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JAKKS Pacific 10-K 2008 Documents found in this filing:UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
D.C. 20549
FORM
10-K
(Mark
One)
For
the transition period from ____________ to ____________
Commission
File Number 0-28104
JAKKS
PACIFIC, INC.
(Exact name
of registrant as specified in its charter)
Registrant’s
telephone number, including area code: (310) 456-7799
Securities
registered pursuant to Section 12(b) of the Exchange Act:
Securities
registered pursuant to Section 12(g) of the Exchange Act:
Title
of Class
Common
Stock, $.001 par value per share
Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined
in
Rule 405 of the Securities Act. Yes £
No
T
Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15 of the Act. Yes £
No
T
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 T
No
£
Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this
Form 10-K. £ Indicate
by a check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of “accelerated
filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (check
one):
T Large
Accelerated
Filer
£ Accelerated
Filer
£ Non-Accelerated
Filer
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yes £ No
T
The
aggregate market value of the voting and non-voting common equity (the only
such
common equity being Common Stock, $.001 par value per share) held by
non-affiliates of the registrant (computed by reference to the closing sale
price of the Common Stock on February 28, 2008 of $27.83) is
$768,963,995.
The
number of shares outstanding of the registrant’s Common Stock, $.001 par value
(being the only class of its common stock), is 28,624,262 (as of February 28,
2008).
Documents
Incorporated by Reference
None.
JAKKS
PACIFIC, INC.
INDEX
TO ANNUAL REPORT ON FORM 10-K
For
the Fiscal Year ended December 31, 2007
Items
in Form 10-K
DISCLOSURE
REGARDING FORWARD-LOOKING STATEMENTS
This
report includes “forward-looking statements” within the meaning of Section 27A
of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of
1934. For example, statements included in this report regarding our financial
position, business strategy and other plans and objectives for future
operations, and assumptions and predictions about future product demand, supply,
manufacturing, costs, marketing and pricing factors are all forward-looking
statements. When we use words like “intend,” “anticipate,” “believe,”
“estimate,” “plan” or “expect,” we are making forward-looking statements. We
believe that the assumptions and expectations reflected in such forward-looking
statements are reasonable, based on information available to us on the date
hereof, but we cannot assure you that these assumptions and expectations will
prove to have been correct or that we will take any action that we may presently
be planning. We have disclosed certain important factors that could cause our
actual results to differ materially from our current expectations elsewhere
in
this report. You should understand that forward-looking statements made in
this
report are necessarily qualified by these factors. We are not undertaking to
publicly update or revise any forward-looking statement if we obtain new
information or upon the occurrence of future events or otherwise.
3
PART
I
Item
1. Business
In
this
report, “JAKKS,” the “Company,” “we,” “us” and “our” refer to JAKKS Pacific,
Inc. and its subsidiaries.
Company
Overview
We
are a
leading multi-line, multi-brand toy company that designs, produces, markets
and
distributes toys and related products, writing instruments and related products,
pet toys, consumables and related products, electronics and related products,
and other consumer products. We focus our business on acquiring or licensing
well-recognized trademarks and brand names, most with long product histories
(“evergreen brands”). We seek to acquire these evergreen brands because we
believe they are less subject to market fads or trends. We also develop
proprietary products marketed under our own trademarks and brand
names. Our products are typically lower-priced toys and accessories,
and include:
Traditional
Toys
Prior
to
2007, we had accounted for seasonal and outdoor products as a separate category.
During 2007, we restructured our internal operations and have consolidated
this
product group within the Traditional category. These products share key
characteristics, including common management, distribution and marketing
strategies. We have restated our prior segment reporting to reflect this
change.
Craft,
Activity and Writing Products
Pet
Products
4
We
continually review the marketplace to identify and evaluate evergreen brands
that we believe have the potential for significant growth. We endeavor to
generate growth within these brands by:
In
addition to developing our proprietary brands and marks, licensing popular
brands enables us to use these high-profile marks at a lower cost than we would
incur if we purchased these marks or developed comparable marks on our own.
By
licensing marks, we have access to a far greater range of marks than would
be
available for purchase. We also license technology produced by unaffiliated
inventors and product developers to improve the design and functionality of
our
products.
We
have
obtained an exclusive worldwide license for our joint venture with THQ Inc.
(“THQ”), which develops, publishes and distributes video games based on
WWE
characters and themes. Since the joint venture’s first title release in 1999, it
has released 35 new titles. We have recognized approximately $93.3 million
in
profit from the joint venture through December 31, 2007. We and the joint
venture are named as defendants in lawsuits commenced by WWE, pursuant to which
WWE is seeking treble, punitive and other damages (including disgorgement of
profits) in an undisclosed amount and a declaration that the video game license
with the joint venture and an amendment to our toy licenses with WWE are void
and unenforceable (see “Legal Proceedings”).
We
sell
our products through our in-house sales staff and independent sales
representatives to toy and mass-market retail chain stores, department stores,
office supply stores, drug and grocery store chains, club stores, toy specialty
stores and wholesalers. Our three largest customers are Wal-Mart, Target and
Toys ‘R’ Us, which account for approximately 19.3%, 14.5% and 14.1%,
respectively, of our net sales in 2007. No other customer accounted for more
than 10.0% of our net sales in 2007.
Our
Growth Strategy
The
execution of our growth strategy has resulted in increased revenues and
earnings. In 2006 and 2007, we generated net sales of $765.4 million and $857.1
million, respectively, and net income of $72.4 million and $89.0 million,
respectively. Approximately 24.3% and 1.4% of our increased net sales in 2006
and 2007, respectively, were attributable to our acquisitions since 2005. Key
elements of our growth strategy include:
•
Expand
Core Products. We
manage our existing and new brands through strong product development
initiatives, including introducing new products, modifying existing products
and
extending existing product lines to maximize their longevity. Our marketing
teams and product designers strive to develop new products or product lines
to
offer added technological, aesthetic and functional improvements to our
extensive portfolio. We use multiple methods including real-scan technology,
articulated joints and a flexible rubberized coating to enhance the life-like
feel of our action toys, and expanded to classic characters and special
techniques such as vinyl figures. These innovations appeal to collectors and/or
produce higher quality and better likenesses of the representative
characters.
•
Enter
New Product Categories. We
use our extensive experience in the toy and other consumer product industries
to
evaluate products and licenses in new product categories and to develop
additional product lines. We began marketing licensed classic video games for
simple plug-in use with television sets and expanded into several related
categories through the licensing of this category from our current licensors,
such MTV Networks which owns Nickelodeon.
•
Pursue
Strategic Acquisitions. We
intend to supplement our internal growth with selected strategic acquisitions.
Most recently, in June 2005, we acquired the assets of Pet Pal Corp. which
expanded our offerings and distribution into pet toy, treats and related
products, and in February 2006, we acquired the business of Creative Designs
International, Ltd., a leading manufacturer of girls’ dress-up and role-play
toys. We will continue focusing our acquisition strategy on
businesses or brands that have compatible product lines and offer valuable
trademarks or brands.
•
Acquire
Additional Character and Product Licenses. We
have acquired the rights to use many familiar corporate, trade and brand names
and logos from third parties that we use with our primary trademarks and brands.
Currently, among others, we have license agreements with WWE,
Nickelodeon,
Disney®,
and
Warner
Bros®,
as
well as with the licensors of the many popular licensed children’s characters
previously mentioned, among others. We intend to continue to pursue new licenses
from these entertainment and media companies and other licensors. We also intend
to continue to purchase additional inventions and product concepts through
our
existing network of product developers. 5
•
Expand
International Sales. We
believe that foreign markets, especially Europe, Australia, Canada, Latin
America and Asia, offer us significant growth opportunities. In 2007, our sales
generated outside the United States were approximately $126.1 million, or 14.7%
of total net sales. We intend to continue to expand our international sales
by
capitalizing on our experience and our relationships with foreign distributors
and retailers. We expect these initiatives to continue to contribute to our
international growth in 2008.
•
Capitalize
On Our Operating Efficiencies. We
believe that our current infrastructure and operating model can accommodate
significant growth without a proportionate increase in our operating and
administrative expenses, thereby increasing our operating margins.
The
execution of our growth strategy, however, is subject to several risks and
uncertainties and we cannot assure you that we will continue to experience
growth in, or maintain our present level of, net sales (see “Risk Factors,”
beginning on page 12). For example, our growth strategy will place additional
demands on our management, operational capacity and financial resources and
systems. The increased demand on management may necessitate our recruitment
and
retention of additional qualified management personnel. We cannot assure you
that we will be able to recruit and retain qualified personnel or expand and
manage our operations effectively and profitably. To effectively manage future
growth, we must continue to expand our operational, financial and management
information systems and to train, motivate and manage our work force. There
can
be no assurance that our operational, financial and management information
systems will be adequate to support our future operations. Failure to expand
our
operational, financial and management information systems or to train, motivate
or manage employees could have a material adverse effect on our business,
financial condition and results of operations.
Moreover,
implementation of our growth strategy is subject to risks beyond our control,
including competition, market acceptance of new products, changes in economic
conditions, our ability to obtain or renew licenses on commercially reasonable
terms and our ability to finance increased levels of accounts receivable and
inventory necessary to support our sales growth, if any.
Furthermore,
we cannot assure you that we can identify attractive acquisition candidates
or
negotiate acceptable acquisition terms, and our failure to do so may adversely
affect our results of operations and our ability to sustain growth.
Finally,
our acquisition strategy involves a number of risks, each of which could
adversely affect our operating results, including difficulties in integrating
acquired businesses or product lines, assimilating new facilities and personnel
and harmonizing diverse business strategies and methods of operation; diversion
of management attention from operation of our existing business; loss of key
personnel from acquired companies; and failure of an acquired business to
achieve targeted financial results.
Recent
Acquisitions
In
February 2006, we acquired substantially all of the assets of Creative Designs
International, Ltd. and a related Hong Kong company, Arbor Toys Company Limited
(collectively, “Creative Designs”). The total initial consideration of $111.1
million consisted of cash paid at closing in the amount of $101.7 million,
the
issuance of 150,000 shares of our common stock valued at approximately $3.3
million and the assumption of liabilities in the amount of $6.1 million, and
resulted in the recording of goodwill in the amount of $53.6 million. Goodwill
represents anticipated synergies to be gained via the combination of Creative
Designs with us. In addition, we agreed to pay an earn-out of up to
an aggregate of $20.0 million in cash over the three calendar years following
the acquisition based on the achievement of certain financial performance
criteria, which will be recorded as goodwill when and if earned. For the years
ended December 31, 2006 and 2007, $6.9 million and $6.7 million, respectively,
of the earn-out was earned and recorded as goodwill. Creative Designs
is a leading designer and producer of dress-up and role-play toys. This
acquisition expands our product offerings in the girls role-play and dress-up
area and brings new product development and marketing talent to us. Our results
of operations have included Creative Designs from the date of
acquisition.
Industry
Overview
According
to Toy Industry Association, Inc., the leading toy industry trade group, the
United States is the world’s largest toy market, followed by Japan and Western
Europe. Total retail sales of toys, excluding video games, in the United States,
were approximately $22.1 billion in 2007. We believe the two largest United
States toy companies, Mattel and Hasbro, collectively hold a dominant share
of
the domestic non-video toy market. In addition, hundreds of smaller companies
compete in the design and development of new toys, the procurement of character
and product licenses, and the improvement and expansion of previously introduced
products and product lines. In the United States video game segment, total
retail sales of video game software were approximately $17.9 billion in
2007. 6
Over
the
past few years, the toy industry has experienced substantial consolidation
among
both toy companies and toy retailers. We believe that the ongoing consolidation
of toy companies provides us with increased growth opportunities due to
retailers’ desire to not be entirely dependent on a few dominant toy companies.
Retailer concentration also enables us to ship products, manage account
relationships and track retail sales more effectively and
efficiently.
Products
We
focus
our business on acquiring or licensing well-recognized trademarks or brand
names, and we seek to acquire evergreen brands which are less subject to market
fads or trends. Generally, our license agreements for products and concepts
call
for royalties ranging from 1% to 14% of net sales, and some may require minimum
guarantees and advances. Our principal products include:
Traditional
Toys
Electronics
Products
Our
electronic products category includes our Plug
It In & Play TV Games, EyeClops™
Bionic
Eye products and
Laser
Challenge® product
lines. Our current Plug
It In & Play TV
Games
titles
include licenses from Namco®,
Disney,
Marvel®
and
Nickelodeon,
and
feature such games as SpongeBob
SquarePants®,
Dora
the Explorer,
Disney
Princess®,
Ms.
Pac-Man®
and
Pac-Man®.
We
regularly release new Plug
It In & Play TV
Games
titles
for the pre-school and leisure gamer segments including Wheel
of Fortune®,
Deal
or No Deal®, Jeopardy®, Sesame
Street®
and
Thomas
the Tank™.
Wheels
Division Products
Our
toy
vehicle line includes toy and activity vehicles and other toys. We also produce
radio controlled vehicles. Our toy vehicle line is comprised of an assortment
of
rugged die-cast and plastic vehicles that range in size from four-and
three-quarter inch to big-wheeled seventeen inch vehicles. The breadth of the
line is extensive, with themes ranging from emergency, fire, farm and
construction, to racing and jungle adventure.
The
Road
Champs product
line consists of highly detailed, die-cast replicas of new and classic cars,
trucks, motorcycles, emergency vehicles and service vehicles, primarily in
1/43
scale (including police cars, fire trucks and ambulances), buses and aircraft.
Through licenses, we produce replicas of well-known vehicles including those
from Ford®,
Chevrolet®
and
Porsche®.
We
believe that these licenses increase the perceived value of the products and
enhance their marketability.
Our
extreme sports offerings include our MXS
line of
motorcycles with riders, off-road vehicles, personal watercraft, surfboards
and
skateboards, which are sold individually and with playsets and
accessories.
