MEGA Brands Inc.

Transcription

MEGA Brands Inc.

MEGA Brands Inc.
Annual Repor t 2 0 0 6
Financial Highlights
Years Ended December 31
2002
2003
2004
2005
2006
188,807
219,691
234,581
384,863
547,347
132,160
56,647
138,041
81,650
132,744
101,837
254,318
130,545
397,778
149,569
-
-
-
291,576
93,287
333,667
213,680
Gross profit
89,991
102,447
105,922
170,195
218,525
Net earnings
Net earnings before Specified Items (2)
20,166
20,166
28,805
28,805
25,177
25,177
39,608
39,608
25,348
53,2 17
0.83
0.76
1.07
0.98
0.93
0.86
1.35
1.26
1.65
1.56
(U.S. $ thousands, except per share data)
(1)
Net sales
Geographic Segmentation
North America
International
Product Segmentation
Toys
Stationery & Activities
Earnings per share before Specified Items (2)
Basic
Diluted
(1)
Net sales and gross profit in 2005 and 2006 were restated according to EIC-156, ''Accounting by a Vendor for Consideration Given to a Customer (Including a Reseller of
the Vendor's Product)''. Such restatement does not have an impact on net earnings. Please refer to the section titled “Adoption of EIC-156” on page 13 of the Management
Discussion and Analysis (‘MD&A”).
(2) Net earnings before Specified Items and Earnings per share before Specified Items do not have any standardized meaning under Canadian Generally Accepted Accounting
Principles (“GAAP”) and are therefore unlikely to be comparable to similar measures presented by other companies. The Corporation believes this to be a relevant measure
because it excludes items that are not typical of ongoing operations. Please refer to the section titled “Specified Items Affecting Operations” on page 9 of the MD&A.
547.3
Net Sales
Segmented Sales 2006
US$ Millions
384.9
219.7
Stationery
& Activities
234.6
39%
188.8
International
Toys
61%
27%
North America
73%
By Product Lines
2002
2003
2004
2005
2006
By Geographic Market
Our Mission is
to nurture creativity
in every child
and every family.
MEGA Brands is a trusted family of leading
global brands in construction toys, games & puzzles,
arts & crafts and stationery.
MEGA Brands provides stimulating
creative experiences through
innovative, well-designed, affordable
and high-quality products.
Toys
Preschool Construction
Products:
Market Position: #1 Worldwide
Building blocks, character role-play, vehicles
Growth drivers: Licenses, educational benefits of block play, wider product
range reaching broader target age, new play patterns,
products and geographic markets
New in 2007:
Building Imagination Bag
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M EGA B ra n d s Annual Repor t 20 0 6
Building Imagination Bag, Dora the Explorer and Go Diego Go!,
Cars, CAT® Ride-On
Toys
Boys 5+ Construction
Products:
Building sets, character role-play, vehicles
Growth drivers: Market share gains in existing markets, new play patterns,
products and geographic markets
New in 2007:
NEO Shifters™, Plasma Dragons™,
Pirates of the Caribbean: At World’s End, Spider-Man 3
NEO Shifters™
3
Toys
Magnetix
Products:
Building sets, character role-play, vehicles
Growth drivers: New play patterns, storage expansion and new geographic markets
New in 2007:
iCoaster™, Build-off Cases, MagnaFormers™
iCoaster™
4
Toys
Games & Puzzles
Products:
Market Position: #2 North America*
Games & Puzzles for all ages
Growth drivers: New designs and themes, top licenses, breadth of product portfolio
New in 2007:
Disney® properties,Triazzle, Fairy Princess Game
*(Puzzles)
Esphera Puzzle
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Activities
Products:
Market Position: #2 North America
Craft, art and role-play activities, flocked posters, jewelry,
dough, scrapbooking, easels & furniture
Growth drivers: Market share gains in North America, new geographic markets,
play patterns and products
New in 2007:
Rose Art smART easel™
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Rose Art smART easel™, B’Chic™, On the Go™,
Disney® Arts & Crafts, new packaging, new international markets
Art Materials
Products:
Crayons, colored pencils, children’s markers, glue,
paints & brushes, chalk
Growth drivers: New distribution channels, new geographic markets,
products and categories
New in 2007:
Color Start™, Pix™, new packaging
*(Food, drug and mass retailers)
Crayons
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Writing Instruments
Products:
Pens, mechanical pencils, woodcase pencils,
adult markers and highlighters
Growth drivers: New distribution channels, geographic markets,
products and categories
New in 2007:
SRX™, entry in new markets, new packaging
*(Food, drug and mass retailers)
Pens
8
Boards & Accessories
Products:
Market Position: #2 North America
Dry erase and cork presentation boards, dry erase markers
and erasers, locker organizers
Growth drivers: New distribution channels, products and categories
New in 2007:
Penetration in office superstores
Dry erase board
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Chairman’s Letter
Dear Shareholders,
ver the course of 40 years, MEGA Brands has earned
an enviable reputation with consumers worldwide.
Millions of families trust us to deliver quality products
that offer stimulating, fun and educational play experiences
for children. This is the foundation on which our company
was built and this global equity with the consumer will
never be compromised.
O
In 2006 and in the first quarter of 2007, our company faced
many challenges with the Magnetix® product recall, management changes and integration, resulting in some disruptions
to financial performance. The management team, supported
by more than 6,000 dedicated employees worldwide,
responded diligently in the interest of maintaining long-term
shareholder value.
As the founder and as a major shareholder of this company,
I feel very confident about its fundamental strengths.
MEGA Brands has a unique portfolio of creative products
to market across a global distribution platform. Most
important of all, our company has an exceptional capacity
for innovation which was highlighted again in 2006 with over
60 awards. In our business, the combination of trusted
brands and a culture of innovation is the powerful driver
of long-term value.
Dr. Toy's Best Vacation Toys
(Small Maxi Bag)
10
The Toy Insider Hot 20 Toys
for the Holiday Season
(POTC Black Pearl)
Acknowledgements
I take this opportunity to thank the members of our Board of
Directors for their counsel and their dedication to their
responsibilities as directors and committee chairs. In 2006,
we welcomed Dr. Larry Light, an internationally renowned
marketing professional as well as Daniel T. Motulsky, Partner
and Managing Director of the global investment bank Lazard
Frères & Co., to the board as independent directors. We also
bid adieu to David I. Foley and Michel Coutu, who deserve
our gratitude for their years of service to the company.
In closing, I would like to acknowledge with a special
thank you, the perseverance and passion of the global
MEGA Brands team.
Victor J. Bertrand Sr.
Chairman and Founder
Learning Magazine's
Teachers' Choice Award
(Magtastik™ Starter Set)
The National Parenting Center
2006 Seal of Appproval
(Tiny'n Tuff® Off-Road Set™)
Message to Shareholders
M
EGA Brands has an exceptional creative products
portfolio, strong license partners and great brands.
In North America, we are the #1 or #2 player in most of
our major product segments, we are #2 worldwide in construction toys, and we have many opportunities to build on our
leading positions and enter new categories across the globe.
Parents' Choice Award
(CAT® Construction Site)
Oppenheim Toy Portfolio
Best Toy Award Gold Seal
(Lil’ Train™)
Our growth strategy — based on innovation, licensing, international market penetration and acquisitions — will continue
to generate long-term shareholder value. For 2007, we have
highlighted in the preceding pages some of the exciting
new products that will lead our performance.
North America
Our preschool segment is in great shape and our leadership
position continues to improve. Growing demand for
Mega Bloks® building toys, the successful launch of Dora
and Diego and the upcoming launches of Disney Cars and our
Caterpillar products will contribute incremental sales
through the rest of the year.
In Boys 5-plus, we are off to a great start with shipments
of Pirates of the Caribbean and Spider-Man construction
sets and a positive consumer response to our new
Dragons™ line. The highlight of our second half in this
category is NEO Shifters™, a new and exciting collection
of buildable robots.
The Magnetix® range will feature more new play patterns,
the most exciting being iCoaster™, the world’s first magnetpowered toy roller coaster with a music mixing studio that
works with all popular MP3 players.
In art materials, many new innovations will fuel continued
growth, including Pix™ mess-free art sets and Color Start™,
which are hitting retail shelves starting in the third quarter
of 2007. Our Boards segment is growing with important new
distribution in the office supply channel.
International
Our international business continues to be a strong growth
engine for our company. Our strategy is to increase our share
of existing markets, penetrate new territories and introduce
Stationery & Activities to our international customer base.
In construction, the combination of Mega Bloks® and
Magnetix® makes us stronger. We are gaining market share
globally and in 2006, we captured the #1 position in the
United Kingdom and Spain. In Stationery & Activities, we have
strengthened our sales team in several countries and are
launching our exciting new products worldwide.
Outlook
With strong execution from our global team and the
continued support of our retail partners worldwide,
we believe MEGA Brands is well positioned for growth.
The fundamentals of our business are strong. After a challenging
year in 2006 with many unexpected events, we are focused
on delivering strong operating results in 2007.
For the long-term, we have a sound growth strategy, a unique
creative products portfolio and a talented and experienced
global team to drive results.
Creativity to the Rescue.
In Games & Puzzles, we are launching new games and adding
many new Disney themes to our puzzle assortment.
In Stationery & Activities, we are bringing innovation, strong
licenses and a fresh new look to our lines. Our key driver for
fall is the Rose Art smART easel™, a collapsible, easy-to-store,
portable easel that comes with its own art supplies. For girls,
our new B’Chic™ brand leads the way. We are also introducing
Brian the Brain™, a digital roommate with unique features
that permit personal interaction with kids via text to speech
and voice recognition.
Marc Bertrand
President and
Chief Executive Officer
Vic Bertrand
Chief Operating Officer
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Directors & Executive Officers
Directors
Executive Officers
Victor J. Bertrand
Chairman of the Board
MEGA Brands Inc.
Marc Bertrand
President and Chief Executive Officer
Marc Bertrand
MEGA Brands Inc.
Vic Bertrand
MEGA Brands Inc.
Jean-Guy Desjardins
Chairman and Chief Executive Officer
Centria Inc. and Fiera YMG Cap.
Kathleen Campisano
Executive Vice-President
and Chief Marketing Officer
Sylvain Duval
Executive Vice-President Global Operations
Al Hunyadi
President Stationery & Activities
Dr. Larry Light
Arcature LLP
Michel Moggio
Vice-President International
Peter T. Main
Company Director and Consultant
Alain Tanguay
Executive Vice-President
and Chief Financial Officer
Daniel T. Motulsky
Managing Director
Lazard Frères & Co.
Paula Roberts
Vice-President Strategic Communications
SickKids Foundation
12
Vic Bertrand
Gerardo Yepez Reyna
President Toys
MANAGEMENT’S DISCUSSION AND ANALYSIS
AND
CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006 and 2005
TABLE OF CONTENTS
MANAGEMENT’S DISCUSSION AND ANALYSIS
Forward-Looking Statements..............................................................................................................................................3
Corporate Overview ............................................................................................................................................................4
Industry Overview ...............................................................................................................................................................4
Strategy, Objectives and 2006 Developments ...................................................................................................................5
Selected Financial Information .........................................................................................................................................11
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005..........................................................13
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004..........................................................17
Liquidity and Capital Resources.......................................................................................................................................18
Selected Quarterly Financial Information ........................................................................................................................20
Three-Month Period Ended December 31, 2006 Compared to Three-Month Period Ended December 31, 2005......20
Shares Outstanding ............................................................................................................................................................22
Significant Accounting Policies and Use of Estimates ...................................................................................................22
Risks and Uncertainties.....................................................................................................................................................27
CONSOLIDATED FINANCIAL STATEMENTS
Management’s Responsibility for Financial Reporting ..................................................................................................34
Auditors’ Report ................................................................................................................................................................35
Consolidated Statements of Earnings ..............................................................................................................................36
Consolidated Statement of Retained Earnings (Deficit) ................................................................................................37
Consolidated Balance Sheets ............................................................................................................................................38
Consolidated Statement of Cash Flows............................................................................................................................39
Notes to Consolidated Financial Statements....................................................................................................................40
2006 Annual Report - MEGA Brands Inc.
2
MANAGEMENT'S DISCUSSION AND ANALYSIS
For the fourth quarter and year ended December 31, 2006
This Management's Discussion and Analysis of Financial Position and Results of Operations (“MD&A”), which is current as of
April 1, 2007, should be read in conjunction with the audited Consolidated Financial Statements and Notes thereto for the years
ended December 31, 2006 and 2005. The financial information in this MD&A and in our financial statements has been prepared
in accordance with Canadian Generally Accepted Accounting Principles ("GAAP") of the Canadian Institute of Chartered
Accountants (“CICA”). We also present certain non-GAAP financial measures, which we believe are useful to investors for
comparing our performance from period to period. Please refer to the “Specified Items Affecting Operations” section of this
MD&A.
All figures in this MD&A are expressed in U.S. dollars, (reporting and functional currency) unless otherwise indicated.
Throughout this MD&A, MEGA Brands Inc. (formerly Mega Bloks Inc.) and its subsidiaries are referred to as “MEGA Brands”,
the “Corporation”, “we”, “our” and “us”. The name “MEGA Brands America” refers to Rose Art Industries, Inc., Warren
Industries, Inc. and their respective subsidiaries, as they were at the time of the acquisition.
FORWARD-LOOKING STATEMENTS
All statements in this MD&A that do not directly and exclusively relate to historical facts constitute “forwardlooking statements”. These statements represent the Corporation's intentions, plans, expectations and beliefs. In
certain instances, these statements require us to make assumptions and there is significant risk that these
assumptions may not be correct. Furthermore, these statements are subject to risks, uncertainties and other factors,
many of which are beyond the Corporation's control. These factors include and are not restricted to: realization of
synergies, litigation and its inherent uncertainty, including the recovery of the full product liability settlement
amount and risks associated with product recalls, international operations, insurance coverage, difficulty in
predicting consumer preferences and development and acceptance of new products, rate of growth or profitability,
dependence on a few large customers, fluctuations in the price of plastic resins and other raw materials as well as
currency rates, seasonality of toy and stationery industries, risks related to licensed products, retail environment,
construction toy litigation and financing and interest rate matters. The words “believe”, “estimate”, “expect”,
“intend”, “anticipate”, “foresee”, “plan”, and similar expressions and variations thereof, identify certain of such
forward-looking statements, which speak only as of the date on which they are made. The Corporation disclaims any
intention or obligation to publicly update or revise any forward-looking statements, whether as a result of new
information, future events or otherwise, other than as required by applicable legislation. Readers are cautioned not to
place undue reliance on these forward-looking statements. More information about the risks that could cause our
actual results to significantly differ from our current expectations can be found in the “Risks and Uncertainties”
section of this MD&A. When we state that we believe that the Corporation is well positioned for continued growth,
that we anticipate sales growth in the upcoming year and that there is strong growth potential for ROSE ART® and
MAGNETIX® brands in international markets, that we expect to realize operational efficiencies in 2007, that we
expect to recover from insurers and through other recourses substantially the full amount paid to settle the lawsuits
relating to injuries to children resulting from the ingestion of magnets and that we expect to recover the full amounts
of the escrow fund provided for under the Stock Purchase Agreement (“SPA”), we have assumed that we will
succeed in realizing the cost and revenue synergies from the integration of MEGA Brands America including
without limitation the synergies resulting from the downsizing and closing of manufacturing plants in North
America and the concentration of distribution in one facility, that we will maintain or increase the quality of
products manufactured in new locations, that we will be successful in reducing inventory levels, that we will
maintain service levels in our new distribution facility, that we will be able to attract and retain key personnel in key
positions, that international markets that we service through our sales and marketing organization will have a strong
interest both in ROSE ART brands and in other products that we will offer, that the retail markets into which we sell
will continue to demonstrate strong demand for the Corporation's product lines, that our insurers will not
successfully deny any material portion of the claims, and that any such portion which may be denied will be
recoverable against former shareholders of MEGA Brands America, and that the number and quantum of selfinsured product liability claims will not be material. As described in the “Risks and Uncertainties” section of this
MD&A, there are risks and uncertainties that could mean that one or more of these assumptions ultimately turn out
to be incorrect and that we do not therefore experience the growth that we anticipate.
3
CORPORATE OVERVIEW
MEGA Brands designs, manufactures and markets high quality toys and stationery products. Headquartered in
Montreal, the Corporation has approximately 6,000 employees with offices, manufacturing facilities or distribution
centers in 14 countries. The Corporation's products are sold in over 100 countries.
The Corporation operates under two geographical segments, North America and International, with sales and
marketing conducted through two product lines.

Toys product lines are comprised of MEGA BLOKS® construction toys in the preschool and boys 5-plus
categories, MAGNETIX® building sets for children 6-plus and MEGA™ games and puzzles for families.

