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The following is an excerpt from a 10-K/A SEC Filing, filed by YES ENTERTAINMENT CORP on 10/24/1997.
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YES ENTERTAINMENT CORP - 10-K/A - 19971024 - PART_I

PART I

ITEM 1. BUSINESS

GENERAL

YES! Entertainment Corporation ("YES!" or the "Company") develops, manufactures and markets toys and other entertainment products, including a variety of interactive products. YES! applies innovative technology available in other industries to design products that are fun for children and build on their natural creativity. Most of YES!'s products target children between the ages of two and twelve, a market of over 45 million in North America alone.

YES! has introduced several lines of products since being founded in December 1992. A substantial portion of the Company's current products are marketed under the YES! Gear brand. YES! Gear is principally comprised of the Company's Yak Bak, Mega and T.R.A.P.S. lines of products. These products, which include both children's electronic and audio products, are designed to appeal to kids six to twelve years of age with their high impact design and unique play activities. The Company also markets Power Penz, a line of pens that incorporate toys and activities. In 1996, the Company also launched a line of food activity products with the Mrs. Fields Baking Factory, a toy cookie oven using mixes developed in conjunction with the Mrs. Fields Development Corporation, and V- Link, a new line of communication products designed to be a short-range, toll- free radiophone system that includes voice-messaging, conference call and private conversation features.

In 1997, the Company expects to introduce a number of new products and product lines. These include the Baskin-Robbins Ice Cream Maker, a toy ice cream maker with which children can prepare ice cream for their family using delicious mixes developed in conjunction with Baskin-Robbins USA, Co., Air Vectors, a line of small vehicles for boys that transform and launch flying objects, such as airplanes or missiles, YES! Pre-School, a line of pre-school products which incorporate popular features from YES!'s highly successful Yak Bak line, YES! Girl, a line of electronic toys and activities specially for girls, Disgusting Designs, a ghoulish new art activity center for boys, and Radical Air, a line of toy guns that shoot foam balls that expand to three times their original size in the air.

YES! was incorporated in California in September 1992 and began operations in November 1992. The Company changed its state of incorporation from California to Delaware in October 1996. The Company had net revenues of $69.7 million, $55.7 million, $36.4 million and $25.9 million in 1996, 1995, 1994 and 1993, respectively. The Company incurred operating losses from its inception through the quarter ended June 30, 1995, incurred a net loss of approximately $12.6 million in 1996, and had an accumulated deficit of approximately $52.7 million at December 31, 1996.

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The Company's initial public offering of Common Stock occurred in June 1995 at which time the Company's Common Stock and Redeemable Common Stock Purchase Warrants issued in connection with the initial public offering ("IPO Warrants") commenced trading on the Nasdaq SmallCap Market. The Company's Common Stock and IPO Warrants were included on the Nasdaq National Market in November 1995. All of the outstanding IPO Warrants were exercised in December 1995 and January 1996 at an exercise price of $4.00 per share. Pursuant to the exercise of the IPO Warrants, the Company raised approximately $19.8 million.

YES!, YAK BAK and COMES TO LIFE BOOKS are registered trademarks and YES! GEAR, POWER PENZ, AIR VECTORS, YES! PRE-SCHOOL, YES! GIRL, DISGUSTING DESIGNS, RADICAL AIR WEAPONS, T.R.A.P.S., YAK BAK WARP'R, YAK BAK SFX, YAK BAKWARDS, YAK MANIAK, MEGA MIKE, MIGHTY MEGA MOUTH SPORTS, SECRETS, CODER, LASER SHOTS, QUICK FLIPS, PEN PHONE, HANDY CANDY, V-LINK, MONSTER MARKER HAND, MOLDY BODY PARTS, PET TOONIES, GIZMOS, MUSIC GIZMOS, INSTRUMENT GISMOS, DANCE STUDIO, YES! EXTREME, STROBES, YAK BAK BALLS, SFX BALLS, YES! GAMES and SLAP TRAP are trademarks of YES! Entertainment Corporation. All rights reserved. MRS. FIELDS is a registered trademark of the Mrs. Fields Development Corporation. BASKIN 31 ROBBINS is a registered trademark of the Baskin-Robbins USA, Co. NICKELODEON is a registered trademark of Nickelodeon, a programing service of Viacom International, Inc.

