SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED: COMMISSION FILE NUMBER:
JANUARY 31, 1999 0-22545

DSI TOYS, INC.
(Exact name of Registrant as specified in its charter)

TEXAS 74-1673513
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)

1100 WEST SAM HOUSTON PARKWAY NORTH
HOUSTON, TEXAS 77043
(Address of principal executive offices) (Zip Code)

Registrant's telephone number including area code: (713) 365-9900

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
Common Stock, $.01 par value Nasdaq

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

None

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 [X] No [ ]

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. [ ]

The aggregate market value of the voting stock held by non-affiliates of the
Registrant as of April, 26, 1999 was $12,856,975. As of April 26, 1999, there
were 6,566,038 shares of common stock, $.01 par value, outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive Proxy Statement for the registrant's 1999 Annual
Meeting of Stockholders to be held on May 24, 1999 are incorporated by reference
in Part III of this Form 10-K.

TABLE OF CONTENTS

Page

Safe Harbor Statement........................................................1

Part I

Item 1. Business.............................................................1
Item 2. Properties..........................................................11
Item 3. Legal Proceedings...................................................12
Item 4. Submission of Matters to a Vote of Security Holders.................12

Part II

Item 5. Market for Registrant's Common Equity and Related Shareholder
Matters.........................................................13
Item 6. Selected Consolidated Financial Data................................14
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................15
Item 8. Financial Statements and Supplementary Data.........................20
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.............................................21

Part III

Item 10. Directors and Executive Officers of the Registrant...............22
Item 11. Executive Compensation...........................................22
Item 12. Security Ownership of Certain Beneficial Owners and Management...22
Item 13. Certain Relationships and Related Transactions...................22

Part IV

Item 14. Exhibits, Financial Statement Schedules, and Reports on
Form 8-K......................................................22

Signatures..................................................................23

Index to Consolidated Financial Statements and Schedule....................F-1

Index to Exhibits..........................................................E-1

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SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT
OF 1995: STATEMENTS IN THIS REPORT THAT ARE NOT HISTORICAL FACTS, INCLUDING
STATEMENTS ABOUT PLANS AND EXPECTATIONS REGARDING PRODUCTS AND OPPORTUNITIES,
DEMAND AND ACCEPTANCE OF NEW AND EXISTING PRODUCTS, CAPITAL RESOURCES AND FUTURE
FINANCIAL CONDITION AND RESULTS ARE FORWARD-LOOKING. FORWARD-LOOKING STATEMENTS
INVOLVE RISKS AND UNCERTAINTIES, WHICH MAY CAUSE THE COMPANY'S ACTUAL RESULTS IN
FUTURE PERIODS TO DIFFER MATERIALLY AND ADVERSELY FROM THOSE EXPRESSED. THESE
UNCERTAINTIES AND RISKS INCLUDE CHANGING CONSUMER PREFERENCES, LACK OF SUCCESS
OF NEW PRODUCTS, LOSS OF THE COMPANY'S CUSTOMERS, LIQUIDITY OF THE COMPANY,
COMPETITION, AND OTHER FACTORS DISCUSSED IN THIS REPORT AND FROM TIME TO TIME IN
THE COMPANY'S FILINGS WITH THE SECURITIES AND EXCHANGE COMMISSION.
EXCEPT AS OTHERWISE INDICATED, REFERENCES TO THE "COMPANY" REFER TO DSI
TOYS, INC. AND ITS WHOLLY OWNED SUBSIDIARY, DSI (HK) LTD. ("DSI(HK)"). THE TERMS
"FISCAL YEAR" AND "FISCAL" REFER TO THE COMPANY'S FISCAL YEAR WHICH IS THE YEAR
ENDING JANUARY 31 OF THE FOLLOWING CALENDAR YEAR MENTIONED (E.G., A REFERENCE TO
FISCAL 1998 IS A REFERENCE TO THE FISCAL YEAR ENDED JANUARY 31, 1999).

PART I

ITEM 1. BUSINESS

GENERAL

The Company designs, develops, markets and distributes toys and children's
consumer electronics. The Company's core product categories are (i) juvenile
audio products, including walkie-talkies, pre-school audio products, pre-teen
audio products and musical toys; (ii) girls' toys, including dolls, play sets
and accessories; and (iii) boys' toys, including radio-controlled vehicles,
action figures and western and military action toys. Founded in 1970, the
Company historically was principally a supplier of non-proprietary toys to deep
discount stores and regional drug store chains. With the addition of new senior
management personnel in 1990, the Company began to market its product line to
major toy retailers by emphasizing packaging and developing in-house brands.
Further, in fiscal 1993, the Company began to emphasize the development and
marketing of proprietary products, consisting of toys developed by the Company
incorporating concepts licensed from outside inventors, products designed
in-house, products for which the Company owns the molds and products
incorporating trademarks licensed to the Company.

Traditionally a supplier of juvenile audio products and boys' toys, the
Company has diversified its product offerings in recent years, primarily through
its expansion into the girls' toys category with the introduction of the
Rosie(R) doll in fiscal 1995, into radio-controlled vehicles with the
introduction of the Kawasaki(R) Ninja(R) Supergyro(TM) motorcycle in fiscal 1997
and the Burnin' Thunder(TM) Super Sound R/C vehicle in 1998, into action games
with the introduction of Hoppin' Poppin' Spaceballs(R) in fiscal 1997, and into
construction sets with the introduction of BlockMen(TM) in fiscal 1998.

The Company offers several licensed products under the Kawasaki(R) brand
name, including musical instruments and radio-controlled vehicles. The Company
also has developed and currently is marketing products incorporating several
in-house brand names, including Tech-Link(TM) (walkie-talkies), LA Rock(R)
(musical toys and audio products), American Frontier(TM) (western role play
toys), BlockMen(TM) (construction sets), and My Music Maker(R) (musical toys and
pre-school audio products). The Company believes that it is the leading supplier
of walkie-talkies to United States toy retailers.

The Company sells primarily to retailers, including mass merchandising
discounters such as Wal-Mart, Kmart and Target, specialty toy retailers such as
Toys "R" Us, Kay-Bee Toy & Hobby, F.A.O. Schwarz, Zany Brainy, Noodle Kidoodle
and QVC, and deep discount stores such as Family Dollar Stores, Inc.,
Consolidated Stores Corporation and Value City Department Stores, Inc. Although
the

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Company's sales have been made primarily to customers based in the United
States, international net sales accounted for approximately 21% of the Company's
net sales during fiscal 1998.

Approximately 72% of the Company's net sales (by dollar volume) were made
FOB Asia during fiscal 1998. Products sold FOB Asia are shipped directly to
customers from the factory and are not carried by the Company in inventory. The
Company also maintains an inventory of certain products in its Houston, Texas
facilities, principally to support sales to the Company's customers of
continuous stock items that are offered by the customers on a year-round basis.

On April 15, 1999, the Company entered into a Stock Purchase and Sale
Agreement (the "Stock Purchase Agreement") with MVII, LLC, a California limited
liability company controlled by Tom Martin, which contemplates several related
transactions: (i) MVII purchased 566,038 shares of common stock from the Company
for $1.2 million on April 15, 1999; (ii) MVII commenced a tender offer to
purchase up to 1.6 million shares of the outstanding common stock of the Company
at $4.38 per share in cash (the "Offer") on April 21, 1999; and (iii) subject to
shareholder and other approvals, MVII will purchase an additional 1,792,453
shares of common stock (subject to upward adjustments not to exceed in the
aggregate 140,000 shares) from the Company for $3.8 million simultaneously with
the purchase of shares in the tender offer. Upon consummation of the
transactions, MVII will own more than 47% of the Company's outstanding shares
and will be entitled to nominate four of the six members of the board of
directors. (These transactions are described in greater detail in the Company's
Schedule 14D-9 filed with the Securities and Exchange Commission on April 22,
1999.)

PRODUCTS

The following table depicts the Company's net sales, as a percentage of
total net sales, by product category for the fiscal years indicated.
Product Category

1998 1997 1996
-------- -------- --------
Juvenile audio products .................... 72.6% 50.2% 49.5%
Girls' toys ................................ 5.8 31.0 40.8
Boys' toys ................................. 14.5 9.8 6.0
Other ...................................... 7.1 9.0 3.7
-------- -------- --------
Total ................................ 100.0% 100.0% 100.0%
======== ======== ========

Between 30% and 40% of the Company's products (by dollar volume of net
sales) are replaced each year through the introduction of new products. As a
result of this turnover, product development is a critical and ongoing concern.
The Company develops both proprietary and non-proprietary products. The
Company's proprietary product lines currently consist of products (i) that are
licensed from outside inventors and designers, (ii) that incorporate trademarks
licensed by the Company, (iii) that are designed in-house or (iv) for which the
Company owns the molds to manufacture the toys. For each product in the fourth
proprietary category, the Company or the inventor owns the intellectual property
of the design, and the Company owns the required tooling, dies and molds
necessary to manufacture the product. Proprietary toys accounted for
approximately 47%, 58%, and 59% of the Company's net sales for fiscal 1998,
1997, and 1996, respectively. The Company's proprietary products generally yield
higher gross margins to the Company than non-proprietary toys.

Non-proprietary products are defined by the Company as toys designed and
manufactured by independent toy manufacturers and marketed by the Company,
usually on an exclusive basis in the Company's primary markets. The Company
selects its non-proprietary product introductions on the basis of the Company's
evaluation of several factors, including the quality and pricing of the product,
as well as whether the product presents an opportunity for the Company to
utilize packaging and marketing to differentiate the product from other toys.
The Company often markets these toys under in-house brands,

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such as Digi-Tech(TM), My Music Maker(R), and LA Rock(R). Non-proprietary
products accounted for approximately 53%, 42%, and 41% of the Company's net
sales for fiscal 1998, 1997, and 1996, respectively.

LICENSE AGREEMENTS

The Company enters into license agreements with toy inventors and
designers that give the Company the right to manufacture and market a product or
technology invented or designed by the inventor. In return, the Company agrees
to pay to the inventor a percentage of net sales of the Company's product that
is based on the inventor's product or technology. Typically, this annual royalty
ranges from 4% to 7% of net sales. Sales of products that are based on products
or technology acquired by the Company from the inventor thereof, such as the
Burnin' Thunder(TM) Super Sound R/C vehicle, accounted for approximately 24%,
46%, and 41% of the Company's net sales during fiscal 1998, 1997, and 1996,
respectively. The acquisition of licenses typically requires the payment of
non-refundable advances and/or guaranteed minimum royalties.

The Company has a license agreement with Kawasaki Motors Corp., USA
authorizing the Company to use the Kawasaki(R) brand name in connection with
several different products, including a complete line of electronic musical
instruments, including keyboards, and the Kawasaki(R) Ninja(R) Supergyro(TM)
Motorcycle.

Effective November 1, 1998, the Company entered into a consumer products
license agreement with Titan Sports, Inc. authorizing the Company to use the
intellectual property associated with the World Wrestling Federation(R),
including the name, the logo, and the names, nicknames and identifying indicia
of the individuals who perform at World Wrestling Federation(R) events in
connection with the sale, marketing and distribution of certain of the Company's
products.

On December 1, 1998, the Company entered into a retail license agreement
with Discovery Communications, Inc. authorizing the Company to use the Marks
Discovery Channel(R), Explore Your World(R), Discovery Facts(R), and Reality
Rules(R) as well as Discovery Channel(R) photography, images and artwork in
connection with the sale, marketing and distribution of certain of the Company's
products.

As of January 31, 1999, the Company was required to make an aggregrate of
approximately $170,000 in payments of guaranteed royalties under certain
licenses in fiscal 1999 and $590,000 thereafter through fiscal 2002.

The Company believes that by developing licensed products based
principally on popular, classic properties and trademarks, it can establish a
licensed product portfolio that is characterized by a longer product life cycle
than is typical in the toy industry. The Company intends to continue to develop
its licensed product line by targeting licensing opportunities where it can take
advantage of licensor advertising, publicity and media exposure. CUSTOMERS

The Company made sales to over 450 different customers in approximately

45 countries during fiscal 1998. The table below sets forth the Company's net

sales by geographic area as a percentage of total net sales for the specified
fiscal years.

Geographic Area 1998 1997 1996
-------- -------- --------
United States .............................. 79.0% 80.6% 81.4%
Europe ..................................... 12.8 10.8 9.2
Canada and Mexico .......................... 4.0 4.2 3.7
Australia and New Zealand .................. 2.3 2.4 2.4
South and Central America .................. 1.1 1.2 1.7
Asia ....................................... 0.5 0.3 1.4
Middle East and Africa ..................... 0.3 0.5 0.2
-------- -------- --------
Total ................................... 100.0% 100.0% 100.0%
======== ======== ========

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The Company's principal customers are retailers, including mass
merchandising discounters such as Wal-Mart, Kmart and Target, specialty toy
retailers such as Toys "R" Us, Kay Bee Toy & Hobby, F.A.O. Schwarz, Zany Brainy,
Noodle Kidoodle, and QVC, and deep discount stores such as Family Dollar Stores,
Inc., Consolidated Stores Corporation and Value City Department Stores, Inc. The
Company's top five customers accounted for approximately 48.1% of the Company's
net sales in fiscal 1998. Wal-Mart (18.7%) and Toys "R" Us (10.6%) each
accounted for more than 10% of the Company's net sales during fiscal 1998. For
the prior two fiscal years, the only customers that accounted for more than 10%
of the Company's net sales were Toys "R" Us (22.2%) and Wal-Mart (16.6%) for
fiscal 1997, and Wal-Mart (19.5%), Kmart (13.7%) and Toys "R" Us (12.0%) for
fiscal 1996. During fiscal 1998, the Company's sales to Toys "R" Us, Wal-Mart,
Kmart, Target and Kay-Bee Toy & Hobby, the five largest toy retailers in the
United States, decreased as a percentage of the Company's net sales to 46.3%
compared to 57.3% during fiscal 1997 and 54.5% during fiscal 1996. The Company
does not have long-term contractual arrangements with its customers.

