DSI TOYS INC - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED: COMMISSION FILE NUMBER:
DECEMBER 31, 2001 0-22545

DSI TOYS, INC.
(Exact name of Registrant as specified in its charter)

TEXAS 74-1673513
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)

1100 WEST SAM HOUSTON PARKWAY, NORTH
HOUSTON, TEXAS 77043
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: (713) 365-9900

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

Title of each class Name of each exchange on which registered
------------------- -----------------------------------------
Common Stock, $.01 par value Nasdaq

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

None

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

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

The aggregate market value of the voting common stock held by
non-affiliates of the Registrant as of March 15, 2002 was $1,934,209.

As of March 15, 2002 there were 9,066,365 shares of common stock, $.01 par
value, outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive Proxy Statement for the registrant's 2002 Annual
Meeting of Shareholders to be held on June 18, 2002, are incorporated by
reference in Part III of this Form 10-K.

TABLE OF CONTENTS

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PART I

ITEM 1. BUSINESS

GENERAL DEVELOPMENT OF THE BUSINESS

Except as otherwise indicated, references to the "Company" refer to DSI
Toys, Inc. and its four wholly owned Hong Kong subsidiaries, DSI(HK) Limited
("DSI(HK)"), Meritus Industries Limited, RSP Products Limited and Elite Dolls
Limited. The terms "fiscal year" and "fiscal" refer to the Company's fiscal year
which is the year ending December 31 of the calendar year mentioned (e.g., a
reference to fiscal 2001 is a reference to the fiscal year ended December 31,
2001). Effective December 31, 1999, the Company changed its fiscal year end from
January 31 to a calendar year end.

The Company designs, develops, markets and distributes high quality,
innovative dolls, toys and consumer electronics products. Core products include
TECH-LINK -Registered Trademark- communications products, KAWASAKI
- -Registered Trademark- electronic musical instruments, GEARHEAD -TM- remote
control vehicles, the LAZERDOODLE -TM- electronic drawing toy and a full range
of special feature doll brands including SASSY SECRETS -TM-, SOMERSAULT
SARA -TM-, TOO CUTE TWINS -TM-, CHILDHOOD VERSES -TM-, PRIDE & JOY -Registered
Trademark-, LITTLE DARLINGS -Registered Trademark-, along with interactive plush
products including KITTY KITTY KITTENS -Registered Trademark-, FRISKY KITTENS
- -TM-, PUPPY PUPPY PUPPIES -Registered Trademark-, and girls' activity products,
AIR NAILS SALON -TM-, and TWIST AND TWIRL BRAIDER -TM-.

The Company was incorporated in Texas in 1970. Its executive offices are
located at 1100 West Sam Houston Parkway North, Houston, Texas,
telephone (713) 365-9900. The Company maintains its primary worldwide website at
www.dsitoys.com.

MERITUS ACQUISITION

Effective January 7, 2000, the Company acquired by way of merger Meritus
Industries, Inc. ("Meritus"), a privately held toy manufacturer, engaged in the
manufacturing and marketing of dolls, doll houses, doll accessories, and girls'
toys. As a result of the merger, the Company added the FOREVER GIRL FRIENDS
- -Registered Trademark- brand accessories for 11-1/2" fashion dolls, and LITTLE
DARLINGS -Registered Trademark- brand value-priced action feature dolls to its
product offerings, as well as the ELITE DOLLS -TM- brand, which was created by
Meritus specifically to manufacture and market LIFETIME PLAY DOLLS -TM-, a line
of exquisite 18" dolls and accessories suitable for playing or collecting.

The Company also acquired with the merger with Meritus, three
wholly-owned Hong Kong subsidiaries: Meritus Industries Limited, RSP Products
Limited, and Elite Dolls Limited, which were engaged in doll manufacturing
operations. The Company has transferred the operations of these entities to DSI
(HK) and is in the process of liquidating the three acquired subsidiaries.

DESCRIPTION OF BUSINESS SEGMENTS AND PRODUCTS

The Company has three major product categories which represent the
Company's operating segments: Juvenile Audio Products, Girls' Toys and Boys'
Toys. Notwithstanding the foregoing, because these operating segments all have
similar economic characteristics, the Company has one reportable business
segment. For additional information with respect to the Company's business
segment reporting, see Note 12 to the Consolidated Financial Statements.

JUVENILE AUDIO PRODUCTS

The Juvenile Audio Product category consists of Youth Communications
products and Musical Instruments. Products in the Youth Communications line
include walkie-talkies, wrist watch walkie-talkies, audio products and novelty
electronic products. The category brands include TECH-LINK -Registered
Trademark- and MICRO LINK -TM- communications products, Harley-Davidson
- -Registered Trademark- walkie-talkies and bike alarms, and the Company's new
BIOSCAN -TM-

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ROOM GUARDIAN -TM-, and the LAZERDOODLE -TM- electronic drawing toy. The Musical
Instrument line includes the branded line of KAWASAKI -Registered Trademark-
guitars, drum pads, saxophones and keyboards.

GIRLS' TOYS

The Girls' Toys product category includes dolls, interactive plush toys,
play sets, accessories, and girls' activity toys. The Girls' Toys portfolio of
brands includes SASSY SECRETS -TM-, SOMERSAULT SARA -TM-, TOO CUTE TWINS -TM-,
CHILDHOOD VERSES -TM-, PRIDE & JOY -Registered Trademark-, LITTLE DARLINGS
- -Registered Trademark-, along with interactive plush products including KITTY
KITTY KITTENS -Registered Trademark-, FRISKY KITTENS -TM-, PUPPY PUPPY PUPPIES
- -Registered Trademark-, and girls' activity products, AIR NAILS SALON -TM-, and
TWIST AND TWIRL BRAIDER -TM-.

BOYS' TOYS

The Boys' Toys product category includes radio control and infra-red
control vehicles. The brands in this product category are GEARHEAD -TM- radio
control vehicles, including the INSECTOR -Registered Trademark-, and the unique
ultra-articulated STREET SAVAGE -TM-. The GEARHEAD -TM- brand also includes
GEARHEAD -TM- JR. infra-red control vehicles.

PRODUCT INTRODUCTIONS

New product introductions during 2001 included Kawasaki Mega Chords
Guitar, Kawasaki Mega Deluxe Drum Pad, TOO CUTE TWINS -TM-, and SUSIE SO
SMART -TM- interactive electronic dolls; KITTY KITTY KITTENS -Registered
Trademark- plush toys and the unique STREET SAVAGE -TM- radio control vehicle.

The following table depicts the Company's net sales, as a percentage of
total net sales, by product category for the fiscal years indicated.

The significant increase in Girls' Toys as a percentage of net sales
reflects the acquisition of Meritus and its product lines in January 2000.
Meritus was engaged in the development, manufacture and marketing of Girls' Toys
only.

Between 30% and 40% of the Company's products (by dollar volume of net
sales) are replaced each year through the introduction of new products. As a
result of this turnover, product development is critical to the Company's
business. The Company develops both proprietary and non-proprietary products.
The Company's proprietary product lines consist of products that (i) are
licensed from outside inventors and designers, (ii) incorporate trademarks
licensed to the Company, (iii) are designed in-house, or (iv) are manufactured
using Company owned tooling, dies and molds based on a proprietary design or
idea owned by the Company or the inventor. Proprietary toys accounted for
approximately 80%, 78%, and 72% of the Company's net sales for fiscal 2001,
2000, and 1999, respectively. The Company's proprietary products generally yield
higher gross margins to the Company than non-proprietary products.

Non-proprietary products are defined by the Company as toys designed and
manufactured by independent toy manufacturers and marketed by the Company,
usually on an exclusive basis in the Company's primary markets. The Company
selects its non-proprietary products after an evaluation of several factors,
including the quality and pricing of the product, as well as whether the product
presents an opportunity for the Company to utilize packaging and marketing to
differentiate the product from other toys. The Company often markets these toys
under in-house brands, such as TECH-LINK -Registered Trademark- and MY MUSIC
MAKER -Registered Trademark-. Non-proprietary products accounted for
approximately 20%, 22%, and 28% of the Company's net sales for fiscal 2001, 2000
and 1999, respectively.

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CUSTOMERS

The Company made sales to over 850 different customers in approximately
50 countries during fiscal 2001. The table below sets forth the Company's net
sales by geographic area as a percentage of total net sales for the specified
fiscal years.

The Company's principal customers are retailers, including mass
merchandising discounters such as WalMart, Kmart and Target, specialty toy
retailers such as Toys "R" Us, Kay Bee Toy & Hobby and QVC, and deep discount
stores such as Family Dollar Stores, Inc., Consolidated Stores Corporation and
Value City Department Stores, Inc. The Company's top five customers accounted
for approximately 53.2% of the Company's net sales in fiscal 2001. During fiscal
2001, Wal-Mart and Kmart accounted for 21.1% and 10.4%, respectively, of the
Company's net sales. In fiscal 2000, Wal-Mart and Toys "R" Us accounted for
18.1% and 11.5% respectively, of the Company's annual net sales. The only
customer that accounted for more than 10% of the Company's annual net sales in
fiscal 1999 was Wal-Mart (20.8%). During fiscal 2001, the Company's sales to
Toys "R" Us, Wal-Mart, Kmart, Target and Kay-Bee Toy & Hobby, the five largest
toy retailers in the United States, increased as a percentage of the Company's
net sales to 49.2% compared to 46.1% of net sales during fiscal 2000 and 42.5%
of net sales during fiscal 1999. The Company does not have long-term contractual
arrangements with its customers.

The increase in sales in the United States in fiscal 2000 over fiscal
1999, as a percentage of the total net sales, reflects the effects of the
addition of Meritus, which historically had minimal international sales.
Notwithstanding the foregoing, within the United States the Company and Meritus
had very similar customer bases; as a result there was no change in the
Company's top five customers due to the Meritus acquisition.

MARKETING AND SALES

The Company's selling strategy consists of in-house sales personnel and
a network of independent, commission-based sales representatives. Significant
product presentations are made by either executive management, in the case of
new product presentations, or in-house sales personnel. The independent sales
representatives manage the day-to-day account administration.

New toys are marketed primarily by members of the Company's executive
management and sales department at the Company's showrooms in Hong Kong, New
York and Dallas during major, international toy shows in those cities (Hong Kong
in January, July and September/October, Dallas in January, and New York in
February and October). The Company also maintains a showroom at its headquarters
in Houston.

In international markets, the Company generally sells its products to
independent distributors. These distributors retain their own sales
representatives and product showrooms where products are marketed and sold. The
Company also sells directly to international retailers, principally as a result
of contacts made at the Company's showrooms.

ADVERTISING

In recent years, the Company has allocated the majority of its
advertising budget to television promotion, retailer-based programs and print
advertising. During 2001, the Company devoted the bulk of its television
advertising to the fall and Christmas season, principally to promote TOO CUTE
TWINS -TM- and FASHION BUZZ -TM- AIR NAILS SALON -TM-. In addition, during 2001
and 2000 the Company utilized a portion of its advertising budget on print
advertising for the PRIDE & JOY -Registered Trademark- product line as well as
participating in retailer based programs. The Company expects to continue using
promotional programs involving television and consumer magazine advertising of
certain, unique proprietary products, as well as year-round public relations
programs, participation in national consumer-based toy test awards programs,
internet linkages where appropriate, trade advertising and traditional
retailer-based ad programs including cooperative promotional ads, special offers
and retail catalogues.

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MANUFACTURING

The Company annually contracts with 30 or more independent manufacturers
located within a 300-mile radius of Hong Kong, principally in the Peoples'
Republic of China (the "PRC"), for the manufacture of its products. The Company
may use more than one manufacturer to produce a single product. The
manufacturers that accounted for more than 10% of the Company's purchases of
products during fiscal 2001 were Wah Lung (16.7%), which manufactured dolls and
girls playsets; Potex Toys Manufacturer, Ltd. (11.8%), which manufactured
musical instruments and infrared control vehicles; and Loyal Technology Co. Ltd.
(10.1%), which manufactured walkie-talkies and audio products. Manufacturing
commitments are made on a purchase order basis. The Company does not have
long-term contractual arrangements with its manufacturers.

Decisions related to the choice of manufacturer for non-proprietary
products generally are based on reliability, merchandise quality, price and the
manufacturer's ability to meet the Company's or its customers' delivery
requirements. Proprietary products designed by the Company are placed with a
specific manufacturer whose expertise is in that type of toy. The Company
currently has its tooling placed in several different manufacturing facilities
and generally receives delivery 60 to 90 days after issuing its purchase orders
to the manufacturer.

The Company subsidiary, DSI(HK), monitors manufacturing operations,
including quality control, production scheduling and order fulfillment from the
manufacturers. DSI(HK) utilizes a quality control and assurance staff of degreed
engineers and inspectors. The principal materials used in the production of the
Company's products are plastics, integrated circuits, batteries, corrugated
paper (used in packaging and packing material) and textiles. The Company
believes that an adequate supply of materials used in the manufacture and
packaging of its products is readily available from existing and alternative
sources at reasonable prices.

DISTRIBUTION

The Company distributes its products either FOB Asia or through direct
sales made from inventory maintained at its U.S. distribution facilities. For
FOB Asia sales, the customer places its order and provides shipping
instructions; the toys are then manufactured and shipped directly from the
factory to the customer or its freight consolidator.

The Company's primary distribution facility has been located in
Houston, Texas. Basic, continuous stock toys that are offered by retailers on
a year-round basis have historically been shipped to customers by the Company
from its inventory in Houston. During 2001, the Company contracted with a
public warehouse fulfillment center in Fife, Washington for a portion of its
domestic distribution to increase the speed of distribution to customers of
faster-selling television promoted items and to evaluate potential
distribution cost savings. In addition, certain faster-selling toys are often
shipped directly to major customers for seasonal selling and stocked by the
Company in Houston and now Fife for peak season back-up and continuous
supply. The Company also maintains inventory which is intended for specific
customers for peak holiday season support, as well as some inventory which is
available for smaller retailers and for opportunistic selling strategies.

The Company decided in March 2002 to consolidate its inventory and
transfer all its domestic distribution to the Fife facility during 2002. The
decision was based on successful distribution performance and cost savings
achieved from using the Fife facility in 2001, along with the expiration of the
Company's primary Houston facility lease in August 2002.

Most of the Company's larger customers have instituted electronic data
interchange ("EDI") programs to reduce the retailers' inventory carrying
requirements and place more inventory risk on the supplier. When selling toys
out of its domestic inventory, the Company participates in the EDI programs of
most of its customers who have established EDI programs, including Wal-Mart,
Kmart, Toys "R" Us, Target and Kay-Bee Toy & Hobby. Although these programs
require the Company to bear some inventory risk, the Company believes the
programs can be utilized to monitor store inventory levels, schedule production
to meet anticipated reorders and maintain sufficient inventory levels to serve
its customers.

