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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

or

Commission file number: 0-22663

THE MIDDLETON DOLL COMPANY
(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (262) 523-4300

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

On November 12, 2004, there were 3,727,589 shares outstanding of the Registrant’s common stock, 6-2/3 cents par value.

THE MIDDLETON DOLL COMPANY
FORM 10-Q INDEX

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THE MIDDLETON DOLL COMPANY AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

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THE MIDDLETON DOLL COMPANY AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (Continued)

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THE MIDDLETON DOLL COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

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THE MIDDLETON DOLL COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS – (Continued)
(Unaudited)

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THE MIDDLETON DOLL COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’EQUITY
(Unaudited)

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THE MIDDLETON DOLL COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

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THE MIDDLETON DOLL COMPANY AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS
(Unaudited)

NOTE 1.    NATURE OF BUSINESS

The consolidated financial statements of The Middleton Doll Company (the “Parent”) include the accounts of the Parent, Bando McGlocklin Small Business Lending Corporation (“BMSBLC”), Lee Middleton Original Dolls, Inc. (“LMOD”) and License Products (“LPI”). All significant intercompany accounts and transactions have been eliminated in consolidation. The term “Company”, when used herein, refers to the Parent, BMSBLC, LMOD and LPI on a consolidated basis.

LMOD is a designer and distributor of collectible vinyl dolls and vinyl play dolls. LPI designs, develops and markets a line of proprietary time pieces. BMSBLC makes loans and leases buildings to small businesses and participates in loans with third party loan originators.

NOTE 2.    BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management of the Company, all adjustments necessary to present fairly the financial position as of September 30, 2004 and December 31, 2003, the results of operations for the three and nine months ended September 30, 2004 and 2003 and statements of changes in shareholders’ equity and cash flows for the nine months ended September 30, 2004 and 2003 have been made. Such adjustments consisted only of normal recurring items. Operating results for the three and nine month periods ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. The accounting policies followed by the Company are set forth in Note 1 to the Company’s consolidated financial statements contained in the Company’s 2003 Annual Report on Form 10-K. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

The balance sheet for consumer products is classified due to its normal business cycle being less than twelve months. Financial services’ balance sheet is not classified as its normal business cycle is greater than twelve months.

In preparing consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for doubtful accounts, valuation of inventories and deferred tax assets. See discussion of “Critical Accounting Policies” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

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NOTE 3.    INVENTORY

Inventories of LMOD and LPI are valued at the lower of cost or market and utilize the first-in, first-out (FIFO) method to determine cost. The components of inventory are as follows:

NOTE 4.    INCOME TAXES

The Parent and its qualified REIT subsidiary, BMSBLC, qualify as a real estate investment trust under the Internal Revenue Code. Accordingly, the REIT is not subject to income tax on taxable income that is distributed to common shareholders. However, the REIT may retain capital gains from the sale of real estate and pay income tax on that gain.

Income tax benefit recorded by the Company that is attributable to the Consumers Product segment is calculated based on the determination of net income (loss) before the elimination of intercompany expenses. Valuation allowances are established against these deferred income tax benefits when necessary to reduce deferred income tax assets to the amount expected to be realized. During the first quarter of 2004, management determined, based on the level of continuing losses of the consumer products segment, that it would suspend the recognition of additional deferred income tax assets until the consumer products segment operating performance improves and supports the recognition of any additional net deferred income tax assets. As a result of this determination, management provided a valuation allowance of $0.73 million against the net operating losses generated by the consumer products segment during the nine months ended September 30, 2004.

NOTE 5.    LOSS PER SHARE

See Exhibit 11 for the computation of the net income (loss) per common share.

NOTE 6.    COMMITMENTS

Undisbursed construction and loan commitments totaled $5.56 million at September 30, 2004.

ITEM 2.     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

        Amounts presented as of September 30, 2004, and December 31, 2003, and for the three and nine month periods ended September 30, 2004, and September 30, 2003, include the consolidation of two segments. The financial services segment includes The Middleton Doll Company (the “Parent”) and Bando McGlocklin Small Business Lending Corporation (“BMSBLC”), a 100% owned subsidiary of the Parent. The consumer products segment includes Lee Middleton Original Dolls, Inc. (“LMOD”), a 99% owned subsidiary of the Parent and License Products, Inc. (“LPI”), a 100% owned subsidiary of LMOD. The term “Company”, when used herein, refers to the Parent, BMSBLC, LMOD and LPI on a consolidated basis.

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        The loan and real estate portfolios of the Parent and BMSBLC are administered and managed by InvestorsBank (the “Bank”), a wholly-owned subsidiary of InvestorsBancorp, Inc. under a “Second Amended and Restated Management and Services and Allocation of Expenses Agreement” dated January 1, 2004, (the “Management Agreement”). In addition, the Bank provides certain management services to LMOD. George R. Schonath, President and Chief Executive Officer of the Parent and BMSBLC, is also President and Chief Executive Officer of the Bank and InvestorsBancorp, Inc. George Schonath and members of his family own all of the outstanding stock of InvestorsBancorp, Inc.

        For the loan and real estate management services provided under the Management Agreement, the Bank receives an annual fee, payable monthly, equal to 0.25% (1/4 of 1%) of the total amount of loans under management and 6% of the rents from the real estate portfolio. The Management Agreement provides for the sharing of operating expenses between the Bank and BMSBLC, as well as certain expenses of employees of the Bank who provide accounting, reporting and related services to the Parent and BMSBLC. Additionally, for its services in providing ongoing credit analysis, loan and lease monitoring, workout services, and management services to LMOD, the Bank receives an annual fee of $365,000, payable monthly. The Parent and BMSBLC currently have only one paid employee, a Vice President of the Company and BMSBLC. George Schonath, the President and Chief Executive Officer, provides services to the Parent, BMSBLC and LMOD under the Management Agreement and is not separately compensated by any of those entities.

        During the past four years there has been a significant decrease in net sales of the consumer products segment. This decrease is primarily attributable to intense pricing competition from dolls produced in China. In June of 2004, LMOD transferred production of its high quality, lifelike Artist Studio Collection (ASC) dolls to a contract manufacturer in China to reduce manufacturing costs. The manufacturer in China that was selected to make ASC dolls is a current supplier who has devoted a separate unit and staff exclusively dedicated to the manufacture of these dolls. Limited doll production will continue at the LMOD facilities in Belpre, Ohio.

        Eight of LMOD’s Newborn Nursery Adoption Center departments, developed by LMOD for department stores owned by the Saks Department Store Group, are now open. The centers are located in Parisian stores in Birmingham, Alabama; Atlanta, Georgia; and Rochester Hills, Michigan; Proffitt’s stores in Chattanooga, Tennessee, and Sanford, Florida; a Carson Pirie Scott store in Lombard, Illinois, a Boston Store in Milwaukee, Wisconsin; and a Younkers store in Des Moines, Iowa. The Newborn Nursery Adoption Centers are located in the children’s department and provide an opportunity for little girls to experience the “adoption” of their very own lifelike baby doll in a simulated hospital nursery and helps parents to teach their children moral values and parenting responsibilities of a parent-child relationship.

