| JAKKS PACIFIC INC Item 1A Risk Factors From time to time, including in this Annual Report on Form 10-K, we publish forward-looking statements, as disclosed in our Disclosure Regarding Forward-Looking Statements, beginning immediately following the Table of Contents of this Annual Report |
| We note that a variety of factors could cause our actual results and experience to differ materially from the anticipated results or other expectations expressed or anticipated in our forward-looking statements |
| The factors listed below are illustrative of the risks and uncertainties that may arise and that may be detailed from time to time in our public announcements and our filings with the Securities and Exchange Commission, such as on Forms 8-K, 10-Q and 10-K We undertake no obligation to make any 13 _________________________________________________________________ [55]Table of Contents revisions to the forward-looking statements contained in this Annual Report on Form 10-K to reflect events or circumstances occurring after the date of the filing of this report |
| The outcome of litigation in which we have been named as a defendant is unpredictable and a materially adverse decision in any such matter could have a material adverse affect on our financial position and results of operations |
| We are defendants in litigation matters, as described under “Legal Proceedings” in our periodic reports filed pursuant to the Securities Exchange Act of 1934, including the lawsuit commenced by WWE and the purported securities class action and derivative action claims stemming from the WWE lawsuit (see “Legal Proceedings”) |
| These claims may divert financial and management resources that would otherwise be used to benefit our operations |
| Although we believe that we have meritorious defenses to the claims made in each and all of the litigation matters to which we have been named a party, and intend to contest each lawsuit vigorously, no assurances can be given that the results of these matters will be favorable to us |
| A materially adverse resolution of any of these lawsuits could have a material adverse affect on our financial position and results of operations |
| Our inability to redesign, restyle and extend our existing core products and product lines as consumer preferences evolve, and to develop, introduce and gain customer acceptance of new products and product lines, may materially and adversely impact our business, financial condition and results of operations |
| Our business and operating results depend largely upon the appeal of our products |
| Our continued success in the toy industry will depend on our ability to redesign, restyle and extend our existing core products and product lines as consumer preferences evolve, and to develop, introduce and gain customer acceptance of new products and product lines |
| Several trends in recent years have presented challenges for the toy industry, including: • The phenomenon of children outgrowing toys at younger ages, particularly in favor of interactive and high technology products; • Increasing use of technology; • Shorter life cycles for individual products; and • Higher consumer expectations for product quality, functionality and value |
| We cannot assure you that: • our current products will continue to be popular with consumers; • the product lines or products that we introduce will achieve any significant degree of market acceptance; or • the life cycles of our products will be sufficient to permit us to recover licensing, design, manufacturing, marketing and other costs associated with those products |
| Our failure to achieve any or all of the foregoing benchmarks may cause the infrastructure of our operations to fail, thereby adversely affecting our business, financial condition and results of operations |
| 14 _________________________________________________________________ [56]Table of Contents The failure of our character-related and theme-related products to become and/or remain popular with children may materially and adversely impact our business, financial condition and results of operations |
| The success of many of our character-related and theme-related products depends on the popularity of characters in movies, television programs, live wrestling exhibitions, auto racing events and other media |
| We cannot assure you that: • media associated with our character-related and theme-related product lines will be released at the times we expect or will be successful; • the success of media associated with our existing character-related and theme-related product lines will result in substantial promotional value to our products; • we will be successful in renewing licenses upon expiration on terms that are favorable to us; or • we will be successful in obtaining licenses to produce new character-related and theme-related products in the future |
| There are risks associated with our license agreements |
| • Our current licenses require us to pay minimum royalties Sales of products under trademarks or trade or brand names licensed from others account for substantially all of our net sales |
| Product licenses allow us to capitalize on characters, designs, concepts and inventions owned by others or developed by toy inventors and designers |
| Our license agreements generally require us to make specified minimum royalty payments, even if we fail to sell a sufficient number of units to cover these amounts |
| In addition, under certain of our license agreements, if we fail to achieve certain prescribed sales targets, we may be unable to retain or renew these licenses |
| • Some of our licenses are restricted as to use Under many of our license agreements, including WWE and Nickelodeon, the licensors have the right to review and approve our use of their licensed products, designs or materials before we may make any sales |