SALES AND MARKETING

The Company's selling strategy consists of supporting the marketing and
sales efforts of its executive management with a combination of in-house sales
personnel and a network of independent, commission-based sales representatives.
Significant product presentations are made by either executive management, in
the case of new product presentations, or in-house sales personnel. The
independent sales representatives manage the day-to-day account administration.

New toys are marketed primarily by members of the Company's executive
management and sales department at the Company's showrooms in Hong Kong, New
York and Dallas during the times when major, international toy shows are taking
place in those cities (Hong Kong in January, June and September/October, Dallas
in January, and New York in February). The Company also maintains a showroom at
its headquarters in Houston.

As is customary in the toy industry, the Company historically has
permitted certain customers to return slow-moving items for credit or has
provided price protection by making any price reductions effective as to certain
products then held by retailers in inventory. The Company expects that it will
continue to make such accommodations in the future.

In international markets, the Company generally sells its products to
independent distributors. These distributors retain their own sales
representatives and product showrooms at which products such as the Company's
are marketed and sold. The Company also makes some sales directly to
international retailers, principally as a result of contacts made at the
Company's showrooms.

ADVERTISING

In recent years, the Company allocated a majority of its advertising
budget to television promotion. The Company utilized a television campaign for
the first time in fiscal 1995 in connection with the introduction of the
Rosie(R) doll. The Company increased its television advertising budget in fiscal
1996 and fiscal 1997, using television commercials to promote the Rosie(R) and
Pattie(R) dolls in fiscal 1996, and Rosie(R), Baby Pick Me Up(TM), Dreamie
Sweets(R), and Hoppin Poppin' Spaceballs(R) in fiscal 1997. Although the Company
intends to continue to utilize a promotional strategy that includes advertising
of certain proprietary products, spending on television advertising in fiscal
1998 was significantly reduced. The Company will continue to expend portions of
its advertising budget to promote its products through the Internet, public
relations, special offers, retail catalogs, advertisement in trade magazines,
cooperative promotional efforts of retailers, and limited television advertising
of certain proprietary products.

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MANUFACTURING

The Company annually contracts with over 30 independent manufacturers
located principally in the Peoples' Republic of China (the "PRC") within a
200-mile radius of Hong Kong for the manufacturing of its products. The Company
may use more than one manufacturer to produce a single product. The only
manufacturers that accounted for more than 10% of the Company's purchases of
products during fiscal 1998 were GMT Industrial Ltd. (29.8%), which manufactured
walkie-talkies and musical toy products for the Company and Loyal Technology Co.
Ltd. (24.4%), which manufactured walkie-talkies and radios for the Company.
Manufacturing commitments are made on a purchase order basis. The Company does
not have long-term contractual arrangements with its manufacturers.

Decisions related to the choice of manufacturer for non-proprietary
products generally are based on reliability, quality of merchandise, price and
the ability of the manufacturer to meet the Company's or its customers' timing
requirements for delivery. Proprietary products designed by the Company are
placed with a specific manufacturer whose expertise is in that type of toy. The
Company currently has its tooling placed in several different manufacturing
facilities and generally receives delivery 60 to 90 days after its orders are
booked.

The Company's Hong Kong subsidiary, DSI(HK), monitors manufacturing
operations, including quality control, production scheduling and order
fulfillment from the manufacturers. DSI(HK) utilizes a quality control and
assurance staff of degreed engineers and inspectors.

The principal materials used in the production of the Company's products
are plastics, integrated circuits, batteries, corrugated paper (used in
packaging and packing material) and textiles. The Company believes that an
adequate supply of materials used in the manufacture and packaging of its
products is readily available from existing and alternative sources at
reasonable prices.

DISTRIBUTION

The Company distributes its products either through FOB Asia sales or
through direct sales made from inventory maintained at its Houston facilities.
For FOB Asia sales, the customer places its order and shipping instructions, and
the toys are then manufactured and shipped directly to the customer or its
freight consolidator from the factory.

Basic, continuous stock toys that are offered by retailers on a year-round
basis generally are shipped to customers by the Company from its inventory in
Houston. In addition, certain faster-selling toys are often shipped directly to
major customers for seasonal selling and are stocked by the Company in Houston
for peak season back-up and continuous supply. The Company also maintains
inventory which is intended for specific customers for peak holiday season
support as well as some inventory which is available for smaller retailers and
for opportunistic selling strategies.

Most of the Company's larger customers have instituted electronic data
interchange ("EDI") programs to reduce the retailers' inventory carrying
requirements and place more inventory risk on the supplier. When selling toys
out of its Houston inventory, the Company participates in the EDI programs of
most of its customers who have established EDI programs, including Kmart,
Wal-Mart, Toys "R" Us, Target and Kay-Bee Toy & Hobby. Although these programs
require the Company to bear some inventory risk, the Company believes the
programs can be utilized to monitor store inventory levels, schedule production
to meet anticipated reorders and maintain sufficient inventory levels to serve
its customers.

COMPETITION

The toy industry is highly competitive. Dun & Bradstreet categorizes over
1,000 companies as toy manufacturers. Competitive factors include product
appeal, new product introductions industry wide,

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space allocation by the major retailers, price and order fulfillment. The
Company competes with many companies that have greater financial resources and
advertising budgets than the Company. The largest United States toy companies
are Mattel, Inc. and Hasbro, Inc., and the Company considers Alaron, Inc.,
Play-By-Play Toys & Novelties, Inc., Toy Biz, Inc., KIDdesigns, Inc., and MGA
Entertainment to be among its other competitors. In addition, due to the low
barriers to entry into the toy business, the Company competes with many smaller
toy companies, some of which market single products.

SEASONAL PATTERNS

The toy industry is very seasonal with the holiday selling season
representing over two-thirds of annual sales at retail. To accommodate this peak
selling season, holiday toy lines are introduced early in the first quarter at
toy shows in Hong Kong, Dallas and New York. Generally, retailers commit to
their holiday season purchases that will be shipped FOB Asia during the first
two calendar quarters and those orders are shipped from Asia to the retailers'
distribution centers on a scheduled basis from May through September. During the
last three fiscal years, an average of 88% of the Company's annual Hong
Kong-based sales have occurred between the months of May through October. Sales
from Houston historically have tended to occur closer to the holiday season to
provide peak holiday season inventory to certain large retailers and to ship to
smaller retailers that have not chosen to purchase products FOB Asia. During the
last three fiscal years, an average of 56% of the Company's annual Houston-based
sales have occurred during the months of August through November.

GOVERNMENT AND INDUSTRY REGULATION

The Company is subject to the provisions of the Federal Hazardous
Substances Act and the Federal Consumer Product Safety Act. Such Acts empower
the United States Consumer Products Safety Commission (the "CPSC") to protect
the public from hazardous goods. The CPSC has the authority to exclude from the
market goods that are found to be hazardous and require a manufacturer to
repurchase such goods under certain circumstances. The Company sends samples of
all of its marketed products to independent laboratories to test for compliance
with the CPSC's rules and regulations, as well as with the product standards of
the Toy Manufacturers of America, Inc. (TMA). The Company is not required to
comply with the product standards of the TMA, but voluntarily does so. Similar
consumer protection laws exist in state and local jurisdictions within the
United States as well as certain foreign countries. The Company designs its
products to meet the highest safety standards imposed or recommended either by
government or industry regulatory authorities. To date, the Company has not been
found to be in material violation of any governmental product standard with
respect to the Company's products.

TARIFFS AND DUTIES

In December 1994, the United States approved a trade agreement pursuant to
which import duties on toys, games, dolls and other specified items were
eliminated effective January 1, 1995 from products manufactured in all Most
Favored Nation ("MFN") countries (including the PRC). Increases in quotas,
duties, tariffs or other changes or trade restrictions which may be imposed in
the future could have a material adverse effect on the Company's financial
condition, operating results or ability to import products. In particular, the
Company's costs would be increased if the PRC's MFN status is revoked. The loss
of MFN status for the PRC would result in substantial duties on the cost of toy
products manufactured in the PRC and imported into the United States and would
most likely adversely affect Company's financial condition and results of
operations.

In 1996, the United States government proposed retaliatory trade sanctions
against the PRC, which would have included increased duties on selected
products, but would not have included the Company's products originating in the
PRC. The United States and PRC eventually agreed on settlement terms avoiding
these sanctions. Any future imposition of trade sanctions by the United States
and subsequent retaliatory actions by the PRC government could result in supply
disruptions and higher merchandise costs to the Company. The Company could
attempt to mitigate the effects of an increase in

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duties by shifting its manufacturing to other countries, but there can be no
assurance that the Company would be successful in this regard or that the
Company would not be adversely affected.

INTELLECTUAL PROPERTY

The Company has been utilizing the mark "DSI" since 1991, believes it has
common law trademark rights to the mark, and has filed a trademark application
with the United States Patent and Trademark Office. The Company believes it has
the rights to use the mark in the manner in which it is currently used.

The Company has rights to use certain United States registered trademarks
for various products and product categories currently being marketed including:
Air Guitar(R), Big Bam Boom(R), LA Rock(R), and Rosie(R). The Company believes
it has the rights to use these marks for the product lines on which they are
currently used.

The Company believes it has trademark rights with respect to certain
additional products and product lines, including DSI Electronics(TM), American
Frontier(TM), BlockMen(TM), Tech-Link(TM), Sax-a-Boom(TM), Space Squad(TM), and
Sweet Faith(TM) in the United States. The Company believes it has the rights to
use these marks for the product lines on which they are, or will be, used.

HUMAN RESOURCES

As of January 31, 1999, the Company had a total of 70 employees, of whom
39 are employees of DSI(HK) and are based in Hong Kong and 31 are employees of
DSI and are based in Houston. Of the Houston based employees, 6 are engaged in
sales and marketing, 6 are involved in design and development, 5 are involved in
warehousing and distribution and 14 are involved in finance and administration.
Of the Hong Kong based employees, 8 are engaged in sales and merchandising, 11
are engaged in engineering, including product quality assurance and quality
control, 11 are involved in finance and administration and 9 are involved in
shipping and distribution. None of the Company's employees is subject to a
collective bargaining agreement. The Company has experienced no work stoppages
and believes that its labor relations are satisfactory.

RISK FACTORS

CHANGING CONSUMER PREFERENCES, RELIANCE ON NEW PRODUCT INTRODUCTION. As a
result of changing consumer preferences, many toys are successfully marketed for
only one or two years, if at all. There can be no assurance that (i) any of the
Company's current successful products or product lines will continue to be
popular with consumers for any significant period of time or (ii) new products
and product lines introduced by the Company will achieve an acceptable degree of
market acceptance, or that if such acceptance is achieved, it will be maintained
for any significant period of time. Furthermore, sales of the Company's existing
products are expected to decline over time and may decline at rates faster than
expected. The Company's success is dependent upon the Company's ability to
enhance existing product lines and develop new products and product lines. The
failure of the Company's new products and product lines to achieve and sustain
market acceptance and to produce acceptable margins could have a material
adverse effect on the Company's financial condition and results of operations.

DEPENDENCE ON LIMITED NUMBER OF CUSTOMERS. For fiscal 1998, the Company's
five largest customers accounted for 48.1% of the Company's net sales. Sales to
Toys "R" Us, Wal-Mart and Kay-Bee Toy & Hobby, the Company's three largest
customers, aggregated 37.2% of the Company's net sales during the same period.
The Company expects to continue to rely on a relatively small number of
customers for a significant percentage of sales for the foreseeable future.
Because a large portion of the Company's sales are concentrated in the Company's
five largest customers and these customers represent a significant share of the
market for toy sales to consumers, the loss of any one of them as a customer, or
a significant reduction in sales to any one of them, would have a material
adverse effect on the Company's financial condition and results of operations.
See "Business--Customers".

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LIQUIDITY. Effective February 2, 1999, the Company entered into an
agreement with Sunrock Capital Corp. pursuant to which Sunrock provides a
revolving line of credit for up to $10 million (the "Revolver"). Borrowings
under the Revolver are utilized by the Company to finance accounts receivable,
inventory, and other operating and capital requirements. The Revolver matures
February 2, 2002 and contains covenants relating to the condition of the
Company. If the Company fails to maintain compliance with the financial covenant
contained in the Revolver, the maturity date will be accelerated.

On April 15, 1999, the Company entered into a Stock Purchase Agreement
with MVII, LLC, a California limited liability company controlled by Tom Martin,
which contemplates several related transactions: (i) MVII purchased 566,038
shares of common stock from the Company for $1.2 million on April 15, 1999; (ii)
MVII commenced a tender offer to purchase up to 1.6 million shares of the
outstanding common stock of the Company at $4.38 per share in cash on April 21,
1999; and (iii) subject to shareholder and other approvals, MVII will purchase
an additional 1,792,453 shares of common stock (subject to upward adjustments
not to exceed in the aggregate 140,000 shares) from the Company for $3.8 million
simultaneously with the purchase of shares in the tender offer. Upon
consummation of the transactions, MVII will own more than 47% of the Company's
outstanding shares and will be entitled to nominate four of the six members of
the board of directors. (These transactions are described in greater detail in
the Company's Schedule 14D-9 filed with the Securities and Exchange Commission
on April 22, 1999.)