Stationery and Activities product lines are comprised of art materials (crayons, colored pencils, highlighters
and markers) sold mainly under the ROSE ART® brand; writing instruments (pens, mechanical pencils and
woodcase pencils) sold mainly under the ROSE ART, SRX ® and USA GOLD® brands; dry-erase and cork
presentation boards, organizers and accessories sold mainly under the BOARD DUDES® brand, and ROSE
ART and MEGA craft and activity sets.
INDUSTRY OVERVIEW
The traditional toy industry, which excludes video games and computer hardware and software, represents annual
sales at wholesale of approximately $16 billion in North America and $40 billion worldwide. The Corporation
competes in categories with total estimated manufacturers' shipments of approximately $4 billion in North America
and $6 billion in the rest of the world.
Worldwide sales of traditional toys have been growing in recent years despite lower sales in North America. In
North America, sales declined between 2003 and 2005 mainly as a result of lower purchases for children 12 years of
age and older due to the growing popularity of electronic games and a decline in the number of children in the 5-9
age group. An additional factor in the sales decrease was the intense competition among retailers which resulted in a
reduction of shelf space for traditional toys and lower prices. North American toy sales stabilized in 2006 and
demographic trends are shifting favorably, with growth forecasted in the number of children aged 5-9 during the
next several years. Outside North America, demand for traditional toys is increasing with strong potential in many
parts of the world mainly due to higher disposable incomes.
The Corporation is a significant player in selected categories of the growing $94.1 billion stationery market in North
America. The Corporation currently participates in product categories which amount to approximately $16 billion in
estimated manufacturer shipments. Most of the Corporation's products are currently sold in the School Supply
segment of the stationery market, which represents approximately 14% of total manufacturers' shipments, and is
served mainly by mass retailers and food and drug stores. The much larger Office Supply segment of the stationery
market, which is served mainly by specialty retailers, offers the Corporation an attractive growth opportunity.
4
STRATEGY, OBJECTIVES AND 2006 DEVELOPMENTS
MEGA Brands has achieved 22 consecutive years of profitability and sales growth since the launch of its first
construction blocks in 1985. This success is driven by product innovation and strong execution against our strategic
objectives.
Product Innovation
Product innovation is the key success factor in the toy industry and the main driver of sales growth. In 2006, we
renewed approximately 40% of the previous year's toy sales with new product lines and extensions, enhancements
and replacements of existing lines. We meet this competitive necessity by investing 3-4% of sales on new product
design, engineering, prototyping and development.
With over 60 awards and mentions for exceptional design, innovation, learning attributes and play experience, 2006
was a banner year for innovation. Toy testers and critics were particularly excited by our MAGTASTIK® product
line which was selected for more than a dozen awards including Dr. Toy's Smart Play/Smart Toy Program, the Gold
Seal for Oppenheim Toy Portfolio's Best Toy Award, and Toy Wishes Top 12 Toys of the Year. The MAGNETIX
MagnaCase was singled out as one of Dr. Toy's 100 Best Children's Products and 10 Best Toys of 2006.
Our CAT® Super Tower Crane garnered the 2006 Toy of the Year Award from Family Fun Magazine and the
Parents' Choice Approved Award. The Pirates of the Caribbean line won Today's Parent Seal of Approval and The
Black Pearl, a fully buildable ship playset was selected as one of The Toy Insider's Hot 20 Toys for the Holiday
Season. Many other products received awards and mentions in 2006, including Tiny 'N Tuff® Off-Road Set,
Buildable Noah's Ark™ and MEGA Wagon™.
Strategic Licensing
Licensed products, which accounted for approximately 19.0% of sales in 2006 compared to approximately 20.0% in
2005, complement our internal product development initiatives. In recent years, we have entered into licensing
agreements with affiliates of The Walt Disney Corporation, Marvel Enterprises Inc., NASCAR and others. Our
focus is on evergreen brands with enduring popularity that have the potential to expand our product lines and drive
incremental sales growth. The percentage of our annual sales based on licenses is lower than the 30-35% average for
the North American toy industry.
In 2006, we announced a multi-year licensing partnership with MTV Networks to develop construction toys based
on Dora the Explorer, Go Diego Go! and The Backyardigans. New products based on these popular Nickelodeon
character brands will launch in 2007 beginning in the United States and Canada with an expansion to the United
Kingdom, France, Australia and Latin America later in the year and other countries in 2008. Dora the Explorer is
among the top-rated preschool television shows in the world, the number one preschool license in North America,
the number one overall toy license in France and Canada, and the number one girls' license in the United Kingdom.
5
STRATEGY, OBJECTIVES AND 2006 DEVELOPMENTS (Continued)
Building on our successful relationship with Disney, one of the world's most successful children's brands, we
announced a multi-year agreement in 2006 to launch a global line of arts and crafts products based on popular
Disney properties. The new line will feature Disney Princess and Pirates of the Caribbean, with products available in
North America, Europe, Scandinavia, Africa and the Middle East in 2007. We are also offering preschool vehicles
based on the Disney Pixar movie ''Cars''.
Our 2007 product lines will include playsets based on two major theatrical releases scheduled for Spring 2007:
Disney's ''Pirates of the Caribbean: At World's End'' and Marvel’s ''Spider-Man 3''.
International Growth
Penetration of international markets is an important driver of our long-term growth. We have established a strong
sales, marketing and logistics organization in Europe and Mexico, a marketing partnership with Bandai in Japan, as
well as distributorships covering another 60 global markets. Our international sales increased 14.6% in 2006 to
$149.6 million compared to $130.5 million in 2005.
We expect continued international growth for the MEGA BLOKS brand through market share gains in Western
Europe and Australia, penetration of new markets in Central and Eastern Europe, and sales growth in Latin America,
Asia, the Middle East and Africa. In 2006, MEGA Brands was the leader in the construction category in both the
United Kingdom and in Spain, the first time we surpassed the former leader in these important European markets.
We increased our share in virtually all of our international markets in 2006. In the Australia and Pacific regions, we
positioned ourselves for continued market penetration by establishing a subsidiary in Australia, following several
years of sales growth through distributors.
We believe there is strong growth potential for the ROSE ART and MAGNETIX brands in international markets
through our existing sales and marketing organization. In 2006, we expanded the distribution of MAGNETIX
products into several new markets in Europe, Asia and Latin America, and we prepared the ground for the
introduction of arts and crafts and stationery products in our international markets in 2007. We selected a portfolio
of ROSE ART craft and activity sets and adapted these products for introduction into our key European markets for
2007, complemented by a broad assortment of Disney licensed products. In stationery, we have a dedicated sales
force in five markets - United Kingdom, France, Italy, Mexico and Australia - and our products will be available at
retail for the 2007 back-to-school season.
Growth by Acquisition
We plan to supplement our internal growth with selected strategic acquisitions that will reinforce our product range
and consumer reach. In identifying attractive acquisition candidates, we are looking to: expand into basic and
growing categories, strengthen our position in current core competencies, expand shelf space into multiple aisles,
strengthen relationships with key retailers, expand global distribution and enter into new retail channels.
Furthermore, we are looking for acquisitions that will offer significant synergies. Our priority in 2007 is to fully
realize the benefits of the integration of MEGA Brands America.
The acquisition of The Board Dudes, Inc. (''Board Dudes''), which closed in February, 2006, positioned the
Corporation as the second largest supplier of dry erase and cork presentation boards and accessories, a $400 million
category in the North American stationery market, based on manufacturers' shipments.
6
STRATEGY, OBJECTIVES AND 2006 DEVELOPMENTS (Continued)
Growth by Acquisition (Continued)
The integration of MEGA Brands America, which we acquired in July 2005, progressed significantly to plan during
2006. The following actions were implemented during the year.

We opened a 450,000 sq. ft. distribution center in Fife, Washington State, in April 2006 to receive and process
all products manufactured in China for sale in North America.

After completing our 2006 manufacturing requirements, we closed plants in Eugene, Oregon (Fuzzy® flocked
posters) and Lafayette, Indiana (games and puzzles) and relocated production to China.

Following the 2006 back-to-school season, we relocated the production of crayons, paints and dough to our
facility in Shenzhen, China, resulting in a corresponding downsizing of the Woodridge, New Jersey, plant.

Distribution centers for products relocated to China were closed down or downsized at all three plants. We also
downsized our Montreal distribution center and consolidated some of its activities into our Montreal
manufacturing facility.

At the end of 2006, we closed a plant in China and consolidated manufacturing in a single, expanded facility.
Manufacturing costs for the product lines relocated to China were incurred in our North American plants in 2006.
The Corporation also incurred costs for setting up the Fife, Washington distribution center which offset savings on
freight incurred for transporting products manufactured in China from the West Coast to the Montreal distribution
center.
With the integration of MEGA Brands America essentially completed by the end of 2006, we expect to realize
between $7-10 million of operational efficiencies in 2007.
We estimate that our North American plants will supply approximately 25% of consolidated net sales, our plant in
China for 25%, focusing on high-volume production, and our Asian supplier base, mainly in China, for the
remaining 50%.
OTHER DEVELOPMENTS
Shareholders adopted a special resolution on June 15, 2006, authorizing the Corporation to change its legal name to
MEGA Brands Inc. The Corporation filed the amendment to its articles of incorporation under the Canada Business
Corporations Act to change its name on June 22, 2006. The legal names of the Corporation's principal subsidiaries
were changed to MEGA Brands America, Inc. (formerly Rose Art Industries, Inc.), MEGA Brands International
(formerly Mega Bloks International Sàrl) and MEGA Brands Europe NV (formerly Mega Bloks Europe NV).
On May 8, 2006, the former shareholders of Rose Art Industries, Inc. initiated litigation against the Corporation in
the U.S. District Court for the Southern District of New York (“Rosen Litigation”). The plaintiffs are seeking
payment of the Contingent Purchase Price under the terms of the Stock Purchase Agreement (“SPA”) entered into
between them and the Corporation effective July 26, 2005. The Corporation has filed an answer and counter claim
denying each and every material allegation relating to the lawsuit. The Corporation's counter claim alleges that the
former shareholders failed to uphold certain terms of the SPA. The Corporation accrued as a reserve $51.0 million in
its 2005 audited consolidated financial statements with respect to the Contingent Purchase Price pending final
determination of the amount owed, if any. As at December 31, 2006, no disbursements had been made and the
Corporation will continue to maintain the reserve until the lawsuit is resolved. No trial date had been set as at April
1, 2007. The Corporation is currently awaiting the Court's ruling on a number of procedural issues after which it
expects to enter into a protracted discovery period.
7
OTHER DEVELOPMENTS (continued)
On November 17, 2006, Jeffrey and Lawrence Rosen, the former shareholders of Rose Art Industries, Inc., filed
proceedings before the American Arbitration Association against the Corporation seeking unspecified damages for
the Corporation's alleged breach of their respective employment agreements. The Corporation is contesting the
proceedings.
On March 31, 2006, the Corporation jointly announced with the US Consumer Products Safety Commission
(''CPSC'') a voluntary recall and replacement program of MAGNETIX building sets in the hands of families with
children under the age of six. This action was taken in response to the death of a toddler and injuries to several
children resulting from magnet ingestion.
On October 24, 2006, the Corporation announced that it had settled four lawsuits and ten claims related to injuries to
children resulting from the ingestion of magnets. Terms of the settlement include no admission of liability. The
aggregate amount paid to settle the lawsuits and claims is $13.5 million and is recorded as a product liability
settlement expense in the 2006 consolidated statement of earnings. The Corporation expects to recover substantially
the full amount from its insurers and through other recourses, although there can be no assurance that a favorable
outcome will be achieved. Discussions with our insurers in this regard are underway. On September 14, 2006 and on
December 5, 2006, two lawsuits related to magnet ingestion requiring surgical removal were served on the
Corporation and remain outstanding. They are being handled by the Corporation's insurers. On March 29, 2007 the
Corporation learned that a third lawsuit had been filed in U.S. District Court in Denver by the family of a child who
is alleged to have sustained similar injuries. The lawsuit has been reported to our insurers. The Corporation is also
aware of at least seven other incidents in which children are alleged to have required surgery following the ingestion
of multiple magnets. Lawsuits have not been filed in these matters as of April 1, 2007. The Corporation is not able
to assess with any certainty the outcome of these lawsuits and claims or impact, if any. As such, no amounts have
been reserved in our year-end financial statements.
The Corporation's portfolio of product liability insurance was renewed on December 1, 2006. As a result of the
voluntary recall and replacement program and the ensuing publicity and product liability lawsuits and claims against
the Corporation, the cost of insurance coverage for MAGNETIX products manufactured before May 1, 2006 was
prohibitive. After careful consideration of the risks and an analysis of the costs of insurance, the Corporation
determined that it was more economically advantageous, all factors considered, to self-insure these risks. As such,
the Corporation is self-insured for incidents occurring after December 1, 2006, for MAGNETIX products
manufactured prior to May 1, 2006.
On March 28, 2007, the Corporation learned that a competitor who sells magnetic building sets primarily in Europe,
Plastwood S.R.L. and Plastwood Corporation, filed a complaint against MEGA Brands America and MEGA Brands
in the Western District of Washington. The complaint is based in significant part on representations alleged to have
been made prior to the Corporation's acquisition of MEGA Brands America. The complaint does not provide
support for Plastwood's allegations of its own lost sales and other consequences. The Corporation believes it has
valid defenses to the complaint and intends to defend the action vigorously. As such, no amounts have been reserved
in our year-end financial statements.
The Corporation incurred significant litigation expenses in 2006, particularly in the fourth quarter, related mainly to
the Rosen Litigation. Management believes that these expenses were warranted under the circumstances and will be
offset by the benefit of asserting the Corporation's rights under the SPA and its insurance policies. The Rosen
Litigation has delayed recovery against the $15 million escrow fund provided for under the SPA. Management
expects that the resolution of the Rosen Litigation will also resolve the issue of the claims against the escrow fund,
although there can be no assurance that a favorable outcome will be achieved.
8
SPECIFIED ITEMS AFFECTING OPERATIONS
The Corporation recorded Specified Items Affecting Operations in 2006. Depending on their nature, the 2006
Specified Items were recorded against net sales, in cost of sales or as operating expenses. This classification was
determined in accordance with GAAP.
The following table summarizes all Specified Items Affecting Operations during the year.
(U.S. $ thousands, except per share data)
(Unaudited)
Year ended
December 31,
2006
Three-month
period ended
December 31,
2006
16,029
15,490
8,303
4,769
44,591
13,758
1,463
8,303
3,678
27,202
MAGNETIX product replacement expenses
Product liability settlement and related expenses
Integration expenses
Litigation expenses
MAGNETIX product replacement expenses

The Corporation recorded credits and charges of $6.6 million ($5.9 million in the fourth quarter) as a reduction
of net sales. The net impact of these charges on gross profit amounted to $6.1 million for the year ($5.5 million
in the fourth quarter).

The Corporation recorded write-offs of MAGNETIX components of $4.3 million ($4.3 million in the fourth
quarter) as a result of the redesign of such components. These amounts are recorded in cost of sales.

The Corporation recorded product replacement expenses of $5.6 million ($4.0 million in the fourth quarter),
consisting of freight costs to meet customer shipment dates due to manufacturing delays for redesigned
MAGNETIX products, development costs for the redesign of MAGNETIX components, and product
replacements for consumers under the voluntary recall and replacement program for MAGNETIX products
jointly announced with the CPSC. The total amount is recorded as a separate line item in operating expenses.

The Corporation settled four lawsuits and ten claims related to magnet ingestion and recorded product liability
settlement and related expenses of $15.5 million, consisting of $13.5 million for the product liability settlement
recorded in the third quarter and $2.0 million of related legal expenses ($1.5 million in the fourth quarter). The
total amount is recorded as a separate line item in operating expenses.

The Corporation recorded a charge of $4.7 million mostly related to inventory write-offs ($4.7 million in the
fourth quarter) following plant closures as part of the integration of MEGA Brands America. This amount is
recorded in cost of sales.

