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LeapFrog Enterprises Inc. (NYSE:LF)

Q4 2008 Earnings Call

March 2, 2009 5:00 pm ET

Executives

Karen Sansot – Director of Investor Relations

Jeffrey Katz – Chief Executive Officer

William B. Chiasson – Chief Financial Officer

Analysts

Anthony Gikas - Piper Jaffray

Gerrick Johnson - BMO Capital Markets

Sean McGowan - Needham & Company

Drew Crum - Stifel Nicolaus & Co. Inc.

John Taylor - Arcadia

Edward Woo - Wedbush Morgan Securities Inc.

Operator

Good afternoon. My name is [Lisa] and I’ll be your conference operator today. At this time I would like to welcome everyone to the LeapFrog Q4 and full year 2008 earnings conference call. (Operator Instructions)

Ms. Sansot, you may begin your conference.

Karen Sansot

Thank you. Good afternoon and welcome to LeapFrog Enterprises conference call to review the results of our fourth quarter and year ended December 31, 2008. I’m Karen Sansot, Director of Investor Relations for LeapFrog.

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; and anticipated 2009 financial results. 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 unprompted answers to questions posed.

A variety of factors, many of which are beyond our control, affect our results, performance and business strategy and can cause actual results to differ materially from those projected in such forward-looking statements. Some of these factors are described in our 2008 annual report on 10-K to be filed with the SEC this month, 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.

With that, I will turn the call over to Jeff Katz.

Jeffrey Katz

Thanks Karen and I’d like to welcome you all to our call. Thank you very much for joining us. 2008 as you all know was a year like no other that we have seen, not in my generation of management nor our predecessor’s generation of management has seen such a thing.

Today I’m going to be reporting on our results and our approach to 2009 but I also am going to tell you how we saw the year. I’m going to tell you those things that we view that went right and those things that I would do differently if I was clairvoyant and could have foreseen more than I did.

With that in mind, my comments are going to go a bit longer and a bit deeper than what you may have heard on some other calls. I hope for those on the East Coast that’s okay. To me it seemed necessary.

So you’ve seen our release and you know that our fourth quarter was impacted by well known economic factors that were unusual in scope and dramatic in the speed at which they accelerated. Many in our industry said, “Toys are resilient. Christmas will come. It always does.” But overall retail traffic declined on year-over-year basis at an accelerating pace into December at least according to Department of Commerce data.

Exchange rates worsened throughout the period. Christmas really did not come until about December 23rd as we measured it and percent off in many categories and certainly for electronic learning became the most important marketing message above all others. And yet LeapFrog we had what I would call a fair year in the United States. We grew sales. We increased our brand preference and product purchase intent scores. We improved our gross margin. We reduced costs. We rolled out several new products including one very strategic winner, Tag. And we estimate that we grew share in our electronic learning category of toy products. And importantly we improved cash flow significantly.

But we also had products that did not work as we had hoped. We had sell through campaigns that were less effective than we anticipated and some of our higher priced items were beyond the price range of today’s cash strapped family. And we were late, late, late to the discounting scene and thus spent too much on advertising media and not nearly enough on price promotion.

All of this resulted in 2008 operating results well below expectations and high year-end inventories which will impact the first part of our 2009 performance. And that, ladies and gentlemen, is a very bitter pill to swallow.

Here are the facts for 2008. Sales increased 23% during the first nine months of the year as we launched our first 4 web-connected products, a new content library and the Learning Path. Initial retailer feedback on our new product lineup was terrific and we entered the holiday planning season with robust plans with retail for sell-in. We shipped according to those plans at the end of the third quarter and into the fourth quarter before we really understood the severity of the economic situation and its impact on the consumer.

To be clear, our products were fully built by early September and its our sense that the severity of the recessions’ impact was not fully grasped by us and many retailers until at earliest October and on some product categories and for some retailers considerably later. In the end we over built and we over shipped based on what we thought November and December would look like and in hindsight we should have reduced prices fast like some of our competitors did, particularly for our core Leapster line and for Didj.

We should have skinnied back media spend and increased discount and trade support far sooner than we ultimately did. And our minimum advertised price policy also as it turns out hindered retailers’ ability to be as tactical as they might have chosen to [been].

Having said that, hindsight is wonderful but it is patently unclear how much better a different plan would have worked. Simply put, we could not compensate for all that confronted the business and fourth quarter sales were weaker than expected. Net sales for the fourth quarter were $138 million, down 24% from the prior year and net loss for the quarter was $0.70 per share compared to a net loss of $0.52 in the prior year.

For the full year 2008, net sales were up 4% to over $459 million and net loss narrowed 33% to $68 million or $1.07 per share. We are disappointed that the current economic crisis has delayed the growth we were experiencing from the launch of our new product portfolio. Nevertheless, the fundamentals of our business are moving in the right direction regardless of the bad consumer economy. The changes we implemented in 2008 have helped substantially narrow our losses and restart our reading business. We have sharpened our differentiation through our Connected and Learning Path strategies and we have boosted gross margin.

We achieved a number of important milestones in 2008 and I want to reinforce what you may already know as they are real indicators of our progress. As planned, we’ve successfully brought to market a portfolio of new and innovative products in 2008 including three highly compelling Connected products; our Tag Reading System, which won Educational Toy of the Year in the United States, in Australia and in France; a web-connected version of the original Leapster called Leapster2 and the Didj Custom Gaming and Learning System.

These products drove 7% growth in U.S. sales or 11% when we exclude the school segment year-over-year. A good number, I think, given the market followed in the fourth quarter and a good number considering the provisions we have booked to reflect our inventory overhang and other items in the market as the year ended.

Tag has performed well, beating our internal sales plan for the year and delivering tie ratios that have exceeded those of our former hit product LeapPad; 2.8 in year one for Tag versus 1.6 tie ratio for LeapPad in its launch year. Reading, which five years ago dominated our business at over 60% of sales is back, it is growing and that is because of Tag. Tag is one product, perhaps the only product, in a range that did well with virtually no discounting on the hardware throughout the season.

