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Executives

Eileen VanEss – Vice President, Investor Relations, Treasurer

Jeffrey G. Katz - President, Chief Executive Officer, Director

William B. Chiasson - Chief Financial Officer and Principal Financial Officer

Analysts

Gerrick Johnson - BMO Capital Markets

Sean McGowan - Needham & Company

Tony Gikas - Piper Jaffray

Edward Woo - Wedbush Morgan Securities

Drew Crum - Stifel Nicolaus

John Taylor - Arcadia

Brooks Tomlin - Private Investor

LeapFrog Enterprises, Inc. (LF) Q3 2008 Earnings Call November 3, 2008 5:00 PM ET

Operator

Good afternoon. My name is Don and I will be your conference operator today. At this time, I would like to welcome everyone to the LeapFrog Q3 2008 financial results conference call. (Operator Instructions) Ms. VanEss, you may begin your conference.

Eileen VanEss

Thank you, Don. Good afternoon and welcome to LeapFrog Enterprise’s conference call to review the results of our third quarter ended September 30, 2008. I’m Eileen VanEss, Vice President of Investor Relations and Treasurer.

Before we begin, we wish to remind you that certain statements made today will include forward-looking statements about management’s expectations, including expectations regarding the timing, scope, and success of product launches, expected benefits of new products and services, anticipated 2008 financial results, including expected net sales, margins, expenses, and profitability. In addition, we expect the questions posed in the Q&A portion of this call may prompt additional answers that contain additional forward-looking statements not included in our prepared remarks. This cautionary language concerns forward-looking statements in both our prepared remarks and our impromptu answers to questions posed.

A variety of factors, many of which are beyond our control, affect our results, performance, business strategy and could cause actual results to differ materially from those projected in such forward-looking statements. Some of these factors are described in our 2007 annual report on Form 10-K, which was filed with the SEC on March 13, 2008, as well as in LeapFrog's other public statements and filings. LeapFrog does not update forward-looking statements and we expressly disclaim any obligation to do so.

And with that, I will turn it over to Jeff.

Jeffrey G. Katz

Thank you, Eileen. Welcome to our call today and I would like to thank everybody for joining us this afternoon. Today I am going to start with a review of our third quarter and then share what we know so far about the fourth quarter and how that is shaping up and end with some discussion of strategies for 2009.

Our third quarter results were on track with our expectations. We entered 2008 planning for our largest and what we think is our most important launch year ever. Our key focus for the third quarter was completing our new product launches and preparing for the peak holiday selling season. So far Tag, our new reading product, is definitely on track to be one of our biggest selling products this year and certainly our biggest launch ever and it’s exciting to be back in reading, which has historically been such a key part of our business.

Third quarter sales were driven by the continued rollout of our new products, notably Leapster 2 and the Didj educational gaming systems in the U.S. and Canada, and the Tag reading system in our international markets.

In general, we think our two new gaming handhelds set the stage for continued growth in an important business for us, the educational gaming business. Leapster 2 lets the preschool game player have access to new online play activities and rewards and Didj is a huge step up in technology and the quality of game play. It incorporates unique customization and avatar features and the first of its kind, create your own curriculum concept which we think will be the model for our educational gaming approach in the future. And all of these products integrate with the learning path, which provides parents with real skill-based learning feedback on their child’s achievement.

Leapster 2 and Didj began shipping in July and our Crammer handheld study device began shipping late in September. These launches have gone very well and our products have already won numerous mentions, awards, and top back-to-school and holiday accolades. We received a sensational review, for example, on Leapster 2 and Didj by the Associated Press, which drove home the point that kids really do have fun with our products while learning. And our Tag and Leapster 2 won five gold prizes at the practical school awards in the U.K. Tag won the South Africa toy of the year award and Tag has also earned the honors as top educational toy in France. All of this an indication that Tag will be a winning platform around the world.

Press response to our final 2008 launches, the learning path and Crammer, has also been good. Commenting on Crammer, ABC [Tech Bytes], which runs on over 40 affiliates said studying has gone high tech, and Pop Gadgets said why bother pouring over dozens of books when the rest of the world is gaining an unfair advantage by going digital?

Content is a big part of our plan for 2008 and even more so as we look ahead and so far we are pleased to see that our extensive content library for ClickStart, Tag, Leapster 2, and Didj is being well-received by retailers and consumers alike. The portfolio includes many strong licenses like Hannah Montana for Didj, which will be in stores in December, and an exclusive holiday special for Indiana Jones and the Kingdom of the Crystal Skull, which will be released concurrent with the DVD release of Indy.

We have also been really pleased with the performance of titles that are already in the market, such as Dr. Seuss’ Cat in the Hat for Tag and the Star Wars titles for both Leapster 2 and Didj.