The Corporation recorded integration expenses of $3.6 million ($3.6 million in the fourth quarter), mainly
related to branding, plant asset write-offs, plant closure costs and other miscellaneous integration charges. This
amount is recorded as a separate line item in operating expenses.
9
SPECIFIED ITEMS AFFECTING OPERATIONS (Continued)
Litigation expenses

The Corporation recorded litigation expenses of $4.8 million ($3.7 million in the fourth quarter), mainly for the
Rosen Litigation. This amount is recorded as a separate line item in operating expenses.
Management believes that under the terms of the acquisition of MEGA Brands America, all claims and expenses
related to MAGNETIX, as well as certain other expenses, are recoverable against the sellers, including but not
limited to the $15.0 million escrow fund provided for in the SPA. However, the Corporation also expects to recover
substantially the full amount of the $13.5 million product liability settlement from its insurers and through other
recourses, there can be no assurance that a favorable outcome will be achieved.
10
SELECTED FINANCIAL INFORMATION
The following table presents a summary of selected consolidated income statement data for the years ended
December 31, 2006, 2005 and 2004, as well as the three-month periods ended December 31, 2006 and 2005:
Three-month periods
ended December 31,
(Unaudited)
Years ended December 31,
(Audited)
(U.S. $ thousands, except per
share data)
2006
2005
2004
2006
2005
Net sales
547,347
384,863
215,456
164,805
166,234
Cost of sales
328,822
214,668
123,821
113,272
88,559
Gross profit
218,525
170,195
91,635
51,533
77,675
26,808
24,573
13,382
10,562
13,067
18,334
9,402
5,691
5,858
3,658
109,815
71,074
37,244
24,540
28,658
2,796
(3,117)
(858)
589
Marketing and advertising
expenses
Research and developement
expenses
Other selling, distribution and
administrative expenses
Loss (gain) on foreign currency
translation
Product liability settlement and
related expenses
Voluntary product recall and
replacement
Litigation expenses
Unusual items
Earnings (loss) from operations
Interest and other expenses
Interest on long-term debt
Other interest
Earnings (loss) before income
taxes
Income taxes
Current
Future
Net earnings
Earnings per share
Basic
Diluted
WEIGHTED AVERAGE
NUMBER OF
OUTSTANDING SHARES
Basic
Diluted
(4,846)
15,490
-
-
1,463
-
5,612
4,769
3,573
-
-
5,158
3,995
3,678
3,573
-
-
38,970
62,350
33,277
(1,278)
22,526
177
22,703
9,310
954
10,264
1,207
170
1,377
6,419
371
6,790
16,267
52,086
31,900
(8,068)
26,602
(1,217)
(7,864)
(9,081)
5,473
7,005
12,478
7,427
(704)
6,723
(5,126)
(5,703)
(10,829)
360
5,331
5,691
25,348
39,608
25,177
2,761
20,911
0.79
0.74
1.35
1.26
0.93
0.86
0.09
0.08
0.66
0.61
2006
2005
2004
2006
2005
32,220,495
34,189,034
29,281,145
31,390,456
27,185,175
29,331,615
32,352,319
34,289,179
31,854,644
34,080,643
11
31,703
5,127
(26)
5,101
SELECTED FINANCIAL INFORMATION (Continued)
The following tables present a summary of selected consolidated balance sheet data as at December 31, 2006, 2005
and 2004 and Canadian dollar data for the years ended December 31, 2006, 2005 and 2004 as supplementary
information for Canadian investors:
As at December 31,
(Canadian $ thousands, except per share data)
2006
$
2005
$
2004
$
124,725
43,213
800,442
311,954
101,605
39,351
720,495
300,953
101,092
32,221
183,155
24,572
Balance Sheet Data
Working capital1)
Property, plant and equipment
Total assets
Total debt
Year ended December 31,
(Canadian $ thousands, except per share data)
(Unaudited)
2006
$
2005
$
2004
$
637,823
29,538
448,481
46,155
251,071
29,339
0.92
0.86
1.58
1.47
1.08
1.00
Canadian Dollar Data2)
Net sales
Net earnings
Earnings per share
Basic
Diluted
1)
2)
Working capital is defined as current assets minus current liabilities.
U.S. dollar financial data is converted into Canadian dollars at the December 31, 2006 period end exchange rate of CA$1.1653 per
US$1.00, using the translation of convenience method.
Contractual Obligations
The following table presents a summary of contractual obligations for the following years:
Years
Long-term debt
Capital leases
Operating leases
Total contractual
obligations
2007
9,000
609
13,465
2008
9,000
195
10,189
2009
4,200
9,209
2010
42,600
8,192
2011
2,600
3,637
After
5 years
243,750
1,268
Total
311,150
804
45,960
23,074
19,384
13,409
50,792
6,237
245,018
357,914
12
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 2006 COMPARED TO YEAR ENDED DECEMBER 31, 2005
Adoption of EIC-156
In 2006, the Corporation adopted a new guideline issued by the Emerging Issues Committee of the CICA called
EIC-156, ''Accounting by a Vendor for Consideration Given to a Customer (Including a Reseller of the Vendor's
Product)''. As a result, certain allowances given to customers in the normal course of business, for which the fair
market value cannot be precisely determined, are recorded as a reduction of sales. Under the former accounting
standard used by the Corporation, such allowances were included in sales, cost of sales goods sold and marketing
and advertising expenses. For comparative purposes, the Corporation has reclassified such allowances for 2005. The
adoption of EIC-156 reduced net sales by $25.8 million in 2006 and $22.2 million in 2005 and by $9.8 million and
$9.7 million in the fourth quarters of 2006 and 2005, respectively.
Net Sales
Net sales increased 42.2% in 2006 to $547.3 million compared to $384.9 million in 2005. Higher net sales reflect
mainly the inclusion of MEGA Brands America for the full year in 2006 compared to approximately five months in
2005, as well as organic growth in construction toys. Recorded against net sales in 2006 are $6.6 million of
Specified Items.
Net sales of Toys product lines reached $333.7 million in 2006 compared to $291.6 million in 2005, an increase of
14.4%. The majority of this increase reflects the inclusion of magnetic construction toys and games and puzzles for
the full year compared to approximately five months in 2005. Organic growth in construction toys also contributed
to the higher net sales.
Net sales of Stationery and Activities product lines increased 129.0% to $213.7 million compared to $93.3 million in
2005. This growth reflects the inclusion of MEGA Brands America for the full year in 2006 compared to
approximately five months in 2005, as well as the contribution from Board Dudes.
Net sales in North America increased 56.4% to $397.8 million compared to $254.3 million in 2005, mainly as a
result of the inclusion of MEGA Brands America for the full year in 2006 compared to approximately five months in
2005. Net sales of construction toys were stable, with higher sales in the preschool category and MAGNETIX offset
by a slight decline in boys 5-plus products.
International net sales were up 14.6% to $149.6 million compared to $130.5 million in 2005. The Corporation
increased its market share in the construction toy category in virtually all international markets in 2006 and gained
the leadership position in this category in the United Kingdom and Spain for the first time. International net sales
accounted for 27.3% of consolidated net sales in 2006 compared to 33.9% in 2005.
Cost of Sales
Cost of sales increased 53.1% to $328.8 million in 2006 compared to $214.7 million in 2005. The majority of this
increase is due to the inclusion of MEGA Brands America for the full year in 2006 compared to approximately five
months in 2005. Recorded in cost of sales 2006 are $8.5 million of Specified Items.
13
YEAR ENDED DECEMBER 31, 2006 COMPARED TO YEAR ENDED DECEMBER 31, 2005 (Continued)
Gross Profit
Reflecting the growth in net sales, gross profit increased 28.4% to $218.5 million in 2006 compared to $170.2
million in 2005. Gross margin declined to 39.9% compared to 44.2% in 2005. The decline in gross margin in 2006 is
explained mainly by additional freight costs incurred in order to meet customer deadlines for the delivery of
redesigned MAGNETIX products and higher magnet costs due to the escalation in commodity prices, for a
combined impact of approximately $10.0 million. In addition, Specified Items impacting gross profit amounted to
$15.1 million. Plastic resin prices in 2006 were in line with 2005 and did not negatively impact gross margin.
Operating Expenses
Marketing and advertising expenses increased to $26.8 million in 2006 compared to $24.6 million in 2005. This
increase reflects the inclusion of MEGA Brands America for the full year in 2006 compared to approximately five
months in 2005. As a percentage of net sales, such expenses declined to 4.9% compared to 6.4% in 2005. This
decrease reflects the proportionately lower marketing and advertising expenses for Stationery and Activities product
lines.
Research and development expenses were $18.3 million in 2006 compared to $9.4 million in 2005. This increase
reflects mainly the inclusion of MEGA Brands America for the full year in 2006 compared to approximately five
months in 2005. As a percentage of sales, such expenses increased to 3.3% compared to 2.4% in 2005.
Other selling, distribution and administrative expenses were $109.8 million in 2006 compared to $71.1 million in
2005. This increase reflects mainly the inclusion of MEGA Brands America for the full year in 2006 compared to
approximately five months in 2005. These expenses were 20.1% of net sales in 2006 compared to 18.5% in 2005.
Earnings from Operations
As a result of the above, earnings from operations were $39.0 million in 2006 compared to $62.4 million in 2005.
Earnings from operations resulted in a loss of $11.7 million in North America compared to earnings of $40.3 million
in 2005. International earnings from operations rose to $50.7 million compared to $22.1 million in 2005.
Non-Operating Expenses
Interest expense was $22.7 million in 2006 compared to $10.3 million in 2005, reflecting mainly borrowings used to
finance the acquisition of the MEGA Brands America. The acquisition closed on July 26, 2005, which accounts for
most of the difference in interest expense between the two years, with the balance explained by higher interest rates
in 2006.
The Corporation recorded an income tax recovery of $9.1 million in 2006 compared to an income tax charge of
$12.5 million in 2005. Before Specified Items, the effective tax rate in 2006 was 12.6% compared to 24.0% in 2005,
reflecting mainly the proportionately higher earnings from operations in lower tax jurisdictions in 2006 compared to
2005. The tax rate used to establish income tax expense is the applicable estimated effective rate of each entity of
the Corporation. The effective tax rate also takes into consideration the financing structure put in place following the
acquisition of MEGA Brands America. As a result of this acquisition, the Corporation also expects to benefit from
cash flow savings of approximately $100.0 million over a period of 15 years from the deductibility of goodwill for
tax purposes in the United States.
14
Net Earnings
Net earnings were $25.3 million or $0.74 diluted earnings per share in 2006 compared to $39.6 million or $1.26
diluted earnings per share in 2005. Basic earnings per share were $0.79 in 2006 compared to $1.35 in 2005.
Impact of Specified Items
The following tables present the impact of Specified Items on the 2006 statement of earnings. Management believes
that an analysis of 2006 and fourth quarter 2006 operating performance before Specified Items is appropriate
because such items are not typical of ongoing operations.
(US $ thousands)
Twelve-month periods ended December 31,
Audited
2006
Unaudited
Specified
Items
2006
Unaudited
Before
Specified
Items1)
Audited
2005
Net Sales
547,347
6,606
553,953
384,863
Cost of sales
328,822
(8,541)
320,281
214,668
Gross profit
218,525
15,147
233,672
170,195
Marketing and advertising expenses
Research and development expenses
Other selling distribution and administrative expenses
Loss (gain) on foreign currency translation
Voluntary product recall and replacement
Litigation expenses
26,808
18,334
109,815
(4,846)
15,490
5,612
4,769
3,573
–
–
–
–
(15,490)
(5,612)
(4,769)
(3,573)
26,808
18,334
109,815
(4,846)
–
–
–
–
24,573
9,402
71,074
2,796
–
–
–
–
Earnings from operations
38,970
44,591
83,561
62,350
22,703
–
22,703
10,264
Earnings (loss) before income taxes
16,267
44,591
60,858
52,086
Income taxes
(9,081)
16,722
7,641
12,478
Net earnings
25,348
27,869
53,217
39,608
0.86
0.82
1.65
1.56
1.35
1.26
Earnings per share - Basic
Earnings per share - Diluted
0.79
0.74
15
(US $ thousands)
Three-month periods ended December 31,
Unaudited
2006
Unaudited
Specified
Items
2006
Unaudited
Before
Specified
Items1)
Unaudited
2005
Net Sales
164,805
5,865
170,670
166,234
Cost of sales
113,272
(8,628)
104,644
88,559
Gross profit
51,533
14,493
66,026
77,675
Other selling distribution and administrative expenses
Litigation expenses
10,562
5,858
24,540
(858)
1,463
3,995
3,678
3,573
–
–
–
–
(1,463)
(3,995)
(3,678)
(3,573)
10,562
5,858
24,540
(858)
–
–
–
–
13,067
3,658
28,658
589
–
–
–
–
(1,278)
27,202
25,924
31,703
6,790
–
6,790
5,101
(8,068)
27,202
19,134
26,602
Income taxes
(10,829)
10,200
(629)
5,691
Net earnings
2,761
17,002
19,763
20,911
0.09
0.08
0.53
0.50
0.61
0.58
0.66
0.61
Earnings (loss) before income taxes
Earnings per share - Basic
Earnings per share - Diluted
1)
The terms ''net sales before Specified Items'', ''cost of sales before Specified Items'', ''gross profit before Specified Items'', ''gross margin
before Specified Items'', ''earnings (loss) from operations before Specified Items'',''earnings (loss) before income taxes before Specified
Items'', ''net earnings before Specified Items'' and ''diluted earnings per share before Specified Items'' do not have any standardized
meaning under GAAP and are therefore unlikely to be comparable to similar measures presented by other companies. We present them as
a measure of operating performance of our ongoing business without the effects of unusual items. We exclude such items because they
affect the comparability of our financial results between periods and could potentially distort the analysis of trends in business
performance.
16
YEAR ENDED DECEMBER 31, 2005 COMPARED TO YEAR ENDED DECEMBER 31, 2004
Net Sales
Net sales increased 78.6% to $384.9 million in 2005, compared to $215.5 million in 2004. The main factors
contributing to this overall growth were the inclusion of MEGA Brands America as of July 26, 2005 and the
continued success of our construction toy business as a result of strong penetration in international markets.
Net sales of Toys product lines increased by 35.2% to $291.6 million in 2005 compared to $215.5 million in 2004.
This strong increase was driven primarily by higher sales of preschool and boys 5-plus products in all key European
markets, Latin America and Canada, and the addition of magnetic construction toys and games and puzzles
following the acquisition of MEGA Brands America. This increase was partly offset by a slight decline in
construction toy sales in the U.S. reflecting an overall challenging retail environment for the toy industry and the
cautious inventory approach of major retailers.
Net sales of Stationery and Activities product lines were $93.3 million in 2005 compared to nil in 2004. The
Corporation was not active in these categories prior to the acquisition of MEGA Brands America.
Net sales in North America increased 100.1% to $254.3 million in 2005 compared to $127.1 million in 2004.
International net sales were $130.5 million in 2005, an increase of 47.6% compared to $88.4 million in 2004.
Reflecting the net sales of MEGA Brands America in 2005, which are concentrated mainly in North America,
international net sales accounted for 33.9% of consolidated net sales compared to 41.0% in 2004.
Gross Profit
Gross profit reached $170.2 million in 2005 compared to $91.6 million in 2004, an increase of 85.8%. The increase
in gross profit was driven primarily by sales growth. Gross margin was 44.2% in 2005 compared to 42.5% in 2004.
The increase in gross margin was mainly due to changes in product and customer mix compared to 2004. This was
partially offset by lower gross margin generated by stationery products and higher resin costs incurred during the
first six months of 2005.
Operating Expenses
Marketing and advertising expenses were $24.6 million in 2005, compared to $13.4 million in 2004, an increase of
83.6%. As a percentage of net sales, such expenses were 6.4% in 2005 compared to 6.2% in 2004.
Research and development expenses increased to $9.4 million in 2005 compared to $5.7 million in 2004. This
increase reflects mainly the inclusion of MEGA Brands America in 2005.
Other selling, distribution and administrative expenses were up 108.4% to $71.1 million in 2005 compared to $34.1
million in 2004. These expenses represented 18.5% of net sales in 2005 compared to 15.8% in 2004. This increase is
mainly explained by the expenses of MEGA Brands America from the date of acquisition and higher distribution
costs, reflecting the significant growth in international sales in 2005.
In 2004, the Corporation recorded Specified Items of $5.2 million which were presented in earnings from operations
as unusual items. These Specified Items consisted of a loss of $3.6 million due to the fact that certain derivative
financial instruments ceased to qualify for hedge accounting as well as a $1.6 million charge in connection with
professional and consulting services related to the expansion of the Corporation's presence in the German market.
17
Earnings from Operations
Earnings from operations increased 87.4% to $62.4 million in 2005 compared to $33.3 million in 2004.
Non-Operating Expenses
Interest expense was $10.3 million in 2005 compared to $1.4 million in 2004, reflecting mainly higher borrowings
used to finance the acquisition of MEGA Brands America and, to a lesser extent, higher average interest rates
compared to the previous year.
Income taxes were $12.5 million in 2005 compared to $6.7 million in 2004. The effective tax rate was 24.0% in
2005 compared to 21.1% in 2004. This increase reflects mainly the impact of the acquisition of MEGA Brands
America, which resulted in higher earnings in higher tax jurisdictions.
Net Earnings
Net earnings increased 57.3% to $39.6 million or $1.26 diluted earnings per share compared to $25.2 million or
$0.86 per share in 2004. Basic earnings per share increased to $1.35 in 2005 compared to $0.93 in 2004.
LIQUIDITY AND CAPITAL RESOURCES
Historically, our primary sources of liquidity have been cash flows from operations and short-term borrowings under
a revolving credit facility. Cash flows from operations could be negatively impacted by decreased demand for our
products, which could result from factors such as adverse economic conditions and changes in public and consumer
preferences, or by increased costs associated with manufacturing and distribution of products. Our primary capital
needs are related to inventory financing, accounts receivable funding, debt servicing and capital expenditures for
new product line initiatives. As a result of the seasonal nature of the toy and stationery industries, working capital
requirements are variable throughout the year. Working capital needs typically grow through the first three quarters
as inventories are built-up for the peak sales period.
Operating Activities
Cash flows from operating activities in 2006 amounted to $15.9 million compared to $25.0 million in 2005. This
decrease is explained mainly by lower earnings from operations resulting from the Specified Items affecting
operations incurred during the year.
Financing Activities
Cash flows from financing activities in 2006 were $14.3 million, reflecting mainly a draw-down of $40.0 million of
the Corporation's revolving credit facility and the repayment of $29.0 million of long-term debt. In 2006, the
Corporation repaid $20.0 million of the principal amount of its $40-million Term A debt and concurrently increased
the maximum amount of its revolving credit facility to $120.0 million from $100.0 million. For 2005, cash flows
