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LeapFrog Enterprises (NYSE:LF)

Imperial Capital Global Opportunities Conference Call

September 19, 2013 10:30 AM ET

Executives

Ray Arthur - CFO

Analysts

Lee Giordano - Imperial Capital

Lee Giordano - Imperial Capital

Okay good morning. My name is Lee Giordano. I am the consumer retail equity analyst here at Imperial Capital, and on behalf of Imperial and myself, it's my pleasure to welcome LeapFrog here to our Seventh Annual Global Opportunities Conference; and with us from the company today is Ray Arthur, CFO; and Karen Sansot, Director of Investor Relations.

And with that, I will hand it over to Ray.

Ray Arthur

Okay. Thank you, Lee. So my obligatory statement before we start today, we may make some forward-looking statements regarding products, expectations. We take no obligation to update those, and as you know, those results can be significantly different than what we expect as of today.

With that said, the agenda for the day is, I am going to cover the strong demand for supplemental education, talk about why LeapFrog is a leader in children's supplemental education, how the company is undergoing a significant transformation, go through a bit of our financial performance, and then our future growth opportunities.

Make no mistake, children are our future. You’ve got to love this baby. Though children are our future, yet 50% of children that are entering kindergarten have difficulties. Interestingly enough in 2010, there was a study done at Chicago Primary School, and only four out of 100 children knew the letters and numbers, which is pretty amazing. And sadly, only 69% of high school attendees in the U.S. actually graduate. So, the first time in America's history, this generation is going to be less well educated than their parents.

So, not surprisingly, 53% of Americans are dissatisfied with quality of education students receive in the U.S., and people are searching for supplemental education solutions to help their kids compete in the worldwide marketplace.

For those of you that are parents know you want to help your kids do the best. Most people know that education and knowledge are fundamental to participating in a very competitive marketplace, and generally, more education means more opportunity, more compensation at the end of the day. And make no mistake, with 665 million kids in primary schools, it's an extremely competitive environment, and it's really interesting and we see the number of English speakers in the U.S. going from 1 billion to over 2 billion in the next decade, and that's because -- and we primarily see this coming from Asia, because Asians do believe that English is the language of business, so they want their kids to be prepared, so we see a tremendous opportunity in English as a second language or English as a foreign language.

That said, what our research shows us, is that we expect K-to-12 learning to grow at a CAGR of about 33% over the next five years, and educational gaming could grow at 30% plus over the next five years, so some incredible growth opportunities in supplemental education.

That said, we believe we are the leader in children's supplemental education, and it is because that's all we do. Our company mission is to help children achieve their potential, and we started this 18 years ago. We were founded in 1995 by Mike Wood, he was an individual who wanted to help his child learn how to read. He went out to the marketplace to find product that would help his child learn how to read and saw very little that was out there. His credo was the trick to the whole message, you just have to make learning fun, and if you can make learning fun, the kids will focus on the fun, and they will learn regardless without even thinking that they are actually doing that.

And with that, he introduced the LeapPad, the original in 1999, and then we have gone through an iteration of products over the years landing in 2013 with the introduction of the LeapReader, which is a first learn-to-read and write system. The writing piece is the innovative part coming from Tag, which was our learn-to-read system. And then LeapPad Ultra, which is our first entry into WiFi in the children's tablet space.

Our efforts over the past have really resulted in some great products. We have the number one pre-selling electronic learning toy, the number one learn-to-read system, number one selling learning game system in Leapster GS. The number one selling kids learning tablet, which is Leapster, and number one selling learning content, it's really due to the compelling and engaging entertainment filled with rich nutritious education that we provide that is coming through these platforms.

And in fact LeapFrog had the number one selling toy last year in the U.S. Three of the top four selling toys in the U.S., and four of the top 10 selling toys in the U.S. So, I think it's a testimony to the quality of the educational entertainment that is provided through our platforms.

And the content really is key to our success. We have a team of learning experts that we keep on staff; doctorates in cognitive development, early childhood education. They either develop or they curate and approve every piece of content that is put on our platform and available to our customers.

