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EX-31.1 - EXHIBIT 31.1 - JAKKS PACIFIC INCa6496963_ex31-1.htm
EX-31.2 - EXHIBIT 31.2 - JAKKS PACIFIC INCa6496963_ex31-2.htm
EX-32.1 - EXHIBIT 32.1 - JAKKS PACIFIC INCa6496963_ex32-1.htm
EX-32.2 - EXHIBIT 32.2 - JAKKS PACIFIC INCa6496963_ex32-2.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q
 

(Mark one)
x    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2010

OR

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

For the transition period from ______ to ______

Commission file number: 0-28104

 JAKKS Pacific, Inc.
(Exact Name of Registrant as Specified in Its Charter)
 

Delaware
95-4527222
(State or Other Jurisdiction of Incorporation or Organization)
(I.R.S. Employer Identification No.)

22619 Pacific Coast Highway
Malibu, California
90265
(Address of Principal Executive Offices)
(Zip Code)

Registrant’s Telephone Number, Including Area Code: (310) 456-7799
 

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 registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o   No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer
¨
Accelerated filer
x
Non-accelerated filer
¨
(Do not check if a smaller 
reporting company)
Smaller reporting company
¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨   No x
 

The number of shares outstanding of the issuer’s common stock is 27,615,600 as of November 4, 2010.
 
1

 
  
JAKKS PACIFIC, INC. AND SUBSIDIARIES

INDEX TO QUARTERLY REPORT ON FORM 10-Q
Quarter Ended September 30, 2010

ITEMS IN FORM 10-Q
 
   
Page
     
 
 
 
 
 
 
     
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
None
Item 3.
Defaults Upon Senior Securities
None
Item 4.
Reserved
 
Item 5.
Other Information
None
     
Exhibit 31.1
 
Exhibit 31.2
 
Exhibit 32.1
 
Exhibit 32.2
 

DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS

This report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. For example, statements included in this report regarding our financial position, business strategy and other plans and objectives for future operations, and assumptions and predictions about future product demand, supply, manufacturing, costs, marketing and pricing factors are all forward-looking statements. When we use words like “intend,” “anticipate,” “believe,” “estimate,” “plan”, “expect” or words of similar import, we are making forward-looking statements. We believe that the assumptions and expectations reflected in such forward-looking statements are reasonable and are based on information available to us on the date hereof, but we cannot assure you that these assumptions and expectations will prove to have been correct or that we will take any action that we may presently be planning. We are not undertaking to publicly update or revise any forward-looking statement if we obtain new information or upon the occurrence of future events or otherwise.
 
2

 
 
JAKKS PACIFIC, INC. AND SUBSIDIARIES

(In thousands, except share amounts)

   
December 31,
2009
   
September
30, 2010
 
   
(*)
   
(Unaudited)
 
ASSETS
             
Current assets
             
Cash and cash equivalents
 
$
254,837
   
$
218,593
 
Marketable securities
   
202
     
206
 
Accounts receivable, net of allowances for uncollectible accounts of $2,543, and $3,315, respectively
   
129,930
     
287,370
 
Inventory
   
34,457
     
60,459
 
Income tax receivable
   
35,015
     
 
Deferred income taxes
   
19,467
     
42,294
 
Prepaid expenses and other current assets
   
34,259
     
26,957
 
Total current assets
   
508,167
     
635,879
 
Property and equipment
               
Office furniture and equipment
   
12,218
     
12,302
 
Molds and tooling
   
55,054
     
60,195
 
Leasehold improvements
   
6,540
     
6,825
 
Total
   
73,812
     
79,322
 
Less accumulated depreciation and amortization
   
52,598
     
60,806
 
Property and equipment, net
   
21,214
     
18,516
 
Deferred income taxes
   
53,502
     
56,326
 
Intangibles and other, net
   
40,604
     
29,593
 
Investment in video game joint venture
   
6,727
     
 
Goodwill
   
1,571
     
3,446
 
Trademarks, net
   
2,308
     
2,308
 
Total assets
 
$
634,093
   
$
746,068
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities
               
Accounts payable
 
$
37,613
   
$
119,794
 
Accrued expenses
   
64,051
     
73,921
 
Reserve for sales returns and allowances
   
33,897
     
29,936
 
Capital lease obligation
   
155
     
34
 
Income tax payable
   
     
4,432
 
Convertible senior notes
   
20,262
     
 
Total current liabilities
   
155,978
     
228,117
 
Convertible senior notes, Net
   
86,728
     
88,774
 
Other liabilities
   
2,490
     
2,968
 
Income taxes payable
   
16,788
     
16,926
 
Total liabilities
   
261,984
     
336,785
 
Stockholders’ equity
               
Preferred stock, $.001 par value; 5,000,000 shares authorized; nil outstanding
   
     
 
Common stock, $.001 par value; 100,000,000 shares authorized; 27,638,769 and 27,616,979 shares issued and outstanding, respectively
   
28
     
28
 
Additional paid-in capital
   
303,474
     
302,496
 
Retained earnings
   
72,835
     
111,014
 
Accumulated comprehensive loss
   
(4,228
)
   
(4,255)
 
Total stockholders’ equity
   
372,109
     
409,283
 
Total liabilities and stockholders’ equity
 
$
634,093
   
$
746,068
 
 
(*) Derived from audited financial statements
See notes to condensed consolidated financial statements.
 
3

 
 
JAKKS PACIFIC, INC. AND SUBSIDIARIES

(In thousands, except per share data)
 
   
Three Months Ended
September 30,
(Unaudited)
   
Nine Months Ended
September 30,
(Unaudited)
 
  
 
2009
   
2010
   
2009
   
2010
 
  
                       
Net sales
 
$
351,438
   
$
348,677
   
$
604,932
   
$
549,277
 
Cost of sales
   
235,729
     
237,720
     
458,318
     
369,858
 
Gross profit
   
115,709
     
110,957
     
146,614
     
179,419
 
Selling, general and administrative expenses
   
63,363
     
59,378
     
171,673
     
140,194
 
Write-down of intangible assets
   
     
     
8,221
     
 
Write-down of goodwill
   
     
     
407,125
     
 
Income (Loss) from operations
   
52,346
     
51,579
     
(440,405
)
   
39,225
 
Profit (Loss) from video game joint venture
   
(1,919)
     
     
(21,924
)
   
6,000
 
Interest income
   
28
     
99
     
277
     
251
 
Interest expense, net of benefit
   
(1,267)
     
(1,547)
     
(3,800
)
   
(5,751)
 
Income (Loss) before provision (benefit) for income taxes
   
49,188
     
50,131
     
(465,852
)
   
39,725
 
Provision (Benefit) for income taxes
   
15,480
     
9,771
     
(82,200
)
   
1,547
 
Net income (loss)
 
$
33,708
   
$
40,360
   
$
(383,652
)
 
$
38,178
 
Income (Loss) per share – basic
 
$
1.24
   
$
1.47
   
$
(14.11
)
 
$
1.39
 
Income (Loss) per share – diluted
 
$
1.06
   
$
1.23
   
$
(14.11
)
 
$
1.26
 

See notes to condensed consolidated financial statements.
 
4

 
 
JAKKS PACIFIC, INC. AND SUBSIDIARIES

(In thousands)
 
   
Nine Months Ended
September 30,
(Unaudited)
 
   
2009
   
2010
 
             
CASH FLOWS FROM OPERATING ACTIVITIES
           
Net Income (Loss)
  $ (383,652 )   $ 38,178  
Adjustments to reconcile net income  (loss) to net cash provided (used) by operating   activities:
               
Depreciation and amortization
    27,026       22,809  
Share-based compensation expense
    3,302       3,616  
Loss (gain) on disposal of property and equipment
    2,377       (35 )
Deferred income taxes
    (74,993 )     (25,651 )
Write-down of intangible assets
    8,221       -  
Write-down of goodwill
    407,125       -  
Write-down of deferred offering costs
    -       495  
Changes in operating assets and liabilities:
               
Accounts receivable
    (104,044 )     (157,440 )
Inventory
    14,160       (26,002 )
Prepaid expenses and other current assets
    7,146       7,302  
Receivable from joint venture
    52,403       6,727  
Income tax receivable
    (4,535 )     35,015  
Accounts payable
    33,876       82,181  
Accrued expenses
    13,361       9,870  
Income taxes payable
    (7,190 )     4,570  
Reserve for sales returns and allowances
    12,186       (3,961 )
Other liabilities
    4,620       478  
Total adjustments
    395,041       (40,026 )
Net cash provided (used) by operating activities
    11,389       (1,848 )
CASH FLOWS FROM INVESTING ACTIVITIES
               
Purchase of property and equipment
    (16,160 )     (9,614 )
Change in other assets
    2,876       2,008  
Proceeds from sale of property and equipment
          67  
Cash paid for net assets of business acquired
    (12,253 )     (1,875 )
Net purchase of marketable securities
    (6 )     (4 )
 Net cash used in investing activities
    (25,543 )     (9,418 )
CASH FLOWS FROM FINANCING ACTIVITIES
               
Retirement of convertible notes
          (20,262 )
Common stock surrendered
    (1,400 )     (40 )
Common stock repurchased
          (4,554 )
Decrease in capital lease obligations
    (171 )     (122 )
Net cash used in financing activities
    (1,571 )     (24,978 )
Net decrease in cash and cash equivalents
    (15,725 )     (36,244 )
Cash and cash equivalents, beginning of period
    169,520       254,837  
Cash and cash equivalents, end of period
  $ 153,795     $ 218,593  
Cash paid during the period for:
               
Income taxes
  $ 4,875     $ 3,542  
Interest
  $ 2,825     $ 2,630  
 
 
5

 


Non cash investing and financing activity:
 
In January 2009, two executive officers surrendered an aggregate of 74,836 shares of restricted stock at a value of $1.4 million to cover their income taxes due on the 2009 vesting of restricted shares granted to them in 2007 and 2008. This restricted stock was subsequently retired by the Company. Also in January 2009, an employee surrendered 551 shares of restricted stock at a value of $11,367 to cover his income taxes due on the December 31, 2008 vested shares.

In August 2010, certain employees surrendered an aggregate of 2,523 shares of restricted stock at a value of $39,813 to
cover their income taxes due on the 2010 vesting of the restricted shares granted to them in 2006.

See Notes 8 and 9 for additional supplemental information to the condensed consolidated statements of cash flows.
See notes to condensed consolidated financial statements.
 
 
6

 
 
JAKKS PACIFIC, INC. AND SUBSIDIARIES

(Unaudited)
September 30, 2010

Note 1 — Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures are adequate to prevent the information presented from being misleading. These financial statements should be read in conjunction with Management’s Discussion and Analysis of financial condition and results of operations and the financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K, which contains audited financial information for the three years in the period ended December 31, 2009.

The information provided in this report reflects all adjustments (consisting solely of normal recurring items) that are, in the opinion of management, necessary to present fairly the financial position and the results of operations for the periods presented. Interim results are not necessarily indicative of results to be expected for a full year.