| If a licensor refuses to permit our use of any licensed property in the way we propose, or if their review process is delayed, our development or sale of new products could be impeded |
| • New licenses are difficult and expensive to obtain Our continued success will depend substantially on our ability to obtain additional licenses |
| Intensive competition exists for desirable licenses in our industry |
| We cannot assure you that we will be able to secure or renew significant licenses on terms acceptable to us |
| In addition, as we add licenses, the need to fund additional royalty advances and guaranteed minimum royalty payments may strain our cash resources |
| • A limited number of licensors account for a large portion of our net sales We derive a significant portion of our net sales from a limited number of licensors |
| If one or more of these licensors were to terminate or fail to renew our license or not grant us new licenses, our business, financial condition and results of operations could be adversely affected |
| 15 _________________________________________________________________ [57]Table of Contents The toy industry is highly competitive and our inability to compete effectively may materially and adversely impact our business, financial condition and results of operations |
| The toy industry is highly competitive |
| Globally, certain of our competitors have financial and strategic advantages over us, including: • greater financial resources; • larger sales, marketing and product development departments; • stronger name recognition; • longer operating histories; and • greater economies of scale |
| In addition, the toy industry has no significant barriers to entry |
| Competition is based primarily on the ability to design and develop new toys, to procure licenses for popular characters and trademarks and to successfully market products |
| Many of our competitors offer similar products or alternatives to our products |
| Our competitors have obtained and are likely to continue to obtain licenses that overlap our licenses with respect to products, geographic areas and markets |
| We cannot assure you that we will be able to obtain adequate shelf space in retail stores to support our existing products or to expand our products and product lines or that we will be able to continue to compete effectively against current and future competitors |
| An adverse outcome in the litigation commenced against us by WWE or a decline in the popularity of WWE could adversely impact our video game joint venture with THQ The joint venture with THQ depends entirely on a single license, which gives the venture exclusive worldwide rights to produce and market video games based on World Wrestling Entertainment characters and themes |
| An adverse outcome against us, THQ or the joint venture in the lawsuit commenced by WWE (see the first Risk Factor, above) would adversely impact our rights under the joint venture’s single license, which would adversely effect the joint venture’s and our business, financial condition and results of operation |
| Furthermore, the popularity of professional wrestling, in general, and World Wrestling Entertainment, in particular, is subject to changing consumer tastes and demands |
| The relative popularity of professional wrestling has fluctuated significantly in recent years |
| A decline in the popularity of World Wrestling Entertainment could adversely affect the joint venture’s and our business, financial condition and results of operations |
| The termination of THQ’s manufacturing licenses and the inability of the joint venture to otherwise obtain these licenses from other manufacturers would materially adversely affect the joint venture’s and our business, financial condition and results of operations |
| The joint venture relies on hardware manufacturers and THQ’s non-exclusive licenses with them for the right to publish titles for their platforms and for the manufacture of the joint venture’s titles |
| If THQ’s manufacturing licenses were to terminate and the joint venture could not otherwise obtain these licenses from other manufacturers, the joint venture would be unable to publish additional titles for these manufacturers’ platforms, which would materially adversely affect the joint venture’s and our business, financial condition and results of operations |
| 16 _________________________________________________________________ [58]Table of Contents The failure of the joint venture or THQ to perform as anticipated could have a material adverse affect on our financial position and results of operations |
| The joint venture’s failure to timely develop titles for new platforms that achieve significant market acceptance, to maintain net sales that are commensurate with product development costs or to maintain compatibility between its personal computer CD-ROM titles and the related hardware and operating systems would adversely affect the joint venture’s and our business, financial condition and results of operations |
| Furthermore, THQ controls the day-to-day operations of the joint venture and all of its product development and production operations |
| Accordingly, the joint venture relies exclusively on THQ to manage these operations effectively |
| THQ’s failure to effectively manage the joint venture would have a material adverse effect on the joint venture’s and our business and results of operations |
| We are also dependent upon THQ’s ability to manage cash flows of the joint venture |
| If THQ is required to retain cash for operations, or because of statutory or contractual restrictions, we may not receive cash payments for our share of profits, on a timely basis, or at all |
| The amount of preferred return that we receive from the joint venture after June 30, 2006 is subject to change, which could adversely affect our results of operations |
