MEGA Brands Inc. Annual Report 2006 · PDF fileDiluted 0.76 0.98 0.86 1.26 1.56 2002 2003 ... $ $ $ $ $ $ $ $ MEGA Brands Inc $ $ $ $ $ $ $ $ $ $ $ $ $ $ $

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Years Ended December 31

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Net sales (1) 188,807 219,691 234,581 384,863 547,347Geographic Segmentation

North America 132,160 138,041 132,744 254,318 397,778International 56,647 81,650 101,837 130,545 149,569

Product SegmentationToys - - - 291,576 333,667Stationery & Activities - - - 93,287 213,680

Gross profit 89,991 102,447 105,922 170,195 218,525

Net earnings 20,166 28,805 25,177 39,608 25,348Net earnings before Specified Items (2) 20,166 28,805 25,177 39,608 53,217

Earnings per share before Specified Items (2)

Basic 0.83 1.07 0.93 1.35 1.65Diluted 0.76 0.98 0.86 1.26 1.56

2002 2003 2004 2005 2006

188.8219.7 234.6

384.9

547.3

Toys

61%North America

73%

International27%

Stationery& Activities39%

(1) Net sales and gross profit in 2005 and 2006 were restated according to EIC-156, ''Accounting by a Vendor for Consideration Given to a Customer (Including a Reseller of the Vendor's Product)''. Such restatement does not have an impact on net earnings. Please refer to the section titled “Adoption of EIC-156” on page 13 of the ManagementDiscussion and Analysis (‘MD&A”).

(2) Net earnings before Specified Items and Earnings per share before Specified Items do not have any standardized meaning under Canadian Generally Accepted AccountingPrinciples (“GAAP”) and are therefore unlikely to be comparable to similar measures presented by other companies. The Corporation believes this to be a relevant measurebecause it excludes items that are not typical of ongoing operations. Please refer to the section titled “Specified Items Affecting Operations” on page 9 of the MD&A.

Net SalesUS$ Millions

Segmented Sales 2006

By Product Lines By Geographic Market

Financial Highlights

MEGA Brands provides stimulating

creative experiences through

innovative, well-designed, affordable

and high-quality products.

Our Mission is to nurture creativityin every child and every family.

MEGA Brands is a trusted family of leading global brands in construction toys, games & puzzles,arts & crafts and stationery.

2 MEGA Brands Annua l Repor t 2006

Products: Building blocks, character role-play, vehicles

Growth drivers: Licenses, educational benefits of block play, wider product range reaching broader target age, new play patterns,products and geographic markets

New in 2007: Building Imagination Bag, Dora the Explorer and Go Diego Go!,Cars, CAT® Ride-On

Toys

Preschool Construction MMaarrkkeett PPoossiittiioonn:: #1 Worldwide

Building Imagination Bag

Products: Building sets, character role-play, vehicles

Growth drivers: Market share gains in existing markets, new play patterns,products and geographic markets

New in 2007: NEO Shifters™, Plasma Dragons™,Pirates of the Caribbean:At World’s End, Spider-Man 3

Toys

MEGA Brands Annua l Repor t 2006 3

Boys 5+ Construction Market Position: #2 Worldwide

NEO Shifters™

Products: Building sets, character role-play, vehicles

Growth drivers: New play patterns, storage expansion and new geographic markets

New in 2007: iCoaster™, Build-off Cases, MagnaFormers™

Magnetix

Toys

Market Position: #1 Worldwide

iCoaster™



Products: Games & Puzzles for all ages

Growth drivers: New designs and themes, top licenses, breadth of product portfolio

New in 2007: Disney® properties,Triazzle, Fairy Princess Game

Toys

Market Position: #2 North America*Games & Puzzles

*(Puzzles)

Esphera Puzzle


Stationery & Activities

Products: Craft, art and role-play activities, flocked posters, jewelry,dough, scrapbooking, easels & furniture

Growth drivers: Market share gains in North America, new geographic markets,play patterns and products

New in 2007: Rose Art smART easel™, B’Chic™, On the Go™,Disney® Arts & Crafts, new packaging, new international markets

Activities Market Position: #2 North America

Rose Art smART easel™


Products: Crayons, colored pencils, children’s markers, glue,paints & brushes, chalk

Growth drivers: New distribution channels, new geographic markets,products and categories

New in 2007: Color Start™, Pix™, new packaging

Art Materials


Market Position: #2 North America*

*(Food, drug and mass retailers)

Crayons

Market Position: #3 North America*



Products: Pens, mechanical pencils, woodcase pencils,adult markers and highlighters

Growth drivers: New distribution channels, geographic markets,products and categories

New in 2007: SRX™, entry in new markets, new packaging

Writing Instruments

*(Food, drug and mass retailers)

Pens

Market Position: #2 North America


Products: Dry erase and cork presentation boards, dry erase markers and erasers, locker organizers

Growth drivers: New distribution channels, products and categories

New in 2007: Penetration in office superstores

Boards & Accessories


Dry erase board


Chairman’s Letter

AcknowledgementsI take this opportunity to thank the members of our Board ofDirectors for their counsel and their dedication to theirresponsibilities as directors and committee chairs. In 2006,we welcomed Dr. Larry Light, an internationally renownedmarketing professional as well as Daniel T. Motulsky, Partnerand Managing Director of the global investment bank LazardFrères & Co., to the board as independent directors. We alsobid adieu to David I. Foley and Michel Coutu, who deserve our gratitude for their years of service to the company.

In closing, I would like to acknowledge with a special thank you, the perseverance and passion of the global MEGA Brands team.

Victor J. Bertrand Sr.Chairman and Founder

Dear Shareholders,

Over the course of 40 years, MEGA Brands has earned an enviable reputation with consumers worldwide.Millions of families trust us to deliver quality products

that offer stimulating, fun and educational play experiencesfor children. This is the foundation on which our companywas built and this global equity with the consumer will never be compromised.

In 2006 and in the first quarter of 2007, our company facedmany challenges with the Magnetix® product recall, manage-ment changes and integration, resulting in some disruptionsto financial performance. The management team, supportedby more than 6,000 dedicated employees worldwide,responded diligently in the interest of maintaining long-termshareholder value.

As the founder and as a major shareholder of this company,I feel very confident about its fundamental strengths. MEGA Brands has a unique portfolio of creative products to market across a global distribution platform. Most important of all, our company has an exceptional capacity for innovation which was highlighted again in 2006 with over 60 awards. In our business, the combination of trustedbrands and a culture of innovation is the powerful driver of long-term value.

Dr. Toy's Best Vacation Toys(Small Maxi Bag)

The Toy Insider Hot 20 Toys for the Holiday Season

(POTC Black Pearl)

Learning Magazine's Teachers' Choice Award(Magtastik™ Starter Set)

The National Parenting Center2006 Seal of Appproval

(Tiny'n Tuff® Off-Road Set™)


Message to Shareholders

In art materials, many new innovations will fuel continuedgrowth, including Pix™ mess-free art sets and Color Start™,which are hitting retail shelves starting in the third quarterof 2007. Our Boards segment is growing with important newdistribution in the office supply channel.

InternationalOur international business continues to be a strong growthengine for our company. Our strategy is to increase our shareof existing markets, penetrate new territories and introduceStationery & Activities to our international customer base.

In construction, the combination of Mega Bloks® andMagnetix® makes us stronger. We are gaining market shareglobally and in 2006, we captured the #1 position in theUnited Kingdom and Spain. In Stationery & Activities, we havestrengthened our sales team in several countries and arelaunching our exciting new products worldwide.

OutlookWith strong execution from our global team and the continued support of our retail partners worldwide, we believe MEGA Brands is well positioned for growth.

The fundamentals of our business are strong. After a challengingyear in 2006 with many unexpected events, we are focused on delivering strong operating results in 2007.

For the long-term, we have a sound growth strategy, a uniquecreative products portfolio and a talented and experiencedglobal team to drive results.

Creativity to the Rescue.

Marc Bertrand Vic BertrandPresident and Chief Operating OfficerChief Executive Officer

MEGA Brands has an exceptional creative products portfolio, strong license partners and great brands. In North America, we are the #1 or #2 player in most of

our major product segments, we are #2 worldwide in cons-truction toys, and we have many opportunities to build on ourleading positions and enter new categories across the globe.

Our growth strategy — based on innovation, licensing, inter-national market penetration and acquisitions — will continueto generate long-term shareholder value. For 2007, we havehighlighted in the preceding pages some of the exciting new products that will lead our performance.

North AmericaOur preschool segment is in great shape and our leadershipposition continues to improve. Growing demand for Mega Bloks® building toys, the successful launch of Dora and Diego and the upcoming launches of Disney Cars and ourCaterpillar products will contribute incremental salesthrough the rest of the year.

In Boys 5-plus, we are off to a great start with shipments of Pirates of the Caribbean and Spider-Man construction sets and a positive consumer response to our new Dragons™ line. The highlight of our second half in this category is NEO Shifters™, a new and exciting collection of buildable robots.

The Magnetix® range will feature more new play patterns, the most exciting being iCoaster™, the world’s first magnet-powered toy roller coaster with a music mixing studio thatworks with all popular MP3 players.

In Games & Puzzles, we are launching new games and addingmany new Disney themes to our puzzle assortment.

In Stationery & Activities, we are bringing innovation, stronglicenses and a fresh new look to our lines. Our key driver forfall is the Rose Art smART easel™, a collapsible, easy-to-store,portable easel that comes with its own art supplies. For girls,our new B’Chic™ brand leads the way. We are also introducingBrian the Brain™, a digital roommate with unique featuresthat permit personal interaction with kids via text to speechand voice recognition.

Parents' Choice Award(CAT® Construction Site)

Oppenheim Toy Portfolio Best Toy Award Gold Seal

(Lil’ Train™)


Directors & Executive Officers

Executive Officers

Marc Bertrand

President and Chief Executive Officer

Vic Bertrand

Chief Operating Officer

Kathleen Campisano

Executive Vice-President

and Chief Marketing Officer

Sylvain Duval

Executive Vice-President Global Operations

Al Hunyadi

President Stationery & Activities

Michel Moggio

Vice-President International

Alain Tanguay

Executive Vice-President

and Chief Financial Officer

Gerardo Yepez Reyna

President Toys

Directors

Victor J. BertrandChairman of the BoardMEGA Brands Inc.

Marc BertrandPresident and Chief Executive OfficerMEGA Brands Inc.

Vic BertrandChief Operating OfficerMEGA Brands Inc.

Jean-Guy DesjardinsChairman and Chief Executive OfficerCentria Inc. and Fiera YMG Cap.

Dr. Larry LightPresident and Chief Executive OfficerArcature LLP

Peter T. MainCompany Director and Consultant

Daniel T. MotulskyManaging Director Lazard Frères & Co.

Paula RobertsVice-President Strategic CommunicationsSickKids Foundation

MANAGEMENT’S DISCUSSION AND ANALYSIS AND CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006 and 2005

2006 Annual Report - MEGA Brands Inc. 2

TABLE OF CONTENTS MANAGEMENT’S DISCUSSION AND ANALYSIS

Forward-Looking Statements..............................................................................................................................................3

Corporate Overview ............................................................................................................................................................4

Industry Overview ...............................................................................................................................................................4

Strategy, Objectives and 2006 Developments ...................................................................................................................5

Selected Financial Information .........................................................................................................................................11

Year Ended December 31, 2006 Compared to Year Ended December 31, 2005..........................................................13

Year Ended December 31, 2005 Compared to Year Ended December 31, 2004..........................................................17

Liquidity and Capital Resources.......................................................................................................................................18

Selected Quarterly Financial Information ........................................................................................................................20

Three-Month Period Ended December 31, 2006 Compared to Three-Month Period Ended December 31, 2005......20

Shares Outstanding ............................................................................................................................................................22

Significant Accounting Policies and Use of Estimates ...................................................................................................22

Risks and Uncertainties .....................................................................................................................................................27

CONSOLIDATED FINANCIAL STATEMENTS

Management’s Responsibility for Financial Reporting ..................................................................................................34

Auditors’ Report ................................................................................................................................................................35

Consolidated Statements of Earnings ..............................................................................................................................36

Consolidated Statement of Retained Earnings (Deficit) ................................................................................................37

Consolidated Balance Sheets ............................................................................................................................................38

Consolidated Statement of Cash Flows............................................................................................................................39

Notes to Consolidated Financial Statements....................................................................................................................40


MANAGEMENT'S DISCUSSION AND ANALYSIS For the fourth quarter and year ended December 31, 2006 This Management's Discussion and Analysis of Financial Position and Results of Operations (“MD&A”), which is current as of April 1, 2007, should be read in conjunction with the audited Consolidated Financial Statements and Notes thereto for the years ended December 31, 2006 and 2005. The financial information in this MD&A and in our financial statements has been prepared in accordance with Canadian Generally Accepted Accounting Principles ("GAAP") of the Canadian Institute of Chartered Accountants (“CICA”). We also present certain non-GAAP financial measures, which we believe are useful to investors for comparing our performance from period to period. Please refer to the “Specified Items Affecting Operations” section of this MD&A. All figures in this MD&A are expressed in U.S. dollars, (reporting and functional currency) unless otherwise indicated. Throughout this MD&A, MEGA Brands Inc. (formerly Mega Bloks Inc.) and its subsidiaries are referred to as “MEGA Brands”, the “Corporation”, “we”, “our” and “us”. The name “MEGA Brands America” refers to Rose Art Industries, Inc., Warren Industries, Inc. and their respective subsidiaries, as they were at the time of the acquisition. FORWARD-LOOKING STATEMENTS All statements in this MD&A that do not directly and exclusively relate to historical facts constitute “forward-looking statements”. These statements represent the Corporation's intentions, plans, expectations and beliefs. In certain instances, these statements require us to make assumptions and there is significant risk that these assumptions may not be correct. Furthermore, these statements are subject to risks, uncertainties and other factors, many of which are beyond the Corporation's control. These factors include and are not restricted to: realization of synergies, litigation and its inherent uncertainty, including the recovery of the full product liability settlement amount and risks associated with product recalls, international operations, insurance coverage, difficulty in predicting consumer preferences and development and acceptance of new products, rate of growth or profitability, dependence on a few large customers, fluctuations in the price of plastic resins and other raw materials as well as currency rates, seasonality of toy and stationery industries, risks related to licensed products, retail environment, construction toy litigation and financing and interest rate matters. The words “believe”, “estimate”, “expect”, “intend”, “anticipate”, “foresee”, “plan”, and similar expressions and variations thereof, identify certain of such forward-looking statements, which speak only as of the date on which they are made. The Corporation disclaims any intention or obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, other than as required by applicable legislation. Readers are cautioned not to place undue reliance on these forward-looking statements. More information about the risks that could cause our actual results to significantly differ from our current expectations can be found in the “Risks and Uncertainties” section of this MD&A. When we state that we believe that the Corporation is well positioned for continued growth, that we anticipate sales growth in the upcoming year and that there is strong growth potential for ROSE ART® and MAGNETIX® brands in international markets, that we expect to realize operational efficiencies in 2007, that we expect to recover from insurers and through other recourses substantially the full amount paid to settle the lawsuits relating to injuries to children resulting from the ingestion of magnets and that we expect to recover the full amounts of the escrow fund provided for under the Stock Purchase Agreement (“SPA”), we have assumed that we will succeed in realizing the cost and revenue synergies from the integration of MEGA Brands America including without limitation the synergies resulting from the downsizing and closing of manufacturing plants in North America and the concentration of distribution in one facility, that we will maintain or increase the quality of products manufactured in new locations, that we will be successful in reducing inventory levels, that we will maintain service levels in our new distribution facility, that we will be able to attract and retain key personnel in key positions, that international markets that we service through our sales and marketing organization will have a strong interest both in ROSE ART brands and in other products that we will offer, that the retail markets into which we sell will continue to demonstrate strong demand for the Corporation's product lines, that our insurers will not successfully deny any material portion of the claims, and that any such portion which may be denied will be recoverable against former shareholders of MEGA Brands America, and that the number and quantum of self-insured product liability claims will not be material. As described in the “Risks and Uncertainties” section of this MD&A, there are risks and uncertainties that could mean that one or more of these assumptions ultimately turn out to be incorrect and that we do not therefore experience the growth that we anticipate.


CORPORATE OVERVIEW MEGA Brands designs, manufactures and markets high quality toys and stationery products. Headquartered in Montreal, the Corporation has approximately 6,000 employees with offices, manufacturing facilities or distribution centers in 14 countries. The Corporation's products are sold in over 100 countries. The Corporation operates under two geographical segments, North America and International, with sales and marketing conducted through two product lines.

