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LeapFrog Enterprises, Inc. (NYSE:LF)

Q4 2012 Earnings Call

February 6, 2013 05:00 pm ET

Executives

John Barbour – Chief Executive Officer

Ray Arthur – Chief Financial Officer

Karen Sansot – Senior Director of Investor Relations

Analysts

Lee Giordano – Imperial Capital

Gerrick Johnson – BMO Capital Markets

Drew Crum – Stifel Nicolaus

Mike Swartz – Suntrust Robinson Humphrey

Sean McGowan – Needham & Company

John Taylor – Arcadia Inc.

Ed Woo – Ascendiant Capital

Jim Chartier – Monness, Crespi, Hardt & Co.

Operator

Good morning. My name is Amanda and I will be your conference operator today. At this time I would like to welcome everyone to the LeapFrog Q4 2012 Earnings Conference Call. (Operator instructions.) Ms. Karen Sansot, you may begin your conference.

Karen Sansot

Thank you. Good afternoon and welcome to the LeapFrog Enterprises conference call to review our results for Q4 and year ended December 31, 2012. I’m Karen Sansot, Senior Director of Investor Relations. Today on the call we have John Barbour, our Chief Executive Officer; and Ray Arthur, our Chief Financial Officer.

Before we begin I have a couple housekeeping items to go over. We’ll be hosting our annual Investor Event for institutional investors and security analysts on Tuesday, February 12th in New York. Please contact me if you’d like to learn more about the event. This event will also be webcast on our Investor Relations website at www.leapfroginvestor.com. Please refer to this website for current information about LeapFrog.

We’d also like to let you know that we will have a closed communication period during which we will be unavailable to talk with analysts or investors about our business. This period will begin on Monday, March 25th and last until we announce our Q1 results which we expect to announce sometime in early May.

And now the Safe Harbor statement: we wish to remind you that our statements today will include forward-looking statements including management’s expectations regarding anticipated Q1 and full year 2013 financial results. In addition we expect the questions posted in the Q&A portion of this call to prompt answers that contain additional forward-looking statements not included in our prepared remarks. You should be aware that actual results might differ materially from those projected in any forward-looking statements.

Some important factors that could cause actual results to differ materially from those in the forward-looking statements are described in our most recent Form 10(k) filed with the SEC. LeapFrog makes these statements as of today, February 6, 2013, and disclaims any duty to update them. I would now like to turn the call over to John Barbour.

John Barbour

Thank you, Karen, and good afternoon everyone. As the CEO and a shareholder of LeapFrog I’m incredibly happy with the quality of execution from our team in 2012. Despite a tough global economy and a declining US toy industry, we achieved our third straight year of sales growth, growing our US business by 24%, our international business by 38% for a combined year-on-year increase of 28%.

Our world-class team delivered the bottom line as well, nearly tripling our income from operations and continued to drive shareholder value. In addition to significantly improving execution we also made strong progress in the transformation of our business from an educational toy company to a leading educational entertainment company. We have the best portfolio of educational entertainment platforms in the world with our captivating LeapPad Tablet, Leapster Gaming, and Tag Learn to Read solutions.

The combination of incredibly fun and engaging games, videos, books, eBooks, apps and music each filled [with the nutrition] of learning with easy-to-use hardware that is specifically designed for children is proving to be a winning strategy in the global marketplace. Virtually every parent wants to see their children have the best opportunities in life, and most see education as the key to their future success. As a result, more and more parents are eager to find effective learning solutions that can augment their child’s education in a way that children find fun and engaging.

LeapFrog stands out in a market that is overloaded and filled to the brim with educational digital content that’s either dry and boring that children rarely play with or is fun, fizzy, and free, that keeps children amused but at most there’s only a thin veneer of education within them. LeapFrog’s proven 18-year track record of providing quality educational entertainment products for children has made it the trusted brand for parents.

Unlike the bulk of our competition, our learning solutions are packed with rich, nutritious education that is delivered through fun and engaging entertainment experiences. Our in-house child development experts continually search the education world looking for all that is best in early childhood teaching methods, and over the years have built an extensive proprietary curricula in scope and sequence that incorporate it into our award-winning products.

As I said last year and I believe was clearly proven in the market over the holiday season, most parents know that taking a cheap adult tablet, throwing a colorful rubber bumper around it and filling it with free fuzzy apps and Wi-Fi access does not create a true learning experience that will significantly help prepare children for a very competitive future. I believe parents voted with their pocketbooks in 2012 and as a result, our award-winning line of LeapFrog cartridge content became the number one top-selling toy in the US and a top-ten selling toy in UK based on sales according to NPD Data.

We have more products on NPD’s list of the US 2012 top ten selling toys than any other manufacturer with three of the top four and four of the top ten. In the UK, we also had two of the top ten selling toys. In addition, net sales of digital download content from our curated selection of over 475 titles including LeapFrog-developed content and content from 30 media partners were nearly 4x the prior year as families took advantage of our 24/7 online app center. Unlike our competition, every single piece of content in our app center has either been developed or selected by a qualified child development expert.