| Through June 30, 2006, we are entitled to receive a guaranteed percentage preferred return from the joint venture at varying rates of net sales of the video games depending on the cumulative unit sales and platform of each particular game, as well as on the royalties earned by the joint venture from the publishing of game guides by third parties |
| We are now in negotiations with THQ to determine our preferred return from the joint venture subsequent to June 30, 2006 |
| In the event we are unable to reach an agreement with THQ on such issue, our joint venture agreement with THQ provides that the determination of the preferred return will be submitted to arbitration |
| Any resulting change to the preferred return, depending on the level thereof and the ongoing performance of the joint venture, may result in our experiencing reduced net income, which would adversely affect our results of operations |
| We may not be able to sustain or manage our rapid growth, which may prevent us from continuing to increase our net revenues |
| We have experienced rapid growth in our product lines resulting in higher net sales over the last six years, which was achieved through acquisitions of businesses, products and licenses |
| For example, revenues associated with companies we acquired since 2003 were approximately dlra67dtta1 million and dlra168dtta9 million, in 2005 and 2004, respectively, representing 10dtta1prca and 29dtta4prca of our total revenues for those periods |
| As a result, comparing our period-to-period operating results may not be meaningful and results of operations from prior periods may not be indicative of future results |
| We cannot assure you that we will continue to experience growth in, or maintain our present level of, net sales |
| Our growth strategy calls for us to continuously develop and diversify our toy business by acquiring other companies, entering into additional license agreements, refining our product lines and expanding into international markets, which will place additional demands on our management, operational capacity and financial resources and systems |
| The increased demand on management may necessitate our recruitment and retention of qualified management personnel |
| We cannot assure you that we will be able to recruit and retain qualified personnel or expand and manage our operations effectively and profitably |
| To effectively manage future growth, we must continue to 17 _________________________________________________________________ [59]Table of Contents expand our operational, financial and management information systems and to train, motivate and manage our work force |
| There can be no assurance that our operational, financial and management information systems will be adequate to support our future operations |
| Failure to expand our operational, financial and management information systems or to train, motivate or manage employees could have a material adverse effect on our business, financial condition and results of operations |
| In addition, implementation of our growth strategy is subject to risks beyond our control, including competition, market acceptance of new products, changes in economic conditions, our ability to obtain or renew licenses on commercially reasonable terms and our ability to finance increased levels of accounts receivable and inventory necessary to support our sales growth, if any |
| Accordingly, we cannot assure you that our growth strategy will continue to be implemented successfully |
| If we are unable to acquire and integrate companies and new product lines successfully, we will be unable to implement a significant component of our growth strategy |
| Our growth strategy depends in part upon our ability to acquire companies and new product lines |
| Revenues associated with our acquisitions since 2003 represented approximately 10dtta1prca and 29dtta4prca of our total revenues in 2005 and 2004, respectively |
| Future acquisitions will succeed only if we can effectively assess characteristics of potential target companies and product lines, such as: • attractiveness of products; • suitability of distribution channels; • management ability; • financial condition and results of operations; and • the degree to which acquired operations can be integrated with our operations |
| We cannot assure you that we can identify attractive acquisition candidates or negotiate acceptable acquisition terms, and our failure to do so may adversely affect our results of operations and our ability to sustain growth |
| Our acquisition strategy involves a number of risks, each of which could adversely affect our operating results, including: • difficulties in integrating acquired businesses or product lines, assimilating new facilities and personnel and harmonizing diverse business strategies and methods of operation; • diversion of management attention from operation of our existing business; • loss of key personnel from acquired companies; and • failure of an acquired business to achieve targeted financial results |
| A limited number of customers account for a large portion of our net sales, so that if one or more of our major customers were to experience difficulties in fulfilling their obligations to us, cease doing business with us, significantly reduce the amount of their purchases from us or return substantial amounts of our products, it could have a material adverse effect on our business, financial condition and results of operations |
| Our three largest customers accounted for 59dtta1prca of our net sales in 2005 |
| Except for outstanding purchase orders for specific products, we do not have written contracts with or commitments from any of our customers |
| A substantial reduction in or termination of orders from any of our largest customers could adversely affect our business, financial condition and results of operations |