Certain reclassifications have been made to prior year balances in order to conform to the current year presentation.

The condensed consolidated financial statements include the accounts of JAKKS Pacific, Inc. and its wholly-owned subsidiaries (collectively the “Company”).

Note 2 — Business Segments, Geographic Data, Sales by Product Group, and Major Customers

The Company is a worldwide producer and marketer of children’s toys and other consumer products, principally engaged in the design, development, production, marketing and distribution of its diverse portfolio. The Company’s reportable segments are Traditional Toys, Craft/Activity/Writing Products, and Pet Products, each of which includes worldwide sales.

The Traditional Toys segment includes action figures, vehicles, playsets, plush products, dolls, accessories, pretend play products including Halloween costumes and accessories, dress-up costumes and accessories, electronic products, novelty toys, collectibles, construction toys, compounds, infant and pre-school toys, water toys, kites, and related products.

Craft/Activity/Writing Products include do-it-yourself kits, pens, pencils, stationery products, crayons, markers, paints, and other related craft and activity products.

Pet Products include pet toys, treats, apparel and related pet products.

Segment performance is measured at the operating income level. All sales are made to external customers, and general corporate expenses have been attributed to the various segments based on sales volumes. Segment assets are comprised of accounts receivable and inventories, net of applicable reserves and allowances, goodwill and other assets.
 

 
7

 
 
JAKKS PACIFIC, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 2 — Business Segments, Geographic Data, Sales by Product Group, and Major Customers - (continued)

Results are not necessarily those that would be achieved were each segment an unaffiliated business enterprise. Information by segment and a reconciliation to reported amounts as of December 31, 2009 and September 30, 2010 and for the three and nine months ended September 30, 2009 and 2010 are as follows (in thousands):
 
 
                           
    Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
Net Sales
  2009     2010     2009       2010  
                                 
Traditional Toys
 
$
324,092
   
$
341,398
   
$
548,142
   
$
533,688
 
Craft/Activity/Writing Products
   
23,787
     
5,246
     
46,165
     
9,288
 
Pet Products
   
3,559
     
2,033
     
10,625
     
6,301
 
   
$
351,438
   
$
348,677
   
$
604,932
   
$
549,277
 
 
 
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2009
     
2010
     
2009
     
2010
 
Operating Income(Loss)
                               
Traditional Toys
 
$
48,273
   
$
50,503
   
$
(341,451
)
 
$
38,660
 
Craft/Activity/Writing Products
   
3,543
     
776
     
(87,469
)
   
527
 
Pet Products
   
530
     
300
     
(11,485
)
   
38
 
   
$
52,346
   
$
51,579
   
$
(440,405
)
 
$
39,225
 
 
 
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2009
   
2010
   
2009
   
2010
 
Depreciation and Amortization Expense
                       
Traditional Toys
  $ 14,133     $ 11,831     $ 24,577     $ 22,341  
Craft/Activity/Writing Products
    1,247       100       1,998       172  
Pet Products
    229       86       451       296  
    $ 15,609     $ 12,017     $ 27,026     $ 22,809  
 


   
December 31,
   
September 30,
 
   
2009
   
2010
 
Assets
           
Traditional Toys
 
$
565,516
   
$
730,180
 
Craft/Activity/Writing Products
   
57,022
     
8,805
 
Pet Products
   
11,555
     
7,083
 
   
$
634,093
   
$
746,068
 
 
 
 
8

 
 
JAKKS PACIFIC, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 2 — Business Segments, Geographic Data, Sales by Product Group, and Major Customers - (continued)

The following tables present information about the Company by geographic area as of December 31, 2009 and September 30, 2010 and for the three and nine months ended September 30, 2009 and 2010 (in thousands):
 
   
December 31,
   
September 30,
 
   
2009
   
2010
 
Long-live Assets
           
United States
 
 $
19,917
   
17,426
 
 Europe
   
-
     
104
 
Canada
   
-
     
24
 
 Hong Kong
   
1,297
     
962
 
   
$
21,214
   
$
18,516
 

 
 
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2009
   
2010
   
2009
   
2010
 
Net Sales by Geographic Area
                       
United States
  $ 289,000     $ 288,754     $ 499,879     $ 457,674  
Europe
    31,504       29,644       50,733       41,697  
Canada
    17,181       18,593       27,193       25,782  
Hong Kong
    1,176       380       3,674       3,392  
Other
    12,577       11,306       23,453       20,732  
    $ 351,438     $ 348,677     $ 604,932     $ 549,277  


 
 
Major Customers

Net sales to major customers for the three and nine months ended September 30, 2009 and 2010 were as follows (in thousands, except for percentages):
 
   
Three Months Ended September 30,
    Nine Months Ended September 30,
   
2009
   
2010
    2009     2010  
   
Amount
   
Percentage of
Net Sales
   
Amount
   
Percentage of
Net Sales
   
Amount
   
Percentage of
Net Sales
   
Amount
   
Percentage of
Net Sales
 
                                                 
Wal-Mart
  $ 93,521       26.6 %   $ 81,943       23.5 %   $ 152,074       25.1 %   $ 127,181       23.2 %
Toys ‘R’ Us
    39,111       11.1       45,958       13.2       64,945       10.7       66,977       12.2  
Target
    50,956       14.5       39,167       11.2       100,888       16.7       75,448       13.7  
    $ 183,588       52.2 %   $ 167,068       47.9 %   $ 317,907       52.5 %   $ 269,606       49.1 %
 
No other customer accounted for more than 10% of the Company’s total net sales.

For the year ended December 31, 2009 and the nine months ended September 30, 2010, the Company’s three largest customers accounted for approximately 50.7% and 45.7%, respectively, of net accounts receivable. The concentration of the Company’s business with a relatively small number of customers may expose the Company to material adverse effects if one or more of its large customers were to experience financial difficulty. The Company performs ongoing credit evaluations of its top customers and maintains an allowance for potential credit losses.
 

 
9

 

JAKKS PACIFIC, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 3 — Inventory

Inventory, which includes the ex-factory cost of goods, in-bound freight, duty and warehouse costs, is stated at the lower of cost (first-in, first-out) or market and consists of the following (in thousands):
 
   
December 31,
2009
   
September 30,
2010
 
             
Raw materials
 
$
6,995
   
$
5,300
 
Finished goods
   
27,462
     
55,159
 
   
$
34,457
   
$
60,459
 

Note 4 — Revenue Recognition and Reserve for Sales Returns and Allowances

Revenue is recognized upon the shipment of goods to customers or their agents, depending on terms, provided that there are no uncertainties regarding customer acceptance, the sales price is fixed or determinable, and collectability is reasonably assured and not contingent upon resale.

Generally, the Company does not allow product returns. It provides a negotiated allowance for breakage or defects to its customers, which is recorded when the related revenue is recognized. However, the Company does make occasional exceptions to this policy and consequently accrues a return allowance in gross sales based on historic return amounts and management estimates. The Company also will occasionally grant credits to facilitate markdowns and sales of slow moving merchandise. These credits are recorded as a reduction of gross sales at the time of occurrence.

The Company also participates in cooperative advertising arrangements with some customers, whereby it allows a discount from invoiced product amounts in exchange for customer purchased advertising that features the Company’s products. Typically, these discounts range from 1% to 6% of gross sales, and are generally based on product purchases or on specific advertising campaigns. Such amounts are accrued when the related revenue is recognized or when the advertising campaign is initiated. These cooperative advertising arrangements are accounted for as direct selling expenses.

The Company’s reserve for sales returns and allowances amounted to $33.9 million as of December 31, 2009, compared to $29.9 million as of September 30, 2010. This decrease was primarily due to certain customers taking their year-end allowances related to 2009 and lower sales during 2010.


 
10

 

JAKKS PACIFIC, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 5 — Convertible Senior Notes

In November 2009 the Company sold an aggregate of $100.0 million of 4.50% Convertible Senior Notes due 2014 (the “Notes”). The Notes are senior unsecured obligations that pay interest semi-annually at a rate of 4.50% per annum and will mature on November 1, 2014. The conversion rate will initially be 63.2091 shares of JAKKS common stock per $1,000 principal amount of notes (equivalent to an initial conversion price of approximately $15.82 per share of common stock), subject to adjustment in certain circumstances. Prior to August 1, 2014, holders of the Notes may convert their Notes only upon specified events. Upon conversion, the Notes may be settled, at the Company’s election, in cash, shares of its common stock, or a combination of cash and shares of its common stock. Holders of the Notes may require the Company to repurchase for cash all or some of their Notes upon the occurrence of a fundamental change (as defined).

The Company used a portion of the net proceeds from the offering to repurchase $77.7 million of its 4.625% convertible senior notes due in 2023 and repurchased all of the remaining $20.3 million of its 4.625% convertible senior notes at par plus accrued interest in June and August 2010.


Convertible Senior Notes Consist of the Following (in thousands):

   
December 31,
2009
   
September 30,
2010
 
Current Liabilities
           
4.625% Convertible senior notes
  $ 20,262     $  
Long Term Liabilities
               
4.50% Convertible senior notes
  $ 100,000     $ 100,000  
Unamortized discounts
    (13,272 )     (11,226 )
Net carrying amount of 4.50% convertible senior notes
  $ 86,728     $ 88,774  





 



Note 6 — Income Taxes

The Company’s income tax expense of $1.5 million for the nine months ended September 30, 2010 reflects an effective tax expense rate of 3.9%. Included in the tax expense of $1.5 million is a tax benefit of $11.1 million primarily related to a reduction in tax reserves resulting from the effective settlement of tax audits of the Company’s 2003 through 2006 income tax returns, the receipt of a refund of tax resulting from the tax audits of the Company's 2003 through 2009 income tax returns and an adjustment related to transfer pricing. Absent this discrete tax benefit, the Company’s effective tax rate for the nine months ended September 30, 2010 is 31.8%. The Company’s tax benefit for the nine months ended September 30, 2009 was $82.2 million and reflected an effective tax benefit rate of 17.6%.