In 2012 we achieved significant market share growth in all the major markets which we operate. Innovation has proved to be a key growth driver in many markets around the world, and I’m proud that LeapFrog has lived up to its heritage as an innovation leader in the children’s market. Consistent innovation is never easy. It takes great people working in a highly collaborative environment where creativity, experimentation and calculated risk taking are encouraged.

Over the last two years we have built a world-class leadership team filled with individuals that have proven track records in large companies as well as developing fast-paced entrepreneurial ventures. We work every day with an extraordinary team of child development and educational experts, platform designers, content creators, game designers, marketing professionals, system engineers and more to create products that are truly magical and make learning fun because at LeapFrog, we were founded on the belief that if you make learning fun it will be dramatically more effective.

We have the best talent in the business and they’re delivering the world’s best educational entertainment for children, resulting in exceptional financial performance. In 2012, LeapFrog exceeded all expectations and delivered 28% net sales growth. Operating income nearly tripled and we’re generating meaningful cash flow. Our cash bond increased 67% to $120 million at the end of December and is likely heading to nearly $200 million over the next couple of months. This growing cash balance will provide us the capital to invest in new innovations and potential acquisitions to continue to accelerate our growth.

As we look to 2013 we are very excited about our market-leading portfolio and our new product launches for this year including a new Learn to Read system, new iPhone and iPad app activity products, and new LeapPad Tablets. Over the last two years we have sold nearly 9 million connected platforms. We now have 13 million connected parents in our ecosystem. In 2013, we plan to make long-term investments in content, online communities, systems, and new platforms to support our global growth and build richer relationships with families, teachers, and caregivers. These investments will enable us to continue our market leadership and grow.

About 95% of our sales today occur in English-speaking countries. In 2012 we launched LeapPad in France and French-speaking Canada for the first time, and the platform and its content and accessories sold phenomenally well. Over the last two years, net sales in our international segment grew at a 33% compounded annual growth rate. We see global expansion as another substantial growth opportunity for LeapFrog over the next few years, and in 2013 we will increase investment to localized products for new market expansion in 2014.

When I joined LeapFrog about two years ago I arrived in Emeryville with thoughts on where I hoped we could be at the end of 2011 and 2012. I can tell you that we’ve made so much more progress than I’d dreamed possible. We’ve built a terrific business with a number of unique, powerful, hard-to-replicate assets that I believe will keep us ahead of the market in terms of growth and financial performance.

2012 was an incredible year in the history of LeapFrog, and I’m very proud of the LeapFrog team and I’m energized and very excited about the opportunities ahead of us. I’d like to end by thanking all the LeapFrog team, our terrific Board of Directors, and all of our business partners for their incredible contribution to our growth in 2012. Now I’ll turn over the call to Ray Arthur, LeapFrog’s CFO who will talk about 2012 performance and 2013 outlook.

Ray Arthur

Thank you, John, and good afternoon, everyone. This time last year we indicated that continued positive product momentum together with disciplined growth and expense management would put us in a position to grow our earnings and deliver continued strong cash flows. And we did just that in 2012.

We delivered 28% net sales growth, reduced operating expenses as a percentage of net sales, nearly tripled operating profit, and more than quadrupled net income. In addition we maintained strong operating cash flow, improved working capital by almost $80 million and increased our cash balance by 67%. While 2012 is only one step on a much longer journey we are extremely proud of what we’ve been able to achieve this past year.

A moment on comparability before I review Q4 and full year: our results for the current and prior years include some nonrecurring items and trends that impacted our year-over-year and quarter-over-quarter comparisons, most notably in the tax line. In Q4 2012 we released $20.3 million of an allowance against our domestic deferred tax assets that was originally put in place in 2006.

The decision to release was based on many factors, including three years of successive and increasing net income which allowed us to conclude that we would generate future income sufficient to utilize a portion of our deferred tax assets. The remaining balance of the valuation allowance at year end 2012 was approximately $70 million. We will reevaluate the need for this valuation allowance in the later part of the second half of 2013.

In addition, our results included $6.4 million and $2.9 million in 2012 and 2011 respectively of previously unrecognized tax benefits due to the expiration of statutes of limitation in certain of our foreign jurisdictions. Also notable is that the LeapPad Tablet family of products was sold for the full year in 2012 as compared to less than half the year in 2011, and higher than planned inventory levels at the end of 2010 resulting from weaker than expected demand late in that year negatively impacted sales for Q1 2011 which added to the favorable 2012 over 2011 comparison.

Now let me provide insight into our Q4 financial performance as summarized in the financial tables accompanying the press release. Worldwide net sales for the quarter were $245 million, up 16% compared to a year ago and were not materially impacted by changes in currency exchange rates. Sales growth was driven primarily by strong content sales, higher consumer demand for the LeapPad Learning Tablets and accessories and the LeapsterGS game system. These gains were partially offset by declining sales of our older platforms nearing the end of their lifecycles. Our sales were strong in both the US and in international markets.