The reason that content is so rich and nutritious is over the last 11 years, we have built what we call proprietary scoping sequence. This is a grouping of 2,600 different skillsets that we believe children between three and eight need to learn to be able to reach the potential in life, and the way we develop our content is we take those 2,600 skill sets, we put them into logical groupings, and then we go out and we build the game around it. Then we go test it with kids, and then we bring it back and we iterate the game, so we make sure that it is as good as it can potentially be. So it's not like we build a game and throw education into it. The first and primary purpose is to educate. So, it starts with these skill sets, and then progresses through to the ultimate game experience.

We do extensive consumer testing. So we have a kid product labs within our Emeryville headquarters. We have 2,500 families that have signed up to be candidates to come in and test product with, and just to give you an idea, last year we did 1,600 plus kid-parent tests, where they come in and test out new product and they tell us what they think of it.

We have also got 300 families that we have tested in 2013 in a home environment, where we put new product in to see how that product is interacting with families and children.

Another key component of our learning content is, it's kind of a personalized learning journey; and what you will find is that kids that get personalized learning experiences are those that do best in education. So for instance, if you buy one of our LeapPad products and bring it home and you have a child who is 5 and a child who is 7, we will set up a profile in that product indicating their age and their name, and when they come into play with that unit, they will sign-in with their profile.

What the units then do in coordination with our content is they will place that child in the respective start point in that content that is associated with their age. So, if you are having a five and a seven year old, and they are playing the same game, they will get different experiences as they get into the content. And that's not just all, after they get in and they are placed in that appropriate level, our content auto levels up or down. So, if your five year old goes in and starts that five year old level, the content after the first few play experiences will say, maybe they are a little above our target range in that five-year-old area. So, they will actually ask them increasingly difficult questions and grade up that game.

On the other hand, if they are not doing quite as well as a five year might be, they will level down, so they can feel successful and start learning at a different level, but still progress forward and achieve objectives of whether it be math, geography, or science.

So through all this, what we have been able to do is really generate a lot of valuable consumer relationships. We have now got over 13 million connected parents, and that number is about a year old, but we don’t want to keep putting that new number up every time we come out as we don't want people to know how many more connected customers we are getting. And over 1 million Facebook likes, which I think is testimony to the quality of our product.

And it's not just me sitting here, saying that from parenting and industry organizations, we've received over 1,200 awards, more than anybody else in the industry. And it's not just those organizations, they are telling us our products are meeting their needs. 90% of all our product reviews are four stars and greater, and our current line features more than 4,000 five star reviews. So we are extremely happy with response to our products. In fact, one of the compensation objectives of our producers and designers and people that project or put together our content, is that they receive four or more stars in their reviews.

And it's followed with an exceptional brand. It's top of the mind. When we go out and ask a mom, what does she think about the LeapFrog brand, they think about top of the market share. They are the leader in the marketplace. It's quality products, it's -- the range of learning is provided is very vast. Quality, depth of learning; learning and learn-to-read products, and you can see the rest of the growth here. But the brand has a very strong response of consumers, especially in that area, where you have three to eight year olds.

So we have helped millions of children over the years. We have sold over 100 million books through our Tag and Tag Junior learn-to-read systems, and now that's being followed by the LeapReader, learn-to-read and write system. We have gone through tablets and gaming systems, Leapster 2, Explore, LeapPad, Ultra Now, 60 million games apps and videos have been sold, and then over 100 million toys have been sold over the years. So we have actually got an install base out there, more than 55 million platforms that we sold over the years.

That said, LeapFrog is kind of in the early innings of transformation. John Barbour is our CEO. He has been there just over two years. He came in March 2011 from retirement. Interesting story is, he has been in the toy industry for a number of years. Was with Toys “R” Us for a number of years as well. He basically was the first CEO of Toysrus.com, and ended up running their international and Americas division of Toys Inc., before he retired, went into some venture capital stuff. And during that time, he wrote a thesis on LeapFrog, and I think he actually tried to buy the company at one point, but it didn't go forward; and his thesis was, you guys are thinking of your business the wrong way. You're thinking of yourselves as the toy company, and you're really not. What you are, is an educational entertainment company.

