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.
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.
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.
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.
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.”
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.”
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