By segment, net sales for our US segment were $178 million, up 11% compared to a year ago; and from a POS perspective growth was strong in the US, leading healthy year-end inventory at retail. In our international segment, net sales were $67 million, up 35% compared to a year ago and were positively impacted by two points from changes in currency exchange rates.

Gross profit for the quarter was $109 million, an increase of 17% compared to the prior year and gross margin rate was 44.7%, up 20 basis points year-over-year due primarily to higher sales resulting in better leverage of fixed costs and lower freight costs. Operating expenses for the quarter were $66 million, up 10% compared to $60 million a year ago but down 150 basis points as a percentage of net sales.

SG&A and R&D both increased as a result of higher year-end variable compensation expense as we exceeded our established annual financial performance targets. In addition, our advertising expense was up 12% year-over-year due to higher investment in television advertising to drive continued demand for our content, LeapPad Learning Tablets and accessories. However, advertising expenses were down 40 basis points as a percentage of net sales.

Our profitability results for Q4 were also solid. Income from operations was $43 million, up 28% compared to $34 million a year ago due to our sales growth, operating leverage, and expense control. Net income per diluted share was $0.89, up 82% compared to $0.49 a share a year ago. Net income for Q4 2012 included a $0.29 benefit from the partial reversal of a valuation allowance established in 2006 against our deferred tax assets.

Now I’ll review our full-year 2012 results. Worldwide net sales for the year were $581 million, up 28% compared to a year ago and were not materially impacted by changes in currency exchange rates. Sales growth was driven primarily by the continued success of our content, higher consumer demand for the LeapPad learning tablets and accessories, and the introduction of the LeapsterGS game system. We also benefited from a full year of LeapPad sales since the product launched in the second half of 2011, as well as an easier comparison in Q1 2011 due to excess retail inventory at the end of 2010.

Our sales were again strong in US and international markets and in fact we gained share in all our key markets. Our US segment sales were $425 million, up 24% compared to a year ago. In addition our POS of our products for the year were strong, bucking the overall toy industry decline in the US according to NPD.

Net sales for our international segment were $156 million, up 38% compared to a year ago and were negatively impacted by one point from changes in currency exchange rates. POS was strong in all our key markets and we expanded our product offering in some strategically important countries. For instance, we launched LeapPad for the first time in France and in French-speaking Canada.

Moving on to results by business line, worldwide sales for the year were as follows: multimedia learning sales increased 60%. Strong sales of cartridges and digital content, accessories, LeapPad1, LeapPad2, and the successful introduction of LeapsterGS were partially offset by the decline of our older platforms nearing the end of their product lifecycles. Interactive reading sales declined 11% likely due in part to the success of LeapPad which includes several learn to read options and the end of life of our Tag platform which will be replaced by a new Learn to Read system in 2013. Learning toy sales decreased 12% as sales from our new line, Touch Magic, were more than offset by declines in some of our other toy lines.

Gross profit for the year was $245 million, an improvement of 32% compared to the prior year and is the highest level we have achieved since 2005. Gross margin rate was 42.1%, up 120 basis points compared to a year ago. The improvement was driven by proportionately lower discounts and allowances and higher sales volumes, which reduced the impact of fixed costs, partially offset by a higher mix of lower-margin hardware.

Operating expenses for the year were $181 million, an increase of 11% but down 460 basis points as a percentage of net sales. In fact, as a percentage of net sales this is the lowest level of annual spend we have achieved since LeapFrog became a public company with each major category within operating expenses declining as a percent of sales year-on-year.

That said, SG&A and R&D were up 15% and 8% respectively primarily driven by higher year-end variable compensation expense as we exceeded the established annual financial performance targets. Advertising expense was up $3 million or 9% year-over-year as we invested more in TV advertising to drive continued demand for our multimedia learning family of products including content, accessories and hardware, including the launch of LeapPad2.

Income from operations was $64 million, up nearly threefold compared to $24 million a year ago and the highest operating income the company has delivered since 2003. Net income per diluted share was $1.24 a share and includes a $0.29 per share benefit from the partial reversal of a valuation allowance established in 2006 against our deferred tax assets and a $0.09 and $0.04 per share benefit in 2012 and 2011 respectively from the recognition of previously unrecognized tax benefits due to statutes’ expirations. Excluding these items net income per diluted share was $0.86 and $0.26 for 2012 and 2011 respectively, up over threefold compared to the prior year as adjusted and is the highest EPS we have reported since 2003.

Now, turning to the balance sheet, cash and equivalents at year end were $120 million, an increase of $48 million compared to a year ago and it is the second largest year-over-year increase in our cash balance since 2002. Importantly, operating cash flow remained strong at $68 million through the year, relatively flat to the prior year, and we produced $93 million of adjusted EBITDA versus $49 million last year. Our cash balance continues to grow as we collect year-end receivables and stands at just over $190 million today.