DEPENDENCE ON INDEPENDENT DESIGNERS, LICENSES AND OTHER PROPRIETARY
RIGHTS. For most of its proprietary products, the Company is dependent on
concepts, technologies and other intellectual property rights licensed from
third parties, such as rights to trademarks. For each of these proprietary
products and product lines, the Company typically enters into a license
agreement with the owner of the intellectual property to permit the Company to
use the intellectual property. These license agreements typically provide for
royalty payments by the Company to the licensor based on the net sales of the
product incorporating the licensed property. For fiscal 1998, net sales of
products developed and sold under the Company's license agreements accounted for
41% of the Company's net sales, including 25% of the Company's net sales
attributable to sales of products incorporating the Kawasaki(R) trademark. The
Company's existing license agreements generally have terms ranging from 2 to 30
years. The Company's license agreement with Kawasaki Motors Corp., USA was
extended in June 1998 for a four-year period, through December 31, 2002. There
can be no assurance that the Company will be able to procure new license
agreements, renew existing license agreements (on commercially reasonable terms,
or at all), or that existing license agreements will not be terminated. The
Company's license agreements may contain restrictions on products manufactured
and permitted sales territories, and may give the licensor the right to approve
the manufacturer to be utilized by the Company to produce the product. Certain
of the Company's license agreements are non-exclusive. Licenses that overlap the
Company's licenses with respect to products, geographic areas and markets have
been and may continue to be granted to competitors of the Company. See
"Business--License Agreements".

In addition to rights licensed from third parties, the Company also relies
on a combination of design patent, copyright, trademark and trade secret
protection and non-disclosure agreements with employees to establish and protect
the proprietary rights that the Company has in its products. There can be no
assurance that the Company's competitors will not independently develop or
acquire proprietary technologies that are substantially equivalent or superior
to those of the Company. There also can be no assurance that the measures
adopted by the Company to protect its proprietary rights will be adequate to do
so. The ability of the Company's competitors to develop or acquire technologies
or other proprietary rights equivalent or superior to those of the Company or
the inability of the Company to enforce its proprietary rights could have a
material adverse effect on the Company.

The Company does not believe that any of its products infringe on the
proprietary rights of third parties in any material respect. There can be no
assurance, however, that third parties will not claim infringement by the
Company with respect to current or future products. Any such claim, with or
without

-8-

merit, could be time-consuming, result in costly litigation, cause product
shipment delays or require the Company to enter into royalty or licensing
agreements. Such royalty or licensing agreements, if required, may not be
available on terms acceptable to the Company or at all, which could have a
material adverse effect on the business, results of operations and financial
condition of the Company.

INVENTORY MANAGEMENT. Most of the Company's largest retail customers
utilize an inventory management system to track sales of products and rely on
reorders being rapidly filled by the Company and other suppliers rather than
maintaining large product inventories. These types of systems put pressure on
suppliers like the Company to promptly fill customer orders and also shift some
of the inventory risk from the retailer to suppliers. Production of excess
products by the Company to meet anticipated retailer demand could result in
price markdowns and increased inventory carrying costs for the Company.
Similarly, if the Company fails to predict consumer demand for a product, it may
not be able to deliver an adequate supply of products on a timely basis and
will, as a result, lose sales opportunities. See "Business--Distribution".

RETURNS AND MARKDOWNS. As is customary in the toy industry, the Company
historically has permitted certain customers to return slow-moving items for
credit or has provided price protection by making any price reductions effective
as to certain products then held by retailers in inventory. The Company expects
that it will continue to be required to make such accommodations in the future.
Any significant increase in the amount of returns or markdowns could have a
material adverse effect on the Company's financial condition and results of
operations. See "Business--Sales and Marketing".

SEASONALITY AND QUARTERLY FLUCTUATIONS. The Company's sales are seasonal
in that a substantial portion of net sales is made to retailers in anticipation
of the Christmas holiday season. During fiscal 1998, 80% of the Company's net
sales were made during the Company's second and third fiscal quarters (May
through October) in connection with retail sales for the Christmas holiday
season. Adverse business or economic conditions during these periods could
adversely affect results of operations for the full year. The Company's
financial results for a particular quarter may not be indicative of results for
an entire year, and the Company's revenues and/or expenses will vary from
quarter to quarter. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Seasonality" and "Business--Seasonal
Patterns".

RELIANCE ON MANUFACTURERS BASED IN HONG KONG AND CHINA, TRADE RELATIONS.
To date, most of the Company's products have been manufactured by Hong Kong
manufacturers at facilities located in the PRC. According to reports published
by the TMA, the PRC is the world's largest producer of toys. The Company does
not have any long-term contracts with its manufacturers. In the event of any
such disruption or other political or economic change in Hong Kong or the PRC
affecting the Company's business, the Company would be required to seek
alternate manufacturing sources. The Company currently does not have in place
plans or arrangements for securing alternate manufacturing sources in the event
that its present relationships with manufacturers prove impracticable to
maintain, and there can be no assurance that there would be sufficient
alternative facilities to meet the increased demand for production that would
likely result from a disruption of manufacturing operations in the PRC.
Furthermore, such a shift to alternate facilities would likely result in
increased manufacturing costs and could subject the Company's products to
increased duties, tariffs or other restrictions. During fiscal 1998, two
manufacturers accounted for approximately 54% of the Company's purchases of
products. The loss of either of these manufacturers, or a substantial
interruption of the Company's manufacturing arrangements with either of these
manufacturers, could cause a delay in production of the Company's products for
delivery to its customers and could have a material adverse effect on the
Company. While the Company believes that alternate manufacturers exist, there
can be no assurance that alternate arrangements could be provided in a timely
manner or on terms acceptable to the Company. See "Business--Manufacturing" and
"Business--Tariffs and Duties".

-9-

Currently, the PRC has MFN trade status. As such, most toys imported into
the United States from the PRC are not subject to import duties. Recently,
however, the United States and the PRC have at times been at odds over trade
policies. There can be no assurance that in the future trade relations between
the United States and the PRC will not deteriorate or that the MFN status of the
PRC will not be altered or revoked such that, as a result, the United States
would impose duties or other trade sanctions that would affect the cost of toys
imported from the PRC. Increases in quotas, duties, tariffs or other changes or
trade restrictions which may be imposed in the future would have a material
adverse effect on the Company's financial condition, operating results or
ability to import products. In particular, the Company's costs would be
increased if the PRC's MFN status is revoked. The loss of MFN status for the PRC
would result in substantial duties on the cost of toy products manufactured in
the PRC and imported into the United States and would most likely adversely
affect Company's financial condition and results of operations. The imposition
of such duties could have a material adverse effect on the Company. See
"Business--Tariffs and Duties".

ACQUISITION RISKS. The Company may from time to time evaluate and pursue
acquisition opportunities on terms management considers favorable to the
Company. A successful acquisition involves an assessment of the business
condition and prospects of the acquisition target, which includes factors beyond
the Company's control. This assessment is necessarily inexact and its accuracy
is inherently uncertain. In connection with such an assessment, the Company
performs a review it believes to be generally consistent with industry
practices. This review, however, will not reveal all existing or potential
problems, nor will it permit a buyer to become sufficiently familiar with the
acquisition target to assess fully its deficiencies. There can be no assurance
that any such acquisition would be successful or that the operations of the
acquisition target could be successfully integrated with the Company's
operations. Any unsuccessful acquisition could have a material adverse effect on
the Company.

GENERAL RISKS OF FOREIGN OPERATIONS. Foreign operations are generally
subject to risks such as transportation delays and interruptions, political and
economic disruptions, the imposition of tariffs and import and export controls,
difficulties in staffing and managing foreign operations, longer payment cycles,
problems in collecting accounts receivable, changes in governmental policies,
restrictions on the transfer of funds, currency fluctuations and potentially
adverse tax consequences. While the Company to date has not experienced any
material adverse effects due to its foreign operations, there can be no
assurance that such events will not occur in the future. Any growth of the
Company's international operations will subject the Company to greater exposure
to risks of foreign operations. The occurrence of such an event, particularly
one affecting the Company's relations with its manufacturers in the PRC, would
have a material adverse effect on the Company.

PRODUCT SAFETY AND LIABILITY, REGULATION. Products that have been or may
be developed or sold by the Company may expose the Company to potential
liability from personal injury or property damage claims by end-users of such
products. The Company has never been and is not presently a defendant in any
product liability lawsuit; however, there can be no assurance that such a suit
will not be brought in the future against the Company. The Company currently
maintains product liability insurance coverage in the amount of $2.0 million per
occurrence, with a $5.0 million excess product liability policy. There can be no
assurance that the Company will be able to maintain such coverage or obtain
additional coverage on acceptable terms, or that such insurance will provide
adequate coverage against all potential claims. Moreover, even if the Company
maintains adequate insurance, any successful claim could materially and
adversely affect the reputation and prospects of the Company, as well as divert
management time. The CPSC has the authority under certain federal laws and
regulations to protect consumers from hazardous goods. The CPSC may exclude from
the market goods it determines are hazardous, and may require a manufacturer to
repurchase such goods under certain circumstances. Some state, local and foreign
governments have similar laws and regulations. In the event that such laws or
regulations change or the Company is found in the future to have violated any
such law or regulation, the

-10-

sale of the relevant product could be prohibited and the Company could be
required to repurchase such products. See "Business--Government and Industry
Regulation".

COMPETITION. The toy industry is highly competitive. Many of the Company's
competitors have longer operating histories, broader product lines and greater
financial resources and advertising budgets than the Company. In addition, the
toy industry has nominal barriers to entry. Competition is based primarily on
the ability to design and develop new toys, procure licenses for popular
products, characters and trademarks, and successfully market products. Many of
the Company's competitors offer similar products or alternatives to the
Company's products. The Company's products compete with other products for
retail shelf space. There can be no assurance that shelf space in retail stores
will continue to be available to support the Company's existing products or any
expansion of the Company's products and product lines. There can be no assurance
that the Company will be able to continue to compete effectively in this
marketplace. See "Business--Competition".

CONTROL BY CURRENT MANAGEMENT. As of January 31, 1999, the directors and
officers of the Company and their affiliates beneficially owned, or had the
right to vote, in the aggregate approximately 35% of the outstanding common
stock. In the event the Management Shareholders (M. D. Davis, B. B. Conrad, J.
R. Crosby, J. N. Matlock and D. A. Smith) do not tender any shares owned by them
into the Offer and the minimum tender condition is otherwise met, there is a
possibility that, upon consummation of the transactions contemplated by the
Stock Purchase Agreement, including the Offer, MVII will be the beneficial owner
of, or have the right to vote, up to 68%, and Tom Martin, through his control of
MVII will beneficially own, or have the right to vote, up to 70% of the total
number of shares of common stock then outstanding (assuming (i) there are upward
adjustments in the aggregate of 140,000 shares, and (ii) no other shares are
issued), by virtue of MVII's and Martin's right to vote shares held by the
Management Shareholders pursuant to certain agreements and irrevocable proxies.
To the best of the Company's knowledge, all of the Management Shareholders
currently intend to tender Shares owned by them into the Offer. As a result of
such persons' ownership and/or control of common stock and their directorship
and management positions, they have significant influence over all matters
requiring approval by the shareholders of the Company, including the election of
directors.

POSSIBLE VOLATILITY OF STOCK PRICE. The market price of the common stock
has been and may continue to be highly volatile and has been and could be
subject to wide fluctuations in response to quarterly variations in operating
results, announcements of new products by the Company or its competitors,
changes in financial estimates by securities analysts, or other events or
factors. In the event that the Company's operating results are below the
expectations of public market analysts and investors in one or more future
quarters, it is likely that the price of the Company's common stock will be
materially adversely affected. General market fluctuations may adversely affect
the market price of the Company's common stock.

ITEM 2. PROPERTIES

The Company's principal executive offices and showroom and principal
warehouse are located in Houston, Texas, where the Company occupies
approximately 14,000 square feet of office and showroom space and 32,000 square
feet of dock-high warehouse space. The Company leases this space pursuant to a
lease that terminates on August 31, 2002. The base rental for this lease is
currently $18,433 per month ($4.81 per square foot on an annual basis). The
lease provides for an annual increase in rent based on projected cost of living
and tax escalation adjustments.

The Company leases a 2,200 square foot showroom in the Toy Center building
in New York at 200 Fifth Avenue. This lease commenced on January 1, 1993 and
will terminate on April 30, 2003. The base rental for this lease is $6,026 per
month ($32.87 per square foot on an annual basis), subject to cost of living and
tax escalations. The facility is staffed only during toy shows and specially
scheduled customer showings.

-11-

The Company leases 7,178 square feet of office and showroom space in Hong
Kong under a lease that commenced on March 23, 1998 and terminates in March
2001. The base rental for the lease term is $26,034 per month based on current
currency exchange rates ($43.52 per square foot on an annual basis).

The Company is leasing 1,080 square feet of showroom space in the World
Trade Center Building in Dallas, Texas for a three-year term that expires May
31, 1999. The base rental for this lease is currently $993 per month ($11.03 per
square foot on an annual basis). The Company has renewed this lease for an
additional three-year term from June 1, 1999 through May 31, 2002. The base
rental for the first year of the renewal term is $1033 per month ($11.47 per
square foot on an annual basis).

The Company leases a small storage facility in Hong Kong. From time to
time, the Company rents short-term warehouse space in Houston to accommodate
fluctuating storage needs.

ITEM 3. LEGAL PROCEEDINGS

Effective August 28, 1998 the Company entered into a confidential
agreement which settled all claims in the lawsuit brought by a former
independent sales representative for the Company (Anderson-Crawford Associates,
Inc., et al vs. DSI Toys, Inc., et al., CA. No. 286,815-401, Probate Court No. 3
of Harris County, Texas). The settlement did not have a material adverse effect
on either the Company's financial position or results of operations.

The Company is involved in various legal proceedings and claims incident
to the normal conduct of its business. The Company believes that such legal
proceedings and claims, individually and in the aggregate, are not likely to
have a material adverse effect on its financial position or results of
operations. The Company maintains product liability and general liability
insurance in amounts it believes to be reasonable. ITEM 4. SUBMISSION OF MATTERS
TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of stockholders during the fourth
quarter of fiscal 1998.

