SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (Mark One) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________ to _________ Commission File Numbers: 333-32385-05 and 333-32385 HEDSTROM HOLDINGS, INC. HEDSTROM CORPORATION (Exact name of registrant as specified in its charter) Delaware 51-0329830 Delaware 51-0329829 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 585 Slawin Court, Mount Prospect, Illinois 60056-2183 (Address of principal executive offices, including zip code) (847) 803-9200 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: None 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 voting stock held by non-affiliates of the registrant as of March 30, 1999 was $6,124,747. On March 30, 1999, there were outstanding: (i) 36,142,883 shares of Common Stock, par value $.01 per share, of Hedstrom Holdings, Inc., (ii) 31,520,000 shares of Non-Voting Common Stock, par value $.01 per share, of Hedstrom Holdings, Inc. and (iii) 10 shares of Common Stock, par value $.01 per share, of Hedstrom Corporation. HEDSTROM HOLDINGS, INC. HEDSTROM CORPORATION 1998 ANNUAL REPORT ON FORM 10-K TABLE OF CONTENTS Item 1. Business Item 2. Properties Item 3. Legal Proceedings Item 4. Submission of Matters to a Vote of Security Holders PART II Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters Item 6. Selected Financial Data Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Item 8. Financial Statements and Supplementary Data Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure PART III Item 10. Directors and Executive Officers of the Registrant Item 11. Executive Compensation. Item 12. Security Ownership of Certain Beneficial Owners and Management Item 13. Certain Relationships and Related Transactions PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K Item 1. Business This Form 10-K and future filings by the Company on Form 10-Q and Form 8-K and future oral and written statements by the Company and its management may include, certain forward-looking statements, including (without limitation) statements with respect to anticipated future operating and financial performance. Year 2000 compliance and other similar forecasts and statements of expectation. Words such as "expects", "anticipates", "intends", "plans", " believes", "seeks", "estimates", and "should", and variations of these words and similar expressions, are intended to identify these forward looking statements. Forward-looking statements by the Company and its management are based on estimates, projections, beliefs and assumptions of management and are not guarantees of future performance. The Company disclaims any obligation to update or revise any forward-looking statement based on the occurrence of future events, the receipt of new information, or otherwise. Actual future performance, outcomes and results may differ materially from those expressed in forward-looking statements made by the Company and its management. General Hedstrom Holdings, Inc. ("Holdings") is a holding company whose primary operating subsidiary is Hedstrom Corporation ("Hedstrom") or the "Company"). The principal shareholders of Holdings are Hicks, Muse, Tate & Furst Equity Fund II, L.P. ("HM Fund II"), an affiliate of Hicks, Muse, Tate & Furst Incorporated ("Hicks Muse"), certain affiliates of Hicks Muse and certain members of Holding's senior management. Hicks Muse is a private investment firm based in Dallas, New York, St. Louis and Mexico City that specializes in acquisitions, recapitalizations and other principal investing activities. In October 1995, HM Fund II, together with certain other investors (the "HM Group"), acquired an 82% common equity interest in Holdings in a transaction that was accounted for as a recapitalization (the "1995 Recapitalization"). The total enterprise value of Hedstrom at the time of the 1995 Recapitalization, including the assumption and refinancing of certain indebtedness, was approximately $75 million. The HM Group paid approximately $27 million for its common equity interest, which, together with Holdings senior management's 18% retained common equity ownership, implied a total equity value of Holdings at that time of approximately $33 million. In June of 1997, Hedstrom acquired ERO, Inc. ("ERO") and its subsidiaries, manufacturers and marketers of children's leisure products (the "Acquisition"). In connection with the Acquisition, HM Fund II purchased 31,520,000 shares of Holding's non-voting common stock for an aggregate purchase price of $39,400,000. On July 24, 1998 the Company acquired Backyard Products Limited, a leading manufacturer and supplier of wood gym sets and accessories. Hedstrom is a leading North American manufacturer and marketer of well-established children's leisure and activity products. The Company's diversified product lines are in such "evergreen" product categories as outdoor gym sets, wood gym kits and slides, spring horses, trampolines, playballs, arts and crafts kits, game tables, and indoor sleeping bags, play tents and wall decorations. The Company considers such product categories to be "evergreen" because each is characterized by proven longevity, demonstrated market demand and consistent sales over time. The Company's products are sold primarily through national retailers, mass merchants, home improvement centers, sporting goods stores, drug store chains and supermarkets. For the twelve month period ended December 31, 1998, the Company's net sales, cash flow from operations and EBITDA were $301.7, $7.4 and $36.7 million, respectively. The Company's outdoor gym set product line accounted for approximately 20% of the Company's net sales for the fiscal year ended December 31, 1998. No other product line accounted for more than 10% of the Company's net sales in fiscal year 1998. Hedstrom's operations are conducted through five principal operating divisions (or segments). The Bedford Division in Bedford, Pennsylvania manufactures and markets in the United States and Canada outdoor gym sets, wood gym kits and slides, spring horses, trampolines and gym accessories. The Ashland Division in Ashland, Ohio manufactures and markets in the United States a wide variety of children's playballs and ball pit products. The Montreal Division in Montreal, Canada is a fully integrated manufacturer of children's products, including arts and crafts kits, game tables and certain other children's bulk play products such as play kitchens and battery-operated ride-on vehicles. It also manufactures and markets a broad line of school supplies featuring popular licensed characters, including back packs, book bags, lunch kits and stationery products such as portfolios, binders, study kits, pencils and theme books marketed under the Impact brand name. The ERO Division in Hazlehurst, Georgia produces the Slumber Shoppe line of products, including indoor sleeping bags and play tents featuring popular licensed characters, a water sports line of products including flotation jackets, masks, fins, goggles and snorkels sold to the children's market utilizing ERO's license portfolio and to the children's and adults' markets under the Coral brand name. It also markets licensed room decorations for young children, consisting principally of stick-on and peel-off wall decorations under the Priss Prints brand name. The International Division in Bracknell, United Kingdom and Milton, Ontario Canada produces and distributes gym sets and other products manufactured by all of Holdings' domestic divisions. Hedstrom utilizes excess capacity at both the Bedford Division and the Ashland Division to manufacture components for a variety of OEMs of industrial and consumer products. Customers Four of the Company's customers (Wal-Mart, Toys R Us, K-Mart and Target) account for over 50% of the Company's sales. As a result, the Company's operations can be significantly impacted by these customers. Although Hedstrom has well-established relationships with these customers, it does not have long term contracts with any of them. A decrease in business from any of these customers could have a material adverse effect on the Company's results of operations and financial condition. During 1998, well-publicized changes in the inventory policies and purchasing practices of Toys R Us, the Company's second largest customer in 1998, and, to a lesser extent, those of the Company's other customers adversely affected the 1998 sales levels of the Company and of the industry generally. As a consequence, the Company's operating income in fiscal 1998 was significantly less than anticipated. Although management does not anticipate similar events in fiscal 1999, there can be no assurance that competitive pressures in the retail sector will not result in continued pressure on the Company's sales and operating income. As a result of the aforementioned competitive pressures, there recently have been a number of consolidations and business failures in the retail sector. As a result, there may be a further concentration of the Company's customer base, as well as an adverse change in the Company's credit exposure. Although management has no reason to believe that there are any significant credit risks associated with any of its key customers, a credit failure by a key customer or a significant number of smaller customers would have a material adverse effect on Hedstrom's results of operations. Acquisitions See Note 3 to the consolidated financial statements for a discussion of the Company's acquisitions. Products Bedford Division Outdoor Gym Sets. The Bedford Division produces a broad selection of painted metal gym sets and composite metal and plastic gym sets. Each of the Company's outdoor gym sets consists of a heavy-duty metal frame which supports several hanging, swinging rides such as contoured swing seats, glide rides and trapezes. In addition, the Company's outdoor gym sets often incorporate a plastic slide and climbing tower. The Company sells its outdoor gym sets as complete, ready-to-assemble kits. The Company's outdoor gym set line consists of 12 styles available in a variety of colors that sell at retail prices between $99.99 and $299.99. In 1997, the Company began to emphasize wood complete gym sets, which consist of all components necessary to construct a wood gym set. This product line was enhanced through the acquisition of Backyard Products Ltd. in 1998. As the leading manufacturer of ready-to-assemble wood gym sets, the Company markets and sells this product line under the Backyard Escapes brand. These products consist of all components necessary to build wood gym sets including pre-cut, pre-drilled, treated lumber, swings, plastic slides and accessories. These products generally sell for retail prices between $299.99 and $799.99. Wood Gyms and Slides. The Bedford Division produces wood gym kits which it markets primarily through home improvement centers and building supply stores. Wood gym kits consist of components necessary to construct a wood gym set, such as nuts, bolts and framing brackets, and are typically sold together with accessories such as swings, climbing towers and plastic slides. The Company does not sell the lumber, nails or the tools required to construct the wood gym kits. The retailers that carry the Company's wood gym kits benefit from the sale of such items, particularly the lumber. The Company currently offers wood gym kits with designs and layouts ranging from simple swing set designs to more elaborate designs in the shape of pirate ships and trains. The Company's wood gym kits generally sell for retail prices between $69.99 and $324.99, and the Company's slides generally sell for retail prices between $79.99 and $129.99. Spring Horses. The Bedford Division designs and manufactures 14 different styles of spring horses for use by children ages 9 months to six years old. The Company manufactures the body of the horse, paints it to a specific style and packages it with a metal frame manufactured by the Company. Trampolines. The Bedford Division designs, manufactures and imports three different styles of trampolines primarily for use by children. This relatively new product line was enhanced during 1997 by the acquisition of Bollinger Industries, Inc.'s trampoline business. Gym Accessories, OEM and Other. The Bedford Division designs, manufactures, sources and sells a broad line of accessories that complement its outdoor gym sets and wood gym kits. Accessories include swing seats, climbing ropes, ladders and nets. Many of the Company's outdoor gym sets may be customized with various accessories sold both in connection with the initial purchase of an outdoor gym set and as upgrades or replacement parts for the Company's large base of installed units. The Company is currently offering over 65 individual accessory items. In addition, the Company has undertaken efforts to identify new products that the Bedford Division can manufacture during the May through November period when its manufacturing capacity historically has been underutilized. During the second half of 1997, the Company began producing one such product, "Turbo Hoops," which is a home version of the popular basketball game found in taverns and other commercial establishments. In addition, the Company is seeking opportunities to utilize seasonal excess capacity at the Bedford Division to manufacture products for OEMs. Sales to OEM customers will better enable it to cost-effectively maintain a core of full- time, highly skilled workers and a high level of plant utilization year-round, resulting in a consistent source of revenue and profitability for the Bedford Division. For fiscal years 1998, 1997 and 1996, the Bedford Division accounted for 36.1%, 33.1% and 65.7%, respectively, of the Company's net sales. Ashland Division The Ashland Division produces a wide variety of children's playballs ranging in size from 4" to 36" in diameter, including both premium playballs and non-premium playballs. Premium Playballs. The Company's premium playballs generally include stylized printing on all or one-half of the ball's surface or contain fun novelty items inside the ball. The premium playballs that are decorated with stylized printing feature either popular characters from the Company's extensive license portfolio or the Company's proprietary playball patterns. The Company's proprietary playball patterns include holograms, sparkles and other geometric patterns. In addition to playballs with stylized printing, the Company produces a line of "goofballs" that contain items inside the ball such as plastic spiders, worms and beads. The Company's premium playballs generally sell at retail prices between $1.99 and $8.99. Non-Premium Playballs. The Company's non-premium playballs include decorated playballs with stripes or other simple patterns, undecorated playballs and athletic-style playballs such as footballs, basketballs, baseballs, volleyballs and soccer balls. Non-premium playballs are available in a wide range of colors and sizes. This product line experienced significant growth over the last two years from the introduction of an 18" diameter playball, a new size in the playball category. The Company's non-premium playballs generally sell at retail prices between $1.99 and $24.99. Ball Pits. In fiscal 1995, the Company developed and introduced home and backyard versions of the popular ball pits used by children in commercial locations such as McDonald's. The Company sells its ball pit product as a complete, ready-to-assemble set including an inflatable tent-like enclosure and 250 to 400 ball pit balls. The Company sources the enclosures from several overseas manufacturers and packages the enclosures with ball pit balls manufactured at the Ashland Division. Management believes that one of the Company's competitive advantages in this product category is its ability to manufacture high-quality ball pit balls using a patented process for which the Company has an exclusive licensing agreement. Hedstrom currently offers four ball pit models. OEM and Other. The Ashland Division complements its core playball and ball pit businesses and smoothes seasonal production requirements by manufacturing a variety of custom-fabricated plastic products for toy, sporting goods, hospital supply, decorating and lighting companies. Sales to OEM customers enable the Ashland Division to cost-effectively maintain a core of full- time, highly skilled workers and result in a high level of plant utilization year-round while providing a consistent source of revenue and profitability. For fiscal years 1998, 1997 and 1996, the Ashland Division accounted for 12.9%, 14.3% and 34.3%, respectively, of the Company's net sales. Montreal Division The Montreal Division manufactures and markets over 700 children's leisure and activity products, including arts and crafts kits, game tables, battery operated ride-ons and a line of back-to- school/stationery products marketed under the Impact brand name. The Montreal Division's arts and crafts kits and Impact back-to- school stationery products, over 700 products combined, are being repostioned under one new brand, Express Ways!, to take advantage of the synergy between the two categories within the trade and the consumer and provide a stronger competitive advantage. The Montreal Division's game tables and battery operated ride-ons are being repositioned under the Hedstrom brand name to take advantage of that brand's established identity of leadership in bulk toys. Arts and crafts products include a broad variety of children's activity kits, chests and boxes that include stickers, stamps, candles, paints, clay, beads, sand art and magic sets. Back-to- school and stationery products utilize characters popular with children such as Star Wars characters, Pooh and Barbie. Game tables combine a wide variety of popular table games such as pool, table tennis, knock hockey, foosball and basketball, into a single game table. For example, the 5-in-1 game table includes pool, table tennis, knock hockey, shuffleboard and curling. The 10- in-1 game table includes each of those games plus foosball, arcade and floor basketball, English pub darts and racquetball. Battery-operated ride-ons utilize 6-volt or 12-volt battery power to motorize child-size versions of adult vehicles. Designed for 3 to 7 year old children, these vehicles reach speeds of 2.5 to 4.5 miles per hour. The Montreal Division was acquired in June of 1997 in connection with the ERO Acquisition. For fiscal years 1998 and 1997, the Montreal Division accounted for 20.3% and 25.3% of the Company's net sales, respectively. ERO Division ERO's product offerings consist of its Slumber Shoppe line of products, its water sports line of products and its Priss Prints line of products. The Slumber Shoppe line of products includes indoor sleeping bags, carrying cases, play tents and selected children's furniture, all of which feature popular licensed characters and are marketed for children between the ages of two and ten. The core product within this line is the slumber bag, a lightweight indoor sleeping bag used for slumber parties, sleepovers and children's nap times. Play tents (also called slumber tents and play houses) are designed to be used indoors and give children a private area that can be used as a clubhouse, fort or special play area. ERO also sells foam and bean bag chairs featuring licensed characters. The water sports line of products includes a full range of personal flotation devices (such as flotation vests) and swim and pool products (including masks, fins, snorkels and goggles). These products are directed at the children's market using the Company's license portfolio, and at the children's and adults' markets under the Coral brand name. Priss Prints sells self-adhesive wall decorations for children's rooms that can be removed without any damage to the wall or paint. Such wall decorations use licensed characters and proprietary designs. For 1998, such licensed characters included Looney Tunes, Barbie(TM), Pooh, Mickey for Kids and other popular characters. New product offerings include licensed character borders, night-lights, switchplates, hooks and drawer knobs. The ERO Division was acquired in June of 1997 in connection with the ERO acquisition. For fiscal years 1998 and 1997, the ERO Division accounted for 24.3% and 23.6% of the Company's net sales, respectively. International Division The International Division, located in the United Kingdom and Canada, produces and distributes gym sets and other products manufactured by all of Holdings' Domestic Divisions. For the fiscal years 1998 and 1997, the International Division accounted for 6.4% and 3.6% of the Company's net sales, respectively. Sales by the International Division were insignificant prior to 1997 and were included within the Ashland and Bedford Divisions' net sales. Sales and Marketing The Company's sales force for the Bedford, Ashland and ERO Divisions is comprised of a Senior Vice President, four sales managers of national accounts, one sales manager of home centers and one international sales manager who deal directly with customers and outside vendor representatives. These outside vendor representatives include approximately 22 manufacturers representative organizations with over 100 sales representatives that service Hedstrom's mass merchant and home center customers. The Company's sales force for the Montreal Division is comprised of several in-house sales managers and three outside vendor representatives. Hedstrom's marketing activities include customer service, product development and advertising and promotions. The Company utilizes six customer service representatives to serve retail customers by tracking and confirming orders and answering general inquiries. Hedstrom's consumer relations department is staffed with trained professionals who, through an "800" number, assist end-users in assembling products and purchasing spare parts. Hedstrom's product development staff consists of engineering and design professionals. The product development process involves extensive product engineering, model making and sample testing. An important element in the Company's marketing strategy is the ability to differentiate its products from those of its competitors and stimulate sales by using popular licensed characters and well- known brand names on its products. Accordingly, the Company emphasizes the acquisition and maintenance of a broad portfolio of licensed characters. Rather than pursuing a few licensed characters with speculative appeal, the Company maintains multiple licenses in several categories, including both classic (e.g., Mickey's Stuff for Kids, Barbie(TM), Pooh and 101 Dalmatians) and contemporary characters. The Company's license agreements typically have a term of two years and require payments by the Company of approximately 12-16% of licensed product revenues. The renewal terms of certain license agreements are based upon the attainment of specified sales levels, whereas others are based on informal understandings or arrangements. License agreements typically are subject to termination by the licensor upon failure of the licensee to meet various performance standards. Under the terms of certain of its license agreements, the Company is required to pay minimum guaranteed fees to the licensors over the life of the agreement or on a prepaid basis. The guaranteed license fees payable by the Company have been insignificant due to the Company's having exceeded its minimum royalty requirements. Approximately 25% of the Company's net sales for the fiscal year ended December 31, 1998 were derived from sales of licensed products. Approximately 89% of such net sales were attributable to licenses covering ten licensed characters and approximately 54% of such net sales were derived from licenses with Disney Enterprises, Inc. and its affiliates. Approximately 29% of the Company's Pro Forma Net Sales for the fiscal year ended December 31, 1997 were derived from sales of licensed products. Approximately 91% of such net sales would have been attributable to licenses covering ten licensed characters and approximately 65% of such net sales would have been derived from licenses with Disney Enterprises, Inc. and its affiliates. The ERO Division derives a significant portion of its revenues from sales of products featuring licensed characters. Although the ERO Division intends to renew key existing licenses and obtain new licenses, there can be no assurance that it will be able to do so. The failure to renew key existing licenses or obtain new licenses would have a material adverse effect on the Company's results of operations. International The Company's sales to customers located outside the United States totaled $45.7 million, $30.8 million and $12.6 million, for the fiscal years ended December 31, 1998, December 31, 1997 and for the fiscal year ended July 31, 1996, respectively. Competition The Company generally operates in a highly-competitive environment. Competition in the markets for the Company's products is based