Our accounts receivable balance was $180 million at year end, an increase of only 14% despite the 16% increase in sales in Q4. Our portfolio is in excellent shape and our collections have remained strong, with days sales outstanding declining by one day to 66 days compared to 67 days in 2011. Our inventory balance was $40 million, up $6 million or 18% compared to a year ago largely due to the strong demand for multimedia learning products which required us to bring in 2013 production early and lower than expected sales of Learn to Read and toy products. But channel inventories are down double digits from last year and we believe we are in good shape entering 2013.

Now let me turn to our 2013 outlook. We’re very excited about our market-leading portfolio and new product launches for 2013 including our new Learn to Read system, new iPhone and iPad app activity products, and new LeapPad Tablets. As a result, despite a global economy that remains sluggish and a US toy industry that declined in 2012 we plan to continue to grow our business at a pace significantly ahead of the market and expect net sales to increase at a high single digit percentage growth rate.

Like 2012, we will also be prepared to chase upside wherever possible. To support our market-leading growth and our ongoing business transformation we plan to make long-term investments in content, international expansion, online communities, systems, and new platforms. But even with this investment for the future we expect our operating margin as a percentage of net sales to remain consistent with 2012.

Additional guidance will be provided at a later date when we have more clarity regarding our book tax accounting position. The ultimate outcome of our book tax accounting position will have no impact on cash taxes paid. We do not expect to pay any significant amount of US federal taxes in the next several years.

Specifically, to Q1 2013 guidance is as follows: we expect net sales to increase by about 10% compared to Q1 2012 and we expect net loss per share to be in the range of $0.07 to $0.09 which includes a tax benefit at a 37.5% effective tax rate compared to a net loss per share of $0.14 in Q1 2012. Q1 2012 results did not include a net tax benefit related to the period operating loss.

I’d like to spend another moment on guidance and taxes. Remember, in 2006 and subsequent years the company recorded reserves against its deferred tax assets. In 2012, a portion - $20.3 million or $0.29 per diluted share – of these reserves were released at year end. As a result in 2013 the company will report for book taxes purposes tax expense or benefit at an effective rate of 37.5%. In addition, the company had remaining reserves against its deferred tax assets of approximately $70 million at year end 2012.

Of importance is that we will be reporting normal provision for taxes in 2013 but in addition we will review the remaining valuation allowances in the later part of 2013 to determine if these reserves are still necessary. If they are deemed to be no longer necessary this would have a significant impact to the current-year tax line. Last, for comparability purposes at least in our models we normalize taxes for current and historical periods using a 37.5% effective tax rate. We believe this practice excludes swings to changes in tax positions and promotes comparability year-on-year.

In closing, as we look to 2013 and beyond we are very encouraged and believe that we are well positioned to grow our earnings and deliver strong cash flow growth. We are the leader in children’s educational entertainment with a brand that parents and children love and an exceptionally strong product portfolio. We have the market-leading products and exciting new product launches in 2013.

Our strong product portfolio, together with disciplined growth and expense management positions us well for continued growth. That concludes our prepared remarks and we would now like to open the call for questions. Operator, who would like to ask the first question?

Question-and-Answer Session

Operator

(Operator instructions.) Your first question comes from Lee Giordano with Imperial Capital.

Lee Giordano – Imperial Capital

Thanks, good afternoon everybody. Can you talk a little bit more about the economics of the third-party content that’s being developed out there and added to your apps versus your internally developed apps? And then can you also remind me what percentage of your content right now is exclusive to the LeapFrog platforms that you can’t get anywhere else? Thanks.

Ray Arthur

We generally don’t get into the economics of our third-party content. I think suffice it to say at the end of the day we have very little development costs related to that third-party content and so when we do make a sale of it that does fall to the bottom line. I think though the more and more third-party content we do sell, that could put some pressure on the gross margin percentage but the gross margin dollars will go up.

Lee Giordano – Imperial Capital

Okay. And then you’ve talked in the past about getting gross margins into that mid-40% range. What do you see as the potential timing for achieving that goal and could margins potentially go even higher over the longer term? Thanks.

Michael Barbour

I think when we talked of that before it was before we moved into the digital distribution business. So I think as you look at gross margins our business is going to be made up of quite a complicated mix of products. Of course when we sell more cartridge content our gross margin goes up; we sell more hardware traditionally our margin comes down a little bit. We sell more digital content we develop ourselves it goes up; we sell more digital content that we distribute, it goes down. And I think when you look at that it’s going to depend on how our business develops across those mixes. But it is important as Ray mentioned, the more third-party digital content that we sell the likelihood is our gross margin will decline but our operating profit should increase. Hopefully that helps.

