UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

 

Commission file number 1-6682

 

Hasbro, Inc.

(Exact Name of Registrant, As Specified in its Charter)

 

 

Registrant’s telephone number, including area code (401) 431-8697

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ  or  No o.

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o  or  No þ.

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ  or  No o.

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one:)

Large accelerated filer þ     Accelerated filer o     Non-Accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o  or  No þ.

 

The aggregate market value on June 24, 2005 (the last business day of the Company’s second quarter) of the voting common stock held by non-affiliates of the registrant, computed by reference to the closing price of the stock, was approximately $3,265,605,760. The registrant does not have non-voting common stock outstanding.

 

The number of shares of common stock outstanding as of February 9, 2006 was 177,988,289.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of our definitive proxy statement for our 2006 Annual Meeting of Shareholders are incorporated by reference into Part III of this Report.

 

 

PART I

 

 

General Development and Description of Business and Business Segments

 

Except as expressly indicated or unless the context otherwise requires, as used herein, “Hasbro”, the “Company”, “we”, or “us”, means Hasbro, Inc., a Rhode Island corporation organized on January 8, 1926, and its subsidiaries. Unless otherwise specifically indicated, all dollar or share amounts herein are expressed in thousands of dollars or shares, except for per share amounts.

 

Overview

 

We are a worldwide leader in children’s and family leisure time and entertainment products and services, including the design, manufacture and marketing of games and toys. Both internationally and in the U.S., our widely recognized core brands such as PLAYSKOOL, TONKA, SUPER SOAKER, MILTON BRADLEY, PARKER BROTHERS, TIGER, and WIZARDS OF THE COAST provide what we believe are the highest quality play experiences in the world. Our offerings encompass a broad variety of games, including traditional board, card, hand-held electronic, trading card, roleplaying, plug and play and DVD games, as well as electronic learning aids and puzzles. Toy offerings include boys’ action figures, vehicles and playsets, girls’ toys, electronic toys, plush products, preschool toys and infant products, children’s consumer electronics, electronic interactive products, creative play and toy related specialty products. In addition, we license certain of our trademarks, characters and other property rights to third parties for use in connection with consumer promotions and for the sale of noncompeting toys and non-toy products.

 

In managing our business in 2005, we focused on two major areas, toys and games. Organizationally, our principal segments were U.S. Toys, Games, and International. In 2005, our U.S. Toys segment engaged in the development, marketing and selling of toy and children’s consumer electronic products in the United States. Our Games segment included the development, manufacturing, marketing and selling of games, as well as electronic learning aids and puzzles, in the United States. Within the International segment, we developed, manufactured, marketed and sold both toy and game products in non-U.S. markets. Financial information with respect to our segments and geographic areas is included in note 15 to our financial statements, which are included in Item 8 of this Form 10-K.

 

Beginning in 2006 we restructured our business by combining the existing U.S. Toys and Games segments and adding to this combined segment our Mexican and Canadian operations, which were formerly managed as part of the International segment. Under this new structure, all of our toy and game business in the United States, Canada, and Mexico is managed as one North American segment under common leadership. We believe this restructuring will allow us to better focus our efforts in the development, marketing and selling of products in this North American market. In 2006 we will continue to have an International segment, comprised of our operations in Europe and the Asia Pacific and Latin American regions. The International segment will manage toy and game sales, and the related marketing and certain development activity outside of North America. In addition, the Hasbro Properties Group outlicenses our intellectual property to third parties on a worldwide basis.

 

In 2006, our Global Operations segment will be responsible for arranging product manufacturing and sourcing for all of our other segments.

 

The remainder of this business discussion is formatted consistently with our 2005 segment structure.

 

U.S. Toys

 

The U.S. Toys segment’s strategy in 2005 was based on growing core brands through innovation and reinvention, introducing new initiatives driven by consumer and marketplace insights and leveraging opportunistic toy lines and licenses. In order to meet shifting consumer dynamics, the execution of this strategy centered on consumer insights, which are used to inform and motivate our product development. We use consumer insights to drive innovation across our business. In recent years, a major source of innovation

has been technology, which the U.S. Toys segment has used to address the issue of “children getting older younger.” This represents the trend whereby children at younger ages are shifting from traditional toys to electronic devices, such as MP3 players, cell phones and other entertainment and lifestyle products. Major 2005 brands and products included STAR WARS, VIDEONOW, I-DOG, PLAYSKOOL, MY LITTLE PONY, NERF, TRANSFORMERS and LITTLEST PET SHOP. In the U.S. Toys segment, our products are organized into one of four categories, boys’ toys, girls’ toys, preschool, and tween products.

 

Our boys’ toys include a wide range of core properties such as G.I. JOE and TRANSFORMERS action figures, and the TONKA line of trucks and interactive toys. Other products include entertainment-based licensed products based on popular movie and television characters, such as STAR WARS toys and accessories. In 2005 our STAR WARS based line of toys and accessories was extremely successful, bolstered by the theater and DVD release of STAR WARS EPISODE III: REVENGE OF THE SITH. As boys become more sophisticated in their evaluation of entertainment, our boys’ toys are increasingly competing with video games for boys’ attention. Role-playing is a vital part of our boys’ toys business. As demonstrated in 2005 through the introduction of STAR WARS LIGHT SABERS and the DARTH VADER VOICE-CHANGER, we seek to develop products that will allow boys to look and act like their favorite characters. In the action figure area, a key part of our strategy focuses on the importance of reinforcing the storyline associated with these products through the use of media-based entertainment, primarily television. In 2006, both G.I. JOE and TRANSFORMERS will continue to have television programming to assist in providing exposure to the characters and story lines associated with these products. In addition, a key factor in the success of 2005 was the performance of our sports action brands such as NERF products. We expect the momentum in this line to continue in 2006 as we introduce innovative new products such as NERF SHOWTIME HOOPS. In January 2006, we completed a licensing agreement with Marvel Entertainment, Inc. and its subsidiary Marvel Characters, Inc. to produce action figures and other toys and games based on their library of intellectual property, including SPIDERMAN and the FANTASTIC 4. We expect certain products related to this license to begin shipping late in 2006, with the full extent of the licensed products being recognized in 2007 and thereafter.

 

In our girls’ toy category, we seek to provide a traditional and wholesome play experience. Girls’ toys include the MY LITTLE PONY and LITTLEST PET SHOP lines as well as the EASY BAKE oven. In 2005, the MY LITTLE PONY brand was supported by the DVD release of MY LITTLE PONY: A VERY MINTY CHRISTMAS. In 2006, we plan to support this brand with two new DVD releases. The LITTLEST PET SHOP will build on its strong reintroduction in 2005 with new electronic play patterns in 2006. We also plan to enter a new category in 2006, large dolls, with the reintroduction of BABY ALIVE, a doll incorporating animatronic technology.

 

Our preschool toy category encompasses a range of products for preschoolers in the various stages of development, from infant to kindergarteners. Our preschool products include a portfolio of core brands marketed primarily under the PLAYSKOOL trademark. The PLAYSKOOL line includes such well-known products as MR. POTATO HEAD, WEEBLES, SIT ‘N SPIN and GLOWORM, along with a successful line of infant toys including STEP START WALK N‘ RIDE, 2-IN-1 TUMMY TIME GYM and BUSY BALL POPPER. Through our AGES & STAGES system, we seek to provide consumer friendly information that assists parents in understanding the developmental milestones their children will encounter as well as the role each PLAYSKOOL product can play in helping children to achieve these developmental milestones. In 2006, a major focus of our preschool line will be on one of the fastest growing segments of the preschool toy market, electronic learning aids, with the planned introduction of two new product lines: ION, an interactive educational gaming system, and TJ BEARYTALES, an electronic story telling bear. In addition, in 2006, the PLAY-DOH brand will be celebrating its 50^th anniversary and will be supported by a variety of promotional programs.

 

Our tweens toy category generally markets products under the TIGER ELECTRONICS brand and seeks to target those children who have outgrown traditional toys. The age group targeted by this category is generally 8 to 12 years old. In recent years, we have used our consumer insights and electronic innovation to develop a strong line of products focusing on this target audience. Our major tweens toys product lines in 2005 included VIDEONOW, I-DOG and CHATNOW. As demonstrated through our 2005 launch of I-DOG,

an interactive pet that acts as an accessory to an MP3 player, we seek to draw on the popularity of electronic trends in our tween product offerings. In 2006, we plan to continue offering innovative new products in this category, including ZOOMBOX.

 

Games

 

Our Games segment strategy focused on providing product innovation based on consumer insights, including an understanding of consumer attitudes and behaviors. We market our games and puzzles under several well known core brands, including MILTON BRADLEY, PARKER BROTHERS, TIGER GAMES, AVALON HILL, and WIZARDS OF THE COAST. Major 2005 products included TRIVIAL PURSUIT, CANDY LAND, MONOPOLY and MAGIC: THE GATHERING.

 

The MILTON BRADLEY, PARKER BROTHERS, TIGER GAMES and AVALON HILL brand portfolios consist of a broad assortment of games for children, tweens, families and adults. Core game items include MONOPOLY, BATTLESHIP, GAME OF LIFE, SCRABBLE, CHUTES AND LADDERS, CANDY LAND, TROUBLE, MOUSETRAP, OPERATION, HUNGRY HUNGRY HIPPOS, CONNECT FOUR, TWISTER, YAHTZEE, JENGA, SIMON, CLUE, SORRY!, RISK, BOGGLE, and TRIVIAL PURSUIT, as well as a line of jigsaw puzzles for children and adults, including BIG BEN and CROXLEY. In 2005 we added to our puzzle portfolio through the acquisition of the assets and product lines of Wrebbit Inc., a creator and manufacturer of innovative puzzles, including three dimensional puzzles marketed under the PUZZ-3D brand. We seek to keep our core brands relevant through sustained marketing programs as well as by offering consumers new ways to experience them. In 2006 we plan to continue this strategy through the introduction of core brand extensions such as BIG TROUBLE, YAHTZEE TURBO and TRIVIAL PURSUIT 80’S EDITION. Another way we seek to keep our core brands fresh is through co-branding of some of our most popular lines. By developing and introducing products such as CANDY LAND: DORA EDITION and MONOPOLY: STAR WARS EDITION, we are able to extend our brand franchises by appealing to a broader consumer base. In 2006 we plan to continue to capitalize on popular licensed franchises including DISNEY, the SIMPSONS, STAR WARS and NICKLEODEON.

 

In addition to our core brands strategy, the games segment seeks to extend beyond traditional board games by developing technology-based platforms that reflect evolving consumer lifestyles. In 2005 we continued to offer many DVD extensions of our traditional games, such as our CANDY LAND DVD game. In 2006 we plan to continue this focus on innovative new games through the introduction of TWISTER DANCE, a DVD-based game, GIGA PETS COMBO, a combination of a hand-held and plug n’ play game, as well a variety of other new technology-enabled games. We have a series of marketing initiatives designed to encourage game play among a wide variety of audiences, including promotional programs designed to support the family games and adult games lines, respectively. In 2005 we introduced our GAMES MAKE GREAT GIFTS marketing campaign, which we plan to continue in 2006.

 

WIZARDS OF THE COAST offers a variety of successful trading card and roleplaying games, including MAGIC: THE GATHERING and DUNGEONS & DRAGONS. In addition to maintaining our focus on the success of MAGIC: THE GATHERING in both trading cards and online formats, our 2006 strategy will also focus on expanding our successful miniatures lines and our publishing business. The miniatures lines of pre-painted plastic characters are designed to enhance the roleplaying experience. We will also seek to continue the success of WIZARDS OF THE COAST’s publishing endeavors that have produced several books that were included on the New York Times Bestseller list in recent years. In 2006 we will seek to expand our marketing to younger readers by encouraging them to read through the placement of books in schools and libraries throughout the U.S.

 

International

 

In addition to our business in the United States, in 2005 we operated in more than 25 countries, selling a representative range of the toy and game products marketed in the United States, together with some items that are sold only internationally. In 2005 all of our international operations were managed under our International segment. In addition to growing core brands and leveraging opportunistic toy lines and licenses,

we seek to grow our international business by continuing to expand into Eastern Europe and emerging markets in Asia and Latin America. Key international brands for 2005 included MILTON BRADLEY and PARKER BROTHERS games, STAR WARS, ACTION MAN, FURBY, FURREAL FRIENDS, BEYBLADE, PLAY-DOH, PLAYSKOOL, MONOPOLY, and MAGIC: THE GATHERING. In 2006 our Canadian and Mexican operations are being moved into our new North American segment along with the U.S. Toys and Games segments. Our other international operations, primarily in Europe, the Asia Pacific region and Latin America, will be managed as separate geographic units under common leadership within our International segment.

 

Other Segments

 

In our Operations segment, we source production of substantially all of our toy products and certain of our game products through unrelated manufacturers in various Far East countries, principally China, using a Hong Kong based subsidiary for quality control and order coordination purposes. See “Manufacturing and Importing” below for more details concerning overseas manufacturing. In 2006 our Global Operations segment will continue to source product for our marketing and sales subsidiaries, and is expected to also manage our manufacturing operations in North America and Europe.

 

Our other segment, the Hasbro Properties Group, generates revenue through the out-licensing worldwide of certain of our intellectual properties to third parties for promotional and merchandising uses in businesses which do not compete directly with our own product offerings.

 

Other Information

 

To further extend our range of products in the various segments of our business, we have Hong Kong operations that sell our toy and game products directly to retailers, primarily on a direct import basis. These sales are reflected in the revenue of the related segment where the customer resides.

 

Certain of our products are licensed to other companies for sale in selected countries where we do not otherwise have a direct business presence.

