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Executives

Karen Sansot

John Barbour - Chief Executive Officer, Director and Member of Non-Executive Officer Stock Award Committee

Raymond L. Arthur - Chief Financial Officer

Analysts

Scott W. Hamann - KeyBanc Capital Markets Inc., Research Division

John Taylor

Michael A. Swartz - SunTrust Robinson Humphrey, Inc., Research Division

Lee J. Giordano - Imperial Capital, LLC, Research Division

Sean P. McGowan - Needham & Company, LLC, Research Division

Stephanie S. Wissink - Piper Jaffray Companies, Research Division

David M. King - Roth Capital Partners, LLC, Research Division

Gerrick L. Johnson - BMO Capital Markets U.S.

Edward M. Woo - Ascendiant Capital Markets LLC, Research Division

Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division

LeapFrog Enterprises (LF) Q2 2013 Earnings Call August 1, 2013 5:00 PM ET

Operator

Good afternoon. My name is Ian, and I will be your conference operator today. At this time, I would like to welcome everyone to the LeapFrog Q2 2013 Earnings Conference Call. [Operator Instructions].

Karen Sansot, Senior Director of Investor Relations, you may now begin your conference.

Karen Sansot

Thank you. Good afternoon, everyone, and welcome to the LeapFrog Enterprises conference call to review our results for the second quarter ended June 30, 2013. 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 quick housekeeping item to go over. Our closed communication period, during which we will be unavailable to talk with investors and analysts about our business, will begin on Monday, September 30, and will last until we announce our third quarter results, which we expect to announce in early November.

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 third quarter and full year 2013 financial results. In addition, we expect the questions posed 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, August 1, 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, everybody. As the CEO and a shareholder of LeapFrog, I am pleased with our performance to date and the progress we are making on our 2013 strategic initiatives. Despite economic headwinds and weak industry trends year-to-date, we continue to post market-leading results.

In the first half of this year, we delivered solid sales, earnings and cash flow growth. We launched our 2013 multimedia product line to our retail partners, press, investors and industry influencers around the world, and their feedback was exceptionally positive. Early consumer demand for our new LeapReader reading and writing system and LeapPad Ultra tablet in recent online presales has been excellent. We added over 250 new pieces of top-quality content to our learning library. And our life-changing learning solutions continue to be recognized for their exceptional education and entertainment value, receiving many prestigious awards. While we still have our own 3 quarters of our year still ahead of us, we're on track to have a successful 2013.

Now let me take a few minutes to talk about our first half performance. We delivered market-leading net sales growth of 16% year-on-year despite challenging economic and industry conditions in most of the markets in which we operate. Our net sales in the U.S. increased by 15%, and our net sales in International markets increased by 17%.

In the first half of the year, we delivered double-digit net sales growth in our multimedia learning and learning toys businesses. More specifically, within our multimedia learning business, we delivered double-digit net sales growth in each of the content, platforms and accessories segments. As a result of our net sales growth and continued expense control, we improved our operating results by 41% and were EBITDA positive in the first half of the year, which is a first for LeapFrog in our 11 years as a public company.

We delivered $79 million of operating cash flow, up 29% year-over-year, while also delivering $61 million of free cash flow, up 19% year-over-year. The sales growth we achieved in the first half significantly outpaced the traditional toy industry. We believe this is a direct result of our strategic business shift over the last 2 to 3 years into the children's educational entertainment market.

Our current portfolio of learning solutions spans several different entertainment categories, such as kid's learning tablets, educational gaming systems, reading and writing systems, videos, toys, books, music, software cartridges and downloadable apps, with many more children's entertainment categories offering potential growth opportunities for us in the future.

The success of our learning solutions stems from the growing body of research that shows the critical importance of early childhood development, the concern amongst parents about the quality of education their young children are receiving and increasing competitiveness in higher education and ultimately, the workplace.

Parents want to help their children get the best start in life, and they understand that early success in education is critical. As a result, parents are looking for supplemental learning solutions for their children when they're not at school. With our leading educational entertainment portfolio, LeapFrog is well positioned to fulfill this need. We have an 18-year heritage of making the best educational entertainment and have won more than 1,200 industry, educational and parenting awards.

We have a very valuable brand that parents trust and our proprietary Scope and Sequence, built by learning experts over our 18-year history, that covers more than 2,600 skills. Our Scope and Sequence includes a number of critical learning methods and skills recently validated at some of the best teaching schools across the world. Our ability to quickly incorporate these breakthroughs into our content is a major differentiator and a competitive advantage for LeapFrog. To date, we have more than 13 million parents connected to our ecosystem, and we have the best team in the business that's dedicated every day to making life-changing learning solutions for children.

As we head toward the holiday season, I believe that we're better positioned for success than we were in 2012. All of our new tablet introductions for holiday 2013 are stronger. Consumers in the U.S. this year will have a choice at retail of 8 unique LeapPad SKUs at 4 different price points, starting at an entry price of $79, to the ultimate children's learning tablet at $149. At $79, $99, $129 and $149, LeapPad2, LeapPad2 Power, LeapPad2 licensed bundles and LeapPad Ultra provide a compelling selection of awesome kid's learning tablets at a variety of prices to fit every family's budget this holiday.