The learning path went live in September, in our view is probably the single most important enhancement to LeapFrog's product portfolio this year. It’s just getting started but so far we are getting a good response. We are seeing very solid connect rates for Tag and even stronger connect rates for Didj. Parents really like the learning path because for the first time, they have a window into their child’s unique learning progress with things like personalized achievement feedback, expert guidance and educational recommendations. And kids, well they like Tag Rewards, the Leapster Art Studio, which are now online, and they really like the Didj micro-mod game downloads. We’ll have a lot more to do with learning path but as one of our retailers put it, learning path is your best kept secret, he said, meaning that it’s a big differentiator and we have a lot of work to do to be sure that consumers know about it and so that they are engaging with it.

I agree with that point of view and marketing the learning path will be a big part of our strategy for 2009 and beyond but we are real pleased that it is launched and that it is doing well.

Turning now to LeapFrog's school -- over the years, we have gotten a lot of questions about this business segment from investors and we have taken numerous steps in the path to ensure the school business is a profitable contributor to LeapFrog, but the numbers have been clear. The giants, meaning the large educational publishers in this market are getting bigger and everyone else is getting smaller fast.

In response, we are reducing our school headcount to a small targeted group of fewer than 10 people and we are shifting our focus to working rather than in direct sales to working with large school publishers to help them use our technology platforms, notably our Tag, Tag Composer authoring tool, the learning path platform, and the Didj custom handheld player, into their own sales programs. The reductions have already taken place, our partner development program is well underway, and we are having good conversations with potential partners globally.

Now I am sure that what you are all most anxious to hear about today is how the holiday season is shaping up for LeapFrog, given the very difficult economic conditions we are all facing. As most of you know, history does show that the holiday toy shopper shows up in good times and bad. That being said, we just don’t have a lot of visibility right now and that makes it tough to forecast holiday season sales.

Some analysts are expecting a decline as deep as 5%, the worst holiday season since the ’91 recession, and clearly retailers will be managing inventory risk more carefully than ever. What we do know is that we are entering the 2008 holiday season with the best product portfolio we have had in years and our product line seems to be working. Consumers and retailers like our products a lot.

We also know that the consumer is extremely value conscious right now to make the most of the holiday season, therefore, we are turning up the heat on marketing, advertising, and promotions -- in-store, television, and online. Our media buying focus in the U.S. is weighted very heavily on Tag but also on Leapster 2, Didj, and importantly on software. We began implementing our own promotional programs in early October and retailer promotional support began ramping up in the second half of October but will hit its peak in November and December.

Consistent with our strong product plan, this is also the strongest retail promotional program we have seen in years and goes well beyond what was planned earlier this year.

From what we can see, promotions and sharper price points are in fact driving sales and while we expect that Q4 shipments may be softer than we had foreseen at the beginning of the year, sell-through at retail looks like it should be okay. We’ll see some margin pressure in Q4 due to discounting and promotions and we will be managing inventory very carefully.

With regard to inventory, we believe we will end the year in good shape compared to last year and that any remaining inventory will be from products that we intend to sell in 2009 and in 2010.

Against this backdrop, however, we have reduced our expectations for what otherwise had momentum to be a very strong fourth quarter. Certainly shipments over the next five weeks will substantially determine our Q4 outcome but we felt it was prudent to moderate our guidance for full-year sales growth in light of these unprecedented and challenging economic conditions.

Before discussing the outlook for 2009, I would like to turn the call over to Bill Chiasson, our Chief Financial Officer, and Bill will go into the financials in some detail.

William B. Chiasson

Thanks, Jeff. Before I go into the details of the quarter, there are several key highlights I would like to underscore. First, net sales for the quarter were up 35% compared to last year and this increase was driven by the worldwide shipments of our new Tag reading system, Leapster 2, and Didj educational gaming systems.

Gross margins were 43.8% -- that’s up 1.6 percentage points from last year, and the increase reflects the positive impact of margins on the new products, although the improvement was dampened somewhat by the high percentage of sales of hardware platforms, which typically carry relatively lower margins, and expense control continues to be very good. Combined, selling, general and administrative and research and development costs decreased by over 30% from last year, while advertising investment increased by 14% to support the new product launches and overall our operating expenses were down just over 20% compared to the third quarter last year.

And as a result of these items, we posted an income of $24 million in the quarter, compared to a loss of $10.3 million last year.

Now let me run through sales by segment. Net sales in the U.S. consumer business increased 40% to $153.6 million in the third quarter of 2008, compared to $109.5 million last year. Net sales of new products, including content introduced in 2008, accounted for over half of the total sales for the quarter and all of the sales increase.