from financing activities were $291.9 million, resulting mainly from borrowings and an issue of capital stock to
finance the acquisition of MEGA Brands America.
18
LIQUIDITY AND CAPITAL RESOURCES (Continued)
Investing Activities
Cash flows used for investing activities in 2006 were $36.0 million, including $17.5 million for acquisitions of
property, plant and equipment and the balance coming mainly from the acquisition of Board Dudes. For 2005, cash
flows used for investing activities amounted to $303.0 million, reflecting mainly the acquisition of MEGA Brands
America.
We expect the level of capital expenditure to be higher in 2007 but to remain proportionally in line with sales
growth.
BALANCE SHEETS
As at December 31, 2006, current assets stood at $345.6 million compared to $297.2 million at the end of 2005. This
increase is due mainly to higher inventories which rose to $140.6 million in 2006 compared to $82.3 million in
2005. In 2006, the Corporation built up inventories of basic products in anticipation of plant closures which occurred
mainly in the fourth quarter. In addition, production levels in the last few months of 2006 were higher than usual due
to demand for products tied to two movies scheduled for North American release in May 2007. The Corporation's
objective is to reduce inventory levels to approximately $110.0 million by the end of 2007. Trade accounts
receivable declined to $153.1 million in 2006 compared to $167.4 million in 2005 due to timing of shipments and
customer payments.
Current liabilities increased to $220.9 million in 2006 compared to $195.6 million in 2005. This increase is due to
higher accounts payable and accrued liabilities which rose to $153.4 million in 2006 compared to $108.0 million in
2005. The Corporation accrued US$51.0 million in its 2005 audited consolidated financial statements as additional
consideration for the former shareholders of Rose Art Industries, Inc. pending final determination of the amount
owed, if any. No disbursements were made in regard to this additional consideration as at December 31, 2006. The
Corporation did not make an accrual for additional consideration based on the financial performance of MEGA
Brands America in 2006.
Working capital stood at $124.7 million as at December 31, 2006 compared to $101.6 million at the end of 2005.
This increase is due mainly to higher inventories at the end of 2006.
Long-term debt at the end of 2006 was $312.0 million compared to $301.0 million in 2005. As at December 31,
2006, the Corporation's debt was comprised of $14.4 million under its Term A facility maturing in 2009, $256.8
million under its Term B facility maturing in 2012 and $40.0 million drawn against its $120.0 million revolving
credit facility. The Corporation entered into interest-rate swap agreements in 2005 to convert $150.0 million of its
Term B facility from variable to fixed interest rates. The Corporation was in compliance with all covenants of its
credit facility as at December 31, 2006.
As at December 31, 2006, the Corporation held cash and cash equivalents of $13.7 million and had $80.0 million of
availability under its revolving credit facility. Based on its forecasts, the Corporation believes that cash flows from
operating activities combined with liquidity available under its revolving credit facility will be sufficient to meet its
requirements for working capital, acquisition of property, plant and equipment, debt repayments and other financial
obligations. The Corporation also believes that its ability to access capital markets, if necessary, provides for any
additional liquidity that may be required.
Please refer to the ''Balance Sheet Data'' and ''Contractual Obligations'' tables on page 12 of this MD&A for
additional information about the Corporation's financial position.
19
SEASONALITY AND QUARTERLY FLUCTUATIONS
We have historically experienced significant quarterly fluctuations in operating results and anticipate these
fluctuations in the future. Operating results for any quarter are not necessarily indicative of results for any future
period and are comparable only with corresponding periods of prior years. Our profitability is typically lower for the
first two quarters as a result of fairly constant fixed operating expenses while net sales are at their lowest levels of
the year. This seasonality is consistent with the results of other companies in our business. As a result of the
seasonal nature of our business, our statements of cash flows for any quarter are generally not indicative of cash
flows for a full year. Therefore, year-over-year comparisons between statements of cash flows are generally more
meaningful than with the previous year-end.
SELECTED QUARTERLY FINANCIAL INFORMATION
The following table presents selected quarterly financial information for the years 2006 and 2005.
(US $ thousands, except per share data)
(Unaudited)
Net Sales
As a % of full year
Gross profit
Net earnings
EPS Basic
EPS Diluted
(US $ thousands, except per share data)
(Unaudited)
Net Sales
As a % of full year
Gross profit
Net earnings
EPS Basic
EPS Diluted
2006
Q1
Q2
Q3
Q4
78,564
14.3
34,199
3,886
578
0.02
0.02
102,200
18,7
42,246
10,162
4,050
0.13
0.12
201,778
36.9
90,547
26,200
17,959
0.56
0.53
164,805
30.1
51,533
(1,278)
2,761
0.09
0.08
Q3
Q4
154,203
40.1
67,284
32,567
20,415
0.67
0.62
166,234
43.2
77,675
31,703
20,911
0.66
0.61
2005
Q1
28,323
7.3
11,387
(1,434)
(1,178)
(0.04)
(0.04)
Q2
36,103
9.4
13,849
(485)
(540)
(0.02)
(0.02)
THREE-MONTH PERIOD ENDED DECEMBER 31, 2006 COMPARED TO THREE-MONTH PERIOD
ENDED DECEMBER 31, 2005
Consolidated net sales in the fourth quarter of 2006 were $164.8 million compared to $166.2 million in the fourth
quarter of 2005.
Net sales of Toys product lines increased 4.2% to $123.1 million in the fourth quarter of 2006 compared to $118.1
million in the 2005 period. Net sales increased in all product categories except games and puzzles.
Net sales of Stationery and Activities product lines declined to $41.7 million compared to $48.1 million in the fourth
quarter of 2005. This is explained mainly by lower sales of licensed craft and activity sets in the fourth quarter of
2006 compared to the corresponding 2005 period.
20
ENDED DECEMBER 31, 2005 (Continued)
Net sales in North America were $116.9 million in the fourth quarter of 2006, compared to $127.0 million in the
corresponding 2005 period. Net sales of preschool and boys 5-plus construction toys matched the levels achieved in
the fourth quarter of 2005, while sales declined in craft and activity sets and games and puzzles. Stationery sales
were higher than in the fourth quarter of 2005.
International net sales increased 22.0% to $47.9 million compared to $39.3 million in the fourth quarter of 2005.
Sales growth was achieved in preschool, boys 5-plus and magnetic construction toys compared to the fourth quarter
of 2005. International sales accounted for 29.1% of consolidated net sales in the fourth quarter of 2006 compared to
23.6% in the same 2005 period.
Cost of sales increased 28.0% to $113.3 million in the fourth quarter of 2006 compared to $88.6 million in the
corresponding 2005 period. This increase is explained by additional freight costs incurred in order to meet customer
deadlines for the delivery of redesigned MAGNETIX products and higher magnet costs due to the escalation in
commodity prices, for a combined impact of approximately $10.0 million. Cost of sales in the fourth quarter of 2006
also includes Specified Items of $8.5 million.
Gross profit declined to $51.5 million compared to $77.7 million in the fourth quarter of 2005 and gross margin
decreased to 31.3% of sales compared to 46.7% in the same 2005 period. Plastic resin prices were in line with the
levels during the fourth quarter of 2005 and did not negatively impact gross margin.
Marketing and advertising expenses were $10.6 million compared to $13.1 million in the fourth quarter of 2005. As
a percentage of net sales, such expenses were 6.4% compared to 7.9% in the fourth quarter of 2005. This decrease is
due mainly to timing differences in such expenditures in 2006 compared to 2005. Marketing and advertising
expenses for the first nine months of 2006 were 41.2% higher than in the corresponding 2005 period.
Research and development expenses increased to $5.9 million or 3.6% of sales, compared to $3.7 million or 2.2% of
sales in the fourth quarter of 2005.
Other selling, distribution and administrative expenses were $23.7 million compared to $29.2 million in the fourth
quarter of 2005. These expenses represented 14.4% of net sales in the fourth quarter of 2006 compared to 17.6% in
2005. This decrease is explained by an overall leveraging of administrative expenses and lower bonus payouts
compared to 2005.
As a result of the above, loss from operations in the fourth quarter of 2006 was $1.3 million compared to earnings
from operations of $31.7 million in the fourth quarter of 2005. Earnings from operations resulted in a loss of $34.4
million in North America compared to earnings of $25.4 million in the fourth quarter of 2005. International earnings
from operations increased to $33.1 million compared to $6.3 million in the fourth quarter of 2005.
Interest expense was $6.8 million compared to $5.1 million in the fourth quarter of 2005, reflecting mainly higher
average interest rates in the 2006 period.
The Corporation recorded an income tax recovery of $10.8 million in the fourth quarter of 2006 compared to $5.7
million of income taxes in the fourth quarter of 2005. Before Specified Items, the effective tax rate in the fourth
quarter of 2006 was a recovery of 3.3% compared to a charge of 21.4% for the corresponding 2005 period.
21
ENDED DECEMBER 31, 2005 (Continued)
Net earnings in the fourth quarter of 2006 were $2.8 million or $0.08 diluted earnings per share compared to $20.9
million or $0.61 diluted earnings per share in the fourth quarter of 2005. Basic earnings per share in the fourth
quarter of 2006 were $0.09 compared to $0.66 in the same 2005 period.
Cash flows from operating activities before changes in non-cash working capital items were $3.0 million in the
fourth quarter of 2006 compared to $30.5 million for the same period in 2005, mainly due to Specified Items
recorded during the fourth quarter of 2006. After changes in non-cash working capital items, operating cash flow
was $28.7 million compared to $11.0 million in the fourth quarter of 2005.
SHARES OUTSTANDING
The basic weighted average number of common shares outstanding in 2006 was 32,220,495 compared to 29,281,145
in 2005. The diluted weighted average number of shares outstanding in 2006 was 34,189,034 compared to
31,390,456 in 2005. The total number of shares outstanding as at December 31, 2006 was 32,664,913 compared to
32,105,575 at the end of 2005. As at April 1, 2007, there was a total of 2,617,306 stock options outstanding.
OUTLOOK FOR 2007
We believe we have a strong product line-up in all of our categories for 2007, with the introduction of many new
products, an exceptional licensed products offering and the launch of arts and crafts and stationery products in new
geographic markets. We expect net sales to increase in North America and in our International markets. Earnings
will be supported by operating synergies resulting from the integration of MEGA Brands America in 2006.
SIGNIFICANT ACCOUNTING POLICIES AND USE OF ESTIMATES
Principles of consolidation and reporting currency
Consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting
principles (“GAAP”) using the U.S. dollar (functional currency) as the reporting currency.
The consolidated financial statements include the accounts of the Corporation and its wholly owned subsidiaries
since the date of acquisition. All intercompany balances and transactions have been eliminated on consolidation.
Use of estimates
Preparation of financial statements in conformity with GAAP requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the
reported amounts of revenue and expenses during the reporting period. Actual results could differ from those
estimates. The most significant areas requiring the use of management estimates relates to: inventory valuation,
valuation of year-end provision on accounts receivable, future income taxes, intangible assets, goodwill, reserves
and allowances, specifically those related to the integration costs, general liability and income taxes.
Revenue recognition
Revenue is recognized when (i) persuasive evidence of an arrangement exists, (ii) products are shipped to customers
and customer takes ownership and assumes risk of loss, (iii) collection of the respective receivable is probable, and
(iv) sales price is fixed or determinable. Accruals for customer discounts, rebates, incentives and defective
allowances are recorded as the related revenues are recognized.
22
SIGNIFICANT ACCOUNTING POLICIES AND USE OF ESTIMATES (Continued)
Vendor allowance
assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the
reported amounts of revenue and expenses during the reporting period. Actual results could differ from those
estimates. The most significant areas requiring the use of management estimates relates to: inventory valuation,
valuation of year-end provision on accounts receivable, future income taxes, intangible assets, goodwill, reserves
and allowances, specifically those related to the integration costs, general liability and income taxes.
Self-insurance
The Corporation is primarily self-insured for MAGNETIX products manufactured before May 1, 2006. Required
accruals for self-insurance liabilities are determined by management based on claims filed and an estimate of claims
incurred but not yet reported, and are not discounted.
Research expenses are charged to earnings net of related tax credits. Unless these expenses meet Canadian GAAP
for deferral, development expenses are charged to earnings, net of the related tax credits. Research and development
expenses are presented net of tax credits of $0.3 million for the year ended December 31, 2006 (2005 - $0.9
million).
Foreign currency translation
Monetary assets and liabilities denominated in currencies other than U.S. dollars (foreign currencies) and monetary
assets and liabilities from foreign integrated subsidiaries are translated at the rates of exchange at the balance sheet
date. Non-monetary balance sheet items denominated in foreign currencies and non-monetary balance sheet items
from foreign integrated subsidiaries are translated at the rates of exchange prevailing at the respective transaction
dates. Revenue and expense items arising from transactions in foreign currencies and from foreign integrated
subsidiaries are translated into U.S. dollars at average rates during each reporting period. Gains or losses on foreign
exchange are recorded in the consolidated statements of earnings.
All unrealized translation gains and losses on assets and liabilities denominated in foreign currencies are included in
earnings for the year.
Derivative Financial Instruments
The Corporation uses various derivative financial instruments to manage interest rate risk and foreign exchange rate
risk and formally documents when required all relationships between derivatives and the items they hedge, and its
risk management objective and strategy for using various hedges. Derivatives that are economic hedges but do not
qualify for hedge accounting are recognized at fair value with the changes in fair value recorded in earnings. The
Corporation does not use derivative financial instruments for speculative or trading purposes.
When hedge accounting is applied, the Corporation formally assesses, both at the hedge's inception and on an
ongoing basis, whether the derivatives used in hedging transactions are highly effective in offsetting changes in fair
values or cash flows of hedged items. Gains and losses on foreign currency forward contracts designated as effective
for hedge accounting are recognized in the consolidated statements of earnings during the same period as the
underlying revenues and expenses. For interest rate swaps, the difference between the swap rate and the actual rate
is reflected against the related interest expense.
23
Gains and losses associated with derivative instruments, which have been terminated or cease to be effective prior to
maturity, are deferred under other assets or liabilities and recognized in the consolidated statement of earnings in the
period in which the underlying hedged transaction is recognized. In the event a designated hedged item is sold,
extinguished or matures prior to the termination of the related derivative instrument, a gain or loss on such
derivative instrument is recognized in the consolidated statement of earnings.
The following table summarizes our foreign currency commitments as at December 31, 2006:
Foreign currency contracts
Sell – Euro to $US
– GBP to $US
Notional
amount
$
6,000
3,000
Average
exchange
rate
Maturing
up to
1.3021
1.8746
Dec. 2007
Dec. 2007
Notional
equivalent
$
7,813
5,624
Fair market
value
$
(154)
(243)
The following table summarizes our interest rate swap agreements as at December 31, 2006:
Interest rate swaps
Notional
amount
$
150,000
Fixed
rate
Maturing
4.66325%
July 2012
Fair market
value
$
2,828
Stock Options and Share Units
The Corporation uses the fair value method to account for all stock-based compensations. This method requires
awards of stock options to be measured on their date of grant using the fair value method. They are expensed and
credited to contributed surplus over their vesting period, and reclassified to capital stock when stock options are
exercised.
The Corporation's share unit plan, which became effective February 24, 2005, allows the Board of Directors to grant
bonuses in the form of share units that are time and performance based, which vest primarily over a three-year
period. The plan is non-dilutive and will be settled in shares purchased from the secondary market, or in cash, at the
option of the Corporation. The share units are accounted for as liabilities on a fair value basis by using the quoted
market price of the common shares at the end of each period. The share units are treated as stock-based
compensation and are expensed and credited to accrued liabilities over the vesting period.
Earnings per share
Basic earnings per share is based on the weighted-average number of units outstanding during the period. The
dilutive effect of stock options is determined using the treasury stock method.
Cash and cash equivalents
Cash and cash equivalents include cash and short-term investments in money market instruments with maturities of
three months or less.
24
Inventories
Inventories are stated at the lower of cost and market value. Cost is established based on the first-in, first-out
method. Market value is defined as replacement cost for raw materials and net realizable value for work in process
and finished goods.
Property, plant and equipment are recorded at cost and are amortized over the lesser of their estimated useful lives
and the term of the lease using the straight-line method and the following amortization periods:
Buildings
Machinery and equipment
Computer equipment
Leasehold improvements
25 years
3 to 15 years
3 to 5 years
Over the terms of the leases
Government grants
Government grants for property, plant and equipment acquisitions are netted against property, plant and equipment
and are amortized on the same basis as the related asset. Government grants to create employment are recorded in
earnings as a reduction of the related expenses when conditions are met.
Intangible assets
Intangible assets with a finite service life are accounted for at cost less accumulated amortization. They consist of
customer relationships and intellectual property which are amortized over twenty years and noncompetition
covenants which are amortized over five years.