All of these tablets work with LeapFrog's unique world-class library of more than 800 life-changing content experiences. Our LeapFrog library gives parents a safe and easy way to find top-quality eBooks, games, apps, videos and music for their children. All designed or approved by our highly experienced team of learning experts. Presales of our new LeapPad Ultra are strong, selling out at leapfrog.com in a matter of days. And the LeapPad Ultra is still available in presale on a few online stores right now and will be available on store shelves later this month.

On the International front, the LeapPad Ultra has already been named one of the top 10 holiday items for 2013 by 3 major U.K. retailers: Hamleys, The Entertainer and Argos. In addition, the recent launch of LeapPad2 in France is a big success, and we're expecting significant growth over last year's LeapPad1 sales. Early sales reads indicate that our new LeapReader learn to read and write platform is a significant step up from its predecessor, the Tag. Presale orders of LeapReader exceeded our expectations globally and initial point-of-sale results have been very encouraging. With the transition to new fall planograms, LeapReader will be widely available on retail shelves in the coming weeks.

With the new reading and writing titles and fresh 3D books available and the launch of our new LeapReader download store in late July, with its additional audio eBooks, LeapReader is poised for a very strong performance this fall.

Sales of our handheld learning gaming system, LeapsterGS, are growing significantly. The $10 price drop from $69 to $59 on LeapsterGS has had a very positive impact on retail sales and extended our market share lead in this category, reaffirming that we have the best handheld learning gaming system in the business that's even better at $59.

We have some great new additions to our learning toy line. We showcased our new Read With Me Scout and Violet, our Learn to Write with Mr. Pencil app toy at our New York media event in June. The response to these new reading and writing skill building toys was unanimously positive. They've just started to hit the shelves, and early sales numbers are looking good.

Retail partner space and promotion commitments for holiday 2013 are greater than last year. Our major retail partners around the world are excited about the quality and quantity of our new introductions for this holiday season. As a result, we have commitments for greater space and stronger promotion support for holiday 2013 for many of them.

Our supply chain is improving. Our terrific sales growth over the last couple of years put a significant amount of pressure on supply chain. Our ability to meet this higher demand while also shipping our new platforms earlier than ever before are clear examples that our focus and improvements in operational efficiency in this area are paying off. Our new improved supply chain helped drive our sales growth in quarter 2 and will give us the opportunity for earlier sales reads and allow us to more effectively meet consumer demand in the holiday season.

While we're very encouraged by the early results of our 2013 product launches and commitments for greater retail partner support, we realize it's still very early in the year. Holiday sales are significant portion of overall business, and there are fewer shopping days this year between Thanksgiving and Christmas and no indications that the challenges facing the economy and our industry will lessen anytime soon.

There's no question that we'll face even greater tablet competition this holiday season, although none of those competitors have a vast curated content library of children's content like we have. And remember, the #1 things parents are looking for when selecting a learning tablet for a young child is the quality and quantity of safe, fun, educational content available.

Our results for the year will ultimately depend upon the strength of the consumer environment and sales of our learning solutions during the important holiday season. We believe that we have the strongest product and content portfolio, marketing campaigns and retail promotions ever as we head into the holiday season.

While we're keenly focused on delivering results for this year, we're also making significant long-term investments in our business to drive future growth. Investments in content, new business categories, line refreshments and extensions, international expansion, online communities and internal operating systems. I spoke about these investments at length on our last earnings call.

Since our last call, we had Ken Adams, our new Senior Vice President of Sales, who joins us after having a very successful 28-year career at Hasbro. I have known Ken for over 15 years, and I can tell you he's widely respected as one of the top sales executives in the industry and has a proven record in developing top sales teams and deploying highly effective growth strategies. We're incredibly excited to have Ken on our team.

So in summary, we're off to a great start and making really good progress in our 2013 business plans. We delivered solid first half financial results, launched our 2013 product line, continued to receive prestigious awards and have good sales momentum getting into the holiday season. We've made good progress against our beginning of the year annual guidance, which if achieved, will be the third year running that we will deliver strong top and bottom line growth, and we're probably one of the few companies in the industry with consistent year-on-year growth. We're passionate about helping children achieve their potential. That's why the LeapFrog team continues to drive innovation and excellence in children's learning solutions and why we're keenly focused on building for the long term.

I'd like to finish by thanking all of the dedicated LeapFrog employees around the world for their incredible commitment and passion in delivering pure learning fun across the globe that helps children achieve their potential. I'm very proud of the progress we've achieved together.

Now I will turn the call to Ray Arthur, LeapFrog's CFO, who will talk more about our Q2 performance and 2013 outlook in more detail.

Raymond L. Arthur

Thank you, John, and good afternoon, everyone. Our second quarter performance was solid and exceeded our expectations. The results highlight the growing demand for our industry-leading educational entertainment products and validate the tremendous potential of the LeapFrog brand. We're happy with the continued momentum and we entered the back half of the year in strong financial shape with a number of exciting new product launches.

Worldwide net sales for the quarter were $83 million, up 16% compared to last year's $71 million in sales. The impact on net sales from changes in currency exchange rates was immaterial. During the quarter, due to improved supply-chain efficiencies, we were also able to ship over $4 million of new product that we originally planned for the third quarter in order to satisfy retailer demands.

