About EDGAR Online | Login
 
Enter your Email for a Free Trial:
The following is an excerpt from a 10-K SEC Filing, filed by DSI TOYS INC on 3/28/2003.
Next Section Next Section Previous Section Previous Section
DSI TOYS INC - 10-K - 20030328 - PART_I

PART I

ITEM 1.  BUSINESS

 

General Development of the Business

 

Except as otherwise indicated, references to the “Company” refer to DSI Toys, Inc. and its wholly owned Hong Kong subsidiary, DSI(HK) Limited (“DSI(HK)”).  The terms “fiscal year” and “fiscal” refer to the Company’s fiscal year which is the year ending December 31 of the calendar year mentioned ( e.g ., a reference to fiscal 2002 is a reference to the fiscal year ended December 31, 2002).  Effective December 31, 1999, the Company changed its fiscal year end from January 31 to a calendar year end.

 

The Company designs, develops, markets and distributes high quality, innovative dolls, toys and consumer electronics products.  Core products include Tech-Link ® communications products, KAWASAKI® electronic musical instruments, GearHead ™ remote control vehicles, DJ Skribble ® ’s Spinheads ™ musical figures and toys, a full range of special feature doll brands including Sweet Faith® , Pride & Joy® , Too Cute Twins ® and Lovin’ Touch™ life-like dolls, Baby Knows Her Name™ talking doll, Childhood Verses™ nursery rhyme dolls , Little Darlings® dolls and Collectible Plush, including Kitty, Kitty, Kittens® and Puppy, Puppy, Puppies® .

 

The Company was incorporated in Texas in 1970.   Its executive offices are located at 10110 West Sam Houston Parkway South, Suite 150, Houston, Texas, 77099, telephone (713) 365-9900.  The Company’s website can be reached at http://www.DSIToys.com.

 

Meritus Acquisition

 

Effective January 7, 2000, the Company acquired by way of merger Meritus Industries, Inc. (“Meritus”), a privately held toy manufacturer, engaged in the manufacturing and marketing of dolls, doll houses, doll accessories, and girls’ toys.  As a result of the merger, the Company added the Forever Girl Friends ® brand accessories for 11-1/2” fashion dolls, and Little Darlings® brand value-priced action feature dolls to its product offerings, as well as the Elite Dolls ™ brand, which was created by Meritus specifically to manufacture and market Lifetime Play Dolls™ , a line of exquisite 18” dolls and accessories suitable for playing or collecting.

 

The Company also acquired three wholly-owned Hong Kong subsidiaries in the merger with Meritus: Meritus Industries Limited, RSP Products Limited, and Elite Dolls Limited, each of which were engaged in doll manufacturing operations.  The Company transferred the operations of these entities to DSI (HK) and liquidated the three acquired subsidiaries effective October 22, 2002.

 

Description of Business Segments and Products

 

The Company has three major product categories which represent the Company’s operating segments: Juvenile Audio Products, Girls’ Toys and Boys’ Toys.  Because these operating segments all have similar economic characteristics, the Company has one reportable business segment.  For additional information with respect to the Company’s business segment reporting, see Note 13 to the Consolidated Financial Statements.

 

Juvenile Audio Products

 

The Juvenile Audio Product category consists of Youth Electronics products and Musical Instruments.  Products in the Youth Electronics line include walkie-talkies, wrist watch walkie-talkies, audio products and novelty electronic products.  The category brands include Tech-Link ® communications products, walkie-talkies and bike alarms, the new BioScan Room Guardian™, and DJ Skribble ®’s Spinheads™ , a new line of musical toys .   The Musical Instrument line also includes the branded line of KAWASAKI® guitars, drum-pads, saxophones and keyboards.

 

1



 

Girls’ Toys

 

The Girls’ Toys product category includes dolls, interactive plush toys, play sets, accessories, and girls’ activity toys.  The Girls’ Toys portfolio of brands includes Baby Knows Her Name™, Lovin’ Touch™, Childhood Verses™, Pride & Joy®, and Little Darlings®, along with interactive plush products and girls’ activity products such as Twist and Twirl Braider™.

 

Boys’ Toys

 

The Boys’ Toys product category includes radio control and infra-red control vehicles.  The brands in this product category are GearHead ™ radio control vehicles, including the Insector ®, and the unique ultra-articulated Street Savage™ and Crazy Taxi ™, based on the popular Sega of America, Inc. arcade and home video game of the same name.