| In addition, pressure by large customers seeking price reductions, financial incentives, changes in other terms of sale or for us to bear the risks and the cost of carrying inventory also 18 _________________________________________________________________ [60]Table of Contents could adversely affect our business, financial condition and results of operations |
| If one or more of our major customers were to experience difficulties in fulfilling their obligations to us, cease doing business with us, significantly reduce the amount of their purchases from us or return substantial amounts of our products, it could have a material adverse effect on our business, financial condition and results of operations |
| In addition, the bankruptcy or other lack of success of one or more of our significant retailers could negatively impact our revenues and bad debt expense |
| We depend on our key personnel and any loss or interruption of either of their services could adversely affect our business, financial condition and results of operations |
| Our success is largely dependent upon the experience and continued services of Jack Friedman, our Chairman and Chief Executive Officer and Stephen G Berman, our President and Chief Operating Officer |
| We cannot assure you that we would be able to find an appropriate replacement for Mr |
| Friedman or Mr |
| Berman if the need should arise, and any loss or interruption of Mr |
| Friedman’s or Mr |
| Berman’s services could adversely affect our business, financial condition and results of operations |
| We depend on third-party manufacturers, and if our relationship with any of them is harmed or if they independently encounter difficulties in their manufacturing processes, we could experience product defects, production delays, cost overruns or the inability to fulfill orders on a timely basis, any of which could adversely affect our business, financial condition and results of operations |
| We depend on over forty third-party manufacturers who develop, provide and use the tools, dies and molds that we own to manufacture our products |
| However, we have limited control over the manufacturing processes themselves |
| As a result, any difficulties encountered by the third-party manufacturers that result in product defects, production delays, cost overruns or the inability to fulfill orders on a timely basis could adversely affect our business, financial condition and results of operations |
| We do not have long-term contracts with our third-party manufacturers |
| Although we believe we could secure other third-party manufacturers to produce our products, our operations would be adversely affected if we lost our relationship with any of our current suppliers or if our current suppliers’ operations or sea or air transportation with our overseas manufacturers were disrupted or terminated even for a relatively short period of time |
| Our tools, dies and molds are located at the facilities of our third-party manufacturers |
| Although we do not purchase the raw materials used to manufacture our products, we are potentially subject to variations in the prices we pay our third-party manufacturers for products, depending on what they pay for their raw materials |
| We have substantial sales and manufacturing operations outside of the United States subjecting us to risks common to international operations |
| We sell products and operate facilities in numerous countries outside the United States |
| For the year ended December 31, 2005, sales to our international customers comprised approximately 15dtta0prca of our net sales |
| We expect our sales to international customers to account for a greater portion of our revenues in future fiscal periods |
| Additionally, we utilize third-party manufacturers 19 _________________________________________________________________ [61]Table of Contents located principally in The People’s Republic of China (“China”) which are subject to the risks normally associated with international operations, including: • currency conversion risks and currency fluctuations; • limitations, including taxes, on the repatriation of earnings; • political instability, civil unrest and economic instability; • greater difficulty enforcing intellectual property rights and weaker laws protecting such rights; • complications in complying with laws in varying jurisdictions and changes in governmental policies; • greater difficulty and expenses associated with recovering from natural disasters; • transportation delays and interruptions; and • the potential imposition of tariffs |
| • the pricing of intercompany transactions may be challenged by taxing authorities in both Hong Kong and the United States, with potential increases in income taxes |
| Our reliance on external sources of manufacturing can be shifted, over a period of time, to alternative sources of supply, should such changes be necessary |
| However, if we were prevented from obtaining products or components for a material portion of our product line due to medical, political, labor or other factors beyond our control, our operations would be disrupted while alternative sources of products were secured |
| Also, the imposition of trade sanctions by the United States against a class of products imported by us from, or the loss of “normal trade relations” status by China, could significantly increase our cost of products imported from that nation |
| Because of the importance of our international sales and international sourcing of manufacturing to our business, our financial condition and results of operations could be significantly and adversely affected if any of the risks described above were to occur |