Action
Figures and Accessories
We
have
an extensive toy license with the WWE pursuant to which we have the right,
until
December 31, 2009, to develop and market a full line of toy products based
on
the popular WWE
professional wrestlers. These wrestlers perform throughout the year at live
events that attract large crowds, many of which are broadcast on free and cable
television, including pay-per-view specials. We launched this product line
in
1996 with various series of 6 inch articulated action figures that have movable
body parts. We continually expand and enhance this product line by using
technology in the development and in the products themselves. The 6 inch figures
currently make up a substantial portion of our overall WWE
line,
which has since grown to include many other new products including playsets.
Our
strategy has been to release new figures and accessories frequently and to
offer
many exclusive programs to our retail partners to keep the line fresh and
relevant to WWE’s television programming, and to retain the interest of the
consumers.
We
also
develop, manufacture and distribute other action figures and action figure
accessories including those based on the animated series Pokemon,
and the
Disney feature film The Chronicles of Narnia: Prince Caspian. 7
Role-play
and Dress-up Products
Our
line
of role-play and dress-up products features entertainment and consumer products
properties such as Disney
Princess,
Hannah
Montana
and
Dora
the Explorer
for
girls and Black
& Decker
and
Pirates
of the Caribbean
for
boys. These products generated a significant amount of sales in 2007, and we
expect that level of sales to continue in 2008.
Infant
and Pre-school Toys
Our
pre-school toys include plush and electronic toys based on Care
Bears, The Wiggles, Barney
licenses
and more, some branded under Child
Guidance® and
others under Play
Along®. In
2007,
we also introduced new pre-school foam play products called Gorilla
Blocks™.
Our
line
of children’s indoor slumber bags features Dora
the Explorer,
SpongeBob
SquarePants
and
Pokémon
brands,
in
addition to our own proprietary designs.
Dolls
Dolls
include large, fashion and mini dolls and related accessories based on
Cabbage
Patch Kids®,
Hannah
Montana,
The
Cheetah Girls,
Puppy
in My Pocket and Friends,
Hairspray
the
movie and Disney
Princess
dolls
and private label fashion dolls for other retailers and sold to Disney Stores
and Disney Parks and Resorts.
Seasonal/
Outdoor Products
We
have a
wide range of seasonal toys and outdoor and leisure products. Our Go
Fly A Kite
product
line includes youth and adult kites and a wide array of decorative flags,
windsocks, and windwheels. Our Funnoodle
pool
toys include the basic Funnoodle pool floats and a variety of other pool toys.
Our The
Storm
product
line includes water guns, gliders and sport balls. Another outdoor product
is
our Fly
Wheels XPV and
Flight,
extensions of our original Fly
Wheels
vehicle
line.
Junior
Sports Products
Our
junior sports products include Gaksplat,
toy
paintball products and
The
Storm,
which
include a variety of mini sport balls and activity products.
Craft,
Activity and Writing Products
We
market
products into the toy activity category which contain a broad range of
activities, such as make and paint your own characters, jewelry making, art
studios, posters, puzzles and other projects. These activities, which feature
popular characters, such as Nickelodeon’s Dora
the Explorer,
among
others, have immediate visual appeal and brand recognition. Our product lines
also include stationery, back-to-school and office pens, pencils, markers,
notebooks and craft products such as Blopens
and
Vivid
Velvet
activities. These products are primarily marketed under our Flying
Colors and
Pentech
brands,
in addition to various private label and other brands.
Pet
Products
We
entered the Pet Products category with our acquisition of Pet Pal, whose
products include pet toys, treats, beds, clothes and related pet products.
These
products are marketed under JAKKS Pets™ and licenses include American
Kennel Club,
The
Cat Fanciers’ Association,
Bratz®,
Disney
and
Marvel,
as well
as numerous other entertainment and consumer product properties.
World
Wrestling Entertainment Video Games
In
June
1998, we formed a joint venture with THQ, a developer, publisher and distributor
of interactive entertainment software for the leading hardware game platforms
in
the home video game market. The joint venture entered into a license agreement
with the WWE under which it acquired the exclusive worldwide right to publish
WWE
video
games on all hardware platforms. The term of the license agreement expires
on
December 31, 2009, and the joint venture has a right to renew the license for
an
additional five years provided that there is an absence of a material
breach of the license agreement and that certain royalty minimums are met.
Those
minimums have been met. We and the joint venture are named as defendants in
lawsuits commenced by WWE, pursuant to which WWE is claiming that there have
been material breaches with respect to the video game license and is seeking
treble, punitive and other damages (including disgorgement of profits) in an
undisclosed amount and a declaration that the video game license with the joint
venture and an extension of our toy licenses with WWE are void and unenforceable
(see “Legal Proceedings”). 8
The
games
are designed, developed, manufactured and distributed by or through THQ. THQ
arranges for the manufacture of the CD-ROMs and game cartridges used in the
various video game platforms under non-exclusive licenses with Sony, Nintendo
and Microsoft. No other licenses are required for the manufacture of the
personal computer titles.
The
joint
venture agreement provides for us to have received guaranteed preferred returns
through June 30, 2006 at varying rates of the joint venture’s net sales
depending on the cumulative unit sales and platform of each particular game.
The
preferred return was subject to change after June 30, 2006 and was to be
set for the distribution period beginning July 1, 2006 and ending
December 31, 2009 (the “Next Distribution Period”). The agreement provides
that the parties will negotiate in good faith and agree to the preferred return
not less than 180 days prior to the start of the Next Distribution Period.
It further provides that if the parties are unable to agree on a preferred
return, the preferred return will be determined by arbitration. Since the
parties have not reached an agreement with respect to the preferred return
for
the Next Distribution Period, the preferred return for the Next distribution
Period is to be determined through arbitration. The preferred
return is accrued in the quarter in which the licensed games are sold and the
preferred return is earned. Based on the same rates as set forth
under the original joint venture agreement, an estimated receivable of $35.3
million has been accrued for the eighteen months ended December 31, 2007,
pending the resolution of this outstanding issue.
The
joint
venture currently publishes titles for the Sony, Nintendo and Microsoft
consoles, Sony® and Nintendo® hand-held platforms, mobile/wireless and personal
computers. It will also publish titles for new hardware platforms when, and
as
they are introduced to the market and have established a sufficient installed
base to support new software. These titles are marketed to our existing
customers as well as to game, electronics and other specialty stores, such
as
Electronics Boutique and Best Buy.
The
following table presents our results with the joint venture since its
inception:
Wrestling
video games have demonstrated consistent popularity. We believe that the success
of WWE
titles
is
dependent on the graphic look and feel of the software, the depth and variation
of game play and the popularity of WWE.
We
believe that as a franchise property, WWE
titles
have brand recognition and sustainable consumer appeal, which may allow the
joint venture to use titles over an extended period of time through the release
of sequels and extensions and to re-release such products at different price
points in the future.
Sales,
Marketing and Distribution
We
sell
all of our products through our own in-house sales staff and independent sales
representatives to toy and mass-market retail chain stores, department stores,
office supply stores, drug and grocery store chains, club stores, toy specialty
stores and wholesalers. Our three largest customers are Wal-Mart, Target and
Toys ‘R’ Us, which accounted for approximately 58.7% of our net sales in 2006
and 47.9% of our net sales in 2007. With the addition of the Pet
Pal®
product
line, we began to distribute pet products to key pet supply retailers Petco
and
Petsmart in addition to many other pet retailers and our existing customers.
Except for purchase orders relating to products on order, we do not have written
agreements with our customers. Instead, we generally sell products to our
customers pursuant to letters of credit or, in some cases, on open account
with
payment terms typically varying from 30 to 90 days. From time to time, we allow
our customers credits against future purchases from us in order to facilitate
their retail markdown and sales of slow-moving inventory. We also sell our
products through e-commerce sites, including Toysrus.com and
Amazon.com. 9
We
contract the manufacture of most of our products to unaffiliated manufacturers
located in The People’s Republic of China (“China”). We sell the finished
products on a letter of credit basis or on open account to our customers, many
of whom take title to the goods in Hong Kong or China. These methods allow
us to
reduce certain operating costs and working capital requirements. A portion
of
our sales originate in the United States, so we hold certain inventory in our
warehouse and fulfillment facilities. To date, a significant portion of all
of
our sales has been to domestic customers. We intend to continue expanding
distribution of our products into foreign territories and, accordingly, we
have:
Outside
of the United States, we currently sell our products primarily in Europe,
Australia, Canada, Latin America and Asia. Sales of our products abroad
accounted for approximately $99.1 million, or 12.9% of our net sales, in 2006
and approximately $126.1 million, or 14.7% of our net sales, in 2007. We believe
that foreign markets present an attractive opportunity, and we plan to intensify
our marketing efforts and further expand our distribution channels
abroad.
We
establish reserves for sales allowances, including promotional allowances and
allowances for anticipated defective product returns, at the time of shipment.
The reserves are determined as a percentage of net sales based upon either
historical experience or on estimates or programs agreed upon by our customers
and us.
We
obtain, directly, or through our sales representatives, orders for our products
from our customers and arrange for the manufacture of these products as
discussed below. Cancellations generally are made in writing, and we take
appropriate steps to notify our manufacturers of these cancellations. We may
incur costs or other losses as a result of cancellations.
We
maintain a full-time sales and marketing staff, many of whom make on-site visits
to customers for the purpose of showing product and soliciting orders for
products. We also retain a number of independent sales representatives to sell
and promote our products, both domestically and internationally. Together with
retailers, we occasionally test the consumer acceptance of new products in
selected markets before committing resources to large-scale
production.
We
publicize and advertise our products in trade and consumer magazines and other
publications, market our products at international, national and regional toy,
stationery and other specialty trade shows, conventions and exhibitions and
carry on cooperative advertising programs with toy and mass market retailers
and
other customers which include the use of print and television ads and in-store
displays. We also produce and broadcast television commercials for several
of
our product lines, including our WWE
action
figure line, Disney
large
role playsets, Plug
It In & Play TV
Games,
Puppy
in My Pocket and Friends, EyeClops, Hannah Montana and
Cabbage
Patch Kids.
We may
also advertise some of our other products on television, if we expect that
the
resulting increase in our net sales will justify the relatively high cost of
television advertising.
Product
Development
Each
of
our product lines has an in-house manager responsible for product development.
The in-house manager identifies and evaluates inventor products and concepts
and
other opportunities to enhance or expand existing product lines or to enter
new
product categories. In addition, we create proprietary products to fully exploit
our concept and character licenses. Although we do have the capability to create
and develop products from inception to production, we generally use
third-parties to provide a portion of the sculpting, sample making, illustration
and package design required for our products in order to accommodate our
increasing product innovations and introductions. Typically, the development
process takes from three to nine months from concept to production and shipment
to our customers.
We
employ
a staff of designers for all of our product lines. We occasionally acquire
our
other product concepts from unaffiliated third parties. If we accept and develop
a third party’s concept for new toys, we generally pay a royalty on the toys
developed from this concept that are sold, and may, on an individual basis,
guarantee a minimum royalty. In addition, we engage third party developers
to
program our line of Plug
it in & Play TV Games.
Royalties payable to inventors and developers generally range from 1% to 2.5%
of
the wholesale sales price for each unit of a product sold by us. We believe
that
utilizing experienced third-party inventors gives us access to a wide range
of
development talent. We currently work with numerous toy inventors and designers
for the development of new products and the enhancement of existing
products. 10
Safety
testing of our products is done at the manufacturers’ facilities by quality
control personnel employed by us or by independent third-party contractors
engaged by us. Safety testing is designed to meet or exceed regulations imposed
by federal and state, as well as applicable international governmental
authorities, our retail partners, licensors and the Toy Industry Association.
We
also closely monitor quality assurance procedures for our products for safety
purposes. In addition, independent laboratories engaged by some of our larger
customers and licensors test certain of our products.
Manufacturing
and Supplies
Most
of
our products are currently produced by overseas third-party manufacturers,
which
we choose on the basis of quality, reliability and price. Consistent with
industry practice, the use of third-party manufacturers enables us to avoid
incurring fixed manufacturing costs, while maximizing flexibility, capacity
and
production technology. Substantially all of the manufacturing services performed
overseas for us are paid for on open account with the manufacturers. To date,
we
have not experienced any material delays in the delivery of our products;
however, delivery schedules are subject to various factors beyond our control,
and any delays in the future could adversely affect our sales. Currently, we
have ongoing relationships with over eighty different manufacturers. We believe
that alternative sources of supply are available to us, although we cannot
be
assured that we can obtain adequate supplies of manufactured
products.
Although
we do not conduct the day-to-day manufacturing of our products, we are
extensively involved in the design of the product prototype and production
tools, dies and molds for our products and we seek to ensure quality control
by
actively reviewing the production process and testing the products produced
by
our manufacturers. We employ quality control inspectors who rotate among our
manufacturers’ factories to monitor the production of substantially all of our
products.
The
principal raw materials used in the production and sale of our toy products
are
plastics, zinc alloy, plush, printed fabrics, paper products and electronic
components, all of which are currently available at reasonable prices from
a
variety of sources. Although we do not manufacture our products, we own the
tools, dies and molds used in the manufacturing process, and these are
transferable among manufacturers if we choose to employ alternative
manufacturers. Tools, dies and molds represent a substantial portion of our
property and equipment with a net book value of $12.6 million in 2006 and $14.4
million in 2007. Substantially all of these assets are located in
China.
Trademarks
and Copyrights
Most
of
our products are produced and sold under trademarks owned by or licensed to
us.
We typically register our properties, and seek protection under the trademark,
copyright and patent laws of the United States and other countries where our
products are produced or sold. These intellectual property rights can be
significant assets. Accordingly, while we believe we are sufficiently protected,
the loss of some of these rights could have an adverse effect on our business,
financial condition and results of operations.