 

Product Introductions

 

New product introductions during 2002 included KAWASAKI® foldable keyboards and drumpads, the LazerDoodle ™ electronic drawing toy, the Somersault Sara ™ interactive electronic doll, and the Dual Fusion™ radio control vehicle.

 

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

 

Product Category

 

2002

 

2001

 

2000

 

Juvenile Audio Products

 

40.3

%

38.8

%

39.5

%

Girls’ Toys

 

40.1

 

46.4

 

39.8

 

Boys’ Toys

 

12.6

 

12.6

 

18.0

 

Other

 

7.0

 

2.2

 

2.7

 

Total

 

100.0

%

100.0

%

100.0

%

 

Between 30% and 40% of the Company’s products (by dollar volume of net sales) are replaced each year through the introduction of new products.  As a result of this turnover, product development is critical to the Company’s business.  The Company develops both proprietary and non-proprietary products.  The Company’s proprietary product lines consist of products that (i) are licensed from outside inventors and designers, (ii) incorporate trademarks licensed to the Company, (iii) are designed in-house, or (iv) are manufactured using Company-owned tooling, dies and molds based on a proprietary design or idea owned by the Company or the inventor.   Proprietary toys accounted for approximately 86%, 80%, and 78% of the Company’s net sales for fiscal 2002, 2001, and 2000, respectively.  The Company’s proprietary products generally yield higher gross margins to the Company than non-proprietary products.

 

Non-proprietary products are defined by the Company as toys designed and manufactured by independent toy manufacturers and marketed by the Company, usually on an exclusive basis in the Company’s primary markets.  The Company selects its non-proprietary products after an evaluation of several factors, including the quality and pricing of the product, as well as whether the product presents an opportunity for the Company to utilize packaging and marketing to differentiate the product from other toys.  The Company often markets these toys under in-house brands, such as Tech-Link® and My Music Maker ®.  Non-proprietary products accounted for approximately 14%, 20%, and 22% of the Company’s net sales for fiscal 2002, 2001 and 2000, respectively.

 

2



 

Customers

 

The Company made sales to over 500 different customers in approximately 40 countries during fiscal 2002. The table below sets forth the Company’s net sales by geographic area as a percentage of total net sales for the specified fiscal years.

 

Geographic Area

 

2002

 

2001

 

2000

 

United States

 

81.1

%

82.8

%

81.1

%

All Foreign Countries

 

18.9

 

17.2

 

18.9

 

 

The Company’s principal customers are retailers, including mass merchandising discounters such as Wal-Mart, Kmart and Target, specialty toy retailers such as Toys “R” Us, Kay Bee Toy & Hobby and QVC, and deep discount stores such as Family Dollar Stores, Inc., Consolidated Stores Corporation and Value City Department Stores, Inc.  The Company’s top five customers accounted for approximately 52.9% of the Company’s net sales in fiscal 2002.  During fiscal 2002, Wal-Mart and Kmart accounted for 26.8% and 9.5%, respectively, of the Company’s net sales. In fiscal 2001, Wal-Mart and Kmart accounted for 21.1% and 10.4% respectively, of the Company’s annual net sales.  In fiscal 2000, Wal-Mart and Toys “R” Us accounted for 18.1% and 11.5%, respectively, of the Company’s annual net sales.  During fiscal 2002, the Company’s sales to Toys “R” Us, Wal-Mart, Kmart, Target and Kay-Bee Toy & Hobby, the five largest toy retailers in the United States, decreased as a percentage of the Company’s net sales to 44.5% compared to 49.2% of net sales during fiscal 2001 and 46.1% of net sales during fiscal 2000.  The Company does not have long-term contractual arrangements with its customers.

 

Marketing and Sales

 

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

 

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

 

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

 

Advertising

 

In recent years, the Company has allocated the majority of its advertising budget to television promotion, retailer-based programs and print advertising.  During 2002, the Company devoted the bulk of its television advertising to the fall and Christmas season, principally to promote Too Cute Twins® and Somersault Sara™ .   In addition, during 2002 and 2001 the Company utilized a portion of its advertising budget on print advertising for the Pride & Joy® product line as well as participating in retailer based programs.   The Company expects to continue using promotional programs involving television and consumer magazine advertising of certain, unique proprietary products, as well as year-round public relations programs, participation in national consumer-based toy test awards programs, internet linkages where appropriate, trade advertising and traditional retailer-based ad programs including cooperative promotional ads, special offers and retail catalogues.

