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Executives

Karen Sansot - Director Investor Relations

Jeff Katz - Chairman and CEO

Bill Chiasson – CFO

Analysts

Drew Crum – Stifel Nicolaus

Sean McGowan – Needham & Company

Ed Woo – Wedbush

LeapFrog Enterprises, Inc. (LF) Q4 2009 Earnings Call February 11, 2010 8:30 AM ET

Operator

(Operator Instructions)  Welcome everyone to the LeapFrog Q4 and Full Year 2009 Conference Call. Ms. Sansot you may begin your conference.

Karen Sansot

Welcome to LeapFrog Enterprise’s conference call to review our results for the fourth quarter and full year ended December 31, 2009. I’m Karen Sansot, Director of Investor Relations. Today on the call we have Jeff Katz, our Chairman and CEO; and Bill Chiasson, our CFO.

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 2010 financial results.

In addition, we expect the questions posed in the Q&A portion of this call to prompt additional answers that contain additional forward looking statements not included in our prepared remarks. This reminder concerns forward looking statements in both our prepared remarks and our answers to questions.

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 what is discussed today in any forward looking statements. Some of these factors are described in our most recent forms Form 10-K and 10-Q filed with the SEC, as well as in LeapFrog's other public statements and filings. LeapFrog makes these statements as of today and disclaims any duty to update them.

On this call today, we will also discuss point of sale data and non-GAAP information. Please refer to the press release we issued today which is posted on our website at www.LeapFrogInvestor.com for explanations of point of sale data and non-GAAP information and a reconciliation of non-GAAP to GAAP financial measures.

I would now like to turn the call over to Jeff Katz.

Jeff Katz

As we entered the year we set an aggressive goal for the company, while dealing with what the economists and pundants seem to be calling the great recession, substantial inventory overhang as we started the year and a $68 million net loss in 2008. We were determined at LeapFrog to make dramatic improvements in our financial performance, continuing the progress we had been making but much more dramatically get closer to the kind of performance this company is capable of delivering.

In what was arguably a challenging year we grew point of sale or POS as we will refer to it today by 4% year over year, which compares favorably to a toy industry that was relatively flat overall for the year. This drove a four point increase in our share of the electronic learning toy segment to 44% measured by NPD. We increased our retail footprint, market share and brand metrics in our category.

We improved gross margin by two percentage points despite the necessary promotions and a 17% sales or shipment decline. We cut our expenses by 31%, we reduced our net loss to just under $3 million or achieving essentially a break even result. Importantly, we generated $21 million of adjusted EBITDA and we improved our bottom line performance by over $1.00 a share.

Today we’re a stronger company than we were when we entered these rough economic times about 18 months ago. This is the direct result of the actions we’ve taken. Our first initiative in the course of the year was clearly to drive POS and to get inventory that was at retail to better than appropriate levels. We work with our retail partners to develop promotional and marketing campaigns that drove a lot of volume frankly. We also leveraged our systems and our processes so that we could better match inventory with retail demand. Today, inventory levels at retail are lean and comparable to 2007.

This past year we also increased our presence at retail. We maintained shelf space at the big three retailers while increasing our focus with online retailers, department stores, electronic stores. In the coming year we will add book retailers as well as drug and grocery store chains to our points of distribution. We believe that this increased distribution will be incremental to earnings and help us reach new customers, very important for us, and build more broadly the ubiquity what is already a terrific brand, the LeapFrog brand.

We improved results in our international segment, gross margin expanded five points and we reduced our operating expenses by nearly 48%. The streamlining of our international business resulted in a $10 million operating profit, a big change in our international segment.

Another large initiative for the year was to grow our interactive reading business. We invested in Tag which is proving itself to be a terrific product. We launched Tag Jr. which expanded our reading demographic. Our Tag franchise is now a significant new business for us that’s tracking ahead of the famous LeapPad business in terms of sales and software tie ratios at the same stage of its lifecycle.

POS for our interactive reading business grew 41% in 2009 and software to hardware tie ratios of Tag were north of 3%. This higher mix of interactive reading and software based books contributed to our gross margin improvement.

Another initiative was to grow POS by adding innovative and attractively priced products to our portfolio, especially important given the weak economy and again, beginning to get new customers into the LeapFrog brand. We introduced the Scout line of toys with most products in that line priced under $20. The Scout line has become a significant new franchise for us and it drove our 7% POS growth for stand alone learning toys during the year.

My Pal Scout and My Pal Violet in particular sold over a million units and brought new customers into our learning path system. Scout and Violet can be personalized, they connect to our learning path system which enables us to start building relationships directly with customers who have young children and who can benefit from LeapFrog products over the next five to six years.