Competition
Competition
in the toy industry is intense. Globally, certain of our competitors have
greater financial resources, larger sales and marketing and product development
departments, stronger name recognition, longer operating histories and benefit
from greater economies of scale. These factors, among others, may enable our
competitors to market their products at lower prices or on terms more
advantageous to customers than those we could offer for our competitive
products. Competition often extends to the procurement of entertainment and
product licenses, as well as to the marketing and distribution of products
and
the obtaining of adequate shelf space. Competition may result in price
reductions, reduced gross margins and loss of market share, any of which could
have a material adverse effect on our business, financial condition and results
of operations. In each of our product lines we compete against one or both
of
the toy industry’s two dominant companies, Mattel and Hasbro. In addition, we
compete in our Flying
Colors
and
Pentech
product
categories, with Mega Brands (Rose Art® ), Hasbro (Play-Doh®) and Binney &
Smith (Crayola®), and in our toy vehicle lines, with RC2. We also compete with
numerous smaller domestic and foreign toy manufacturers, importers and marketers
in each of our product categories. Our joint venture’s principal competitors in
the video game market are Electronic Arts and Activision.
Seasonality
and Backlog
In
2007,
approximately 70.4% of our net sales were made in the third and fourth quarters.
Generally, the first quarter is the period of lowest shipments and sales in
our
business and the toy industry generally and therefore the least profitable
due
to various fixed costs. Seasonality factors may cause our operating results
to
fluctuate significantly from quarter to quarter. However, our writing instrument
and activity products generally are counter-seasonal to the traditional toy
industry seasonality due to the higher volume generally shipped for
back-to-school beginning in the second quarter. In addition, our seasonal
products are primarily sold in the spring and summer seasons. Our results of
operations may also fluctuate as a result of factors such as the timing of
new
products (and related expenses) introduced by us or our competitors, the
advertising activities of our competitors, delivery schedules set by our
customers and the emergence of new market entrants. We believe, however, that
the low retail price of most of our products may be less subject to seasonal
fluctuations than higher priced toy products. 11
We
ship
products in accordance with delivery schedules specified by our customers,
which
usually request delivery of their products within three to six months of the
date of their orders for orders shipped FOB China or Hong Kong and within three
days on orders shipped domestically. Because customer orders may be canceled
at
any time without penalty, our backlog may not accurately indicate sales for
any
future period.
Government
and Industry Regulation
Our
products are subject to the provisions of the Consumer Product Safety Act
(“CPSA”), the Federal Hazardous Substances Act (“FHSA”), the Flammable Fabrics
Act (“FFA”) and the regulations promulgated thereunder. The CPSA and the FHSA
enable the Consumer Products Safety Commission (“CPSC”) to exclude from the
market consumer products that fail to comply with applicable product safety
regulations or otherwise create a substantial risk of injury, and articles
that
contain excessive amounts of a banned hazardous substance. The FFA enables
the
CPSC to regulate and enforce flammability standards for fabrics used in consumer
products. The CPSC may also require the repurchase by the manufacturer of
articles. Similar laws exist in some states and cities and in various
international markets. We maintain a quality control program designed to ensure
compliance with all applicable laws.
Employees
As
of
February 28, 2008, we employed 598 persons, all of whom are full-time employees,
including three executive officers. We employed 419 people in the United States,
154 people in Hong Kong and 25 people in China. We believe that we have good
relationships with our employees. None of our employees are represented by
a
union.
Environmental
Issues
We
are
subject to legal and financial obligations under environmental, health and
safety laws in the United States and in other jurisdictions where we operate.
We
are not currently aware of any material environmental liabilities associated
with any of our operations.
Available
Information
We
make
available free of charge on or through our Internet website,
www.jakkspacific.com, our annual report on Form 10-K, quarterly reports on
Form
10-Q, current reports on Form 8-K, and amendments to these reports filed or
furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act
of
1934 as soon as reasonably practicable after we electronically file such
material with, or furnish it to, the SEC.
Our
Corporate Information
We
were
formed as a Delaware corporation in 1995. Our principal executive offices are
located at 22619 Pacific Coast Highway, Malibu, California 90265. Our telephone
number is (310) 456-7799 and our Internet Website address is
www.jakkspacific.com. The contents of our website are not incorporated in or
deemed to be a part of this Annual Report or Form 10-K.
Item
1A. Risk
Factors
From
time
to time, including in this Annual Report on Form 10-K, we publish
forward-looking statements, as disclosed in our Disclosure Regarding
Forward-Looking Statements, beginning immediately following the Table of
Contents of this Annual Report. We note that a variety of factors could cause
our actual results and experience to differ materially from the anticipated
results or other expectations expressed or anticipated in our forward-looking
statements. The factors listed below are illustrative of the risks and
uncertainties that may arise and that may be detailed from time to time in
our
public announcements and our filings with the Securities and Exchange
Commission, such as on Forms 8-K, 10-Q and 10-K. We undertake no obligation
to
make any revisions to the forward-looking statements contained in this Annual
Report on Form 10-K to reflect events or circumstances occurring after the
date
of the filing of this report.
The
outcome of litigation in which we have been named as a defendant is
unpredictable and a materially adverse decision in any such matter could have
a
material adverse affect on our financial position and results of
operations.
We
are
defendants in litigation matters, as described under “Legal Proceedings” in our
periodic reports filed pursuant to the Securities Exchange Act of 1934,
including the lawsuit commenced by WWE and the purported securities class action
and derivative action claims stemming from the WWE lawsuit (see “Legal
Proceedings”). These claims may divert financial and management resources that
would otherwise be used to benefit our operations. Although we believe that
we
have meritorious defenses to the claims made in each and all of the litigation
matters to which we have been named a party, and intend to contest each lawsuit
vigorously, no assurances can be given that the results of these matters will
be
favorable to us. A materially adverse resolution of any of these lawsuits could
have a material adverse effect on our financial position and results of
operations. 12
Our
inability to redesign, restyle and extend our existing core products and product
lines as consumer preferences evolve, and to develop, introduce and gain
customer acceptance of new products and product lines, may materially and
adversely impact our business, financial condition and results of
operations.
Our
business and operating results depend largely upon the appeal of our products.
Our continued success in the toy industry will depend on our ability to
redesign, restyle and extend our existing core products and product lines as
consumer preferences evolve, and to develop, introduce and gain customer
acceptance of new products and product lines. Several trends in recent years
have presented challenges for the toy industry, including:
We
cannot
assure you that:
Our
failure to achieve any or all of the foregoing benchmarks may cause the
infrastructure of our operations to fail, thereby adversely affecting our
business, financial condition and results of operations.
The
failure of our character-related and theme-related products to become and/or
remain popular with children may materially and adversely impact our business,
financial condition and results of operations.
The
success of many of our character-related and theme-related products depends
on
the popularity of characters in movies, television programs, live wrestling
exhibitions, auto racing events and other media. We cannot assure you
that:
Our
failure to achieve any or all of the foregoing benchmarks may cause the
infrastructure of our operations to fail, thereby adversely affecting our
business, financial condition and results of operations.
There
are risks associated with our license agreements.
Sales
of
products under trademarks or trade or brand names licensed from others account
for substantially all of our net sales. Product licenses allow us to capitalize
on characters, designs, concepts and inventions owned by others or developed
by
toy inventors and designers. Our license agreements generally require us to
make
specified minimum royalty payments, even if we fail to sell a sufficient number
of units to cover these amounts. In addition, under certain of our license
agreements, if we fail to achieve certain prescribed sales targets, we may
be
unable to retain or renew these licenses. 13
Under
the
majority of our license agreements the licensors have the right to review and
approve our use of their licensed products, designs or materials before we
may
make any sales. If a licensor refuses to permit our use of any licensed property
in the way we propose, or if their review process is delayed, our development
or
sale of new products could be impeded.
Our
continued success will depend substantially on our ability to obtain additional
licenses. Intensive competition exists for desirable licenses in our industry.
We cannot assure you that we will be able to secure or renew significant
licenses on terms acceptable to us. In addition, as we add licenses, the need
to
fund additional royalty advances and guaranteed minimum royalty payments may
strain our cash resources.
We
derive
a significant portion of our net sales from a limited number of licensors.
If
one or more of these licensors were to terminate or fail to renew our license
or
not grant us new licenses, our business, financial condition and results of
operations could be adversely affected.
The
toy industry is highly competitive and our inability to compete effectively
may
materially and adversely impact our business, financial condition and results
of
operations.
The
toy
industry is highly competitive. Globally, certain of our competitors have
financial and strategic advantages over us, including:
In
addition, the toy industry has no significant barriers to entry. Competition
is
based primarily on the ability to design and develop new toys, to procure
licenses for popular characters and trademarks and to successfully market
products. Many of our competitors offer similar products or alternatives to
our
products. Our competitors have obtained and are likely to continue to obtain
licenses that overlap our licenses with respect to products, geographic areas
and markets. We cannot assure you that we will be able to obtain adequate shelf
space in retail stores to support our existing products or to expand our
products and product lines or that we will be able to continue to compete
effectively against current and future competitors.
An
adverse outcome in the litigation commenced against us and against our video
game joint venture with THQ by WWE, or a decline in the popularity of WWE,
could
adversely impact our interest in that joint
venture.
The
joint
venture with THQ depends entirely on a single license, which gives the venture
exclusive worldwide rights to produce and market video games based on World
Wrestling Entertainment characters and themes. An adverse outcome against us,
THQ or the joint venture in the lawsuit commenced by WWE, or an adverse outcome
against THQ or the joint venture in the lawsuit commenced by WWE against THQ
and
the joint venture (see the first Risk Factor, above, and “Legal Proceedings”),
would adversely impact our rights under the joint venture’s single license,
which would adversely affect the joint venture’s and our business, financial
condition and results of operation.
Furthermore,
the popularity of professional wrestling, in general, and World Wrestling
Entertainment, in particular, is subject to changing consumer tastes and
demands. The relative popularity of professional wrestling has fluctuated
significantly in recent years. A decline in the popularity of World Wrestling
Entertainment could adversely affect the joint venture’s and our business,
financial condition and results of operations.
14
The
termination of THQ’s manufacturing licenses and the inability of the joint
venture to otherwise obtain these licenses from other manufacturers would
materially adversely affect the joint venture’s and our business, financial
condition and results of operations.
The
joint
venture relies on hardware manufacturers and THQ’s non-exclusive licenses with
them for the right to publish titles for their platforms and for the manufacture
of the joint venture’s titles. If THQ’s manufacturing licenses were to terminate
and the joint venture could not otherwise obtain these licenses from other
manufacturers, the joint venture would be unable to publish additional titles
for these manufacturers’ platforms, which would materially adversely affect the
joint venture’s and our business, financial condition and results of
operations.
The
failure of the joint venture or THQ to perform as anticipated could have a
material adverse affect on our financial position and results of
operations.
The
joint
venture’s failure to timely develop titles for new platforms that achieve
significant market acceptance, to maintain net sales that are commensurate
with
product development costs or to maintain compatibility between its personal
computer CD-ROM titles and the related hardware and operating systems would
adversely affect the joint venture’s and our business, financial condition and
results of operations.
Furthermore,
THQ controls day-to-day operations of the joint venture and all of its product
development and production operations. Accordingly, the joint venture relies
exclusively on THQ to manage these operations effectively. THQ’s failure to
effectively manage the joint venture would have a material adverse effect on
the
joint venture’s and our business and results of operations. We are also
dependent upon THQ’s ability to manage cash flows of the joint venture. If THQ
is required to retain cash for operations, or because of statutory or
contractual restrictions, we may not receive cash payments for our share of
profits, on a timely basis, or at all.
The
amount of preferred return that we now receive from the joint venture is subject
to change, which could adversely affect our results of
operations.
The
joint
venture agreement provides for us to have received guaranteed preferred returns
through June 30, 2006 at varying rates of the joint venture’s net sales
depending on the cumulative unit sales and platform of each particular game.
The
preferred return was subject to change after June 30, 2006 and was to be
set for the distribution period beginning July 1, 2006 and ending
December 31, 2009 (the “Next Distribution Period”). The agreement provides
that the parties will negotiate in good faith and agree to the preferred return
not less than 180 days prior to the start of the Next Distribution Period.
It further provides that if the parties are unable to agree on a preferred
return, the preferred return will be determined by arbitration. Since the
parties have not reached an agreement with respect to the preferred return
for
the Next Distribution Period, the preferred return for the Next Distribution
Period is to be determined through arbitration. The preferred return
is accrued in the quarter in which the licensed games are sold and the preferred
return is earned. Based on the same rates as set forth under the
original joint venture agreement, an estimated receivable of $35.3 million
has
been accrued for the eighteen months ending December 31, 2007, pending the
resolution of this outstanding issue.
Any
adverse change to the preferred return for the next distribution period as
well
as the ongoing performance of the joint venture may result in our experiencing
reduced net income, which would adversely affect our results of
operations.
We
may not be able to sustain or manage our rapid growth, which may prevent us
from
continuing to increase our net revenues.
We
have
experienced rapid growth in our product lines resulting in higher net sales
over
the last six years, which was achieved through acquisitions of businesses,
products and licenses. For example, revenues associated with companies we
acquired since 2005 were approximately $185.6 million and $11.8 million, in
2006
and 2007, respectively, representing 24.3% and 1.4% of our total revenues for
those periods. As a result, comparing our period-to-period operating results
may
not be meaningful and results of operations from prior periods may not be
indicative of future results. We cannot assure you that we will continue to
experience growth in, or maintain our present level of, net sales.
Our
growth strategy calls for us to continuously develop and diversify our toy
business by acquiring other companies, entering into additional license
agreements, refining our product lines and expanding into international markets,
which will place additional demands on our management, operational capacity
and
financial resources and systems. The increased demand on management may
necessitate our recruitment and retention of qualified management personnel.
We
cannot assure you that we will be able to recruit and retain qualified personnel
or expand and manage our operations effectively and profitably. To effectively
manage future growth, we must continue to expand our operational, financial
and
management information systems and to train, motivate and manage our work force.