Our educational gaming business was also a strong performer for the holiday season and remains a leader in its category. For the year we generated our highest ever sales of educational gaming handhelds and software led by Leapster and Leapster2. Didj contributed as well, but I’ll say more about that in a moment.

Web sales, a major focus area for 2008, grew about 20% from last year; a favorable result but still even on the web we felt the effects of economy in the fourth quarter. Content was a big area for us in 2008. Content is as you well know really our best opportunity to drive margins and mitigate the seasonality of product sales. The driving content to be a bigger part of our business was and will continue to be a top priority.

We’re pleased with the scope of our library; 22 Tag books, 33 Leapster titles and 11 Didj games plus there have been hundreds of thousands of micro-mod awards downloads to Didj and these numbers will get bigger. We’re pleased with the quality of our licenses from Star Wars to Pixar to Indy to Seuss and so on. Software sales reached $101 million, up 7% for the year, 29% sales overall.

And now that we’ve implemented our Connected strategy and we’ve launched Tag, we expect to be able to drive this number upwards more than ever. Our proprietary Learning Path while not a major part of our marketing campaigns in 2008 has already become one of LeapFrog’s key differentiators and it will move much more front and center in 2009. We now have more than a million connected consumers with whom we have the opportunity to communicate relevant content or product upgrades that are fit to what their child might need each time that consumer connects or if they signed up for the Learning Path each time our database suggests their child is ready for a next learning step.

We know that a Connected consumer is worth about 70% more to us in sales than someone who simply buys our products online and we know that a parent who has gone all the way into the Learning Path detailed pages, which is about 40% of the total, is worth more than 10x that value. By the end of 2009 we expect to have over 3 million Connected consumers. We think there is substantial value in our Learning Path Ecosystem as we call it and therefore a key part of our 2009 plan is to emphasize investments in developing, marketing and monetizing the Learning Path.

In total, consumer feedback on our new products and the Learning Path has been positive. The research and the consumer review data would say very positive, especially so for Tag. Bringing these great new products to market successfully was our biggest achievement last year but let me be clear, we did have some misses. First this was the wrong year to go light with new toy introductions. The relative absence of new toy products or SKUs and a particular bias towards higher priced platform products clearly hurt us. If we had had more toy SKUs at entry price points and if we had had sharper price points on our existing toy line and other products such as our platforms we would have seen a better top line and better sell through performance.

In 2009 we are introducing an expanded line in the learning toy area including our well received Scout line of products and at prices ranging from $17.99 to $24.99 we’ll have more low price points in the range than we’ve had in quite a while.

Didj. Didj got good reviews from consumers and showed strong Connect rates. In fact it has our highest Connect rate of any product which should suggest to us it could eventually generate the best tie ratios. But its price point launching at $89 was way, way too high and because of that it fared less well than the Leapster franchise and beneath our expectations with few exceptions. Also in the budget cutting that occurred in the latter part of the year we should have spared investments in media for Didj which addressed the kid rather than the parent audience, as this would have helped the nag factor which did prove successful in other categories of toys.

Finally and also in perfect hindsight we age graded this product at six to ten, too high for current trends in the toy aisle. But we know now that five-year-old kids are playing Didj. In fact, 45% of Didj kid users are five years of age. And even four-year-olds are playing with Didj as are kids who have grown tired of Leapster but whose parents still want a fun learning product for them.

And these kids love Didj and tests show they love it even relative to the juggernaut known as DS. So where to with Didj? How do we get much better sales performance for what is a very good learning product?

We have since reduced our price on Didj from $89 to $79 suggested retail and there has been some and I’m sure there’ll be a lot more promotional activity that is happening below that. And we’re seeing good sell through at this point. Next we’ll fix the packaging on in-store product to the degree that we can and on new shipments to say “5 plus” instead of “6 to 10” which the data show will help a lot.

Finally and very importantly we’re going to use our quite large database to market Didj as a perfect complement to Tag since its customization and high graphics resolution and now its lower price should prove attractive to Tag kids and their parents. That campaign began last week and will drive against a coupon which is redeemable at retail and I look forward to seeing how it does. But the price is better, the product is excellent and other improvements in terms of retail merchandising ought to boost the sales performance of this product through the year.

A word about international, it declined primarily because of the strengthening of the U.S. dollar and the international recession. We are not where we need to be in international nor where I expected to be candidly. In future calls and presentations I will be saying more about our plans and results. Principally I would say that this is going to take more time given the world’s economy, but for now we’re going to cut costs significantly to get our contribution from these markets in line and we are going to go back to work to make our platforms, particularly Tag and Leapster, to make their platform penetration grow.

And we have a lot of work as well to get content sales where we need them. Our progress here has been too slow but we get it and we’re addressing it.

Looking ahead we expect that inventory overhang from the fourth quarter combined with the weak economy will result in soft shipment levels in the first part of 2009 and as we sell through remaining product. The good news is that so far in the current quarter we have seen sell through volumes exceeding last year which reflects well on our product demand and we hope bodes well for the 2009 holiday season as hard as that may be to believe, sitting here today.

Let me spend a few moments then on 2009 before asking Bill Chiasson to review the financial details and our outlook. According to our research, we entered the year 2009 with a brand that measures stronger to competitors than it ever has in our category. Recent Wall Street Journal articles suggest that when times are tough, it is the valued brands that perform better. We hope that is true but we feel great about the brand in any case. We entered 2009 with great products. Tag is the consumer winner and Educational Toy of the Year and it is generating tie ratios beyond the best product ever in this category, our own LeapPad.

We have numerous pricing and merchandising fixes, some of which I mentioned above which are being implemented now to quicken sell through performance and to strongly address any competitive threat. Leapster and now Leapster2 are category leaders and they are selling well. With our Learning Path strategy we expect to improve tie ratio. Both Tag and Leapster2 will see product and marketing improvements later this year. In other words, our best products will get better.