primarily on cost, characters licensed (for licensed character products), product design and quality, reputation, customer service, new product innovation and creative marketing and distribution approaches. Competitive factors in the market for character licenses include royalty levels, breadth of product lines, timely royalty reporting and payment, artistic applications and compliance with licensors' guidelines. Bedford Division. Management believes that the Company's sales of outdoor gym sets for the fiscal year ended December 31, 1998, represented approximately 98% of the total sales in the U.S. market for outdoor painted metal gym sets and composite metal and plastic gym sets. The Company's principal competitor in this product line is RDM, Inc., formerly known as Roadmaster Corporation, which was purchased out of bankruptcy in late 1997. Certain custom gym set manufacturers also compete in this market. Management believes that the Company holds the second largest share of the total U.S. wood gym kit market behind Playcor Corporation (formerly known as Swing- N-Slide Corporation). Ashland Division. Based on the Company's sales of playballs for the fiscal year ended December 31, 1998, management estimates that the Company accounted for approximately 85% of total sales in the U.S. market for children's playballs. The Company's largest competitor in this product line is National Latex Corporation. Montreal Division. In the arts and crafts and back-to- school/stationery product categories, the Company competes with Hallmark Corporation's Binney & Smith unit (under the Crayola brand name), Rose Art, Lisa Frank, NSI, Creativity for Kids, Stuart Hall and Mead Corporation. In the game table category, the Company competes with Toy Biz, Sportscraft and Monneret. Competition in the battery-operated ride-on category includes Fisher Price ( a subsidiary of Mattel) and Peg Perego. ERO Division. The Company's main competitors with respect to its Slumber Shoppe product line are Bibb and Coleman, which produces non-licensed slumber bags, and Fisher Price which produces non- licensed slumber tents. Management believes that the Company has a market share of greater than 75% with respect to licensed sleeping bags and slumber tents. With respect to its water sports product line, the Company's competitors include Sterns, Kent and Aqua Leisure. The Company competes primarily against Borden, Infantino, Dolly and 3M in the overall room decor industry. Management believes that the Company is a market leader in this business. International Division. Management believes that the Company is the leading marketer for outdoor childrens toys within the United Kingdom with its major competitors being Kettler in Germany and AMCA in France. Additionally, management believes that the Company is the leading provider of gym sets in Canada. The Company's main competitors in Canada are Flexible Flyer, Jump King and Grand Toys. Manufacturing and Supply; Raw Materials Bedford Division Production Process. The Bedford Division's main production, warehousing and distribution facilities are located in Bedford, Pennsylvania. The manufacturing process for the Company's outdoor gym sets and accessories consists of eight integrated operations: steel tube-forming, metal stamping, secondary fabrication, painting, plastic forming, plastic coating, assembly and packaging. Steel tubes are used primarily for the main structural supports of the Company's gym sets. The Bedford Division can produce up to 8,000 gym sets per day depending on the type of outdoor gym sets then in production. Backyard Products production, warehousing and distribution facilities are located in a 120,000 square foot facility in Collingwood, Ontario. The manufacturing process for the company's outdoor gym sets consists of five integrated operations; wood milling, wood processing, wood staining, assembly and packaging. Backyard Products can produce up to 1,000 wooden gym sets a day depending on the type of gym set in production. Capacity. Management believes that the Bedford Division presently has adequate capacity to meet anticipated future production requirements at times of peak demand. The division also has the capability to outsource or increase capacity in all of its processes in the future should backlog develop. Quality Assurance. The Bedford Division maintains an extensive quality assurance program that includes the development of plans for effective control of manufacturing processes, supplier surveys to assure manufacturing capability and a formal product release system to assure that product goals are achieved. Quality assurance personnel verify that manufacturing employees are correctly performing quality inspections by, among other things, auditing incoming raw materials, manufacturing processes and finished products. All manufacturing employees are trained and provided with the tools necessary to determine whether manufactured parts meet specifications. Employees assemble one unit from each production lot to verify conformance to safety standards. Raw Materials. The primary raw materials used by the Bedford Division include sheet and band steel, wood and plastic resin. Most of the division's steel raw materials (which represented approximately one-third of the Bedford Division's total raw materials purchased in 1998) are currently sourced from a single supplier. The Company typically enters into a one-year supply contract with this supplier each August. These contracts protect the Company from price increases while allowing for downward adjustments if market prices should fall. Management believes that alternative sources of supply are readily available for substantially all of the raw materials used by the Bedford Division, including steel. Components Purchases. Management periodically evaluates the economics of producing internally rather than purchasing certain plastic components used in the production and assembly of its outdoor gym sets. The Company currently is using excess capacity in its Montreal Division plant to produce certain plastic slides and swings for the Bedford Division. Ashland Division Facilities. The Ashland Division's production facilities are located in two facilities in Ashland, Ohio. The main plant houses most of the division's production capacity. It includes a warehouse and distribution center. A second leased facility is used primarily to serve the division's OEM customer base and, to a lesser degree, as a source of increased playball capacity. The second plant also houses the division's administrative offices and showrooms. The Ashland Division also has three satellite facilities strategically located in Carrollton, Texas, Reno, Nevada and Dothan, Alabama. These facilities are used primarily to manufacture undecorated playballs for regional customers and to inflate premium and non- premium playballs that are shipped from Ashland. Production Process. The Ashland Division manufactures its products utilizing two manufacturing processes: (i) rotational molding for polyvinyl playballs and polyethylene plastic OEM products and (ii) blow molding for plastic ball pit balls. All playballs are inflated at Ashland during production to ensure that they meet the Company's quality standards, then deflated for storage or shipping. The Company believes its satellite playball plants provide it with a competitive advantage by minimizing the distance that inflated balls must be shipped, and thereby reducing shipping costs. Capacity. Management believes that the Ashland Division has adequate capacity to meet anticipated future production requirements at times of peak demand and has ample space within its existing facilities to expand capacity. Ball Pit License. The Company has entered into a year-to-year licensing agreement with Euro-Matic, Ltd. ("Euro-Matic"), a United Kingdom-based company that holds the patent for the ball pit balls that the Company produces. Using machinery and molds supplied by Euro-Matic, the Company manufactures ball pit balls for sale by Euro-Matic to the "institutional market," including McDonald's, Discovery Zone, hospitals, schools, and similar institutions and businesses. The Company receives a fixed fee for each ball manufactured. In addition, Euro-Matic provides the Company with molds that the Company uses with its own machinery to produce ball pit balls that the Company packages with its ball bit products for sale to the retail market. Quality Assurance. The Ashland Division maintains a rigorous quality control process. The division has three quality assurance personnel who are trained in methods of statistical process control and continuous improvement. Raw Materials. The Ashland Division manufactures its products from commodity raw materials such as plastic resins, pigments and other chemicals that generally are available from numerous sources. The Company has not entered into any supply contracts with any of the Ashland Division's vendors. Management believes that alternate sources of supply are readily available for all of the raw materials used by the Ashland Division. Montreal Division The Montreal Division's production facilities are located in Montreal, Quebec. The Division also owns a facility in Plattsburgh, New York which is used to distribute products in the United States. The Montreal Division manufactures all of its plastic components and crayons, mixes its own paint and prints all labels, cartons, coloring books, stickers and instruction sheets. All of the Montreal Division's products are manufactured with non-toxic materials to comply with industry standards for children's products and applicable environmental laws. ERO Division The ERO Division produces or assembles slumber bags, personal flotation devices, juvenile furniture and children's wall decoration products at the ERO Division's Hazlehurst, Georgia facility. To reduce lead times and inventory levels with respect to these product lines, the ERO Division utilizes just-in-time manufacturing and sourcing systems. The ERO Division purchases its play tents, slumber mates, swim, aqua fitness, back-to-school and wall decoration products from manufacturers located in the United States, Taiwan, Hong Kong and the People's Republic of China. The ERO Division's pricing and supply of imported products has not been affected by the recent economic problems in Asia. The ERO Division's largest suppliers for its domestic operations provide printed fabric for the slumber bags, liners for the slumber bags, vinyl prints for room decorations, polyester fiber to fill the slumber bags and zippers and buckles. The ERO Division works closely with its suppliers in order to consolidate the purchasing function and to foster teamwork between the ERO Division and its suppliers. For each of the aforementioned products, the ERO Division maintains alternative sources of supply. International Division The Company leases and operates a production facility in Holyhead, United Kingdom. The facility is used to manufacture various gym set lines. The International Division produces gym sets in a similar fashion as those at the Bedford Division with its primary raw materials being sheet and band steel. Products other than metal gym sets are primarily sourced from the Company's other divisions. Backlog The Company monitors the inventory level of each of its key customers, which allows the Company to anticipate customer orders and fill such orders within days. As a result of such monitoring and the Company's just-in-time manufacturing of several of its principal products, the Company does not generate significant backlog. Seasonality Historically, the Company's sales have been highly seasonal, with its peak selling season occurring during the first two calendar quarters of the year. However, management believes the ERO acquisition has helped the Company to better balance its sales throughout the year because the ERO and Montreal Division's peak selling season occurs during the third and fourth calendar quarters of the year. Net sales for the Company for each calendar quarter during the fiscal year ended December 31, 1998 were 26.0%, 27.6%, 21.3% and 25.1%, respectively, of total net sales for the twelve month period. Pro Forma Net Sales for the Company for each calendar quarter during the fiscal year ended December 31, 1997 were 22.7%, 25.6%, 20.9% and 30.8%, respectively, of total Pro Forma Net Sales for such twelve-month period. Environmental Certain of the Company's operations, including the use of solvents, paints and other materials that contain chemicals that are considered hazardous under various environmental laws, are subject to federal, state, local and foreign environmental laws and regulations which govern, among other things, the discharge of pollutants into the air and water, and the handling and disposal of solid and hazardous wastes. Permits are required for certain of the Company's operations, and these permits are subject to modification, renewal and revocation by issuing authorities. Governmental authorities have the power to enforce compliance with applicable laws and regulations, and violations may result in fines, injunctions, including the cessation of operations, or both. Management believes that the Company's operations currently comply in all material respects with applicable environmental laws and regulations. Under the Clean Air Act Amendments of 1990 (the "CAA"), the Environmental Protection Agency has been directed, among other things, to develop standards and permit procedures with respect to certain air pollutants. Because many of the implementing regulations have not yet been promulgated, the Company cannot make a final assessment of the impact of the CAA. Based upon its preliminary review of the CAA, however, management currently believes that compliance with the CAA and other environmental laws and regulations will not have a material adverse effect on the Company. Government Regulations The Company is subject to the provisions of, among other laws, the Federal Hazardous Substances Act and the Federal Consumer Product Safety Act. These laws empower the Consumer Product Safety Commission (the "CPSC") to protect consumers from hazardous products and other articles. The CPSC has the authority to exclude from the market products which are found to be unsafe or hazardous and can require a manufacturer to recall such products under certain circumstances. Similar laws exist in some states and cities in the United States and in Canada and Europe. While the Company believes that it is, and will continue to be, in compliance in all material respects with applicable laws, rules and regulations, there can be no assurance that the Company's products will not be found to violate such laws, rules and regulations, or that more restrictive laws, rules or regulations will not be adopted in the future which could make compliance more difficult or expensive or otherwise have a material adverse effect on the Company's business, financial condition and results of operations. Employees As of December 31, 1998, the Company employed 2,234 people. Approximately 10% of the Company's employees are unionized, all of whom are employed in the Ashland Division. These employees are represented by the Rubber Workers Union, which is affiliated with the United States Steel Workers Union. Members of the Rubber Workers Union in Ashland, Ohio ceased production at the Ashland Division Plant on October 3, 1998. The work stoppage at the Ashland facility was resolved on October 10, 1998 when a tentative agreement was reached. The new collective bargaining agreement was ratified by the rank and file on October 12, 1998 and will expire on October 2, 2001. The work stoppage did not have a material effect on the Company's operations or its ability to service its customers on a timely basis. The Company believes that it has a good relationship with its employees. Item 2. Properties Management believes that the Company's facilities are in good condition and that it has sufficient capacity to meet its current and projected manufacturing and distribution needs. The Company's principal executive offices are located at 585 Slawin Court, Mount Prospect, Illinois 60056. The following table summarizes certain information regarding the Company's principal operating facilities all of which are owned by the Company or one of its subsidiaries. Approximate Square Location Footage Description of Use ------------------- ------------ --------------------- Saint Laurent, Quebec 800,000 Montreal Division sales, administration, manufacturing and distribution Bedford, Pennsylvania 472,000 Bedford Division manufacturing, warehouse and administration Ashland, Ohio 273,000 Ashland Division manufacturing, warehouse and administration Hazlehurst, Georgia 230,000 ERO Division manufacturing and distribution Plattsburgh, New York 80,000 Montreal Division manufacturing and distribution Leased Facilities The Company also leases various facilities in the U.S., Canada and United Kingdom. Such facilities range in size from 120,000 square feet in Collingwood, Ontario to 1,400 square feet in the United Kingdom. Item 3. Legal Proceedings The Company is from time to time involved in lawsuits arising in the ordinary course of business. The Company maintains product liability insurance and management does not believe that the outcome of any such lawsuits, individually or in the aggregate, will have a material adverse effect on the Company's financial condition. Although historically the Company has not been required to pay any material liability claims, there can be no assurance that the Company will not incur claims which are in excess or outside of its insurance coverage. Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted during the fourth quarter of the year ended December 31, 1998. PART II Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters There is no established public trading market for the Company's common stock. As of March 30, 1999, there were 61 record holders of Holdings common stock and 1 record holder of Holdings' non-voting common stock. The terms of the Company's indebtedness impose significant restrictions on the Company's ability to make dividend payments (see further discussion of such in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations", and Note 6 to the Company's consolidated financial statements in Item 8). The Company has not paid cash dividends historically, and does not intend to do so in the foreseeable future. Item 6. Selected Financial Data The following information should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements of Holdings and the notes thereto contained elsewhere herein. Holdings historically had a fiscal year ending July 31 but changed its fiscal year to December 31, effective in 1997. Fiscal Year Fiscal Year Five Months Ended Ended Ended December 31, December 31, December 31, Fiscal Year Ended July 31, (Dollars in thousands, except per 1998 1997 1996 1995 1996 1995 1994 share amounts) ------------ ---------- ---- ---- ---- ---- ---- (unaudited) Income Statement Data: Net sales ......................... $301,696 $256,146 $23,994 $31,792 $133,194 $133,862 $108,655 Cost of sales ..................... 210,607 172,390 21,973 26,000 105,068 107,312 87,170 -------- -------- ------- ------- ------- ------- ------- Gross profit ...................... 91,089 83,756 2,021 5,792 28,126 26,550 21,485 Selling, general and administrative Expenses ......................... 66,917 47,052 7,546 7,067 24,603 19,207 18,181 -------- -------- ------- ------- ------- ------- ------- Operating income (loss)............ 24,172 36,704 (5,525) (1,275) 3,523 7,343 3,304 Recapitalization expenses(a) _ _ _ 9,600 9,600 _ _ Interest expense .................. 31,335 19,131 2,115 1,773 5,896 4,573 2,982 -------- -------- ------- ------- ------- ------- ------- Income (loss) before income taxes.. (7,163) 17,573 (7,640) (12,648) (11,973) 2,770 322 Income tax expense (benefit)....... (436) 7,997 (2,869) (4,074) (3,857) 1,440 103 -------- -------- ------- ------- ------- ------- ------- Income (loss) from continuing Operations ....................... (6,727) 9,576 (4,771) (8,574) (8,116) 1,330 219 Loss from discontinued operations(b) .................... _ _ _ _ _ (585) (3,180) -------- -------- ------- ------- ------- ------- ------- Net income (loss) ................. $ (6,727) $ 9,576 $(4,771) $(8,574) $(8,116) $ 745 $ (2,961) ======== ======== ======= ======= ======= ======= ======= Diluted earnings per share (c) ($0.10) $0.18 Diluted weighted average shares Outstanding(c) .................... 67,663 52,416 Other Financial Data: Net cash provided by (used in): Operating activities $7,414 $(9,779) $2,978 $(19,209) $(17,744) $ 396 $1,344 Investing activities (34,713) (146,387) (1,309) (1,342) (6,490) (2,574) (2,988) Financing activities 20,789 165,622 (9,134) 19,842 31,135 2,899 1,060 EBITDA(d) .......................... 36,717 45,772 (3,549) (393) 9,420 10,088 5,529 Depreciation and amortization(e) 12,545 9,068 1,976 882 3,347 2,745 2,225 Capital expenditures ............... 11,292 6,395 1,376 1,342 6,738 2,574 2,988 Balance Sheet Data (end of period): Total assets ....................... $395,767 $387,539 $72,075 $70,459 $85,024 $69,809 $60,005 Total debt (including current maturities) ...................... 313,489 289,404 60,471 57,750 69,706 32,710 29,811 Stockholders' equity (deficit) 38,599 47,164 (3,097) 2,055 1,674 15,392 14,647 __________ (a) In connection with the 1995 Recapitalization, Holdings incurred approximately $9.6 million in costs, all of which were expensed. (b) During fiscal 1995, Holdings discontinued the operations of its Hedstrom Holdings II subsidiary. Hedstrom Holdings II was involved in the manufacturing of traffic control devices. The sole customer of Hedstrom Holdings II was a related party with which Holdings no longer has an ongoing relationship. (c) Due to the ERO acquisition, net income (loss) per share for the five months ended December 31, 1996 and 1995 and for the three fiscal years ended July 31, 1996 has no significant relevance to current amounts. (d) EBITDA represents operating income plus depreciation and amortization and, for the twelve months ended July 31, 1996, certain other one-time charges aggregating $2.55 million, as follows: (i) $0.8 million related to a one-time design adjustment to one of Hedstrom's outdoor gym set accessories to address certain alleged defects, (ii) a non-cash inventory write-down of $0.75 million related to the mix shift in Hedstrom's outdoor gym set product line, and (iii) a $1.0 million non-cash write-off of advertising barter credits by Hedstrom in connection with its decision to discontinue its trial advertising campaign. Management believes EBITDA for the twelve months ended July 31, 1996, as adjusted for these one- time charges, provides a more meaningful comparison of historical results. EBITDA as determined by Holdings may not be comparable to the EBITDA measure as reported by other companies. EBITDA is not intended to represent cash flow from operations as defined by GAAP and should not be considered as an indicator of operating performance or an alternative to cash flow or operating income (as measured by GAAP) or as a measure of liquidity. In addition, this measure does not represent funds available for discretionary use. It is included herein to provide additional information with respect to the ability of Holdings to meet its future debt service, capital expenditures and working capital requirements. (e) Depreciation and amortization included herein excludes the amortization of deferred financing costs that is included in interest expense. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion generally relates to the historical consolidated results of operations and financial condition of Holdings and Hedstrom. The comparison between years is naturally affected by the significant impact of the Acquisition of ERO, Inc. The following discussion and analysis should be read in conjunction with the consolidated financial statements of Holdings, and the notes thereto, included elsewhere herein. For purposes of this discussion, references to "Hedstrom", where appropriate, include Holdings and Hedstrom and its subsidiaries (including, with respect to periods after the consummation of the ERO acquisition, ERO and its subsidiaries). General Hedstrom is a leading United States manufacturer and marketer of well-established children's leisure and activity products. Hedstrom has five principal divisions. The Bedford Division principally manufacturers and markets in the United States and Canada painted metal and composite metal and plastic outdoor gym sets, wood gym kits and sets and slides, spring horses, trampolines and gym accessories. The Ashland Division manufactures and markets in the United States a wide variety of children's playballs and ball pit products. The Montreal Division manufactures children's products including arts and craft kits, game tables, battery operated cars and back-to-school products. The ERO Division manufactures and distributes slumber products, water sports products and room decor items. The International Division manufactures and distributes painted metal gym sets and sells other products manufactured by Hedstrom's other divisions. Forward Looking Statements This Form 10-K and future filings by the Company on Form 10-Q and Form 8-K and future oral and written statements by the Company and its management may include, certain forward-looking statements, including (without limitation) statements with respect to anticipated future operating and financial performance, Year 2000 compliance and other similar forecasts and statements of expectation. Words such as "expects", "anticipates", "intends", "plans", "believes", "seeks", "estimates", and "should", and variations of These words and similar expressions, are intended to identify these forward looking statements. Forward-looking statements by the Company and its management are based on estimates, projections, beliefs and assumptions of management and are not guarantees of future performance. The Company disclaims any obligation to update or revise any forward-looking statement based on the occurrence of future events, the receipt of new information, or otherwise. Actual future performance, outcomes and results may differ materially from those expressed in forward-looking statements made by the Company and its management. Fiscal Year Change Hedstrom historically had a fiscal year ending July 31 but changed its fiscal year-end to December 31, effective in 1997. Management implemented this change primarily to improve the accuracy of Hedstrom's annual budgeting process. Hedstrom's retail customers generally do not determine outdoor gym set product placements for the upcoming peak Spring selling season until the preceding Fall. In the past, Hedstrom prepared its budgets without the benefit of knowing what its outdoor gym set placements would be for the upcoming fiscal year. As a result of the change in Hedstrom's fiscal year, Hedstrom has presented financial statements for the five-month period ended December 31, 1996 and for the comparable period in 1995. Management does not believe that a comparison of such periods is meaningful because, given the concentration of Hedstrom's net sales in the first and second calendar quarters, overall changes in production levels in the comparably less active period from August to December can have a significant impact on stated profitability for such period due to the absorption of fixed manufacturing costs. This is especially true when comparing the above-mentioned five-month period in 1996 versus the same five-month period in 1995. In late 1996, management took several steps to increase the daily production capacity of outdoor gym sets in an effort to increase its capacity during peak production periods, thereby reducing inventory levels and related material and warehouse expense. As a result of these efforts, Hedstrom is now able to manufacture gym sets on a just-in-time basis in response to specific customer orders. The move to just-in-time manufacturing in late calendar 1996 precluded the need to begin manufacturing gym sets in 1996 for sale in 1997 and thus, unlike in late 1995, Hedstrom expensed the fixed overhead incurred at its idle outdoor gym set operations. As a result of the switch to just-in-time manufacturing, Hedstrom's operating results were significantly better in the second calendar quarter of 1997 versus the second calendar quarter of 1996 because, among other things, it produced outdoor gym sets in the second calendar quarter of 1997, whereas in the same period of 1996, Hedstrom met consumer demand for outdoor gym sets out of inventory. Net Sales Hedstrom computes net sales by deducting sales allowances, including allowances for returns, volume discounts and promotions (including cooperative advertising), from its gross sales. Where information concerning net sales by product line is provided in this filing, Hedstrom has estimated net sales by attributing sales allowances to each product line in proportion to the individual product line's percentage of gross sales. In 1996, Hedstrom revised certain of its promotional policies, effectively increasing the sales thresholds at which Hedstrom's customers earn certain promotional discounts, which increased Hedstrom's profitability in 1997. Results of Operations The following table sets forth net sales and gross profit for each of Hedstrom's five operating divisions for the periods indicated: Twelve Months Ended December 31, ---------------------- 1998 1997 1996 (In millions) ---- ---- ---- (unaudited) Net sales: Bedford Division ........... $109.0 $ 84.8 $ 82.4 Ashland Division ........... 38.9 36.8 43.0 Montreal Division .......... 61.2 64.8 _ ERO Division ............... 73.4 60.5 _ International Division ..... 19.2 9.2 - ------ ------ ------ Total net sales .... $301.7 $256.1 $125.4 ====== ====== ====== Gross profit: Bedford Division ........... $ 22.3 $ 21.2 $ 13.1 Ashland Division ........... 10.6 9.5 11.2 Montreal Division .......... 21.0 24.0 _ ERO Division ............... 33.5 27.1 _ International Division ..... 3.7 2.0 - ------ ------ ------ Total gross profit.. $ 91.1 $ 83.8 $ 24.3 ====== ====== ====== Fiscal Year Ended December 31, 1998 Compared to Fiscal Year Ended December 31, 1997 Net Sales. Hedstrom's total net sales increased to $301.7 million in the fiscal year ended December 31, 1998 from $256.1 million in fiscal 1997, an increase of $45.6 million. Such increase was attributable to higher sales at the Bedford, International, and Ashland Divisions, and also the inclusion of the ERO and Montreal Divisions for the full year 1998 versus only the last seven months of fiscal 1997. Net sales of the Bedford Division increased by $24.2 million for fiscal 1998 versus fiscal 1997. The increase was attributable primarily to increased sales of trampolines as a result of the acquisition of Bollinger Industries Inc.'s trampoline business, higher sales of metal gym sets as a result of increased market penetration, and increased wood gym sales as a result of the acquisition of Backyard Products Limited (see Note 3 of the Notes to Consolidated Financial Statements). These increases were partially offset by lower sales of spring horses during the year due to inventory reduction efforts by Toys R Us. Additionally, increased sales of preschool products were offset by lower sales of OEM products. The net sales of the International Division for fiscal 1998 increased by $10.0 million as compared to fiscal 1997. The increase can be attributed to the acquisition of certain assets of Bestoy, a U.K. manufacturer, during the first quarter of 1998. The inclusion of the ERO and the Montreal Divisions for the full fiscal year 1998 versus only seven months of fiscal 1997 resulted in increased sales of $9.3 million. Net sales of the Ashland Division increased by $2.1 million versus the prior year mainly as a result of greater demand for children's ball pits, the effects of which were partially offset by lower sales of OEM products. On a pro-forma basis, net sales of the ERO Division decreased approximately 15% mainly as a result of inventory reduction efforts by Toys R Us. On a pro-forma basis, net sales of the Montreal Division decreased approximately 21% due to limited new product offerings related to arts and crafts and game tables and lower sales of Impact products attributable to the Company's elimination of non profitable products during 1998. Gross Profit. As a result of the increase in Hedstrom's total net sales, total gross profit increased to $91.1 million in fiscal 1998 from $83.8 million in fiscal 1997. As a percentage of net sales, gross profit decreased to 30.2% in fiscal 1998 from 32.7% in fiscal 1997. The decrease in total gross profit percentage in fiscal 1998 was due to lower gross margin percentages at the Bedford, and Montreal Divisions, which were partially offset by a higher gross margin percentage at the ERO Division. The gross profit percentage of the Montreal Division decreased to 34.3% for fiscal 1998 from 37.0% for fiscal 1997. The decrease in the Montreal Division's gross profit margin was mainly a result of unfavorable production variances during the first five months of the year, as a result of the seasonal nature of the business, which were not included in the fiscal 1997 results due to the timing of the acquisition by Hedstrom. Additionally, margins were negatively impacted by an unfavorable product sales mix and low margin "close- out" sales of Impact products. The Bedford Division's gross profit percentage decreased from 25.0% in fiscal 1997 to 20.5% in fiscal 1998. The decline in the Bedford Division's gross profit percentage for fiscal 1998 was due mainly to an unfavorable product mix. Sales of trampolines, which carry a lower gross profit percentage, increased as a percentage of total Bedford Division sales, while sales of metal gym sets, which generally carry a higher overall gross margin, decreased as a percentage of total Bedford Division sales. Additionally, gym set margins were negatively impacted by a shift in sales to mass merchants which resulted in lower average selling prices. The ERO Division's gross profit percentage increased to 45.6% for fiscal 1998 versus 44.8% for fiscal 1997. The increase in the ERO Division was due primarily to favorable manufacturing variances, as well as a more favorable product sales mix and more favorable material costs. The Ashland and International Divisions gross margins fluctuated slightly from the prior year as a result of changes in product sales mix. On a pro-forma basis, the gross profit percentage of the ERO Division increased in fiscal 1998 as compared to fiscal 1997 due to more favorable product sales mix and more favorable material costs. On a pro-forma basis, the gross profit percentage of the Montreal Division remained relatively unchanged as favorable material costs were offset by unfavorable production variances related to volume. Selling, General and Administrative Expense. Total selling, general and administrative expenses increased to $66.9 million in fiscal 1998 from $47.1 million in fiscal 1997. Expressed as a percentage of net sales, selling, general and administrative expenses increased to 22.2% in fiscal 1998 from 18.4% in fiscal 1997. The increase was due principally to the inclusion of the ERO and Montreal Divisions for the full year, which experience relatively high selling, general and administrative expenses, and the inclusion of amortization of acquisition-related intangible assets and royalty expenses. In addition, provision for bad debts was increased to cover accounts receivable risk related to Caldor and Service Merchandise. The Company also wrote off approximately $0.7 million of barter credits during fiscal 1998. Interest Expense. For fiscal 1998, interest expense increased by $12.2 million to $31.3 million. The increase in interest expense was a result of higher average debt levels associated with the acquisition-related debt and higher working capital requirements. Income Tax Expense. Holdings' effective income tax rate in 1998 was 6.1% as compared with an effective income tax rate of 45.5% in 1997. The decrease was attributable to the large amount of non- deductible goodwill generated by the ERO acquisition, unbenefitted foreign losses and certain foreign income which will be taxed. Fiscal Year Ended December 31, 1997 Compared to Twelve Months Ended December 31, 1996 A comparison of Hedstrom's results of operations for the fiscal year ended December 31, 1997 with the same period in 1996 is necessarily affected by the impact of the consummation of the ERO Acquisition in June 1997. Due to the inclusion of seven months of operations of the ERO and Montreal Divisions in the fiscal year ended December 31, 1997, management does not believe that comparisons with the same period in 1996 is meaningful. Net Sales. Hedstrom's total net sales increased to $256.1 million in the fiscal year ended December 31, 1997 from $125.4 million in 1996, an increase of $130.7 million. Such increase was attributable to the inclusion of the ERO and Montreal Divisions and an increase in sales at the Bedford Division, offset by a decline in sales at the Ashland Division. Net sales of the Bedford Division increased primarily as a result of (i) the restructuring of several promotional allowances, (ii) increased sales of trampolines due to the business acquired from Bollinger Industries, Inc., (iii) an increase in OEM sales, (iv) new product introductions and (v) the acquisition of M.A. Henry Limited in August of 1997. These increases were partially offset by a decrease resulting from a shift in product mix to lower-priced outdoor gym sets. Net sales of the Ashland Division decreased primarily as a result of a decrease in sales of certain undecorated playballs which decrease was partially offset by the increase in market share of ball pits. On a pro-forma basis, the net sales of the ERO Division increased approximately 12% in 1997 as compared to 1996 due to increased account penetration in the Slumber Shoppe and Priss Prints product lines. On a pro-forma basis, the net sales of the Montreal Division decreased by approximately 4% in 1997 primarily due to a decline in the overall arts and crafts market which decrease was offset by the introduction of its battery-operated car. Gross Profit. As a result of the increase in Hedstrom's total net sales, total gross profit increased to $83.8 million in 1997 from $24.3 million in 1996. As a percentage of net sales, gross profit increased to 32.7% in 1997 from 19.4% in 1996 due in part to the inclusion of the results of the ERO and Montreal Divisions, whose combined gross profit margin of 40.8% is higher than the other divisions of Hedstrom. The Bedford Division's gross profit margin in 1997 increased to 24.4% from 15.9% in 1996, primarily as a result of the benefits of (i) a 1996 Cost Reduction Plan, and (ii) improvements in promotional programs, which benefits were partially offset by a decrease in net sales attributable to sales of lower- priced and lower-margin outdoor gym sets. Gross profit margin in the Ashland Division increased to 26.4% in 1997 from 26.0% in 1996 primarily as a result of an increase in selling prices and the favorable effects of the 1996 Cost Reduction Plan, the effects of which were partially offset by a reduction in production volume. On a pro-forma basis, the gross profit percentage of the ERO Division increased in 1997 as compared to 1996 due to increased production volume and lower material costs. On a pro-forma basis, the gross profit percentage of the Montreal Division decreased in 1997 due primarily to (i) decreased production volume, (ii) the start-up costs of producing a new product, battery-operated cars and (iii) a shift in sales mix from higher-margin arts and crafts products to lower-margin battery-operated cars. Selling, General and Administrative Expenses. Selling, general and administrative expenses increased to $47.1 million in 1997 from $25.1 million in 1996. As a percentage of net sales, selling, general and administrative expenses decreased to 18.4% in 1997 from 20.0% in 1996, due principally to a reduction in warehouse and shipping costs resulting from Hedstrom's implementation of just-in- time manufacturing of outdoor gym sets and the discontinuation of certain print advertising programs. This reduction was partially offset by the inclusion of the ERO and Montreal Divisions relatively high selling, general and administrative expenses, which include the amortization of acquisition-related intangible assets and royalty expense. Interest Expense. Interest expense increased as a result of the incurrence of acquisition-related indebtedness and higher interest rates. Income Tax Expense. Holdings' effective income tax rate in 1997 was 45.5% as compared with an effective income tax rate of 38.1% in 1996. The increase was attributable to the acquisition of ERO, which generated a large amount of non-deductible goodwill and a higher amount of income derived from foreign sources which have a higher effective tax rate than the U.S. sources. Liquidity and Capital Resources of the Company Working Capital and Cash Flows Net cash provided by operating activities was $7.4 million for the fiscal year ended December 31, 1998. The cash provided by operations reflects the seasonal nature of the Company's sales. The ERO and Montreal Division's sales and accounts receivable build during the second half of the year and are liquidated in the first half of the following year. The Bedford, Ashland and International Divisions build sales and accounts receivable during the first half of the year and liquidate during the second half of the year. Net cash used for investing activities was $34.7 million during the fiscal year ended December 31, 1998, including $16.8 million used for the acquisition of Backyard Products Limited (as discussed in Note 3 of the Notes to Consolidated Financial Statements), $11.3 million used for the acquisition of property, plant and equipment, $3.0 million of contingency payments relating to the ERO acquisition (as discussed in Note 3 of the Notes to Consolidated Financial Statements) and $3.6 million used to purchase certain assets from Bestoy, a U.K. manufacturer. Net cash provided by financing activities was $20.8 million, representing net proceeds from an additional $30.0 million of Tranche B Term Loans used to fund the acquisition of Backyard Products Limited and paydown a portion of the Company's outstanding balance of the Company's Revolving Credit Facility. The Company also made $8.0 million of principal payments on the Company's other term loans. Liquidity Interest payments on the Senior Subordinated Notes and interest and principal payments under the Senior Credit Facilities represent significant cash requirements for the Company. The Senior Subordinated Notes require semiannual interest payments of $5.5 million. Borrowings under the Senior Credit Facilities bear interest at floating rates and require interest payments on varying dates depending on the interest rate option selected by the Company. Outstanding borrowings under the Senior Credit Facilities consisted of $130.7 million under the Term Loan Facilities, comprised of $66.5 million of Tranche A Term Loans maturing in 2003 and $64.2 million of Tranche B Term Loans maturing in 2005. The Senior Credit Facilities also include a $70 million Revolving Credit Facility. As of December 31, 1998, a balance of $34.9 million was outstanding under the Revolving Credit Facility. The Term Loan Facilities will require principal repayments in 1999 according to the following schedule: Date Tranche A Term Loans Tranche B Term Loans -------------- -------------------- -------------------- March 31, 1999 $4,000,000 $125,000 June 30, 1999 1,000,000 125,000 September 30, 1999 4,000,000 125,000 December 31, 1999 1,000,000 125,000 The Revolving Credit Facility terminates and all amounts outstanding thereunder mature on the maturity date of the Tranche A Term Loan Facility in 2003. At present, the Discount Notes do not require cash interest payments. Rather, principal will accrete to an aggregate principal amount of $44,612,000 on June 1, 2002. Commencing on such date, Holdings will be required to make semiannual interest payments of $2,676,720. The Company's remaining liquidity demands are for capital expenditures and for working capital needs. The Senior Credit Facilities impose an annual limit of $10.0 million on the Company's capital expenditures and investments (subject in any given year to a roll-over of up to $4.0 million of unused capital expenditure capacity from the previous year). The Senior Credit Facilities impose significant restrictions on the Company's ability to make dividend payments. The Company's primary sources of liquidity are cash flows from operations and borrowings under the Revolving Credit Facility. As of December 31, 1998, approximately $22.6 million was available to the Company (subject to borrowing base limitations) for borrowings under the Revolving Credit Facility. Management believes that cash generated from operations, together with borrowings under the Revolving Credit Facility, will be sufficient to meet the Company's working capital and capital expenditures needs for the foreseeable future. The Company has established avaluation allowance which fully reserves deferred tax assets associated with the Company's operations in the United Kingdom, which are not assured of realization. However, the Company believes it is more likely than not to realize the remaining net deferred tax asset and accordingly no valuation allowance has been provided. This conclusion is based on, (i) projections (which include the ERO and Montreal Divisions) of sufficient taxable U.S. income to fully realize the net operating loss carryforwards by the end of calendar year 1999, (ii) the tax loss carryforwards included in the net deferred tax asset were generated in very recent periods and do not begin to expire until the years 2011-2018, (iii) the significant excess of book basis over tax basis relative to the net assets of ERO, Inc. and (iv) the carryback of $5,545,000 in net operating loss carryforwards which will result in a 1999 tax refund of $6,745,000. Management continually evaluates the realizability of the net deferred tax assets and the need for a valuation allowance on such assets. Montreal Division In 1997, subsequent to its acquisition by the Company, the Montreal Division experienced a decline in sales of its arts and crafts product line, a new product line experienced initial quality problems and the former owners of the Montreal Division announced they were leaving the Company. These events triggered an assessment of recoverability of the book value of the non-current assets, including goodwill, of the Montreal Division. Results of the assessment indicated there was no impairment of value under Statement of Financial Accounting Standards No. 121 ("SFAS 121") as of December 31, 1997. Management has put in place a new management team, instituted certain cost reduction programs and is actively developing new versions of current products. Management believes these factors will improve the future cash flow and profitability of the Montreal Division. Adoption of Recently Issued Accounting Pronouncements The Financial Accounting Standards Board has issued SFAS No. 133, "Accounting for Derivative and Similar Financial Instruments For Hedging Activities". This pronouncement revises the accounting for derivative financial instruments. It requires entities to recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. The adoption of this statement is required for fiscal years beginning after June 15, 1999. The Company has entered into interest rate swap agreements to hedge exposure to variable interest rate debt. The Company will recognize these derivatives at fair value in its financial statements if these agreements are outstanding as of January 1, 2000. The adoption of this pronouncement is not expected to have a significant impact on the Company's financial position or results of operations. The Financial Accounting Standards Board has issued SFAS No. 134 "Accounting For Mortgage-Backed Securities". SFAS No. 134 will have no effect on the financial condition or results of operations of the Company. Year 2000 Date Conversion The Company relies on a significant number of computer programs and computer technologies (collectively, "IT") and non-IT Systems for its key operations, including product design, finance and various administrative functions. In July of 1997 the Company began an impact assessment of the Year 2000 on its business systems and ability to provide product, information, and services to its business partners before, during and after the Year 2000. As a result of this assessment the Company adopted a two phase plan to attain Year 2000 compliance. Phase I of the Company's Year 2000 compliance plan addresses its mainframe business systems which need to be converted to handle Year 2000 dates. Phase II addresses computer hardware, stand-alone systems, and embedded systems which may need to be upgraded by the end of 1999. Conversion of Phase I data bases and programs was completed in July 1998. The systems testing phase is now in progress and is anticipated to be completed in the first quarter of 1999. The Company plans to install the converted business systems in April 1999. Assessment of all computer hardware, stand-alone systems, communications hardware and software which may require replacement or upgrade by January 2000 is now in progress. The Company has identified all systems which it believes are not Year 2000 compliant. Remediation of these systems will take place throughout 1999. In addition, the Company is evaluating the Year 2000 readiness of its key vendors to ensure that its ability to produce and deliver products is not materially impacted. As this evaluation is completed, the Company will decide what further actions, if any, are appropriate. The Company anticipates that its Year 2000 compliance costs will approximate $1.0 million. The Company believes that it has funds available through its existing credit facilities to address the Year 2000 costs. These costs will include software, hardware and consulting expenses which are being expensed as incurred. The Company believes its current worse case scenario would be the inability of suppliers to deliver key raw materials. The Company is currently devising contingency plans which could among other things include carrying excess stock of key raw materials such as steel at December 31, 1999. While the Company is confident that the Year 2000 issues are manageable and will be dealt with in a timely fashion, this conclusion is forward looking and involves uncertainty and risks. The ultimate result may be impacted by a variety of factors such as, but not limited to, the ability to successfully remediate existing IT systems, the failure to identify problems associated with non-IT systems and problems associated with supplier or customer information systems any of which could have a material adverse effect on the Company's ability to successfully address Year 2000 issues. Item 8. Financial Statements and Supplementary Data REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of Hedstrom Holdings, Inc.: We have audited the accompanying consolidated balance sheets of Hedstrom Holdings, Inc. (a Delaware corporation) and subsidiary as of December 31, 1998 and 1997, and the related consolidated statements of income, stockholders' equity, and cash flows for the two years ended December 31, 1998, the five months ended December 31, 1996, and the fiscal year ended July 31, 1996. These financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Hedstrom Holdings, Inc. and subsidiary as of December 31, 1998 and 1997, and the results of their operations and their cash flows for the two years ended December 31, 1998, the five months ended December 31, 1996, and the fiscal year ended July 31, 1996 in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule appearing on page 52 of this Form 10-K is presented for the purpose of complying with the Securities and Exchange Commission's rules and is not a part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN LLP Dallas, Texas February 5, 1999 HEDSTROM HOLDINGS, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS (In thousands, except share data) December 31, December 31, 1998 1997 ------- ------- ASSETS CURRENT ASSETS: Cash and cash equivalents .......... $ 4,334 $ 10,844 Trade accounts receivable, net of allowance for bad debts of $5,280 and $2,297 ............... 