PRODUCTS

YES!'s product lines span major markets for children's and teen products. These include educational and licensed products, children's electronics and publishing, activity products, and electronic learning products, as well as new product categories that YES!'s innovative approach to product development is helping to create, such as audio recording and distortion products, functional toys (i.e. toys that work as other types of products, such as pens) and children's and teen communications. The majority of the Company's products target children ages two to twelve, although the Company's V-Link product targets consumers between the ages of ten and seventeen.

The Company introduced a number of new product lines in 1996 and expects to introduce several new product lines in 1997. The Company expects that the 1997 product lines, certain of which are technically complex, will place great demands on management and other Company resources. There can be no assurance that the products under development will be successfully developed, or if successfully developed, that they will achieve market acceptance. In addition, if the Company is not able to complete successful development, tooling, manufacture and marketing of its 1997 product lines, the Company's operating results and financial condition will be materially adversely affected.

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YES! GEAR

The Company's current line of YES! Gear products comprises over 30 SKUs. All of these products are designed around the idea of combining technical innovation in a low cost product that provides children with opportunity for creative expression. YES! Gear is principally comprised of the Company's Yak Bak, Mega and T.R.A.P.S. lines of products.

Yak Bak. The Yak Bak line of products combines solid state recording, playback and sound effects technology in colorful, highly stylized micro-sized recorders that permit children to record and play back their customized messages. Designed to fit comfortably into a child's hand and pocket, each of the Yak Bak products is available in a number of different colors. All Yak Bak packaging is designed to achieve maximum impact in a retail store and allow customers to test the product before purchasing it.

YES! launched its YES! Gear product line in December 1994 with the introduction of Yak Bak, a simple, highly stylized six-second recording and playback device. Since then, the Company has introduced a number of extensions to the Yak Bak product, including Yak Bak Warp'r, a more fully featured version of the original Yak Bak product, which includes a voice pitch modulator, that alters the voice recording to permit the recorder to play back the recording in new ways; Yak Bak SFX, which incorporates built-in sound effects and extended recording features that allow a child to create a wide variety of messages and custom recordings; and Yak Bakwards, a Yak Bak device that permits the user to play back a recorded message in reverse (thereby creating a whole new language for children). The Company has also extended the recordability features of the Yak Bak into other formats appealing to children, including balls, wristwatches, motion detectors and a variety of pens that include the Yak Warp'r, Yak Bak SFX and Yak Bakwards features.

In 1997, the Company expects to extend the Yak Bak line further with the introduction of Yak Maniak, a Yak Bak device that incorporates echo, reverb and tremolo capability to permit kids to make new and exciting recordings. The Company also expects to launch a line of Yak Bak SFX products themes for girls under the Ms. Yak mark.

Mega Products. In 1996, the Company introduced a line of voice amplification products. In 1997, the Company will continue these types of products with its Mega Mike and Mighty Mega Mouth Sports products. Mega Mike is a voice amplification device that clips to the user's belt, attached to which is a microphone into which children can speak. With the addition of applause, booing, laughter and rim shot sound effects, Mega Mike transforms children into one-man stand-up comedians. Mighty Mega Mouth Sports is a high sound volume device that let's kids blast their voice and add popular sports sound effects sounds.

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T.R.A.P.S. In 1996, the Company introduced a line of remote activated pranks and effects products marketed under the name Techno Remote Activated Pranks (or T.R.A.P.S.). Each of the T.R.A.P.S. is activated by a radio frequency transponder that allows the user to initiate his or her prank or effect from a hidden or remote location. The remote control device activates all four T.R.A.P.S., which include a squirt cannon, a water or air balloon popper, a sound effects generator and a bug drop, which releases plastic bugs from a ceiling location.

POWER PENZ.

