Heelys, Inc (HLYS) - Description of business

We are a designer, marketer and distributor of innovative, action sports-inspired products under the HEELYS brand targeted to the youth market. Our primary product, HEELYS-wheeled footwear, is patented, dual-purpose footwear that incorporates a stealth, removable wheel in the heel. HEELYS-wheeled footwear allows the user to seamlessly transition from walking or running to skating by shifting weight to the heel. Users can transform HEELYS-wheeled footwear into street footwear by removing the wheel. Our distinctive product offering has driven our growth, and we believe that our HEELYS brand is becoming synonymous with an increasingly popular lifestyle activity. We believe that the growing exposure of our HEELYS brand will allow us to selectively introduce additional product categories in the future by taking advantage of our expertise in product development and sourcing, strong retail relationships and knowledge of our target consumer.

We were initially incorporated as Heeling, Inc. in Nevada in 2000 and were reincorporated in Delaware in August 2006 and changed our name to Heelys, Inc. Through our general and limited partner interests, we own 100% of Heeling Sports Limited, a Texas limited partnership, which was formed in May 2000.

We are subject to the informational requirements of the Exchange Act, and, accordingly, file reports, proxy statements and other information with the Securities and Exchange Commission (the “SEC”). We maintain a website on the World Wide Web at www.heelys.com. We make available, free of charge through our website, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, including exhibits thereto, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after the reports are electronically filed with, or furnished to the SEC. Our reports that are filed with, or furnished to, the SEC are also available at the SEC’s website at www.sec.gov , that contains material regarding issuers that file electronically with the SEC . You may also obtain copies of any of our reports filed with, or furnished to, the SEC, free of charge, at the SEC’s public reference room at 100 F Street, N.E., Washington, DC 20549.

Information regarding the operation of the Public Reference Room may be obtained by calling the Securities and Exchange Commission at 1-800-SEC-0330.

Our Business

We currently offer HEELYS-wheeled footwear in a wide variety of styles and colors at domestic retail price points ranging from $59.99 to $99.99 depending upon performance features, comfort and materials. HEELYS-wheeled footwear is protected by numerous patents and trademarks, enabling us to capture the emerging demand for our unique offering in the United States and other countries where we can enforce our patents. In 2006, approximately 98% of our net sales was derived from the sale of our HEELYS-wheeled footwear. We also sell branded accessories, such as replacement wheels, helmets and other protective gear, and a limited variety of apparel items.

We sell our products through distribution channels that merchandise our products in a manner that we believe enhances and protects our HEELYS brand image. Domestically, our products can be purchased from full-line sporting goods retailers such as The Sports Authority, Modell’s and Dick’s Sporting Goods; specialty apparel and footwear retailers, such as Journeys and The Finish Line; and select department stores, such as Nordstrom and Mervyn’s. Our products can also be purchased from select online retailers such as Zappos.com. In 2006, 85.7% of our net sales were derived from retailers in the United States. Internationally, our products are sold to independent distributors with exclusive rights to specified international territories.

Initial Public Offering of Our Common Stock and Use of Proceeds

On December 7, 2006, a registration statement (File No. 333-137046) relating to our initial public offering of our common stock was declared effective by the SEC. In this offering we sold a total of 3,125,000 shares of our common stock and selling stockholders sold 4,263,750 shares of our common stock, which included 963,750 shares resulting from the exercise of the underwriters’ over-allotment option. All common stock registered under the registration statement were sold at a price to the public of $21.00 per share. We did not receive any proceeds from the selling stockholders’ sale of their shares. The offering closed on December 13, 2006. Bear, Stearns & Co., Inc., Wachovia Capital Markets, LLC, J.P. Morgan Securities Inc. and CIBC World Markets Corp. acted as managing underwriters.

The gross proceeds from the shares of common stock sold by us were $65.6 million. The net proceeds to us from the offering were approximately $58.8 million, after deducting an aggregate of $4.6 million in underwriting discounts and commissions and $2.2 million in other expenses incurred in connection with the offering. We used $8.5 million of these proceeds to repay amounts outstanding under our revolving credit facility and $8.5 million for working capital purposes. We intend to use the remaining proceeds to fund infrastructure improvements, including expanding and upgrading our information technology systems; hire new employees; for marketing and advertising programs; product development; working capital needs; and other general corporate purposes.

Target Market

The growth and longstanding popularity of skateboarding, inline skating, roller skating and scooter riding in the United States reflect consumers’ interest in wheeled sports activities. For example, skateboarding and inline skating have remained a part of youth culture for more than 40 and 25 years, respectively. Our HEELYS-wheeled footwear, which we believe has broad patent protection relative to other wheeled sports products, appeals to many of these same consumers. While the market for HEELYS-wheeled footwear has grown significantly since our first product was introduced in 2000, we believe this market continues to have growth potential.

Our products appeal to a broad range of young, active consumers around the world who enjoy wheeled sports activities. Our primary market is six to fourteen year-old boys and girls, an age group in the

United States that the U.S. Census Bureau estimated to be 36.4 million people in 2005 and projected to grow to 38.2 million people by 2015. Based on our sales of more than 5.2 million pairs of HEELYS-wheeled footwear in the United States during 2006, we believe that our target market offers significant growth potential for both HEELYS-wheeled footwear and future product introductions. In addition, we believe we benefit from greater repeat purchases by our consumers relative to other wheeled sports products, driven by the natural replacement cycle of children’s footwear and the new styles that we offer each season.

We believe that our products have become more popular in recent years due to the trend among young people away from traditional team sports and toward individual, action sports. For example, SGMA International, a sporting goods industry trade group, estimated that from 1998 to 2005, U.S. participation in basketball, baseball and soccer declined 24.6%, 16.7% and 6.4%, respectively, while U.S. participation in snowboarding, skateboarding and surfing increased 33.7%, 58.3% and 90.5%, respectively. We believe events such as the X Games, the inclusion of snowboarding medal events in the Winter Olympics and the national recognition of leading boardsport athletes have broadened general awareness and increased the popularity of the action sports youth lifestyle. The trend towards individual, action sports has influenced the styles and performance features of our products and our marketing strategies.

Business Strengths

We attribute our success to the following business strengths:

·        Stro ng Brand Recognition.   We believe that our brand awareness is a significant competitive strength. We have positioned the HEELYS brand to represent a fun, youthful and active image and we believe it now defines an emerging lifestyle activity with a following among consumers in our target market. According to data collected by NPD, a retail and apparel industry research group, HEELYS-wheeled footwear had a 51.0% market share in retail sales dollars and a 37% market share in units sold for skateboard-related footwear brands for the quarter ended December 31, 2006.

·        Appealing, High-Quality Products.   We strive to provide high-quality, stylish products. We carefully select our independent manufacturers and diligently monitor their manufacturing process to ensure the quality of their finished goods. To stimulate demand for our products and encourage repeat purchases by consumers, we endeavor to consistently offer a line of wheeled footwear that combines style, comfort and high-quality components including ABEC-rated bearings, specially formulated polyurethane wheels and abrasion-resistant outsoles and upper materials. We have generally introduced more than 20 standard styles each year in an attempt to respond to changing consumer tastes and preferences.

·        Focus on Innovation with Intellectual Property Protection.   Our innovative HEELYS-wheeled footwear is highly differentiated from other wheeled sports products and athletic footwear. We believe that our patents and pending patent applications enable us to maintain this differentiation. We own more than 80 issued patents and pending patent applications in more than 25 countries, of which more than 55 are related to our HEELYS-wheeled footwear. We also have more than 75 registered trademarks and pending trademark applications in more than 30 countries. We believe that our experience introducing HEELYS-wheeled footwear to the market and our growing brand awareness will allow us to successfully develop and introduce additional products incorporating innovative designs and technologies that appeal to our target consumers.