Toys product lines are comprised of MEGA BLOKS® construction toys in the preschool and boys 5-plus categories, MAGNETIX® building sets for children 6-plus and MEGA™ games and puzzles for families.

Stationery and Activities product lines are comprised of art materials (crayons, colored pencils, highlighters and markers) sold mainly under the ROSE ART® brand; writing instruments (pens, mechanical pencils and woodcase pencils) sold mainly under the ROSE ART, SRX® and USA GOLD® brands; dry-erase and cork presentation boards, organizers and accessories sold mainly under the BOARD DUDES® brand, and ROSE ART and MEGA craft and activity sets.

INDUSTRY OVERVIEW The traditional toy industry, which excludes video games and computer hardware and software, represents annual sales at wholesale of approximately $16 billion in North America and $40 billion worldwide. The Corporation competes in categories with total estimated manufacturers' shipments of approximately $4 billion in North America and $6 billion in the rest of the world. Worldwide sales of traditional toys have been growing in recent years despite lower sales in North America. In North America, sales declined between 2003 and 2005 mainly as a result of lower purchases for children 12 years of age and older due to the growing popularity of electronic games and a decline in the number of children in the 5-9 age group. An additional factor in the sales decrease was the intense competition among retailers which resulted in a reduction of shelf space for traditional toys and lower prices. North American toy sales stabilized in 2006 and demographic trends are shifting favorably, with growth forecasted in the number of children aged 5-9 during the next several years. Outside North America, demand for traditional toys is increasing with strong potential in many parts of the world mainly due to higher disposable incomes. The Corporation is a significant player in selected categories of the growing $94.1 billion stationery market in North America. The Corporation currently participates in product categories which amount to approximately $16 billion in estimated manufacturer shipments. Most of the Corporation's products are currently sold in the School Supply segment of the stationery market, which represents approximately 14% of total manufacturers' shipments, and is served mainly by mass retailers and food and drug stores. The much larger Office Supply segment of the stationery market, which is served mainly by specialty retailers, offers the Corporation an attractive growth opportunity.


STRATEGY, OBJECTIVES AND 2006 DEVELOPMENTS MEGA Brands has achieved 22 consecutive years of profitability and sales growth since the launch of its first construction blocks in 1985. This success is driven by product innovation and strong execution against our strategic objectives. Product Innovation Product innovation is the key success factor in the toy industry and the main driver of sales growth. In 2006, we renewed approximately 40% of the previous year's toy sales with new product lines and extensions, enhancements and replacements of existing lines. We meet this competitive necessity by investing 3-4% of sales on new product design, engineering, prototyping and development. With over 60 awards and mentions for exceptional design, innovation, learning attributes and play experience, 2006 was a banner year for innovation. Toy testers and critics were particularly excited by our MAGTASTIK® product line which was selected for more than a dozen awards including Dr. Toy's Smart Play/Smart Toy Program, the Gold Seal for Oppenheim Toy Portfolio's Best Toy Award, and Toy Wishes Top 12 Toys of the Year. The MAGNETIX MagnaCase was singled out as one of Dr. Toy's 100 Best Children's Products and 10 Best Toys of 2006. Our CAT® Super Tower Crane garnered the 2006 Toy of the Year Award from Family Fun Magazine and the Parents' Choice Approved Award. The Pirates of the Caribbean line won Today's Parent Seal of Approval and The Black Pearl, a fully buildable ship playset was selected as one of The Toy Insider's Hot 20 Toys for the Holiday Season. Many other products received awards and mentions in 2006, including Tiny 'N Tuff® Off-Road Set, Buildable Noah's Ark™ and MEGA Wagon™. Strategic Licensing Licensed products, which accounted for approximately 19.0% of sales in 2006 compared to approximately 20.0% in 2005, complement our internal product development initiatives. In recent years, we have entered into licensing agreements with affiliates of The Walt Disney Corporation, Marvel Enterprises Inc., NASCAR and others. Our focus is on evergreen brands with enduring popularity that have the potential to expand our product lines and drive incremental sales growth. The percentage of our annual sales based on licenses is lower than the 30-35% average for the North American toy industry. In 2006, we announced a multi-year licensing partnership with MTV Networks to develop construction toys based on Dora the Explorer, Go Diego Go! and The Backyardigans. New products based on these popular Nickelodeon character brands will launch in 2007 beginning in the United States and Canada with an expansion to the United Kingdom, France, Australia and Latin America later in the year and other countries in 2008. Dora the Explorer is among the top-rated preschool television shows in the world, the number one preschool license in North America, the number one overall toy license in France and Canada, and the number one girls' license in the United Kingdom.


STRATEGY, OBJECTIVES AND 2006 DEVELOPMENTS (Continued) Building on our successful relationship with Disney, one of the world's most successful children's brands, we announced a multi-year agreement in 2006 to launch a global line of arts and crafts products based on popular Disney properties. The new line will feature Disney Princess and Pirates of the Caribbean, with products available in North America, Europe, Scandinavia, Africa and the Middle East in 2007. We are also offering preschool vehicles based on the Disney Pixar movie ''Cars''. Our 2007 product lines will include playsets based on two major theatrical releases scheduled for Spring 2007: Disney's ''Pirates of the Caribbean: At World's End'' and Marvel’s ''Spider-Man 3''. International Growth Penetration of international markets is an important driver of our long-term growth. We have established a strong sales, marketing and logistics organization in Europe and Mexico, a marketing partnership with Bandai in Japan, as well as distributorships covering another 60 global markets. Our international sales increased 14.6% in 2006 to $149.6 million compared to $130.5 million in 2005. We expect continued international growth for the MEGA BLOKS brand through market share gains in Western Europe and Australia, penetration of new markets in Central and Eastern Europe, and sales growth in Latin America, Asia, the Middle East and Africa. In 2006, MEGA Brands was the leader in the construction category in both the United Kingdom and in Spain, the first time we surpassed the former leader in these important European markets. We increased our share in virtually all of our international markets in 2006. In the Australia and Pacific regions, we positioned ourselves for continued market penetration by establishing a subsidiary in Australia, following several years of sales growth through distributors. We believe there is strong growth potential for the ROSE ART and MAGNETIX brands in international markets through our existing sales and marketing organization. In 2006, we expanded the distribution of MAGNETIX products into several new markets in Europe, Asia and Latin America, and we prepared the ground for the introduction of arts and crafts and stationery products in our international markets in 2007. We selected a portfolio of ROSE ART craft and activity sets and adapted these products for introduction into our key European markets for 2007, complemented by a broad assortment of Disney licensed products. In stationery, we have a dedicated sales force in five markets - United Kingdom, France, Italy, Mexico and Australia - and our products will be available at retail for the 2007 back-to-school season. Growth by Acquisition We plan to supplement our internal growth with selected strategic acquisitions that will reinforce our product range and consumer reach. In identifying attractive acquisition candidates, we are looking to: expand into basic and growing categories, strengthen our position in current core competencies, expand shelf space into multiple aisles, strengthen relationships with key retailers, expand global distribution and enter into new retail channels. Furthermore, we are looking for acquisitions that will offer significant synergies. Our priority in 2007 is to fully realize the benefits of the integration of MEGA Brands America. The acquisition of The Board Dudes, Inc. (''Board Dudes''), which closed in February, 2006, positioned the Corporation as the second largest supplier of dry erase and cork presentation boards and accessories, a $400 million category in the North American stationery market, based on manufacturers' shipments.


STRATEGY, OBJECTIVES AND 2006 DEVELOPMENTS (Continued) Growth by Acquisition (Continued) The integration of MEGA Brands America, which we acquired in July 2005, progressed significantly to plan during 2006. The following actions were implemented during the year. We opened a 450,000 sq. ft. distribution center in Fife, Washington State, in April 2006 to receive and process

all products manufactured in China for sale in North America.

After completing our 2006 manufacturing requirements, we closed plants in Eugene, Oregon (Fuzzy® flocked posters) and Lafayette, Indiana (games and puzzles) and relocated production to China.

Following the 2006 back-to-school season, we relocated the production of crayons, paints and dough to our facility in Shenzhen, China, resulting in a corresponding downsizing of the Woodridge, New Jersey, plant.

Distribution centers for products relocated to China were closed down or downsized at all three plants. We also downsized our Montreal distribution center and consolidated some of its activities into our Montreal manufacturing facility.

At the end of 2006, we closed a plant in China and consolidated manufacturing in a single, expanded facility. Manufacturing costs for the product lines relocated to China were incurred in our North American plants in 2006. The Corporation also incurred costs for setting up the Fife, Washington distribution center which offset savings on freight incurred for transporting products manufactured in China from the West Coast to the Montreal distribution center. With the integration of MEGA Brands America essentially completed by the end of 2006, we expect to realize between $7-10 million of operational efficiencies in 2007. We estimate that our North American plants will supply approximately 25% of consolidated net sales, our plant in China for 25%, focusing on high-volume production, and our Asian supplier base, mainly in China, for the remaining 50%. OTHER DEVELOPMENTS Shareholders adopted a special resolution on June 15, 2006, authorizing the Corporation to change its legal name to MEGA Brands Inc. The Corporation filed the amendment to its articles of incorporation under the Canada Business Corporations Act to change its name on June 22, 2006. The legal names of the Corporation's principal subsidiaries were changed to MEGA Brands America, Inc. (formerly Rose Art Industries, Inc.), MEGA Brands International (formerly Mega Bloks International Sàrl) and MEGA Brands Europe NV (formerly Mega Bloks Europe NV). On May 8, 2006, the former shareholders of Rose Art Industries, Inc. initiated litigation against the Corporation in the U.S. District Court for the Southern District of New York (“Rosen Litigation”). The plaintiffs are seeking payment of the Contingent Purchase Price under the terms of the Stock Purchase Agreement (“SPA”) entered into between them and the Corporation effective July 26, 2005. The Corporation has filed an answer and counter claim denying each and every material allegation relating to the lawsuit. The Corporation's counter claim alleges that the former shareholders failed to uphold certain terms of the SPA. The Corporation accrued as a reserve $51.0 million in its 2005 audited consolidated financial statements with respect to the Contingent Purchase Price pending final determination of the amount owed, if any. As at December 31, 2006, no disbursements had been made and the Corporation will continue to maintain the reserve until the lawsuit is resolved. No trial date had been set as at April 1, 2007. The Corporation is currently awaiting the Court's ruling on a number of procedural issues after which it expects to enter into a protracted discovery period.


OTHER DEVELOPMENTS (continued) On November 17, 2006, Jeffrey and Lawrence Rosen, the former shareholders of Rose Art Industries, Inc., filed proceedings before the American Arbitration Association against the Corporation seeking unspecified damages for the Corporation's alleged breach of their respective employment agreements. The Corporation is contesting the proceedings. On March 31, 2006, the Corporation jointly announced with the US Consumer Products Safety Commission (''CPSC'') a voluntary recall and replacement program of MAGNETIX building sets in the hands of families with children under the age of six. This action was taken in response to the death of a toddler and injuries to several children resulting from magnet ingestion. On October 24, 2006, the Corporation announced that it had settled four lawsuits and ten claims related to injuries to children resulting from the ingestion of magnets. Terms of the settlement include no admission of liability. The aggregate amount paid to settle the lawsuits and claims is $13.5 million and is recorded as a product liability settlement expense in the 2006 consolidated statement of earnings. The Corporation expects to recover substantially the full amount from its insurers and through other recourses, although there can be no assurance that a favorable outcome will be achieved. Discussions with our insurers in this regard are underway. On September 14, 2006 and on December 5, 2006, two lawsuits related to magnet ingestion requiring surgical removal were served on the Corporation and remain outstanding. They are being handled by the Corporation's insurers. On March 29, 2007 the Corporation learned that a third lawsuit had been filed in U.S. District Court in Denver by the family of a child who is alleged to have sustained similar injuries. The lawsuit has been reported to our insurers. The Corporation is also aware of at least seven other incidents in which children are alleged to have required surgery following the ingestion of multiple magnets. Lawsuits have not been filed in these matters as of April 1, 2007. The Corporation is not able to assess with any certainty the outcome of these lawsuits and claims or impact, if any. As such, no amounts have been reserved in our year-end financial statements. The Corporation's portfolio of product liability insurance was renewed on December 1, 2006. As a result of the voluntary recall and replacement program and the ensuing publicity and product liability lawsuits and claims against the Corporation, the cost of insurance coverage for MAGNETIX products manufactured before May 1, 2006 was prohibitive. After careful consideration of the risks and an analysis of the costs of insurance, the Corporation determined that it was more economically advantageous, all factors considered, to self-insure these risks. As such, the Corporation is self-insured for incidents occurring after December 1, 2006, for MAGNETIX products manufactured prior to May 1, 2006. On March 28, 2007, the Corporation learned that a competitor who sells magnetic building sets primarily in Europe, Plastwood S.R.L. and Plastwood Corporation, filed a complaint against MEGA Brands America and MEGA Brands in the Western District of Washington. The complaint is based in significant part on representations alleged to have been made prior to the Corporation's acquisition of MEGA Brands America. The complaint does not provide support for Plastwood's allegations of its own lost sales and other consequences. The Corporation believes it has valid defenses to the complaint and intends to defend the action vigorously. As such, no amounts have been reserved in our year-end financial statements. The Corporation incurred significant litigation expenses in 2006, particularly in the fourth quarter, related mainly to the Rosen Litigation. Management believes that these expenses were warranted under the circumstances and will be offset by the benefit of asserting the Corporation's rights under the SPA and its insurance policies. The Rosen Litigation has delayed recovery against the $15 million escrow fund provided for under the SPA. Management expects that the resolution of the Rosen Litigation will also resolve the issue of the claims against the escrow fund, although there can be no assurance that a favorable outcome will be achieved.


SPECIFIED ITEMS AFFECTING OPERATIONS The Corporation recorded Specified Items Affecting Operations in 2006. Depending on their nature, the 2006 Specified Items were recorded against net sales, in cost of sales or as operating expenses. This classification was determined in accordance with GAAP. The following table summarizes all Specified Items Affecting Operations during the year.

(U.S. $ thousands, except per share data)

Year ended December 31,

2006

Three-month period ended December 31,

2006 (Unaudited) MAGNETIX product replacement expenses 16,029 13,758 Product liability settlement and related expenses 15,490 1,463 Integration expenses 8,303 8,303 Litigation expenses 4,769 3,678 44,591 27,202 MAGNETIX product replacement expenses The Corporation recorded credits and charges of $6.6 million ($5.9 million in the fourth quarter) as a reduction

of net sales. The net impact of these charges on gross profit amounted to $6.1 million for the year ($5.5 million in the fourth quarter).

The Corporation recorded write-offs of MAGNETIX components of $4.3 million ($4.3 million in the fourth quarter) as a result of the redesign of such components. These amounts are recorded in cost of sales.

The Corporation recorded product replacement expenses of $5.6 million ($4.0 million in the fourth quarter), consisting of freight costs to meet customer shipment dates due to manufacturing delays for redesigned MAGNETIX products, development costs for the redesign of MAGNETIX components, and product replacements for consumers under the voluntary recall and replacement program for MAGNETIX products jointly announced with the CPSC. The total amount is recorded as a separate line item in operating expenses.

Product liability settlement and related expenses The Corporation settled four lawsuits and ten claims related to magnet ingestion and recorded product liability

settlement and related expenses of $15.5 million, consisting of $13.5 million for the product liability settlement recorded in the third quarter and $2.0 million of related legal expenses ($1.5 million in the fourth quarter). The total amount is recorded as a separate line item in operating expenses.

Integration expenses The Corporation recorded a charge of $4.7 million mostly related to inventory write-offs ($4.7 million in the

fourth quarter) following plant closures as part of the integration of MEGA Brands America. This amount is recorded in cost of sales.

The Corporation recorded integration expenses of $3.6 million ($3.6 million in the fourth quarter), mainly related to branding, plant asset write-offs, plant closure costs and other miscellaneous integration charges. This amount is recorded as a separate line item in operating expenses.


SPECIFIED ITEMS AFFECTING OPERATIONS (Continued) Litigation expenses The Corporation recorded litigation expenses of $4.8 million ($3.7 million in the fourth quarter), mainly for the

Rosen Litigation. This amount is recorded as a separate line item in operating expenses. Management believes that under the terms of the acquisition of MEGA Brands America, all claims and expenses related to MAGNETIX, as well as certain other expenses, are recoverable against the sellers, including but not limited to the $15.0 million escrow fund provided for in the SPA. However, the Corporation also expects to recover substantially the full amount of the $13.5 million product liability settlement from its insurers and through other recourses, there can be no assurance that a favorable outcome will be achieved.


