LeapFrog Lows

The recession does not seem to be good for the educational gaming company LeapFrog, which announced rather depressing Q4 2008 results earlier this month. The company has been trying to do a turnaround and with its new product, Tag, the 2008 holiday season was extremely critical.

Q4 revenues of $137.8 million were significantly lower than the market’s expectations of $180.0 million and fell 24% over the year. Loss per share of $0.70 was also higher than the Street’s expected $0.21 and increased significantly from the loss of $0.51 per share suffered last year. Net sales in the US segment were $105 million, down 22% from a year ago.

For the year, revenues of $459.1 million were up 4% annually while loss per share of $1.07 improved by 33% over the year. Revenue from the US segment grew by 7% over the year to $363 million while international sales of $96 million were down 7% from a year ago. The impact of the US dollar strengthening over other currencies had a 4% negative impact on international revenues.

By segment, Platform sales were 43% compared to 36% a year ago. Contribution from Software sales was down marginally to 29% in the year from 30% a year ago while Standalone Products sales fell to 28% in 2008 compared to 34% in 2007.

LeapFrog, like so many US companies, is also looking to rationalize its cost structure. It is already scaling its business on the assumption of a significant sales decline in the coming year. Additionally, it is looking to save through sourcing from lower input cost areas such as contract manufacturing partners in Asia. Finally, it is planning to manage lower inventory levels in the coming year and will make this a focus area.

Optimizing product mix and price points are also key variables to LeapFrog’s business model. The current quarter’s performance was an illustration of mismanagement of these two as LeapFrog over-built and over-shipped products based on what it had thought the holiday season would look like and did not reduce prices, replace media spend with discounts or increase trade support fast enough for products like the Leapster (a handheld learning game system) line and Didj (another handheld system that can be connected to a computer). This led to slower sales and higher inventories.

Having realized this mistake, the company has now reduced prices on some core products such as Didj, is repositioning products for different age groups, and introducing an expanded line in the learning toy area at lower price points.

During the year, they launched quite a few successful products such as the Tag reading system, Leapster2, a web-connected version of the original Leapster, and the Didj Custom Gaming and Learning System. Jeff Katz’s vision of creating Connected products seems to be reaching a stage of fruition. One core product, Didj, showed the highest Connect rate of any of their products. Tag also outperformed the market expectations even in the current conditions and was perhaps the only product that did well with virtually no discounting on the hardware throughout the season.

In the coming year, LeapFrog will continue to focus on content. In 2008 the company added 22 Tag books, 33 Leapster titles and 11 Didj games and is looking to increase these numbers in 2009.

The stock is trading at all-time lows of $1.61 with a market capitalization of $102.72 million. While I still believe it has potential, this deep recession is a very bad time for discretionary spend in expensive learning toys, and it will take at least until the 2010 holiday season for market demand to reach erstwhile strength levels. I therefore do not recommend the stock at all.