In December 1995, the Company began shipping a new line of functional toys under the Power Penz mark. Power Penz are a series of activity toys that take form in a fully functional ball-point pen. In 1995, the Company introduced four mechanical Power Penz, consisting of a dart launcher, a helicopter, a miniature race car launcher, and a combination telescope, microscope and rear view mirror, and two electrical Power Penz, consisting of a sound effects toy and a mini directional amplifier. In 1996, the Company expanded the Power Penz line to include Secrets and Coder, pens that wrote in (and illuminated with a built-in UV light) invisible ink, Laser Shots, pens that fire and sense beams of infrared light that allow kids to aim and fire at each other's pens, Quick Flips, pens that house grooming and cosmetic devices for girls and spy activities for boys that flip out of the body of the pen, and Rimshot, pens that house a basketball hoop and launch miniature basketballs.

The Company expects to expand the Power Penz line in 1997 to include Pen Phone, pens that work as short range infrared walkie talkies, Handy Candy candy dispensing pens, FM radio pens, drumming pens, and many other new and exciting activities in a pen.

LICENSED FOOD

Mrs. Fields Baking Factory. In 1996, the Company entered the children's food products market with the introduction of the Mrs. Fields Baking Factory, a toy oven that permits children to bake cookies, muffins and brownies for their families and friends, using recipes developed in conjunction with the Mrs. Fields Development Corporation. Each oven displays the familiar Mrs. Fields red and white color scheme and logo and comes complete with a set of baking pans and utensils. The mixes, which come with the oven and are also sold separately, are designed to taste like the real Mrs. Fields cookies available at any one of the hundreds of Mrs. Fields cookie outlets throughout the United States.

Baskin-Robbins Ice Cream Maker. In 1997, the Company expects to build on the success of the Mrs. Fields Baking Factory when it launches the Baskin- Robbins Ice Cream Maker, which makes real ice cream using Baskin-Robbins mixes, including some that have been developed exclusively for YES!. Like the Mrs. Fields Baking Factory, the

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Baskin-Robbins Ice Cream Maker will be sold with a variety of mixes, and refills will be available in a number of different flavors.

COMMUNICATIONS

In late 1996, the Company introduced V-Link, a new communications product marketed principally to teens ages ten to seventeen. V-Link is designed to permit teens to communicate with each other within up to a 1,000 foot radius (such as in a school or at a shopping mall) without any toll or monthly charges. V-Link also includes voice mail and messaging capabilities, together with the ability to have private conversations or talk on a party line.

V-Link is a complicated consumer electronics product, and the Company has incurred substantial expense in completing the development and tooling for its manufacture. In 1996, the Company also devoted a substantial portion of its marketing budget to the introduction of V-Link, which occurred later than anticipated. The Company's 1996 financial results were materially adversely impacted as the result of delays in the introduction of V-Link, as well as in obtaining formal regulatory approval for the sale of V-Link. If the Company is unable to effectively market V-Link in 1997, or if V-Link is not well-received by teen consumers in 1997, the Company will be unable to recover its investment in the development and manufacturing of inventory of V-Link, which may have a material adverse effect on the Company's 1997 financial results.

NEW CATEGORIES FOR 1997

The Company has or is in the process of developing a number of new lines of products for 1997 that will significantly expand the breadth of YES!'s product offerings. Specifically, the Company will move into new categories of products, including vehicles, pre-school, girls items, foam products and electronic games.

Vehicles. Air Vectors is YES!'s initial foray into the popular toy vehicle category. YES! is attempting to enter this category with a new and exciting feature -- Air Vectors cars will race ahead, then transform and launch planes or missiles from the vehicles superstructure, which continue their forward motion in flight. The Company's initial vehicles will be themed as racing cars, military vehicles and off-road vehicles. The Company is currently developing the Air Vectors line which it expects will be shipped late in the 1997 selling season.

YES! PreSchool. At Toy Fair 1997, the Company introduced a new line of pre- school electronic products to address the growing three to six year old market. These products include Yakkins, a line of molded plastic characters into which children can record sounds and messages for playback, Pet Toonies,a line of animals that play popular kids songs in that animal's own sounds, and Music Gizmos and Instrument Gizmos, a line of highly stylistic devices that play pre- set tunes and musical sounds in a variety of different ways depending on how a child "builds" their gizmo.