·        In-Depth Understanding of Our Target Market.   We employ a grass-roots marketing model that enables us to regularly interact with and maintain an in-depth understanding of our target market. In 2006, our event marketing managers, or “EMMs,” coordinated more than 3,000 in-store clinics and demonstrations, allowing us to communicate our brand message in an interactive, fun

environment. In addition, our EMMs use online marketing techniques such as hosting message boards and contributing to skate-oriented chat rooms. We also sponsor “team riders” to showcase HEELYS-wheeled footwear in high-traffic, public areas. Through these multifaceted interactions with our target consumers, we continually refine our understanding of their evolving preferences. We intend to use this insight to develop new HEELYS-wheeled footwear models, strengthen and extend our HEELYS brand and offer additional product categories.

·        Compelling Value Proposition for Retail Customers.   We believe that our differentiated product offering and brand name represent a compelling value proposition for our retail customers. Our products have historically enabled our retail customers to achieve high sales volumes at or near our suggested retail prices, rapid inventory turns and attractive margins. These results have allowed us to develop strong relationships and expand our product offerings with our retail customers, and add new retail customers.

·        Flexible and Efficient Sourcing Model.   By outsourcing manufacturing, we eliminate the need to purchase raw materials and limit the amounts we are required to spend on working capital, capital expenditures and overhead. This enables us to focus our resources on developing new products and brand-enhancing activities. We do not have any long-term manufacturing contracts, choosing instead to retain the flexibility to change our manufacturing sources if necessary. We have developed systems and procedures that enable us to actively monitor product quality, control product costs and facilitate timely product delivery.

·        Senior Management Team with Deep Industry Experience.   Our senior management team, which has overseen our company since its inception, has been instrumental in developing our HEELYS brand, establishing strong relationships with retail customers and international distributors and directing our growth. Our Chief Executive Officer has approximately 30 years of experience in the branded footwear and action sports industries and has held senior level positions at the Rollerblade division of Benetton Group S.p.A. and L.A. Gear. Our Senior Vice President—Global Sales has more than 25 years of sales and marketing experience in the athletic apparel and footwear industries and has held executive level and sales positions at L.A. Gear, Kaepa, Nike, Stride-Rite and Wilson Sporting Goods.

Growth Strategy

We plan to continue growing our net sales and earnings through the following strategies:

·        Increase Awareness and Popularity of our HEELYS Brand.   We plan to increase the awareness and popularity of our HEELYS brand, which we believe will fuel demand for our products. By conveying our brand message through word-of-mouth, grass-roots and traditional marketing, we seek to strengthen our understanding of and broaden our target market. We believe that enhanced brand awareness will allow us to expand sales of our current products and successfully offer new product categories.

·        Broaden Our Relationships with Existing Retail Customers.   Many of our retail customers do not initially sell our products in all of their stores, choosing to evaluate consumer acceptance of our products in a limited number of stores. As the demand for our products continues to grow and our relationships with our retail customers develop, we believe that certain of our retail customers will continue to increase the number of stores in which our products are sold and expand the selection of our products that they offer. Based on the success that these retailers have had selling our products, we believe that we will have opportunities to expand our sales with existing retail customers in the future. In addition, we encourage our independent distributors to pursue similar growth strategies with their customers.

·        Expand Our Customer Base.   We intend to increase our domestic distribution by selectively adding new retail customers. In particular, we believe that there are a number of regions in the United States where our products are under-distributed and we intend to add retailers in these regions to increase our distribution. We believe that international distribution also represents a significant growth opportunity for us. We intend to take advantage of this opportunity by encouraging our existing distributors to expand their market presence and by establishing relationships with distributors in new international markets.

·        Develop and Selectively Acquire New Products and Brands.   Our vision is to become an action-sports lifestyle company, consistently bringing innovative branded products to the global market. We intend to leverage our HEELYS brand and our reputation for innovation, quality, performance and comfort by expanding our apparel and accessories product offerings, entering new product categories and increasing the breadth of HEELYS branded products sold by our existing retail customers. In addition to continually updating our HEELYS-wheeled footwear offering with new colors, materials and textures to keep our style assortment fresh and developing related products and technologies, we believe opportunities exist to acquire complementary brands and products that appeal to our target market.

Products

Our primary product is HEELYS-wheeled footwear, patented, dual-purpose footwear that incorporates a stealth, removable wheel in the heel. HEELYS-wheeled footwear allows the user to seamlessly transition from walking or running to skating by shifting weight to the heel. Users can remove the wheel to transform HEELYS-wheeled footwear into street footwear. HEELYS-wheeled footwear is offered in more than 20 styles, incorporating various comfort and performance features and colors at five retail price points. We traditionally offer a new line of HEELYS-wheeled footwear twice each year for the spring/summer selling season and the back-to-school and holiday selling seasons.

HEELYS-wheeled footwear can be classified into the following three categories:

		Single-Wheel.   Our single-wheel HEELYS-wheeled footwear has one detachable wheel and are available in various sizes for men, women and children. We offer wheels of various performance capabilities in order to appeal to beginners and advanced users. Single-wheel HEELYS-wheeled footwear represented approximately 89.1% of our net sales in 2006. Suggested domestic retail prices for our single-wheel HEELYS-wheeled footwear generally range from $59.99 to $99.99.
		Two-Wheel.   Our two-wheel HEELYS-wheeled footwear includes two detachable wheels, are designed for novice users and are offered only in children’s sizes. This category represented approximately 5.6% of our net sales in 2006. The suggested domestic retail price for our two-wheel HEELYS-wheeled footwear is generally $59.99.
		Grind-and-Roll.   Grind-and-roll HEELYS-wheeled footwear represents our highest performance category and are preferred by enthusiasts seeking a challenging and exciting action sports experience. This category features a single detachable wheel and a patented, hard nylon plate in the arch, enabling the consumer to slide, or “grind,” on hand railings and other similar surfaces. Consumers can use our grind-and-roll HEELYS-wheeled footwear to perform distinctive maneuvers, similar to those performed by skateboarders and inline skaters. The grind-and-roll category represented approximately 3.3% of our net sales in 2006. The suggested domestic retail price for our grind-and-roll HEELYS-wheeled footwear is generally $89.99.

In addition to offering our standard styles, we collaborate with certain of our retail customers to develop HEELYS-wheeled footwear styles that these retail customers have the exclusive rights to sell. This special make-up program enables these customers to differentiate their HEELYS-wheeled footwear product offering and allows us to broaden our product range. These exclusive products are made to order and shipped directly to our retail customers, thereby mitigating our inventory risk. In 2006, special make-up program products represented approximately 23.5% of our net sales.

In the past, we sold less-expensive wheeled footwear under the “Cruz” brand name exclusively to certain of our independent distributors. The Cruz brand represented approximately 17.7% and 3.3% of our net sales in 2004 and 2005, respectively. Although we have not sold any Cruz branded footwear since 2005, we may choose to re-launch this product line in the future.

We also offer a selection of HEELYS branded accessories, including protective gear such as helmets and wrist, elbow and knee guards, heel plugs, wheel bags and replacement wheels and a limited variety of apparel items. We plan to take advantage of growing consumer awareness of our brand name and our strong retail relationships to expand our HEELYS branded accessories offerings. In response to demand from certain of our retail customers, we began to offer HEELYS branded apparel and additional accessories in the third quarter of 2006.