-12-

PART II

ITEM 5. MARKET FOR REGISTRANT'S EQUITY AND RELATED STOCKHOLDER MATTERS

MARKET INFORMATION

The Company's common stock is traded on The Nasdaq Stock Market's SmallCap
Market under the symbol "DSIT". Prior to August 17, 1998, the Company's common
stock was traded on The Nasdaq National Market. The table sets forth, for the
periods indicated, the reported high and low close sale prices of the Company's
common stock since May 29, 1997, the date of the Company's initial public
offering, as reported on The Nasdaq National Market and The Nasdaq SmallCap
Market:

HIGH LOW
-------- --------
Fiscal Year 1997:
2nd Quarter ....................... 8-1/16 7-1/16
3rd Quarter ....................... 9-7/8 4-7/16
4th Quarter ....................... 4-9/16 1-1/2

Fiscal Year 1998:
1st Quarter ....................... 1-5/8 2-7/8
2nd Quarter ....................... 15/16 2
3rd Quarter ....................... 13/16 1-3/4
4th Quarter ....................... 1-1/16 1-13/16

STOCKHOLDERS

According to the records of the Company's transfer agent, as of April
26, 1999, there were 91 holders of record of the Company's common stock. The
Company believes that a substantially larger number of beneficial owners hold
such shares in depository or nominee form.

DIVIDENDS AND DISTRIBUTIONS

The Company has never declared nor paid cash dividends to date on its
common stock and does not anticipate paying any cash dividends on its common
stock in the near future. In addition, the Company's credit facility prohibits
the payment of dividends.

-13-

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

The following table sets forth selected consolidated financial data for
the Company. The selected consolidated financial data were derived from the
Company's consolidated financial statements. All dollar amounts are stated in
thousands, except for per share data:

YEAR ENDED JANUARY 31,
--------------------------------------------------------
Statement of Operations Data: 1999 1998 1997 1996 1995
-------- -------- -------- -------- --------

Net sales ....................... $ 52,723 $ 73,624 $ 63,219 $ 63,146 $ 45,219
Income (loss) before income
taxes and extraordinary item .. (1,071) (7,034) 3,371 3,776 1,473
Income (loss) before
extraordinary item ............ (738) (4,705) 2,151 2,327 969
Net income (loss) ............... (738) (5,186) 2,151 2,327 969

Basic earnings (loss) per
share before extraordinary
item .......................... $ (.12) $ (.91) $ .61 $ .66 $ .28
Basic earnings (loss) per share . $ (.12) $ (1.00) $ .61 $ .66 $ .28
Diluted earnings (loss) per share
before extraordinary item ..... $ (.12) $ (.91) $ .58 $ .66 $ .28
Diluted earnings (loss)
per share .................... $ (.12) $ (1.00) $ .58 $ .66 $ .28

JANUARY 31,
--------------------------------------------------------
Balance Sheet Data: 1999 1998 1997 1996 1995
-------- -------- -------- -------- --------
Working capital ................. $ 391 $ 6,265 $ 2,621 $ 3,510 $ 2,121
Total assets .................... 12,955 21,207 15,316 16,402 9,822
Long-term debt, including
capital leases ................ 2,541 7,495 14,203 18,188 17
Total liabilities ............... 10,549 18,049 24,738 27,984 4,675
Shareholders' equity (deficit) .. 2,405 3,159 (9,422) (11,582) 5,147

-14-

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

GENERAL

The following discussion and analysis should be read in conjunction with
the financial statements and related notes contained elsewhere herein.

The Company designs, develops, markets and distributes a variety of toys
and children's consumer electronics. The Company's core product categories are
(i) juvenile audio products, including walkie-talkies, pre-school audio
products, pre-teen audio products and musical toys; (ii) girls' toys, including
dolls, play sets and accessories; and (iii) boys' toys, including radio control
vehicles, action figures and western and military action toys. Historically, the
majority of the Company's sales have been made to customers based in the United
States. All of the Company's international sales are denominated in United
States dollars. Therefore, the Company is not subject to exchange rate risk with
respect to international sales.

In December 1995, a series of transactions (the "Recapitalization") was
consummated whereby the Company repurchased 77.7% of the then outstanding common
stock from the then sole shareholder of the Company for $22.2 million and issued
2,719,000 shares of common stock to a group of new investors for $3.8 million.
The Recapitalization resulted in the incurrence of an aggregate of $17.9 million
of additional indebtedness. The stock purchased by the Company from its former
sole shareholder is held as treasury stock. On June 3, 1997, the Company
completed its initial public offering of 2,500,000 shares of its common stock,
which resulted in net proceeds to the Company of $17.7 million. All of the net
proceeds were used to repay debt of the Company.

-15-

RESULTS OF OPERATIONS

The following table sets forth the Company's results of operations as a
percentage of net sales for the fiscal years indicated:

1998 1997 1996
------ ------ ------
Net sales ..................................... 100.0% 100.0% 100.0%
Cost of goods sold ............................ 79.8 75.1 66.5
------ ------ ------
Gross profit .................................. 20.2 24.9 33.5
Selling, general and administrative expenses .. 20.8 32.9 24.6
------ ------ ------
Operating income (loss) ....................... (0.6) (8.0) 8.9
Interest expense .............................. 1.6 1.8 4.1
Other income .................................. (0.2) (0.3) (0.5)
------ ------ ------
Income (loss) before income taxes and

extraordinary item ............................ (2.0) (9.5) 5.3
Provision for (benefit from) income taxes ..... 0.6 (3.1) 1.9
------ ------ ------
Income (loss) before extraordinary item ....... (1.4) (6.4) 3.4
Extraordinary item (net of tax) ............... -- (0.6) --
------ ------ ------
Net income (loss) ............................. (1.4) (7.0) 3.4
====== ====== ======

FISCAL YEAR 1998 COMPARED TO 1997

NET SALES. Net sales during fiscal 1998 decreased $20.9 million, or 28.4%,
to $52.7 million, from $73.6 million in fiscal 1997.

Net sales of juvenile audio products increased $1.3 million, or 3.5%, to
$38.3 million during fiscal 1998, from $37.0 million during fiscal 1997. The
increase was primarily attributable to continued strength in walkie-talkies and
musical keyboards, partially offset by a decline in pre-school audio products.
Net sales of girls' toys decreased $19.7 million, or 86.5%, to $3.1 million
during fiscal 1998, from $22.8 million during fiscal 1997. Sales for fiscal 1997
were driven principally by the TV promotion of three dolls (Baby Pick Me Up(R),
Dreamie Sweets(R) and Rosie(R)). Sales for 1998 were comprised principally of
sales of one new non-promoted doll (Baby Learns To Walk(TM)) and final closeouts
of 1997 doll inventory. Net sales of boys' toys increased $392,000, or 5.4%, to
$7.6 million during fiscal 1998 from $7.2 million during fiscal 1997. This
increase was attributable to the introduction of the BlockMen(TM) construction
sets and the new radio-controlled "Burnin' Thunder" (TM) car, partially offset
by a decrease in sales of the radio-controlled Kawasaki(R) Ninja(R) motorcycle.
Net sales of products in other categories decreased $2.9 million, or 43.4%, to
$3.7 million during fiscal 1998, from $6.6 million during fiscal 1997. The
decrease was due primarily to decreased sales of handheld electronic games and
Hoppin' Poppin' Spaceballs(R), an action game that was TV promoted in 1997.

International net sales decreased $3.2 million, or 22.3%, to $11.1 million
during fiscal 1998 from $14.3 million in fiscal 1997. The decline was due
primarily to decreased sales of TV promotable items, principally dolls.
International net sales were 21.0% of total sales for fiscal 1998 as compared to
19.4% of total sales in fiscal 1997.

GROSS PROFIT. Gross profit decreased $7.6 million, or 41.9%, to $10.7
million during fiscal 1998 from $18.3 million in fiscal 1997. Gross profit as a
percentage of net sales decreased to 20.2% during fiscal 1998 from 24.9% in
fiscal 1997. Such decrease was primarily due to decreased sales of TV-promoted
toys, principally dolls, which generally have higher gross margins to cover the
related costs of TV advertising.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses decreased $13.3 million, or 54.8%, to $11.0 million
during fiscal 1998 from $24.3 million in fiscal 1997. The decrease resulted
primarily from the decreased TV advertising expense during fiscal 1998.

-16-

INTEREST EXPENSE. As a result of debt repayment using the proceeds from
the Company's initial public offering in June 1997, interest expense decreased
$485,000, or 35.7%, to $875,000 during fiscal 1998 from $1.4 million in fiscal
1997.

OTHER INCOME. Other income decreased $125,000, or 53.9%, to $107,000
during fiscal 1998 from $232,000 during fiscal 1997. In 1997, the Company
received interest income related to certain insurance proceeds. The effects of
foreign currency translation also contributed to the decrease.

EXTRAORDINARY ITEM. As a result of debt repayment using the net
proceeds of the Company's initial public offering, $481,000 of debt issuance
cost (net of tax) was written off in fiscal 1997

INCOME TAXES. In fiscal 1998, the Company incurred a loss before income
taxes and extraordinary item of $1.1 million, which resulted in a benefit from
income taxes of $333,000 compared to a $2.3 million benefit from income taxes
during fiscal 1997.

NET INCOME (LOSS). As a result of the foregoing factors, the Company's
net loss for fiscal year 1998 was $738,000 compared to a net loss of $5.2
million for fiscal 1997.

FISCAL YEAR 1997 COMPARED TO 1996

NET SALES. Net sales during fiscal 1997 increased $10.4 million, or 16.5%,
to $73.6 million, from $63.2 million in fiscal 1996.

Net sales of juvenile audio products increased $5.6 million, or 18.0%, to
$37.0 million during fiscal 1997, from $31.3 million during fiscal 1996. This
increase was due primarily to increased sales of walkie talkies. Net sales of
girls' toys decreased $3.0 million, or 11.6%, to $22.8 million during fiscal
1997, from $25.8 million during fiscal 1996. The decrease was due to decreased
sales of dolls primarily related to softness of large doll sales industry-wide.
Net sales of boys' toys increased $3.5 million, or 91.6%, to $7.2 million during
fiscal 1997 from $3.8 million during fiscal 1996. The growth in net sales of
boys' toys was primarily attributable to the newly introduced Kawasaki(R)
Ninja(R) Supergyro(TM) Motorcycle. Net sales of products in other categories
increased $4.3 million, or 183.5%, to $6.6 million during fiscal 1997, from $2.3
million during fiscal 1996. This increase was due primarily to the introduction
of the Hoppin' Poppin' Spaceballs(R) game.

International net sales increased $2.5 million, or 21.0%, to $14.3 million
during fiscal 1997 from $11.8 million in fiscal 1996. The growth was due
primarily to increased net sales to the United Kingdom, Canada, France, Spain,
and Australia and partially offset by decreased net sales to Germany and Japan.
International net sales were 19.4% of total sales for fiscal 1997 as compared to
18.6% of total sales in fiscal 1996.

GROSS PROFIT. Gross profit decreased $2.9 million, or 13.5%, to $18.3
million during fiscal 1997 from $21.2 million in fiscal 1996. Gross profit as a
percentage of net sales decreased to 24.9% during fiscal 1997 from 33.5% in
fiscal 1996. Such decrease was related primarily to the decrease in sales of
TV-promoted dolls, which generally have higher margins, and close-out sales of
the doll inventory at less than cost.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased $8.7 million, or 55.7%, to $24.3 million
during fiscal 1997 from $15.6 million in fiscal 1996. The increase resulted
primarily from television advertising expenses related to the introduction of
several new products. The Company produced commercials and purchased significant
airtime for four products for fiscal 1997 as compared to two products for the
prior fiscal year.

INTEREST EXPENSE. As a result of debt repayment using the net proceeds of
the Company's initial public offering, interest expense decreased $1.2 million,
or 46.7%, to $1.4 million during fiscal 1997 from $2.6 million in fiscal 1996.

-17-

OTHER INCOME. Other income decreased $113,000, or 32.7%, to $232,000
during fiscal 1997 from $345,000 during fiscal 1996. This decrease was due
primarily to decreased interest income on certain insurance proceeds.

EXTRAORDINARY ITEM. As a result of debt repayment using the net proceeds
of the Company's initial public offering, $481,000 of debt issuance cost (net of
tax) was written off.

INCOME TAXES. In fiscal 1997, the Company incurred a loss before income
taxes and extraordinary item of $7 million which resulted in a benefit from
income taxes of $2.3 million compared to a $1.2 million provision for income
taxes during fiscal 1996.

NET INCOME (LOSS). As a result of the foregoing factors, the Company's
net loss for fiscal year 1997 was $5.2 million compared to net income of $2.2
million for fiscal 1996.

LIQUIDITY AND CAPITAL RESOURCES

The Company historically has funded its operations and capital
requirements by cash generated from operations and borrowings. The Company's
primary capital needs have consisted of acquisitions of inventory, financing
accounts receivable and capital expenditures for product development.

The Company's operating activities provided net cash of $6.3 million
during fiscal 1998, consisting primarily of decreases in accounts receivable and
inventories, and a net decrease in income taxes receivable and payable,
partially offset by decreases in accounts payable and accrued liabilities and an
increase in prepaid expenses. Net cash used in investing activities during
fiscal 1998 was $1.3 million and was the result of capital expenditures,
increases in other assets and the payment of life insurance premiums on behalf
of a shareholder. Net cash used by financing activities was $4.8 million during
fiscal 1998 and represented net payments under revolving lines of credit. The
Company's working capital at January 31, 1999 was $391,000 and unrestricted cash
was $554,000.

The seasonal nature of the toy business results in complex working capital
needs. The Company's working capital needs, which the Company generally
satisfies through short-term borrowings, are greatest in the first two fiscal
quarters. To manage these working capital requirements, the Company maintains a
line of credit facility (the "Hong Kong Credit Facility") with State Street Bank
and Trust Company, Hong Kong Branch, and the Revolver.