 
11

 
 
JAKKS PACIFIC, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 7 — Earnings/(Loss) Per Share

The following table is a reconciliation of the weighted average shares used in the computation of earnings and loss per share for the periods presented (in thousands, except per share data):
 
    Three Months Ended September 30,  
   
2009
   
2010
 
   
Income/(Loss)
   
Weighted
Average
Shares
   
Per-Share
   
Income/(Loss)
   
Weighted
Average
Shares
   
Per-Share
 
                                     
Earnings per share – basic
                                   
Income available to common
                                   
stockholders
  $ 33,708       27,183     $ 1.24     $ 40,360       27,379     $ 1.47  
Effect of dilutive securities:
                                               
Convertible senior notes
    737       4,900               1,289       6,321          
Options and warrants
            14               31                  
Unvested restricted stock grants
            408               243                  
Earnings per share – diluted
                                               
Income available to common
                                               
stockholders plus assumed exercises
                                               
and conversion
  $ 34,445       32,505     $ 1.06     $ 41,649       33,974     $ 1.23  
 
 
   
Nine Months Ended September 30,
 
   
2009
    2010  
   
Income/(Loss)
   
Weighted
Average
Shares
   
Per-Share
   
Income/(Loss)
   
Weighted
Average
Shares
   
Per-Share
 
                                     
Earnings per share – basic
                                   
Income (loss) available to common
                                   
stockholders
  $ (383,652 )     27,193     $ (14.11 )   $ 38,178       27,489     $ 1.39  
Effect of dilutive securities:
                                               
Convertible senior notes
                        5,434       6,940          
Options and warrants
                                  25          
Unvested restricted stock grants
                                  238          
Earnings per share – diluted
                                               
Income (loss) available to common
                                               
stockholders plus assumed exercises
                                               
and conversion
  $ (383,652 )     27,193     $ (14.11 )   $ 43,612       34,692     $ 1.26  

 
12

 
 
JAKKS PACIFIC, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 7 — Earnings/(Loss) Per Share (continued)

Basic earnings/(loss) per share has been computed using the weighted average number of common shares outstanding. Diluted earnings/(loss) per share has been computed using the weighted average number of common shares and common share equivalents outstanding (which consist of warrants, options and convertible debt to the extent they are dilutive). For the three months and nine months ended September 30, 2010, the convertible notes interest and related common share equivalent of 6,320,910 and 6,940,027, respectively, and diluted options and unvested restricted stock grants outstanding of 367,328 and 361,090, respectively, were excluded from the diluted earnings/(loss) per share calculation because they were anti-dilutive. Potentially dilutive stock options of 439,792 and 283,156 for the three months ended September 30, 2009 and 2010, respectively, were excluded from the computation of diluted earnings/(loss) per share as the average market price of the Company’s common stock did not exceed the weighted average exercise price of such options and to have included them would have been anti-dilutive. Potentially dilutive stock options of 397,800 and 317,293 for the nine months ended September 30, 2009 and 2010, respectively, were excluded from the computation of diluted earnings/(loss) per share as the average market price of the Company’s common stock did not exceed the weighted average exercise price of such options and to have included them would have been anti-dilutive.  Potentially dilutive unvested restricted stock of 408,305 and 243,218 for the three months ended September 30, 2009 and 2010, respectively, were excluded from the computation of earnings/(loss) per share as to have included them would have been anti-dilutive.  Potentially dilutive unvested restricted stock of 352,315 and 238,192 for the nine months ended September 30, 2009 and 2010, respectively, were excluded from the computation of earnings/(loss) per share as to have included them would have been anti-dilutive.

Note 8 — Common Stock and Preferred Stock

The Company has 105,000,000 authorized shares of stock consisting of 100,000,000 shares of $.001 par value common stock and 5,000,000 shares of $.001 par value preferred stock.

In January 2010, the Company issued an aggregate of 240,000 shares of restricted stock at an aggregate value of approximately $2.9 million to two of its executive officers, of which 120,000 shares vest, subject to certain Company financial performance criteria, in January 2011, and 120,000 shares vested in July 2010.  In addition, an aggregate of 40,950 shares of restricted stock was issued to its five non-employee directors, which vest in January 2011, at an aggregate value of approximately $0.5 million.

In April 2010, the Company issued 5,507 shares of restricted stock to a non-employee director, which vested in July 2010, at a value of approximately $0.1 million. Also, the company issued 5,000 shares of restricted stock at a value of approximately $0.1 million to an employee, which vests over a three-year period. Additionally, the company issued 5,000 shares of restricted stock at a value of approximately $0.1 million to an employee, which vests over a five-year period.

In August 2010, certain employees surrendered an aggregate of 2,523 shares of restricted stock at a value of $39,813 to cover their income taxes due on the 2010 vesting of the restricted shares granted to them in 2006.  Also, in August 2010, the Company repurchased 291,574 shares of its common stock at a price of $15.62 per share for a total cost of $4.6 million.  The repurchased stock represented approximately 1.0% of the company’s then outstanding shares of common stock at the time of the repurchase and was subsequently retired by the Company.

       All issuances of common stock, including those issued pursuant to stock option and warrant exercises, restricted stock grants and acquisitions, are issued from the Company’s authorized but not issued shares.

 
 
13

 
 
JAKKS PACIFIC, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 9 — Business Combinations

The Company acquired the following entities to further enhance its existing product lines and to continue diversification into other toy categories and seasonal businesses:

In October 2008, the Company acquired substantially all of the assets of Tollytots Limited (“Tollytots”). The total initial consideration of $26.8 million consisted of $12.0 million in cash and the assumption of liabilities in the amount of $14.8 million, and resulted in goodwill of $4.1 million, of which $3.1 million has been determined to be impaired and was written off in the quarter ended June 30, 2009. In addition, the Company agreed to pay an earn-out of up to an aggregate amount of $5.0 million in cash over the three calendar years following the acquisition based on the achievement of certain financial performance criteria, which will be recorded as goodwill when and if earned. In the first earn-out period ended December 31, 2009, no portion of the earn-out was earned. Tollytots is a leading designer and producer of licensed baby dolls and baby doll pretend play accessories based on well-known brands, and was included in our  results of operations from the date of acquisition.

In October 2008, the Company acquired all of the stock of Kids Only, Inc. and a related Hong Kong company, Kids Only Limited (collectively, “Kids Only”). The total initial consideration of $23.8 million consisted of $20.4 million in cash and the assumption of liabilities in the amount of $3.4 million, and resulted in goodwill of $13.2 million, of which $12.7 million has been determined to be impaired and was written off in the quarter ended June 30, 2009. In addition, the Company agreed to pay an earn-out of up to an aggregate amount of $5.6 million in cash over the three years following the acquisition based on the achievement of certain financial performance criteria, which will be recorded as goodwill when and if earned. The first earn-out period ended September 30, 2009 and the full earn-out amount of $1.9 million was paid in April 2010. The second earn-out period ended September 30, 2010.  The company is evaluating the earn-out agreement to determine the amount of earn-out that will be paid related to the second earn-out period.  Kids Only is a leading designer and producer of licensed indoor and outdoor kids’ furniture and children’s toy products, including baby dolls and accessories, activity trays and room decor  and was included in our results of operations from the date of acquisition.

In December 2008, the Company acquired certain assets of Disguise, Inc. and a related Hong Kong company, Disguise Limited (collectively, “Disguise”). The total initial consideration of $60.6 million consisted of $38.6 million in cash and the assumption of liabilities in the amount of $22.0 million, and resulted in goodwill of $30.6 million, all of which has been determined to be impaired and was written off in the quarter ended June 30, 2009. Disguise is a leading designer and producer of Halloween costumes, and accessories and was included in our results of operations from the date of acquisition.
 
Refer to Note 11 for information on the write-down of goodwill.

Note 10 — Joint Venture

The Company owned a fifty percent interest in a joint venture with THQ Inc. (“THQ”). Pursuant to a Settlement Agreement and Mutual Release dated December 22, 2009, the joint venture was terminated on December 31, 2009 and THQ is obligated to pay the Company an aggregate of $20.0 million in fixed payments of $6.0 million on each of June 30, 2010 and 2011 and $4.0 million on each of June 30, 2012 and 2013 which the Company will record as income on a cash basis when received (see Note 14).  On June 30, 2010 we received the fixed payment from THQ in the amount of $6.0 million, which was recognized as income during the quarter.  We did not recognize any income from our video game joint venture in 2010, as compared to a loss of $1.9 million in 2009.


 
14

 
 
JAKKS PACIFIC, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 10 — Joint Venture (continued)

As of December 31, 2009 and September 30, 2010, the balance of Investment in video game joint venture is comprised of the following components (in thousands):

   
December 31
   
September 30,
 
   
2009
   
2010
 
Preferred return receivable
 
$
6,727
   
$
-
 
                 

Note 11 — Goodwill

The changes in the carrying amount of goodwill for the nine months ended September 30, 2010 are as follows (in thousands):

   
Traditional
Toys
 
Balance at beginning of the period
 
$
1,571
 
Adjustments to goodwill during the period
   
1,875
 
         
Balance at end of the period
 
$
3,446
 

The Company applies a fair value-based impairment test to the net book value of goodwill and indefinite-lived intangible assets on an annual basis and, if certain events or circumstances indicate that an impairment loss may have been incurred, on an interim basis. The analysis of potential impairment of goodwill requires a two-step process. The first step is the estimation of fair value. If step one indicates that an impairment potentially exists, the second step is performed to measure the amount of impairment, if any. Goodwill impairment exists when the estimated fair value of goodwill is less than its carrying value.
 
During the second quarter of 2009, the Company determined that the significant decline in its market capitalization was likely to be sustained and that an interim goodwill impairment test was required. As a result of such testing, the Company determined that $407.1 million, or all of the goodwill related to previous acquisitions, including the acquisition of Disguise in December 2008, was impaired. This amount was charged to expense in Write-down of Goodwill in the second quarter of 2009.

At December 31, 2009, the Company recorded deferred tax liabilities related to the Tollytots and Kids Only acquisitions that resulted in Goodwill of $1.6 million.

In April 2010, the Company made an earn-out payment in the amount of $1.9 million related to the Kids Only acquisition that was recorded as goodwill.


 
15

 

JAKKS PACIFIC, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Note 12 — Intangible Assets Other Than Goodwill

Intangible assets consists primarily of licenses, product lines, customer relationships, debt offering costs from the issuance of the Company’s convertible senior notes and trademarks. Amortized intangible assets are included in the Intangibles and other, net, in the accompanying balance sheets. Trademarks are disclosed separately in the accompanying balance sheets. Intangible assets are as follows (in thousands, except for weighted useful lives):
 
         
December 31, 2009
   
September 30, 2010
   
Weighted
Useful
Lives
   
Gross
Carrying
Amount
   
Accumulated
Amortization
   
Net
Amount
   
Gross
Carrying
Amount
 
Accumulated
Amortization
   
Net
Amount
   
(Years)
                                 
                                       
Amortized Intangible Assets:
                                     
Acquired order backlog
 
.50
   
$
2,393
   
$
(2,393
)
 
$
   
$
2,393
 
$
(2,393)
  $
Licenses
 
4.84
     
85,788
     
(57,396
)
   
28,392
     
85,788
   
(64,015)
   
21,773
Product lines
 
3.62
     
19,100
     
(18,285
)
   
815
     
19,100
   
(18,589)
   
511
Customer relationships
 
5.32
     
6,296
     
(2,912
)
   
3,384
     
6,296
   
(3,808)
   
2,488
Non-compete/Employment contracts
 
3.84
     
3,133
     
(2,823
)
   
310
     
3,133
   
(2,919)
   
214
Debt offering costs
 
5.00
     
4,444
     
(372
)
   
4,072
     
3,678
   
(672)
   
3,006
Total amortized intangible assets
         
121,154
     
(84,181
)
   
36,973
     
120,388
   
(92,396)
   
27,992
Unamortized Intangible Assets:
                                               
Trademarks
         
2,308 
     
     
2,308
     
2,308
 
   
2,308
         
$
123,462
   
$
(84,181
)
 
$
39,281
   
$
122,696
  $
(92,396)
  $
30,300

Amortization expense related to limited life intangible assets was $6.5 million and $4.4 million for the three months ended September 30, 2009 and 2010, respectively.  Amortization expense related to limited life intangible assets was $10.4 million and $8.5 million for the nine months ended September  30, 2009 and 2010, respectively.

