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Form 10-Q

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

(Mark One)

For the quarterly period ended June 30, 2004

Commission file number 0-7024

The First Years Inc.

(Exact name of registrant as specified in its charter)

One Kiddie Drive, Avon, Massachusetts 02322-1171

(Address of principal executive offices)

(Zip Code)

(508) 588-1220

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year,

if changed since last report)

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 whether the Company is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

The number of shares of Registrant’s common stock outstanding on July 31, 2004 was 8,355,770.

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THE FIRST YEARS INC.

INDEX

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THE FIRST YEARS INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to condensed consolidated financial statements.

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THE FIRST YEARS INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

THREE AND SIX MONTHS ENDED JUNE 30, 2004 AND 2003

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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THE FIRST YEARS INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE

SIX MONTHS ENDED JUNE 30, 2004 AND 2003

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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THE FIRST YEARS INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation — Amounts in the accompanying balance sheet as of December 31, 2003 are condensed from the Company’s audited balance sheet as of that date. All other condensed financial statements are unaudited but, in the opinion of the Company, contain all normal recurring adjustments necessary to present fairly the financial position as of June 30, 2004 and the results of operations and cash flows for the periods ended June 30, 2004 and 2003. Certain reclassifications were made to prior year amounts in order to conform to the current year presentation. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The results of operations for the six-month period ended June 30, 2004 are not necessarily indicative of the results to be expected for the full year.

Stock-Based Compensation — Pursuant to Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” the Company applies the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” to its stock options and other stock-based compensation plans.

In accordance with APB No. 25, compensation cost for stock options is recognized in income based on the excess, if any, of the quoted market price of the stock at the grant date of the award or other measurement date over the amount an employee must pay to acquire the stock. Generally, the exercise price for stock options granted to employees equals or exceeds the fair market value of the Company’s common stock at the date of grant, thereby resulting in no recognition of compensation expense by the Company.

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation. The estimated fair value of each of the Company’s options is calculated using the Binomial option-pricing model.

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2. Common Stock - The Company has 50,000,000 authorized shares of $.10 par value common stock with 10,963,383 and 10,944,970 shares issued and 8,349,019 and 8,337,350 shares outstanding as of June 30, 2004 and December 31, 2003, respectively.

3. Earnings Per Share - Computation of earnings per share (“EPS”) is as follows:

All options to purchase shares of common stock for the three months and the six months ended June 30, 2004 were included in the computation of diluted EPS because the exercise prices of those options were less than the average market price of the Company’s common stock. Options to purchase 576,389 shares of common stock for the three months ended June 30, 2003 and options to purchase 698,941 shares of common stock for the six months ended June 30, 2003 were not included in the computation of diluted EPS because the exercise prices of those options were greater than the average market price of the Company’s common stock.

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4. Derivative Instruments — From time to time, the Company uses derivative financial instruments in the form of foreign currency forward exchange contracts to manage foreign currency risks on future cash flows emanating from sales denominated in foreign currencies and the receipt of cash from such transactions. It is the Company’s policy to execute such instruments with creditworthy banks and not to enter into derivative financial instruments for speculative purposes.

Currency contracts are designated as, and are highly effective as, hedges of anticipated sales in specific currencies. Prior to an anticipated transaction closing, the gain or loss on the forward exchange contract is accumulated in other comprehensive income, and reclassified against revenue when the hedged transaction is recorded. Subsequent changes in the value of the contract are recorded in the income statement, generally as an offset to gains or losses on the receivables generated by the sales transactions.

During the six months ended June 30, 2004, the Company did not enter into any forward exchange currency contracts and therefore did not reclassify any amount into results of operations.

5. Comprehensive Income — Comprehensive income for the three and six months ended June 30, 2004 and 2003 is as follows:

6. Borrowings & Line of Credit — During the first six months of 2004 and 2003, the Company did not borrow against its $10,000,000 unsecured line of credit established with a bank.

7. Concentrations & Export Sales — The Company derives sales from products carrying The First Years brand as well as products sold under licensing agreements. During the first six months of 2004 and 2003, net sales of The First Years brand products were approximately $53,137,000 and $46,648,000, respectively, while net sales derived from license and specialty products amounted to approximately $20,941,000 and $21,184,000 in the first six months of 2004 and 2003, respectively. Net export sales, primarily to Europe, Canada, South America, and the Pacific Rim, were approximately $11,124,000 and $9,803,000 during the first six months of 2004 and 2003, respectively.