There can be no assurance that our operational, financial and management
information systems will be adequate to support our future operations. Failure
to expand our operational, financial and management information systems or
to
train, motivate or manage employees could have a material adverse effect on
our
business, financial condition and results of operations. 15
In
addition, implementation of our growth strategy is subject to risks beyond
our
control, including competition, market acceptance of new products, changes
in
economic conditions, our ability to obtain or renew licenses on commercially
reasonable terms and our ability to finance increased levels of accounts
receivable and inventory necessary to support our sales growth, if any.
Accordingly, we cannot assure you that our growth strategy will continue to
be
implemented successfully.
If
we are unable to acquire and integrate companies and new product lines
successfully, we will be unable to implement a significant component of our
growth strategy.
Our
growth strategy depends in part upon our ability to acquire companies and new
product lines. Revenues associated with our acquisitions since 2005 represented
approximately 24.3% and 1.4% of our total revenues in 2006 and 2007,
respectively. Future acquisitions will succeed only if we can effectively assess
characteristics of potential target companies and product lines, such
as:
We
cannot
assure you that we can identify attractive acquisition candidates or negotiate
acceptable acquisition terms, and our failure to do so may adversely affect
our
results of operations and our ability to sustain growth. Our acquisition
strategy involves a number of risks, each of which could adversely affect our
operating results, including:
A
limited number of customers account for a large portion of our net sales, so
that if one or more of our major customers were to experience difficulties
in
fulfilling their obligations to us, cease doing business with us, significantly
reduce the amount of their purchases from us or return substantial amounts
of
our products, it could have a material adverse effect on our business, financial
condition and results of operations.
Our
three
largest customers accounted for 47.9% of our net sales in 2007. Except for
outstanding purchase orders for specific products, we do not have written
contracts with or commitments from any of our customers. A substantial reduction
in or termination of orders from any of our largest customers could adversely
affect our business, financial condition and results of operations. In addition,
pressure by large customers seeking price reductions, financial incentives,
changes in other terms of sale or for us to bear the risks and the cost of
carrying inventory also could adversely affect our business, financial condition
and results of operations. If one or more of our major customers were to
experience difficulties in fulfilling their obligations to us, cease doing
business with us, significantly reduce the amount of their purchases from us
or
return substantial amounts of our products, it could have a material adverse
effect on our business, financial condition and results of operations. In
addition, the bankruptcy or other lack of success of one or more of our
significant retailers could negatively impact our revenues and bad debt
expense.
We
depend on our key personnel and any loss or interruption of either of their
services could adversely affect our business, financial condition and results
of
operations.
Our
success is largely dependent upon the experience and continued services of
Jack
Friedman, our Chairman and Chief Executive Officer, and Stephen G. Berman,
our
President and Chief Operating Officer. We cannot assure you that we would be
able to find an appropriate replacement for Mr. Friedman or Mr. Berman if the
need should arise, and any loss or interruption of Mr. Friedman’s or Mr.
Berman’s services could adversely affect our business, financial condition and
results of operations. 16
We
depend on third-party manufacturers, and if our relationship with any of them
is
harmed or if they independently encounter difficulties in their manufacturing
processes, we could experience product defects, production delays, cost overruns
or the inability to fulfill orders on a timely basis, any of which could
adversely affect our business, financial condition and results of
operations.
We
depend
on many third-party manufacturers who develop, provide and use the tools, dies
and molds that we own to manufacture our products. However, we have limited
control over the manufacturing processes themselves. As a result, any
difficulties encountered by the third-party manufacturers that result in product
defects, production delays, cost overruns or the inability to fulfill orders
on
a timely basis could adversely affect our business, financial condition and
results of operations.
We
do not
have long-term contracts with our third-party manufacturers. Although we believe
we could secure other third-party manufacturers to produce our products, our
operations would be adversely affected if we lost our relationship with any
of
our current suppliers or if our current suppliers’ operations or sea or air
transportation with our overseas manufacturers were disrupted or terminated
even
for a relatively short period of time. Our tools, dies and molds are located
at
the facilities of our third-party manufacturers.
Although
we do not purchase the raw materials used to manufacture our products, we are
potentially subject to variations in the prices we pay our third-party
manufacturers for products, depending on what they pay for their raw
materials.
We
have substantial sales and manufacturing operations outside of the United States
subjecting us to risks common to international
operations.
We
sell
products and operate facilities in numerous countries outside the United States.
For the year ended December 31, 2007 sales to our international customers
comprised approximately 14.7% of our net sales. We expect our sales to
international customers to account for a greater portion of our revenues in
future fiscal periods. Additionally, we utilize third-party manufacturers
located principally in China which are subject to the risks normally associated
with international operations, including:
Our
reliance on external sources of manufacturing can be shifted, over a period
of
time, to alternative sources of supply, should such changes be necessary.
However, if we were prevented from obtaining products or components for a
material portion of our product line due to medical, political, labor or other
factors beyond our control, our operations would be disrupted while alternative
sources of products were secured. Also, the imposition of trade sanctions by
the
United States against a class of products imported by us from, or the loss
of
“normal trade relations” status by China, could significantly increase our cost
of products imported from that nation. Because of the importance of our
international sales and international sourcing of manufacturing to our business,
our financial condition and results of operations could be significantly and
adversely affected if any of the risks described above were to
occur.
17
Our
business is subject to extensive government regulation and any violation by
us
of such regulations could result in product liability claims, loss of sales,
diversion of resources, damage to our reputation, increased warranty costs
or
removal of our products from the market, and we cannot assure you that our
product liability insurance for the foregoing will be
sufficient.
Our
business is subject to various laws, including the Federal Hazardous Substances
Act, the Consumer Product Safety Act, the Flammable Fabrics Act and the rules
and regulations promulgated under these acts. These statutes are administered
by
the CPSC, which has the authority to remove from the market products that are
found to be defective and present a substantial hazard or risk of serious injury
or death. The CPSC can require a manufacturer to recall, repair or replace
these
products under certain circumstances. We cannot assure you that defects in
our
products will not be alleged or found. Any such allegations or findings could
result in:
Any
of
these results may adversely affect our business, financial condition and results
of operations. There can be no assurance that our product liability insurance
will be sufficient to avoid or limit our loss in the event of an adverse outcome
of any product liability claim.
We
depend on our proprietary rights and our inability to safeguard and maintain
the
same, or claims of third parties that we have violated their intellectual
property rights, could have a material adverse effect on our business, financial
condition and results of operations.
We
rely
on trademark, copyright and trade secret protection, nondisclosure agreements
and licensing arrangements to establish, protect and enforce our proprietary
rights in our products. The laws of certain foreign countries may not protect
intellectual property rights to the same extent or in the same manner as the
laws of the United States. We cannot assure you that we or our licensors will
be
able to successfully safeguard and maintain our proprietary rights. Further,
certain parties have commenced legal proceedings or made claims against us
based
on our alleged patent infringement, misappropriation of trade secrets or other
violations of their intellectual property rights. We cannot assure you that
other parties will not assert intellectual property claims against us in the
future. These claims could divert our attention from operating our business
or
result in unanticipated legal and other costs, which could adversely affect
our
business, financial condition and results of operations.
Market
conditions and other third-party conduct could negatively impact our margins
and
implementation of other business initiatives.
Economic
conditions, such as rising fuel prices and decreased consumer confidence, may
adversely impact our margins. In addition, general economic conditions were
significantly and negatively affected by the September 11th terrorist attacks
and could be similarly affected by any future attacks. Such a weakened economic
and business climate, as well as consumer uncertainty created by such a climate,
could adversely affect our sales and profitability. Other conditions, such
as
the unavailability of electronics components, may impede our ability to
manufacture, source and ship new and continuing products on a timely basis.
Significant and sustained increases in the price of oil could adversely impact
the cost of the raw materials used in the manufacture of our products, such
as
plastic.
We
may not have the funds necessary to purchase our outstanding convertible senior
notes upon a fundamental change or other purchase date, as required by the
indenture governing the notes.
On
June
15, 2010, June 15, 2013 and June 15, 2018, holders of our convertible senior
notes may require us to purchase their notes, which repurchase may be made
for
cash. In addition, holders may also require us to purchase their notes for
cash
upon the occurrence of certain fundamental changes in our board composition
or
ownership structure, if we liquidate or dissolve under certain circumstances
or
if our common stock ceases being quoted on an established over-the-counter
trading market in the United States. If we do not have, or have access to,
sufficient funds to repurchase the notes, then we could be forced into
bankruptcy. In fact, we expect that we would require third-party financing,
but
we cannot assure you that we would be able to obtain that financing on favorable
terms or at all. 18
We
have a material amount of goodwill which, if it becomes impaired, would result
in a reduction in our net income.
Goodwill
is the amount by which the cost of an acquisition accounted for using the
purchase method exceeds the fair value of the net assets we acquire. Current
accounting standards require that goodwill no longer be amortized but instead
be
periodically evaluated for impairment based on the fair value of the reporting
unit. As of December 31, 2007, we have not had any impairment of Goodwill,
which
is reviewed on a quarterly basis and formally evaluated on an annual
basis.
At
December 31, 2007, approximately $353.3 million, or 36.0%, of our total assets
represented goodwill. Declines in our profitability may impact the fair value
of
our reporting units, which could result in a write-down of our goodwill.
Reductions in our net income caused by the write-down of goodwill would
adversely affect our results of operations.
Item
2. Properties
The
following is a listing of the principal leased offices maintained by us as
of
February 22, 2008:
Item
3. Legal
Proceedings
On
October 19, 2004, we were named as defendants in a lawsuit commenced by WWE
in
the U.S. District Court for the Southern District of New York concerning our
toy
licenses with WWE and the video game license between WWE and the joint venture
company operated by THQ and us, encaptioned World Wrestling Entertainment,
Inc.
v. JAKKS Pacific, Inc., et al., 1:04-CV-08223-KMK (the “WWE Action”). The
complaint also named as defendants THQ, the joint venture, certain of our
foreign subsidiaries, Jack Friedman (our Chairman and Chief Executive Officer),
Stephen Berman (our Executive Vice President and Chief Operating Officer,
President and Secretary and a member of our Board of Directors), Joel Bennett
(our Chief Financial Officer), Stanley Shenker and Associates, Inc., Bell
Licensing, LLC, Stanley Shenker and James Bell.
WWE
sought treble, punitive and other damages (including disgorgement of profits)
in
an undisclosed amount and a declaration that the video game license with the
joint venture, which is scheduled to expire in 2009 (subject to joint venture’s
right to extend that license for an additional five years), and an amendment
to
our toy licenses with WWE, which are scheduled to expire in 2009, are void
and
unenforceable. This action alleged violations by the defendants of the Racketeer
Influenced and Corrupt Organization Act (“RICO”) and the anti-bribery provisions
of the Robinson-Patman Act, and various claims under state law.
On
February 16, 2005, we filed a motion to dismiss the WWE Action. On March 30,
2005, the day before WWE’s opposition to our motion was due, WWE filed an
Amended Complaint seeking, among other things, to add the Chief Executive
Officer of THQ as a defendant and to add a claim under the Sherman Act. The
Court allowed the filing of the Amended Complaint and ordered a two-stage
resolution of the viability of the Complaint, with motions to dismiss the
federal jurisdiction claims based on certain threshold issues to proceed and
all
other matters to be deferred for consideration if the Complaint survived
scrutiny with respect to the threshold issues. The Court also stayed discovery
pending the determination of the motions to dismiss.
The
motions to dismiss the Amended Complaint based on these threshold issues were
fully briefed and argued and, on March 31, 2006, the Court granted the part
of
our motion seeking dismissal of the Robinson-Patman Act and Sherman Act claims
and denied the part of our motion seeking to dismiss the RICO claims on the
basis of the threshold issue that was briefed (the “March 31
Order”). 19
On
April 7, 2006, we sought certification to appeal from the portion of the March
31 Order denying our motion to dismiss the RICO claim on the one ground that
was
briefed. Shortly thereafter, WWE filed a motion for reargument with respect
to
the portion of the March 31 Order that dismissed the Sherman Act claim and,
alternatively, sought judgment with respect to the Sherman Act claim so that
it
could pursue an immediate appeal. At a court conference on April 26, 2006 the
Court deferred the requests for judgment and for certification and set up
briefing schedules with respect to our motion to dismiss the RICO claim on
grounds that were not the subject of the first round of briefing, and our motion
to dismiss the action based on the release contained in a January 15, 2004
Settlement Agreement and General Release between WWE and the Company (the
“Release”). The Court also established a briefing schedule for WWE’s motion for
reargument of the dismissal of the Sherman Act claim. These motions were argued
and submitted in September 2006. Discovery remained stayed.
On
November 30, 2007, the Court indicated that the WWE Action would be dismissed.
On December 21, 2007 the Court dismissed the WWE Action with prejudice (the
"December 2007 Order") based on (1) the failure to plead RICO injury; (2) the
bar of the RICO statute of limitations; (3) the denial of WWE’s motion for
reconsideration of the Sherman Act claim; and (4) the lack of subject matter
jurisdiction with respect to the pendent state law claims. Thereafter, WWE
filed
an appeal to the Second Circuit Court of Appeals. We filed a motion for
reconsideration of the part of the December 2007 Order that stated that the
Release did not bar the WWE Action. That motion has been fully briefed and
submitted to the Court. We also filed a cross-appeal based on the Court's
earlier order denying our request to dismiss based on the lack of a cognizable
enterprise and based on the December 2007 Order's statement with respect to
the
Release. A scheduling order was issued by the Second Circuit with respect to
the
Appeal. Thereafter, WWE moved to dismiss our cross-appeal. That motion is in
the
process of being briefed. We moved for a declaration that the Appeal was stayed
by virtue of the motion for reconsideration. That motion is in the process
of
briefing.
In
November 2004, several purported class action lawsuits were filed in the United
States District Court for the Southern District of New York: (1) Garcia v.