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LICENSE AGREEMENTS

Various license agreements with third parties, including Kawasaki Motors
Corp., U.S.A., ("Kawasaki") and inventors, permit the Company to utilize the
trademark, character or product of the licensor in its product line. In return,
the Company agrees to pay to the licensor a percentage of net sales ("royalty
rate") of the licensed product. Typically, these royalty rates range from 4% to
7% of net sales. Sales of licensed products such as the INSECTOR -Registered
Trademark- R/C vehicle, the PRIDE & JOY -Registered Trademark- brand dolls, and
the KAWASAKI -Registered Trademark- musical instruments accounted for
approximately 68%, 59%, and 54% of the Company's net sales during fiscal 2001,
2000, and 1999, respectively. The acquisition of licenses also typically
requires the payment of non-refundable advances and/or guaranteed minimum
royalties.

The Company initially entered into a license agreement with Kawasaki in
January of 1994, and that agreement, together with subsequent amendments, and
renewals thereof, has authorized the Company to use the KAWASAKI -Registered
Trademark- brand name in connection with several different products, including
R/C motorcycles, bicycle accessories, walkie-talkies and a complete line of
electronic musical instruments, including keyboards, guitars and percussion
instruments. The current agreement with Kawasaki expires on December 31, 2002.
The Company has commenced negotiations to renew the license for a multi-year
period and anticipates entering into such renewal prior to the 2002 year end.

The Company has also entered into licensing agreements with
Harley-Davidson Motor Company, Inc. for the Harley-Davidson -Registered
Trademark- trademarks and service marks for the marketing and sale of
communication products, and GM Design Center, General Motors Corporation for the
Chevrolet Super Sport Roadster (SSR) trademark and related names, emblems and
body designs for the marketing and sale of R/C vehicles.

As of December 31, 2001, the aggregate guaranteed royalties payable by
the Company under all of its licenses total approximately $150,000 in fiscal
2002 and $225,000 thereafter through fiscal 2003. During fiscal 2001 and 2000,
the Company's license strategy has changed to reduce its long-term commitments
to licensors in favor of larger advance royalty payments. The Company believes
that this strategy will better match royalty liabilities with the product life
cycles and minimize potential negative impact on future earnings.

The Company believes that by developing licensed products based
principally on popular properties and trademarks, it can establish a licensed
product portfolio that is characterized by products with a longer life cycle
than is typical in the toy industry. The Company intends to continue to develop
its licensed product lines by targeting licensing opportunities to take
advantage of advertising, publicity and media exposure.

COMPETITION

The toy industry is highly competitive. Dun & Bradstreet categorizes
over 1,000 companies as toy manufacturers. Competitive factors include product
appeal, new product introductions, space allocation by the major retailers,
price and order fulfillment capability. The Company competes with many companies
that have greater financial resources and advertising budgets than the Company,
including Mattel, Inc. and Hasbro, Inc., the largest U.S. toy companies. The
Company also considers Trendmaster, Inc., The Lego Company, Inc., Playmates
Toys, Inc., ToyMax International, Inc., Toy Biz, Inc., KIDdesigns, Inc., and MGA
Entertainment to be among its other competitors. In addition, due to the low
barriers to entry into the toy business, the Company competes with many smaller
toy companies, some of which market single products.

SEASONALITY

Retail sales of toy products are seasonal, with a majority of retail
sales occurring during the Christmas holiday period: September through December.
As a result, shipments of toy products to retailers are typically greater in
each of the third and fourth quarters than in the first and second quarters
combined. This seasonality is increasing as the large toy retailers are becoming
more efficient in their inventory control systems. See "Risk Factors."

In anticipation of this seasonal increase in retail sales, the Company
significantly increases its production during the second quarter in advance of
the peak selling period, with a corresponding build-up of inventory levels. This
results in significant peaks in the second and third quarters in the respective
levels of inventories

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and accounts receivable, which result in seasonal working capital financing
requirements. See "Seasonal Financing."

SEASONAL FINANCING

The Company's financing of seasonal working capital typically peaks in
the third quarter of the year, when accounts receivable are at their highest due
to increased sales volume and sales programs, and when inventories are at their
highest in anticipation of expected second half sales volume. See "Seasonality."
The Company financed its seasonal working capital requirements in 2001
primarily by using internally generated cash and borrowings under its line of
credit with State Street Bank and Trust Company (the "Hong Kong Credit
Facility") and its revolving line of credit (the "Revolver") with Sunrock
Capital Corp. ("Sunrock").

The Hong Kong Credit Facility terminated on November 30, 2001. The
Company replaced the Hong Kong Credit Facility with a line of credit with Dao
Heng Bank Limited ("Dao Heng Facility") effective December 4, 2001, under terms
which are not materially different from the previous facility. Additionally, the
Company borrows, as needed, against customers' letters of credit with several
Hong Kong banks. The bank is selected based on the most advantageous terms to
the Company and as directed by customers.

The Company believes that cash flows from operations and amounts
available under its lines of credit will be adequate to meet its seasonal
requirements.

GOVERNMENT AND INDUSTRY REGULATION

The Company is subject to the provisions of the Federal Hazardous
Substances Act and the Federal Consumer Product Safety Act. Such Acts empower
the United States Consumer Products Safety Commission (the "CPSC") to protect
the public from hazardous goods. The CPSC has the authority to exclude from the
market goods that are found to be hazardous and require a manufacturer to
repurchase such goods under certain circumstances. The Company sends samples of
all of its marketed products to independent laboratories to test for compliance
with the CPSC's rules and regulations, as well as with the product standards of
the Toy Manufacturers of America, Inc. ("TMA"). The Company is not required to
comply with the product standards of the TMA but voluntarily does so. Similar
consumer protection laws exist in state and local jurisdictions within the
United States, as well as in certain foreign countries. The Company designs its
products to meet the highest safety standards imposed or recommended both by
government and industry regulatory authorities.

TARIFFS AND DUTIES

In December 1994, the United States approved a trade agreement pursuant
to which import duties on toys, games, dolls and other specified items were
eliminated, effective January 1, 1995, from products manufactured in all Most
Favored Nation countries (including the PRC). Increases in quotas, duties,
tariffs or other changes or trade restrictions which may be imposed in the
future could have a material adverse effect on the Company's financial
condition, operating results or ability to import products.

On October 12, 2000, federal legislation was signed into law
establishing Permanent Normal Trade Relations with the PRC, thereby eliminating
the previous risk experienced by the Company that the PRC's Most Favored Nation
status would be revoked, which could have subjected the Company to increased
duties, supply disruptions and higher costs of goods.

INTELLECTUAL PROPERTY

Most of the Company's products and product lines are marketed and sold
under trademarks, trade names and copyrights, including, without limitation: AIR
GUITAR -Registered Trademark-, BIG BAM BOOM -Registered Trademark-, ELITE
- -Registered Trademark-, FOREVER GIRLFRIENDS -Registered Trademark-,
GEARHEAD -TM-, INSECTOR -Registered Trademark-, PRIDE & JOY
- -Registered Trademark-, ROSIE -Registered Trademark-, SASSY SECRETS -TM-, STREET
SAVAGE -TM-, SWEET FAITH -Registered Trademark- and TECH-LINK -Registered
Trademark-. The Company considers its trademarks and trade names to be
significant assets in that they provide product and brand recognition.

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The Company customarily seeks trademark, or copyright protection, when
applicable, covering its products and product lines. Several of these trademarks
and copyrights relate to product lines that are significant to the Company's
business and operations. While the Company believes that its rights to these
properties are adequately protected, there can be no assurance that its rights
can be successfully asserted in the future or will not be invalidated,
circumvented or challenged. See "Risk Factors."

HUMAN RESOURCES

As of December 31, 2001, the Company had a total of 95 employees, of
whom 47 were based in Houston and 48 were employees of DSI(HK).

RISK FACTORS

This Risk Factors section is written to be responsive to the Securities
and Exchange Commission's "Plain English" guidelines. In this section the words
"we", "ours" and "us" refer only to the Company and its subsidiaries and not any
other person.

CHANGING CONSUMER PREFERENCES, RELIANCE ON NEW PRODUCT INTRODUCTION.
Consumer preferences are difficult to predict and the introduction of new
products is critical in our industry. Our business and operating results depend
largely upon the appeal of our products. A decline in the popularity of our
existing products and product lines or the failure of new products and product
lines to achieve and sustain market acceptance could result in lower overall
revenues and margins, which in turn could have a material adverse effect on our
business, financial condition, and results of operations. Our continued success
in the toy industry will depend on our ability to redesign, restyle and extend
our existing core products and product lines, and to develop, introduce and gain
customer acceptance of new products and product lines. As a result of changing
consumer preferences, individual products typically have short life cycles of
two years or less. There can be no assurance that:

- any of our current products or product lines will continue to be
popular with consumers for any significant period of time;

- any new products and product lines introduced by us will achieve
an adequate degree of market acceptance, or that if such
acceptance is achieved, it will be maintained for any significant
period of time;

- any new products' life cycles will be sufficient to permit us to
recover development, manufacturing, marketing and other costs of
the products.

DEPENDENCE ON LIMITED NUMBER OF CUSTOMERS. A small number of our
customers account for a large share of our net sales. For fiscal 2001, our five
largest customers accounted for approximately 50% of our net sales. Sales to
Wal-Mart, Kmart and Toys "R" Us, our three largest customers, accounted for
approximately 40% of our net sales during the same period.

On January 22, 2002, the Kmart Corporation ("Kmart") filed for
Chapter 11 bankruptcy. Kmart was our second largest customer in 2001,
comprising 10% of sales. Kmart is requiring normal trade terms from companies
desiring to do business with them in 2002, and in return is offering a
second-priority lien or "Trade Creditor Lien" in Kmart's owned merchandise
inventory. Due to Kmart's market share we have accepted this lien position and
will sell to Kmart in 2002. As Kmart is continuing business, and is indicating
interest in expanding our line in 2002, it is unknown what effect, if any,
Kmart's bankruptcy will have on our 2002 sales. Kmart to date has closed
approximately 300 stores, reducing our distribution outlets with Kmart in 2002.
We believe however, that based on Kmart's overtures and its strong position
with the other primary toy distributors in the United States, the effect will
not be material.

We expect to continue to rely on Kmart and a relatively small number of
other customers for a significant percentage of sales for the foreseeable
future. If some of these customers were to cease doing

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business with us, or to significantly reduce the amount of their purchases from
us, it could have a material adverse effect on our business, financial condition
and results of operations.

LIQUIDITY. Borrowings under the Revolver, the Dao Heng Facility, and the
discounting of customers' Letters of Credit with other banks, are utilized by us
to finance accounts receivable, inventory, and other operating and capital
requirements. We entered into the Revolver, on February 21, 1999, and amended
the Revolver on March 30, 2001 to increase the Company's credit line from
$10 million to $17.5 million. The Revolver matures March 31, 2004, and contains
covenants relating to our financial condition. If we fail to maintain compliance
with the financial covenants contained in the Revolver, the maturity date can or
will be accelerated, among other remedies which may be pursued by the lender.
The Dao Heng Facility was obtained on December 4, 2001, and is subject to
periodic review, and may be canceled by the bank upon notice. The discounted
letters of credit mature on shipment of goods to customers.

DEPENDENCE ON INDEPENDENT DESIGNERS, LICENSES AND OTHER PROPRIETARY
RIGHTS. We are dependent on concepts, technologies and other intellectual
property rights licensed from third parties, such as rights to trademarks, with
respect to several of our proprietary products. For each of these proprietary
products and product lines, we typically enter into a license agreement with the
owner of the intellectual property to permit us to use the intellectual
property. These license agreements typically provide for royalty payments by us
to the licensor based on the net sales of the product incorporating the licensed
property. For fiscal 2001, net sales of products developed and sold under our
license agreements accounted for approximately 68% of our net sales, of which
approximately 13% of net sales were attributable to sales of products
incorporating the KAWASAKI -Registered Trademark- trademark. The current
agreement with Kawasaki expires on December 31, 2002. The Company has commenced
negotiations to renew the license for a multi-year period and anticipates
entering into such renewal prior to the 2002 year end. The failure to procure
new license agreements, renew existing license agreements (on commercially
reasonable terms, or at all), or maintain existing license agreements could have
a material adverse effect on our business, financial condition and results of
operations.

In addition to the foregoing, we are dependent on our intellectual
property rights and we cannot give assurances that we will be able to
successfully protect such rights. We rely on a combination of trade secret,
copyright, trademark, patent and other proprietary rights laws to protect our
rights to valuable intellectual property related to our proprietary products. We
also rely on license and other agreements that establish ownership rights and
maintain confidentiality. We cannot assure you that such intellectual property
rights can be successfully asserted in the future or will not be invalidated,
circumvented or challenged. Laws of certain foreign countries in which our
products may be sold do not protect intellectual property rights to the same
extent as the laws of the U.S. The failure to protect our proprietary
information and any successful intellectual property challenges or infringement
proceedings against us could have a material adverse effect on our business,
financial condition and results of operations.

We do not believe that any of our products infringe on the proprietary
rights of third parties in any material respect. There can be no assurance,
however, that third parties will not claim infringement by us with respect to
current or future products. Any such claim, with or without merit, could be
time-consuming, result in costly litigation, cause product shipment delays or
require us to enter into royalty or licensing agreements. Such royalty or
licensing agreements, if required, may not be available on terms acceptable to
us or at all, which could have a material adverse effect on our business,
financial condition, and results of operations.

INVENTORY MANAGEMENT. Most of our larger retail customers utilize an
inventory management system to track sales of products and rely on reorders
being rapidly filled by us and other suppliers rather than maintaining large
product inventories. These types of systems put pressure on suppliers like us to
promptly fill customer orders and also shift a significant portion of inventory
risk and carrying costs from the retailer to the supplier. The limited amount of
inventory carried by retailers may serve to reduce or delay retail sales of our
products. In addition, the logistics of supplying more product within shorter
time periods will increase the risk that we fail to achieve tight and compressed
shipping schedules. These inventory management systems require us to accurately
forecast demand for products. The failure to accurately predict and respond to
retail demand could result in our

8

overproducing items, which could in turn result in price markdowns and increased
inventory carrying costs for us, as well as underproducing more popular items.

RETURNS AND MARKDOWNS. As is customary in the toy industry, we
historically have permitted certain customers to return slow-moving items for
credit and have allowed price reductions as to certain products then held by
retailers in inventory. We expect that we will continue to make such
accommodations in the future. Any significant increase in the amount of returns
or markdowns could have a material adverse effect on our business, financial
condition and results of operations.

SEASONALITY. Our business is seasonal and therefore our annual operating
results depend, in large part, on our sales during the relatively brief
Christmas holiday season. A substantial portion of our net sales is made to
retailers in anticipation of the Christmas holiday season. This seasonality is
increasing as large toy retailers become more efficient in their control of
inventory levels through quick response management techniques. This seasonal
pattern requires significant use of working capital mainly to manufacture
inventory during the year, prior to the Christmas holiday season, and requires
accurate forecasting of demand for products during the Christmas holiday season.
During fiscal 2001, 76% of the Company's net sales were made during the third
and fourth fiscal quarters. Adverse business or economic conditions during these
periods could adversely affect our results of operations for the full year. In
addition, failure to accurately predict and respond to consumer demand may have
a material adverse effect on our business, financial condition and results of
operations.