Intangible assets with indefinite service life, consisting of the trade name and intellectual property, are accounted for
at cost and are not amortized. The trade name and intellectual property are tested for impairment annually or more
frequently if changes in circumstances indicate a potential impairment. As at December 31, 2006, the Corporation
has performed an impairment test and no write-down was necessary.
Goodwill
Goodwill represents the excess of the acquisition cost of companies over the fair value of the identifiable net assets
acquired and is not amortized. Goodwill is tested for impairment annually or more frequently if changes in
circumstances indicate a potential impairment. As at December 31, 2006, the Corporation has performed an
impairment test and no write-down was necessary.
25
Deferred charges
Deferred charges are comprised mainly of financing charges. The financing charges are recorded at cost and are
amortized according to the straight-line method over the term of the credit facility.
Impairment of long-lived assets
Long-lived assets are reviewed for impairment by management whenever events or changes in circumstances
indicate that the carrying amount of an asset may not be recoverable. Impairment is assessed by comparing the
carrying amount of an asset with its expected future net undiscounted cash flows from use together with its residual
value (net recoverable value). If such assets are considered to be impaired, the impairment to be recognized is
measured by the amount by which the carrying amount of the assets exceeds the fair value.
Future income taxes
The Corporation uses the tax liability method to account for income taxes. Under this method, future tax assets and
liabilities are determined according to differences between the carrying amounts and tax bases of assets and
liabilities. They are measured by applying enacted or substantively enacted tax rates and laws at the date of the
financial statements for the years in which the temporary differences are expected to reverse. It is more likely than
not that all of the future income tax assets will be realized.
New accounting policies
The CICA has issued the following new Handbook Sections and guidelines:
a)
EIC-156, “Accounting by a Vendor for Consideration Given to a Customer (Including a Reseller of the
Vendor's Product)”, was issued and provides guidance to companies that give incentives to customers or
resellers in the form of cash, equity, free gifts, coupons and other. The adoption of EIC-156 is effective for
fiscal years beginning on or after January 1, 2006. The adoption of this guideline reduced net sales by $25.8
million in 2006 and $22.2 million in 2005.
b)
Handbook Section 3831, “Non-Monetary Transactions”, effective for transactions initiated in periods
beginning on or after January 1, 2006. This section prescribes to record non-monetary transactions at fair value
unless the transaction has no commercial substance, it is an exchange of product or property, it is a nonmonetary non-reciprocal transfer to owners or it is not reliably measurable. The adoption of this new
Handbook Section did not have a material impact on the December 31, 2006 consolidated financial statements.
c)
Impact of accounting pronouncements not yet implemented
The CICA has issued the following new Handbook sections that must be adopted by the Corporation for the fiscal
year beginning on January 1, 2007. The Corporation is currently evaluating the impact of the adoption of these new
sections on the consolidated financial statements.
i)
Handbook Section 1506, “Accounting Changes”: This Section established criteria for changing accounting
policies, together with the accounting treatment and disclosure of changes in accounting policies and estimates,
and correction of errors.
26
ii)
Handbook Section 3855, “Financial Instruments - Recognition and Measurement”: This Section describes the
standards for recognizing and measuring financial assets, financial liabilities and non-financial derivatives. All
financial assets, except for those classified as held-to-maturity, and derivative financial instruments must be
measured at their fair value. All financial liabilities must be measured at their fair value if they are classified as
held for trading purposes; if not, they are measured at their carrying value.
iii)
Handbook Section 3865, “Hedges”: This Section describes when hedge accounting is appropriate. Hedge
accounting ensures that all gains, losses, revenues and expenses from the derivative and the item it hedges are
recorded in the statement of earnings in the same period.
iv)
Handbook Section 1530, “Comprehensive Income”, and Section 3251, “Equity”: Comprehensive income is the
change in equity of an enterprise during a period arising from transactions and other events and circumstances
from non-owner sources. It includes items that would normally not be included in net income such as changes
in the foreign currency translation adjustment relating to self-sustaining foreign operations and unrealized
gains or losses on available-for-sale financial instruments. This Section describes how to report and disclose
comprehensive income and its components. Section 3251 replaces Section 3520, “Surplus”, and describes the
changes in how to report and disclose equity and changes in equity as a result of the new requirements of
Section 1530. Upon adoption of this Section, the consolidated financial statements will include a statement of
comprehensive income.
RISKS AND UNCERTAINTIES
Realization of Synergies from the Integration of MEGA Brands America
We may not realize the expected synergies of the MEGA Brands America acquisition, including anticipated sales
growth or the estimated revenue and cost synergies. The expected cost synergies resulting from the recent
acquisition of MEGA Brands America assume that (i) we will continue to manufacture products that maintain or
increase the level of product quality; (ii) our new distribution center is able to meet customer demand in a timely and
efficient manner; (iii) that we are able to retain key personnel and attract qualified employees to consolidate the
integration of MEGA Brands America at both the operations and administrative level. In addition and beyond the
matters outlined in “Specified Items Affecting Operations”, the overall integration of the companies may result in
unanticipated operational issues, expenses and liabilities, and a diversion of management's attention, which could
have a material adverse effect on our financial condition, business operations, business prospects and results of
operations.
27
RISKS AND UNCERTAINTIES (Continued)
Litigation
We are involved in a number of litigious matters, including but not limited to environmental and product liability
and there can be no assurance that additional litigation will not arise in the future. As previously disclosed, the
former shareholders of Rose Art Industries, Inc. filed on May 8, 2006 a complaint against the Corporation seeking
payment of certain amounts due under the SPA. Additionally, on November 17, 2006, two of the former
shareholders who held executive positions with Rose Art Industries, Inc. filed arbitration proceedings seeking
unspecified damages for the Corporation's alleged breach of their employment agreements. The unfavorable
disposition of pending or future litigation and arbitration could have a material adverse effect on our financial
condition and results of operations. Litigation may result in substantial costs and expenses and may significantly
divert the attention of management regardless of the outcome. There can be no assurance that we will be able to
achieve a favorable settlement of pending litigation or obtain a favorable disposition of litigation that is not settled.
In addition, current and future litigation, governmental proceedings, labor disputes or environmental matters could
lead to increased costs or interruption of our normal business.
Risks and Uncertainties (Continued)
We are subject to regulation by the CPSC and similar state, provincial and international regulatory authorities and
our products could be subject to involuntary recalls and other actions by such authorities. We may also voluntarily
recall selected products out of concern for product safety. On March 31, 2006, we jointly announced with the CPSC
a voluntary recall and replacement program of MAGNETIX building sets in the hands of families with children
under the age of six. This action was taken in response to the death of a toddler and injuries to several children
resulting from magnet ingestion. Approximately 14,000 consumer contacts were received under this program in
2006. The Corporation, jointly with the CPSC, continues to monitor the performance of these toys in the market to
ensure that all safety standards are met.
We may experience defects in products after their production and sale to consumers. Recalls or defects could result
in the rejection of our products by consumers, damage to our reputation, lost sales, negative publicity, fines or
penalties diverted development resources and increased customer service and support costs, any of which could have
a material adverse effect on our financial condition, business operations and/or business prospects. Individuals may
sustain injuries from our products and we may be subject to claims and lawsuits resulting from such injuries.
On October 24, 2006, the Corporation announced that it had settled four lawsuits and ten claims related to injuries to
children resulting from the ingestion of magnets. The aggregate amount paid to settle the lawsuits and claims is
$13.5 million and is recorded as a product liability settlement expense in the 2006 consolidated statement of
earnings. The Corporation expects to recover substiantially the full amount from its insurers and through other
recourses, although there can be no assurance that a favorable outcome will be achieved. Discussions with our
insurers in this regard are underway.
On September 14, 2006 and on December 5, 2006, two lawsuits related to magnet ingestion requiring surgical
removal were served on the Corporation and remain outstanding. On March 29, 2007 the Corporation learned that a
third lawsuit had been filed in U.S. District Court in Denver by the family of a child who is alleged to have sustained
similar injuries. The Corporation is also aware of at least seven other incidents in which children are alleged to have
required surgery following the ingestion of multiple magnets. The Corporation is not able to assess with any
certainty the outcome of theses lawsuits and claims or impact, if any. As such, no amounts have been reserved in our
year-end financial statements. There can be no assurance that additional incidents, lawsuits or claims will not arise,
or that additional enquiries by the CPSC or other regulatory authorities in respect of MAGNETIX or other products
will not be brought in the future, or result in additional product recalls.
28
In addition to the foregoing, on March 28, 2007, the Corporation learned that a competitor who sells magnetic
building sets primarily in Europe, Plastwood S.R.L. and Plastwood Corporation, filed a complaint against MEGA
Brands America and MEGA Brands in the Western District of Washington. The complaint is based in significant
part on representations alleged to have been made prior to the Corporation's acquisition of MEGA Brands America.
The complaint does not provide support for Plastwood's allegations of its own lost sales and other consequences.
The Corporation believes it has valid defenses to the complaint and intends to defend the action vigorously.
However, there can be no assurance of a favorable outcome.
International Operations
Our own sales, manufacturing and distribution facilities, as well as the utilization of third-party distribution,
independent sales representatives and contract manufacturers, are subject to the risks normally associated with
international operations, including: (i) costs associated with the repatriation of earnings; (ii) civil unrest and political
and economic instability; (iii) significantly concentrated outbreaks of communicable diseases; (iv) greater difficulty
protecting intellectual property rights; (v) complications in complying with foreign laws, fiscal regulations and
changes in governmental policies; (vi) increased delivery lead time and potential for transportation delays and
interruptions; (vii) the imposition of tariffs or trade sanctions; (viii) the loss of “most favored” trading status by the
People's Republic of China in the United States or the European Union and; (ix) the difficulty of attracting and
retaining local financial managers with knowledge and experience of North American accounting and internal
control standards, and possessing English-language skills. There can be no assurance that these risks will not result
in a material adverse effect on our financial condition and results of operations.
Insurance Coverage
Although the Corporation believes it has adequate product liability insurance generally, there is a risk that claims or
liabilities could exceed or fall outside the scope of our insurance coverage, or impede our ability to obtain adequate
insurance coverage in the future. As a result of the voluntary recall and replacement campaign with the CPSC on
March 31, 2006 aimed at MAGNETIX building sets and the ensuing publicity and product liability lawsuits and
claims against the Corporation, the cost of insurance coverage for these products manufactured before May 1, 2006
was prohibitive and as such, the Corporation is self-insured for incidents occuring after December 1, 2006 for
MAGNETIX products manufactured before May 1, 2006. Consequently, the unfavorable disposition of any selfinsured MAGNETIX related litigation could have a material adverse effect on our financial condition and results of
operations.
As at April 1, 2007, insurance coverage has been confirmed subject to a standard reservation of rights for two of the
three outstanding product liability lawsuits. For the most recent lawsuit filed March 29, 2007, coverage has not been
assessed.
29
Consumer Preferences
Our business and operating results depend largely upon the appeal of our toy and stationery products. Our continued
success will depend on our ability to enhance and extend existing product lines and to develop, introduce and gain
consumer acceptance of new products. However, consumer preferences in our industry are continuously changing
and are difficult to predict. Individual products typically have short life cycles, and there have been recent trends
towards children outgrowing toys at younger ages, particularly in favor of interactive and high technology products,
and an increased use of high technology in toys. There can be no assurance that: (i) any of our current product lines
will continue to be popular for any significant period of time; (ii) any new products we introduce will achieve an
adequate degree of market acceptance; or (iii) any new products' life cycles will be sufficient to permit us to recover
development, manufacturing, marketing and other costs. A decline in the popularity of our existing products or the
failure of new products to achieve and sustain market acceptance and to produce acceptable margins could have a
material adverse effect on our financial condition and results of operations. Additionally, ongoing negative publicity
surrounding MAGNETIX toys in the U.S. and other key markets may result in a loss of consumer confidence in the
brand.
Rate of Growth or Profitability
There can be no assurance that our rate of growth will continue or that we will be able to maintain our present level
of net sales or profitability. Furthermore, future growth, if achieved, may place a strain on our management and
financial controls systems, and there can be no assurance that management would be able to manage such growth
effectively. Failure to manage any future growth experienced by us could have a material adverse effect on our
financial condition and results of operations.
Customer Concentration
For the year ended December 31, 2006, our two largest customers accounted for approximately 39.1% of net sales.
We do not have firm purchase commitments from any of our customers. If some of these customers were to cease
doing business with us or to reduce the amount of their purchases, by virtue of experiencing financial difficulty or
otherwise, it could have a material adverse effect on our sales, financial condition and results of operations. In
addition, most large retail chains have begun to sell private-label toys, arts and crafts and office products designed
and branded by the retailers themselves. Such private label items may be sold at prices lower than our comparable
products, and may result in lower purchases of our products by such retailers. Additionally, in recent years, several
large customers engaged in price cutting of toy products during the holiday season, and arts and crafts and stationery
products during the back-to-school season, which, if these trends continue, could have a material adverse effect on
our gross profit, profitability and consumer perception of the brand equity of our products.
Prices of Raw Materials
Our principal raw material is plastic resin, which is subject to the volatility in crude oil prices. We do not hedge
against adverse price fluctuations. Furthermore, limited supplier production capacity and strong demand have placed
upward pressure on the price of resin. There can be no assurance that this pressure will decline. While we have
succeeded in passing on a portion of the increase in the price of plastic resin to our customers, there is no assurance
we will be able to continue to do so, particularly if there are substantial price increases or that price increases occur
over a sustained period. Prices of other raw materials are also subject to fluctuations. Unfavorable swings in
commodity prices could have a material adverse effect on our financial condition and results of operations.
30
Currency Fluctuations
We are exposed to market risks attributable to fluctuations in foreign currency exchange rates, primarily changes in
the value of the U.S. dollar versus other currencies such as the Canadian dollar, Euro, British pound, Mexican peso
and Australian dollar. Our policy is to stabilize earnings by limiting foreign currency exposure mainly through
forward exchange contracts. Our risk management approach is to have hedging mechanisms in place for a maximum
period of 24 months. Our hedging policy strictly prohibits unauthorized speculative foreign exchange transactions.
We only enter into forward contract agreements with solid financial counterparties. Furthermore, in order to limit
the risk of incurring losses in the event the counterparty does not fulfill its obligation, we only enter into forward
exchange contract agreements with members of our lending syndicate. We do this because we are not required to
provide additional security and/or guarantees to the members of the lending syndicate other than the security
package already in place under our credit agreement.
Seasonality
Our business is seasonal and therefore our annual operating results depend in large part on our sales during the third
and fourth quarters. This seasonality is increasing as large retailers become more efficient in their control of
inventory levels through just-in-time inventory management systems. Retailers require the Corporation to ship
products closer to the time they expect to sell the products to consumers creating shorter lead times for production
and increased pressure to fill orders promptly. The logistics of supplying more products within shorter time periods
increases the risk that we will fail to achieve compressed shipping schedules, which may reduce our sales and affect
our financial performance.
Risks Relating to Licensed Products
While we attempt to balance our licensed and non-licensed product offerings, and to make a judicious selection of