Our biggest initiative for the year was that we really started to leverage our Learning Path system and develop personalized product suggestions for our connected customers, in addition to providing them with customized feedback on their children’s learning progress. We now have three million connected customers to our Learning Path system up from a million customers a year ago.

We delivered 300 million customized marketing impressions to our connected customers. This contributed to our POS growth and benefited both retailers and LeapFrog nearly 200,000 directly trackable sales transactions we made at retail as a result of the Learning Path. Of course this will grow dramatically.

We discovered that about 85% of coupons, for example, that we’ve sent to our connected customers are used at retail which helps us drive traffic to retail stores and target marketing promotions in what I would call a private marketplace manner. Our Learning Path connected strategy is helping to build brand awareness and increase brand perception.

Over 50% of people surveyed said that the Learning Path increased their perception of LeapFrog based on our survey data over half of Tag owners, for example, bought a LeapFrog product based on a recommendation from the Learning Path or from a LeapFrog personalized email. The majority of those purchases were made at retail.

Other surveys tell us that 97% of Tag Jr. and 98% of Scout owners say they are very likely to buy another connected product from LeapFrog. This is all part of our so called connected strategy to create great learning products that deliver fun, interactive play experiences, and connect to our Learning Path system.

Our product portfolio starts with early developmental learning toys and then graduates them to interactive reading platforms and educational gaming platforms which have software based book and game content. Learning Path provides personalized learning feedback to customers and increases customer engagement through rewards, game trailers, and demos, and new content downloads.

It also enables us to develop personalized marketing for our customers including, importantly, next purchase recommendations. We have a strong leadership team and together we made a lot of progress this past year. The benefits of the strategy are starting to come to fruition. We grew POS, we strengthened our brand and market position, we broadened our product portfolio, and we continued to investment in product innovation.

We also reinvented our cost structure by improving operational systems and processes, focusing on fewer but more strategic projects. Of course we realigned headcount in conjunction with our economic reality. We are developing more effective advertising techniques which really showed themselves in the year 2009. Given all of this, our strong fourth quarter results, we are well positioned for 2010 and beyond.

Now I’d like to turn the call over to Bill Chiasson.

Bill Chiasson

To say the very least, we had a very strong holiday sales performance. The point of sales demand for our products was strong, up 5% for the fourth quarter. That’s higher than our initial expectations and drove significant retail orders towards the end of the quarter. This demand also resulted in a very strong quarter for us. Sales were up 37%, gross margin reached 44% which was up nine points from last year, operating expenses declined by 36%, and net income per share was $0.46 an improvement of $1.15 a share year over year.

As Jeff mentioned, we have very good momentum going into 2010. This momentum, combined with low retail inventory levels, puts us in a good position for growth. In 2010 we expect sales growth of 10% to 20% and positive operating and net income.

Let me talk about the full year results. I’ll keep these comments brief. I urge you to take a look at today’s earnings release for additional detail. Net sales for the year were $380 million down 17% year over year. Sales in the US segment were $306 million down 16% and international sales were $73 million down 23%, and sales were down across all countries.

Our net sales for the first three quarters were significantly impacted by the high retail inventories as we entered into 2008 and you’ll recall through September sales were down 40% year over year. At the start of the fourth quarter therefore retail inventories were at a more appropriate level and fourth quarter net sales increased that 37% that I mentioned before.

By business line, our net sales in the US for the year were that Interactive Reading was up 19%, Educational Gaming was down 34%, Stand Alone Learning Toys were up 13% and sales through LeapFrog.com were up 18%.

Our Interactive Reading business, Tag and Tag Jr. did phenomenally well this year as well as in their software based books. Our Educational Gaming business was the most impacted by the high retail inventories as we entered in the year, particularly the hardware platforms. Gaming sales were down for the year due to that inventory overhang as well as disappointing sales of Didj.

Stand Alone Learning Toys were up for the year as a result of adding innovative, attractively prices products that Jeff referred to, to our portfolio and it was led by the new Scout product line. Sales through LeapFrog.com also did well and benefited from direct marketing to our Connected customers through the Learning Path system.

By platform, our net sales mix for the year was as follows. Hardware sales were 26% of the US net sales down 39% from a year ago. As I mentioned before, LeapShare hardware was most affected by the inventory overhang. Software net sales were 36% of the total up from 31% a year ago. Toy sales were 33% up 25% year ago. All other was 5% which is same as last year.