INTERNATIONAL OPERATIONS. Our sales and manufacturing operations outside
the United States subject us to risks normally associated with international
operations. Various international risks could negatively impact our
international sales and manufacturing operations, which could have a material
adverse effect on our business, financial condition and results of operations.
For the year ended December 31, 2001, our international net revenues comprised
approximately 17% of our total consolidated net revenues. We expect
international sales to continue to account for a significant portion of our
total revenues. In addition, we utilize third-party manufacturers principally
located in the PRC. Our international sales and manufacturing operations are
subject to the risks normally associated with international operations,
including:

- limitations, including taxes, on the repatriation of earnings;

- political instability, civil unrest and economic instability;

- greater difficulty enforcing intellectual property rights and
weaker laws protecting such rights;

- greater difficulty and expense in conducting business abroad;

- complications in complying with foreign laws and changes in
governmental policies;

- transportation delays and interruptions;

- currency conversion risks and currency fluctuations; and

- the imposition of tariffs.

These risks could negatively impact our international sales and manufacturing
operations, which could have a material adverse effect on our business,
financial condition and results of operations.

During fiscal 2001, three manufacturers accounted for approximately 39%
of our purchases of products. The loss of any of these manufacturers, or a
substantial interruption of our manufacturing arrangements with any of these
manufacturers, could cause a delay in the production of our products for
delivery to our customers and could have a material adverse effect on our
business, financial condition and results of operations. While we believe that
our reliance on external sources of manufacturing can be shifted, over a period
of time, to alternative sources of supply, there can be no assurance that
alternate arrangements could be provided in a timely manner or on terms
acceptable to us. Furthermore, the imposition of trade sanctions by the United
States or the European

9

Union against a class of products imported by us from, or the loss of "permanent
normal trade relations" status by, the PRC could significantly increase our cost
of products imported into the United States or Europe.

ACQUISITION RISKS. We may from time to time evaluate and pursue
acquisition opportunities on terms that we consider favorable. A successful
acquisition involves an assessment of the business condition and prospects of
the acquisition target, which includes factors beyond our control. This
assessment is necessarily inexact, and its accuracy is inherently uncertain. In
connection with such an assessment, we perform a review that we believe to be
generally consistent with industry practices. This review, however, will not
reveal all existing or potential problems, nor will it permit a buyer to become
sufficiently familiar with the acquisition target to assess fully its
deficiencies. There can be no assurance that any such acquisition would be
successful or that the operations of the acquisition target could be
successfully integrated with our operations. Any unsuccessful acquisition could
have a material adverse effect on our business, financial condition and results
of operations.

PRODUCT SAFETY, LIABILITY AND REGULATION. Products that have been or
may be developed or sold by us may expose us to potential liability from
personal injury or property damage claims by end-users of such products. We
currently maintain product liability insurance coverage in amounts which we
believe to be sufficient for our business risks. There can be no assurance
that we will be able to maintain such coverage or obtain additional coverage
on acceptable terms, or that such insurance will provide adequate coverage
against all potential claims. Moreover, even if we maintain adequate
insurance, any successful claim could materially and adversely affect our
business, financial condition, and results of operations.

In addition to the foregoing, the CPSC has the authority under certain
federal laws and regulations to protect consumers from hazardous goods. The CPSC
may exclude from the market goods it determines are hazardous and may require a
manufacturer to repurchase such goods under certain circumstances. Some state,
local and foreign governments have similar laws and regulations. In the event
that such laws or regulations change or in the future we are found to have
violated any such law or regulation, the sale of the relevant product could be
prohibited, and we could be required to repurchase such products.

COMPETITION. The toy industry is highly competitive. Many of our
competitors have longer operating histories, broader product lines and greater
financial resources and advertising budgets than us. In addition, the toy
industry has nominal barriers to entry. Competition is based primarily on the
ability to design and develop new toys, procure licenses for popular products,
characters and trademarks, and successfully market products. Many of our
competitors offer similar products or alternatives to our products. Our products
compete with other products for retail shelf space. There can be no assurance
that shelf space in retail stores will continue to be available to support our
existing products or any expansion of our current products and product lines.
There can be no assurance that we will be able to continue to compete
effectively in this marketplace.

CONTROL BY CURRENT MANAGEMENT. As of March 15, 2002, our directors and
executive officers beneficially owned an aggregate of 5,829,120 shares of Common
Stock (excluding convertible securities and the shares underlying same), which
represents approximately 64% of the total issued and outstanding shares of
Common Stock of the Company. As a result, it would be extremely difficult, if
not impossible, to obtain majority support for shareholder proposals opposed by
management and the Board of Directors.

POSSIBLE VOLATILITY OF STOCK PRICE. The market price of the Common Stock
has been and may continue to be highly volatile and has been and could be
subject to wide fluctuations in response to quarterly variations in operating
results, announcements of new products by us or our competitors, changes in
financial estimates by securities analysts, or other events or factors. In the
event our operating results are below the expectations of public market analysts
and investors in one or more future quarters, it is likely that the price of the
Common Stock would be materially adversely affected. In addition, general market
fluctuations may adversely affect the market price of the Common Stock.

10

EXECUTIVE OFFICERS OF THE REGISTRANT

The current executive officers of the Company, all of whom are appointed
annually by the Board of Directors to serve at the pleasure of the Board, are as
follows:

JOSEPH S. WHITAKER has served as a director since June 1, 1999, and
President and Chief Executive Officer since December 1, 2001. He joined the
Company on June 1, 1999 as Senior Vice President, New Business Development. He
also serves as Vice President of, and owns less than a 1% membership interest in
MVII, LLC, a California limited liability company ("MVII") controlled by E.
Thomas Martin, Chairman of the Board of Directors. For the five years prior to
joining the Company, Mr. Whitaker operated a consulting business in La Jolla,
California, providing services related to marketing, licensing and product
development to the toy industry.

ROBERT L. WEISGARBER has served as Chief Financial Officer of the
Company since March 1999. Prior to his employment by the Company, he served as
Executive Vice President and Chief Financial Officer for SteelWorks, Inc., an
office products manufacturer in Des Moines, Iowa. From 1993 to 1995, he was Vice
President, Administration for Texberry Container Corporation in Houston, Texas.

THOMAS W. NEVILLE has served as Senior Vice President, Worldwide Sales
of the Company since October 1999. He has been employed by the Company since
November 1994, serving as Key Accounts Manager from November 1994 through
December 1995; National Sales Manager from December 1995 through December 1997;
and Vice President, Sales from December 1997 until his promotion to his current
position.

GREGORY A. BARTH has served as Senior Vice President of Worldwide
Operations, Business Planning and Logistics since April 2001. Prior to that,
Mr. Barth was President of G.A.B. Sales Consulting from 1990-1997, working
for a variety of clients including the Company from April 2000 until being
employed by the Company in 2001.

11

CHAN TIT YU (ALFRED CHAN) has served as the Managing Director of the
Company's wholly-owned subsidiary, DSI(HK) since January 2002. From 2000 to
2002, he was Director and Chief Operating Officer for Toy Options, Ltd., a UK
listed group. He served as Vice President, Product Development and Engineering
for PLAYMATES Toys (HK) Ltd. from 1997 to 2000, and was Senior Director,
Engineering and Quality for TYCO Hong Kong Ltd. from 1996 to 1997.

WILLIAM J. KERNER has served as Vice President of Research and
Development of the Company since December 1999. Prior to that, he was Senior
Director of Design for Tyco Toys/Mattel, Inc., MatchBox Division from 1995
through December 1999, and Director of Product Design, Matchbox Division at Tyco
from 1992 until 1995.

THOMAS V. YARNELL has been an employee of the Company since February
1989, serving as Administrative Vice President since October 1989, Corporate
Secretary since April 1991, and General Counsel since December 1995.

E. THOMAS MARTIN has served as the Chairman of the Board of the Company
since June 1, 1999. He is the sole Manager and President of MVII. Mr. Martin is
President of Martin Resorts, Inc., a private California corporation which owns
and operates coastal hotels in California. Mr. Martin was the Chief Executive
Officer and a partner in Martin & MacFarlane, Inc. and Martin Media, L.P.,
national outdoor advertising companies, until their sale to Chancellor Media in
September of 1998. Mr. Martin also manages various real estate ventures. He is
the Chairman of the Executive Committee.

12

(1) The Company does not intend to renew this lease. The Company is in
negotiations to lease approximately 16,000 square feet of office
space in Houston, Texas for a term of approximately five years for
executive offices, showroom and consumer services. The Company
anticipates executing the lease in April, 2002 and occupying its new
offices on August 1, 2002.

The Company contracted during 2001 with Regal Logistics, Inc.
("Regal") in Fife, Washington to provide storage and fulfillment
distribution of certain products. A warehousing transition period
will occur in 2002 by maximizing inventory shipments to Regal and
minimizing inventory shipments to Houston. After the expiration of
the current Houston facility lease, the Regal facility will be the
Company's primary U.S. distribution facility. The Company
anticipates it will lease warehouse space from Regal commencing in
June, 2002.

(2) The Company intends to terminate this lease effective September 30,
2002 and is seeking to sublease the space until then.

(3) The Company has begun negotiations to renew this lease and
anticipates executing the renewal in May, 2002.

(4) The Company did not renew this lease.

In addition to the above listed facilities, the Company leases a small
storage facility in Hong Kong, in addition to public warehouse space in Houston
to accommodate fluctuating inventory needs. The foregoing properties consist of
block, cinder block or concrete block buildings which the Company believes are
in good condition and well maintained.

13

ITEM 3. LEGAL PROCEEDINGS

The Company is involved in various legal proceedings and claims incident
to the normal conduct of its business. The Company believes that such legal
proceedings and claims, individually and in the aggregate, are not likely to
have a material adverse effect on its financial position or results of
operations. The Company maintains product liability and general liability
insurance in amounts it believes to be reasonable.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of shareholders during the fourth
quarter of fiscal 2001.

14

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION

The Company's Common Stock is traded on The Nasdaq Stock Market's
SmallCap Market under the symbol "DSIT." Prior to August 17, 1998, the Company's
Common Stock was traded on The Nasdaq National Market. The table sets forth, for
the periods indicated, the reported high and low close sale prices of the
Company's Common Stock as reported on The Nasdaq SmallCap Market:

On February 14, 2002, the Company received notice from the Nasdaq Stock
Market Inc. that the Company's common stock had closed below the minimum $1.00
per share requirement for continued inclusion on the Nasdaq SmallCap Market
under Marketplace Rule 4310(c)(4) (the "Rule"). If, prior to August 13, 2002,
the Company's common stock closes at $1.00 or more for a minimum of 10
consecutive trading days, the Company will receive notification that it is in
compliance with the Rule. If compliance is not demonstrated by August 13, 2002,
and if the Company does not meet initial listing requirements, the Company will
receive notification that its securities will be delisted. If this occurs, the
Company may appeal the delisting determination to a Nasdaq Listing
Qualifications Panel.

STOCKHOLDERS

According to the records of the Company's transfer agent, as of
March 15, 2002, there were 102 holders of record of the Company's Common Stock.
The Company believes that a substantially larger number of beneficial owners
hold such shares in depository or nominee form.

DIVIDENDS AND DISTRIBUTIONS

The Company has never declared nor paid cash dividends on its Common
Stock and does not anticipate paying any cash dividends on its Common Stock in
the near future. In addition, the Company's credit facility prohibits the
payment of dividends.

INVESTMENT WARRANT

On March 19, 2001, the Company issued to MVII an Investment Warrant to
acquire 1.8 million shares of the Company's Common Stock, at a purchase price of
$2.7 million. The Investment Warrant is exercisable in whole on in part, for a
ten-year period beginning June 3, 2002. The Investment Warrant was subject to
certain

15

anti-dilution adjustments. In connection with the issuance of the Investment
Warrant, the Company and MVII entered into a Registration Rights Agreement,
pursuant to which MVII was granted certain piggyback registration rights with
respect to the shares of the Common Stock underlying the Warrant. Shares of
Common Stock acquired by MVII upon exercise of the Warrant are subject to the
terms of a Shareholders' and Voting Agreement dated as of April 5, 1999, among
MVII and certain of the Company's other shareholders. Proceeds from the sale of
the Investment Warrant were used by the Company for current working capital.

The Investment Warrant was issued by the Company to MVII in reliance on
the exemption from registration set forth in Section 4(2) of the Securities Act
of 1933, as amended. The Company believes the Section 4(2) exemption from
registration was available based upon the established criteria for effecting a
private offering by virtue of the following facts, among others: (i) MVII had
access to the type of information that would be included in a registration
statement, (ii) MVII's principals have adequate financial means to bear the risk
of MVII's additional investment in the Company and can be described as
sophisticated, (iii) MVII was the only offeree in the transaction, (iv) MVII
acquired the Investment Warrant for investment and not with a view toward
distribution, (v) the Investment Warrant contains restrictions on resale of the
Investment Warrant and the Common Stock issued upon exercise of the Investment
Warrant, and (vi) no underwriters were involved nor were any underwriters'
commissions paid in connection with the transactions.

On January 31, 2002, at the request of NASDAQ and with the agreement of
MVII, the Company issued an amended and restated Investment Warrant, which
amended and restated in its entirety the Investment Warrant by removing all
anti-dilution provisions. In addition, the Company and MVII entered into an
Amended and Restated Registration Rights Agreement, which amended and restated
in its entirety the Registration Rights Agreement, by removing all of the
provisions regarding the anti-dilution provisions of the original Investment
Warrant.

16

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

The following table sets forth selected consolidated financial data for
the Company. The selected consolidated financial data were derived from the
Company's consolidated financial statements. All dollar amounts are stated in
thousands, except per share data.

The information should be read in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
the financial statements and notes thereto included elsewhere in this report.

17

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

GENERAL

The following discussion and analysis should be read in conjunction with
the financial statements and notes thereto, and the information included
elsewhere herein.

The Company designs, develops, markets and distributes high quality,
innovative dolls, toys and consumer electronics products. Core products include
TECH-LINK -Registered Trademark- communications products, KAWASAKI
- -Registered Trademark- electronic musical instruments, GEARHEAD -TM- remote
control vehicles, the LAZERDOODLE -TM- electronic drawing toy and a full range
of special feature doll brands including SASSY SECRETS -TM-, SOMERSAULT SARA
- -TM-, TOO CUTE TWINS -TM-, CHILDHOOD VERSES -TM-, PRIDE & JOY -Registered
Trademark-, LITTLE DARLINGS -Registered Trademark-, along with interactive plush
products including KITTY KITTY KITTENS -Registered Trademark-, FRISKY KITTENS
- -TM-, PUPPY PUPPY PUPPIES -Registered Trademark-, and girls' activity products,
AIR NAILS SALON -TM-, and TWIST AND TWIRL BRAIDER -TM-.

The Company has three major product categories: Juvenile Audio Products,
Girls' Toys and Boys' Toys.