As of September 30, 2009, the Company determined that the tradenames “Child Guidance” and “Play Along” and certain tradenames associated with its Craft and Activity product lines would either be discontinued or were under-performing. Consequently, the intangible assets associated with these tradenames were written off to Write-down of Intangible Assets, resulting in a non-cash charge of $8.2 million.


 
16

 

JAKKS PACIFIC, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 13 — Comprehensive Income (Loss)

The table below presents the components of the Company’s comprehensive loss for the three and nine months ended September 30, 2009 and 2010 (in thousands):
 
 
   
Three Months
Ended September 30,
   
Nine Months
Ended September 30,
 
  
 
2009
   
2010
   
2009
   
2010
 
   
 
                   
Net income (loss)
 
$
33,708
     
40,360
   
$
(383,652
)
   
38,178
 
Other comprehensive income (loss):
                               
Foreign currency translation adjustment
   
1
     
5
     
1
     
(27)
 
Comprehensive income (loss)
 
$
33,709
     
40,365
   
$
(383,651
)
   
38,151
 
 

Note 14— Litigation

On October 12, 2006, World Wrestling Entertainment, Inc. (“WWE”) commenced a lawsuit in Connecticut state court against THQ/JAKKS Pacific LLC, alleging that sales of WWE video games in Japan and other countries in Asia were not lawful (the “Connecticut Action”). The lawsuit sought, among other things, a declaration that WWE is entitled to terminate the video game license and monetary damages. In 2007, WWE filed an amended complaint in the Connecticut Action to add the principal part of the state law claims present in the action filed by WWE in the Southern District of New York (the “WWE Action”) to the Connecticut Action; the WWE Action was finally dismissed in 2009. THQ filed a cross-complaint that asserted claims by THQ and Mr. Farrell, THQ’s Chief Executive Officer, for indemnification from the Company in the event that WWE prevailed on its claims against THQ and Farrell and also asserted claims by THQ that the Company breached its fiduciary duties to THQ in connection with the videogame license between WWE and the THQ/JAKKS Pacific joint venture and sought equitable and legal relief, including substantial monetary and exemplary damages against the Company in connection with its claim. Thereafter, the WWE claims and the THQ cross-claims in the Connecticut Action were all dismissed with prejudice pursuant to settlement agreements that the Company entered into with WWE and THQ dated December 22, 2009. The settlement agreement with THQ provides for payments to the Company in the aggregate amount of $20.0 million payable $6.0 million, $6.0 million, $4.0 million and $4.0 million on June 30, 2010, 2011, 2012 and 2013, respectively. The $6.0 million payment due on June 30, 2010 was received in the second quarter of 2010.

The Company is a party to, and certain of its property is the subject of, various other pending claims and legal proceedings that routinely arise in the ordinary course of its business. The Company does not believe that any of these claims or proceedings will have a material effect on its business, financial condition or results of operations.


 
17

 
 
JAKKS PACIFIC, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 15 — Share-Based Payments

The Company’s 2002 Stock Award and Incentive Plan (the “Plan”) provides for the awarding of stock options and restricted stock to employees, officers and non-employee directors. The Plan is more fully described in Notes 14 and 16 to the Consolidated Financial Statements in the Company’s 2009 Annual Report on Form 10-K.

The following table summarizes the total share-based compensation expense and related tax benefits recognized for the three and nine months ended September 30, 2009 and 2010 (in thousands):
 

 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2009
   
2010
   
2009
   
2010
 
                         
Stock option compensation expense (benefit)
 
$
95
   
$
   
$
181
   
$
(224)
 
Tax benefit (loss) related to stock option compensation
 
$
29
   
$
   
$
63
   
$
(82)
 
Restricted stock compensation expense (benefit)
 
$
(772
 
$
1,526
   
$
3,121
   
$
3,840
 
Tax benefit (loss) related to restricted stock compensation
 
$
(340
 
$
575
   
$
1,137
   
$
1,447
 

 
Stock option activity pursuant to the Plan for nine months ended September 30, 2010 is summarized as follows:
 
   
Plan Stock Options (*)
 
   
Number of
Shares
   
Weighted
Average
Exercise
Price
 
Outstanding, December 31, 2009
   
444,715
   
$
19.63
 
Granted
   
-
     
-
 
Exercised
   
-
     
-
 
Cancelled
   
(120,950)
     
20.70
 
Outstanding, September 30, 2010
   
323,765
   
$
19.22
 

* The stock option activity excludes 100,000 of fully vested warrants issued in connection with a license amendment during 2003 with an initial exercise price of $11.35 per share, which expire August 14, 2013 and are outstanding at September 30, 2010.

Restricted stock award activity pursuant to the Plan for the nine months ended September 30, 2010 is summarized as follows:
 
   
Restricted Stock Awards
 
   
Number of
Shares
   
Weighted
Average
Price on
grant date
 
             
Outstanding, December 31, 2009
   
436,443
   
$
20.24
 
Awarded
   
296,457
     
12.24
 
Vested
   
(178,526)
     
23.11
 
Forfeited
   
(24,150)
     
17.98
 
Outstanding, September 30, 2010
   
530,224
   
$
14.90
 
 
 
 
18

 
 
 
The following discussion and analysis of financial condition and results of operations should be read together with our Condensed Consolidated Financial Statements and Notes thereto which appear elsewhere herein.
 
Critical Accounting Policies and Estimates
 
The accompanying consolidated financial statements and supplementary information were prepared in accordance with accounting principles generally accepted in the United States of America. Significant accounting policies are discussed in Note 2 to the Consolidated Financial Statements set forth in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2009. Inherent in the application of many of these accounting policies is the need for management to make estimates and judgments in the determination of certain revenues, expenses, assets and liabilities. As such, materially different financial results can occur as circumstances change and additional information becomes known. The policies with the greatest potential effect on our results of operations and financial position include:
 
Allowance for Doubtful Accounts. Our allowance for doubtful accounts is based on management’s assessment of the business environment, customers’ financial condition, historical collection experience, accounts receivable aging, customer disputes and the collectability of specific customer accounts. If there were a deterioration of a major customer’s creditworthiness, or actual defaults were higher than our historical experience, our estimates of the recoverability of amounts due to us could be overstated, which could have an adverse impact on our operating results. The allowance for doubtful accounts is also affected by the time at which uncollectible accounts receivable balances are actually written off.
 
Major customers’ accounts are monitored on an ongoing basis; more in depth reviews are performed based on changes in customer’s financial condition and/or the level of credit being extended. When a significant event occurs, such as a bankruptcy filing by a specific customer, and on a quarterly basis, the allowance is reviewed for adequacy and the balance or accrual rate is adjusted to reflect current risk prospects.
 
Revenue Recognition. Our revenue recognition policy is to recognize revenue when persuasive evidence of an arrangement exists, title transfer has occurred (product shipment), the price is fixed or readily determinable, and collectability is probable. Sales are recorded net of sales returns and discounts, which are estimated at the time of shipment based upon historical data. JAKKS routinely enters into arrangements with its customers to provide sales incentives, support customer promotions, and provide allowances for returns and defective merchandise. Such programs are based primarily on customer purchases, customer performance of specified promotional activities, and other specified factors such as sales to consumers. Accruals for these programs are recorded as sales adjustments that reduce gross revenue in the period the related revenue is recognized.
 
Goodwill and other indefinite-lived intangible assets. Goodwill and indefinite-lived intangible assets are not amortized, but are tested for impairment at least annually at the reporting unit level.
 
Factors we consider important which could trigger an impairment review include the following:
 
significant underperformance relative to expected historical or projected future operating results;
 
significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and
 
significant negative industry or economic trends.
 
Due to the subjective nature of the impairment analysis significant changes in the assumptions used to develop the estimate could materially affect the conclusion regarding the future cash flows necessary to support the valuation of long-lived assets, including goodwill. The valuation of goodwill involves a high degree of judgment and consists of a comparison of the fair value of a reporting unit with its book value. Based on the assumptions underlying the valuation, impairment is determined by estimating the fair value of a reporting unit and comparing that value to the reporting unit’s book value. If the implied fair value is more than the book value of the reporting unit, an impairment loss is not indicated. If impairment exists, the fair value of the reporting unit is allocated to all of its assets and liabilities excluding goodwill, with the excess amount representing the fair value of goodwill. An impairment loss is measured as the amount by which the book value of the reporting unit’s goodwill exceeds the estimated fair value of that goodwill.


 
19

 
 
As of June 30, 2009, the Company determined that the significant decline in its market capitalization was likely to be sustained. The Company’s market capitalization was not significantly affected by the substantial resolution of the WWE lawsuit, and the lower revenue expectations for 2009 versus 2008 were factors that indicated that an interim goodwill impairment test was required. As a result, the Company determined that $407.1 million, or all of the goodwill related to previous acquisitions, including the acquisition of Disguise in December 2008, was impaired. This amount is included in “Write-down of Goodwill” in the accompanying consolidated statements of operations.

As of June 30, 2009, the Company determined that the tradenames “Child Guidance” and “Play Along” and certain tradenames associated with our Craft and Activity product lines would either be discontinued or were under performing. Consequently, the intangible assets associated with these tradenames were written off to “Write-down of Intangible Assets”, resulting in a non-cash charge of $8.2 million.
 
Goodwill and Intangible assets amounted to $33.7 million as of September 30, 2010.
 
Reserve for Inventory Obsolescence. We value our inventory at the lower of cost or market. Based upon a consideration of quantities on hand, actual and projected sales volume, anticipated product selling prices and product lines planned to be discontinued, slow-moving and obsolete inventory is written down to its net realizable value.
 
Failure to accurately predict and respond to consumer demand could result in the Company under producing popular items or over producing less popular items. Furthermore, significant changes in demand for our products would impact management’s estimates in establishing our inventory provision.
 
Management estimates are monitored on a quarterly basis and a further adjustment to reduce inventory to its net realizable value is recorded, as an increase to cost of sales, when deemed necessary under the lower of cost or market standard.
 
Income Allocation for Income Taxes. Our quarterly income tax provision and related income tax assets and liabilities are based on estimated annual income as allocated to the various tax jurisdictions based upon our transfer pricing study, US and foreign statutory income tax rates, and tax regulations and planning opportunities in the various jurisdictions in which the Company operates. Significant judgment is required in interpreting tax regulations in the US and foreign jurisdictions, and in evaluating worldwide uncertain tax positions. Actual results could differ materially from those judgments, and changes from such judgments could materially affect our consolidated financial statements.
 