brands and entertainment properties which we license from third-parties, there is a risk that guaranteed royalty
payments and advances thereon which we are required to pay to licensors may not be recouped from the sale of
licensed products. Additionally, the sale of licensed products relating to entertainment properties, particularly
theatrical releases, often presents limited durations during which our customers will carry licensed product
inventory, which consequently could reduce demand for such licensed products.
Retail Environment
The retail environment is highly competitive and there is no assurance that retailers who sell our products will not
experience liquidity problems such as those that led to a rationalization of the mass-market retail channel in North
America in recent years. If our key customers were to delay payments or cease doing business as a result of liquidity
problems or bankruptcy, this could have a material adverse effect on our financial condition and results of
operations.
Construction Toy Litigation
We are currently involved in litigation proceedings, which, regardless of the outcome, may result in substantial
expenses and divert the attention of management. The most significant proceedings against us involve our principal
competitor, The Lego Group (“Lego”). Lego continues to challenge the Corporation's sale of functionally and
aesthetically compatible construction toys in various markets. There can be no assurance that we will achieve a
favorable outcome in any of these markets. The unfavorable disposition of pending litigation could have a material
adverse effect on our financial condition, operations and business prospects.
31
On July 10, 2006, the Office for Harmonization of the Internal Market of the European Union (Trade Marks and
Designs) Grand Board of Appeal (“OHIM”) affirmed the cancellation of a three-dimensional Community
Trademark registration for a brick design in the name of Lego Juris A/S (“Lego”), with respect to wares described as
“construction toys”. Lego subsequently appealed this decision to the European Court of First Instance, where the
matter is now pending. The Corporation believes that the trend of jurisprudence in such matters favors public access
to useful product configurations, like the basic Lego block, which are no longer protected by patents, and the
Corporation does not expect Lego to succeed with its appeal.
Financing and Interest Rates
Increases in interest rates, both domestically and internationally, could negatively affect the cost of financing both
our operations and investments. Any reduction in our credit ratings could increase the cost of obtaining financing.
Additionally, our ability to issue long-term debt and obtain seasonal financing could be adversely affected by factors
such as an inability to meet our debt covenant requirements. The ability to conduct our operations could be
negatively impacted should these or other adverse conditions affect our primary sources of liquidity.
DISCLOSURE CONTROLS AND PROCEDURES
We comply with Multilateral Instrument 52-109 - Certification of Disclosure in Issuers' Annual and Interim Filings
issued by the Canadian Securities Administrators. The President and Chief Executive Officer and the Executive
Vice-President and Chief Financial Officer together with Management, have evaluated the effectiveness of the
Corporation's disclosure controls and procedures and the design of internal controls over financial reporting
(“ICFR”) as at December 31, 2006. They have concluded that the Corporation's disclosure controls and procedures
were adequate and effective to ensure that material information relating to the Corporation and its subsidiaries is
complete and reliable.
During the course of its evaluation, which focused intensively on the integration of MEGA Brands America and its
subsidiaries, Management identified a limited number of significant weaknesses that were not considered material
either individually or in the aggregate. In response to the significant weaknesses identified, additional manual
controls were performed for the annual closing process.
The following significant, non-material ICFR weaknesses have been identified and are described in conjunction with
their corresponding remediation plans:
1.
Lack of sufficient resources in our accounting and finance organization. Due to sustained organic growth
combined with the acquisition of MEGA Brands America and its subsidiaries, the Corporation lacks a
sufficient complement of personnel with a level of financial reporting expertise commensurate with our
financial reporting requirements. In fiscal 2007, we began to implement a finance structure designed to meet
the challenges presented by the overall growth of the Corporation. As such, additional accounting professionals
will be hired to remediate this aspect of its ICFR.
2.
Monitoring of non-routine and non-systematic transactions. We did not have effective compliance with
controls that are in place to monitor and accurately record non-routine and non-systematic transactions. This
weakness is primarily related to the difficulty of ensuring that internal controls are well-understood and
harmonized across the organization. A key aspect of the remediation plan in regard to this significant, nonmaterial ICFR weakness took place in December 2006, when the Corporation converted the MEGA Brands
America information technology platform to the one used by the Corporation to ensure consistent and timely
communication of financial and accounting information. The Corporation has performed additional manual
testing to ensure that the accounting for such non-routine and non-systematic transactions is appropriate and
materially correct.
32
DISCLOSURE CONTROLS AND PROCEDURES (Continued)
3.
Controls over financial reporting of foreign subsidiaries. We did not have effective compliance with controls
that are in place to ensure adherence to the ICFR of foreign subsidiaries, particularly as concerns the
monitoring and tracking o inventory in our China manufacturing facility and at the Fife, Washington
distribution center of MEGA Brands America. To address this ICFR weakness, the Corporation has instituted
the process of analyzing inventory variances on a monthly basis and has seconded senior finance personnel to
supervise the accounting procedures and inventory controls at the close of each quarter. The information
technology platform of our Chinese facility will be converted in 2007 to ensure more consistent and timely
communication of financial and accounting information. With respect to the Fife facility, MEGA Brands
America has already converted to the information technology platform used by the Corporation to ensure
consistent and timely communication of financial and accounting information.
ADDITIONAL INFORMATION
Additional information about MEGA Brands, including our Annual Information Form, is available on SEDAR at
www.sedar.com.
33
MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL REPORTING
The accompanying Consolidated Financial Statements of MEGA Brands Inc. have been prepared by management
and approved by the Board of Directors. Management is responsible for the information and representation contained
in these financial statements and in other sections of this Annual Report.
To meet its responsibility for the integrity and objectivity of data in the Consolidated Financial Statements,
management has developed and maintains a system of internal accounting controls. Management believes that this
system of internal accounting controls provides reasonable assurance that the financial records are reliable and form a
proper basis for preparation of financial statements, and that the assets are properly accounted for and safeguarded.
The Board of Directors carries out its responsibility for financial statements in this Annual Report principally through
its Audit Committee. The Company’s auditors have full access to the Audit Committee, with and without management
being present. The Consolidated Financial Statements have been audited by PricewaterhouseCoopers LLP Chartered
Accountants, and their report is shown as part of the Consolidated Financial Statements.
(signed)
Marc Bertrand
(signed)
Alain Tanguay
Executive Vice-President and Chief Financial Officer
April 1, 2007
34
AUDITORS’ REPORT
To the Shareholders of MEGA Brands Inc.
(formerly Mega Bloks Inc.)
We have audited the consolidated balance sheet of MEGA Brands Inc. as at December 31, 2006 and the
consolidated statements of earnings, retained earnings and cash flows for the year then ended. These financial
statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on
these financial statements based on our audit.
We conducted our audit in accordance with Canadian generally accepted auditing standards. Those standards require
that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial statement presentation.
In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position
of MEGA Brands Inc. as at December 31, 2006 and the results of its operations and its cash flows for the year then
ended in accordance with Canadian generally accepted accounting principles.
The consolidated financial statements as at December 31, 2005 and for the year then ended were audited by other
auditors who expressed an opinion without reservation on those statements in their report dated March 23, 2006.
(signed)
PricewaterhouseCoopers
Chartered Accountants
Montréal, Québec
April 1, 2007
35
MEGA Brands Inc.
Consolidated Statements of Earnings
For the years ended December 31, 2006 and 2005
(in thousands of U.S. dollars, except per share amounts)
2006
$
2005
$
Net sales (note 3)
547,347
384,863
Cost of sales
328,822
214,668
Gross profit (note 4)
218,525
170,195
Other selling, distribution and administrative expenses
Voluntary product recall and replacement (note 4)
Product liability settlement and related expenses (note 5)
Integration expenses (note 6)
Litigation expenses (note 7)
26,808
18,334
109,815
(4,846)
5,612
15,490
3,573
4,769
24,573
9,402
71,074
2,796
-
38,970
62,350
22,526
177
9,310
954
22,703
10,264
16,267
52,086
(1,217)
(7,864)
5,473
7,005
(9,081)
12,478
25,348
39,608
0.79
0.74
1.35
1.26
Interest on long-term debt
Other interest (note 8)
Earnings before income taxes
Income taxes (note 9)
Current
Future
Net earnings for the year
Earnings per share (note 10)
Basic
Diluted
The accompanying notes are an integral part of these consolidated financial statements.
36
MEGA Brands Inc.
Consolidated Statements of Retained Earnings (Deficit)
(in thousands of U.S. dollars)
2006
$
2005
$
(12,712)
(52,320)
25,348
39,608
Retained earnings (deficit) – End of year
12,636
(12,712)
Deficit – Beginning of year
37
MEGA Brands Inc.
Consolidated Balance Sheets
As at December 31, 2006 and 2005
2006
$
2005
$
13,658
161,612
140,630
9,317
8,354
12,025
19,567
173,666
82,280
13,396
8,324
345,596
297,233
Property, plant and equipment (note 14)
43,213
39,351
Intangible assets (note 15)
79,517
72,230
Goodwill (note 16)
300,829
306,973
Deferred charges
3,281
4,708
28,006
-
Assets
Current assets
Accounts receivable (note 12)
Inventories (note 13)
Income taxes
Future income taxes (note 9)
Prepaid expenses
800,442
720,495
153,437
57,825
9,609
108,025
74,075
4,744
8,784
220,871
195,628
302,345
292,169
27,782
12,682
550,998
500,479
236,088
231,592
Liabilities
Current liabilities
Accounts payable and accrued liabilities
Additional consideration accrued on business combination (note 11)
Income taxes
Current portion of long-term debt
Long-term debt (note 17)
Shareholders’ Equity
Capital stock (note 18)
Contributed surplus (note 19)
720
Retained earnings (deficit)
12,636
(12,712)
249,444
220,016
800,442
720,495
Commitments and contingencies (note 22)
Approved by the Board of Directors
(signed) Marc Bertrand, Director
(signed) Vic Bertrand, Director
38
1,136
MEGA Brands Inc.
Consolidated Statements of Cash Flows
2006
$
2005
$
25,348
39,608
12,462
1,044
667
2,126
(7,864)
(2,610)
10,343
1,538
161
732
7,005
1,680
31,173
(15,300)
61,067
(36,026)
15,873
25,041
(28,998)
(624)
40,000
3,882
-
300,000
(13,409)
(36,382)
(11,000)
57,158
(4,457)
14,260
291,910
(17,456)
304
(18,890)
(9,977)
(1,391)
(291,623)
(36,042)
(302,991)
Increase (decrease) in cash and cash equivalents
(5,909)
13,960
Cash and cash equivalents – Beginning of year
19,567
5,607
Cash and cash equivalents – End of year
13,658
19,567
Cash flow from
Operating activities
Items not affecting cash and cash equivalents
Amortization of property, plant and equipment
Amortization of deferred charges
Amortization of intangible assets
Stock-based compensation plans
Future income taxes
Loss (gain) on foreign currency
Changes in non-cash operating working capital items (note 20)
Financing activities
Proceeds from long-term debt
Repayment of long-term debt
Repayment of subsidiary indebtedness upon acquisition
Change in revolving credit facility
Issuance of capital stock
Addition of deferred charges
Investing activities
Acquisition of property, plant and equipment
Acquisition of intangible assets
Proceeds from disposal of property, plant and equipment
Business combinations (note 11)
Supplementary disclosure of cash flow information (note 20)
39
MEGA Brands Inc.
Notes to Consolidated Financial Statements
(column figures are expressed in thousands of U.S. dollars, except per share data)
1
Nature of business
On June 15, 2006, the shareholders adopted a special resolution authorizing the Corporation to change its legal
name to MEGA Brands Inc. (formerly Mega Bloks Inc.). On June 22, 2006, the Corporation filed the
amendment to its articles of incorporation under the Canada Business Corporations Act to change its name. The
legal names of the Corporation’s principal subsidiaries have been changed to MEGA Brands America, Inc.
(formerly Rose Art Industries, Inc.), MEGA Brands Europe NV (formerly Mega Bloks Europe NV) and MEGA
Brands International (formerly Mega Bloks International Sàrl).
The Corporation designs, manufactures and markets a broad line of toys and stationery and activities products.
The Corporation sells and distributes its products in over 100 countries under the MEGA BLOKS, ROSE ART,
MAGNETIX and BOARD DUDES brands.
2
Significant accounting policies
Principles of consolidation and reporting currency
Consolidated financial statements have been prepared in accordance with Canadian generally accepted
accounting principles (“GAAP”) using the U.S. dollar (functional currency) as the reporting currency.
The consolidated financial statements include the accounts of the Corporation and its wholly owned
subsidiaries since the date of acquisition. All intercompany balances and transactions have been eliminated on
consolidation.
Use of estimates
assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and
the reported amounts of revenue and expenses during the reporting period. Actual results could differ from
those estimates. The most significant areas requiring the use of management estimates relates to: inventory
valuation, valuation of year-end provision on accounts receivable, future income taxes, intangible assets,
goodwill, reserves and allowances, specifically those related to the integration costs, general liability and
income taxes.
Revenue recognition
Revenue is recognized when (i) persuasive evidence of an arrangement exists, (ii) products are shipped to
customers and customer takes ownership and assumes risk of loss, (iii) collection of the respective receivable is
probable, and (iv) sales price is fixed or determinable. Accruals for customer discounts, rebates, incentives and
defective allowances are recorded as the related revenues are recognized.
40
MEGA Brands Inc.
Vendor allowance
The cash considerations received from vendors are deemed a reduction of the prices of the vendors’ products or
services and are accounted for as a reduction of cost of sales and related inventory when recognized in the
Corporation’s consolidated statements of earnings and balance sheets. Certain exceptions apply when the cash
considerations received are either a reimbursement of incremental selling costs incurred by the Corporation, or
a payment for assets or services delivered to the vendors.
Self-insurance
The Corporation is primarily self-insured for MAGNETIX products manufactured before May 1, 2006.
Required accruals for self-insurance liabilities are determined by management based on claims filed and an
estimate of claims incurred but not yet reported, and are not discounted.
Research expenses are charged to earnings net of related tax credits. Unless these expenses meet Canadian
GAAP for deferral, development expenses are charged to earnings, net of the related tax credits. Research and
development expenses are presented net of tax credits of $0.3 million for the year ended December 31, 2006
(2005 – $0.9 million).
Foreign currency translation
Monetary assets and liabilities denominated in currencies other than U.S. dollars (foreign currencies) and
monetary assets and liabilities from foreign integrated subsidiaries are translated at the rates of exchange at the
balance sheet date. Non-monetary balance sheet items denominated in foreign currencies and non-monetary
balance sheet items from foreign integrated subsidiaries are translated at the rates of exchange prevailing at the
respective transaction dates. Revenue and expense items arising from transactions in foreign currencies and
from foreign integrated subsidiaries are translated into U.S. dollars at average rates during each reporting
period. Gains or losses on foreign exchange are recorded in the consolidated statements of earnings.
All unrealized translation gains and losses on assets and liabilities denominated in foreign currencies are
included in earnings for the year.
Derivative financial instruments
The Corporation uses various derivative financial instruments to manage interest rate risk and foreign exchange
rate risk and formally documents when required all relationships between derivatives and the items they hedge,
and its risk management objective and strategy for using various hedges. Derivatives that are economic hedges
but do not qualify for hedge accounting are recognized at fair value with the changes in fair value recorded in
earnings. The Corporation does not use derivative financial instruments for speculative or trading purposes.
41
MEGA Brands Inc.
When hedge accounting is applied, the Corporation formally assesses, both at the hedge’s inception and on an
ongoing basis, whether the derivatives used in hedging transactions are highly effective in offsetting changes in
fair values or cash flows of hedged items. Gains and losses on foreign currency forward contracts designated as
effective for hedge accounting are recognized in the consolidated statements of earnings during the same period
as the underlying revenues and expenses. For interest rate swaps, the difference between the swap rate and the
actual rate is reflected against the related interest expense.
Gains and losses associated with derivative instruments, which have been terminated or cease to be effective
prior to maturity, are deferred under other assets or liabilities and recognized in the consolidated statement of
earnings in the period in which the underlying hedged transaction is recognized. In the event a designated
hedged item is sold, extinguished or matures prior to the termination of the related derivative instrument, a gain
or loss on such derivative instrument is recognized in the consolidated statement of earnings.
Stock options and share units
The Corporation uses the fair value method to account for all stock-based compensations. This method requires
awards of stock options to be measured on their date of grant using the fair value method. They are expensed
and credited to contributed surplus over their vesting period, and reclassified to capital stock when stock
options are exercised.
The Corporation’s share unit plan, which became effective February 24, 2005, allows the Board of Directors to