 

During the 2005 fiscal year, revenues generated from the sale of STAR WARS products produced under our license with Lucas Licensing and Lucasfilm were approximately $494,000, which was 16% of our consolidated net revenues in 2005. No other line of products constituted 10% or more of our consolidated net revenues in 2005. No individual line of products accounted for 10% or more of our consolidated net revenues during our 2004 fiscal year. During the 2003 fiscal year, revenues from our BEYBLADE line of products were 11% of our consolidated net revenues. No other line of products constituted 10% or more of our consolidated revenues in 2003.

 

Working Capital Requirements

 

Our working capital needs are primarily financed through cash generated from operations and, when necessary, short-term borrowings and proceeds from our accounts receivable securitization program. Our borrowings and the use of our accounts receivable program generally reach peak levels during the fourth quarter of each year. This corresponds to the time of year when our receivables also generally reach peak levels as part of the production and shipment of product in preparation for the holiday shipping season. Our historical revenue pattern is one in which the second half of the year is more significant to our overall business than the first half and, within the second half of the year, the fourth quarter is the more prominent. The strategy of retailers has been to make a higher percentage of their purchases of toy and game products within or close to the fourth quarter holiday consumer buying season, which includes Christmas. This trend has become more pronounced over the past few years and we expect that it will continue.

 

The toy and game business is also characterized by customer order patterns which vary from year to year largely because of differences each year in the degree of consumer acceptance of a product line, product availability, marketing strategies and inventory policies of retailers, the dates of theatrical releases of major motion pictures for which we have product licenses, and changes in overall economic conditions. As a result, comparisons of our unshipped orders on any date with those at the same date in a prior year are not

necessarily indicative of our sales for that year. Moreover, quick response inventory management practices now being used result in fewer orders being placed significantly in advance of shipment with more orders being placed for immediate delivery. Unshipped orders at January 29, 2006 and January 23, 2005 were approximately $123,000 and $131,000, respectively. It is a general industry practice that orders are subject to amendment or cancellation by customers prior to shipment. The backlog of unshipped orders at any date in a given year can also be affected by programs that we may employ to incent customers to place orders and accept shipments early in the year. This method is a general industry practice. The programs that we plan to employ to promote sales in 2006 are substantially the same as those we employed in 2005. These are primarily fixed programs, for which a customer may qualify based on purchases of Company products throughout the year.

 

Historically, we commit to the majority of our inventory production and advertising and marketing expenditures for a given year prior to the peak third and fourth quarter retail selling season. Our accounts receivable increase during the third and fourth quarter as customers increase their purchases to meet expected consumer demand in the holiday season. Due to the concentrated timeframe of this selling period, payments for these accounts receivable are generally not due until later in the fourth quarter or early in the first quarter of the subsequent year. The timing difference between expenses paid and revenues collected makes it necessary for us to borrow varying amounts during the year. During 2005 and 2004, we utilized cash from our operations, proceeds from our accounts receivable securitization program, borrowing under our secured amended and restated revolving credit agreement as well as our uncommitted lines of credit to meet our cash flow requirements.

 

Royalties, Research and Development

 

Our success is dependent on innovation through the continuing development of new products and the redesign of existing items for continued market acceptance. In 2005, 2004, and 2003, we spent $150,586, $157,162, and $143,183, respectively, on activities relating to the development, design and engineering of new products and their packaging (including items brought to us by independent designers) and on the improvement or modification of ongoing products. Much of this work is performed by our internal staff of designers, artists, model makers and engineers.

 

In addition to the design and development work performed by our own staff, we deal with a number of independent toy and game designers for whose designs and ideas we compete with other toy and game manufacturers. Rights to such designs and ideas, when acquired by us, are usually exclusive and the agreements require us to pay the designer a royalty on our net sales of the item. These designer royalty agreements, in some cases, also provide for advance royalties and minimum guarantees.

 

We also produce a number of toys under trademarks and copyrights utilizing the names or likenesses of characters from movies, television shows and other entertainment media, for whose rights we compete with other toy and game manufacturers. Licensing fees for these rights are generally paid as a royalty on our net sales of the item. Licenses for the use of characters are generally exclusive for specific products or product lines in specified territories. In many instances, advance royalties and minimum guarantees are required by these license agreements. In 2005, 2004, and 2003, we incurred $247,283, $223,193, and $248,423, respectively, of total royalty expense. A portion of this expense relates to amounts paid in prior years as royalty advances. Our royalty expenses in any given year vary depending upon the timing of movie releases and other entertainment. In 2005, royalty expense increased due to the release of STAR WARS EPISODE III: REVENGE OF THE SITH, and the corresponding increase of our sales of STAR WARS licensed products. We have $37,107 of prepaid royalties, which are a component of prepaid expenses and other current assets on our balance sheet. Included in other assets is $89,408 representing the long-term portion of royalty advances already paid. As further detailed in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, based on contracts in effect at December 25, 2005, the Company may be required to pay approximately $66,770 of minimum guaranteed royalties at various times from 2006 through 2010. Amounts paid and advances to be paid relate to anticipated revenues from licensed properties to be sold in the years 2006 through 2018. In addition, in January 2006, we entered into a five-year arrangement with Marvel Entertainment, Inc., and its subsidiary Marvel Characters, Inc. (“Marvel”), to develop products based on

certain Marvel properties, including SPIDERMAN, for retail sale beginning on January 1, 2007. The agreement requires us to make guaranteed minimum payments in the amount of $205,000. Of this $205,000 in guaranteed payment, $100,000 was paid in February 2006, $70,000 is expected to be paid in 2007 upon the release of SPIDERMAN 3 and the remainder is to be paid upon the release of SPIDERMAN 4, whose release date is yet to be determined.

 

Marketing and Sales

 

Our products are sold nationally and internationally to a broad spectrum of customers, including wholesalers, distributors, chain stores, discount stores, mail order houses, catalog stores, department stores and other traditional retailers, large and small, as well as internet-based “e-tailers.” Our own sales forces account for the majority of sales of our products. Remaining sales are generated by independent distributors who sell our products, for the most part, in areas of the world where we do not otherwise maintain a direct presence. We maintain showrooms in New York and selected other major cities worldwide as well as at many of our subsidiary locations. Although we had more than 2,500 customers in the United States and Canada during 2005, including specialty retailers carrying trading card games and toy-related products, there has been significant consolidation at the retail level over the last several years in our industry, which we expect to continue. As a result, the majority of our sales are to large chain stores, distributors and wholesalers. While the consolidation of customers provides us with certain benefits, such as potentially more efficient product distribution and other decreased costs of sales and distribution, this consolidation also creates additional risks to our business associated with a major customer having financial difficulties or reducing its business with us. In addition, customer concentration may decrease the prices we are able to obtain for some of our products and reduce the number of products we would otherwise be able to bring to market. During 2005, sales to our three largest customers, Wal-Mart Stores, Inc., Toys ‘R Us, Inc. and Target Corporation, represented 24%, 12% and 12%, respectively, of consolidated net revenues, and sales to our top five customers accounted for approximately 53% of our consolidated net revenues.

 

We advertise many of our toy and game products extensively on television. Generally our advertising highlights selected items in our various product groups in a manner designed to promote the sale of not only the selected item, but also other items we offer in those product groups as well. We introduce many of our new products to major customers during the year prior to the year of introduction of such products for retail sale. In addition, we showcase many of our new products in New York City at the time of the American International Toy Fair in February.

 

In 2005 we spent $366,371 on advertising, promotion and marketing programs compared to $387,523 in 2004 and $363,876 in 2003.

 

Manufacturing and Importing

 

During 2005 substantially all of our products were manufactured in third party facilities in the Far East as well as in our two owned facilities located in East Longmeadow, Massachusetts and Waterford, Ireland.

 

Most of our products are manufactured from basic raw materials such as plastic, paper and cardboard, although certain products also make use of electronic components. All of these materials are readily available but may be subject to significant fluctuations in price. We generally enter into agreements with suppliers at the beginning of a fiscal year that establish prices for that year. For this reason, we are generally insulated, in the short-term, from increases in the prices of raw materials. However, severe increases in the prices of any of these materials may require renegotiation with our suppliers during the year. Our manufacturing processes and those of our vendors include injection molding, blow molding, spray painting, printing, box making and assembly. We purchase most of the components and accessories used in our toys and certain of the components used in our games, as well as some finished items, from manufacturers in the United States and in other countries. However, the countries of the Far East, and particularly the People’s Republic of China, constitute the largest manufacturing center of toys in the world and the substantial majority of our toy products are manufactured in China. The 1996 implementation of the General Agreement on Tariffs and Trade reduced or eliminated customs duties on many of the products imported by us.

We believe that the manufacturing capacity of our third party manufacturers, together with our own facilities, as well as the supply of components, accessories and completed products which we purchase from unaffiliated manufacturers, are adequate to meet the anticipated demand in 2006 for our products. Our reliance on designated external sources of manufacturing could be shifted, over a period of time, to alternative sources of supply for our products, should such changes be necessary or desirable. However, if we were to be prevented from obtaining products from a substantial number of our current Far East suppliers due to political, labor or other factors beyond our control, our operations and our ability to obtain products would be disrupted while alternative sources of product were secured. The imposition of trade sanctions by the United States or the European Union against a class of products imported by us from, or the loss of “normal trade relations” status by, the People’s Republic of China could significantly disrupt our operations and increase the cost of our products imported into the United States or Europe.

 

We purchase dies and molds, principally from independent United States and international sources.

 

Competition

 

We are a worldwide leader in the design, manufacture and marketing of games and toys, but our business is highly competitive. We compete with several large toy and game companies in our product categories, as well as many smaller United States and international toy and game designers, manufacturers and marketers. Competition is based primarily on meeting consumer entertainment preferences and on the quality and play value of our products. To a lesser extent, competition is also based on product pricing.

 

In addition to contending with competition from other toy and game companies, in our business we must deal with the phenomena that many children have been moving away from traditional toys and games at a younger age. We refer to this as “children getting older younger.” As a result, our products not only compete with the offerings of other toy and game manufacturers, but we must compete, particularly in meeting the demands of older children, with the entertainment offerings of many other companies, such as makers of video games and consumer electronic products.

 

The volatility in consumer preferences with respect to family entertainment and low barriers to entry continually create new opportunities for existing competitors and start-ups to develop products which compete with our toy and game offerings.

 

Employees

 

At December 25, 2005, we employed approximately 5,900 persons worldwide, approximately 3,300 of whom were located in the United States.

 

Trademarks, Copyrights and Patents

 

We seek to protect our products, for the most part, and in as many countries as practical, through registered trademarks, copyrights and patents to the extent that such protection is available, cost effective, and meaningful. The loss of such rights concerning any particular product is unlikely to result in significant harm to our business, although the loss of such protection for a number of significant items might have such an effect.

 

Government Regulation

 

Our toy and game products sold in the United States are subject to the provisions of The Consumer Product Safety Act (the “CPSA”), The Federal Hazardous Substances Act (the “FHSA”), The Flammable Fabrics Act (the “FFA”), and the regulations promulgated thereunder. In addition, certain of our products, such as the mixes for our EASY BAKE ovens, are also subject to regulation by the Food and Drug Administration.

 

The CPSA empowers the Consumer Product Safety Commission (the “CPSC”) to take action against hazards presented by consumer products, including the formulation and implementation of regulations and uniform safety standards. The CPSC has the authority to seek to declare a product “a banned hazardous substance” under the CPSA and to ban it from commerce. The CPSC can file an action to seize and condemn

an “imminently hazardous consumer product” under the CPSA and may also order equitable remedies such as recall, replacement, repair or refund for the product. The FHSA provides for the repurchase by the manufacturer of articles that are banned.

 

Consumer product safety laws also exist in some states and cities within the United States and in Canada, Australia and Europe. We maintain laboratories that employ testing and other procedures intended to maintain compliance with the CPSA, the FHSA, the FFA, international standards, and our own standards. Notwithstanding the foregoing, there can be no assurance that our products are or will be hazard free. Any material product recall could have an adverse effect on our results of operations or financial condition, depending on the product and scope of the recall, and could negatively affect sales of our other products, as well.

 

The Children’s Television Act of 1990 and the rules promulgated thereunder by the United States Federal Communications Commission, as well as the laws of certain foreign countries, place limitations on television commercials during children’s programming.

 

We maintain programs to comply with various United States federal, state, local and international requirements relating to the environment, plant safety and other matters.

 

Financial Information About International and United States Operations and Export Sales

 

The information required by this item is included in note 15 of the Notes to Consolidated Financial Statements included in Item 8 of Part II of this report and is incorporated herein by reference.

 

Availability of Information

 

Our internet address is http://www.hasbro.com. We make our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, available free of charge on or through our website as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.

 

 

Forward-Looking Information and Risk Factors that May Affect Future Results

 

From time to time, including in this Annual Report on Form 10-K and in our annual report to shareholders, we publish “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These “forward-looking statements” may relate to such matters as anticipated financial performance, business prospects, technological developments, new products, the timing of entertainment releases, marketing and promotional efforts, research and development activities, liquidity, and similar matters. Forward-looking statements are inherently subject to risks and uncertainties. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. These statements may be identified by the use of forward-looking words or phrases such as “anticipate,” “believe,” “could,” “expect,” “intend,” “looking forward,” “may,” “planned,” “potential,” “should,” “will” and “would” or any variations of words with similar meanings. We note that a variety of factors could cause our actual results and experience to differ materially from the anticipated results or other expectations expressed or anticipated in our forward-looking statements. The factors listed below are illustrative and other risks and uncertainties may arise as are or may be detailed from time to time in our public announcements and our filings with the Securities and Exchange Commission, such as on Forms 8-K, 10-Q and 10-K. We undertake no obligation to make any revisions to the forward-looking statements contained in this Annual Report on Form 10-K or in our annual report to shareholders to reflect events or circumstances occurring after the date of the filing of this report. Unless otherwise specifically indicated, all dollar or share amounts herein are expressed in thousands of dollars or shares, except for per share amounts.

