ended December 31, 2006 (see Note 15 - Restructuring Charge –
Discontinuance of Automotive Collectible Product Lines).  In 2008, the
      Company recorded charges of $2.7 million in the North America segment to
      write-off undepreciated tooling primarily related to discontinued product
      lines.  The charges for 2008 are included in cost of sales, other
      in the accompanying consolidated statement of operations for the year ended
      December 31, 2008.





Goodwill
      and Intangible Assets





In
      accordance with the provisions of Statement of Financial Accounting Standards
      (SFAS) No. 142, “Goodwill and Other Intangible Assets,” the Company tests
      goodwill and other intangible assets with indefinite useful lives for impairment
      on an annual basis or on an interim basis if an event occurs that might reduce
      the fair value of the reporting unit below its carrying value.  The
      fair value of the Company's reporting units and its separately indentifiable
      intangible assets are determined based on the discounted cash flows associated
      with the reporting unit or indentifiable intangible asset.  The Company
      conducts testing for impairment during the fourth quarter of its fiscal
      year.  Intangible assets that do not have indefinite lives are
      amortized over their useful lives.  In the fourth quarter of 2008, the
      Company recorded an impaiment charge, writing-off its entire balance of goodwill
      (see Note 5 - Goodwill and Intangible Assets).





F-10


Other
      Non-Current Assets





Other
      non-current assets at December 31, 2007 and 2008, consist primarily of deferred
      financing fees, as well as the Company’s investments in the development of
      intellectual properties, including development of a media property under a
      collaborative arrangement.  In 2008, the Company recorded a $2.1 million
      non-cash write-off of an investment.  The deferred financing fees
      are being amortized over the related borrowing period.  Amortization
      and write-offs of deferred financing fees for the years ended December 31,
      2006,
      2007 and 2008, were $0.7 million, $0.6 million and $0.9 million, respectively,
      and are included in interest expense of the accompanying consolidated statements
      of operations.





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 primarily for defective
      merchandise, volume programs and co-op advertising.  All allowances
      are accrued throughout the year as sales are recorded.  The allowances
      are based on the terms of the various programs in effect; however, management
      also takes into consideration historical trends and specific customer and
      product information when making its estimates.  For the volume
      programs, the Company generally sets a volume target for the year with each
      participating customer and issues the discount if the target is
      achieved.  The allowance for the volume program is accrued throughout
      the year, and if it becomes clear to management that the target for a
      participating customer will not be reached, the Company will change the estimate
      for that customer as required.





Accrued
      Royalties





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





Foreign
      Currency Translation/Transactions





Foreign
      subsidiary assets and liabilities are recorded in their respective functional
      currencies and translated into U.S. dollars at the rates of exchange at the
      balance sheet date, while statement of operations 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, 2006, 2007 and 2008, have been recorded as
      components of accumulated other comprehensive income (loss) in stockholders’
equity.  The net exchange losses resulting from transactions in
      foreign currencies for the year ended December 31, 2006, were $1.4
      million.  The net exchange gains resulting from transactions in
      foreign currencies for the years ended December 31, 2007 and 2008, were $1.0
      million and $2.8 million, respectively.  The net exchange losses and
      gains are included in other expense (income) in the accompanying consolidated
      statements of operations.





Included
      in the accompanying consolidated statement of stockholders’ equity in 2008 is an
      out of period adjustment to properly reflect foreign currency translation,
      recorded as income tax expense in previous years, as accumulated other
      comprehensive income (loss) as of December 31, 2008.  The adjustment
      decreased accumulated other comprehensive income (loss) and increased retained
      earnings as of December 31, 2008, and had no effect on total stockholders’
equity as of December 31, 2008.





F-11


Comprehensive
      Income (Loss)





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 distribution to owners, in a financial statement for the period
      in
      which they are recognized.  The Company has chosen to disclose
      comprehensive income, which encompasses net income, foreign currency translation
      adjustments and pension liability adjustments, net of income tax effects, as
      part of the accompanying consolidated statements of stockholders’
equity.  The income tax expense (benefit) related to the components of
      comprehensive income (loss) in 2006, 2007 and 2008 was $0.5 million, $0.6
      million and $(1.8) million, respectively.





Revenue
      Recognition





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





The
      Company ordinarily accepts returns only for defective merchandise.  In
      certain instances, where retailers are unable to resell the quantity of products
      that they have purchased from the Company, the Company may, in accordance with
      industry practice, assist retailers in selling excess inventory by offering
      credits and other price concessions, which are typically evaluated and issued
      annually.  Other allowances can also be issued primarily for defective
      merchandise, volume programs and co-op advertising.  Allowances are
      accrued throughout the year, as sales are recorded.





Shipping
      and Handling Costs





Shipping
      and handling costs, which comprise only those costs incurred to transport
      products to the customer, are included in selling, general and administrative
      expenses in the accompanying consolidated statements of
      operations.  For the years ended December 31, 2006, 2007 and 2008,
      shipping and handling costs were $17.3 million, $22.5 million and $14.0 million,
      respectively.  Shipping and handling costs for the year ended December
      31, 2007 and 2008, include items related to the 2007 recalls of $5.0 million
      and
      $(1.8) million, respectively.





Advertising





The
      Company expenses the production costs of advertising the first time the
      advertising takes place.  Advertising expense, including promotion and
      placement costs, for the years ended December 31, 2006, 2007 and 2008, was
      $12.4
      million, $20.7 million and $17.2 million, respectively.  Advertising
      expense is included in net sales and selling, general and administrative
      expenses in the accompanying consolidated statements of operations.





Prepaid
      advertising expenses, such as prepayments on magazine advertisements and artwork
      costs of $0.2 million and an immaterial amount, are included in prepaid
      expenses in the accompanying consolidated balance sheets at December 31, 2007
      and 2008, respectively.





Product
      Recalls





The
      Company establishes a reserve for product recalls on a product-specific basis
      during the period in which the circumstances giving rise to the recall become
      known and estimable.  Facts underlying the recall, including, among
      others, estimates of retailer inventory returns, consumer replacement costs,
      shipping costs and fines and penalties, are considered when establishing a
      product recall reserve.  In 2007 and 2008, the Company also considered
      additional replacement costs or refunds, donations, notice charges, claims
      administration, licensor indemnification claims and plaintiffs' legal fees
      related to settlement of the class action lawsuits (see Note 16 - Product
      Recalls).  The Company's legal costs to defend recall-related matters
      are expensed as incurred.  When facts or circumstances become known that
      would indicate that the recall reserve is either not sufficient to cover or
      exceeds the estimated product recall expenses, the reserve is adjusted, as
      appropriate.





F-12


Stock-based
      Compensation





Effective
      January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based
      Payment.”  The Company elected to use the modified prospective
      application of SFAS No. 123R for awards issued prior to January 1,
      2006.




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





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





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





Income
      and Other Taxes





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





Effective
      January 1, 2007, the Company adopted FASB Interpretation No. (FIN) 48,
“Accounting for Uncertainty in Income Taxes – an interpretation of FASB
      Statement No. 109.”  Management considers certain tax exposures and
      all available evidence when evaluating and estimating our tax positions and
      tax
      benefits, which may require periodic adjustments to the tax-related
      balances.  Estimates for such tax contingencies are classified in
      other current liabilities and other non-current liabilities in the accompanying
      consolidated balance sheets.