SELECTED FINANCIAL INFORMATION The following table presents a summary of selected consolidated income statement data for the years ended December 31, 2006, 2005 and 2004, as well as the three-month periods ended December 31, 2006 and 2005:

Years ended December 31,

(Audited)

Three-month periods ended December 31,

(Unaudited) (U.S. $ thousands, except per

share data) 2006 2005 2004 2006 2005 Net sales 547,347 384,863 215,456 164,805 166,234 Cost of sales 328,822 214,668 123,821 113,272 88,559 Gross profit 218,525 170,195 91,635 51,533 77,675 Marketing and advertising

expenses 26,808 24,573 13,382 10,562 13,067 Research and developement

expenses 18,334 9,402 5,691 5,858 3,658 Other selling, distribution and

administrative expenses 109,815 71,074 37,244 24,540 28,658 Loss (gain) on foreign currency

translation (4,846) 2,796 (3,117) (858) 589 Product liability settlement and

related expenses 15,490 - - 1,463 - Voluntary product recall and

replacement 5,612 - - 3,995 - Litigation expenses 4,769 - - 3,678 - Integration expenses 3,573 - - 3,573 - Unusual items - - 5,158 - - Earnings (loss) from operations 38,970 62,350 33,277 (1,278) 31,703 Interest and other expenses

Interest on long-term debt 22,526 9,310 1,207 6,419 5,127 Other interest 177 954 170 371 (26)

22,703 10,264 1,377 6,790 5,101 Earnings (loss) before income

taxes 16,267 52,086 31,900 (8,068) 26,602 Income taxes

Current (1,217) 5,473 7,427 (5,126) 360 Future (7,864) 7,005 (704) (5,703) 5,331

(9,081) 12,478 6,723 (10,829) 5,691 Net earnings 25,348 39,608 25,177 2,761 20,911 Earnings per share

Basic 0.79 1.35 0.93 0.09 0.66 Diluted 0.74 1.26 0.86 0.08 0.61

WEIGHTED AVERAGE NUMBER OF OUTSTANDING SHARES 2006 2005 2004 2006 2005

Basic 32,220,495 29,281,145 27,185,175 32,352,319 31,854,644 Diluted 34,189,034 31,390,456 29,331,615 34,289,179 34,080,643


SELECTED FINANCIAL INFORMATION (Continued) The following tables present a summary of selected consolidated balance sheet data as at December 31, 2006, 2005 and 2004 and Canadian dollar data for the years ended December 31, 2006, 2005 and 2004 as supplementary information for Canadian investors: As at December 31, (Canadian $ thousands, except per share data) 2006 2005 2004 $ $ $ Balance Sheet Data Working capital1) 124,725 101,605 101,092 Property, plant and equipment 43,213 39,351 32,221 Total assets 800,442 720,495 183,155 Total debt 311,954 300,953 24,572 Year ended December 31, (Canadian $ thousands, except per share data) 2006 2005 2004 (Unaudited) $ $ $ Canadian Dollar Data2) Net sales 637,823 448,481 251,071 Net earnings 29,538 46,155 29,339 Earnings per share

Basic 0.92 1.58 1.08 Diluted 0.86 1.47 1.00

1) Working capital is defined as current assets minus current liabilities. 2) U.S. dollar financial data is converted into Canadian dollars at the December 31, 2006 period end exchange rate of CA$1.1653 per

US$1.00, using the translation of convenience method. Contractual Obligations The following table presents a summary of contractual obligations for the following years: Years

2007 2008 2009 2010 2011 After

5 years Total Long-term debt 9,000 9,000 4,200 42,600 2,600 243,750 311,150 Capital leases 609 195 - - - - 804 Operating leases 13,465 10,189 9,209 8,192 3,637 1,268 45,960 Total contractual

obligations 23,074 19,384 13,409 50,792 6,237 245,018 357,914


RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 2006 COMPARED TO YEAR ENDED DECEMBER 31, 2005 Adoption of EIC-156 In 2006, the Corporation adopted a new guideline issued by the Emerging Issues Committee of the CICA called EIC-156, ''Accounting by a Vendor for Consideration Given to a Customer (Including a Reseller of the Vendor's Product)''. As a result, certain allowances given to customers in the normal course of business, for which the fair market value cannot be precisely determined, are recorded as a reduction of sales. Under the former accounting standard used by the Corporation, such allowances were included in sales, cost of sales goods sold and marketing and advertising expenses. For comparative purposes, the Corporation has reclassified such allowances for 2005. The adoption of EIC-156 reduced net sales by $25.8 million in 2006 and $22.2 million in 2005 and by $9.8 million and $9.7 million in the fourth quarters of 2006 and 2005, respectively. Net Sales Net sales increased 42.2% in 2006 to $547.3 million compared to $384.9 million in 2005. Higher net sales reflect mainly the inclusion of MEGA Brands America for the full year in 2006 compared to approximately five months in 2005, as well as organic growth in construction toys. Recorded against net sales in 2006 are $6.6 million of Specified Items. Net sales of Toys product lines reached $333.7 million in 2006 compared to $291.6 million in 2005, an increase of 14.4%. The majority of this increase reflects the inclusion of magnetic construction toys and games and puzzles for the full year compared to approximately five months in 2005. Organic growth in construction toys also contributed to the higher net sales. Net sales of Stationery and Activities product lines increased 129.0% to $213.7 million compared to $93.3 million in 2005. This growth reflects the inclusion of MEGA Brands America for the full year in 2006 compared to approximately five months in 2005, as well as the contribution from Board Dudes. Net sales in North America increased 56.4% to $397.8 million compared to $254.3 million in 2005, mainly as a result of the inclusion of MEGA Brands America for the full year in 2006 compared to approximately five months in 2005. Net sales of construction toys were stable, with higher sales in the preschool category and MAGNETIX offset by a slight decline in boys 5-plus products. International net sales were up 14.6% to $149.6 million compared to $130.5 million in 2005. The Corporation increased its market share in the construction toy category in virtually all international markets in 2006 and gained the leadership position in this category in the United Kingdom and Spain for the first time. International net sales accounted for 27.3% of consolidated net sales in 2006 compared to 33.9% in 2005. Cost of Sales Cost of sales increased 53.1% to $328.8 million in 2006 compared to $214.7 million in 2005. The majority of this increase is due to the inclusion of MEGA Brands America for the full year in 2006 compared to approximately five months in 2005. Recorded in cost of sales 2006 are $8.5 million of Specified Items.


YEAR ENDED DECEMBER 31, 2006 COMPARED TO YEAR ENDED DECEMBER 31, 2005 (Continued) Gross Profit Reflecting the growth in net sales, gross profit increased 28.4% to $218.5 million in 2006 compared to $170.2 million in 2005. Gross margin declined to 39.9% compared to 44.2% in 2005. The decline in gross margin in 2006 is explained mainly by additional freight costs incurred in order to meet customer deadlines for the delivery of redesigned MAGNETIX products and higher magnet costs due to the escalation in commodity prices, for a combined impact of approximately $10.0 million. In addition, Specified Items impacting gross profit amounted to $15.1 million. Plastic resin prices in 2006 were in line with 2005 and did not negatively impact gross margin. Operating Expenses Marketing and advertising expenses increased to $26.8 million in 2006 compared to $24.6 million in 2005. This increase reflects the inclusion of MEGA Brands America for the full year in 2006 compared to approximately five months in 2005. As a percentage of net sales, such expenses declined to 4.9% compared to 6.4% in 2005. This decrease reflects the proportionately lower marketing and advertising expenses for Stationery and Activities product lines. Research and development expenses were $18.3 million in 2006 compared to $9.4 million in 2005. This increase reflects mainly the inclusion of MEGA Brands America for the full year in 2006 compared to approximately five months in 2005. As a percentage of sales, such expenses increased to 3.3% compared to 2.4% in 2005. Other selling, distribution and administrative expenses were $109.8 million in 2006 compared to $71.1 million in 2005. This increase reflects mainly the inclusion of MEGA Brands America for the full year in 2006 compared to approximately five months in 2005. These expenses were 20.1% of net sales in 2006 compared to 18.5% in 2005. Earnings from Operations As a result of the above, earnings from operations were $39.0 million in 2006 compared to $62.4 million in 2005. Earnings from operations resulted in a loss of $11.7 million in North America compared to earnings of $40.3 million in 2005. International earnings from operations rose to $50.7 million compared to $22.1 million in 2005. Non-Operating Expenses Interest expense was $22.7 million in 2006 compared to $10.3 million in 2005, reflecting mainly borrowings used to finance the acquisition of the MEGA Brands America. The acquisition closed on July 26, 2005, which accounts for most of the difference in interest expense between the two years, with the balance explained by higher interest rates in 2006. The Corporation recorded an income tax recovery of $9.1 million in 2006 compared to an income tax charge of $12.5 million in 2005. Before Specified Items, the effective tax rate in 2006 was 12.6% compared to 24.0% in 2005, reflecting mainly the proportionately higher earnings from operations in lower tax jurisdictions in 2006 compared to 2005. The tax rate used to establish income tax expense is the applicable estimated effective rate of each entity of the Corporation. The effective tax rate also takes into consideration the financing structure put in place following the acquisition of MEGA Brands America. As a result of this acquisition, the Corporation also expects to benefit from cash flow savings of approximately $100.0 million over a period of 15 years from the deductibility of goodwill for tax purposes in the United States.


YEAR ENDED DECEMBER 31, 2006 COMPARED TO YEAR ENDED DECEMBER 31, 2005 (Continued) Net Earnings Net earnings were $25.3 million or $0.74 diluted earnings per share in 2006 compared to $39.6 million or $1.26 diluted earnings per share in 2005. Basic earnings per share were $0.79 in 2006 compared to $1.35 in 2005. Impact of Specified Items The following tables present the impact of Specified Items on the 2006 statement of earnings. Management believes that an analysis of 2006 and fourth quarter 2006 operating performance before Specified Items is appropriate because such items are not typical of ongoing operations.

(US $ thousands) Twelve-month periods ended December 31,

Audited

2006

Unaudited Specified

Items 2006

Unaudited Before

Specified Items1)

Audited 2005

Net Sales 547,347 6,606 553,953 384,863 Cost of sales 328,822 (8,541) 320,281 214,668 Gross profit 218,525 15,147 233,672 170,195 Marketing and advertising expenses 26,808 – 26,808 24,573 Research and development expenses 18,334 – 18,334 9,402 Other selling distribution and administrative expenses 109,815 – 109,815 71,074 Loss (gain) on foreign currency translation (4,846) – (4,846) 2,796 Product liability settlement and related expenses 15,490 (15,490) – – Voluntary product recall and replacement 5,612 (5,612) – – Litigation expenses 4,769 (4,769) – – Integration expenses 3,573 (3,573) – – Earnings from operations 38,970 44,591 83,561 62,350 Interest and other expenses 22,703 – 22,703 10,264 Earnings (loss) before income taxes 16,267 44,591 60,858 52,086 Income taxes (9,081) 16,722 7,641 12,478 Net earnings 25,348 27,869 53,217 39,608 Earnings per share - Basic 0.79 0.86 1.65 1.35 Earnings per share - Diluted 0.74 0.82 1.56 1.26


YEAR ENDED DECEMBER 31, 2006 COMPARED TO YEAR ENDED DECEMBER 31, 2005 (Continued)

(US $ thousands) Three-month periods ended December 31,

Unaudited

2006

Unaudited Specified

Items 2006

Unaudited Before

Specified Items1)

Unaudited 2005

Net Sales 164,805 5,865 170,670 166,234 Cost of sales 113,272 (8,628) 104,644 88,559 Gross profit 51,533 14,493 66,026 77,675 Marketing and advertising expenses 10,562 – 10,562 13,067 Research and development expenses 5,858 – 5,858 3,658 Other selling distribution and administrative expenses 24,540 – 24,540 28,658 Loss (gain) on foreign currency translation (858) – (858) 589 Product liability settlement and related expenses 1,463 (1,463) – – Voluntary product recall and replacement 3,995 (3,995) – – Litigation expenses 3,678 (3,678) – – Integration expenses 3,573 (3,573) – – Earnings from operations (1,278) 27,202 25,924 31,703 Interest and other expenses 6,790 – 6,790 5,101 Earnings (loss) before income taxes (8,068) 27,202 19,134 26,602 Income taxes (10,829) 10,200 (629) 5,691 Net earnings 2,761 17,002 19,763 20,911 Earnings per share - Basic 0.09 0.53 0.61 0.66 Earnings per share - Diluted 0.08 0.50 0.58 0.61

1) The terms ''net sales before Specified Items'', ''cost of sales before Specified Items'', ''gross profit before Specified Items'', ''gross margin

before Specified Items'', ''earnings (loss) from operations before Specified Items'',''earnings (loss) before income taxes before Specified Items'', ''net earnings before Specified Items'' and ''diluted earnings per share before Specified Items'' do not have any standardized meaning under GAAP and are therefore unlikely to be comparable to similar measures presented by other companies. We present them as a measure of operating performance of our ongoing business without the effects of unusual items. We exclude such items because they affect the comparability of our financial results between periods and could potentially distort the analysis of trends in business performance.


YEAR ENDED DECEMBER 31, 2005 COMPARED TO YEAR ENDED DECEMBER 31, 2004 Net Sales Net sales increased 78.6% to $384.9 million in 2005, compared to $215.5 million in 2004. The main factors contributing to this overall growth were the inclusion of MEGA Brands America as of July 26, 2005 and the continued success of our construction toy business as a result of strong penetration in international markets. Net sales of Toys product lines increased by 35.2% to $291.6 million in 2005 compared to $215.5 million in 2004. This strong increase was driven primarily by higher sales of preschool and boys 5-plus products in all key European markets, Latin America and Canada, and the addition of magnetic construction toys and games and puzzles following the acquisition of MEGA Brands America. This increase was partly offset by a slight decline in construction toy sales in the U.S. reflecting an overall challenging retail environment for the toy industry and the cautious inventory approach of major retailers. Net sales of Stationery and Activities product lines were $93.3 million in 2005 compared to nil in 2004. The Corporation was not active in these categories prior to the acquisition of MEGA Brands America. Net sales in North America increased 100.1% to $254.3 million in 2005 compared to $127.1 million in 2004. International net sales were $130.5 million in 2005, an increase of 47.6% compared to $88.4 million in 2004. Reflecting the net sales of MEGA Brands America in 2005, which are concentrated mainly in North America, international net sales accounted for 33.9% of consolidated net sales compared to 41.0% in 2004. Gross Profit Gross profit reached $170.2 million in 2005 compared to $91.6 million in 2004, an increase of 85.8%. The increase in gross profit was driven primarily by sales growth. Gross margin was 44.2% in 2005 compared to 42.5% in 2004. The increase in gross margin was mainly due to changes in product and customer mix compared to 2004. This was partially offset by lower gross margin generated by stationery products and higher resin costs incurred during the first six months of 2005. Operating Expenses Marketing and advertising expenses were $24.6 million in 2005, compared to $13.4 million in 2004, an increase of 83.6%. As a percentage of net sales, such expenses were 6.4% in 2005 compared to 6.2% in 2004. Research and development expenses increased to $9.4 million in 2005 compared to $5.7 million in 2004. This increase reflects mainly the inclusion of MEGA Brands America in 2005. Other selling, distribution and administrative expenses were up 108.4% to $71.1 million in 2005 compared to $34.1 million in 2004. These expenses represented 18.5% of net sales in 2005 compared to 15.8% in 2004. This increase is mainly explained by the expenses of MEGA Brands America from the date of acquisition and higher distribution costs, reflecting the significant growth in international sales in 2005. In 2004, the Corporation recorded Specified Items of $5.2 million which were presented in earnings from operations as unusual items. These Specified Items consisted of a loss of $3.6 million due to the fact that certain derivative financial instruments ceased to qualify for hedge accounting as well as a $1.6 million charge in connection with professional and consulting services related to the expansion of the Corporation's presence in the German market.