Our POS for the year was up 4% while the overall toy industry sales in the US were flat to down about 1% according to NPD data. By business line, retail point of sale dollars in the US were as follows. POS in the Interactive Reading was 41% for the year with strong sales at retail of Tag, Tag Jr. and their software based book content. The retail sales of Tag and Tag Jr. software are outpacing sales growth and tie ratios that we saw in our hit product line LeapPad and Little Leaps when they were first introduced.

POS in the Educational Gaming market segment was down 10% and this was due to the exit of Didj and promotional activity to rebalance retail inventories. Unit POS of the LeapShare hardware was down about 3.5% and software was up about 0.5% versus 2008. POS in the Stand Alone Learning Toys was 7% primarily due to sales of our new Scout line. The Scout toy line has become a significant new franchise for us in the flagship products. My Pal Scout and My Pal Violet connect to the Learning Path and acquire connected consumers at a very young age.

For the year, as detailed in our press release, we improved our gross margin by two points. We reduced our operating expenses by 31% and significantly improved our bottom line.

In the press release you’ll also see that our year end cash decreased year over year. We had very strong sale reorders late in the fourth quarter which resulted in an increase in our receivable balances of almost $60 million year over year. When we collect theses receivables in the first quarter we expect cash to peak at around $100 to $105 million which is about $10 to $15 million higher than the comparable period last year.

For the 2010 outlook, as both Jeff and I noted at the beginning our remarks, we enter 2010 with good momentum. It’s led by a strong POS, market share gains, improved product mix, and significant reductions in our cost structure. And a more efficient personalized marketing by leveraging our Learning Path connected strategy. Inventory levels are lean which should also help us to a good start to the year.

As a result, and despite what we expect to be a continued rocky economy, we believe this momentum will contribute to a sales growth of 10% to 20% for the year. We’ll continue to grow our Tag franchise and launch new initiatives in gaming, release innovative content but we expect this to be our best content year ever and have a strong holiday toy line. You’ll be able to see many of these new products at our Inventor event in New York next Tuesday.

While margins will continue to be under pressure we believe cost improvements and a continued focus on content will blunt the negative pressures. We’ll keep the lid on expenses and invest the marketing dollars cautiously behind profitable growth. There’s still a lot in front of us but at this time our expectation is that we will build on the 2009 results and achieve positive operating profit and net income for the full year.

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

Jeff Katz

We feel good about the progress we made this year, that is to say in 2009. Our Learning Path strategy is strong and our strategic portfolio is broader and deeper. Continued innovation, leading path expanded distribution and lower cost structure these all set us up very well for the future. We are excited about our 2010 products, especially our lineup of content and we’re excited about the further impact in this year of the Learning Path.

Plans for 2011 are far along, well underway and our team has an excellent process for keeping the pipeline filled with innovation and highly competitive concepts. As I step into the Executive Chairman role, the Board and I have great confidence in LeapFrog’s management team and really their vision and leadership that’ll drive long term shareholder value.

Bill, many of you know Bill, most of you do, has been my partner over the past few years as we’ve really remade LeapFrog from a company that sadly had in 2006 a net loss of $145 million and just one rock star product that was in decline. This company has been transformed into one now that has been able in a really challenging year to generate $21 million of adjusted EBITDA improved cash flow. Today LeapFrog has multiple strong product franchises, a connected strategy that is unique, innovative, and is driving customer engagement and value.

We have a deep and an innovative product pipeline ahead of us. We have state of the art operational systems and the expertise to really operate them effectively, a robust business model that leverages a dramatically lower cost structure, a supremely healthy balance sheet and a strong team of talent. We’ve created a lot of momentum. While I’ll continue to play an active role in strategy, technology plans and product development process, Bill and the Executive Team are the stars who will continue to innovate and take LeapFrog forward.

We’ll be talking about our long term vision and where product innovation is headed at our Investor event. Bill and I will be taking you through those items in some detail. You’ll be able to meet a few members of our executive team. When we get into the product innovation part I think you’ll be, as I am, really excited by what we talk about and what’s ahead.

As part of our executive team introductions, by the way, we’d love and look forward to introducing you to Mark Etnyre who will be our new Chief Financial Officer when Bill steps into the Chief Executive role. Mark joined LeapFrog two years ago from Microsoft, a company you may have some familiarity with, where he held several significant financial roles and since joining our LeapFrog team he has brought really strong leadership to the accounting function, the controlling function, he’s build a very talented team.

He’s played a key role in building the strong financial discipline across the company. We’re really looking forward to seeing many of you in New York. If you’d like to attend I hope you’ll contact Karen to sign up for the event.