In dollar terms, we saw increases for both platforms and software, while standalone products fell. As with last year, our product mix was skewed towards platforms, as with last quarter. The mix of net sales of platforms, software, and standalone products as a percent of the U.S. consumer net sales were as follows: as expected, this was a heavy hardware quarter for us and platforms were about $75.1 million, or 49% of net sales in the third quarter this year. And that compares to 35% of net sales last year in the third quarter. Software was about $43 million, or 28% of net sales in the third quarter of this year, compared to 30% last year. So while in absolute terms and absolute dollars the software sales increased from year to year, as percentage of the mix software was down slightly.

That leaves net sales of our standalone products at $35.1 million, or 23% of net sales in the third quarter this year, down from 35% of net sales recorded last year. This decline mostly reflects the relative lack of new news in our toy line, and as Jeff will talk about in a few minutes, we’ll be introducing a number of new products next year.

Net sales in our international segment increased 26% to $38.2 million in the third quarter from $30 million last year. Currency did not have much of an impact and excluding the effect of the stronger U.S. dollar, our international segment sales would have increased by 27% for the quarter, and the increase in net sales was driven primarily by the launch of the Tag reading system.

Sales in our school segment decreased 35% to $2.8 million in the third quarter from $4.3 million last year. As we discussed last quarter, the declines are being driven primarily by increased competition and budgetary issues impacting school funding. And as Jeff discussed, we have taken aggressive actions to refocus this business and we will continue to manage this business with an eye towards being able to achieve a positive contribution margin.

On to gross profit and gross margin, overall gross margin improved to 43.8% of sales for the third quarter of 2008 and that’s up 1.6 percentage points from the 42.2% recorded last year. The improved gross margin was aided by the introduction of new products in the U.S. and overseas, which carry higher margins as compared to last year’s product portfolio where we were discounting to move old product. However, and as I mentioned earlier, we also saw a significant increase in the percentage of hardware sales. As you know, our hardware typically carries a lower margin than software and as a result, the high percentage of hardware sales had a dampening effect on the overall improvement in gross margin. And while these hardware sales tempered the increase in gross margins, we are very pleased with the results in establishing our base of new platforms as this typically augers well for software sales longer term.

By segment, gross margins were as follows -- in the U.S. consumer segment, gross margin for the U.S. consumer segment was 45.6% for the quarter, about the same as the 46% recorded last year.

In the international segment, gross margin for the third quarter of 2008 was 38%, an increase of 11.2 percentage points from last year, and this was a result of new product shipments, Tag and Leapster 2, in the international markets during the third quarter.

And in our school segment, the gross margin fell to 28.6% from 51.2% last year. The decrease in 2008 was due to the impact of fixed costs, such as warehousing, on a significantly lower sales base in 2008 as compared to 2007.

On to operating expenses, our selling, general, and administrative expense for the quarter was $20.6 million. That’s a decrease of $14 million, or 40% from 2007. Affecting the comparison to last year is the relatively high legal expense in the third quarter of last year, which included $7.5 million resulting from the settlement of the patent lawsuit. Even excluding the effect of the settlement costs in last year results, our overhead costs have been reduced significantly. We have streamlined administrative functions and we have leveraged improved processes and systems to drive lower spending.

Research and development expense decreased to $11.7 million for the third quarter 2008, compared to $14.2 million last year. The decrease was driven primarily by the timing of the platform development cycle. For example, in 2007, we invested heavily in developing our new Tag, Didj, and Leapster 2 platforms, whereas in 2008, we focused our R&D activity on relatively less costly software content development. We also shifted certain aspects of the product development cycle to our third party vendors during late 2007, which reduced our overall research and development employee related expenses in 2008.

Advertising spending increased to $14.6 million from $12.8 million for the third quarter last year to support our new product launches. We expect advertising expense will increase in the fourth quarter 2008 as compared to 2007 as we’ll be investing heavily in promotions for our new products to support sales in the 2008 holiday season.

Higher sales, improved gross margins, and expense control all contributed to moving us to an operating income of $29.3 million for the third quarter 2008, compared to a loss of $10.6 million for the third quarter last year.

With regard to other income and expense, total other income and expense was a loss of $1.4 million in the third quarter of 2008, compared to income of $900,000 for the same quarter last year. Included in this category was $1.1 million for the impairment of the value of our auction rate securities. As of the end of the quarter, we have approximately $8.7 million of auction rate securities, which had an original purchase price of $14 million, and the remainder of the decline is primarily attributable to lower interest income and changes in the net effects of foreign currencies on the financial statements year to year.

The provision for income taxes in the third quarter of 2008 was $3.9 million, compared to $600,000 last year. The higher tax expense reflects the relatively higher profitability of our non-U.S. operations. And for the full year 2008, we expect total tax expense to be between $1 million and $3 million.

Turning now to the balance sheet, we feel good about our balance sheet. As we mentioned in our press release, we have a strong portfolio of products, clean inventories, and the liquidity to get through this difficult economic period. Our cash balance decreased during the quarter to $23.6 million, reflecting the seasonal working capital needs of the business. Between our cash balances and our credit facility, we feel good about our liquidity.