        LMOD is working towards increasing sales of playdolls through the Newborn Nursery Adoption Centers and will also continue to develop new products for the Artist Studio Collection line of dolls while emphasizing high product quality. During the past two years, operating expenses, particularly in the sales and marketing area, have been reduced. However, general and administrative expenses have not significantly decreased primarily due to long-term leases in effect until 2006 for the headquarters location in Westerville, Ohio, and the warehouse facilities in Columbus, Ohio. Management is attempting to achieve further reductions in operating expenses by continuing to focus on controlling expenses.

        During the past four years there has also been a significant decrease in the loan portfolio of the financial products segment resulting in a corresponding decrease in interest income on loans. The financial services segment is at a lending disadvantage with other institutions such as banks, due to its higher cost of funds. Also, the existing management agreement with InvestorsBank prevents it from making new loans to other than existing customers without the prior consent of InvestorsBank. As a result, the size of the loan and leased property portfolio of BMSBLC has decreased and total revenues and earnings have also decreased.

        Due to the Parent’s required redemption of $16.85 million of outstanding preferred stock on July 1, 2008, BMSBLC expects to materially reduce its lending activities over the next four years. During the second quarter of 2004, the Board of Directors of the Company approved a plan to convert loans and leased properties of BMSBLC to cash as loans mature and leased properties are sold. The proceeds will be used to reduce outstanding debt and to redeem preferred stock at maturity. Under this policy, BMSBLC does not intend to make new loans or purchase new properties to lease, with only limited exceptions for participations with InvestorsBank. This reduction in assets will reduce the income available for common stock dividends in each of the next four years. As a result, the Board of Directors has changed the common stock dividend policy from the payment of quarterly dividends to an annual dividend which would be payable in January for the preceding year. During the first six months of 2004, dividends totaling $0.20 per share were paid to common stock shareholders. No dividends were paid on the common stock during the third quarter of 2004. If the financial services’ taxable income (which includes intercompany interest income and rental income) for the year ended December 31, 2004, exceeds $0.20 per common share, a dividend will be paid to the common shareholders on January 31, 2005. The preferred stock dividend of $0.335 per share per quarter ($1.34 annual dividend per preferred share) will continue to be paid on a quarterly basis.

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        Effective July 14, 2004, the Company’s common stock (DOLL) and preferred stock (DOLLP) began trading on the OTC Bulletin Board. The Company voluntarily delisted from The Nasdaq National Market because the shareholders’ equity in the Company no longer met the minimum NASDAQ requirement of $10.0 million.

Results of Operations

For the three months ended September 30, 2004 and September 30, 2003

        The Company’s total net income applicable to common shareholders for the three months ended September 30, 2004 equaled $0.18 million, or $0.05 per common share (diluted), as compared to a loss of $0.08 million, or $0.02 per common share (diluted), for the three months ended September 30, 2003, a significant increase.

        The consumer products segment’s net income increased $0.57 million when comparing the third quarter of 2004 to the third quarter of 2003, primarily due to the shipment of a holiday order of $1.58 million at LMOD. Gross profit margin at LMOD also increased during the third quarter of 2004 primarily due to decreased production costs associated with the transfer of doll production to China. Income tax expense on the income earned during the three months ended September 30, 2004 was not recorded by the consumer products segment due to available net operating losses which could not be utilized. For the three months ended September 30, 2003, the consumer products segment recorded an income tax benefit of $0.38 million.

        For the financial services segment both rental income and loan income decreased when comparing the third quarter of 2004 to the third quarter of 2003. Gains on sales of leased properties (net of income taxes) also decreased $0.10 million between the two quarters. Due to the sale of a leased property, $0.09 million in debt issue costs and $0.04 million of rent receivable was expensed in the third quarter of 2004.

Consumer Products

        Net sales for the consumer products segment for the three months ended September 30, 2004, increased 21% to $5.29 million from $4.37 million for the three months ended September 30, 2003. This was due to increased sales of $0.80 million at LMOD and increased sales of $0.12 million at LPI. During the third quarter of 2004, LMOD’s sales of playdolls increased $1.03 million. This increase was due to a shipment of a holiday order of $1.58 million by a large retailer and $0.26 million of start-up sales for Newborn Nursery dolls and accessories for Saks Department Stores. Without these orders, playdoll sales would have decreased by $0.81 million when comparing the third quarter of 2004 to the third quarter of 2003 due to a lack of distribution channels and lower dealer sales. However, LMOD is working towards increasing sales of playdolls through the Newborn Nursery Adoption Center concept. LMOD’s dealers have also been minimizing their inventory levels of collectible dolls due to sluggishness in that doll market resulting in a $0.23 million decrease in the sales of artist-designed collectible dolls when comparing the third quarters of 2004 and 2003.

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        Cost of goods sold increased 3% to $3.28 million for the three months ended September 30, 2004, compared to $3.19 million for the three months ended September 30, 2003. LMOD’s cost of goods sold increased to $2.32 million from $2.26 million while LPI’s cost of goods sold increased to $0.96 million from $0.93 million. Total gross profit margin increased to 38% from 27% in the prior year. LMOD’s gross profit margin increased to 38% from 24% primarily due to decreased production costs with the transfer of doll production to China. Management believes that gross profit margin will continue to improve when the transfer of production to China is complete. LPI’s gross profit margin increased to 37% for the third quarter of 2004 as compared to 33% for the third quarter of 2003.

        Total operating expenses of the consumer products segment for the three months ended September 30, 2004, were $1.74 million compared to $1.85 million for the three months ended September 30, 2003, a 6% decrease. LMOD’s total operating expenses decreased $0.23 million to $1.27 million when comparing the three months ended September 30, 2004 to the three months ended September 30, 2003. Operating expenses are expected to decrease further as restructuring costs and legal fees associated with the favorable outcome of recent copyright infringement lawsuits are reduced. Sales and marketing expense decreased $0.26 million primarily due to personnel reductions and decreases in advertising and catalog printing costs. New product development costs at LMOD increased $0.08 million primarily due to employment contract provisions and general and administrative expenses decreased $0.05 million primarily due to personnel reductions. LPI’s operating expenses increased $0.12 million to $0.46 million for the third quarter of 2004. Sales and marketing expenses increased $0.09 million primarily due to increases in shared advertising fees and sample costs while general and administrative expenses increased $0.03 million primarily due to salary increases and building expenses.

        Interest expense increased $0.01 million when comparing the third quarter of 2004 to the third quarter of 2003. In July of 2004, InvestorsBank extended a $2.0 million line of credit to LMOD (with the Parent as a co-borrower) at the prime rate. Proceeds from the loan were used to pay off the $1.1 million line of credit LMOD owed to the Parent. At September 30, 2004, the outstanding balance on the InvestorsBank line of credit was $0.49 million. Other income increased $0.02 million primarily due to rental income LPI received from a tenant in its building. In September of 2004, LPI purchased the building in which it was a tenant, from BMSBLC. BMSBLC financed the transaction and the purchase price of $3.67 million was determined by an independent appraiser and represented the fair market value of the building at the time of the sale. The fair market value of the transaction approximated the carrying value to BMSBLC and no gain or loss was recognized on the transaction.