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YES! Girl. The Company in 1997 expects to expand into the girls category with a new line of YES! Girl products, themed especially for creative girls. The Company's entree into this category is Dance Studio, a portable dance instructor that calls out dance steps to little girls. Girls can dance to preset routines, or create their own, and can vary the pace and beat of their new dances.

YES! Extreme. The Company also is creating a new category of action sports and play activities. These will include three new product lines.

Strobes

In 1997, the Company expects to introduce a line of high bounce balls that contain impact activated strobing lights. Bounce the ball and brilliant red lights begin to flash inside, creating a whole new dynamic of day and night ball play.

Radical Air Weapons (R.A.W.)

The Company is developing and expects to introduce in 1997 a line of toy guns that shoot expanding foam balls. Unlike other foam guns, these balls expand quickly to more than three times their compacted size as they fly through the air.

Yak Balls and SFX Balls

Finally, the Company expects to extend both the recording and sound effects features of the Yak Bak and Yak Bak SFX products into a line of miniature baseballs and footballs under the Yak Bak Balls and SFX Balls names.

Activities. The Company expects to introduce in 1997 Disgusting Designs, a ghoulish new painting and arts design center for young boys. The design center is comprised of a Zombie head and finger that incorporates all sorts of painting activities, including paint filled brains, crayon teeth, eyeballs that are brushes, sponge tongues and stamp and fingers. Other accessories sold separately include a Monster Marker Hand and a Moldy Body Parts molding kit, which lets kids mold their own creepy sculptures that they can then decorate.

YES! Games. In 1997, the Company expects to introduce a product into the electronic games category. Slap Trap is an electronic game module that contains four different game plays that challenge user's memory and reaction time. Slap Trap is designed for family fun.

PRODUCT DESIGN AND DEVELOPMENT

The Company's product development combines the use of independent outside designers with internal development to develop new product lines.

INDEPENDENT DESIGNERS

The Company continually evaluates new product ideas generated by a number of outside independent designers with whom the Company communicates on a regular basis. When the Company decides to develop a product based upon an idea presented

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by an independent designer, the Company enters into a license agreement with the designer. These license agreements typically provide for the payment of royalties based on net sales of the new product. Such arrangements exist for most of the Company's lines of products.

INTERNAL DEVELOPMENT

A substantial portion of the Company's internal development efforts focus primarily on further development of ideas originally submitted by independent designers. Product design and development is a joint effort between the Company's product development, marketing, sales and engineering groups. Each group brings its unique expertise, allowing the creation of ideas which combine the latest technologies, current trends and strongest consumer and retailer demands.

The Company tests product concepts and prototypes through consumer market research techniques, including focus groups and in-home use tests. The also meets with a number of retailers across the country to preview prototype products, determine levels of interest and help refine details of the product lines prior to production. In addition, the Company frequently previews advertising plans, public relations plans, point-of-purchase displays, packaging and other matters with retailers prior to production.

In 1996, 1995 and 1994, the Company incurred research and development expenses of approximately $4.6 million, $2.8 million and $4.9 million, respectively. Substantially all of the Company's research and development expense is spent on new product development.

MANUFACTURING, PRODUCTION AND DISTRIBUTION

The Company's present strategy is to contract for substantially all of its manufacturing requirements. Most of the Company's product lines are manufactured overseas by unaffiliated contract manufacturers which have facilities in Hong Kong and the People's Republic of China. Certain of the Company's products and components of products are manufactured in the United States.

The Company chooses manufacturers based on price, quality of merchandise, reliability and ability to meet the Company's timing requirements for delivery. Manufacturing commitments are made on a purchase order basis. The Company is generally required to post a letter of credit prior to shipment.

The Company has not entered into any long-term contracts with any of its manufacturers.

The Company has a group of employees located in California and Hong Kong whosupervise the Company's manufacturing contractors. These employees' responsibilities include the establishment and ongoing development of close relationships with the manufacturers, setting product and manufacturing standards,

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performing production planning and quality assurance functions including inspection at various stages, tracking costs, performing and/or working with manufacturing engineering, and oversight of the manufacturing processes. In order to source a variety of raw materials and components, provide quality control, and administer contracts with manufacturers on location, the Company established a subsidiary in Hong Kong, Entertainment Products, Ltd.