YEAR ENDED DECEMBER 31, 2005 COMPARED TO YEAR ENDED DECEMBER 31, 2004 (Continued) Earnings from Operations Earnings from operations increased 87.4% to $62.4 million in 2005 compared to $33.3 million in 2004. Non-Operating Expenses Interest expense was $10.3 million in 2005 compared to $1.4 million in 2004, reflecting mainly higher borrowings used to finance the acquisition of MEGA Brands America and, to a lesser extent, higher average interest rates compared to the previous year. Income taxes were $12.5 million in 2005 compared to $6.7 million in 2004. The effective tax rate was 24.0% in 2005 compared to 21.1% in 2004. This increase reflects mainly the impact of the acquisition of MEGA Brands America, which resulted in higher earnings in higher tax jurisdictions. Net Earnings Net earnings increased 57.3% to $39.6 million or $1.26 diluted earnings per share compared to $25.2 million or $0.86 per share in 2004. Basic earnings per share increased to $1.35 in 2005 compared to $0.93 in 2004. LIQUIDITY AND CAPITAL RESOURCES Historically, our primary sources of liquidity have been cash flows from operations and short-term borrowings under a revolving credit facility. Cash flows from operations could be negatively impacted by decreased demand for our products, which could result from factors such as adverse economic conditions and changes in public and consumer preferences, or by increased costs associated with manufacturing and distribution of products. Our primary capital needs are related to inventory financing, accounts receivable funding, debt servicing and capital expenditures for new product line initiatives. As a result of the seasonal nature of the toy and stationery industries, working capital requirements are variable throughout the year. Working capital needs typically grow through the first three quarters as inventories are built-up for the peak sales period. Operating Activities Cash flows from operating activities in 2006 amounted to $15.9 million compared to $25.0 million in 2005. This decrease is explained mainly by lower earnings from operations resulting from the Specified Items affecting operations incurred during the year. Financing Activities Cash flows from financing activities in 2006 were $14.3 million, reflecting mainly a draw-down of $40.0 million of the Corporation's revolving credit facility and the repayment of $29.0 million of long-term debt. In 2006, the Corporation repaid $20.0 million of the principal amount of its $40-million Term A debt and concurrently increased the maximum amount of its revolving credit facility to $120.0 million from $100.0 million. For 2005, cash flows from financing activities were $291.9 million, resulting mainly from borrowings and an issue of capital stock to finance the acquisition of MEGA Brands America.


LIQUIDITY AND CAPITAL RESOURCES (Continued) Investing Activities Cash flows used for investing activities in 2006 were $36.0 million, including $17.5 million for acquisitions of property, plant and equipment and the balance coming mainly from the acquisition of Board Dudes. For 2005, cash flows used for investing activities amounted to $303.0 million, reflecting mainly the acquisition of MEGA Brands America. We expect the level of capital expenditure to be higher in 2007 but to remain proportionally in line with sales growth. BALANCE SHEETS As at December 31, 2006, current assets stood at $345.6 million compared to $297.2 million at the end of 2005. This increase is due mainly to higher inventories which rose to $140.6 million in 2006 compared to $82.3 million in 2005. In 2006, the Corporation built up inventories of basic products in anticipation of plant closures which occurred mainly in the fourth quarter. In addition, production levels in the last few months of 2006 were higher than usual due to demand for products tied to two movies scheduled for North American release in May 2007. The Corporation's objective is to reduce inventory levels to approximately $110.0 million by the end of 2007. Trade accounts receivable declined to $153.1 million in 2006 compared to $167.4 million in 2005 due to timing of shipments and customer payments. Current liabilities increased to $220.9 million in 2006 compared to $195.6 million in 2005. This increase is due to higher accounts payable and accrued liabilities which rose to $153.4 million in 2006 compared to $108.0 million in 2005. The Corporation accrued US$51.0 million in its 2005 audited consolidated financial statements as additional consideration for the former shareholders of Rose Art Industries, Inc. pending final determination of the amount owed, if any. No disbursements were made in regard to this additional consideration as at December 31, 2006. The Corporation did not make an accrual for additional consideration based on the financial performance of MEGA Brands America in 2006. Working capital stood at $124.7 million as at December 31, 2006 compared to $101.6 million at the end of 2005. This increase is due mainly to higher inventories at the end of 2006. Long-term debt at the end of 2006 was $312.0 million compared to $301.0 million in 2005. As at December 31, 2006, the Corporation's debt was comprised of $14.4 million under its Term A facility maturing in 2009, $256.8 million under its Term B facility maturing in 2012 and $40.0 million drawn against its $120.0 million revolving credit facility. The Corporation entered into interest-rate swap agreements in 2005 to convert $150.0 million of its Term B facility from variable to fixed interest rates. The Corporation was in compliance with all covenants of its credit facility as at December 31, 2006. As at December 31, 2006, the Corporation held cash and cash equivalents of $13.7 million and had $80.0 million of availability under its revolving credit facility. Based on its forecasts, the Corporation believes that cash flows from operating activities combined with liquidity available under its revolving credit facility will be sufficient to meet its requirements for working capital, acquisition of property, plant and equipment, debt repayments and other financial obligations. The Corporation also believes that its ability to access capital markets, if necessary, provides for any additional liquidity that may be required. Please refer to the ''Balance Sheet Data'' and ''Contractual Obligations'' tables on page 12 of this MD&A for additional information about the Corporation's financial position.


SEASONALITY AND QUARTERLY FLUCTUATIONS We have historically experienced significant quarterly fluctuations in operating results and anticipate these fluctuations in the future. Operating results for any quarter are not necessarily indicative of results for any future period and are comparable only with corresponding periods of prior years. Our profitability is typically lower for the first two quarters as a result of fairly constant fixed operating expenses while net sales are at their lowest levels of the year. This seasonality is consistent with the results of other companies in our business. As a result of the seasonal nature of our business, our statements of cash flows for any quarter are generally not indicative of cash flows for a full year. Therefore, year-over-year comparisons between statements of cash flows are generally more meaningful than with the previous year-end. SELECTED QUARTERLY FINANCIAL INFORMATION The following table presents selected quarterly financial information for the years 2006 and 2005. (US $ thousands, except per share data) 2006 (Unaudited) Q1 Q2 Q3 Q4 Net Sales 78,564 102,200 201,778 164,805 As a % of full year 14.3 18,7 36.9 30.1 Gross profit 34,199 42,246 90,547 51,533 Earnings (loss) from operations 3,886 10,162 26,200 (1,278) Net earnings 578 4,050 17,959 2,761 EPS Basic 0.02 0.13 0.56 0.09 EPS Diluted 0.02 0.12 0.53 0.08

(US $ thousands, except per share data) 2005 (Unaudited) Q1 Q2 Q3 Q4 Net Sales 28,323 36,103 154,203 166,234 As a % of full year 7.3 9.4 40.1 43.2 Gross profit 11,387 13,849 67,284 77,675 Earnings (loss) from operations (1,434) (485) 32,567 31,703 Net earnings (1,178) (540) 20,415 20,911 EPS Basic (0.04) (0.02) 0.67 0.66 EPS Diluted (0.04) (0.02) 0.62 0.61

THREE-MONTH PERIOD ENDED DECEMBER 31, 2006 COMPARED TO THREE-MONTH PERIOD ENDED DECEMBER 31, 2005 Consolidated net sales in the fourth quarter of 2006 were $164.8 million compared to $166.2 million in the fourth quarter of 2005. Net sales of Toys product lines increased 4.2% to $123.1 million in the fourth quarter of 2006 compared to $118.1 million in the 2005 period. Net sales increased in all product categories except games and puzzles. Net sales of Stationery and Activities product lines declined to $41.7 million compared to $48.1 million in the fourth quarter of 2005. This is explained mainly by lower sales of licensed craft and activity sets in the fourth quarter of 2006 compared to the corresponding 2005 period.


THREE-MONTH PERIOD ENDED DECEMBER 31, 2006 COMPARED TO THREE-MONTH PERIOD ENDED DECEMBER 31, 2005 (Continued) Net sales in North America were $116.9 million in the fourth quarter of 2006, compared to $127.0 million in the corresponding 2005 period. Net sales of preschool and boys 5-plus construction toys matched the levels achieved in the fourth quarter of 2005, while sales declined in craft and activity sets and games and puzzles. Stationery sales were higher than in the fourth quarter of 2005. International net sales increased 22.0% to $47.9 million compared to $39.3 million in the fourth quarter of 2005. Sales growth was achieved in preschool, boys 5-plus and magnetic construction toys compared to the fourth quarter of 2005. International sales accounted for 29.1% of consolidated net sales in the fourth quarter of 2006 compared to 23.6% in the same 2005 period. Cost of sales increased 28.0% to $113.3 million in the fourth quarter of 2006 compared to $88.6 million in the corresponding 2005 period. This increase is explained by additional freight costs incurred in order to meet customer deadlines for the delivery of redesigned MAGNETIX products and higher magnet costs due to the escalation in commodity prices, for a combined impact of approximately $10.0 million. Cost of sales in the fourth quarter of 2006 also includes Specified Items of $8.5 million. Gross profit declined to $51.5 million compared to $77.7 million in the fourth quarter of 2005 and gross margin decreased to 31.3% of sales compared to 46.7% in the same 2005 period. Plastic resin prices were in line with the levels during the fourth quarter of 2005 and did not negatively impact gross margin. Marketing and advertising expenses were $10.6 million compared to $13.1 million in the fourth quarter of 2005. As a percentage of net sales, such expenses were 6.4% compared to 7.9% in the fourth quarter of 2005. This decrease is due mainly to timing differences in such expenditures in 2006 compared to 2005. Marketing and advertising expenses for the first nine months of 2006 were 41.2% higher than in the corresponding 2005 period. Research and development expenses increased to $5.9 million or 3.6% of sales, compared to $3.7 million or 2.2% of sales in the fourth quarter of 2005. Other selling, distribution and administrative expenses were $23.7 million compared to $29.2 million in the fourth quarter of 2005. These expenses represented 14.4% of net sales in the fourth quarter of 2006 compared to 17.6% in 2005. This decrease is explained by an overall leveraging of administrative expenses and lower bonus payouts compared to 2005. As a result of the above, loss from operations in the fourth quarter of 2006 was $1.3 million compared to earnings from operations of $31.7 million in the fourth quarter of 2005. Earnings from operations resulted in a loss of $34.4 million in North America compared to earnings of $25.4 million in the fourth quarter of 2005. International earnings from operations increased to $33.1 million compared to $6.3 million in the fourth quarter of 2005. Interest expense was $6.8 million compared to $5.1 million in the fourth quarter of 2005, reflecting mainly higher average interest rates in the 2006 period. The Corporation recorded an income tax recovery of $10.8 million in the fourth quarter of 2006 compared to $5.7 million of income taxes in the fourth quarter of 2005. Before Specified Items, the effective tax rate in the fourth quarter of 2006 was a recovery of 3.3% compared to a charge of 21.4% for the corresponding 2005 period.


THREE-MONTH PERIOD ENDED DECEMBER 31, 2006 COMPARED TO THREE-MONTH PERIOD ENDED DECEMBER 31, 2005 (Continued) Net earnings in the fourth quarter of 2006 were $2.8 million or $0.08 diluted earnings per share compared to $20.9 million or $0.61 diluted earnings per share in the fourth quarter of 2005. Basic earnings per share in the fourth quarter of 2006 were $0.09 compared to $0.66 in the same 2005 period. Cash flows from operating activities before changes in non-cash working capital items were $3.0 million in the fourth quarter of 2006 compared to $30.5 million for the same period in 2005, mainly due to Specified Items recorded during the fourth quarter of 2006. After changes in non-cash working capital items, operating cash flow was $28.7 million compared to $11.0 million in the fourth quarter of 2005. SHARES OUTSTANDING The basic weighted average number of common shares outstanding in 2006 was 32,220,495 compared to 29,281,145 in 2005. The diluted weighted average number of shares outstanding in 2006 was 34,189,034 compared to 31,390,456 in 2005. The total number of shares outstanding as at December 31, 2006 was 32,664,913 compared to 32,105,575 at the end of 2005. As at April 1, 2007, there was a total of 2,617,306 stock options outstanding. OUTLOOK FOR 2007 We believe we have a strong product line-up in all of our categories for 2007, with the introduction of many new products, an exceptional licensed products offering and the launch of arts and crafts and stationery products in new geographic markets. We expect net sales to increase in North America and in our International markets. Earnings will be supported by operating synergies resulting from the integration of MEGA Brands America in 2006. SIGNIFICANT ACCOUNTING POLICIES AND USE OF ESTIMATES Principles of consolidation and reporting currency Consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting principles (“GAAP”) using the U.S. dollar (functional currency) as the reporting currency. The consolidated financial statements include the accounts of the Corporation and its wholly owned subsidiaries since the date of acquisition. All intercompany balances and transactions have been eliminated on consolidation. Use of estimates Preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. The most significant areas requiring the use of management estimates relates to: inventory valuation, valuation of year-end provision on accounts receivable, future income taxes, intangible assets, goodwill, reserves and allowances, specifically those related to the integration costs, general liability and income taxes. Revenue recognition Revenue is recognized when (i) persuasive evidence of an arrangement exists, (ii) products are shipped to customers and customer takes ownership and assumes risk of loss, (iii) collection of the respective receivable is probable, and (iv) sales price is fixed or determinable. Accruals for customer discounts, rebates, incentives and defective allowances are recorded as the related revenues are recognized.


SIGNIFICANT ACCOUNTING POLICIES AND USE OF ESTIMATES (Continued) Vendor allowance Preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. The most significant areas requiring the use of management estimates relates to: inventory valuation, valuation of year-end provision on accounts receivable, future income taxes, intangible assets, goodwill, reserves and allowances, specifically those related to the integration costs, general liability and income taxes. Self-insurance The Corporation is primarily self-insured for MAGNETIX products manufactured before May 1, 2006. Required accruals for self-insurance liabilities are determined by management based on claims filed and an estimate of claims incurred but not yet reported, and are not discounted. Research and development expenses Research expenses are charged to earnings net of related tax credits. Unless these expenses meet Canadian GAAP for deferral, development expenses are charged to earnings, net of the related tax credits. Research and development expenses are presented net of tax credits of $0.3 million for the year ended December 31, 2006 (2005 - $0.9 million). Foreign currency translation Monetary assets and liabilities denominated in currencies other than U.S. dollars (foreign currencies) and monetary assets and liabilities from foreign integrated subsidiaries are translated at the rates of exchange at the balance sheet date. Non-monetary balance sheet items denominated in foreign currencies and non-monetary balance sheet items from foreign integrated subsidiaries are translated at the rates of exchange prevailing at the respective transaction dates. Revenue and expense items arising from transactions in foreign currencies and from foreign integrated subsidiaries are translated into U.S. dollars at average rates during each reporting period. Gains or losses on foreign exchange are recorded in the consolidated statements of earnings. All unrealized translation gains and losses on assets and liabilities denominated in foreign currencies are included in earnings for the year. Derivative Financial Instruments The Corporation uses various derivative financial instruments to manage interest rate risk and foreign exchange rate risk and formally documents when required all relationships between derivatives and the items they hedge, and its risk management objective and strategy for using various hedges. Derivatives that are economic hedges but do not qualify for hedge accounting are recognized at fair value with the changes in fair value recorded in earnings. The Corporation does not use derivative financial instruments for speculative or trading purposes. When hedge accounting is applied, the Corporation formally assesses, both at the hedge's inception and on an ongoing basis, whether the derivatives used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. Gains and losses on foreign currency forward contracts designated as effective for hedge accounting are recognized in the consolidated statements of earnings during the same period as the underlying revenues and expenses. For interest rate swaps, the difference between the swap rate and the actual rate is reflected against the related interest expense.


SIGNIFICANT ACCOUNTING POLICIES AND USE OF ESTIMATES (Continued) Gains and losses associated with derivative instruments, which have been terminated or cease to be effective prior to maturity, are deferred under other assets or liabilities and recognized in the consolidated statement of earnings in the period in which the underlying hedged transaction is recognized. In the event a designated hedged item is sold, extinguished or matures prior to the termination of the related derivative instrument, a gain or loss on such derivative instrument is recognized in the consolidated statement of earnings. The following table summarizes our foreign currency commitments as at December 31, 2006:

Foreign currency contracts Notional amount

Average exchange

rate Maturing

up to Notional

equivalent Fair market

value $ $ $ Sell – Euro to $US 6,000 1.3021 Dec. 2007 7,813 (154) – GBP to $US 3,000 1.8746 Dec. 2007 5,624 (243) The following table summarizes our interest rate swap agreements as at December 31, 2006:

Interest rate swaps Notional amount

Fixed rate Maturing

Fair market value

$ $ 150,000 4.66325% July 2012 2,828 Stock Options and Share Units The Corporation uses the fair value method to account for all stock-based compensations. This method requires awards of stock options to be measured on their date of grant using the fair value method. They are expensed and credited to contributed surplus over their vesting period, and reclassified to capital stock when stock options are exercised. The Corporation's share unit plan, which became effective February 24, 2005, allows the Board of Directors to grant bonuses in the form of share units that are time and performance based, which vest primarily over a three-year period. The plan is non-dilutive and will be settled in shares purchased from the secondary market, or in cash, at the option of the Corporation. The share units are accounted for as liabilities on a fair value basis by using the quoted market price of the common shares at the end of each period. The share units are treated as stock-based compensation and are expensed and credited to accrued liabilities over the vesting period. Earnings per share Basic earnings per share is based on the weighted-average number of units outstanding during the period. The dilutive effect of stock options is determined using the treasury stock method. Cash and cash equivalents Cash and cash equivalents include cash and short-term investments in money market instruments with maturities of three months or less.