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





F-13


Earnings
      (Loss) Per Common Share from Continuing Operations





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





Year
                Ended December 31,(in
                thousands, except per share data)
            
            2006
            
            
            2007
            
            
            2008Income
                (loss) from continuing operations
            
            $
            43,770
            
            
            $
            21,576
            
            
            $
            (205,752
            )Weighted
                average common and common equivalent shares outstanding:Weighted
                average common shares outstanding
            
            
            20,884
            
            
            
            20,395
            
            
            
            17,406Add
                effect of diluted securities – assumed exercise of stock
                options
              and
                vesting of restricted stock awards
            
            
            493
            
            
            
            353
            
            
            
            —Weighted
                average common and common equivalent shares outstanding
            
            
            21,377
            
            
            
            20,748
            
            
            
            17,406Basic
                earnings (loss) per common share from continuing
                operations
            
            $
            2.09
            
            
            $
            1.05
            
            
            $
            (11.82
            )Diluted
                earnings (loss) per common share from continuing
                operations
            
            $
            2.04
            
            
            $
            1.04
            
            
            $
            (11.82
            )





The
      computation of diluted earnings (loss) per common share from continuing
      operations excludes 447,975 shares, 571,586 shares and 1,921,142 shares in
      2006,
      2007 and 2008, respectively, because the options were anti-dilutive.
      Additionally, unvested restricted stock awards of 57,851 were not included
      in
      the computation of diluted earnings (loss) per common share for the year ended
      December 31, 2008.  Because actual results for 2008 generated a loss
      from continuing operations, any potential common shares would be anti-dilutive,
      and accordingly, were excluded from the diluted earnings (loss) per common
      share
      calculation.




Concentration
      of Credit Risk





Concentration
      of credit risk is limited to accounts receivable and is subject to the financial
      conditions of certain major customers.  The Company's top three
      customers, Target, Toys "R" Us/Babies "R" Us and Wal-Mart, combined accounted
      for 44.2%, 42.6% and 40.1% of the Company's net sales in 2006, 2007 and
      2008, respectively.  Over the last three years each of these three
      customers accounted for between 12.1% and 16.3% of the Company's net
      sales.  No other customers accounted for more than 10.0% of the Company's
      net sales in any of the years ended December 31, 2006, 2007 or
      2008.


Additionally, over
        the last two years, each of these three customers accounted for between 12.3%
        and 18.8% of the Company's accounts receiveable.  No other
        customers accounted for more than 10.0% of the Company's accounts receivables
        at
        December 31, 2007 and 2008.  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.





F-14




Supplier
      Concentration





The
      Company’s purchases from two of its third-party, dedicated suppliers were 10.3%
      and 10.0% in 2006, respectively, of its total product purchases.  The
      Company did not have purchases from any of its third-party, dedicated suppliers
      in 2007 that were greater than 10.0% of its total product
      purchases.  The Company’s purchases from one of its third-party,
      dedicated suppliers was 10.1% in 2008 of its total product
      purchases.  There were no other suppliers accounting for more than
      10.0% of total product purchases in any of the years ended December 31, 2006,
      2007 and 2008.





Recently
      Issued Accounting Pronouncements





In
      September 2006, the FASB issued SFAS No. 157, “Fair Value
      Measurements.”  This Statement defines fair value, establishes a
      framework for measuring fair value in generally accepted accounting principles
      and expands disclosures about fair value measurements.  This Statement
      applies under other accounting pronouncements that require or permit fair value
      measurement.  However, this Statement does not require any new fair
      value measurements.  This Statement is effective for the financial
      statements issued for the fiscal years beginning after November 15, 2007, and
      interim periods within those fiscal years.  In February 2008, the FASB
      issued FASB Staff Position (FSP) No. FAS 157-2, “Effective Date of FASB
      Statement No. 157,” which provides a one year deferral of the effective date of
      SFAS No. 157 for non-financial assets and non-financial liabilities, except
      those that are recognized or disclosed in the financial statements at fair
      value
      at least annually.  In accordance with FSP FAS No. 157-2, the Company
      has only adopted the provisions for SFAS No. 157 with respect to its financial
      assets and liabilities that are measured at fair value within the financial
      statements as of January 1, 2008.  Based upon this one year deferral,
      the provisions of SFAS No. 157 have not been applied to non-financial assets
      and
      non-financial liabilities.  The major category of assets and
      liabilities that are measured at fair value, for which the Company has not
      applied the provisions of SFAS No. 157, is intangible assets.





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





F-15


3.  BUSINESS
      COMBINATIONS





Angels
      Landing, Inc.





On
      May
      24, 2007, the Company acquired substantially all of the assets of Angels
      Landing, Inc. (Angels Landing), a privately-held, start-up developer and
      marketer of infant and toddler travel gear under the Compass brand name (the
      Compass Business) based in Kettering, Ohio.  Closing consideration
      consisted of $6.6 million of cash, excluding transaction expenses.  At
      December 31, 2008, contingent purchase price of $0.3 million, based on
      sales relating to the Compass Business in 2008, is in escrow awaiting
      disposition.  This transaction has been accounted for under the
      purchase method of accounting, and accordingly, the operating results of the
      Compass Business have been included in the accompanying consolidated statements
      of operations since the effective date of the acquisition.  The excess
      of the aggregate purchase price over the fair market value of net assets
      acquired of $4.2 million was reflected as goodwill in the accompanying
      consolidated balance sheet at December 31, 2007.





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





(in
                thousands)Total
                purchase price, including expenses, net of cash acquired
            
            
            
            
            $
            6,472Less:Current
                assets
            
            $
            1,351Property,
                plant and equipment
            
            
            817Intangible
                assets
            
            
            890Liabilities
            
            
            (485
            )
            
            
            (2,573
            )Excess
                of purchase price over net assets acquired
            
            
            
            
            
            $
            3,899





In
      the
      fourth quarter of 2008, the Company recorded an impairment charge, writing-off
      its entire balance of goodwill (see Note 5 – Goodwill and Intangible
      Assets).  The unaudited pro forma consolidated results of operations
      for the Compass Business are not presented due to the immateriality of its
      results of operations.





Mother’s
      Intuition Inc.





On
      November 30, 2007, the Company acquired substantially all of the assets of
      Mother’s Intuition Inc. (MI), a privately-held, start-up developer and marketer
      of women’s prenatal bodycare products based in Mission Viejo,
      California.  Closing consideration consisted of $2.2 million of cash,
      excluding transaction expenses.  The transaction included an
      additional $1.5 million in deferred purchase price, $0.5 million which was
      paid
      on December 31, 2008, and $1.0 million which will be paid in two equal
      installments of $0.5 million each on December 31, 2009 and December 31,
      2010.  This deferred purchase price is included in other current
      liabilities and other non-current liabilities in the accompanying consolidated
      balance sheets at December 31, 2007 and 2008.  Additional cash
      consideration of up to $10.5 million may be earned in the transaction by MI
      based on achieving certain aggregate financial targets in each of the three
      years beginning in 2008 through 2010.  The financial targets for 2008
      were not met.  This transaction has been accounted for under the
      purchase method of accounting, and accordingly, the operating results of MI
      have
      been included in the accompanying consolidated statements of operations since
      the effective date of the acquisition.  The excess of the aggregate
      purchase price over the fair market value of net assets acquired of $3.4 million
      was reflected as goodwill in the accompanying consolidated balance sheet at
      December 31, 2007.





F-16


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





(in
                thousands)Total
                purchase price, including expenses, net of cash acquired
            
            
            
            
            $
            3,748Less:Current
                assets
            
            $
            153Intangible
                assets
            
            
            180Liabilities
            
            
            (76
            )
            
            
            (257
            )Excess
                of purchase price over net assets acquired
            
            
            
            
            
            $
            3,491





During
      the fourth quarter of 2008, the Company recorded an impairment charge,
      writing-off its entire balance of goodwill (see Note 5 – Goodwill and Intangible
      Assets).  The unaudited pro forma consolidated results of operations
      of MI are not presented due to the immateriality of its results of
      operations.





Terminated
      Aquisition Costs





On
      June
      23, 2008, the Company announced it signed a definitive purchase agreement to
      acquire certain net assets of the children's book division of a
      privately-held publishing company.  However, on September 30, 2008,
      the Company announced that due to adverse capital markets, it terminated the
      purchase agreement.  Costs of $1.4 million, incurred by the Company
      related to this proposed transaction, are included in terminated
      acquisition costs on the accompanying consolidated statement of operations
      for
      the year ended December 31, 2008.





4.  BUSINESS
      SEGMENTS





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





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





Segment
      performance is measured at the operating income (loss) 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.