Volatility of consumer preferences, combined with the high level of competition and low barriers to entry in the family entertainment industry make it difficult to maintain the long-term success of existing product lines or consistently introduce successful new products. In addition, an inability to develop and introduce planned new products and product lines in a timely manner may damage our business.

 

The family entertainment business is a fashion industry. Our success is critically dependent upon the consumer appeal of our products, principally games and toys. Our failure to successfully anticipate, identify and react to children’s interests and the preferences in family entertainment could significantly lower sales of our products and harm our profitability.

 

A decline in the popularity of our existing products and product lines, or the failure of our new products and product lines to achieve and sustain market acceptance, could significantly lower our sales and operating margins, which would harm our profitability, business and financial condition. In our industry, it is important to identify and offer what are considered to be the “hot” toys and games on children’s wish lists. Our continued success will depend on our ability to develop, market and sell popular toys, games and children’s electronic products which are sought after by both children and their parents. We seek to achieve and maintain market popularity for our products through the redesign and extension of our existing family entertainment properties in ways that capture consumer interest and imagination and remain relevant in today’s world, and by developing, introducing and gaining customer interest for new family entertainment products. This process involves anticipating and extending successful play patterns and identifying entertainment concepts and properties that appeal to children’s imaginations. However, consumer preferences with respect to family entertainment are continuously changing and are difficult to anticipate. Individual family entertainment products and properties generally, and high technology products in particular, often have short consumer life cycles.

 

Not only must we address rapidly changing consumer tastes and interests but we face competitors who are also constantly monitoring consumer tastes, seeking ideas which will appeal to consumers and introducing new products that compete with our products for consumer purchasing. In addition to existing competitors, the barriers to entry for new participants in the family entertainment industry are low. New participants with a popular product idea or property can gain access to consumers and become a significant source of competition for our products.

 

The challenge of developing and offering products that are sought after by children is compounded by the trend of children “getting older younger”. By this we mean that children are losing interest in traditional toys at younger ages and, as a result, at younger and younger ages, our products compete with the offerings of video game suppliers, consumer electronics companies and other businesses outside of the traditional toy and game industry.

 

In addition to designing and developing products based on our own brands, we seek to fulfill consumer preferences and interests by producing products based on popular entertainment properties developed by other parties and licensed to us. The success of entertainment properties released theatrically for which we have a license, such as STAR WARS related products, can significantly affect our revenues. If we produce a line of products based on a movie or television series, the success of the movie or series has a critical impact on the level of consumer interest in the associated products we are offering. In addition, competition in our industry for access to entertainment properties can lessen our ability to secure, maintain, and renew popular licenses to entertainment products on beneficial terms, if at all, and to attract and retain the talented employees necessary to design, develop and market successful products based on these properties. The loss of ownership rights granted pursuant to any of our licensing agreements could harm our business and competitive position.

 

There is no guarantee that:

 

1) Any of our current products or product lines will continue to be popular;

 

2) Any property for which we have a significant license will achieve or sustain popularity;

 

3) Any new products or product lines we introduce will be considered interesting to consumers and achieve an adequate market acceptance;

4) Any new product’s life cycle will be sufficient to permit us to profitably recover development, manufacturing, marketing, royalties (including royalty advances and guarantees) and other costs of producing and selling the product; or

 

5) We will be able to manufacture, source and ship new or continuing products in a timely basis to meet constantly changing consumer demands, a risk that is heightened by our customers’ compressed shipping schedules and the seasonality of our business.

 

In developing new products and product lines, we have anticipated dates for the associated product introductions. When we state that we will introduce, or anticipate introducing, a particular product or product line at a certain time in the future those expectations are based on completing the associated development and implementation work in accordance with our currently anticipated development schedule. Unforeseen delays or difficulties in the development process, or significant increases in the planned cost of development, may cause the introduction date for products to be later than anticipated or, in some situations, may cause a product introduction to be discontinued. Similarly, the success of our products is often dependent on the timelines and effectiveness of related advertising and media efforts. Television programming, movie and DVD releases, comic book releases, and other media efforts are often critical in generating interest in our products. Not only our efforts, but the efforts of third parties, heavily impact the launch dates and success of these media efforts. When we say that products or brands will be supported by certain media releases, those statements are based on our current plans and expectations. Unforeseen factors may delay these media releases or even lead to their cancellation. Any delay or cancellation of planned product development work, introductions, or media support may decrease the number of products we sell and harm our business.

 

Our business is seasonal and therefore our annual operating results will depend, in large part, on our sales during the relatively brief holiday season. Further, this seasonality is increasing, as large retailers become more efficient in their control of inventory levels through quick response inventory management techniques.

 

Sales of our family entertainment products at retail are extremely seasonal, with a majority of retail sales occurring during the period from September through December in anticipation of the holiday season, including Christmas. This seasonality is increasing, as large retailers become more efficient in their control of inventory levels through quick response inventory management techniques. These customers are timing their orders so that they are being filled by suppliers, such as us, closer to the time of purchase by consumers. For toys, games and other family entertainment products which we produce a majority of retail sales occur in the fourth quarter, close to the holiday season. As a consequence, the majority of our sales to our customers occur in the period from September through December, as our customers do not want to maintain large on-hand inventories throughout the year to meet consumer demand. While these techniques reduce a retailer’s investment in inventory, they increase pressure on suppliers like us to fill orders promptly and thereby shift a significant portion of inventory risk and carrying costs to the supplier.

 

The limited inventory carried by retailers may also reduce or delay retail sales, resulting in lower revenues for us. If we or our customers determine that one of our products is more popular at retail than was originally anticipated, we may not have sufficient time to produce and ship enough additional product to fully capture consumer interest in the product. Additionally, the logistics of supplying more and more product within shorter time periods increases the risk that we will fail to achieve tight and compressed shipping schedules, which also may reduce our sales and harm our financial performance. This seasonal pattern requires significant use of working capital, mainly to manufacture or acquire inventory during the portion of the year prior to the holiday season, and requires accurate forecasting of demand for products during the holiday season in order to avoid losing potential sales of popular products or producing excess inventory of products that are less popular with consumers. Our failure to accurately predict and respond to consumer demand, resulting in our underproducing popular items and/or overproducing less popular items, would reduce our total sales and harm our results of operations. In addition, as a result of the seasonal nature of our business, we would be significantly and adversely affected, in a manner disproportionate to the impact on a company with sales spread more evenly throughout the year, by unforeseen events, such as a terrorist attack or economic shock, that harm the retail environment or consumer buying patterns during our key selling season, or by events, such

as strikes or port delays, that interfere with the shipment of goods, particularly from the Far East, during the months leading up to the holiday purchasing season.

 

The continuing consolidation of our retail customer base means that economic difficulties or changes in the purchasing policies of our major customers could have a significant impact on us.

 

We depend upon a relatively small retail customer base to sell the majority of our products. For the fiscal year ended December 25, 2005, Wal-Mart Stores, Inc., Toys ‘R Us, Inc., and Target Corporation accounted for approximately 24%, 12% and 12%, respectively, of our consolidated net revenues and our five largest customers, including Wal-Mart, Toys ‘R Us and Target, in the aggregate accounted for approximately 53% of our consolidated net revenues. While the consolidation of our customer base may provide certain benefits to us, such as potentially more efficient product distribution and other decreased costs of sales and distribution, this consolidation also means that if one or more of our major customers were to experience difficulties in fulfilling their obligations to us, cease doing business with us, significantly reduce the amount of their purchases from us or return substantial amounts of our products, it could harm our business, financial condition and results of operations. Increased concentration among our customers could also negatively impact our ability to negotiate higher sales prices for our products and could result in lower gross margins than would otherwise be obtained if there were less consolidation among our customers. In addition, the bankruptcy or other lack of success of one or more of our significant retail customers could negatively impact our revenues and bad debt expense.

 

We may not realize the full benefit of our licenses if the licensed material has less market appeal than expected or if sales revenue from the licensed products is not sufficient to earn out the minimum guaranteed royalties.

 

An important part of our business involves obtaining licenses to produce products based on various theatrical releases, such as STAR WARS movies. The license agreements we enter to obtain these rights usually require us to pay minimum royalty guarantees that may be substantial, and in some cases may be greater than what we are ultimately able to recoup from actual sales, which could result in write-offs of such amounts that would harm our results of operations. At December 25, 2005, we had $126,515 of prepaid royalties, $37,107 of which are included in prepaid expenses and other current assets and $89,408 of which are included in other assets. Under the terms of existing contracts as of December 25, 2005, we are required to pay future minimum guaranteed royalties and other licensing fees totaling approximately $66,770. Acquiring or renewing licenses may require the payment of minimum guaranteed royalties that we consider to be too high to be profitable, which may result in losing licenses we currently hold when they become available for renewal, or missing business opportunities for new licenses. As a licensee, we have no guaranty that a particular brand will translate into successful toy or game products.

 

In addition to contracts existing as of the end of our 2005 fiscal year, in January 2006, we entered into a license arrangement with Marvel Entertainment, Inc., and its subsidiary Marvel Characters, Inc. This license arrangement, which grants us the right to produce certain products based on Marvel’s characters for five years for retail sales beginning in 2007, requires us to make guaranteed minimum payments in the amount of up to $205,000. There is no guarantee that we will sell enough licensed merchandise under the agreement to earn-out the $205,000 in guaranteed payments and make a profit.

 

We anticipate that the shorter theatrical duration for movie releases will make it increasingly difficult for us to sell licensed products based on entertainment properties and may lead our customers to reduce their demand for these products in order to minimize inventory risk. Furthermore, there can be no assurance that a successful brand will continue to be successful or maintain a high level of sales in the future. In the event that we are not able to acquire or maintain advantageous licenses, our revenues and profits may be harmed.

Our substantial sales and manufacturing operations outside the United States subject us to risks associated with international operations.

 

We operate facilities and sell products in numerous countries outside the United States. For the year ended December 25, 2005, our net revenues from international customers comprised approximately 40% of our total consolidated net revenues. We expect our sales to international customers to continue to account for a significant portion of our revenues. Additionally, we utilize third-party manufacturers located principally in the Far East and we have a manufacturing facility in Ireland. These sales and manufacturing operations are subject to the risks associated with international operations, including:

 

1) Currency conversion risks and currency fluctuations;

 

2) Limitations, including taxes, on the repatriation of earnings;

 

3) Political instability, civil unrest and economic instability;

 

4) Greater difficulty enforcing intellectual property rights and weaker laws protecting such rights;

 

5) Complications in complying with laws in varying jurisdictions and changes in governmental policies;

 

6) Natural disasters and the greater difficulty and expense in recovering therefrom;

 

7) Transportation delays and interruptions; and

 

8) The imposition of tariffs.

 

Our reliance on external sources of manufacturing can be shifted, over a period of time, to alternative sources of supply, should such changes be necessary. However, if we were prevented from obtaining products or components for a material portion of our product line due to political, labor or other factors beyond our control, our operations would be disrupted while alternative sources of products were secured. In particular, as the majority of our toy products, in addition to certain other products, are manufactured in the People’s Republic of China, health conditions and other factors affecting social and economic activity in China and affecting the movement of people and products into and from China to our major markets, including North America and Europe, could have a significant negative impact on our operations. Factors that could negatively affect our business include a potential revaluation of the Chinese yuan, which may result in an increase in the cost of producing products in China, or increases in labor costs and difficulties in moving products manufactured in the Far East through the ports on the western coast of North America. Also, the imposition of trade sanctions by the United States or the European Union against a class of products imported by us from, or the loss of “normal trade relations” status with, the People’s Republic of China, could significantly increase our cost of products imported into the United States or Europe and harm our business. Because of the importance of our international sales and international sourcing of manufacturing to our business, our financial condition and results of operations could be significantly harmed if any of the risks described above were to occur.

 

Part of our strategy for remaining relevant to older children is to offer innovative children’s toy and game electronic products. The margins on many of these products are lower than more traditional toys and games and such products may have a shorter lifespan than more traditional toys and games. As a result, increasing sales of children’s toy and game electronic products may lower our overall operating margins and produce more volatility in our business.

 

As children have grown “older younger” and have become interested in more and more sophisticated and adult products, such as videogames and consumer electronics, at younger and younger ages, we have needed to work even harder to keep our products relevant for these consumers. One initiative we have been pursuing to capture the interest of older children is to offer innovative children’s electronic toys and games. Examples of such products in the last few years include VIDEONOW, CHATNOW, MISSION PAINTBALL and I-DOG. These products, if successful, can be an effective way for us to connect with tween consumers and increase

sales. However, children’s electronics, in addition to the risks associated with our other family entertainment products, also face certain additional risks.

 

Our costs for producing electronic products tend to be higher than for many of our other more traditional products, such as board games and action figures. The ability to reflect higher costs in higher prices is constrained by heavy competition in consumer electronics. As a consequence, our margins on the sales of electronic products tend to be lower than for more traditional products. In addition, the pace of change in product offerings and consumer tastes in the electronics area is potentially even greater than for our other products. This pace of change means that the window in which a product can achieve and maintain consumer interest may be even shorter.

 

Market conditions, including commodity and fuel prices, public health conditions and other third party conduct could negatively impact our margins and our other business initiatives.