Product Design and Development

We continually update and refine our product offerings in response to evolving consumer preferences. For example, in 2002 we introduced the grind plate for our grind-and-roll HEELYS-wheeled footwear and the two-wheel HEELYS-wheeled footwear, and in 2003 we introduced specific styles for girls and the “sole saver” heel plug, which provides a finished look to the footwear by covering the wheel cavity when the wheel is removed. We believe that introducing new products, performance features and designs allows us to maintain premium price points, encourages repeat purchases and creates incremental consumer demand for our products. We monitor changing consumer trends and identify new product opportunities through close, interactive contact with our target consumers, frequent dialogue between our EMMs, and our retail customers and input from our sponsored “team riders” who are paid to use and promote our products.

Our product development efforts include both incremental improvements to our existing products and entirely new technologies and product categories. Incremental improvements to our existing products include introducing new styles, improving the materials used in our wheels and designing lighter shoes with greater durability and enhanced comfort and performance features.

Our product design and development process is rigorous and highly collaborative, using input from our sales staff, product development professionals, retail customers, EMMs and consumers. We focus not only on the performance of our products, but also on production cost and efficiency. Prior to hiring our Vice President—Design and Development in October 2006, we outsourced the aesthetic, non-technical aspects of our product design, such as color and style, to independent product designers.

Sales

We carefully control the distribution of our products to protect and enhance our HEELYS brand and maintain our ability to offer our products at premium price points. We sell our products domestically directly to retail customers and internationally through independent distributors. Currently, we do not sell our products to mass merchants or directly to consumers.

Domestic Sales

As of December 31, 2006, our customer base of retail customers in the United States included more than 800 accounts that operated more than 7,400 stores. Based on communications with those customers,

we believe that as of December 31, 2006, our HEELYS-wheeled footwear was offered for sale in more than 5,000 of those stores. These retail customers include a variety of full-line sporting goods retailers, specialty apparel and footwear retailers and select department stores. Our products are also sold through select online retailers. We attempt to choose retail customers who appeal to our target market and who are able and willing to merchandise our products in a manner that we believe is consistent with our brand message and positioning. Big 5 Sporting Goods, Dick’s Sporting Goods, Modell’s, The Sports Authority, Journeys, The Finish Line, Nordstrom, Mervyn’s and Zappos.com are examples of our domestic retail customers. In 2004, 2005 and 2006, our domestic net sales were $13.8 million, $36.6 million and $161.3 million, respectively, representing 64.9%, 83.2% and 85.7% of our total net sales, respectively.

We believe that there are numerous opportunities to expand our domestic distribution. We intend to increase our domestic distribution by expanding the number of stores in which HEELYS-wheeled footwear is sold by existing retail customers and by adding new retail customers. Due to our limited funding at our inception, we focused our marketing resources on specific regions of the country that we believed embraced wheeled sports and innovative products such as HEELYS-wheeled footwear. As the exposure of our products and brand name increased and our financial position improved, we expanded our focus to other regions of the country.

We are committed to providing the highest levels of service to our retail customers. We maintain a national sales force of 19 independent sales representatives, each of whom is assigned an exclusive territory and is compensated on a commission basis, and who together are responsible for substantially all of our domestic sales. We believe that our product line represents a significant percentage of the sales made by these independent sales representatives. Our Senior Vice President—Global Sales, who oversees our independent sales representatives, and our independent sales representatives are supported by our twelve-person sales and customer service department.

International Sales

As of December 31, 2006, we offered our products internationally through more than 29 independent distributors, each of which has exclusive rights to a designated territory. In 2006, our largest international territories by net sales were the United Kingdom, Canada and Ireland. We select our independent distributors based on their relationships with appropriate retailers, their ability to effectively represent the HEELYS brand and their execution of our distribution strategy. In order to maintain a consistent brand image throughout the world, we provide marketing, distribution and product training support to our independent distributors. Each distributor must meet minimum sales goals and is responsible for funding its local marketing campaigns, maintaining its own inventory and providing sufficient sales, distribution and customer service infrastructure. In 2004, 2005 and 2006, our international net sales were $7.5 million, $7.4 million and $26.9 million, respectively, representing 35.1%, 16.8% and 14.3% of our total net sales, respectively. In 2004, Japan accounted for 19.4% of our total net sales.   Since 2004, no country other than the United States has accounted for 10% or more of our net sales. We believe that international distribution represents a meaningful growth opportunity for us that we intend to take advantage of by encouraging our existing distributors to expand their market presence and by establishing relationships with distributors in new international markets.

Principal Customers

In 2004, A.G. Corporation in Japan accounted for 19.4% of our net sales and Big 5 Sporting Goods represented 15.8% of our net sales. In 2005, Big 5 Sporting Goods, Journeys and The Sports Authority represented 12.3%, 11.3% and 10.6% of our net sales, respectively. In 2006, Journeys accounted for 12.7% of our net sales. No other retail customer or independent distributor accounted for 10% or more of our net sales in any of these periods.

Marketing

Our marketing strategy is to position our products and the HEELYS brand to represent a lifestyle that includes excitement, individuality and the unique culture of action sports. To promote awareness of our HEELYS brand, we utilize a multi-faceted strategy that includes event marketing activities, television advertising, point-of-purchase, or “POP,” displays and product placement and public relations opportunities. While we fund the cost of these activities domestically, our independent distributors are solely responsible for these costs in their markets.

Event Marketing Activities

We employ a team of six EMMs that enables us to reach consumers at the grass-roots level and help drive foot traffic to our retail customers’ locations. EMMs increase consumer awareness of our products by hosting in-store product clinics and demonstrations, teaching store personnel how to use our products, employing “guerrilla” marketing methods such as arranging for our sponsored “team riders” to skate in high traffic public areas and using online marketing techniques such as hosting message boards and contributing to skate-oriented chat rooms. EMMs educate retail sales personnel on techniques to maximize sell-through of our products and to promote product awareness and safety.

Television Advertising

Television advertisements are an important and highly effective tool for increasing awareness of our brand and products among our target consumers because these advertisements allow us to show consumers HEELYS-wheeled footwear in action. Advertisements air in selected regions of the United States during our primary selling seasons on cable channels such as ABC’s Family Channel, Nickelodeon and The Cartoon Network. As part of our regional television advertising strategy, we feature the name of a local retail customer at the end of our television advertisements. This tactic is intended to drive consumers to specific retail customers and allows us to evaluate the effectiveness of our advertising. We ran our first national cable television advertising campaign in the fourth quarter of 2005. During 2006, we continued utilizing both regional and national television advertising campaigns and expect to continue to follow this approach in the future.

Point-of-Purchase Displays

Certain of our retail customers have committed valuable floor space to POP displays we provide to enhance the presentation of our products. Through the use of these POP displays, we are able to present the HEELYS brand message to consumers in a consistent manner and increase our shelf space in our retail customers’ locations. EMMs ensure that our merchandise is effectively featured using POP displays.

Product Placement

Because HEELYS-wheeled footwear is highly differentiated from other wheeled sports products and other footwear, we often receive requests from television shows, magazines and news organizations to review or highlight our products. While we have not paid for product placement, our products have been featured in numerous television and print spots, including television networks such as CNN and CNBC; television shows such as So You Think You Can Dance , Good Morning America , Radical Sabbatical , Livin’ Large , CSI: Miami and Invent This ; magazines and newspapers such as Time , People , The Wall Street Journal , In Style , Newsweek and Sports Illustrated; and the World Book Encyclopedia and McGraw-Hill school textbooks. HEELYS-wheeled footwear was used in the Miramax film Spy Kids 2 as well as in the Lionsgate film Employee of the Month ; and has been featured in pop artist Usher’s music videos and television specials. We believe that product placement activities enable us to build awareness of our products and our HEELYS brand in a cost-effective manner.