Early in October, we drew $30 million on our credit facility to ensure access to this liquidity, given the recent upheaval in the credit markets, but we expect to repay this amount prior to year-end.

Accounts receivable was $160.2 million at September 30, 2008, as compared to $118.5 million at the same time last year. Our day sales outstanding at September 30, 2008 were 76 days, compared to 79 days at the end of the same period last year. And inventories were $97 million at September 30, 2008, down from $110 million at the same time last year. The decrease was largely the result of continued improvement in information systems and the strong controls we have put in place. A clear indicator of the improved inventory management is that at the end of the third quarter, our day sales of inventories were 97 days compared to 153 days at the same time last year.

Turning to the outlook, while we are pleased with our results thus far this year, as Jeff mentioned, the retail environment has been much weaker than we or anyone could have anticipated. Although we don’t know exactly what November and December will bring, these months are unlikely to make up for the weak retail environment in recent months. Accordingly, we have adjusted our guidance for the full year -- specifically, our revised expectations for 2008 are: to have sales growth of 10% to 15% as compared to the full year 2007; gross margin improvement versus last year; and a 15% reduction in overall selling, general, and administrative and research and development spending as compared to last year as well.

I will now turn the call back over to Jeff to talk about our strategies and priorities going forward.

Jeffrey G. Katz

Thank you, Bill. Clearly the 2008 holiday season will be more challenging than any of us would have ever anticipated. What’s important though is that our new products are providing the innovation and value being sought by parents, and this bodes well for us, we think, particularly when consumers finally do, and we think they will, come out of their bunkers.

Looking ahead to 2009 and beyond with our new product portfolio now in market, we are going to continue to drive towards profitability by managing our product mix for the best gross margins and improving tie ratios. We expect 2009 as well to reflect further improvements in our cost structure beyond the progress we’ve reported so far in 2008.

Nevertheless, we will continue our emphasis on product innovation despite the tough environment. We are planning a number of new product launches in 2009 in reading and in educational gaming. Content and connectivity are also major themes of our 2009 plan and leveraging the learning path will be a key priority for us, as I have mentioned, as we work to monetize the value of our many, many connected consumers in 2009.

Our learning toy product line will also be an important area for us in 2009 with significant new products due to roll out, and in 2009 and 2010 we are going to be very focused on boosting our performance outside of the United States, principally by concurrently launching our full line of products in international markets, including the learning path.

We will have more to say about 2009 on our year-end call but for now, I would like to open up the call to your questions and I will ask the operator to let us know who would like to begin.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Gerrick Johnson with BMO Capital Markets.

Gerrick Johnson - BMO Capital Markets

Good afternoon. One part of the guidance that I didn’t see was the part about the nominal loss for the year -- do you still expect a nominal loss for the year and what’s the revised expectation there?

William B. Chiasson

At this time, we are not giving specific guidance for the order of magnitude of the loss but clearly we have taken down our overall sales guidance and with that and where we expect margins and expenses to be, we’ll let you determine where you would see that range but we are not giving specific guidance for earnings at this time.

Gerrick Johnson - BMO Capital Markets

Okay. And on the advertising program in the third quarter, has it done for you what you thought it would do, and has it performed as expected?

Jeffrey G. Katz

What we are seeing from the advertising is a strong increase in -- a strong up-tick in awareness of all of the product lines, in particular good Tag awareness and great awareness of Didj relative to sort of existing products like Leapster, and also strong up-drive of intent to purchase.

What’s really hard to read is the sell-through implications, because in contrast while you have real up-drive and intent to purchase, you have this really strong headwind in terms of consumer confidence, you know, consumer confidence metrics that essentially nobody has ever seen before that are weak. So it’s hard to know, is the advertising working -- it looks like it is working on a metrics basis. Principally we can also see that when some discounting is introduced. We see very, very strong sell-through occur but in the absence of discounting, it is kind of hard to measure just yet. We do think that if retail traffic trends improve these strong intend-to-purchase metrics bode well for sell-through. In particular, we have seen some pretty robust trends online and we have also seen -- as I say, as retail promotions occur, we have seen some rather dramatic up-ticks in sell-through.

But a very hard year to kind of measure in the classical way. I apologize for being a little circuitous in my answer but it is really difficult to measure so far.

Gerrick Johnson - BMO Capital Markets

I appreciate the granularity in the answer. Thank you very much. That’s all I have. Thanks.

Operator

Your next question comes from the line of Sean McGowan with Needham & Company.

Sean McGowan - Needham & Company

Thank you. I have a couple of questions and if I start running off, I’ll just re-queue -- could you, Jeff, could you compare what you are seeing right now in terms of relative velocity of Didj versus Leapster 2? You sound pretty upbeat about how Didj is doing. Would you say it’s kind of -- I know that Leapster 2 might be expected to be a bigger product but is it selling kind of at the same velocity relative to expectations?