8. Pending Merger – On June 4, 2004, the Company, RC2 Corporation, and RBVD Acquisition Corp., a wholly-owned subsidiary of RC2 Corporation (“RBVD”), entered into an Agreement and Plan of Merger (the “Merger Agreement”), which provides for the merger of RBVD with and into the Company, with the Company being the surviving corporation (the “Merger”). Under the Merger Agreement, upon consummation of the Merger, each share of the Company’s common stock outstanding immediately prior to the effective time of the Merger will be converted automatically into the right to receive $18.60 in cash, without interest. The Merger is subject to approval by the Company’s shareholders and other certain closing conditions. A meeting date of September 14, 2004, has been established for a meeting of the Company’s shareholders to vote upon the Merger Agreement, and the Merger is expected to close in

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the third quarter of 2004. There can be no assurance, however, that the Merger will be consummated in a timely manner or at all, due to the failure of the Company’s shareholders to approve the Merger Agreement, the failure of the parties to satisfy the other closing conditions, or other factors. In connection with the Merger, in the second quarter of 2004 the Company incurred $1.2 million of non-operating costs, principally legal fees, associated with the negotiation and execution of the Merger Agreement and the preparation of proxy and other merger-related materials. These costs are not expected to be tax deductible, and, as a result have caused a significant increase in the tax rate from 35% and 39% for the three and six month periods ended June 30, 2003 to 54% and 45% for the three and six month periods ended June 30, 2004.

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THE FIRST YEARS INC.

Part I, Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Statements in this Quarterly Report on Form 10-Q that are not strictly historical are “forward-looking” statements, as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements are typically identified by the words: believe, expect, anticipate, intend, estimate and similar expressions, which by their nature refer to future events. Actual future results may differ materially from those anticipated depending on a variety of factors which include, but are not limited to, trends in sales of The First Years Brand^® and licensed products including the effect of reduced economic activity, continued success of new Disney character refreshed graphics, continued maintenance of favorable license arrangements, disruptions to the Company’s business as a result of the announcement and pendency of the proposed merger with RC2 Corporation, the potential negative effects on the Company if the merger is not consummated for any reason, continued success of market research identifying new product opportunities, successful introduction of new products, continued product innovation, the success of new enhancements to the Company’s brand image, growth in domestic and international sales, ability to attract and retain key personnel, sales and earnings results, and general economic conditions affecting consumer spending, including uncertainties relating to global political conditions, such as terrorism and the conflict in Iraq. Additional information with respect to risk factors is contained in the Company’s most recent Annual Report on Form 10-K as filed with the Securities and Exchange Commission. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company does not intend to update any of the forward-looking statements after the date of this Report to conform these statements to actual results or changes in the Company’s expectations, except as required by law.

Critical Accounting Policies and Estimates

This discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related notes. Some of these estimates require difficult, subjective and/or complex judgments about matters that are inherently uncertain, and, as a result, actual results may differ from those estimates. Due to the judgment and estimation involved, the following summarized accounting policies and their application are considered to be critical to understanding the business operations, financial condition, and results of operations of The First Years Inc.

Revenue Recognition — In accordance with Staff Accounting Bulletin No. 104, we recognize revenue when products are shipped or delivered and substantial risks of ownership transfer to the customer, a firm sales agreement is in place, and collectibility of the fixed or determinable sales price is reasonably assured. Common to our industry, customers may be authorized to return selected products and we reduce sales and accounts receivable for actual returns and estimate future returns based on historical trends and information available to us, including the pattern of returns immediately following the reporting period. We also maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers deteriorates, resulting in an impairment of their ability to make payments, additional allowances may be required.