JAKKS
Pacific, Inc. et al., Civil Action No. 04-8807 (filed on November 5, 2004),
(2)
Jonco Investors, LLC v. JAKKS Pacific, Inc. et al., Civil Action No. 04-9021
(filed on November 16, 2004), (3) Kahn v. JAKKS Pacific, Inc. et al., Civil
Action No. 04-8910 (filed on November 10, 2004), (4) Quantum Equities L.L.C.
v.
JAKKS Pacific, Inc. et al., Civil Action No. 04-8877 (filed on November 9,
2004), and (5) Irvine v. JAKKS Pacific, Inc. et al., Civil Action No. 04-9078
(filed on November 16, 2004) (the “Class Actions”). The complaints in the Class
Actions alleged that defendants issued positive statements concerning increasing
sales of our WWE licensed products which were false and misleading because
the
WWE licenses had allegedly been obtained through a pattern of commercial
bribery, our relationship with the WWE was being negatively impacted by the
WWE’s contentions and there was an increased risk that the WWE would either seek
modification or nullification of the licensing agreements with us. Plaintiffs
also alleged that we misleadingly failed to disclose the alleged fact that
the
WWE licenses were obtained through an unlawful bribery scheme. The plaintiffs
in
the Class Actions were described as purchasers of our common stock, who
purchased from as early as October 26, 1999 to as late as October 19, 2004.
The
Class Actions sought compensatory and other damages in an undisclosed amount,
alleging violations of Section 10(b) of the Securities Exchange Act of 1934
(the
“Exchange Act”) and Rule 10b-5 promulgated thereunder by each of the defendants
(namely the Company and Messrs. Friedman, Berman and Bennett), and violations
of
Section 20(a) of the Exchange Act by Messrs. Friedman, Berman and Bennett.
On
January 25, 2005, the Court consolidated the Class Actions under the caption
In
re JAKKS Pacific, Inc. Shareholders Class Action Litigation, Civil Action No.
04-8807. On May 11, 2005, the Court appointed co-lead counsels and provided
until July 11, 2005 for an amended complaint to be filed; and a briefing
schedule thereafter with respect to a motion to dismiss. The motion to dismiss
was fully briefed and argument occurred on November 30, 2006. The motion was
granted in January 2008 to the extent that the Class Actions were dismissed
without prejudice to plaintiffs’ right to seek leave to file an amended
complaint based on statements that the WWE licenses were obtained from the
WWE
as a result of the long-term relationship with WWE. A motion seeking leave
to
file an amended complaint was filed on February 25, 2008.
We
believe that the claims in the WWE Action and the Class Actions are without
merit and we intend to defend vigorously against them. However, because these
Actions are in their preliminary stages or are on appeal, we cannot assure
you
as to the outcome of the Actions, nor can we estimate the range of our potential
losses.
On
December 2, 2004, a shareholder derivative action was filed in the Southern
District of New York by Freeport Partner, LLC against us, nominally, and against
Messrs. Friedman, Berman and Bennett, Freeport Partners v. Friedman, et al.,
Civil Action No. 04-9441 (the “Derivative Action”). The Derivative Action seeks
to hold the individual defendants liable for damages allegedly caused to us
by
their actions and in particular to hold them liable on a contribution theory
with respect to any liability we incur in connection with the Class Actions.
On
or about February 10, 2005, a second shareholder derivative action was filed
in
the Southern District of New York by David Oppenheim against us, nominally,
and
against Messrs. Friedman, Berman, Bennett, Blatte, Glick, Miller and Skala,
Civil Action 05-2046 (the “Second Derivative Action”). The Second Derivative
Action seeks to hold the individual defendants liable for damages allegedly
caused to us by their actions as a result of alleged breaches of their fiduciary
duties. On or about March 16, 2005, a third shareholder derivative action was
filed. It is captioned Warr v. Friedman, Berman, Bennett, Blatte, Glick, Miller,
Skala, and JAKKS (as a nominal defendant), and it was filed in the Superior
Court of California, Los Angeles County (the “Third Derivative Action”). The
Third Derivative Action seeks to hold the individual defendants liable for
(1)
damages allegedly caused to us by their alleged breaches of fiduciary duty,
abuse of control, gross mismanagement, waste of corporate assets and unjust
enrichment; and (2) restitution to us of profits, benefits and other
compensation obtained by them. Stays/and or extensions of time to answer are
in
place with respect to the derivative actions. 20
On
March
1, 2005, we delivered a Notice of Breach of Settlement Agreement and Demand
for
Indemnification to WWE (the “Notification”). The Notification asserted that
WWE’s filing of the WWE Action violated a Covenant Not to Sue contained in a
January 15, 2004 Settlement Agreement and General Release (“General Release”)
entered into between WWE and us and, therefore, that we were demanding
indemnification, pursuant to the Indemnification provision contained in the
General Release, for all losses that the WWE’s actions have caused or will cause
to us and our officers, including but not limited to any losses sustained by
us
in connection with the Class Actions. On March 4, 2005, in a letter from its
outside counsel, WWE asserted that the General Release does not cover the claims
in the WWE Action.
On
March
30, 2006, WWE’s counsel wrote a letter alleging breaches by the joint venture of
the video game agreement relating to the manner of distribution and the payment
of royalties to WWE with respect to sales of the WWE video games in Japan.
WWE
has demanded that the alleged breaches be cured within the time periods provided
in the video game license, while reserving all of its rights, including its
alleged right of termination of the video game license.
On
April
28, 2006 the joint venture responded, asserting, among other things, that WWE
had acquiesced in the manner of distribution in Japan and the payment of
royalties with respect to such sales and, in addition, had separately released
the joint venture from any claims with respect to such matter, including the
payment of royalties with respect to such sales, and that there is therefore
no
basis for an allegation of a breach of the license agreement. While the joint
venture does not believe that WWE has a valid claim, it tendered a protective
“cure” of the alleged breaches with a full reservation of rights. WWE “rejected”
that cure and reserved its rights.
On
October 12, 2006, WWE commenced a lawsuit in Connecticut state court against
THQ
and THQ/JAKKS Pacific LLC (the “LLC”), involving a claim set forth above
concerning allegedly improper sales of WWE video games in Japan and other
countries in Asia (the “Connecticut Action”). The lawsuit seeks, among other
things, a declaration that WWE is entitled to terminate the video game license
and monetary damages and raised Connecticut Unfair Trade Practices Act (“CUTPA”)
and contract claims against THQ and the LLC. A motion to strike the CUTPA claim
was denied in May 2007.
In
March
2007, WWE filed a motion seeking leave to amend its complaint in the Connecticut
Action to add the principal part of the state law claims present in the WWE
Action to the Connecticut Action. That motion further sought, inter alia, to
add
our Company and Messrs. Friedman, Berman and Bennett (the “Individual
Defendants”) as defendants in the Connecticut Action. The motion was argued on
May 8, 2007 and was granted from the bench, subject to a decision that the
schedule was suspended and no discovery matters would be addressed until
pleading motions were resolved. In June 2007, our Company and the Individual
Defendants moved for a stay of the Connecticut Action, inter
alia,
based
on the pendency of the WWE Action. On July 30, 2007, in light of the
pending motion to dismiss in the WWE Action, the Court ordered a 120-day stay
of
the Connecticut Action (the "Stay"). In November 2007 we moved for a
continuation of the Stay. WWE served discovery and sought leave to file an
amended complaint alleging the state law claims from the WWE Action. Thereafter
we moved for a conference and a stay of discovery. A conference was held on
January 14, 2008 at which WWE was allowed to amend its complaint to assert
the
state law claims set forth in the WWE Action and a briefing schedule was
established with respect to a combined motion to strike and a motion for summary
judgment (the "Dispositive Motion"). The Court subsequently denied the motion
for a protective order except to the extent that we are to submit a response
to
the discovery requests at the end of March 2008. Also, the Court granted
permission for WWE to submit a proposed case management order. WWE did so in
February 2008 and it provided for a trial on or after October 2009. On February
22, 2008, we submitted a response in which we requested that no case management
order be adopted prior to the determination of the Dispositive Motion because
it
would moot such a case management order but that if a case management order
is
to be adopted it should provide for a trial, if the matter is not fully
dismissed, not before June 2010.
We
believe that the claims in the Connecticut Action are without merit and we
intend to defend vigorously against them. However, because this action is in
its
preliminary stage, we cannot assure you as to the outcome of the action, nor
can
we estimate the range of our potential losses. THQ and the LLC have stated
that
they believe the claims in the Connecticut Action prior to the additional claims
in the amended complaint are without merit and intend to defend themselves
vigorously. However, because this action is in its preliminary stage, we cannot
assure you as to the outcome, nor can we estimate the range of our potential
losses, if any.
21
Our
agreement with THQ provides for payment of a preferred return to us in
connection with our joint venture. The preferred return is subject to change
after June 30, 2006 and is to be set for the distribution period beginning
July
1, 2006 and ending December 31, 2009 (the “Next Distribution Period”). The
agreement provides that the parties will negotiate in good faith and agree
to
the preferred return not less than 180 days prior to the start of the Next
Distribution Period. It further provides that if the parties are unable to
agree
on a preferred return, the preferred return will be determined by arbitration.
The parties have not reached an agreement with respect to the preferred return
for the Next Distribution Period and the preferred return is to be determined
through arbitration. On April 30, 2007, THQ filed an action in the Superior
Court, Los Angeles County, to compel arbitration and to appoint an arbitrator
pursuant to the relevant provisions of the agreement. An order was issued that
identified five potential arbitrators. The parties did not agree on an
arbitrator. JAKKS served notices of disqualification on four of the potential
arbitrators; THQ objected; the Court struck the disqualification notices and
appointed an arbitrator, who was then stricken by JAKKS. JAKKS appealed the
Court’s order with respect to the disclosure and disqualification process and
the appellate court took the appeal and stayed the proceedings. The Court
rendered a decision on the matter on February 28, 2008 which decision affirmed
the lower court's decision ruling that disclosure was not required until after
the arbitrator was nominated to serve by the Court. We
are a party to, and certain of our property is the subject of, various other
pending claims and legal proceedings that routinely arise in the ordinary course
of our business, but we do not believe that any of these claims or proceedings
will have a material effect on our business, financial condition or results
of
operations. 22
PART
II
Item
5. Market
for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases
of Equity Securities
Market
Information
Our
common stock is traded on the Nasdaq Global Select exchange under the symbol
“JAKK.” The following table sets forth, for the periods indicated, the range of
high and low sales prices for our common stock on this exchange.
Performance
Graph
The
graph
and tables below display the relative performance of our common stock, the
Russell 2000 Price Index (the “Russell 2000”) and a peer group index, by
comparing the cumulative total stockholder return (which assumes reinvestment
of
dividends, if any) on an assumed $100 investment in our common stock, the
Russell 2000 and the peer group index over the period from January 1, 2003
to December 31, 2007.
In
accordance with recently enacted regulations implemented by the Securities
and
Exchange Commission, we retained the services of an expert compensation
consultant. In the performance of its services, such consultant used
a peer group index for its analysis of our compensation policies. We
believe that these companies represent a cross-section of publicly-traded
companies with product lines and businesses similar to our own throughout the
comparison period and, accordingly, we are using the same peer group for
purposes of the performance graph. Our peer group index includes the following
companies: Activision,
Inc., Electronic Arts, Inc., EMak Worldwide, Inc., Hasbro, Inc., Leapfrog
Enterprises, Inc., Marvel Enterprises, Inc., Mattel, Inc., Russ Berrie and
Company, Inc., RC2 Corp., Take-Two Interactive, Inc. and THQ
Inc.
23
The
historical performance data presented below may not be indicative of the future
performance of our common stock, any reference index or any component company
in
a reference index.
 Annual
Return Percentage
Indexed
Returns
Security
Holders
To
the
best of our knowledge, as of February 27, 2008, there were 179 holders of record
of our common stock. We believe there are numerous beneficial owners of our
common stock whose shares are held in “street name.”
Dividends
We
have
never paid any cash dividends on our common stock. We currently intend to retain
our future earnings, if any, to finance the growth and development of our
business and/or buy back in the market some of our outstanding common stock,
but
may consider implementing a plan to pay cash dividends on our common stock
in
the future.
Equity
Compensation Plan Information
The
table
below sets forth the following information as of the year ended December 31,
2007 for (i) all compensation plans previously approved by our stockholders
and
(ii) all compensation plans not previously approved by our stockholders, if
any: 24
(a)
the
number of securities to be issued upon the exercise of outstanding options,
warrants and rights;
(b)
the
weighted-average exercise price of such outstanding options, warrants and
rights; and
(c)
other
than securities to be issued upon the exercise of such outstanding options,
warrants and rights, the number of securities remaining available for future
issuance under the plans.
Equity
compensation plans approved by our stockholders consists of the 2002 Stock
Award
and Incentive Plan. Equity compensation plans not approved by our security
holders consist of a fully-vested warrant issued by us in 2003 (and expiring
in
2013) in connection with license costs relating to our video game joint
venture.
Item
6. Selected
Financial Data
You
should read the financial data set forth below in conjunction with “Management’s
Discussion and Analysis of Financial Condition and Results of Operations” and
our consolidated financial statements and the related notes (included in Item
8).
In
February 2006, we acquired Creative Designs. Also, effective January
1, 2006, we implemented SFAS 123R, which requires the expensing of share-based
compensation.
In
June
2005, we acquired the Pet
Pal
line of
products. 25
In
June
2004, we acquired Play Along.
Item
7. Management’s
Discussion and Analysis of Financial Condition and Results of
Operations
The
following Management’s Discussion and Analysis of Financial Condition and
Results of Operations contains forward-looking statements that involve risks
and
uncertainties. Our actual results could differ materially from those anticipated
in these forward-looking statements as a result of various factors. You should
read this section in conjunction with our consolidated financial statements
and
the related notes (included in Item 8).