        Interest expense on intercompany loans has been eliminated for consolidation purposes. At September 30, 2004, LMOD owed the Parent $4.20 million consisting of a line of credit of $0.50 million and an unsecured note of $3.70 million. In addition, LMOD owed BMSBLC $2.04 million secured by a first mortgage on real estate. The average interest rate on LMOD’s notes was 5.1% at September 30, 2004. At September 30, 2004, LPI owed BMSBLC $8.02 million consisting of a line of credit of $1.85 million, an unsecured note of $2.5 million, and a first mortgage on real estate of $3.67 million. The average interest rate on LPI’s notes was 5.21% at September 30, 2004. Before intercompany eliminations, interest expense for the consumer products segment and interest income to the financial services segment was $0.14 million for the three months ended September 30, 2004. Intercompany eliminations also included $0.05 million in rent paid by LPI to BMSBLC for July and August of 2004. As of January, 2004, LMOD no longer pays management fees to BMSBLC, which increases working capital at LMOD, but reduces taxable income at BMSBLC.

        For the three months ended September 30, 2004, the income tax expense based on the income for the period was offset by an adjustment to the valuation allowance on the deferred tax asset for net operating loss carryforwards. Consumer products’ income tax benefit for the three months ended September 30, 2003, was $0.38 million.

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Financial Services

        The financial services segment net income after the preferred stock dividend payment decreased $0.31 million for the three months ended September 30, 2004, compared to the three months ended September 30, 2003.

        Interest income on loans decreased 35% to $0.50 million for the three months ended September 30, 2004, as compared to $0.77 million for the three months ended September 30, 2003. This decrease was primarily due to a $21.07 million decrease in the average total loans outstanding when comparing the three months ended September 30, 2004, to the three months ended September 30, 2003. In the present competitive interest rate environment, BMSBLC is at a lending disadvantage with other institutions such as banks, due to its higher cost of funds. During the three months ended September 30, 2004, competitive pressures resulted in a reduction of $5.26 million in loans due to pay-offs and normal principal reductions accounted for $0.81 million in payoffs. During the three months ended September 30, 2004, $4.47 million of new loan participations through InvestorsBank were added to the loan portfolio. The Parent’s and BMSBLC’s management agreement with InvestorsBank prevents them from making new loans to other than existing customers without the prior consent of InvestorsBank. Also, due to the requirement to redeem $16.85 million of preferred stock on July 1, 2008, the Parent and BMSBLC will use the proceeds of loan maturities, payoffs, and sales of leased properties to reduce outstanding indebtedness and therefore they do not intend to make any new loans or purchase any new properties, except for the purchase of loan participations from InvestorsBank. Participations with InvestorsBank comprised approximately 63% of the loan portfolio at September 30, 2004. These factors are resulting in BMSBLC’s inability to maintain the size of its loan and leased property portfolio and management anticipates the resulting decline will continue until July 1, 2008, at which point management expects that the loan and leased property portfolio will be reduced to zero.

        Rental income decreased 10% to $0.76 million for the three months ended September 30, 2004, as compared to $0.84 million for the three months ended September 30, 2003. Rental income for the three months ended September 30, 2004 decreased $0.02 million due to sales of leased property. During the third quarter of 2004, one tenant was on nonaccrual resulting in a reduction of $0.01 million in rental income, and three buildings were vacant resulting in a reduction of $0.07 million in rental income. Scheduled rent adjustments added $0.02 million to rental income in the third quarter of 2004.

        Net interest margin is determined by dividing the total of interest income on loans and rental income less interest expense by the total of average loans and leased properties. The interest margin for the three months ended September 30, 2004 was 4.57% compared to 4.07% for the three months ended September 30, 2003. The increase in the interest margin was primarily due to leased properties comprising a larger percentage of earning assets in 2004. During the third quarter of 2004, average loans outstanding (net of intercompany loans) of $38.25 million generated $0.50 million in interest income and average leased properties (net of intercompany properties) of $28.43 million generated $0.76 million in rental income. The average gross return for the third quarter on rental properties was approximately 10.7% while the average gross return on loans was approximately 5.2%. During the third quarter of 2003, average loans outstanding (net of intercompany loans) of $59.32 million generated $0.77 million in interest income and average leased properties (net of intercompany properties) of $32.35 million generated $0.84 million in rental income. The average gross return during the third quarter of 2003 on rental properties was approximately 10.4% while the average gross return on loans was approximately 5.2%.

        During the quarter ended September 30, 2004, there was one sale of a leased property to a third party resulting in a gain of $0.04 million, net of income taxes, compared to a gain of $0.14 million, net of income taxes, from the sale of one leased property in the quarter ended September 30, 2003. In September of 2004, LPI purchased the building in which it was a tenant, from BMSBLC. BMSBLC financed the transaction and the purchase price of $3.67 million was determined by an independent appraiser and represented the fair market value of the building at the time of the sale. The fair market value of the transaction approximated the carrying value to BMSBLC and no gain or loss was recognized on the transaction. At September 30, 2004, BMSBLC owned 20 properties with a net carrying value of $25.02 million of which $20.32 million was pledged as collateral to the debt facility. Three vacant rental properties with a net carrying value of $4.11 million were available for sale or lease at September 30, 2004, and one rental property with a net carrying value of $0.40 million was on non-accrual status.

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        Interest expense decreased 28% to $0.48 million for the three months ended September 30, 2004, as compared to $0.67 million for the three months ended September 30, 2003, primarily due to a decrease in the outstanding average debt balance. The average debt balance decreased $26.07 million when comparing the third quarter of 2004 to the third quarter of 2003 as a result of the decrease in loans as explained above. However, BMSBLC’s cost of funds is based primarily on variable interest rates. Beginning in the third quarter of 2003, a substantial amount of commercial paper which had matured was not able to be replaced by sales of additional commercial paper, requiring BMSBLC to draw upon the back-up bank line of credit which has a higher interest rate than commercial paper. As a result, BMSBLC’s cost for variable funds was 44 basis points higher when comparing the third quarter of 2004 to the third quarter of 2003. To help offset this increase, BMSBLC reduced higher fixed rate debt with proceeds from loan payoffs. The average cost of funds was 3.52% for the third quarter of 2004 as compared to 3.27% for the third quarter of 2003.

        BMSBLC’s debt facility consists of commercial paper and drawn letters of credit backed by a $50 million line of credit that matures on June 24, 2005. The debt facility was reduced by $15 million when it was renewed in June of 2004. A further reduction of $20 million is anticipated at the renewal date in 2005. At September 30, 2004, BMSBLC had $3.64 million in lending capability with outstanding unfunded commitments of $5.56 million. Beginning in the third quarter of 2003, a substantial amount of commercial paper which had matured was not able to be replaced by sales of additional commercial paper, requiring BMSBLC to draw upon the back-up bank line of credit which has a higher interest rate than commercial paper. This higher cost of funds lessens BMSBLC’s ability to compete with banks and other financial institutions for loans, resulting in a decreased ability to replace loans that are paid-off. Additionally, the 2008 redemption requirements of $16.9 million of preferred stock requires the Company to focus on asset quality while de-leveraging the balance sheet. For a summary of the current levels of bank debt and commercial paper, see “Liquidity and Capital – Financial Services”, herein.

