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JAKKS PACIFIC INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

May 13, 2014

The following discussion and analysis of financial condition and results of operations should be read together with our Condensed Consolidated Financial Statements and Notes thereto, which appear elsewhere herein.

Critical Accounting Policies and Estimates

The accompanying consolidated financial statements and supplementary information were prepared in accordance with accounting principles generally accepted in the United States of America. Significant accounting policies are discussed in Note 2 to the Consolidated Financial Statements set forth in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013. Inherent in the application of many of these accounting policies is the need for management to make estimates and judgments in the determination of certain revenues, expenses, assets and liabilities. As such, materially different financial results can occur as circumstances change and additional information becomes known. The policies with the greatest potential effect on our results of operations and financial position include:

Allowance for Doubtful Accounts. Our allowance for doubtful accounts is based upon management's assessment of the business environment, customers' financial condition, historical collection experience, accounts receivable aging, customer disputes and the collectability of specific customer accounts. If there were a deterioration of a major customer's creditworthiness, or actual defaults higher than our historical experience, our estimates of the recoverability of amounts due to us could be overstated, which could have an adverse impact on our operating results. Our allowance for doubtful accounts is also affected by the time at which uncollectible accounts receivable balances are actually written off.

Major customers' accounts are monitored on an ongoing basis; more in-depth reviews are performed based upon changes in a customer's financial condition and/or the level of credit being extended. When a significant event occurs, such as a bankruptcy filing by a specific customer, and on a quarterly basis, the allowance is reviewed for adequacy and the balance or accrual rate is adjusted to reflect current risk prospects.

Revenue Recognition. Our revenue recognition policy is to recognize revenue when persuasive evidence of an arrangement exists, title transfer has occurred (product shipment), the price is fixed or readily determinable and collectability is probable. Sales are recorded net of sales returns and discounts, which are estimated at the time of shipment based upon historical data. We routinely enter into arrangements with our customers to provide sales incentives and support customer promotions and we provide allowances for returns and defective merchandise. Such programs are primarily based upon customer purchases, customer performance of specified promotional activities and other specified factors such as sales to consumers. Accruals for these programs are recorded as sales adjustments that reduce gross revenue in the period in which the related revenue is recognized.

Goodwill and other indefinite-lived intangible assets. Goodwill and indefinite-lived intangible assets are not amortized, but are tested for impairment at least annually at the reporting unit level.

Factors we consider important that could trigger an impairment review include the following:

? significant underperformance relative to expected historical or projected future operating results; ? significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and ? significant negative industry or economic trends.



Due to the subjective nature of the impairment analysis, significant changes in the assumptions used to develop the estimate could materially affect the conclusion regarding the future cash flows necessary to support the valuation of long-lived assets, including goodwill. The valuation of goodwill involves a high degree of judgment. Based upon the assumptions underlying the valuation, impairment is determined by estimating the fair value of a reporting unit and comparing that value to the reporting unit's book value. If the implied fair value is more than the book value of the reporting unit, an impairment loss is not indicated. If impairment exists, the fair value of the reporting unit is allocated to all of its assets and liabilities excluding goodwill, with the excess amount representing the fair value of goodwill. An impairment loss is measured as the amount by which the book value of the reporting unit's goodwill exceeds the estimated fair value of that goodwill.

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Goodwill, Trademarks (net) and Intangible assets amounted to $103.1 million as of March 31, 2014 and $104.6 million as of December 31, 2013.

Reserve for Inventory Obsolescence. We value our inventory at the lower of cost or market. Based upon a consideration of quantities on hand, actual and projected sales volume, anticipated product selling prices and product lines planned to be discontinued, slow-moving and obsolete inventory is written down to its net realizable value.

Failure to accurately predict and respond to consumer demand could result in us under-producing popular items or over-producing less popular items. Furthermore, significant changes in demand for our products would impact management's estimates in establishing our inventory provision.

Management's estimates are monitored on a quarterly basis and a further adjustment to reduce inventory to its net realizable value is recorded, as an increase to cost of sales, when deemed necessary under the lower of cost or market standard.

Discrete Items for Income Taxes. A discrete tax benefit of $44,000 related to a reduction in tax reserves resulting from closed statutes of limitation was recognized during the three months ended March 31, 2014. During this same period in 2013, we recognized a discrete tax benefit of $0.1 million related to a reduction in tax reserves resulting from closed statutes of limitation.

Income taxes and interest and penalties related to income tax payable. We do not file a consolidated return for our foreign subsidiaries. We file federal and state returns and our foreign subsidiaries each file returns as required. Deferred taxes are provided on an asset and liability method, whereby deferred tax assets are recognized as deductible temporary differences and operating loss and tax credit carry-forwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.

Management employs a threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return. Tax benefits that are subject to challenge by tax authorities are analyzed and accounted for in the income tax provision.