Jeffrey G. Katz

I think again, versus expectations, it’s sort of -- almost nothing is where we had hoped it to be and I -- let me give you some real relevance. When we launched Tag first at retail and online, it boomed. And then we kind of hit the September -- I don’t know what you would call it, but it was bad. So now things seem to be moving again. My sense of Leapster 2 versus Didj is Leapster 2 seems to be performing quite a lot better but it is a Leapster branded device, and it’s also $69, so it has a well-known brand name, it’s clearly the next new Leapster, and that seems to be working well for it. Didj is at $89 and what we have seen so far is that Didj gets great consumer reviews but $89 is a tough price point for an unknown brand, and so there again that’s been where we have discounted promotionally Didj just to sort of understand how much is price point and how much awareness. The product has really moved well, so I would say our view in this environment is that for a new brand, that’s a tough price point.

Sean McGowan - Needham & Company

Well, that raises a question I would have for the whole line -- so how do you, in this kind of a holiday season, how do you discount without doing permanent lasting damage to the margins going forward and the perceived price? Do you do it with couponing? Do you do it with free software? Is it actual dollars off price on the hardware?

Jeffrey G. Katz

We have really shied away from dollars off the hardware. We have, as you mentioned, used sort of software bundling. We have used gift cards, and that has worked very well. It absolutely is an issue if you just mark the price down, call it a tough year to get the price back to where you think it needs to be and could be in a slightly healthier economic time. You know, we have launched Leapster at $89 or $99 way back when, and LMACs at $89 sold reasonably well as sort of a premium Leapster product, $30 above base price Leapster. So ultimately, we are going to try and be careful to not dilute the base price of what is really a premium product, which means we will use other promotional techniques, like bundling in particular and gift cards in really narrow windows. And just to top it off, Didj is not meant to be a real high-volume product for us this year. It’s meant to be a premium sort of, as LMACs was, it’s sort of a premium product which is expected to sell in lesser quantities, but we really like the quality of game play that the consumer gets and we like the customization and we think ultimately that’s reflective of where the product is going to go.

Sean McGowan - Needham & Company

Okay. For 2009, are you planning any major new platforms?

Jeffrey G. Katz

Yes, we are.

Sean McGowan - Needham & Company

Will we hear about that on Thursday?

Jeffrey G. Katz

You will hear about that at our New York Toy Fair event, Sean. I think we are not going to say too much. Obviously retailers are in the loop and at the Dallas Toy Fair, that was on sort of review but I think at our New York event, we will be a little bit quiet about that yet.

Sean McGowan - Needham & Company

Okay, thanks. If I can circle back to your question, I think you’ve answered it but I will ask it more directly, Bill -- any comment on cash flow expectations for the year?

William B. Chiasson

We still expect to be building cash by the end of the year from our current levels. This is the time of the year where towards the end of the year, it will start collections on the receivables that we have built up at the $160 million level that you saw at the end of the third quarter. Where they actually come in I think is a little dependent on how the final shipments wind up and the timing of them in the fourth quarter. But we still feel very good about where our overall cash levels are.

Sean McGowan - Needham & Company

So not reaffirming the cash flow neutral?

William B. Chiasson

No reaffirming it but still feeling very good about where cash is coming in.

Sean McGowan - Needham & Company

Okay, that’s helpful. Thank you. In the -- I think you specified that, in other costs, that was the impairment of the auction rate securities -- any sense of where that can go?

William B. Chiasson

No, I mean, it’s also dependent upon the credit markets, which of course have had a lot of turmoil over the last couple of months as well.

Sean McGowan - Needham & Company

Okay. Regarding the reduced expectations for the school division, is there any -- was there any profit impact in the one-time severance charges or anything like that in the third quarter from this decision to --

William B. Chiasson

We did record a $400,000 charge for the severance in the third quarter. Those people are essentially have gone by now but most of them went out during the month of October and there was about a $400,000 charge to adjust the inventory costs, given where the current sales levels are.

Sean McGowan - Needham & Company

That’s in addition to the severance then?

William B. Chiasson

Yes, in addition to the severance.

Sean McGowan - Needham & Company

Okay. I think that’s it. Thank you very much.

Operator

Your next question comes from the line of Tony Gikas with Piper Jaffray.

Tony Gikas - Piper Jaffray

Good afternoon, guys, a couple of questions. Could you talk a little bit about the tie ratios on the Tag and Leapster 2 and the Didj, I guess, at this point? Second question, maybe just sort of reaffirm the shelf space changes that we are seeing increase on a year-over-year basis at Target and Walmart?

And then while Q3 was a larger hardware quarter, do we expect that the mix will be favorable towards software in the fourth quarter? And then I have a follow-up.