69,522 82,702 Taxes receivable ................... 6,745 - Inventories ........................ 53,722 47,464 Deferred income taxes .............. 6,016 4,379 Prepaid expenses and other current assets .......................... 4,130 4,801 -------- -------- Total current assets ....... 144,469 150,190 -------- -------- PROPERTY, PLANT, AND EQUIPMENT, at cost, net of accumulated depreciation ...... 48,102 42,823 GOODWILL, net of accumulated amortization of $7,341 and $2,384 ................. 186,826 170,941 OTHER ASSETS: Deferred financing fees, net of accumulated amortization of $4,755 and $1,576 ............................... 14,295 17,474 Deferred charges and other, net of accumulated amortization of $2,372 and $1,629 ....................... 500 1,387 Deferred income taxes .............. 1,575 4,724 -------- -------- Total other assets ......... 16,370 23,585 -------- -------- Total assets ............... $395,767 $387,539 ======== ======== HEDSTROM HOLDINGS, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS (In thousands, except share data) December 31, December 31, 1998 1997 ------- ------- LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Revolving line of credit ........... $34,920 $35,500 Current portion of long-term debt .. 11,905 9,222 Accounts payable ................... 20,709 23,381 Accrued expenses - Compensation ..................... 2,958 4,066 Commissions and royalties ........ 5,044 5,365 Acquisition costs ................ 230 6,354 Customer allowances .............. 7,234 7,193 Other ............................ 7,504 4,612 -------- -------- Total current liabilities .. 90,504 95,693 -------- -------- LONG-TERM DEBT Senior Subordinated Notes .......... 110,000 110,000 Senior Discount Notes .............. 26,584 23,288 Term loans ......................... 123,736 104,375 Notes payable to related parties ... 2,500 2,500 Capital leases ..................... 1,690 1,605 Other .............................. 2,154 2,914 -------- -------- Total long-term debt ....... 266,664 244,682 -------- -------- STOCKHOLDERS' EQUITY: Preferred stock, $.01 par value, 10,000,000 shares authorized, no shares issued or outstanding ................ - - Common stock, $.01 par value, 50,000,000 shares authorized, 36,142,883 shares issued and outstanding, respectively ...................... 361 361 Non-voting common stock, $.01 par value, 40,000,000 shares authorized, 31,520,000 shares issued and outstanding 315 315 Additional paid-in capital ......... 51,553 51,553 Accumulated other comprehensive loss . (2,616) (778) Accumulated deficit ................ (11,014) (4,287) -------- -------- Total stockholders' equity 38,599 47,164 -------- -------- Total liabilities and stockholders' equity $395,767 $387,539 ======== ======== The accompanying notes to consolidated financial statements are an integral part of these statements. HEDSTROM HOLDINGS, INC. AND SUBSIDIARY CONSOLIDATED INCOME STATEMENTS (In thousands, except per share amounts) For the For the For the Five For the Fiscal Year Fiscal Year Months Fiscal Year Ended Ended Ended Ended December 31, December 31, December 31, July 31, 1998 1997 1996 1996 ------- ------- ------- ------- NET SALES ....................... $301,696 $256,146 $ 23,994 $133,194 COST OF SALES ................... 210,607 172,390 21,973 105,068 -------- -------- -------- -------- Gross profit ................ 91,089 83,756 2,021 28,126 SELLING, GENERAL, AND ADMINISTRATIVE EXPENSES 66,917 47,052 7,546 24,603 -------- -------- -------- -------- Operating income (loss) ..... 24,172 36,704 (5,525) 3,523 RECAPITALIZATION EXPENSES ....... - - - 9,600 INTEREST EXPENSE ................ 31,335 19,131 2,115 5,896 -------- -------- -------- -------- INCOME (LOSS) BEFORE INCOME TAXES (7,163) 17,573 (7,640) (11,973) INCOME TAX EXPENSE (BENEFIT) .... (436) 7,997 (2,869) (3,857) -------- -------- -------- ------- NET INCOME (LOSS) ............... $ (6,727) $ 9,576 $ (4,771) $(8,116) ======== ======== ======== ======= BASIC NET INCOME PER COMMON SHARE: Net income .................... $ (0.10) $ 0.18 Weighted average shares outstanding 67,663 52,153 DILUTED NET INCOME PER COMMON SHARE AND COMMON SHARE EQUIVALENTS: Net income .................... $ (0.10) $ 0.18 Weighted average shares and common share equivalents outstanding ....... 67,663 52,416 The accompanying notes to consolidated financial statements are an integral part of these statements. HEDSTROM HOLDINGS, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) For the For the For the For the Fiscal Fiscal Five Fiscal Year Year Months Year Ended Ended Ended Ended December 31, December 31, December 31, July 31, 1998 1997 1996 1996 -------- ------- ------- ------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) ....... $ (6,727) $ 9,576 $ (4,771) $ (8,116) Adjustments to reconcile net income (loss) to net cash provided by (used for) operating activities- Depreciation of property, plant and equipment 7,588 5,802 1,626 2,903 Amortization of goodwill and deferred charges 4,957 3,266 350 511 Amortization of deferred financing fees and original issue discount 6,475 3,246 - - Deferred income tax provision (benefit) (4,033) 7,027 (2,862) (3,808) Gain on the disposition of property, plant, and equipment ................. (1) (1) (60) (182) Provision for losses on accounts receivable, net of recoveries ............ 3,183 1,246 64 37 Changes in assets and liabilities Accounts receivable . 9,966 (46,754) 9,734 (892) Taxes receivable .... (6,745) - - - Inventories ......... (4,243) 4,874 (2,042) (139) Prepaid expenses .... 761 298 (119) 6 Accounts payable .... (3,630) 1,709 1,851 (7,906) Accrued expenses .... (137) (68) (793) (158) -------- -------- -------- -------- Net cash provided by (used for) operating activities ................ 7,414 (9,779) 2,978 (17,744) -------- -------- -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Acquisition of ERO, Inc. (3,037) (122,600) - - Acquisition of Backyard Products, Ltd. (16,805) - - - Acquisition of certain assets of Bollinger Industries, Inc. .......... - (14,928) - - Acquisitions of property, plant, and equipment (11,292) (6,395) (1,376) (6,738) Proceeds from the sale of property, plant, and equipment ................. - 8 67 248 Other acquisitions ...... (3,579) (2,472) - - -------- -------- -------- -------- Net cash used for investing activities (34,713) (146,387) (1,309) (6,490) -------- -------- -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Net proceeds from the issuance of Senior Subordinated Notes .... - 110,000 - - Net proceeds from the issuance of new Term Loans 30,000 110,000 - - Net proceeds from the issuance of Senior Discount Notes .................. - 21,618 - - Borrowings on new Revolving Credit Facility, net (580) 35,500 - - Repayments on new term loans (7,956) (1,125) - - Borrowings (repayments) of old term loans, net - (92,767) - 35,000 Debt financing and other transaction costs - (21,000) - - Borrowings (repayments) on old revolving lines of credit, net ............... - (42,400) (9,050) (2,360) Net proceeds from issuance of voting common stock - 3,401 - 27,242 Net proceeds from issuance of non-voting common stock - 40,000 - - Redemption of common stock from existing stockholders - - - (29,772) Redemption of preferred stock from existing stockholders . - - - (3,072) Notes payable to related parties - - - 2,500 Capital lease (payments) borrowings and other (675) 2,395 (84) 1,597 -------- -------- -------- -------- Net cash provided by (used for) financing activities 20,789 165,622 (9,134) 31,135 -------- -------- -------- -------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ............. (6,510) 9,456 (7,465) 6,901 CASH AND CASH EQUIVALENTS: Purchased cash .......... - 855 - - Beginning of year/period 10,844 533 7,998 1,097 -------- -------- -------- -------- End of year/period ...... $ 4,334 $ 10,844 $ 533 $ 7,998 ======== ======== ======== ======== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Income taxes paid ....... $3,733 $ 4,431 $ 45 $ 503 Interest paid ........... $24,897 $ 13,922 $ 1,534 $ 5,036 SUPPLEMENTAL DISCLOSURE OF ASSETS ACQUIRED: See Note 3 The accompanying notes to consolidated financial statements are an integral part of these statements. HEDSTROM HOLDINGS, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (In thousands, except share data) Accumulated Preferred Stock Common Stock Additional Other Paid-In Comprehensive Accumulated Shares Par Value Shares Par Value Capital Loss Deficit Total --------- ------ ---------- ---- ------ ------------ ----------- ------ BALANCE AT JULY 31, 1995 3,005,555 $ 3,006 33,231,090 $ 332 $12,964 $ - $ (910) $ 15,392 Paid-in-kind dividends on preferred stock 66,277 66 - - - (66) - Redemption of common stock from existing stockholders - - (27,531,941) (275) (29,497) - - (29,772) Redemption of preferred stock from existing stockholders (3,071,832) (3,072) - - - - - (3,072) Sale of common stock to new stockholders .. - - 27,242,350 272 26,970 - - 27,242 Net loss ........ - - - - - - (8,116) (8,116) -------- Comprehensive Loss - - - - - - - (8,116) --------- ------- ---------- ----- ------- ------- ------- -------- BALANCE AT JULY 31, 1996 - - 32,941,499 329 10,437 - (9,092) 1,674 Net loss ........ - - - - - - (4,771) (4,771) -------- Comprehensive Loss - - - - - - - (4,771) --------- ------- ---------- ----- ------- ------- ------- -------- BALANCE AT DECEMBER 31, 1996 - - 32,941,499 329 10,437 - (13,863) (3,097) Issuance of voting common stock - - 3,201,384 32 3,369 - - 3,401 Issuance of non-voting common stock ........... - - 31,520,000 315 39,685 - - 40,000 Acquisition transaction costs - - - - (1,938) - - (1,938) Foreign currency translation adjustment - - - - - (778) - (778) Net income ...... - - - - - - 9,576 9,576 -------- Comprehensive Income - - - - - - - 8,798 --------- ------- ---------- ----- ------- ------- ------- -------- BALANCE AT DECEMBER 31, 1997 - - 67,662,883 676 51,553 (778) (4,287) 47,164 Foreign Currency translation Adjustment .... - - - - - (1,838) - (1,838) Net Loss ........ - - - - - - (6,727) (6,727) -------- Comprehensive Loss - - - - - - - (8,565) --------- ------- ---------- ----- ------ ------- -------- -------- BALANCE AT DECEMBER 31, 1998 - $ - 67,662,883 $ 676 $ 51,553 $(2,616) $(11,014) $ 38,599 ========= ======= ========== ===== ======== ======= ======== ======== The accompanying notes to consolidated financial statements are an integral part of these statements. HEDSTROM HOLDINGS, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. NATURE OF OPERATIONS: Hedstrom Holdings, Inc. ("Holdings") is a holding Company with no operations, other than its 100% ownership of Hedstrom Corporation ("Hedstrom", and together with Holdings, the "Company"). The Company is a manufacturer and marketer of well-established children's leisure and activity products. The Company's products fall within five principal divisions: Bedford, Ashland, Montreal, ERO and International. Through its facility in Bedford, Pennsylvania, the Bedford Division manufactures and distributes gym set products consisting of metal gym sets, composite metal and plastic gym sets, wood gym sets, wood gym kits, plastic outdoor slides and gym set accessories. Through its facility in Ashland, Ohio, the Ashland Division manufactures playball products, which consist of premium playballs made of plastic or vinyl and decorated with popular licensed characters or designs, nonpremium playballs that generally have minimal decoration, athletic balls targeted at young children, and ball pit products. Through its facility in Montreal, Canada, the Montreal Division manufactures children's products including arts and crafts kits, game tables, battery operated ride-on vehicles and back-to-school items. Through its facility in Hazlehurst, Georgia, the ERO Division manufactures and distributes slumber products, water sports products and room decorations for children. Through its facility in the United Kingdom and Canada, the International Division produces and distributes gym sets and other products manufactured by its Domestic Divisions. The Company sells its products through major national toy retailers, mass merchants, supermarkets, drug store chains, and home centers primarily in the United States, Canada, and the United Kingdom. The Company employed 2,234 people at December 31, 1998, 10% of which are represented by the Rubber Workers Union. The collective bargaining agreement with the Rubber Workers Union expires on October 2, 2001. Four of the Company's customers (Wal-Mart, Toys R Us, K-Mart and Target) account for over 50% of the Company's sales. As a result, the Company's operations can be significantly impacted by these customers. Although Hedstrom has well-established relationships with these customers, it does not have long term contracts with any of them. A decrease in business from any of these customers could have a material adverse effect on the Company's results of operations and financial condition. During 1998, well-publicized changes in the inventory policies and purchasing practices of Toys R Us, the Company's second largest customer in 1998, and, to a lesser extent, those of the Company's other customers adversely affected the 1998 sales levels of the Company and of the industry generally. As a consequence, the Company's operating income in fiscal 1998 was significantly less than anticipated. Although management does not anticipate similar events in fiscal 1999, there can be no assurance that competitive pressures in the retail sector will not result in continued pressure on the Company's sales and operating income. As a result of the aforementioned competitive pressures, there recently have been a number of consolidations and business failures in the retail sector. As a result, there may be a further concentration of the Company's customer base, as well as an adverse change in the Company's credit exposure. Although management has no reason to believe that there are any significant credit risks associated with any of its key customers, a credit failure by a key customer or a significant number of smaller customers would have a material adverse effect on Hedstrom's results of operations. The ERO Division derives a significant portion of its revenues from sales of products featuring licensed characters. Although the ERO Division intends to renew key existing licenses and obtain new licenses, there can be no assurance that it will be able to do so. The failure to renew key existing licenses or obtain new licenses would have a material adverse effect on the Company's results of operations. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Principles of Consolidation The accompanying consolidated financial statements include the accounts of Hedstrom Holdings, Inc. and its wholly owned subsidiary, Hedstrom Corporation. Effective June 12, 1997, Hedstrom acquired ERO, Inc. ("ERO"), which became a wholly owned subsidiary of Hedstrom (see Note 3). The accompanying consolidated financial statements reflect the operations of ERO since June 1, 1997. Management does not believe that the 1997 over 1996 comparisons are meaningful, given the 1997 acquisition of ERO. All intercompany balances and transactions have been eliminated in consolidation. Fiscal Year Prior to August 1, 1996, the Company's fiscal year ended on July 31. Effective January 1, 1997, the Company changed its fiscal year to a calendar year ending on December 31. The following consolidated financial statements include the twelve month period from January 1, 1996 to December 31, 1996 for comparative purposes only. Consolidated Income Statement For the twelve months ended December 31, 1996 (Unaudited) (In thousands) NET SALES .............................. $125,396 COST OF SALES .......................... 101,041 -------- Gross profit ................. 24,355 SELLING, GENERAL, AND ADMINISTRATIVE EXPENSES ................................ 25,082 ------- Operating loss ................ (727) ------- INTEREST EXPENSE ........................ 6,238 INCOME TAX BENEFIT ...................... (2,652) -------- NET LOSS ................................ $ (4,313) ======== Consolidated Statement of Cash Flows For the twelve months ended December 31, 1996 (Unaudited) (In thousands) CASH FLOWS FROM OPERATING ACTIVITIES: Net loss ............................... $(4,313) Adjustments to reconcile net loss to net cash provided by operating activities Depreciation and amoritization ....... 4,401 Changes in assets and liabilities: Accounts receivable ............... 3,804 Inventories ....................... 4,088 Accounts payable .................. (5) Accrued expenses .................. 1,434 Other ............................. (4,966) ------ Net cash provided by operating activities ............................ 4,443 ------ CASH FLOWS FROM INVESTING ACTIVITIES Acquisitions of property, plant and equipment .................. (6,457) ------ Net cash used for investing activities ........................... (6,457) ------ Net cash provided by financing activities ........................... 2,159 ------ NET INCREASE IN CASH AND CASH CASH EQUIVALENTS ....................... 145 CASH AND CASH EQUIVALENTS: Beginning of period .................. 388 ------- End of period ........................ $ 533 ======= Cash and Cash Equivalents Cash and cash equivalents include short-term investments with original maturities of three months or less. These investments are stated at cost which approximates market. Inventories Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out (FIFO) method. The cost of manufactured products includes materials, direct labor, and an allocation of plant overheads. The cost of purchased products includes inbound freight and duty. Property, Plant, and Equipment Property, plant, and equipment acquired in the normal course of business are stated at cost. Property, plant, and equipment acquired in connection with the acquisitions of ERO and other companies are stated at fair market value as of that date as determined by independent appraisals, where appropriate. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Additions and improvements are capitalized, while expenditures for maintenance and repairs are charged to operations as incurred. The cost and accumulated depreciation of property sold or retired are removed from the respective accounts and the resultant gains or losses, if any, are included in current operations. The estimated useful lives of property, plant, and equipment are as follows: Buildings and improvements ....... 5-40 years Machinery and equipment .......... 3-12 years Computer hardware and software ... 3-5 years Furniture and fixtures ........... 5-10 years Depreciation is allocated to cost of sales and selling, general, and administrative expense based upon the related asset's use. Depreciation of approximately $6,696,000, $5,184,000, $1,576,000 and $2,797,000 is included in cost of sales for the fiscal years ended December 31, 1998, December 31, 1997, for the five months ended December 31, 1996, and for the fiscal year ended July 31, 1996, respectively. Depreciation of approximately $892,000, $618,000, $50,000 and $106,000 is included in selling, general, and administrative expense for the fiscal years ended December 31, 1998, December 31, 1997, for the five months ended December 31, 1996, and for the fiscal year ended July 31, 1996, respectively. Long-lived assets and certain identifiable intangibles, including goodwill, to be held and used by the Company are reviewed for impairment whenever changes in circumstances indicate that the carrying amount of an asset may not be recoverable. In the event that facts and circumstances indicate that the cost of long-lived assets may be impaired, an evaluation of recoverability is performed. If an evaluation is required, the estimated future undiscounted cash flows associated with the asset would be compared to the asset's carrying amount to determine if a write-down to fair value is required. Goodwill Goodwill, representing the excess of the cost over the net tangible and identifiable intangible assets of acquired businesses, is stated at cost and is amortized on a straight-line basis over forty years. Amortization of goodwill of $4,214,000 and $2,384,000 is included in selling, and administrative expense for the fiscal years ended December 31, 1998 and December 31, 1997, respectively. The Company had no Goodwill during fiscal year 1996 or on December 31, 1996. Goodwill is reviewed for impairment in accordance with the policy, as discussed above. Deferred Financing Fees Deferred financing fees, representing costs incurred in connection with obtaining borrowings under long-term debt agreements, are stated at cost and are amortized over the life of the related debt. Amortization of deferred financing fees of $3,179,000 and $1,576,000 is included in interest expense for the fiscal years ended December 31, 1998 and December 31, 1997, respectively. Deferred Charges and Other, Net Deferred charges and other on the accompanying balance sheets is comprised of the following (in thousands): December 31, December 31, 1998 1997 ----------- ----------- Deferred expenses .................... $ 2,872 $ 2,546 Barter credits ....................... - 470 ------- -------- 2,872 3,016 Less-Accumulated amortization ........ (2,372) (1,629) ------- -------- $ 500 $ 1,387 ======= ======== Deferred expenses primarily relate to costs the Company incurs to obtain shelf space, and replace competitors products, at certain of its retail customers. In connection with these transactions, the Company obtains a commitment from the retailer that it will exclusively stock the Company's products for a period not less than three years. As a result, these costs are deferred and amortized over a 36-month period on a straight-line basis. Amortization expense is included in selling, general, and administrative expense on the accompanying income statements and was $743,000, $882,000, $350,000 and $358,000 for the fiscal years ended December 31, 1998, December 31, 1997, for the five months ended December 31, 1996 and for the fiscal year ended July 31, 1996, respectively. Prior to the recapitalization discussed in Note 12, the Company had capitalized certain financing costs and organizational costs. These costs were immediately expensed in connection with the recapitalization and are included in recapitalization expenses on the accompanying July 31, 1996, income statement. The deferred financing costs were being amortized over the period of the underlying debt on a straight-line basis and organizational costs were being amortized over a 60-month period. Prior to the recapitalization, amortization of deferred financing costs was $67,000 in the fiscal year ended July 31, 1996 and is included in interest expense on the accompanying income statements. Amortization of organizational costs prior to the recapitalization was $85,000 in the fiscal year ended July 31, 1996 and is included in selling, general, and administrative expense on the accompanying income statements. During the fiscal year ended July 31, 1995, the Company exchanged certain finished goods inventory with a cost basis of approximately $320,000 for barter credits. Although the barter credits had a stated value of approximately $3,200,000, they were recorded at an amount equal to the cost basis of the inventory exchanged, such that no profit was recognized on the transaction. The barter credits can be used principally for the purchase of print and media advertising; however, cash must be used in addition to the barter credits to secure the advertising. During the fiscal year ended December 31, 1997, the five months ended December 31, 1996 and the fiscal year ended July 31, 1996, the Company utilized approximately $49,000, $262,000 and $262,000, respectively, of these barter credits. As a result of the Company's decision to reduce its advertising expenditures during calendar 1997, management determined that all of its barter credits may not be fully utilized prior to their expiration in August 1998. Therefore, the Company wrote-off an additional $1,000,000 of the barter credits during the fiscal year ended July 31, 1996. During 1998 management assessed the realizable value of the remaining barter credits and determined that it was unlikely that any significant value would be realized. As a result, the Company wrote-off the remaining barter credits totaling $747,000. Revenue Recognition The Company recognizes revenue when title to the goods transfers. For the majority of the Company's sales, this occurs at the time of shipment. Income Taxes Deferred income taxes are determined under the asset and liability method in accordance with Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes". Deferred income taxes arise from temporary differences between the income tax basis of assets and liabilities and their reported amounts in the financial statements. Net Income (Loss) Per Common Share Basic earnings per share is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed by dividing the net income (loss) by the weighted average number of shares of common stock and other dilutive securities. Excluded from the computation of diluted earnings per share are options to purchase 2.4 million and 1.8 million shares of common stock in 1998 and 1997 respectively. These options were outstanding during these respective years, but were excluded because the option exercise price was greater than the average market price of the common shares. Due to the ERO acquisition, described in Note 3, net income (loss) per share for the five months ended December 31, 1996 and for the fiscal year ended July 31, 1996 have no significant relevance to current amounts. Fair Value of Financial Instruments The carrying amount reported in the consolidated balance sheets for cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses approximates fair value because of the immediate or short-term maturity of these financial instruments. The carrying amount reported for long-term debt approximates fair market value because the underlying instruments are at rates similar to current rates offered to the Company for debt with the same remaining maturities. Foreign Currency Translation The financial position and results of operations of the Company's foreign subsidiaries are measured using each subsidiary's local currency as the functional currency. Assets and liabilities of the foreign subsidiaries are translated to U.S. dollars using exchange rates in effect at balance sheet dates. Income and expense items are translated at monthly average rates of exchange. The resultant translation gains or losses are included as a component of accumulated other comprehensive loss in stockholders' equity and designated as a foreign currency translation adjustment. Transaction gains or losses were not significant in any year. Stock-Based Compensation Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (SFAS 123), encourages, but does not require companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company's stock at the date of the grant over the amount the employee must pay to acquire the stock. See Note 9. Reclassifications Certain 1997 and 1996 amounts have been reclassified to conform with their current year presentation. Use of Estimates The preparation of financial statements in conformity 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 for the reporting period. Actual results could differ from those estimates. Recent Accounting Pronouncements Holdings has adopted SFAS No. 130, "Reporting Comprehensive Income," effective January 1, 1998. SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. Comprehensive income is defined as the total of net income and all other non-owner changes in equity. The accompanying Consolidated Statement of Stockholders' Equity has been restated to disclose comprehensive income for each year presented. Holdings has adopted SFAS No. 131, "Disclosure about Segments of An Enterprise and Related Information." This pronouncement changes the requirements under which public businesses must report segment information. The objective of the pronouncement is to provide information about a company's different types of business activities and different economic environments. SFAS No. 131 requires companies to select segments based on their internal reporting system. Restatement of prior year segment disclosure was required upon adoption of SFAS No. 131. See Note 13. Holdings has adopted SFAS No. 132, "Employees' Disclosures about Pension and Other Postretirement Benefits", as of January 1, 1998. This pronouncement revises employers' disclosures about pension and other postretirement benefit plans. It does not change the measurement or recognition of those plans, however, it does require additional information on changes in the benefit obligations and fair values of plan assets in order to facilitate financial analysis. The Company has revised its disclosures accordingly. See Note 8. The Financial Accounting Standards Board has issued SFAS No. 133, "Accounting for Derivative and Similar Financial Instruments For Hedging Activities". This pronouncement revises the accounting for derivative financial instruments. It requires entities to recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. The adoption of this statement is required for fiscal years beginning after June 15, 1999. The Company has entered into interest rate swap agreements to hedge exposure to variable interest rate debt. The Company will recognize these derivatives at fair value in its financial statements if these agreements are outstanding as of January 1, 2000. The adoption of this pronouncement is not expected to have a significant impact on the Company's financial position or results of operations. The Financial Accounting Standards Board has issued SFAS No. 134 "Accounting For Mortgage-Backed Securities". SFAS No. 134 will have no effect on the disclosures, financial condition or results of operations of the Company. 3. ACQUISITIONS: On April 10, 1997, Hedstrom and HC Acquisition Corp., a wholly owned subsidiary of Hedstrom, entered into an Agreement and Plan of Merger (the "Merger Agreement") with ERO to acquire ERO for a total enterprise value of approximately $200 million. Pursuant to the Merger Agreement, HC Acquisition Corp. commenced and, on June 12, 1997, consummated a tender offer for all of the outstanding shares of the common stock of ERO at a purchase price of $11.25 per share (the "Tender Offer"). Holdings also assumed a purchase price contingency related to ERO, Inc.'s acquisition of the Montreal Division in October of 1995. The contingency included an additional $3.7 million of purchase price contingent upon achievement of certain conditions. As those conditions were met as of December 31, 1997, Holdings accrued a liability for the contingency against goodwill. This was reflected in accrued expenses-acquisition costs in the consolidated balance sheet. The payment was made in March 1998. Upon consummation of the Tender Offer, (i) HC Acquisition Corp. was merged with and into ERO (the "Merger") with ERO surviving the Merger as a wholly owned subsidiary of Hedstrom, (ii) certain of ERO's outstanding indebtedness was refinanced by Hedstrom (the "ERO Refinancing") and (ii) Hedstrom refinanced (the "Hedstrom Refinancing") its existing revolving credit facility and term loan facility (the Merger, the Tender Offer, the ERO Refinancing and the Hedstrom Refinancing, are collectively referred to herein as the "Acquisition"). Holdings and Hedstrom required approximately $301.1 million in cash to consummate the Acquisition, including approximately (i) $122.6 million paid in connection with the Tender Offer and the Merger, (ii) $82.6 million paid in connection with the ERO Refinancing, (iii) $74.9 million paid in connection with the Hedstrom Refinancing and (iv) $21.0 million incurred in respect of fees and expenses. The funds required to consummate the Acquisition were provided by (i) $75.0 million of term loans under a new six- year senior secured term loan facility (the "Tranche A Term Loan Facility"), (ii) $35.0 million of term loans under a new eight-year senior secured term loan facility (on July 24, 1998 the Tranche B Term Loan was increased to $65.0 million to allow for the acquisition of Backyard Products Limited, see further discussion below) (the "Tranche B Term Loan Facility" and, together with the Tranche A Term Loan Facility, the "Term Loan Facilities"), (iii) $16.1 million of borrowings under a new $70.0 million senior secured revolving credit facility (the "Revolving Credit Facility" and, together with the Term Loan Facilities, the "Senior Credit Facilities"), (iv) $110.0 million of gross proceeds from the offering by Hedstrom of 10% Senior Subordinated Notes Due 2007 (the "Senior Subordinated Notes"), (v) $25.0 million of gross proceeds from the offering by Holdings of 44,612 units consisting of 12% Senior Discount Notes Due 2009 (the "Discount Notes") and 2,705,896 shares of Common Stock, $.01 par value per share, of Holdings ("Holdings Common Stock") and (vi) $40.0 million of gross proceeds from the private placement of 31,520,000 shares of Non-Voting Common Stock, $.01 par value per share, of Holdings ("Holdings Non- Voting Common Stock") and 480,000 shares of Holdings Common Stock. The Revolving Credit Facility is also used to finance certain seasonal working capital requirements. The acquisition of ERO has been accounted for under the purchase method of accounting, and accordingly, the purchase price has been allocated to the assets acquired and the liabilities assumed based upon fair value at the date of the acquisition of ERO. The excess of the purchase price over the fair values of the tangible net assets acquired was approximately $159.8 million, has been recorded as goodwill and is being amortized on a straight-line basis over 40 years. In the event that facts and circumstances indicate that the goodwill may be impaired, an evaluation of recoverability would be performed. If an evaluation is required, the estimated future undiscounted cash flows associated with the asset would be compared to the assets carrying amount to determine if an adjustment is required. The fair value of assets acquired and liabilities assumed, reflecting the final allocation, was as follows (in thousands): Current assets .............. $ 53,500 Net property,plant and equipment................... 20,000 Other assets ................ 9,400 Goodwill .................... 159,800 Liabilities assumed ......... (120,100) --------- Cash paid for ERO........ $ 122,600 ========= In 1997, subsequent to the acquisition of ERO, the Montreal Division experienced a decline in sales of its arts and crafts product line, a new product line experienced initial quality problems and the former owners of Montreal announced they were leaving the Company. These events triggered an assessment of recoverability of the book value of the non-current assets, including goodwill, of this Division. Results of the assessment indicated there was no impairment of value under Statement of Financial Accounting Standards No. 121 ("SFAS 121") as of December 31, 1997. Management has put in place a new management team, instituted certain cost reduction programs, established a quality control function and is actively developing new versions of current products. Management believes these factors will improve the future cash flow and profitability of this Division. On July 24, 1998 the Company acquired 100% of the outstanding shares of Backyard Products Limited, approximately $13.9 million, a leading Canadian manufacturer and supplier of wood gym sets and accessories. The purchase price of approximately $16.8 million was financed through an amendment to the Company's existing Senior Credit Facilities, which increased the Tranche B Term Loan by $30 million. The $30 million proceeds from the amendment were used to fund the acquisition as well as to pay down borrowings under the Revolving Credit Facility. The acquisition was accounted for as a purchase; accordingly, the purchase price was allocated to the underlying assets and liabilities based on their respective estimated fair values at the date of the acquisition. The estimated value of assets acquired was $3.4 million and the liabilities assumed was $2.7 million. The excess of the purchase price over the value of the net assets acquired of, $16.1 million was recorded as goodwill and will be amortized over 40 years. 4. INVENTORIES: Inventories are comprised of the following (in thousands): December 31, December 31, 1998 1997 ------------ ----------- Raw materials ..................... $21,421 $16,502 Work-in-process ................... 9,013 5,690 Finished goods .................... 23,288 25,272 ------- ------- $53,722 $47,464 ======= ======= 5. PROPERTY, PLANT, AND EQUIPMENT: Property, plant, and equipment is comprised of the following (in thousands): December 31, December 31, 1998 1997 ------------ ----------- Buildings and improvements....... $17,183 $16,567 Machinery and equipment .......... 47,392 40,131 Computer software and hardware ... 3,095 1,469 Furniture and fixtures ........... 2,076 1,277 ------- ------ 69,746 59,444 Less - Accumulated depreciation .. (25,453) (20,430) ------- ------- 44,293 39,014 Land ............................. 3,809 3,809 ------- ------- $48,102 $42,823 ======= ======= 6. DEBT Debt consists of the following (in thousands): December 31, December 31, 1998 1997 ----------- ----------- Senior Subordinated Notes .......... $110,000 $110,000 Term Loans ......................... 134,158 112,375 Senior Discount Notes .............. 26,584 23,288 Revolving Credit Facility .......... 34,920 35,500 Other .............................. 7,827 8,241 -------- -------- $313,489 $289,404 ======== ======== Term Loans and Revolving Credit Facility As discussed in Note 3, in connection with the ERO acquisition, Hedstrom obtained the Senior Credit Facilities. The Senior Credit Facilities consist of (a) a six-year Tranche A Senior Secured Term Loan Facility providing for term loans to Hedstrom in a principal amount of $75 million; (b) an eight-year Tranche B Senior Secured Term Loan Facility providing for term loans to Hedstrom in a principal amount of $35 million (on July 24, 1998 the Tranche B Term Loan was increased to $65.0 million to allow for the acquisition of Backyard Products Limited, see Note 3 for further discussion); and (c) a Senior Secured Revolving Credit Facility providing for revolving loans to Hedstrom and the issuance of letters of credit for the account of Hedstrom in an aggregate principal and stated amount at any time not to exceed $70 million. Borrowings under the Revolving Credit Facility will be available based upon a borrowing base not to exceed 85% of eligible accounts receivable and 50% of eligible inventory. The obligations of Hedstrom under the Senior Credit Facilities are unconditionally, fully and irrevocably guaranteed (jointly and severally) by Holdings and each of Hedstrom's direct or indirect domestic subsidiaries (collectively, the "Senior Credit Facilities Guarantors"). In addition, the Senior Credit Facilities will be secured by first priority or equivalent security interests in (i) all the capital stock of, or other equity interests in, each direct or indirect domestic subsidiary of Hedstrom and 65% of the capital stock of, or other equity interests in, each direct foreign subsidiary of Hedstrom, or any of its domestic subsidiaries and (ii) all tangible and intangible assets (including, without limitation, intellectual property and owned real property) of Hedstrom and the Senior Credit Facilities Guarantors. On December 30, 1998, the Company amended the Senior Credit Facility. The amendment allows for less restrictive financial covenants.In addition, the amendment allows, at Hedstrom's option, the interest rates per annum applicable to the Senior Credit Facilities to be either (i) the Eurocurrency Rate (as defined) plus 3.0% in the case of the Tranche A Term Loan Facility and the Revolving Credit Facility or 3.5% in the case of the Tranche B Term Loan Facility or (ii) the Alternate Base Rate (as defined) plus 2.0% in the case of the Tranche A Term Loan Facility and the Revolving Credit Facility or 2.5% in the case of the Tranche B Term Loan Facility. The Alternate Base Rate is the highest of (a) Credit Suisse First Boston's Prime Rate (as defined) or (b) the federal funds effective rate from time to time plus 0.5%. The applicable margin in respect of the Tranche A Term Loan Facility and the Revolving Credit Facility will be adjusted from time to time by amounts to be agreed upon based on the achievement of certain performance targets to be determined. The Senior Credit Facilities contain a number of covenants that, among other things, restrict the ability of Hedstrom to dispose of assets, incur additional indebtedness, repay other indebtedness or amend other debt instruments, pay dividends, create liens on assets, make investments or acquisitions, engage in mergers or consolidations, make capital expenditures, or engage in certain transactions with affiliates. In addition, under the Senior Credit Facilities, Hedstrom is required to comply with specified minimum interest coverage and maximum leverage ratios. At December 31, 1998, the Company was in compliance with all of the amended restrictive covenants contained in the Senior Credit Facility. Senior Discount Notes In connection with the ERO acquisition, Holdings received $25.0 million of gross proceeds from the issuance by Holdings of 44,612 units, consisting of the Discount Notes and 2,705,896 shares of Holdings common stock. Of the $25.0 million in gross proceeds, $3.4 million ($1.25 per share) was allocated to the common stock, based upon management's estimate of fair market value, and $21.6 million was allocated to Discount Notes. The Discount Notes are unsecured obligations of Holdings and have an aggregate principal amount at maturity (June 1, 2009) of $44.6 million, representing a yield to maturity of 12%. No cash interest will accrue on the Discount Notes prior to June 1, 2002. Thereafter, cash interest will be payable on June 1 and December 1 of each year, commencing December 1, 2002. Amortization of the original issue discount, which is included in interest expense, totaled $3,296,000 and $1,670,000 during the fiscal years ended December 31, 1998 and December 31, 1997, respectively. Except as set forth below, the Discount Notes will not be redeemable at the option of Holdings prior to June 1, 2002. On and after such date, the Discount Notes will be redeemable, at Holdings' option, in whole or in part, at the following redemption prices (expressed in percentages of principal amount at maturity), plus accrued and unpaid interest to the redemption date: if redeemed during the 12-month period commencing on June 1 of the years set forth below: Redemption Period Price(%) ------------ ---------- 2002 ................................... 106.000 2003 ................................... 104.000 2004 ................................... 102.000 2005 and thereafter .................... 100.000 In addition, at any time and from time to time prior to June 1, 2000, Holdings may redeem in the aggregate up to 40% of the accreted value of the Discount Notes with the proceeds of one or more equity offerings by Holdings so long as there is a public market at the time of such redemption, at a redemption price (expressed as a percentage of accreted value on the redemption date) of 112%, plus accrued and unpaid interest, if any, to the redemption date; provided however, that at least $26.8 million aggregate principal amount at maturity of the Discount Notes remains outstanding after each such redemption. At any time on or prior to June 1, 2002, the Discount Notes may also be redeemed as a whole at the option of Holdings upon the occurrence of a change of control (as defined) at a redemption price equal to 100% of the accreted value thereof plus the applicable premium as of, and accrued and unpaid interest, if any, to the date of redemption. The Discount Notes Indenture contains certain covenants that, among other things, limit (i) the incurrence of additional indebtedness by Holdings and its restricted subsidiaries (as defined), (ii) the payment of dividends and other restricted payments by Holdings and its restricted subsidiaries, (iii) restrictions on distributions from restricted subsidiaries, (iv) asset sales, (v) transactions with affiliates, (vi) sales or issuances of restricted subsidiary capital stock and (vii) mergers and consolidations. Senior Subordinated Notes The $110.0 million Senior Subordinated Notes bear interest at 10% per annum, payable on June 1 and December 1 of each year, commencing December 1, 1997. The Senior Subordinated Notes mature on June 1, 2007. Except as set forth below, the Senior Subordinated Notes are not redeemable at the option of Hedstrom prior to June 1, 2002. On and after such date, the Senior Subordinated Notes are redeemable, at Hedstrom's option, in whole or in part, at the following redemption prices (expressed in percentages of principal amount), plus accrued and unpaid interest to the redemption date: if redeemed during the 12-month period commencing on June 1 of the years set forth below: Redemption Period Price(%) --------- ---------- 2002 ..................................105.000 2003 ..................................103.333 2004 ..................................101.667 2005 and thereafter ...................100.000 In addition, at any time and from time to time prior to June 1, 2000, Hedstrom may redeem in the aggregate up to $44.0 million principal amount of Senior Subordinated Notes with the proceeds of one or more equity offerings so long as there is a public market at the time of such redemption (provided that if the equity offering is an offering by Holdings, a portion of the net cash proceeds thereof equal to the amount required to redeem any such Senior Subordinated Notes is contributed to the equity capital of Hedstrom), at a redemption price (expressed as a percentage of principal amount) of 110%, plus accrued and unpaid interest, if any, to the redemption date; provided, however, that at least $66.0 million aggregate principal amount of the Senior Subordinated Notes remains outstanding after each such redemption. The Senior Subordinated Notes are unsecured senior subordinated obligations of Hedstrom and are unconditionally and fully guaranteed (jointly and severally) on a senior basis by Holdings and on a senior subordinated basis by each domestic subsidiary of Hedstrom. The Senior Subordinated Notes are subordinated to all senior indebtedness (as defined) of Hedstrom and rank pari passu in right of payment with all senior subordinated indebtedness (as defined) of Hedstrom. The Senior Subordinated Notes Indenture contains certain covenants that, among other things, limit (i) the incurrence of additional indebtedness by Hedstrom and its restricted subsidiaries (as defined), (ii) the payment of dividends and other restricted payments by Hedstrom and its restricted subsidiaries, (iii) restrictions on distributions from restricted subsidiaries, (iv) asset sales, (v) transactions with affiliates, (vi) sales or issuances of restricted subsidiary capital stock and (vii) mergers and consolidations. Other Debt Other debt consists of a $2.5 million Holdings note payable to the previous owners of Holdings as well as various other mortgages, capital leases and equipment loans. The $2.5 million note payable bears interest at 10% per annum and is payable at the earlier of April 30, 2002, or when the Company has met certain cash flow levels. The mortgages and equipment loans have varying interest rates and maturities. Interest Rate Swaps As of December 31, 1998, the Company had interest rate swap agreements in place with two of its lenders under which the Company exchanged a variable interest rate for a fixed interest rate. The Company anticipates that the counter parties to the swap agreements will fully perform their obligations. During the fiscal year ended December 31, 1998, the effect of the swap agreements were immaterial. Terms of the swap agreements are as follows at December 31, 1998: Notional Amounts Fixed Interest Rate Expiration Date ---------------- ------------------- --------------- $30 million 8.05% October 28, 1999 $12 million 8.555% December 29, 2000 Maturities Aggregate maturities of long-term debt over the next five years are as follows (in thousands): 1999 - $11,905; 2000 - $14,655; 2001 - $17,156; 2002; - $22,156; and 2003 - $33,552. 