Net sales for our U.S. segment were $58 million, up 19% compared to the $49 million reported a year ago. Net sales growth in the U.S. segment was largely driven by increased sales of learning tablets and learn to read platforms, including the recently launched LeapPad Ultra, LeapPad2 Power and LeapReader reading and writing system.

In our International segment, net sales were $25 million, up 10% compared to the $22 million reported a year ago. Changes in currency exchange rates had a 1% negative impact on net sales in the current quarter. Our sales growth was largely driven by increased sales of learning tablets and learn to read platforms.

Let me now turn to results by business line. Worldwide net sales of multimedia learning platforms and content, which includes learning platforms, content and accessories, increased 20% year-over-year. Our learning tablet and learn to read businesses each had double-digit net sales growth. Additionally, within our multimedia learning business we delivered net sales growth in each of hardware, content and accessories. Sales of LeapFrog hardware were particularly strong and more than offset expected declines in older platforms that we're transitioning out of, such as LeapPad1, which is our first-generation LeapPad platform; Leapster2; and Leapster Explorer that has been replaced by LeapsterGS; and Tag, a 5-year-old learn to read system that has been replaced by LeapReader, our new learn to read and write system launched in the second quarter.

As to learning toys, net sales increased 13%, driven by sales of our new Read With Me Scout and Violet line and Learn to Write with Mr. Pencil app toy.

Gross profit for the quarter was $31 million, an increase of 8% compared to the $29 million reported for the prior year. Gross margin rate was 37.2%, down 270 basis points year-over-year. Gross margin rate declined due to mix as hardware increased as a percentage of sales, given new platform launches for LeapPad Ultra, LeapPad2 Power and LeapReader. This decline was partially offset by higher sales volume, resulting in better leverage of fixed costs.

Operating expenses for the quarter were $36 million, flat compared to the $36 million reported a year ago, and were down 720 basis points as a percentage of sales. SG&A increased 8%, primarily due to an increase in headcount to pursue our strategic priorities but declined as a percentage of sales by 200 basis points. R&D expenses were relatively flat, decreasing 2% due primarily to the timing of development projects.

Advertising, including our marketing and retail programs, decreased about $2 million, or 38% year-over-year as we shifted some spending to the second half of the year. In addition, Easter occurred in the first quarter of 2013 compared to the second quarter of 2012, shifting some of our advertising dollars into Q1. We expect our advertising to sales ratio to be flat for the year compared to prior year.

Net loss for the quarter was $3 million, an improvement of $5 million over the $8 million loss reported for the prior year. Net loss for basic and diluted share was $0.05, an improvement of $0.07 compared to the $0.12 loss per share a year ago. Normalized net loss for basic and diluted share was $0.04, an improvement of $0.03 year-over-year. Normalized earnings have been adjusted to reflect an effective 37.5% tax rate. And in the second quarter of 2013 normalized net loss per share was better than GAAP net loss per share by $0.01, primarily due to certain discrete tax expenses.

Adjusted EBITDA, which is EBITDA adjusted for stock-based compensation and other income and expense, was $2.6 million, an improvement of $3.3 million year-over-year and the first positive EBITDA the company has seen in the second quarter since the company went public.

Now let me turn to the balance sheet. Cash and equivalents finished at $181 million, an increase of $54 million or 43% compared to a year ago. Our accounts receivable balance was $62 million, an increase of $11 million compared to a year ago due to higher sales occurring later in the quarter compared to the prior year. Our portfolio was in good shape, and our DSO is relatively flat to last year at 67 days compared to an actual 65 days a year ago.

Our inventory balance was $67 million, up $14 million, or 26%, compared to a year ago due to improved supply-chain efficiencies that allowed us to get new product to market faster. Our inventory consists of top-quality products. And overall, we believe both LeapFrog and retail channel inventories are at appropriate levels to meet consumer demands.

Deferred taxes increased $24 million due to the reversal of a portion of the valuation allowance against our deferred tax assets in the fourth quarter last year, and we still maintained approximately $70 million in valuation allowances against our deferred tax assets that, in essence, are not on our balance sheet. Accounts payable is up $13 million related to the planned increase in inventory as we prepare for the holiday season. And additionally, accounts payable is up as we receive more inventory later in the quarter than we did last year. In summary, our balance sheet is in excellent shape.

Also worth mentioning is that Mollusk Holdings, which is controlled by Larry Ellison, has completed the sale of their position at LeapFrog common stock and accordingly is no longer selling shares under their 10b5-1 plan.

I'll finish our prepared remarks with our outlook. We expect net sales in the third quarter to increase at mid to high single-digit growth rate compared to the third quarter of 2012. We expect third quarter gross margin to increase in dollar terms year-on-year and gross margin rate to improve from our second quarter rate, but this rate will still come in below the prior year, given our projected shipments of new hardware platforms and increased duties as a result of Congress not, as of yet, renewing a duty reduction on educational tablets and reading systems, which Congress has done in each of the past 12 years.