F-17


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, 2006, 2007
      and 2008, are as follows:





Year
                Ended December 31,(in
                thousands)
            
            2006
            
            
            2007
            
            
            2008Net
                sales:North
                America
            
            $
            432,769
            
            
            $
            381,792
            
            
            $
            327,311International
            
            
            86,794
            
            
            
            108,081
            
            
            
            110,451Sales
                and transfers between segments
            
            
            (734
            )
            
            
            (874
            )
            
            
            (733
            )Combined
                total
            
            $
            518,829
            
            
            $
            488,999
            
            
            $
            437,029Operating
                income (loss):North
                America
            
            $
            58,061
            
            
            $
            19,092
            
            
            $
            (235,393
            )International
            
            
            14,219
            
            
            
            14,811
            
            
            
            (2,664
            )Sales
                and transfers between segments
            
            
            (37
            )
            
            
            (108
            )
            
            
            73Combined
                total
            
            $
            72,243
            
            
            $
            33,795
            
            
            $
            (237,984
            )Depreciation
                and amortization:North
                America
            
            $
            14,003
            
            
            $
            13,487
            
            
            $
            14,656International
            
            
            1,233
            
            
            
            1,356
            
            
            
            1,623Combined
                total
            
            $
            15,236
            
            
            $
            14,843
            
            
            $
            16,279Capital
                expenditures:North
                America
            
            $
            12,810
            
            
            $
            9,733
            
            
            $
            7,758International
            
            
            1,586
            
            
            
            1,734
            
            
            
            1,664Combined
                total
            
            $
            14,396
            
            
            $
            11,467
            
            
            $
            9,422





December
                31,2007
            
            
            2008Total
                assets:North
                America
            
            $
            513,289
            
            
            $
            235,499International
            
            
            136,956
            
            
            
            101,151Combined
                total
            
            $
            650,245
            
            
            $
            336,650





Under
      the
      enterprise-wide disclosure requirements of SFAS No. 131, the Company reports
      net
      sales by product category and by distribution channel.  Beginning in
      2008, the Company reclassified its product categories and distribution channels
      to be more closely aligned with its strategic direction and organizational
      structure.  The presentation is consistent with how the Company views
      its business.  The Company groups its products into two product
      categories: mother, infant and toddler products, and preschool, youth and adult
      products.  Amounts for the years ended December 31, 2006, 2007 and
      2008, are as shown in the tables below:





Year
                Ended December 31,(in
                thousands)
            
            2006
            
            
            2007
            
            
            2008Mother,
                infant and toddler products
            
            $
            175,735
            
            
            $
            184,936
            
            
            $
            178,548Preschool,
                youth and adult products
            
            
            343,094
            
            
            
            304,063
            
            
            
            258,481Net
                sales
            
            $
            518,829
            
            
            $
            488,999
            
            
            $
            437,029Chain
                retailers
            
            $
            352,555
            
            
            $
            333,775
            
            
            $
            307,341Specialty
                retailers, wholesalers, OEM dealers and other
            
            
            166,274
            
            
            
            155,224
            
            
            
            129,688Net
                sales
            
            $
            518,829
            
            
            $
            488,999
            
            
            $
            437,029





F-18


5.  GOODWILL
      AND INTANGIBLE ASSETS





The
      Company completed its annual goodwill impairment tests as of October 1, 2006
      and
      2007, which resulted in no impairment.  Primarily due to the decline
      in the Company's market capitalization, in the fourth quarter of 2008, the
      Company recorded a goodwill impairment charge of $231.9 million and $12.1
      million in the North America and International segments, respectively, to
      write-off all of its recorded goodwill.  The impairment charge is
      included in impairment of goodwill and other intangible assets in the
      accompanying consolidated statement of operations for the year ended December
      31, 2008.





The
      carrying value of goodwill by reporting unit for the years ended 2007 and 2008
      is shown below:





(in
                thousands)
            
            North
                America
            
            
            International
            
            
            TotalBalance
                at December 31, 2006
            
            $
            223,836
            
            
            $
            15,231
            
            
            $
            239,067Compass
                Business acquisition
            
            
            4,250
            
            
            
            —
            
            
            
            4,250MI
                acquisition
            
            
            3,449
            
            
            
            —
            
            
            
            3,449Other
                adjustments
            
            
            659
            
            
            
            389
            
            
            
            1,048Balance
                at December 31, 2007
            
            
            232,194
            
            
            
            15,620
            
            
            
            247,814Compass
                Business fair value allocation
            
            
            (351
            )
            
            
            —
            
            
            
            (351
            )MI
                fair value allocation
            
            
            42
            
            
            
            —
            
            
            
            42Impairment
            
            
            (231,885
            )
            
            
            (12,101
            )
            
            
            (243,986
            )Other
                adjustments
            
            
            —
            
            
            
            (3,519
            )
            
            
            (3,519
            )Balance
                at December 31, 2008
            
            $
            —
            
            
            $
            —
            
            
            $
            —





Other
      adjustments made during the year ended December 31, 2007, primarily relate
      to an
      adjustment to deferred taxes related to fixed assets on prior acquisitions
      and
      currency exchange rate changes.  Other adjustments made during the
      year ended December 31, 2008, relate to currency exchange rate
      changes.




In
        2006,
        the Company recorded an impairment charge for intangible assets in the North
        America segment of $2.8 million as a result of the Company’s decision to
        discontinue its automotive collectible product lines (see Note 15 -
        Restructuring Charge – Discontinuance of Automotive Collectible Product Lines)
        and is included in restructuring charge related to discontinued automotive
        collectibles within operating expense in the accompanying consolidated statement
        of operations for the year ended December 31, 2006.  The annual
        impairment test for intangible assets in 2007 resulted in no impairment to
        intangible assets. In the fourth quarter of 2008, the Company recorded an
        intangible asset impairment charge in the North America segment of $11.9
        million
        which is included in impairment of goodwill and other intangible assets in
        the
        accompanying consolidated statement of operations for the year ended December
        31, 2008.


The
      components of net intangible assets are as follows:





December
                31,(in
                thousands)
            
            2007
            
            
            2008Gross
                amount of amortizable intangible assets:Customer
                relationships
            
            $
            8,582
            
            
            $
            8,582Other
            
            
            4,321
            
            
            
            4,32112,903
            
            
            
            12,903Accumulated
                amortization of amortizable intangible assets:Customer
                relationships
            
            
            706
            
            
            
            939Other
            
            
            2,815
            
            
            
            3,4713,521
            
            
            
            4,410Intangible
                assets not subject to amortization:Licenses
                and trademarks
            
            
            87,293
            
            
            
            74,011Total
                intangible assets, net
            
            $
            96,675
            
            
            $
            82,504





F-19


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





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





(in
                thousands)2009
            
            $
            5782010
            
            
            3722011
            
            
            3322012
            
            
            3192013
            
            $
            279





6.  INCOME
      TAXES





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





Year
                Ended December 31,(in
                thousands)
            
            2006
            
            
            2007
            
            
            2008Income
                from continuing operations before income taxes:United
                States
            
            $
            58,061
            
            
            $
            20,186
            
            
            $
            (239,729
            )Foreign
            
            
            10,187
            
            
            
            13,862
            
            
            
            (1,764
            )$
            68,248
            
            
            $
            34,048
            
            
            $
            (241,493
            )





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





The
      significant components of income tax expense allocated to continuing operations
      are as follows:





Year
                Ended December 31,(in
                thousands)
            
            2006
            
            
            2007
            
            
            2008CurrentFederal
            
            $
            20,928
            
            
            $
            6,667
            
            
            $
            1,088State
            
            
            2,407
            
            
            
            546
            
            
            
            (94
            )Foreign
            
            
            3,601
            
            
            
            5,618
            
            
            
            4,83926,936
            
            
            
            12,831
            
            
            
            5,833DeferredFederal
            
            
            (1,608
            )
            
            
            (157
            )
            
            
            (36,690
            )State
            
            
            (154
            )
            
            
            (96
            )
            