 

Economic and public health conditions, including factors that impact the strength of the retail market and retail demand, or our ability to manufacture and deliver products, can have a significant impact on our business. The success of our family entertainment products is dependant on consumer purchasing of those products. Consumers may not purchase our products because the products do not capture consumer interest and imagination. But consumer spending on our products can also be harmed by factors that negatively impact consumer’s budgets generally, and which are not due to our product offerings. Significant increases in the costs of other products which are required by consumers, such as gasoline and home heating fuels, may reduce household spending on entertainment products we offer. In addition, rising fuel and raw material prices, for components such as resin, or increased transportation costs, may increase our costs for producing and transporting our products, which in turn may reduce our margins and harm our business.

 

In addition, general economic conditions and employment levels can impact demand for our products. Economic conditions were significantly harmed by the September 11, 2001 terrorist attacks and could be similarly affected by any future attacks. Economic conditions may also be negatively impacted by wars and other conflicts, increases in critical commodity prices, or the prospect of such events. Such a weakened economic and business climate, as well as consumer uncertainty created by such a climate, could harm our sales and profitability.

 

Other conditions, such as the unavailability of electrical components, may impede our ability to manufacture, source and ship new and continuing products on a timely basis. Additional factors outside of our control could delay or increase the cost of implementing our business initiatives and product plans or alter our actions and reduce actual results. For example, work stoppages, slowdowns or strikes, or the occurrence or threat of wars or other conflicts, could impact our ability to manufacture or deliver product, resulting in increased costs and/or lost sales for our products.

 

Our business is dependent on intellectual property rights and we may not be able to protect such rights successfully. In addition, we have a material amount of acquired product rights which, if impaired, would result in a reduction of our income.

 

Our intellectual property, including our license agreements and other agreements that establish our ownership rights and maintain the confidentiality of our intellectual property, are of great value. We rely on a combination of trade secret, copyright, trademark, patent and other proprietary rights laws to protect our rights to valuable intellectual property related to our brands. From time to time, third parties have challenged, and may in the future try to challenge, our ownership of our intellectual property. In addition, our business is subject to the risk of third parties counterfeiting our products or infringing on our intellectual property rights. We may need to resort to litigation to protect our intellectual property rights, which could result in substantial costs and diversion of resources. Our failure to protect our intellectual property rights could harm our business and competitive position. Much of our intellectual property has been internally developed and has no carrying value on our balance sheet. As of December 25, 2005, we had approximately $609,678 of acquired product and licensing rights included in other assets on our balance sheet. Declines in the profitability of the acquired brands or licensed products may impact our ability to recover the carrying value of the related assets and

could result in an impairment charge. Reduction in our net income caused by impairment charges could harm our financial results.

 

We may not realize the anticipated benefits of future acquisitions or those benefits may be delayed or reduced in their realization.

 

Although we have not made any major acquisitions in the last few years, acquisitions have been a significant part of our historical growth and have enabled us to further broaden and diversify our product offerings. In making acquisitions, we target companies that we believe offer attractive family entertainment products. However, we cannot be certain that the products of companies we may acquire in the future will achieve or maintain popularity with consumers. In some cases, we expect that the integration of the product lines of the companies that we acquire into our operations will create production, marketing and other operating synergies which will produce greater revenue growth and profitability and, where applicable, cost savings, operating efficiencies and other advantages. However, we cannot be certain that these synergies, efficiencies and cost savings will be realized. Even if achieved, these benefits may be delayed or reduced in their realization. In other cases, we acquire companies that we believe have strong and creative management, in which case we plan to operate them autonomously rather than fully integrating them into our operations. We cannot be certain that the key talented individuals at these companies will continue to work for us after the acquisition or that they will continue to develop popular and profitable products or services.

 

From time to time, we are involved in litigation, arbitration or regulatory matters where the outcome is uncertain and which could entail significant expense.

 

As is the case with many large multinational corporations, we are subject from time to time to regulatory investigations, litigation and arbitration disputes. Because the outcome of litigation, arbitration and regulatory investigations is inherently difficult to predict, it is possible that the outcome of any of these matters could entail significant expense for us and harm our business.

 

We rely on external financing, including our credit facilities and accounts receivable securitization facility, to fund our operations. If we were unable to obtain or service such financing, or if the restrictions imposed by such financing were too burdensome, our business would be harmed.

 

Due to the seasonal nature of our business, in order to meet our working capital needs, particularly those in the third and fourth quarters, we rely on our revolving credit facility and our other credit facilities for working capital. We currently have an amended and restated revolving credit agreement, which provides for a $350,000 revolving credit facility. The credit agreement contains certain restrictive covenants setting forth minimum cash flow and coverage requirements, and a number of other limitations, including restrictions on capital expenditures, investments, acquisitions, share repurchases, incurrence of indebtedness and dividend payments. These restrictive covenants may limit our future actions, and financial, operating and strategic flexibility. In addition, our financial covenants were set at the time we entered into our credit facility. Our performance and financial condition may not meet our original expectations, causing us to fail to meet such financial covenants. If we were unable to meet our financial covenants, or if we failed to comply with other covenants in our credit facility, we could face significant negative consequences, including loss of the ability to raise capital under these facilities to fund our operations.

 

As an additional source of working capital and liquidity, we currently have a $250,000 accounts receivable securitization program. Under this program, we sell on an ongoing basis, substantially all of our U.S. dollar denominated trade accounts receivable to a bankruptcy remote special purpose entity. Under this facility, the special purpose entity is able to sell, on a revolving basis, undivided ownership interests in the eligible receivables to bank conduits. During the term of the facility, we must maintain certain performance ratios. If we fail to maintain these ratios, we could be prevented from accessing this cost-effective source of working capital and short-term financing.

 

We believe that our cash flow from operations, together with our cash on hand and access to existing credit facilities and our accounts receivable securitization facility, are adequate for current and planned needs

in 2006. However, our actual experience may differ from these expectations. Factors that may lead to a difference include, but are not limited to, the matters discussed herein, as well as future events that might have the effect of reducing our available cash balance, such as unexpected material operating losses or increased capital or other expenditures, as well as increases in inventory or accounts receivable that are ineligible for sale under our securitization facility, or future events that may reduce or eliminate the availability of external financial resources.

 

We also may choose to finance our capital needs, from time to time, through the issuance of debt securities. Our ability to issue such securities on satisfactory terms, if at all, will depend on the state of our business and financial condition, any ratings issued by major credit rating agencies, market interest rates, and the overall condition of the financial and credit markets at the time of the offering. The condition of the credit markets and prevailing interest rates have fluctuated in the past and are likely to fluctuate in the future. Variations in these factors could make it difficult for us to sell debt securities or require us to offer higher interest rates in order to sell new debt securities. The failure to receive financing on desirable terms, or at all, could damage our ability to support our future operations or capital needs or engage in other business activities.

 

As of December 25, 2005, we had approximately $527.7 million of total principal amount of indebtedness outstanding. If we are unable to generate sufficient available cash flow to service our outstanding debt we would need to refinance such debt or face default. There is no guarantee that we would be able to refinance debt on favorable terms, or at all. This total indebtedness includes $249,996 in aggregate principal amount of 2.75% senior convertible debentures that we issued in 2001. On December 1, 2011 and December 1, 2016, and upon the occurrence of certain fundamental corporate changes, holders of the 2.75% senior convertible debentures may require us to purchase their debentures. At that time, the purchase price may be paid in cash, shares of common stock or a combination of the two, at our discretion, provided that we will pay accrued and unpaid interest in cash. We may not have sufficient cash at that time to make the required repurchases and may be required to settle in shares of common stock.

 

We previously issued warrants that provide the holder with an option through January 2008 to sell all of these warrants to us for a price to be paid, at our election, of either $100,000 in cash or $110,000 in our common stock, such stock being valued at the time of the exercise of the option. Should we be required to settle these warrants under this option, we believe that we will have adequate funds to settle in cash if necessary. However, we may not have sufficient funds at that time to make the required payment and may be required to settle the warrants in stock.

 

As a manufacturer of consumer products and a large multinational corporation, we are subject to various government regulations, violation of which could subject us to sanctions. In addition, we could be the subject of future product liability suits, which could harm our business.

 

As a manufacturer of consumer products, we are subject to significant government regulations under The Consumer Products Safety Act, The Federal Hazardous Substances Act, and The Flammable Fabrics Act. In addition, certain of our products are subject to regulation by the Food and Drug Administration. While we take all the steps we believe are necessary to comply with these acts, there can be no assurance that we will be in compliance in the future. Failure to comply could result in sanctions which could have a negative impact on our business, financial condition and results of operations.

 

In addition to government regulation, products that have been or may be developed by us may expose us to potential liability from personal injury or property damage claims by the users of such products. There can be no assurance that a claim will not be brought against us in the future. While we currently maintain product liability insurance coverage in amounts we believe sufficient for our business risks, we may not be able to maintain such coverage or such coverage may not be adequate to cover all potential claims. Moreover, even if we maintain sufficient insurance coverage, any successful claim could significantly harm our business, financial condition and results of operations.

 

As a large, multinational corporation, we are subject to a host of governmental regulations throughout the world, including antitrust, customs and tax requirements, anti-boycott regulations and the Foreign Corrupt

Practices Act. Our failure to successfully comply with any such legal requirements could subject us to monetary liabilities and other sanctions that could harm our business and financial condition.

 

We have a material amount of goodwill which, if it becomes impaired, would result in a reduction in our net income.

 

Goodwill is the amount by which the cost of an acquisition accounted for using the purchase method exceeds the fair value of the net assets we acquire. Current accounting standards require that goodwill no longer be amortized but instead be periodically evaluated for impairment based on the fair value of the reporting unit. At December 25, 2005, approximately $467,061 or 14.1%, of our total assets represented goodwill. Declines in our profitability may impact the fair value of our reporting units, which could result in a further write-down of our goodwill. Reductions in our net income caused by the write-down of goodwill could harm our results of operations.

 

 

None

 

 

 

 

 

In addition to the above listed facilities, the Company either owns or leases various other properties approximating an aggregate of 169,000 square feet which are utilized by its various segments. The Company also either owns or leases an aggregate of approximately 533,600 square feet not currently being utilized in its operations or previously included in restructuring actions, which are currently subleased or offered for sublease.

 

The foregoing properties consist, in general, of brick, cinder block or concrete block buildings which the Company believes are in good condition and well maintained.

 

The Company believes that its facilities are adequate for its current needs.

 

 

We are currently party to certain legal proceedings, none of which, individually or in the aggregate, we believe to be material to our financial condition.

 

 

None.

Executive Officers of the Registrant

 

The following persons are the executive officers of the Company. Such executive officers are elected annually. The position(s) and office(s) listed below are the principal position(s) and office(s) held by such persons with the Company, or its subsidiaries or divisions employing such person. The persons listed below generally also serve as officers and directors of certain of the Company’s various subsidiaries at the request and convenience of the Company.

 

 

 

 

PART II

 

 

The Company’s common stock, par value $.50 per share (the “Common Stock”), is traded on the New York Stock Exchange under the symbol “HAS”. The following table sets forth the high and low sales prices as reported on the Composite Tape of the New York Stock Exchange and the cash dividends declared per share of Common Stock for the periods listed.

 

 

The approximate number of holders of record of the Company’s Common Stock as of February 9, 2006 was 9,400.

 

Dividends

 

Declaration of dividends is at the discretion of the Company’s Board of Directors and will depend upon the earnings and financial condition of the Company and such other factors as the Board of Directors deems appropriate. Payment of dividends is further subject to restrictions contained in agreements relating to the Company’s outstanding short-term and long-term debt. Under the most restrictive agreement, dividend payments are restricted to the greater of $50 million per annum or 50% of the prior fiscal year consolidated net income.

 

Issuer Repurchases of Common Stock

 

Repurchases Made in the Fourth Quarter (in whole numbers of shares and dollars)

 

On May 19, 2005, the Company’s Board of Directors authorized the repurchase of up to $350 million in common stock. This authorization replaced a prior authorization, dated December 6, 1999 of $500 million, which had $204.5 million remaining. Purchases of the Company’s common stock may be made in the open market or through privately negotiated transactions. The Company has no obligation to repurchase shares under the authorization, and the timing, actual number, and the value of the shares that are repurchased will depend on a number of factors, including the price of the Company’s stock. The Company may suspend or discontinue the program at any time and there is no expiration date.

 

 

 

 

 

 

The following discussion should be read in conjunction with the audited consolidated financial statements of the Company included elsewhere in this document.

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements concerning the Company’s expectations and beliefs. See Item 1A “Forward-Looking Information and Risk Factors That May Affect Future Results” for a discussion of other uncertainties, risks and assumptions associated with these statements.

 

(Thousands of Dollars and Shares Except Per Share Data)

 

Executive Summary

 

The Company earns revenue and generates cash through the sale of a variety of toy and game products. The Company sells these products both within the United States and in a number of international markets. While many of the Company’s products are based on brands the Company owns or controls, the Company also offers products which are licensed from outside inventors. The Company also licenses rights to produce products based on movie, television, music and other family entertainment properties, such as STAR WARS.

 

For the past several years, the Company has focused on growing core owned and controlled brands, developing new and innovative products which respond to market insights, and optimizing efficiencies within the Company to reduce costs, increase operating profits and strengthen its balance sheet. While the Company has sought to achieve a more sustainable revenue base by developing and maintaining its core brands and avoiding reliance on licensed entertainment properties, the Company continues to opportunistically enter into or leverage existing strategic licenses which complement its brands and leverage its key strengths.