Jeffrey G. Katz

I’ll start and maybe Bill can back me up a bit on following up about tie ratio and margin trend.

So tie ratios on Tag have certainly come out of the gate strong, very strong. We have continued to see up-tick and while I am not sure whether we will release the numbers -- Bill, help me out on that -- but we are sort of -- we have clearly launched substantially higher than we launched with the LeapPad, so tie ratio certainly going north of two on a launch season is good, and we’ve seen much higher numbers on that than that even at certain retailers.

Leapster 2, the Leapster tie ratios are quite high, north of four. Now we have a big installed base so the Leapster 2 software, while enhanced for Leapster 2, is compatible with the Leapster player, so you get sort of the benefit of both platforms really working on a software volume perspective.

But I would say very good tie ratios out of the gate for Tag and continued tie ratio growth for Leapster in general.

In terms of shelf space, yes, we do have substantially more shelf space at most retailers this year versus last year, particularly -- that’s particularly true in the second half of the year. And as I say, we -- until we hit this certain season, you know, it was really looking to be a very productive shelf space. Again, we haven’t -- I haven’t seen the impacts yet of recent trends, which is to say I think we want to see how the season goes before we crow too much about shelf productivity, but certainly space is up.

William B. Chiasson

I think there was one other question regarding the software and the shipments of those and you are right -- third quarter was a very heavy hardware month for us and we expect hardware shipments to be still good in the fourth quarter, but software should certainly start picking up in anticipation of really the fifth -- what we call the fifth quarter, the early 2009 sell-through at the retail, so we see some -- we do typically expect to see software sales picking up.

Tony Gikas - Piper Jaffray

Okay, and then just going back to the shelf space, do we expect that those end caps at Target are going to come back here in early or mid-November? And then just maybe a quick comment on your comfort level with your inventory levels and retail inventories today?

Jeffrey G. Katz

So there are a variety of promotions at all retailers through December -- palettes, end caps, tabs, et cetera, so yes, depending on the retailer, there is a wide variety of features that will be in place for a variety of products, so you will see more of that activity really throughout the season now.

Tony, what was your second question?

Tony Gikas - Piper Jaffray

Just your comfort level with your inventory and at retail.

Jeffrey G. Katz

I think we feel pretty good, having reacted to inventory fairly early in the process -- certainly as early as August and September, we were taking sort of a several risk positions on product, so I think our inventory we feel good about and retail inventory is -- we feel good about. Now granted, we are driving higher sales year over year, so they are going to be looking at a higher inventory position but we expect pretty good sell-through, and all of the product that is on hand at retail will be product that is going to be continuing to drive forward in ’09, so I feel pretty good about it on a year-over-year basis.

Tony Gikas - Piper Jaffray

Okay, and then last question, and sorry, I think you answered this but did you say that the other expense item, I think it was $1.6 million, and that was pricing of the auction rate securities?

William B. Chiasson

The total change in the other area was $1.4 million; of that, about $1.1 million was the valuation adjustment to the auction rate securities.

Tony Gikas - Piper Jaffray

Okay. Thank you, guys. Good luck.

Operator

Your next question comes from the line of Edward Woo with Wedbush.

Edward Woo - Wedbush Morgan Securities

Is there any change in the competitive landscape?

Jeffrey G. Katz

Change in the competitive landscape -- nothing quarter -- you know, nothing different from what we reported when we talked about the second quarter, that really comes to mind, so I think in our category, we still have a pretty good product position relative to the competitive situation. And as we look to ’09, it is at least early for us to know what issues pro and con we may face, so I would say no changes since our last quarterly conference call of note.

Bill, anything that comes to your --

William B. Chiasson

No.

Edward Woo - Wedbush Morgan Securities

And the other question I had is you know, obviously the weakness in the U.S. has been very well documented but what about -- are you seeing anything that in the global area that you think would correlate with what is going on in the U.S.?

Jeffrey G. Katz

Well, you know, I will tell you that in Mexico and Canada, they do not appear to have gotten the cataclysm memo, so those markets, while not un-impacted, I think have been surprisingly robust from our observation and at least so far, it’s very early in the holiday selling season and, for example, Europe, it’s been less pronounced than here. Those are much less credit-based consumer economies than here, although the U.K. is still a pretty heavy credit card debt users but less so than here and at least in those markets, there has also been less banking industry fear. So I would say less impact in Europe and I would have to say Mexico and maybe even Canada, almost no impact visible.

So what does that mean for this market? Well, I think it does indicate that we will see some recovery but I can’t give you a prediction when. But a lot of -- we know a lot of this is definitely fear-based holding back by consumers and so when that fear subsides and a little bit of certainty comes back, we would expect to see the consumer come back and we feel like they will be buying our product. That much the data does show.

Edward Woo - Wedbush Morgan Securities

Thank you.

Operator

Your next question comes from the line of Drew Crum with Stifel Nicolaus.