        Other miscellaneous income remained the same at $0.04 million for the three months ended September 30, 2004 and 2003. Other miscellaneous income is composed primarily of prepayment penalties, letter of credit fees and late payment fees.

        Depreciation expense decreased $0.04 million due to leased property sales and vacancies when comparing the three months ended September 30, 2004 to 2003. Management fees under the management fee agreement with InvestorsBank decreased $0.01 million due to the decrease in loans under management when comparing the third quarter of 2004 to 2003. Other operating expenses increased when comparing the two quarters due to the sale of a leased property in the third quarter of 2004, debt issue costs of $0.09 million were expensed and $0.04 million of rent receivable was charged-off. However, leased property expenses decreased by $0.06 million due to two buildings that were sold.

        The Parent and its qualified REIT subsidiary, BMSBLC, qualify as a real estate investment trust under the Internal Revenue Code. Accordingly, they are not subject to income tax on taxable income that is distributed to common shareholders. However, the REIT may retain capital gains from the sale of real estate and pay income tax on that gain. In January, 2004, the Parent paid $0.18 million in capital gains taxes which were accrued at December 31, 2003.

        Interest expense on intercompany loans has been eliminated for consolidation purposes. At September 30, 2004, LMOD owed the Parent $4.20 million consisting of a line of credit of $0.50 million and an unsecured note of $3.70 million. LMOD owed BMSBLC $2.04 million secured by a first mortgage on real estate. The average interest rate on LMOD’s notes was 5.1% at September 30, 2004. At September 30, 2004, LPI owed BMSBLC $8.02 million consisting of a line of credit of $1.85 million, an unsecured note of $2.5 million, and a first mortgage on real estate of $3.67 million. The average interest rate on LPI’s notes was 5.21% at September 30, 2004. Before intercompany eliminations, interest expense for the consumer products segment and interest income to the financial services segment was $0.14 million for the three months ended September 30, 2004. Intercompany eliminations also included $0.05 million in rent paid by LPI to BMSBLC for July and August of 2004. As of January, 2004, LMOD no longer pays management fees to BMSBLC, which increases working capital at LMOD, but reduces taxable income at BMSBLC. As of November 12, 2003, the Parent extended a guarantee to a supplier of LMOD in which the Parent has agreed to unconditionally guarantee all obligations of LMOD to the supplier. It is anticipated that the maximum amount of the guarantee will not exceed $0.60 million, however, the amount of the guarantee is unlimited and the amount of the obligation may increase in the future.

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For the nine months ended September 30, 2004 and September 30, 2003

        The Company’s total net loss applicable to common shareholders for the nine months ended September 30, 2004 equaled ($1.39) million, or ($0.37) per common share (diluted), as compared to ($0.10) million, or ($0.03) per common share (diluted), for the nine months ended September 30, 2003.

        The consumer products segment did not record any income tax benefit based on the losses incurred during the first nine months of 2004. Management determined in 2004, based on the level of the continuing losses of the consumer products segment, that it would suspend the recognition of additional net deferred income tax assets until operating performance improves. For the first nine months of 2003, an income tax benefit of $1.16 million was recorded. When comparing the first nine months of 2004 to the first nine months of 2003, the net loss before income taxes was $0.76 million less primarily due to a holiday order of $1.58 million at LMOD in the third quarter of 2004.

        During the first nine months of 2004 and 2003, the consumer products segment losses were primarily due to lower sales as a result of the soft economy, pricing pressure from collectible dolls produced in China, and lower margins due to price reductions. In June of 2004, LMOD transferred production of its high quality, lifelike Artist Studio Collection (ASC) dolls to a contract manufacturer in China to reduce manufacturing costs. As a result, gross profit percentages at LMOD started to improve during the third quarter of 2004; however, sales remain slow.

        For the financial services segment during the first nine months of 2004 both rental and loan income decreased in comparison with the first nine months of 2003 due to loans being paid-off and leased properties being sold. However, lower dividend payments in 2004 on the adjustable rate preferred stock of $0.27 million increased net income by that amount. During the first nine months of 2004, the financial services segment did not have any gains from the termination of interest rate swaps while during the first nine months of 2003, the termination of interest rate swaps resulted in $0.48 million of income. The sale of leased properties, net of taxes, contributed $0.04 million in income in 2004 and $0.34 million in income in 2003.

        The financial statements are presented on a consolidated basis which eliminates all intercompany accounts and transactions. Common stock dividends are based on the financial services’ taxable income (which includes intercompany interest income and rental income). Intercompany interest income and rental income totaled $0.57 million for the nine months ended September 30, 2004, or $0.15 per common share. During the first six months of 2004, dividends totaling $0.20 per share were paid to common stock shareholders. No dividends were paid on the common stock during the third quarter of 2004. If the financial services’ taxable income for the year ended December 31, 2004, exceeds $0.20 per common share, a dividend will be paid to the common shareholders on January 31, 2005.

Consumer Products

        Net sales from consumer products for the nine months ended September 30, 2004 decreased 6% to $10.85 million from $11.59 million for the nine months ended September 30, 2003. This was due to decreased sales of $0.70 million at LMOD and decreased sales of $0.04 million at LPI. Artist Studio Collection (ASC) dolls are primarily sold through the LMOD dealer network and playdolls are primarily sold through dealers and a few larger retailers. LMOD dealers have been minimizing their inventory levels due to sluggishness in the collectible doll market resulting in a $1.47 million sales decrease in ASC doll sales when comparing the first nine months of 2004 to the first nine months of 2003. LMOD’s sales of playdolls increased $0.77 million when comparing the first nine months of 2004 to the first nine months of 2003. This increase was due to a shipment of a holiday order of $1.58 million by a large retailer and $0.26 million of start-up sales for Newborn Nursery dolls and accessories for Saks Department Stores. Without these orders, playdoll sales would have decreased by $1.07 million when comparing the first nine months of 2004 to the first nine months of 2003, primarily due to a lack of distribution channels and lower dealer sales. However, LMOD is working towards increasing sales of playdolls through the Newborn Nursery Adoption Center concept.

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        Cost of goods sold decreased 4% to $7.43 million for the nine months ended September 30, 2004, compared to $7.73 million for the nine months ended September 30, 2003. LMOD’s cost of goods sold decreased to $4.98 million from $5.31 million while LPI’s cost of goods sold increased to $2.46 million from $2.43 million. Total gross profit margin decreased to 32% from 33% in the prior year. LMOD’s gross profit margin decreased to 29% from 31%. Production costs decreased during the third quarter of 2004 with the transfer of doll production to China; however, this was offset by lower margins during the first half of 2004 due to price reductions on the line of artist-designed collectible dolls. Management believes that gross profit margins will improve when the transfer of production to China is complete. LPI’s gross profit margin decreased to 37% from 38%.