 

The Company’s core brands represent Company-owned or Company-controlled brands, such as G.I. JOE, TRANSFORMERS, MY LITTLE PONY, MONOPOLY, MAGIC: THE GATHERING, PLAYSKOOL and TONKA, which the Company views as presenting potential to be successful over the long term. The Company has a large portfolio of owned and controlled brands, which can be introduced in new formats and platforms over time. These brands may also be further extended by pairing a licensed concept with a core-brand. By focusing on core brands, the Company is working to build a more consistent revenue stream and basis for future growth. However, the volatility of consumer preferences and the high level of competition in the toy and game industry make it challenging to maintain the long-term success of existing product lines and to consistently introduce successful new products.

 

In addition to its focus on core brands, the Company’s strategy also involves trying to meet ever-changing consumer preferences by identifying and offering innovative products based on market opportunities and insights. In 2005, the Company’s position as a leader in developing innovative electronic products for children was reinforced with the introduction of products such as I-DOG, VIDEONOW XP, ZOOMBOX and the reintroduction of an enhanced, interactive FURBY. The Company believes its strategy of focusing on the development of its core brands and continuing to identify innovative new products will help to prevent the Company from being dependent on the success of any one product line.

 

With the theatrical release of Lucasfilm’s STAR WARS EPISODE III: REVENGE OF THE SITH in May 2005, and the subsequent holiday season DVD release, sales of product related to the Company’s strategic STAR WARS license rose substantially in 2005. Aggregate net revenues from products associated with this license were approximately $494,000 in 2005 and accounted for 16% of consolidated net revenues. Pairing this key licensed property with the Company’s ability to design and produce action figures, role playing toys, and games, as well as the ability to launch an integrated marketing campaign to promote the product globally, was the key to this line’s success. While the Company’s strategy has continued to focus on growing its core brands and developing innovative, new products, the Company will continue to evaluate and enter into arrangements to license properties when the Company believes it is economically attractive. In early 2006, the Company announced it entered into a license with Marvel Entertainment, Inc. and Marvel Characters, Inc. to produce toys and games based on Marvel’s portfolio of characters. While gross profits of theatrical entertainment-based products are generally higher than many of the Company’s other products, sales from

these products also incur royalty expenses payable to the licensor. Such royalties reduce the impact of these higher gross margins. In certain instances, such as with Lucasfilm’s STAR WARS, the Company may also incur amortization expense on property right based assets acquired from the licensor of such properties, further impacting profit made on these items.

 

The Company’s strategy in the last several years has also involved reducing fixed costs and increasing operating margins. The Company ended 2005 with a strong balance sheet. The Company has achieved its targeted debt to capitalization ratio and will continue making scheduled debt repayments.

 

In 2005, utilizing cash from operations, the Company reacquired the digital gaming rights on several of its core brands which had previously been licensed to a third party, and purchased the assets of Wrebbit Inc., a maker of innovative puzzles, which complement the Company’s current product portfolio. The Company will continue to evaluate acquisitions which may complement its current product offerings or allow it entry into an area which is adjacent to and complementary to the toy and game business.

 

As part of its continuous effort to focus on consumer demands, better anticipate the needs of its retail customers, provide a more integrated toy and game marketing plan, place a greater company-wide focus on its core brands and thereby improve its overall business, in January 2006 the Company announced that it has simplified and integrated its operating segment structure. The Company’s North American toy and games business will be managed under common leadership beginning in 2006, providing a combined focus on developing, marketing, and selling products in the U.S., Canada and Mexico. The International segment will consist of the Company’s European, Asia Pacific and Latin American marketing operations. The Company’s world-wide manufacturing and product sourcing operations will be managed through its Global Operations segment. The Hasbro Properties Group will continue to be responsible for the world-wide outlicensing of the Company’s intellectual properties and will work closely with the North American and International segments on the development and licensing of the Company’s brands. The remainder of this Discussion and Analysis is presented according to the 2005 segment structure under which the Company operated.

 

Summary

 

The relationship between various components of the results of operations, stated as a percent of net revenues, is illustrated below for each of the three fiscal years ended December 25, 2005.

 

Results of Operations

 

Net earnings for the fiscal year ended December 25, 2005 were $212,075, or $1.09 per diluted share. This compares to net earnings for fiscal 2004 and 2003 of $195,977 and $157,664, or $.96 and $.85 per diluted share, respectively.

 

Net earnings and basic and diluted earnings per share for 2005 include income tax expense of approximately $25,800 related to the Company’s repatriation of approximately $547,000 of foreign earnings in the fourth quarter of 2005 pursuant to the special incentive provided by the American Jobs Creation Act of 2004.

 

Net earnings and basic and diluted earnings per share for 2003 include a cumulative effect of accounting change, net of tax, of $(17,351), or $(.09) per diluted share, relating to the adoption of Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of Liabilities and Equity” (“SFAS 150”).

 

Consolidated net revenues for the year ended December 25, 2005 were $3,087,627 compared to $2,997,510 in 2004 and $3,138,657 in 2003. Most of the Company’s revenues and operating profits were derived from its three principal segments: U.S. Toys, Games and International, which are discussed in detail below.

 

The following table presents net revenues and operating profit data for the Company’s three principal segments for each of the three fiscal years ended December 25, 2005:

 

 

U.S. Toys

 

U.S. Toys segment net revenues for the year ended December 25, 2005 increased 13% to $1,074,540 from $952,923 in 2004. This increase is predominantly due to increased revenues from STAR WARS related products as the result of the theatrical and DVD releases of STAR WARS EPISODE III: REVENGE OF THE SITH in 2005. In addition to the increase in STAR WARS related revenues, 2005 U.S. Toys revenues were also positively impacted by the successful reintroduction of LITTLEST PET SHOP and FURBY products as well as increased sales of NERF products. These increases were partially offset by decreased sales of VIDEONOW and FURREAL FRIENDS products as well as the continued decline in BEYBLADE products. In addition, other boys’ toys products such as G.I. JOE and TRANSFORMERS were negatively impacted by the success of STAR WARS products.

 

U.S. Toys operating profit increased to $79,991 in 2005 from $7,185 in 2004. The increase was due primarily to the increase in revenue. U.S. Toys gross profit was also positively impacted by the change in product mix with increased sales of high margin lines such as STAR WARS and LITTLEST PET SHOP products and decreased sales of VIDEONOW products which carry a lower gross margin. The increase in gross profit was partially offset by increased royalty and amortization expense resulting from increased sales of STAR WARS products. U.S. Toys product development costs decreased as the result of efficiencies gained from its realignment in 2004. This realignment streamlined the U.S. Toys workforce and moved certain product development outside of the U.S. Advertising expense also decreased for U.S. Toys in 2005 primarily

due to the high percentage of sales from STAR WARS products, which do not require as much advertising and promotion to raise awareness as an internally-developed product would.

 

U.S. Toys segment net revenues for the year ended December 26, 2004 decreased 10% to $952,923 from 2003. The results reflect an overall softness in the boys’ toy business, as demonstrated primarily by decreased sales of BEYBLADE, and to a lesser extent, lower sales of TRANSFORMERS and G.I. JOE products. Decreased sales of PLAYSKOOL and ZOIDS products also contributed to the overall decrease in revenues. These decreases were partially offset by increased sales of VIDEONOW products, increased shipments of MY LITTLE PONY products, which were reintroduced in the third quarter of 2003, and revenues from the new product launch of LAZER TAG. Net revenues in 2004 were also positively impacted by increased shipments of STAR WARS products over 2003.

 

The decrease in U.S. Toys’ operating profit to $7,185 in 2004 from 2003, primarily relates to decreased gross profit as a result of the lower net revenues as well as a change in product mix, including the decline in sales of BEYBLADE products which carry a higher gross margin and increased sales of VIDEONOW hardware, which carry a lower gross margin. Competitive price pressures and customer sales allowances related to VIDEONOW also contributed to lower gross margin. Increased advertising expense related to core brands and new product introductions also contributed to the decline in operating profit. U.S. Toys’ 2004 operating profit was also impacted by charges of $6,900 associated with organizational and staffing changes made in December 2004. The decrease in operating profit was partially offset by decreased royalties, driven by lower sales of BEYBLADE products, as well as lower selling, distribution, and administration expenses as a result of a combination of lower sales activity and the Company’s cost reduction initiatives.

 

Games

 

Games segment net revenues for the year ended December 25, 2005 decreased 8% to $730,635 from 2004. The decrease in revenues primarily reflects decreased revenues from trading card games, primarily DUEL MASTERS and MAGIC: THE GATHERING. The decreased revenues also reflect a reduction in board game sales primarily due to lower revenues from TRIVIAL PURSUIT, which had higher revenues in 2004 as a result of the release of TRIVIAL PURSUIT 1990’S EDITION. Revenues were positively impacted by STAR WARS revenues, primarily the plug and play LIGHT SABER BATTLE game, as well as increased sales of CANDY LAND products as a result of core brand extensions including CANDY LAND: DORA EDITION and the CANDY LAND DVD game.

 

Games segment operating profit decreased 50% in 2005 to $69,477 from 2004. The decrease in operating profit is primarily due to decreased gross profit due to the decline in revenues and specifically, the decline in trading card games, which have a high gross margin. Games segment operating profit was also negatively impacted by a loss of approximately $23,000 in the electronic games category, which included charges associated with inventory obsolescence and customer allowances related to plug and play games.

 

Games segment net revenues for the year ended December 26, 2004 decreased slightly by 1% to $796,032 from 2003. The decrease in revenues was primarily due to decreased sales of board games. Partially offsetting this decrease were increased revenues from products in the electronic and pre-school categories including strong sales of ELEFUN and WHAC-A-MOLE. Revenues from trading card games increased slightly with sales of DUEL MASTERS, which was introduced in the fourth quarter of 2003 offsetting decreased revenues from other trading card games, including MAGIC: THE GATHERING, which had one less release in 2004 than in 2003.

 

Games segment operating profit decreased 21% to $137,628 in 2004 from 2003. The decrease reflects lower gross margin as a result of a change in the mix of trading card game revenue, higher product development and royalty expenses associated with DVD games, and increased advertising expense.

 

International

 

International segment net revenues for the year ended December 25, 2005 increased by 3% to $1,231,761 from 2004. The increase in revenues was primarily the result of increased sales of STAR WARS products in

2005 and, to a lesser extent, the successful reintroduction of LITTLEST PET SHOP and FURBY products and the introduction of B-DAMAN products. These increases were partly offset by decreased sales of BEYBLADE and ACTION MAN products as well as decreased sales of FURREAL FRIENDS and VIDEONOW products. Revenues for board games grew internationally in 2005, while the Company experienced decreased revenues in its trading card games, primarily DUEL MASTERS and MAGIC: THE GATHERING. International net revenues were negatively impacted by currency translation of approximately $700 as a result of the stronger U.S. dollar.

 

International operating profit increased 5% to $148,135 in 2005 from 2004. Increased gross profit as a result of increased revenues was partially offset by higher amortization and royalty expenses as a result of the higher sales of licensed products, primarily STAR WARS products, in 2005. International operating profit was negatively impacted by $2,913 due to the translation of foreign currencies to the U.S. dollar.

 

International segment net revenues increased slightly by 1% to $1,194,630 in 2004 from 2003. International segment 2004 net revenues were positively impacted by currency translation of approximately $78,000 as the result of the weaker U.S. dollar. Excluding the favorable impact of foreign exchange, International net revenues decreased 6% in local currency for the year ended December 26, 2004. The decrease in local currency revenue was primarily the result of lower sales of BEYBLADE products, and, to a lesser extent, decreased sales of ACTION MAN. These decreases were partially offset by increased revenues from MY LITTLE PONY products, which were introduced in the third quarter of 2003, and higher sales of FURREAL FRIENDS, DUEL MASTERS, and VIDEONOW products. To a lesser extent, 2004 revenues were also positively impacted by increased sales of core brand products, including PLAYSKOOL and MONOPOLY products, as well as TRIVIAL PURSUIT products including TRIVIAL PURSUIT 20th ANNIVERSARY EDITION.

 

International segment operating profit increased significantly by 54% to $140,784 in 2004 from 2003. International gross profits and operating profits were positively impacted by the cessation of manufacturing at the Company’s Valencia, Spain facility at the end of 2003. Operating profit in 2003 included cash charges of approximately $18,400 associated with severance related to this cost reduction initiative. The improvement in operating profit in 2004 over 2003 was also due to lower royalty expense primarily from decreased sales of BEYBLADE, which was partially offset by an increase in advertising expense as a result of the Company’s ongoing initiative to raise awareness of its core brands. In 2004, there was a net favorable translation impact to International segment operating profit of approximately $4,800 for the year.

 

Gross Profit

 

The Company’s gross profit margin increased slightly to 58.3% for the year ended December 25, 2005 from 58.2% in 2004. This increase was primarily due to increased sales of STAR WARS products, which generally carry a higher gross margin, which is offset by royalty and amortization expense. Gross profit margin in 2005 was also impacted by decreased sales of VIDEONOW products that have lower gross margins. These increases were largely offset by inventory obsolescence and customer allowances on plug and play games as well as lower sales of trading card games that carry a higher gross margin.

 

The Company’s gross profit margin decreased to 58.2% for the year ended December 26, 2004 from 59.0% in 2003. The decrease in 2004 from 2003 was due to changes in product mix, primarily decreased sales of BEYBLADE products, which carry a higher gross margin. Gross margin was also negatively impacted by increased sales of VIDEONOW hardware products, which carry a lower gross margin, and decreased margin on VIDEONOW products due to competition and customer sales allowances. 2003 gross profit includes charges incurred by the Company to cease manufacturing operations in Spain, comprised primarily of severance costs as well as non-cash charges associated with fixed assets. The production activities previously performed in Spain were transferred to the Company’s other manufacturing facilities or outsourced to third party suppliers.