7. INCOME TAXES: The sources of pretax income (loss) for the fiscal years ended December 31, 1998 and December 31, 1997 were as follows (in thousands): 1998 1997 ---- ---- Domestic ... $(14,174) $ 9,877 Foreign .... 7,011 7,696 -------- ------- $ (7,163) $17,573 ======== ======= The Company has not provided for U.S. federal and foreign income withholding taxes on its foreign subsidiaries' undistributed earnings as of December 31, 1998 and December 31, 1997, because such earnings are considered to be indefinitely reinvested. Repatriation of these earnings would not materially increase the Company's tax liability. If these earnings were distributed in the form of dividends or otherwise, foreign tax credits could be used to offset the U.S. income taxes due on income earned from foreign sources. Pretax income from foreign sources in periods prior to 1997 were not significant. The components of the provisions (benefits) for income taxes are as follows (in thousands): For the Fiscal For the Fiscal For the Five For the Fiscal Year Ended Year Ended Months Ended Year Ended December 31, December 31, December 31, July 31, 1998 1997 1996 1996 --------------- -------------- ------------ ------------- Current State ......... $ - $ 339 $ 33 $ 43 U.S. federal... - (2,745) (40) (92) Foreign ....... 3,597 3,376 - - ------- ------- --------- --------- 3,597 970 (7) (49) ------- ------- --------- --------- Deferred: State ......... (773) 412 - - U.S. federal... (3,511) 6,133 (2,862) (3,808) Foreign ...... 251 482 - - ------- ------- --------- --------- (4,033) 7,027 (2,862) (3,808) ------- ------- --------- --------- $ (436) $ 7,997 $ (2,869) $ (3,857) ======= ======= ========= ========= The provisions (benefits) for income taxes differ from those computed using the statutory U.S. federal income tax rate as a result of the following (in thousands) For the Fiscal For the Fiscal For the Five For the Fiscal Year Ended Year Ended Months Ended Year Ended December 31, December 31, December 31, July 31, 1998 1997 1996 1996 --------------- -------------- ------------- -------------- Current: Amount Rate Amount Rate Amount Rate Amount Rate ------ ---- ------ ---- ------ ---- ------ ---- Expected provision (benefit)... $(2,435) (34)% $5,975 34% $(2,598) (34)% $(4,071) (34)% State income taxes, net of federal benefit............ (511) (7) 495 3 (219) (3) (183) (1) Foreign corporate tax in excess of 34%................. 459 6 826 5 47 - 151 1 Foreign loss nottax benefited . 980 14 - - - - - - Nondeductible Goodwill ........ 994 14 727 4 - - - - Recapitalization costs ........ - - - - - - 479 4 Other.......................... 77 1 (26) - (99) (1) (233) (2) ------- ---- ------ ---- ------- ----- ------- ----- Actual Provision(benefit) $ (436) (6)% $7,997 46% $(2,869) (38)% $(3,857) (32)% ======= ==== ====== ==== ======= ===== ======= ===== The net deferred tax assets are comprised of the following (in thousands): December 31, December 31, 1998 1997 ------------ ------------ Current deferred tax asset: Allowances for accounts receivable $1,329 $ 568 Accrued Liabilities ........................ 4,153 3,656 Other ...................................... 534 155 ------ ------- Current deferred tax asset............... 6,016 4,379 ------ ------- Noncurrent deferred tax asset: Tax over book depreciation ................. (4,274) (4,056) Net operating loss carryforward............. 3,154 6,480 Accrued Interest on Senior Discount Notes... 2,094 644 Recapitalization costs ..................... 735 1,104 Other ...................................... 615 552 Valuation Allowance (749) - ------ ------- Noncurrent deferred tax asset............ 1,575 4,724 ------ ------- Net deferred tax asset ....................... $7,591 $ 9,103 ====== ======= The Company has net operating loss carryforwards of $8,170,000 to apply against future taxable income. Such carryforwards expire between 2011 and 2018. The Company has recorded current taxes receivable of $6,745,000. This receivable consists of an overpayment of Canadian and U.S. taxes of $1,200,000 and the carryback of $5,545,000 of net operating losses. The valuation allowance fully reserves deferred tax assets associated with the Company's operations in the United Kingdom, which are not expected to be realized. However, the Company believes it is more likely than not to realize the remaining net deferred tax asset and accordingly no valuation allowance has been provided. This conclusion is based on, (i) projections (which include the ERO and Montreal Divisions) of sufficient taxable U.S. income to fully realize the net operating loss carryforwards by the end of calendar year 1999, (ii) the tax loss carryforwards included in the net deferred tax asset were generated in very recent periods and do not begin to expire until the years 2011-2018, (iii) the significant excess of book basis over tax basis relative to the net assets of ERO, Inc. and (iv) the carryback of $5,545,000 million in net operating loss carryforwards which will result in a 1999 tax refund of $6,745,000. Management continually evaluates the realizability of the net deferred tax assets and the need for a valuation allowance on such assets. 8. EMPLOYEE BENEFIT PLANS: All employees of the Bedford and Ashland Divisions are eligible to participate in either the Union Employees' Tax Sheltered Savings Plan or the tax-sheltered Savings Plan (collectively the "Hedstrom Plans"), depending upon the employment status of the employees as union or nonunion after meeting certain requirements. The Union Employees' Tax Sheltered Savings Plan covers all union employees 18 years of age or older who have worked for 1,000 consecutive hours within a 12-month period. The tax-sheltered Savings Plan covers all nonunion employees 18 years of age or older who have been employed for 120 consecutive days within a 12-month period. For the Hedstrom Plans, the employees may contribute from 1% to 15% of their compensation (either before tax, after tax, or a combination thereof) to the Plans. The Company provides matching contributions at the rate of 50% of the employee's contribution up to 6% of gross wages as defined by the Plans agreements. The Company may make annual discretionary contributions to the Hedstrom Plans. Discretionary contributions during the fiscal years ended December 31, 1998, December 31, 1997, the five months ended December 31, 1996, and for the fiscal year ended July 31, 1996, aggregated approximately $730,000, $607,000, $218,000 and $634,000, respectively. U.S. Employees of the ERO and Montreal Divisions are covered by a contributory profit sharing plan established pursuant to the provisions of Section 401(k) of the Internal Revenue Code which provides retirement benefits for eligible employees of the Company (the "ERO Plan"). Eligible employees may contribute from 1% to 15% of their compensation. The Company may provide matching contributions at the rate of 50% of the employee's contribution up to 6% of the employee's gross wages. Discretionary contributions during the fiscal years ended December 31, 1998 and December 31, 1997, were $179,000 and $171,000, respectively. 9. STOCK-BASED COMPENSATION PLAN: The company maintains two stock option plans, the 1995 Stock Option Plan and the 1997 Stock Option Plan (the "Plans") which authorize grants of stock options of up to 2,446,236 and 2,750,000 shares, respectively, to key employees of the Company. Options are granted at the fair market value at the date of grant, as determined by management. Options issued under the Plan expire ten years from date of grant and vest equally over periods of time ranging from two to three years, as determined by the Company's Option Committee of the Board of Directors. The following is a summary of stock option transactions from July 31, 1996 through December 31, 1998: Average Shares Option Prices Exercise Price --------- ------------- -------------- Shares under option at July 31, 1996....... 2,174,216 $1.00 $1.00 Options granted ......................... 200,000 1.00 1.00 Options exercised ....................... _ _ _ Options terminated ...................... - - - --------- -------------- --------- Shares under option at December 31, 1996... 2,374,216 $1.00 $1.00 --------- -------------- --------- Options granted ......................... 1,767,912 1.25 1.25 Options exercised ....................... - - - Options terminated ...................... - - - --------- ------------- --------- Shares under option at December 31, 1997... 4,142,128 1.00 to 1.25 1.11 --------- ------------- --------- Options granted 765,000 1.65 1.65 Options exercised _ _ _ Options terminated (135,000) 1.25 1.25 --------- -------------- -------- Shares exercisable at December 31, 1998 4,772,128 $1.00 to $1.65 $1.23 ========= ============== ======== Shares under option at December 31, 1998 2,896,853 $1.00 to $1.65 $1.05 Shares exercisable at December 31, 1997 1,516,144 $1.00 $1.00 Shares exercisable at December 31, 1996 724,739 $1.00 $1.00 Shares exercisable at July 31, 1996 - - - At December 31, 1998, 22,020 and 402,088 remaining options are available for grant under the 1995 Stock Option Plan and the 1997 Stock Option Plan, respectively. The weighted average remaining contractual life of shares under option at December 31, 1998 was 8 years. The Company has adopted APB Opinion 25 "Accounting for Stock Issued to Employees" and related interpretations in accounting for its stock option plan. Accordingly, no compensation cost has been recognized for the stock option plans. Due to the Acquisition, net income per share for the fiscal year ended July 31, 1996 have no significant relevance to current amounts. Had compensation cost for the Company's plans been determined based on the fair value at the date of grant for awards in the fiscal years ended December 31, 1998 and December 31, 1997, the Company's total and per share net income would have been as follows (dollars in thousands, except per share amounts): 1998 1997 Net income: ---- ---- As reported ......................... $(6,727) $9,576 Pro forma ........................... (7,004) 9,212 Basic net income per common share As reported ......................... $(0.10) $0.18 Pro forma ........................... (0.10) 0.18 Diluted net income per common share and common share equivalent: As reported ......................... $(0.10) $0.18 Pro forma ........................... (0.10) 0.18 The weighted average fair value of options granted is $1.06 and $0.71 during the fiscal years ended December 31, 1998 and December 31, 1997, respectively. The fair value of each option is estimated on the date of the grant using the minimum value method with the following assumptions used for the grant in December 1998; risk free interest rates of 4.53%; expected dividend yield of 0% and expected life of ten years. 10. COMMITMENTS AND CONTINGENCIES: Leases The Company leases production equipment under capital leases with terms expiring at various times through 2004. The net capital lease asset of $2,276,0000 and $1,825,000 as of December 31, 1998 and December 31, 1997, respectively, is included in property, plant, and equipment on the accompanying consolidated balance sheets. Aggregate future minimum lease payments related to capital leases are as follows: 1999 - $662,000; 2000 - $662,000; 2001 - $613,000; 2002 - $492,000; 2003 - $281,000; and thereafter - $89,000. The portion related to interest over the remaining life of the capital leases was $309,000 at December 31, 1998. The Company leases production equipment under operating lease agreements with terms expiring at various times through 2003. Rent expense under operating leases for the fiscal years ended December 31, 1998, December 31, 1997, for the five months ended December 31, 1996, and for the fiscal year ended July 31, 1996, aggregated $2,232,000, $2,309,000, $936,000 and $2,500,000, respectively. Aggregate future minimum lease commitments for noncancelable operating leases that have initial or remaining lease terms in excess of one year as of December 31, 1998, are as follows: 1999 - $2,017,000; 2000; - $1,459,000; 2001 - $946,000; 2002 - $626,000; 2003 - $195,000; and thereafter $388,000. Legal Matters There are various claims and pending legal actions against the Company, primarily involving product liability, seeking damages in varying amounts. In the opinion of management, the amount of ultimate liability with respect to these actions will not materially affect the financial position or results of operations of the Company. 11. RELATED-PARTY TRANSACTIONS: On October 27, 1995, in connection with the recapitalization discussed in Note 12, the Company entered into a ten-year agreement with Hicks Muse, pursuant to which it pays Hicks Muse an annual fee (initially $175,000) for management and advisory services in connection with the organization, management, and operations of the Company. The annual fee is adjustable each July 31st to an amount equal to 0.1% of the consolidated net sales of the Company during the previous twelve months, but in no event less than $175,000. Management fees and related expenses under this agreement amounted to $329,000, $257,000, $82,000 and $207,000 for the fiscal years ended December 31, 1998, December 31, 1997, for the five months ended December 31, 1996, and for the fiscal year ended July 31, 1996, respectively, and are included in selling, general, and administrative expenses on the accompanying income statements. On October 27, 1995, in connection with the recapitalization discussed in Note 12, the Company entered into a ten-year agreement with an affiliate of Hicks Muse pursuant to which it paid this affiliate a financial advisory fee of approximately $1,175,000 as compensation for its services as financial advisor in connection with the recapitalization. In addition, this Hicks Muse affiliate will be entitled to receive a fee equal to 1.5% of the transaction value, as defined, for each add-on transaction, as defined, in which the Company is involved. 12. RECAPITALIZATION: Prior to October 27, 1995, the majority of Holdings common stock was held by Arnold E. Ditri, President and Chief Executive Officer, and Alastair H. McKelvie, Executive Vice President. The remaining common stock was held by John H. Hurshman and the Fidelity Investment Charitable Gift Trust. On October 27, 1995, Holdings was purchased by Hicks, Muse, Tate & Furst Equity Fund II, L.P. ("HM Fund II"). Concurrently, all of the outstanding preferred stock was redeemed, the outstanding common stock held by John H. Hurshman and the Fidelity Investment Charitable Trust was redeemed, a majority of the outstanding common stock of Arnold E. Ditri and Alastair H. McKelvie was redeemed, new common shares were issued to HM Fund II, new debt facilities were obtained and existing debt facilities were repaid as part of the transaction. As Arnold Ditri and Alastair H. McKelvie retained a minority investment in Holdings, the transaction was accounted for as a recapitalization, and existing account balances were carried forward. The Company expensed all of its costs associated with the recapitalization, which totaled approximately $9,600,000. In connection with the recapitalization, Holdings effected a common stock split of 39,095.40 shares for one and increased the authorized shares from 1,000 (par value $.01) to 50,000,000 (par value $.01). After the recapitalization, the majority of the common stock is held by HM Fund II. The remaining common stock was held by Arnold E. Ditri, Alastair H. McKelvie, various other members of management, and various other investment groups. 13. SEGMENT AND GEOGRAPHIC INFORMATION: Effective January 1, 1998, the Company adopted SFAS No. 131, "Disclosure About Segments of an Enterprise and Related Information." SFAS 131 requires companies to identify their operating segments based upon the internal financial information reported to the company's chief operating decision maker. The Company's operating decision maker is its Chief Executive Officer (CEO). Financial information reported to the CEO reflects five business segments: the Bedford Division, the Ashland Division, the ERO Division, the Montreal Division and the International Division. The CEO evaluates performance of each segment based upon the operating earnings (loss) of each segment. The accounting policies of segments are the same as those described in the summary of accounting policies in Note 1 to the consolidated financial statements. The Company develops, manufactures and sells a variety of children's leisure and activity products. The Bedford Division principally manufactures and markets in the United States and Canada outdoor gym sets, wood gym kits and slides, spring horses, trampolines and gym accessories. The Ashland Division principally manufactures and markets in the United States a wide variety of children's playballs and ball pit products. The Montreal Division principally manufactures and markets children's products including arts and crafts, game tables, certain other children's bulk play products such as play kitchens and battery-operated ride-on vehicles. In addition, this division includes a broad line of school supplies featuring popular licensed characters. The ERO Division produces the Slumber Shoppe line of products including products such as indoor sleeping bags and play tents featuring popular licensed characters, a water sports line of products including flotation jackets, masks, fins, goggles and snorkels. Additionally the division produces licensed room decorations for young children, consisting principally of stick-on and peel-off wall decorations. The International Division produces and distributes gym sets and other products, manufactured by its domestic divisions, outside of the United States. For the Five For the Fiscal For the Fiscal Years Months Ended Year Ended Ended December 31, December 31, July 31, ------------------ ------------ ------------- 1998 1997 1996 1996 ---- ---- ---- ---- Bedford Division Net revenues $109,031 $84,784 $12,652 $83,891 Operating earnings (loss) 4,558 7,873 (4,959) (1,601) Identifiable assets 56,092 61,111 43,388 55,442 Capital expenditures 4,514 1,861 681 4,919 Depreciation and amortization 4,364 3,987 1,454 2,507 Ashland Division Net revenues 38,846 36,837 11,341 49,303 Operating earnings (loss) 2,498 1,891 (566) 5,124 Identifiable assets 22,102 25,336 27,410 28,169 Capital expenditures 2,106 1,756 695 1,819 Depreciation and amortization 1,433 1,267 454 907 ERO Division Net revenues 73,442 60,517 - - Operating earnings (loss) 15,190 12,582 - - Identifiable assets 40,316 35,930 - - Capital expenditures 1,670 354 - - Depreciation and amortization 1,574 707 - - Montreal Division Net revenues 61,193 64,785 - - Operating earnings (loss) 3,896 14,320 - - Identifiable assets 65,226 66,796 - - Capital expenditures 2,784 2,424 - - Depreciation and amortization 4,917 3,107 - - International Division Net revenues 19,184 9,225 - - Operating earnings (loss) (1,970) 38 - - Identifiable assets 6,063 2,076 - - Capital expenditures 218 - - - Depreciation and amortization 257 - - - Corporate, other non-segments and Intercompany Eliminations Identifiable assets 205,968 196,290 1,277 1,413 Depreciation and amortization 6,475 3,246 68 - Consolidated totals from continuing operations Net revenues 301,696 256,146 23,994 133,194 Operating earnings (loss) 24,172 36,704 (5,525) 3,523 Identifiable assets 395,767 387,539 72,075 85,024 Capital expenditures 11,292 6,395 1,376 6,738 Depreciation and amortization 19,020 12,314 1,976 3,414 Significant Concentration of Customers All trade accounts receivable are unsecured. A significant level of the Company's net sales is generated from four retail companies that serve national markets. Sales to the Company's top four customers aggregated approximately $166.2 million, $137.4 million, $61.3 million and $63.9 million for the fiscal years ended December 31, 1998, December 31, 1997, for the five months ended December 31, 1996 and for the fiscal year ended July 31, 1996, respectively. Three of the Company's customers accounted for over 10% of the Company's net sales during the fiscal year ended December 31, 1998. Total revenues generated from each of these three customers were $65.9 million, $50.1 million and $34.2 million, respectively. Two of the Company's customers each accounted for over 10% of the Company's net sales during the fiscal year ended December 31, 1997. Total revenues generated from each of these two customers were $54.9 million, and $41.7 million, respectively. Three of the Company's customers each accounted for over 10% of the Company's net sales for the five months ended December 31, 1996. Total revenues generated from each of these three customers were $3.6 million, $2.9 million and $2.6 million, respectively. Three of the Company's customers each accounted for over 10% of the Company's net sales during the fiscal year ended July 31, 1996. Total revenues generated from each of these three customers were $25.3 million, $16.0 million and $16.0 million, respectively. Sales to the aforementioned major customers are made by all of the Company's divisions. During fiscal years ended December 31, 1998 and 1997, the Company's outdoor gym set product line, produced by the Bedford Division, accounted for approximately 20% of the Company's net sales for the fiscal year. No other product line accounted for more than 10% of the Company's net sales for the fiscal years ended December 31, 1998 and 1997. For the five month period ended December 31, 1996 gym sets accounted for 28% of the Company's net sales, while wood kits, produced at the Bedford division, accounted for 18% of the Company's net sales and Ball Pits, produced at the Ashland Division, accounted for 13% of the Company's net sales. No other product line accounted for more than 10% of the Company's net sales for the five month period ended December 31, 1996. For the fiscal year ended July 31, 1996, the Company's outdoor gym set product line accounted for approximately 51% of the Company's net sales and the undecorated play ball product line, produced at the Ashland Division, accounted for 11% of the Company's net sales. No other product line accounted for more than 10% of the Company's net sales for the fiscal year ended July 31, 1996. Summarized geographic information as of and for the fiscal years ended December 31, 1998 and December 31, 1997 is as follows (in thousands): Other ------------------------- United Foreign States Canada Operations Elminations Total -------- ------- ---------- ----------- -------- Fiscal Year Ended December 31, 1998 ----------------------------------- Sales to unaffiliated customers...... $265,611 $19,988 $16,097 $ - $301,696 Transfers between geographic areas... 7,665 37,436 - (45,101) - -------- ------- ------- -------- -------- Total net sales...................... $273,276 $57,424 $16,097 $(45,101) $301,696 ======== ======= ======= ======== ======== Operating income.................... $ 14,537 $12,422 $(2,731) $ (56) $ 24,172 ======== ======= ======= ======== ======== Identifiable assets.................. $355,475 $38,272 $(9,368) $ (7,348) $395,767 ======== ======= ======= ======== ======== Fiscal Year Ended Decmeber 31, 1997 ----------------------------------- Sales to unaffiliated customers...... $229,601 $14,322 $12,223 $ - $256,146 Transfers between geographic areas... 5,344 38,306 - (43,650) - -------- ------- ------- -------- -------- Total net sales...................... $234,945 $52,628 $12,223 $(43,650) $256,146 ======== ======= ======= ======== ======== Operating income.................... $ 23,936 $13,259 $ (451) $ (40) $ 36,704 ======== ======= ======= ======== ======== Indentifiable assets................. $360,968 $52,176 $ 8,440 $(34,045) $387,539 ======== ======= ======= ======== ======== The Company generated no material foreign income for the fiscal years ended July 31, 1996 and 1995 and owned no material foreign assets at July 31, 1996 and 1995. 