JUVENILE AUDIO PRODUCTS

The Juvenile Audio Product category consists of Youth Communications
products and Musical Instruments. Products in the Youth Communications line
include walkie-talkies, wrist watch walkie-talkies, audio products and novelty
electronic products. The category brands include TECH-LINK -Registered
Trademark- and MICRO LINK -TM- communications products, Harley-Davidson
- -Registered Trademark- walkie-talkies and bike alarms, and the Company's new
BIOSCAN -TM- ROOM GUARDIAN -TM-, and the LAZERDOODLE -TM- electronic drawing
toy. The Musical Instrument line includes the branded line of KAWASAKI
- -Registered Trademark- guitars, drum pads, saxophones and keyboards.

GIRLS' TOYS

The Girls' Toys product category includes dolls, interactive plush toys,
play sets, accessories, and girls' activity toys. The Girls' Toys portfolio of
brands includes SASSY SECRETS -TM-, SOMERSAULT SARA -TM-, TOO CUTE TWINS -TM-,
CHILDHOOD VERSES -TM-, PRIDE & JOY -Registered Trademark-, LITTLE DARLINGS
- -Registered Trademark-, along with interactive plush products including KITTY
KITTY KITTENS -Registered Trademark-, FRISKY KITTENS -TM-, PUPPY PUPPY PUPPIES
- -Registered Trademark-, and girls' activity products, AIR NAILS SALON -TM-, and
TWIST AND TWIRL BRAIDER -TM-.

BOYS' TOYS

The Boys' Toys product category includes radio control and infra-red
control vehicles. The brands in this product category are GEARHEAD -TM- radio
control vehicles, including the INSECTOR -Registered Trademark-, and the unique
ultra-articulated STREET SAVAGE -TM-. The GEARHEAD -TM- brand also includes
GEARHEAD -TM- JR. infra-red control vehicles.

PRODUCT INTRODUCTIONS

New product introductions during 2001 included KAWASAKI Mega Chords
Guitar, KAWASAKI Mega Deluxe Drum, TOO CUTE TWINS -TM-, and SUSIE SO SMART
- -TM-interactive electronic dolls; KITTY KITTY KITTENS -Registered Trademark-
plush toys and the unique STREET SAVAGE -TM- radio control vehicle.

SIGNIFICANT ACCOUNTING POLICIES

Our significant accounting policies are more fully described in Note
2 to our consolidated financial statements. Certain of our accounting
policies require the application of significant judgment by management in
selecting the appropriate assumptions for calculating financial estimates. By
their nature, these judgments are subject to an inherent degree of
uncertainty. These judgments are based on our historical experience, terms
with current customers, our observance of trends in the industry, information
provided by our customers and information available from other outsides
sources, as appropriate. Our significant accounting policies include:

18

REVENUE RECOGNITION - The Company recognizes revenue when products
are shipped and title passes to unaffiliated customers. In most cases, title
transfers to our customers when the product has been presented to shipment
forwarders on FOB Asia sales and when the product is picked up from our
distribution facilities on domestic sales. The Securities and Exchange
Commission's Staff Accounting Bulletin (SAB) No. 101, "Revenue Recognition",
provides guidance on the application of generally accepted accounting
principles to selected revenue recognition issues. The Company has concluded
that its revenue recognition policy is appropriate and in accordance with
generally accepted accounting principles and SAB No. 101.

ALLOWANCE FOR DOUBTFUL ACCOUNTS - Accounts receivable are reduced by
an allowance for amounts that may become uncollectible in the future. The
Company's estimate for its allowance is based on two methods which are
combined to determine the total amount reserved. First, the company evaluates
specific accounts where we have information that the customer may have an
inability to meet its financial obligations (bankruptcy, etc.). In these
cases, the company uses its judgement, based on the best available facts and
circumstances, and records a specific reserve for that customer against
amounts due to reduce the receivable to the amount that is expected to be
collected. These specific reserves are reevaluated and adjusted as additional
information is received that impacts the amounts reserved. Second, a general
reserve is established for all other customers based on historical collection
and write-off experience. If circumstances change, the Company's estimates of
the recoverability of amounts due the Company could be reduced by a material
amount.

ALLOWANCE FOR RETURNS AND DEFECTIVES - The Company records a
provision for estimated sales returns and defectives on sales in the same
period as the related revenue is recorded. Our sales to customers generally
do not give them the right to return product or to cancel firm orders.
However, as is common in the industry, we sometimes accept returns for stock
balancing and negotiate accommodations to customers, which includes price
discounts, credits and returns, when demand for specific product falls below
expectations. Additionally, customers are given credit for any defective
products they may have received. The allowance estimates are based on
historical sales returns and defective rates, analysis of credit memo data
and other known factors. If the data the Company uses to calculate these
estimates does not properly reflect future returns and defectives, revenue
could be overstated and future operating results adversely affected.

INVENTORIES - Inventory is valued at the lower of cost or market. The
Company reviews the book value of slow-moving items, discounted product lines
and individual products to determine if these items are properly valued. The
Company identifies these items and assesses the ability to dispose of them at
a price greater than cost. If it is determined that cost is less than market
value, then cost is used for inventory valuation. If market value is less
than cost, then the Company establishes a reserve for the amount required to
value the inventory at market. If the Company is not able to achieve its
expectations of the net realizable value of the inventory at its current
value, the Company would adjust its reserve accordingly.

DEFERRED TAXES - The Company recognizes deferred tax assets and
liabilities based on the differences between the financial statement carrying
amounts and the tax bases of assets and liabilities. Generally accepted
accounting principles require that we review deferred tax assets for
recoverability and if needed, establish a valuation allowance for those
amounts deemed unrecoverable. The review considers historical taxable income,
projected future taxable income, and the expected timing of the reversals of
temporary differences. Deferred tax assets of the Company are primarily the
result of unused net operating loss carry-forwards and foreign tax credits
which expire over a range of years. In 2001, the Company recorded a valuation
allowance of $566,000 related to foreign tax credits expiring in 2002, as it
was determined that it was more likely than not that these credits would not
be realized.

GOODWILL - The Company made an acquisition in 2000 that included a
significant amount of goodwill and other intangible assets. Under generally
accepted accounting principles through December 31, 2001, these assets were
amortized over their estimated useful lives, and were to be tested
periodically to determine if they were

19

recoverable from future operating earnings over their useful lives. We recorded
goodwill amortization expense of $513,396 and $513,360, respectively in 2001 and
2000.

Effective in 2002, goodwill will no longer be amortized but will be
subject to at least an annual impairment test based on its estimated fair
value. Other intangible assets meeting certain criteria will continue to be
amortized over their useful lives and also subject to an impairment test.
There are many assumptions and estimates underlying the determination,
including future cash flow and operating results. Management engaged an
independent company to assist in valuing the Company's goodwill at December
31, 2001. Based on this review, at this time an impairment charge is not
anticipated.

RESULTS OF OPERATIONS

The following table sets forth the Company's results of operations as a
percentage of net sales for the fiscal years indicated:

FISCAL YEAR 2001 COMPARED TO FISCAL YEAR 2000

NET SALES. Net sales during fiscal 2001 decreased $2.5 million, or 3.6%,
to $67.9 million, from $70.4 million in fiscal 2000. The decrease was due
primarily to reduced sales of Boys' Toys and Juvenile Audio products, partially
offset by sales of Girls' Toys.

Net sales of Juvenile Audio Products decreased $1.5 million, or 5.2%, to
$26.3 million during fiscal 2001, from $27.8 million during fiscal 2000. The
major product groups in this category are Youth Communications and Musical
Instruments, providing $14.6 million and $11.7 million respectively in 2001
sales, compared to $14.2 million and $13.6 million respectively in 2000. The
Youth Communications product group increase reflects sales of EBRAIN -TM-
personal communicator, introduced in fall 2001, partially offset by decreases in
walkie-talkie sales, due to increased competition in non-branded products.
Musical Instruments sales decreased primarily in keyboards, which is a result of
decreased warehouse club business with one, non-primary customer.

Net sales of Girls' Toys increased $3.5 million, or 12.4%, to
$31.5 million in fiscal 2001 from $28.0 million in fiscal 2000. The sales
increase in Girls' Toys was driven by the television promoted
TOO CUTE TWINS -TM- doll line, the girls activity toy AIR NAILS SALON -TM- and
the plush toy KITTY KITTY KITTENS -Registered Trademark-, partially offset by
declines in sales of dolls in the PRIDE & JOY -Registered Trademark-,
ELITE -Registered Trademark- and other general doll lines.

Net sales of Boys' Toys decreased $4.1 million, or 32.4% to $8.6 million
during fiscal 2001 from $12.7 million in fiscal 2000. The decrease is due
primarily to the discontinuation of the BLOCKMEN -Registered Trademark- line
of products sold

20

in 2000 and decreased sales of the primary 2000 R/C vehicle, INSECTOR
- -Registered Trademark-, and other boys' items, partially offset by sales of the
new 2001 R/C vehicle, STREET SAVAGE -TM-.

Net sales of products in other categories decreased approximately
$460,000 or 0.5% to $1.5 million during fiscal 2001 from $1.9 million in fiscal
2000. The decrease is attributable to lower sales of games, video phones,
doorbells and other discontinued lines, partially offset by increased sales of
preschool products.

International net sales decreased $1.6 million, or 12.0%, to $11.7
million during fiscal 2001 from $13.3 million in fiscal 2000. The decrease
reflects the strength of the U.S. dollar against foreign currencies; thereby
negatively affecting sales distributors potential retail price points and
margins. International net sales were 17.2% of total net sales for fiscal 2001
as compared to 18.9% of total net sales in fiscal 2000.

GROSS PROFIT. Gross profit decreased approximately $400,000 or 2.0%
to $19.9 million during fiscal 2001 from $20.3 million in fiscal 2000. Gross
profit as a percentage of net sales increased to 29.3% during fiscal 2001
from 28.9% in fiscal 2000. The percentage increase reflects the continued
focus on sales of proprietary products, such as the TOO CUTE TWINS -TM- doll,
AIR NAILS SALON -TM- girls' activity toy, and the STREET SAVAGE -TM- R/C
vehicle, versus lower margin, more volume-driven non-proprietary products.
Proprietary products, which were 80% of our total net sales in 2001, generate
a higher margin percentage.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses decreased $200,000 to $20.1 million, or 1.3%, during
fiscal 2001 from $20.3 million in fiscal 2000. The decrease reflects reductions
of approximately $945,000 and $846,000 in advertising and commission expenses,
due to lower sales volume. Additionally, professional fees decreased $356,000,
as expenses associated with the 2000 Meritus merger were non-reoccuring, along
with a $120,000 decrease in various operating expenses. Partially offsetting
these decreases, was an approximate $525,000 increase in employee compensation,
due to employee additions and a significant increase in receivables' bad debt
expense. The $1.7 million provision for uncollectible accounts receivable is
primarily related to the January, 2002 bankruptcy filing of K-mart Corp. (SEE
NOTE 15 TO CONSOLIDATED FINANCIAL STATEMENTS.)

INTEREST EXPENSE. Interest expense decreased approximately $319,000 or
21.6% to $1.2 million in fiscal 2001 from $1.5 million during fiscal 2000. The
decrease was due primarily to lower interest borrowing rates in 2001 as compared
to 2000.

INCOME TAXES. In fiscal 2001, the Company generated a loss before income
taxes of $1.0 million compared to a $1.3 million loss before income taxes during
fiscal 2000. A significant contributor to the 2001 loss was a $1.7 million
provision for uncollectible accounts receivable. The provision is not included
in taxable income for 2001, but will be in a future year when the underlying
receivables are written-off against the provision. As a result, the Company
believes its ability to use Foreign Tax Credits expiring in 2002 has been
potentially negated, and therefore has recorded a $566,000 valuation allowance
for the credits in 2001.

NET LOSS. The Company's net loss for fiscal 2001 was approximately
$1.4 million compared to a net loss of approximately $849,000 for fiscal 2000.
The 2001 net loss was due in significant part to the required increase in the
uncollectible receivables provision related to the Kmart bankruptcy. The
$1.7 million provision offset all other gains made in reduction of selling,
general and administrative expense by management in response to the reduced 2001
sales volumes from 2000. (SEE NOTE 12 TO THE CONSOLIDATED FINANCIAL STATEMENTS.)

FISCAL YEAR 2000 COMPARED TO FISCAL YEAR 1999

All component changes are affected by the change in the Company's fiscal
year in 1999 (fiscal 2000 reflects 12 months activity versus 11 months activity
in fiscal 1999).

NET SALES. Net sales during fiscal 2000 increased $22.9 million, or
48.1%, to $70.4 million, from $47.6 million in fiscal 1999. A substantial
portion of this increase, $10.6 million, was due to the acquisition of Meritus
and its product lines. Excluding these Meritus items, net sales increased
$12.3 million or 25.8% compared to fiscal 1999, primarily due to increased sales
of Girls' Toys.

21

Net sales of Juvenile Audio Products decreased $1.3 million, or 4.1%, to
$27.8 million during fiscal 2000, from $29.1 million during fiscal 1999. The
major product groups in this category are Youth Communications and Musical
Instruments, providing $14.2 million and $13.6 million respectively in 2000
sales. Decreases occurred in both product groups in 2000, as more emphasis was
placed on branded products like TECH LINK -Registered Trademark- and KAWASAKI
- -Registered Trademark-, requiring customers to reposition their inventory from
the non-branded product lines sold in prior years.

Net sales of Girls' Toys increased $21.1 million, or 304.8%, to $28.0
million in fiscal 2000 from $7.0 million in fiscal 1999. Meritus items
contributed $10.6 million of this increase. Excluding these Meritus items,
Girls' Toys net sales increased $10.4 million or 251.4% compared to fiscal
1999. With respect to non-Meritus items, the sales increase in Girls' Toys
was driven by the television promoted HUSH LI'L BABY -Registered Trademark-
doll and the continued expansion and growth of the PRIDE AND JOY -Registered
Trademark- doll line.

Net sales of Boys' Toys increased $3.8 million, or 40.3% to
$12.7 million during fiscal 2000 from $8.9 million in fiscal 1999. The increase
reflects the successful introduction of the television promoted INSECTOR
- -Registered Trademark- R/C vehicle in 2000, partially offset by decreases in
sales of BLOCKMEN -Registered Trademark- and other military type products.

Net sales of products in other categories decreased approximately
$700,000, or 24.7%, to $1.9 million during fiscal 2000 from $2.6 million in
fiscal 1999. The decrease reflects continued reduction in sales of HOPPIN'
POPPIN' SPACEBALLS -Registered Trademark- and other hand-held and outdoor games,
as well as a decrease in sales of the TALKING DOORBELL -Registered Trademark-
products introduced in fiscal 1998.

International net sales increased $2.4 million, or 21.7%, to
$13.3 million during fiscal 2000 from $10.9 million in fiscal 1999.
International net sales were 18.9% of total net sales for fiscal 2000 as
compared to 22.9% of total net sales in fiscal 1999.