We’re expanding our content library; more scope, best licenses. Our learning toy line will improve as will the range of price points, in particular what we would call low price points will improve quite a lot. And we’ve moved some of our upcoming launches selectively. We’ve moved them early to get the sales ball rolling with consumers and with retailers earlier than we typically would.

Our mantra for this year? Sell more Tag, sell more handhelds, sell more content, create Learning Path connections. If we do this we’ll drive margin, we’ll drive content sales, we’ll drive more engaged consumers.

But there is more. Some of our new products like Tag Jr. and Scout are getting terrific retailer feedback despite the economy. Zippity, co-branded with LeapFrog and Disney, is a fabulous new product. Its price may be an issue, but we will manage supply and we will merchandise this to make sell through satisfying for retailers and it will make consumers happy. It’s a fabulous product. It is innovative and we’re proud as can be of this truly new kind of play and learning form.

We have cut costs to deal with the reality of the global recession. We will do more if we need to and we will keep our product pipeline full.

Operating earnings and cash flow even under pessimistic assumptions will improve. And now with that introduction I would like to turn over the call to Bill Chiasson, our Chief Financial Officer and he will go into the financials in some detail. Thank you Bill.

William B. Chiasson

Thanks Jeff and good afternoon everyone. Before going through the details of our 2008 results I’d like to spend a few minutes to discuss the impact of the economic crisis on our performance. Clearly our results for the year were significantly affected by the sudden and rapid decline in the economy, especially in the fourth quarter.

Specifically, LeapFrog sales increased 23% during the first nine months of 2008 as we launched our first four web-connected products, an expansive new library of content and the learning feedback technology that we market as Learning Path. The support from retailers and consumers was strong evidence of the success of the strategy that we initiated some time ago.

However, as a result of the chaotic macroeconomic environment in the fourth quarter of 2008, conditions changed. Our fourth quarter sales results were weaker than expected, declining 24% year versus year in the fourth quarter of 2007, which slowed our overall 2008 full year sales growth to 4% as retailers pulled back aggressively on their purchases in response to weak consumer demand.

Even as our shipments to retailers slowed down, the impact to the decelerated consumer spending was even more significant than that anticipated by most and retail inventories at the end of the year were higher than desired. In addition to the negative impact to lower sales, we recorded around $24 million in charges and provisions related to the recession that impacted our income during the year. The charges related to several items. We made provisions to recognize the costs associated with rebalancing retail inventories. This includes about $6 million from promotional allowances and $2 million to provide for sales returns.

We increased our allowance for doubtful accounts by $5 million which we believe is appropriately conservative a position given the continued deterioration of the global retail environment. We also incurred a charge of $5 million associated with the restructuring of the business and reducing headcount. We expect the cost savings from this restructuring will be about $10 million in 2009.

And in addition we also recorded a non-operating charge for the continued erosion of the auction rate securities we hold. Uncertainties in the credit and financial markets have prevented us from liquidating our auction rate securities. The fair value of these securities investments have declined by $8.4 million from their original cost value of $14 million and $6 million of the decline was recorded in 2008 alone.

Despite the general economic weakness, our balance sheet remains strong. We ended the year with a cash balance of $79 million and zero debt on our $100 million asset backed line. And as of the end of February we have cash on hand of about $90 million or $1.41 a share. Operating cash flow for 2008 was positive at $12 million which is an improvement of $27 million from last year and capital expenditures were $20.3 million compared to $27 million in 2007. Total cash use for the year was $14 million.

We believe much of the investment in the new products is behind us and in 2009 we’re focused on enhancing our reading, educational gaming and learning toy lines while further reducing our cost structure.

Now to go on to a detailed discussion of our 2008 results, net sales for the year were $459 million. That’s up 4% from the $442 million a year ago or 5% using constant exchange rates. Net sales in our U.S. segment were $363 million, up 7% from $339 million a year ago. The U.S. consumer sales were $347 million, up 11% due to the introduction of new products, while school sales were $16 million, down 39%. In 2008 we reduced our direct marketing efforts to schools given their severe funding cuts.

The mix of our U.S. sales was as follows. Platform sales were 43% in 2008 compared to 36% in 2007. Software sales were 29% in 2008 compared to 30% in 2007. And stand alone product sales were 28% in 2008 compared to 34% in 2007.

Our reading line was up 65% for the year, driven by the introduction of the Tag reading system and the educational gaming line was up 24% due to the sales of Leapster2, classic Leapster and Didj. Learning toys were down 34%, impact by fewer new products and competitive discounting in the fourth quarter.

International sales were $96 million, down 7% from $104 million a year ago. Excluding the impact of foreign exchange, international sales would have been down 3%. While the sales were up in Canada and Mexico, sales were down considerably in Europe which is experiencing a recession at least equal that in the U.S.

Gross profit for the year was up $181 million, up 5% from $173 million a year ago and gross margin was 39.5% up a bit compared to 207. The increase in gross profit was primarily the result of increased sales of new products with higher margins. These were partially offset by several items. First, the gross profit in the school business was down $8 million as we implemented the restructuring of this business.

We also incurred about $2.5 million to comply with the requirements for the Consumer Products Safety Improvement Act of 2008. This act requires that products that have excessive levels of prohibited materials be removed from material by February 10, 2009. It’s a dramatic new law that allows for no lead in products marketed to kids age 12 and under. To put this in perspective, if ballpoint pens were marketed directly to kids under 12, they would fail the test since they have some lead in their tip. That is why our compliance cost was primarily associated with the FLY Pentop Computer targeted at children ages 8 to 14.

Additionally as discussed earlier, we have recorded some expenses in our 2008 results in response to the chaotic economic environment. Specifically, we established reserves about $6 million in allowance to markdowns and $2 million for sales returns. Both items are intended to support actions retailers will be taking to reduce their inventories in 2009.