Inventories — Inventories, consisting of finished goods, unpackaged components, and supplies, are stated at the lower of cost or market with cost determined using the first-in, first-out method. We make certain obsolescence and other assumptions to adjust inventory based on historical experience and current information. We write down inventory for estimated obsolete or unmarketable inventory equal to the difference between the costs of inventory and estimated market value, based upon assumptions about future demand and market conditions. In the event of a write down of inventory, we also review molds associated with those products to determine whether there has been a significant impairment to the carrying value of the asset. If the carrying value of these assets is considered not to be recoverable, such assets are written down as appropriate. These assumptions, although consistently applied, can have a significant impact on current and future operating results and financial position.

Sales Incentives — Sales incentives offered to customers to promote the sales of our products include costs related to cooperative advertising programs, promotions, slotting fees or buydowns, and certain rebates. In determining these costs, we reflect activity and make estimates of certain costs of promotional activity based on historical arrangements and information available to us. Costs associated with sales incentives are reflected as a reduction of revenue when recognized.

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A. Results of Operations - Second Quarter of 2004 Compared with Second Quarter of 2003

Net Sales

Consolidated net sales for the second quarter of 2004 was $36.9 million, an increase of $3.0 million or 9%, as compared to net sales of $33.9 million in the second quarter of 2003. Domestic sales increased 7% and international sales increased 19% compared to the same period in 2003. This increase reflects increased sales in The First Years brand key product programs, particularly Take & Toss^® feeding, supported by an improved licensed and specialty business. In the second quarter of 2004, net sales of The First Years brand products increased 9% primarily due to a continued expansion of key product programs into top retailers. Net sales of licensed and specialty products increased by 7% principally due to the timing of promotional activities and product distribution.

Net sales of The First Years brand products as a percentage of total net sales remained consistent at 71% in the second quarter of 2004 as compared to the second quarter of 2003. As a percentage of net sales, sales of licensed and specialty products also remained consistent at 29% in the second quarter of 2004. International net sales as a percentage of total net sales increased to 17% in the second quarter of 2004 compared to 15% in the same period of 2003.

Cost of Sales and Gross Profit

Cost of products sold in the second quarter of 2004 was $23.4 million, an increase of $1.5 million or 7%, as compared to $21.8 million in the comparable period of 2003. As a percentage of net sales, cost of products sold and gross profit in the second quarter of 2004 changed modestly to 63% and 37%, compared to 64% and 36%, respectively, in the second quarter of 2003.

Selling, General, and Administrative Expenses

Selling, general, and administrative expenses in the second quarter of 2004 were $9.7 million, an increase of $0.7 million or 8%, as compared to $9.0 million in the second quarter of 2003. As a percentage of net sales, selling, general, and administrative costs remained consistent at approximately 26%. The dollar increase in selling, general, and administrative expenses was primarily due to increased marketing and product development costs.

Merger-Related Costs

During the second quarter of 2004, the Company incurred $1.2 million in costs associated with the proposed merger with RC2 Corporation. These non-operating costs were principally legal fees related to the negotiation and execution of the Merger agreement with RC2 Corporation and proxy preparation and other merger matters. These costs are not expected to be tax deductible, and, as a result have caused a significant increase in the tax rate from 35% to 54% for the three-month period ended June 30, 2003 and 2004, respectively.

Net Income

Net income for the second quarter of 2004 decreased 37% to $1.3 million or $0.15 per diluted share, compared with $2.0 million or $0.24 per diluted share in the comparable period of 2003. As a percentage of net sales, net income decreased from 6.0% to 3.5% in the second quarter of 2004. The decrease in net income is principally due to merger-related costs, as operating income increased 25% over the comparable period in 2003. Net income for the quarter, excluding merger-related costs, would have been $2.4 million or $.28 per diluted share, an increase of 19% and 17%, respectively, over the prior year comparable period.

B. Results of Operations - First Half of 2004 Compared with First Half of 2003

Net Sales

Consolidated net sales for the first half of 2004 was $74.1 million, an increase of $6.2 million or 9%, as compared to net sales of $67.8 million in the first half of 2003. Domestic sales increased 8% and international sales increased 13% compared to the same period in 2003. This increase reflects increased sales (19% and 9% in the first and second quarters of 2004) in The First Years brand product programs, particularly Take & Toss feeding, and a continued focus on key customers in Canada and Europe. Net sales of licensed and specialty products decreased modestly (1%), with sales declines in the first quarter of the year substantially offset by improved second quarter sales performance related to product distribution and promotional timing.