 

The Company aggressively monitors its levels of inventory, attempting to avoid unnecessary expenditures of cash and potential charges related to obsolescence. The Company’s failure to accurately predict and respond to consumer demand could result in overproduction of less popular items, which could result in higher obsolescence costs, causing a reduction in gross profit.

Expenses

 

The Company’s operating expenses, stated as percentages of net revenues, are illustrated below for the three fiscal years ended December 25, 2005:

 

 

Amortization increased to $102,035 in 2005 from $70,562 in 2004 and $76,053 in 2003. The increase in amortization in 2005 relates to increased amortization of STAR WARS property rights due to the theatrical and DVD releases of STAR WARS EPISODE III: REVENGE OF THE SITH. Amortization of these rights is based on actual sales of products as a portion of total expected sales of related products related to this licensing right. The decrease in amortization expense in 2004 from 2003 primarily relates to 2003 charges related to certain unprofitable product lines. The Company expects amortization expense to decrease in 2006 from 2005 levels due to lower expected sales of STAR WARS products.

 

Royalty expense increased to $247,283, or 8.0% of net revenues in 2005 from $223,193, or 7.4% of net revenues in 2004 and $248,423, or 7.9% of net revenues in 2003. Increased royalty expense in 2005 relates primarily to increased sales of STAR WARS related products. The increase from STAR WARS products was partially offset by lower sales of BEYBLADE, SHREK and DISNEY products. Lower royalty expense in 2004 compared to 2003 is primarily due to the decreased sales of BEYBLADE products partly offset by a $7,200 charge related to future minimum guarantees not expected to be fully realized related to the Disney license agreement. The Company expects royalty expense to decrease in both dollars and as a percentage of net revenues in 2006 compared to 2005, due to the lower expected revenues of STAR WARS related products.

 

Research and product development decreased in 2005 to $150,586, or 4.9% of net revenues, from $157,162, or 5.2% of net revenues in 2004. The decrease reflects increased efficiencies in the U.S. Toys product development resulting from its realignment in 2004. This realignment streamlined the U.S. Toys workforce and moved certain product development outside of the U.S. While the Company strives to incur these costs in the most efficient manner possible, investment in research and product development costs is an important component to the Company’s strategy to grow core brands and to create new and innovative toy and game products. The increase in expenditures for research and product development from $143,183, or 4.6% of net revenues in 2003 to $157,162, or 5.2% of net revenues in 2004 reflects higher development costs associated with electronic toys such as VIDEONOW COLOR and electronic games such as MISSION PAINT BALL plug and play, as well as DVD games.

 

Advertising expense in 2005 decreased in dollars and as a percentage of net revenues to $366,371, or 11.8% of net revenues, in 2005 from $387,523, or 12.9% of net revenues in 2004. This decrease reflects higher sales of STAR WARS products, which do not require the same amount of advertising as the Company’s non-entertainment based products. The Company continues to focus on marketing to raise awareness of its core brands, as well as to introduce new products. Advertising expense increased in dollars and as a percentage of net revenues to $387,523, or 12.9% of net revenues in 2004 from $363,876, or 11.6% of net revenues in 2003. The Company expects advertising to increase as a percentage of revenues in 2006 from 2005 as an increased percentage of revenues will come from core brands and new products due to the lower expected sales of STAR WARS product.

 

Selling, distribution and administration expenses increased in dollars but decreased as a percentage of net revenues to $624,560, or 20.2% of net revenues in 2005, from $614,401, or 20.5% of net revenues in 2004. The increase in administration costs in dollars primarily reflects increased performance incentive bonus provisions reflecting the Company’s improved performance. Selling, distribution and administration expenses decreased in dollars and as a percentage of net revenues to $614,401, or 20.5% of net revenues in 2004, from

$674,544, or 21.5% of net revenues in 2003. The decrease in 2004 from 2003 reflects lower expenses resulting from the Company’s cost reduction and business efficiency initiatives, and lower levels of performance incentive bonus provisions relating to lower revenues and operating earnings. Additionally, the 2003 amount included costs associated with the Company’s closure of its retail stores operated under the Wizards of the Coast and Gamekeeper names.

 

Interest Expense

 

Interest expense decreased to $30,537 in 2005 from $31,698 in 2004 and $52,462 in 2003. Decreased interest expense, resulting from lower levels of debt, were largely offset by increased interest expense as a result of higher interest rates. The decrease in interest expense mainly reflects the Company’s strategy to reduce its long-term debt. The Company repurchased or repaid principal amounts of long-term debt of $93,303 in 2005, $56,697 in 2004, and $368,937 in 2003.

 

Approximately 72% of the decrease in interest expense from 2003 to 2004 was attributable to lower levels of short-term and long-term debt in 2004 than in 2003 with the remaining 28% decrease in interest expense due to lower effective interest rates, primarily the result of interest rate swap agreements that reduce the amount of the Company’s debt subject to fixed interest rates. The Company will continue to review the amount of long-term debt outstanding as part of its strategic capital structure objective of maintaining a debt to capitalization ratio between 25% and 30%.

 

Other (Income) Expense, Net

 

Other income, net of $30,929 for the year ended December 25, 2005 compares to other expense, net of $1,226 and $48,090 for the years ended December  26, 2004 and December 28, 2003. Other income, net in 2005 primarily consists of interest income of $24,157, which compares to $7,729 in 2004 and $4,377 in 2003. The increase in interest income primarily relates to increases in invested cash balances in 2005.

 

Other income, net in 2005 also includes non-cash income of $2,080 compared to $12,710 in 2004 and a non-cash charge to earnings of $13,630 in 2003, related to the change in the fair value of certain warrants required to be classified as a liability. These warrants are required to be adjusted to their fair value each quarter through earnings. The fair value of these warrants is primarily affected by the Company’s stock price, but is also affected by the Company’s stock price volatility and dividends, as well as risk-free interest rates. Assuming the Company’s stock volatility and dividend payments, as well as risk-free interest rates remain constant, the fair value of the warrants would increase and the Company would recognize a charge to earnings as the price of the Company’s stock increases. If the price of the Company’s stock decreases and the Company’s stock volatility, dividend payments, and the risk-free interest rates remain constant, the fair value of the warrants will decrease and the Company will recognize income. Based on a hypothetical increase in the Company’s stock price to $22.00 per share at December 25, 2005 from its actual price of $20.36 a share on that date, the Company would have recognized a non-cash charge of approximately $7,790 rather than actual non-cash income recorded of $2,080 for the year ended December 25, 2005, to reflect the change in the fair value of the warrants from their fair value of $125,940 at December 26, 2004.

 

Other expense, net in 2004 also includes a $8,988 write-down of the value of the common stock of Infogrames, held by the Company as an available-for-sale investment. This write-down resulted from an other-than-temporary decline in the fair value of this investment.

 

Other expense, net in 2003 includes a loss on extinguishment of debt of $20,342 relating to the 8.50% Notes due 2006, repurchased pursuant to a tender offer in the fourth quarter of 2003. Under the tender offer, the Company repurchased notes totaling $167,257 in aggregate principal amount.

 

Income Taxes

 

Income tax expense was 31.8% of pretax earnings in 2005 compared with 24.6% of pretax earnings in 2004 and 28.3% of pretax earnings in 2003. Income tax expense for 2005 includes approximately $25,800 related to the repatriation in the fourth quarter of 2005 of $547,000 of foreign earnings pursuant to the special

incentive provided by the American Jobs Creation Act of 2004. Income tax expense for 2005 was also reduced by approximately $4 million, due primarily to an Internal Revenue Service examination of tax years ending in December 2001. Absent these items and the effect of the adjustment of certain warrants to their fair value, which has no tax effect, the 2005 effective tax rate would have been 24.9%.

 

Absent the effect of the adjustment of certain warrants to their fair value, which has no tax effect, the 2004 and 2003 effective tax rates would have been 25.9% and 26.8%, respectively. The 2004 and 2003 effective tax rates were negatively impacted by increases in the valuation allowance primarily attributable to decreases in the value of the Company’s available-for-sale investment in Infogrames Entertainment SA. The decrease in the adjusted rate, to 24.9% in 2005 from 25.9% in 2004, is also due to the tax impact of higher operating profits in jurisdictions with lower statutory tax rates.

 

Cumulative Effect of Accounting Changes

 

On June 30, 2003, the first day of the third quarter of fiscal 2003, the Company adopted Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of Liabilities and Equity” (“SFAS 150”). SFAS 150 required the Company to reclassify certain warrants recorded as equity to a liability, and adjust the warrants to their fair value through earnings as of that date. On the date of adoption, the Company reclassified $107,669 from equity, where the warrants had previously been recorded, to current liabilities. A cumulative effect of accounting change of $17,351 was recorded to adjust the amount of this liability to its fair value on the adoption date. There was no tax benefit associated with this charge.

 

Liquidity and Capital Resources

 

The Company has historically generated a significant amount of cash from operations. In 2005, the Company funded its operations and liquidity needs primarily through cash flows from operations, and, when needed, proceeds from its accounts receivable securitization program and borrowings under its unsecured credit facilities. During 2006, the Company expects to continue to fund its working capital needs primarily through operations and, when needed, using proceeds from the accounts receivable securitization program and borrowings under its available lines of credit. The Company believes that the funds available to it, including cash expected to be generated from operations and funds available through its securitization program and other available lines of credit, are adequate to meet its needs for 2006. However, unforeseen circumstances in the toy or game industry, such as softness in the retail environment or unanticipated changes in consumer preferences, could result in a significant decline in revenues and operating results for the Company, which could result in the Company being in non-compliance with its debt covenants and unable to use funding from its accounts receivable securitization program. Non-compliance with its debt covenants could result in the Company being unable to utilize borrowings under its revolving credit facility and other bank lines, a circumstance which potentially could occur when operating shortfalls would most require supplementary borrowings to enable the Company to continue to fund its operations. Also, non-compliance with covenants under its accounts receivable securitization program could result in the Company being unable to utilize this program. In addition, a significant deterioration in the business of a major U.S. customer could result in a decrease in eligible accounts receivable that would prevent the Company from being able to fully utilize its accounts receivable securitization program.

 

During the last four fiscal years, as part of its strategy of reducing long-term debt and its overall debt-to-capitalization ratio, the Company has repurchased or repaid approximately $646,000 in principal amount of long-term debt, primarily using cash from operations. Remaining principal amounts of long-term debt at December 25, 2005, including portions classified as current, were $527,726. The Company believes that the reduction in its debt-to-capitalization ratio has improved its liquidity situation by decreasing cash required to service outstanding debt, thereby increasing the ability of the Company to obtain additional financing should the need to do so arise.

 

At December 25, 2005, cash and cash equivalents, net of short-term borrowings, were $927,592 compared to $707,043 and $497,393 at December 26, 2004 and December 28, 2003, respectively. Hasbro generated

approximately $497,000, $359,000, and $454,000 of cash from its operating activities in 2005, 2004 and 2003, respectively. The increase in 2005 from 2004 is primarily due to the mix of products in 2005 net revenues. Net earnings in 2005 included increased non-cash expenses primarily as a result of increased STAR WARS revenues. Increased royalty expense in 2005 related to revenues from STAR WARS products. A portion of these royalties had been paid in prior years and recorded as a prepaid expense. The Company paid an advance of $35,000 in 2005 related to STAR WARS royalties. In addition, the Company had increased amortization expense in 2005, which did not impact the cash flows from operations. Although net earnings before cumulative effect of accounting change increased to $195,977 in 2004 from $175,015 in 2003, the decrease in cash from operations in 2004 as compared to 2003 was primarily the result of changes in operating assets and liabilities, further discussed below.

 

Accounts receivable decreased to $523,232 at December 25, 2005 from $578,705 at December 26, 2004. Fourth quarter days sales outstanding decreased to 44 days in 2005 from 49 days in 2004 and 2003. The decrease in days sales outstanding from 2004 primarily reflects improved collections, increased utilization of the securitization facility in 2005 and decreases in international accounts receivable due to the stronger U.S. dollar in 2005. In 2003, the Company entered into a revolving accounts receivable securitization facility whereby the Company is able to sell undivided interests in qualifying accounts receivable on an ongoing basis. At December 25, 2005 and December 26, 2004, there was $250,000 and $206,055, respectively, sold under this program. The December 25, 2005 accounts receivable balance includes a decrease of approximately $23,884 related to the currency impact of the weaker U.S. dollar. Inventories decreased to $179,398 at December 25, 2005 from $194,780 at December 26, 2004. The decrease in inventory represents higher levels of inventory at December 26, 2004 due to lower levels of sales in the fourth quarter of 2004. In addition, inventories decreased approximately $5,900 due to the stronger U.S. dollar in 2005. The increase in inventory to $194,780 at December 26, 2004 from $168,979 at December 28, 2003 reflects lower than normal inventory levels in 2003 and, to a lesser extent, lower revenues in the fourth quarter of 2004. Inventory levels at year-end 2003 were at their lowest point since 1990.