Operating expenses for the year were $242 million, down 12% from $274 million a year ago. We reduced our full time headcount to 633 by year-end which is down 26% from a year ago and its down 36% from levels about 18 months ago. Over the past two years, we’ve focused on reducing our cost structure by improving operational processes and focusing only on the most important strategic projects.

Selling, general and administrative expenses were $115 million, down 19% from $142 million a year ago. SG&A is down primarily due to the lower compensation costs which are down $12 million from 2007 and lower legal costs than in 2007. In 2007 we incurred a cost of about $11 million for the settlement of a patent claim. These cost improvements were partially offset by about $5 million in allowance for doubtful accounts and again we’ve taken a conservative position for doubtful accounts, given the continued deterioration of the global retail environment.

Also, we recognized a charge of about $5 million associated with the cost reduction efforts announced last November. These cost reduction actions are expected to drive about $10 million in savings in 2009. Research and development expenses were $48 million, down 18% from $59 million a year ago, due mostly to lower headcount.

As we completed the development of several new platforms, including the Tag Reading System, the Leapster2 and Didj handheld gaming systems, and the Learning Path web-based system, we’ve been able to reduce our cost structure by improving efficiency in our operations and eliminating unnecessary expenditures. This effort has included headcount reductions and migration of certain aspects of our product development cycle to external parties.

Advertising expenses were $67 million, up 5% from $64 million a year ago. We increased our ad spend in 2008 due to new product launches.

Our operating loss for the year was $60 million, a 41% improvement from the loss of $101 million a year ago. Other expense was $6 million, down $4 million of other income a year ago, due primarily to a $6 million charge for the impairment of the auction rate securities. The net loss for the year was $68 million, a 33% improvement from $101 million a year ago and the net loss per share was $1.07 compared to $1.60 a year ago.

Now moving on to the fourth quarter results, net sales in the fourth quarter were $138 million, down 24% from $181 million last year. As noted at the beginning of my remarks, the chaotic macroeconomic environment in the fourth quarter of 2008 drove retailers here in the U.S. and globally to pull back dramatically on purchases. Net sales in our U.S. segment were $105 million, down 22% from a year ago. The reading category was up 81% and Tag did very well and exceeded our expectations. Web sales were also up 10% but below expectations due to the weak economy. And both the educational and gaming toys product lines were down in the quarter, with learning toys declining 40% due to a tough competitive climate with discounting.

The school business, which is now part of the U.S. segment, was down 70% due to the strategic restructuring. International sales were $33 million, down 31% from a year ago and excluding the impact of foreign exchange, international sales would have been down 19%. Sales were down in most regions most notably in Europe.

Gross profit for the quarter was $48 million, down 29% from a year ago and gross margin was 35%, down two points from prior year. Impacting the gross profit decline from 2007 were the sales declines as retailers pulled back on purchases as a result of reductions in consumer demand. There was a $3 million decline in gross profit in the school business as we implemented the restructuring of this business. The $2.5 million charge to comply with the requirements of the Consumer Product Safety Improvement Act.

And despite the pullback of purchases by retailers in the fourth quarter, retail inventories are higher than desired and as a result we have provided for markdowns, discounts and product returns to support the retail efforts to rebalance their inventories. Combined, these resulted in about $8 million reduction to the 2008 gross profit. In 2007 also we incurred about $8 million in write-offs from discontinued products and our year-over-year comparison was favorable for this, since we didn’t incur a similar charge in 2008.

Operating expenses for the quarter were $87 million, down 11% from a year ago, primarily due to lower headcount. Selling, general and administrative expenses were $31 million, down 18% to lower headcount and related compensation costs, as well as some lower legal spending. These expenses were partially offset by the increases in the provision for doubtful accounts and the costs associated with the cost reduction efforts we announced last November.

Research and development expenses were $12 million, down 29%. As mentioned before, a great deal of the investment for our new product launches is already behind us. Advertising expenses were $40 million, down slightly from a year ago. We reduced our advertising budget once we realized consumers were pulling back in the fourth quarter. In hindsight, though, back in October we should have shifted spending towards retail promotions but didn’t see the severity of the downward sales slope.

The operating loss for the quarter was $39 million compared to $30 million in the prior year. And the net loss for the quarter was $44 million compared to $33 million a year ago and the loss per share was $0.70 compared to $0.51 a year ago.

Now turning to the balance sheet, we ended the year with $79 million in cash and no debt. Our net cash use for the year was only $14 million which is an improvement of $27 million over the prior year. And again we have access to $100 million asset backed line that expires late in 2010.

Inventories were $58 million, up from $52 million a year ago and higher than desired. Days inventory on hand was 74. The inventory we have on hand is first quality and primarily includes recently introduced products.

Our accounts receivable were $90 million, down from $127 million a year ago and the days sales outstanding improved by 18 days from 2007. Long term investments were $5 million, down from $11 million a year ago. The decrease is due to the write-off of the auction rate securities as we’ve reduced the carrying value of these instruments based on recent valuations.

Now looking out to 2009, the global economic downturn is one of the greatest difficulties currently facing all businesses. We believe this recession will continue at a minimum through most of this year and will impact retailer and consumer attitudes both here in the U.S. as well as globally. While we expect that there will ultimately be a recovery, we believe that it is prudent for us to manage through this environment with caution. We enter into the year with a healthy balance sheet and a strong liquidity position. We’re debt free and as of the end of February we have a net cash position of $90 million or about $1.41 a share.

We also have the asset backed lending facility which will be available to us through most of 2010 and this facility can grow up to $100 million of availability as working capital grows and again it is completely un-drawn.

Our priorities for 2009 are to strategically invest in core product lines such as reading, educational gaming, content, the lower price learning toys and Learning Path; to sell more Tag, Leapster and content and launch the new Connected products; to introduce the improved products in our learning toy line including our attractively priced Scout line and Zippity, our first co-branded product with Disney.