Management believes that its strategy to contract for substantially all manufacturing requirements provides the Company with financial flexibility and the most efficient use of its capital. However, since the Company does not have its own manufacturing facilities, it is dependent on close working relationships with its contract manufacturers for the supply and quality of its products. These manufacturers are based in Hong Kong with manufacturing facilities located in the People's Republic of China. The Company expects to continue to use a limited number of contract manufacturers and accordingly will continue to be highly dependent upon sources outside the Company for timely production and quality workmanship. Given the highly seasonal nature of the Company's business, any unusual delay or quality control problems of suchmanufacturers, or delays in product deliveries, delays in locating or providing new tooling to acceptable substitute manufacturers or delays in increasing the production of alternative manufacturers, would have a material adverse effect on the Company's operating results and financial condition. Foreign manufacturing is subject to a number of risks, including transportation delays and interruptions, political and economic disruptions, labor strikes, the imposition of tariffs and import and export controls, changes in governmental policies, and fluctuations in currency exchange rates, the occurrence of which could have a material adverse effect on the Company's business. The Company is working with its manufacturers to ensure timely delivery of the Company's product. However, there can be no assurance that the manufacturers will be able to meet the Company's production schedules. In addition, manufacturing in Hong Kong and the People's Republic of China entails certain more specific risks, including the return of Hong Kong to governance by the People's Republic of China in June 1997 and recent political tensions between the People's Republic of China and the Republic of China (Taiwan). There can be no assurance that these events will not result in disruptions to the Company's production schedules.

The Company maintains a quality control and quality assurance program and has established process controls, inspection and test criteria for each of its products. These methods are applied by the Company or its agents regularly to product samples in each manufacturing location prior to shipment and each shipment must pass quality control inspection. Once the products arrive in the United States, samples are subject to spot inspection to ensure quality. The Company's international distributors also maintain quality control programs, typically relying on an inspection agent who certifies the quality of the products prior to their shipment from Hong Kong to the international distributor.

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The Company has identified certain components in its products which its contract manufacturers are allowed to purchase only from designated approved suppliers in order to ensure quality. Each manufacturer submits samples from early production runs to independent testing laboratories to determine whether the manufacturer is producing to certified safety and product standards. On an ongoing basis, random samples are drawn from each manufacturer for full-scale testing.

The Company's products are shipped from the point of manufacture by sea and air transport to the Company's California distribution facility. As a result, delivery may be subject to labor disruptions, particularly in the maritime shipping industry, as well as to limitations on the availability of air cargo space for the shipment of items in certain circumstances. To date, the Company has not been materially affected by any such disruptions or constraints. In addition, extensive reliance on air shipment is expensive and may adversely impact the Company's profitability.

At the Company's California distribution facility, the Company performs inventory planning and management, takes delivery of products, inspects, warehouses and ships products to its retailers' distribution points. Truck transport is used for delivery from the Company's distribution facility to the retailers' distribution points or designated retail locations.

MARKETING AND SALES

YES!'s marketing budget is primarily expended for television advertising and point-of-purchase display programs. The Company has expended a majority of its advertising for national television spots and the production of television commercials which support the majority of YES!'s product lines. In conjunction with television advertising and public relations and promotions programs, the Company also uses point-of-purchase displays to serve as the final link in a marketing chain that educates consumers and motivates them to purchase YES! products.

Additionally, many of the Company's products benefit from the strong market identification of its licensed characters and brands. The Company has contracts for the licensing right to use various well-known children's characters and consumer brands and will continue to negotiate contracts for rights for future products. Most of these character licenses provide for advances against future royalties, minimum guaranteed payments and a royalty based on net sales.

The Company's products are sold throughout the United States primarily by the Company's direct sales force to toy retailers, toy distributors, catalog showrooms, mass merchants, department stores and discount stores. Retailers of YES! products in 1996, 1995 and 1994 included toy retailers, such as Toys "R" Us, Inc. ("TRU") and Kay Bee Toy Stores, and general retailers, such as Wal-Mart Stores, Inc. ("Wal-Mart"), Target Stores, K-Mart, Service Merchandise Co., Inc. and Hills Stores Company, Inc. The Company also uses sales representative organizations typically either to address less concentrated

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markets or in connection with certain of the Company's products, including V- Link, that sell outside normal toy retail channels.