We accrue a tax reserve for additional income taxes, which may become payable in future years as a result of audit adjustments by tax authorities. The reserve is based upon management's assessment of all relevant information and is periodically reviewed and adjusted as circumstances warrant. As of December 31, 2013 and March 31, 2014, our income tax reserves were approximately $2.6 million and $2.6 million , respectively, and relate to the potential income tax audit adjustments, primarily in the areas of fixed asset depreciation in Hong Kong and ongoing state tax audits.

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Share-Based Compensation. We grant restricted stock awards to our employees (including officers) and to non-employee directors under our 2002 Stock Award and Incentive Plan (the "Plan"), which incorporated the shares remaining under our Third Amended and Restated 1995 Stock Option Plan. The benefits provided under the Plan are share-based payments. We amortize over a requisite service period, the net total deferred restricted stock expense based upon the fair value of the stock on the date of the grants. In certain instances, the service period may differ from the period in which each award will vest. Additionally, certain groups of grants are subject to an expected forfeiture rate calculation.

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Results of Operations

The following unaudited table sets forth, for the periods indicated, certain statement of income data as a percentage of net sales.

Three Months Ended March 31, 2013 2014 Net sales 100 % 100 % Cost of sales 70.1 71.5 Gross profit 29.9 28.5 Selling, general and administrative expenses 60.5 46.6 Loss from operations (30.6 ) (18.1 ) Equity in net (loss) income of joint venture (0.8 ) 0.4 Interest income 0.1 0.1 Interest expense (3.6 ) (2.7 )



Loss before provision (benefit) for income taxes (34.9 ) (20.3 ) Provision (benefit) for income taxes

0.4 (0.6 ) Net loss (35.3 )% (19.7 )%



The following unaudited table summarizes, for the periods indicated, certain income statement data by segment (in thousands).

Three Months Ended March 31, 2013 2014 Net Sales



Traditional Toys and Electronics $ 38,117$ 35,592

Role Play, Novelty and Seasonal Toys 39,952 46,918

78,069 82,510



Cost of Sales

Traditional Toys and Electronics 26,866 27,683



Role Play, Novelty and Seasonal Toys 27,824 31,272

54,690 58,955



Gross Profit

Traditional Toys and Electronics 11,251 7,910 Role Play, Novelty and Seasonal Toys 12,128 15,645 $ 23,379$ 23,555 23

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Comparison of the Three Months Ended March 31, 2013 and 2014

Net Sales

Traditional Toys and Electronics. Net sales of our Traditional Toys and Electronics segment were $35.6 million for the three months ended March 31, 2014, compared to $38.1 million for the prior year period, representing a decrease of $2.5 million, or 6.6%. The decrease in net sales was due to a variety of factors, including decreased orders from several retailers, and the tapering off of sales of action figures based on the animation series Monsuno®, Winx Club® dolls, and unit sales of Spy Net® offset in part by an increase in unit sales of our 31 inch boys action figures.

Role Play, Novelty and Seasonal Toys. Net sales of our Role Play, Novelty and Seasonal Toys were $46.9 million for the three months ended March 31, 2014 compared to $40.0 million for the prior year period, representing an increase of $6.9 million, or 17.4%. The increase in net sales was primarily due to an increase in units sales of our role play and dress up products based on the Frozen® property and increased unit sales of our Maui Toys division.

Cost of Sales

Traditional Toys and Electronics. Cost of sales of our Traditional Toys and Electronics segment was $27.7 million, or 77.8% of related net sales, for the three months ended March 31, 2014 compared to $26.9 million, or 70.5% of related net sales, for the prior year period, representing an increase of $0.8 million, or 3.0%. The dollar increase in cost of sales and increase of cost as a percentage of sales is due to closeout sales and an increase in royalty expense. Royalties as a percentage of sales increased due to changes in the product mix to more products with higher royalty rates from products with lower royalty rates or proprietary products with no royalty rates. Our depreciation of molds and tools for the segment was comparable year over year.

Role Play, Novelty and Seasonal Toys. Cost of sales of our Role Play, Novelty and Seasonal Toys segment was $31.3 million, or 66.7% of related net sales, for the three months ended March 31, 2014, compared to $27.8 million, or 69.6% of related net sales, for the prior year period, representing an increase of $3.5 million, or 12.4%. The dollar increase in cost of sales is primarily due to the increase in unit sales year over year. Our depreciation of molds and tools for the segment was comparable year over year. Royalties as a percentage of sales was also comparable year over year and are in line with the increase of sales.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $38.5 million for the three months ended March 31, 2014 and $47.2 million for the prior year period, constituting 46.6% and 60.5% of net sales, respectively. Selling, general and administrative expenses decreased $8.7 million from the prior year period, primarily due to decreases in legal and financial advising fees related to the unsolicited indication of interest to acquire the Company ($0.6 million), employee salaries and benefits ($2.2 million), travel and entertainment ($0.4 million), legal and other professional expense ($1.8 million), media buys and other product marketing ($2.5 million), product development and testing ($1.4 million), and recovery of bad debt expenses ($0.5 million),offset in part by increases in temporary help ($0.2 million), and acquisition amortization ($0.5 million).