We also expect an increase in operating expenses year-over-year due to higher headcount supporting our strategic investments in the future. This growth rate is expected to be in line with our net sales growth for the quarter. As a result, we expect third quarter GAAP and normalized net income per diluted share to be flat to normalized net income per diluted share in the third quarter of 2012, which was $0.32. This compares to a GAAP net income per diluted share of $0.62 in the third quarter of 2012, which included substantial nonrecurring tax benefits due to expired statutes of limitations.

For the full year, we are reiterating our guidance. We expect net sales to increase at a high single-digit percentage growth rate compared to 2012. We expect operating margins to be relatively flat to 2012 as we make long-term investments in content, new business categories, international expansion, online communities and systems. Much of these investments will begin to impact operating costs in the third and more so in the fourth quarter of 2013.

We expect operating income improvement to be driven largely by net sales growth. We're also expecting other expense of about $2 million, which is consistent with 2012. And as a result, we expect net income per diluted share to be in the range of $0.57 to $0.60 for both GAAP and normalized net income per diluted share, excluding any potential discrete tax adjustment related to our valuation allowances.

These amounts also include the impact of an approximate 3% increase in fully diluted common shares from year end 2012 due to more in the money options and divesting in exercise of restricted stock units and stock options, respectively. This guidance compares to GAAP and normalized net income per diluted share for 2012 of $1.24 and $0.56, respectively.

While we did slightly exceed our expectations in the first half of the year, we are not raising our full year 2013 guidance. Our full year sales are highly dependent upon the consumer environment during the important holiday season. There's still much of the year ahead of us, and the current consumer environment continues to be very challenging. In addition, as we have consistently messaged, we are investing in our business in 2013 and this investment will impact operating costs in the third and more so in the fourth quarter of 2013.

As we look to full year of 2013 and years beyond, we believe that we are well positioned to grow our earnings and deliver strong cash flow. We are the leader in children's educational entertainment with a brand that parents and children love. We have the best learning solutions, exciting new product launches and many growth opportunities.

That concludes our prepared remarks, and we'd now like to open the call for questions. Operator, who would like to ask the first question?

Question-and-Answer Session

Operator

[Operator Instructions] And your first question comes from the line of Scott Hamann at KeyBanc Capital Markets.

Scott W. Hamann - KeyBanc Capital Markets Inc., Research Division

Just in terms of the gross margin, a question on kind of the magnitude of the shortfall versus last year, was driven by mix versus potentially the learning tablet duty thing and how you're thinking about that for the balance of the year. Because it seems to me like the LeapReader, at least historically under the Tag platform, has been a higher-margin product and just trying to understand that dynamic a little bit.

Raymond L. Arthur

The duty issue is probably about $1.5 million annual issue to $2 million, so it's not the major driver here. The major driver is just selling in so much hardware, which is -- runs at a lower margin rate than content and accessories. And ultimately, as the platforms are sold through, the follow-on content will be sold. So we don't expect this to be a permanent situation. It's more Q2, Q3, with hopefully seeing margin rates start to tick up in Q4 with more content sales.

Scott W. Hamann - KeyBanc Capital Markets Inc., Research Division

Okay. And then just a follow-up on the guidance. I mean, I think you kind of hit on the fact that you said the first half was above your expectations and you didn't raise the guidance. Is the variability really tied to the sales portion of it? Or do you have some optionality on marketing spend or some other stuff that's kind of flowing through the rest of the P&L?

Raymond L. Arthur

Realistically, we're only about 25% through our sales year. So raising guidance for the balance of the year based on that very small amount of the year being done just didn't seem prudent to us. In addition, we do have -- we are investing in the business this year in terms of a number of different initiatives that will impact us in operating expenses later in the year. So we believe that it is prudent at this point to maintain our guidance, which we've said is mid to high single-digit sales growth and maintaining constant operating margin with that of last year.

John Barbour

And let's not forget, there are fewer shopping days between Thanksgiving and Christmas that traditionally gives a little bit of a ding to the business. And there's nothing we see in the horizon at the moment that is going to reduce the economic headwinds that we've been facing this year and the rest of the industry has been facing too.

Operator

And your next question comes from the line of John Taylor at Arcadia.

John Taylor

I've got a couple of questions, if I may. The spending you're doing to -- strategic spending you're doing that's coming out of the P&L this year, I wonder if you could give us a sense of when you start to see return on that. Is it most likely to happen in the first half of next year? Is that something that's more likely to happen in the second half of next year?

John Barbour

I think you're going to see it happening more in the second half of next year. I mean, first half is only about, running numbers, 25% of our business. So I don't see it having a dramatic impact. I think our business is so seasonal that it will have impact for second half of next year and, basically, following the next couple of years beyond that as well for some of the more longer-term things we are working on.

Raymond L. Arthur

J.T., some of that stuff is systems that we'll be working on into 2014.

John Taylor

Okay. So there will be some spillover then in the first half of next year as well?

John Barbour

Yes, I mean, we have a business as you know that lost money for a good many years and only in the last couple of years has started to really turn around and turn around fairly explosively. So there's a bunch of systems that we haven't really invested much in over the years that need some work, and so we're investing in that. We're investing in product. We're investing in International. We're fortunate this market we're focused on, the children's educational entertainment market, we feel has a lot of growth ahead of it. And that's going to take some investment.