We will further reduce our cost structure and of course maintain the healthy balance sheet. We’re expecting sales to be down considerably in the first three quarters of 2009 due to the continued weakness in the economy and the related expectations that retailers will reduce their inventory levels across the board. Overall we expect a sales decline for the year.

As I mentioned, in 2008 we generated $12 million in cash flow from operations and investments were $23 million, and the net cash usage of $14 million. We expect to improve on this in 2009 and our internal plans are built around a breakeven net cash usage for the year, but given the lack of adequate visibility its challenging to adequately project demand. As a result, we’re not providing traditional guidance for the year.

We are taking several actions to achieve our objectives in this foggy environment. As noted, we’re scaling the business on the assumption that there will be a significant sales decline for the year and consistent with that expectation, we’re aggressively managing our cost structure. We expect to achieve sourcing savings emanating from lower input costs and product cost reductions achieved from working with our contract manufacturing partners in Asia. And additionally we have reduced our operating expenses by about 30% from 2008 levels and as part of this we’re focusing much of our marketing efforts towards retail promotion activity which we believe is important to the consumer.

In addition to reducing our costs, we’re focused on optimizing our product mix and price points. We realize the consumer has become more value conscious and as a result we’re adjusting our product mix accordingly. We’ve already reduced pricing for key products such as Leapster2 and Didj, and the recent point of sale trends have been encouraging. We’re increasing promotional support for retailers to allow for sharper pricing at retail and better in-store merchandising opportunities. We’re also allowing for the elimination of [mapped] pricing on some products to provide flexibility to the retailers.

In 2009 we have a more attractively priced line with Scout at $19.99, Tag Jr. at $34.99 and some learning toys below $20. There may be some margin impact from lower prices but by getting more products in the consumers hands we expect to benefit from higher software tie ratios, more viral marketing and greater connectivity. The result of having more products in consumers hands is that we’ll be in a better position when the economy turns around.

As a result of our conservative shipment plans, we’re also expecting to lower inventories and improve inventory turns in 2009. Capital spending is targeted to be around $15 to $20 million, down from recent spending levels of $28 to $25 million. We’ve made most of the significant investments we need to bring our product portfolio to market and view this as sufficient to support our long term plans. That said, we also realize that conditions can change for the better but they can also worsen. We’ve identified action items that’ll allow us to shift gears dependent on the changes to the outlook.

So net, even with very pessimistic assumptions for the year, we’re striving to improve on our cash flow performance by further reducing costs, introducing new products and content, and carefully managing our product mix and pricing.

And now I’d like to turn the call back over to Jeff.

Jeffrey Katz

Thank you Bill. So as you have heard and I’m sure you have heard in the marketplace we anticipate that 2009 will be another challenging year, certainly for top line performance and as I mentioned earlier and as Bill discussed we have taken actions to improve our products, to stimulate content sales, to sharpen price points where sell through velocity or competition warrant, and introduce new lower price point products into the learning toy line.

We have cut costs and we will do more if the situation in the world worsens beyond our expectations. And in the interim, our products for 2010 are already taking shape. Our plans for 2009 are in implementation mode and the best brand in kids learning and play still looks like a good place to be.

So with that I’d like to open up the call to your questions and I’ll ask the operator to let us know who would like to begin.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Anthony Gikas - Piper Jaffray.

Anthony Gikas - Piper Jaffray

Do you think that the economy was really 100% the culprit for the revenue shortfalls or did product performance or acceptance by consumers disappoint a little bit there? Second question, on the schoolhouse division is that still a priority for the company or as we’re moving into a continued tough economic environment over the next couple of years and school spending is still at risk has there been any more discussions about I guess shutting that side of the business down? And then on the operating costs, Bill, you said that operating costs would be down 30% this year. Is that in absolute dollars on a year-over-year from 2008 or that’s just the run rate that you’ve reduced?

William B. Chiasson

Why don’t I go ahead with the operating expense first. That would be absolute dollars for 2009.

Jeffrey Katz

Okay, Tony, to your question about the economy. It’s certainly a mixed bag. Let me try to give you some specifics. Look, I think Tag sold better than planned. It sold through about at planned with virtually no discounting to the hardware. I think that’s a good performance and we probably would have sold more if we had either been a little less hardnosed about discounting the hardware and given retailers a bit of flexibility on minimized advertised price. But I think it sold well for launch year. It certainly sold far more than LeapPad did in a launch year at better tie ratios but there probably was an upside to be had if we had been more tactical and had that opportunity.

Back to the economy, you know, look, there was massive discounting happening. And if you look in our aisle at our competitors, almost all in the gaming line in particular a big shortfall to our sales growth was actually Leapster plus Leapster2. And while Leapster2 was on a roll through September, very large double-digit year-over-year increases, when discounts started to put competitors products in our category underneath the price of Leapster or at the price of Leapster, that call it 40 or 50% discount comparables, you know the product names, that took a massive swath of sales momentum away from a high sales velocity product.

And you could call that recession or you could call that discount competition. I think we saw that – I think we reacted to it later than we should have. But at the end of the day, they’re doing that because of the economy I think.

And then there were certain products, Didj, you know, that I’ve spoken to where while it was never expected to be the size of Leapster that was more of a call it a marketing plan problem, came in with a price that was too high, with packaging that supported an age grade which you know was wrong for our aisle. And I would call that our problem.

But honestly, if I look at the core, Tag was a good performer and that was me. You know, we needed more Tag and we needed some Tag upside so it’s hard to be more definitive than that, Tony, but I don’t feel like this was an all in and executing problem. These products are good. Leapster is clearly best product in its category and selling well.

And when you look at what happened to sell through performance of that product in particular, up until competitors started to either under price or match price it with higher priced product, that really shows what happened when discounting began and to some degree we didn’t react.