Net sales of The First Years brand products as a percentage of total net sales increased to 72% in the first half of 2004 as compared to 69% in the first half of 2003. As a percentage of net sales, sales of licensed and specialty products decreased to 28% in the first half of 2004 as compared to 31% in the first half of 2003. International net sales as a percentage of total net sales increased to 15% in the first half of 2004 compared to 14% in the same period of 2003.

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Cost of Sales and Gross Profit

Cost of products sold in the first half of 2004 was $47.0 million, an increase of $3.5 million or 8%, as compared to $43.5 million in the comparable period of 2003. As a percentage of net sales, cost of products sold and gross profit in the first half of 2004 were 63% and 37%, compared to 64% and 36%, respectively, in the first half of 2003.

Selling, General, and Administrative Expenses

Selling, general, and administrative expenses in the first half of 2004 were $19.0 million, an increase of $1.7 million or 10%, as compared to $17.4 million in the first half of 2003. As a percentage of net sales, selling, general, and administrative costs remained consistent at approximately 26%. The dollar increase in selling, general, and administrative expenses was primarily due to increased marketing and product development costs.

Merger-Related Costs

During the first half of 2004, the Company incurred $1.2 million in costs associated with the proposed merger with RC2 Corporation. These non-operating costs were principally legal fees related to the negotiation and execution of the Merger agreement with RC2 Corporation and proxy preparation and other merger matters. These costs are not expected to be tax deductible, and, as a result have caused a significant increase in the tax rate from 39% to 45% for the six-month period ended June 30, 2003 and 2004, respectively.

Net Income

Net income for the first half of 2004 decreased 11% to $3.9 million or $0.44 per diluted share, compared with $4.3 million or $0.52 per diluted share in the comparable period of 2003. As a percentage of net sales, net income decreased from 6% to 5% in the first half of 2004. The decrease in net income is principally due to merger-related costs, as operating income increased 16% over the comparable period in 2003. Net income for the first half, excluding merger-related costs, would have been $5.0 million or $.57 per diluted share, an increase of 15% and 10%, respectively, over the prior year comparable period.

C. Financial Condition

Consolidated assets of $85.3 million at June 30, 2004 were $0.6 million higher than at December 31, 2003.

The Company’s cash and cash equivalents increased by $0.9 million at June 30, 2004 from $24.7 million at December 31, 2003. The increase resulted primarily from $3.1 million provided by operating activities, offset by $1.3 million used for investing and $0.9 million used for financing activities.

Net cash of $3.1 million provided by operating activities consisted primarily of $5.2 million from net income adjusted for non-cash items, offset by $2.1 million used in working capital and other activities. Net cash used in working capital and other activities resulted primarily from a decrease in receivables, accrued payables, accrued royalty expenses, accrued selling expenses, offset by an increase in inventories and prepaid expenses. Days sales outstanding were 58 for the quarter ended June 30, 2004 and 64 for the year ended December 31, 2003. The decrease in days sales outstanding is primarily attributable to a decrease in accounts receivable for the quarter ended June 30, 2004 as compared to the year ended December 31, 2003. Inventory turns were 2.3 for the quarter ended June 30, 2004 and 2.6 for the comparable period in 2003.

Net cash of $1.3 million used in investing activities resulted from capital expenditures. Capital expenditures for the quarter ended June 30, 2004 consisted primarily of additions to machinery and molds for new production molds.

Net cash of $0.9 million was used by financing activities consisted primarily of a cash dividend slightly offset by proceeds on the issuance of common stock under the Company’s stock option plans.

Estimated uses of cash for the full year of 2004 include capital expenditures for building and improvements, machinery and molds, and equipment of approximately $2 – 3 million. We expect to fund expenditures for capital requirements as well as liquidity needs from available cash balances and internally generated funds. We have an unsecured line of credit of $10 million, which is subject to annual renewal at the option of the bank. Any amounts outstanding under the line are payable upon demand by the bank. For the quarter ended June 30, 2004, we had no borrowings under the line of credit and, as of June 30, 2004, there were no balances outstanding.

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Part I, Item 3.