 

Prepaid expenses and other current assets decreased to $185,297 at December 25, 2005 from $219,735 at December 26, 2004. This decrease is primarily related to decreased prepaid royalties as a result of the increased sales of STAR WARS products in 2005. Generally, when the Company enters into a licensing agreement for entertainment-based properties, an advance royalty payment is required at the inception of the agreement. This payment is then recognized in the consolidated statement of operations as the related sales are recorded. The decrease related to prepaid royalties was partially offset by increased deferred taxes. Prepaid expenses and other current assets increased slightly to $219,735 at December 26, 2004 from $211,981 at December 28, 2003. An increase in current prepaid royalties as a result of the 2005 release of STAR WARS EPISODE III: REVENGE OF THE SITH was partially offset by decreased deferred taxes. With respect to the STAR WARS license, the Company has prepaid royalties recorded in both current and non-current assets.

 

Accounts payable and accrued expenses increased to $863,280 at December 25, 2005 from $806,528 at December 26, 2004. This primarily reflects an increase in accrued income taxes primarily as a result of improved earnings in 2005 and, to a lesser extent, taxes payable related to earnings repatriated under the American Jobs Creation Act (the “Act”). In December 2005, the Company repatriated approximately $547,000 under this Act. The increase from accrued income taxes was partially offset by lower accrued royalties at December 25, 2005 due to lower sales of BEYBLADE and SHREK products in the fourth quarter of 2005. These contracts did not require the Company to prepay royalties as these royalty amounts were paid in arrears. Accounts payable and accrued expenses decreased to $806,528 at December 26, 2004 from $905,368 at December 28, 2003. The decrease primarily relates to decreases in accrued bonuses and performance incentives as well as a decrease in accrued income taxes. To a lesser extent, this decrease was also due to a decrease in the value of certain warrants that the Company is required to record as liabilities under SFAS 150. As a result of SFAS 150, the Company classifies certain warrants containing a put option as a current liability and adjusts the amount of this liability to its fair value on a periodic basis.

 

Cash flows from investing activities were a net utilization of $120,671, $84,967, and $64,879 in 2005, 2004 and 2003, respectively. During 2005, the Company expended $65,000 to reacquire the digital gaming rights for its owned or controlled properties from Infogrames Entertainment SA (Infogrames). These rights

were previously held by Infogrames on an exclusive basis as a result of a licensing agreement entered into during 2000. In addition, the Company expended $14,179 to purchase the assets of Wrebbit Inc., a Montreal-based creator and manufacturer of innovative puzzles. In 2005, the Company also had proceeds from the sales of property, plant and equipment of $33,083. These proceeds came primarily from the sale of the Company’s former manufacturing facility in Spain. During 2005, the Company expended approximately $71,000 on additions to its property, plant and equipment while during 2004 and 2003 it expended approximately $79,000 and $63,000, respectively. Of these amounts, 61% in 2005, 58% in 2004, and 66% in 2003 were for purchases of tools, dies and molds related to the Company’s products. The level of capital spending in 2005, 2004, and 2003 was below the level permitted under its outstanding credit facilities. In 2006, the Company expects capital expenditures to continue to be in the range of $70,000 to $90,000. During the three years ended December 25, 2005, depreciation and amortization of plant and equipment was $78,097, $75,618, and $88,070, respectively. In 2004, the Company acquired the remaining unowned interest in its Latin America operations for total consideration of $9,824. This purchase resulted in an increase in goodwill in the amount of $9,390. The Company made no acquisitions of businesses in 2003.

 

The Company commits to inventory production, advertising and marketing expenditures prior to the peak third and fourth quarter retail selling season. Accounts receivable increase during the third and fourth quarter as customers increase their purchases to meet expected consumer demand in the holiday season. Due to the concentrated timeframe of this selling period, payments for these accounts receivable are generally not due until the fourth quarter or early in the first quarter of the subsequent year. This timing difference between expenditures and cash collections on accounts receivable made it necessary for the Company to borrow varying amounts during the year. During 2005 and 2004, the Company primarily utilized cash from operations and its accounts receivable securitization program. During 2003, the Company primarily utilized cash from operations and borrowings under its secured amended and restated revolving credit agreement to meet its cash flow requirements.

 

The Company is party to an accounts receivable securitization program whereby the Company sells, on an ongoing basis, substantially all of its U.S. trade accounts receivable to a bankruptcy remote special purpose entity, Hasbro Receivables Funding, LLC (“HRF”). HRF is consolidated with the Company for financial reporting purposes. The securitization program then allows HRF to sell, on a revolving basis, an undivided interest of up to $250,000 in the eligible receivables it holds to certain bank conduits. The program provides the Company with a cost-effective source of working capital. Based on the amount of eligible accounts receivable as of December 25, 2005, the Company utilized $250,000, which was the maximum available to sell under this program.

 

The Company has an amended and restated credit agreement, which provides it with an unsecured revolving credit facility of $350,000, maturing in March 2007. The Company is not required to maintain compensating balances under the agreement. The amended and restated agreement contains certain restrictive covenants setting forth minimum cash flow and coverage requirements, and a number of other limitations, including with respect to capital expenditures, investments, acquisitions, share repurchases and dividend payments. The Company was in compliance with all restrictive covenants as of and for the fiscal year ended December 25, 2005. The Company had no borrowings outstanding under its committed revolving credit facility at December 25, 2005. The Company also has other uncommitted lines from various banks, of which approximately $44,552 was utilized at December 25, 2005. Amounts available and unused under the committed line at December 25, 2005 were approximately $346,000.

 

Net cash utilized by financing activities was $158,641 in 2005. This amount included repayments in principal amount of long-term debt totaling $93,303. These amounts primarily related to $71,970 of bonds that matured in November of 2005. The remaining amount relates to repayment of long-term debt associated with the Company’s former manufacturing facility in Spain. Dividends paid increased to $58,901 as a result of the increase of the quarterly dividend rate to $0.09 in the first quarter of 2005 from $0.06. In May 2005, the Company’s Board of Directors authorized the repurchase of up to $350 million in common stock. In 2005, the Company repurchased 2,386 shares at an average price of $20.10. The total cost of these repurchases, including transaction costs, was $48,030. The Company received $45,278 in 2005 in proceeds from the exercise of employee stock options.

Net cash utilized by financing activities was $75,824 in 2004. This amount included repurchases in principal amount of long-term debt totaling $56,697 in connection with the Company’s strategy of reducing its overall debt and improving its debt-to-capitalization ratio. The Company received $25,836 from the exercise of stock options during the year. In December 2003, the Company increased its quarterly dividend to $0.06 per share from $0.03 per share. This increased cash paid for dividends to $37,088 from the 2003 amount of $20,851.

 

Net cash utilized by financing activities was $373,307 in 2003. This was primarily the result of the Company’s use of cash flows from operations to repurchase or repay $200,288 in principal amount of 7.95% Notes in March 2003. In addition, the Company repurchased $167,257 in principal amount of 8.50% Notes due 2006 in the fourth quarter of 2003 at a total cost of $188,991. Also in 2003, as the result of the increase in the Company’s stock price during the year, the Company received $39,892 in proceeds from the exercise of employee stock options. The Company also paid $3,378 to repurchase shares issued upon the exercise of certain warrants as well as to terminate a warrant agreement.

 

The Company has outstanding $249,996 in principal amount of senior convertible debentures due 2021. The senior convertible debentures bear interest at 2.75%, which could be subject to an upward adjustment in the rate, not to exceed 11%, should the price of the Company’s stock trade at or below $9.72 per share for 20 of the 30 trading days preceding the fifth day prior to an interest payment date. This contingent interest feature represents a derivative instrument that is recorded on the balance sheet at its fair value, with changes in fair value recognized in the statement of operations. If the closing price of the Company’s stock exceeds $23.76 for at least 20 trading days, within the 30 consecutive trading day period ending on the last trading day of the calendar quarter, or upon other specified events, the debentures will be convertible at an initial conversion price of $21.60 in the next calendar quarter. This contingent conversion feature was not met in 2005. The holders of these debentures may put the notes back to Hasbro in December 2011 and December 2016 at the original principal amount. At that time, the purchase price may be paid in cash, shares of common stock or a combination of the two, at the Company’s discretion. While the Company’s current intent is to settle in cash any puts exercised, there can be no guarantee that the Company will have the funds necessary to settle this obligation in cash. On December 1, 2005, the holders of these debentures had the option to put these notes back to Hasbro. On that date, the Company redeemed $4 of these notes in cash. Due to this put option, these debentures were classified on the Company’s balance sheet in the current portion of long-term debt at December 26, 2004. Subsequent to December 1, 2005, the remaining $249,996 of principal amount of these notes were reclassified to long-term debt.

 

The Company has remaining principal amounts of long-term debt, including current portions, at December 25, 2005 of approximately $527,726. As detailed below in Contractual Obligations and Commercial Commitments, this debt is due at varying times from 2006 through 2028. Of the total principal amount, the Company has $32,743 of 8.50% Notes due in March 2006. In addition, the Company is committed to guaranteed royalty and other contractual payments of approximately $128,220 in 2006, which includes $100,000 of royalty commitments on a contract signed in January 2006 with Marvel Entertainment, Inc. and Marvel Characters, Inc. Also, as detailed in Contractual Obligations and Commercial Commitments, the Company has certain warrants, currently recorded in accrued liabilities, that may be settleable for, at the Company’s option, $100,000 in cash or $110,000 in the Company’s stock, such stock being valued at the time of the exercise of the option. The Company believes that cash from operations, including the securitization facility, and, if necessary, its line of credit, will allow the Company to meet these and other obligations listed. The Company will continue to review the amount of long-term debt outstanding as part of its strategic capital structure objective of maintaining a debt to capitalization ratio between 25% and 30%.

 

On May 19, 2005, the Company’s Board of Directors authorized the repurchase of up to $350 million in common stock. This authorization replaced a prior authorization, dated December 6, 1999 of $500 million, which had $204.5 million remaining. Purchases of the Company’s common stock may be made in the open market or through privately negotiated transactions. The Company has no obligation to repurchase shares under the authorization, and the timing, actual number, and the value of the shares that are repurchased will depend on a number of factors, including the price of the Company’s stock. The Company may suspend or discontinue the program at any time and there is no expiration date. In 2005, the Company repurchased

2,386 shares at an average price of $20.10. The total cost of these repurchases, including transaction costs, was $48,030.

 

Critical Accounting Policies and Significant Estimates

 

The Company prepares its consolidated financial statements in accordance with accounting principles generally accepted in the United States of America. As such, management is required to make certain estimates, judgments and assumptions that it believes are reasonable based on the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses for the periods presented. The significant accounting policies which management believes are the most critical to aid in fully understanding and evaluating the Company’s reported financial results include sales allowances, inventory valuation, recoverability of goodwill and intangible assets, recoverability of royalty advances and commitments and pensions.

 

Sales allowances for customer promotions, discounts and returns are recorded as a reduction of revenue when the related revenue is recognized. Revenue from product sales is recognized upon passing of title to the customer, generally at the time of shipment. Revenue from product sales, less related sales allowances, is added to royalty revenue and reflected as net revenues in the consolidated statements of operations. The Company routinely commits to promotional sales allowance programs with customers. These allowances primarily relate to fixed programs, which the customer earns based on purchases of Company products during the year. Discounts are recorded as a reduction of related revenue at the time of sale. While many of the allowances are based on fixed amounts, certain of the allowances, such as the returns allowance, are based on market data, historical trends and information from customers and are therefore subject to estimation.

 

Inventory is valued at the lower of cost or market. Based upon a consideration of quantities on hand, actual and projected sales volume, anticipated product selling prices and product lines planned to be discontinued, slow-moving and obsolete inventory is written down to its net realizable value. Failure to accurately predict and respond to consumer demand could result in the Company under producing popular items or overproducing less popular items. Management estimates are monitored on a quarterly basis and a further adjustment to reduce inventory to its net realizable value is recorded, as an increase to cost of sales, when deemed necessary under the lower of cost or market standard.

 

Goodwill and other intangible assets deemed to have indefinite lives are tested for impairment at least annually. If an event occurs or circumstances change that indicate that the carrying value may not be recoverable, the Company will perform an interim test at that time. The impairment test begins by allocating goodwill and intangible assets to applicable reporting units. Goodwill is then tested using a two step process that begins with an estimation of the fair value of the reporting unit using an income approach, which looks to the present value of expected future cash flows.

 

The first step is a screen for potential impairment while the second step measures the amount of impairment if there is an indication from the first step that one exists. Intangible assets with indefinite lives are tested for impairment by comparing their carrying value to their estimated fair value which is also calculated using an income approach. The Company’s annual impairment test was performed in the fourth quarter of 2005 and no impairment was indicated. The estimation of future cash flows requires significant judgments and estimates with respect to future revenues related to the respective asset and the future cash outlays related to those revenues. Actual revenues and related cash flows or changes in anticipated revenues and related cash flows could result in a change in this assessment and result in an impairment charge. The estimation of discounted cash flows also requires the selection of an appropriate discount rate. The use of different assumptions would increase or decrease estimated discounted cash flows and could increase or decrease the related impairment charge. At December 25, 2005, the Company has goodwill and intangible assets with indefinite lives of $542,799 recorded on the balance sheet.

 

Intangible assets, other than those with indefinite lives, are reviewed for indications of impairment whenever events or changes in circumstances indicate the carrying value may not be recoverable. Recoverability of the value of these intangible assets is measured by a comparison of the assets’ carrying value

to the estimated future undiscounted cash flows expected to be generated by the asset. If such assets were considered to be impaired, the impairment would be measured by the amount by which the carrying value of the asset exceeds its fair value based on estimated future discounted cash flows. The estimation of future cash flows requires significant judgments and estimates with respect to future revenues related to the respective asset and the future cash outlays related to those revenues. Actual revenues and related cash flows or changes in anticipated revenues and related cash flows could result in a change in this assessment and result in an impairment charge. The estimation of discounted cash flows also requires the selection of an appropriate discount rate. The use of different assumptions would increase or decrease estimated discounted cash flows and could increase or decrease the related impairment charge. Intangible assets covered under this policy were $533,940 at December 25, 2005. During 2005, there were no impairment charges related to these intangible assets.