Regarding school, and please if you want to ask a follow-up question, feel free; I’d like to try and clarify if I can. Regarding school, we’ve gone completely to a reseller kind of approach which means we do have product that sells into the schools both just consumer product that sells into the schools now through resellers. And some custom product which has been developed quite a long time ago which also sells into the schools from resellers, so I think we have very, very modest resources around that. Virtually no R&D in fact. I would say no R&D any more. And it’s just viewed as a small but alternate channel and as it works it should be a solid contributor but from an expense perspective we have minimal expenditures supporting it.

Anthony Gikas - Piper Jaffray

Looking at calendar ‘9 here what percentage of sales do you expect will come from new product, you know, that carry the higher margins, whether it was new product that was released in ’08 or the new product coming in ’09?

Jeffrey Katz

I think we would have to get back to you on that one.

William B. Chiasson

It’s going to be over 50% from introducing in ’08 and ’09 just because of the strength of the ’08 line and the new products coming out. So it’s going to be well over 50% but we’d have to get back to you, Tony.

Jeffrey Katz

I think still the higher margin products particularly Tag and software will be a higher proportion of sales year-over-year and notwithstanding or including the impact of the cheap learning toys that that’s probably what you’re trying to get a handle on. I think Tag and software will more than outweigh the margin implications of learning toys sales growth at lower margins.

Operator

Your next question comes from Gerrick Johnson - BMO Capital Markets.

Gerrick Johnson - BMO Capital Markets

Can you just explain the rationale for the map program? You touched on it in your comments but why was that implemented and also why did you stick to it so long?

Jeffrey Katz

Well, the map program as we call it has been around for quite some time so it was not new. We have sort of historically tried to create a policy that allowed for pretty healthy competition but some of these high performing products try to avoid going into the basement with pricing. And in the case of Tag it’s hard to say whether it was good or bad because it performed somewhat better than planned. We probably needed to have much better than planned performance but that would have compromised margins so I’m not sure where I’d come out on that even today. But it’s been around a long time.

I think we recognized given the harsh economic environment today that pricing gloves are off. That is part of what hurt us in 2008 and some of our high velocity sale product really got slowed down dramatically by competitor products, under pricing and sometimes it was another category, honestly. And we want to not hinder retailers flexibility to do what they think is best. They obviously have similar performance incentives although sometimes they’re not perfectly aligned, but generally speaking they’re aligned with ours.

So it’s a long term program. With Tag we didn’t want to undo it because it had been selling pretty well and at the end of the day what made this company successful was being able to sell a product like LeapPad that had wonderful margins. Tag has better margins. So we don’t want to give up on that principle that has worked in the past and it was starting to work this year until the wheels fell off.

Gerrick Johnson - BMO Capital Markets

Moving on to the marketing campaign, I think you mentioned earlier in your comments that the Learning Path may not have been a key marketing theme or a key advertised theme. Why was that and why didn’t you run more advertising marketing to get awareness of the Learning Path out?

Jeffrey Katz

Yes, yes. Well in terms of television campaign, I mean, Learning Path was obviously unpacked and once people connected we began communicating to them online. But to your point, we decided that Learning Path as a sort of matter of television campaign was sort of tough to convey. And what we instead wanted to do is make sure people knew Tag, what Tag was and why they should buy it. I think that worked reasonably effectively. We also wanted to continue to hype Leapster and Leapster software and I think at least research data shows that message was getting through.

Learning Path just struck us as a complicated thing to try and get across in year one. We could begin to market it online we thought more effectively and this year again you’ll see more PRPs if you will associated. It’s out there. It’s got literally hundreds and thousands of users engaged in it and growing. So it feels like this is a better year to do it.

Having said all that as I mentioned if I had had better forward visibility or insight I think we would have put literally more millions of dollars into a pure price message because that really seemed to be what was driving consumer behavior. And if not a message then certainly at retail more price support to just get things moving.

Gerrick Johnson - BMO Capital Markets

You mentioned Leapster, Leapster2 in there for a second. What was the main difference between the first Leapster and Leapster2 other than the Learning Path?

Jeffrey Katz

Yes, connectivity and online games is absolutely the difference. But you had a lot of price competition going on at $10 or so under Leapster, what we call Leapster classic. So I think selling a value message we saw was really – a functionality message if you will we saw as not working very well in 2008.

Operator

Your next question comes from Sean McGowan - Needham & Company.

Sean McGowan - Needham & Company

First, Bill, can I ask you to when you go through the various components of that $24 million of special provisions that had to be taken, could you go through how much of each one of those was recognized in the quarter versus for the full year?

William B. Chiasson

Yes. Of that $24 million, each of those was predominantly a fourth quarter charge. The one piece that had a portion that came before the fourth quarter was the impairment charge on our auction rate securities. I mentioned before that auction rate securities went down about $6 million for the year. Of that, $3.7 million was in the fourth quarter. The rest was in the first three quarters. Of those other items I mentioned they were all fourth quarter costs.

Sean McGowan - Needham & Company

Second question then, can you give us a snapshot at this point as so we can sort of digest some of this stuff what the operating losses were in the U.S. versus international division?

William B. Chiasson

We don’t have that here. We will certainly make that available.

Sean McGowan - Needham & Company

And you said the international was down 31% in the fourth quarter and in local currencies it would have been 19%.

William B. Chiasson

That’s right.

Sean McGowan - Needham & Company

Jeff could you talk to a little bit more to I think you put out a number there of how many connected customers you have. Was it 2 million?

Jeffrey Katz

It’s approaching 1 million now and we expect that number to be at year-end ’09 about 3 million.

Sean McGowan - Needham & Company

Now that would include some people who have more than one product, right?

Jeffrey Katz

It includes – no it’s actually if you have two connected products you’re still one connected consumer. Yes.

William B. Chiasson

Hey Sean, the loss from operations by segment for the U.S. was 55.8 and international was 4.3.

Sean McGowan - Needham & Company

Would you mind repeating that? 55.8 did you say for the U.S.?

William B. Chiasson

For the U.S. and international was 4.3.