            
            (4,119
            )Foreign
            
            
            (696
            )
            
            
            (106
            )
            
            
            (765
            )(2,458
            )
            
            
            (359
            )
            
            
            (41,574
            )Income
                tax expense
            
            $
            24,478
            
            
            $
            12,472
            
            
            $
            (35,741
            )





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





F-20


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





Year
                Ended December 31,2006
            
            
            2007
            
            
            2008U.S.
                statutory rate
            
            
            35.0
            %
            
            
            35.0
            %
            
            
            35.0
            %State
                taxes, net of federal benefit
            
            
            2.0
            
            
            
            2.0
            
            
            
            —Foreign
            
            
            (1.1
            )
            
            
            (1.8
            )
            
            
            —Impairment
            
            
            —
            
            
            
            —
            
            
            
            (20.5
            )%Other
            
            
            —
            
            
            
            1.4
            
            
            
            0.3Effective
                rate
            
            
            35.9
            %
            
            
            36.6
            %
            
            
            14.8
            %





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





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





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





December
                31,(in
                thousands)
            
            2007
            
            
            2008Deferred
                tax assets attributable toCapital
                loss carry-forward
            
            $
            5,887
            
            
            $
            5,887Stock
                options
            
            
            3,151
            
            
            
            4,824Bad
                debt allowance
            
            
            393
            
            
            
            330Inventory
            
            
            4,307
            
            
            
            4,344Sales
                allowances
            
            
            3,131
            
            
            
            1,971Federal
                credit carry-forwards
            
            
            —
            
            
            
            1,937Net
                operating loss carry-forwards
            
            
            671
            
            
            
            2,658Accrued
                expenses
            
            
            2,483
            
            
            
            2,402Purchase
                accounting
            
            
            682
            
            
            
            587Other
            
            
            884
            
            
            
            2,994Total
                deferred tax assets before valuation allowance
            
            
            21,589
            
            
            
            27,934Valuation
                allowance related to the capital loss carry-forward
            
            
            (5,887
            )
            
            
            (5,887
            )Valuation
                allowance related to partnership investment
            
            
            —
            
            
            
            (126
            )Valuation
                allowance related to net operating loss carry-forwards
            
            
            —
            
            
            
            (1,282
            )Net
                deferred tax assets
            
            
            15,702
            
            
            
            20,639Deferred
                tax liabilities attributable toGoodwill
                and intangible assets
            
            
            (52,647
            )
            
            
            (15,159
            )Property
                and equipment
            
            
            (3,079
            )
            
            
            (1,817
            )Other
            
            
            (856
            )
            
            
            (1,577
            )Total
                deferred tax liabilities
            
            
            (56,582
            )
            
            
            (18,553
            )Net
                deferred tax (liability) asset
            
            $
            (40,880
            )
            
            $
            2,086





No
      provision has been made for U.S. federal or non-U.S. deferred income taxes
      on
      $27.6 million of accumulated and undistributed earnings of foreign subsidiaries
      at December 31, 2008, since it is the present intention of management to
      reinvest the undistributed earnings indefinitely in those foreign
      operations.  The determination of the amount of unrecognized U.S.
      federal or non-U.S. deferred income tax liabilities for unremitted earnings
      is
      not practicable.





Net
      prepaid income taxes at December 31, 2007 and 2008, were $3.1 million and $3.3
      million, respectively.





F-21


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 14 -
      Discontinued Operations).  For tax purposes, this sale generated a
      pre-tax capital loss of $15.6 million.  A valuation allowance of $5.9
      million has been established because the Company does not believe recoverability
      of this amount is more likely than not.  This capital loss
      carry-forward will expire in 2011.





The
      Company’s German subsidiary accumulated a net operating loss carry-forward, for
      which the Company has established a full valuation
      allowance.  While German net operating losses have an unlimited
      carry-forward period, the future projections for taxable income in that
      jurisdiction are undetermined.





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





The
      uncertain tax positions as of December 31, 2007 and 2008, totaled $4.2 million
      and $3.6 million, respectively.  The following table summarizes the
      activity related to the unrecognized tax benefits:





December
                31,(in
                thousands)
            
            2007
            
            
            2008Unrecognized
                tax benefits, beginning of period
            
            $
            4,953
            
            
            $
            4,223Increases
                in positions taken in a prior period
            
            
            546
            
            
            
            224Decreases
                in positions taken in a prior period
            
            
            (727
            )
            
            
            (269
            )Increases
                in positions taken in a current period
            
            
            97
            
            
            
            249Decreases
                due to settlements
            
            
            (204
            )
            
            
            (335
            )Decreases
                due to lapse of statute of limitations
            
            
            (442
            )
            
            
            (510
            )Unrecognized
                tax benefits, end of period
            
            $
            4,223
            
            
            $
            3,582





At
      December 31, 2007 and 2008, approximately $3.0 million and $2.5 million,
      respectively, of total gross unrecognized tax benefits represents the amount
      that, if recognized, would affect the effective income tax rate in future
      periods.  The Company and its subsidiaries are subject to U.S. federal
      income tax, as well as income tax of multiple state and foreign
      jurisdictions.  The Company has substantially concluded all U.S.
      federal income tax matters for years through 2004.  Substantially all
      material state and local and foreign income tax matters have been concluded
      for
      years through 2004.  U.S. federal income tax returns for 2005 through
      2007 are currently open for examination.  In the next twelve months,
      the Company expects to reduce the unrecognized tax position reserves by
      approximately $1.3 million, primarily due to the settlement of various state
      and
      international income tax audits and court cases and the closing of various
      statutes.  The Company’s continuing practice is to recognize interest
      and/or penalties related to income tax matters in income tax
      expense.  During the years ended December 31, 2007 and 2008, the
      Company recorded adjustments for interest of $0.3 million and $0.2 million,
      respectively, and ($0.5) million and an immaterial amount, respectively, for
      potential penalties, related to these unrecognized tax benefits.  In
      total, as of December 31, 2007 and 2008, the Company has recorded a liability
      for interest of $2.0 million and $2.0 million, respectively, and $0.4 million
      and $0.3 million, respectively, for potential penalties.





F-22


7.  DEBT





On
      November 3, 2008, the Company entered into a new credit facility to replace
      its
      previous credit facility.  The credit facility is comprised of a $75.0
      million term loan and a $70.0 million revolving line of credit.  The
      total borrowing capacity available under the credit facility is subject to
      a
      formula based on the Company’s leverage ratio, as defined in the credit
      agreement.  The term loan and the revolving line of credit both have a
      scheduled maturity date of November 1, 2011.  Under this credit
      facility, the term loan and the revolving line of credit bear interest, at
      the
      Company’s option, at a base rate or at LIBOR, plus applicable margins, which are
      based on the Company’s leverage ratio.  Applicable margins vary
      between 2.25% to 3.25% on LIBOR borrowings and 1.25% and 2.25% on base rate
      borrowings.  At December 31, 2008, the applicable margins in effect
      were 3.00% for LIBOR borrowings and 2.00% for base rate
      borrowings.  Principal payments on the term loan commence on March 31,
      2009, at a rate of $3.8 million per calendar quarter, with the remaining
      principal of $33.8 million due on November 1, 2011.  The Company is
      also required to pay a commitment fee which varies between 0.45% to 0.50% per
      annum on the average daily unused portion of the revolving line of
      credit.  At December 31, 2008, the commitment fee in effect was 0.50%
      per annum.





Under
      the
      terms of the new 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, buy back its stock,
      incur
      additional debt and make acquisitions above certain amounts.  The
      credit facility also includes a clean down provision that limits the maximum
      amount of borrowings under the revolving line of credit to $30.0 million for
      a
      period of 60 consecutive days during the first four calendar months of
      2009.  The clean down provision limits decrease to $27.5 million for a
      period of 60 consecutive days during the first four calendar months of 2010
      and
      $25.0 million for a period of 60 consecutive days during the first four calendar
      months of 2011.  On December 31, 2008, the Company had $95.1 million
      outstanding on this credit facility and was in compliance with all
      covenants.  As of the filing date of this report, the Company has met its
      clean down provision requirement for the year 2009.