grant bonuses in the form of share units that are time and performance based, which vest primarily over a
three-year period. The plan is non-dilutive and will be settled in shares purchased from the secondary market,
or in cash, at the option of the Corporation. The share units are accounted for as liabilities on a fair value basis
by using the quoted market price of the common shares at the end of each period. The share units are treated as
stock-based compensation and are expensed and credited to accrued liabilities over the vesting period.
Earnings per share
Basic earnings per share is based on the weighted-average number of units outstanding during the period. The
dilutive effect of stock options is determined using the treasury stock method.
Cash and cash equivalents include cash and short-term investments in money market instruments with
maturities of three months or less.
Inventories
Inventories are stated at the lower of cost and market value. Cost is established based on the first-in, first-out
method. Market value is defined as replacement cost for raw materials and net realizable value for work in
process and finished goods.
42
MEGA Brands Inc.
Property, plant and equipment are recorded at cost and are amortized over the lesser of their estimated useful
lives and the term of the lease using the straight-line method and the following amortization periods:
Buildings
Computer equipment
25 years
3 to 15 years
3 to 5 years
Over the terms of the leases
Government grants
Government grants for property, plant and equipment acquisitions are netted against property, plant and
equipment and are amortized on the same basis as the related asset. Government grants to create employment
are recorded in earnings as a reduction of the related expenses when conditions are met.
Intangible assets
Intangible assets with a finite service life are accounted for at cost less accumulated amortization. They consist
of customer relationships and intellectual property which are amortized over twenty years and non-competition
covenants which are amortized over five years.
Intangible assets with indefinite service life, consisting of the trade name and intellectual property, are
accounted for at cost and are not amortized. The trade name and intellectual property are tested for impairment
annually or more frequently if changes in circumstances indicate a potential impairment. As at December 31,
2006, the Corporation has performed an impairment test and no write-down was necessary.
Goodwill
Goodwill represents the excess of the acquisition cost of companies over the fair value of the identifiable net
assets acquired and is not amortized. Goodwill is tested for impairment annually or more frequently if changes
in circumstances indicate a potential impairment. As at December 31, 2006, the Corporation has performed an
impairment test and no write-down was necessary.
Deferred charges
Deferred charges are comprised mainly of financing charges. The financing charges are recorded at cost and are
amortized according to the straight-line method over the term of the credit facility.
Impairment of long-lived assets
Long-lived assets are reviewed for impairment by management whenever events or changes in circumstances
indicate that the carrying amount of an asset may not be recoverable. Impairment is assessed by comparing the
carrying amount of an asset with its expected future net undiscounted cash flows from use together with its
residual value (net recoverable value). If such assets are considered to be impaired, the impairment to be
recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value.
43
MEGA Brands Inc.
Future income taxes
The Corporation uses the tax liability method to account for income taxes. Under this method, future tax assets
and liabilities are determined according to differences between the carrying amounts and tax bases of assets and
liabilities. They are measured by applying enacted or substantively enacted tax rates and laws at the date of the
financial statements for the years in which the temporary differences are expected to reverse. It is more likely
than not that all of the future income tax assets will be realized.
3
New accounting policies
The CICA has issued the following new Handbook Sections and guidelines:
a)
EIC-156, “Accounting by a Vendor for Consideration Given to a Customer (Including a Reseller of the
Vendor’s Product)”, was issued and provides guidance to companies that give incentives to customers or
resellers in the form of cash, equity, free gifts, coupons and other. The adoption of EIC-156 is effective for
fiscal years beginning on or after January 1, 2006. The adoption of this guideline reduced net sales by
$25.8 million in 2006 and $22.2 million in 2005.
b)
Handbook Section 3831, “Non-Monetary Transactions”, effective for transactions initiated in periods
beginning on or after January 1, 2006. This section prescribes to record non-monetary transactions at fair
value unless the transaction has no commercial substance, it is an exchange of product or property, it is a
non-monetary non-reciprocal transfer to owners or it is not reliably measurable. The adoption of this new
Handbook Section did not have a material impact on the December 31, 2006 consolidated financial
statements.
c)
The CICA has issued the following new Handbook sections that must be adopted by the Corporation for
the fiscal year beginning on January 1, 2007. The Corporation is currently evaluating the impact of the
adoption of these new sections on the consolidated financial statements.
i)
Handbook Section 1506, “Accounting Changes”: This Section established criteria for changing
accounting policies, together with the accounting treatment and disclosure of changes in accounting
policies and estimates, and correction of errors.
ii)
Handbook Section 3855, “Financial Instruments – Recognition and Measurement”: This Section
describes the standards for recognizing and measuring financial assets, financial liabilities and nonfinancial derivatives. All financial assets, except for those classified as held-to-maturity, and
derivative financial instruments must be measured at their fair value. All financial liabilities must be
measured at their fair value if they are classified as held for trading purposes; if not, they are
measured at their carrying value.
44
MEGA Brands Inc.
iii) Handbook Section 3865, “Hedges”: This Section describes when hedge accounting is appropriate.
Hedge accounting ensures that all gains, losses, revenues and expenses from the derivative and the
item it hedges are recorded in the statement of earnings in the same period.
iv) Handbook Section 1530, “Comprehensive Income”, and Section 3251, “Equity”: Comprehensive
income is the change in equity of an enterprise during a period arising from transactions and other
events and circumstances from non-owner sources. It includes items that would normally not be
included in net income such as changes in the foreign currency translation adjustment relating to
self-sustaining foreign operations and unrealized gains or losses on available-for-sale financial
instruments. This Section describes how to report and disclose comprehensive income and its
components. Section 3251 replaces Section 3520, “Surplus”, and describes the changes in how to
report and disclose equity and changes in equity as a result of the new requirements of Section 1530.
Upon adoption of this Section, the consolidated financial statements will include a statement of
comprehensive income.
4
Under a voluntary recall and replacement program of MAGNETIX products jointly announced with the
Consumer Products Safety Commission (“CPSC”) on March 31, 2006, the Corporation recorded product
replacement expenses of $5.6 million, consisting of freight costs to meet customer shipment dates due to
manufacturing delays resulting from design changes to MAGNETIX products, related packaging and
development costs, and product replacements for consumers.
In addition, the Corporation recorded reimbursements of MAGNETIX products returned by customers of $6.6
million as a reduction of sales. The Corporation also recorded write-offs of MAGNETIX components of $4.3
million as a result of design changes to such components and recorded inventory write-offs of $4.2 million
following plant closures as part of the integration of MEGA Brands America. These write-offs have been
included in cost of sales.
5
2006
$
Settlement payments (note 22(b))
Legal expenses
2005
$
13,500
1,990
-
15,490
-
The Corporation expects to recover substantially the full settlement amount of $13.5 million from its insurers
and through other recourses. Since there is no assurance that a favourable outcome will be achieved, no
recovery has been recognized as at December 31, 2006.
45
MEGA Brands Inc.
6
The Corporation recorded integration expenses of $3.6 million mainly related to branding, plant asset
write-offs, travel and professional fees and plant closure costs resulting from the integration of MEGA Brands
America.
7
Litigation expenses
The Corporation recorded litigation expenses of $4.8 million, mainly for the litigation with the former
shareholders of Rose Art (note 22(a)).
8
Other interest
Facility fees net of interest revenue
Write-off of deferred expenses related to previous credit facility
Bridge loan fees
9
2006
$
2005
$
177
-
39
727
188
177
954
Income taxes
a)
The following table is a reconciliation of the differences between the statutory income tax rate and the
effective income tax rate:
Income tax expense at Canadian statutory rate
Benefits arising from financing structures
Effects of foreign tax rate differences
Others
Income tax expense (recovery)
46
2006
$
2005
$
5,209
(8,466)
(11,666)
5,842
16,303
(2,085)
(2,300)
560
(9,081)
12,478
MEGA Brands Inc.
b)
As at December 31, future income taxes are as follows:
Future income tax assets
Accrued integration charges and accrued liabilities
Share issue costs
Loss carryforward
Interest deduction carryforward
Asset revaluation
Others
2006
$
2005
$
3,075
2,856
411
17,882
7,049
2,571
2,516
11,631
1,202
1,557
36,360
14,390
Loss carryforward relates to MEGA Brands America and will expire no later than 2026.
2006
$
Future income tax liabilities
Intangible assets and goodwill
Unrealized portion of foreign exchange gain
Others
Future income taxes – net
Classified in the consolidated financial statements as
Current
Long-term
Future income tax liabilities
Long-term
Future income taxes – net
47
2005
$
7,075
11,914
310
8,483
7,048
4,230
314
2,084
27,782
13,676
8,578
714
8,354
28,006
13,396
-
36,360
13,396
27,782
12,682
8,578
714
MEGA Brands Inc.
10 Earnings per share
The following table sets forth the computation of basic and diluted earnings per share:
Numerator for basic and diluted net earnings per
common share
Net income attributable to common shareholders
Denominator for basic net earnings per common share
Weighted average number of common shares outstanding
Basic earnings per share
2006
2005
$25,348
$39,608
32,220,495
29,281,145
$0.79
$1.35
Denominator for diluted net earnings per common share
Weighted average number of common shares outstanding
Plus impact of stock options
32,220,495
1,968,539
29,281,145
2,109,311
Diluted average number of common shares
34,189,034
31,390,456
Diluted earnings per share
$0.74
$1.26
11 Business combinations
a)
On January 24, 2006, the Corporation, through its subsidiary MEGA Brands America, entered into an
agreement to acquire all voting shares of The Board Dudes, Inc. (“Board Dudes”), a privately held
corporation based in Corona, California. Board Dudes designs and distributes dry-erase boards, cork
boards, foam boards, and school and locker products. The purchase price paid is $17 million subject to
certain adjustments and was financed through existing credit facilities. During the third quarter of 2006, as
part of these adjustments, an amount of $1.9 million was paid to the Board Dudes principals. Contingent
consideration to the selling principals of up to $7 million is payable between 2006 and 2009 depending on
the attainment of certain performance targets. Any additional consideration will be recorded to goodwill.
The transaction closed on February 1, 2006 and the results of operations are included in the consolidated
statement of earnings as of this date.
48
MEGA Brands Inc.
The acquisition was accounted for using the purchase method. The purchase price allocation was finalized
in the fourth quarter of 2006. The fair value of net assets acquired was as follows:
$
Assets acquired
Non-cash working capital
Intangible assets
Goodwill(1)
Long-term debt
3,050
98
7,990
8,376
(624)
Non-cash assets acquired
18,890
43
Net assets acquired
18,933
Consideration
Cash
Acquisition costs
18,296
637
18,933
(1)
b)
Goodwill is deductible for tax purposes.
On July 26, 2005, the Corporation completed the acquisition of all voting shares of Rose Art Industries,
Inc., Warren Industries, Inc. and their subsidiaries (“MEGA Brands America”), headquartered in
Livingston, New Jersey. MEGA Brands America manufactures and markets arts and crafts, magnetic
building sets and features school supplies. MEGA Brands America was a private corporation with a strong
brand recognition in the United States.
The total purchase price consideration includes the assumption of $37 million of outstanding MEGA
Brands America debt, for a net purchase price of $319 million. This purchase price consists of $292
million in cash at closing, $20 million of MEGA Brands America common shares at a price of CA$19.00
per share issued to MEGA Brands America principals upon closing, and $7 million of acquisition costs.
The transaction provides for a contingent payment of up to $50 million payable if MEGA Brands
America’s adjusted earnings before interest, taxes, depreciation and amortization (“EBITDA”) for 2005
exceeds $50 million, based on five times such incremental amount. The transaction also provides for
additional earn-out payments of 50% of the amounts exceeding adjusted EBITDA thresholds of $60
million, $65 million and $70 million in 2005, 2006 and 2007 respectively.
The transaction was fully financed by credit facilities totaling $400 million, including a $100 million
revolving credit facility for working capital purposes.
49
MEGA Brands Inc.
The acquisition was accounted for using the purchase method. As at December 31, 2005, the Corporation
allocated the purchase price on a preliminary basis to the assets acquired and the liabilities assumed based
on management’s best estimates of their fair value and taking into account all relevant information
unavailable at that time. During the second quarter of 2006, the purchase price allocation was finalized and
modified with adjustments primarily relating to non-cash working capital, future income taxes, and a
corresponding entry to goodwill. As at year-end, goodwill was reduced on an after-tax basis by $7.2
million for the decrease in the integration and restructuring reserve, and $7.3 million for additional
consideration accrued and other adjustment to fair value of net assets acquired.
Preliminary
$
Final
$
Assets acquired
Non-cash working capital
Intangible assets
Goodwill(1)
Long-term debt
21,388
6,979
16,013
71,000
306,973
(36,655)
24,947
6,979
14,678
71,000
292,453
(36,655)
Non-cash assets acquired
385,698
7,933
373,402
7,933
Net assets acquired
393,631
381,335
Consideration
Cash
Acquisition costs
Additional consideration accrued on business combination
Issuance of shares to former Rose Art shareholders
292,503
7,053
74,075
20,000
292,503
7,329
61,503
20,000
393,631
381,335
(1)
Goodwill is deductible for tax purposes.
As at December 31, additional consideration accrued on business combination is as follows:
Contingent purchase price
Other incentives
50
2006
$
2005
$
51,000
6,825
51,000
23,100
57,825
74,100
MEGA Brands Inc.
12 Accounts receivable
Trade
Other
2006
$
2005
$
153,076
8,536
167,428
6,238
161,612
173,666
2006
$
2005
$
16,806
17,850
105,974
18,333
12,648
51,299
140,630
82,280
13 Inventories
Raw materials
Work in progress
Finished goods
14 Property, plant and equipment
2006
Cost
$
Land
Buildings
Computer equipment
Computer equipment held under capital leases
Machinery and equipment held under
capital leases
Accumulated
amortization
$
Net book
value
$
44
882
83,594
8,489
10,401
1,997
17
53,277
5,246
2,745
1,602
44
865
30,317
3,243
7,656
395
1,265
572
693
63,459
43,213
106,672
51
MEGA Brands Inc.
2005
Cost
$
Land
Buildings
Computer equipment
Computer equipment held under capital leases
Machinery and equipment held under
capital leases
Accumulated
amortization
$
Net book
value
$
44
889
73,908
7,298
6,127
1,996
7
44,287
4,227
1,896
1,412
44
882
29,621
3,071
4,231
584
1,472
554
918
91,734
52,383
39,351
15 Intangible assets
2006
Cost
$
Trade name(1)
Intellectual property(1)
Intellectual property
Customer relationships
Non-competition covenants
Accumulated
amortization
$
Net book
value
$
67,750
1,500
1,391
8,530
1,210
145
477
242
67,750
1,500
1,246
8,053
968
80,381
864
79,517
2005
Cost
$
Trade name(1)
Intellectual property(1)
Intellectual property
Customer relationships
(1)
Accumulated
amortization
$
Net book
value
$
64,500
1,500
1,391
5,000
36
125
64,500
1,500
1,355
4,875
72,391
161
72,230
Non-amortized indefinite service life intangible asset
52
MEGA Brands Inc.
16 Goodwill
The changes in the carrying value of goodwill are comprised of the following:
2006
$
2005
$
Balance – Beginning of year
306,973
-
Acquisition of Rose Art (note 11)
Acquisition of Board Dudes (note 11)
(14,520)
8,376
306,973
-
Balance – End of year
300,829
306,973
Upon finalization in 2006 of the purchase price allocation of the net assets acquired of MEGA Brands America,
goodwill was reduced by $14.5 million.
17 Long-term debt
Credit facility
Term A loan, maturing March 2009 (note 17(a))
Term B loan, maturing July 2012 (note 17(b))
Revolving term facility, maturing July 2010 (note 17(c))
Other debt
Obligations under capital leases, maturing up to May 2008
(note 17(d))
Mortgage, repaid in 2006 (note 17(e))
Less: Current portion of long-term debt
2006
$
2005
$
14,400
256,750
40,000
40,000
259,350
-
804
-
1,341
262
311,954
9,609
300,953
8,784
302,345
292,169
On July 26, 2005, the Corporation entered into a $400 million Credit Facility with a syndicate of banks. This
Credit Facility was used to finance the acquisition of Rose Art Industries, Inc. The facility is secured by a
movable hypothec on all assets of the Corporation. During the third quarter of 2006, the Corporation amended
the Credit Facility by prepaying $20 million of the Term A loan, and increasing the revolving term facility by
$20 million. Under the terms of the Credit Facility, the Corporation must satisfy certain restrictive
covenants as to financial ratios.
53
MEGA Brands Inc.
The Credit Facility is available under U.S. base rate loans or LIBOR loans at the option of the Corporation. The
Term A loan and the revolving term facility bear interest at the published rates based on U.S. base rate plus
0.25% to 1.25% or LIBOR plus 1.25% to 2.25%. The Term B loan bears interest at the published rates based on
U.S. base rate plus 0.75% or LIBOR plus 1.75%.
a)
The Term A loan is a $40 million credit facility. Payments are due in quarterly installments of 2% and 4%.
b)
The Term B loan is a $260 million credit facility. Payments are due in quarterly installments of 0.25% and
93.25% at maturity.
c)
The revolving term facility is a $120 million (2005 – $100 million) revolving credit facility.
d)
Obligations under capital leases are denominated and payable in Canadian dollars (CA$937), and bear
interest from 3.74% to 7.65%.
e)
The mortgage obligation was fully repaid in 2006, and bore interest at a fixed rate of 6%.
The repayment requirements on the long-term debt during the next five years and thereafter are as follows:
Obligations under capital leases
Years
2007
2008
2009
2010
2011
Thereafter
Credit facility
Total
Principal
$
Principal
repayments
$
Miminum
payments
$
Interest
$
Principal
$
642
199