Discrete Items for Income Taxes. A discrete tax benefit of $11.1 million was recognized during the nine months ended September 30, 2010 primarily related to a reduction in tax reserves resulting from the effective settlement of tax audits of the Company’s 2003 through 2006 income tax returns, the receipt of a refund of tax resulting from the tax audits of the Company's 2003 through 2009 income tax returns and an adjustment related to transfer pricing.

Income taxes and interest and penalties related to income tax payable. We do not file a consolidated return with our foreign subsidiaries. We file federal and state returns and our foreign subsidiaries each file Hong Kong returns, as applicable. Deferred taxes are provided on an asset and liability method whereby deferred tax assets are recognized as deductible temporary differences and operating loss and tax credit carry-forwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.
 
Management employs a threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Tax benefits that are subject to challenge by tax authorities are analyzed and accounted for in the income tax provision.
 
 We accrue a tax reserve for additional income taxes, which may become payable in future years as a result of audit adjustments by tax authorities. The reserve is based on management’s assessment of all relevant information, and is periodically reviewed and adjusted as circumstances warrant. As of September 30, 2010, our income tax reserves are approximately $16.4 million and relate to the potential income tax audit adjustments, primarily in the areas of expense recognition and state taxes.


 
20

 
 
Share-Based Compensation . We grant restricted stock and options to purchase our common stock to our employees (including officers) and non-employee directors under our 2002 Stock Award and Incentive Plan (the “Plan”), which incorporated the shares remaining under our Third Amended and Restated 1995 Stock Option Plan. The benefits provided under the Plan are share-based payments. We estimate the value of share-based awards on the date of grant using the Black-Scholes option-pricing model. The determination of the fair value of share-based payment awards on the date of grant using an option-pricing model is affected by our stock price, as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, cancellations, terminations, risk-free interest rates and expected dividends.
 
Recent Developments
 
In October 2008, the Company acquired substantially all of the assets of Tollytots Limited (“Tollytots”). The total initial consideration of $26.8 million consisted of $12.0 million in cash and the assumption of liabilities in the amount of $14.8 million, and resulted in goodwill of $4.1 million, of which $3.1 million has been determined to be impaired and was written off in the quarter ended June 30, 2009. In addition, the Company agreed to pay an earn-out of up to an aggregate amount of $5.0 million in cash over the three calendar years following the acquisition based on the achievement of certain financial performance criteria, which will be recorded as goodwill when and if earned. In the first earn-out period ended December 31, 2009, no portion of the earn-out was earned. Tollytots is a leading designer and producer of licensed baby dolls and baby doll pretend play accessories based on well-known brands, and was included in our results of operations from the date of acquisition.

In October 2008, the Company acquired all of the stock of Kids Only, Inc. and a related Hong Kong company, Kids Only Limited (collectively, “Kids Only”). The total initial consideration of $23.8 million consisted of $20.4 million in cash and the assumption of liabilities in the amount of $3.4 million, and resulted in goodwill of $13.2 million, of which $12.7 million has been determined to be impaired and was written off in the quarter ended June 30, 2009. In addition, the Company agreed to pay an earn-out of up to an aggregate amount of $5.6 million in cash over the three years following the acquisition based on the achievement of certain financial performance criteria, which will be recorded as goodwill when and if earned. The first earn-out period ended September 30, 2009 and the full earn-out amount of $1.9 million was paid in April 2010. The second earn-out period ended September 30, 2010.  The company is evaluating the earn-out agreement to determine the amount of earn-out that will be paid related to the second earn-out period.  Kids Only is a leading designer and producer of licensed indoor and outdoor kids’ furniture and children’s toy products including baby dolls and accessories,  activity trays and room décor, and was included in our results of operations from the date of acquisition.

In December 2008, the Company acquired certain assets of Disguise, Inc. and a related Hong Kong company, Disguise Limited (collectively, “Disguise”). The total initial consideration of $60.6 million consisted of $38.6 million in cash and the assumption of liabilities in the amount of $22.0 million, and resulted in goodwill of $30.6 million, all of which has been determined to be impaired and was written off in the quarter ended June 30, 2009. Disguise is a leading designer and producer of Halloween  costumes and accessories, and was included in our results of operations from the date of acquisition.

In November 2009, we sold an aggregate of $100.0 million of 4.50% Convertible Senior Notes due 2014 (the “Notes”). These senior unsecured obligations of JAKKS,  pay interest semi-annually at a rate of 4.50% per annum,  mature on November 1, 2014. The conversion rate will initially be 63.2091 shares of our common stock per $1,000 principal amount of notes (equivalent to an initial conversion price of approximately $15.82 per share of common stock), subject to adjustment in certain circumstances. Prior to August 1, 2014, holders of the Notes may convert their Notes only upon specified events. Upon conversion, the Notes may be settled, at our election, in cash, shares of our common stock, or a combination of cash and shares of our common stock. Holders of the Notes may require us to repurchase for cash all or some of their Notes upon the occurrence of a fundamental change (as defined in the Notes). In November 2009, we used a portion of the net proceeds from the offering to repurchase $77.7 million of our 4.625% convertible senior notes due in 2023 and we redeemed all of the remaining $20.3 million of notes in June and August 2010.
 
In December 2009 we entered into a Settlement Agreement and Mutual Release pursuant to which our joint venture with THQ was terminated as of December 31, 2009 and we will receive fixed payments in the aggregate amount of $20.0 million from THQ payable $6.0 million on each of June 30, 2010 and 2011 and $4.0 million on each of June 30, 2012 and 2013 which we will record as income on a cash basis over the term. The $6.0 million payment due on June 30, 2010 was received by us in the second quarter of 2010.


 
21

 
 
Results of Operations
 
The following unaudited table sets forth, for the periods indicated, certain statement of income data as a percentage of net sales.
 
   
Three MonthsEnded
September 30,
   
Nine MonthsEnded
September 30,
 
   
2009
   
2010
   
2009
   
2010
 
   
 
                   
Net sales
   
100.0
%
   
100.0
%
   
100.0
%
   
100.0
%
Cost of sales
   
67.1
     
  68.2
     
75.8
     
67.3
 
Gross profit
   
32.9
     
  31.8
     
24.2
     
32.7
 
Selling, general and administrative expenses
   
18.0
     
  17.0
     
28.3
     
25.5
 
Write-down of intangible assets
   
     
    —
     
1.4
     
 
Write-down of goodwill
   
     
    —
     
67.3
     
 
Income (loss) from operations
   
14.9
     
  14.8
     
(72.8
)
   
7.2
 
Profit (loss) from video game joint venture
   
(0.5
   
    —
     
 (3.6
)    
1.1
 
Interest income
   
     
    —
     
     
 
Interest expense, net of benefit
   
(0.4
)    
   (0.4
   
(0.6
)
   
(1.0
)
Income (loss) before provision (benefit) for income taxes
   
14.0
     
14.4
     
(77.0
   
      7.3
 
Provision (benefit) for income taxes
   
 4.4
     
  2.8
     
        (13.6
   
       0.3
 
Net income (loss)
   
9.6
%
   
   11.6
%
   
(63.4
)%
   
7.0
%

 
The following unaudited table summarizes, for the periods indicated, certain income statement data by segment (in thousands).
 
   
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
   
2009
   
2010
   
2009
   
2010
 
                         
Net Sales
                               
Traditional Toys
 
$
324,092
   
$
341,398
   
$
548,142
   
$
533,688
 
Craft/Activity/Writing Products
   
23,787
     
5,246
     
46,165
     
9,288
 
Pet Products
   
3,559
     
2,033
     
10,625
     
6,301
 
     
351,438
     
348,677
     
604,932
     
549,277
 
Cost of Sales
                               
Traditional Toys
   
216,873
     
232,917
     
412,961
     
359,636
 
Craft/Activity/Writing Products
   
15,344
     
2,910
     
34,335
     
5,288
 
Pet Products
   
3,512
     
1,893
     
11,022
     
4,934
 
     
235,729
     
237,720
     
458,318
     
369,858
 
Gross Profit
                               
Traditional Toys
   
107,219
     
108,481
     
135,181
     
174,052
 
Craft/Activity/Writing Products
   
8,443
     
2,336
     
11,830
     
4,000
 
Pet Products
   
47
     
140
     
(397
)
   
1,367
 
   
$
115,709
   
$
110,957
   
$
146,614
   
$
179,419
 
 
 
 
22

 

Comparison of the Three Months Ended September 30, 2010 and 2009
 
Net Sales

Traditional Toys.   Net sales of our Traditional Toys segment were $341.4 million in 2010, compared to $324.1 million in 2009, representing an increase of $17.3 million, or 5.3%.  The increase in net sales was primarily due to higher unit sales of some products, including Spynet™, role-play, dress-up toys and dolls, including those based on classic Disney Princesses® and Disney Fairies® characters, kids indoor and outdoor furniture, and Halloween costumes and accessories.  This was offset in part by decreases in unit sales of  our WWE® and Pokemon® action figures and accessories, and other JAKKS products, including UltiMotion™, EyeClops® electronics, Cabbage Patch Kids®, JAKKS™ dolls and pretend play products based on Smurfs® plush, and In My Pocket & Friends™.
 
Craft/Activity/Writing Product.  Net sales of our Craft/Activity/Writing Products were $5.2 million in 2010, compared to $23.8 million in 2009, representing a decrease of $18.6 million, or 78.2%.  The decrease in net sales was primarily due to decreases in unit sales of our Girl Gourmet™ and our Flying Colors® and Vivid Velvet® activities products, offset in part by increases in unit sales of Creepy Crawlers® activities products.

Pet Products.  Net sales of our Pet Products were $2.0 million in 2010, compared to $3.6 million in 2009, representing a decrease of $1.6 million, or 44.4%.  The decrease is mainly attributable to less available shelf space for pet products at some of our major customer retail stores, and lower unit sales of consumable pet products.

Cost of Sales
 
Traditional Toys.  Cost of sales of our Traditional Toys segment was $232.9 million, or 68.2% of related net sales, in 2010, compared to $216.9 million, or 66.9% of related net sales, in 2009, representing an increase of $16.0 million, or 7.4%.  This increase primarily consisted of an increase in product costs of $12.5 million due to the mix of the product sold with higher product cost.  Royalty expense increased by $4.6 million and as a percentage of net sales due to changes in the product mix to more products with higher royalty rates from products with lower royalty rates or proprietary products with no royalty rates. Our depreciation of molds and tools decreased by $1.3 million primarily due to decreased purchases of molds and tools in this segment.
    
Craft/Activity/Writing Products.  Cost of sales of our Craft/Activity/Writing Products segment was $2.9 million, or 55.8% of related net sales, in 2010, compared to $15.3 million, or 64.3% of related net sales, in 2009, representing a decrease of $12.4 million, or 81.0%.  This decrease primarily consisted of a decrease in lower sales volume.  Product costs as a percentage of net sales decreased primarily due to the mix of the product sold.  Royalty expense decreased by $0.5 million due to the lower volume of unit sales.  Royalty expense increased as a percentage of net sales due to changes in the product mix to more products with higher royalty rates from products with lower royalty rates or proprietary products with no royalty rates. Our depreciation of molds and tools decreased by $0.6 million primarily due to decreased purchases of molds and tools in this segment.