 

3



 

Manufacturing

 

The Company annually contracts with approximately 30 independent manufacturers located within a 300-mile radius of Hong Kong, principally in the Peoples’ Republic of China (the “PRC”), for the manufacture of its products.  The Company may use more than one manufacturer to produce a single product.  The manufacturers that accounted for more than 10% of the Company’s purchases of products during fiscal 2002 were Wah Lung (19.4%), which manufactured dolls and girls playsets, and Potex Toys Manufacturer, Ltd. (24.4%), which manufactured musical instruments.  Manufacturing commitments are made on a purchase order basis.  The Company does not have long-term contractual arrangements with its manufacturers.

 

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

 

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

 

Distribution

 

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

 

In early 2002, the Company’s primary distribution facility was moved to a public warehouse facility in Fife, Washington in anticipation of the expiration of the Company’s primary Houston facility lease in August, 2002.  The Company contracted with the facility on a limited basis in 2001 to test its distribution ability and performance.  Based on the positive distribution results and the cost savings achieved, the Company in March, 2002, decided to transfer all domestic distribution to the Fife facility.  Additionally, the Fife geographic location enables the Company to increase the speed of distribution to customers for faster-selling television-promoted items.  During the transition process in 2002, the Company continued to ship from both the old primary location and a public over-flow warehouse in Houston.  In 2003, the Company will transition the Houston public warehouse to a defective return center.

 

Historically, basic continuous stock toys that are offered by retailers on a year-round basis are shipped to customers from the Company’s domestic inventory.  In addition, certain faster-selling toys are often shipped directly to major customers for seasonal selling and stocked by the Company in its domestic facilities for peak season back-up and continuous supply.  The Company also maintains inventory which is intended for specific customers for peak holiday season support, as well as some inventory which is available for smaller retailers and for opportunistic selling strategies.

 

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

 

4



 

License Agreements

 

Various license agreements with inventors and other third parties, including Kawasaki Motors Corp., U.S.A. (“Kawasaki”), permit the Company to utilize the trademark, character or product of the licensor in its product line.  In return, the Company agrees to pay to the licensor a percentage of net sales (“royalty rate”) of the licensed product.  Typically, these royalty rates range from 4% to 7% of net sales.  Sales of licensed products such as the Street Savage™ R/C vehicle, the Too Cute Twins® dolls, and the KAWASAKI® musical instruments accounted for approximately 75%, 68%, and 59% of the Company’s net sales during fiscal 2002, 2001, and 2000, respectively.  The acquisition of licenses also typically requires the payment of non-refundable advances and/or guaranteed minimum royalties.

 

The Company initially entered into a license agreement with Kawasaki in January of 1994, and that agreement, together with subsequent amendments, and renewals thereof, has authorized the Company to use the KAWASAKI ® brand name in connection with several different products, including R/C motorcycles, bicycle accessories, walkie-talkies and a complete line of electronic musical instruments, including keyboards, guitars and percussion instruments.  The current agreement with Kawasaki was renewed effective as of January 1, 2003, and now expires on December 31, 2007.

 

The Company has entered into a licensing agreement with Skribbleeno Productions, Inc. for the name, signature, recorded voice, photographic likeness, and sculpted likeness of Scott Ialacci, who is professionally known as DJ Skribble, together with the registered trademark DJ Skribble ® for the marketing and sale of musical toy products.  Further, the Company recently executed a license agreement with Sega of America, Inc. for the use of the intellectual property associated with Crazy Taxi ™ in the marketing and sale of R/C vehicles.

 

As of December 31, 2002, the aggregate guaranteed royalties payable by the Company under all of its licenses totaled approximately $250,000 in fiscal 2003 and $835,000 thereafter through fiscal 2007.  In prior years, the Company changed its license strategy to reduce its long-term commitments to licensors in favor of larger advance royalty payments.  The Company believes that this strategy better matches royalty liabilities with the product life cycles and minimizes the potential negative impact on future earnings.  The Company does enter into agreements on proven properties, like KAWASAKI®, guaranteeing significant royalties in future years, where future sales of the covered products are deemed to be more reliable.