So when he started as CEO, he says, stop it guys, let's not spend five hours a day talking about the pieces of plastic we are putting together. Let's talk about the content that we are providing, as that's what really differentiates us from everybody else. So there has been a much greater focus on content and educational entertainment since John has gotten here. And in fact, he has opened up, what was a proprietary platform, where we only had our own educational entertainment product into it, to a more open platform. So now we sell education entertainment products for others, such as Scholastic and Disney, rather than just providing our own content.

He was also very interested in building community, which will personalize insight to parents about, here is how your child's interacting and dealing with our product. And what he did, is he brought in a leadership team that had worked in both large and small environments, with the thought that these people will be able to take a turnaround company, which is LeapFrog, get it back to sell operations, but then build it into a much larger organization.

So I came over in July '12 from Pep Boys, but I have actually worked with John before. I was working with him at toysrus.com and then ultimately, at Toys “R” Us, Inc. before I came over here. Greg Ahearn is our new CMO, came in same time I did, basically 2012. He was CMO at Toys Inc. He also worked at toysrus.com and worked at OddzOn with John years and years ago.

We are lucky enough to bring in Ken Adams just recently to SVP of Sales. He spent 28 years at Hasbro as a very senior executive in that organization, we are just thrilled to get him. We brought on Brad Rodrigues, SVP of Digital and Community Development. He was with Nike+, he developed that community. So he is going to lead our community development within LeapFrog. And also Jill Waller, who came over from Hasbro to [become our] our VP of Mobile Learning. All these people came to LeapFrog for a reason. They all believe in the mission, and they all believe that this company can be much more than it is today.

Important to think of us, is kind of a razorblade model. Our content delivery platforms are really content delivery platforms. They are designed specifically for children. We do believe we have the best ones out there today, in terms of platforms. You can take them and throw them on the ground, and pick them up and they will still work. I wouldn't try it with your iPad, [that] would break. But they really are just delivering platforms. The key to the business, is really the rich, nutritious and educational content that we provide, that helps change children's lives. And we do that through our learn-to-read and write systems. LeapReader being a great addition. Our learning games system, the Leapster GS, which is a fast-paced learning system, and then our learning tablet.

As I said, it's a life changing content that's created by our team of learning experts, that really makes a difference. And that comes in a number of different forms, it comes in cartridges, it comes in books, [max], and discovery packs. Videos and music, as I am sure, many of you know, we just did another deal with Lionsgate last year. We have three new animated DVDs that we are going to be bringing out, and for those of you that haven't worked at Letter Factory, which is a DVD, (inaudible) a while ago. The amount of four and five star reviews on that product, are as much as any Pixar film that has been produced to date. And then downloadable content. In 2011, John urged the organization to open up its own online store, to be able to provide digital downloads.

I indicated that John also pushed us to include third party content on our platform. The important part about this, is no piece of third party content gets on our platform that isn't age-graded nature, that's appropriate for children and has some learning value on it. But you can see the companies that we are disserting for now, their names out there, Disney, Hasbro, Scholastic, Lionsgate, and more.

It continues to expand. We started in 2011 with about 50 pieces of content. Our library will reach about 1,000 pieces by the end of this year. About 800 of that will be within our digital library and downloadable. So, very excited about that.

And I would say, our vision continues to be -- we want to be the ultimate learning partner for parents. Today, we don't believe there is a trusted resource for parents, especially once you get past baby center and they get to that three to eight year old range, it's where do I go to get my child ready for kindergarten or first grade or second grade. We are working diligently to become that trusted resource. We have spent a lot of money this year and lot of effort, in terms of our web capabilities, that have yet to be introduced, but we will be introducing a new hardgoods website, a new digital website, as well as making our learning path, which is an area where parents can come and see individual feedback on how their [parents] are doing with the gaming. Or they are learning, what are getting right, what are they getting wrong, where might they need more attention. We will have a new learning path out, as well as a revised connect experience that will be more user friendly.

So ultimately, what we would like to be, is the place where mom takes it personally, and she has a three or four year old, that says, what (inaudible) next. What do I need to be ready for kindergarten?