Lee Giordano – Imperial Capital

Yeah, that’s helpful, thanks a lot.

Operator

Your next question comes from the line of Gerrick Johnson with BMO Capital Markets.

Gerrick Johnson – BMO Capital Markets

Hey, good evening. Can you talk about mix, hardware/software/standalone? Was that mix roughly the same as [Q4 2011] or was it materially different?

Ray Arthur

It was approximately the same. No huge swings between year-on-year. The one thing that was, was we did have a little more hardware sale because it wasn’t as scarce as it was the prior year and we were chasing to catch up with production. This year we were in a much better inventory position going into the season.

Michael Barbour

Yeah, and also I think the other thing that changed the mix a little bit, Gerrick, was we showed a lot more accessories this year. So it’s really interesting – if you look at the add-on purchases to a piece of hardware, when you add the content and the accessories together our add-on purchase business increased. But we sold more LeapPads as everybody knows, and the product unfortunately we satisfied… You know, it’s kind of interesting – everybody was concerned about our inventory number at the end of Q3 but in the end I think it proved a wise investment because we satisfied a lot more demand this holiday season than we did the year before but we also drove more add-on purchases, and we drove more digital sales on the back of that as well.

Gerrick Johnson – BMO Capital Markets

Okay great, we like accessories. Can I just ask you something on the balance sheet, Ray – inventory grew 18% yet your payables declined 9%. What’s the dynamic going on there?

Ray Arthur

It’s just timing of payments. There’s nothing fundamentally changing. The inventory that went up just so you guys know, that was basically we had originally planned to bring that in in ’13 and kind of pulled it into ’12 so it’s actually coming in and going out again. It’s not sitting in our warehouses.

John Barbour

Actually if you look at our inventory carryover year-on-year, a higher percentage of it is LeapPad product onboard sort of components planning for Q1 and Q2 business. The rest of the inventory is actually down year-on-year across our brands.

Gerrick Johnson – BMO Capital Markets

Okay, sounds good. I’ll get back in queue, thank you.

Operator

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

Drew Crum – Stifel Nicolaus

Okay, good afternoon everyone. Ray or JB, can you talk about some of the key drivers of sales growth for 2013, not getting into the quantification but just talk about some of the qualitative drivers behind the guidance you’ve provided?

John Barbour

For 2013?

Drew Crum – Stifel Nicolaus

Correct.

Ray Arthur

It’s continued success of our existing product line. It’s the introduction of our Tag replacement that’s going to help drive us. It’s in continued accessory growth that will push us forward as well as we believe more and more content sales that’ll help drive sales.

Michael Barbour

Yeah, and we’re hoping to get a little bit more from our toy business. I mean our new introductions for 2012 for the toy business were a little bit disappointing. We had some older products that were coming towards the end of their life and I think our toy introductions for this year are going to be pretty exciting including our new iPhone/iPad activity products which have already had some pretty rave reviews in pre-shows.

Drew Crum – Stifel Nicolaus

Okay. JB, there was a question earlier about the economics on your software. Maybe to ask it differently can you talk about the content pipeline and what you have planned for 2013, what that mix looks like – original IP versus third-party?

Michael Barbour

If you look at it right now, if you sit and look at our business broken down in terms of physical content and then you break it down in terms of digital content, our goal here is to aggregate everything that is great in educational entertainment. So our people are out there talking to media companies on the content that they have; we’ve now got 30 partners that we have their content on our platform and we plan to significantly increase that again this year.

Every piece of content that we have on our platform has to be reviewed, has to be selected; or if it’s our content has to actually be developed by a child development expert. And as we develop that business, a lot of the mix of that business is really going to depend upon what’s happening in the media marketplaces across our multiple brands and as we go forward. My expectation would be the third-party content would increase an overall share in that business but it’s interesting – it’s not increasing as fast the share as we expected quite simply because our own in-house studios and production team have come up with some really great content for that platform and because of the profitability we can invest in that more than other things we’re doing.

So I think we’re going to see great growth in our content business. The other thing that’s out there that’s most surprising to people has been the success of our cartridge content. I know a number of people on the call have been saying for the last two years, “Oh my goodness, digital content is going to kill cartridge content,” and you know what? I mean it’s incredible to think about it and it’s just amazing, but the number one selling product last year in America was educational entertainment content from LeapFrog. And that is just something that we’re incredibly excited about and incredibly proud of.

So our digital content is still selling exceptionally well and it’s easier for moms to be able to take out a cartridge and move across systems, and moms don’t want to spend the time being the head of IT at home. So we’re super excited about the content that we’re developing, the content that other people are developing for our platform in terms of games and books and software, and other pieces of content that are working out there and working partners with. We see content continue to grow as a share of our business – that’s part of our transition from being an educational toy company to being an educational entertainment company. When we said that two years ago I think people saw where we were going but now you can actually see the results of that transition and that pivot in our business.

Drew Crum – Stifel Nicolaus

Okay, thanks guys.