Manufacturing and Sourcing

We do not own or operate any manufacturing facilities and we purchase our products as finished goods from independent manufacturers. We do not have any long-term manufacturing contracts, choosing instead to retain the flexibility to change our manufacturing sources if necessary. We believe that alternate manufacturing sources are available at comparable costs to those we currently experience.

We carefully monitor all aspects of the production of our HEELYS-wheeled footwear, including the development and manufacturing of prototypes, initial production runs and final product manufacturing. We perform an array of inspection procedures at various stages of the production process, including examination and testing of raw materials and components prior to manufacture, work-in-process at various stages of production and finished goods prior to shipment. Historically, our defective return rate has been less than 1.0% of our net sales. We also conduct on-site visits to our manufacturers’ facilities to confirm that they engage in ethical business practices.

Boss Technical Services, our independent sourcing agent, helps us identify and develop relationships with manufacturers of our footwear products and provides quality inspection, testing, logistics and product development and design assistance. We pay for these services on a commission basis. We also hired a Vice President—Sourcing in December 2006 to manage our relationship with Boss Technical Services and our manufacturers.

Bu Kyung Industrial, which is owned by one of the owners of Boss Technical Services, has manufactured HEELYS-wheeled footwear since our inception and until 2006 was responsible for manufacturing substantially all of our HEELYS-wheeled footwear. Due to rapid growth in demand for our HEELYS-wheeled footwear, in 2006 we began using a number of other manufacturers to supply our products. We expect Bu Kyung Industrial to continue to manufacture a significant portion of our footwear products, but we expect to develop relationships with additional manufacturers in order to secure additional capacity and mitigate the risk associated with using a limited number of manufacturers.

Order Fulfillment and Inventory Management

Our products are inspected, bar coded and packaged by our independent manufacturers and transported by container ship typically to Long Beach, California. Our independent manufacturers mark, label and pre-ticket our products for certain of our larger retail customers. For products sold in the United States, after the products clear U.S. customs, we use an independent freight forwarder and customs broker to ship them via rail by container either to our distribution center located in Carrollton, Texas, or directly to our retail customers. In 2006, approximately 81.2% of our products in the United States were shipped directly to our retail customers. Upon receipt at our warehouse, merchandise is inspected and recorded in our management information systems and packaged for delivery. We maintain electronic data interchange, or “EDI,” connections with many of our larger retail customers in order to automate order tracking and inventory management. Substantially all of our products destined for international distribution are sent directly by our independent manufacturers to our independent distributors.

To allow us to better plan our production volume with our manufacturers, we offer our retail customers discount incentives to place advance orders. We typically receive most of our orders, which are not subject to cancellation, three to four months in advance of the scheduled delivery dates. To manage our inventory risk, we regularly monitor available sell-through data and seek input on anticipated consumer demand from our retail customers.

Intellectual Property—Patents and Trademarks

We have both domestic and international patent coverage for the technology incorporated in our HEELYS-wheeled footwear and own more than 80 patents issued or pending in more than 25 countries, of which more than 55 are related to our HEELYS-wheeled footwear. Our first patent was a method patent

that was issued in June 2002 and includes coverage for wheeled footwear, including HEELYS-wheeled footwear, with a wheel in the heel that allows the user to transition from walking or running to skating by shifting weight to at least one wheel in the heel. We also own a variety of trademarks, with more than 75 registered and pending trademarks in more than 30 countries.

We have vigorously enforced and expect to continue to vigorously enforce our intellectual property rights against infringers domestically and around the world. Despite the challenges inherent in combating infringers in international jurisdictions that may not protect intellectual property rights to the same extent as the United States, we have cooperated with the appropriate authorities and they have conducted successful raids, customs seizures and product confiscations of products that infringe our intellectual property rights in various countries. We have obtained agreements from importers and retailers to cease and desist all infringing activities and, in some cases have been paid monetary compensation. We have also successfully asserted our patent rights against manufacturers of infringing products.

We have an exclusive worldwide license to use intellectual property related to the technology used in our grind-and-roll HEELYS-wheeled footwear. We pay a royalty of 12.0% of our cost on certain products, $1.00 per unit on certain styles of footwear and 25% of any sublicensed revenue of any non-footwear products, apparel and accessories or similar items that absent our license would infringe the trademarks relating to such products under the license agreement. Provided that we make all required royalty payments, at December 31, 2008, title to this intellectual property automatically transfers to us without any further payment. The licensor has the right to reacquire the intellectual property if we fail to make the required royalty payments.

Seasonality

Similar to other vendors of footwear products, sales of our products are subject to seasonality. There are three major buying seasons in footwear: spring/summer, back-to-school and holiday. Shipments for spring/summer take place during the first quarter and early weeks of the second quarter, shipments for back-to-school generally occur over the summer and shipments for the holiday season begin in October and finish in early December. Historically, we have experienced greater revenues in the second half of the year than those in the first half due to a concentration of shopping around the back-to-school and holiday seasons. In 2006, due to the growth of our business and delays we experienced from our independent manufacturers, we experienced a higher percentage of net sales in the third quarter in comparison to the total year than we have experienced in the past, as many orders were delayed from the second quarter to the third quarter, thereby causing the second quarter to be lower than normal and the third quarter to be higher than normal. Our first quarter has typically been our lowest sales quarter. Although weather is a factor in our seasonality, it is difficult to measure its impact. Results for any one quarter are not necessarily indicative of results to be expected for any other quarter or for any year.

Employees

As of December 31, 2006, we employed a total of 41 full-time employees, 36 of whom work in our Carrollton, Texas headquarters. Our full-time employees include 12 in sales and customer service, eight in marketing, eight in executive and administration, two in information technology, five in finance and six in warehousing operations. We also employ temporary warehouse employees during peak shipment periods. We are not a party to any labor agreements and none of our employees are represented by a labor union.

In September 2004, we entered into an agreement with an affiliate of Gevity HR, Inc. a professional employer organization, or “PEO,” under which Gevity provides payroll and employee benefit services and acts as a co-employer of our employees. We believe this arrangement allows us to provide our employees with competitive benefits in a cost-effective manner.

Insurance and Product Liability

We purchase insurance to cover standard risks associated with our business, including policies to cover commercial general liability and other casualty and property risks. Our insurance rates depend upon our safety record as well as trends in the insurance industry. Through our PEO our employees are also covered by workers’ compensation insurance, the cost of which is retrospective and varies depending upon the frequency and severity of claims during the policy year.

We face an inherent risk of exposure to personal injury or product liability claims if, among other things, use of our products results in injury, disability or death. We believe our insurance coverage is sufficient for the risks relating to our products. Our coverage involves retentions with primary and excess liability coverage above the retention amount.

We retain certain property and casualty risks based on our analysis of the risk, the frequency and severity of a loss and the cost of insurance for the risk. We believe that the risk we have assumed through retention is not significant and payments of retained claims will not have an adverse impact on our performance.

Information Technology Systems

Our information technology systems are designed to provide us with, among other things, comprehensive order processing, production, accounting and management information for the sourcing, importing, distribution and marketing aspects of our business. We use the Microsoft Dynamics SL version 6.0 software, with several customizations that enhance this package for our purposes. We also maintain an EDI system that provides a computer link between us and certain of our customers, which enables us to monitor purchases, inventory and retail sales and also improves our efficiency in responding to customer needs. Prior to May 1, 2006, when we hired a Director of Information Technology, we outsourced all of our information technology functions.