GROSS PROFIT. Gross profit increased $6.8 million, or 50.3%, to $20.3
million during fiscal 2000 from $13.5 million in fiscal 1999. Gross profit as
a percentage of net sales increased to 28.9% during fiscal 2000 from 28.4% in
fiscal 1999. The percentage increase reflects the strategic emphasis placed
on proprietary products such as PRIDE & JOY -Registered Trademark- and HUSH
LI'L BABY -Registered Trademark- dolls, the INSECTOR -Registered Trademark-
R/C vehicle, and the successful branding of our TECH-LINK -Registered
Trademark- walkie-talkie lines in addition to the inclusion of the Meritus
doll lines. Proprietary products have a higher margin, and as a result of the
sales emphasis now comprise an increased percentage of our total net sales.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased $9.5 million to $20.3 million, or 87.7%,
during fiscal 2000 from $10.8 million in fiscal 1999. The increase included
major increases in television and other marketing costs of $3.4 million and
approximately $385,000, respectively to support sales of our proprietary
products. In addition, the merger with Meritus added employee costs of
$2.4 million. Other operating costs associated with the New Jersey office and
associated with the increased development activity in Girls' Toys were also a
substantial part of the increase. Professional fees, including attorney and
accounting costs, increased approximately $550,000, a portion of which is
directly related to the Meritus merger. A downturn in the general retail climate
required the Company to make an additional provision for noncollectible accounts
of approximately $150,000. Travel and entertainment expense also increased
approximately $400,000 due primarily to increased 2001 sales activity and focus
on increasing the internal sales responsibility for major accounts.

INTEREST EXPENSE. Interest expense increased approximately $855,000, or
138.1%, to $1.5 million in fiscal 2000 from $619,000 during fiscal 1999. The
increase was due to borrowings associated with the Meritus merger and increased
working capital needs to support the increased 2000 sales.

INCOME TAXES. In fiscal 2000, the Company generated a loss before income
taxes of $1.3 million compared to a $2.1 million profit before income taxes
during fiscal 1999. As a result, the Company generated a tax benefit of
approximately $477,000 during fiscal 2000 compared to a tax expense of
approximately $869,000 in fiscal 1999. The Company expects to realize its 2000
tax benefits from net operating loss carry forwards and foreign income tax
credits by the reduction of tax liabilities on taxable earning in future years.

22

NET INCOME (LOSS). The Company's net loss for fiscal 2000 was
approximately $849,000 compared to a net income of $1.3 million for fiscal 1999.
The 2000 net loss was due, in part, to less than expected sales of our
television promoted products in relation to television advertising costs and
fourth quarter inventory close-outs of BLOCKMEN -Registered Trademark- and other
products introduced in prior years. As discussed above, the gains made by the
Company in net sales and gross profit were exceeded by substantial increases in
selling, general and administrative expenses. In addition, the financial
condition of several customers required a higher than normal provision for
uncollectible accounts receivable.

LIQUIDITY AND CAPITAL RESOURCES

The Company historically has funded its operations and capital
requirements by cash generated from operations and borrowings. The Company's
primary capital needs have consisted of acquisitions of inventory, financing
accounts receivable and capital expenditures for product development.

The Company's operating activities used net cash of $3.4 million during
fiscal 2001, consisting primarily of increases in accounts receivable and
decreases in accounts payable. Net cash used in investing activities during
fiscal 2001 was approximately $525,000 and was mostly due to capital
expenditures. Net cash provided by financing activities was $4.1 million in 2001
and was a result of proceeds from the issuance of common stock warrants and
borrowing under revolving lines of credit, net of payments on long-term debt.
The Company's working capital at December 31, 2001 was $9.2 million and
unrestricted cash was approximately $285,000.

The seasonal nature of the toy business results in complex working
capital needs. The Company's working capital needs, which the Company generally
satisfies through short-term borrowings, are greatest in the last two fiscal
quarters. To manage these working capital requirements, the Company maintains
the Dao Heng Facility and the Revolver. Additionally, the Company discounts
customers' letters of credit at several other Hong Kong banks.

As of December 31, 2001, the Company and Sunrock amended the Revolver to
revise the future covenants and restrictions required by the Revolver.
Management believes the Company will be able to maintain compliance with such
covenants in the future.

On March 19, 2001, the Company issued to MVII an Investment Warrant to
acquire 1.8 million shares of the Company's Common Stock at a purchase price of
$2.7 million. The Investment Warrant is exercisable, in whole or in part, for a
ten-year period beginning June 3, 2002. Proceeds from the sale of the Investment
Warrant were used by the Company for current working capital. The Investment
Warrant was amended and restated in its entirety on January 31, 2002, to remove
all anti-dilution provisions at the request of Nasdaq.

The Company has budgeted approximately $1.3 million for capital
expenditures for fiscal 2002 consisting primarily of purchases of tools and
molds and information technology systems. As of March 19, 2002 the Company had
additional aggregate borrowing capacity of approximately $300,000 under the
Revolver and the Dao Heng Credit Facility. Based on projected fiscal 2002
operating results, the Company believes cash flows from operations and available
borrowings under the Revolver and the Dao Heng Credit Facility will be
sufficient to meet the Company's operating cash requirements and fund its
anticipated capital expenditures. However, there can be no assurance the Company
will meet its projected operating results. In connection with any future cash
needs or acquisition opportunities, the Company may incur additional debt or
issue additional equity or debt securities depending on market conditions and
other factors.

In a series of related transactions with MVII that occurred between
April and June of 1999, the Company received $5 million in exchange for the sale
of approximately 2.5 million shares of the Company's Common Stock. The Company
used those funds to finance the normal business operations of the Company.

In connection with the acquisition of Meritus, the Company borrowed
$5 million from MVII. The debt is evidenced by a promissory note dated
January 7, 2000 (the "MVII Note"). The MVII Note bears interest at a rate of
prime plus 2%, matures on July 1, 2004 and is subordinate to the Revolver. The
proceeds from the MVII Note

23

were used primarily to facilitate the merger with Meritus, including the
satisfaction of Meritus' debt, described below.

On March 6, 2002, pursuant to the terms of the Revolver and the MVII
Note, the Company reborrowed $500,000 of the original principal that the Company
had paid on the MVII Note. The proceeds were used to finance the normal business
operations of the Company.

The Company is obligated to make future minimum royalty payments under
certain of its license agreements. As of December 31, 2001, the Company was
required to make an aggregate of approximately $150,000 in payments of
guaranteed royalties under certain licenses in fiscal 2002 and $225,000
thereafter through fiscal 2003.

RECENT ACCOUNTING PRONOUNCEMENTS

SFAS No. 141 entitled "BUSINESS COMBINATIONS" was issued in June 2001
and became effective July 1, 2001. SFAS No. 141 requires that all business
combinations be accounted for using the purchase method of accounting, which
requires that acquisitions be recorded at fair value as of the date of
acquisition. The pooling-of-interests method of accounting allowed under prior
standards, which reflected business combinations using historical financial
information, is now prohibited.

In June 2001, the FASB issued SFAS No. 142 entitled "GOODWILL AND OTHER
INTANGIBLE ASSETS", which became effective on January 1, 2002. Under SFAS
No. 142, existing goodwill will no longer be amortized, but will be tested for
impairment using a fair value approach. SFAS No. 142 requires goodwill to be
tested for impairment at a level referred to as a reporting unit, generally one
level lower than reportable segments. SFAS No. 142 requires us to perform the
first goodwill impairment test on all reporting units within six months of
adoption. The first step is to compare the fair value with the book value of a
reporting unit. If the fair value of the reporting unit is less than its book
value, the second step will be to calculate the impairment loss, if any. Any
impairment loss from the initial adoption of SFAS No. 142 will be recognized as
a change in accounting principle. After the initial adoption, we will test
goodwill for impairment on an annual basis and between annual tests if an event
occurs or circumstances change that would more likely than not reduce the fair
value of a reporting unit below its carrying amount. Management engaged an
independent company to assist in valuing the Company's goodwill at December 31,
2001. Based on this review, at this time an impairment change is not
anticipated.

In June 2001, the FASB issued SFAS No. 143, "ACCOUNTING FOR ASSET
RETIREMENT OBLIGATIONS". This Statement addresses financial accounting and
reporting for obligations associated with the retirement of tangible long-lived
assets and the associated asset retirement costs. Due to the nature of our
business, this new accounting pronouncement is not expected to have a
significant impact on our reported results of operations and financial
condition.

In August 2001, the FASB issued SFAS No. 144, "ACCOUNTING FOR THE
IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS," which addresses financial
accounting and reporting for the impairment or disposal of long-lived assets.
This statement supersedes SFAS No. 121, "ACCOUNTING FOR THE IMPAIRMENT OF
LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF" and the
accounting and reporting provisions of APB Opinion No. 30, "REPORTING THE
RESULTS OF OPERATIONS - REPORTING THE EFFECTS OF A DISPOSAL OF A BUSINESS AND
EXTRAORDINARY, UNUSUAL AND INFREQUENTLY OCCURRING EVENTS AND TRANSACTIONS," for
the disposal of a segment of a business. This Statement also amends ARB No. 51,
"CONSOLIDATED FINANCIAL STATEMENTS," to eliminate the exception to consolidation
for a subsidiary for which control is likely to be temporary. SFAS No. 144
became effective on January 1, 2002, and interim periods within fiscal 2003,
with early application encouraged. The provisions of this Statement generally
are to be applied prospectively.

24

MERITUS ACQUISITION

Effective January 7, 2000, the Company acquired Meritus by way of
merger. Pursuant to the terms of the merger, the Company acquired all of the
issued and outstanding stock of Meritus for 533,208 shares of the Company's
Common Stock and $2.8 million in other consideration paid to the shareholders of
Meritus. Contemporaneously with the merger, the Company satisfied $4.4 million
of Meritus' debt. The merger was accounted for using the purchase method;
therefore the Company recorded the acquired assets at their fair market value,
generating a significant amount of goodwill. (SEE NOTE 2 TO THE CONSOLIDATED
FINANCIAL STATEMENTS.)

As a result of the merger, the Company added the BABY BEANS -Registered
Trademark- brand soft bean bag dolls, FOREVER GIRL FRIENDS -Registered
Trademark- brand accessories for 11-1/2" fashion dolls, and LITTLE DARLINGS
- -Registered Trademark- brand value-priced action feature dolls to its product
offerings, as welL as the ELITE DOLLS -TM- brand, which was created by Meritus
specifically to manufacture and market "LIFETIME PLAY DOLLS -TM-," a line of
exquisite 18" dolls and accessories suitable for playing or collecting.

INFLATION

The Company does not believe that inflation in the United States, Europe
or Asia in recent years has had a significant effect on its results of
operations.

YEAR 2000

During 1999, the Company concluded its efforts to address the Year 2000
issue. In addition to a review of the Company's management information software
("MIS"), EDI software, and local area network and personal computer operating
systems, readiness reviews were completed on customers and vendors. The Company
did not experience any Year 2000 issues with its internal operating systems or
with its customers or vendors. In addition, the Company did not experience any
loss in revenues due to the Year 2000 issue.

CAUTIONARY STATEMENT

Certain written and oral statements made or incorporated by reference
from time to time by the Company or its representatives in this Form 10-K, other
filings or reports with the Securities and Exchange Commission, press releases,
conferences, or otherwise, are "forward-looking statements" within the meaning
of the Private Securities Litigation Reform Act of 1995. The Company is
including this Cautionary Statement to make applicable and take advantage of the
safe harbor provisions of the Private Securities Litigation Reform Act of 1995
for any such forward-looking statements. Forward-looking statements can be
identified by the use of terminology such as "believe," "anticipate," "expect,"
"estimate," "may," "will," "should," "project," "continue," "plans," "aims,"
"intends," "likely," or other words or phrases of similar terminology.
Management cautions you that forward-looking statements involve risks and
uncertainties which may cause actual results to differ materially from the
forward-looking statements. For a discussion of some of the factors that may
cause actual results to differ materially from those suggested by
forward-looking statements, please read carefully the information under Item 1,
"Risk Factors", of this Form 10-K. In addition to the Risk Factors and other
important factors detailed herein and from time to time in other reports filed
by the Company with the Securities and Exchange Commission, including Forms 8-K,
10-Q, and 10-K, the following important factors could cause actual results to
differ materially from those suggested by any forward-looking statements.

MARKETPLACE RISKS

- Increased competitive pressure, both domestically and
internationally, which may negatively affect the sales of the
Company's products;

- Changes in public and consumer taste, which may negatively affect
the sales of the Company's products;

25

- Significant changes in the play patterns of children, whereby
they are increasingly attracted to more developmentally advanced
products at younger ages, which may affect brand loyalty and the
perceived value of and demand for the Company's products; and

- Possible weaknesses in economic conditions, both domestically and
internationally, which may negatively affect the sales of the
Company's products and the costs associated with manufacturing
and distributing these products.

FINANCING CONSIDERATIONS

- Currency fluctuations, which may affect the Company's reportable
income; significant changes in interest rates, both domestically
and internationally, which may negatively affect the Company's
cost of financing both its operations and investments.

OTHER RISKS

- Changes in laws or regulations, both domestically and
internationally, including those affecting consumer products or
trade restrictions, which may lead to increased costs or
interruption in normal business operations of the Company;

- Future litigation or governmental proceedings, which may lead to
increased costs or interruption in normal business operations of
the Company; and

- Labor disputes, which may lead to increased costs or disruption
of any of the Company's operations.

The risks included herein and in Item 1 "Risk Factors" are not
exhaustive. Other sections of this Form 10-K may include additional factors
which could materially and adversely impact the Company's business, financial
condition, and results of operations. Moreover, the Company operates in a very
competitive and rapidly changing environment. New risk factors emerge from time
to time and it is not possible for management to predict all such risk factors
on the Company's business, financial condition or results of operations or the
extent to which any factor, or combination of factors, may cause actual results
to differ materially from those contained in any forward-looking statements.
Given these risks and uncertainties, investors should not place undue reliance
on forward-looking statements as a prediction of actual results.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

None.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

See "Index to Consolidated Financial Statements and Schedules" included
on page F-1 for information required under this Item 8.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

26

PART III

GENERAL

Information required by Item 10 relating to the executive officers of
the Company appears under the heading "Executive Officers of the Registrant" in
Part I herein. Information required by Item 10 relating to members of the
Company's Board of Directors, as well as information required by Items 11
through 13, is hereby incorporated by reference to the information under the
headings "Election of Directors," "Section 16(a) Beneficial Ownership Reporting
Compliance," "Executive Compensation," "Compensation of Certain Named Executive
Officers," "Management-Employment and Related Agreements," and "Certain
Relationships and Related Transactions" in the Company's definitive Proxy
Statement to be filed pursuant to Regulation 14A and anticipated to be filed
within 120 days after the end of the Company's fiscal year ended December 31,
2001.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a) 1. Financial Statements. Reference is made to the Index on page F-1
for a list of all financial statements filed as part of this
Report.

(a) 2. and (d) Financial Statement Schedules. Reference is made to the Index on
page F-1 for a list of all financial statement schedules filed as
part of this Report.

(a) 3. and (c) Exhibits. Reference is made to the Exhibit Index on page E-1 for
a list of all exhibits filed as part of this Report.

(b) Reports on Form 8-K. The Company filed a Form 8-K dated
October 12, 2001, (filed on October 24, 2001) for the purpose of
reporting the resignation of Michael J. Lyden from his positions
as President and Chief Executive Officer, and member of the Board
of Directors of the Company.