Michael Barbour

You know, one of the other things that I think is kind of interesting in our business that most people don’t notice is that we’re also media partner agnostic. So we have content on our platform from Mattel, from Hasbro, and from other companies that people would sometimes look at us and say “They’re competitors.” They’re not competitors – they’re media partners of ours, and we’re just out there looking for everything that is best in children’s educational entertainment. And that’s our total drive here rather than looking at different companies based upon old-world thinking.

Operator

Your next question comes from the line of Mike Swartz with Suntrust.

Mike Swartz – Suntrust Robinson Humphrey

Hey, good afternoon everyone. Maybe if we can just take a step back and just look at how the competitive environment ended up playing out in 2012 maybe versus your expectations going into ’12, so that would be the first part of the question. The second part is how do you see the competitive landscape shaping up in 2013?

Michael Barbour

So you can imagine, as we talked in Q3 we were kind of interested to see what was going to hit the marketplace. And we’ve always believed that we’ve got the best combination of hardware and software in the marketplace but we were a little apprehensive because we’re going against some pretty big companies out there. But you know what? You can see it in the results. You can see the results and just the fact that if you look at the US we had the number one, the number three and the number four selling product in America. Consumers voted with their pocketbooks and I think you can see the fact that that combination of a tablet that has been specifically designed for children, rather than a repurposed tablet; and then backed up with the best selection of quality educational entertainment in the market really does play in the marketplace. And there’s nobody out there with anything close to what we have as a business here right now.

And it’s interesting – you know, we had all the ballyhoo through the holidays of “Oh my goodness, somebody’s launching a new tablet and it’s going to really take share from us.” And you know, the reality is it didn’t, right? So when you sit down and you look at the marketplace and you look at the market that we play in which are kids 3 through 6, 7 years old we believe that we have a significant market share in that marketplace that we’re going to continue to innovate behind and develop; that we see opportunity as we go forward. And to be frank, I think the rumors of our demise last year because different people were launching tablets were vastly overstated.

Mike Swartz – Suntrust Robinson Humphrey

Okay great, and then just a follow-up. What was your POS in the quarter? I think you said it was up strong but did you actually quantify it?

Ray Arthur

No, I didn’t give an actual number.

Mike Swartz – Suntrust Robinson Humphrey

It is safe to say it was ahead of your US sales growth?

Ray Arthur

I wouldn’t quantify the number. We saw strong POS rolled into a nice clean inventory as we believe it is going into 2013. We’re really encouraged by it when you consider the overall US toy market was down.

Mike Swartz – Suntrust Robinson Humphrey

Okay great, thank you.

Operator

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

Sean McGowan – Needham & Company

Hi everybody. I’ve got a couple of questions and then I want to ask you to clarify something that was in the release. First, you listed in terms of the drivers in Q4 I think you listed content first even before LeapPad sales. You mentioned the quadrupling in the digital downloads and yet only a 20 basis point improvement in gross margin. I would have thought that that kind of content outperformance would have driven gross margins higher. Are you seeing that you’re not getting the gross margins on content that you thought you would?

Ray Arthur

No, that’s not the case but when you look at hardware, it’s such a larger dollar item, right? When you look at a piece at $99 and then you look at content as a $25 item, when you’re selling a lot more hardware and content than you did before that’s just the way it mixes out. But no, I think the margins that we’re seeing on our content whether it be cartridges or whether it be digital is approximately what we had expected.

Sean McGowan – Needham & Company

Okay.

Michael Barbour

And the other thing to remember is of course we’ve got a tail, so that’s the greatest thing about this business is we get the tail of content purchases through this year for the hardware that we sold at the holiday season.

Ray Arthur

And lastly I’d say I mean you’ve kind of got to look at content and hardware and accessories together because it’s really a one business there.

Sean McGowan – Needham & Company

Right, I just wanted to make sure that you weren’t seeing you know, degradation of margins on the software.

Michael Barbour

No, absolutely not.

Sean McGowan – Needham & Company

Can you talk a little bit about what’s different about the Learn to Read product or is that something that’ll wait till next week?

Michael Barbour

Next week.

Sean McGowan – Needham & Company

Okay. And when we get to next week you’ll just give us a little hint and say “Come back in June.”

Michael Barbour

[laughing] Actually no, this may surprise you but we’re actually going to show you the product. But we’re not going to show you our new tablets. With that one we are still very determined. We’re super excited by the tablets we have for this year and you’ll see them in April in New York like everybody else…. Or is it June? Sorry, June, I’m being optimistic. You’ll see then in June in New York and we’ll show you those there, and again, I’m sure everybody will be very excited when they see them.

Sean McGowan – Needham & Company

Okay. And in the release you mentioned the app activity toys. I just want to be clear that you’re not talking about making your content available in the app marketplace. You’re talking about a separate standalone product that’s these activity types of things that we’re seeing, not that it’s like anybody else’s but we’re not talking about making content available on iTunes, right?