SIGNIFICANT ACCOUNTING POLICIES AND USE OF ESTIMATES (Continued) Inventories Inventories are stated at the lower of cost and market value. Cost is established based on the first-in, first-out method. Market value is defined as replacement cost for raw materials and net realizable value for work in process and finished goods. Property, plant and equipment Property, plant and equipment are recorded at cost and are amortized over the lesser of their estimated useful lives and the term of the lease using the straight-line method and the following amortization periods:

Buildings 25 years Machinery and equipment 3 to 15 years Computer equipment 3 to 5 years Leasehold improvements Over the terms of the leases

Government grants Government grants for property, plant and equipment acquisitions are netted against property, plant and equipment and are amortized on the same basis as the related asset. Government grants to create employment are recorded in earnings as a reduction of the related expenses when conditions are met. Intangible assets Intangible assets with a finite service life are accounted for at cost less accumulated amortization. They consist of customer relationships and intellectual property which are amortized over twenty years and noncompetition covenants which are amortized over five years. Intangible assets with indefinite service life, consisting of the trade name and intellectual property, are accounted for at cost and are not amortized. The trade name and intellectual property are tested for impairment annually or more frequently if changes in circumstances indicate a potential impairment. As at December 31, 2006, the Corporation has performed an impairment test and no write-down was necessary. Goodwill Goodwill represents the excess of the acquisition cost of companies over the fair value of the identifiable net assets acquired and is not amortized. Goodwill is tested for impairment annually or more frequently if changes in circumstances indicate a potential impairment. As at December 31, 2006, the Corporation has performed an impairment test and no write-down was necessary.


SIGNIFICANT ACCOUNTING POLICIES AND USE OF ESTIMATES (Continued) Deferred charges Deferred charges are comprised mainly of financing charges. The financing charges are recorded at cost and are amortized according to the straight-line method over the term of the credit facility. Impairment of long-lived assets Long-lived assets are reviewed for impairment by management whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment is assessed by comparing the carrying amount of an asset with its expected future net undiscounted cash flows from use together with its residual value (net recoverable value). If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value. Future income taxes The Corporation uses the tax liability method to account for income taxes. Under this method, future tax assets and liabilities are determined according to differences between the carrying amounts and tax bases of assets and liabilities. They are measured by applying enacted or substantively enacted tax rates and laws at the date of the financial statements for the years in which the temporary differences are expected to reverse. It is more likely than not that all of the future income tax assets will be realized. New accounting policies The CICA has issued the following new Handbook Sections and guidelines: a) EIC-156, “Accounting by a Vendor for Consideration Given to a Customer (Including a Reseller of the

Vendor's Product)”, was issued and provides guidance to companies that give incentives to customers or resellers in the form of cash, equity, free gifts, coupons and other. The adoption of EIC-156 is effective for fiscal years beginning on or after January 1, 2006. The adoption of this guideline reduced net sales by $25.8 million in 2006 and $22.2 million in 2005.

b) Handbook Section 3831, “Non-Monetary Transactions”, effective for transactions initiated in periods

beginning on or after January 1, 2006. This section prescribes to record non-monetary transactions at fair value unless the transaction has no commercial substance, it is an exchange of product or property, it is a non-monetary non-reciprocal transfer to owners or it is not reliably measurable. The adoption of this new Handbook Section did not have a material impact on the December 31, 2006 consolidated financial statements.

c) Impact of accounting pronouncements not yet implemented Impact of accounting pronouncements not yet implemented The CICA has issued the following new Handbook sections that must be adopted by the Corporation for the fiscal year beginning on January 1, 2007. The Corporation is currently evaluating the impact of the adoption of these new sections on the consolidated financial statements. i) Handbook Section 1506, “Accounting Changes”: This Section established criteria for changing accounting

policies, together with the accounting treatment and disclosure of changes in accounting policies and estimates, and correction of errors.


SIGNIFICANT ACCOUNTING POLICIES AND USE OF ESTIMATES (Continued) ii) Handbook Section 3855, “Financial Instruments - Recognition and Measurement”: This Section describes the

standards for recognizing and measuring financial assets, financial liabilities and non-financial derivatives. All financial assets, except for those classified as held-to-maturity, and derivative financial instruments must be measured at their fair value. All financial liabilities must be measured at their fair value if they are classified as held for trading purposes; if not, they are measured at their carrying value.

iii) Handbook Section 3865, “Hedges”: This Section describes when hedge accounting is appropriate. Hedge

accounting ensures that all gains, losses, revenues and expenses from the derivative and the item it hedges are recorded in the statement of earnings in the same period.

iv) Handbook Section 1530, “Comprehensive Income”, and Section 3251, “Equity”: Comprehensive income is the

change in equity of an enterprise during a period arising from transactions and other events and circumstances from non-owner sources. It includes items that would normally not be included in net income such as changes in the foreign currency translation adjustment relating to self-sustaining foreign operations and unrealized gains or losses on available-for-sale financial instruments. This Section describes how to report and disclose comprehensive income and its components. Section 3251 replaces Section 3520, “Surplus”, and describes the changes in how to report and disclose equity and changes in equity as a result of the new requirements of Section 1530. Upon adoption of this Section, the consolidated financial statements will include a statement of comprehensive income.

RISKS AND UNCERTAINTIES Realization of Synergies from the Integration of MEGA Brands America We may not realize the expected synergies of the MEGA Brands America acquisition, including anticipated sales growth or the estimated revenue and cost synergies. The expected cost synergies resulting from the recent acquisition of MEGA Brands America assume that (i) we will continue to manufacture products that maintain or increase the level of product quality; (ii) our new distribution center is able to meet customer demand in a timely and efficient manner; (iii) that we are able to retain key personnel and attract qualified employees to consolidate the integration of MEGA Brands America at both the operations and administrative level. In addition and beyond the matters outlined in “Specified Items Affecting Operations”, the overall integration of the companies may result in unanticipated operational issues, expenses and liabilities, and a diversion of management's attention, which could have a material adverse effect on our financial condition, business operations, business prospects and results of operations.


RISKS AND UNCERTAINTIES (Continued) Litigation We are involved in a number of litigious matters, including but not limited to environmental and product liability and there can be no assurance that additional litigation will not arise in the future. As previously disclosed, the former shareholders of Rose Art Industries, Inc. filed on May 8, 2006 a complaint against the Corporation seeking payment of certain amounts due under the SPA. Additionally, on November 17, 2006, two of the former shareholders who held executive positions with Rose Art Industries, Inc. filed arbitration proceedings seeking unspecified damages for the Corporation's alleged breach of their employment agreements. The unfavorable disposition of pending or future litigation and arbitration could have a material adverse effect on our financial condition and results of operations. Litigation may result in substantial costs and expenses and may significantly divert the attention of management regardless of the outcome. There can be no assurance that we will be able to achieve a favorable settlement of pending litigation or obtain a favorable disposition of litigation that is not settled. In addition, current and future litigation, governmental proceedings, labor disputes or environmental matters could lead to increased costs or interruption of our normal business. Risks and Uncertainties (Continued) We are subject to regulation by the CPSC and similar state, provincial and international regulatory authorities and our products could be subject to involuntary recalls and other actions by such authorities. We may also voluntarily recall selected products out of concern for product safety. On March 31, 2006, we jointly announced with the CPSC a voluntary recall and replacement program of MAGNETIX building sets in the hands of families with children under the age of six. This action was taken in response to the death of a toddler and injuries to several children resulting from magnet ingestion. Approximately 14,000 consumer contacts were received under this program in 2006. The Corporation, jointly with the CPSC, continues to monitor the performance of these toys in the market to ensure that all safety standards are met. We may experience defects in products after their production and sale to consumers. Recalls or defects could result in the rejection of our products by consumers, damage to our reputation, lost sales, negative publicity, fines or penalties diverted development resources and increased customer service and support costs, any of which could have a material adverse effect on our financial condition, business operations and/or business prospects. Individuals may sustain injuries from our products and we may be subject to claims and lawsuits resulting from such injuries. On October 24, 2006, the Corporation announced that it had settled four lawsuits and ten claims related to injuries to children resulting from the ingestion of magnets. The aggregate amount paid to settle the lawsuits and claims is $13.5 million and is recorded as a product liability settlement expense in the 2006 consolidated statement of earnings. The Corporation expects to recover substiantially the full amount from its insurers and through other recourses, although there can be no assurance that a favorable outcome will be achieved. Discussions with our insurers in this regard are underway. On September 14, 2006 and on December 5, 2006, two lawsuits related to magnet ingestion requiring surgical removal were served on the Corporation and remain outstanding. On March 29, 2007 the Corporation learned that a third lawsuit had been filed in U.S. District Court in Denver by the family of a child who is alleged to have sustained similar injuries. The Corporation is also aware of at least seven other incidents in which children are alleged to have required surgery following the ingestion of multiple magnets. The Corporation is not able to assess with any certainty the outcome of theses lawsuits and claims or impact, if any. As such, no amounts have been reserved in our year-end financial statements. There can be no assurance that additional incidents, lawsuits or claims will not arise, or that additional enquiries by the CPSC or other regulatory authorities in respect of MAGNETIX or other products will not be brought in the future, or result in additional product recalls.


RISKS AND UNCERTAINTIES (Continued) In addition to the foregoing, on March 28, 2007, the Corporation learned that a competitor who sells magnetic building sets primarily in Europe, Plastwood S.R.L. and Plastwood Corporation, filed a complaint against MEGA Brands America and MEGA Brands in the Western District of Washington. The complaint is based in significant part on representations alleged to have been made prior to the Corporation's acquisition of MEGA Brands America. The complaint does not provide support for Plastwood's allegations of its own lost sales and other consequences. The Corporation believes it has valid defenses to the complaint and intends to defend the action vigorously. However, there can be no assurance of a favorable outcome. International Operations Our own sales, manufacturing and distribution facilities, as well as the utilization of third-party distribution, independent sales representatives and contract manufacturers, are subject to the risks normally associated with international operations, including: (i) costs associated with the repatriation of earnings; (ii) civil unrest and political and economic instability; (iii) significantly concentrated outbreaks of communicable diseases; (iv) greater difficulty protecting intellectual property rights; (v) complications in complying with foreign laws, fiscal regulations and changes in governmental policies; (vi) increased delivery lead time and potential for transportation delays and interruptions; (vii) the imposition of tariffs or trade sanctions; (viii) the loss of “most favored” trading status by the People's Republic of China in the United States or the European Union and; (ix) the difficulty of attracting and retaining local financial managers with knowledge and experience of North American accounting and internal control standards, and possessing English-language skills. There can be no assurance that these risks will not result in a material adverse effect on our financial condition and results of operations. Insurance Coverage Although the Corporation believes it has adequate product liability insurance generally, there is a risk that claims or liabilities could exceed or fall outside the scope of our insurance coverage, or impede our ability to obtain adequate insurance coverage in the future. As a result of the voluntary recall and replacement campaign with the CPSC on March 31, 2006 aimed at MAGNETIX building sets and the ensuing publicity and product liability lawsuits and claims against the Corporation, the cost of insurance coverage for these products manufactured before May 1, 2006 was prohibitive and as such, the Corporation is self-insured for incidents occuring after December 1, 2006 for MAGNETIX products manufactured before May 1, 2006. Consequently, the unfavorable disposition of any self-insured MAGNETIX related litigation could have a material adverse effect on our financial condition and results of operations. As at April 1, 2007, insurance coverage has been confirmed subject to a standard reservation of rights for two of the three outstanding product liability lawsuits. For the most recent lawsuit filed March 29, 2007, coverage has not been assessed.


RISKS AND UNCERTAINTIES (Continued) Consumer Preferences Our business and operating results depend largely upon the appeal of our toy and stationery products. Our continued success will depend on our ability to enhance and extend existing product lines and to develop, introduce and gain consumer acceptance of new products. However, consumer preferences in our industry are continuously changing and are difficult to predict. Individual products typically have short life cycles, and there have been recent trends towards children outgrowing toys at younger ages, particularly in favor of interactive and high technology products, and an increased use of high technology in toys. There can be no assurance that: (i) any of our current product lines will continue to be popular for any significant period of time; (ii) any new products we introduce will achieve an adequate degree of market acceptance; or (iii) any new products' life cycles will be sufficient to permit us to recover development, manufacturing, marketing and other costs. A decline in the popularity of our existing products or the failure of new products to achieve and sustain market acceptance and to produce acceptable margins could have a material adverse effect on our financial condition and results of operations. Additionally, ongoing negative publicity surrounding MAGNETIX toys in the U.S. and other key markets may result in a loss of consumer confidence in the brand. Rate of Growth or Profitability There can be no assurance that our rate of growth will continue or that we will be able to maintain our present level of net sales or profitability. Furthermore, future growth, if achieved, may place a strain on our management and financial controls systems, and there can be no assurance that management would be able to manage such growth effectively. Failure to manage any future growth experienced by us could have a material adverse effect on our financial condition and results of operations. Customer Concentration For the year ended December 31, 2006, our two largest customers accounted for approximately 39.1% of net sales. We do not have firm purchase commitments from any of our customers. If some of these customers were to cease doing business with us or to reduce the amount of their purchases, by virtue of experiencing financial difficulty or otherwise, it could have a material adverse effect on our sales, financial condition and results of operations. In addition, most large retail chains have begun to sell private-label toys, arts and crafts and office products designed and branded by the retailers themselves. Such private label items may be sold at prices lower than our comparable products, and may result in lower purchases of our products by such retailers. Additionally, in recent years, several large customers engaged in price cutting of toy products during the holiday season, and arts and crafts and stationery products during the back-to-school season, which, if these trends continue, could have a material adverse effect on our gross profit, profitability and consumer perception of the brand equity of our products. Prices of Raw Materials Our principal raw material is plastic resin, which is subject to the volatility in crude oil prices. We do not hedge against adverse price fluctuations. Furthermore, limited supplier production capacity and strong demand have placed upward pressure on the price of resin. There can be no assurance that this pressure will decline. While we have succeeded in passing on a portion of the increase in the price of plastic resin to our customers, there is no assurance we will be able to continue to do so, particularly if there are substantial price increases or that price increases occur over a sustained period. Prices of other raw materials are also subject to fluctuations. Unfavorable swings in commodity prices could have a material adverse effect on our financial condition and results of operations.


RISKS AND UNCERTAINTIES (Continued) Currency Fluctuations We are exposed to market risks attributable to fluctuations in foreign currency exchange rates, primarily changes in the value of the U.S. dollar versus other currencies such as the Canadian dollar, Euro, British pound, Mexican peso and Australian dollar. Our policy is to stabilize earnings by limiting foreign currency exposure mainly through forward exchange contracts. Our risk management approach is to have hedging mechanisms in place for a maximum period of 24 months. Our hedging policy strictly prohibits unauthorized speculative foreign exchange transactions. We only enter into forward contract agreements with solid financial counterparties. Furthermore, in order to limit the risk of incurring losses in the event the counterparty does not fulfill its obligation, we only enter into forward exchange contract agreements with members of our lending syndicate. We do this because we are not required to provide additional security and/or guarantees to the members of the lending syndicate other than the security package already in place under our credit agreement. Seasonality Our business is seasonal and therefore our annual operating results depend in large part on our sales during the third and fourth quarters. This seasonality is increasing as large retailers become more efficient in their control of inventory levels through just-in-time inventory management systems. Retailers require the Corporation to ship products closer to the time they expect to sell the products to consumers creating shorter lead times for production and increased pressure to fill orders promptly. The logistics of supplying more products within shorter time periods increases the risk that we will fail to achieve compressed shipping schedules, which may reduce our sales and affect our financial performance. Risks Relating to Licensed Products While we attempt to balance our licensed and non-licensed product offerings, and to make a judicious selection of brands and entertainment properties which we license from third-parties, there is a risk that guaranteed royalty payments and advances thereon which we are required to pay to licensors may not be recouped from the sale of licensed products. Additionally, the sale of licensed products relating to entertainment properties, particularly theatrical releases, often presents limited durations during which our customers will carry licensed product inventory, which consequently could reduce demand for such licensed products. Retail Environment The retail environment is highly competitive and there is no assurance that retailers who sell our products will not experience liquidity problems such as those that led to a rationalization of the mass-market retail channel in North America in recent years. If our key customers were to delay payments or cease doing business as a result of liquidity problems or bankruptcy, this could have a material adverse effect on our financial condition and results of operations. Construction Toy Litigation We are currently involved in litigation proceedings, which, regardless of the outcome, may result in substantial expenses and divert the attention of management. The most significant proceedings against us involve our principal competitor, The Lego Group (“Lego”). Lego continues to challenge the Corporation's sale of functionally and aesthetically compatible construction toys in various markets. There can be no assurance that we will achieve a favorable outcome in any of these markets. The unfavorable disposition of pending litigation could have a material adverse effect on our financial condition, operations and business prospects.