We are in the process of expanding and upgrading our information technology systems to support recent and expected future growth. Specifically, we plan to add servers and data warehousing machines and enhance our order management, inventory and EDI modules. We will also evaluate and may implement a new warehouse management system, a new customer-relationship management tool that will integrate with our website for improved customer service and an online and off-site backup system with full data recovery and redundancy capability. Although we do not have an enterprise resource planning system, after making these upgrades, we believe our information technology systems will be sufficient to meet our anticipated growth for the foreseeable future.

Competition

We compete with companies that focus on the young consumer across a number of markets, including footwear, sporting goods and recreational products. Many of these companies have substantially greater financial, distribution and marketing resources than we have. Product design, performance, styling, comfort, quality, brand awareness, timeliness of product delivery and pricing are all important elements of competition in the markets for our products. We believe that the strength of our HEELYS brand, the intellectual property related to the design of HEELYS-wheeled footwear, the quality of our products and our relationships with retailers and distributors allow us to compete effectively in the markets we serve. In certain international markets where enforcing our intellectual property rights is more difficult than in the United States, we compete against counterfeit, knockoff and infringing products, which typically are offered at lower prices.

Backlog

We typically receive most of our orders three to four months prior to the date the products are shipped to customers. Generally, these orders are not subject to cancellation prior to the date of shipment. At December 31, 2006, our backlog was approximately $53.2 million, compared to approximately $10.7 million at December 31, 2005. At December 31, 2005, our backlog was approximately $10.7 million, compared to approximately $3.6 million at December 31, 2004. For a variety of reasons, including the timing of release dates for our product offerings, shipments, order deadlines and receipt of orders, backlog may not be a reliable measure of future sales and may not be comparable from one period to another.

Item 1A. Risk Factors

Before deciding to purchase, hold or sell our common stock, you should carefully consider the risks described below in addition to the more detailed description of our business and other cautionary statements and risks described elsewhere, and the other information contained, in this Annual Report on Form 10-K and in our other filings with the SEC, including our subsequent reports on Forms 10-Q and 8-K. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business. If any of these known or unknown risks or uncertainties actually occurs with material adverse effects on us, our business, financial condition and results of operations could be seriously harmed. In that event, the market price for our common stock will likely decline, and you may lose all or part of your investment. Our business, prospects, financial condition or results of operations could be materially and adversely affected by the following:

We depend primarily upon sales from a single product line and the absence of continued demand for our products would have a material adverse effect on our net sales and results of operations.

In 2005 and 2006, we generated approximately 95% and 98% of our net sales, respectively, from our HEELYS-wheeled footwear and we expect to continue to depend upon HEELYS-wheeled footwear for substantially all of our net sales in the foreseeable future. Because we are dependent on a single line of products, factors such as changes in consumer preferences may have a disproportionately greater impact on us than if we offered multiple product categories. If consumer interest in HEELYS-wheeled footwear or wheeled sports activity products in general declines, we would likely experience a significant loss of sales and may be forced to liquidate excess inventories at a discount, which would have a material adverse impact on our business and operations.

If we are unable to enforce our patents, trademarks and other intellectual property rights, competitors may be able to sell products that are substantially similar to our products, which could adversely affect our sales and damage our brand image.

We believe our trademarks, trade names, copyrights, trade secrets, issued and pending patents, trade dress and designs are valuable and integral to our success. The costs associated with obtaining and maintaining our intellectual property rights and protecting our HEELYS brand are significant. Further, we do not know whether our pending or future patent applications will result in the issuance of patents. Even if patents are issued in the future, we cannot predict how the patent claims will be construed and such patents may not provide us with the ability to prevent the development, manufacturing or marketing of infringing products. Enforcement of our patent and other intellectual property rights in the future may be met with defenses, counterclaims and countersuits attacking the validity and enforceability of our patents and other intellectual property rights.

In addition, we may not be able to detect infringement of our intellectual property rights quickly or at all, and at times in the past we have not been, and in the future we may not be, successful combating counterfeit, infringing or knockoff products, thereby damaging our competitive position. For example, on many occasions, we have identified knockoff products sold by others that we believe may infringe upon our

intellectual property rights. Historically, knockoff products have been sold mainly in international markets, but recently we have identified an increasing number of knockoff products being sold domestically. Knockoff products often are sold under a brand name that is the same as or substantially similar to the HEELYS name. Knockoff and counterfeit products may continue to emerge, as others seek to trade on the goodwill of the HEELYS name and benefit from the consumer demand for our products. We may not be able to detect all knockoff and counterfeit products and may lose our competitive position in a given geographic market before we become aware of any such infringement. For example, our net sales in Asia decreased from $12.1 million in 2003 to $5.4 million in 2004, which we believe was primarily due to the presence of lower-priced counterfeit, knockoff and infringing products in certain Asian markets.

To protect our HEELYS brand, we have already spent significant resources and may be required to spend significantly greater resources in the future to monitor and police our intellectual property rights. If we are unsuccessful in enforcing our intellectual property rights, sales of counterfeit, knockoff or infringing products by others could harm our HEELYS brand and adversely affect our business, financial condition and results of operations. Even if we successfully enforce our intellectual property rights, the presence in the market of counterfeit, knockoff or infringing products of poor quality for even a short time period could have a detrimental impact on our HEELYS brand.

We may not be able to obtain and maintain patent, trademark or other intellectual property rights protection in some foreign countries, which could result in us being unable to prevent others from using our HEELYS mark, which could have a material adverse effect on our business.

We depend upon the laws of the countries where our products are sold to protect our intellectual property. Intellectual property rights may be unavailable or limited in some countries because patent laws and standards of patentability vary internationally. Consequently, in certain foreign jurisdictions, we have elected not to apply for patents or trademark registrations. Further, patent and trademark protection may not be available in every country where our products are sold. While we generally apply for patents and trademarks in most countries where we intend to sell patented products, we may not accurately predict all of the countries where patent or trademark protection will ultimately be desirable. If we fail to timely file a patent or trademark application in any such country, we will likely be precluded from doing so at a later date. Failure to adequately pursue and enforce our patent and trademark rights could damage our HEELYS brand, enable others to compete with us and impair our ability to compete effectively.

In some countries where we have sought patent protection, third parties have challenged the validity, enforceability and scope of our patent rights. For example, the validity of our Japanese patent was challenged in May 2004, resulting in the Japan Patent Office issuing an opinion in February 2006 that our Japanese patent is invalid. We filed a lawsuit with the Intellectual Property High Court in Japan in June 2006, and we filed a Request for Trial for Correction in the Japan Patent Office in September 2006 to attempt to overturn the prior opinion. These actions are still proceeding.  In addition, a third party filed a cancellation application in July 2004 with the Taiwan Intellectual Property Office to cancel our issued patent in Taiwan, and this proceeding is still pending. There can be no assurance that we will prevail in these or similar proceedings. Our HEELYS brand, business, financial condition and results of operations could be adversely affected if we fail to obtain and maintain intellectual property right protection in foreign countries where we derive a large amount of our net sales.

Because we are a consumer products company, if we fail to accurately forecast consumer demand and trends in consumer preferences, our HEELYS brand, net sales, customer relationships and results of operations may be adversely affected.