As a result of losses incurred in fiscal 1998, the Company was not in
compliance with certain of the covenants contained in its previous line of
credit with a commercial bank at yearend. However, on February 2, 1999, the
Company secured the Revolver. The Revolver replaces the Company's previous line
of credit. The new terms include interest at the bank's prime rate plus three
quarters of one percent (.75%) and maturity at February 2, 2002. The maximum
loan limit remains at $10 million, subject to the availability of sufficient,
eligible inventory and accounts receivable.

The Company's anticipated fiscal 1999 and 2000 operating cash requirements
include payment of approximately $2.8 million related to television
advertisements run during 1997. Such amount is due to two media companies and is
being paid in monthly installments through April 2000. The Company has budgeted
approximately $900,000 for capital expenditures, consisting primarily of
purchases of tools and molds, for fiscal 1999.

At April 20, 1999, the Company had an additional borrowing capacity of an
aggregate of $1.6 million under the Revolver and the Hong Kong Credit Facility.
Based on projected fiscal 1999 operating results, the Company believes that cash
flows from operations and the available borrowings under the Revolver and the
Hong Kong Credit Facility will be sufficient to meet the Company's operating
cash requirements and fund the Company's anticipated capital expenditures.
However, there can be no assurance that the Company will meet its projected
operating results, and accordingly, the Company is considering all of its
financing

-18-

alternatives. In connection with any future cash needs or acquisition
opportunities, the Company may incur additional debt or issue additional equity
or debt securities depending on market conditions and other factors. If the
transactions with MVII are consummated, the Company will receive an additional
equity infusion of $3.8 million.

The Company is obligated to make future minimum royalty payments under
certain of its license agreements. As of January 31, 1999, the Company was
required to make an aggregrate of approximately $170,000 in payments of
guaranteed royalties under certain licenses in fiscal 1999 and $590,000
thereafter through fiscal 2002.

As part of the Company's strategy, the Company will evaluate potential
acquisitions of other toy businesses or product lines that the Company believes
would complement its existing business. The Company has no present understanding
or agreement with respect to any acquisition.

SEASONALITY

The toy industry is very seasonal with the Christmas holiday season
representing over two-thirds of total annual retail toy sales. The Company has
experienced this seasonal pattern in its net sales. To accommodate this peak
selling season, holiday toy lines are introduced early in the first calendar
quarter. Retailers generally commit to their holiday season purchases during the
first two calendar quarters and those orders are generally shipped to the
retailers' distribution centers on a scheduled basis from May through October.
During fiscal 1998, 80% of the Company's net sales were made during the
Company's second and third fiscal quarters (May through October), generally in
connection with retail sales for the Christmas holiday season. As a result of
the seasonality of the Company's business, the Company expects that it will
incur a loss in the first quarter and fourth quarter of each fiscal year even in
years in which the Company is profitable for the year.

INFLATION

The Company does not believe that inflation in the United States or Europe
in recent years has had a significant effect on its results of operations.

YEAR 2000

Many existing computer systems and programs process transactions using two
digits rather than four digits for the year of a transaction. Unless the
hardware and/or the software has been modified, a significant number of those
computer systems and programs may process a transaction with a date of the year
"2000" as the year "1900", which could cause the system or the program to fail
or create erroneous results before, on or after January 1, 2000 (the "Y2K
Issue").

The Company's principal computer systems consist of: (i) management
information software ("MIS") for accounts receivable, general ledger, payables,
order entry, sales reporting, inventory tracking, product distribution, and
production scheduling; (ii) electronic data interchange ("EDI") for
order-taking, invoicing and the like between the Company and its major
customers; and (iii) local area network and personal computer operating systems.

The MIS systems at the Company's Hong Kong subsidiary have been upgraded
and successfully tested to be Y2K compliant. The MIS systems at the Company's
U.S. headquarters are in the process of

-19-

being upgraded, replaced and tested. To date, the Company has completed
approximately 90% of its upgrades and replacements and approximately 50% of its
testing. Completion of all remediation and testing is expected to be completed
by July 31, 1999.

The Company is currently reprogramming, or replacing, and testing the EDI
software. The Company is communicating with its customers to evaluate their EDI
Y2K compliance. The Company believes that over the upcoming months its major
customers plan to test their EDI systems for internal, intermediary and supplier
Y2K compliance. The Company would be unable to receive and invoice orders from a
customer though EDI if the customer or its EDI intermediaries were not Y2K
compliant. Although the Company does not transmit electronic orders to its
independent manufacturers, delays or non-delivery of goods to the Company could
arise from Y2K Issues affecting their businesses and presently the Company is
communicating with its independent manufacturers to evaluate their Y2K
compliance. The effect of non-compliance by independent manufacturers and other
third parties is not determinable.

The Company's local area network operating system will require upgrades
according to vendors, but such upgrades are available at minimal cost. The
Company also intends to replace personal computers and software found not to be
Y2K compliant. The Company anticipates that these replacements will be completed
by July 31, 1999.

The Company has incurred approximately $12,000 in expenses in connection
with making its computer systems and programs Y2K compliant. The Company expects
to incur additional Y2K costs of approximately $25,000 during 1999. The Company
is utilizing both internal and external sources to address Y2K Issues, and the
Company anticipates Y2K compliance by July 31, 1999. All historical and future
costs have been and will continue to be funded out of existing cash and cash
flow from operations.

The failure to successfully address a material Y2K Issue could result in
an interruption in, or failure of, certain normal business activities or
operations. Such failures could materially and adversely affect the Company's
results of operations, liquidity and financial condition. Particularly because
of the uncertainty of the Y2K readiness of customers, suppliers and contractors,
the Company is unable to assess at this time whether the consequences of the Y2K
Issue will have a material impact on the Company's results of operations,
liquidity or financial condition.

The Company currently has not developed a detailed contingency plan. The
Company assesses its Y2K status regularly and will begin to develop
comprehensive contingency plans if the Company believes it will not complete the
Y2K project in a timely manner. If the Company's Y2K project is not completed on
a timely basis, or if its major customers or suppliers fail to address all of
the Y2K Issues, the Company believes it could have a material adverse impact on
the Company's operations.

The cost of Y2K compliance and the referenced completion dates are
based on management's best estimates and may be updated, as additional
information becomes available. Reference is made to the first paragraph of
Part I of this report, which addresses forward-looking statements made by the
Company.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

See "Index to Consolidated Financial Statements and Schedules" included
on page F-1 for information required under this Item 8.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

-20-

PART III

Information required by Items 10 through 13 is hereby incorporated by
reference to the captions "Principal Shareholders", "Election of Directors",
"Management", and "Certain Relationships and Related Transactions" in the
Company's definitive Proxy Statement to be filed pursuant to Regulation 14A
anticipated to be filed within 120 days after the end of the Company's fiscal
year ended January 31, 1999.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM

8-K

(a) 1. Financial Statements. Reference is made to the Index on page
F-1 for a list of all financial statements filed as part of
this Report.

(a) 2. and (d) Financial Statement Schedules. Reference is made to the Index
on page F-1 for a list of all financial statement schedules
filed as part of this Report.

(a) 3. and (c) Exhibits. Reference is made to the Exhibit Index on page E-1
for a list of all exhibits filed as part of this Report.

(b) Reports on Form 8-K

No reports on Form 8-K were filed by the Company during the
three months ended January 31, 1999.

-21-

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

DSI Toys, Inc.

Dated: April 30, 1999 By:/s/ M. D. DAVIS
M. D. Davis
Chairman and Chief Executive Officer

Dated: April 30, 1999 By:/s/ ROBERT L. WEISGARBER
Robert L. Weisgarber
Chief Financial Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant in the capacities and on the dates indicated.

SIGNATURE TITLE DATE

/s/RICHARD R. NEITZ President, Chief April 30, 1999
Richard R. Neitz Operating Officer and Director

/s/BARRY B. CONRAD Director April 30, 1999
Barry B. Conrad

/s/JACK R. CROSBY Director April 30, 1999
Jack R. Crosby

/S/JOSEPH N. MATLOCK Director April 30, 1999
Joseph N. Matlock

/S/DOUGLAS A. SMITH Director April 30, 1999
Douglas A. Smith

-22-

DSI TOYS, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES

PAGE

FINANCIAL STATEMENTS

Report of Independent Accountants F-2

Consolidated Balance Sheet at January 31, 1999 and 1998 F-3

Consolidated Statement of Operations for fiscal years 1998, 1997
and 1996 F-4

Consolidated Statement of Cash Flows for fiscal years 1998, 1997, and
1996 F-5

Consolidated Statement of Shareholders' Equity for fiscal years 1998,
1997, and 1996 F-6

Notes to Consolidated Financial Statements F-7

SCHEDULES

II. Valuation and Qualifying Accounts and Reserves S-1

All other schedules are omitted because they are not applicable or the required
information is shown in the financial statements or notes thereto.

F-1

REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Shareholders of
DSI Toys, Inc.

In our opinion, the consolidated financial statements listed in the accompanying
index present fairly, in all material respects, the financial position of DSI
Toys, Inc. and its subsidiary (the Company) at January 31, 1999 and 1998, and
the results of their operations and their cash flows for each of the three years
in the period ended January 31, 1999, in conformity with generally accepted
accounting principles. These financial statements are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with generally accepted auditing standards which
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, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.

PricewaterhouseCoopers LLP

Houston, Texas
April 28, 1999

F-2

DSI TOYS, INC.

CONSOLIDATED BALANCE SHEET

JANUARY 31, JANUARY 31,
1999 1998
------------ ------------

ASSETS
Current assets:
Cash ............................................................................. $ 554,197 $ 383,690
Restricted cash .................................................................. 150,000 150,000
Accounts receivable, net ......................................................... 1,069,725 8,008,288
Inventories ...................................................................... 4,207,704 6,437,418
Income tax receivable ............................................................ -- 642,264
Prepaid expenses ................................................................. 1,503,970 894,704
Deferred income taxes ............................................................ 801,000 183,000
------------ ------------
Total current assets ........................................................... 8,286,596 16,699,364

Property and equipment, net ........................................................ 1,642,672 1,252,572
Advances to shareholder (life insurance premiums) .................................. 1,543,814 1,278,401
Deferred income taxes .............................................................. 1,117,000 1,752,000
Other assets ....................................................................... 364,511 224,783
------------ ------------
$ 12,954,593 $ 21,207,120
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
Accounts payable and accrued liabilities ......................................... $ 6,799,290 $ 9,740,201
Current portion of long-term debt ................................................ 824,675 585,783
Income taxes payable ............................................................. 271,920 108,630
------------ ------------
Total current liabilities ...................................................... 7,895,885 10,434,614
Long-term debt ..................................................................... 2,540,522 7,495,000
Deferred income taxes .............................................................. 113,000 119,000
------------ ------------
Total liabilities .............................................................. 10,549,407 18,048,614
Shareholders' equity:
Preferred stock, $.01 par value, 5,000,000 shares authorized,
none issued or outstanding ..................................................... -- --
Common stock, $.01 par value, 20,000,000 shares authorized,
8,719,000 shares issued, 6,000,000 shares outstanding .......................... 87,190 87,190
Additional paid-in capital ....................................................... 21,162,568 21,162,568
Common stock warrants ............................................................ 102,500 102,500
Accumulated other comprehensive income ........................................... 14,296 29,187
Retained earnings ................................................................ 3,699,224 4,437,653
------------ ------------
25,065,778 25,819,098
Less: treasury stock, 2,719,000 shares, at cost .................................. (22,660,592) (22,660,592)
------------ ------------
Total shareholders' equity ..................................................... 2,405,186 3,158,506
Commitments and contingencies (Note 11)
------------ ------------
$ 12,954,593 $ 21,207,120
============ ============

See accompanying notes to consolidated financial statements.

F-3

DSI TOYS, INC.
CONSOLIDATED STATEMENT OF OPERATIONS

FISCAL YEAR
----------------------------------------------------------
1998 1997 1996
------------ ------------ ------------

Net sales ..................................................... $ 52,722,517 $ 73,624,398 $ 63,219,212
Costs of goods sold ........................................... 42,058,919 55,285,501 42,023,044
------------ ------------ ------------
Gross profit .................................................. 10,663,598 18,338,897 21,196,168
Selling, general and administrative expenses .................. 10,967,001 24,245,064 15,569,422
------------ ------------ ------------
Operating income (loss) ....................................... (303,403) (5,906,167) 5,626,746
Interest expense .............................................. 874,907 1,360,067 2,599,942
Other income .................................................. (106,881) (231,968) (344,469)
------------ ------------ ------------
Income (loss) before income taxes
and extraordinary item ................................... (1,071,429) (7,034,266) 3,371,273
Provision for (benefit from) income taxes ..................... (333,000) (2,329,323) 1,220,000
------------ ------------ ------------
Income (loss) before extraordinary item ....................... (738,429) (4,704,943) 2,151,273
Extraordinary item (net of tax) ............................... -- (480,754) --
------------ ------------ ------------

Net income (loss) ............................................. $ (738,429) $ (5,185,697) $ 2,151,273
============ ============ ============
BASIC EARNINGS PER SHARE
Earnings (loss) per share before
extraordinary item ................................... $ (0.12) $ (0.91) $ 0.61
Extraordinary item ....................................... -- (0.09) --
------------ ------------ ------------
Earnings (loss) per share ................................ $ (0.12) $ (1.00) $ 0.61
============ ============ ============
Weighted average shares outstanding ...................... 6,000,000 5,205,479 3,500,000
============ ============ ============
DILUTED EARNINGS PER SHARE
Earnings (loss) per share before
extraordinary item ................................... $ (0.12) $ (0.91) $ 0.58
Extraordinary item ....................................... -- (0.09) --
------------ ------------ ------------
Earnings (loss) per share ................................ $ (0.12) $ (1.00) $ 0.58
============ ============ ============
Weighted average shares outstanding ...................... 6,000,000 5,205,479 3,739,146
============ ============ ============

See accompanying notes to consolidated financial statements.