-
33
4
-
609
195
-
9,000
9,000
4,200
42,600
2,600
243,750
9,609
9,195
4,200
42,600
2,600
243,750
841
37
804
311,150
311,954
54
MEGA Brands Inc.
18 Capital stock
Authorized
An unlimited number of common shares without par value
Issued and outstanding
2006
Number
of shares
Issued pursuant to private
placement(1)
Issued to Rose Art principals
Issued pursuant to exercise of
stock options
Balance – End of year
(1)
32,105,575
Book value
$
231,592
-
-
2005
Number
of shares
Book value
$
27,292,469
154,434
3,100,000
1,285,894
54,513
20,000
559,338
4,496
427,212
2,645
32,664,913
236,088
32,105,575
231,592
Subscription receipts of 3.1 million were exchanged on a one-to-one basis for common shares. These subscription receipts
were originally sold on July 11, 2005 by way of a private placement at CA$22.25 for aggregate proceeds of CA$68,975,000
before fees of $2.3 million.
19 Stock options, share unit and contributed surplus
a)
The Corporation has two stock-based compensation plans whereby options may be granted to officers and
other key employees of the Corporation and its subsidiaries to purchase common shares of the
Corporation.
Under the Initial Stock Option Plan, the subscription price of each option equalled the estimated fair value
of a share of the Corporation at the date of grant.
Immediately prior to the closing of the Initial Public Offering which occurred in 2002, the Corporation
introduced a New Stock Option Plan. Under this plan, options to purchase common shares of the
Corporation are granted at a subscription price of 100% of market value. Market value is determined as the
closing price of the common shares on the Toronto Stock Exchange on the last date of trading prior to the
effective date of the grant.
55
MEGA Brands Inc.
As at December 31, 2006, a total of 4,992,877 common shares remained authorized for issuance under the
Corporation’s stock-based compensation plans. Options are exercisable during a period not to exceed ten
years after the date of the grant. The right to exercise the options accrues over a period of three years of
continuous employment. However, if there is a change of control of the Corporation, the options become
immediately exercisable. Options are adjusted proportionately for any stock dividends or stock splits
attributed to the common shares of the Corporation.
On March 24, 2004, the Board of Directors adopted a recommendation of the Compensation Committee
that the Corporation voluntarily cap stock option grants at 15% of the number of common shares
outstanding even though the Option Plan, as approved by the relevant regulatory authorities, allows for a
significantly higher dilution rate when the available option grants under such plan are combined with
option grants under the Initial Plan.
The following table summarizes all stock options outstanding as at December 31 under the Corporation’s
stock option plans:
2006
2005
Weighted
average
Number
exercise
of options
price
$
(in Canadian dollars)
Weighted
average
Number
exercise
of options
price
$
(in Canadian dollars)
Options outstanding –
Beginning of year
3,233,858
9.01
3,702,541
8.93
Granted
Exercised
Forfeited
(559,338)
(8,914)
7.96
22.13
(427,212)
(41,471)
7.31
19.38
Options outstanding –
End of year
2,665,606
9.18
3,233,858
9.01
Options exercisable –
End of year
2,610,425
8.94
3,009,997
8.12
56
MEGA Brands Inc.
The following table summarizes information about stock options outstanding as at December 31, 2006:
Range of
exercise price
CA$
3.85
14.50
18.25 to 25.65
Number
outstanding
Weighted
average
remaining
contractual
life in years
Weighted
average
exercise
price
CA$
Weighted
average
exercise
price
CA$
Number
exercisable
1,419,274
1,088,846
157,486
2.8
5.4
6.6
3.85
14.50
20.43
1,419,274
1,088,846
102,305
3.85
14.50
20.30
2,665,606
4.1
9.18
2,610,425
8.94
Stock-based compensation expense for stock option amounts to $198 in 2006 (2005 – $451).
b)
The Corporation’s share unit plan, which became effective February 24, 2005, allows the Board of
Directors to grant bonuses in the form of share units that are time and performance vesting after three
years. The plan is non-dilutive and will be settled in shares purchased on the secondary market, or in cash,
at the option of the Corporation.
The following table summarizes the share units outstanding as at December 31, 2006 and 2005 under the
Corporation’s share unit plan:
Number of units
2006
Units outstanding – Beginning of year
2005
65,768
-
Granted
Exercised
Forfeited
295,028
(637)
(5,175)
65,768
-
Units outstanding – End of year
354,984
65,768
$1,928
$281
Share unit plan compensation expenses
Total compensation expense for stock-based employee compensation awards amount to $2,126 in 2006
(2005 – $732).
57
MEGA Brands Inc.
c)
Contributed surplus
The following table summarizes charges to contributed surplus:
2006
$
2005
$
1,136
685
Value of compensation cost associated with
stock-based compensation expense
Stock options exercised
198
(614)
451
-
720
1,136
Balance –End of year
20 Statement of cash flows
a)
Changes in non-cash operating working capital items
Accounts receivable
Inventories
Prepaid expenses
Accounts payable and accrued liabilities
Income taxes
Derivative financial instruments
Foreign currency translation relating to working capital items
b)
2006
$
2005
$
15,004
(56,781)
(3,619)
43,237
(14,061)
(3,678)
4,598
2,179
(2,694)
(400)
(31,203)
1,626
(3,573)
(1,961)
(15,300)
(36,026)
2006
$
2005
$
Supplementary information
Interest paid
Income taxes paid
Non-cash items
Property, plant and equipment acquired by means of
capital leases
Issuance of common shares
58
22,217
14,805
6,534
1,840
(12,572)
-
517
74,075
20,000
MEGA Brands Inc.
21 Derivative financial instruments
Foreign currency risk management
The Corporation enters into certain foreign currency forward contracts to manage the risks associated with
foreign currency exchange rates, namely the Canadian dollar, the euro, the British pound, the Mexican peso and
the Australian dollar. As at December 31, 2006, the Corporation had entered into foreign currency forward
contracts to sell t6 million and GBP3 million at average exchange rates of 1.3021 and 1.8746 respectively, all
maturing in 2007. The fair value of these forward contracts as at December 31, 2006 is $0.4 million in favour
of third parties. These derivative instruments have not been designated as hedges for accounting purposes as the
Corporation has terminated its designation of all hedging relationships for foreign currency forward contracts.
The associated liability is recorded in accrued liabilities and the unrealized loss has been recorded in the foreign
currency translation account.
As at December 31, 2005, the Corporation had entered into foreign currency forward contracts to sell
US$7.25 million, t7.25 million and GBP3.5 million at average exchange rates of 1.2439, 1.3301, and 1.9004
respectively, all maturing in 2006. The fair value of these forward contracts as at December 31, 2005 was
$2.2 million in favour of the Corporation. These derivative instruments were all designated as hedges for
accounting purposes.
Interest rate swaps
The Corporation enters into interest rate swap agreements to convert certain long-term debt from variable to
fixed interest rates in order to achieve an appropriate mix of fixed and variable interest rate debt. The interest
rate swap agreements involve the periodic exchange of payments without the exchange of the notional principal
amount upon which the payments are based, and are recorded as an adjustment of interest expense on the
hedged debt instrument. The related amount payable to, or receivable from, counterparties is included as an
adjustment to accrued interest.
As at December 31, 2006 and 2005, the interest rate swap agreements are with third parties for a notional value
of $150 million at a fixed rate of 4.66325%, maturing in July 2012. The Corporation is applying hedge
accounting to these financial instruments and no amount is recorded in these consolidated financial statements.
As at December 31, 2006, the fair value of these swaps was $2.8 million (2005 – $1 million) in favour of the
Corporation.
Credit risk
The Corporation does not believe it is subject to significant concentration of credit risk. Cash and short-term
investments are in place with major financial institutions. The Corporation is exposed to some credit risk on
accounts receivable; however, the Corporation regularly monitors its credit risk exposure and takes steps to
mitigate the risk of loss, including obtaining credit insurance. The Corporation’s extension of credit is based on
an evaluation of each customer’s financial condition and the Corporation’s ability to obtain credit insurance
coverage for that customer.
59
MEGA Brands Inc.
The Corporation is exposed to credit risk in the event of non-performance by counterparties to its derivative
financial instruments. It minimizes this exposure by entering into contracts with counterparties that are of
high-credit quality. Collateral or other security to support financial instruments subject to credit risk is usually
not obtained. The credit standing of counterparties is regularly monitored.
Fair value
The Corporation has determined that the carrying value of its short-term financial assets and liabilities other
than the derivative financial instruments above approximates fair values as at the balance sheet dates because of
the short-term maturity of those instruments. The fair value of the Corporation’s long-term debt approximates
its carrying value as the majority of long-term debt bears interest at rates that vary based on the U.S. base rate
and LIBOR.
22 Commitments and contingencies
a)
On May 8, 2006, the former shareholders of Rose Art initiated litigation against the Corporation in the
U.S. District Court for the Southern District of New York. The plaintiffs are seeking payment of the
Contingent Purchase Price under the terms of the Stock Purchase Agreement (“SPA”) entered into
between them and the Corporation on July 26, 2005. The Corporation has filed an answer and
counterclaim denying each and every material allegation relating to the lawsuit. The Corporation’s
counterclaim alleges that the former shareholders failed to uphold certain terms of the SPA. The
Corporation accrued US$51.0 million in its 2005 consolidated financial statements with respect to the
Contingent Purchase Price pending final determination of the amount owed, if any. As at December 31,
2006, no disbursements had been made and the Corporation will continue to maintain the accrual until the
lawsuit is resolved. Based on management’s assessment, no additional consideration is due for 2006.
On November 17, 2006, the former shareholders of Rose Art filed arbitration proceedings before the
American Arbitration Association against the Corporation seeking unspecified damages for the
Corporation’s alleged breach of their respective employment agreements. The Corporation is contesting
the proceedings.
b)
On March 31, 2006, the Corporation jointly announced with the U.S. CPSC a voluntary recall and
replacement program of MAGNETIX building sets in the hands of families with children under the age of
six. This action was taken in response to the death of a toddler and injuries to several children resulting
from magnet ingestion.
On October 24, 2006, the Corporation announced that it had settled four lawsuits and ten claims related to
injuries to children resulting from the ingestion of magnets. Terms of the settlement include no admission
of liability. The aggregate amount paid to settle the lawsuits and claims is $13.5 million and is recorded as
a product liability settlement expense in the 2006 consolidated statement of earnings. The Corporation
expects to recover substantially the full amount from its insurers and through other recourses, although
there can be no assurance that a favourable outcome will be achieved.
60
MEGA Brands Inc.
On September 14, 2006 and December 5, 2006, two lawsuits related to magnet ingestion requiring surgical
removal were served on the Corporation and remain outstanding. They are being handled by the
Corporation’s insurers. On March 29, 2007, the Corporation learned that a third lawsuit had been filed in
U.S. District Court in Denver by the family of a child who is alleged to have sustained similar injuries.
The lawsuit has been reported to the Corporation’s insurers. The Corporation is also aware of at least
seven other incidents in which children are alleged to have required surgery following the ingestion of
multiple magnets. Lawsuits have not been filed in these matters as of April 1, 2007.
The Corporation has not been able to assess with any certainty the outcome of these lawsuits and claims or
their impact, if any. Therefore, no amount has been reserved as at December 31, 2006.
c)
On March 28, 2007, the Corporation learned that a competitor who sells magnetic building sets primarily
in Europe, Plastwood S.R.L. and Plastwood Corporation, filed a complaint against the Corporation in the
U.S. District Court for the Western District of Washington alleging damages for false advertising and
unfair and deceptive acts and practices. The Corporation has not been able to assess the outcome of this
lawsuit or its impact, if any. Therefore, no amount has been reserved.
d)
The Corporation is also defending other claims, which arise in the ordinary course of business. The
Corporation believes that the outcome of any individual claim or the aggregate of all such claims will not
have a material impact on its business, financial condition or results of operations.
e)
The Corporation has entered into operating leases for premises, which it occupies, for an amount of
$44.7 million. The minimum annual rent payable (excluding certain occupancy charges) for each of the
next five years is as follows:
$
2007
2008
2009
2010
2011
f)
13,465
10,189
9,209
8,192
3,637
In connection with an agreement with Investissement Québec, an aggregate amount of CA$3.9 million
was granted to the Corporation over a period of three years. This grant was conditional upon acquiring a
certain level of property, plant and equipment and the creation and maintenance of a certain level of
employment for a period of five years terminated in 2006.
In 2001, 2002 and 2003, the Corporation received grants of $1.9 million to acquire certain property, plant
and equipment and to create employment. Approximately 61% of the grants received in 2001, 2002 and
2003 were accounted for as a reduction of property, plant and equipment. The remaining portion of the
grants was recorded in earnings as a reduction of related expenses in 2006.
61
MEGA Brands Inc.
g)
As at December 31, 2006, the Corporation had outstanding letters of guarantee in the amount of $1.6
million (2005 – $2.4 million) relating to financial guarantees issued in the normal course of business.
These guarantees are issued under standby facilities available to the Corporation within the New Credit
Facility.
23 Segmented information
Description of segments
The Corporation operates under two geographical segments, North America and International, with sales and
marketing conducted through two product lines.
a)
The Toys product lines are comprised of MEGA BLOKS construction toys in the preschool and boys 5plus categories, MAGNETIX building sets for children 6-plus and MEGA games and puzzles for the
family.
b)
The Stationery and Activities product lines are comprised of art materials (crayons, coloured pencils,
highlighters and markers) sold mainly under the ROSE ART brand; writing instruments (pens, mechanical
pencils and woodcase pencils) sold mainly under the ROSE ART, SRX and USA GOLD brands; dry-erase
and cork presentation boards, organizers and accessories sold mainly under the BOARD DUDES brand,
and ROSE ART and MEGA craft and activity sets.
c)
Information by segment as to MEGA Brands’ operations in geographic areas is presented below on the
basis the Corporation uses to manage its business. Net sales are categorized based on location of the
customer while long-lived assets are categorized based on their location:
Segmented information
Net sales
Toys
Stationery and Activities
Geographic information
Net sales
North America(1)
International
(1)
Includes net sales for Canada in 2006 of $27.4 million (2005 – $21.1 million).
62
2006
$
2005
$
333,667
213,680
291,576
93,287
547,347
384,863
2006
$
2005
$
397,778
149,569
254,318
130,545
547,347
384,863
MEGA Brands Inc.
North America
International
Property, plant and equipment, intangible assets,
and goodwill
North America(1)
International
(1)
2006
$
2005
$
(11,728)
50,698
40,252
22,098
38,970
62,350
2006
$
2005
$
343,312
80,247
412,752
5,802
423,559
418,554
Includes property, plant and equipment for Canada in 2006 of $31.1 million (2005 – $31.4 million).
Other information
d)
Net sales for the year ending December 31, 2006 to the Corporation’s two largest customers amounted to
$148.8 million (2005 – $91.1 million) and $65.3 million (2005 – $33.5 million).
24 Comparative figures
Certain of the prior year’s figures have been reclassified to conform with the current year’s presentation.
63
(PAGE INTENTIONALLY LEFT BLANK)
64
Shareholder Information
Headquarters
Auditors
4505 Hickmore
Montreal, Quebec
Canada H4T 1K4
Tel.: 514.333.5555
Fax: 514.333.4470
PricewaterhouseCoopers LLP
Investor Relations
Annual and Special Meeting
of Shareholders
Transfer Agent
CIBC Mellon Trust Company
1.800.387.0825
[email protected]
www.megabrands.com
Thursday, June 7, 2007 at 10:30 a.m.
4505 Hickmore
Montreal, Quebec
Listing
The Toronto Stock Exchange
Ticker Symbol: MB
Shares Outstanding
As of March 30, 2007
32,711,213 Common Shares
Trading History (CA$)
High
Low
Close
Average daily volume
Fiscal Year 2006
Fiscal 2007 (First Quarter)
29.75
20.25
26.15
117,165
27.20
24.56
25.36
141,390
FORWARD-LOOKING INFORMATION
All statements herein that do not directly and exclusively relate to historical facts constitute "forward-looking information". These statements represent
the Corporation's intentions, plans, expectations and beliefs. In certain instances, these statements require us to make assumptions and there is significant
risk that these assumptions may not be correct. Furthermore, these statements are subject to risks, uncertainties and other factors, many of which are
beyond the Corporation's control. Actual results could differ materially from the statements reflected in the forward-looking information. In addition, certain
material factors or assumptions were applied in making the statements reflected in the forward-looking information. Additional information about the factors that
could cause actual results to differ from our current expectations and the material factors and assumptions relating to the forward-looking information
can be found in the “Forward-Looking Statements” and “Risks and Uncertainties” sections of the Management’s Discussion and Analysis for the financial
year ended December 31, 2006 and the first quarter ended March 31, 2007 as filed on SEDAR. The words "believe", "estimate", "expect", "intend", "anticipate",
"foresee", "plan", and similar expressions and variations thereof, identify certain of such forward-looking statements, which speak only as of the date on
which they are made. The Corporation disclaims any intention or obligation to publicly update or revise any forward-looking statements, whether as a result
of new information, future events or otherwise, other than as required by applicable legislation. Readers are cautioned not to place undue reliance on these
forward-looking statements.
June 7, 2007
©
MEGA Brands Inc.
The MEGA logo, Creativity to the Rescue, Mega Bloks, Rose Art, Magnetix and Board Dudes are trademarks of MEGA Brands Inc. or its affiliates.
All other trademarks shown and/or used in this document are the property of their respective owners and are used under license by MEGA Brands.
w w w. m e ga b ra n d s . c o m
TM

MEGA Brands Inc.

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