John Taylor

Okay. And then you said, I think, you had about $4 million of early arrivals that you were able to get out the door. Was all of that pretty much in the U.S. or did some of that get split with International markets?

John Barbour

I think the bulk of it was the U.S. And the advantage we had was that we managed to -- as we saw that we were going to get product a little bit earlier than we thought because of some of the operational improvements we made in supply chain and starting to work in product a little bit earlier, that gave us some opportunities to do some early on-shelf promotions with some retail partners. So it was a fortuitous opportunity.

John Taylor

Okay. And then you also mentioned that your inventories are up so -- because of -- on the supply side, I guess, and they were up significantly more than sales were up. So does this set you up for an opportunity to maybe get an extra turn or half a turn in the second half of the year simply because you have stuff on-hand now?

John Barbour

I'm not sure it will do that, but I think it will certainly give us a better read. So you know the sooner we can get new product into the marketplace, the quicker we can get a read on it and the quicker we can go start chasing inventory. I mean, the challenge we do have in a bunch of our platform systems is that the lead times for manufacture of component purchase and then shipping limit our flexibility every day now as we head towards the holiday season, so the earlier read we get in new products, the quicker we can potentially respond. There will be a limit to that response but the quicker we can respond. So a lot of it, J.T., really depends upon what happens over the next 4 to 6 weeks in the sales of those products and against what we're projecting for the year.

Operator

And your next question comes from the line of Mike Swartz at SunTrust.

Michael A. Swartz - SunTrust Robinson Humphrey, Inc., Research Division

Just wanted to ask a question on the commentary about the double-digit sales growth. I mean, was that all commentary about wholesale growth? Or did that also include retail sell-through as well?

Raymond L. Arthur

Are you talking about does it include our customer sales to...

Michael A. Swartz - SunTrust Robinson Humphrey, Inc., Research Division

Yes, were you speaking around, yes, customer sales versus your wholesale shipments?

Raymond L. Arthur

No, we're talking about our sales shipments into the channel.

Michael A. Swartz - SunTrust Robinson Humphrey, Inc., Research Division

And did you have any color that you could provide us on how retail did during the quarter?

Raymond L. Arthur

I think that for the year, we're seeing, if you take away our discontinued products, basically a flat kind of POS.

Michael A. Swartz - SunTrust Robinson Humphrey, Inc., Research Division

Okay, great. And then just a follow-up on gross margin. I know in the first quarter you'd talked about some quality issues that may have impacted that. Did you see that continue into the second quarter? You didn't specifically call it out. And either way, did you kind of get to the bottom of that?

Raymond L. Arthur

Yes, we did not see that continue into Q2 at this point. We continue to monitor.

John Barbour

They weren't really quality issues, they were [indiscernible] issues, defectives. I mean, defective doesn't mean there's a quality issue. There's lots of different reasons why consumers at different times will return product to retail. So I wouldn't define it as a quality issue. I might be nit-picking, but that's not the way I would define it.

Operator

And your next question comes from the line of Lee Giordano at Imperial Capital.

Lee J. Giordano - Imperial Capital, LLC, Research Division

Can you talk a little bit more about the competitive environment for tablet this upcoming holiday versus last year and how you think you're positioned?

John Barbour

Yes, I mean, there's no question that every year we face new competitors and new systems from our existing competitors. And that's why we're constantly focused on trying to create a better mousetrap than everybody else. But the thing I would continue to set back on is that everything we see and the comments we get from people is the availability of safe, proven content -- educational content for kids is a key part of that decision process. And nobody in the marketplace has the curated library of -- at the end of this year, we'll have over 800 pieces of educator either developed or approved content on our platform, and there's no one in the market can even get close to that. So we believe that the selection of tablets that we've got in the marketplace, along with the variety of price points and, more importantly, this market-leading content library stands us in good stead versus the competition. So there's no question it will be competitive, but we believe that we've got the right strategies in place to continue to grow our business.

Lee J. Giordano - Imperial Capital, LLC, Research Division

Got it. And on the International front, are there any countries you'll be in this holiday that you weren't in last year? And then what's the next new region that you'll be entering?

John Barbour

There's no significant countries that we'll be in this year versus last year. I mean, we're very excited about our business in France. It was a bit of a test business for us when we launched LeapPad1 there last year with French software. It was a success last year. And our team over there is doing a wonderful job and going to show some significant growth this year. So there's -- we're excited about what's happening there. And to be frank, our business across International, Chris Spalding, that runs our International business, has done a wonderful job for us for a number of years and continually drives this business up. And it's great to see. Regarding new markets, we're looking at a bunch of markets. Chris and I myself have visited a bunch of new markets. We've talked to a whole bunch of partners. We've run some models. We've talked to experts. We've visited schools. And we're looking at a number of markets at the moment but haven't defined yet which, if any, markets we're going to attack or what timeline we're going to do it in.

Operator

And your next question comes from the line of Sean McGowan at Needham & Company.

Sean P. McGowan - Needham & Company, LLC, Research Division

A couple of questions for me as well. One, Ray, could you comment a bit, if you can, on the year-over-year comparison in gross margin in the International segment. Was that similar delta as the overall gross margin?