Quantitative and Qualitative Disclosure about Market Risk

We are exposed to certain market risks, which include changes in United States and international interest rates as well as changes in currency exchange rates as measured against the United States dollar and each other. We attempt to reduce material risks by using foreign currency forward exchange contracts from time to time and managing our working capital to minimize currency and interest rate exposure.

Foreign Currency Market Risk

Our international operations are subject to certain opportunities and risks, including currency fluctuations. In the quarter ended June 30, 2004, our international sales accounted for 17% of total net sales. The value of the United States dollar affects our financial results, and changes in exchange rates may affect our revenues, gross margins, operating expenses, and retained earnings as expressed in United States dollars. From time to time, we use forward exchange contracts to hedge cash flows arising from sales denominated in foreign currencies to limit the impact of currency fluctuations. Principal currencies hedged include the Euro, the British Pound, and the Canadian Dollar. We also attempt to minimize currency exposure risk through working capital management.

Interest Rate Risks

Changes in interest rates affect interest income earned on the Company’s cash equivalents and short-term investments, composed primarily of U.S. treasury obligations and short-term money market instruments. We do not attempt to reduce or eliminate our market exposure to changes in interest rates in the U.S. or in international operations.

Also see the Company’s disclosure regarding Market Risk in Item 7A of its Annual Report on Form 10-K for the fiscal year ended December 31, 2003, as filed with the SEC.

Part I, Item 4.

Controls and Procedures

We have established disclosure controls and procedures to ensure that material information relating to us, including our consolidated subsidiaries, is made known to the officers who certify our financial reports and to other members of senior management and the Board of Directors.

Evaluation of disclosure controls and procedures. Our management, with the participation of our principal executive officer and principal financial officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our principal executive officer and principal financial officer concluded that these disclosure controls and procedures are effective and designed to ensure that the information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the requisite time periods.

Changes in internal controls. There was no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended) that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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THE FIRST YEARS INC.

PART II - OTHER INFORMATION

Item 1: Legal Proceedings

On June 30, 2004, a putative class action complaint was filed with the Superior Court Department of the Trial Court Civil Action Business Litigation Session of The Commonwealth of Massachusetts, Suffolk County, styled as Arthur Marshall, individually and on behalf of all others similarly situated, vs. The First Years Inc., Ronald J. Sidman, Richard E. Wenz, Beth J. Kaplan, Walker J. Wallace, Kenneth R. Sidman, Lewis M. Weston, Fred T. Page, Evelyn Sidman and Benjamin Peltz. The complaint alleges two causes of action: breach of fiduciary duty by the Company’s directors in connection with the negotiation and execution of the Merger Agreement, and aiding and abetting in the breach of those fiduciary duties by the Company. In connection with these allegations, the complaint asserts that the defendants failed to seek alternatives to the sale of the Company, failed to engage in a meaningful auction to obtain the highest value for the Company’s shareholders, approved unfair terms in the Merger Agreement, and failed to disclose all material information concerning the Merger. The complaint seeks monetary damages and injunctive relief to enjoin the Merger. The Company believes that the allegations contained in the complaint are entirely without merit and intends to defend against the claims vigorously.

In addition, we are involved in legal proceedings which have arisen in the ordinary course of business. We do not believe that these proceedings will have a material adverse effect on our financial position or results of operation.

Item 2: Changes in Securities and Use of Proceeds

Not Applicable

Item 3: Defaults Upon Senior Securities

Not Applicable

Item 4: Submission of Matters to a Vote of Securityholders.

No matters were submitted to a vote of security holders, through solicitation of proxies or otherwise, during the three months ended June 30, 2004.

Item 5:

Not Applicable

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Item 6: Exhibits and Reports on Form 8-K

During the second quarter of 2004, the Company filed the following reports on Form 8-K.

Item 5. Other Items:

On May 7, 2004, the Company furnished a Current Report on Form 8-K, dated the same date, regarding its earnings press release for the quarter ended March 31, 2004 and announcing a quarterly cash dividend.

On June 7, 2004, the Company filed a Current Report on Form 8-K, dated June 4, 2004, regarding its press release announcing the signing of a definitive merger agreement with RC2 Corporation.

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THE FIRST YEARS INC.

SIGNATURES

Pursuant to the requirements 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.

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THE FIRST YEARS INC.

EXHIBIT INDEX

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