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February 17, 2005
Company Watch: LeapFrog Enterprises Inc.
By Brady Willett & Hope Trites

LeapFrog is a former Wall Street darling that has seen its share price fall by nearly 80%. The reason why this dramatic sell off has occurred is because the growth stopped.  The bottom dweller should be aware that not only has growth stopped, but so have the earnings.

LeapFrog Enterprises was founded in 1995 and went public in July 2002. The company designs, develops, and markets technology-based educational products. Following weaker than expected Q4 financial results LF shares fell by 12% to close at a record low of $10.90 a share (Feb. 16, 2005).  Given that the company is unlikely to show any improvement in operations until, at minimum, the second half of 2005, LeapFrog shares could continue to stagnate in the near-term.  However, with a strong balance sheet and tangible equity of $6.64 a share, the company’s shares may find support if an expected seasonal decline in equity and earnings (1Q05-2Q05) can be contained.  In another words, LeapFrog is a potential takeover target that deserves investor attention if the company can hold the fort until the back to school season arrives. And yes, this is a mighty big if.

Leapfrog’s poor financial performance in 2004

After more than five years of explosive growth LeapFrog’s core revenue generator (‘platform’ sales) was hurt by increasingly competitive and well-funded products in 2004 (i.e.  Fisher-Price ‘PowerTouch’). Quite frankly, and despite the fact that Hasbro, Mattel, LeapFrog and other companies do not release specific product-by-product numbers, that Leapfrog did not sell enough product to recoup its costs in the ‘U.S. Consumer’ business segment is a warning that changes are afoot; that Leapfrog no longer demands the margins it once did.


The competitive threats LeapFrog faced in 2004 and will continue to face going forward can not be overstated.  Even so, inflationary pressures (i.e. freight costs), distribution center problems, and management missteps were also to blame for the dismal year.  Judging by the steady increase in expenses last year – specifically advertising expense (+11.2% year-over-year in 4Q04) – it is as if the company believed they could simply throw money at the competition and succeed.

2005 Outlook

With failure well in hand LeapFrog management – at least those that have not fled – have pledged to cut costs. This business goal is akin to a drowning person trying to come up for air, and is part of the reason why the company’s shares have been decimated. To be sure, investors in a growth stock want growth - at any cost!

Amid the management/board changes and beginnings of an in-depth business restructuring, LeapFrog has stopped giving earnings guidance. This is a welcomed action as it should deter speculators from violently moving the stock around during earnings seasons.  That being said, the company has opted to not only give no financial guidance, but very little business guidance as well: the company’s three pronged plan – 1) create profits 2) increase business efficiencies, and 3) grow the business – is heavy on planning, but short on tangible actions.

The company does note that it wants to cut $35-$40 million in expenses in 2005 -- but beyond headcount reductions provides very few specifics about how this can be accomplished. Incidentally, an insider informs me that LeapFrog has been paying ridiculous fees for storing product in a warehouse in Toronto since October 2004. This product is, for lack of a better word, stale, and will, eventually, either need to be written off or shipped elsewhere (perhaps the storage fees are less than the shipping fees?). And although the situation in Canada may not be an accurate indicator of U.S. trends, it would not be outrageous to argue that LeapFrog has $35-$40 million in stale inventory that needs to be taken off the books. So much for the 2005 cost cutting plan...Keep in mind that inventories at the end of 2004 were at $130 million and sales are declining as the company moves into two quarters that historically weak.


Another reason why the company’s near term outlook is bleak is seasonality.  Remembering that the fourth quarter (Xmas season) is usually the company’s strongest, that LeapFrog reported a loss on declining sales does not bode well going forward.  Rather, the quarter ended March is always unprofitable for the company, and the quarter ended June is usually unprofitable. 

There are some positives to consider: namely that the company makes quality, well-liked products and - at least for the moment - has an exceptionally strong balance sheet. Moreover, with the merger mania that is going on in the markets these days there is the possibility that a competitor could try to acquire LeapFrog.  The possibility of being taken over – which Chief Executive Tom Kalinske has said the company is not considering – may be what keeps LF’s stock price at current prices even if the next two quarters prove to be difficult.

Another positive is that the company is growing its International and Education and Training segments strongly. Indeed, assuming the positive guidance from management turns out to be correct - LeapFrog is ‘gaining’ and expected to continue to ‘gain traction’ in France, Spain, Germany, and Japan – International sales (up 59% in 2004) could be a driver of growth for years to come, or at least until the competition arrives.



Financial Concerns

The company proudly stated during it’s conference call that it has – as of Feb. 15 - $175 million in cash and short term investments on hand (this increase over the reported $88 million on December 31, 2004 is the result of receivables being collected following the Christmas season). However, what the company neglected to mention was that at the end of March 2004 the company had more than $200 million in cash and short term investments. Point being, LeapFrog’s financial position, while strong, is nonetheless in decline. Similar trends are also seen in cash flows.


Another concern worth mentioning is that the company will lose a large chunk of its cash from operations when FASB 123R goes into effect (when the benefit from exercised stock options moves down in the statement of cash flows).

Conclusions and Investment Opinion

Leapfrog went from growing by an average of 80% a year (from 2000-2003) to posting an annual decline in sales of 6% in 2004.  Ordinarily one year does not a trend make, but in Leapfrog’s case too many signals are flashing red to ignore:

1) Margins are in free fall.
2) Inventories will need to be written down.
3) Two seasonally weak quarters are directly ahead.

This negative outlook is not meant to scare potential investors. Rather, it is an honest interpretation of LeapFrog’s business right now.  As for tomorrow, the company has an important product launch - the FLY pentop computer – slated for the Fall of 2005. With FLY LeapFrog is acquiring a plethora of new competitors (Sony, Nokia, KDDI, etc.), but the company could also be lining up a landslide of repeat/new customers leading into Christmas 2005.  If FLY generates a mini iPod-like buzz the Leapfrog of old may return for awhile. Conversely, if FLY flops and/or the U.S. consumer hits a wall, Leapfrog could be nearing financial trouble by years-end. 

Regardless of what happens, the drawback to owning LeapFrog is that the company constantly needs to reinvent itself simply to keep margins stable.  To be sure, 5-years from now Leapfrog will be producing – perhaps still using its eight Chinese contractors – a completely different set of products then the company makes today.  This should scare potential LF shareholders into researching and fully understanding the company’s products, competition, industry trends, etc…unfortunately all the research and analysis in the world can not tell the investor that VHS will be favored over the better quality Beta.

In short, owning LF shares now is to gamble that a hot new profit-reviving product is due (FLY?).  Tomorrow, and perhaps on further share price weakness, owning LF becomes a long-term gamble on corporate survival.  The one thing LeapFrog will never be is a valuation story.  Rather, if the company maintain business and cut costs shares are currently cheap by any and all valuation standards, and if 2004 was just the beginning of a downward trend $10.90 will prove to be an expensive price level.  Despite strong growth internationally, as the U.S. consumer goes so goes LeapFrog. That is reason enough to stay away at current price levels, although $6.64 a share would certainly make things more intriguing on the takeover front.

-- No one at or associated with FallStreet.com owns an investment position in LF.
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Webcast - Live Smith Barney Citigroup Toy & Leisure Conference  02/17/05 at 3:25 p.m. ET
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Feb 17: “Transactions being examined include a $1 million purchase of software from LeapFrog SchoolHouse in June. Hornsby did not disclose to the board that he lived with a LeapFrog saleswoman at the time of the acquisition.”


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