F-4

DSI TOYS, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS

FISCAL YEAR
--------------------------------------------------
1998 1997 1996
------------ ------------ ------------

Cash flows from operating activities:
Net income (loss) ................................................... $ (738,429) $ (5,185,697) $ 2,151,273
Adjustments to reconcile net income (loss) to net cash
provided (used) by operating activities:

Depreciation .................................................... 570,779 661,517 596,332
Loss on early retirement of debt ................................ -- 480,754 --
Amortization and write-off of
debt discount and issuance costs ........................... -- 199,152 163,057
Provision for doubtful accounts ................................. (17,424) 145,096 62,160
Loss (gain) on sale of equipment ................................ 200 (3,865) (12,511)
Deferred income taxes ........................................... 11,000 (2,781,000) 686,605
Changes in assets and liabilities:

Accounts receivable ........................................ 6,955,987 (4,921,595) 941,715
Due from shareholder ....................................... -- 151,667 667,616
Inventories ................................................ 2,229,714 (1,822,331) (1,205,125)
Income taxes receivable/payable ............................ 805,554 (726,845) (121,663)
Prepaid expenses ........................................... (609,266) 567,485 (332,183)
Accounts payable and accrued liabilities ................... (2,940,911) 3,481,100 766,398
------------ ------------ ------------
Net cash provided (used) by operating activities ....... 6,267,204 (9,754,562) 4,363,674
Cash flows from investing activities:
Capital expenditures ................................................ (961,304) (726,691) (284,260)
Proceeds from sale of equipment ..................................... 225 6,965 24,037
Life insurance premiums paid for shareholder ........................ (265,413) (357,413) (289,676)
Repayments by shareholder ........................................... -- 511,764 --
Decrease (increase) in other assets ................................. (104,728) 313,085 (392,552)
------------ ------------ ------------
Net cash used in investing activities .................. (1,331,220) (252,290) (942,451)
Cash flows from financing activities:
Net borrowings (repayments) under revolving lines of credit ......... (4,730,655) 4,551,304 (2,088,225)
Net borrowings (repayments) on long-term debt ....................... 15,069 (13,429,418) (2,499,790)
Net proceeds from issuance of common stock .......................... -- 17,744,475 --
Proceeds from issuance of warrants .................................. -- 2,500 --
Debt and stock issue costs .......................................... (35,000) -- --
------------ ------------ ------------
Net cash provided (used) by financing activities ....... (4,750,586) 8,868,861 (4,588,015)
Effect of exchange rate changes on cash ................................... (14,891) 19,689 8,329
------------ ------------ ------------
Net increase (decrease) in cash ........................................... 170,507 (1,118,302) (1,158,463)
Cash and cash equivalents, beginning of year .............................. 383,690 1,501,992 2,660,455
------------ ------------ ------------
Cash and cash equivalents, end of year .................................... $ 554,197 $ 383,690 $ 1,501,992
============ ============ ============

See accompanying notes to consolidated financial statements.

F-5

DSI TOYS, INC.
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (DEFICIT)

COMMON STOCK ADDITIONAL
--------------------------- PAID-IN
SHARES AMOUNT CAPITAL WARRANTS
------------ ------------ ------------ ------------

Balance, January 31, 1996 ... 6,219,000 $ 622 $ 3,504,661 $ 100,000
Comprehensive income:
Net income ..............
Foreign currency
translation adjustments,
net of tax .............

Comprehensive income .

Change in par value of
common stock ............ 61,568 (61,568)
------------ ------------ ------------ ------------
Balance, January 31, 1997 ... 6,219,000 62,190 3,443,093 100,000
Comprehensive loss:
Net loss ................
Foreign currency
translation adjustments,
net of tax .............

Comprehensive loss ........

Issuance of common stock .. 2,500,000 25,000 18,475,000
Stock issuance costs ...... (755,525)
Warrants issued ........... 2,500
------------ ------------ ------------ ------------
Balance, January 31, 1998 ... 8,719,000 87,190 21,162,568 102,500
Comprehensive loss:
Net loss ................
Foreign currency
translation adjustments,
net of tax .............

Comprehensive loss ........
------------ ------------ ------------ ------------
Balance, January 31, 1999 ... 8,719,000 $ 87,190 $ 21,162,568 $ 102,500
============ ============ ============ ============

ACCUMULATED
OTHER
COMPREHENSIVE RETAINED TREASURY
INCOME EARNINGS STOCK TOTAL
------------ ------------ ------------ ------------

Balance, January 31, 1996 ... $ 1,169 $ 7,472,077 $(22,660,592) $(11,582,063)
Comprehensive income:
Net income .............. 2,151,273 2,151,273
Foreign currency
translation adjustments,
net of tax ............. 8,329 8,329
------------
Comprehensive income . 2,159,602
------------
Change in par value of
common stock ............ --
------------ ------------ ------------ ------------
Balance, January 31, 1997 ... 9,498 9,623,350 (22,660,592) (9,422,461)
Comprehensive loss:
Net loss ................ (5,185,697) (5,185,697)
Foreign currency
translation adjustments,
net of tax ............. 19,689 19,689
------------
Comprehensive loss ........ (5,166,008)
------------
Issuance of common stock .. 18,500,000
Stock issuance costs ...... (755,525)
Warrants issued ........... 2,500
------------ ------------ ------------ ------------
Balance, January 31, 1998 ... 29,187 4,437,653 (22,660,592) 3,158,506
Comprehensive loss:
Net loss ................ (738,429) (738,429)
Foreign currency
translation adjustments,
net of tax ............. (14,891) (14,891)
------------
Comprehensive loss ........ (753,320)
------------ ------------ ------------ ------------
Balance, January 31, 1999 ... $ 14,296 $ 3,699,224 $(22,660,592) $ 2,405,186
============ ============ ============ ============

See accompanying notes to consolidated financial statements.

F-6

DSI TOYS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - ORGANIZATION:

DSI Toys, Inc. (the "Company") was incorporated under the laws of the state
of Texas in November 1970. The Company markets and distributes a variety of toys
and children's consumer electronics both within the United States and
internationally, primarily to retailers. The Company's products are manufactured
primarily in China.

In December 1995, the Company sold newly issued common stock representing
77.7% of its common stock to a group of new investors through Rosie Acquisition,
L.L.C. ("RAC") pursuant to a recapitalization transaction (the
"Recapitalization"). In connection with the Recapitalization, the Company issued
2,719,000 new shares of common stock to RAC in exchange for $3.8 million in
cash. Also in connection therewith, the Company purchased 2,719,000 shares of
the common stock of the Company from the previous sole shareholder for
approximately $22.2 million. The previous sole shareholder died on November 19,
1996. Any references to the previous sole shareholder include references to his
estate. The purchase price was funded through (a) cash paid from borrowing of
$10.6 million from banks pursuant to a five-year bank note, a six-year
subordinated note and a bank revolving line of credit; (b) the issuance to the
previous sole shareholder of a $6 million subordinated note and a $1.3 million
promissory note; (c) the transfer of land to the previous sole shareholder with
a cost of approximately $452,000; and (d) approximately $3.8 million in cash
obtained from the sale of common stock to RAC. The subordinated bank note
carries warrants to purchase 388,888 shares of common stock of the Company at an
exercise price of $2.00 per share. In connection with the purchase of treasury
stock, the Company incurred approximately $509,000 in costs and fees, which were
included as the cost of the stock, and approximately $879,000 in debt issuance
costs.

In January 1996, the Company received a note from the previous sole
shareholder of approximately $1.3 million in satisfaction of the balance
receivable from the previous sole shareholder. Such note was offset against the
aforementioned $1.3 million note issued to the previous sole shareholder in
connection with the Recapitalization.

Effective May 1, 1997, the Company's Articles of Incorporation were amended
to (i) authorize the issuance of 5,000,000 shares of $.01 par value preferred
stock, (ii) change the par value of common stock to $.01 and (iii) reduce the
authorized shares of common stock to 20,000,000 shares.

On June 3, 1997, the Company completed its initial public offering (the
"Offering") of 2,500,000 shares of common stock, which provided the Company net
proceeds of $17.7 million. All of the net proceeds were used to repay debt of
the Company. In connection with the Offering, the Company issued warrants to
purchase 250,000 shares of common stock to the lead underwriters. Such warrants
are exercisable at $10.80 per share and expire May 28, 2002.

NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

BASIS OF PRESENTATION

The accompanying consolidated financial statements include the accounts of
DSI (HK) Ltd., a wholly owned subsidiary. All significant intercompany
transactions have been eliminated in consolidation.

These financial statements reflect the historical basis of the Company's
assets and liabilities. No adjustments have been made to reflect an allocation
of the purchase price paid by RAC for its 77.7% interest in the Company.

FISCAL YEAR

The terms "fiscal year" and "fiscal" refer to the Company's fiscal year which
is the year ending January 31 of the following calendar year mentioned (e.g., a
reference to fiscal 1998 is a reference to the fiscal year ended January 31,
1999).

CASH EQUIVALENTS

The Company considers investments with original maturity dates of three
months or less from the date of purchase to be cash equivalents. Restricted cash
held as a compensating balance under a revolving loan supported by letters of
credit is not considered a cash equivalent.

F-7

REVENUE RECOGNITION

Revenues are recognized upon shipment of product by the Company, or in the
case of FOB Asia sales, by the manufacturer, and, at that point, legal
responsibility and title pass to the buyer. The Company provides an allowance
for doubtful accounts and accrues for returns and discounts using a percentage
of gross sales based on historical experience. Provision is made currently for
estimated returns of defective and slow-moving merchandise, price protection and
customer allowances and is included as a reduction of accounts receivable.

INVENTORIES

Inventories consist of finished goods and supplies and are stated at the
lower of cost or market, with cost determined on a first-in, first-out basis.

PROPERTY AND EQUIPMENT

Property and equipment are recorded at cost. Maintenance and repairs are
charged to operations, and replacements or betterments are capitalized. Property
or equipment sold, retired, or otherwise disposed of is removed from the
accounts, and any gains or losses thereon are included in operations.
Depreciation is recorded over the estimated useful lives of the related assets
using the straight-line method for molds and leasehold improvements and an
accelerated method for all other assets.

DEBT ISSUANCE COSTS AND DEBT DISCOUNT

Debt issuance costs and debt discount are amortized over the term of the
related debt on a straight-line basis. As a result of the debt repayment using
the proceeds of the Offering, in 1997 the Company recorded an extraordinary
charge of $481,000 (net of tax) related to the write-off of unamortized debt
issuance and discount costs associated with the retired debt.

ADVERTISING

The cost of producing media advertising is capitalized as incurred and
expensed in the period in which the advertisement is first shown. During interim
periods, media communications costs are accrued in relation to sales when the
advertising is clearly implicit in the related sales arrangement. In any event,
all media communication costs are expensed in the fiscal year incurred. All
other advertising costs are expensed in the period incurred. Television
advertising expense totaled $141,000, $13.5 million, and $6.0 million during
fiscal 1998, 1997 and 1996, respectively. There were no prepaid television
advertising production costs at January 31, 1999 and 1998.

INCOME TAXES

The Company accounts for deferred income taxes using the liability method
which provides for the recognition of deferred tax assets and liabilities based
upon temporary differences between the tax basis of assets and liabilities and
their carrying value for financial reporting purposes. Deferred tax expense or
benefit is the result of changes in deferred tax assets and liabilities during
the period. In estimating future tax consequences, all expected future events
are considered other than enactments of changes in the tax law or rates.

Deferred income taxes are provided on the undistributed earnings of DSI (HK)
Ltd.

FOREIGN CURRENCY TRANSLATIONS

The Company's foreign subsidiary uses the local currency as the functional
currency. Accordingly, assets and liabilities of the Company's foreign
subsidiary are translated using the exchange rate in effect at the balance sheet
date, while income and expenses are translated using average rates. Translation
adjustments are reported as a separate component of shareholders' equity.

FAIR VALUE OF FINANCIAL INSTRUMENTS

The Company's financial instruments recorded on the balance sheet include
cash and cash equivalents, accounts receivable, accounts payable and debt. Due
to their short maturity, the fair value of cash and cash equivalents, accounts
receivable and accounts payable approximates carrying value. The fair value of
the Company's debt approximates the carrying amount of the debt as it is at
variable market rates.

F-8

CONCENTRATION OF CREDIT RISK AND EXPORT SALES

Financial instruments which potentially subject the Company to concentrations
of credit risk consist primarily of trade receivables. The Company sells its
products principally to retail discount stores and toy stores. Concentrations of
credit risk with respect to trade receivables are limited due to the large
number of customers comprising the Company's customer base and their geographic
dispersion. The Company performs ongoing credit evaluations of its customers to
minimize credit risk, and for the majority of its FOB Asia sales, the Company
obtains letters of credit from its customers supporting the accounts receivable.
(See Note 12).

USE OF ESTIMATES

The preparation of financial statements in accordance with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the period. Because of the
inherent uncertainties in their process, actual results could differ from such
estimates. Management believes that the estimates are reasonable.

IMPAIRMENT OF ASSETS

The Company reviews for the impairment of long-lived assets whenever events
or changes in circumstances indicate that the carrying amount of an asset may
not be recoverable. An impairment loss would be recognized when estimated future
cash flows expected to result from the use of the asset and its eventual
disposition is less than its carrying amount. The Company has not identified any
such impairment losses.

EARNINGS PER SHARE

Statement of Financial Accounting Standards No. 128, "Earnings per Share"
(SFAS 128) requires the Company to report both basic earnings per share, which
is based on the weighted average number of common shares outstanding, and
diluted earnings per share, which is based on the weighted average number of
common shares as well as all dilutive potential common shares outstanding.