Drew Crum - Stifel Nicolaus

Good afternoon, everyone. I want to drill down into your revenue guidance for 2008 -- I just want to get a sense as to what the mix looks like. I think previously you had said that you expected around 50% of the revenue to come from new products. I just wanted to confirm that still holds.

William B. Chiasson

I think that’s generally good. In fact, that’s about what we experienced in the third quarter for the U.S. consumer segment.

Drew Crum - Stifel Nicolaus

Okay. And as far as the international deployment of your new product, can you just give us a sense as to where you are and what we should expect in the fourth quarter? Were there any additional countries you will deploy product to?

Jeffrey G. Katz

I think the shipping process began in the third quarter, so I would say no to additional countries from a shipping perspective -- just it’s a matter of quantities at this stage.

Drew Crum - Stifel Nicolaus

And then on the advertising expenses, you guys mentioned you expected it to be up in the fourth quarter. Previously you had mentioned that you thought it would follow revenue growth for the year. Is that still the expectation?

William B. Chiasson

Yeah, it will grow approximately with the revenue growth for the full year, maybe a little more.

Drew Crum - Stifel Nicolaus

Okay. And then finally, Bill, can you just remind us again how foreign currency influences the business, both from a revenue and cost perspective?

William B. Chiasson

Well, from a revenue perspective, as I mentioned in my discussion points, it really hasn’t affected us that much for the quarter, so year to year comparisons haven’t been that significant.

As you probably have been following, as the major currencies have eroded against the dollar significantly in the last month, I think the Euro is down about 10%, the Pound is down about 9% or 10%, et cetera, so when we translate our fourth quarter results, it will be impacted by what the ultimate erosion of those currencies is during the fourth quarter. So we’ll be translating our non-U.S. dollars sales at lower rates. And approximately three-quarters of our international sales are denominated in foreign currencies. Small pieces to distributors are not and as a reference point, last year we had about $47 million of sales internationally.

So that is from a translation side the most significant impact. As we look to next year, we’ll be also looking at the impact of sourcing our product costs outside the U.S. in dollars, and we do source in dollars so there will be an impact there on our product cost for 2009 as well. But at this time, not really ready to talk about what that impact might be.

Drew Crum - Stifel Nicolaus

Okay. Thanks, guys.

Operator

(Operator Instructions) Your next question comes from the line of John Taylor with Arcadia Investment.

John Taylor - Arcadia

I’ve got a couple of questions as well -- on the subject of sourcing, I wonder if as you guys are having preliminary discussions with vendors in China, whether any of the commodity or input costs deflation that we are hearing about is likely to have an impact on your unit costs next year for carry forward product?

Jeffrey G. Katz

I mean, certainly we think there’s been a huge outlet of high pressure on both commodity costs -- you know, resin and anything petroleum derivative, but also labor pressure. As the economy globally weakens, there will be lesser demand for labor and we think that will moderate sort of what had been sharp upward pressure on costs. So yeah, we think it will have an impact at least on trends. As Bill mentioned, it’s a bit early to sort of be able to roll it up and get a very good projection on the impact on product margins. But in general, that’s one of the sort of good news aspects of what is happening. We think we will either be able to make the product slightly more affordable or perhaps eke out a somewhat improved margin on that product, keeping in mind that LeapFrog still does benefit relative to some other people in the market due to electronic components which will continue to go favorably, particularly memory and certain chip technologies.

John Taylor - Arcadia

All right, and then an R&D question -- so last year, you were busy building several different platforms to launch this year. I am wondering how the complexion, the allocation of R&D dollars, is as of today say versus 12 months ago, you know, by platform development, software development, maybe standalone development? Any way you could characterize that for us?

Jeffrey G. Katz

Well, first of all I would say that much of our development has now been externalized, so that means it’s variable, as that is particularly true to content development. Content development in the past had been sort of the development of Tag books and Leapster games and so forth. That had been 50% of our R&D costs in platform development had been about another 50%. Definitely we’ve managed to drive down with our so-called platform architecture initiatives and by externalizing working with partners in the chip business. We’ve really driven down the percentage of R&D that is actually in the platform business, so it’s becoming a lot more cost efficient.

Having said that, we built up pretty big libraries this year, so content development is a bigger proportion of R&D and we expect it to sort of continuously stay that way. Overall, I believe our R&D is on a downward track per dollar of sales and we will continue to put pressure on it without abandoning the product plan. We think there’s some more efficiencies to go, particularly as these third parties get a lot more experienced at building to Leapster or building to Didj or building Tag books. We are already seeing unit costs get a bit better there in terms of R&D.

John Taylor - Arcadia

I guess that’s what I was getting at -- it seems like a lot of the heavy lifting for platform development has been done and now that those are launched, you may have some new things next year but percentage wise, it seems like it ought to head south.