Raymond L. Arthur

International is actually somewhat better. But you got to understand that we don't necessarily allocate all of our costs to International. So had we allocated more of our cost there, improvement probably would have been more aligned with the U.S.

John Barbour

Yes, and they also didn't get the same burst of new product launching at the end of the quarter because their partners just couldn't respond as quick as the ones we had in the States.

Sean P. McGowan - Needham & Company, LLC, Research Division

So was the gross margin internationally up versus a year ago in the second quarter?

Raymond L. Arthur

We don't generally go into that.

Sean P. McGowan - Needham & Company, LLC, Research Division

Okay. On that duty issue, is that something that could be reversed between now and the end of the year? Is it a foregone conclusion that you'll have that expense?

Raymond L. Arthur

We're hopeful and we're not sure about this. But we, as well as other companies that are affected by the potential legislation that's out there, are trying to encourage the Congress to hike up the bill, to adopt it and to make it retroactive, which they've done in previous years. It's just that they're taking up later this year than they have in prior years. So we still have the opportunity that it could come up favorably in our direction.

Sean P. McGowan - Needham & Company, LLC, Research Division

Okay. But the assumption baked into your guidance is that it won't happen.

Raymond L. Arthur

Yes. And Sean, I'm sorry, International margin is up year-on-year.

Sean P. McGowan - Needham & Company, LLC, Research Division

On the issue of the early shipments, I want to tag on to J.T.'s question. He was asking about could you get another turn in there. But let me ask it this way, if your better systems and better being set up are able to pull sales that -- put sales into second quarter that might have come in the third, might you also get sales in the third quarter that might otherwise have waited until the fourth?

Raymond L. Arthur

I mean, that's possible. I wouldn't describe it as pulling sales. The retailers wanted this stuff. There has been strong retail demand for getting LeapPads in stock in previous years. We've always had limited supply and coming in late. So retailers just have an appetite for getting the product in as soon as possible and getting their planogram set. Is there a possibility that some Q4 could come into Q3? I'd say, yes.

John Barbour

But Sean, the thing about it, though, we need to remember is this, it's limited by the fact that of availability to get product. It's actually limited by 2 things: demand and the end product. So there certainly is the potential to get increased sales because of the way that we're planning our inventory, and it will be interesting to see.

Sean P. McGowan - Needham & Company, LLC, Research Division

Okay. So given that then and your guidance for the third quarter, as well as the full year, just basic math implies the potential for the fourth quarter to be down. Are you trying to make a statement there or just...

Raymond L. Arthur

I think what we're -- you know we plan conservatively. We're only 20-some-odd percent into our year, and it's a challenging environment out there today. Is there a possibility that -- you've seen Toys "R" Us and other retailers out there reporting POS declines. We've been fortunate to be doing better than that. But it just doesn't seem prudent at this time to go out and increase sales estimates when we gave estimates at the beginning of the year and we still believe they're valid. We think we'll finish the year with mid to high single-digit sales, and we'll hit those operating earnings numbers.

Operator

And your next question comes from Stephanie Wissink at Piper Jaffray.

Stephanie S. Wissink - Piper Jaffray Companies, Research Division

John, just one question for you, it's back in follow-ups to some of the questions around inventory. But I'm curious on your supply chain efficiency efforts. It sounds like you've actually achieved some nice efficiency there. How does that position you in the holiday with respect to respond to in-season demand? How should we think about that?

John Barbour

So I think one of the key things for all of us to remember is that when you build in the time to ship these platforms into the States, the time it takes to manufacture them and the time that we've got to actually order screens and chips, et cetera, our flexibility for ordering inventory on platforms is fairly limited in terms of growth in the fourth quarter. We've just seen the significant write-offs that Microsoft has made for slightly missing their Surface number. And that's something that we've got to be concerned about as a smaller company. So I would say, as we're running our business, everything we can do to enhance our supply chain is incredibly important, and each of those things gives us another opportunity to run our business more effectively. But when it comes to the fourth quarter and it comes to platforms, we're calling numbers probably a month ago as to what we think we're going to do this year. We're building flexibility into it. And the better efficiencies we've got, the chances are it does give us a little bit of flexibility, but that flexibility is still pretty limited for the fourth quarter. When you think of it, we're ordering screens about 10 weeks before they go into production, then you go into production, then we've got shipping coming across. So I think it's important in terms of people's understanding of flexibility. Operational efficiency does give you some benefits. But if you're getting your reads in these products only 12, 14 weeks before Christmas, if that, it's very tough to make dramatic changes in availability of product.

Stephanie S. Wissink - Piper Jaffray Companies, Research Division

Okay, fair enough. And maybe just a follow-up to that on the component side. You've talked about competition in the tablet category. Can you talk about some of the demand versus supply with some of those key components, particularly related to the LeapPad Ultra?