Michael Barbour

Well, we actually have content available on iTunes.

Sean McGowan – Needham & Company

Right, but you did already. You’ve talked before about that not really being a very attractive option for you so I didn’t know if that signaled a switch.

Michael Barbour

I think we’re like most other companies in the fact that we have content on there and it’s a tough marketplace to make any money on it. On the other hand, there are companies out there that have developed some really interesting products that work with an iPhone or work with an iPad and it’s a hardware/software combination. We’ve got two products that we’ve got that we’re going to show and we are super excited about that. We think they’re both really interesting market segments. Again, we showed them to the trade and had a really good response to them. They’re pretty special.

Sean McGowan – Needham & Company

Okay, great. Thank you.

Operator

Your next question comes from John Taylor with Arcadia Incorporated.

John Taylor – Arcadia Inc.

Hi, congrats on a great year.

Michael Barbour

Thank you.

John Taylor – Arcadia Inc.

So I’ve got a couple of questions. Could you talk a little bit about the standalone toy business, and I wonder if there might be a little bit of gross margin erosion as it related to that because it sounded like a pretty weak segment, weaker than you expected. And what’s the channel inventory situation like, have you already sort of taken the haircuts on that product that you need to? Can you talk about that a little bit?

Ray Arthur

Sales in Q4 were down 11%. I think we’ve taken care of any issues that we have within the business so I don’t think there’s any overhang going forward. But we just, I think with the rest of the industry we kind of rode that trend in the toy area. So I don’t expect any hits coming from that (inaudible) and stuff like that.

John Taylor – Arcadia Inc.

Okay good. And then I was confused – did the French language products ship in ’12 or is that in ’13?

Michael Barbour

’12. We launched it last year and it was a virtual sellout in the marketplace.

John Taylor – Arcadia Inc.

Okay, great. So are you likely to do a new language in ’13 or did you say that was going to be in ’14?

Michael Barbour

’14.

John Taylor – Arcadia Inc.

’14, okay. Alright, and then I wonder if you can go up to 30,000 feet and talk anything about the B2C metrics of you know, your direct relationship with mom and the whole online experience? Sort of building on the learning path thing you guys invested in a few years ago – can you talk about how productive that channel is in terms of pushing product or motivating people?

Michael Barbour

Yeah, I mean we’ve always seen that connection with parents as a really important asset. Another example is over 800,000 likes on Facebook. We’re very active and social; we’re very active in working with parents, caregivers and teachers. We see it as a real important asset as we drive forward. It is an area that we’re going to make significant investments in 2013 behind. We feel there’s a real… In the level of communication that we’ve had so far we feel there’s a really interesting opportunity of building deeper, richer, broader service relationships with those customers.

As you can imagine, having out there that number of connected customers, it allows us and will allow us going forward to actually I think build more effective communication and more cost-effective communication with those families. And it’s been something that we’ve taken advantage of as we launch new product, as we test new product and as we launch new titles. It’s been a great asset for us.

John Taylor – Arcadia Inc.

Yeah. Would you say that’s one of the reasons you had the sales ratio coming down or was there a volume pop that just sort of absorbed your investment spend in advertising in Q4?

Michael Barbour

So what happens is that we’re really lucky that we have Greg Ahearn here because he just brings so much experience from his old life in terms of integrated marketing. So what Greg has done here is really helped us focus on developing these broad-based integrative campaigns, so it’s really making social networks along with our email, along with our TV, along with our PR – getting consistent messaging across. It’s something that we weren’t always firing on all cylinders there. He’s brought an immense amount of discipline to that in our business and that’s the reason why at the end we’re constantly reading our POS numbers and we manage to save some money towards the end of the year – that was a pleasant surprise for all of us.

John Taylor – Arcadia Inc.

Okay, great. Thank you.

Operator

Your next question comes from the line of Ed Woo with Ascendiant Capital.

Ed Woo – Ascendiant Capital

Hi, congratulations on a great year. I was of the view that with the [stock acquisitions] that there could have been more sales you would have chased.

Michael Barbour

So you know, there was opportunity for us to sell more product. We had one major retailer in the office yesterday who was complaining about the amount of business that they left on the table because we were short on product towards the end of the year. I think that’s always a challenge. We’ve been bluntly honest on these calls with people that we dial in a number, we work with our partners and we create the best estimate possible. I think we did a vastly better job this year than we did the year before but you’ve got to remember we had a lot longer time to prepare this year than we did last year. Last year we launched the product just at the end of the summer and therefore had a lot fewer reads to be able to read what was going to happen.

But yeah, I believe that we left an amount on the table. It’s always tough to make sure you’ve got the right amount of product in the right stores in the right location, and it’s tough for all of us. But I believe that we satisfied a lot more of the demand and the demand that we didn’t satisfy we’re satisfying now as we move into Q1.