Demand for our products, and for consumer products in general, is subject to rapidly changing consumer demand and trends in consumer preferences. Therefore, our success depends upon our ability to:

·        identify, anticipate, understand and respond to these trends in a timely manner;

·        expand the number of styles of HEELYS-wheeled footwear we offer to broaden the appeal of our products to a wider range of consumers; and

·        introduce appealing new products and performance features on a timely basis.

We generally must make decisions regarding product designs several months before our products are available for sale, and it can take us up to six months to achieve full production of certain models. Accordingly, at the time we have to make decisions that determine our inventory levels, we cannot be certain that our product offerings will be well received by consumers, in which case we may be forced to liquidate excess inventories at a discount. Conversely, if we underestimate consumer demand for our products, we could have inventory shortages, which would result in lost sales, delays in shipments to retail customers and independent distributors, strains on our relationships with retail customers and independent distributors and diminished brand loyalty. Even if we introduce appealing new styles and products on a timely basis, we may set prices for our products too high to be successful. A decline in demand for our products, or any failure on our part to satisfy increased demand for our products, could adversely affect our net sales and results of operations.

We have significantly increased our sales and the scope of our operations over the past two years. If we fail to manage our growth effectively, we may experience difficulty in filling purchase orders, declines in product quality, increased costs or other operating challenges.

We have:

·        transitioned from purchasing almost all of our footwear products from one independent manufacturer at December 31, 2005 to purchasing from a number of additional manufacturers in the second quarter of 2006;

·        increased the pairs of HEELYS-wheeled footwear sold from 697,000 pairs in 2004, to 1.4 million pairs in 2005 and to 6.2 million pairs in 2006; and

·        increased the number of our full-time employees from 19 at June 30, 2004 to 41 at December 31, 2006.

We anticipate that continued growth of our operations will be required to satisfy increasing consumer demand and to avail ourselves of new market opportunities. The expanding scope of our business and growth in the number of our employees, customers and independent manufacturers have placed and will continue to place a significant strain on our management, information technology systems and other resources. To properly manage our growth, we need to hire additional employees, upgrade our existing financial and reporting systems, improve our business processes and controls and identify and develop relationships with additional independent manufacturers. We may also be required to expand our distribution facilities or add new facilities. Failure to effectively manage our growth could result in difficulty in distributing our products and filling purchase orders, declines in product quality or increased costs, any of which would adversely impact our business and results of operations.

Because we outsource all of our manufacturing to a small number of independent manufacturers, we may face challenges in maintaining a sufficient supply of products to meet demand for our products or experience interruptions in our supply chain. Any shortfall in the supply of our products may decrease our net sales and have an adverse impact on our customer relationships and results of operations.

All of our products are produced by independent manufacturers with which we do not have long-term contracts. As such, any of them could unilaterally terminate its relationship with us or increase the prices it charges us at any time. Until May 2006, one independent manufacturer produced almost all of our HEELYS-wheeled footwear. Commencing in May 2006, when demand for our HEELYS-wheeled footwear products outstripped the capacity of this independent manufacturer, we used additional independent manufacturers to produce HEELYS-wheeled footwear. Although these additional manufacturers have enabled us to increase our monthly production capacity, we may be unable to fill a substantial number of orders placed by our customers on a timely basis. To expedite the delivery of past-due customer orders, we typically ship via air freight for which we pay higher shipping rates. During the second and third quarters of 2006 our inability to deliver customer orders on a timely basis resulted in delayed sales and higher shipping costs which caused us to miss certain internal financial targets. If we cannot procure sufficient quantities of HEELYS-wheeled footwear to meet customer demand in a timely manner, or if the quality of our products declines, customers may cancel orders, refuse shipments, negotiate for reduced purchase prices or ask us to pay extraordinary shipping costs, any of which could have a material adverse effect on our customer relationships and operating results. Additionally, if any of our independent manufacturers fail or refuse to ship any orders for any reason, our business could be adversely affected.

Our operations are dependent upon the strength of our relationships with our retail customers and independent distributors and their success in selling our products, and a small number of retail customers and independent distributors are responsible for a significant percentage of our net sales.

Our success is dependent upon the willingness and ability of our retail customers to market and sell our products to consumers, as well as the success of our independent distributors in developing foreign markets for our products. For the year ended December 31, 2005, Big 5 Sporting Goods, Journeys and The Sports Authority were responsible for approximately 12.3%, 11.3% and 10.6% of our net sales, respectively. For the year ended December 31, 2006, Journeys accounted for approximately 12.7% of our net sales. If any of these or our other significant retail customers or independent distributors were to experience financial difficulties, reduce the quantity of our products it sells or stop selling our products, our financial condition and results of operations could be adversely affected.

We do not have long-term contracts with any of our retail customers or independent distributors, and the loss or material reduction in their business with us could result in reduced sales of our products.

Our retail customers and independent distributors generally purchase products from us on a purchase order basis and do not have long-term contracts with us. Consequently, with little or no notice and without penalty, our retail customers and independent distributors may terminate their relationship with us or materially reduce the level of their purchases of our products. If this were to occur with one or more retail customers or independent distributors who purchase significant quantities of our products, it may be difficult for us to establish substitute relationships in a timely manner, which could have a material adverse effect on our financial condition and results of operations.

We rely on our independent sales representatives for our domestic sales, and if our relationships with a material number of these representatives were terminated, it could result in reduced sales of our products.

We sell substantially all of our products domestically through our network of 19 independent sales representatives. We rely on these independent sales representatives to provide new customer prospects

and market our products to our retail customers. Our independent sales representatives do not sell our products exclusively and may terminate their relationships with us at any time with limited notice. Our ability to maintain and increase our domestic sales depends in large part on our success in maintaining relationships with our independent sales representatives on commercially reasonable terms. Any failure to maintain and develop new satisfactory relationships with independent sales representatives, or any failure of our independent sales representatives to effectively market our products, could adversely affect our domestic sales.

Our current information technology systems may be unable to support our growth, and planned improvements may be inadequate or may not be successfully implemented on a timely basis, which would adversely affect our ability to operate effectively.

We expect to upgrade and implement new information technology systems to facilitate our growth, streamline our financial reporting and improve our internal controls. We have identified a number of significant deficiencies related to the security of our information technology systems that may affect the timeliness and accuracy of recording transactions and which could become material weaknesses in future periods if not remedied. The deficiencies include our need to further enhance access privileges and password settings and provide for more frequent monitoring of production critical processes. In addition, we may experience difficulties in transitioning to new or upgraded systems, including the loss of data and diminished productivity as our personnel become familiar with our new systems. As we grow and our business needs change, we could experience difficulties associated with systems transitions. If we experience difficulties in implementing new or upgraded information technology systems or experience system failures, or if we are unable to successfully modify our information technology systems to respond to changes in our business, our ability to operate effectively could be adversely affected.

Our business could suffer if our independent manufacturers violate legal requirements or fail to conform to generally accepted ethical standards.

We expect our independent manufacturers to comply with applicable legal requirements and generally accepted ethical standards for working conditions and other matters. However, we do not control our independent manufacturers or their business practices. If any of our manufacturers were to use forced or indentured labor or child labor, fail to pay compensation in accordance with local law, fail to operate in compliance with local safety regulations or diverge from other applicable legal requirements or business practices generally accepted as ethical, we would take appropriate action, which could result in an interruption in our product supply. In addition, we could suffer negative publicity and damage to our reputation and the value of our HEELYS brand, which would adversely affect our business and results of operations.

If our independent manufacturers are unable to obtain raw materials, our costs could increase or the delivery of our products could be delayed, which could adversely affect our net sales and results of operations.