        Total operating expenses of the consumer products segment for the nine months ended September 30, 2004 were $4.91 million, compared to $6.02 million for the nine months ended September 30, 2003, an 18% decrease. LMOD’s total operating expenses decreased $1.38 million to $3.68 million for the nine months ended September 30, 2004. Operating expenses are expected to decrease further as restructuring costs and legal fees associated with the favorable outcome of recent copyright infringement lawsuits are reduced. Sales and marketing expense decreased $1.21 million primarily due to personnel reductions and decreases in advertising and catalog printing costs. The LMOD catalog is now available on-line at www.leemiddletondolls.com which reduced the number of catalogs printed. New product development costs increased $0.08 million primarily due to employment contract provisions and general and administrative expenses decreased $0.25 million primarily due to personnel reductions. LPI’s operating expenses increased $0.27 million to $1.24 million for the first nine months of 2004. Sales and marketing expense increased $0.16 million primarily due to a $0.12 million increase in shared advertising costs and $0.02 million in sample costs. New product development costs decreased $0.01 million and general and administrative expenses increased $0.12 million primarily due to salary increases and building expenses.

        Interest expense increased $0.01 million when comparing the first nine months of 2004 to the first nine months of 2003. In July of 2004, InvestorsBank extended a $2.0 million line of credit to LMOD (with the Parent as a co-borrower) at the prime rate. Proceeds from the loan were used to pay off the $1.1 million line of credit LMOD owed to the Parent. At September 30, 2004, the outstanding balance on the InvestorsBank line of credit was $0.49 million. Other income increased $0.09 million primarily due to settlements with defendants regarding legal actions taken to prevent the sale of certain dolls that management believes infringe on LMOD’s copyrights and other intellectual property. Other income also includes rental income LPI received from a tenant in its building. In September of 2004, LPI purchased the building in which it was a tenant, from BMSBLC. BMSBLC financed the transaction and the purchase price of $3.67 million was determined by an independent appraiser and represented the fair market value of the building at the time of the sale.

        Interest expense on intercompany loans has been eliminated for consolidation purposes. At September 30, 2004, LMOD owed the Parent $4.20 million consisting of a line of credit of $0.50 million and an unsecured note of $3.70 million. LMOD owed BMSBLC $2.04 million secured by a first mortgage on real estate. The average interest rate on LMOD’s notes was 5.1% at September 30, 2004. At September 30, 2004, LPI owed BMSBLC $8.02 million consisting of a line of credit of $1.85 million, an unsecured note of $2.5 million, and a first mortgage on real estate of $3.67 million. The average interest rate on LPI’s notes was 5.21% at September 30, 2004. Before intercompany eliminations, interest expense for the consumer products segment and interest income to the financial services segment was $0.37 million for the nine months ended September 30, 2004. Intercompany eliminations also included $0.20 million in rent paid by LPI to BMSBLC through August of 2004. As of January, 2004, LMOD no longer pays management fees to BMSBLC, which increases working capital at LMOD, but reduces taxable income at BMSBLC.

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        Consumer products’ income tax benefit, based on net losses before intercompany charges, was $1.16 million for the nine months ended September 30, 2003. During the quarter ended March 31, 2004, management determined, based on the level of continuing losses of the consumer products segment that it would suspend the recognition of additional net deferred income tax assets until the consumer products segment operating performance improves and supports the recognition of any additional deferred income tax assets. For the nine months ended September 30, 2004, management did not record an income tax benefit based on the loss incurred for that period due to the amount of the existing net operating loss carryforwards. In assessing the recoverability of deferred income tax assets, including net operating loss carryforwards, management considers whether it is more likely than not that some portion or all of the deferred income tax assets will not be realized. The realization of deferred income tax assets in this instance is dependent upon the generation of future taxable income during the periods in which the net operating loss carryforwards would be available to offset the taxable income. Based upon the level of historical taxable income and projections for future taxable income, management believes it is more likely than not that the consumer products segment will realize the benefits of the $2.69 million of net deferred income tax assets recorded as of September 30, 2004 and December 31, 2003. Management provided a valuation allowance of $0.73 million against the net operating losses generated by the consumer products segment during the first nine months of 2004.

Financial Services

        The financial services segment decrease in net income of $0.89 million for the nine months ended September 30, 2004, compared to the nine months ended September 30, 2003, was primarily due to (i) a decrease in net interest income of $0.18 million, (ii) a decrease in rental income of $0.21 million, (iii) a decrease of $0.29 million from the sale of leased properties (net of income taxes), and (iv) a decrease of $.48 million due to the termination of interest rate swaps in the first quarter of 2003. However in the first six months of 2004, lower dividend payments on the preferred stock of $0.27 million caused net income to increase by that amount.

        Interest income on loans decreased 33% to $1.73 million for the nine months ended September 30, 2004, as compared to $2.58 million for the nine months ended September 30, 2003. This decrease was primarily due to a $20.06 million decrease in the average total loans outstanding when comparing the nine months ended September 30, 2004 to the nine months ended September 30, 2003. In the present competitive interest rate environment, BMSBLC is at a lending disadvantage with other institutions such as banks, due to its higher cost of funds. During the first nine months of 2004, competitive pressures resulted in a reduction in loans of $19.05 million due to pay-offs and $2.69 million due to normal principal reductions. The Parent’s and BMSBLC’s management agreement with InvestorsBank prevents them from making new loans to other than existing customers without the prior consent of InvestorsBank. Also, due to the requirement to redeem $16.85 million of preferred stock on July 1, 2008, the Parent and BMSBLC will use the proceeds of loan maturities, payoffs, and sales of leased properties to reduce outstanding indebtedness and therefore they do not intend to make any new loans or purchase any new properties, except for the purchase of loan participations from InvestorsBank. During the first nine months of 2004, $8.12 million of new loan participations through InvestorsBank were added to the loan portfolio. Participations with InvestorsBank comprised approximately 63% of the loan portfolio at September 30, 2004. These factors are resulting in BMSBLC’s inability to maintain the size of its loan and leased property portfolio and management anticipates the resulting decline will continue until July 1, 2008, at which point management expects that the loan and leased property portfolio will be reduced to zero.

        Rental income decreased 8% to $2.29 million for the nine months ended September 30, 2004, as compared to $2.50 million for the nine months ended September 30, 2003. Rental income in 2004 decreased $0.09 million due to leased property sales and vacancies in three buildings resulting in a reduction of $0.24 million in rental income. Additionally, one tenant was on nonaccrual resulting in a reduction of $0.01 million in rental income. A previous tenant who was on nonaccrual vacated their building. To offset these reductions, scheduled rent increases added $0.04 million to rental income and an increase of $0.09 million was due to the completion of construction of a new property in 2003.

        Net interest margin is determined by dividing the total of interest income on loans and rental income less interest expense by the total of average loans and leased properties. The interest margin for the nine months ended September 30, 2004 was 4.30% compared to 3.86% for the nine months ended September 30, 2003. During the first nine months of 2004, average loans outstanding (net of intercompany loans) of $45.31 million generated $1.73 million in interest income and average leased properties (net of intercompany properties) of $29.49 million generated $2.29 million in rental income. The average gross return for the first nine months on rental properties was approximately 10.3% while the average gross return on loans was approximately 5.1%. During the first nine months of 2003, average loans outstanding (net of intercompany loans) of $65.37 million generated $2.58 million in interest income and average leased properties (net of intercompany properties) of $31.23 million generated $2.50 million in rental income. The average gross return during the first nine months of 2003 on rental properties was approximately 10.7% while the average gross return on loans was approximately 5.3%.