That being said, we are very early in the turnaround, but we have been able to get some good financial results, based on a lot of blocking and tackling, and kind of our initial efforts in moving to more of a content company, and focusing on what is important. Our sales trends since 1999 to 2012 has resulted in about 15% CAGR. Our EPS trend has gone from, you can see, a loss of $0.19 in 2009, up to $1.24 last year. I should note, that we reverse the valuation allowance against some of our deferred tax assets that are not on our books. That resulted in a benefit of 2012 EPS -- I will talk about that a little later.

From a sales growth perspective, in the U.S., we have seen about 11% CAGR. Overall, international has grown faster than the U.S., and we see a CAGR there about 29%. We introduced our first non-English speaking hardware platform LeapPad into France last year, in French-speaking Canada. We are very encouraged by those results, handling French (inaudible) in terms of content, because content is the hard thing to localize. But because of these results, we have been localizing much more content to share in France, as we look for other European opportunities, as a great growth driver in the future.

Operating income and margin, of course from a loss in 2009 to operating income of $64 million last year, and our operating margin trend peaked at about 11% last year, and our overall objective there is to get more to -- I guess, a competitive set. So if we are still in the toy competitive set, I'd say Mattel, which is 15 plus.

Net income and EBITDA growth, you can see our net income trend, up to $86 million from the minus 3. Adjusted EBITDA, $93 million worth of EBITDA produced last year. Normalized EPS, this is where I talked about the deferred tax valuation allowance. It's really a technical accounting issue. But when you pull that out, and just say, I use the normalized tax rate, what would earnings per share look like -- well, we have gone from a minus $0.10 in 2009, up to $0.56 in 2012. And just so you all know, there is still $70 million worth of deferred tax assets, that we have a valuation allowance against. Should we continue to perform as we have so far this year, I anticipate those will be put back on our books, which will result in a large asset being put on our books, and a large income to the tax line this year. What it really means is that we have got a tax shield. So I don't anticipate paying cash, U.S. taxes not this year, and probably two more years after that.

Cash and cash equivalents, we have gone from $19 million back at the end of 2010; at the end of 2012, we had $120 million on our balance sheet, no debt. I'd say our balance sheet highlights more recently, as of June 30, 2013, $181 million in cash on our books, $62 million in accounts receivable; $67 million in inventories, no debt, and this is what you see, the valuation allowance against our deferred tax assets. We only have $26 million of those assets on the books. As I said, we will potentially have all those assets back on our books by the end of the year.

First half performance this year, net sales increased 16%. U.S. 15%, international 17%, operating loss improved 41%. I think the real thing here, is due to the first (inaudible) in adjusted EBITDA positive, since the company has gone public back in 2001. So we are very pleased with that performance.

As to growth, I talked about supplemental education. So there is a high demand and a growing demand across the globe. We are expanding our base of current multimedia platforms. There are other areas that we don't participate in today, music, TV, other channels. Developing and launching new earning platforms, I think will continue to see our platforms iterate, as we can put better technology and still retain our price points.

International expansion, this year we have been exploring a number of different markets that can provide growth opportunities for us going forward, and we will continue to pursue those. One thing we can just consistently think about is, how do we put our content on other people's platforms. We have not found a profitable way to do that yet, I think a lot other people that are in the app store for iTunes are not doing very well. In fact, I review many of them trying to seldom sales, because they aren't doing very well. The model is really tough to make money on that, when you have 60,000 learning apps out there, how do you differentiate yourself in that environment.

It's really all about content. So how do we get more life-changing educational entertainment solutions out there, whether they be books, videos, [cartoon shows], whatever the case may be.

Expanding our third party content distribution. As I said, we distribute for 30 people already, what more can we do; and also, huge opportunity is to get a closer, one-on-one relationship with mom, which we don't do very well today, in terms of getting feedback and how their children are doing with our content, and how they might further improve their supplemental educational experience. And just continued scale, benefits from scale and OpEx.

So with that, I will open it up for questions.

Question-and-Answer Session

Unidentified Analyst

Talk about a little, probably expanding a bit on (inaudible) of your content and other people's devices (inaudible)?