In
      conjunction with this new credit facility, the Company incurred approximately
      $2.4 million in financing fees which are included in other non-current assets
      in
      the accompanying consolidated balance sheet at December 31, 2008, and are being
      charged to interest expense using the effective interest rate method
      in the accompanying consolidated statements of operations through the term
      of the credit agreement, which is currently November 1, 2011.





Prior
      to
      November 3, 2008, the Company entered had a credit facility, as amended,
      which was comprised of an $85.0 million term loan and a $100.0 million revolving
      line of credit.  The credit facility also provided for an additional
      $75.0 million of capacity under the revolving line of credit, which was approved
      by the lenders upon the Company’s request in October 2007.  During the
      first quarter of 2007, the term loan was repaid and was no longer available
      for
      borrowing.  The revolving line of credit was to be available until its
      maturity on September 14, 2008.  A portion of the term loan had an
      interest rate of 3.45%, plus applicable margin, through the first three years
      of
      the facility.  The remaining term loan and revolving line of credit
      bore interest, at the Company’s option, at a base rate or at a LIBOR rate plus
      applicable margin.  The applicable margin was based on the Company’s
      ratio of consolidated debt to consolidated EBITDA (earnings before interest,
      taxes, depreciation, amortization and non-cash expense related to equity awards)
      and varied between 0.75% and 1.625%.  The Company was 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.  On September 12, 2008, the
      Company entered into an amendment which extended the maturity date of
      this credit facility to November 14, 2008 and revised the applicable margin
      to vary from 2.00% to 3.50% and the commitment fee to vary from 0.40% to 0.50%
      per annum.  This credit facility was replaced by the November 3, 2008,
      credit facility discussed above.





The
      Company’s Hong Kong subsidiary maintains credit facilities with two banks
      providing for documentary and letter of credits of up to approximately $5.0
      million and overdraft protection of up to $0.2 million.  Amounts
      borrowed are due on demand, but are generally available for 90 days, 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,
      2008, there was $0.5 million outstanding under these credit
      facilities.  No amounts were outstanding under these credit facilities
      at December 31, 2007.


F-23


Non-current
      debt consists of the following:





December
                31,(in
                thousands)
            
            2007
            
            
            2008U.S.
                revolving line of credit, bearing interest in the range of
                approximately
              5.86%
                to 6.51% as of December 31, 2007
            
            $
            95,000
            
            
            $
            —U.S.
                revolving line of credit, bearing interest ranging from 4.00% to
                5.25%
              as
                of December 31, 2008; matures on November 1, 2011
            
            
            —
            
            
            
            20,120Term
                loan payable to banks, bearing interest at 4.94% as of December 31,
                2008,
              with
                quarterly principal payments of $3.8 beginning March 31, 2009
              through
                September 30, 2011, with remaining balance due November 1,
                2011
            
            
            —
            
            
            
            75,000Less
                current maturities
            
            
            (95,000
            )
            
            
            (15,000
            )$
            —
            
            
            $
            80,120





8.  COMMITMENTS
      AND CONTINGENCIES





The
      Company markets a significant portion of its products with licenses from other
      parties.  These licenses are generally limited in scope and duration
      and authorize the sale of specific licensed products on a nonexclusive
      basis.  The Company is party to more than 300 licenses with, among
      others, various entertainment, publishing and media companies, automotive and
      truck manufacturers, and agricultural and construction vehicle and equipment
      manufacturers.  Many of the licenses include minimum guaranteed
      royalty payments that the Company must pay whether or not it meets specified
      sales targets.  Aggregate future minimum guaranteed royalty payments
      are as follows:





Year
                Ending December 31,(in
                thousands)2009
            
            $
            8,7282010
            
            
            10,4982011
            
            
            6,6522012
            
            
            6,3752013
            
            
            6,275Thereafter
            
            
            —Total
            
            $
            38,528





Royalty
      expense for licenses, including guaranteed minimums, was $38.4 million, $34.7
      million and $31.2 million, for 2006, 2007 and 2008, respectively.





Rental
      expense for office and warehouse space and other equipment under cancelable
      and
      noncancelable operating leases amounted to $4.7 million, $4.7 million and $4.6
      million for the years ended December 31, 2006, 2007 and 2008,
      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, 2008, are as follows:





Year
                Ending December 31,(in
                thousands)2009
            
            $
            4,3202010
            
            
            3,0812011
            
            
            2,2382012
            
            
            2,0882013
            
            
            1,799Thereafter
            
            
            9,239Total
            
            $
            22,765






F-24


Unconditional
      purchase obligations include agreements for purchases of product, tooling and
      services such as advertising, and hardware and software
      agreements.  Payments made and allowances given in connection with
      these cancelable and noncancelable long-term unconditional purchase obligations
      amounted to $25.7 million, $28.6 million and $33.7 million for the years ended
      December 31, 2006, 2007 and 2008, respectively.





Commitments
      for future minimum payments with terms extending beyond one year at December
      31,
      2008, for noncancelable unconditional purchase obligations are as
      follows:





Year
                Ending December 31,(in
                thousands)2009
            
            $
            16,1332010
            
            
            14,4142011
            
            
            182012
                and thereafter
            
            
            —Total
            
            $
            30,565





9.  LEGAL
      PROCEEDINGS





See
      Note
      16 - Product Recalls for a description of certain legal proceedings with respect
      to the products subject to the 2007 recalls.





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





10.  COMMON
      STOCK





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





(in
                thousands, except par value)
            
            
            Authorized
              Shares
            
            
            Par
              Value
            
            
            
            Shares
                Outstanding
              at
                December 31, 2007
            
            
            
            Shares
                Outstanding
              at
                December 31, 2008Voting
                common stock
            
            
            28,000
            
            
            $
            0.01
            
            
            
            18,320
            
            
            
            17,245





During
      the years ended December 31, 2007 and 2008, the Company sold a total of 5,570
      shares and 9,514 shares, respectively, out of treasury to Company employees
      under the Employee Stock Purchase Plan (ESPP) for $0.2 million in each of the
      years then ended.  At December 31, 2008, the Company held 5.9 million
      shares of its common stock in treasury.





In
      February 2007, the Company’s Board of Directors authorized the adoption of a
      program to repurchase up to $75.0 million of the Company’s common
      stock.  The program was initially authorized for a period of one
      year.  In October 2007, the Board of Directors authorized a $75.0
      million increase to the stock repurchase program and extended the timing of
      this
      program through December 31, 2008.  Under this program, shares could
      be repurchased from time to time in open market transactions or privately
      negotiated transactions at the Company’s discretion, subject to market
      conditions and other factors.  Shares repurchased by the Company are
      held as treasury shares.  During the year ended December 31, 2008, the
      Company repurchased 1.2 million shares for $24.7 million under this
      program.  Through December 31, 2008, the Company had repurchased an
      aggregate of 4.1 million shares for $112.6 million under the $150.0 million
      stock repurchase authorization.  These repurchases were funded with
      borrowings on the Company’s previous credit facility and with cash flow from
      operations.





F-25


11.  STOCK-BASED
      PAYMENT ARRANGEMENTS





Effective
      January 1, 2006, the Company adopted SFAS No. 123R, “Share-Based
      Payment.”  This Statement is a revision of SFAS No. 123, “Accounting
      for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for
      Stock Issued to Employees.”  This Statement establishes standards for
      the accounting for transactions in which an entity exchanges its equity
      instruments for goods and services and also addresses transactions in which
      an
      entity incurs liabilities in exchange for goods and services that are based
      on
      the fair value of the entity’s equity instruments or that may be settled by the
      issuance of those instruments.  The Company adopted this Statement on
      a modified prospective basis, and therefore, no compensation expense related
      to
      stock-based payment arrangements was recognized in the financial statements
      prior to adoption.