The Company's ten largest customers accounted for approximately 85%, 87% and 68% of sales for the years ending December 31, 1996, 1995 and 1994, respectively. For the year ended December 31, 1996, the Company's two largest customers, TRU and Wal-Mart, accounted for 21% and 20% of net sales, respectively. For the year ended December 31, 1995, TRU and Wal-Mart each accounted for approximately 27% of net sales and for the year ended December 31, 1994, the same two customers accounted for 14% and 21% of net sales, respectively. While the Company intends to expand distribution to new accounts, the Company expects to continue to depend on a relatively small number of customers for a significant percentage of its sales. Significant reductions in sales to any one or more of the Company's largest customers would have a material adverse effect on the Company's operating results. Because orders in the toy industry are generally cancelable at any time without penalty, there can be no assurance that present or future customers will not terminate their purchase arrangements with the Company or significantly change, reduce or delay the amount of products ordered from the Company. Any such termination of a significant customer relationship or change, reduction or delay in significant orders could have a material adverse effect on the Company's operating results.

In connection with the introduction of new products, many companies in the toy industry discount prices of existing products, provide for certain advertising allowances and credits or give other sales incentives to their customers. In addition, in order to address such issues as working capital requirements, sales of inventory and changes in marketing trends, many toy companies allow retailers to return slow-moving products for credit, or if the manufacturer lowers the prices of its products, to provide price adjustments for inventories on hand at the time the price change occurs. The Company has made such accommodations in the past, and expects to make accommodations such as stock balancing, returns, other allowances or price protection adjustments in the future. Any such accommodations by the Company in the future could have a material adverse effect on the Company's operating results. Furthermore, in the past certain of the Company's retail customers have delayed payment beyond the date such payment is due. There can be no assurance that retail customers will not delay payments in the future which would materially impact the Company's ability to predict its cash flow, often to the detriment of the Company's business.

INTERNATIONAL OPERATIONS

International net sales were approximately $14.9 million, $3.8 million and $10.4 million in 1996, 1995 and 1994, respectively, and accounted for approximately 21%, 7% and 29% of the Company's revenue in those respective years. International net sales were substantially lower in 1995 primarily as the result of weakness in the international economy.

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The Company's international products are based on the Company's products developed for the domestic market, so that international product development costs are minimized. In 1996, the Company introduced the YES! Gear line of products internationally, where they were well-received, particularly in Japan. In 1997, the Company expects to introduce all of its domestic 1996 and early 1997 products internationally, with a particular emphasis on expanding European sales.

The Company sells its products internationally through a network of leading toy distributors in their local markets. The Company believes it has and is continuing to develop strong relationships with its key distributors, and that such distributors have a good reputation in, and knowledge of, the markets they serve. The Company believes that by leveraging the distributors' local expertise, the Company is able to generate substantially greater international retail sales than if the Company attempted to obtain such sales directly. In addition, because local market distributors typically pay for the Company's products on a letter of credit and take delivery of such product in Hong Kong, and because the distributors are responsible for the warehousing and promotion of the Company's products in the local market, the Company is able to minimize risks associated with a direct international effort as well as the Company's capital commitments in advance of manufacture of the product, and can maintain a leaner staff requiring fewer resources to support the Company's international operations. The Company also has engaged a sales and marketing company to coordinate sales of the Company's products in Europe; this agency receives a commission on all sales to European countries.

Substantially all international sales are conducted through the Company's Hong Kong subsidiary, Entertainment Products, Ltd. and are denominated in U.S. dollars and therefore the Company has not to date experienced any adverse impact from currency fluctuations. To the extent future sales are not denominated in US dollars, currency exchange fluctuations in the countries where the Company does business could materially adversely affect the Company's business, financial conditions and results of operations.