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Interest Income

Interest income for the three months ended March 31, 2014 was $0.1 million, compared to $0.1 million for the three months ended March 31, 2013.

Interest Expense

Interest expense was $2.2 million in the three months ended March 31, 2014, as compared to $2.8 million in the prior period. The decrease is due to line of credit balances for 2014 were lower compared to 2013. In the three months ended March 31, 2014, we booked interest expense of $2.0 million related to our convertible senior notes payable due in 2014 and 2018 and $0.2 million related to the interest component of our Maui acquisition earn out payment. In the three months ended March 31, 2013, we booked interest expense of $1.9 million related to our convertible senior notes payable due in 2014, $0.8 million related to our credit facility and $0.1 million related to the interest component of our Maui acquisition earn-out payment.

Provision for Income Taxes

Our income tax benefit, which includes federal, state and foreign income taxes and discrete items, was $0.5 million, or an effective tax rate of 2.88%, for the three months ended March 31, 2014. During the comparable period in 2013, our income tax expense was $0.3 million, or an effective tax rate of (1.10%).

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Seasonality and Backlog

The retail toy industry is inherently seasonal. Generally, our sales have been highest during the third and fourth quarters, and collections for those sales have been highest during the succeeding fourth and first quarters. Our working capital needs have been highest during the third and fourth quarters.

While we have taken steps to level sales over the entire year, sales are expected to remain heavily influenced by the seasonality of our toy and Halloween products. The result of these seasonal patterns is that operating results and the demand for working capital may vary significantly by quarter. Orders placed with us are generally cancelable until the date of shipment. The combination of seasonal demand and the potential for order cancellation makes accurate forecasting of future sales difficult and causes us to believe that backlog may not be an accurate indicator of our future sales. Similarly, financial results for a particular quarter may not be indicative of results for the entire year.

Liquidity and Capital Resources

As of March 31, 2014 we had working capital of $120.4 million, compared to $136.3 million as of December 31, 2013. The decrease was primarily attributable to net loss for the quarter as well as lower accrued expenses and accounts payable balances offset partially by the seasonably lower accounts receivable and inventory balances.

Operating activities used net cash of $11.1 million in the three months ended March 31, 2014, as compared to $5.7 million in the prior year period. Net cash was impacted primarily by decreases in accounts receivable and inventory, offset by decreases in accounts payable, accrued expenses and reserves for sales returns and allowances. Our accounts receivable turnover as measured by days sales for the quarter outstanding in accounts receivable was 71 days as of March 31, 2014, comparable to 75 days as of March 31, 2013. Other than open purchase orders issued in the normal course of business, we have no obligations to purchase finished goods from our manufacturers. As of March 31, 2014, we had cash and cash equivalents of $113.6 million.

Our investing activities used net cash of $0.9 million in the three months ended March 31, 2014, as compared to $3.9 million in the prior year period, consisting primarily of cash paid for the purchase of molds and tooling of $1.2 million used in the manufacture of our products. As part of our strategy to develop and market new products, we have entered into various character and product licenses with royalties generally ranging from 1% to 14% payable on net sales of such products. As of March 31, 2014, these agreements required future aggregate minimum guarantees of $48.6 million, exclusive of $23.1 million in advances already paid. Of this $48.6 million future minimum guarantee, $29.5 million is due over the next twelve months.

Our financing activities provided net cash of $8.4 million in the three months ended March 31, 2014, as compared to $14.3 million of cash used in the prior year period, consisting of net proceeds from advances under our secured line of credit, offset in part by the issuance costs of the secured line of credit.

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In October 2011, we acquired all of the stock of Moose Mountain Toymakers Limited, a Hong Kong company, and a related New Jersey company, Moose Mountain Marketing, Inc. (collectively, "Moose Mountain"). The total initial consideration of $31.5 million consisted of $16.0 million in cash and the assumption of liabilities in the amount of $15.5 million, and resulted in goodwill of $13.5 million. In addition, we agreed to pay an earn-out of up to an aggregate amount of $5.3 million in cash over the three calendar years following the acquisition based upon the achievement of certain financial performance criteria. The fair value of the expected earn-out was included in goodwill and assumed liabilities as of the acquisition date. Moose Mountain is a leading designer and producer of foot to floor ride-ons, inflatable environments, wagons, pinball machines and tents and was included in our results of operations from the date of acquisition.