Pet Product .  Cost of sales of our Pet Pal line of products was $1.9 million, or 95.0% of related net sales, in 2010, compared to $3.5 million, or 97.2% of related net sales, in 2009, representing a decrease of $1.6 million, or 45.7%.  This decrease primarily consisted of a decrease in products costs of $1.4 million, which is in line with the lower volume of sales.  Product costs as a percentage of net sales decreased primarily due to the mix of the product sold.  Royalty expense decreased by $0.2 million and as a percentage of sales due to changes in the product mix to products with lower royalty rates or proprietary products with no royalty rates from more products with higher royalty rates. Our depreciation of molds and tools decreased by $0.1 million primarily due to decreased purchases of molds and tools in this segment.

 
 
23

 
 
Selling, General and Administrative Expenses
 
Selling, general and administrative expenses were $59.4 million in 2010 and $63.4 million in 2009, constituting 17.0% and 18.0% of net sales, respectively.  The overall decrease of $4.0 million in such costs was primarily due to decreases in general and administrative expenses ($2.1million), product testing ($1.8 million) and depreciation and amortization ($2.2 million), offset in part by an increase in share-based compensation ($2.2 million). The decrease in general and administrative expenses is primarily due to decreases in salary and employee benefits expense ($3.7 million), rent expense ($1.3 million) and legal expense ($3.5 million), offset in part by increases in bonus expense ($5.5 million) and travel and entertainment ($0.7 million). The decrease in depreciation and amortization is due to a decrease in amortization expenses related to intangible assets other than goodwill ($2.2 million).   Product development expenses decreased ($1.8 million) as a result of tighter controls on spending. 
 
Profit from Video Game Joint Venture
 
We did not recognize any income from our video game joint venture in 2010, as compared to a loss of $1.9 million in 2009 relating primarily to an adjustment to our preferred return as a result of an arbitration decision and legal fees. Pursuant to a Settlement Agreement and Mutual Release dated December 22, 2009, the joint venture was terminated on December 31, 2009.  On June 30, 2010 we received a fixed payment from THQ in the amount of $6.0 million, which was recognized as income during the second quarter.  Additionally, we will receive future payments in the amount of $6.0 million on June 30, 2011 and $4.0 million on each of June 30, 2012 and 2013 which we will record as income on a cash basis over the term (see “Legal Proceedings”).
 
Interest Income
 
 Interest income in the three months ended September 30, 2010 was $0.1 million, as compared  to $28,419  in the three months ended September 30, 2009. This increase is due to higher average cash balances during 2010 compared to 2009.

Interest Expense
 
Interest expense was $1.5 million in the three months ended September 30, 2010, as compared to $1.3 million in the prior period. In the three months ended September  30, 2010, we booked interest expense of $2.0 million related to our convertible senior notes payable, and net interest expense of $0.2 million related to uncertain tax positions taken or expected to be taken in a tax return. In the three months ended September 30, 2009, we booked interest expense of $1.1 million related to our convertible senior notes payable and net interest expense of $0.1 million related to uncertain tax positions taken or expected to be taken in a tax return.

Provision for Income Taxes
 
Our income tax expense, which includes federal, state and foreign income taxes, and discrete items, was $9.8 million, or an effective tax rate expense of 19.5% for the three months ended September 30, 2010.  During the comparable period in 2009, the income tax benefit was $15.5 million, or an effective tax benefit rate of 31.5%.
 

 
24

 
 
Comparison of the Nine Months Ended September 30, 2010 and 2009
 
Net Sales

Traditional Toys.   Net sales of our Traditional Toys segment were $533.7 million in 2010, compared to $548.1 million in 2009, representing a decrease of $14.4 million, or 2.6%.  The decrease in net sales was primarily due to lower unit sales of our WWE® and Pokemon® action figures and accessories, and other JAKKS products, including EyeClops® electronics, Cabbage Patch Kids®, and pretend play products based on Hannah Montana®, In My Pocket & Friends™, and  JAKKS vehicles. This was offset in part by increases in unit sales of some products, including Club Penguin™, Hello Kitty® plush, Plug It In & Play TV Games™, Spynet™, role-play, dress-up toys and dolls, including those based on classic Disney Princesses® and Disney Fairies® characters, large baby dolls and accessories, kids indoor and outdoor furniture, and Halloween costumes and accessories.
 
Craft/Activity/Writing Product.  Net sales of our Craft/Activity/Writing Products were $9.3 million in 2010, compared to $46.2 million in 2009, representing a decrease of $36.9 million, or 79.9%.  The decrease in net sales was primarily due to decreases in unit sales of our Girl Gourmet™, Spa Factory™ and JAKKS activity toys, offset in part by increases in unit sales of our Creepy Crawlers® activities products.

Pet Products.  Net sales of our Pet Products were $6.3 million in 2010, compared to $10.6 million in 2009, representing a decrease of $4.3 million, or 40.6%.  The decrease is mainly attributable to less available shelf space for pet products at some of our major customer retail stores, and lower unit sales of consumable pet products.
 
Cost of Sales
 
Traditional Toys .  Cost of sales of our Traditional Toys segment was $359.6 million, or 67.4% of related net sales, in 2010, compared to $413.0 million, or 75.4% of related net sales, in 2009, representing a decrease of $56.6 million, or 13.7%.  This dollar decrease is primarily due to charges in 2009 of $18.8 million related to the write-down of certain excess and impaired inventory and $32.6 million related to the write-down of license advances and minimum guarantees that were not expected to be earned through sales of that licensed product. Excluding these one time charges, cost of sales was $361.6 million in 2009, or 66.0% of net sales.   Excluding the one time charges in 2009, cost of sales decreased $5.2 million, which primarily consisted of a decrease in depreciation of molds and tools due to decreased purchases in this segment.  Product costs as a percentage of sales are comparable year over year.  Furthermore, royalty expense for our Traditional Toys segment increased by $1.3 million and as a percentage of net sales due to changes in the product mix to more products with higher royalty rates from proprietary products with no royalty rates or products with lower royalty rates.
 
 
 
25

 
 
Craft/Activity/Writing Products .  Cost of sales of our Craft/Activity/Writing Products segment was $5.3 million, or 57.0% of related net sales, in 2010, compared to $34.3 million, or 74.2% of related net sales, in 2009, representing a decrease of $29.0 million, or 84.5%.  The decrease is primarily due to a lower volume of sales.  In addition, this decrease is partially due to charges in 2009 of $4.5 million related to the write-down of certain excess and impaired inventory and $0.3 related to the write-down of license advances and minimum guarantees that were not expected to be earned out through sales of that licensed product.   Excluding these one time charges, cost of sales was $29.6 million, or 64.1% in 2009, representing a decrease of $24.3 million.  Product costs as a percentage of net sales decreased primarily due to the mix of the product sold.  Royalty expense decreased by $2.0 million due to a lower volume of sales, but increased as a percentage of net sales due to changes in the product mix to more products with higher royalty rates from products with lower royalty rates or proprietary products with no royalty rates. Our depreciation of molds and tools increased by $1.0 million primarily due to decreased purchases of molds and tools in this segment.

Pet Products .  Cost of sales of our Pet Pal line of products was $4.9 million, or 77.8% of related net sales, in 2009, compared to $11.0 million, or 103.8% of related net sales, in 2009, representing a decrease of $6.1 million, or 55.5%.  This decrease is primarily due to a lower volume of sales.  In addition, this decrease is partially due to charges of $0.8 million related to the write-down of certain excess and impaired inventory and $0.4 related to the write-down of license advances and minimum guarantees that are not expected to be earned out through sales of that licensed product.  Excluding these one time charges, cost of sales was $9.9 million or 93.4% of net sales in 2009, representing a decrease of  $5.0 million.  Royalty expense decreased by $1.0 million and as a percentage of sales due to changes in the product mix to more products with lower royalty rates or proprietary products with no royalty rates from products with higher royalty rates.  Our depreciation of molds and tools in this segment is comparable year over year.

Selling, General and Administrative Expenses
 
Selling, general and administrative expenses were $140.2 million in 2010 and $171.7 million in 2009, constituting 25.5% and 28.4% of net sales, respectively.  The overall decrease of $31.5 million in such costs was primarily due to the company’s reorganization efforts resulting in decreases in general and administrative expenses ($13.6 million), product development ($6.4 million), depreciation and amortization ($2.7 million), and direct selling expenses ($8.8 million).  The decrease in depreciation and amortization is due to a decrease in amortization expense related to intangible assets other than goodwill ($2.2 million).  The decrease in general and administrative expenses is primarily due to decreases in salary and employee benefits expense ($7.6 million) and legal expense ($7.5 million), offset in part by  increases in travel and entertainment expense ($0.5 million), and donation expense ($0.2 million). Product development expenses decreased as a result of tighter control of spending on product development.  The decrease in direct selling expenses is primarily due to decreases in advertising and promotional expenses of $5.4 million in 2010 in support of several of our product lines, sales commissions ($1.2 million) and other direct selling expenses of $3.4 million.  
 
Write-down of Intangible Assets
 
As of June 30, 2009, we determined that the tradenames “Child Guidance,”  “Play Along” and certain tradenames associated with our Crafts and Activities product lines would either be discontinued or were under-performing.   Consequently, the intangible assets associated with these tradenames were written off to “Write-down of Intangible Assets”, resulting in a non-cash charge of $8.2 million. 

Write-down of Goodwill
 
During the three months ended June 30, 2009, we determined that the significant decline in our market capitalization was likely to be sustained.   Our market capitalization did not change significantly despite the dismissals subject to appeal of the WWE lawsuit, and the lower revenue expectations for 2009 versus 2008 were factors that indicated that an interim goodwill impairment test was required. As a result, we determined that $407.1 million, or all of the goodwill related to previous acquisitions, including the acquisition of Disguise in December 2008, was impaired. This amount is included in “Write-down of Goodwill” in the accompanying condensed consolidated statements of operations.

Profit from Video Game Joint Venture
 
We did not recognize  any income from our video game joint venture in 2010, as compared to a loss of $21.9 million in 2009 related primarily to an adjustment of $23.5 million to our preferred return from prior years as a result of an arbitration decision. Pursuant to a Settlement Agreement and Mutual Release dated December 22, 2009, the joint venture was terminated on December 31, 2009.  On June 30, 2010 we received a fixed payment from THQ in the amount of $6.0 million, which was recognized as income during the second quarter.  Additionally, we will receive future payments in the amount of $6.0 million on June 30, 2011 and $4.0 million on each of June 30, 2012 and 2013 which we will record as income on a cash basis over the term (see “Legal Proceedings”).
 