Stock options and warrants are the only potentially dilutive shares the
Company has outstanding at January 31, 1999. During fiscal 1998 and 1997, the
Company had 1,241,888, and 1,171,888 shares, respectively, of common stock
options and warrants outstanding which were not included in the diluted earnings
per share calculation because the options and warrants would have been
anti-dilutive.

STOCK-BASED COMPENSATION PLANS

The Company applies Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees" (APB 25) and related interpretations in
accounting for its plans and the disclosure-only provision of Statement of
Financial Accocunting Standards No. 123, "Accounting for Stock-Based
Compensation" (SFAS 123) in disclosures regarding the plan.

COMPREHENSIVE INCOME

In fiscal 1998, the Company adopted Statement of Financial Accounting
Standards No. 130, "Reporting Comprehensive Income" (SFAS 130) which establishes
new rules for the reporting and presentation of comprehensive income and its
components in a full set of financial statements. The Company's comprehensive
income is comprised of net income and foreign currency translation adjustments.
The adoption of SFAS 130 had no impact on the Company's net income or total
shareholders' equity. Prior to the adoption of SFAS 130, foreign currency
translation adjustments were reported separately in the statement of
shareholders' equity. The comprehensive income amounts in the prior fiscal
years' financial statements have been reclassified to conform to SFAS 130.

SEGMENT INFORMATION

In fiscal 1998, the Company adopted Statement of Financial Accounting
Standards No. 131, "Disclosures about Segments of an Enterprise and Related
Information" (SFAS 131). SFAS 131 supersedes SFAS 14, "Financial Reporting for
Segments of a Business Enterprise," replacing the "industry segment" approach
with the "management" approach. The management approach designates the internal
organization that is used by management for making operating decisions and
assessing performance as the source of the Company's reportable segments. SFAS
131 also requires disclosures about products and services, geographic areas and
major customers.

F-9

The adoption of SFAS 131 did not affect the Company's results of operations or
financial position but did affect the disclosures of segment information (see
Note 12).

NOTE 3 - ACCOUNTS RECEIVABLE:

Accounts receivable consist of the following as of January 31:

1999 1998
------------ ------------
Trade receivables ...................... $ 2,984,619 $ 10,999,014
Provisions for:
Discounts and markdowns .............. (1,383,808) (1,956,722)
Return of defective goods ............ (407,628) (829,674)
Doubtful accounts .................... (123,458) (204,330)
------------ ------------
Accounts receivable, net ............... $ 1,069,725 $ 8,008,288
============ ============

NOTE 4 - PROPERTY AND EQUIPMENT:

Property and equipment consist of the following as of January 31:

ESTIMATED USEFUL LIVES 1999 1998
----------------------- ---------- ----------
Molds ...................... 3 years $2,978,822 $2,300,345
Equipment, furniture and
fixtures ................... 5-7 years 1,647,244 1,486,254

Leasehold improvements ..... 10 years or lease term 997,420 879,429
Automobiles ................ 3-5 years 84,190 84,216
---------- ----------
5,707,676 4,750,244
Less: accumulated
depreciation ............. 4,065,004 3,497,672
---------- ----------
$1,642,672 $1,252,572
========== ==========

NOTE 5 - ACCOUNTS PAYABLE AND ACCRUED LIABILITIES:

Accounts payable and accrued liabilities consist of the following as of
January 31:

1999 1998
---------- ----------
Trade payables ........................... $4,388,808 $7,518,710
Accrued royalties ........................ 776,590 968,267
Accrued compensation and commissions ..... 973,441 553,608
Other .................................... 660,451 699,616
---------- ----------
$6,799,290 $9,740,201
========== ==========

F-10

NOTE 6 - NOTES PAYABLE

Indebtedness consists of the following as of January 31:

1999 1998
---------- ----------
Bank revolving line of credit for $10 million
with a commercial bank collateralized by all
of the Company's U.S. accounts receivable,
intangibles, equipment, fixtures and inventory
and 65% of the common stock of DSI (HK) Ltd.,
principal due on January 22, 1999; interest at
prime (7.75% at January 31, 1999) ................. $2,528,000 $7,495,000

Revolving bank loan drawn against an $8 million
line of credit, collateralized by a
customer's letter of credit and $150,000
cash, interest at prime (7.75% at January
31, 1999) ......................................... 814,289 577,945

Other ................................................ 22,908 7,838
---------- ----------
3,365,197 8,080,783

Less: current portion ................................ 824,675 585,783
---------- ----------
$2,540,522 $7,495,000
========== ==========

During the third and fourth quarters of fiscal 1998, the Company was out of
compliance with certain of the covenants of the previous line of credit. As a
result, the bank accelerated maturity to January 22, 1999. On February 2, 1999,
the Company replaced the previous line of credit with another revolving credit
facility (the "Revolver").

The Revolver includes a $10 million revolving line of credit commitment,
subject to availability under a borrowing base calculated by reference to the
level of eligible accounts receivable and inventory, as defined in the
agreement. The Revolver matures on February 2, 2002. Interest on borrowings
outstanding under the Revolver is payable monthly in arrears at an annual rate
equal to prime plus .75%. In addition, an unused line fee at an annual rate
equal to .25% applied to the amount by which $10 million exceeds the average
daily principal balance during the month and a collateral management fee of
$2,000 is payable monthly.

The Revolver is collateralized by a lien on substantially all of the
Company's U.S. accounts receivable, intangibles, equipment, fixtures, inventory
and 65% of the outstanding common stock of DSI (HK) Ltd.

The Revolver contains certain restrictive covenants and conditions among
which are prohibition on payment of dividends, limitations on further
indebtedness, restrictions on dispositions and acquisition of assets,
limitations on advances to third parties and compliance with minimum net worth
amounts.

NOTE 7 - INCOME TAXES:

The components of income (loss) before provision for (benefit from) income
taxes by fiscal year were as follows:

1998 1997 1996
------------ ------------ ------------
Domestic ........... $ (2,944,103) $(11,784,930) $ (898,344)
Foreign ............ 1,872,674 4,750,664 4,269,617
------------ ------------ ------------
$ (1,071,429) $ (7,034,266) $ 3,371,273
============ ============ ============

F-11

The provision for income taxes (benefit) by fiscal year is as follows:

1998 1997 1996
----------- ----------- -----------
Current:
Federal ..................... $ (615,358) $ (299,000) $ (185,605)
State ....................... -- -- (14,000)
Foreign ..................... 271,358 750,677 733,000
----------- ----------- -----------
(344,000) 451,677 533,395
----------- ----------- -----------
Deferred:
Federal ..................... 17,000 (2,742,000) 657,605
State ....................... -- -- (11,000)
Foreign ..................... (6,000) (39,000) 40,000
----------- ----------- -----------
11,000 (2,781,000) 686,605
----------- ----------- -----------
(333,000) (2,329,323) 1,220,000
Tax on Extraordinary Item
(Current Federal) .............. -- (270,000) --
----------- ----------- -----------
$ (333,000) $(2,599,323) $ 1,220,000
=========== =========== ===========

The difference between income taxes (benefit) at the statutory federal and
the effective income tax rates by fiscal year is as follows:

1998 1997 1996
----------- ----------- -----------
Taxes (benefit) computed at
statutory rate .................. $ (364,000) $(2,391,000) $ 1,146,000
State income taxes net of federal
benefit ......................... -- -- (16,000)
Nondeductible items ............... -- -- 13,000
Other, net ........................ 31,000 61,677 77,000
----------- ----------- -----------
$ (333,000) $(2,329,323) $ 1,220,000
=========== =========== ===========

Deferred tax assets (liabilities) are comprised of the following at
January 31:

1999 1998
----------- -----------
Allowance for doubtful accounts ............ $ 70,000 $ 63,000
Inventory valuation adjustments ............ 19,000 31,000
Depreciation ............................... 97,000 101,000
Accruals for inventory returns and markdowns 712,000 89,000
Foreign and alternative minimum tax credits 973,000 1,535,000
Net operating loss carryforward ............ -- 1,124,000
Other ...................................... 47,000 155,000
----------- -----------
Gross deferred tax assets ............... 1,918,000 3,098,000
----------- -----------
Unremitted earnings of foreign subsidiary .. -- (1,163,000)
Depreciation ............................... (113,000) (119,000)
----------- -----------
Gross deferred tax liabilities .......... (113,000) (1,282,000)
----------- -----------
Net deferred tax assets (liabilities) ...... $ 1,805,000 $ 1,816,000
=========== ===========

At January 31, 1999, the Company has a $850,000 foreign tax credit
carryforward which will expire if not utilized by January 31, 2003. The Company
believes that the foreign and alternative minimum tax credit carryforwards will
be available to reduce future federal income tax liabilities and has recorded
the tax benefit of

F-12

these carryforwards as noncurrent deferred tax assets. The Company's net
operating loss carryforward for state purposes is not significant.

NOTE 8 - EMPLOYEE BENEFIT PLAN:

The Company maintains a 401(k) Plan (the Plan) for the benefit of its U.S.
employees. The Company may, at its discretion, provide funds to match employee
contributions to the Plan. The Company contributed $35,000, $31,000 and $105,000
in fiscal 1998, 1997 and 1996, respectively, as employer matching contributions
to employee contributions.

NOTE 9 - THE STOCK OPTION PLAN AND WARRANTS:

The Company has reserved 388,888 common shares for issuance upon exercise of
warrants issued to a bank. Such warrants are currently exercisable at a purchase
price of $2 per share and expire December 11, 2005.

In connection with the Offering, the Company issued warrants to purchase
250,000 shares of common stock. Such warrants are exercisable at $10.80 per
share and expire May 28, 2002.

In May 1997, the Board adopted the DSI Toys, Inc. 1997 Stock Option Plan (the
1997 Plan) whereby certain employees may be granted stock options, appreciation
rights or awards related to the Company's common stock. Additionally, the
Company may grant nonstatutory stock options to nonemployee board members. The
Board has authorized 600,000 shares to be available for grant pursuant to the
1997 Plan. Options expire no later than ten years from the date of grant.

Additional awards may be granted under the 1997 Plan in the form of cash,
stock or stock appreciation rights. The stock appreciation right awards may
consist of the right to receive payment in cash or common stock. Any award may
be subject to certain conditions, including continuous service with the Company
or achievement of business objectives.

A summary of the option activity under the 1997 Plan follows: Number of

OUTSTANDING WEIGHTED AVERAGE
OPTIONS OPTION PRICE
----------- ----------------
Options outstanding at January 31, 1997 ... -- --
Granted ................................. 533,000 $ 8.00
----------- ----------------
Options outstanding at January 31, 1998 ... 533,000 8.00
Granted ................................. 82,000 1.41
Surrendered ............................. (12,000) 8.00
----------- ----------------
Options outstanding at January 31, 1999 ... 603,000 7.10
=========== ================

The weighted average fair value at date of grant for options granted during
fiscal 1998 and 1997 was $1.41 and $8.00, respectively. Vesting periods for
options granted range from immediate to seven years from the date of grant in
increments between 5% and 90% per year.

Options outstanding at January 31, 1999 are as follows:

WEIGHTED
WEIGHTED AVERAGE WEIGHTED
NUMBER OF AVERAGE REMAINING NUMBER OF AVERAGE
OUTSTANDING EXERCISE CONTRACTUAL EXERCISABLE EXERCISE
OPTION PRICE OPTIONS PRICE LIFE OPTIONS PRICE
- ------------------------ ----------- -------- ----------- ----------- --------

$1.14 - 1.59 ........... 60,000 $ 1.22 10 3,333 $ 1.59
1.94 - 2.01 ............ 22,000 1.95 10 7,333 1.95
8.00 ................... 521,000 8.00 9 194,299 8.00
----------- -----------
603,000 204,965
=========== ===========

The Company applies APB 25 and related interpretations in accounting for its
stock option plan. Accordingly, no compensation cost has been recognized by the
Company for this plan. The following unaudited pro forma data is

F-13

calculated as if compensation cost for the 1997 Plan was determined based upon
the fair value at the grant date for awards under the plan consistent with the
methodology prescribed under SFAS 123 for fiscal years 1998 and 1997:

1998 1997
------------- -------------
Pro forma net loss ........................... $ (1,323,870) $ (5,593,246)
Pro forma basic loss per common share ........ (.22) (1.07)
Pro forma diluted loss per common share ...... (.22) (1.07)

The fair value of each option granted is estimated on the date of grant using
the Black-Scholes options-repricing model with the following weighted average
assumptions used for grants in fiscal 1998 and 1997: expected volatility of 80%
in fiscal 1998 and 70% in fiscal 1997, risk-free interest rate of 4.64% to
6.52%, no dividend yield and an expected life of seven years.

NOTE 10 - RELATED PARTY TRANSACTIONS:

The Company entered into a consulting agreement with the previous sole
shareholder to serve as a consultant to the Company for three years for annual
compensation of $300,000. The consulting agreement also required the Company to
maintain health and disability insurance policies for the benefit of the
shareholder for the term of his life. Pursuant to the agreement, the Company
agreed to maintain the shareholder's office space for his use for the term of
the agreement and to provide for 180 days the services of certain Company
employees for his outside business, provided that such services shall not exceed
30% of the time of each of such employees. This agreement terminated upon the
shareholder's death on November 19, 1996.

As compensation for consulting services rendered in connection with the
Recapitalization, the Company paid the Vice Chairman of the Board the sum of
$240,000 in three equal payments on January 1, 1998, 1997 and 1996.

The Company paid $100,000 to a partnership controlled by a director of the
Company upon completion of the Offering.

The Company leases its office and warehouse from an entity owned by the
previous sole shareholder of the Company. Rent expense on these leases was
$217,000 each year for fiscal 1998, 1997 and 1996. Management believes that the
rental rates approximate fair market value.