14. QUARTERLY FINANCIAL DATA (unaudited; in thousands): Fiscal Year Ended December 31, 1998 ----------------------------------- 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Total ------ ------ ------ ------ ------- Net sales ............... $78,389 $83,272 $64,353 $75,682 $301,696 Gross profit ............ 22,064 23,081 23,544 22,400 91,089 Net income (loss)(loss)(loss) (259) (339) 150 (6,279) (6,727) Basic net income (loss) per common share $0.00 $(0.01) $0.00 $(0.09) $(0.10) Diluted net income (loss) per common share and common share equivalents 0.00 (0.01) 0.00 (0.09) (0.10) Fiscal Year Ended December 31, 1997 ----------------------------------- 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Total ------ ------ ------ ------ ------- Net sales $47,937 $56,114 $61,462 $90,633 $256,146 Gross profit 13,396 17,076 19,740 33,544 83,756 Net income (loss)(loss)(loss) 3,216 2,769 (919) 4,510 9,576 Basic net income (loss) per common share $0.10 $0.05 $(0.01) $0.07 $0.18 Diluted net income (loss) per common share and common share equivalents 0.10 0.05 (0.01) 0.07 0.18 15. SUBSIDIARY GUARANTORS/NONGUARANTORS FINANCIAL INFORMATION The following is financial information pertaining to Hedstrom and its subsidiary guarantors and subsidiary nonguarantors (with respect to the Senior Subordinated Notes and the Senior Credit Facilities) for the periods in which they are included in Holding's accompanying consolidated financial statements. HEDSTROM CORPORATION AND SUBSIDIARIES CONSOLIDATING BALANCE SHEETS (In thousands) ASSETS At December 31, 1998 At December 31, 1997 --------------------------------------------- -------------------------------------------- Hedstrom Hedstrom Hedstrom Subsidiary Hedstrom Subsidiary Subsidiary Non- Adjustments/ Total Subsidiary Non- Adjustments/ Total Guarantors Guarantors Eliminations Hedstrom Guarantors Guarantor Eliminations Hedstrom ---------- ---------- ------------ -------- ---------- --------- ------------ -------- CURRENT ASSETS: Cash and cash equivalents $ 1,839 $ 2,495 $ - $ 4,334 $ 8,984 $ 1,860 $ - $ 10,844 Trade accounts receivable, net .............. 59,193 10,329 - 69,522 73,625 9,077 - 82,702 Taxes receivable ... 6,095 650 - 6,745 - - - - Inventories ........ 40,742 13,036 (56) 53,722 38,429 9,075 (40) 47,464 Deferred income taxes 6,016 - - 6,016 4,379 - - 4,379 Prepaid expenses and other 3,849 281 - 4,130 4,310 491 - 4,801 -------- -------- -------- -------- -------- -------- -------- -------- Total current assets 117,734 26,791 (56) 144,469 129,727 20,503 (40) 150,190 -------- -------- -------- -------- -------- -------- -------- -------- PROPERTY, PLANT, AND EQUIPMENT, net 31,361 16,741 - 48,102 27,448 15,375 - 42,823 GOODWILL, net ........ 165,835 20,991 - 186,826 152,457 18,484 - 170,941 OTHER ASSETS: Investment in and Advances to Nonguarantor Subsidiaries ...... 56,190 - (56,190) - 44,799 - (44,799) - Deferred financing fees, net 13,357 - - 13,357 16,328 - - 16,328 Deferred charges and other, net ........... 500 - - 500 1,387 - - 1,387 Deferred income taxes 1,092 (1,611) - (519) 4,602 (522) - 4,080 -------- -------- -------- -------- -------- -------- -------- -------- Total other assets 236,974 19,380 (56,190) 200,164 219,573 17,962 (44,799) 192,736 -------- -------- -------- -------- -------- -------- -------- -------- Total assets $386,069 $ 62,912 $(56,246) $392,735 $376,748 $ 53,840 $(44,839) $385,749 ======== ======== ======== ======== ======== ======== ======== ======== HEDSTROM CORPORATION AND SUBSIDIARIES CONSOLIDATING BALANCE SHEETS (In thousands) ASSETS At December 31, 1998 At December 31, 1997 --------------------------------------------- -------------------------------------------- Hedstrom Hedstrom Hedstrom Subsidiary Hedstrom Subsidiary Subsidiary Non- Adjustments/ Total Subsidiary Non- Adjustments/ Total Guarantors Guarantors Eliminations Hedstrom Guarantors Guarantor Eliminations Hedstrom ---------- ---------- ------------ -------- ---------- --------- ------------ -------- LIABILITIES AND STOCKHOLDER'S EQUITY CURRENT LIABILITIES: Revolving line of credit $ 34,920 $ - $ - $ 34,920 $33,282 $ 2,218 $ - $ 35,500 Current portion of long term debt and capital leases 11,417 488 - 11,905 8,492 730 - 9,222 Advances from Nonguarantor Subsidiaries - 39,091 (39,091) - - 31,956 (31,956) - Accounts payable(c) 17,170 3,539 - 20,709 20,784 2,597 - 23,381 Accrued expenses(c) 20,520 2,198 (23) 22,695 25,061 2,432 (16) 27,477 -------- -------- -------- -------- -------- -------- -------- -------- Total current liabilities 84,027 45,316 (39,114) 90,229 87,619 39,933 (31,972) 95,580 -------- -------- -------- -------- -------- -------- -------- -------- LONG-TERM DEBT(a): Senior subordinated notes 110,000 - - 110,000 110,000 - - 110,000 Term loans ......... 123,736 - - 123,736 104,375 - - 104,375 Capital leases ..... 1,690 - - 1,690 1,605 - - 1,605 Other .............. 1,667 487 - 2,154 1,857 1,057 - 2,914 -------- -------- -------- -------- -------- -------- -------- -------- Total long-term debt 237,093 487 - 237,580 217,837 1,057 - 218,894 -------- -------- -------- -------- -------- -------- -------- -------- STOCKHOLDER'S EQUITY Total Stockholder's equity (deficit)(b) 64,949 17,109 (17,132) 64,926 71,292 12,850 (12,867) 71,275 -------- -------- -------- -------- -------- -------- -------- -------- Total liabilities and Stockholder's equity $386,069 $ 62,912 $(56,246) $392,735 $376,748 $ 53,840 $(44,839) $385,749 ======== ======== ======== ======== ======== ======== ======== ======== footnotes to follow HEDSTROM CORPORATION AND SUBSIDIARIES CONSOLIDATING INCOME STATEMENTS (In thousands) Fiscal Year Ended December 31, 1998 Fiscal Year Ended December 31, 1997 ------------------------------------------------ ---------------------------------------------- Hedstrom Hedstrom Hedstrom Subsidiary Hedstrom Subsidiary Subsidiary Non- Ajustments/ Total Subsidiary Non- Ajustments/ Total Guarantors Guarantors Eliminations Hedstrom Guarantors Guarantors Eliminations Hedstrom ---------- ---------- ------------ -------- ---------- ---------- ------------ -------- NET SALES .... $286,159 $60,638 $(45,101) $301,696 $243,344 $56,452 $ (43,650) $256,146 COST OF SALES 213,124 42,528 (45,045) 210,607 175,834 40,166 (43,610) 172,390 -------- ------- -------- -------- ------- ------- --------- -------- Gross profit 73,035 18,110 (56) 91,089 67,510 16,286 (40) 83,756 SG&A EXPENSES 57,412 9,505 - 66,917 42,655 4,397 - 47,052 -------- ------- -------- -------- -------- ------- --------- -------- Operating income (loss) ....... 15,623 8,605 (56) 24,172 24,855 11,889 (40) 36,704 INTEREST EXPENSE(c) 25,546 2,034 - 27,580 15,614 1,492 - 17,106 -------- ------- -------- -------- -------- ------- --------- -------- INCOME (LOSS) BEFORE TAXES ........ (9,923) 6,571 (56) (3,408) 9,241 10,397 (40) 19,598 INCOME TAX EXPENSE (BENEFIT) .... (1,773) 2,899 (23) 1,103 4,532 4,263 (16) 8,779 -------- ------- -------- -------- -------- ------- --------- -------- NET INCOME (LOSS) $ (8,150) $ 3,672 $ (33) $ (4,511) $ 4,709 $ 6,134 $ (24) $ 10,819 ======== ======= ======== ======== ======== ======= ========= ======== HEDSTROM CORPORATION AND SUBSIDIARIES CONSOLIDATING INCOME STATEMENTS (In thousands) For the Five Months Ended For the Fiscal Year Ended December 31, 1996 July 31, 1996 -------------------------------- --------------------------------- Hedstrom Hedstrom Subsidiary Hedstrom Subsidiary Subsidiary Non- Total Subsidiary Non- Total Guarantors Guarantor Hedstrom Guarantors Guarantors Hedstrom ---------- --------- -------- ---------- ---------- -------- NET SALES $23,074 $920 $23,994 $129,074 $4,120 $133,194 COST OF SALES 21,238 735 21,973 101,482 3,586 105,068 ------- ---- ------- -------- ------ -------- Gross profit 1,836 185 2,021 27,592 534 28,126 SG&A EXPENSES 7,225 321 7,546 23,659 944 24,603 ------- ---- ------- -------- ------ -------- Operating income (loss) (5,389) (136) (5,525) 3,933 (410) 3,523 RECAPITALIZATION EXPENSE - - - 9,600 - 9,600 INTEREST EXPENSE(c) 2,010 1 2,011 5,674 34 5,708 ------- ---- ------- -------- ------ -------- INCOME (LOSS) BEFORE TAXES (7,399) (137) (7,536) (11,341) (444) (11,785) INCOME TAX EXPENSE (BENEFIT) (2,775) (54) (2,829) (3,786) - (3,786) ------- ---- ------- -------- ------ -------- NET INCOME (LOSS) $(4,624) $(83) $(4,707) $ (7,555) $ (444) $ (7,999) ======= ==== ======= ======== ====== ======== footnotes to follow HEDSTROM CORPORATION AND SUBSIDIARIES CONSOLIDATING STATEMENTS OF CASH FLOWS (In thousands) Fiscal Year Ended December 31, 1998 Fiscal Year Ended December 31, 1997 ------------------------------------------- -------------------------------------------- Hedstrom Hedstrom Hedstrom Subsidiary Hedstrom Subsidiary Subsidiary Non- Adjustments/ Total Subsidiary Non- Adjustments/ Total Guarantors Guarantors Eliminations Hedstrom Guarantors Guarantors Eliminations Hedstrom --------- ---------- ------------ -------- ---------- ---------- ------------ -------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss)(c) $(8,150) $ 3,672 $ (33) $ (4,511) $ 4,709 $6,134 $ (24) $ 10,819 Depreciation and amortization 12,633 2,883 - 15,516 9,212 1,328 - 10,540 Deferred income tax provision (benefit)(c) (5,122) 1,089 - (4,033) 6,916 - - 6,916 Gain on the disposition of property, plant and equipment (1) - - (1) (1) - - (1) Provision for losses on accounts Receivable 2,683 500 - 3,183 1,246 - - 1,246 Changes in assets and liabilities: Accounts receivable 11,718 (1,752) - 9,966 (40,150) (6,604) - (46,754) Taxes receivable (6,095) (650) - (6,745) - - - - Inventories ..... (984) (3,315) 56 (4,243) 461 4,373 40 4,874 Prepaid expenses and other 551 210 - 761 789 (491) - 298 Accounts payable(c) (4,572) 942 - (3,630) 2,535 (534) - 2,001 Accrued expenses(c) 1,748 (574) (23) 1,151 (1,768) 1,935 (16) 151 ------- ------- ------ ------- -------- ----- ------ -------- Net cash provided by (used for) Operating activities 4,409 3,005 - 7,414 (16,051) 6,141 - (9,910) ------- ------- ------ ------- -------- ----- ------ -------- CASH FLOWS FROM INVESTING ACTIVITIES: Acquisition of ERO, Inc. (3,037) - - (3,037) (122,600) - - (122,600) Acquisition of certain assets of Bollinger Industries, Inc. - - - - (14,928) - - (14,928) Acquisitions of PP&E (8,317) (2,975) - (11,292) (6,395) - - (6,395) Other acquisitions (16,884) (3,500) - (20,384) (2,322) - - (2,322) Proceeds from the sale of PP&E - - - - 8 - - 8 ------- ------- ------ ------- -------- ----- ------ -------- Net cash used for investing Activities (28,238) (6,475) - (34,713) (146,237) - - (146,237) ------- ------- ------ ------- -------- ----- ------ -------- CASH FLOWS FROM FINANCING ACTIVITIES Net proceeds from issuance of Senior Subordinated notes - - - - 110,000 - - 110,000 Net proceeds from issuance of new term loans ... 30,000 - - 30,000 110,000 - - 110,000 Equity contribution from Holdings(b) ..... - - - - 63,750 - - 63,750 Borrowings on new revolving line of credit .. 1,638 (2,218) - (580) 35,500 - - 35,500 Repayments of new Term Loans (7,956) - - (7,956) (1,125) - - (1,125) Repayments of old term loans - - - - (87,017) (5,750) - (92,767) Debt financing cost(b) - - - - (19,750) - - (19,750) Repayments on old revolving lines of credit, net - - - - (42,400) - - (42,400) Advances to-(from) Nonguarantor Subsidiaries (7,135) 7,135 - - (1,078) 1,078 - - Other ............. 137 (812) - (675) 2,395 - - 2,395 ------- ------- ------- -------- -------- ------ ------- -------- Net cash provided by (used for) Financing activities 16,684 4,105 - 20,789 170,275 (4,672) - 165,603 ------- ------- ------- -------- -------- ------ ------- -------- NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (7,145) 635 - (6,510) 7,987 1,469 - 9,456 CASH AND CASH EQUIVALENTS: Purchased Cash - - - - 530 325 - 855 Beginning of period 8,984 1,860 - 10,844 467 66 - 533 ------- ------- ------- -------- -------- ------ ------- -------- End of period ..... $ 1,839 $ 2,495 $ - $ 4,334 $8,984 $1,860 $ - $10,844 ======= ======= ======= ======== ======== ====== ======= ======== footnotes to follow HEDSTROM CORPORATION AND SUBSIDIARIES CONSOLIDATING STATEMENTS OF CASH FLOWS (In thousands) For the Five Months Ended December 31, 1996 For the Fiscal Year Ended July 31, 1996 ------------------------------------- ---------------------------------- Hedstrom Hedstrom Hedstrom Subsidiary Hedstrom Subsidiary Subsidiary Non- Total Subsidiary Non- Total Guarantors Guarantors Hedstrom Guarantors Guarantor Hedstrom ---------- ---------- -------- ---------- --------- -------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss)(c) $(4,624) $ (83) $(4,707) $(7,555) $ (444) $(7,999) Depreciation and amortization 1,973 3 1,976 3,407 7 3,414 Deferred income tax provision (benefit)(c) ........ (2,862) - (2,862) (3,808) - (3,808) Gain on the disposition of property, plant and equipment (60) - (60) - - - Provision for losses on accounts receivable 64 - 64 - - - Other (145) - (145) Changes in assets and liabilities Accounts receivable 8,794 940 9,734 (817) (75) (892) Inventories ..... (2,089) 47 (2,042) (64) (75) (139) Prepaid expenses and other (132) 13 (119) (20) 26 6 Accounts payable(c) 1,793 (6) 1,787 (8,012) (11) (8,023) Accrued expenses(c) (163) (630) (793) 26 (184) (158) ------ ----- ------ ------- ------ ------- Net cash provided by (used for) operating activities 2,694 284 2,978 (16,988) (756) (17,744) ------ ----- ------ ------- ------ ------- CASH FLOWS FROM INVESTING ACTIVITIES: Acquisition of ERO, Inc. - - - - - - Acquisition of certain assets of Bollinger Industries, Inc. - - - - - - Acquisitions of PP&E (1,375) (1) (1,376) (6,735) (3) (6,738) Other acquisitions - - - - - - Proceeds from the sale of PP&E 67 - 67 248 - 248 ------ ----- ------ ------- ------ ------- Net cash used for investing activities (1,308) (1) (1,309) (6,487) (3) (6,490) ------ ----- ------ ------- ------ ------- CASH FLOWS FROM FINANCING ACTIVITIES Redemption of common stock - - - (29,772) - (29,772) Redemption of preferred stock - - - (3,072) - (3,072) Proceeds from sale of common stock - - - 29,742 - 29,742 Term loan borrowings - - - 35,000 - 35,000 Repayments of new term loans - - - - - - Repayments of old term loans - - - - - - Debt financing cost(b) - - - - - - Repayments on old revolving lines of credit, net (8,728) (322) (9,050) (3,162) 802 (2,360) Advances to-(from) - - - - - - Nonguarantor Subsidiaries Other ............. (84) - (84) 1,597 - 1,597 ------ ----- ------ ------- ------ ------- Net cash provided by (used for) financing activities (8,812) (322) (9,134) 30,333 802 31,135 ------ ----- ------ ------- ------ ------- NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (7,426) (39) (7,465) 6,858 43 6,901 CASH AND CASH EQUIVALENTS: Purchased Cash - - - - - - Beginning of period 7,893 105 7,998 1,035 62 1,097 ------ ----- ------ ------- ------ ------- End of period ..... $ 467 $ 66 $ 533 $ 7,893 $ 105 $ 7,998 ====== ====== ====== ======= ====== ======= footnotes to follow HEDSTROM CORPORATION AND SUBSIDIARIES FOOTNOTES Each domestic subsidiary of Hedstrom (the "Subsidiary Guarantors") has fully and unconditionally guaranteed the Senior Subordinated Notes on a joint and several basis. The Company has not presented separate financial statements and other disclosures concerning the Subsidiary Guarantors because management has determined that such information is not material to investors. The column "Total Hedstrom" represents the consolidated financial statements of Hedstrom Corporation and its subsidiaries. Hedstrom Corporation is Holdings' only direct subsidiary. The primary differences between the consolidated amounts of Hedstrom Corporation and the consolidated amounts included in the accompanying consolidated financial statements of Holdings are as follows: (a) Hedstrom Corporation's Long-Term Debt does not include a $2.5 million note payable issued by Holdings in connection with its 1995 recapitalization, and the Senior Discount Notes valued at $26.6 million at December 31, 1998. (b) Hedstrom Corporation's stockholder's equity included Holdings' stockholders' equity plus, as of December 31, 1998 and 1997 only, $21.6 million in proceeds from the issuance of Senior Discount Notes, which proceeds were contributed as equity by Holdings to Hedstrom Corporation and the loss incurred by Holding's discontinued subsidiary Holdings II and as of both December 31, 1997 and December 31, 1996, the $2.5 million note payable described in (a) above. (c) Accounts payable, interest expense, income tax expense and accrued expenses do not reflect the accrued interest, interest expense and the tax benefit of accrued interest on the obligations discussed in (a) above. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10. Directors and Executive Officers of the Registrant MANAGEMENT Directors and Executive Officers of Holdings and Hedstrom The following table sets forth the age and the position of the directors and executive officers of each of Holdings and Hedstrom. Name Age Position --------------- --- ---------------------------------- Robert H. Elman...... 60 Chairman of the Board of Directors of Holdings and Hedstrom Alan B. Menkes....... 39 Director of Holdings and Hedstrom Jack D. Furst......... 40 Director of Holdings and Hedstrom Arnold E. Ditri....... 62 Director of Holdings and Hedstrom; Chief Executive Officer and President of Holdings and Hedstrom David F. Crowley...... 49 Chief Financial Officer of Holdings and Hedstrom Alastair H. McKelvie.. 67 Executive Vice President - Operations of Hedstrom Michael J. Johnston... 51 Executive Vice President - Manufacturing of Hedstrom Alfred C. Carosi, Jr.. 51 Executive Vice President - Sales and Marketing of Hedstrom Robert H. Elman has been the Chairman of the Board of Holdings and Hedstrom since July 1997 and has been a director of Holdings and Hedstrom since October 1995. Mr. Elman is Chairman and Chief Executive of DESA International, Inc. ("DESA International"), a manufacturer of indoor and outdoor heating products and specialty tools. Mr. Elman has served in that capacity since March 1985 when DESA International was formed as part of the leveraged buy out of AMCA International, Inc.'s Consumer Products Division. Prior to 1985, he served as Senior Group Vice President of AMCA International with responsibilities for the Consumer, Automotive Products, Aerospace, and Food Packaging Divisions. Mr. Elman joined AMCA International in 1975 when it acquired DESA Industries, a company he assisted in forming in 1969. Prior to forming DESA Industries, Mr. Elman was employed with ITT and Singer in various management positions in the United States and Europe. Alan B. Menkes has been a director of Holdings and Hedstrom since October 1995. Mr. Menkes is a Partner of Thomas Weisel Partners LLC, a privately held merchant banking firm. From 1996 to 1998, Mr Menkes was a Managing Director and Principal of Hicks Muse. Prior thereto, Mr. Menkes served as a Vice President of Hicks Muse from 1992 to 1995. Before joining Hicks Muse in 1992, Mr. Menkes was employed for five years by The Carlyle Group, a Washington D.C.- based private investment firm, most recently as a Senior Vice President. Jack D. Furst has been a director of Holdings and Hedstrom since July 1997. Mr. Furst is a Managing Director and Principal of Hicks Muse and has held such position since 1989. Prior to joining Hicks Muse, Mr. Furst was a Vice President and subsequently a Partner of Hicks & Haas, Incorporated, a Dallas-based private investment firm from 1987 to May 1989. From 1984 to 1986, Mr. Furst was a merger and acquisition/corporate finance specialist for The First Boston Corporation in New York. Mr. Furst serves on the board of directors of Omni America Holdings Corporation, International Wire Holding Company, Viasystems Group, Inc., Viasystems, Inc. and Cooperative Computing Holding Company, Inc. Arnold E. Ditri was Chairman of the Board of Hedstrom from December 1991 until October 1995 and has been a director of Holdings and Hedstrom since October 1995. He has been President and Chief Executive Officer of Hedstrom since March 1993 and of Holdings since October 1995. Mr. Ditri served as President of Ditri Associates, Inc. from 1981 until 1994. Ditri Associates, with a number of financial partners, specialized in acquiring and building under-achieving companies. From 1984 through 1988, Ditri Associates built Eagle Industries, Inc. in partnership with Great American Management, Inc. of Chicago. From 1961 to 1981, Mr. Ditri was a management consultant with Booz Allen & Hamilton and Touche Ross & Co. He was a partner in Touche Ross from 1967 to 1981. David F. Crowley has been Chief Financial Officer of Hedstrom since 1994 and of Holdings since October 1995. Prior to joining Hedstrom, Mr. Crowley served as Chief Financial Officer and/or Vice President of Finance for various companies owned and operated by Ditri Associates. Prior to joining Ditri Associates, from 1986 to 1990, Mr. Crowley was Treasurer of the Ring Screw Works Company in Detroit, Michigan. From 1974 to 1985, he was employed by Price Waterhouse where he was a Retail and Banking Industry Specialist and served in London, England for two years managing strategic planning and technical projects for the firm. Alastair H. McKelvie has been Executive Vice President of Operations with Hedstrom since 1991. Mr. McKelvie has over 40 years of experience chiefly in manufacturing and general management positions covering a wide range of products, processes, and geographic locations. From 1989 to 1991, Mr. McKelvie served as Executive Vice President for various companies owned and operated by Ditri Associates. Prior to 1989, he served as Executive Vice President of Eagle Industries. From 1965 to 1982, Mr. McKelvie held a number of line and staff positions in the Singer Company including Vice President of Manufacturing in its International Group and General Manager of its two most profitable operating divisions. Michael J. Johnston has been Executive Vice President of Manufacturing of Hedstrom since November 1997. Prior to joining Hedstrom, Mr. Johnston served as Senior Vice President and General Manager Services Company for Philips Consumer Electronics from 1994 to 1997. From 1991 to 1994, he was Vice President of Manufacturing for Black & Decker Household Products Group. From 1989 to 1991, Mr. Johnston was Senior Vice President and General Manager of Danly Die Set, a division of Connell Ltd. Partnership. From 1970 to 1989, he served in various manufacturing-related positions with General Electric Co. Alfred A. Carosi, Jr. has been Executive Vice President of Sales and Marketing with Hedstrom since December 1996. In this position he is also responsible for corporate product development. Prior to joining Hedstrom, Mr. Carosi was Senior Vice President of Marketing and Marketing Services for the Parker Brothers Division of Hasbro, Inc. from 1991 to 1995. From 1990 to 1991, he was Vice President of Children's and Family Programs at NBC. Before joining NBC, Mr. Carosi served as Senior Vice President of Marketing and Marketing Services for Hasbro, Inc. from 1989 to 1990 and for Hasbro's Playskool Division from 1987 to 1988. Prior to 1987, Mr. Carosi worked in various marketing-related capacities for Procter and Gamble, Sara Lee Corp. and Anheuser Busch, Inc. Item 11. Executive Compensation Summary Compensation Table The following table sets forth the compensation awarded to or earned by the President and Chief Executive Officer of Hedstrom and each other executive officer of Hedstrom whose total annual salary and bonus for the year ended December 31, 1998 was in excess of $100,000 (the "Named Executive Officers"). Fiscal years 1997 and 1998 represent the fiscal years ended December 31, 1997 and December 31, 1998. Fiscal year 1996 represents the twelve months ended July 31, 1996. Long Term Compensation Annual Compensation ------------------------------- -------------------------- Securities All Other Fiscal Underlying Compensation Name and Principal Postion Year Salary($)(1) Bonus($)(2) Options(#)(3) ($)(4) -------------------------- ------ ------------ ---------- ------------- -------------- Arnold E. Ditri ................ 1998 $505,000 _ - $4,072 President and Chief Executive 1997 340,000 197,500 456,446 3,791 Officer 1996 333,938 _ 543,544 3,205 David F. Crowley(5) ............ 1998 171,900 - - 4,876 Chief Financial Officer 1997 121,900 48,760 28,233 251 1996 107,705 _ 271,777 270 Alfred A. Carosi, Jr. (6)....... 1998 239,635 _ - 25,875 Executive Vice President - 1997 220,644 90,000 200,000 39,774 Sales and Marketing 1996 17,917 _ 200,000 - Alastair H. McKelvie(7)......... 1998 130,000 _ - - Executive Vice President - 1997 90,000 36,000 28,233 6,408 Operations 1996 82,500 - 271,777 - Michael J. Johnston (7)......... 