John Barbour

Yes, we've not seen and we've not had any issues at the moment in terms of availability or component shortages at this time. And so from that standpoint, it's really just trying to manage the lead times, to be perfectly frank. If anybody sits down with a piece of paper and calculates how many weeks this process actually takes from us ordering the components to getting the product on shelves, you'll see that the timeline is pretty long there. So flexibility in the fourth quarter -- traditionally we've managed to flex a little bit in the fourth quarter. But as everybody knows, we rob the first quarter of inventory at that time by driving massive, massive accelerated programs through there. But unfortunately, it was just essentially moving sales at that time from the first into the fourth quarter. So at the moment, we're not seeing any issues, knock on wood, in terms of componentry. And really, it's just our appetite for risk in terms of ordering up front.

Stephanie S. Wissink - Piper Jaffray Companies, Research Division

Okay. Then Ray, just a couple for you. The advertising spend, as I look at the model over the last 5 years or so, has come down quite significantly. Can you just talk about that line item, in particular, how you're thinking about that as a percentage of sales? That would be helpful. And then I think you made some prepared comments around the share count. If you could just give us those comments again, how we should be thinking about the dilution from these share-count initiatives? That would be very helpful.

John Barbour

Let me cover advertising. Because in the advertising segment, what we're seeing here is we're seeing a couple of big things happening. We're seeing a shift in our advertising from traditional TV advertising into digital advertising and as we start to leverage our 13 million connected parents as we go forward. So as we look at what we're doing, we're driving greater efficiencies across the model that we have as we drive our business going forward, and that's what you're seeing over a multiyear basis in our business. Right? So you're seeing a small shift from traditional TV into digital, but you're seeing a greater efficiency coming from communicating directly to our existing customer base. So moving to more of a sniper approach than a "throw everything against the wall" approach of TV. TV is still incredibly important to our business but we're constantly watching it. The other thing you'll see is a shift this year in advertising because we did some test TV advertising just before summer last year to see whether it was cost effective. It wasn't. We're moving those dollars to later in the year this year, where we feel it will be more effective.

Raymond L. Arthur

The other thing I would say is for your modeling purposes. We're still planning on advertising being about 7% of sales, which is consistent with prior year. As to share count, clearly, there are -- as the share price goes up, the trading price, more options fall into the in the money category and start to fall into the calculation of EPS. Secondly, there are -- this continued investing of RSUs that have been granted over the years, as well as the stock option exercises. And what we have seen is, we had about 69 million fully diluted shares last year. What I think we're going to end up with is around 72 million probably this year. It's about a 3% increase.

Stephanie S. Wissink - Piper Jaffray Companies, Research Division

And how about for next year, how should we think about that, the same type of increase year-on-year?

Raymond L. Arthur

No, I don't think so because a lot of the options that were out there were way under the water because the stock price was trading down. So there was a big increase due to the stock price going from a couple of years ago being at $3 and $4, up to around $10 and then you have an increment up to $12. So I think there will be some impact. I haven't projected it yet. I don't think it's going to be that magnitude, though.

Operator

And your next question comes from the line of Dave King at Roth Capital.

David M. King - Roth Capital Partners, LLC, Research Division

I guess, first off, kind of just following up on some of the other questions, maybe spinning the supply-chain question, operational efficiency, inventory stuff another way. I guess it would be, knowing that you don't really want to -- the appetite for risk of ordering upfront and knowing that you don't have much appetite for that and the point of 12 to 14 weeks of visibility. I guess, to what extent now do you think you are exposed to risk of having too much inventory in the channel? Do you see that as something that you guys are exposed to in any way yet or not? Maybe you can just provide some color there.

John Barbour

I think for those of you who've gone on the call for the last 2.5 years since I've been here, you'll know that I tend to manage things very tightly, and we tend to manage things very tightly, and even at times if it means leaving a little bit of business on the table. So all I can say to you right now is we continue to manage things very tightly. As we look at our inventories right now, we're in a good spot. We're actually better prepared for this holiday season than we have before, and we're feeling good about where inventory sits at the moment and the plans we have for the holiday season.

David M. King - Roth Capital Partners, LLC, Research Division

Fair enough. And then maybe switching gears to the guidance questions a little bit. I mean, I fully appreciate that only 25% of the business has already been done at this point. And holiday, I think, there was a question you kind of answered on that at this point. But maybe as we think about the third quarter, mid to high single digit versus the strong double-digit gains you've already had, plus it is also a little bit down from, I guess, the guidance a little bit slower than what you've even guided to in recent quarters. Maybe you can help us understand and reconcile that, particularly as we think about some of the traction you've had with new products, whether it's LeapReader, what we saw out of Ultra earlier this week, and then maybe you can even touch on LeapPad2 Power and how that's been going on at this point.

John Barbour

So we gave guidance at the beginning of the year. We've been pretty clear. We've been very focused on it. Right? We're a little bit ahead of the game at the moment. If you take the $4 million of hardware that shifted a little bit from -- as we got early shipment potentially from the second quarter, the fact is we're still on plan to do that. That's where we are right now. We're going to continue to focus on that and try and deliver. And if we over-deliver, I promise you, we'll be happy. But right now, that's our guidance. It was the guidance we put on the table, and that's the guidance we're sticking with for the year. Secondly, regarding the sale of new products, it's very early days. We're very excited by the products. As you know, we're sitting here in the middle of the summer and the numbers that we're seeing in these aren't going to change the world. They just give us a really good read as to how things are coming together or a positive read of how we feel about things going forward. We still have a long way to go. I think anyone who is looking at that guidance right now with 25% into it and seeing bigger things in it, I would suggest that you hold your powder at the moment, and we see how the third quarter goes.