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        During the first nine months of 2004, there was one sale of a leased property to a third party resulting in a gain of $0.04 million, net of income taxes, compared to a gain of $0.34 million, net of income taxes, from the sale of two leased properties in the first nine months of 2003. In September of 2004, LPI purchased the building in which it was a tenant, from BMSBLC. BMSBLC financed the transaction and the purchase price of $3.67 million was determined by an independent appraiser and represented the fair market value of the building at the time of the sale. The fair market value of the transaction approximated the carrying value to BMSBLC and no gain or loss was recognized on the transaction. At September 30, 2004, BMSBLC owned 20 properties with a net carrying value of $25.02 million of which $20.32 million was pledged as collateral to the debt facility. Three vacant rental properties with a net carrying value of $4.11 million were available for sale or lease at September 30, 2004, and one rental property with a net carrying value of $0.40 million was on non-accrual status.

        There were no terminations of interest rate swaps during the nine months ended September 30, 2004. The termination of interest rate swaps resulted in income of $0.48 million for the nine months ended September 30, 2003. BMSBLC may periodically use these derivative instruments for purposes of managing interest rate risk. However, there were no interest rate swap agreements in effect at September 30, 2004.

        Interest expense decreased 30% to $1.56 million for the nine months ended September 30, 2004, as compared to $2.24 million for the nine months ended September 30, 2003, primarily due to a decrease in the outstanding average debt balance and due to lower interest rates. The average debt balance decreased $22.02 million when comparing the first nine months of 2004 to 2003 as a result of the decrease in loans as explained above. To decrease the effective interest rate paid by BMSBLC, approximately $6.15 million of higher fixed rate debt was paid-off with proceeds from loan payoffs. Variable interest rates, which also affect BMSBLC’s cost of funds, were approximately 36 basis points lower during the first nine months of 2004 as compared to the first nine months of 2003. This resulted in an average cost of funds of 3.18% for 2004 as compared to 3.54% for 2003 during the first nine months.

        BMSBLC’s debt facility consists of commercial paper and drawn letters of credit backed by a $50 million line of credit that matures on June 24, 2005. The debt facility was reduced by $15 million when it was renewed in June of 2004. A further reduction of $20 million is anticipated at the renewal date in 2005. At September 30, 2004, BMSBLC had $3.64 million in lending capability with outstanding unfunded commitments of $5.56 million. Beginning in the third quarter of 2003, a substantial amount of commercial paper, which had matured, was not able to be replaced by sales of additional commercial paper, requiring BMSBLC to draw upon the back-up bank line of credit which has a higher interest rate than commercial paper. This higher cost of funds lessens BMSBLC’s ability to compete with banks and other financial institutions for loans, resulting in a decreased ability to replace loans that are paid off. Additionally, the 2008 redemption requirements of $16.9 million of preferred stock requires the Company to focus on asset quality while de-leveraging the balance sheet. For a summary of the current levels of bank debt and commercial paper, see “Liquidity and Capital – Financial Services”, herein.

        Other miscellaneous income decreased $0.06 million for the nine months ended September 30, 2004 compared to the nine months ended September 30, 2003, primarily due to a decrease in late payment fees and prepayment penalties.

        Depreciation expense decreased $0.07 million due to leased property sales and vacancies when comparing the nine months ended September 30, 2004 to 2003. Management fees under the management fee agreement with InvestorsBank decreased $0.04 million due to the decrease in loans and leased properties under management when comparing the first nine months of 2004 to 2003. Other operating expenses increased $0.04 million when comparing the first nine months of 2004 to the first nine months of 2003. Primarily due to the sale of a leased property, debt issue costs of $0.09 million were expensed and $0.04 million of rent receivable was charged-off. However, leased property expenses decreased by $0.09 million due to two buildings that were sold.

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        The Parent and its qualified REIT subsidiary, BMSBLC, qualify as a real estate investment trust under the Internal Revenue Code. Accordingly, they are not subject to income tax on taxable income that is distributed to common shareholders. However, the REIT may retain capital gains from the sale of real estate and pay income tax on that gain. In January, 2004, the Parent paid $0.18 million in capital gains taxes which were accrued at December 31, 2003.

        Interest expense on intercompany loans has been eliminated for consolidation purposes. At September 30, 2004, LMOD owed the Parent $4.20 million consisting of a line of credit of $0.50 million and an unsecured note of $3.70 million. LMOD owed BMSBLC $2.04 million secured by a first mortgage on real estate. The average interest rate on LMOD’s notes was 5.1% at September 30, 2004. At September 30, 2004, LPI owed BMSBLC $8.02 million consisting of a line of credit of $1.85 million, an unsecured note of $2.5 million, and a first mortgage on real estate of $3.67 million. The average interest rate on LPI’s notes was 5.21% at September 30, 2004. Before intercompany eliminations, interest expense for the consumer products segment and interest income to the financial services segment was $0.37 million for the nine months ended September 30, 2004. Intercompany eliminations also included $0.20 million in rent paid by LPI to BMSBLC through August of 2004. As of January, 2004, LMOD no longer pays management fees to BMSBLC, which increases working capital at LMOD, but reduces taxable income at BMSBLC. As of November 12, 2003, the Parent extended a guarantee to a supplier of LMOD in which the Parent has agreed to unconditionally guarantee all obligations of LMOD to the supplier. It is anticipated that the maximum amount of the guarantee will not exceed $0.60 million, however, the amount of the guarantee is unlimited and the amount of the obligation may increase in the future.

Liquidity and Capital

Consumer Products

        The consumer products segment’s net loss after intercompany transactions for the nine months ended September 30, 2004, was $1.95 million, which was financed through a $1.07 million reduction in accounts receivable due to the normal reduction in accounts receivable balances after the year-end selling season, an increase in a line of credit of $0.49 million, and a reduction in cash.

        Total assets of consumer products were $17.12 million as of September 30, 2004, and $15.62 million as of December 31, 2003, a 10% increase. Cash decreased to $0.29 million at September 30, 2004, from $0.70 million at December 31, 2003.

        Accounts receivable, net of the allowance for doubtful accounts, decreased to $1.45 million at September 30, 2004, from $2.17 million at December 31, 2003, due to normal collections after the year-end selling season. LPI’s receivables decreased $0.28 million and LMOD’s receivables decreased $0.44 million. At December 31, 2003, LMOD had increased its allowance for doubtful accounts receivable by $0.24 million due to an outstanding receivable from FAO, Inc. which had declared bankruptcy. After selling the receivable to a third party, LMOD collected $0.08 million more than anticipated in the second quarter of 2004, resulting in a reduction in the allowance account.

        Inventory and prepaid inventory, net of the allowance for obsolescence, decreased to $5.11 million at September 30, 2004, compared to $5.56 million at December 31, 2003. LMOD’s inventory decreased $0.47 million and LPI’s inventory increased by $0.02 million. Inventories are valued at the lower of cost or market using the first-in, first-out (FIFO) method.