1998 255,000 127,500 - 172,839 Executive Vice President - 1997 29,423 - 400,000 - Operations 1996 - - - - __________ (1) Includes the following amounts deferred by Messrs. Ditri, Carosi and Johnston, respectively, pursuant to the Company's Savings Plan for the following fiscal years: 1998- $23,575, $10,000 and $3,433; 1997- $18,837, $10,014 and $0; 1996- $15,766, $0, $0 and $0. (2) Amount includes bonuses accrued during each fiscal year but paid shortly thereafter. (3) All stock option grants were made pursuant to the Company's 1995 and 1997 Stock Option Plans. (4) Represents premiums paid by the Company under a group term life insurance plan, and the reimbursement of Mr. Johnston's relocation expenses in 1998 and Mr. Carosi's relocation expenses in 1997. (5) Mr. Crowley was named Chief Financial Officer of the Company effective November, 1994. (6) Mr. Carosi was named Executive Vice President of Sales and Marketing of the Company effective December, 1996. (7) Mr. Johnston was named Executive Vice President of Operations effective November 10, 1997. __________ No option grants were made during the year ended December 31, 1998 to the named executive officers. __________ The following table summarizes the value of options to acquire Holdings Common Stock held by the Named Executive Officers as of December 31, 1998. Option Exercises and Year-End Option Value Table Aggregated Option Exercises in Last Fiscal Year and Fiscal Year End Option Values(1) Number of Securities Underlying Unexercised Value of Unexercised Options at In-the-Money Options at December 31, 1998 December 31, 1998 (2) ---------------------------- --------------------------- Exercisable Unexercisable Exercisable Unexercisable ----------- ------------- ----------- ------------- Arnold E. Ditri.......... 695,693 304,297 $414,163 $121,719 David F. Crowley ........ 281,188 18,822 180,419 7,529 Alfred A. Carosi, Jr..... 200,000 200,000 113,333 96,667 Michael J. Johnston...... 133,333 266,667 53,333 106,667 Alastair H. McKelvie .... 281,188 18,922 180,419 7,529 __________ (1) No options were exercised by a Named Executive Officer in 1998. (2) Assumes a fair market value of $1.65 per share. Because Holdings Common Stock is privately-held, for purposes of the calculation of the value of unexercised options as of December 31, 1998, Hedstrom has assumed a per share fair market value for Holdings Common Stock equal to the per share exercise price of most recently issued options. Item 12. Security Ownership of Certain Beneficial Owners and Management STOCK OWNERSHIP AND CERTAIN TRANSACTIONS Stock Ownership All of the issued and outstanding capital stock of Hedstrom is owned by Holdings. The following table sets forth certain information regarding the beneficial ownership of the outstanding Holdings Common Stock by each person who is known by Holdings to beneficially own more than 5% of the Holdings Common Stock and by the directors of Holdings and the Named Executive Officers, individually, and by the directors and executive officers of Holdings as a group as of March 30, 1999. Shares of Holidings Common Stock Beneficially Owned ------------------- Percent Number of of Shares Class ------------ ------ 5% Stockholders HM Parties(1) ................................. 56,030,600 82.8% c/o Hicks, Muse, Tate & Furst Incorporated 200 Crescent Court, Suite 1600 Dallas, Texas 75201 Officers and Directors Robert H. Elman ................................ 1,625,000 2.4% Alan B. Menkes ................................ 36,370 * Jack D. Furst (1)(2) ........................... 55,451,640 82.0% Arnold E. Ditri (3) ............................ 4,601,993 6.8% David F. Crowley (4) ........................... 312,767 * Alastair H. McKelvie (5) ....................... 2,074,888 3.1% Alfred C. Carosi, Jr. (6) ...................... 200,000 * Michael J. Johnston (6) ........................ 133,333 * All executive officers and directors as a group (10 persons ............................. 64,435,991 95.2% __________ * Represents less than 1% (1) Includes (i) 23,829,000 shares owned of record by HM Fund II, a limited partnership of which the sole general partner is HM2/GP Partners, L.P., a limited partnership of which the sole general partner is Hicks, Muse GP Partners, L.P., a limited partnership of which the sole general partner is Hicks, Muse, Tate & Furst Fund II Incorporated, a corporation affiliated with Hicks Muse; (ii) 31,520,000 shares of Non-Voting Common Stock owned of record by HM Fund II which are convertible into shares of Holdings Common Stock, on a one-for-one basis, at the option of HM Fund II, (iii) 479,400 shares owned of record by Thomas O. Hicks; and (iv) 202,200 shares owned of record by four children's trusts of which Mr. Hicks serves as trustee. Mr. Hicks is a controlling stockholder of Hicks Muse and serves as Chairman of the Board, Chief Executive Officer and Secretary of Hicks Muse. Accordingly, Mr. Hicks may be deemed to be the beneficial owner of Holdings Common Stock held by HM Fund II. John R. Muse, Charles W. Tate, Jack D. Furst, Lawrence D. Stuart, Jr., and Michael J. Levitt are officers, directors and minority stockholders of Hicks Muse and as such may be deemed to share with Mr. Hicks the power to vote or dispose of Holdings Common Stock held by HM Fund II. Each of Messrs. Hicks, Muse, Tate, Furst, Stuart and Levitt disclaims the existence of a group and disclaims beneficial ownership of Holdings Common Stock not respectively owned of record by him. (2) Includes 102,640 shares owned of record by Mr. Furst. Mr. Furst disclaims beneficial ownership of shares not owned of record by him. (3) Includes (i) 3,106,300 shares owned of record by Mr. Ditri, (ii) 800,000 shares owned of record by certain members of Mr. Ditri's family, and (iii) 695,693 shares subject to options that are exercisable within 60 days. Mr. Ditri disclaims beneficial ownership of shares not owned of record by him. (4) Includes (i) 31,579 shares owned of record by Mr. Crowley and (ii) 281,188 shares subject to options that are exercisable within 60 days. (5) Includes (i) 1,793,700 shares owned of record by Mr. McKelvie and (ii) 281,188 shares subject to options that are exercisable within 60 days. (6) Consists of shares subject to options that are exercisable within 60 days. Item 13. Certain Relationships and Related Transactions Certain Transactions Monitoring and Oversight Agreement On October 27, 1995, Holdings and Hedstrom entered into a ten- year agreement (the "Monitoring and Oversight Agreement") with Hicks, Muse & Co. Partners, L.P. ("Hicks Muse Partners"), pursuant to which they pay Hicks Muse Partners an annual fee (initially $175,000) for oversight and monitoring services to Holdings and Hedstrom. The annual fee is adjustable each July 31st to an amount equal to 0.1% of the consolidated net sales of Hedstrom during the previous twelve months, but in no event less than $175,000. Mr. Furst, director of Holdings and Hedstrom, is a principal of Hicks Muse Partners. In addition, Holdings and Hedstrom have agreed to indemnify Hicks Muse Partners, its affiliates and their respective directors, officers and controlling persons, if any, and, agents and employees of Hicks Muse Partners or any of its affiliates from and against all claims, liabilities, losses, damages, and expenses, including legal fees, arising out of or in connection with the services rendered by Hicks Muse Partners in connection with the Monitoring and Oversight Agreement. The Monitoring and Oversight Agreement makes available the resources of Hicks Muse Partners concerning a variety of financial and operational matters. The services that have been and will continue to be provided by Hicks Muse Partners could not otherwise be obtained by Holdings and Hedstrom without the addition of personnel or the engagement of outside professional advisors. In management's opinion, the fees provided for under this agreement reasonably reflect the benefits received and to be received by Holdings and Hedstrom. Financial Advisory Agreement On October 27, 1995, Holdings and Hedstrom entered into a ten- year agreement (the "Financial Advisory Agreement") with HM2/Management Partners, L.P. ("HM2"), pursuant to which they paid HM2 a cash financial advisory fee of approximately $1.175 million as compensation for its services as financial advisor in connection with the acquisition of Holdings and Hedstrom by Hicks Muse. HM2 also will be entitled to receive a fee equal to 1.5% of the transaction value (as defined) for each add-on transaction (as defined) in which Hedstrom is involved. The term "transaction value" means the total value of any add-on transaction (excluding any fees payable pursuant to the Financial Advisory Agreement in connection with such add-on transaction) including the amount of any indebtedness, preferred stock or similar items assumed (or remaining outstanding). The term "add-on transaction" means any future proposal for a tender offer, acquisition, sale, merger, exchange offer, recapitalization, restructuring, or other similar transaction directly or indirectly involving Holdings, Hedstrom, or any of their respective subsidiaries, and any other person or entity. Mr. Furst, a director of Holdings and Hedstrom, is a principal of HM2. In addition, Holdings and Hedstrom have agreed to indemnify HM2, its affiliates and their respective directors, officers and controlling persons, if any, and agents and employees of HM2 from and against all claims, liabilities, losses, damages, and expenses, including legal fees, arising out of or in connection with the services rendered by HM2 in connection with the Financial Advisory Agreement. The Financial Advisory Agreement makes available the resources of HM2 concerning a variety of financial matters. The services that have been and will continue to be provided by HM2 could not otherwise be obtained by Holdings and Hedstrom without the addition of personnel or the engagement of outside professional advisors. In management's opinion, the fees provided for under this agreement reasonably reflect the benefits received and to be received by Holdings and Hedstrom. Stockholders Agreement The investors who purchased or received Holdings Common Stock in connection with or subsequent to the acquisition of Holdings and Hedstrom by Hicks Muse and its affiliates (other than persons who acquired shares of Holdings Common Stock in connection with Holdings Discount Notes offering and their transfers) have entered into a stockholders agreement (the "Stockholders Agreement"). The Stockholders Agreement grants preemptive rights and certain piggy- back registration rights to the parties thereto and contains provisions requiring the parties thereto to sell their shares of Holdings Common Stock in connection with certain sales of Holdings Common Stock by HM Fund II ("drag-along rights") and grants the parties thereto other than HM Fund II the right to include a portion of their shares of Holdings Common Stock in certain sales in which HM Fund II does not exercise its drag-along rights ("tag- along rights"). The Stockholders Agreement terminates on its tenth anniversary date, although the preemptive rights, drag-along rights and tag-along rights contained therein will terminate earlier upon the consummation of a registered underwritten public offering of Holdings Common Stock by Holdings. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) (1) Financial Statements Report of Independent Accountants Consolidated Balance Sheets as of December 31, 1998 and 1997 Consolidated Income Statements for the Fiscal Years Ended December 31, 1998 and December 31, 1997, for the Five Months Ended December 31, 1996 and for the Fiscal Year Ended July 31, 1996. Consolidated Statements of Cash Flows for the Fiscal Years Ended December 31, 1998 and December 31, 1997, for the Five Months Ended December 31, 1996 and for the Fiscal Year Ended July 31, 1996. Consolidated Statements of Stockholders' Equity for the Fiscal Years Ended December 31, 1998 and December 31, 1997, for the Five Months Ended December 31, 1996 and for the Fiscal Year Ended July 31, 1996. Notes to Consolidated Financial Statements (2) Financial Statement Schedule Schedule IX - Valuation and Qualifying Accounts and Reserves All other schedules have been omitted because they are not applicable or are not required, or because the required information has been included in the Consolidated Financial Statements or Notes thereto. (3) Exhibits Description of Exhibits ----------------------- (1) 2.1 - Agreement and Plan of Merger, dated as of April 10, 1997, among Hedstrom Corporation HC Acquisition Corp. and ERO, Inc. (1) 3.1 - Restated Certificate of Incorporation of Hedstrom Holdings, Inc., as filed with the Secretary of State of the State of Delaware on October 27, 1995. (1) 3.2 - Certificate of Amendment of Restated Certificate of Incorporation of Hedstrom Holdings, Inc., as filed with the Secretary of State of the State of Delaware on June 6, 1997. (1) 3.3 - Restated Bylaws of Hedstrom Holdings, Inc. (1) 3.4 - Certificate of Incorporation of New Hedstrom Corp., as filed with the Secretary of State of the State of Delaware on November 20, 1990. (1) 3.5 - Certificate of Amendment of the Certificate of Incorporation of New Hedstrom Corp., as filed with the Secretary of State of the State of Delaware on January 14, 1991. (1) 3.6 - By-Laws of Hedstrom Corporation. (1) 3.7 - Amended and Restated Certificate of Incorporation of ERO, Inc., as filed as Annex A to that certain Certificate of Ownership and & Merger filed with the Secretary of State of the State of Delaware on June 12, 1997 merging HC Acquisition Corp. with and into ERO, Inc. (1) 3.8 - Amended and Restated Bylaws of ERO, Inc. (1) 3.9 - Certificate of Incorporation of ERO Industries, Inc., as filed as Annex A to that certain Certificate of Merger filed with the Secretary of State of the State of Delaware on July 15, 1988 merging GTC Leisure, Inc. with and into ERO Industries, Inc. (1) 3.10 - By-Laws of ERO Industries, Inc. (1) 3.11 - Articles of Incorporation of ERO Marketing, Inc., as filed with the Secretary of State of the State of Illinois on January 21, 1992. (1) 3.12 - Bylaws of ERO Marketing, Inc. (1) 3.13 - Certificate of Incorporation of Priss Prints Acquisition Corp., as filed with the Secretary of State of the State of Delaware on September 19, 1986. (1) 3.14 - Certificate of Amendment of Certificate of Incorporation of Priss Prints Acquisition Corp., as filed with the Secretary of State of the State of Delaware on November 5, 1986. (1) 3.15 - By-Laws of Priss Prints, Inc. (1) 3.16 - Certificate of Incorporation of Impact, Inc., as filed with the Secretary of State of the State of Delaware on November 3, 1993. (1) 3.17 - By-Laws of Impact, Inc. (1) 3.18 - Certificate of Incorporation of ERO Canada, Inc., as filed with the Secretary of State of the State of Delaware on August 3, 1994. (1) 3.19 - By-Laws of ERO Canada, Inc. (1) 3.20 - Certificate of Incorporation of ERO NY Acquisition, Inc., as filed with the Secretary of State of the State of Delaware on October 12,1995. (1) 3.21 - Certificate of Amendment of Certificate of Incorporation of ERO NY Acquisition, Inc., as filed with the Secretary of State of the State of Delaware on January 23, 1996. (1) 3.22 - By-Laws of Montreal Industries, Inc. (1) 4.1 - Indenture, dated as of June 1, 1997, among Hedstrom Corporation, Hedstrom Holdings, Inc., the Subsidiary Guarantors identified on the signature pages thereto and IBJ Schroder Bank & Trust Company, as Trustee. (1) 4.2 - Form of Senior Subordinated Note. (1) 4.3 - Indenture, dated as of June 1, 1997, among Hedstrom Holdings, Inc. and United States Trust Company of New York, as Trustee. (1) 4.4 - Form of Discount Note. (1) 4.5 - [Intentionally Omitted] (1) 4.6 - Registration Rights Agreement, dated as of June 9, 1997, among Hedstrom Corporation and Hedstrom Holdings, Inc., as Issuers, and Credit Suisse First Boston Corporation, Societe Generale Securities Corporation and UBS Securities LLC, as Initial Purchasers. (1) 4.7 - Common Stock Registration Rights Agreement, dated as of June 9, 1997, among Hedstrom Holdings, Inc. and Credit Suisse First Boston Corporation, Societe Generale Securities Corporation and UBS Securities LLC, as Initial Purchasers. (1) 10.1 - Credit Agreement, dated as of June 12, 1997, among Hedstrom Corporation Hedstrom Holdings, Inc., the Lenders from time to time parties thereto, Societe Generale, as Documentation Agent, UBS Securities LLC, as Syndication Agent, and Credit Suisse First Boston Corporation, as Administrative Agent. (1) 10.2 - Form of Tranche A Note. (1) 10.3 - Form of Tranche B Note. (1) 10.4 - Form of Revolving Credit Note. (1) 10.5 - Form of Swing Line Note. (1) 10.6 - Master Guarantee and Collateral Agreement, dated as of June 12, 1997, made by (1) 10.7 - Open End Mortgage, dated as of June 12, 1997, from Hedstrom Corporation, as Mortgagor, to Credit Suisse First Boston Corporation, as Mortgagee. (1) 10.8 - Open End Mortgage and Security Agreement, dated as of June 12, 1997, from Hedstrom Corporation, as Mortgagor, to Credit Suisse Corporation, as Mortgagee. (1) 10.9 - Deed and Security Agreement, dated as of June 12, 1997, from ERO Industries, Inc., as Grantor, to Credit Suisse First Boston Corporation, as Grantee. (1) 10.10 - Mortgage of Shares, dated as of June 12, 1997, between Hedstrom Corporation, as Chargor, and Credit Suisse First Boston, as Administrative Agent. (1) 10.11 - Mortgage of Shares, dated as of June 12, 1997, between Montreal Industries, Inc., as Chargor, and Credit Suisse First Boston, as Administrative Agent. (1) 10.12 - Stockholders Agreement, dated as of October 27, 1995, among Hedstrom Holdings and the holders listed on the signature pages thereof. (1) 10.13 - First Amendment to Stockholders Agreement, dated as of June 1, 1997, between Hedstrom Holdings, Inc. and Hicks, Muse, Tate & Furst Equity Fund II, L.P. (1) 10.14 - Form of Subordinated Note issued by Hedstrom Holdings, Inc. (1) 10.15 - Amendment and Waiver, dated as of June 12, 1997, between Hedstrom Holdings, Inc. and Alan Plotkin, as Holder Representative, regarding the Subordinated Notes of Hedstrom Holdings, Inc. (1) 10.16 - Form of Promissory Note (Series A) issued by Hedstrom Holdings, Inc. (1) 10.17 - Amendment and Waiver, dated as of June 12, 1997, between Hedstrom Holdings, Inc. and Alan Plotkin, as Holder Representative, regarding the Promissory Notes (Series A) of Hedstrom Holdings, Inc. (1) 10.18 - Form of Promissory Note (Series B) issued by Hedstrom Holdings, Inc. (1) 10.19 - Amendment and Waiver, dated as of June 12, 1997, between Hedstrom Holdings, Inc. and Alan Plotkin, as Holder Representative, regarding the Promissory Notes (Series B) of Hedstrom Holdings, Inc. (1) 10.20 - Executive Employment Agreement, dated as of October 27, 1995, among Hedstrom Holdings, Inc., Hedstrom Corporation and Arnold E. Ditri (1) 10.21 - Executive Employment Agreement, dated as of October 27, 1995, between Hedstrom Corporation and Alastair McKelvie. (1) 10.22 - Monitoring and Oversight Agreement, dated as of October 27, 1995, among Hedstrom Holdings, Inc., Hedstrom Corporation and Hicks, Muse & Co. Partners, L.P. (1) 10.23 - Financial Advisory Agreement, dated as of October 27, 1995, among Hedstrom Holdings, Inc., Hedstrom Corporation and HM2/Management Partners, L.P. (1) 10.24 - Hedstrom Holdings, Inc. 1995 Stock Option Plan. (2) 10.25 - The Third Restatement of ERO Industries, Inc. Retirement Income Plan (401(k)). (4) 10.26 - The Hedstrom Corporation Tax Sheltered Savings Plan (401(k)). (4) 10.27 - 1997 Hedstrom Holdings, Inc. Stock Option Plan. (4) 10.28 - Amendment Number One, dated November 11, 1997, and Amendment Number Two, dated December 19, 1997, to the Credit Agreement, dated as of June 12, 1997, among Hedstrom Corporation, Hedstrom Holdings, Inc., the financial institutions party thereto and Credit Suisse First Boston, as agent. (4) 10.29 - Specimen and listing of all license agreements between Disney Enterprises, Inc. and Hedstrom Corporation and its Subsidiaries. (3) 10.30 - Second Amendment to the Third Restatement of ERO Industries, Inc. Retirement Income Plan (401(k)). (5) 10.31 - Stock Purchase Agreement, dated July 24, 1998 by and between Hedstrom Corporation and Richard Boyer. (5) 10.32 - Amendment Number Three dated July 24, 1998 to the Credit Agreement, dated as of June 12, 1997, among Hedstrom Corporation, Hedstrom Holdings, Inc., the financial institution party thereto and Credit Suisse First Boston, as agent. (5) 10.33 - Collective Bargaining Agreement, dated October 3, 1998 by and between Hedstrom Corporation and The United Steel Workers of America, AFL-CIO-CLC, on behalf of its affiliated Local Union No. 524L 10.34 - Amendment Number Four dated December 30, 1998 to the Credit Agreement, dated as of June 12, 1997, among Hedstrom Corporation, Hedstrom Holdings, Inc., the financial institutions party thereto and Credit Suisse First Boston, as agent. 11.1 - Computation of Earnings Per Share. (1) 21.1 - Subsidiaries of the Company. 23.1 - Consent of Arthur Andersen LLP, independent auditors. 27.1 - Financial Data Schedule ____________ (1) Incorporated by reference to the respective exhibit to Holdings' and Hedstrom's Registration Statement on Form S-1 (File Nos. 333-32385-05 and 333-32385). (2) Incorporated by reference to ERO, Inc.'s Report on Form 10-K (File No. 0-19942) for the fiscal year ended December 31, 1993. (3) Incorporated by reference to ERO, Inc.'s Report on Form 10-K (File No. 0-19942) for the fiscal year December 31, 1996. (4) Incorporated by reference to Holdings' and Hedstrom's Report on Form 10-K (File Nos. 333-32385-05 and 333-32385) for the fiscal year December 31, 1997. (5) Incorporated by reference to Holdings' and Hedstrom's Report on Form 10-Q (File Nos. 333-32385-05 and 333-32385) for the quarterly period ended June 30, 1998. (b) Reports on Form 8-K No reports on Form 8-K were filed by the Company during the fourth quarter of 1998. > SIGNATURE PAGE Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, each of the Co-Registrants has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Mount Prospect, State of Illinois, on the 30th day of March, 1999. HEDSTROM HOLDINGS, INC. HEDSTROM CORPORATION /s/ ARNOLD E. DITRI By ------------------- Arnold E. Ditri President and Chief Executive Officer Pursuant to the requirements of the Securities Act of 1934, as amended, this report has been signed by the following persons in the capacities and on the dates indicated. Signature Title Date - ------------------- --------------------------------- -------------- /s/ ROBERT H. ELMAN Chairman of the Board of Directors March 30, 1999 - --------------------- Direcotr of the Co-Registrants Robert H. Elman listed above /s/ ARNOLD E. DITRI President, Chief Executive Officer March 30, 1999 - --------------------- and Director of the Co-Registrants Arnold E. Ditri listed above (Principal Executive Officer) /s/ DAVID F. CROWLEY Chief Financial Officer of the March 30, 1999 - --------------------- Co-Registrants listed above David F. Crowley (Principal Financial and Accounting Officer) /s/ ALAN B. MENKES Director of the Co-Registrants March 30, 1999 - --------------------- listed above Alan B. Menkes /s/ JACK D. FURST Director of the Co-Registrants March 30, 1999 - --------------------- listed above Jack D. Furst Hedstrom Holdings, Inc. Schedule IX Valuation and Qualifying Accounts and Reserves As of and for the Fiscal Years Ended December 31, 1998, December 31, 1997 and as of and for the Fiscal Year Ended July 31, 1996 Additions Deletions -------------------- ----------------------- Foreign Balance at Charged to Charged Currency Balance at Beginning Costs and to Other Translation End of Year Expenses Accounts Write-offs Adjustment of Year ---------- ---------- ---------- ---------- ---------- ---------- 1998 Allowance for doubtful accounts ........ $2,297,000 $3,183,000 $151,000(3) $ (344,000) $(7,000) $5,280,000 Accumulated amortization of goodwill ... 2,384,000 4,957,000 - - - 7,341,000 Amortization ofdeferred financing fees.. 3,246,000 6,475,000 - - - 9,721,000 Accumulated amortization of deferred charges .............................. 1,629,000 743,000 - - - 2,372,000 1997 Allowance for doubtful accounts.......... 505,000 1,258,000 751,000(1) (196,000) (21,000) 2,297,000 Accumulated amortization of goodwill..... - 2,384,000 - - - - Amortization of deferred financing fees.. - - - - - - Accumulated amortization of deferred charges ............................... 747,000 882,000 - - - 1,629,000 1996 Allowance for doubtful accounts........... 405,000 76,000 - (39,000) (1,000) 441,000 Accumulated amortization of deferred charges................................ 2,907,000 520,000 - (3,030,000)(2) - 397,000 (1) Represents reserve established on the opening balance sheet pursuant to the ERO, Inc. acquisition. (2) Represents a write-off in connection with the Company's 1995 Recapitalization. (3) Represents reserve established on the opening balance sheet pursuant to the Backyard Products, Ltd. acquisition.