At
      December 31, 2008, 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 years ended December 31, 2006, 2007 and 2008, are as
      follows:





Year
                Ended December 31,(in
                thousands)
            
            2006
            
            
            2007
            
            
            2008Total
                expense recognized for stock-based payment plans
            
            $
            3,856
            
            
            $
            4,705
            
            
            $
            6,078Amount
                of related income tax benefit recognized in determining net
                income
            
            $
            1,430
            
            
            $
            1,774
            
            
            $
            2,291





Stock-based
      compensation expense is included in (a) cost of sales, other and (b) selling,
      general and administrative expenses in the accompanying consolidated statements
      of operations for the years ended December 31, 2006, 2007 and 2008.





Employee
      Stock Purchase Plan





The
      Company has an ESPP to provide its employees with an opportunity to purchase
      common stock of the Company through accumulated payroll
      deductions.  The plan allows eligible employees to purchase shares of
      the Company’s common stock through quarterly offering periods commencing on each
      January 1, April 1, July 1 and October 1.  The price for each share of
      common stock purchased equals 90.0% of the last quoted sales price of a share
      of
      the Company’s common stock as reported by NASDAQ on the first day of the
      quarterly offering period or the last day of the quarterly offering period,
      whichever is lower.  The Company has reserved 500,000 shares of common
      stock held in treasury for issuance under the plan of which 451,706 shares
      remain available as of December 31, 2008.  The plan was to initially
      terminate on July 1, 2007.  However, in May 2007, the Board of
      Directors approved an extension of the plan for an additional five years, and
      it
      is now scheduled to terminate on July 1, 2012.





The
      fair
      value of each option for shares subscribed under the ESPP during the years
      ended
      December 31, 2006, 2007 and 2008, is estimated on the date of grant based on
      the
      Black-Scholes option pricing model with the following assumptions:





2006
            
            
            2007
            
            
            2008Weighted
                average expected life
            
            3
                months
            
            3
                months
            
            3
                monthsWeighted
                average risk-free rate of return
            
            
            4.7
            %
            
            
            4.8
            %
            
            
            1.8
            %Weighted
                average expected volatility
            
            
            25.9
            %
            
            
            42.0
            %
            
            
            76.7
            %Weighted
                average dividend yield
            
            None
            
            None
            
            None





The
      weighted average fair value of options granted under the ESPP in 2006, 2007
      and
      2008, was $4.99, $9.07 and $7.70, respectively.





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





F-26


Stock
      Incentive Plan





The
      Company maintained a stock incentive plan, under which options could be granted
      to purchase up to 2,300,000 shares of common stock to executives or key
      employees of the Company.  Some of the options that were granted
      vested immediately, and the rest 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.  The plan became dormant in 2005 upon approval of the 2005 Stock
      Incentive Plan, as discussed below.  No future issuances are
      authorized from this plan.





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





During
      2005, a new stock incentive plan was approved by the Company’s
      stockholders.  Under this plan, restricted stock awards or options to
      purchase stock may be granted for up to 1,200,000 shares of common
      stock.  During 2008, the Company’s stockholders approved an increase
      of 1,000,000 shares of common stock to be available for grants of restricted
      stock awards or options to purchase stock.  Options granted may vest
      immediately or over a five-year period.  These options expire on the
      tenth anniversary of the date of grant or 90 days after the date of termination
      of the employee’s employment with the Company.  Under this plan,
      cancelled options revert back into the plan and are available for future
      issuance.  Restricted stock awards generally vest over a two to three
      year period.





The
      fair
      value of stock options granted under the stock incentive plans during the years
      ended December 31, 2006, 2007 and 2008, is estimated on the date of grant based
      on the Black-Scholes option pricing model with the following
      assumptions:





2006
            
            
            2007
            
            
            2008Weighted
                average expected life
            
            7
                years
            
            7
                years
            
            7
                yearsWeighted
                average risk-free rate of return
            
            
            4.6
            %
            
            
            4.7
            %
            
            
            2.9
            %Weighted
                average expected volatility
            
            
            54.5
            %
            
            
            48.4
            %
            
            
            40.5
            %Weighted
                average dividend yield
            
            None
            
            None
            
            None





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





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





F-27


A
      summary
      of stock option activity for the Company’s stock incentive plans for the years
      ended December 31, 2006, 2007 and 2008, is as follows:





Shares
            
            
            Weighted
                Average Exercise Price
            
            
            Aggregate
                Intrinsic Value
              (in
                000s)
            
            
            Weighted
                Average Remaining Contractual Life
            
            
            Shares
                Available
              for
                Future GrantsOutstanding
                as of December 31, 2005
            
            
            1,562,842
            
            
            $
            16.14
            
            
            
            
            
            
            
            
            
            1,173,8492006Granted
            
            
            259,124
            
            
            
            35.71Exercised
            
            
            327,475
            
            
            
            11.05Forfeited
            
            
            82,290
            
            
            
            29.23Outstanding
                as of December 31, 2006
            
            
            1,412,201
            
            
            
            20.15
            
            
            
            
            
            
            
            
            
            934,2252007Granted
            
            
            257,009
            
            
            
            39.12Exercised
            
            
            156,100
            
            
            
            12.67Forfeited
            
            
            5,400
            
            
            
            33.90Expired
            
            
            16,320
            
            
            
            9.84Outstanding
                as of December 31, 2007
            
            
            1,491,390
            
            
            
            24.27
            
            
            
            
            
            
            
            
            
            641,3792008Granted
            
            
            639,500
            
            
            
            19.44Exercised
            
            
            82,118
            
            
            
            11.64Forfeited
            
            
            115,600
            
            
            
            29.93Expired
            
            
            12,030
            
            
            
            33.53Outstanding
                as of December 31, 2008
            
            
            1,921,142
            
            
            $
            22.80
            
            
            $
            1,552
            
            
            
            6.6
            
            
            
            1,073,855Exercisable
                and vested as of December 31, 2008
            
            
            1,020,525
            
            
            $
            20.07
            
            
            $
            1,552Expected
                to vest at December 31, 2008
            
            
            883,422
            
            
            
            25.92
            
            
            
            —Total
                vested and expected to vest
            
            
            1,903,947
            
            
            $
            22.78
            
            
            $
            1,552
            
            
            
            6.5





The
      following table summarizes information about stock options outstanding at
      December 31, 2008:





Range
                of
              Exercise
                Prices
            Number
              Outstanding
            Weighted
              Average
              Remaining
              Contractual
              Life
            Weighted
              Average
              Exercise
                Price
            Number
              Exercisable
            Weighted
              Average
              Exercise
                Price$  1.41
                - $  5.00
            116,249
            1.5
            $  2.37
            116,249
            $ 
                 2.37$  7.94
                - $12.45
            284,152
            4.2
            8.99
            224,152
            8.06$13.39
                - $20.10
            142,097
            4.7
            14.00
            129,097
            13.66$20.23
                - $29.94
            715,376
            8.0
            21.60
            225,476
            23.89$31.27
                - $43.06
            663,268
            7.2
            $35.49
            325,551
            $
                34.56





The
      weighted average fair value of options granted under the Company’s stock
      incentive plans for the years ended December 31, 2006, 2007 and 2008, was
      $21.48, $21.54 and $9.00 per share, respectively.  The total intrinsic
      value of options exercised during the years ended December 31, 2006, 2007 and
      2008, was $9.3 million, $4.4 million and $1.0 million,
      respectively.





As
      of
      December 31, 2008, there was $9.2 million of total unrecognized compensation
      cost related to nonvested stock-based compensation arrangements granted under
      the Company’s stock incentive plans.  That cost is expected to be
      recognized over a weighted average period of 3.2 years.  The total
      fair value of options vested during the year ended December 31, 2008, was $5.7
      million.