Critical
Accounting Policies
The
accompanying consolidated financial statements and supplementary information
were prepared in accordance with accounting principles generally accepted in
the
United States of America. Significant accounting policies are discussed in
Note
2 to the Consolidated Financial Statements, Item 8. Inherent in the application
of many of these accounting policies is the need for management to make
estimates and judgments in the determination of certain revenues, expenses,
assets and liabilities. As such, materially different financial results can
occur as circumstances change and additional information becomes known. The
policies with the greatest potential effect on our results of operations and
financial position include:
Allowance
for Doubtful Accounts. Our
allowance
for doubtful accounts is based on management’s assessment of the business
environment, customers’ financial condition, historical collection experience,
accounts receivable aging, customer disputes and the collectibility of specific
customer accounts. If there were a deterioration of a major customer’s
creditworthiness, or actual defaults were higher than our historical experience,
our estimates of the recoverability of amounts due to us could be overstated,
which could have an adverse impact on our operating results. The allowance
for
doubtful accounts is also affected by the time at which uncollectible accounts
receivable balances are actually written off.
Major
customers’ accounts are monitored on an ongoing basis; more in depth reviews are
performed based on changes in customer’s financial condition and/or the level of
credit being extended. When a significant event occurs, such as a bankruptcy
filing by a specific customer, and on a quarterly basis, the allowance is
reviewed for adequacy and the balance or accrual rate is adjusted to reflect
current risk prospects.
Revenue
Recognition. Our
revenue recognition policy is to recognize
revenue when persuasive evidence of an arrangement exists, title transfer has
occurred (product shipment), the price is fixed or readily determinable, and
collectibility is probable. We recognize revenue in accordance with Staff
Accounting Bulletin No. 104, “Revenue Recognition.” Sales are recorded net
of sales returns and discounts, which are estimated at the time of shipment
based upon historical data. JAKKS routinely enters into arrangements with its
customers to provide sales incentives, support customer promotions, and provide
allowances for returns and defective merchandise. Such programs are based
primarily on customer purchases, customer performance of specified promotional
activities, and other specified factors such as sales to consumers. Accruals
for
these programs are recorded as sales adjustments that reduce gross revenue
in
the period the related revenue is recognized. Accruals for these programs are
recorded as sales adjustments that reduce gross revenue in the period the
related revenue is recognized.
Goodwill
and other indefinite-lived intangible assets. In
accordance with Statement of Financial Accounting Standards (“SFAS”) 142,
Goodwill
and Other Intangible Assets, goodwill
and indefinite-lived intangible assets are not amortized, but are tested for
impairment at least annually at the reporting unit level.
Factors
we consider important which could trigger an impairment review include the
following:
26
Due
to
the subjective nature of the impairment analysis significant changes in the
assumptions used to develop the estimate could materially affect the conclusion
regarding the future cash flows necessary to support the valuation of long-lived
assets, including goodwill. The valuation of goodwill involves a high degree
of
judgment and consists of a comparison of the fair value of a reporting unit
with
its book value. Based on the assumptions underlying the valuation, impairment
is
determined by estimating the fair value of a reporting unit and comparing that
value to the reporting unit’s book value. If the implied fair value is more than
the book value of the reporting unit, an impairment loss is not indicated.
If
impairment exists, the fair value of the reporting unit is allocated to all
of
its assets and liabilities excluding goodwill, with the excess amount
representing the fair value of goodwill. An impairment loss is measured as
the
amount by which the book value of the reporting unit’s goodwill exceeds the
estimated fair value of that goodwill.
SFAS
No. 142 requires that goodwill be allocated to various reporting units,
which are either at the operating segment level or one reporting level below
the
operating segment, for purposes of evaluating whether goodwill is impaired.
For
2007, JAKKS' reporting units are: Traditional Toys, Craft and Writing, and
Pet
products. Goodwill is allocated within JAKKS' reporting units based on an
allocation of brand-specific goodwill to the reporting units selling those
brands. As of October 1, 2007, JAKKS performed the annual impairment test
required by SFAS No. 142 and determined that its goodwill was not impaired.
There were no events or circumstances that indicated the impairment test should
be performed again at December 31, 2007.
To
determine the fair value of our reporting units, we generally use a present
value technique (discounted cash flow) corroborated by market multiples when
available and as appropriate. The factor most sensitive to change with respect
to our discounted cash flow analyses is the estimated future cash flows of
each
reporting unit which is, in turn, sensitive to our estimates of future revenue
growth and margins for these businesses. If actual revenue growth and/or margins
are lower than our expectations, the impairment test results could differ.
We
applied what we believe to be the most appropriate and consistent valuation
methodology for each of the reporting units. If we had established different
reporting units or utilized different valuation methodologies, the impairment
test results could differ.
Goodwill
and intangible assets amounted to $397.6 million as of December 31,
2007.
Reserve
for Inventory Obsolescence. We
value our inventory at the lower of cost or market. Based upon a consideration
of quantities on hand, actual and projected sales volume, anticipated product
selling prices and product lines planned to be discontinued, slow-moving and
obsolete inventory is written down to its net realizable value.
Failure
to accurately predict and respond to consumer demand could result in the Company
under producing popular items or overproducing less popular items. Furthermore,
significant
changes in demand for our products would impact management’s estimates in
establishing our inventory provision.
Management
estimates are monitored on a quarterly basis and a further adjustment to reduce
inventory to its net realizable value is recorded, as an increase to cost of
sales, when deemed necessary under the lower of cost or market standard.
Income
Allocation for Income Taxes.
Our
income tax provision and related income tax assets and liabilities are based
on
actual income as allocated to the various tax jurisdictions based upon our
transfer pricing study, US and foreign statutory income tax rates, and tax
regulations and planning opportunities in the various jurisdictions in which
the
Company operates. Significant judgment is required in interpreting
tax regulations in the US and foreign jurisdictions, and in evaluating worldwide
uncertain tax positions. Actual results could differ materiality from
those judgments, and changes in judgments could materially affect our
consolidated financial statements.
Income
taxes and interest and penalties related to income tax
payable. We
do not
file a consolidated return with our foreign subsidiaries. We file
federal and state returns and our foreign subsidiaries each file Hong Kong
returns, as applicable. Deferred taxes are provided on a liability
method whereby deferred tax assets are recognized as deductible temporary
differences and operating loss and tax credit carry-forwards and deferred tax
liabilities are recognized for taxable temporary
differences. Temporary differences are the differences between the
reported amounts of assets and liabilities and their tax
basis. Deferred tax assets are reduced by a valuation allowance when,
in the opinion of management, it is more likely than not that some portion
or
all of the deferred tax assets will not be realized. Deferred tax
assets and liabilities are adjusted for the effects of changes in tax laws
and
rates on the date of enactment.
As
of
January 1, 2007, we adopted the provisions of FASB Interpretation No. 48 (“FIN
48”), Accounting
for Uncertainty in Income Taxes,
which
prescribes a recognition threshold and measurement process for recording in
the
financial statements uncertain tax positions taken or expected to be taken
in a
tax return. As of the date of adoption, tax benefits that are subject
to challenge by tax authorities are analyzed and accounted for in the income
tax
provision. The cumulative effect of the potential liability for
unrecognized tax benefits prior to the adoption of FIN 48, along with the
associated interest and penalties, are recognized as a reduction in the January
1, 2007 balance of retained earnings.
We
accrue
a tax reserve for additional income taxes and interest, which may become payable
in future years as a result of audit adjustments by tax
authorities. The reserve is based on management’s assessment of all
relevant information, and is periodically reviewed and adjusted as circumstances
warrant. As of December 31, 2007, our income tax reserves are
approximately $20.3 million and relate to the potential income tax audit
adjustments, primarily in the areas of income allocation and transfer
pricing. 27
We
recognize current period interest expense and the reversal of previously
recognized interest expense that has been determined to not be assessable due
to
the expiration of the related audit period or other compelling factors on the
income tax liability for unrecognized tax benefits as interest expense, and
penalties and penalty reversals related to the income taxes payable as
other expense in our consolidated statements of operations.
Share-Based
Compensation.
We
grant restricted stock and options to purchase our common stock to our employees
(including officers) and non-employee directors under our 2002 Stock Award
and
Incentive Plan (the “Plan”), which incorporated the shares remaining under our
Third Amended and Restated 1995 Stock Option Plan. The benefits provided under
the Plan are share-based payments subject to the provisions of revised Statement
of Financial Accounting Standards No. 123 (Revised) (SFAS 123R), Share-Based
Payment.
Effective January 1, 2006, we began to use the fair value method to apply the
provisions of SFAS 123R. We estimate the value of share-based awards on the
date
of grant using the Black-Scholes option-pricing model. The determination of
the
fair value of share-based payment awards on the date of grant using an
option-pricing model is affected by our stock price, as well as assumptions
regarding a number of complex and subjective variables. These variables include
our expected stock price volatility over the term of the awards, actual and
projected employee stock option exercise behaviors, cancellations, terminations,
risk-free interest rates and expected dividends.
Recent
Developments
In
February 2006, we acquired substantially all of the assets of Creative Designs
International, Ltd. and a related Hong Kong company, Arbor Toys Company Limited
(collectively, “Creative Designs”). The total initial purchase price of $111.1
million consisted of $101.7 million in cash, 150,000 shares of our common stock
at a value of approximately $3.3 million and the assumption of liabilities
in
the amount of $6.1 million. In addition, we agreed to pay an earn-out of up
to
an aggregate amount of $20.0 million in cash over the three calendar years
following the acquisition based on the achievement of certain financial
performance criteria, which will be recorded as goodwill when and if earned.
For
the years ended December 31, 2006 and 2007, $6.9 million and $6.7 million,
respectively, of the earn-out was earned and recorded as
goodwill. Creative Designs is a leading designer and producer of
dress-up and role-play toys and was included in our results of operations from
the date of acquisition.
Results
of Operations
The
following table sets forth, for the periods indicated, certain statement of
operations data as a percentage of net sales.
28
The
following unaudited table summarizes, for the periods indicated, certain income
statement data by segment (in thousands).
Comparison
of the Years Ended December 31, 2007 and 2006
Net
Sales
Traditional
Toys. Net
sales of our Traditional Toys segment were $793.0 million in 2007, compared
to
$692.5 million in 2006, representing an increase of $100.5 million, or
14.5%. The increase in net sales was primarily due to impact of sales
related to our Creative Designs line of products for the full twelve months
ended December 31, 2007, as compared to only a part of the twelve months ended
December 31, 2006 (as a result of the February 2006 acquisition of Creative
Designs), which had incremental sales of $17.4 million, and increases in sales
of WWE and Pokemon action figures and accessories, role-play and dress-up toys,
Bio Bytes ™, Eye Clops™ Bionic Eye, Child Guidance pre-school toys, Hannah
Montana dolls and accessories, In My Pocket toys, Cheetah Girls toys,
Sweet Secrets toys, Funnoodle pool toys and our Fly Wheels XPV® toys, offset in
part by decreases in sales of Dragonball Z ® action figures, JAKKS ™ dolls, Plug
It In & Play TV Games, wheels products, Telestory ®, Vmigo ®, Sky Dancers ®,
Doodle Bears ® Dragon Flyz ™, Trolls ™, Care Bears®, Cabbage Patch Kids®,
Speedstacks ®, Snugglers ™, RC Flight toys and our Go Fly A Kite® and junior
sports products.
Craft/Activity/Writing
Products. Net
Sales of our Craft/Activity/Writing Products were $39.6 million in 2007,
compared to $52.8 million in 2006, representing a decrease of $13.2 million,
or
25.0%. The decrease in net sales was primarily due to decreases in
sales of our Flying Colors and Vivid Velvet activities products and our Pentech
and Color Workshop writing instruments and related products.
Pet
Products. Net
Sales of our Pet Pal line of products were $24.5 million in 2007, compared
to
$20.1 million in 2006, representing an increase of $4.4 million, or
21.9%. The increase is attributable to the expanding line of products
and expanding distribution.
Cost
of Sales
Traditional
Toys. Cost
of sales of our Traditional Toys segment was $490.3 million, or 61.8% of related
net sales, in 2007, compared to $429.4 million, or 62.0% of related net sales,
in 2006, representing an increase of $60.9 million, or 14.2%. The
increase primarily consisted of an increase in product costs of $41.1 million,
which is in line with the higher volume of sales. Product costs as a
percentage of sales decreased primarily due to the mix of the product sold
with
lower product cost. Furthermore, royalty expense for our Traditional
Toys segment increased by $16.9 million and as a percentage of net sales due
to
changes in the product mix to more products with higher royalty rates from
products with lower royalty rates or proprietary products with no royalty
rates. Additionally, certain royalty advances and guarantees were
written off for licensed product whose sell-off period had expired or was
projected to not recoup the advances through future sales or meet its
contractual minimum guaranty. Our depreciation of molds and tools
increased by $2.9 million due to the depreciation of new products being sold
in
this segment. 29
Craft/Activity/Writing
Products. Cost
of sales of our Craft/Activity/Writing Products segment was $27.0 million,
or
68.1% of related net sales, in 2007, compared to $29.0 million, or 55.0% of
related net sales, in 2006, representing a decrease of $2.0 million, or
6.9%. The decrease consisted of a decrease in product costs of $2.2
million, which is in line with the lower volume of sales. Product
costs as a percentage of net sales increased primarily due to the mix of the
product sold and sell-off of closeout
product. Royalty expense increased by $0.3 million
and as a percentage of net sales due to changes in the product mix to more
products with higher royalty rates from products with lower royalty rates or
proprietary products with no royalty rates. Additionally, certain royalty
advances and guarantees were written off for licensed product whose sell-off
period had expired or was projected to not recoup the advances through future
sales or meet its contractual minimum guaranty. Our depreciation of
molds and tools decreased by $0.2 million due to lower level of product in
this
segment requiring molds and tools.
Pet
Products. Cost
of sales of our Pet Pal line of products was $16.2 million, or 66.2% of related
net sales, in 2007, compared to $12.1 million, or 60.5% of related net sales,
in
2006, representing an increase of $4.1 million, or 33.9%. The
increase primarily consisted of an increase in product costs of $3.5 million,
which is in line with the higher volume of sales. Product costs as a
percentage of net sales increased primarily due to the mix of the product
sold. Royalty expense increased by $0.4 million, which was in line
with the higher volume of sales. Additionally, our depreciation of
molds and tools was comparable year-over-year.