 

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

 

Competition

 

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

 

Seasonality

 

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

 

5



 

In anticipation of this seasonal increase in retail sales, the Company significantly increases its production during the second quarter in advance of the peak selling period, with a corresponding build-up of inventory levels.    This results in significant peaks in the second and third quarters in the respective levels of inventories and accounts receivable, which result in seasonal working capital financing requirements.  See “Seasonal Financing.”

 

Seasonal Financing

 

The Company’s financing of seasonal working capital typically peaks in the third quarter of the year, when accounts receivable are at their highest due to increased sales volume and sales programs, and when inventories are at their highest in anticipation of expected second half sales volume.  See “Seasonality.”  The Company financed its seasonal working capital requirements in 2002 primarily by using internally generated cash and borrowings under its line of credit with Dao Heng Bank Limited (the “Dao Heng Facility”), a line of credit facility with Standard Chartered Bank (the “Standard Chartered Facility”) and its revolving line of credit (the “Revolver”) with Sunrock Capital Corp. (“Sunrock”).  Additionally, the Company borrows, as needed, against customers’ letters of credit with several Hong Kong banks.  The bank is selected based on the most advantageous terms to the Company and as directed by customers. See “Management’s Discussion And Analysis Of Financial Condition And Results Of Operations - Liquidity and Capital Resources.”

 

Government and Industry Regulation

 

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

 

Tariffs and Duties

 

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

 

Intellectual Property

 

Most of the Company’s products and product lines are marketed and sold under trademarks, trade names and copyrights, including, without limitation: Big Bam Boom®, Childhood Verses™, Elite®, Forever Girlfriends®, Gearhead™, Insector®, Pride & Joy®, Rosie®, Street Savage™, Sweet Faith®, Tech-Link® and Too Cute Twins®.   The Company considers its trademarks and trade names to be significant assets in that they provide product and brand recognition.

 

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

 

6



 

Human Resources

 

As of December 31, 2002, the Company had a total of 76 employees, 43 of which were based in Houston and 33 were employees of DSI(HK) based in Hong Kong.

 

Risk Factors

 

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

 

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

 

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

 

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

 

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

 

Dependence on Limited Number of Customers.   A small number of our customers account for a large share of our net sales.  For fiscal 2002, our five largest customers accounted for approximately 53% of our net sales. Sales to Wal-Mart, the Kmart Corporation (“Kmart”), and QVC, our three largest customers, accounted for approximately 45% of our net sales during the same period.

 

On January 22, 2002, Kmart filed for Chapter 11 bankruptcy.  Kmart was our second largest customer in 2002 and 2001, comprising 9.5% and 10% of sales, respectively.  Kmart required normal trade terms from companies desiring to do business with them in 2002, and in return offered a second-priority lien or “Trade Creditor Lien” in Kmart’s owned merchandise inventory.  Due to Kmart’s market share we accepted this lien position and sold to Kmart in 2002. Kmart is continuing business and is currently scheduled to exit bankruptcy in April 2003.  Kmart has either closed, or announced the closing of, approximately 600 stores, which reduces our distribution outlets with Kmart and could result in reduced sales to Kmart.

 

We expect to continue to rely on Kmart and a relatively small number of other customers for a significant percentage of sales for the foreseeable future.  If some of these customers were to cease doing business with us, or to significantly reduce the amount of their purchases from us, it could have a material adverse effect on our business, financial condition and results of operations.

 

Liquidity. We utilize borrowings under the Revolver, the Dao Heng Facility, the Standard Chartered Facility and the discounting of customers’ letters of credit with other banks to finance accounts receivable, inventory, and other operating and capital requirements.  We entered into the Revolver on February 21, 1999, and amended the Revolver on March 30, 2001, to increase the Company’s credit line from $10 million to $17.5 million. The Revolver matures March 31, 2004, and contains covenants relating to our financial condition. If we fail to maintain compliance with the financial covenants contained in the Revolver, the maturity date can or will be accelerated, among other remedies which may be pursued by the lender.