In July 2012, we acquired all of the stock of Maui, Inc., an Ohio corporation, Kessler Services, Inc., a Nevada corporation, and A.S. Design Limited, a Hong Kong corporation (collectively, "Maui"). The initial cash consideration totaled $36.2 million. In addition, we agreed to pay an earn-out of up to an aggregate amount of $18.0 million in cash over the three calendar years following the acquisition based upon the achievement of certain financial performance criteria, which has been accrued and recorded as goodwill as of the acquisition date. All future changes to the earn-out liability will be charged to income. Maui is a leading manufacturer and distributor of spring and summer activity toys and impulse toys and was included in our results of operations from the date of acquisition.

In September 2012, we entered into a secured credit facility with Wells Fargo Bank, National Association (the "WF Loan Agreement"). The WF Loan Agreement provided for a $75.0 million working capital revolving credit facility. The amounts outstanding under the revolving credit facility were originally payable in full upon maturity of the credit facility on April 30, 2013. By Amendment to the Loan Agreement dated March 28, 2013, the Bank granted an over advance of up to $30.0 million of which $29.0 million was advanced on March 29, 2013. In addition, the maturity date was changed to April 2, 2013, on which we paid off the credit facility in full.

On March 27, 2014, the Company and its domestic subsidiaries entered into a secured credit facility with General Electric Capital Corporation (the "Loan Agreement"). The Loan Agreement provides for a $75.0 million working capital revolving credit facility subject to availability based on prescribed advance rates on certain accounts receivable and inventory. The amounts outstanding under the revolving credit facility are payable in full upon maturity of the credit facility on March 27, 2017. The credit facility is secured by a substantial amount of the assets of the Company. The amount outstanding on the credit facility as of March 31, 2014 is $10.0 million; the total borrowing capacity was approximately $12.8 million.

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In November 2009, we sold an aggregate principal amount of $100.0 million of 4.50% Convertible Senior Notes (the "2014 Notes") due 2014. The 2014 Notes, which are senior unsecured obligations, pay interest semi-annually at a rate of 4.50% per annum and mature on November 1, 2014. The initial conversion rate was 63.2091 shares of our common stock per $1,000 principal amount of notes (equivalent to an initial conversion price of approximately $15.82 per share of common stock), subject to adjustment in certain circumstances. As a result of the cash dividends declared by the Board of Directors and paid in 2011, 2012 and 2013 of $0.10 per share, $0.40 per share and $0.24 per share, respectively, and the above-market self-tender offer completed in July 2012, the current conversion rate is 68.8564 shares of JAKKS common stock per $1,000 principal amount of notes (or approximately $14.52 per share). Prior to August 1, 2014, holders of the 2014 Notes may convert their notes only upon specified events. Upon conversion, the 2014 Notes may be settled, at our election, in cash, shares of our common stock or a combination of cash and shares of our common stock. Holders of the 2014 Notes may require us to repurchase for cash all or some of their notes upon the occurrence of a fundamental change (as defined in the 2014 Notes). The Company repurchased $61.0 million of the 2014 Notes during the quarter ended September 30, 2013 and there is $39.0 million outstanding as of March 31, 2014.

In July 2013, we sold an aggregate of $100.0 million principal amount of 4.25% Convertible Senior Notes due 2018 (the "2018 Notes"). The 2018 Notes, which are senior unsecured obligations, pay interest semi-annually in arrears on August 1 and February 1 of each year at a rate of 4.25% per annum and will mature on August 1, 2018. The initial conversion rate for the 2018 Notes will be 114.3674 shares of our common per $1,000 principal amount of notes, equivalent to an initial conversion price of approximately $8.74 per share of common stock, subject to adjustment in certain events. Holders of the 2018 Notes may convert their notes upon the occurrence of specified events. Upon conversion, the 2018 Notes will be settled in shares of the Company's common stock. We used $61.0 million of the approximate $95.9 million in net proceeds from the offering to repurchase at par $61.0 million principal amount of 2014 Notes. The remainder of the net proceeds will be used for general corporate purposes.

We believe that our cash flows from operations and cash and cash equivalents will be sufficient to meet our working capital and capital expenditure requirements and provide us with adequate liquidity to meet our anticipated operating needs for at least the next 12 months. Although operating activities are expected to provide cash, to the extent we grow significantly in the future, our operating and investing activities may use cash and, consequently, this growth may require us to obtain additional sources of financing. There can be no assurance that any necessary additional financing will be available to us on commercially reasonable terms, if at all. As of December 31, 2013 and March 31, 2014, we held cash and short term investments held by our foreign subsidiaries of $77.7 million and $83.5 million, respectively. Although a significant portion of our cash is held by our foreign subsidiaries off-shore, we intend to finance our long-term liquidity requirements out of net cash provided by operations and net cash and cash equivalents and availability under our credit facility. As of March 31, 2014, we do not have any off-balance sheet arrangements.

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