Jeffrey G. Katz

That is the trend. I think the caution I would say is any time you look ahead three years, that is where you are trying to push innovation again and you start to sort of decide how much should I be investing for 2011 brand new, ground up initiative? But having said that, I think we are much -- we are more efficient. We think we can still get more efficient and we will have more to say about that when we do the year-end call. S

John Taylor - Arcadia

Okay, great. And then last question on the kind of guidance, I guess -- so you -- you are not giving us anything specific as it relates to marginal loss or modest loss for the year and kind of what the delta is with the new expectation. I wonder though if whatever that number is, I wonder if you could break it into baskets for us in the sense of how much percentage wise, roughly how much of it comes from the downward revenue guidance, how much might come from margin pressure related to discounting, and how much of it might come from a step-up in advertising spend in order to make sure that you exit the year clean.

William B. Chiasson

The last two points are probably very much related, as we make sure that the consumer gets attention of it and the retailer gives us the support we need in order to move the product through retail, so we have taken into account as we expect margins in the back part, in the fourth quarter to be somewhat moderated from initial expectations. That said, it would be really difficult to split it between those two buckets but both of those are affecting our outlook for the fourth quarter.

John Taylor - Arcadia

Thank you.

Operator

Your next question comes from the line of Brooks Tomlin, a private investor.

Brooks Tomlin - Private Investor

Good afternoon. Congratulations on a -- I have two questions, real quick. Well, actually I’ve been investing [with you all] for a while and a proud parent of kids who use your products. Steve Jobs in his earnings release about a couple of weeks ago said October and April are two of the months that they have the lowest sales and the least visibility. Is that something that is generally coinciding with your company as well? Is October typically a tough month for visibility?

Jeffrey G. Katz

Well actually October is typically a pretty good month for visibility. That I think is the real challenge for everybody. Retailers have these fairly good models that look at sell-through in September and October and they use those to project what they are going to need at the end of the day around the holidays, and so when the consumer stays home in September or October, or a much reduced level of purchase activity compared to a traditional September -- those models actually don’t work. So for us, I can’t speak to -- I thought Steve Jobs had an intravenous crystal ball to a higher power but for us who don’t have the intravenous crystal ball, normally we get a fairly good read, particularly in October, with the sort of traditional holiday build-up and based on that, we and retailers together can alter or enhance our plans, shipping plans.

So this has been a very -- well, an unprecedented year in that those models basically don’t have any data, or they have very, very little data with which to sort of make a prediction. So what happens instead is obviously the products that are red hot -- for us, you know, Leapster is pretty much a hot product and Tag frankly is, even in this bad time, looks like a pretty strong product. But for the rest of the portfolio, it’s very hard to get a read because the data is kind of sparse.

Brooks Tomlin - Private Investor

I understand. One follow-up question -- I emailed Ms. VanEss about this and you had an advertisement on the Yahoo! home page back in September, I want to say early September -- can you give any insight into how much the web traffic to LeapFrog.com expanded with that advertisement?

Jeffrey G. Katz

Well, we had very good -- what we had a big traffic up-tick to actually that ad principally was driving traffic to our demo site, so you can online see a demonstration of Tag and Didj and so forth, and we’ve had well in excess of $1 million online demonstrations from our ads like the Yahoo! ad, so that’s another reason we think our marketing program is working when the consumer is ready to buy, because there’s been, as I say, well over a million demonstrations of these products conducted online. So it’s been pretty large but again, those were driving demonstration traffic rather than raw sell-through traffic.

Brooks Tomlin - Private Investor

Excellent. Thanks for taking the questions.

Operator

And there are no further questions at this time, sir.

Jeffrey G. Katz

Well, very good. Again, I want to thank everybody for your questions and for joining us late for the people on the East, late in the evening on the call today. We have been very diligent, we think, over the past couple of years, to get this, these product launches and prepare for a very big and we think so far beneficial product launch. We are honestly, we are really pleased with the growth ramp that was happening through the third quarter and we think that these learning products we have brought to market will be very effective for us as the consumer environment does improve.

So we think we are well-positioned to make the most of the holiday season. It will be a unique holiday selling season. I think we are all aligned on that and when the consumer is out, we think we will do well for those consumers who do come out for that budget they do choose to disperse. We feel pretty good about how sell-through will go but more to learn on the actual size and shipping levels for the quarter, of course.

We are looking forward to seeing some of you at our upcoming investor meeting in New York, which is later this week. There we’ll discuss in more detail our current product lineup, as well as our strategic priorities for 2009 and beyond. And for those of you who don’t live in the East, we’ll be webcasting the presentation and if you still need to register for the meeting or need more details, I hope you will please contact Eileen VanEss and with that, I will wish you a good evening and good night.

Operator

And this concludes today’s LeapFrog Q3 2008 financial results conference call. You may now disconnect.

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