The production capacity of our independent manufacturers is dependent, in part, upon the availability of raw materials. Our manufacturers may experience shortages of raw materials, which could result in increased costs to us or delays in deliveries of our products from our manufacturers. As a result, we could experience cancellation of orders, refusal to accept deliveries or a reduction in our sales prices and profit margins, any of which could harm our net sales and results of operations.

Because our products are manufactured in Asia and a portion of our sales activities occur outside of the United States, we are subject to international business, political, operational, financial and economic risks that could adversely affect our net sales and results of operations.

Conducting business internationally entails numerous risks which could interrupt or otherwise adversely affect our business, including:

·        increased transportation costs;

·        delays and other logistical problems relating to the transportation of goods shipped by ocean freight;

·        work stoppages, strikes, lockouts or increased security concerns at seaports;

·        tariffs, import and export controls and other barriers, such as quotas and local content rules;

·        restrictions on the transfer of funds;

·        changing economic conditions;

·        changes in governmental policies and regulations;

·        limitations on the level of intellectual property protections;

·        poor or unstable infrastructure of certain foreign countries;

·        trade sanctions, political unrest, terrorism, war, epidemics and pandemics;

·        expropriation and nationalization; and

·        difficulties in understanding and complying with local laws, regulations and customs in foreign jurisdictions.

These factors and the failure to effectively respond to them could result in, among other things, poor quality in our products, product shortages, delivery delays, decreased net sales and increased costs.

We are subject to foreign exchange risk, and if the U.S. dollar significantly weakens compared to the currency in the markets where our products are produced, our manufacturers could increase the prices they charge us for our products, which could reduce our profitability.

We pay for our products and we pay commissions to our independent sourcing agent in U.S. dollars, and our independent distributors pay us in U.S. dollars. International sales accounted for approximately 35.1% of our net sales in 2004, 16.8% of our net sales in 2005 and 14.3% of our net sales in 2006. We do not engage in any foreign currency hedging transactions. If the U.S. dollar strengthens compared to the currency in the foreign markets where our products are sold, our products will be more expensive in those markets making them less attractive to consumers. If the U.S. dollar significantly weakens compared to the currency in the foreign markets where our products are produced, our manufacturers could increase the prices they charge us for our products, which could reduce our profitability. There can be no assurance that we can effectively mitigate our foreign exchange risk.

HEELYS-wheeled footwear could become subject to import duties in the United States, and if we cannot increase our prices to compensate for such duties, it could reduce our profitability.

HEELYS-wheeled footwear is currently classified by U.S. Customs and Border Protection as a skate, and as such we do not pay import duties to the United States. This customs classification can be changed at any time and, although we would vigorously oppose any proposed change, there can be no assurance that we would prevail. If the classification for HEELYS-wheeled footwear changed and HEELYS-wheeled

footwear became subject to an import duty, it might be difficult to increase our prices to compensate for any such duty, which could reduce our profitability.

Third parties may claim that we are infringing their intellectual property rights, and such claims may be costly to defend, may require us to pay licensing fees, damages or other amounts and may prevent or limit the manufacture, marketing or sale of our products.

Third parties may successfully claim that we are infringing their intellectual property rights. While we do not believe that any of our products infringe valid intellectual property rights of third parties, we may be unaware of the intellectual property rights of others that may cover some of our technology or products. For example, because many patent applications in the United States are not publicly disclosed immediately after they are filed, we could adopt technology without knowledge of a pending patent application, which technology would infringe a third-party patent once that patent is issued.

Our competitors in both the United States and foreign countries may have applied for or obtained, or may in the future apply for or obtain, patents that will prevent, limit or otherwise interfere with our ability to make, market or sell our products. Although we may conduct our own independent review of patents issued to certain third parties, we cannot assure you that we will be aware of all pre-existing technology that may subject us to patent litigation. If we are forced to defend against infringement claims, whether or not such claims are resolved in our favor, we could encounter expensive and time-consuming litigation which could divert the attention of our management and other key personnel from our business operations. Furthermore, if we are found to be infringing intellectual property rights of others, we could be required to pay licensing fees or damages. In addition, if we are not able to obtain license agreements on terms acceptable to us, or at all, we may be prevented from manufacturing, marketing or selling our products. As a result, our net sales could be significantly reduced and our cost of sales could be significantly increased, either of which could have an adverse effect on our business.

We are dependent on our management team and other personnel, and the failure to attract and retain such individuals could adversely affect our operations.

Our future success will depend in large part on our ability to retain Michael G. Staffaroni, Michael W. Hessong, Charles D. Beery and Patrick F. Hamner and to attract and retain other qualified managerial personnel. Our management and other employees can terminate their employment with us at any time, and we do not maintain key person life insurance. Our inability to attract or retain qualified employees, or the loss of any key employee, could harm our business and results of operations. We recently hired a Vice President—Marketing, a Vice President—Design and Development and a Vice President—Sourcing. Our failure to successfully integrate any of these individuals into our management team could adversely affect our business and results of operations.

We are subject to product liability, warranty and recall claims and our insurance coverage may not cover such claims, which could cause us to incur substantial costs and adversely affect our business.

Due to the inherent risk of injury related to the use of our products, our business exposes us to claims for product liability and warranty claims if our products actually or allegedly fail to perform as expected, or the use of our products results or is alleged to result in personal injury, disability or death. There can be no assurance that we will be able to successfully defend or settle the product liability claims and lawsuits to which we are and in the future may be subject.

We attach warning labels to our products and packaging relating to safe usage and the risk of injury. However, if a product liability claim is brought against us, the content of the warnings, the placement of them or both may be considered inadequate by courts, exposing us to liability. We cannot be certain that our safety warning labels are adequate. Product liability claims could result in us having to expend

significant time and expense to defend these claims and to pay, if necessary, settlement amounts or damages, which could adversely affect our financial condition. In addition, claims that use of our products resulted in an injury, disability or death could cause our HEELYS brand image and operating performance to suffer by damaging our reputation and prospects and by diverting the time and attention of our management, even if we are not at fault.

There can be no assurance that our product liability insurance coverage will be adequate, that our insurers will be financially viable when payment of a claim is required or that we will be able to obtain such insurance in the future on acceptable terms, if at all.

If any of our products are or are alleged to be defective, we may be required to recall that product. Any product recall could cause us to incur substantial cost, and irreparably harm our relationships with our customers, which could adversely affect our business.

Additional bans on the use of our HEELYS-wheeled footwear due to public safety and liability concerns could adversely affect our net sales and results of operations.

Various places of business and other institutions, such as shopping malls and schools, have imposed bans on the use of our HEELYS-wheeled footwear due to public safety and liability concerns. If the number of businesses and other institutions instituting such bans increases in the future, consumers could find our HEELYS-wheeled footwear less appealing, which could adversely affect our net sales and result of operations.

Expanding our distribution to mass merchants could have a material adverse effect on our gross margin, brand image and results of operations.

We sell our products to sporting goods retailers, specialty apparel and footwear retailers and select department stores in an effort to maintain a high-quality image for our HEELYS brand and premium price points for our products. Although we do not currently anticipate distributing to mass merchants, if we choose to do so in the future it could have a material adverse effect on our gross margin and could negatively affect our HEELYS brand image and our reputation with consumers, which could adversely affect our results of operations and financial condition.

Our operating results are subject to seasonal and quarterly variations in our net sales and net income, which could adversely affect the price of our common stock.