Although the Company's international sales division works closely with its foreign distributors, the Company cannot directly control such distributors' sales and marketing activities and, accordingly, cannot manage the Company's product sales in foreign markets. While the Company believes the distributors to whom the Company has granted foreign market rights are highly qualified, all of these distributors also distribute, either on behalf of themselves or other toy manufacturers, other product lines of toys, including product lines of toys that may be competitive with those of the Company. There can be no assurance that these distributors will manage effectively the sale of the Company's products worldwide or that their marketing efforts will prove effective. In addition, although the Company attempts to structure its international sales in U.S. dollar denominated transactions only, certain transactions may

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be denominated in the local currency. Accordingly, the Company's international sales may be disrupted by currency fluctuations or other events beyond the Company's control, including political or regulatory changes. In addition, the Company's international distributors are also subject to local rules and regulations which can substantially affect the profitability or ability of the Company or its international distributors to sell the Company's products internationally.

PATENTS AND LICENSES

Certain of the Company's product lines also incorporate concepts or technologies created by outside designers, some of which are patented. In addition, many of the Company's products incorporate other intellectual property rights, such as characters or brand names, that are proprietary to third parties. The Company typically enters into a license agreement to acquire the rights to the concepts, technologies or other rights for use with the Company's products. Substantially all of these licenses are exclusive for the children's and youth markets. These license agreements typically provide for the retention of ownership of the technology, concepts or other intellectual property by the licensor and the payment of a royalty to the licensor. Such royalty payments generally are based on the net sales of the licensed product for the duration of the license and, depending on the revenues generated from the sale of the licensed product, may be substantial. In addition, such agreements often provide for an advance payment of royalties and may require the Company to guarantee payment of a minimum level of royalties that may exceed the actual royalties generated from net sales of the licensed product. Some of these agreements have fixed terms and may need to be renewed or renegotiated prior to their expiration in order for the Company to continue to sell the licensed product. Certain of the Company's licenses require that certain minimum performance goals be met in order for the Company to renew or extend its licenses. The termination or non- renewal of a key license would materially adversely affect the Company's operating results and financial condition.

In addition to rights licensed from third parties, the Company also relies on a combination of patents, copyright, trademark and trade secret protection, non-disclosure agreements and work-for-hire arrangements to establish and protect the proprietary rights it has in its products. There can be no assurance that the Company's competitors will not independently develop or acquire patented or other proprietary technologies that are substantially equivalent or superior to those of the Company. There also can be no assurance that the measures adopted by the Company to protect its proprietary rights will be adequate to do so or that the Company's products do not infringe on third party intellectual property rights, including patents. Reverse engineering and grey market production of successful toy products is common in the industry. The ability of the Company's competitors to acquire technologies or other proprietary rights equivalent or superior to those of the Company or the inability of the Company to enforce its proprietary rights would have a material adverse effect on the Company's operating results and financial condition.

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Intellectual property matters are frequently litigated on allegations that third party proprietary rights have been infringed. Such litigation can be expensive and time-consuming to prosecute or defend against and, if decided adversely to the Company, may preclude the Company from enjoining competitors from utilizing technology or designs the Company considers proprietary or prevent the Company from selling its products or require that the Company pay significant and unanticipated royalties. The Company has defended two such lawsuits and, although the Company prevailed in each instance, each lawsuit was expensive and time-consuming to defend. In addition, such lawsuits could have the effect of causing the Company's customers to delay or cancel purchase orders until they are resolved.

COMPETITION

The Company's product lines span major segments both within and beyond the scope of the traditional toy industry. Accordingly, the Company's products compete in a number of different markets with a number of different competitors. Market leaders from which the Company faces competition include Mattel, Inc., Hasbro, Inc., Tyco Toys, Inc. (which recently merged with Mattel, Inc.), Tiger Electronics and Video Technology Industries, Inc. Product innovation, quality, product identity through marketing and promotion, and strong distribution capabilities are all important attributes of successful companies in the toy industry. The Company believes that it is generally competitive with other toy companies on these factors.

In recent years, leading toy retailers have gained significant market share. They generally feature a large selection of toys, some at discount prices, and maintain lean inventories to reduce their inventory risk. Continued consolidation among discount-oriented retailers can be expected to require toy companies such as the Company to keep prices competitive and to implement and maintain production and inventory control methods permitting these toy companies to respond quickly to changes in demand.