 
 
26

 
 
Interest Income
 
Interest income in the nine months ended September 30, 2010 was $0.3million, comparable to $0.3 million in the nine months ended September 30, 2009.


Interest Expense
 
Interest expense was $5.8 million in 2010, as compared to $3.8 million in 2009.  In 2010, we booked interest expense of $6.9 million related to our convertible senior notes payable offset in part by a net benefit of $0.6 million related to uncertain tax positions taken or expected to be taken in a tax return.  In 2009, we booked interest expense of $3.3 million related to our convertible senior notes payable and net interest expense of $0.4 million related to uncertain tax positions taken or expected to be taken in a tax return.

Provision for Income Taxes
 
Our income tax expense, which includes federal, state and foreign income taxes, and discrete items, was $1.5 million, or an effective tax expense rate expense of 3.9% for the nine months ended September 30, 2010. During the comparable period in 2009, the income tax benefit was $82.2 million, or an effective tax benefit rate of 17.6%.

The income tax benefit for the nine months ended September 30, 2010 included a discrete benefit of $11.1 million primarily related to a reduction in tax reserves resulting from the effective settlement of tax audits of the Company’s 2003 through 2006 income tax returns, the receipt of a refund of tax resulting from the tax audits of the Company's 2003 through 2009 income tax returns and an adjustment related to transfer pricing.  (see Note 6 of the Notes to Condensed Consolidated Financial Statements, supra.). Exclusive of the discrete items, the September 30, 2010 effective tax provision rate would be 31.8%.


 
27

 
 
Seasonality and Backlog
 
The retail toy industry is inherently seasonal. Generally, our sales have been highest during the third and fourth quarters, and collections for those sales have been highest during the succeeding fourth and first fiscal quarters. Our working capital needs have been highest during the third and fourth quarters.
 
While we have taken steps to level sales over the entire year, sales are expected to remain heavily influenced by the seasonality of our toy and Halloween products. The result of these are seasonal patterns is that operating results and demand for working capital may vary significantly by quarter. Orders placed with us for shipment are generally cancelable until the date of shipment. The combination of seasonal demand and the potential for order cancellation makes accurate forecasting of future sales difficult and causes us to believe that backlog may not be an accurate indicator of our future sales. Similarly, financial results for a particular quarter may not be indicative of results for the entire year.

Liquidity and Capital Resources

As of September 30, 2010, we had working capital of $407.8 million, compared to $352.1 million as of December 31, 2009. The increase was primarily attributable to seasonally high accounts receivable and inventory balances offset partially by higher accrued expenses and accounts payable balances.
 
Operating activities used net cash of $1.8 million in the first nine  months of 2010, as compared to a net cash provided of $11.4 million in the prior year period. Net cash was provided primarily from receipt of payments for outstanding receivables. Our accounts receivable turnover as measured by days sales for the quarter outstanding in accounts receivable was 76 days as of September 30, 2010, no change from 76 days as of September 30, 2009. Other than open purchase orders issued in the normal course of business, we have no obligations to purchase finished goods from our manufacturers. As of September 30, 2010, we had cash and cash equivalents of $218.6 million.
 
Our investing activities used net cash of $9.4 million in the nine months ended September 30, 2010, as compared to $25.5 million in the prior year period, consisting primarily of cash paid for the Kids Only earn-out of $1.9 million and the purchase of office furniture and equipment and molds and tooling of $9.6 million used in the manufacture of our products.  As part of our strategy to develop and market new products, we have entered into various character and product licenses with royalties generally ranging from 1% to 14% payable on net sales of such products. As of September 30, 2010, these agreements required future aggregate minimum guarantees of $75.0 million, exclusive of $53.9 million in advances already paid. Of this $75.0 million future minimum guarantee, $52.8 million is due over the next twelve months.
 
Our financing activities used net cash of $25.0 million in the nine months ended September 30, 2010, as compared to $1.6 million in the prior year period, consisting primarily of cash paid to redeem the  remainder of our 4.625% convertible senior notes due 2023, and the $4.5 million repurchase of restricted shares from the Friedman Estate, which were subsequently retired by the Company.
 
 
 
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In October 2008, we acquired substantially all of the assets of Tollytots . The total initial consideration of $26.8 million consisted of $12.0 million in cash and the assumption of liabilities in the amount of $14.8 million, and resulted in goodwill of $4.1 million, of which $3.1 million has been determined to be impaired and was written off in the quarter ended June 30, 2009. In addition, we agreed to pay an earn-out of up to an aggregate amount of $5.0 million in cash over the three calendar years following the acquisition based on the achievement of certain financial performance criteria, which will be recorded as goodwill when and if earned. In the first earn-out period ended December 31, 2009, no portion of the earn-out was earned. Tollytots is a leading designer and producer of licensed baby dolls and baby doll pretend play accessories based on well-known brands and was included in our results of operations from the date of acquisition.

In October 2008, we acquired substantially all of the stock of Kids Only. The total initial consideration of $23.8 million consisted of $20.4 million in cash and the assumption of liabilities in the amount of $3.4 million, and resulted in goodwill of $13.2 million, of which $12.7 million has been determined to be impaired and was written off in the quarter ended June 30, 2009. In addition, we agreed to pay an earn-out of up to an aggregate amount of $5.6 million in cash over the three  years following the acquisition based on the achievement of certain financial performance criteria, which will be recorded as goodwill when and if earned. The first earn-out period ended September 30, 2009 and the full earn-out amount of $1.9 million was paid in April 2010. The second earn-out period ended September 30, 2010.  The company is evaluating the earn-out agreement to determine the amount of earn-out that will be paid related to the second earn-out period.  Kids Only is a leading designer and producer of licensed indoor and outdoor kids’ furniture, and children’s toy products including baby dolls and accessories, activity trays and room décor,  and was included in our results of operations from the date of acquisition.

In December 2008, the Company acquired certain assets of Disguise. The total initial consideration of $60.6 million consisted of $38.6 million in cash and the assumption of liabilities in the amount of $22.0 million, and resulted in goodwill of $30.6 million, all of which has been determined to be impaired and was written off in the quarter ended June 30, 2009. Disguise is a leading designer and producer of Halloween costumes and accessories and was included in our results of operations from the date of acquisition.
 
In November 2009, we sold an aggregate of $100.0 million of 4.50% Convertible Senior Notes due 2014 (the “Notes”). The Notes are senior unsecured obligations of JAKKS, will pay interest semi-annually at a rate of 4.50% per annum and will mature on November 1, 2014. The conversion rate will initially be 63.2091 shares of our common stock per $1,000 principal amount of notes (equivalent to an initial conversion price of approximately $15.82 per share of common stock), subject to adjustment in certain circumstances. Prior to August 1, 2014, holders of the Notes may convert their Notes only upon specified events. Upon conversion, the Notes may be settled, at our election, in cash, shares of our common stock, or a combination of cash and shares of our common stock. Holders of the Notes may require us to repurchase for cash all or some of their Notes upon the occurrence of a fundamental change (as defined in the Notes). We used a portion of the net proceeds from the offering to repurchase $77.7 million of our 4.625% convertible senior notes due in 2023 in November 2009 and we redeemed all of the remaining $20.3 million of notes in June and August 2010.

 
We believe that our cash flows from operations and cash and cash equivalents will be sufficient to meet our working capital and capital expenditure requirements and provide us with adequate liquidity to meet our anticipated operating needs for at least the next 12 months. Although operating activities are expected to provide cash, to the extent we grow significantly in the future, our operating and investing activities may use cash and, consequently, this growth may require us to obtain additional sources of financing. There can be no assurance that any necessary additional financing will be available to us on commercially reasonable terms, if at all. We intend to finance our long-term liquidity requirements out of net cash provided by operations and net cash and cash equivalents. As of September 30, 2010, we do not have any off-balance sheet arrangements.
 
 
 
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Market risk represents the risk of loss that may impact our financial position, results of operations or cash flows due to adverse changes in financial and commodity market prices and rates. We are exposed to market risk in the areas of changes in United States and international borrowing rates and changes in foreign currency exchange rates. In addition, we are exposed to market risk in certain geographic areas that have experienced or remain vulnerable to an economic downturn, such as China. We purchase substantially all of our inventory from companies in China, and, therefore, we are subject to the risk that such suppliers will be unable to provide inventory at competitive prices. While we believe that, if such an event were to occur we would be able to find alternative sources of inventory at competitive prices, we cannot assure you that we would be able to do so. These exposures are directly related to our normal operating and funding activities. Historically, we have not used derivative instruments or engaged in hedging activities to minimize our market risk.
 
Interest Rate Risk
 
In November 2009, we issued convertible senior notes payable of $100.0 million with a fixed interest rate of 4.50% per annum, all of which remain outstanding as of September 30, 2010. Accordingly, we are not generally subject to any direct risk of loss arising from changes in interest rates.
 
Foreign Currency Risk
 
We have wholly-owned subsidiaries in Hong Kong, China, Canada, and the United Kingdom. Sales made by the Hong Kong subsidiaries are denominated in U.S. dollars. However, purchases of inventory are typically denominated in Hong Kong dollars and local operating expenses are denominated in the local currency of the subsidiary, thereby creating exposure to changes in exchange rates. Changes in the local currency/U.S. dollar exchange rates may positively or negatively affect our operating results. We do not believe that near-term changes in these exchange rates, if any, will result in a material effect on our future earnings, fair values or cash flows, and therefore, we have chosen not to enter into foreign currency hedging transactions. We cannot assure you that this approach will be successful, especially in the event of a significant and sudden change in the value of the Hong Kong dollar or Chinese Yuan relative to the U.S. dollar. We incorporated a subsidiary in Spain  in 2010 and have limited operation in the UK and Spain and, therefore, we have a nominal currency translation risk at this time.
 
Item 4. Controls and Procedures
 
Our Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Report, have concluded that as of that date, our disclosure controls and procedures were effective. There were no changes in our internal control over financial reporting identified in connection with the evaluation required by Exchange Act Rule 13a-15(d) that occurred during the period covered by this Report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
 
 
 
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OTHER INFORMATION
 
Item 1. Legal Proceedings
 
On October 12, 2006, World Wrestling Entertainment, Inc. (“WWE”) commenced a lawsuit in Connecticut state court against THQ/JAKKS Pacific LLC, alleging that sales of WWE video games in Japan and other countries in Asia were not lawful (the “Connecticut Action”). The lawsuit sought, among other things, a declaration that WWE is entitled to terminate the video game license and monetary damages. In 2007, WWE filed an amended complaint in the Connecticut Action to add the principal part of the state law claims present in the action filed by WWE in the Southern District of New York (the “WWE Action”) to the Connecticut Action; the WWE Action was finally dismissed in 2009. THQ filed a cross-complaint that asserted claims by THQ and Mr. Farrell, THQ’s Chief Executive Officer, for indemnification from the Company in the event that WWE prevailed on its claims against THQ and Farrell and also asserted claims by THQ that the Company breached its fiduciary duties to THQ in connection with the videogame license between WWE and the THQ/JAKKS Pacific joint venture and sought equitable and legal relief, including substantial monetary and exemplary damages against the Company in connection with its claim. Thereafter, the WWE claims and the THQ cross-claims in the Connecticut Action were all dismissed with prejudice pursuant to settlement agreements that the Company entered into with WWE and THQ dated December 22, 2009.(the “Settlements”).
 