RISKS AND UNCERTAINTIES (Continued) On July 10, 2006, the Office for Harmonization of the Internal Market of the European Union (Trade Marks and Designs) Grand Board of Appeal (“OHIM”) affirmed the cancellation of a three-dimensional Community Trademark registration for a brick design in the name of Lego Juris A/S (“Lego”), with respect to wares described as “construction toys”. Lego subsequently appealed this decision to the European Court of First Instance, where the matter is now pending. The Corporation believes that the trend of jurisprudence in such matters favors public access to useful product configurations, like the basic Lego block, which are no longer protected by patents, and the Corporation does not expect Lego to succeed with its appeal. Financing and Interest Rates Increases in interest rates, both domestically and internationally, could negatively affect the cost of financing both our operations and investments. Any reduction in our credit ratings could increase the cost of obtaining financing. Additionally, our ability to issue long-term debt and obtain seasonal financing could be adversely affected by factors such as an inability to meet our debt covenant requirements. The ability to conduct our operations could be negatively impacted should these or other adverse conditions affect our primary sources of liquidity. DISCLOSURE CONTROLS AND PROCEDURES We comply with Multilateral Instrument 52-109 - Certification of Disclosure in Issuers' Annual and Interim Filings issued by the Canadian Securities Administrators. The President and Chief Executive Officer and the Executive Vice-President and Chief Financial Officer together with Management, have evaluated the effectiveness of the Corporation's disclosure controls and procedures and the design of internal controls over financial reporting (“ICFR”) as at December 31, 2006. They have concluded that the Corporation's disclosure controls and procedures were adequate and effective to ensure that material information relating to the Corporation and its subsidiaries is complete and reliable. During the course of its evaluation, which focused intensively on the integration of MEGA Brands America and its subsidiaries, Management identified a limited number of significant weaknesses that were not considered material either individually or in the aggregate. In response to the significant weaknesses identified, additional manual controls were performed for the annual closing process. The following significant, non-material ICFR weaknesses have been identified and are described in conjunction with their corresponding remediation plans: 1. Lack of sufficient resources in our accounting and finance organization. Due to sustained organic growth

combined with the acquisition of MEGA Brands America and its subsidiaries, the Corporation lacks a sufficient complement of personnel with a level of financial reporting expertise commensurate with our financial reporting requirements. In fiscal 2007, we began to implement a finance structure designed to meet the challenges presented by the overall growth of the Corporation. As such, additional accounting professionals will be hired to remediate this aspect of its ICFR.

2. Monitoring of non-routine and non-systematic transactions. We did not have effective compliance with

controls that are in place to monitor and accurately record non-routine and non-systematic transactions. This weakness is primarily related to the difficulty of ensuring that internal controls are well-understood and harmonized across the organization. A key aspect of the remediation plan in regard to this significant, non-material ICFR weakness took place in December 2006, when the Corporation converted the MEGA Brands America information technology platform to the one used by the Corporation to ensure consistent and timely communication of financial and accounting information. The Corporation has performed additional manual testing to ensure that the accounting for such non-routine and non-systematic transactions is appropriate and materially correct.


DISCLOSURE CONTROLS AND PROCEDURES (Continued) 3. Controls over financial reporting of foreign subsidiaries. We did not have effective compliance with controls

that are in place to ensure adherence to the ICFR of foreign subsidiaries, particularly as concerns the monitoring and tracking o inventory in our China manufacturing facility and at the Fife, Washington distribution center of MEGA Brands America. To address this ICFR weakness, the Corporation has instituted the process of analyzing inventory variances on a monthly basis and has seconded senior finance personnel to supervise the accounting procedures and inventory controls at the close of each quarter. The information technology platform of our Chinese facility will be converted in 2007 to ensure more consistent and timely communication of financial and accounting information. With respect to the Fife facility, MEGA Brands America has already converted to the information technology platform used by the Corporation to ensure consistent and timely communication of financial and accounting information.

ADDITIONAL INFORMATION Additional information about MEGA Brands, including our Annual Information Form, is available on SEDAR at www.sedar.com.


MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL REPORTING The accompanying Consolidated Financial Statements of MEGA Brands Inc. have been prepared by management and approved by the Board of Directors. Management is responsible for the information and representation contained in these financial statements and in other sections of this Annual Report. To meet its responsibility for the integrity and objectivity of data in the Consolidated Financial Statements, management has developed and maintains a system of internal accounting controls. Management believes that this system of internal accounting controls provides reasonable assurance that the financial records are reliable and form a proper basis for preparation of financial statements, and that the assets are properly accounted for and safeguarded. The Board of Directors carries out its responsibility for financial statements in this Annual Report principally through its Audit Committee. The Company’s auditors have full access to the Audit Committee, with and without management being present. The Consolidated Financial Statements have been audited by PricewaterhouseCoopers LLP Chartered Accountants, and their report is shown as part of the Consolidated Financial Statements. (signed) Marc Bertrand President and Chief Executive Officer (signed) Alain Tanguay Executive Vice-President and Chief Financial Officer April 1, 2007


AUDITORS’ REPORT To the Shareholders of MEGA Brands Inc. (formerly Mega Bloks Inc.) We have audited the consolidated balance sheet of MEGA Brands Inc. as at December 31, 2006 and the consolidated statements of earnings, retained earnings and cash flows for the year then ended. These financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with Canadian generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of MEGA Brands Inc. as at December 31, 2006 and the results of its operations and its cash flows for the year then ended in accordance with Canadian generally accepted accounting principles. The consolidated financial statements as at December 31, 2005 and for the year then ended were audited by other auditors who expressed an opinion without reservation on those statements in their report dated March 23, 2006. (signed) PricewaterhouseCoopers Chartered Accountants Montréal, Québec April 1, 2007

MEGA Brands Inc. Consolidated Statements of Earnings For the years ended December 31, 2006 and 2005 (in thousands of U.S. dollars, except per share amounts)


2006

$ 2005

$

Net sales (note 3) 547,347 384,863 Cost of sales 328,822 214,668 Gross profit (note 4) 218,525 170,195 Marketing and advertising expenses 26,808 24,573 Research and development expenses 18,334 9,402 Other selling, distribution and administrative expenses 109,815 71,074 Loss (gain) on foreign currency translation (4,846) 2,796 Voluntary product recall and replacement (note 4) 5,612 - Product liability settlement and related expenses (note 5) 15,490 - Integration expenses (note 6) 3,573 - Litigation expenses (note 7) 4,769 - Earnings from operations 38,970 62,350 Interest and other expenses Interest on long-term debt 22,526 9,310 Other interest (note 8) 177 954 22,703 10,264 Earnings before income taxes 16,267 52,086 Income taxes (note 9) Current (1,217) 5,473 Future (7,864) 7,005 (9,081) 12,478 Net earnings for the year 25,348 39,608 Earnings per share (note 10) Basic 0.79 1.35 Diluted 0.74 1.26 The accompanying notes are an integral part of these consolidated financial statements.

MEGA Brands Inc. Consolidated Statements of Retained Earnings (Deficit) For the years ended December 31, 2006 and 2005 (in thousands of U.S. dollars)


2006

$ 2005

$

Deficit – Beginning of year (12,712) (52,320) Net earnings for the year 25,348 39,608 Retained earnings (deficit) – End of year 12,636 (12,712) The accompanying notes are an integral part of these consolidated financial statements.

MEGA Brands Inc. Consolidated Balance Sheets As at December 31, 2006 and 2005 (in thousands of U.S. dollars)


2006

$ 2005

$

Assets Current assets Cash and cash equivalents 13,658 19,567 Accounts receivable (note 12) 161,612 173,666 Inventories (note 13) 140,630 82,280 Income taxes 9,317 - Future income taxes (note 9) 8,354 13,396 Prepaid expenses 12,025 8,324 345,596 297,233 Property, plant and equipment (note 14) 43,213 39,351 Intangible assets (note 15) 79,517 72,230 Goodwill (note 16) 300,829 306,973 Deferred charges 3,281 4,708 Future income taxes (note 9) 28,006 - 800,442 720,495 Liabilities Current liabilities Accounts payable and accrued liabilities 153,437 108,025 Additional consideration accrued on business combination (note 11) 57,825 74,075 Income taxes - 4,744 Current portion of long-term debt 9,609 8,784 220,871 195,628 Long-term debt (note 17) 302,345 292,169 Future income taxes (note 9) 27,782 12,682 550,998 500,479 Shareholders’ Equity Capital stock (note 18) 236,088 231,592 Contributed surplus (note 19) 720 1,136 Retained earnings (deficit) 12,636 (12,712) 249,444 220,016 800,442 720,495 Commitments and contingencies (note 22)

Approved by the Board of Directors (signed) Marc Bertrand, Director (signed) Vic Bertrand, Director

MEGA Brands Inc. Consolidated Statements of Cash Flows For the years ended December 31, 2006 and 2005 (in thousands of U.S. dollars)


2006

$ 2005

$

Cash flow from Operating activities Net earnings for the year 25,348 39,608 Items not affecting cash and cash equivalents

Amortization of property, plant and equipment 12,462 10,343 Amortization of deferred charges 1,044 1,538 Amortization of intangible assets 667 161 Stock-based compensation plans 2,126 732 Future income taxes (7,864) 7,005 Loss (gain) on foreign currency (2,610) 1,680

31,173 61,067 Changes in non-cash operating working capital items (note 20) (15,300) (36,026) 15,873 25,041 Financing activities Proceeds from long-term debt - 300,000 Repayment of long-term debt (28,998) (13,409) Repayment of subsidiary indebtedness upon acquisition (624) (36,382) Change in revolving credit facility 40,000 (11,000) Issuance of capital stock 3,882 57,158 Addition of deferred charges - (4,457) 14,260 291,910 Investing activities Acquisition of property, plant and equipment (17,456) (9,977) Acquisition of intangible assets - (1,391) Proceeds from disposal of property, plant and equipment 304 - Business combinations (note 11) (18,890) (291,623) (36,042) (302,991) Increase (decrease) in cash and cash equivalents (5,909) 13,960 Cash and cash equivalents – Beginning of year 19,567 5,607 Cash and cash equivalents – End of year 13,658 19,567 Supplementary disclosure of cash flow information (note 20) The accompanying notes are an integral part of these consolidated financial statements.

MEGA Brands Inc. Notes to Consolidated Financial Statements December 31, 2006 and 2005 (column figures are expressed in thousands of U.S. dollars, except per share data)


1 Nature of business

On June 15, 2006, the shareholders adopted a special resolution authorizing the Corporation to change its legal name to MEGA Brands Inc. (formerly Mega Bloks Inc.). On June 22, 2006, the Corporation filed the amendment to its articles of incorporation under the Canada Business Corporations Act to change its name. The legal names of the Corporation’s principal subsidiaries have been changed to MEGA Brands America, Inc. (formerly Rose Art Industries, Inc.), MEGA Brands Europe NV (formerly Mega Bloks Europe NV) and MEGA Brands International (formerly Mega Bloks International Sàrl). The Corporation designs, manufactures and markets a broad line of toys and stationery and activities products. The Corporation sells and distributes its products in over 100 countries under the MEGA BLOKS, ROSE ART, MAGNETIX and BOARD DUDES brands.

2 Significant accounting policies

Principles of consolidation and reporting currency Consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting principles (“GAAP”) using the U.S. dollar (functional currency) as the reporting currency. The consolidated financial statements include the accounts of the Corporation and its wholly owned subsidiaries since the date of acquisition. All intercompany balances and transactions have been eliminated on consolidation. Use of estimates Preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. The most significant areas requiring the use of management estimates relates to: inventory valuation, valuation of year-end provision on accounts receivable, future income taxes, intangible assets, goodwill, reserves and allowances, specifically those related to the integration costs, general liability and income taxes. Revenue recognition Revenue is recognized when (i) persuasive evidence of an arrangement exists, (ii) products are shipped to customers and customer takes ownership and assumes risk of loss, (iii) collection of the respective receivable is probable, and (iv) sales price is fixed or determinable. Accruals for customer discounts, rebates, incentives and defective allowances are recorded as the related revenues are recognized.



Vendor allowance The cash considerations received from vendors are deemed a reduction of the prices of the vendors’ products or services and are accounted for as a reduction of cost of sales and related inventory when recognized in the Corporation’s consolidated statements of earnings and balance sheets. Certain exceptions apply when the cash considerations received are either a reimbursement of incremental selling costs incurred by the Corporation, or a payment for assets or services delivered to the vendors. Self-insurance The Corporation is primarily self-insured for MAGNETIX products manufactured before May 1, 2006. Required accruals for self-insurance liabilities are determined by management based on claims filed and an estimate of claims incurred but not yet reported, and are not discounted. Research and development expenses Research expenses are charged to earnings net of related tax credits. Unless these expenses meet Canadian GAAP for deferral, development expenses are charged to earnings, net of the related tax credits. Research and development expenses are presented net of tax credits of $0.3 million for the year ended December 31, 2006 (2005 – $0.9 million). Foreign currency translation Monetary assets and liabilities denominated in currencies other than U.S. dollars (foreign currencies) and monetary assets and liabilities from foreign integrated subsidiaries are translated at the rates of exchange at the balance sheet date. Non-monetary balance sheet items denominated in foreign currencies and non-monetary balance sheet items from foreign integrated subsidiaries are translated at the rates of exchange prevailing at the respective transaction dates. Revenue and expense items arising from transactions in foreign currencies and from foreign integrated subsidiaries are translated into U.S. dollars at average rates during each reporting period. Gains or losses on foreign exchange are recorded in the consolidated statements of earnings. All unrealized translation gains and losses on assets and liabilities denominated in foreign currencies are included in earnings for the year. Derivative financial instruments The Corporation uses various derivative financial instruments to manage interest rate risk and foreign exchange rate risk and formally documents when required all relationships between derivatives and the items they hedge, and its risk management objective and strategy for using various hedges. Derivatives that are economic hedges but do not qualify for hedge accounting are recognized at fair value with the changes in fair value recorded in earnings. The Corporation does not use derivative financial instruments for speculative or trading purposes.



When hedge accounting is applied, the Corporation formally assesses, both at the hedge’s inception and on an ongoing basis, whether the derivatives used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. Gains and losses on foreign currency forward contracts designated as effective for hedge accounting are recognized in the consolidated statements of earnings during the same period as the underlying revenues and expenses. For interest rate swaps, the difference between the swap rate and the actual rate is reflected against the related interest expense. Gains and losses associated with derivative instruments, which have been terminated or cease to be effective prior to maturity, are deferred under other assets or liabilities and recognized in the consolidated statement of earnings in the period in which the underlying hedged transaction is recognized. In the event a designated hedged item is sold, extinguished or matures prior to the termination of the related derivative instrument, a gain or loss on such derivative instrument is recognized in the consolidated statement of earnings. Stock options and share units The Corporation uses the fair value method to account for all stock-based compensations. This method requires awards of stock options to be measured on their date of grant using the fair value method. They are expensed and credited to contributed surplus over their vesting period, and reclassified to capital stock when stock options are exercised. The Corporation’s share unit plan, which became effective February 24, 2005, allows the Board of Directors to grant bonuses in the form of share units that are time and performance based, which vest primarily over a three-year period. The plan is non-dilutive and will be settled in shares purchased from the secondary market, or in cash, at the option of the Corporation. The share units are accounted for as liabilities on a fair value basis by using the quoted market price of the common shares at the end of each period. The share units are treated as stock-based compensation and are expensed and credited to accrued liabilities over the vesting period. Earnings per share Basic earnings per share is based on the weighted-average number of units outstanding during the period. The dilutive effect of stock options is determined using the treasury stock method. Cash and cash equivalents Cash and cash equivalents include cash and short-term investments in money market instruments with maturities of three months or less. Inventories Inventories are stated at the lower of cost and market value. Cost is established based on the first-in, first-out method. Market value is defined as replacement cost for raw materials and net realizable value for work in process and finished goods.