F-28


Restricted
      stock awards require no payment from the grantee.  The related
      compensation cost of each award is calculated using either the market price
      on
      the grant date or the market price on the last day of the reported period and
      is
      expensed equally over the vesting period.  A summary of restricted
      stock awards for the Company’s stock incentive plan for the years ended December
      31, 2007 and 2008, is as follows:





Number
                of Shares
            
            
            Weighted
                Average
              Grant
                Date
              Fair
                Value
            
            Weighted
              Average
              Remaining
              Contractual
              LifeUnvested
                restricted stock awards as of December 31, 2006
            
            
            —
            
            
            $
            —2007Granted
            
            
            39,837
            
            
            
            38.32Vested
            
            
            4,195
            
            
            
            40.57Unvested
                restricted stock awards as of December 31, 2007
            
            
            35,642
            
            
            
            38.052008Granted
            
            
            34,496
            
            
            
            17.39Vested
            
            
            9,939
            
            
            
            41.75Forfeited
            
            
            2,348
            
            
            
            42.61Unvested
                restricted stock awards as of December 31, 2008
            
            
            57,851
            
            
            $
            21.90
            
            2.0





As
      of
      December 31, 2008, there was $0.9 million of total unrecognized compensation
      cost related to nonvested stock-based compensation arrangements granted under
      the Company’s stock incentive plan for restricted stock awards.  That
      cost is expected to be recognized over a weighted average period of 2.0
      years.





12.  RELATED
      PARTY TRANSACTIONS





The
      Company purchased $17.9 million and $11.0 million of product during 2006
      and 2007, from a company in which a relative of a Company stockholder and
      former director of the Company has an ownership
      interest.  Additionally, in 2008, the Company purchased, from the same
      company, $4.8 million of product through May 2008, at which time the former
      director completed his board of directors tenure.  Accounts payable to
      this company were $1.0 million as of December 31, 2007.  The Company
      also purchased $9.7 million and $4.4 million of product during 2006 and 2007,
      from another company in which relatives of a Company stockholder and former
      director of the Company had ownership interests.  Accounts payable to
      this company were $1.0 million as of December 31, 2007.





13.  EMPLOYEE
      BENEFIT PLANS





The
      Company is self-insured on medical benefits offered to employees up to a limit
      of $0.1 million per employee or $2.0 million in aggregate per coverage
      year.  Claims are expensed when incurred, and a provision is recorded
      for claims incurred but not yet paid based on a monthly average of claims
      activity.  The Company holds excess loss coverage for those amounts
      that exceed the self-insured limits.





The
      Company has a 401(k) savings plan.  Employees meeting certain
      eligibility requirements, as defined, may contribute up to 100.0% of pre-tax
      gross wages, limited to a maximum annual amount as set periodically by the
      IRS.  The Company made matching contributions of 100.0% on the first
      4.0% of employees’ annual wages and 50.0% on the next 6.0% of employees’ annual
      wages.  For the years ended December 31, 2006, 2007 and 2008, the
      Company contributions were $1.3 million, $1.2 million and $1.1 million,
      respectively.


F-29


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 a liability in its balance sheet and to
      recognize changes in that funded status in the year in which the changes occur
      through accumulated other comprehensive income (loss).  This Statement
      also requires an employer to measure the funded status of a plan as of the
      date
      of its year-end statement of financial position.





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








Reconciliation
                of Beginning and End of Year Fair Value of Plan Assets and
                ObligationsDecember
                31,(in
                thousands)
            
            2006
            
            
            2007
            
            
            2008Change
                in benefit obligationBenefit
                obligation at beginning of year
            
            $
            14,599
            
            
            $
            14,522
            
            
            $
            13,415Service
                cost
            
            
            105
            
            
            
            107
            
            
            
            101Interest
                cost
            
            
            789
            
            
            
            820
            
            
            
            854Actuarial
                gain
            
            
            (509
            )
            
            
            (1,518
            )
            
            
            (563
            )Benefits
                paid and plan expenses
            
            
            (462
            )
            
            
            (516
            )
            
            
            (593
            )Benefit
                obligation at end of year
            
            $
            14,522
            
            
            $
            13,415
            
            
            $
            13,214Change
                in plan assetsFair
                value of assets at beginning year
            
            $
            11,464
            
            
            $
            12,404
            
            
            $
            13,281Actual
                return on plan assets
            
            
            1,402
            
            
            
            778
            
            
            
            (3,688
            )Employer
                contributions
            
            
            —
            
            
            
            615
            
            
            
            —Benefits
                paid and plan expenses
            
            
            (462
            )
            
            
            (516
            )
            
            
            (593
            )Fair
                value of assets at end of year
            
            $
            12,404
            
            
            $
            13,281
            
            
            $
            9,000Funded
                Status at End of Year
            
            $
            (2,118
            )
            
            $
            (134
            )
            
            $
            (4,214
            )Amounts
                Recognized in the Consolidated Balance SheetsOther
                non-current liabilities
            
            $
            2,118
            
            
            $
            134
            
            
            $
            4,214Accumulated
                other comprehensive income (loss)
            
            $
            4,914
            
            
            $
            3,228
            
            
            $
            7,253Amounts
                Recognized in Accumulated Other Comprehensive Income
                (Loss)Prior
                service cost
            
            $
            133
            
            
            $
            114
            
            
            $
            95Actuarial
                loss
            
            
            4,781
            
            
            
            3,114
            
            
            
            7,158Accumulated
                other comprehensive loss
            
            $
            4,914
            
            
            $
            3,228
            
            
            $
            7,253Information
                for Pension Plans with an Accumulated Benefit Obligation in Excess
                of Plan
                AssetsProjected
                benefit obligation
            
            $
            14,522
            
            
            $
            13,415
            
            
            $
            13,214Accumulated
                benefit obligation
            
            
            14,522
            
            
            
            13,415
            
            
            
            13,214Fair
                value plan assets
            
            $
            12,404
            
            
            $
            13,281
            
            
            $
            9,000





F-30





Year
                Ended December 31,(in
                thousands)
            
            2006
            
            
            2007
            
            
            2008Components
                of Net Periodic Benefit CostService
                cost
            
            $
            105
            
            
            $
            107
            
            
            $
            101Interest
                cost
            
            
            789
            
            
            
            820
            
            
            
            854Expected
                return on plan assets
            
            
            (981
            )
            
            
            (1,012
            )
            
            
            (1,110
            )Amortization
                of prior service cost
            
            
            19
            
            
            
            19
            
            
            
            19Amortization
                of net loss
            
            
            441
            
            
            
            384
            
            
            
            190Net
                periodic benefit cost
            
            $
            373
            
            
            $
            318
            
            
            $
            54Other
                Changes in Plan Assets and Projected Benefit Obligation
              as
                Other Comprehensive (Income) LossNet
                actuarial (gain) loss
            
            
            
            
            
            $
            (1,284
            )
            
            $
            4,234Amortization
                of net actuarial gain
            
            
            
            
            
            
            (384
            )
            
            
            (190
            )Amortization
                of prior service cost
            
            
            
            
            
            
            (19
            )
            
            
            (19
            )Total other
                comprehensive (income) loss
            
            
            
            
            
            $
            (1,687
            )
            
            $
            4,025Estimated
                Items That Will Be Amortized from Accumulated Other Comprehensive
                Income
              (Loss)
                into Net Periodic Benefit Cost During 2009Prior
                service cost
            
            
            
            
            
            
            
            
            
            $
            19Actuarial
                loss
            
            
            
            
            
            
            
            
            
            
            231Expected
                recognition of expense
            
            
            
            
            
            
            
            
            
            $
            250Reconciliation
                of Funded StatusFunded
                status
            
            $
            (2,118
            )
            
            $
            (134
            )
            
            $
            (4,214
            )Unrecognized
                net actuarial loss
            
            
            4,781
            
            
            
            3,114
            
            
            
            7,158Unrecognized
                prior service cost
            
            
            133
            
            
            
            114
            
            
            
            95Prepaid
                benefit cost
            
            $
            2,796
            
            
            $
            3,094
            
            
            $
            3,039Estimated
                Future Benefit Payments2009
            
            
            
            
            
            
            
            
            
            $
            5862010
            
            
            
            
            
            
            
            
            
            
            5992011
            
            
            
            
            
            
            
            
            
            
            6362012
            
            
            
            
            
            
            
            
            
            
            6702013
            
            
            