In November 2004, several purported class action lawsuits were filed in the United States District Court for the Southern District of New York: (1) Garcia v. JAKKS Pacific, Inc. et al., Civil Action No. 04-8807 (filed on November 5, 2004), (2) Jonco Investors, LLC v. JAKKS Pacific, Inc. et al., Civil Action No. 04-9021 (filed on November 16, 2004), (3) Kahn v. JAKKS Pacific, Inc. et al., Civil Action No. 04-8910 (filed on November 10, 2004), (4) Quantum Equities L.L.C. v. JAKKS Pacific, Inc. et al., Civil Action No. 04-8877 (filed on November 9, 2004), and (5) Irvine v. JAKKS Pacific, Inc. et al., Civil Action No. 04-9078 (filed on November 16, 2004) (the “Class Actions”). The complaints in the Class Actions alleged that defendants issued positive statements concerning increasing sales of our WWE licensed products which were false and misleading because the WWE licenses had allegedly been obtained through a pattern of commercial bribery, our relationship with the WWE was being negatively impacted by the WWE’s contentions and there was an increased risk that the WWE would either seek modification or nullification of the licensing agreements with us. Plaintiffs also alleged that we misleadingly failed to disclose the alleged fact that the WWE licenses were obtained through an unlawful bribery scheme. The plaintiffs in the Class Actions were described as purchasers of our common stock, who purchased from as early as October 26, 1999 to as late as October 19, 2004. The Class Actions sought compensatory and other damages in an undisclosed amount, alleging violations of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 promulgated thereunder by each of the defendants (namely the Company and Messrs. Friedman, Berman and Bennett), and violations of Section 20(a) of the Exchange Act by Messrs. Friedman, Berman and Bennett. On January 25, 2005, the Court consolidated the Class Actions under the caption In re JAKKS Pacific, Inc. Shareholders Class Action Litigation, Civil Action No. 04-8807. On May 11, 2005, the Court appointed co-lead counsels and provided until July 11, 2005 for an amended complaint to be filed; and a briefing schedule thereafter with respect to a motion to dismiss. The motion to dismiss was fully briefed and argument occurred on November 30, 2006. The motion was granted in January 2008 to the extent that the Class Actions were dismissed without prejudice to plaintiffs’ right to seek leave to file an amended complaint based on statements that the WWE licenses were obtained from the WWE as a result of the long-term relationship with WWE. A motion seeking leave to file an amended complaint was granted and an amended complaint filed. Briefing was completed with respect to a motion to dismiss that was scheduled for argument in October 2008. The Court adjourned the argument date. The parties notified the Court that an agreement to resolve this action was reached. In November 2009, a motion was filed by plaintiffs’ counsel for preliminary approval of this agreement, which provides for the matter to be settled for $3.9 million, without any admission of liability on the part of the Company, or its officers and directors.  On June 29, 2010, the Court found preliminary that the settlement was fair and scheduled the Fairness Hearing for October 19, 2010.  On October 19, 2010, the Court approved the settlement of the Class Actions.

On December 2, 2004, a shareholder derivative action was filed in the Southern District of New York by Freeport Partner, LLC against us, nominally, and against Messrs. Friedman, Berman and Bennett, Freeport Partners v. Friedman, et al., Civil Action No. 04-9441 (the “Derivative Action”). The Derivative Action seeks to hold the individual defendants liable for damages allegedly caused to us by their actions and in particular to hold them liable on a contribution theory with respect to any liability we incur in connection with the Class Actions. On or about February 10, 2005, a second shareholder derivative action was filed in the Southern District of New York by David Oppenheim against us, nominally, and against Messrs. Friedman, Berman, Bennett, Blatte, Glick, Miller and Skala, Civil Action 05-2046 (the “Second Derivative Action”). The Second Derivative Action seeks to hold the individual defendants liable for damages allegedly caused to us by their actions as a result of alleged breaches of their fiduciary duties. On or about March 16, 2005, a third shareholder derivative action was filed. It is captioned Warr v. Friedman, Berman, Bennett, Blatte, Glick, Miller, Skala, and JAKKS (as a nominal defendant), and it was filed in the Superior Court of California, Los Angeles County (the “Third Derivative Action”). The Third Derivative Action seeks to hold the individual defendants liable for (1) damages allegedly caused to us by their alleged breaches of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets and unjust enrichment; and (2) restitution to us of profits, benefits and other compensation obtained by them. Agreement to resolve the Derivative Actions has been reached, but it is also subject to Court approval.   Preliminary approval was granted on July 12, 2010.  A Company insurer has provided $3.9 million in connection with the Class Action settlement agreement and has agreed to provide an additional $165,000 upon final approval of the settlement of the Derivative Actions.  The Fairness Hearing with respect to the Derivative Actions was also scheduled for October 19, 2010.  On October 19, 2010, the Court approved the settlement of the Derivative Actions but reserved based on further briefing with respect to the legal fees to claimants’ counsel, which fees are to be paid by the insurer.
 
We are a party to, and certain of our property is the subject of, various other pending claims and legal proceedings that routinely arise in the ordinary course of our business, but we do not believe that any of these claims or proceedings will have a material effect on our business, financial condition or results of operations.
 
 
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From time to time, including in this Quarterly Report on Form 10-Q, we publish forward-looking statements, as disclosed in our Disclosure Regarding Forward-Looking Statements beginning immediately following the Table of Contents of this Report. We note that a variety of factors could cause our actual results and experience to differ materially from the anticipated results or other expectations expressed or anticipated in our forward-looking statements. The factors listed below are the risks and uncertainties that may arise and that may be detailed from time to time in our public announcements and our filings with the Securities and Exchange Commission, such as on Forms 8-K, 10-Q and 10-K. We undertake no obligation to make any revisions to the forward-looking statements contained in this Report to reflect events or circumstances occurring after the date of the filing of this report.
 
Our inability to redesign, restyle and extend our existing core products and product lines as consumer preferences evolve, and to develop, introduce and gain customer acceptance of new products and product lines, may materially and adversely impact our business, financial condition and results of operations.
 
Our business and operating results depend largely upon the appeal of our products. Our continued success in the toy industry will depend on our ability to redesign, restyle and extend our existing core products and product lines as consumer preferences evolve, and to develop, introduce and gain customer acceptance of new products and product lines. Several trends in recent years have presented challenges for the toy industry, including:

 
Age Compression: The phenomenon of children outgrowing toys at younger ages, particularly in favor of interactive and high technology products;

 
Increasing use of technology;

 
Shorter life cycles for individual products; and

 
Higher consumer expectations for product quality, functionality and value.

We cannot assure you that:

 
our current products will continue to be popular with consumers;

 
the product lines or products that we introduce will achieve any significant degree of market acceptance; or

 
the life cycles of our products will be sufficient to permit us to recover licensing, design, manufacturing, marketing and other costs associated with those products.

Our failure to achieve any or all of the foregoing benchmarks may cause the infrastructure of our operations to fail, thereby adversely affecting our business, financial condition and results of operations.

The failure of our character-related and theme-related products to become and/or remain popular with children may materially and adversely impact our business, financial condition and results of operations.
 
The success of many of our character-related and theme-related products depends on the popularity of characters in movies, television programs, live wrestling exhibitions, auto racing events and other media. We cannot assure you that:

 
● 
media associated with our character-related and theme-related product lines will be released at the times we expect or will be successful;
 
 
the success of media associated with our existing character-related and theme-related product lines will result in substantial promotional value to our products;
 
 
we will be successful in renewing licenses upon expiration on terms that are favorable to us; or

 
we will be successful in obtaining licenses to produce new character-related and theme-related products in the future.

Our failure to achieve any or all of the foregoing benchmarks may cause the infrastructure of our operations to fail, thereby adversely affecting our business, financial condition and results of operations.
 
There are risks associated with our license agreements.

 
Our current licenses require us to pay minimum royalties
 
 
 
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Sales of products under trademarks or trade or brand names licensed from others account for substantially all of our net sales. Product licenses allow us to capitalize on characters, designs, concepts and inventions owned by others or developed by toy inventors and designers. Our license agreements generally require us to make specified minimum royalty payments, even if we fail to sell a sufficient number of units to cover these amounts. In addition, under certain of our license agreements, if we fail to achieve certain prescribed sales targets, we may be unable to retain or renew these licenses.

 
Some of our licenses are restricted as to use

Under the majority of our license agreements the licensors have the right to review and approve our use of their licensed products, designs or materials before we may make any sales. If a licensor refuses to permit our use of any licensed property in the way we propose, or if their review process is delayed, our development or sale of new products could be impeded.

 
New licenses are difficult and expensive to obtain

Our continued success will depend substantially on our ability to obtain additional licenses. Intensive competition exists for desirable licenses in our industry. We cannot assure you that we will be able to secure or renew significant licenses on terms acceptable to us. In addition, as we add licenses, the need to fund additional royalty advances and guaranteed minimum royalty payments may strain our cash resources.

 
A limited number of licensors account for a large portion of our net sales

We derive a significant portion of our net sales from a limited number of licensors. If one or more of these licensors were to terminate or fail to renew our license or not grant us new licenses, our business, financial condition and results of operations could be adversely affected.

The toy industry is highly competitive and our inability to compete effectively may materially and adversely impact our business, financial condition and results of operations.

The toy industry is highly competitive. Globally, certain of our competitors have financial and strategic advantages over us, including:

 
greater financial resources;

 
larger sales, marketing and product development departments;

 
stronger name recognition;

 
longer operating histories; and

 
greater economies of scale.
 
 
In addition, the toy industry has no significant barriers to entry. Competition is based primarily on the ability to design and develop new toys, to procure licenses for popular characters and trademarks and to successfully market products. Many of our competitors offer similar products or alternatives to our products. Our competitors have obtained and are likely to continue to obtain licenses that overlap our licenses with respect to products, geographic areas and markets. We cannot assure you that we will be able to obtain adequate shelf space in retail stores to support our existing products or to expand our products and product lines or that we will be able to continue to compete effectively against current and future competitors.


We may not be able to sustain or manage our growth, which may prevent us from continuing to increase our net revenues.

We have experienced rapid growth in our product lines resulting in higher net sales over the last nine years, which was achieved through acquisitions of businesses, products and licenses. For example, revenues associated with companies we acquired since 2008 were approximately $169.0 million and $169.6 million, for the year ended December 31, 2009 and the nine months ended September 30, 2010, respectively, representing 21.0% and 30.9% of our total revenues for those periods. As a result, comparing our period-to-period operating results may not be meaningful and results of operations from prior periods may not be indicative of future results.