We have experienced, and expect to continue to experience, substantial seasonal and quarterly variations in our net sales and net income. These variations are primarily related to increased sales of our products during the holiday selling season. Our quarterly results of operations may also fluctuate significantly as a result of a variety of other factors, including, among other things, the timing of holidays and advertising initiatives and changes in our product mix. In addition, variations in weather conditions may significantly affect our results of operations.

As a result of these seasonal and quarterly fluctuations, we believe that comparisons of our operating results between different quarters within a single year are not necessarily meaningful and that these comparisons cannot be relied upon as indicators of our future performance. Any seasonal or quarterly fluctuations that we report in the future may differ from the expectations of market analysts and investors. This could cause the price of our common stock to fluctuate significantly.

As a relatively young consumer products company, we may not be able to compete effectively, which could have a negative impact on our sales and our business.

We compete with companies that sell to young consumers in several different product markets, including footwear, sporting goods and recreational products. These markets are intensely competitive and we expect competition to increase in the future. A number of our competitors have significantly greater financial, marketing, distribution and manufacturing resources than we do, as well as greater brand awareness in the markets in which they operate. We also compete with counterfeit, knockoff and infringing products, which are often sold at lower prices. If we fail to remain competitive with respect to the quality, design, price and timely delivery of products, our business, financial condition and results of operations could be materially adversely affected.

We may have difficulty identifying and successfully integrating acquisitions into our business and any acquisitions we make could result in adverse consequences.

We may make acquisitions of complementary companies and products. The pursuit of acquisitions may divert the attention of management and cause us to incur significant expenses identifying, investigating and pursuing suitable acquisitions, whether or not they are consummated.

We have limited experience acquiring other businesses and may not be able to successfully integrate any acquired operations with our business or effectively manage the combined business following an acquisition. We also may not achieve the anticipated benefits of an acquisition due to any of the following factors:

·        unanticipated costs associated with making the acquisition and operating the acquired business;

·        harm to our business relationships with independent manufacturers, retail customers and independent distributors;

·        loss of key employees of the acquired business; or

·        difficulties associated with entering product categories or markets in which we have little or no prior experience.

If we experience any of the difficulties noted above, our business and financial condition could be adversely affected.

The trading price of our common stock may fluctuate significantly.

Volatility in the trading price of our common stock may prevent you from being able to sell your shares of our common stock at prices equal to or greater than your purchase price. The trading price of our common stock could fluctuate significantly for various reasons, including:

·        our operating and financial performance and prospects;

·        our quarterly or annual earnings or those of other companies in our industry;

·        the public’s reaction to our press releases, other public announcements and filings with the SEC;

·        changes in earnings estimates or recommendations by research analysts who track our common stock or the stock of other companies in our industry;

·        strategic actions by us or our competitors;

·        new laws or regulations or new interpretations of existing laws or regulations applicable to our business;

·        changes in accounting standards, policies, guidance, interpretations or principles;

·        changes in general economic conditions in the United States and global economies or financial markets, including such changes resulting from war or incidents of terrorism; and

·        sales of our common stock by us or members of our management team.

In addition, in recent years, the stock market has experienced significant price and volume fluctuations. This volatility has had a significant impact on the trading price of securities issued by many companies, including companies in our industry. The changes frequently occur irrespective of the operating performance of the affected companies. Hence, the trading price of our common stock could fluctuate based upon factors that have little or nothing to do with our business.

Existing stockholders significantly influence our corporate governance.

As of December 31, 2006 our executive officers, key employees, directors and their affiliates beneficially owned, in the aggregate, approximately 71% of our outstanding common stock. In addition, Capital Southwest Venture Corporation, or “CSVC,” which owns approximately 34.5% of our common stock, has the contractual right to designate (i) two nominees for director to be included in management’s slate of director nominees, so long as it owns at least 15% of the outstanding shares of our common stock, and (ii) one such nominee so long as it owns at least 10%, but less than 15%, of the outstanding shares of our common stock. As a result, through its designees, CSVC may significantly influence our corporate governance.

Our Certificate of Incorporation and By-Laws and Delaware law contain provisions that could discourage a third party from acquiring us and consequently decrease the value of an investment in our common stock.

Our Certificate of Incorporation and By-Laws and Delaware corporate law contain provisions that could delay or prevent a change in control of our company or changes in our management. Among other things, these provisions:

·        authorize our board of directors, without prior stockholder approval, to issue preferred stock with rights, privileges and preferences, including voting rights, senior to those of our common stock;

·        prohibit stockholder action by written consent, thereby requiring all stockholder actions to be taken at a meeting of our stockholders;

·        establish advance notice requirements for submitting nominations for election to the board of directors and for proposing matters that can be acted upon by stockholders at a meeting; and

·        impose restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding common stock.

These provisions could discourage proxy contests, make it more difficult for our stockholders to elect directors and take other corporate actions and may discourage, delay or prevent a change in control or changes in our management that a stockholder might consider favorable. Any delay or prevention of a change in control or change in management that stockholders might otherwise consider to be favorable could deprive you of the opportunity to sell your common stock at a price in excess of the prevailing trading price and cause the trading price of our common stock to decline.

As a public company, we will be required to meet periodic reporting requirements under SEC rules and regulations. Complying with federal securities laws as a public company is expensive and we will incur significant time and expense enhancing, documenting, testing and certifying our internal control over financial reporting. Any deficiencies in our financial reporting or internal controls could adversely affect our business and the trading price of our common stock.

SEC rules require that, as a publicly traded company, we file periodic reports containing our financial statements within a specified time following the completion of quarterly and annual periods. Prior to the completion of our initial public offering in December 2006, we were not required to comply with SEC requirements to have our financial statements completed and reviewed or audited within a specified time and, as such, we may experience difficulty in meeting the SEC’s reporting requirements. Any failure by us to file our periodic reports with the SEC in a timely manner could harm our reputation and reduce the trading price of our common stock.

As a public company we will incur significant legal, accounting, insurance and other expenses. The Sarbanes-Oxley Act of 2002, as well as compliance with other SEC and Nasdaq rules, will increase our legal and financial compliance costs and make some activities more time-consuming and costly. Furthermore, SEC rules require that our chief executive officer and chief financial officer periodically certify the existence and effectiveness of our internal control over financial reporting. Our independent registered public accounting firm will be required, beginning with our Annual Report on Form 10-K for our fiscal year ending on December 31, 2007, to attest to our assessment of our internal control over financial reporting. This process generally requires significant documentation of policies, procedures and systems, review of that documentation by our internal accounting staff and our outside auditors and testing of our internal control over financial reporting by our internal accounting staff and our outside independent registered public accounting firm. Documentation and testing of our internal controls, which we have not undertaken in the past, will involve considerable time and expense, may strain our internal resources and have an adverse impact on our operating costs.

During the course of our testing, we may identify deficiencies which would have to be remediated to satisfy the SEC rules for certification of our internal control over financial reporting. As a consequence, we may have to disclose in periodic reports we file with the SEC significant deficiencies or material weaknesses in our system of internal controls. The existence of a material weakness would preclude management from concluding that our internal control over financial reporting is effective, and would preclude our independent auditors from issuing an unqualified opinion that our internal control over financial reporting is effective. In addition, disclosures of this type in our SEC reports could cause investors to lose confidence in our financial reporting and may negatively affect the trading price of our common stock. Moreover, effective internal controls are necessary to produce reliable financial reports and to prevent fraud. If we have deficiencies in our disclosure controls and procedures or internal control over financial reporting it may negatively impact our business, results of operations and reputation.

Item 1B.                   Unresolved Staff Comments

None.