            
            
            
            
            
            
            
            7482014
                to 2018
            
            
            
            
            
            
            
            
            
            $
            4,635





Assumptions


2006
            
            
            2007
            
            
            2008Weighted
                Average Assumptions Used to Determine
              Benefit
                Obligations at December 31Discount
                rate
            
            
            5.75
            %
            
            
            6.50
            %
            
            
            6.89
            %Rate
                of compensation increase
            
            
            N/A
            
            
            
            N/A
            
            
            
            N/AWeighted
                Average Assumptions Used to Determine Net
              Periodic
                Benefit Cost for the Years Ended December 31Discount
                rate
            
            
            5.50
            %
            
            
            5.75
            %
            
            
            6.50
            %Expected
                return on plan assets
            
            
            8.50
            %
            
            
            8.50
            %
            
            
            8.50
            %Rate
                of compensation increase
            
            
            N/A
            
            
            
            N/A
            
            
            
            N/A





F-31


Expected
      Return on Plan Assets





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





Projected
      Annual Returns





Based
      on
      the current target allocation of assets, the expected return model estimates
      a
      long-term average (50th
      percentile) rate of return (nominal) of 7.75% per year for the
      Plan.  The model incorporates real return assumptions for each asset
      class adjusting for variations in volatility, correlation and
      inflation.  The following table sets out the projected annual
      returns.





Percentile
                ReturnsTime
              Period
            
            75th
            
            
            50th
            
            
            25th1
                year
            
            
            0.55
            %
            
            
            7.75
            %
            
            
            15.46
            %5
                years
            
            
            4.47
            
            
            
            7.75
            
            
            
            11.1310
                years
            
            
            5.42
            
            
            
            7.75
            
            
            
            10.1320
                years
            
            
            6.10
            %
            
            
            7.75
            %
            
            
            9.43
            %





Plan
      Assets





The
      allocation of assets between major asset categories as of December 31, 2007
      and
      2008, as well as the target allocation, are as follows:





Percentage
                of Plan AssetsTarget
            
            
            December
                31,Asset
                Category
            
            Allocation
            
            
            2007
            
            
            2008Large
                cap domestic equity securities
            
            
            45
            %
            
            
            49
            %
            
            
            47
            %Small
                cap domestic equity securities
            
            
            9
            
            
            
            4
            
            
            
            16International
                equity securities
            
            
            6
            
            
            
            17
            
            
            
            3Fixed
                income securities
            
            
            40
            
            
            
            30
            
            
            
            34Total
            
            
            100
            %
            
            
            100
            %
            
            
            100
            %





Explanation
      of Investment Strategies and Policies





The
      Company employs a total return on 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.





F-32


Employer
      Contributions





During
      the year ended December 31, 2008, the Company did not make any contributions
      to
      the Plan.  There are no minimum required contributions to the Plan for
      fiscal year 2009.  However, the Company may make contributions to the
      Plan at its discretion.  The Company is not expecting a reversion of
      the Plan assets to the employer during the next year.





14.  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 was consistent with the Company’s strategic focus to
      achieve sustainable organic growth and to concentrate its efforts on its higher
      growth infant, toddler and preschool product lines.  This transaction
      was effective November 1, 2006, and the results of this sold business are
      presented as discontinued operations in the accompanying consolidated statements
      of operations and consolidated statements of cash flows.  The sold
      business was primarily reported under the North America segment.





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





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





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





F-33


15.  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 was consistent with the Company’s strategy to focus on sustainable
      organic growth and to allocate resources to its higher growth infant, toddler
      and preschool product lines.  As a result of discontinuing these
      product lines, the Company recorded the following charges, which are presented
      in restructuring charge related to discontinued automotive collectibles in
      the
      accompanying consolidated statement of operations for the year ended December
      31, 2006:





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





16.  PRODUCT
      RECALLS





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





Following
      the announcement of the June 2007 recall, a total of 23 putative class action
      lawsuits were filed against the Company in various federal and state courts
      with
      respect to the products subject to the June 2007 and September 2007
      recalls.  During 2008, the Company reached a settlement with the
      plaintiffs in the various class action lawsuits against the Company in state
      courts which arose from or related to the Company’s recall of certain Thomas & Friends Wooden
      Railway products.  This settlement was later amended to include the
      plaintiffs in the federal class actions.  The class subject to the
      settlement was basically defined as all persons in the United States who did
      not
      opt out of the class and who purchased or owned other than for resale the
      Company’s Thomas &
Friends Wooden Railway products
      which were recalled in June 2007 and
      September 2007.  The amended settlement agreement provides class
      members with several relief options, including cash refunds, replacement
      products and coupons, as well as provides limited reimbursement for blood
      testing for lead during the specified limited time periods with caps on the
      amount of individual claims and a total cap of $0.5 million on all
      claims.  Under the amended settlement agreement, the Company also
      agreed to pay attorney’s fees and costs to the plaintiff’s counsel totaling $3.0
      million.  The amended settlement agreement also provides that the
      Company will take certain quality control measures.  The claim period
      ran until October 6, 2008, and less than 50 persons opted out of the
      class.  The settlement received final approval from the court on
      August 6, 2008, and the Company paid the attorney’s fees of $3.0 million during
      the third quarter of 2008.  The amended settlement agreement resolves
      all claims of the class, other than for individual claims for personal injuries
      or for persons opting out of the class, with respect to the June 2007 and
      September 2007 recalls of certain Thomas & Friends Wooden
      Railway toys.





F-34


With
      the
      final approval of the settlement agreement and the end of the claim period,
      the
      class action lawsuits relating to the June 2007 and September 2007 recalls
      have
      been resolved.  The Company may be subject to individual claims for
      personal injuries or other claims or government inquiries (including the inquiry
      by the Consumer Product Safety Commission (CPSC) described in the next
      paragraph) relating to the 2007 recalls.  No assurances can be given
      as to the outcome of any such claims or government inquiries.





During
      2008, the Company received an inquiry from the CPSC for information regarding
      the recalls of certain Thomas
& Friends Wooden Railway toys
      in June 2007 and September 2007 for the
      purpose of asserting whether the CPSC may impose a fine on the
      Company.  The Company is in the process of responding to this inquiry,
      and at this time, the CPSC has not yet imposed a fine upon the
      Company.





During
      2008, HIT Entertainment (the Licensor), the licensor who has granted the
      licenses under which the Company markets the property affected by the June
      2007
      and September 2007 recalls (the Licenses), sent a letter demanding that the
      Company indemnify it for certain costs in connection with the recalls and
      alleging that the Company had not complied with several provisions in the
      Licenses.  On July 7, 2008, the Company announced it had reached an
      agreement with the Licensor which modifies existing license agreements and
      provides a release to the Company in connection with past indemnification claims
      related to the recall of certain products and other legal
      matters.  The agreement provides an extension to the license term on
      the Thomas &
Friends Wooden Railway product
      line, along with an immediate reduction in
      licensing payments on this product line, and a shortening of the license term
      on
      the Take Along Thomas &
Friends die-cast product
      line to the end of 2009.  This license
      agreement provides for a six month sell-off period following the license
      termination date.  In addition, the Company made a one-time cash payment to
      the Licensor of $15.0 million in exchange for a release from indemnification
      claims.  This payment is included in recall-related items on the
      accompanying consolidated statement of operations for the year ended December
      31, 2008.





The
      Company recorded charges of $28.3 million and $14.3 million related to the
      2007
      recalls for the years ended December 31, 2007 and 2008, respectively. 
Accrued recall-related items included on the accompanying consolidated
      balance sheets at December 31, 2007 and 2008, represent charges based
      on the latest estimates of retailer inventory returns, consumer product
      replacement costs, shipping costs and fines and penalties as of the date of
      this
      filing, as well as additional replacement costs or refunds, donations, notice
      charges, claims administration and plaintiffs' legal fees related to the
      settlement of the class action lawsuits.  It is reasonably possible
      that actual costs associated with the recalls and related litigation could
      differ significantly from the estimates recorded.








F-35