 

7



 

The Company’s net losses for the period ended December 31, 2002, and its overall financial condition resulted in the Company being out of compliance with certain financial covenants required under the Revolver.  Therefore, the Company’s $7.0 million debt under the Revolver as of December 31, 2002, has been reclassified as a current liability.  As a result, the Company’s current liabilities exceeded its current assets by $6.5 million as of December 31, 2002. If Sunrock were to accelerate the Revolver, which it has the option to do, the $7.0 million debt would become immediately due and payable.

 

Sunrock has recently completed a transaction with Wells Fargo & Company in which Wells Fargo purchased most of  Sunrock’s existing loans.  Sunrock has retained certain credit facilities, including the Revolver.  Based on discussions with Sunrock, the Company’s management believes that although Sunrock will not amend the Revolver, nor grant a waiver for the Company’s non-compliance, Sunrock will not accelerate the Revolver at this time.

 

The Dao Heng Facility and the Standard Chartered Facility were obtained on December 4, 2001, and April 29, 2002, respectively, are subject to periodic review, and may be canceled by the bank upon notice.  The Standard Chartered Facility affords DSI(HK) a credit limit in the aggregate of up to HKD 19,000,000 (approximately US $2.4 million as of December 31, 2002) in the form of a line of credit financing facility based on actual shipments of product and opened letters of credit.  The Dao Heng Facility affords DSI(HK) a credit limit in the aggregate of up to US$6,000,000. The Company has guaranteed DSI(HK)’s obligations under the Dao Heng Credit Facility and the Standard Chartered Facility.  See “Management’s Discussion And Analysis Of Financial Condition And Results Of Operations - Liquidity and Capital Resources.”

 

The Company purchases goods, services and supplies from a number of vendors.  The Company currently is in arrears in making its payment obligations to certain of these vendors.

 

To the extent the Company’s cash reserves and cash flows from operations are insufficient to meet future cash requirements, the Company will need to successfully raise additional capital through an equity infusion or the issuance of debt.  The Company’s executive management believes that the Company will be required to either obtain a new revolving loan or obtain necessary additional capital to allow the Company to continue its normal operations for the foreseeable future. However, there can be no assurance the Company will meet its projected operating results or be successful either in obtaining additional capital, or obtaining a new revolving loan.

 

The Company has held discussions and negotiations with several lenders regarding a credit facility to replace the Revolver.  Management is negotiating with one of those institutions regarding a replacement credit facility that will become effective at the close of the anticipated going private transaction, which is discussed in Item  7 below.  Management believes that the going private transaction will close and that the Company will be able to continue its operations until that time.

 

Dependence on Independent Designers, Licenses and Other Proprietary Rights.   We are dependent on concepts, technologies and other intellectual property rights licensed from third parties, such as rights to trademarks, with respect to several of our proprietary products.  For each of these proprietary products and product lines, we typically enter into a license agreement with the owner of the intellectual property to permit us to use the intellectual property.  These license agreements typically provide for the Company to pay royalties to the licensor based on the net sales of the product incorporating the licensed property.  For fiscal 2002, net sales of products developed and sold under our license agreements accounted for approximately 75% of our net sales, of which approximately 24% of net sales were attributable to sales of products incorporating the KAWASAKI® trademark.  In November 2002, the license agreement with Kawasaki® was renewed, extending the license agreement for an additional 5 years.  The license now expires on December 31, 2007.  The failure to procure new license agreements, renew existing license agreements (on commercially reasonable terms, or at all), or maintain existing license agreements could have a material adverse effect on our business, financial condition and results of operations.

 

8



 

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

 

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

 

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

 

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

 

Seasonality.   Our business is seasonal and therefore our annual operating results depend, in large part, on our sales during the relatively brief Christmas holiday season.  A substantial portion of our net sales is made to retailers in anticipation of the Christmas holiday season.  This seasonality is increasing as large toy retailers become more efficient in their control of inventory levels through quick response management techniques.  This seasonal pattern requires significant use of working capital mainly to manufacture inventory during the year, prior to the Christmas holiday season, and requires accurate forecasting of demand for products during the Christmas holiday season.  During fiscal 2002, 72% of the Company’s net sales were made during the third and fourth fiscal quarters.  Adverse business or economic conditions during these periods could adversely affect our results of operations for the full year.   In addition, failure to accurately predict and respond to consumer demand may have a material adverse effect on our business, financial condition and results of operations.