Ray Arthur

I think there was an article, which -- I know there was an article on the journal, I just don't remember the exact date, and I think it was the first month of this year, might be the second, and they were talking about how many people generated more than $1 million in revenue on Apple's platform in the fourth quarter of last year, and I think -- how many hundreds of thousands of apps are out there? Hundreds of thousands of apps on Apple, I believe. And they were saying, about 80 of those apps, actually made more than $1 million in revenue in the fourth quarter last year.

So, it just tells you, those are -- Apple does a great job, they have a ton of content out there, but how do you differentiate yourself within that sea of apps. What we have found is, we are much better off using our own library on our own platform. That being said, we will continue to look forward and see if there are other ways that might make more sense, maybe a subscription, maybe some other model that might work better within that environment.

The other thing is, the Android. There are so many different versions of Android out there in terms of the operating system, but it's hard to develop a software that's going to work across all of those platforms and operate in a way that's not buggy, and that would kind of represent our brand the way we would like to do it. That said, we continue to look and see whether there's something that we are going to be able to do to get our content on other people's platforms, but we are only going to do it if we can make money out of it.

Unidentified Analyst

Can you breakout the margins between the hardware and software?

Ray Arthur

The hardware is generally electronics margins, so they are not high. The margin is in the software, and the software -- we have three types of software. We have that third-party software that we distributed, which would be something from say, Nickelodeon, and we do nothing basically besides curate it, make sure it's age appropriate, and we think it fits within our library, and for that, we will do the iTunes model – where I am not saying these are the numbers, but they are approximately -- iTunes will pay 70% to the developer, and they will keep 30%. So you can see, it's a 30% margin to say there.

But then the other content is basically our own IP where we develop the game, where we license the IP, and there we see margins from the 70 to 90s. So that's really where the profitability of the business lies. Yes?

Unidentified Analyst

Ray, there were some concerns about the bugginess for the Ultra, can you address the (inaudible)?

Ray Arthur

Sure, as with any electronics products, for those of you that buy a new digital camera or computer, the first thing you generally do is you go update the firmware, and in fact I have been told that on most new Apple products, they do 15 firmware updates in the first 30 days. Because of our supply chain and the speed of development within the electronics industry, it takes six weeks to get product over here from Asia to get into the store shelves, so we have to ship it with beta versions of firmware on there. And then we provide a firmware update process.

I would say we are not overly proud of the firmware update process we put together, because it was clunky. We jumped on, as soon as we found out the issues that were out there, we made it a lot easier to do the firmware update process, and that addressed 98% of the bugginess that was there with the original units, and we still have one or two bugs that we will work through, but they are not material to the operation of the unit. We could have done a better job with the firmware update process. We have now gotten a process that's more into -- that tells you the progress that’s going on. So you don't think that the unit might have frozen while it's updating.

But interestingly enough, our reviews are basically about four star on the Amazon, which is similar to LeapPad 1. LeapPad 1 had similar issues to this with the firmware update, so we will continue to get better at that process, but with the unit itself, we are still very encouraged with, and our retailers have not given any pushback as to what's going on, kind of their response to us was, “what's the big deal, it's an electronic product, everybody does firmware updates.”

Unidentified Analyst

Ray, can you talk about the competitive environment for learning tablets this year versus say last year, anything jumped out at you? I know Samsung is coming out with a new kid’s tablet business?

Ray Arthur

Yes, Samsung is coming out with a new kid's tablet. We have not seen it yet, so we don't know exactly what it includes. Most of the other tablets are within the electronics section of the stores. Our products are in the electronic learning aid store, so it's primarily VTech. That being said, Nabi has come out with, what they say is a new learning system called Wings. We haven't seen it yet, because it hasn't been introduced even though they are selling the product. As to the other products, they are the ones we have competed against before, and we have prevailed. So, we believe we still have the best tablet for a three to eight year old. Lot of those Androids are really for, I think older kids or family tablets. So at least in the past, we have not seen them be a major impact on us. As you can see, having four of the top 10 toys in the last year -- educational toys in the U.S. kind of proves the point.

I think we're done. Thank you.

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