Will Connected Toys Propel LeapFrog Forward?

Before going into analysis of LeapFrog’s (NYSE:LF) recent quarter, let’s take a look at some numbers that put the company’s situation into context: Worldwide toy sales reached $78 billion in 2008, registering a 0.8% decline over the year, according to a recently released NDP Group report. At constant exchange rates, sales would have increased 2.3% over the year. The United States is the biggest market for toys and contributes 30% of the global share. Within the country, sales fell 2% over the year to $21.7 billion, but board game sales grew 6% over the year to $794 million. The global toy market is expected to grow to $80.3 billion by the year 2012, with growth being driven by emerging markets.

Last year’s holiday season was a dismal one for toy manufacturers; sales fell 5% in the quarter. This season, sales are expected to be flat to down 2% with the biggest sales being driven by low-cost products. A Gallup poll indicates that Americans are looking to spend an average $616 on gifts in the 2009 holiday season, which is the lowest amount since 2002 and is 29% lower than the previous year’s holiday budget of $866. Amid such trends, smaller players such as LeapFrog are going through tough times.

LeapFrog’s revenues for Q2 fell 27.7% over the year to $49.4 million with a net loss of $0.19 compared with a loss of $0.32 earned a year ago. Net sales from the United States segment fell 31% over the year to $38.8 million while international sales fell 14% over the year to $10.6 million. On a constant currency basis, international sales would have fallen 3% over the year. The market was looking for a loss of $0.34 per share on revenues of $41.6 million.

Despite lower revenues, the company is managing to improve its point-of-sale trends, an improvement primarily driven by the success of LeapFrog’s Tag products. Retail point-of-sale dollars grew 4% over the year for the 26 weeks ended July 4.

To expand within the toddler segment, the company recently extended Tag and launched a toddler-focused “book explorer.” The product is targeted for children two to four years old and will help them engage with books through sounds and activities. There are nine titles for this age group in the Tag series.

Continuing with its drive towards connected toys, LeapFrog launched new applications for the iPhone and iPod Touch. The downloadable games are designed for six- to ten-year-olds and deliver educational content through the phone. One example is Number Rumble, which allows kids to practice simple math skills. Is this a good strategy for LeapFrog? Most six-year-olds don’t own iPhones or even iPod Touches. On the other hand, the iPhone is so popular that LeapFrog might benefit from a “publicity standpoint to appear to be catering to the growing audience of iPhone and iPod touch owners.”

Of course, LeapFrog is not the only company working in connected toys. Mattel is introducing a line of Web-enabled toys tied to the upcoming 3D movie “Avatar.” These toys are connected to online content through 3D tag that can be scanned with a webcam. At the recent TechCrunch 50 conference in San Francisco, Shervin Pishevar introduced the ToyBots platform for connected toys with 3G, WiFi, GPS, and accelerometer capabilities. ToyBots claims that its platform will “disrupt the gaming, entetainment and toy industries.” But as one TechCrunch reader points out, LeapFrog has been developing connected toy platforms in one form or another for about 10 years, with mixed success. Products such as My Pal Scout and the LeapPad generally get good reviews on consumer sites, but the toy market, as LeapFrog knows, is notoriously difficult.

Jeff Katz, LeapFrog’s CEO, acknowledges that LeapFrog has a long way to go in its turnaround.  But there seems to be a note of confidence: LeapFrog projects Q3 revenues of $100 million to $120 million and believes that sales will be higher over the year in Q4. Let’s see how the iPhone games and other connected toys will contribute to the bottom line in the next few quarters.

The stock is trading at $4.03 with a market capitalization of about $258 million, up from the 52-week low of $0.57 in March and the low-to-mid $2 range at which the stock traded for much of the summer.