Selling,
General and Administrative Expenses
Selling,
general and administrative expenses were $216.7 million in 2007 and $202.5
million in 2006, constituting 25.3% and 26.5% of net sales,
respectively. The overall increase of $14.2 million in such costs was
primarily due to increases in general and administrative expenses ($16.8
million), the incremental overhead related to a full quarter impact of
operations of Creative Designs ($1.5 million) for the three months ended March
31, 2007 (as compared to a partial quarter of operations for the three months
ended March 31, 2006 as a result of the February 2006 acquisition thereof),
product development ($2.2 million) and stock based compensation ($2.6 million),
offset in part by decreases in other selling expenses ($7.0
million), and amortization expense related to intangible assets other
than goodwill ($1.9 million). The increase in general and
administrative expenses is primarily due to an increase in salary and payroll
taxes ($5.8 million) to support our growing business which includes a lower
allocation of JAKKS’ overhead to the video game joint venture ($1.2 million),
bonus expense ($10.6 million) based on a stronger EPS growth in 2007
compared to 2006, donations expense (2.1 million), rent expense ($1.1 million)
and travel and entertainment expense ($0.8 million), offset in part by decreases
in other expenses as a result of the reversal of FIN 48 penalties related to
income taxes payable ($0.6 million) and the buyout of our New York showroom
lease ($1.3 million) and legal and other professional fees ($1.4
million). The
decrease in direct selling expenses is primarily due to a decrease in
advertising and promotional expenses of $10.9 million in 2007 in support of
several of our product lines, offset in part by an increase in sales commissions
($1.2 million) and other direct selling expenses ($2.7 million). From
time to time, we may increase or decrease our advertising efforts, if we deem
it
appropriate for particular products.
Profit
from Video Game Joint Venture
Profit
from our video game joint venture in 2007 increased to $21.1 million, as
compared to $13.2 million in 2006, due to the strong performance of the new
Smackdown vs. Raw 2007 game and stronger sales of existing titles in 2007
compared to 2006. Furthermore, we devoted and allocated $1.2 million less of
JAKKS’ overhead to the video game joint venture. The amount of the
preferred return we will receive from the joint venture after June 30, 2006
became subject to change (see “Risk Factors”, infra,
and
Note 4 of the Notes to Consolidated Financial Statements, supra).
Interest
Income
Interest
income in 2007 was $6.8 million, as compared to $4.9 million in
2006. The increase is due to higher average cash balances and higher
interest rates during 2007 compared to 2006.
Interest
Expense
Interest
expense was $5.5 million and $4.5 million for 2007 and 2006, respectively.
The
increase is due to net interest accrued pursuant to our January 1, 2007 adoption
of the provisions of FIN 48. Interest expense of $4.5 million related to our
convertible senior notes payable were comparable in 2007 and 2006.
Provision
for Income Taxes
Provision
for income taxes includes federal, state and foreign income taxes at effective
tax rates of 31.7% in 2006, and 31.3% in 2007, benefiting from a flat 17.5%
tax
rate on the Company’s income arising in, or derived from, Hong Kong for each of
2006 and 2007. The effective rate in 2007 reflects the recognition of
certain discrete income tax adjustments recognized in the quarter ended
September 30, 2007. These adjustments included the reconciliation of
the 2006 income tax provision to the actual income tax liability as reflected
in
the Company’s income tax return, and the reduction in income tax expense due to
the recognition of a previously recorded potential income tax liability for
uncertain tax positions that are no longer subject to audit due to the closure
of the audit period. These discrete items resulted in approximately a
2.1% reduction in the effective income tax rate for the twelve months ended
December 31, 2007. As of December 31, 2007, the Company had net
deferred tax assets of approximately $7.3 million for which an allowance of
$0.9
million has been provided since, in the opinion of management, realization
of
the future benefit is uncertain. 30
Comparison
of the Years Ended December 31, 2006 and 2005
Net
Sales
Traditional
Toys. Net
sales of our Traditional Toys segment were $692.5 million in 2006, compared
to
$589.7 million in 2005, representing an increase of $102.8 million or
17.4%. The increase in net sales was primarily due to the addition of
the Creative Designs line of products, which we acquired in February 2006,
with
sales of $181.1 million and increases in sales of WWE actions figures and
accessories, Doodle Bear, Speed Stacks, Snugglers, Dragonflyz, Trolls, Fly
Wheels XPV and Flight toys and our Funnoodle pool toys, offset in part by
decreases in sales of Plug It In & Play TV Games, wheels products, dolls,
Sky Dancers, Care Bears, Cabbage Patch Kids, Go Fly A Kite and junior sports
products.
Craft/Activity/Writing
Products. Net
Sales of our Craft/Activity/Writing Products were $52.8 million in 2006,
compared to $62.0 million in 2005, representing a decrease of $9.2 million
or
14.8%. The decrease in net sales was primarily due to decreases in
sales of our Flying Colors activities and our Pentech and Color Workshop writing
instruments and related products, offset in part by an increase in sales of
our
Creepy Crawlers® activity sets.
Pet
Products. Net
Sales of our Pet Pal line of products, which we acquired in June 2005, were
$20.1 million in 2006, compared to $9.8 million in 2005, representing an
increase of $10.3 million or 105.1%. The increase is attributable to
the growth in sales of this new line of products through our existing
distribution channels and having sales for the entire year in 2006.
Cost
of Sales
Traditional
Toys. Cost
of sales of our Traditional Toys segment was $429.4 million in 2006, compared
to
$348.6 million in 2005, representing an increase of $80.8 million or
23.2%. The increase primarily consisted of an increase in product
costs of $74.5 million, which is in line with the higher volume of
sales. Furthermore, royalty expense for our Traditional Toys segment
decreased by $1.5 million and as a percentage of net sales due to changes in
the
product mix to more products with lower royalty rates or proprietary products
with no royalty rates, from products with higher royalty
rates. Product costs as a percentage of sales increased due to the
mix of the product sold and sell-through of closeout product. Our
depreciation of molds and tools increased by $7.9 million due to new products
being sold in this segment.
Craft/Activity/Writing
Products. Cost
of sales of our Craft/Activity/Writing Products was $29.0 million in 2006,
compared to $39.9 million in 2005, representing a decrease of $10.9 million
or
27.3%. The decrease primarily consisted of decreases in product costs
of $8.6 million and royalty expense of $2.2 million, which were in line with
the
lower volume of sales. Additionally, our depreciation of molds and
tools was comparable year-over-year.
Pet
Products. Cost
of sales of our Pet Pal line of products, which we acquired in June 2005, was
$12.1 million in 2006, compared to $6.3 million in 2005, representing an
increase of $5.8 million or 92.1%. The increase primarily consisted
of increases in product costs of $4.8 million and royalty expense of $0.8
million, which were in line with the higher volume of
sales. Additionally, our depreciation of molds and tools increased by
$0.3 million.
Selling,
General and Administrative Expenses
Selling,
general and administrative expenses were $202.5 million in 2006 and $178.7
million in 2005, constituting 26.5% and 27.0% of net sales,
respectively. The overall increase of $23.8 million in such costs was
primarily due to the addition of overhead related to the operations of Creative
Designs ($20.3 million), increases in product development ($2.7 million),
amortization expense related to intangible assets other than goodwill ($7.4
million) and stock-based compensation ($3.1 million), offset in part by a
decrease in other selling expenses ($12.0 million). Increased grants
of restricted stock awards to our non-employee directors and the increase in
the
price of our common stock in 2006 compared to 2005 resulted in stock-based
compensation expense of $6.5 million in 2006, compared to $3.4 million in
2005. The decrease in direct selling expenses is primarily due to
efficiencies gained by closing two third-party warehouses, and decreases in
sales commission expense of $1.9 million and advertising and promotional
expenses of $6.4 million in 2006 in support of several of our product
lines. From time to time, we may increase or decrease our advertising
efforts, if we deem it appropriate for particular products.
Profit
from Video Game Joint Venture
Profit
from our video game joint venture in 2006 increased to $13.2 million, as
compared to $9.4 million in 2005, due to the strong performance of the three
new
games released and stronger sales of existing titles in 2006, offset by the
reduction of $0.1 million to THQ for their share of profit on our sales of
WWE
themed Plug It In & Play TV Games compared to 2005, in which period four new
games were released and $0.8 million was earned by THQ for the WWE themed Plug
It In & Play TV Games. The amount of the preferred return we will receive
from the joint venture after June 30, 2006 is subject to change (see “Risk
Factors” and “World Wrestling Entertainment Video Games”). 31
Other
Expense
Other
expense in 2005 of $1.4 million related to the write-off of an investment in
a
Chinese joint venture. There was no such expense in
2006.
Interest
Income
Interest
income in 2006 was $4.9 million, as compared to $5.2 million in
2005. This decrease is due to lower average cash balances in 2006 as
a result of our acquisition of Creative Designs, offset in part by higher
interest rates during 2006 compared to 2005.
Interest
Expense
Interest
expense in 2006 of $4.5 million related to the convertible senior notes payable
was comparable to 2005.
Provision
for Income Taxes
Provision
for income taxes included federal, state and foreign income taxes at effective
tax rates of 34.3% in 2005 and 31.7% in 2006, benefiting from a flat 17.5%
Hong
Kong Corporation Tax on our income arising in, or derived from, Hong Kong for
each of 2005 and 2006. The decrease in the effective tax rate in 2006 is due
to
the effect, in 2005, of a one-time repatriation of undistributed earnings from
our international subsidiaries, which created additional taxes in 2005 on 15%
of
the dividends received. As of December 31, 2006, we had net deferred tax assets
of approximately $8.2 million for which an allowance of $0.9 million has been
provided since, in the opinion of management, realization of this portion of
the
future benefit is uncertain.
Quarterly
Fluctuations and Seasonality
We
have
experienced significant quarterly fluctuations in operating results and
anticipate these fluctuations in the future. The operating results for any
quarter are not necessarily indicative of results for any future period. Our
first quarter is typically expected to be the least profitable as a result
of
lower net sales but substantially similar fixed operating expenses. This is
consistent with the performance of many companies in the toy
industry.
The
following table presents our unaudited quarterly results for the years
indicated. The seasonality of our business is reflected in this quarterly
presentation.
During
the fourth quarter of 2005, we recorded a non-cash charge, which impacted net
income, of $3.6 million for restricted stock, and we repatriated $105.5 million
from our Hong Kong subsidiaries which resulted in incremental income tax expense
of $5.4 million and reduced net income.
During
2007, we recorded net interest expense of $0.9 million related to FIN
48.
32
Recent
Accounting Standards
In
June
2006, the Financial Accounting Standards Board issued FASB Interpretation No.
48
(“FIN 48”), Accounting
for Uncertainty in Income Taxes,
which
prescribes a recognition threshold and measurement process for recording in
the
financial statements uncertain tax positions taken or expected to be taken
in a
tax return. Under FIN 48, the tax benefit of uncertain tax positions
may be recognized only if it is more likely than not that the tax position
will
be sustained, based solely on its technical merits presuming the tax authority
has full knowledge of all relevant information. Additionally, FIN 48
provides guidance on the de-recognition, classification, and accounting in
interim periods and disclosure requirements for uncertain tax
positions. In the first quarter of 2007, we adopted FIN 48 which
resulted in the recognition of an increased current and non-current income
tax
payable for unrecognized tax benefits of $15.6 million. We have also
recognized an additional liability of $2.5 million for penalties and $2.8
million for interest on the income tax liability. These increases to
the liabilities resulted in a reduction of $19.1 million to the January 1,
2007
balance of retained earnings, net of related tax benefits. Current
interest on income tax liabilities is recognized as interest expense and
penalties on income tax liabilities are recognized as other expense in the
consolidated statement of income. During the year ended December 31,
2007, we accrued an additional $0.9 million of net interest
expense.
In
December 2007, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard No. 141 (Revised) (“FAS 141(R)”), Business
Combinations.
The
provisions of this statement are effective for business combinations for which
the acquisition date is on or after the beginning of the first annual reporting
period beginning after December 15, 2008. Earlier application is not permitted.
FAS141(R) replaces FAS 141 and provides new guidance for valuing assets and
liabilities acquired in a business combination. We will adopt FAS141(R) in
calendar year 2009.
In
September 2006, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard No. 157 (“FAS 157”) Fair
Value Measurements.
This
standard provides new definitions for fair value and establishes a framework
for
measuring fair value in financial statements. FAS 157 becomes effective for
us
as of January 1, 2008. We anticipate that the effect of the adoption of FAS
157
will be immaterial to our financial statements.
Liquidity
and Capital Resources
As
of
December 31, 2007, we had working capital of $355.7 million, as compared to
$280.4 million as of December 31, 2006. This increase was primarily attributable
to our operating activities, offset in part by the disbursement of earn-out
payments related to our Play Along, Creative Designs and Pet Pal
acquisitions.
Operating
activities provided net cash of $87.7 million in the year ended December 31,
2007, as compared to $63.7 million in 2006. Net cash was provided primarily
by
net income of $90.0 million and non-cash charges and changes in working capital.
Accounts receivable turnover as measured by days sales outstanding in accounts
receivable for the three months ended December 31, 2007 decreased from
approximately 58 days as of December 31, 2006 to approximately 55 days as of
December 31, 2007 primarily due to the larger volume of sales for the quarter
ended December 31, 2007 compared to the volume of sales for the quarter ended
December 31, 2006. Other than open purchase orders, issued in the normal course
of business, we have no obligations to purchase finished goods from our
manufacturers. As of December 31, 2007, we had cash and cash equivalents of
$241.3 million.