Property, plant and equipment Property, plant and equipment are recorded at cost and are amortized over the lesser of their estimated useful lives and the term of the lease using the straight-line method and the following amortization periods:

Buildings 25 years Machinery and equipment 3 to 15 years Computer equipment 3 to 5 years Leasehold improvements Over the terms of the leases

Government grants Government grants for property, plant and equipment acquisitions are netted against property, plant and equipment and are amortized on the same basis as the related asset. Government grants to create employment are recorded in earnings as a reduction of the related expenses when conditions are met. Intangible assets Intangible assets with a finite service life are accounted for at cost less accumulated amortization. They consist of customer relationships and intellectual property which are amortized over twenty years and non-competition covenants which are amortized over five years. Intangible assets with indefinite service life, consisting of the trade name and intellectual property, are accounted for at cost and are not amortized. The trade name and intellectual property are tested for impairment annually or more frequently if changes in circumstances indicate a potential impairment. As at December 31, 2006, the Corporation has performed an impairment test and no write-down was necessary. Goodwill Goodwill represents the excess of the acquisition cost of companies over the fair value of the identifiable net assets acquired and is not amortized. Goodwill is tested for impairment annually or more frequently if changes in circumstances indicate a potential impairment. As at December 31, 2006, the Corporation has performed an impairment test and no write-down was necessary. Deferred charges Deferred charges are comprised mainly of financing charges. The financing charges are recorded at cost and are amortized according to the straight-line method over the term of the credit facility. Impairment of long-lived assets Long-lived assets are reviewed for impairment by management whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment is assessed by comparing the carrying amount of an asset with its expected future net undiscounted cash flows from use together with its residual value (net recoverable value). If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value.



Future income taxes The Corporation uses the tax liability method to account for income taxes. Under this method, future tax assets and liabilities are determined according to differences between the carrying amounts and tax bases of assets and liabilities. They are measured by applying enacted or substantively enacted tax rates and laws at the date of the financial statements for the years in which the temporary differences are expected to reverse. It is more likely than not that all of the future income tax assets will be realized.

3 New accounting policies The CICA has issued the following new Handbook Sections and guidelines: a) EIC-156, “Accounting by a Vendor for Consideration Given to a Customer (Including a Reseller of the

Vendor’s Product)”, was issued and provides guidance to companies that give incentives to customers or resellers in the form of cash, equity, free gifts, coupons and other. The adoption of EIC-156 is effective for fiscal years beginning on or after January 1, 2006. The adoption of this guideline reduced net sales by $25.8 million in 2006 and $22.2 million in 2005.

b) Handbook Section 3831, “Non-Monetary Transactions”, effective for transactions initiated in periods beginning on or after January 1, 2006. This section prescribes to record non-monetary transactions at fair value unless the transaction has no commercial substance, it is an exchange of product or property, it is a non-monetary non-reciprocal transfer to owners or it is not reliably measurable. The adoption of this new Handbook Section did not have a material impact on the December 31, 2006 consolidated financial statements.

c) Impact of accounting pronouncements not yet implemented The CICA has issued the following new Handbook sections that must be adopted by the Corporation for the fiscal year beginning on January 1, 2007. The Corporation is currently evaluating the impact of the adoption of these new sections on the consolidated financial statements. i) Handbook Section 1506, “Accounting Changes”: This Section established criteria for changing

accounting policies, together with the accounting treatment and disclosure of changes in accounting policies and estimates, and correction of errors.

ii) Handbook Section 3855, “Financial Instruments – Recognition and Measurement”: This Section describes the standards for recognizing and measuring financial assets, financial liabilities and non-financial derivatives. All financial assets, except for those classified as held-to-maturity, and derivative financial instruments must be measured at their fair value. All financial liabilities must be measured at their fair value if they are classified as held for trading purposes; if not, they are measured at their carrying value.



iii) Handbook Section 3865, “Hedges”: This Section describes when hedge accounting is appropriate. Hedge accounting ensures that all gains, losses, revenues and expenses from the derivative and the item it hedges are recorded in the statement of earnings in the same period.

iv) Handbook Section 1530, “Comprehensive Income”, and Section 3251, “Equity”: Comprehensive income is the change in equity of an enterprise during a period arising from transactions and other events and circumstances from non-owner sources. It includes items that would normally not be included in net income such as changes in the foreign currency translation adjustment relating to self-sustaining foreign operations and unrealized gains or losses on available-for-sale financial instruments. This Section describes how to report and disclose comprehensive income and its components. Section 3251 replaces Section 3520, “Surplus”, and describes the changes in how to report and disclose equity and changes in equity as a result of the new requirements of Section 1530. Upon adoption of this Section, the consolidated financial statements will include a statement of comprehensive income.

4 Voluntary product recall and replacement

Under a voluntary recall and replacement program of MAGNETIX products jointly announced with the Consumer Products Safety Commission (“CPSC”) on March 31, 2006, the Corporation recorded product replacement expenses of $5.6 million, consisting of freight costs to meet customer shipment dates due to manufacturing delays resulting from design changes to MAGNETIX products, related packaging and development costs, and product replacements for consumers. In addition, the Corporation recorded reimbursements of MAGNETIX products returned by customers of $6.6 million as a reduction of sales. The Corporation also recorded write-offs of MAGNETIX components of $4.3 million as a result of design changes to such components and recorded inventory write-offs of $4.2 million following plant closures as part of the integration of MEGA Brands America. These write-offs have been included in cost of sales.

5 Product liability settlement and related expenses

2006

$ 2005

$

Settlement payments (note 22(b)) 13,500 - Legal expenses 1,990 -

15,490 -

The Corporation expects to recover substantially the full settlement amount of $13.5 million from its insurers and through other recourses. Since there is no assurance that a favourable outcome will be achieved, no recovery has been recognized as at December 31, 2006.



6 Integration expenses

The Corporation recorded integration expenses of $3.6 million mainly related to branding, plant asset write-offs, travel and professional fees and plant closure costs resulting from the integration of MEGA Brands America.

7 Litigation expenses

The Corporation recorded litigation expenses of $4.8 million, mainly for the litigation with the former shareholders of Rose Art (note 22(a)).

8 Other interest

2006

$ 2005

$

Facility fees net of interest revenue 177 39 Write-off of deferred expenses related to previous credit facility - 727 Bridge loan fees - 188 177 954

9 Income taxes

a) The following table is a reconciliation of the differences between the statutory income tax rate and the effective income tax rate:

2006

$ 2005

$

Income tax expense at Canadian statutory rate 5,209 16,303 Benefits arising from financing structures (8,466) (2,085) Effects of foreign tax rate differences (11,666) (2,300) Others 5,842 560 Income tax expense (recovery) (9,081) 12,478



b) As at December 31, future income taxes are as follows:

2006

$ 2005

$

Future income tax assets Property, plant and equipment 3,075 - Accrued integration charges and accrued liabilities 2,856 11,631 Share issue costs 411 1,202 Loss carryforward 17,882 - Interest deduction carryforward 7,049 - Asset revaluation 2,571 - Others 2,516 1,557 36,360 14,390

Loss carryforward relates to MEGA Brands America and will expire no later than 2026.

2006

$ 2005

$

Future income tax liabilities Property, plant and equipment 7,075 7,048 Intangible assets and goodwill 11,914 4,230 Unrealized portion of foreign exchange gain 310 314 Others 8,483 2,084 27,782 13,676 Future income taxes – net 8,578 714 Classified in the consolidated financial statements as

Future income tax assets Current 8,354 13,396 Long-term 28,006 -

36,360 13,396

Future income tax liabilities Long-term 27,782 12,682

Future income taxes – net 8,578 714



10 Earnings per share

The following table sets forth the computation of basic and diluted earnings per share:

2006 2005

Numerator for basic and diluted net earnings per common share

Net income attributable to common shareholders $25,348 $39,608 Denominator for basic net earnings per common share Weighted average number of common shares outstanding 32,220,495 29,281,145 Basic earnings per share $0.79 $1.35 Denominator for diluted net earnings per common share Weighted average number of common shares outstanding 32,220,495 29,281,145

Plus impact of stock options 1,968,539 2,109,311

Diluted average number of common shares 34,189,034 31,390,456 Diluted earnings per share $0.74 $1.26

11 Business combinations

a) On January 24, 2006, the Corporation, through its subsidiary MEGA Brands America, entered into an agreement to acquire all voting shares of The Board Dudes, Inc. (“Board Dudes”), a privately held corporation based in Corona, California. Board Dudes designs and distributes dry-erase boards, cork boards, foam boards, and school and locker products. The purchase price paid is $17 million subject to certain adjustments and was financed through existing credit facilities. During the third quarter of 2006, as part of these adjustments, an amount of $1.9 million was paid to the Board Dudes principals. Contingent consideration to the selling principals of up to $7 million is payable between 2006 and 2009 depending on the attainment of certain performance targets. Any additional consideration will be recorded to goodwill. The transaction closed on February 1, 2006 and the results of operations are included in the consolidated statement of earnings as of this date.



The acquisition was accounted for using the purchase method. The purchase price allocation was finalized in the fourth quarter of 2006. The fair value of net assets acquired was as follows:

$

Assets acquired Non-cash working capital 3,050 Property, plant and equipment 98 Intangible assets 7,990 Goodwill(1) 8,376 Long-term debt (624)

Non-cash assets acquired 18,890 Cash and cash equivalents 43

Net assets acquired 18,933

Consideration

Cash 18,296 Acquisition costs 637

18,933

(1) Goodwill is deductible for tax purposes.

b) On July 26, 2005, the Corporation completed the acquisition of all voting shares of Rose Art Industries,

Inc., Warren Industries, Inc. and their subsidiaries (“MEGA Brands America”), headquartered in Livingston, New Jersey. MEGA Brands America manufactures and markets arts and crafts, magnetic building sets and features school supplies. MEGA Brands America was a private corporation with a strong brand recognition in the United States. The total purchase price consideration includes the assumption of $37 million of outstanding MEGA Brands America debt, for a net purchase price of $319 million. This purchase price consists of $292 million in cash at closing, $20 million of MEGA Brands America common shares at a price of CA$19.00 per share issued to MEGA Brands America principals upon closing, and $7 million of acquisition costs. The transaction provides for a contingent payment of up to $50 million payable if MEGA Brands America’s adjusted earnings before interest, taxes, depreciation and amortization (“EBITDA”) for 2005 exceeds $50 million, based on five times such incremental amount. The transaction also provides for additional earn-out payments of 50% of the amounts exceeding adjusted EBITDA thresholds of $60 million, $65 million and $70 million in 2005, 2006 and 2007 respectively. The transaction was fully financed by credit facilities totaling $400 million, including a $100 million revolving credit facility for working capital purposes.



The acquisition was accounted for using the purchase method. As at December 31, 2005, the Corporation allocated the purchase price on a preliminary basis to the assets acquired and the liabilities assumed based on management’s best estimates of their fair value and taking into account all relevant information unavailable at that time. During the second quarter of 2006, the purchase price allocation was finalized and modified with adjustments primarily relating to non-cash working capital, future income taxes, and a corresponding entry to goodwill. As at year-end, goodwill was reduced on an after-tax basis by $7.2 million for the decrease in the integration and restructuring reserve, and $7.3 million for additional consideration accrued and other adjustment to fair value of net assets acquired.

Preliminary

$ Final

$

Assets acquired Non-cash working capital 21,388 24,947 Property, plant and equipment 6,979 6,979 Future income tax assets 16,013 14,678 Intangible assets 71,000 71,000 Goodwill(1) 306,973 292,453 Long-term debt (36,655) (36,655)

Non-cash assets acquired 385,698 373,402 Cash and cash equivalents 7,933 7,933

Net assets acquired 393,631 381,335

Consideration

Cash 292,503 292,503 Acquisition costs 7,053 7,329 Additional consideration accrued on business combination 74,075 61,503 Issuance of shares to former Rose Art shareholders 20,000 20,000

393,631 381,335

(1) Goodwill is deductible for tax purposes.

As at December 31, additional consideration accrued on business combination is as follows:

2006

$ 2005

$

Contingent purchase price 51,000 51,000 Other incentives 6,825 23,100

57,825 74,100



12 Accounts receivable

2006

$ 2005

$

Trade 153,076 167,428 Other 8,536 6,238 161,612 173,666

13 Inventories

2006

$ 2005

$

Raw materials 16,806 18,333 Work in progress 17,850 12,648 Finished goods 105,974 51,299 140,630 82,280

14 Property, plant and equipment

2006

Cost

$

Accumulated amortization

$

Net book value

$

Land 44 - 44 Buildings 882 17 865 Machinery and equipment 83,594 53,277 30,317 Computer equipment 8,489 5,246 3,243 Leasehold improvements 10,401 2,745 7,656 Computer equipment held under capital leases 1,997 1,602 395 Machinery and equipment held under

capital leases 1,265 572 693 106,672 63,459 43,213



2005

Cost

$


$

Net book value

$

Land 44 - 44 Buildings 889 7 882 Machinery and equipment 73,908 44,287 29,621 Computer equipment 7,298 4,227 3,071 Leasehold improvements 6,127 1,896 4,231 Computer equipment held under capital leases 1,996 1,412 584 Machinery and equipment held under

capital leases 1,472 554 918 91,734 52,383 39,351

15 Intangible assets

2006

Cost

$


$

Net book value

$

Trade name(1) 67,750 - 67,750 Intellectual property(1) 1,500 - 1,500 Intellectual property 1,391 145 1,246 Customer relationships 8,530 477 8,053 Non-competition covenants 1,210 242 968

80,381 864 79,517

2005

Cost

$


$

Net book value

$

Trade name(1) 64,500 - 64,500 Intellectual property(1) 1,500 - 1,500 Intellectual property 1,391 36 1,355 Customer relationships 5,000 125 4,875

72,391 161 72,230

(1) Non-amortized indefinite service life intangible asset



16 Goodwill

The changes in the carrying value of goodwill are comprised of the following:

2006

$ 2005

$

Balance – Beginning of year 306,973 - Acquisition of Rose Art (note 11) (14,520) 306,973 Acquisition of Board Dudes (note 11) 8,376 - Balance – End of year 300,829 306,973

Upon finalization in 2006 of the purchase price allocation of the net assets acquired of MEGA Brands America, goodwill was reduced by $14.5 million.

17 Long-term debt

2006

$ 2005

$

Credit facility Term A loan, maturing March 2009 (note 17(a)) 14,400 40,000 Term B loan, maturing July 2012 (note 17(b)) 256,750 259,350 Revolving term facility, maturing July 2010 (note 17(c)) 40,000 - Other debt Obligations under capital leases, maturing up to May 2008

(note 17(d)) 804 1,341 Mortgage, repaid in 2006 (note 17(e)) - 262 311,954 300,953 Less: Current portion of long-term debt 9,609 8,784 302,345 292,169 On July 26, 2005, the Corporation entered into a $400 million Credit Facility with a syndicate of banks. This Credit Facility was used to finance the acquisition of Rose Art Industries, Inc. The facility is secured by a movable hypothec on all assets of the Corporation. During the third quarter of 2006, the Corporation amended the Credit Facility by prepaying $20 million of the Term A loan, and increasing the revolving term facility by $20 million. Under the terms of the Credit Facility, the Corporation must satisfy certain restrictive covenants as to financial ratios.



The Credit Facility is available under U.S. base rate loans or LIBOR loans at the option of the Corporation. The Term A loan and the revolving term facility bear interest at the published rates based on U.S. base rate plus 0.25% to 1.25% or LIBOR plus 1.25% to 2.25%. The Term B loan bears interest at the published rates based on U.S. base rate plus 0.75% or LIBOR plus 1.75%. a) The Term A loan is a $40 million credit facility. Payments are due in quarterly installments of 2% and 4%.

b) The Term B loan is a $260 million credit facility. Payments are due in quarterly installments of 0.25% and

93.25% at maturity.

c) The revolving term facility is a $120 million (2005 – $100 million) revolving credit facility.

d) Obligations under capital leases are denominated and payable in Canadian dollars (CA$937), and bear interest from 3.74% to 7.65%.

e) The mortgage obligation was fully repaid in 2006, and bore interest at a fixed rate of 6%. The repayment requirements on the long-term debt during the next five years and thereafter are as follows:

Obligations under capital leases Credit facility Total

Years

Miminum payments

$ Interest

$ Principal

$ Principal

$

Principal repayments

$

2007 642 33 609 9,000 9,609 2008 199 4 195 9,000 9,195 2009 - - - 4,200 4,200 2010 - - - 42,600 42,600 2011 - - - 2,600 2,600 Thereafter - - - 243,750 243,750 841 37 804 311,150 311,954



18 Capital stock

Authorized An unlimited number of common shares without par value

Issued and outstanding

2006 2005

Number of shares

Book value

$

Number of shares

Book value

$

Balance – Beginning of year 32,105,575 231,592 27,292,469 154,434 Issued pursuant to private

placement(1) - - 3,100,000 54,513 Issued to Rose Art principals - - 1,285,894 20,000 Issued pursuant to exercise of

stock options 559,338 4,496 427,212 2,645 Balance – End of year 32,664,913 236,088 32,105,575 231,592

(1) Subscription receipts of 3.1 million were exchanged on a one-to-one basis for common shares. These subscription receipts

were originally sold on July 11, 2005 by way of a private placement at CA$22.25 for aggregate proceeds of CA$68,975,000 before fees of $2.3 million.