27

SIGNATURES

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

DSI Toys, Inc.

Dated: April 1, 2002 By: /s/ JOSEPH S. WHITAKER
------------------------------------------------
Joseph S. Whitaker
President, Chief Executive Officer and Director

Dated: April 1, 2002 By: /s/ ROBERT L. WEISGARBER
------------------------------------------------
Robert L. Weisgarber
Chief Financial Officer

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

SIGNATURE TITLE DATE
--------- ----- ----

/s/ E. THOMAS MARTIN Chairman April 01, 2002
- --------------------------------- ---------------------------
E. Thomas Martin

/s/ M.D. DAVIS Director April 01, 2002
- --------------------------------- ---------------------------
M.D. Davis

/s/ JOSEPH N. MATLOCK Director April 01, 2002
- --------------------------------- ---------------------------
Joseph N. Matlock

/s/ ROBERT L. BURKE Director April 01, 2002
- --------------------------------- ---------------------------
Robert L. Burke

/s/ JOHN MCSORLEY Director April 01, 2002
- --------------------------------- ---------------------------
John McSorley

/s/ WALTER S. REILING Director April 01, 2002
- --------------------------------- ---------------------------
Walter S. Reiling

28

DSI TOYS, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES

All other schedules are omitted because they are not applicable or the required
information is shown in the financial statements or notes thereto.

F-1

REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Shareholders of
DSI Toys, Inc.

In our opinion, the consolidated financial statements listed in the accompanying
index present fairly, in all material respects, the financial position of DSI
Toys, Inc. and its subsidiaries (the "Company") at December 31, 2001 and 2000,
and the results of their operations and their cash flows for each of the three
years in the period ended December 31, 2001, in conformity with accounting
principles generally accepted in the United States of America. In addition, in
our opinion, the financial statement schedule listed in the accompanying index
presents fairly, in all material respects, the information set forth therein
when read in conjunction with the related consolidated financial statements.
These financial statements and financial statement schedule are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements and financial statement schedule based on
our audits. We conducted our audits of these statements in accordance with
auditing standards generally accepted in the United States of America, which
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, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

PricewaterhouseCoopers LLP

Houston, Texas
March 29, 2002

F-2

DSI TOYS, INC.
CONSOLIDATED BALANCE SHEET

See accompanying notes to consolidated financial statements.

F-3

DSI TOYS, INC.
CONSOLIDATED STATEMENT OF OPERATIONS

See accompanying notes to consolidated financial statements.

F-4

DSI TOYS, INC
CONSOLIDATED STATEMENT OF CASH FLOWS

See accompanying notes to consolidated financial statements.

F-5

DSI TOYS, INC.
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY

See accompanying notes to consolidated financial statements.

F-6

DSI TOYS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - ORGANIZATION:

DSI Toys, Inc. (the "Company") was incorporated under the laws of the State
of Texas in November 1970. The Company markets and distributes a variety of toys
and children's consumer electronics both within the United States and
internationally, primarily to retailers. The Company's products are manufactured
primarily in the People's Republic of China.

Effective May 1, 1997, the Company's Articles of Incorporation were amended
to (i) authorize the issuance of 5,000,000 shares of $.01 par value preferred
stock, (ii) change the par value of common stock to $.01 and (iii) reduce the
authorized shares of common stock to 20,000,000 shares.

On June 3, 1997, the Company completed its initial public offering (the
"Offering") of 2,500,000 shares of common stock, which provided the Company net
proceeds of $17.7 million. All of the net proceeds were used to repay debt of
the Company. In connection with the Offering, the Company issued warrants to
purchase 250,000 shares of common stock to the lead underwriters. Such warrants
are exercisable at $10.80 per share and expire May 28, 2002.

Effective May 28, 1999, the Company's Articles of Incorporation were
amended to increase the authorized shares of common stock to 35,000,000 shares.

Effective June 1, 1999, the Company consummated transactions with MVII, LLC
("MVII") pursuant to a Stock Purchase and Sale Agreement dated April 15, 1999.
As a result of those transactions, MVII made a total investment of $12 million
in the Company's common stock, $5 million of which was paid directly to the
Company for the purchase of 2,458,491 shares of common stock.

On March 19, 2001, the Company issued to MVII an Investment Warrant to
acquire 1.8 million shares of the Company's Common Stock, in exchange for a cash
purchase price of $2.7 million. The Investment Warrant is exercisable for no
additional consideration, in whole or in part, for a ten-year period beginning
June 4, 2002. Proceeds from the sale of the Investment Warrant were used by the
Company for current working capital.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

BASIS OF PRESENTATION

The accompanying consolidated financial statements include the accounts of
wholly-owned subsidiaries DSI(HK) Limited, Meritus Limited, and RSP Limited. All
significant intercompany transactions have been eliminated in consolidation.

FISCAL YEAR

The Company's fiscal year is the year ending December 31 of the calendar
year mentioned. Prior to December 31, 1999, the terms "fiscal year" and "fiscal"
refer to January 31 of the following calendar year mentioned (e.g., a reference
to fiscal 1998 was a reference to the fiscal year ended January 31, 1999).

CASH EQUIVALENTS

The Company considers investments with original maturity dates of three
months or less from the date of purchase to be cash equivalents. Restricted
cash, held as a compensating balance under a revolving loan supported by letters
of credit is not considered a cash equivalent.

F-7

REVENUE RECOGNITION

Revenues are recognized upon shipment of product by the Company, or in the
case of FOB Asia sales, by the manufacturer, and, at that point, legal
responsibility and title pass to the buyer. The Company provides an allowance
for doubtful accounts and accrues for returns and discounts using a percentage
of gross sales based on historical experience. Provision is made currently for
estimated returns of defective and slow-moving merchandise, price protection and
customer allowances and is included as a reduction of accounts receivable and
revenues.

INVENTORIES

Inventories consist of finished goods and supplies and are stated at the
lower of cost or market, with cost determined on a first-in, first-out basis.
The Company provides an allowance for obsolete inventory when appropriate to
reflect current market value.

PROPERTY AND EQUIPMENT

Property and equipment are recorded at cost. Maintenance and repairs are
charged to operations, and replacements or betterments are capitalized. Property
or equipment sold, retired, or otherwise disposed of is removed from the
accounts, and any gains or losses thereon are included in operations.
Depreciation is recorded over the estimated useful lives of the related assets
using the straight-line method for molds and leasehold improvements and an
accelerated method, which approximates the straight line method, for all other
assets.

DEBT ISSUANCE COSTS AND DEBT DISCOUNT

Debt issuance costs and debt discount are amortized over the term of the
related debt on a straight-line basis.

ADVERTISING

The cost of producing media advertising is capitalized as incurred and
expensed in the period in which the advertisement is first shown. During interim
periods, media communications costs are accrued in relation to sales when the
advertising is clearly implicit in the related sales arrangement. In any event,
all media communication costs are expensed in the fiscal year incurred. All
other advertising costs are expensed in the period incurred. Television
advertising expense totaled $2,500,000, $3,621,000 and $275,000 during fiscal
2001, 2000 and 1999, respectively. Prepaid television advertising production
costs of $130,000 and $101,000 respectively are included in prepaid expenses at
December 31, 2001 and 2000. The Company entered into advertising barter
transactions in which the Company recorded $730,000, $529,000 and $311,000 in
advertising expenses in fiscal 2001, 2000 and 1999, respectively. In addition,
prepaid expenses at December 31, 2000 included $200,000 in bartered, prepaid
2001 print advertising. There is no bartered prepaid advertising expense at
December 31, 2001. Management believes these amounts approximate fair value.

INCOME TAXES

The Company accounts for deferred income taxes using the liability method
which provides for the recognition of deferred tax assets and liabilities based
upon temporary differences between the tax basis of assets and liabilities and
their carrying value for financial reporting purposes. Deferred tax expense or
benefit is the result of changes in deferred tax assets and liabilities during
the period. In estimating future tax consequences, all expected future events
are considered other than enactments of changes in the tax law or rates.

U.S. deferred income taxes are provided on the undistributed earnings of
the wholly-owned subsidiaries.

F-8

FOREIGN CURRENCY TRANSLATIONS

The Company's foreign subsidiary uses the local currency as the functional
currency. Accordingly, assets and liabilities of the Company's foreign
subsidiary are translated using the exchange rate in effect at the balance sheet
date, while income and expenses are translated using average rates. Translation
adjustments are reported as a separate component of shareholders' equity.

FAIR VALUE OF FINANCIAL INSTRUMENTS

The Company's financial instruments recorded on the balance sheet include
cash and cash equivalents, accounts receivable, accounts payable and debt. Due
to their short maturity, the fair value of cash and cash equivalents, accounts
receivable and accounts payable approximates carrying value. The fair value of
the Company's debt approximates the carrying amount of the debt as it is at
variable market rates.

CONCENTRATION OF CREDIT RISK AND EXPORT SALES

Financial instruments which potentially subject the Company to
concentrations of credit risk consist primarily of trade receivables. The
Company sells its products principally to retail discount stores and toy stores.
Five customers comprise a significant portion of the Company's sales (50% in
2001), and therefore, receivables from one or all of these customers may, at any
point in time, comprise a large portion of the Company's total receivables,
providing an increased concentration of credit risk. Additionally, the customer
base is primarily located in the United States, though overall the Company's
customer base is large and geographically dispersed across the globe. The
Company performs ongoing credit evaluations of its customers to minimize credit
risk, and for the majority of its FOB Asia sales, the Company obtains letters of
credit from its customers supporting the accounts receivable. (See Note 12).

USE OF ESTIMATES

The preparation of financial statements in accordance with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the period. Because of the inherent uncertainties in their
process, actual results could differ from such estimates. Management believes
that the estimates are reasonable.

IMPAIRMENT OF ASSETS

The Company reviews for the impairment of long-lived assets, including
goodwill, whenever events or changes in circumstances indicate that the carrying
amount of an asset may not be recoverable.

Goodwill has been amortized over 20 years using the straight-line method in
2001 and 2000. In 2002, the Company will adopt, Statement of Financial
Accounting Standards, No. 142, "Goodwill and Other Intangible Assets", which
eliminates amortization of goodwill beginning in January 2002 and requires an
annual impairment test based on its estimated fair value, using future
discounted cash flow and other factors. The initial valuation will be done as of
December 31, 2001, with any impairment recorded in 2002. The Company engaged an
independent company to assist in this fair value assessment. Based on this
review, at this time an impairment adjustment is not anticipated.

EARNINGS PER SHARE

The Company reports both basic earnings per share, which is based on the
weighted average number of common shares outstanding, and diluted earnings per
share, which is based on the weighted average number of common shares as well as
all dilutive potential common shares outstanding.

Stock options and warrants are the only potentially dilutive shares the
Company has outstanding at December 31, 2001. The 729,500 shares and 866,500
shares, respectively of common stock options and

F-9

warrants outstanding were not included in the diluted earnings per share
calculation during fiscal 2001 and 2000, because the options and warrants would
be anti-dilutive. During fiscal 1999, the Company's warrants, for which the
exercise price was less than the average market price of the common shares, were
included in the computation of diluted earnings per share, increasing the
weighted average number of shares outstanding by 114,439 shares. The Company's
remaining 996,500 shares of common stock options and warrants were not included
in the calculation because the exercise price of the options and warrants were
greater than the average market price of the common shares.

STOCK-BASED COMPENSATION PLANS

The Company applies Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees" (APB 25) and related interpretations in
accounting for its plans and the disclosure-only provision of Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" (SFAS 123) in disclosures regarding the plan.

RECENT ACCOUNTING PRONOUNCEMENTS

SFAS No. 141 entitled "BUSINESS COMBINATIONS" was issued in June 2001 and
became effective July 1, 2001. SFAS No. 141 requires that all business
combinations be accounted for using the purchase method of accounting, which
requires that acquisitions be recorded at fair value as of the date of
acquisition. The pooling-of-interests method of accounting allowed under prior
standards, which reflected business combinations using historical financial
information, is now prohibited.

In June 2001, the FASB issued SFAS No. 142 entitled "GOODWILL AND OTHER
INTANGIBLE ASSETS" which became effective on January 1, 2002. Existing goodwill
will no longer be amortized, but will be tested for impairment using a fair
value approach. SFAS No. 142 requires goodwill to be tested for impairment at a
level referred to as a reporting unit, generally one level lower than reportable
segments. SFAS No. 142 requires the Company to perform the first goodwill
impairment test on all reporting units within six months of adoption. The first
step is to compare the fair value with the book value of a reporting unit. If
the fair value of the reporting unit is less than its book value, the second
step will be to calculate the impairment loss, if any. Any impairment loss from
the initial adoption of SFAS No. 142 will be recognized as a change in
accounting principle. After the initial adoption, the Company will test goodwill
for impairment on an annual basis and between annual tests if an event occurs or
circumstances change that would more likely than not reduce the fair value of a
reporting unit below its carrying amount. Management engaged an independent
company to assist in valuing the Company's goodwill at December 31, 2001. Based
on this review, at this time an impairment adjustment is not anticipated.

In June 2001, the FASB issued SFAS No. 143, "ACCOUNTING FOR ASSET
RETIREMENT OBLIGATIONS". This Statement addresses financial accounting and
reporting for obligations associated with the retirement of tangible long-lived
assets and the associated asset retirement costs. Due to the nature of our
business, this new accounting pronouncement is not expected to have a
significant impact on our reported results of operations and financial
condition.

In August 2001, the FASB issued SFAS No. 144, "ACCOUNTING FOR THE
IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS," which addresses financial
accounting and reporting for the impairment or disposal of long-lived assets.
This statement supersedes SFAS No. 121, "ACCOUNTING FOR THE IMPAIRMENT OF
LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF" and the
accounting and reporting provisions of APB Opinion No. 30, "REPORTING THE
RESULTS OF OPERATIONS - REPORTING THE EFFECTS OF A DISPOSAL OF A BUSINESS AND
EXTRAORDINARY, UNUSUAL AND INFREQUENTLY OCCURRING EVENTS AND TRANSACTIONS," for
the disposal of a segment of a business. This Statement also amends ARB No. 51,
"CONSOLIDATED FINANCIAL STATEMENTS," to eliminate the exception to consolidation
for a subsidiary for which control is likely to be temporary. SFAS No. 144
became effective on January 1, 2002, and interim periods within fiscal 2003,
with early application encouraged. The provisions of this Statement generally
are to be applied prospectively. The Company has not determined the effect, if
any, adoption of SFAS No. 144 will have on the financial position and results of
operations.

F-10

NOTE 3 - ACCOUNTS RECEIVABLE:

Accounts receivable consist of the following:

The 2001 provision for doubtful accounts includes $1,650,000 related to
trade receivables due from K-mart Corp., which filed for Chapter 11 bankruptcy
on January 22, 2002 (see Note 15).