        Property and equipment, net of accumulated depreciation, increased by $3.19 million as of September 30, 2004, compared to December 31, 2003. Property and equipment increased by $3.85 million while accumulated depreciation increased by $0.66 million. In September of 2004, LPI purchased the building in which it was a tenant, from BMSBLC. BMSBLC financed the transaction and the purchase price of $3.67 million was determined by an independent appraiser and represented the fair market and carrying value of the building at the time of the sale. Other prepaid expenses decreased $0.12 million from December 31, 2003 to September 30, 2004.

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        Prepaid corporate taxes decreased by $0.01 million due to a reduction in taxes to the State of Ohio based on LMOD’s net worth, which had declined. The deferred income tax asset of $2.69 million remained the same between September 30, 2004, and December 31, 2003. At December 31, 2003, the consumer products segment had unused federal net operating loss carryforwards of approximately $5.6 million. During the three months ended March 31, 2004, management determined, based on the level of continuing losses of the consumer products segment that it would suspend the recognition of additional deferred net income tax assets until the consumer products segment operating performance improves and supports the recognition of any additional deferred income tax assets.

        Goodwill was recorded when the Company purchased the remaining interest in the stock from the estate of Lee Middleton, the founder of LMOD, on April 30, 1998. The purchase price exceeded the carrying value by $0.62 million. At September 30, 2004 and December 31, 2003, the balance of the goodwill, net of previous accumulated amortization, was $0.51 million. Management has concluded that the goodwill is not impaired as of September 30, 2004.

        Other liabilities decreased $0.03 million to $1.44 million at September 30, 2004, from $1.47 million at December 31, 2003.

        Due to the losses suffered by the consumer products segment, it is unable to borrow money from outside financial sources and is dependent on the financial backing of the Parent and BMSBLC for its borrowing requirements. In July of 2004, InvestorsBank extended a $2.0 million line of credit to LMOD with the Parent as a co-borrower on the line. Proceeds of $1.1 million from this line of credit were used to reduce a $1.1 million intercompany loan between LMOD and the Parent. The outstanding balance on the line of credit at September 30, 2004, was $0.49 million.

Financial Services

        During the first nine months of 2004, the financial products segment’s net income after intercompany transactions was $1.24 million. Dividends of $0.68 million were paid to preferred stockholders and dividends of $0.75 million were paid to common stockholders.

        Total assets of financial services were $64.98 million as of September 30, 2004, and $86.59 million as of December 31, 2003. Cash decreased to $0.41 million at September 30, 2004 from $0.65 million at December 31, 2003.

        Interest and rent receivable decreased to $0.28 million as of September 30, 2004, from $0.36 million at December 31, 2003. The rent receivable is shown net of an allowance for doubtful accounts of $150,000 at December 31, 2003. Upon the sale of a leased property in the third quarter of 2004, $0.04 million of rent receivable was charged-off and the allowance account of $0.15 million was applied toward the remaining rent receivable. At September 30, 2004, five non-performing loans totaling $1.19 million in principal were on non-accrual, resulting in $0.02 million of interest income which would have been recorded for the nine months ending September 30, 2004, had the non-accruing loans been current in accordance with their original terms. One tenant was on non-accrual resulting in $0.01 million of rental income which would have been recorded for the nine months ended September 30, 2004 had the tenant been current in accordance with the lease.

        Total loans (excluding intercompany loans) decreased by $13.60 million, or 26%, to $38.69 million at September 30, 2004, from $52.29 million at December 31, 2003, with a corresponding decrease in liabilities. As of September 30, 2004 and December 31, 2003, management did not provide an allowance for loan losses due to management’s belief that the collateral which secured nonperforming loans was adequate to fully secure the debtors’ obligation to BMSBLC. At September 30, 2004, BMSBLC’s real estate loan portfolio had a 51.5% weighted average of loan to fair market value ratio consisting of 38 loans totaling $37.93 million.

        Leased properties, net of accumulated depreciation, decreased to $25.02 million as of September 30, 2004, compared to $30.81 million as of December 31, 2003, primarily due to the sale of two leased properties with a net book value of $5.28 million and due to $0.51 million of depreciation for the nine months ended September 30, 2004. Three vacant rental properties with a net carrying value of $4.11 were available for sale or lease at September 30, 2004, and one rental property with a net carrying value of $0.40 million was on non-accrual status. Management believes that the carrying value of the properties are not impaired as of September 30, 2004.

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        Property and equipment and other assets, including prepaid amounts, decreased by $1.90 million. At December 31, 2003, BMSBLC’s other assets included a $1.65 million receivable from the sale of a leased property. In January, 2004, this receivable was financed by BMSBLC as a loan causing other assets to decrease by that amount. The balance of the decrease was primarily due to reductions in prepaid items and the Parent’s redemption of $.05 million of stock it held as an investment. Property and equipment decreased $0.01 million due to depreciation.

        The financial services’ total consolidated indebtedness at September 30, 2004, decreased $18.24 million, primarily as the result of the payment of indebtedness from the proceeds of the payoff of loans in the loan portfolio.

        BMSBLC’s debt facility consists of commercial paper and drawn letters of credit backed by a $50 million line of credit that matures on June 24, 2005. The debt facility was reduced by $15 million when it was renewed in June of 2004. A further reduction of $20 million is anticipated at the renewal date in 2005. Proceeds from loan payoffs and from the sale of leased properties have been used to reduce debt. At September 30, 2004, the debt facility had $3.64 million available for funding purposes.

        At September 30, 2004, the outstanding commercial paper balance was $6.37 million. BMSBLC also had drawn $37.60 million against its bank line of credit to replace outstanding commercial paper that had matured and was unable to be replaced by sales of additional commercial paper. The bank line of credit has an interest rate which is approximately 40 basis points higher than that paid on commercial paper, resulting in a reduction of net income for the nine months ended September 30, 2004. At December 31, 2003, the outstanding commercial paper balance was $34.00 million and the outstanding balance on bank lines of credit were $19.23 million.

        Long-term debt consists primarily of fixed rate debt. During the first nine months of 2004, BMSBLC paid off long-term debt of $8.98 million and replaced it with short-term debt from the bank line of credit at a lower interest rate. An additional $2.37 million of long-term debt was paid off in October of 2004. BMSBLC was in compliance with the covenants contained in its debt agreements as of September 30, 2004.

        Accrued liabilities decreased to $0.96 million at September 30, 2004, as compared to $1.13 million at December 31, 2003.

        Due to the Parent’s required redemption of $16.85 million of outstanding preferred stock on July 1, 2008, BMSBLC expects to materially curtail its lending activities and purchase of leased properties over the next four years. During the second quarter of 2004, the Board of Directors of the Company approved a plan to convert loans and leased properties of BMSBLC to cash as loans mature and leased properties are sold. The proceeds will be used to reduce outstanding debt and to redeem preferred stock at maturity. Under this policy, BMSBLC does not intend to make new loans or purchase new properties to lease, with only limited exceptions for participations with InvestorsBank. This reduction in assets will reduce the income available for common stock dividends in each of the next four years. As a result, the Board of Directors has changed the common stock dividend policy from the payment of quarterly dividends to an annual dividend which would be payable in January for the preceding year. During the first nine months of 2004, common stock dividends totaled $0.20 per share. If the Parent’s and BMSBLC’s taxable income for the year ended December 31, 2004, exceeds $0.20 per common share, a dividend will be paid to the common shareholders on January 31, 2005. The preferred stock dividend of $0.335 per share per quarter ($1.34 annual dividend per preferred share) will continue to be paid on a quarterly basis.