| Our business is subject to extensive government regulation and any violation by us of such regulations could result in product liability claims, loss of sales, diversion of resources, damage to our reputation, increased warranty costs or removal of our products from the market, and we cannot assure you that our product liability insurance for the foregoing will be sufficient |
| Our business is subject to various laws, including the Federal Hazardous Substances Act, the Consumer Product Safety Act, the Flammable Fabrics Act and the rules and regulations promulgated under these acts |
| These statutes are administered by the Consumer Product Safety Commission (“CPSC”), which has the authority to remove from the market products that are found to be defective and present a substantial hazard or risk of serious injury or death |
| The CPSC can require a manufacturer to recall, repair or replace these products under certain circumstances |
| We cannot assure you that defects in our products will not be alleged or found |
| Any such allegations or findings could result in: • product liability claims; • loss of sales; • diversion of resources; • damage to our reputation; • increased warranty costs; and • removal of our products from the market |
| 20 _________________________________________________________________ [62]Table of Contents Any of these results may adversely affect our business, financial condition and results of operations |
| There can be no assurance that our product liability insurance will be sufficient to avoid or limit our loss in the event of an adverse outcome of any product liability claim |
| We depend on our proprietary rights and our inability to safeguard and maintain the same, or claims of third parties that we have violated their intellectual property rights, could have a material adverse effect on our business, financial condition and results of operations |
| We rely on trademark, copyright and trade secret protection, nondisclosure agreements and licensing arrangements to establish, protect and enforce our proprietary rights in our products |
| The laws of certain foreign countries may not protect intellectual property rights to the same extent or in the same manner as the laws of the United States |
| We cannot assure you that we or our licensors will be able to successfully safeguard and maintain our proprietary rights |
| Further, certain parties have commenced legal proceedings or made claims against us based on our alleged patent infringement, misappropriation of trade secrets or other violations of their intellectual property rights |
| We cannot assure you that other parties will not assert intellectual property claims against us in the future |
| These claims could divert our attention from operating our business or result in unanticipated legal and other costs, which could adversely affect our business, financial condition and results of operations |
| Market conditions and other third-party conduct could negatively impact our margins and implementation of other business initiatives |
| Economic conditions, such as rising fuel prices and decreased consumer confidence, may adversely impact our margins |
| In addition, general economic conditions were significantly and negatively affected by the September 11th terrorist attacks and could be similarly affected by any future attacks |
| Such a weakened economic and business climate, as well as consumer uncertainty created by such a climate, could adversely affect our sales and profitability |
| Other conditions, such as the unavailability of electronics components, may impede our ability to manufacture, source and ship new and continuing products on a timely basis |
| Significant and sustained increases in the price of oil could adversely impact the cost of the raw materials used in the manufacture of our products, such as plastic |
| We may not have the funds necessary to purchase our outstanding convertible senior notes upon a fundamental change or other purchase date, as required by the indenture governing the notes |
| On June 15, 2010, June 15, 2013 and June 15, 2018, holders of our convertible senior notes may require us to purchase their notes, which repurchase may be made for cash |
| In addition, holders may also require us to purchase their notes for cash upon the occurrence of certain fundamental changes in our board composition or ownership structure, if we liquidate or dissolve under certain circumstances or if our common stock ceases being quoted on an established over-the-counter trading market in the United States |
| If we do not have, or have access to, sufficient funds to repurchase the notes, then we could be forced into bankruptcy |
| In fact, we expect that we would require third-party financing, but we cannot assure you that we would be able to obtain that financing on favorable terms or at all |
| We have a material amount of goodwill which, if it becomes impaired, would result in a reduction in our net income |
| Goodwill is the amount by which the cost of an acquisition accounted for using the purchase method exceeds the fair value of the net assets we acquire |
| Current accounting standards require that goodwill no longer be amortized but instead be periodically evaluated for impairment based on 21 _________________________________________________________________ [63]Table of Contents the fair value of the reporting unit |
| As at December 31, 2005, we have not had any impairment of Goodwill, which is reviewed on a quarterly basis and formally evaluated on an annual basis |
| At December 31, 2005, approximately dlra269dtta3 million, or 36dtta0prca, of our total assets represented goodwill |
| Declines in our profitability may impact the fair value of our reporting units, which could result in a further write-down of our goodwill |
| Reductions in our net income caused by the write-down of goodwill would adversely affect our results of operations |