NOTE 4 - PROPERTY AND EQUIPMENT:

Property and equipment consist of the following:

NOTE 5 - ACCOUNTS PAYABLE AND ACCRUED LIABILITIES:

Accounts payable and accrued liabilities consist of the following:

F-11

NOTE 6 - NOTES PAYABLE:

Indebtedness consists of the following:

The bank revolving credit facility (the "Revolver") includes a $17.5
million revolving line of credit commitment, subject to availability under a
borrowing base calculated by reference to the level of eligible accounts
receivable and inventory, as defined in the agreement. The Revolver matures on
March 31, 2004. Interest on borrowings outstanding under the Revolver is payable
monthly in arrears at an annual rate equal to prime plus .75%. In addition, an
unused line fee at an annual rate equal to .50% applied to the amount by which
$17.5 million exceeds the average daily principal balance during the month and a
collateral management fee of $2,500 is payable monthly.

The Revolver contains certain restrictive covenants and conditions among
which are prohibition on payment of dividends, limitations on further
indebtedness, restrictions on dispositions and acquisition of assets,
limitations on advances to third parties and compliance with minimum net worth
and net income amounts and designation as the "Senior Indebtedness" as relates
to the related party debt described below.

F-12

The $868,000 Letter of Credit collateralizing the $1,690,000 promissory
note, is provided for the benefit of the Company by MVII. Expense associated
with the letter of credit are reimbursed to MVII by the Company. Payment to MVII
on the $5,000,000 promissory note is subject to the terms of a subordination
agreement between MVII and the Revolver bank, which places restrictions on
payment to MVII, based on the borrowing capacity available to the Company under
the Revolver.

The Company's ability to meet its maturing debt and other cash requirements
is dependent on the continuation of sufficient lending arrangements, additional
cash infusions, and/or cash from operations. In connection with any future cash
needs or acquisition opportunities, the Company may incur additional debt or
issue additional equity or debt securities depending on market conditions, as
well as other factors. However, there can be no assurance the Company will meet
its projected operating results.

F-13

NOTE 7 - INCOME TAXES:

The components of income (loss) before provision for (benefit from) income
taxes by fiscal year were as follows:

The provision for income taxes (benefit) by fiscal year is as follows:

The difference between income taxes (benefit) at the statutory federal and
the effective income tax rates by fiscal year is as follows:

F-14

Deferred tax assets (liabilities) are comprised of the following:

The Internal Revenue Service regulations restrict the utilization of U.S.
net operating loss carryforwards and other tax attributes such as foreign tax
credits for any company in which an "ownership change" as defined in Section 382
of the Internal Revenue Code has occurred. In June of 1999, the Company had a
Section 382 change in ownership. As a result, the Company's U.S. net operating
losses and tax credits are subject to limitation of approximately $1,230,000 per
year. For the current fiscal year, this limitation did not impact the Company's
utilization of U.S. net operating losses and foreign tax credits.

At December 31, 2001, the Company has approximately $1,671,000 in foreign
tax credit carryforwards which expire between December 31, 2001 through December
31, 2006. The Company also has approximately $82,000 in alternative minimum tax
credit carryforwards which do not expire. With the exception of approximately
$566,000 of foreign tax credits expiring during the tax year December 31, 2002,
the Company believes that the foreign and alternative minimum tax credit
carryforwards will be available to reduce future federal income tax liabilities,
and has recorded the related tax benefit as a non-current deferred tax asset.
The Company has federal net operating loss carryforwards (NOL) of approximately
$610,000 which expire in 2020. The Company's state net operating loss
carryforward is not significant. The benefit from utilization of net operating
loss carryforwards could be subject to limitations if significant ownership
changes occur in the Company. The Company's ability to realize the entire
benefit of its deferred tax asset requires that the Company achieve certain
future earnings levels prior to the expiration of its foreign tax credit and NOL
carryforwards. The Company could be required to record a valuation allowance for
a portion or all of its deferred tax asset if market conditions deteriorate and
future earnings are below, or projected to be below, its current estimates.

NOTE 8 - EMPLOYEE BENEFIT PLAN:

The Company maintains a 401(k) Plan (the Plan) for the benefit of its U.S.
employees. The Company may, at its discretion, provide funds to match employee
contributions to the Plan. The Company contributed approximately $63,000,
$54,000 and $27,000 in fiscal 2001, 2000 and 1999, respectively, as employer
matching contributions to employee contributions.

F-15

NOTE 9 - THE STOCK OPTION PLAN AND WARRANTS:

The Company has reserved 388,888 common shares for issuance upon exercise
of warrants issued to a bank. Such warrants are currently exercisable at a
purchase price of $2 per share and expire December 11, 2005.

In connection with the Offering, the Company issued warrants to purchase
250,000 shares of common stock. Such warrants are exercisable at $10.80 per
share and expire May 28, 2002.

On March 19, 2001, the Company issued to MVII an Investment Warrant to
acquire 1.8 million shares of the Company's Common Stock at a purchase price of
$2.7 million. The Investment Warrant is exercisable, in whole or in part, for a
ten-year period beginning June 4, 2002. Proceeds from the sale of the Investment
Warrant were used by the Company for current working capital.

In May 1997, the Board adopted the DSI Toys, Inc. 1997 Stock Option Plan
(the 1997 Plan) whereby certain employees may be granted stock options,
appreciation rights or awards related to the Company's common stock.
Additionally, the Company may grant nonstatutory stock options (as defined in
the 1997 Plan) to nonemployee board members. The Board authorized 600,000 shares
to be available for grant pursuant to the 1997 Plan. Options expire no later
than ten years from the date of grant.

Additional awards may be granted under the 1997 Plan in the form of cash,
stock or stock appreciation rights. The stock appreciation right awards may
consist of the right to receive payment in cash or common stock. Any award may
be subject to certain conditions, including continuous service with the Company
or achievement of business objectives.

In May 1999, the 1997 Plan was amended to authorize 900,000 shares to be
available for grant.

In May 2000, the 1997 Plan was amended to authorize 1,200,000 shares to be
available for grant.

A summary of the option activity under the 1997 Plan, as amended, follows:

F-16

The weighted average fair value at date of grant for options granted during
fiscal 2001, 2000 and 1999 was $3.13, $3.19 and $3.13 respectively. Vesting
periods for options granted range from immediate to seven years from the date of
grant in increments between 5% and 90% per year.

Options outstanding at December 31, 2001 are as follows:

The Company applies APB 25 and related interpretations in accounting for
its stock option plan. Accordingly, no compensation cost has been recognized by
the Company for this plan. The following unaudited pro forma data is calculated
as if compensation cost for the 1997 Plan was determined based upon the fair
value at the grant date for awards under the plan consistent with the
methodology prescribed under SFAS 123 for fiscal years 2001, 2000 and 1999:

The fair value of each option granted is estimated on the date of grant
using the Black-Scholes options-repricing model with the following weighted
average assumptions used for grants in fiscal 2001, 2000 and 1999: expected
volatility of 80% in fiscal 2001, 80% in fiscal 2000 and 104% in fiscal 1999,
risk-free interest rate of 4.64% to 6.37%, no dividend yield and an expected
life of seven years.

NOTE 10 - RELATED PARTY TRANSACTIONS:

The Company leases its office and warehouse in Houston from an entity owned
by the previous sole shareholder of the Company. Rent expense on these leases
was approximately $367,000, $325,000 and $199,000 respectively for fiscal 2001,
2000, and 1999. Management believes that the rental rates approximate fair
market value.

On June 11, 1999, the Company entered into a consulting agreement with a
director (and former CEO), for a term of three years. Compensation for the three
year term is $450,000 payable in equal monthly installments of $12,500.

On January 7, 2000, the Company borrowed $5,000,000 from MVII, LLC (a
California limited liability company controlled by the Chairman, and including
certain other directors) evidenced by a Promissory Note. The Note, which bears
interest at a rate of prime plus 2% per annum, requires monthly interest
payments from the date of the Note and principal payments beginning June 1,
2000, subject to subordination terms of the Revolver (see Note 6).

On March 6, 2002, pursuant to the terms of the Revolver and the MVII Note,
the Company reborrowed $500,000 of the original principal that the Company had
paid on the MVII Note. The proceeds were used to finance normal business
operations of the Company.

F-17

Also on January 7, 2000, as discussed in Note 15, the Company merged with
Meritus Industries, Inc. Pursuant to the merger terms, one of Meritus' primary
shareholders was subsequently elected to the Board. In addition to the stock
received in the transaction, the shareholder received $1.1 million in cash and a
note receivable for $1.7 million. The note, bearing interest at 10.0375% per
annum, requires quarterly principal and interest payments beginning April 1,
2000.

Additional related party transactions are described in Notes 1, 11 and 16.

NOTE 11 - COMMITMENTS AND CONTINGENCIES:

In the normal course of business, the Company is involved in product and
intellectual property issues which sometimes result in litigation. It is the
opinion of management that the ultimate resolution of such matters will not have
a material adverse effect on the Company's financial position, results of
operations or cash flows, taken as a whole.

The Company leases its facilities under various operating leases which
expire from 2001 to 2010. Rent expense, including amounts paid to a related
party, for fiscal 2001, 2000, and 1999 amounted to $966,971, $1,008,183 and
$573,000, respectively. Aggregate minimum rental commitments under
non-cancelable leases are as follows for the specified fiscal years:

2002 872,929
2003 270,759
2004 167,316
2005 167,316
2006 167,316
Thereafter thru 2010 557,720
---------------------
$ 2,203,356
=====================

The lease for the Company's primary executive offices, showroom and
warehouse expires August 31, 2002. The Company is in negotiations to lease for
about five years approximately 16,000 square feet of office space in Houston,
Texas for executive offices, showroom and consumer services. The Company
anticipates occupying its new offices on August 1, 2002.

The Company is in negotiations to lease approximately 75,000 square feet of
warehouse space in Fife, Washington. The Company anticipates signing the lease
in June, 2002.

Royalty expense under licensing agreements aggregated approximately
$3,310,000, $2,989,000 and $1,829,000, in fiscal 2001, 2000 and 1999,
respectively. At December 31, 2001, minimum guaranteed royalties payable under
these agreements of $150,000 in fiscal 2002 and $225,000 through 2003, are
included in accrued royalties payable and prepaid expenses and other assets.

The Company has employment agreements with executives at December 31, 2001
that aggregate $750,000, are adjusted annually by the CPI change, and expire in
the next 15-35 months.

In fiscal 2000, the Company terminated its obligations for current and
future insurance premium payments on certain life insurance policies. In prior
years, the Company paid premiums for the policies owned by the Tommy and JoBeth
Moss Joint Life Insurance Trust, (the "Trust"), and was entitled to repayment of
the advanced premiums, plus related cumulative interest, upon the death of
JoBeth Moss. The Company agreed to forgo the cumulative amounts due the Company
in exchange for the Trust extinguishing the future obligations for insurance
premium payments. The premiums recorded for general and administrative expense
in 1999 were approximately $243,000.

F-18

NOTE 12 - SEGMENT INFORMATION:

The Company designs, develops, markets and distributes a variety of toys
and children's consumer electronics. These product lines are grouped into three
major categories which represent the Company's operating segments, as follows:

Juvenile Audio Products, including walkie-talkies, pre-school audio
products, pre-teen audio products and musical toys; Girls' Toys, including
dolls, play sets and accessories; and Boys' Toys, including radio control
vehicles, action figures and western and military action toys.

These operating segments all have similar economic characteristics: the
marketing of children's products. Based on these similarities, the Company's
products can be aggregated into one reportable segment for purposes of this
disclosure.

The Company sells its products through (i) the Hong Kong operation, where
products are shipped directly from contract manufacturers to the Company's
customers, and (ii) the United States operation, where products are shipped from
the Company's warehouse in Houston to its customers.

Financial information for fiscal 2001, 2000, and 1999 for the U.S. and Hong
Kong operations is as follows:

F-19

Sales to major customers that exceeded 10% of the Company's total net sales
consist of the following for the specified fiscal years (See Note 15):

Approximately 17% of the Company's sales were exports to foreign countries
during fiscal 2001, and 19% and 23% during fiscal 2000 and 1999, respectively.

NOTE 13 - SUPPLEMENTAL CASH FLOW INFORMATION:

Additional cash flow information by fiscal year is as follows:

F-20

NOTE 14 - QUARTERLY FINANCIAL INFORMATION (UNAUDITED):

NOTE 15 - SUBSEQUENT EVENTS

On January 22, 2002, the Kmart Corporation (Kmart) filed for Chapter 11
bankruptcy. At December 31, 2001, the Company's receivables included
$1,653,548 due from Kmart, all of which were still outstanding at the date of
filing. Based on the listing of Kmart's unsecured debt and financial position
contained in the filing, the Company does not anticipate that any of the
outstanding balance will be recovered. Accordingly, the Company has recorded
an allowance for doubtful accounts in 2001 equal to the entire December 31,
2001 Kmart outstanding balance, or $1,653,548.

Kmart was the Company's second largest customer in 2001, comprising 10% of
sales. Kmart is requiring normal trade terms from companies desiring to do
business with them in 2002, offering a

F-21

second-priority lien or "Trade Creditor Lien" in Kmart's owned merchandise
inventory. Due to Kmart's market share, the Company has accepted this lien
position and will sell to Kmart in 2002.

On March 6, 2002, pursuant to the terms of the Revolver and the MVII Note,
the Company reborrowed $500,000 of the original principal that the Company paid
on the MVII Note. The proceeds were used to finance normal business operations
of the Company.

As of December 31, 2001, the Company and Sunrock amended the Revolver to
revise the future covenants and restrictions required by the Revolver.
Management believes the Company will be able to maintain compliance with such
covenants in the future.

F-22

NOTE 16 - BUSINESS COMBINATION

On January 7, 2000, the Company acquired by way of a merger all of the
issued and outstanding stock of Meritus Industries, Inc. ("Meritus") in exchange
for (i) 600,000 unregistered shares of the Company's common stock, less 66,792
shares of the Company's common stock, which shares were initially held by the
Company and payable to Walter and Susan Reiling (the "Reilings") upon
satisfaction of certain post-closing conditions as set forth in the Closing and
Holdback Agreement between the parties; (ii) $884,034 in cash; and (iii) the
Company's Subordinated Secured Promissory Note for $1,690,000 paid to the
Reilings, who were the sole shareholders of Meritus. At the end of the holdback
period (June 7, 2000), the post-closing conditions were not satisfied and none
of the held back (66,792) shares was paid to the Reilings. The market value of
the shares issued was $1,081,415 and was satisfied by the issuance of 347,365
shares of new stock and 185,843 shares in treasury stock. Contemporaneously with
the merger, the Company satisfied approximately $4.4 million of Meritus' debt.

The acquisition was accounted for utilizing the purchase method; therefore
the Company recorded the acquired assets at their estimated fair market value.
Goodwill generated by the transaction has been amortized over 20 years using the
straight-line method in 2001 and 2000. In 2002, and thereafter the market value
of the goodwill will be evaluated annually and an impairment charge recorded if
appropriate in accordance with Statement of Financial Accounting Standards No.
142, "Goodwill and Other Intangible Assets".

Commensurate with the merger, the Company borrowed $5,000,000 from MVII,
LLC, a California limited liability company controlled by E. Thomas Martin
("MVII"), evidenced by a promissory note dated January 7, 2000. The proceeds
from the note were used for the payment of the Meritus debt discussed above.