David M. King - Roth Capital Partners, LLC, Research Division

Fair enough. And we definitely appreciate the conservatism, I guess. And then maybe one last question then for Ray. Any update on the valuation allowance against the DTA and when you might expect to recover that? Is it still this year?

Raymond L. Arthur

Well, I think that we'll continue to monitor our operations. And when we get to the point where we feel really pretty certain about our results for this year, projected results for this year, that -- we'll address that amount. That could be as early as Q3. It could be in Q -- but if we make the assumption that we hit our plan, it's going to be sometime this year, Q3 or Q4.

Operator

And your next question comes from the line of Gerrick Johnson at BMO Capital Markets.

Gerrick L. Johnson - BMO Capital Markets U.S.

Ray, you said earlier that POS in the quarter was flat, excluding discontinued items. Are you kind of shortchanging yourself there because LeapPad1, Tag, they're still there for the entire half of the year and the new stuff is barely on the shelf. Can you tell us what POS was if you did include those discontinued items?

John Barbour

Those items were included in the number. We don't consider them discontinued. Those things are Leapster3 -- Leapster2, sorry. The original stuff that we actually started to get out of last year, which there was some early sale on the beginning of last year.

Raymond L. Arthur

What I would say is that since these new products have been introduced, we're starting to see improvement in POS, which is encouraging.

Gerrick L. Johnson - BMO Capital Markets U.S.

A couple of days ago, you put out a press release indicating that the Ultra had sold out on preorder on leapfrog.com. How many units do you allocate to presell on leapfrog.com?

John Barbour

As you can probably guess, that would be something our competitors would love to know, Gerrick. So we've decided not to disclose that.

Operator

And your next question comes from the line of Ed Woo at Ascendiant Capital.

Edward M. Woo - Ascendiant Capital Markets LLC, Research Division

Is the LeapPad Ultra and the LeapPad2 Power, is that going to be rolled out in all English-speaking markets this year and where will it be, typically, the Ultra, in the retail store? Will it be with the rest of your LeapFrog products or will it be in the electronics category?

John Barbour

The first question is that LeapPad Ultra and LeapPad2 Power are going into all of our major markets. And secondly, we're really excited about having 8 LeapPad SKUs all together within the LeapFrog section in-store, with price points going from $79 up to $149. We feel that we've covered an incredible gamut of opportunity there for parents of all incomes to be able to get into this brand and deliver a great educational experience for their kids. So we're definitely exactly where we're going to stay in store, and we feel really excited about the line that's there. And when you add the GS at $59 now, we feel we've got a pretty unbeatable spread there of market-leading products with the best content library in the space.

Edward M. Woo - Ascendiant Capital Markets LLC, Research Division

Great. And the other question I had was you mentioned that gross margin was affected based on the higher allocation of hardware. Was there any impact on the lowering of the LeapPad2 from $100 -- or $99 to $79 and also the introduction of, I guess, the Power, that obviously effectively cuts the price from $140 to $100?

John Barbour

Can you run that again, I'm sorry.

Edward M. Woo - Ascendiant Capital Markets LLC, Research Division

Sure, sure. You mentioned that gross margin was negatively affected because of a higher mix of hardware sales in the quarter. I was wondering if there was any impact in the quarter at all from the reduction of the LeapPad2 retail price from $99 to $79?

John Barbour

No, no, none at all. That wasn't really the impact. It was more of an impact of mix of shipping more hardware than we originally -- than we did last year as a mix against content.

Raymond L. Arthur

And accessories.

Operator

And your last question comes from the line of Drew Crum at Stifel.

Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division

So J.B., you talked about retail commitments being up on the whole. Can you talk about your retail commitments through your tablet devices, specifically? And then also, you talked about the experience you had in the quarter with the LeapsterGS cutting price. How did that impact profits and are you more apt to get flexible or creative with pricing given the range of price points you have on the tablet devices now?

John Barbour

Yes, I mean, let's talk to the GS first. When GS in year 2, we had some component reductions that allowed us to bring our price down. I can't say exactly, I think we're making the same or slightly less on the GS but I don't think that had a dramatic impact on marginality. Regarding retail commitments on tablets, we're super excited with the response that the retailers have given to our products. I was in all of the meetings where we showed our new tablet line to all of our major partners and have the chance to see both their space commitments and their promotional commitments, some of the ones in the States, and that doesn't -- the U.K. is pretty similar on that side. As we sit and we model the business and model the support, we feel that we've got a higher level of support than we have last year. Now it's important to say, within those stores, the likelihood is they're going to have more tablets in their stores as well, so we're going to have more competition. So it's not just a one-sided street. I think we've got the best selection, best range in the business and we've got better support. But there will be more competition in the stores as well.

Operator

At this time, I'd like to turn the call back over to Karen.

Karen Sansot

Great. Well, thank you, everyone, for joining us on our call today. And please feel free to call Ray or me with any follow-up questions. Thanks and goodbye.

Operator

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

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