19 Stock options, share unit and contributed surplus

a) The Corporation has two stock-based compensation plans whereby options may be granted to officers and other key employees of the Corporation and its subsidiaries to purchase common shares of the Corporation.

Under the Initial Stock Option Plan, the subscription price of each option equalled the estimated fair value of a share of the Corporation at the date of grant. Immediately prior to the closing of the Initial Public Offering which occurred in 2002, the Corporation introduced a New Stock Option Plan. Under this plan, options to purchase common shares of the Corporation are granted at a subscription price of 100% of market value. Market value is determined as the closing price of the common shares on the Toronto Stock Exchange on the last date of trading prior to the effective date of the grant.



As at December 31, 2006, a total of 4,992,877 common shares remained authorized for issuance under the Corporation’s stock-based compensation plans. Options are exercisable during a period not to exceed ten years after the date of the grant. The right to exercise the options accrues over a period of three years of continuous employment. However, if there is a change of control of the Corporation, the options become immediately exercisable. Options are adjusted proportionately for any stock dividends or stock splits attributed to the common shares of the Corporation. On March 24, 2004, the Board of Directors adopted a recommendation of the Compensation Committee that the Corporation voluntarily cap stock option grants at 15% of the number of common shares outstanding even though the Option Plan, as approved by the relevant regulatory authorities, allows for a significantly higher dilution rate when the available option grants under such plan are combined with option grants under the Initial Plan. The following table summarizes all stock options outstanding as at December 31 under the Corporation’s stock option plans:

2006 2005

Number of options

Weighted average exercise

price $

Number of options


price $

(in Canadian dollars) (in Canadian dollars)

Options outstanding – Beginning of year 3,233,858 9.01 3,702,541 8.93

Granted - - - - Exercised (559,338) 7.96 (427,212) 7.31 Forfeited (8,914) 22.13 (41,471) 19.38

Options outstanding –

End of year 2,665,606 9.18 3,233,858 9.01

Options exercisable – End of year 2,610,425 8.94 3,009,997 8.12



The following table summarizes information about stock options outstanding as at December 31, 2006:

Range of exercise price

CA$

Number outstanding

Weighted average

remaining contractual life in years


price CA$

Number exercisable


price CA$

3.85 1,419,274 2.8 3.85 1,419,274 3.85 14.50 1,088,846 5.4 14.50 1,088,846 14.50 18.25 to 25.65 157,486 6.6 20.43 102,305 20.30 2,665,606 4.1 9.18 2,610,425 8.94

Stock-based compensation expense for stock option amounts to $198 in 2006 (2005 – $451).

b) The Corporation’s share unit plan, which became effective February 24, 2005, allows the Board of

Directors to grant bonuses in the form of share units that are time and performance vesting after three years. The plan is non-dilutive and will be settled in shares purchased on the secondary market, or in cash, at the option of the Corporation.

The following table summarizes the share units outstanding as at December 31, 2006 and 2005 under the Corporation’s share unit plan:

Number of units 2006 2005

Units outstanding – Beginning of year 65,768 - Granted 295,028 65,768 Exercised (637) - Forfeited (5,175) - Units outstanding – End of year 354,984 65,768 Share unit plan compensation expenses $1,928 $281

Total compensation expense for stock-based employee compensation awards amount to $2,126 in 2006 (2005 – $732).



c) Contributed surplus

The following table summarizes charges to contributed surplus:

2006

$ 2005

$

Balance – Beginning of year 1,136 685 Value of compensation cost associated with

stock-based compensation expense 198 451 Stock options exercised (614) - Balance –End of year 720 1,136

20 Statement of cash flows

a) Changes in non-cash operating working capital items

2006

$ 2005

$

Accounts receivable 15,004 2,179 Inventories (56,781) (2,694) Prepaid expenses (3,619) (400) Accounts payable and accrued liabilities 43,237 (31,203) Income taxes (14,061) 1,626 Derivative financial instruments - (3,573) Additional consideration accrued on business combination (3,678) - Foreign currency translation relating to working capital items 4,598 (1,961) (15,300) (36,026)

b) Supplementary information

2006

$ 2005

$

Interest paid 22,217 6,534 Income taxes paid 14,805 1,840 Non-cash items

Property, plant and equipment acquired by means of capital leases - 517

Additional consideration accrued on business combination (12,572) 74,075 Issuance of common shares - 20,000



21 Derivative financial instruments

Foreign currency risk management The Corporation enters into certain foreign currency forward contracts to manage the risks associated with foreign currency exchange rates, namely the Canadian dollar, the euro, the British pound, the Mexican peso and the Australian dollar. As at December 31, 2006, the Corporation had entered into foreign currency forward contracts to sell t6 million and GBP3 million at average exchange rates of 1.3021 and 1.8746 respectively, all maturing in 2007. The fair value of these forward contracts as at December 31, 2006 is $0.4 million in favour of third parties. These derivative instruments have not been designated as hedges for accounting purposes as the Corporation has terminated its designation of all hedging relationships for foreign currency forward contracts. The associated liability is recorded in accrued liabilities and the unrealized loss has been recorded in the foreign currency translation account. As at December 31, 2005, the Corporation had entered into foreign currency forward contracts to sell US$7.25 million, t7.25 million and GBP3.5 million at average exchange rates of 1.2439, 1.3301, and 1.9004 respectively, all maturing in 2006. The fair value of these forward contracts as at December 31, 2005 was $2.2 million in favour of the Corporation. These derivative instruments were all designated as hedges for accounting purposes. Interest rate swaps The Corporation enters into interest rate swap agreements to convert certain long-term debt from variable to fixed interest rates in order to achieve an appropriate mix of fixed and variable interest rate debt. The interest rate swap agreements involve the periodic exchange of payments without the exchange of the notional principal amount upon which the payments are based, and are recorded as an adjustment of interest expense on the hedged debt instrument. The related amount payable to, or receivable from, counterparties is included as an adjustment to accrued interest. As at December 31, 2006 and 2005, the interest rate swap agreements are with third parties for a notional value of $150 million at a fixed rate of 4.66325%, maturing in July 2012. The Corporation is applying hedge accounting to these financial instruments and no amount is recorded in these consolidated financial statements. As at December 31, 2006, the fair value of these swaps was $2.8 million (2005 – $1 million) in favour of the Corporation. Credit risk The Corporation does not believe it is subject to significant concentration of credit risk. Cash and short-term investments are in place with major financial institutions. The Corporation is exposed to some credit risk on accounts receivable; however, the Corporation regularly monitors its credit risk exposure and takes steps to mitigate the risk of loss, including obtaining credit insurance. The Corporation’s extension of credit is based on an evaluation of each customer’s financial condition and the Corporation’s ability to obtain credit insurance coverage for that customer.



The Corporation is exposed to credit risk in the event of non-performance by counterparties to its derivative financial instruments. It minimizes this exposure by entering into contracts with counterparties that are of high-credit quality. Collateral or other security to support financial instruments subject to credit risk is usually not obtained. The credit standing of counterparties is regularly monitored. Fair value The Corporation has determined that the carrying value of its short-term financial assets and liabilities other than the derivative financial instruments above approximates fair values as at the balance sheet dates because of the short-term maturity of those instruments. The fair value of the Corporation’s long-term debt approximates its carrying value as the majority of long-term debt bears interest at rates that vary based on the U.S. base rate and LIBOR.

22 Commitments and contingencies

a) On May 8, 2006, the former shareholders of Rose Art initiated litigation against the Corporation in the U.S. District Court for the Southern District of New York. The plaintiffs are seeking payment of the Contingent Purchase Price under the terms of the Stock Purchase Agreement (“SPA”) entered into between them and the Corporation on July 26, 2005. The Corporation has filed an answer and counterclaim denying each and every material allegation relating to the lawsuit. The Corporation’s counterclaim alleges that the former shareholders failed to uphold certain terms of the SPA. The Corporation accrued US$51.0 million in its 2005 consolidated financial statements with respect to the Contingent Purchase Price pending final determination of the amount owed, if any. As at December 31, 2006, no disbursements had been made and the Corporation will continue to maintain the accrual until the lawsuit is resolved. Based on management’s assessment, no additional consideration is due for 2006. On November 17, 2006, the former shareholders of Rose Art filed arbitration proceedings before the American Arbitration Association against the Corporation seeking unspecified damages for the Corporation’s alleged breach of their respective employment agreements. The Corporation is contesting the proceedings.

b) On March 31, 2006, the Corporation jointly announced with the U.S. CPSC a voluntary recall and replacement program of MAGNETIX building sets in the hands of families with children under the age of six. This action was taken in response to the death of a toddler and injuries to several children resulting from magnet ingestion. On October 24, 2006, the Corporation announced that it had settled four lawsuits and ten claims related to injuries to children resulting from the ingestion of magnets. Terms of the settlement include no admission of liability. The aggregate amount paid to settle the lawsuits and claims is $13.5 million and is recorded as a product liability settlement expense in the 2006 consolidated statement of earnings. The Corporation expects to recover substantially the full amount from its insurers and through other recourses, although there can be no assurance that a favourable outcome will be achieved.



On September 14, 2006 and December 5, 2006, two lawsuits related to magnet ingestion requiring surgical removal were served on the Corporation and remain outstanding. They are being handled by the Corporation’s insurers. On March 29, 2007, the Corporation learned that a third lawsuit had been filed in U.S. District Court in Denver by the family of a child who is alleged to have sustained similar injuries. The lawsuit has been reported to the Corporation’s insurers. The Corporation is also aware of at least seven other incidents in which children are alleged to have required surgery following the ingestion of multiple magnets. Lawsuits have not been filed in these matters as of April 1, 2007. The Corporation has not been able to assess with any certainty the outcome of these lawsuits and claims or their impact, if any. Therefore, no amount has been reserved as at December 31, 2006.

c) On March 28, 2007, the Corporation learned that a competitor who sells magnetic building sets primarily in Europe, Plastwood S.R.L. and Plastwood Corporation, filed a complaint against the Corporation in the U.S. District Court for the Western District of Washington alleging damages for false advertising and unfair and deceptive acts and practices. The Corporation has not been able to assess the outcome of this lawsuit or its impact, if any. Therefore, no amount has been reserved.

d) The Corporation is also defending other claims, which arise in the ordinary course of business. The Corporation believes that the outcome of any individual claim or the aggregate of all such claims will not have a material impact on its business, financial condition or results of operations.

e) The Corporation has entered into operating leases for premises, which it occupies, for an amount of $44.7 million. The minimum annual rent payable (excluding certain occupancy charges) for each of the next five years is as follows:

$

2007 13,465 2008 10,189 2009 9,209 2010 8,192 2011 3,637

f) In connection with an agreement with Investissement Québec, an aggregate amount of CA$3.9 million

was granted to the Corporation over a period of three years. This grant was conditional upon acquiring a certain level of property, plant and equipment and the creation and maintenance of a certain level of employment for a period of five years terminated in 2006. In 2001, 2002 and 2003, the Corporation received grants of $1.9 million to acquire certain property, plant and equipment and to create employment. Approximately 61% of the grants received in 2001, 2002 and 2003 were accounted for as a reduction of property, plant and equipment. The remaining portion of the grants was recorded in earnings as a reduction of related expenses in 2006.



g) As at December 31, 2006, the Corporation had outstanding letters of guarantee in the amount of $1.6 million (2005 – $2.4 million) relating to financial guarantees issued in the normal course of business. These guarantees are issued under standby facilities available to the Corporation within the New Credit Facility.

23 Segmented information

Description of segments The Corporation operates under two geographical segments, North America and International, with sales and marketing conducted through two product lines. a) The Toys product lines are comprised of MEGA BLOKS construction toys in the preschool and boys 5-

plus categories, MAGNETIX building sets for children 6-plus and MEGA games and puzzles for the family.

b) The Stationery and Activities product lines are comprised of art materials (crayons, coloured pencils, highlighters and markers) sold mainly under the ROSE ART brand; writing instruments (pens, mechanical pencils and woodcase pencils) sold mainly under the ROSE ART, SRX and USA GOLD brands; dry-erase and cork presentation boards, organizers and accessories sold mainly under the BOARD DUDES brand, and ROSE ART and MEGA craft and activity sets.

c) Information by segment as to MEGA Brands’ operations in geographic areas is presented below on the basis the Corporation uses to manage its business. Net sales are categorized based on location of the customer while long-lived assets are categorized based on their location:

Segmented information

2006 $

2005 $

Net sales

Toys 333,667 291,576 Stationery and Activities 213,680 93,287

547,347 384,863

Geographic information

2006 $

2005 $

Net sales

North America(1) 397,778 254,318 International 149,569 130,545

547,347 384,863

(1) Includes net sales for Canada in 2006 of $27.4 million (2005 – $21.1 million).



2006

$ 2005

$

Earnings from operations North America (11,728) 40,252 International 50,698 22,098

38,970 62,350

2006

$ 2005

$

Property, plant and equipment, intangible assets, and goodwill North America(1) 343,312 412,752 International 80,247 5,802

423,559 418,554

(1) Includes property, plant and equipment for Canada in 2006 of $31.1 million (2005 – $31.4 million). Other information d) Net sales for the year ending December 31, 2006 to the Corporation’s two largest customers amounted to

$148.8 million (2005 – $91.1 million) and $65.3 million (2005 – $33.5 million).

24 Comparative figures

Certain of the prior year’s figures have been reclassified to conform with the current year’s presentation.


(PAGE INTENTIONALLY LEFT BLANK)

Shareholder Information

Auditors

PricewaterhouseCoopers LLP

Transfer Agent

CIBC Mellon Trust Company1.800.387.0825

Annual and Special Meeting of Shareholders

Thursday, June 7, 2007 at 10:30 a.m.4505 HickmoreMontreal, Quebec

Headquarters

4505 HickmoreMontreal, QuebecCanada H4T 1K4Tel.: 514.333.5555Fax: 514.333.4470

Investor Relations

[email protected]

Listing

The Toronto Stock ExchangeTicker Symbol: MB

Shares Outstanding

As of March 30, 200732,711,213 Common Shares

Trading History (CA$)

Fiscal Year 2006 Fiscal 2007 (First Quarter)

High 29.75 27.20

Low 20.25 24.56

Close 26.15 25.36

Average daily volume 117,165 141,390

FORWARD-LOOKING INFORMATIONAll statements herein that do not directly and exclusively relate to historical facts constitute "forward-looking information". These statements represent the Corporation's intentions, plans, expectations and beliefs. In certain instances, these statements require us to make assumptions and there is significant risk that these assumptions may not be correct. Furthermore, these statements are subject to risks, uncertainties and other factors, many of which are beyond the Corporation's control. Actual results could differ materially from the statements reflected in the forward-looking information. In addition, certain material factors or assumptions were applied in making the statements reflected in the forward-looking information. Additional information about the factors thatcould cause actual results to differ from our current expectations and the material factors and assumptions relating to the forward-looking information can be found in the “Forward-Looking Statements” and “Risks and Uncertainties” sections of the Management’s Discussion and Analysis for the financial year ended December 31, 2006 and the first quarter ended March 31, 2007 as filed on SEDAR. The words "believe", "estimate", "expect", "intend", "anticipate", "foresee", "plan", and similar expressions and variations thereof, identify certain of such forward-looking statements, which speak only as of the date on which they are made. The Corporation disclaims any intention or obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, other than as required by applicable legislation. Readers are cautioned not to place undue reliance on these forward-looking statements.

June 7, 2007

©MEGA Brands Inc. The MEGA logo, Creativity to the Rescue, Mega Bloks, Rose Art, Magnetix and Board Dudes are trademarks of MEGA Brands Inc. or its affiliates.

All other trademarks shown and/or used in this document are the property of their respective owners and are used under license by MEGA Brands.

TM

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Documents

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