PRO FORMA RESULTS OF OPERATIONS

Presented below is a pro forma statement of operations for fiscal year
ended December 1999. The proforma reflects the combined operations of the
Company and Meritus as if the merger of the Company and Meritus occurred on
January 1, 1998.

F-23

DSI TOYS, INC. AND SUBSIDIARY

VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (SCHEDULE II)

(IN THOUSANDS)

S-1

EXHIBIT INDEX

2.1 Articles/Certificate of Merger of Meritus Industries, Inc. into
the Company, dated January 7, 2000 (filed as Exhibit 2.2 to the
Company's Form 8-K dated January 7, 2000), incorporated herein by
reference.

3.1 Amended and Restated Articles of Incorporation of the Company.
(1)

3.1.1 Amendment to Amended and Restated Articles of Incorporation of
the Company (filed as Exhibit 3.1.1 to the Company's Form 10-Q
for the quarterly period ended April 30, 1999), incorporated
herein by reference. (3)

3.2 Amended and Restated Bylaws of the Company. (1)

3.3 Amendment to Amended and Restated Bylaws of the Company. (1)

4.1 Form of Common Stock Certificate. (1)

4.2 Form of Warrant Agreement among the Company and Representatives
to purchase 250,000 shares of common stock. (1)

4.3 Common Stock Purchase Warrant No. A-1 dated December 11, 1995,
issued to Hibernia Corporation to purchase 388,888 shares of
common stock. (1)

4.4 Registration Rights Agreement by and between the Company and
Hibernia Corporation. (1)

4.5 Registration Rights Agreement by and between the Registrant and
Tommy Moss. (1)

4.6 Form of Investment Warrant by and between the Company and MVII,
LLC, dated March 19, 2001(filed as Exhibit 4.6 to the Company's
Form 10-K for the fiscal year ended December 31, 2000),
incorporated herein by reference.

4.7 Registration Rights Agreement by and between the Company and
MVII, LLC, dated March 19, 2001 (files as Exhibit 4.7 to the
Company's Form 10-K for the fiscal year ended December 31, 2000),
incorporated herein by reference.

4.8* Amended and Restated Investment Warrant by and between the
Company and MVII, LLC, dated January 31, 2002.

4.9* Amended and Restated Registration Rights Agreement by and between
the Company and MVII, LLC dated January 31, 2002.

10.1 1997 Stock Option Plan. (1)

10.2 Agreement for Sale of Stock between Rosie Acquisition, L.L.C. and
DSI Acquisition, Inc. and Diversified Specialists, Inc. and Tommy
Moss, dated December 11, 1995. (1)

10.3 Employment Agreement dated December 11, 1995 by and between the
Company and M.D. Davis. (1)

10.4 Employment Agreement dated December 11, 1995 by and between the
Company and Richard R. Neitz. (1)

10.5 Employment Agreement dated December 11, 1995 by and between the
Company and Yau Wing Kong. (1)

E-1

10.6 Employment Agreement dated December 11, 1995 by and between the
Company and Dale Y. Chen. (1)

10.7 Employment Agreement dated December 11, 1995 by and between the
Company and Thomas V. Yarnell. (1)

10.8 Employment Agreement dated March 16, 1997 by and between the
Company and J. Russell Denson. (1)

10.9 Letter Loan Agreement between the Company and Bank One, Texas,
N.A. dated December 11, 1995, evidencing a revolving line of
credit and a term note (the "Bank One Letter Loan Agreement").
(1)

10.10 First Amendment to Bank One Letter Loan Agreement, dated January
31, 1996. (1)

10.11 Second Amendment to Bank One Letter Loan Agreement, dated August
1, 1996. (1)

10.12 Third Amendment to Bank One Letter Loan Agreement, dated November
14, 1996. (1)

10.13 Fourth Amendment to Bank One Letter Loan Agreement, dated January
31, 1997. (1)

10.14 Fifth Amendment to Bank One Letter Loan Agreement, dated January
31, 1997. (1)

10.15 Line of Credit Facility with State Street Bank and Trust Company,
Hong Kong Branch, dated April 1, 1997, evidencing a $5,000,000
line of credit. (1)

10.16 Underwriting Agreement dated May 28, 1997 among the Company, the
Tommy Moss Living Trust, Hibernia Corporation and Tucker Anthony
Incorporated and Sutro & Co. Incorporated (filed as Exhibit 10.1
to the Company's Form 10-Q for the quarterly period ended April
30, 1997), incorporated herein by reference.

10.17 Warrant Agreement dated May 28, 1997 by and among the Company,
Tucker Anthony Incorporated and Sutro & Co. Incorporated (filed
as Exhibit 10.2 to the Company's Form 10-Q for the quarterly
period ended April 30, 1997), incorporated herein by reference.

10.18 Renewal and Modification of Line of Credit Facility with State
Street Bank and Trust Company, Hong Kong Branch, dated June 6,
1997, evidencing an $8,000,000 line of credit (filed as Exhibit
10.1 to the Company's Form 10-Q for the quarterly period ended
July 31, 1997), incorporated herein by reference.

10.19 Debenture by DSI(HK) Limited to State Street Bank and Trust
Company, Hong Kong Branch, dated July 29, 1997 (filed as Exhibit
10.2 to the Company's Form 10-Q for the quarterly period ended
July 31, 1997), incorporated herein by reference.

10.20 Amended and Restated Bank One Letter Loan Agreement, dated
October 22, 1997 (filed as Exhibit 10.1 to the Company's Form
10-Q for the quarterly period ended October 31, 1997),
incorporated herein by reference.

10.21 First Amendment to Amended and Restated Bank One Letter Loan
Agreement, dated January 31, 1998 (filed as Exhibit 10.21 to the
Company's Form 10-K for the annual period ended January 31,
1998), incorporated herein by reference.

10.22 Second Amendment to Amended and Restated Bank One Letter Loan
Agreement, dated September 30, 1998 (filed as Exhibit 10.22 to
the Company's Form 10-Q for the quarterly period ended October
31, 1998), incorporated herein by reference.

10.23 Employment Agreement dated August 20, 1998 by and between the
Company and Howard G. Peretz. (2)

E-2

10.24 Loan and Security Agreement by and between the Company and
Sunrock Capital Corp. dated February 2, 1999. (2)

10.25 Stock Pledge Agreement by and between the Company and Sunrock
Capital Corp. dated February 2, 1999. (2)

10.26 Assignment of Deposit Account by and between the Company and
Sunrock Capital Corp. dated February 2, 1999. (2)

10.27 Trademark Security Agreement by and between the Company and
Sunrock Capital Corp. dated February 2, 1999. (2)

10.28 Patent Collateral Assignment by and between the Company and
Sunrock Capital Corp. dated February 2, 1999. (2)

10.29 Stock Purchase and Sale Agreement dated April 15, 1999 by and
between the Company and MVII, LLC (filed as Exhibit 2 to the
Company's Schedule 14D-9 filed by the Company on April 22, 1999),
incorporated herein by reference.

10.30 Stock Purchase and Sale Agreement, dated April 15, 1999, between
the Company and MVII, LLC (filed as Exhibit 99.2 to the Schedule
14D-9 filed by the Company on April 22, 1999), incorporated
herein by reference.

10.31 Shareholders' and Voting Agreement dated April 15, 1999, by and
among the Company, MVII, LLC, certain management shareholders of
the Company and a limited partnership controlled by a management
shareholder (filed as Exhibit 99.4 to the Schedule 14D-9 filed by
the Company on April 22, 1999), incorporated herein by reference.

10.32 Registration Rights Agreement dated April 15, 1999, by and among
the Company, MVII, LLC, certain management shareholders of the
company and a limited partnership controlled by a management
shareholder (filed as Exhibit 99.5 to the Schedule 14D-9 filed by
the Company on April 22, 1999), incorporated herein by reference.

10.33 Irrevocable Proxy dated April 15, 1999, between MVII, LLC and
Conrad. (3)

10.34 Irrevocable Proxy dated April 15, 1999, between MVII, LLC and
Davis. (3)

10.35 Irrevocable Proxy dated April 15, 1999, between MVII, LLC and
Matlock. (3)

10.36 Irrevocable Proxy dated April 15, 1999, between MVII, LLC and
Rust Capital. (3)

10.37 Irrevocable Proxy dated April 15, 1999, between MVII, LLC and
Smith. (3)

10.38 Consulting Agreement dated June 1, 1999, between the Company and
Davis. (3)

10.39 Amendment dated May 5, 1999, to Loan and Security Agreement,
dated as of February 2, 1999, by and between Sunrock Capital
Corp. and the Company. (3)

10.40 Amendment No. 1 dated June 30, 1999, to Loan and Security
Agreement, by and between Sunrock Capital Corp. and the Company.
(4)

10.41 Employment Agreement dated June 17, 1999 by and between the
Company and Michael J. Lyden. (4)

10.42 Employment Agreement dated June 1, 1999, by and between the
Company and Joseph S. Whitaker. (4)

10.43 Amendment to 1997 Stock Option Plan dated May 24, 1999. (4)

E-3

10.44 Restated Employment Agreement dated December 31, 1999, by and
between DSI(HK) Limited and Yau Wing Kong (filed as Exhibit 10/44
to the Company's Form 10-K for the 11 month period ended December
31, 1999), and incorporated herein by reference.

10.45 Agreement and Plan of Merger between Meritus Industries, Inc.
et al. and the Company, dated October 7, 1999 (filed as Exhibit
10.45 to the Company's Form 10-Q for the quarterly period ended
October 31, 1999), incorporated herein by reference.

10.46 Closing and Holdback Agreement dated January 7, 2000, by and
between the Company and Meritus Industries, Inc., et al. (filed
as Exhibit 2.3 to the Company's Form 8-K dated January 7, 2000),
incorporated herein by reference.

10.47 Shareholders' and Voting Agreement dated January 7, 2000, by and
among the Company, MVII, LLC and Walter S. and Susan Reiling
(filed as Exhibit 10.1 to the Company's Form 8-K dated January 7,
2000), incorporated herein by reference.

10.48 Limited Irrevocable Proxy dated January 7, 2000, between MVII,
LLC and Walter S. and Susan Reiling (filed as Exhibit 10.2 to the
Company's Form 8-K dated January 7, 2000), incorporated herein by
reference.

10.49 Registration Rights Agreement dated January 7, 2000, by and
between the Company and Walter S. and Susan Reiling (filed as
Exhibit 10.3 to the Company's Form 8-K dated January 7, 2000),
incorporated herein by reference.

10.50 Subordinated Secured Promissory Note dated January 7, 2000, from
the Company to Walter S. and Susan Reiling (filed as Exhibit 10.4
to the Company's Form 8-K dated January 7, 2000), incorporated
herein by reference.

10.51 Promissory Note dated January 7, 2000, from the Company to MVII,
LLC (filed as Exhibit 10.5 to the Company's Form 8-K dated
January 7, 2000), incorporated herein by reference.

10.52 Amendment No. 2 dated January 7, 2000, to Loan and Security
Agreement, by and between Sunrock Capital Corp. and the Company
(filed as Exhibit 10.6 to the Company's Form 8-K dated January 7,
2000), incorporated herein by reference.

10.53 Employment Agreement dated January 7, 2000, by and between the
Company and Beth Reiling (filed as Exhibit 10.7 to the Company's
Form 8-K dated January 7, 2000), incorporated herein by
reference.

10.54 Employment Agreement dated January 7, 2000, by and between the
Company and Joseph Reiling (filed as Exhibit 10.8 to the
Company's Form 8-K dated January 7, 2000), incorporated herein by
reference.

10.55 Amendment No. 2 to DSI Toys, Inc. 1997 Stock Option Plan (filed
as Exhibit 10.11 to the Company's Form 10-Q for the quarterly
period ended June 30, 2000), incorporated herein by reference.

10.56 Amendment No. 3 dated July 14, 2000, to Loan and Security
Agreement, by and between Sunrock Capital Corp. and the Company
(filed as Exhibit 10.12 to the Company's Form 10-Q for the period
ended June 30, 2000), incorporated herein by reference.

10.57 Amendment No. 4 dated March 30, 2001, to Loan and Security
Agreement, by and between Sunrock Capital Corp. and the Company
(filed as Exhibit 10.57 to the Company's Form 10-K for the annual
period ended December 31, 2000), incorporated herein by
reference.

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10.58 Employment Agreement dated April 1, 2001, but executed April 23,
2001, by and between the Company and Gregory A. Barth (filed as
Exhibit 10.2 to the Company's Form 10-Q for the quarterly period
ended March 31, 2001), incorporated herein by reference.

10.59 Amendment No. 5 to Loan and Security Agreement, dated August 13,
2001, by and between Sunrock Capital Corp. and the Company (filed
as Exhibit 10.3 to the Company's Form 10-Q for the quarterly
period ended June 30, 2001), incorporated herein by reference.

10.60 Amendment No. 6 to Loan and Security Agreement, dated August 13,
2001, by and between Sunrock Capital Corp. and the Company (filed
as Exhibit 10.4 to the Company's Form 10-Q for the quarterly
period ended June 30, 2001), incorporated herein by reference.

10.61* First Amendment to Employment Agreement by and between the
Company and Joseph S. Whitaker, dated December 1, 2001.

10.62* Line of Credit Facility with Dao Heng Bank Limited evidencing a
$6,000,000 line of credit, dated December 4, 2001.

10.63* Memorandum of Re-borrowing of Principal by and between the
Company and MVII, LLC, dated March 6, 2002.

10.64* Amendment No. 7 dated March 20, 2002, to Loan and Security
Agreement by and between Sunrock Capital Corp. and the Company.

10.65* Unconditional Guaranty Agreement dated March 20, 2002, by the
Company and Dao Heng Bank Limited.

10.66* Amendment No. 8 dated March 29, 2002, to Loan and Security
Agreement by and between Sunrock Capital Corp. and the Company.

21* Subsidiaries.

99.1 DSI Toys, Inc. Audit Committee of the Board of Directors,
Charter, adopted by the Board of Directors on May 23, 2000 (filed
as Exhibit 99.1 to the Company's Form 10-Q for the period ended
June 30, 2000), incorporated herein by reference.

99.2 Amendment No. 1 to the Audit Committee of the Board of Directors
Charter, adopted by the Board of Directors on March 31, 2001
(filed as Exhibit 99.2 to the Company's Form 10-K for the fiscal
year ended December 31, 2000), incorporated herein by reference.

(1) Filed as a part of the Registrant's Registration Statement on Form S-1 (No.
333-23961) and incorporated herein by reference.

(2) Filed as the indicated numbered exhibit to the Company's Form 10-K for the
annual period ended January 31, 1999, and incorporated herein by reference.

(3) Filed as the indicated numbered exhibit to the Company's Form 10-Q for the
quarterly period ended April 30, 1999, and incorporated herein by
reference.

(4) Filed as the indicated numbered exhibit to the Company's Form 10-Q for the
quarterly period ended July 31, 1999, and incorporated herein by reference.

* Filed herewith

E-5