The Company pays insurance premiums for certain life insurance policies owned
by the Tommy and JoBeth Moss Joint Life Insurance Trust, and is entitled to
repayment of the advanced premiums upon the death of JoBeth Moss. The
receivables related to these policies as of January 31, 1999 and 1998 amounted
to $1,543,814 and $1,278,401, respectively, and are collateralized by the
related insurance policies. The Trust is restricted from borrowing against the
policies until the receivable is satisfied in full.

Additional related party transactions are described in Notes 1 and 11.

NOTE 11 - COMMITMENTS AND CONTINGENCIES:

In the normal course of business, the Company is involved in product and
intellectual property issues which sometimes result in litigation. It is the
opinion of management that the ultimate resolution of such matters will not have
a material adverse effect on the Company's financial position or results of
operations taken as a whole.

The Company leases its facilities under various operating leases which expire
from 1998 to 2003. Rent expense, including amounts paid to a related party, for
fiscal 1998, 1997, and 1996 amounted to $625,000, $693,000 and $687,000,
respectively. Aggregate minimum rental commitments under noncancelable leases
are as follows for the specified fiscal years:

1999 ................................. $ 587,327
2000 ................................. 583,475
2001 ................................. 324,426
2002 ................................. 135,965
----------
$1,631,193
==========

F-14

Royalty expense under licensing agreements aggregated $1,298,000, $3,069,000
and $1,578,000 in fiscal 1998, 1997 and 1996, respectively. At January 31, 1999,
minimum guaranteed royalties payable under these agreements in fiscal 1999 and
thereafter through 2002 of $170,000 and $590,000, respectively, are included in
accrued royalties payable and prepaid expenses.

NOTE 12 - SEGMENT INFORMATION:

The Company designs, develops, markets and distributes a variety of toys and
children's consumer electronics. These product lines are grouped into four major
categories which represent the Company's operating segments, as follows:

Juvenile audio products, including walkie-talkies, pre-school audio products,
pre-teen audio products and musical toys; girls' toys, including dolls, play
sets and accessories, and boys' toys, including radio control vehicles, action
figures and western and military action toys.

These operating segments all have similar economic characteristics: the
marketing of children's products. Based on these similarities, the Company's
products can be aggregated into one reportable segment for purposes of this
disclosure.

The Company sells its products through (i) the Hong Kong operation, where
products are shipped directly from contract manufacturers to DSI's customers,
and (ii) the United States operation, where products are shipped from DSI's
warehouse in Houston to its customers.

Financial information for fiscal 1998, 1997 and 1996 for the U.S. and Hong
Kong operations is as follows:

UNITED STATES HONG KONG CONSOLIDATED
------------- ------------ ------------
FISCAL 1998:
Net sales ...................... $ 14,817,505 $ 37,905,012 $ 52,722,517
Operating income (loss) ........ (4,110,596) 3,807,193 (303,403)
Depreciation expense............ 275,146 295,632 570,778
Capital expenditures............ 255,940 705,364 961,304
Total assets at fiscal year end 9,438,517 3,516,076 12,954,593

FISCAL 1997:
Net sales ...................... 28,550,033 45,074,365 73,624,398
Operating income (loss) ........ (8,722,057) 2,815,890 (5,906,167)
Depreciation expense............ 266,914 394,603 661,517
Capital expenditures............ 294,613 432,078 726,691
Total assets at fiscal year end 18,071,267 3,135,853 21,207,120

FISCAL 1996:
Net sales ...................... 27,970,378 35,248,834 63,219,212
Operating income ............... 3,033,677 2,593,069 5,626,746
Depreciation expense............ 236,159 360,173 596,332
Capital expenditures............ 183,676 100,584 284,260
Total assets at fiscal year end 11,394,682 3,921,066 15,315,748

Sales to major customers that exceeded 10% of the Company's total net

sales consist of the following for the specified fiscal years:

1998 1997 1996
------ ------ ------
Wal-Mart .......................... 19% 17% 19%
Toys "R" Us ....................... 11% 22% 12%
Kmart ............................. 4% 10% 14%

Approximately 21% of the Company's sales were exports to foreign countries
during fiscal 1998 and 19% during fiscal 1997 and 1996.

F-15

NOTE 13 - SUPPLEMENTAL CASH FLOW INFORMATION:

Additional cash flow information by fiscal year is as follows:

1998 1997 1996
---------- ---------- ----------
Cash paid (received) for:

Interest .............................. $ 614,150 $ 379,063 $2,360,538
Income taxes .......................... (1,149,829) 1,139,929 655,058
Noncash activities included the following:

Accounts receivable write-off ......... $ 63,946 $ 45,932 $ 25,188

NOTE 14 - QUARTERLY FINANCIAL INFORMATION (UNAUDITED):

FISCAL QUARTER ENDED
-----------------------------------------------------------
4/30/98 7/31/98 10/31/98 1/31/99
------------ ------------ ------------ ------------

Net sales ............................. $ 5,926,126 $ 17,524,808 $ 24,563,262 $ 4,708,321
Operating income (loss) ............... (796,703) 626,935 2,466,318 (2,599,953)
Income (loss) before income taxes ..... (1,008,027) 442,294 2,216,365 (2,722,061)
Net income (loss) ..................... (645,137) 271,754 1,429,788 (1,794,834)
Basic earnings (loss) per share ....... $ (0.11) $ 0.05 $ 0.24 $ (0.30)
Diluted earnings (loss) per share ..... $ (0.11) $ 0.05 $ 0.24 $ (0.30)

FISCAL QUARTER ENDED
-----------------------------------------------------------
4/30/97 7/31/97 10/31/97 1/31/98
------------ ------------ ------------ ------------
Net sales ............................. $ 7,427,707 $ 24,382,768 $ 30,018,242 $ 11,795,681
Operating income (loss) ............... (293,897) 2,871,310 (6,059,281) (2,424,299)
Income (loss) before income taxes
and extraordinary item .............. (750,895) 2,622,301 (6,295,634) (2,610,038)
Net income (loss) ..................... (480,753) 1,197,519 (4,029,206) (1,873,257)
Basic earnings (loss) per share ....... $ (0.14) $ 0.23 $ (0.67) $ (0.31)
Diluted earnings (loss) per share ..... $ (0.14) $ 0.22 $ (0.67) $ (0.31)

NOTE 15 - SUBSEQUENT EVENT:

On April 15, 1999, the Company entered into a Stock Purchase and Sale
Agreement with MVII, LLC, a California limited liability company controlled by
Tom Martin, which contemplates several related transactions: (i) MVII purchased
566,038 shares of common stock from the Company for $1.2 million on April 15,
1999; (ii) MVII commenced a tender offer to purchase up to 1.6 million shares of
the outstanding common stock of the Company at $4.38 per share in cash on April
21, 1999; and (iii) subject to shareholder and other approvals, MVII will
purchase an additional 1,792,453 shares of common stock (subject to upward
adjustments not to exceed in the aggregate 140,000 shares) from the Company for
$3.8 million simultaneously with the purchase of shares in the tender offer.
Upon consummation of the transactions, MVII will own more than 47% of the
Company's outstanding shares and will be entitled to nominate four of the six
members of the board of directors.

F-16

DSI TOYS, INC. AND SUBSIDIARY
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (SCHEDULE II)

(IN THOUSANDS)

BALANCE CHARGED BALANCE CHARGED BALANCE CHARGED BALANCE
AT TO COSTS AT TO COSTS AT TO COSTS AT
JANUARY AND JANUARY AND JANUARY AND JANUARY
DESCRIPTION 31, 1996 EXPENSES DEDUCTIONS 31, 1997 EXPENSES DEDUCTIONS 31, 1998 EXPENSES DEDUCTIONS 31, 1999
- --------------------------- -------- -------- ---------- -------- -------- ---------- -------- -------- ---------- --------

Reserves deducted
from assets:

Trade receivables ........ 68 62 (25) 105 145 (46) 204 (17) (64) 123
Discounts and markdowns .. 700 1,037 (966) 771 2,447 (1,261) 1,957 1,559 (2,132) 1,384
Return of defective goods 288 801 (872) 217 2,617 (2,004) 830 2,416 (2,838) 408
-------- -------- ---------- -------- -------- ---------- -------- -------- ---------- --------
1,056 1,900 (1,863) 1,093 5,209 (3,311) 2,991 3,958 (5,034) 1,915
======== ======== ========== ======== ======== ========== ======== ======== ========== ========

S-1

EXHIBIT INDEX

3.1 Amended and Restated Articles of Incorporation. (1)

3.2 Amended and Restated Bylaws. (1)

3.3 Amendment to Bylaws. (1)

4.1 Form of Common Stock Certificate. (1)

4.2 Form of Warrant Agreement among the Company and Representatives to
purchase 250,000 shares of common stock. (1)

4.3 Common Stock Purchase Warrant No. A-1 dated December 11, 1995,
issued to Hibernia Corporation to purchase 388,888 shares of common
stock. (1)

4.4 Registration Rights Agreement by and between the Company and
Hibernia Corporation. (1)

4.5 Registration Rights Agreement by and between the Registrant and
Tommy Moss. (1)

10.1 1997 Stock Option Plan. (1)

10.2 Agreement for Sale of Stock between Rosie Acquisition, L.L.C. and
DSI Acquisition, Inc. and Diversified Specialists, Inc. and Tommy
Moss, dated December 11, 1995. (1)

10.3 Employment Agreement dated December 11, 1995 by and between the
Company and M. D. Davis. (1)

10.4 Employment Agreement dated December 11, 1995 by and between the
Company and Richard R. Neitz. (1)

10.5 Employment Agreement dated December 11, 1995 by and between the
Company and Yau Wing Kong. (1)

10.6 Employment Agreement dated December 11, 1995 by and between the
Company and Dale Y. Chen. (1)

10.7 Employment Agreement dated December 11, 1995 by and between the
Company and Thomas V. Yarnell. (1)

10.8 Employment Agreement dated March 16, 1997 by and between the Company
and J. Russell Denson. (1)

10.9 Letter Loan Agreement between the Company and Bank One, Texas, N.A.
dated December 11, 1995, evidencing a revolving line of credit and a
term note (the "Bank One Letter Loan Agreement"). (1)

10.10 First Amendment to Bank One Letter Loan Agreement, dated January 31,
1996. (1)

10.11 Second Amendment to Bank One Letter Loan Agreement, dated August 1,
1996. (1)

10.12 Third Amendment to Bank One Letter Loan Agreement, dated November
14, 1996. (1)

10.13 Fourth Amendment to Bank One Letter Loan Agreement, dated January
31, 1997. (1)

10.14 Fifth Amendment to Bank One Letter Loan Agreement, dated January 31,
1997. (1)

10.15 Line of Credit Facility with State Street Bank and Trust Company,
Hong Kong Branch, dated April 1, 1997, evidencing a $5,000,000 line
of credit. (1)

10.16 Underwriting Agreement dated May 28, 1997 among the Company, the
Tommy Moss Living Trust, Hibernia Corporation and Tucker Anthony
Incorporated and Sutro & Co. Incorporated. (2)

10.17 Warrant Agreement dated May 28, 1997 by and among the Company,
Tucker Anthony Incorporated and Sutro & Co. Incorporated. (3)

10.18 Renewal and Modification of Line of Credit Facility with State
Street Bank and Trust Company, Hong Kong Branch, dated June 6, 1997,
evidencing an $8,000,000 line of credit. (4)

10.19 Debenture by DSI (HK) Limited to State Street Bank and Trust
Company, Hong Kong Branch, dated July 29, 1997. (5)

E-1

10.20 Amended and Restated Bank One Letter Loan Agreement, dated October
22, 1997. (6)

10.21 First Amendment to Amended and Restated Bank One Letter Loan
Agreement, dated January 31, 1998. (7)

10.22 Second Amendment to Amended and Restated Bank One Letter Loan
Agreement, dated September 30, 1998. (8)

10.23 Employment Agreement dated August 20, 1998 by and between the
Company and Howard G. Peretz.*

10.24 Loan and Security Agreement by and between the Company and Sunrock
Capital Corp. dated February 2, 1999.*

10.25 Stock Pledge Agreement by and between the Company and Sunrock
Capital Corp. dated February 2, 1999.*

10.26 Assignment of Deposit Account by and between the Company and Sunrock
Capital Corp. dated February 2, 1999.*

10.27 Trademark Security Agreement by and between the Company and Sunrock
Capital Corp. dated February 2, 1999.*

10.28 Patent Collateral Assignment by and between the Company and Sunrock
Capital Corp. dated February 2, 1999.*

10.29 Stock Purchase and Sale Agreement dated April 15, 1999 by and
between the Company and MVII, LLC.(9)

21 Subsidiaries. (1)

27 Financial Data Schedule.*

(1) Filed as a part of the Registrant's Registration Statement on Form S-1
(No. 333-23961) and incorporated herein by reference.

(2) Filed as Exhibit 10.1 to the Company's Form 10-Q for the quarterly period
ended April 30, 1997, and incorporated herein by reference.

(3) Filed as Exhibit 10.2 to the Company's Form 10-Q for the quarterly period
ended April 30, 1997, and incorporated herein by reference.

(4) Filed as Exhibit 10.1 to the Company's Form 10-Q for the quarterly period
ended July 31, 1997, and incorporated herein by reference.

(5) Filed as Exhibit 10.2 to the Company's Form 10-Q for the quarterly period
ended July 31, 1997, and incorporated herein by reference.

(6) Filed as Exhibit 10.1 to the Company's Form 10-Q for the quarterly period
ended October 31, 1997, and incorporated herein by reference.

(7) Filed as Exhibit 10.21 to the Company's Form 10-K for the annual period
ended January 31, 1998, and incorporated herein by reference.

(8) Filed as Exhibit 10.22 to the Company's Form 10-Q for the quarterly period
ended October 31, 1998, and incorporated herein by reference.

(9) Filed as Exhibit 2 to the Company's Schedule 14D-9 and incorporated herein
by reference.

* Filed herewith.

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