Ed Woo – Ascendiant Capital

It’s good to see that your guidance for revenue will be up for Q1 after last year’s Q1 [when you didn’t have a lot of product in hand]. Is it a matter of again acceleration after the holidays or is it that you guys are able to manage the production supply side better to be able to put product back on shelves?

Michael Barbour

We’re managing supply. I mean we did… I’ll be frank. We did rob a little bit of our Q1 volume to satisfy demand in Q4. That’s always a piece of flexibility we’ve got and we’re chasing inventory right now. I mean there’s still a lot of demand out there. As soon as the LeapPad hits our warehouse today it immediately gets shipped out to our retail partners. So there’s still a demand for LeapPads out there and we’re still chasing product, and we plan to stay that way through the year. We’re going to be hopefully chasing product for quite some time.

We are very excited about the opportunity ahead of us in 2013. Last year, you know, we’d been in the marketplace for six, seven months and we were apprehensive and concerned about what was going to happen. And in the end we’re excited about the results we got and we’re going to build on them this year.

Ed Woo – Ascendiant Capital

Great. And then the other question I have is you mentioned your iPhone applications. Do you see this as possibly broadening in terms of more development on iPhones and Android systems to have some of your learning educational content on different platforms? Or is it still something that you’re just targeting for very specific applications?

Michael Barbour

So it’s interesting. With our pivot to educational entertainment, it actually opens up many new doors for us as a company to develop other ecosystems and other platforms. So the ability to create these entertainment experiences for children that kids find really compelling and engaging and fun, and then by building in a proprietary curricula in scope and sequence into them there’s many other broader opportunities and businesses that we can go into as we develop.

You’ve just got to look at the installed base of iPhones and iPads out there and see the type of opportunity that exists out there for really top-quality experiences in education. The challenge actually for many parents, and they tell us this all the time, is they go out to some of these new systems and you know what? To be frank, you or I could develop an education app and stick it on some of these platforms with absolutely no education at all and still sell it for $0.50, and potentially make a lot of money. But it’s not going to deliver much of an education experience for children.

The app world is still very much a Wild West. So we’re big believers that there’s a lot of demand out there for really true educational entertainment product, a product that the kids love to play in and is going to deliver that life-changing education. And you’re going to see more things from us as we move forward and diversify our business, moving into other areas of children’s entertainment and other platforms and ecosystems that we feel we can put the LeapFrog magic in.

Ed Woo – Ascendiant Capital

Just out of curiosity, do your contracts with some of the media partners allow you to import your software from LeapPad into the Apple store or the Google store?

Michael Barbour

We wouldn’t really comment about contracts at this time. Sorry, Ed.

Ed Woo – Ascendiant Capital

Okay, no problem. Well thank you and good luck.

Michael Barbour

Anytime, thank you.

Operator

Your next question comes from the line of Jim Chartier of Monness, Crspi, Hardt.

Jim Chartier – Monness, Crespi, Hardt & Co.

Hi, good evening. My first question on the gross margin, was there any impact on the gross margin from the product transition in Q4 similar to what you talked about in Q3?

Roy Arthur

Nope, none to speak of.

Jim Chartier – Monness, Crespi, Hardt & Co.

Okay. And then Q1 last year I believe you talked about some incremental retail programs to sell content. Are you doing anything different this year in terms of your content programs at retail?

Michael Barbour

Yeah, I mean most of our retail partners moving into Q1 had programs to drive content sales and accessory sales and you know, those are what’s going to hopefully drive our Q1 performance – those incremental displays. When you place as many LeapPads into consumers’ hands in Q4 it does create an opportunity as you move through this year to keep fresh content and offer new accessories for those products. So you’re going to see promotions across our retail distribution, not just in the States but across the world, making sure that our access to our content are out there in front of consumers.

Jim Chartier – Monness, Crespi, Hardt & Co.

Great. And any thoughts on share repurchases, what level of cash you feel comfortable with on the balance sheet before you’d consider doing share repurchases?

Ray Arthur

I think right now what we’re doing is looking at that cash as providing us the ability to go out and potentially either acquire some strategic assets or to help develop our international operations. So we are not looking at that as something that we’re intending at least in the short-term at redirecting towards return to shareholders or a dividend. That doesn’t mean that at some point in the future we might not do that but right now we feel we are in a great position with a great product portfolio and if we can find complementary businesses out there that we can fold into our environment that would be an excellent use for that kind of cash.

Michael Barbour

Yeah, we at LeapFrog, we’re in a different place than we were two years ago. We really believe that we have a clear vision of where we’re going, a clear mission and we are super excited about the future.

Jim Chartier – Monness, Crespi, Hardt & Co.

Thanks a lot, best of luck.

Michael Barbour

Thank you.

Karen Sansot

Good, well thank you everyone for joining us on the call today and please feel free to call Ray or me with any follow-up questions. Thanks.

Operator

This concludes today’s conference call. You may now disconnect.

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