Our
investing activities used cash of $33.7 million in the year ended December
31,
2007, as compared to $121.9 million in 2006, consisting primarily of cash paid
for the Creative Designs earn-out of $6.7 million, the Play Along earn-out
of
$6.7 million, the Pet Pal earn-out of $2.0 million and the purchase of office
furniture and equipment and molds and tooling of $18.1 million used in the
manufacture of our products and other assets. In 2006, our investing activities
consisted primarily of cash paid for the purchase of net assets in the Creative
Designs acquisition of $101.7 million, the Play Along earn-out of $6.7 million,
the Pet Pal earn-out of $1.5 million and the purchase of office furniture and
equipment and molds and tooling of $11.2 million used in the manufacture of
our
products and other assets. As part of our strategy to develop and
market new products, we have entered into various character and product licenses
with royalties generally ranging from 1% to 14% payable on net sales of such
products. As of December 31, 2007, these agreements required future aggregate
minimum guarantees of $38.2 million, exclusive of $26.2 million in advances
already paid. Of this $38.2 million future minimum guarantee, $21.3
is due over the next twelve months. We do not have any significant
capital expenditure commitments as of December 31, 2007.
Our
financing activities provided net cash of $2.8 million in the year ended
December 31, 2007, as compared to $3.1 million in 2006. In 2007, cash was
primarily provided from the exercise of stock options and the tax benefit from
stock options exercised. In 2006, cash was primarily provided from the exercise
of stock options and the tax benefit from stock options exercised.
33
The
following is a summary of our significant contractual cash obligations for
the
periods indicated that existed as of December 31, 2007 and is based on
information appearing in the notes to the consolidated financial statements
(in
thousands):
The
above
table excludes any potential uncertain income tax liabilities that may become
payable upon examination of the Company’s income tax returns by taxing
authorities. Such amounts and periods of payment cannot be reliably estimated.
See Note 12 to the financial statements for further explanation of the Company’s
uncertain tax positions. The above table also excludes our contractual
obligation with one of our executives regarding his retirement plan. Such
amounts and periods of payment cannot be reliably estimated. See Note 15 to
the
financial statements for further explanation of the Company’s retirement plan
commitment.
In
February 2008, our Board of Directors authorized us to repurchase up to $30.0
million of our common stock. To date, no shares have been repurchased by
us.
In
October 2004, the American Jobs Creation Act of 2004 (the “Act”) was signed into
law. The Act created a one-time incentive for U.S. corporations to repatriate
undistributed earnings from their international subsidiaries by providing an
85%
dividends-received deduction for certain international earnings. The deduction
was available to corporations during the tax year that included October 2004,
or
in the immediately subsequent tax year. In the fourth quarter of 2005, our
Board
of Directors approved a plan to repatriate $105.5 million in foreign earnings,
which was completed in December 2005. The federal and state income tax expense
related to this repatriation was approximately $5.4 million.
In
October 2004, we were named as a defendant in a lawsuit commenced by WWE (the
“WWE Action”). The complaint also named as defendants, among others, the joint
venture with THQ Inc., certain of our foreign subsidiaries and our three
executive officers. The complaint was dismissed and an appeal has been filed
with respect to the Judgment dismissing the WWE Action. In November 2004,
several purported class action lawsuits were filed in the United States District
Court for the Southern District of New York, alleging damages associated with
the facts alleged in the WWE Action. In January 2008, the complaint was
dismissed without prejudice to seeking leave to file an amended complaint.
Such
leave was sought in February 2008. Three shareholder derivative actions have
also been filed against us, nominally, and against certain of our Board members
(the “Derivative Actions”). The Derivative Actions seek to hold the individual
defendants liable for damages allegedly caused to our Company by their actions,
and, in one of the Derivative Actions, seeks restitution to our Company of
profits, benefits and other compensation obtained by them. In October
2006, WWE commenced a lawsuit against THQ and the joint venture concerning
allegedly improper sales of WWE video games in Japan and other countries in
Asia, seeking among other things, a declaration that WWE is entitled to
terminate its video games license with the joint venture and monetary damages
(the “Connecticut Action”). In spring 2007, WWE amended the complaint in the
Connecticut Action to allege the matters set forth in the WWE Action.
Thereafter, WWE amended the complaint in the Connecticut Action to allege state
claim laws that had been alleged in the WWE Action. WWE submitted a proposed
case management order in February 2008 and it provided for a trial on or after
October 2009. On February 22, 2008, we submitted a response in which we
requested that no case management order be adopted prior to the determination
of
the motion to strike and for summary judgment because it would moot such a
case
management order but that if a case management order is to be adopted it should
provide for a trial, if the matter is not fully dismissed, not before June
2010.
See
“Legal Proceedings.”
In
June
2005, we purchased substantially all of the operating assets and assumed certain
liabilities relating to the Pet Pal line of pet products, including toys, treats
and related pet products. The total initial purchase price of $10.6 million
was
paid in cash. In addition, we agreed to pay an earn-out of up to an aggregate
amount of $25.0 million in cash over the three years ending June 30, 2008
following the acquisition based on the achievement of certain financial
performance criteria, which will be recorded as goodwill when and if
earned. During the years ended December 31, 2006 and 2007, $1.5
million and $2.0 million, respectively, of the earn-out was earned and recorded
as goodwill. Goodwill of $4.6 million arose from this transaction,
which represents the excess of the purchase price over the fair value of assets
acquired less liabilities assumed. This acquisition expands our product
offerings and distribution channels. Our results of operations have included
Pet
Pal from the date of acquisition.
In
February 2006, we acquired substantially all of the assets of Creative Designs.
The total initial purchase price of $111.1 million consisted of $101.7 million
in cash, 150,000 shares of our common stock at a value of approximately $3.3
million and the assumption of liabilities in the amount of $6.1 million. In
addition, we agreed to pay an earn-out of up to an aggregate amount of $20.0
million in cash over the three calendar years following the acquisition based
on
the achievement of certain financial performance criteria, which will be
recorded as goodwill when and if earned. For the years ended December 31, 2006
and 2007, $6.9 million and $6.7 respectively, of the earn-out was earned and
recorded as goodwill. Creative Designs is a leading designer and
producer of dress-up and role-play toys and is included in our results of
operations from the date of acquisition. 34
In
June
2003, we sold an aggregate of $98.0 million of 4.625% Convertible Senior Notes
due June 15, 2023. The notes may be converted into shares of our common stock
at
an initial conversion price of $20.00 per share, or 50 shares per note, subject
to certain circumstances. The notes may be converted in each quarter subsequent
to any quarter in which the closing price of our common stock is at or above
a
prescribed price for at least 20 trading days in the last 30 trading day period
of the quarter. The prescribed price for the conversion trigger is
$24.00 through June 30, 2010, and increases nominally each quarter
thereafter. Cash interest is payable at an annual rate of 4.625% of
the principal amount at issuance, from the issue date to June 15, 2010, payable
on June 15 and December 15 of each year, commencing on December 15, 2003. After
June 15, 2010, interest will accrue at the same rate on the outstanding notes
until maturity. At maturity, we will redeem the notes at their accreted
principal amount, which will be equal to $1,811.95 (181.195%) per $1,000
principal amount at issuance, unless redeemed or converted
earlier. The notes were not convertible as of December 31, 2007, but
are convertible in the first quarter of 2008.
We
may
redeem the notes at our option in whole or in part beginning on June 15, 2010,
at 100% of their accreted principal amount plus accrued and unpaid interest,
if
any, payable in cash. Holders of the notes may also require us to repurchase
all
or part of their notes on June 15, 2010, for cash, at a repurchase price of
100%
of the principal amount per note plus accrued and unpaid interest, if any.
Holders of the notes may also require us to repurchase all or part of their
notes on June 15, 2013 and June 15, 2018 at a repurchase price of 100% of the
accreted principal amount per note plus accrued and unpaid interest, if any.
Any
repurchases at June 15, 2013 and June 15, 2018 may be paid in cash, in shares
of
common stock or a combination of cash and shares of common stock.
We
believe that our cash flows from operations and cash and cash equivalents will
be sufficient to meet our working capital and capital expenditure requirements
and provide us with adequate liquidity to meet our anticipated operating needs
for at least the next 12 months. Although operating activities are expected
to
provide cash, to the extent we grow significantly in the future, our operating
and investing activities may use cash and, consequently, this growth may require
us to obtain additional sources of financing. There can be no assurance that
any
necessary additional financing will be available to us on commercially
reasonable terms, if at all. We intend to finance our long-term liquidity
requirements out of net cash provided by operations and net cash and cash
equivalents. As of December 31, 2007, we do not have any off-balance
sheet arrangements.
Exchange
Rates
Sales
from our United States and Hong Kong operations are denominated in U.S. dollars
and our manufacturing costs are denominated in either U.S. or Hong Kong dollars.
Operations and operating expenses of all of our operations are denominated
in
local currency, thereby creating exposure to changes in exchange rates. Changes
in the Hong Kong dollar/U.S. dollar exchange rate may positively or negatively
affect our operating results. The exchange rate of the Hong Kong dollar to
the
U.S. dollar has been fixed by the Hong Kong government since 1983 at HK$7.80
to
US$1.00 and, accordingly, has not represented a currency exchange risk to the
U.S. dollar. We cannot assure you that the exchange rate between the United
States and Hong Kong currencies will continue to be fixed or that exchange
rate
fluctuations between the United States and Hong Kong currencies will not have
a
material adverse effect on our business, financial condition or results of
operations.
Item
7A. Quantitative
and Qualitative Disclosures About Market Risk
Market
risk represents the risk of loss that may impact our financial position, results
of operations or cash flows due to adverse changes in financial and commodity
market prices and rates. We are exposed to market risk in the areas of changes
in United States and international borrowing rates and changes in foreign
currency exchange rates. In addition, we are exposed to market risk in certain
geographic areas that have experienced or remain vulnerable to an economic
downturn, such as China. We purchase substantially all of our inventory from
companies in China, and, therefore, we are subject to the risk that such
suppliers will be unable to provide inventory at competitive prices. While
we
believe that, if such an event were to occur we would be able to find
alternative sources of inventory at competitive prices, we cannot assure you
that we would be able to do so. These exposures are directly related to our
normal operating and funding activities. To date, we have not used derivative
instruments or engaged in hedging activities to minimize our market
risk.
Interest
Rate Risk
In
June
2003, we issued convertible senior notes payable of $98.0 million with a fixed
interest rate of 4.625% per annum, which remain outstanding as of December
31,
2007. Accordingly, we are not generally subject to any direct risk of loss
arising from changes in interest rates. 35
Foreign
Currency Risk
We
have
wholly-owned subsidiaries in Hong Kong and China. Sales are made by these
operations on FOB China or Hong Kong terms and are denominated in U.S. dollars.
However, purchases of inventory and Hong Kong operating expenses are typically
denominated in Hong Kong dollars and local operating expenses in China are
denominated in local currency, thereby creating exposure to changes in exchange
rates. Changes in the Chinese Yuan or Hong Kong dollar/U.S. dollar exchange
rates may positively or negatively affect our gross margins, operating income
and retained earnings. A gain in Hong Kong dollars gave rise to the
other comprehensive loss in the balance sheet at December 31, 2007. The exchange
rate of the Hong Kong dollar to the U.S. dollar has been fixed by the Hong
Kong
government since 1983 at HK$7.80 to US$1.00 and, accordingly, has not
represented a currency exchange risk to the U.S. dollar. We do not believe
that
near-term changes in these exchange rates, if any, will result in a material
effect on our future earnings, fair values or cash flows, and therefore, we
have
chosen not to enter into foreign currency hedging transactions. We cannot assure
you that this approach will be successful, especially in the event of a
significant and sudden change in the value of the Hong Kong dollar or Chinese
Yuan. 36
Item
8. Consolidated
Financial Statements and Supplementary Data
Report
of Independent Registered Public Accounting Firm
The
Board
of Directors and Stockholders
JAKKS
Pacific, Inc.
Malibu,
California
We
have
audited the accompanying consolidated balance sheets of JAKKS Pacific, Inc.
(the
“Company”) as of December 31, 2007 and 2006 and the related consolidated
statements of income, other comprehensive income, stockholders’ equity and cash
flows for the years then ended. These financial statements are the
responsibility of the Company’s management. Our responsibility is to express an
opinion on these 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 audits to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures
in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In
our
opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of JAKKS Pacific, Inc. as of December
31, 2007 and 2006, and the results of its operations and its cash flows for
the
years then ended, in conformity with accounting principles generally accepted
in
the United States of America.
As
more
fully described in Note 2 to the consolidated financial statements, effective
January 1, 2007, the Company adopted the provisions of FASB Interpretation
No.
48, “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB
Statement No. 109,” and effective January 1, 2006, the Company adopted the
provisions of Statement of Financial Accounting Standards No. 123(R),
“Share-Based Payment.”
We
also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), JAKKS Pacific, Inc.’s internal control over
financial reporting as of December 31, 2007, based on criteria established
in
Internal
Control - Integrated Framework
issued
by the Committee of Sponsoring Organizations of the Treadway Commission (COSO)
and our report dated February 28, 2008 expressed an unqualified opinion
thereon.
37
REPORT
OF
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The
Board
of Directors and Stockholders
JAKKS
Pacific, Inc. and Subsidiaries
We
have
audited the accompanying consolidated statements of income, other comprehensive
income, stockholders’ equity, and cash flows and the financial statement
schedule of JAKKS Pacific, Inc. and Subsidiaries (Company) for the year ended
December 31, 2005. These financial statements are the responsibility
of the Company’s management. Our responsibility is to express an
opinion on these financial statements 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
the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation. We believe that our audit provides a reasonable basis
for our opinion.
In
our
opinion, the consolidated financial statements and schedule referred to above
present fairly, in all material respects, the results of operations and cash
flows of JAKKS Pacific, Inc. and Subsidiaries for the year ended December 31,
2005 in conformity with accounting principles generally accepted in the United
States of America.
PKF
Certified
Public Accountants
A
Professional Corporation
Los
Angeles, California
February
13, 2006 38
JAKKS
PACIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED
BALANCE SHEETS
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