 

International Operations.   Our sales and manufacturing operations outside the United States subject us to risks normally associated with international operations.  Various international risks, including the war with Iraq, could negatively impact our international sales and manufacturing operations, which could have a material adverse effect on our business, financial condition and results of operations.  For the year ended December 31, 2002, our international net revenues comprised approximately 19% of our total consolidated net revenues.  We expect international sales to continue to account for a significant portion of our total revenues.  In addition, we utilize third-party manufacturers principally located in the PRC.  Our international sales and manufacturing operations are subject to the risks normally associated with international operations, including:

 

9



 

                                          limitations, including taxes, on the repatriation of earnings;

 

                                          political instability, civil unrest and economic instability;

 

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

 

                                          greater difficulty and expense in conducting business abroad;

 

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

 

                                          transportation delays and interruptions;

 

                                          currency conversion risks and currency fluctuations; and

 

                                          the imposition of tariffs.

 

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

 

During fiscal 2002, two manufacturers accounted for approximately 44% of our purchases of products.  The loss of any of these manufacturers, or a substantial interruption of our manufacturing arrangements with any of these manufacturers, could cause a delay in the production of our products for delivery to our customers and could have a material adverse effect on our business, financial condition and results of operations.  While we believe that our reliance on external sources of manufacturing can be shifted, over a period of time, to alternative sources of supply, there can be no assurance that alternate arrangements could be provided in a timely manner or on terms acceptable to us. Furthermore, the imposition of trade sanctions by the United Sates or the European Union against a class of products imported by us from, or the loss of “permanent normal trade relations” status by, the PRC could significantly increase our cost of products imported into the United States or Europe.

 

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

 

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

 

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

 

10



 

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

 

Control by Current Management.   As of March 15, 2003, our directors and executive officers beneficially owned an aggregate of 7,627,391 shares of common stock (excluding convertible securities and the shares underlying same), which represents approximately 70% of the total issued and outstanding shares of common stock of the Company.  As a result, it would be extremely difficult, if not impossible, to obtain majority support for  shareholder proposals opposed by management and the Board of Directors.

 

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

 

Executive Officers of the Registrant

 

The executive officers of the Company as of December 31, 2002, all of whom are appointed annually by the Board of Directors to serve at the pleasure of the Board, are as follows:

 

Name

 

Age

 

Position

 

Executive Officer
Since

 

 

 

 

 

 

 

Joseph S. Whitaker

 

62

 

Chief Executive Officer and President

 

1999

Robert L. Weisgarber

 

51

 

Chief Financial Officer

 

1999

Gregory A. Barth(1)

 

51

 

Senior Vice President of Worldwide Operations, Business Planning and Logistics

 

2001

Chan Tit Yu (Alfred Chan)

 

55

 

Managing Director of DSI(HK)

 

2002

William J. Kerner(2)

 

48

 

Vice President, Research and Development

 

1999

Milan Seda(3)

 

55

 

Vice President, Research and Development

 

N/A

Robert M. Erickson

 

49

 

Vice President Marketing

 

2002

Thomas V. Yarnell

 

49

 

Administrative Vice President, Corporate Secretary and General Counsel

 

1989

C. Shelton Suter

 

44

 

Vice President/Controller

 

2000

E. Thomas Martin

 

59

 

Chairman of the Board

 

1999

 


(1)                                   Gregory A. Barth’s employment contract terminates on March 31, 2003. Mr. Barth will leave the employment of the Company at that time.

 

(2)                                   William J. Kerner left the Company’s employment on March 7, 2003.

 

(3)                                   Milan Seda was hired by the Company, but does not begin his employment until April 1, 2003.

 

11



 

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

 

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

 

Gregory A. Barth has served as Senior Vice President of Worldwide Operations, Business Planning and Logistics since April 2001.  Prior to that time, Mr. Barth was President of G.A.B. Sales Consulting from 1997-2001, working for a variety of clients including the Company from April 2000 until being employed by the Company in 2001. Mr. Barth’s employment contract terminates on March 31, 2003.  Mr. Barth will leave the employment of the Company at that time.