The toy industry is highly competitive. Many of the Company's competitors have substantially greater assets and resources than those of the Company. Other competitors market non-promoted products that compete with the Company on the basis of price. Some of these products are competitive with those of the Company, which supports sales with advertising and therefore necessitates higher price points. The relatively low barriers to entry into the toy industry and the limited proprietary nature of many toy products also permit new competitors to enter the industry easily. As a result, successful new products or product concepts often are duplicated and offered to the Company's customers and through other channels of distribution at lower prices than the Company may be required to charge to recapture product development and marketing expenses. Certain companies have already introduced, and the Company anticipates other companies will introduce toys and published products that compete with the Company's existing and new products. Such competition has forced

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in the past, and may force in the future, price reductions, which would adversely affect the Company's operating results and financial condition.

GOVERNMENT AND INDUSTRY REGULATION (p. 10)

The Company is subject to the provisions of the Federal Hazardous Substances Act and the Federal Consumer Product Safety Act. Those laws empower the Consumer Product Safety Commission to protect children from hazardous toys and other articles. The Consumer Product Safety Commission has the authority to exclude from the market articles which are found to be hazardous and can require a manufacturer to repurchase such toys under certain circumstances. In the pre- production stages and periodically thereafter, the Company sends sample toys to independent laboratories to test for compliance with the Consumer Product Safety Commission's rules and regulations, as well as with the voluntary product standards of the Toy Manufacturers of America. Similar laws exist in specific jurisdictions within the United States as well as in certain foreign countries. The Company designs its products to exceed the highest safety standards imposed either by government or industry regulatory authorities. In the event that the Company violates any such rule or regulation, sale of the offending product could be enjoined. To date, the Company has not experienced any material governmental or voluntary safety compliance problems with respect to its products. In the event that the Company violates any such rule or regulation, sale of the offending product could be enjoined.

Certain of the Company's products may also be subject to other government rules and regulations. For instance, the Company's V-Link product is subject to Federal Communications Commission ("FCC") rules and regulations. On December 13, 1996, the Company voluntarily ceased shipments of its V-Link products pending receipt of final marketing approval from the FCC to sell V-Link, which the Company had inadvertently not obtained prior to commencing V-Link sales. While the Company did obtain such approval, the Company was required to pay a $31,000 fine to the FCC as a result of its failure to obtain FCC marketing approval and take certain other remedial steps to help ensure that the Company meets its FCC obligations in the future. There can be no assurance that the Company may not be required to obtain government approval for other products in the future, that such approval can be obtained, or that seeking such approvals will not result in delays in product introductions.

EMPLOYEES

As of February 28, 1997, the Company had a total of 123 employees, of whom 74 were based in the United States and 49 were based in Hong Kong. The Company is staffed in the functions necessary to operate a successful business in the toy industry, including product development, marketing, sales, management of outside functions and internal operations. The Company intends to keep overhead low and utilize outside resources whenever practical.

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None of the Company's employees is represented by a collective bargaining arrangement, nor has the Company ever experienced any work stoppage. The Company believes that its relations with its employees are good.

ITEM 2. PROPERTIES

The Company leases all of its facilities, including executive offices of 17,335 square feet in Pleasanton, California, warehouse space of 84,000 square feet in Hayward, California, manufacturing facilities of 6,700 square feet in Carson, California and a showroom of 8,300 square feet in New York, New York. The Company's wholly-owned Hong Kong subsidiary leases approximately 4,500 square feet of office space in Kowloon, Hong Kong. The Company believes that suitable space will be available on reasonable terms should the Company require additional space. In 1996, the Company's total rent expense was $1.2 million.

The Company's management information system is based on an IBM AS400 computer and personal computers running commercially available software. The Company believes this information system is adequate to meet the Company's business needs for the foreseeable future, as enhanced by available technology.

ITEM 3. LEGAL PROCEEDINGS

The Company is involved from time to time in litigation incidental to its business. The Company believes that none of its pending litigation matters, individually or in the aggregate, will have a material adverse effect on the Company's operating results or financial condition.

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

There were no matters submitted to a vote of security holders during the fourth quarter of fiscal 1996.

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BROKERAGE PARTNERS