Operator

Your next question comes from Drew Crum - Stifel Nicolaus & Co. Inc.

Drew Crum - Stifel Nicolaus & Co. Inc.

I wonder if I could just start with the topic of mix again. Just directionally where should it be in 2009 among platforms, software and stand alone?

Jeffrey Katz

We’re not going to provide guidance on those specifically but I would expect that software or content sales will increase in 2009 relative to the total especially since 2008 was such a heavy platform business. So expect to see relative hardware and software sales picking up. That said we also have some good launches in our learning toy line so should see some between software and learning toys improving in the mix overall there.

William B. Chiasson

We’ve been seeing software sales as a percent in the 33 to 30% of sales. With the big hardware launch here we expected to see it somewhat softer. So that would be what I would call a more normalized level. Obviously with our Learning Path strategy we would expect to see that boost somewhat higher. But I’m not sure at the one year trend.

Drew Crum - Stifel Nicolaus & Co. Inc.

And just to follow on to that is it fair to assume that stand alone becomes a larger percentage of the total given the new products you have coming to market in 2009?

William B. Chiasson

Yes, that may balance itself out, Drew, because you’ve got a number of things changing including software so yes we’d expect to see learning toys grow but also software sales relative grow.

Drew Crum - Stifel Nicolaus & Co. Inc.

And staying on the topic of content, Jeff, could you just update us on your planned rollout as far as titles for the various platforms in 2009?

Jeffrey Katz

See if I can – I’m going to give you a few things from memory. I may have to get the specifics back but I think at the end of – so we’re adding about 22 Tag books and at the end of 2009 I believe we’ll be up to I want to say nearly 40 Tag books. And Leapster will remain at just under 40 Leapster titles because we phase them out and we bring some in in terms of those that are actually listed versus in inventory. In Didj games we’re at 11 as ’08 and I think we’re going up to 15 or 16.

Drew Crum - Stifel Nicolaus & Co. Inc.

And just this last question that may be a longer term strategic question for you guys, when you talked about Didj not working one of the reasons behind that being age created a product. I mean tactically going forward do you guys skew away from that older age category and focus more on the zero to six age category? I mean just talk to us about strategically what you want to do going forward.

Jeffrey Katz

Yes. Well in our aisle, sort of electronic learning toys, that aisle has definitely gotten younger which is to say that moms and kids who have an interest at sort of above six are probably shopping for other kind of electronics products like Nintendo products or Xbox or iPod. So I think our view of this question, and we see this in Didj, right? We actually have six and eight year olds using the product. We can see that in the database. But the traffic that retailers are streaming through their aisles has gotten a bit younger than it was three to five years ago, at least for our products. I mean we used to sell product for eight and ten year olds in our aisle.

So I think that means yes, absolutely, sort of zero to five or six at the high end. But one of the things that we’re seeing now with Didj is we can actually market direct to a six and seven year old because a year previously they are a five year old Tag user or a five year old Leapster2 user. So with a fairly large database we can expect to have a certain volume product that’s marketed to direct and that traffic can go into retail or it can go to some other location to pick up the product.

But I do think the main point is yes, I think the traffic in the aisle has gotten a bit younger for our category of products.

Operator

Your next question comes from John Taylor – Arcadia.

John Taylor - Arcadia

First on the international side I think you voiced some dissatisfaction the way things turned out. Is there anything in particular on your action plan for ’09 that we want to pursue to address some of that?

Jeffrey Katz

I think the basics for us in ’09 are we’re going to be pretty focused on price competition, less head in the clouds than I was pretty clear we were for part of ’08. And also a lot of merchandising issues, I mean we had some obvious display issues in certain markets. [Woolworth] did hurt us as you can imagine, right? They were a reasonably significant player for us and not only did we lose some sell-in and sell through capability there but we also took a few charges related to their bad debt if you will.

So the main thing I think is going to be a lot about merchandising and shelf execution and there’s going to be a fair degree of price promotions this year.

John Taylor - Arcadia

Yes, because as I recall you launched the three platforms simultaneously around the world, didn’t you? So it’s not like you’ve got the delayed –

Jeffrey Katz

Yes, certainly Tag that was launched around the world and Canada to choose one international market did very well and in France less well. And I just think a lot of that had to do with our merchandising.

John Taylor - Arcadia

And then as you’re looking at the retail inventory situation, this is a two part question I guess. Number one, when do you expect to see the logjam break in terms of when you guys might get some reasonable reorders on stuff? So when does the retail inventory run off? And the second question is and it’s kind of related to previous questions about mix and so on, I mean, should we expect the first and second quarter to be fairly heavy in terms of software given the install base bump and the fourth quarter, third or fourth quarter load in of new product kind of thing?

Jeffrey Katz

Yes, let me take the first piece on the retail inventory. Clearly retailers are going to be bringing down their inventories in the first half of the year and well into the third quarter as well. So we expect to see that continuing for a sizable piece of the year and impacting our shipments in during that same time period. The second question was related to the content sales because of the platform base that’s in there and our – we are seeing strong content sales on strong POS and expect to see that translated into shipments as well. So we do feel good about what’s happening on content.

John Taylor - Arcadia

Yes, because it seems like if retailers are heavy with the hardware that’s going to – it’d be harder to get a reorder on that sort of thing than if refilling orders on the software. Is that a fair way to think about the first nine months?

Jeffrey Katz

Yes, I mean that’s easier for a buyer to go out and replen software for a lot of reasons that you’d be familiar with. And they’ll probably take a more aggressive stance we think overall on inventory on the hardware side. So not only burn it down but burn it down below traditional levels just due to the nature of the economic situation.

John Taylor - Arcadia

And on the stand alone side, how many – do you know offhand how many SKUs you have planned in ’09 versus ’08?

Jeffrey Katz

Not top of my mind but we can clearly get that.

John Taylor - Arcadia

So are those mostly weighted to the September quarter load in or do you have load ins going before that?