 

The recoverability of royalty advances and contractual obligations with respect to minimum guaranteed royalties is assessed by comparing the remaining minimum guaranty to the estimated future sales forecasts and related cash flow projections to be derived from the related product. If sales forecasts and related cash flows from the particular product do not support the recoverability of the remaining minimum guaranty or, if the Company decides to discontinue a product line with royalty advances or commitments, a charge to royalty expense to write-off the remaining minimum guaranty is required. The preparation of revenue forecasts and related cash flows for these products requires judgments and estimates. Actual revenues and related cash flows or changes in the assessment of anticipated revenues and cash flows related to these products could result in a change to the assessment of recoverability of remaining minimum guaranteed royalties. At December 25, 2005, the Company had $126,515 of prepaid royalties, $37,107 of which are included in prepaid expenses and other current assets and $89,408 which are included in other assets.

 

The Company, except for certain international subsidiaries, has pension plans covering substantially all of its full-time employees. Pension expense is based on actuarial computations of current and future benefits using estimates for expected return on assets, expected compensation increases, and applicable discount rates. The Company estimates expected return on assets using a weighted average rate based on historical market data for the investment classes of assets held by the plan, the allocation of plan assets among those investment classes, and the current economic environment. Based on this information, the Company’s estimate of expected return on domestic plan assets was 8.75% in 2005, 2004 and 2003. A decrease in the estimate used for expected return on plan assets would increase pension expense, while an increase in this estimate would decrease pension expense. A decrease of .25% in the estimate of expected return on plan assets would increase pension expense for U.S. plans by approximately $470. Expected compensation increases are estimated using a combination of historical compensation increases with expected compensation increases in the Company’s long-term business forecasts. Based on this analysis, the Company’s estimate of expected long-term compensation increases for its U.S. plans was 4.0% in 2005, 2004 and 2003. Increases in estimated compensation increases would result in higher pension expense while decreases would lower pension expense. Discount rates are selected based upon rates of return at the measurement date on high quality corporate bond investments currently available and expected to be available during the period to maturity of the pension benefits. Based on this long-term corporate bond yield at September 30, 2005, the Company’s measurement date for its pension assets and liabilities, the Company selected a discount rate for its domestic plans of 5.50%. A decrease in the discount rate would result in greater pension expense while an increase in the discount rate would decrease pension expense. A decrease of .25% in the Company’s discount rate would increase pension expense and the projected benefit obligation by approximately $995 and $11,110, respectively. In accordance with Statement of Financial Accounting Standards No. 87, “Employers Accounting for Pensions”, actual results that differ from the actuarial assumptions are accumulated and, if outside a certain corridor, amortized over future periods and, therefore generally affect recognized expense and the recorded obligation in future periods. Assets in the plan are valued on the basis of their fair market value on the measurement date. In 2005 and 2004, the Company recorded a minimum pension liability for its U.S. plans of $53,329 and $43,196, respectively. This amount represents the amount by which the accumulated benefit obligation exceeds the sum of the fair market value of plan assets and accrued amounts previously recorded.

Contractual Obligations and Commercial Commitments

 

In the normal course of its business, the Company enters into contracts related to obtaining rights to produce product under license, which may require the payment of minimum guarantees, as well as contracts related to the leasing of facilities and equipment. In addition, the Company has $527,726 of long-term debt outstanding at December 25, 2005, including current portions and excluding fair value adjustments. Future payments required under these and other obligations as of December 25, 2005 are as follows:

 

 

In addition to the above commitments, in January 2006, the Company entered into a five-year license arrangement with Marvel Entertainment, Inc., and its subsidiary Marvel Characters, Inc. (together “Marvel”) to develop products based on certain Marvel properties for retail sales beginning on January 1, 2007. The arrangement requires the Company to make guaranteed minimum payments in the amount of $205,000 with $100,000 paid in February 2006. Of the remaining payments, $70,000 is expected to be paid in 2007 upon the release of the motion picture SPIDERMAN 3 and the remainder to be paid upon the release of the motion picture SPIDERMAN 4, whose release date is yet to be determined. The agreement also requires the Company to make minimum expenditures on marketing and promotional activities, including the spending of at least $15,000 associated with the motion picture SPIDERMAN 3. Certain of the future minimum guaranteed contractual royalty payments are contingent upon the theatrical release of the related entertainment property.

 

Included in the Thereafter column above is $249,996 in principal amount of senior convertible debt due 2021. The holders of these debentures may put the notes back to the Company in December 2011 and December 2016 at the principal amount. At that time, the purchase price may be paid in cash, shares of common stock or a combination of the two.

 

In addition to the above, the Company has certain warrants outstanding at December 25, 2005 that contain a put option that would require the Company to repurchase the warrants for a price to be paid, at the Company’s election, of either $100,000 in cash or $110,000 in shares of the Company’s common stock, such stock being valued at the time of the exercise of the option. The Company’s current intent is to settle this put option in cash if exercised. In accordance with SFAS 150, these warrants are recorded as an accrued liability at fair value at December 25, 2005. In addition, the Company expects to make contributions totaling approximately $21,000 to its pension plans in 2006. The Company also has letters of credit of approximately $33,600 at December 25, 2005.

 

Financial Risk Management

 

The Company is exposed to market risks attributable to fluctuations in foreign currency exchange rates primarily as the result of sourcing products priced in U.S. dollars, Hong Kong dollars and Euros while marketing those products in more than twenty currencies. Results of operations may be affected primarily by changes in the value of the U.S. dollar, Hong Kong dollar, Euro, British pound, Canadian dollar and Mexican peso and, to a lesser extent, currencies in Latin American and Asia Pacific countries.

 

To manage this exposure, the Company has hedged a portion of its forecasted foreign currency transactions using forward foreign exchange contracts, and purchased foreign currency options. The Company estimates that a hypothetical immediate 10% depreciation of the U.S. dollar against foreign currencies could

result in an approximate $9,200 decrease in the fair value of these instruments. A decrease in the fair value of these instruments would be substantially offset by decreases in the related forecasted foreign currency transaction.

 

The Company is also exposed to foreign currency risk with respect to its net cash and cash equivalents or short-term borrowing positions in currencies other than the U.S. dollar. The Company believes, however, that the on-going risk on the net exposure should not be material to its financial condition. In addition, the Company’s revenues and costs have been and will likely continue to be affected by changes in foreign currency rates. From time to time, affiliates of the Company may make or receive intercompany loans in currencies other than their functional currency. The Company manages this exposure at the time the loan is made by using foreign exchange contracts. Other than as set forth above, the Company does not hedge foreign currency exposures. The Company reflects all derivatives at their fair value as an asset or liability on the balance sheet. The Company does not speculate in foreign currency exchange contracts.

 

At December 25, 2005, the Company had fixed rate long-term debt, including current portions and excluding fair value adjustments, of $527,726. At December  25, 2005, the Company had fixed-for-floating interest rate swaps with notional amounts of $100,000. The interest rate swaps are designed to adjust the amount of the Company’s debt subject to a fixed interest rate. The interest rate swaps are matched with specific long-term debt issues and are designated and effective as hedges of the change in the fair value of the associated debt. Changes in fair value of these contracts are wholly offset in earnings by changes in the fair value of long-term debt. At December 25, 2005, these contracts had a fair value of $663, with $636 included in other assets, and the remaining $27 included in prepaid expenses and other current assets, with corresponding fair value adjustments to increase long-term debt and current portions of long-term debt, respectively. Changes in interest rates affect the fair value of fixed rate debt not hedged by interest rate swap agreements while affecting the earnings and cash flows of the long-term debt hedged by the interest rate swaps. The Company estimates that a hypothetical one percentage point decrease or increase in interest rates would increase or decrease the fair value of this long-term debt by approximately $15,900 or $13,600, respectively. A hypothetical one percentage point change in interest rates would increase or decrease 2006 pretax earnings and cash flows by $729 and $375, respectively.

 

The Economy and Inflation

 

The Company continued to experience difficult economic environments in some parts of the world during 2005. The principal market for the Company’s products is the retail sector. Revenues from the Company’s top 5 customers, all retailers, accounted for approximately 53%, 50%, and 52% of its consolidated net revenues in 2005, 2004 and 2003, respectively. In the past two years certain customers in the retail sector have experienced economic difficulty. The Company monitors the creditworthiness of its customers and adjusts credit policies and limits as it deems appropriate.

 

The Company’s revenue pattern continues to show the second half of the year, and within that half, the fourth quarter, to be more significant to its overall business for the full year. The Company expects that this concentration will continue, particularly as more of its business shifts to larger customers with order patterns concentrated in the second half of the year. The concentration of sales in the second half of the year and, specifically, the fourth quarter increases the risk of (a) underproduction of popular items, (b) overproduction of less popular items, and (c) failure to achieve tight and compressed shipping schedules. The business of the Company is characterized by customer order patterns which vary from year to year largely because of differences in the degree of consumer acceptance of a product line, product availability, marketing strategies, inventory levels, policies of retailers and differences in overall economic conditions. The trend of larger retailers has been to maintain lower inventories throughout the year and purchase a greater percentage of product within or close to the fourth quarter holiday consumer selling season, which includes Christmas.

 

Quick response inventory management practices now being used result in more orders being placed for immediate delivery and fewer orders being placed well in advance of shipment. To the extent that retailers do not sell as much of their year-end inventory purchases during this holiday selling season as they had anticipated, their demand for additional product earlier in the following fiscal year may be curtailed, thus

negatively impacting the Company’s revenues. In addition, the bankruptcy or other lack of success of one of the Company’s significant retailers could negatively impact the Company’s future revenues.

 

The effect of inflation on the Company’s operations during 2005 was not significant and the Company will continue its policy of monitoring costs and adjusting prices, accordingly.

 

Other Information

 

Hasbro uses the intrinsic-value method of accounting for stock options granted to employees. As required by the Company’s existing stock plans, stock options are granted at, or above, the fair market value of the Company’s stock, and, accordingly, no compensation expense is recognized for these grants in the consolidated statement of operations. The Company records compensation expense related to other stock-based awards, such as restricted stock grants, over the period the award vests, typically three years.

 

On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which amends SFAS 123 and SFAS 95 “Statement of Cash Flows”. SFAS 123(R) requires companies to measure all employee stock-based compensation awards using a fair value method and record such expense in its consolidated financial statements. In addition, the adoption of SFAS 123(R) requires additional accounting and disclosure related to the income tax and cash flow effects resulting from share-based payment arrangements. SFAS 123(R) is effective for the Company as of December 26, 2005, the first day of the 2006 fiscal year. The Company will adopt SFAS 123(R) on the prospective basis as defined in the statement. Under this adoption method, the Company will record expense relating to employee stock-based compensation awards in the periods subsequent to adoption. This expense will be based on all unvested options as of the adoption date as well as all future stock-based compensation awards. Based on the current options outstanding, the Company’s 2006 pretax expense for those options is expected to be between $16,000 and $17,000. This amount may increase to the extent that options are granted in 2006.

 

On October 22, 2004, the American Jobs Creation Act of 2004 (the “Act”) was signed into law. The Act created a one-time incentive for U.S. corporations to repatriate undistributed earnings from their international subsidiaries by providing an 85% dividends-received deduction for certain international earnings. In the fourth quarter of 2005, the Company repatriated approximately $547,000 of foreign earnings under the provisions of the Act which resulted in income tax of $25,844.

 

The Company is not aware of any material amounts of potential exposure relating to environmental matters and does not believe its environmental compliance costs or liabilities to be material to its operating results or financial position.

 

 

The information required by this item is included in Item 7 of Part II of this Report and is incorporated herein by reference.

 

 

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Shareholders

Hasbro, Inc.:

 

We have audited the accompanying consolidated balance sheets of Hasbro, Inc. and subsidiaries as of December 25, 2005 and December 26, 2004, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the fiscal years in the three-year period ended December 25, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about 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. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hasbro, Inc. and subsidiaries as of December 25, 2005 and December 26, 2004, and the results of their operations and their cash flows for each of the fiscal years in the three-year period ended December 25, 2005, in conformity with U.S. generally accepted accounting principles.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Hasbro, Inc.’s internal control over financial reporting as of December 25, 2005, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 21, 2006, expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

 

As discussed in note 1 to the consolidated financial statements, during the fourth quarter of 2004, the Company adopted Emerging Issues Task Force Issue 04-08, “The Effect of Contingently Convertible Instruments on Diluted Earnings per Share”. As discussed in note 6 to the consolidated financial statements, effective June 30, 2003, the first day of the Company’s third quarter of fiscal 2003, the Company adopted the provisions of Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of Liabilities and Equity”.

 

 

Providence, Rhode Island

February 21, 2006

HASBRO, INC. AND SUBSIDIARIES

Consolidated Balance Sheets
December 25, 2005 and December 26, 2004
(Thousands of dollars except share data)

 

 

See accompanying notes to consolidated financial statements.

HASBRO, INC. AND SUBSIDIARIES

Consolidated Statements of Operations
Fiscal Years Ended in December
(Thousands of dollars except per share data)

 

 

See accompanying notes to consolidated financial statements.

HASBRO, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows
Fiscal Years Ended in December
(Thousands of dollars)

 

 

See accompanying notes to consolidated financial statements.

HASBRO, INC. AND SUBSIDIARIES

 

Consolidated Statements of Shareholders’ Equity

(Thousands of dollars)