 

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

 

William J. Kerner served as Vice President of Research and Development of the Company December 1999 through March 7, 2003.  Prior to that, he was Senior Director of Design for Tyco Toys/Mattel, Inc., MatchBox Division from 1995 through December 1999, and Director of Product Design, Matchbox Division at Tyco from 1992 until 1995.

 

Milan Seda will officially begin employment with the Company on April 1, 2003.  Prior to joining the Company, from October 1999 he served as the President and CEO of Toy Works Centre, Inc., a company that provides design and development services to toy companies and toy inventors.  From February 1998 through January 2000, Mr. Seda was the President and General Partner of Business By Design, Inc., a graphic and design services company.

 

Robert M. Erickson has been an employee of the Company since September 2000.  Until September 2001, he served as Director of Marketing – Boys Division.  From September 2001 through November 2002 he was Director of Marketing, and he now serves as Vice President of Marketing.  Prior to employment with the Company, Mr. Erickson was Director of Marketing for The Ertl Company, Inc. from February 1995 through April 1999, and Director of Marketing for Toymax, Inc. from August 1999 until September 2000.

 

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

 

C. Shelton Suter has served as Vice President and Controller of the Company since January 2000.  Prior to joining the Company, he was the Treasurer and Controller of Ansaldo Ross Hill, Inc., in Houston, Texas, from July 1997 through December 1999.

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

 

12



 

ITEM 2.  PROPERTIES

 

Location

 

Use

 

Square
Feet

 

Type of
Possession

 

Expiration
Dates

 

Houston,
Texas

 

Executive Office and Showroom

 

16,608

 

Lease

 

10/31/07

 

 

 

 

 

 

 

 

 

 

 

Fife,
Washington

 

Warehouse and Distribution Center

 

75,000

 

Service and Rate Agreement

 

12/31/06

 

 

 

 

 

 

 

 

 

 

 

New York,
New York

 

Showroom

 

5,148

 

Lease

 

4/30/10

 

 

 

 

 

 

 

 

 

 

 

Hong Kong

 

Administrative Office and Showroom

 

12,877

 

Lease

 

3/22/06

 

 

 

 

 

 

 

 

 

 

 

Hong Kong

 

Warehouse

 

2,600

 

Lease

 

3/07/04

 

 

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

 

ITEM 3.  LEGAL PROCEEDINGS

 

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

 

The Company is the defendant in a lawsuit styled Rymax Corp. d/b/a Rymax Marketing Services, Inc, (“Rymax”) v. DSI Toys, Inc. in the Superior Court of New Jersey Law Division:  Morris County; civil action docket number MRSL-3799-02.  In the lawsuit, Rymax claims that the Company failed to pay commissions due to Rymax and demands judgment for damages in the amount of $45,061.67 plus interest, attorney fees and costs of court.  The Company does not believe it owes these damages and may bring a counterclaim against Rymax for an amount exceeding $75,000.00 for goods shipped and sold to them.  At this time, the Company is attempting to negotiate a settlement of the entire controversy.

 

The Company is the defendant in a lawsuit styled The Cartoon Network, LP, LLLP (“TCN”) v. DSI Toys, Inc. in the State Court of Fulton County, State of Georgia, Civil Action File No. 03VS046924C.  In the lawsuit, TCN claims the Company is indebted to TCN for $725,051.70 for television advertisements aired by TCN, together with interest at the rate of 18% per annum until paid. The Company is in negotiations with TCN and believes it has recorded an adequate amount for the ultimate settlement.

 

The Company has received a demand letter from the Chapter 7 Trustee for bankruptcy cases that are pending in the Southern District of New York involving Play Co. Toys & Entertainment Corp., Toys International.Com, Inc. and Play Co. Toys Canyon Country, Inc.  The Trustee alleges that a payment received by the Company from Toys International.Com, Inc. in the amount of $93,834.56 was a preferential transfer that is recoverable under Bankruptcy Code Sections 547 and 550.  The Company has responded to the demand letter that the payment was a payment on an invoice for delivered goods made in the regular course of business. At this time the Company and the Trustee are in negotiations to settle the matter in its entirety.

 

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

 

No matters were submitted to a vote of shareholders during the fourth quarter of fiscal 2002.

 

13


EDGAR® is a federally registered trademark of the U.S. Securities and Exchange Commission. EDGAR®Online is not affiliated with or approved by the U.S. Securities and Exchange Commission.