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Critical Accounting Policies

        In preparing consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The following areas require management to make estimates that are susceptible to significant change in the near term.

Consumer Products

        Allowance for doubtful accounts. LMOD and LPI provide an allowance for doubtful accounts based on management’s estimate of uncollectible amounts. The estimate is based on historical collection experience and a review of the current status of trade accounts receivable.

        Inventory valuation. Inventories are valued at lower of cost or market using the first-in, first-out (FIFO) method.

        Allowance for obsolete inventory. LMOD and LPI provide an allowance for obsolete inventory items based on management’s estimate. The estimate is based on items which are slow-moving or obsolete and for which management feels that full value cannot be realized.

        Amortization of goodwill. The Financial Accounting Standards Board issued Statement 142, Goodwill and Other Intangible Assets, effective for fiscal years beginning after December 15, 2001 (i.e., January 1, 2002 for calendar year companies). This statement provides that goodwill and indefinite lived intangible assets are no longer amortized against income but are reviewed at least annually for impairment. An impairment review is designed to determine whether the fair value, and the related recorded goodwill, of a reporting unit is below its carrying value. Any goodwill impairment losses will be charged to operations.

        Deferred income tax assets. Amounts provided for income tax expense are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable under tax laws. Deferred income tax assets and liabilities are computed for differences between the financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. As changes in tax laws or rates are enacted, deferred income tax assets and liabilities are adjusted through the provision for income taxes. The differences relate principally to different methods used for depreciation for income tax purposes, vacation accruals, health insurance, deferred revenue, net operating losses, capitalization requirements of the Internal Revenue Code, allowances for doubtful accounts and obsolete inventory and charitable contribution carryforwards. Valuation allowances are established when necessary to reduce deferred income tax assets to the amount expected to be realized.

Financial Services

        Accrual of interest income. Interest income is accrued on the unpaid principal balance of loans. The accrual of interest income on loans is discontinued when, in the opinion of management, there is reasonable doubt as to whether the collateral securing the borrower’s obligation is sufficient to pay all principal, accrued interest and other expenses. Loans are returned to accrual status when the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

        Accrual of rental income. Rent is accrued on a monthly basis based on lease agreements. If it is determined by management that the lessee will not be able to make rent payments as required by the lease agreement, the accrual of rent is discontinued until management determines the rent to be collectible.

        Allowance for loan losses. Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the amount of unpaid principal, reduced by the allowance for loan losses. Management reviews the value of the collateral securing each loan to determine if an allowance for loan losses is necessary. In this review, management takes into account the projected cash flow of the business from all sources including capital contributions, conversion of collateral to cash, and net income plus depreciation.

        Leased properties. Leased properties are recorded at cost and are depreciated using the straight-line method. The costs of normal repairs and maintenance are charged to expense as incurred.

        Nonperforming loans. A loan is considered nonperforming when the scheduled principal and/or interest payments are more than ninety days past due. Nonperforming loans are not automatically placed on non-accrual status. For a discussion of when loans are placed on non-accrual status, see “Accrual of interest income” above.

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        Unfunded commitments. Unfunded commitments are recorded in the financial statements when they are funded or when related fees are incurred or received.

        Derivative Instruments. The Company designates all derivative instruments as either fair value hedges or cash flow hedges and records the hedge on the balance sheet at its fair market value. The net gain/loss on instruments classified as cash flow hedges are reported as changes in other comprehensive income. The net gain/loss on instruments classified as fair value hedges are reported as increases/decreases in current year earnings. All derivatives are marked to market on the balance sheet.

        Fair Value of Financial Instruments. Financial Accounting Standards Board Statement No. 107, “Disclosures About Fair Value of Financial Instruments”, requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. Statement No. 107 excludes certain financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995

        This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934. The Company intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and is including this statement for purposes of these safe harbor provisions. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies and expectations of the Company, are generally identifiable by use of the words “may”, “will”, “could”, “believe”, “expect”, “intend”, “anticipate”, “estimate”, “project”, or similar expressions. The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations and future prospects of the Company and the subsidiaries include, but are not limited to, changes in: interest rates, general economic conditions, including the condition of the local real estate market, legislative/regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the loan or real estate portfolios, competition, the accessibility of funding sources at competitive rates, demand for the Company’s consumer products, the degree of success of the Company’s strategy to reduce prices on its collectible dolls and reduce expenses, the realization of the deferred income tax benefit, payment when due of principal and interest on loans made by the Company, payment of rent by lessees on Company properties and the necessity to make additions to the Company’s loan loss reserve. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.

Item 3.    Quantitative and Qualitative Disclosures About Market Risk

        The Parent and BMSBLC assume interest rate risk (the risk that general interest rate levels will change) as a normal component of its operations. As a result, fair values of the Parent’s and BMSBLC’s financial instruments will change when interest rate levels fluctuate and that change may be either favorable or unfavorable to the Company.

        The Parent and BMSBLC’s debt structure and interest rate risk are managed through the use of fixed and variable rate debt. Management attempts to match variable rate loans with variable rate debt and fixed rate loans with fixed rate debt to the extent believed necessary to minimize interest rate risk. The Parent and BMSBLC’s fixed rate loans are matched with fixed rate debt, which reduces market rate risk. Variable rate loans are also matched against variable rate debt.

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        A significant portion of BMSBLC’s fixed rate loans and fixed rate leases are matched against fixed rate debt; however, the portfolio is not completely matched. A portion of BMSBLC’s fixed rate assets are funded with variable rate debt and in the present low interest rate environment this mismatch has been favorable to BMSBLC. In a rising interest rate environment, the margin of difference between the fixed rate asset and the variable debt becomes smaller and less favorable to BMSBLC. At September 30, 2004, an increase of 1% in the interest rate paid on the variable debt would increase the Company’s annual pre-tax profits in an amount approximating $11,000.

Item 4.    Controls and Procedures

        Based on an evaluation performed by the Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2004.

        Based on an evaluation performed by the Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, there were no changes in the Company’s internal control over financial reporting identified in such evaluation that occurred during the quarter ended September 30, 2004 that has materially affected, or is likely to materially affect, the Company’s internal control over financial reporting.

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PART II.    OTHER INFORMATION

Item 1.    LEGAL PROCEEDINGS

Item 2.    CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

Item 3.    DEFAULTS UPON SENIOR SECURITIES

Item 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Item 5.    OTHER INFORMATION

Item 6.    EXHIBITS

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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunder duly authorized.

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THE MIDDLETON DOLL COMPANY AND SUBSIDIARIES
QUARTERLY REPORT ON FORM 10-Q

EXHIBIT INDEX

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