Jeffrey Katz

We do have before that. We’re actually as I mentioned in my comments, we actually are going to ship some of the Scout line and the Tag Jr. in line earlier so we’ll see some shipments of that product as early as second quarter.

John Taylor - Arcadia

And then, so on the online piece of the business, you guys think in terms of customer acquisition costs to build up that user base from 1 million to 3 million and if so, can you give us any sense of how you think about it, general metrics, that sort of thing?

Jeffrey Katz

So we just – so you and I are sort of talking about the same thing and please redirect me if I’m off the base of your question, we certainly use the retail shelf as a basis to get customers to in effect connect. And once they connect we can either show them relevant product every time they connect or we’ll have their email information and if we have an opt in we can market directly to them. So that to me is a little bit different than the LeapFrog website which is all about marketing to consumers who have a preference for just buying direct from the brand owner.

So essentially people who come at who want to buy directly from our store, we’re actually not willing to invest very much in acquiring those customers. They have a natural preference; we’ll just let them come but we won’t spend a lot of marketing dollars to have them come to us preferentially.

As opposed to something like Leapster2 while it’s in our interests and we do look at customer value rather than acquisition costs so we to my point if we can get a consumer to buy Leapster2 and buy and go all the way into the Learning Path, they’re worth about 10 times more than somebody who just buys Leapster2 and never connects if you will. So they put the cartridge in and play but they never connect.

John Taylor - Arcadia

Yes, I guess that’s what I was getting at. That’s a pretty impressive delta between a non-connected and a connected and I wondered if you think about investing in somehow trying to motivate in a different way down the road than you have so far.

Jeffrey Katz

Well, we certainly are looking at that and part of the reason the Scout plush is priced the way it is priced is to make it very attractive for the consumer to buy that thing and connect because the real value to us is the acquisition of the Scout plush mom and child. With Leapster it’s a little bit more of a mixed bag because Leapster is a good platform in its own right because we know they’re going to buy somewhere in the four to six Leapster titles through their two year ownership.

John Taylor - Arcadia Research

And then I’m not quite sure I know how to phrase this diplomatically so I’m just going to put it out there. With the share price where it is now and with you guys sort of a couple of years into trying to get LeapFrog back on its feet and growing again, I wonder kind of how you’re thinking about locking up loyalty and making sure that everybody sticks around for a while for the good times if and when they come back.

Jeffrey Katz

In terms of employee motivation we are clearly focused on that. We will do some things for the management team to make them excited about that low share price. And then there’s the senior folks of us who are more visible in terms of Form 4 filings and we’re part of the “No Bonus, We Love It Here” Club.

John Taylor - Arcadia

Could you explain to us what that is?

Jeffrey Katz

The “No Bonus, We Love It Here” Club?

John Taylor – Arcadia

Yes.

Jeffrey Katz

You know I think, look, we’re living with our performance and while I really love the product we introduced it’s accurate to say we needed more upside from even in a [heart] here and I think even where our share price is the senior management team that is to say my direct supports and I are committed to keep after it but we don’t think we earned a bonus this year but we’re not going anywhere.

And you know what? It’s that kind of market. So I think at least for a while there’s not a lot of attrition there. That’s not going to last forever. But for the what I call the middle management ranks, there is a bonus club there. There’s many individuals who did a lot of great work reflected in the product. They’re going to get compensated for that. And then for some of the up and coming managers, they’re going to see some value from $1.44 share price that I hope has some upside there. I do think our company has been pounded a little bit – you know we’re trading at cash, right? So perhaps that’s a little unfair given what we do have as assets and capabilities.

And so I think those senior management people or those management people should see some upside value in the stock grants they’re going to receive courtesy of our board’s reviewing of the motivation and talent of that team. But the topmost people are kind of believe we’re accountable and we’re moving forward and going to drive better performance.

John Taylor - Arcadia

And then Bill I guess last question for you, are there any covenants that people are keeping particular scrutiny on in terms of the expiry date of your line of credit? Is there anything that’s getting close or anything like that?

William B. Chiasson

No. In fact given our current position there’s not even a real need to be testing the covenants. We’re in fine shape with those. We do have our line of credit is still – has an expiration of November, 2010 so it’s quite a ways off before we need to increase its tenure although we’ll probably be looking that much sooner anyway.

Operator

Your last question comes from Edward Woo - Wedbush Morgan Securities Inc.

Edward Woo - Wedbush Morgan Securities Inc.

Sales for the first three quarters will be down significantly. Is that correct?

William B. Chiasson

That’s right.

Edward Woo - Wedbush Morgan Securities Inc.

Can we make any assumptions about what Q4 will look like?

William B. Chiasson

No, we’re not going to give traditional guidance on that. We do expect sales for the year to be down however.

Edward Woo - Wedbush Morgan Securities Inc.

The last question I have is in terms of additional cost cutting opportunities do you see any big opportunities possibly either in material costs, R&D or offshore development?

William B. Chiasson

We are aggressively pursuing a lot of the manufacturing savings, working with the contract manufacturers. We have seen cost savings there and we’ll continue to realize those as well in 2009 and our 2010 product lines as well. And we have seen some input cost reductions as well that should be able to offset some of the lower margin products as well. So we feel good about the direction our manufacturing costs are going.

Jeffrey Katz

Operator, anything else?

Operator

There are no further questions at this time. Do you have any closing remarks?

Jeffrey Katz

Just that I appreciate everybody’s joining us for the call today. I know that we went a bit long. If you have questions please do feel free to contact Karen Sansot in Investor Relations. I hope you have her number, 510-420-4803, if you’ve got any follow-up questions you may have. And we look forward to being as proactive as we can at responding to your questions. Thank you very much. Have a good evening and I hope everybody is surviving the snowstorm back east. Bye-bye.

Operator

This does conclude today’s conference call. You may now disconnect.

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Source: LeapFrog Enterprises Inc. Q4 2008 Earnings Call Transcript
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