Now Bill, Karen and myself would like to open up the call to your questions. I would ask the operator to find out who might like to begin.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Drew Crum – Stifel Nicolaus

Drew Crum – Stifel Nicolaus

I wonder if you could drill down with the International sales in the quarter, they looked a little flat. Maybe you can talk about your plans for 2010 with the International business, are you looking to expand that. You mentioned in your prepared remarks that you’re going to be getting into some different retail categories, is that part of the plans for International as well?

Jeff Katz

We clearly constrained our approach in International to go from growing International to growing earnings contribution in International. In general, some rocky economies depending on the marketplace contributed to the sales decline. We were, frankly most focused on driving improved earnings contribution from the segment. We knew we would drive sales down in some markets.

As to new distribution I think we have grown points of distribution pretty significantly in several markets, particularly the United Kingdom. Our opportunities in International I would tell you remain pretty basic so in the coming few years we’ll just be working harder to drive awareness and penetration of, for example our reading business, we have a lot of new products coming into learning toys.

Our building blocks having really improved our International cost structure are more about now just driving product penetration more effectively in key markets like Western Europe in particular, some of the Asian. Perhaps Bill can go into a couple more details.

Bill Chiasson

One thing I’d like to point out is that as we focused this year on really making sure that we had the International business situated correctly, we focused a lot on improving its profitability. The business has turned around, I think Jeff mentioned in his comments from a loss last year of about $4 million to a reported profit of $10 million for the International segment.

Of course we don’t allocate a lot of the fixed costs of the corporate spending there but it’s still a significant improvement in its profitability. We think we’ve established a good base outside of the US. We are focusing a lot on our English related languages, Queen’s English, and obviously the Canadian business as where growth will be and we feel good about prospects to be profitable going forward.

Drew Crum – Stifel Nicolaus

The Educational Gaming category, is there a point of sales number you can provide for the fourth quarter and just give us a sense as to where inventory is with that category entering 2010?

Bill Chiasson

I don’t have the fourth quarter point of sale. Inventory levels are in good shape. We have had some low stock levels at some of the retailers in some of the Leap Share lines and those are going to be fully stocked in the first quarter. There was a strong push for demand for them in the fourth quarter. It did have a good surge at the end of the year.

Drew Crum – Stifel Nicolaus

You mentioned in your remarks that you expected margins to be under pressure in 2010. Could you discuss the source of those pressures or get into a little more detail there?

Bill Chiasson

The key thing is that it’s going to continue, as I said, to be tough economic environment in 2010. While things have stabilized a bit there is still relatively high unemployment so still relatively low consumer spending. We expect the pressures, therefore, are going to be the same kind of continuation of much of what we’ve seen. We expect to see that same kind of pressure in 2010. That said, we will continue to focus on using product mix, improving our content sales to help blunt that as well as the cost reduction efforts that we’ve put in place.

Operator

Your next question comes from Sean McGowan – Needham & Company

Sean McGowan – Needham & Company

When you look at the shipments in the quarter versus the point of sale in the quarter, and I know inventories were very high at the beginning of the year. Any concern that they’re higher at the end of the year then you’d like them to be?

Jeff Katz

We’re still pretty lean according to historical standards. While there’s clearly going to be some situations where stock got in so late that it didn’t move adequately, let’s say to the shelf at the key times. I think it was worked pretty carefully so even adding that in we’re at close to historical lows on inventory. The off seems frankly at retail and at LeapFrog we’re pretty focused on that issue. We’re looking good, in fact it’s fair to say to your question and also a little bit relating to Drew’s that we’re still chasing a lot of out of stock situations right now.

Sean McGowan – Needham & Company

I was wondering if you wouldn’t mind repeating some of the detail that you gave before on the Interactive Reading, Education how much was up and down. Related to that, is LeapFrog.com that’s not in addition to those sales, those are sales that are spread out through those categories.

Bill Chiasson

That’s correct. LeapFrog.com is spread out throughout that. What is it you are specifically looking for?

Sean McGowan – Needham & Company

Some of the numbers came a little too quick, 19% increase in Interactive, Reading was it down 34% in Games, up 13% in Stand Alone and I didn’t get what LeapFrog.com was.

Bill Chiasson

You’re talking about on a shipment line Interactive Reading was up 19%, Gaming was down 34% and as I mentioned, Gaming was most affected by the high retail inventory overhand that we entered the year. Stand Alone learning toys were up 13% and LeapFrog.com was up 18%.

Sean McGowan – Needham & Company

Looking at the Educational Gaming, that includes Leapster1 and 2, correct?

Bill Chiasson

Correct.

Sean McGowan – Needham & Company

We would expect the normal decline in Leapster1 year on year. Can you share with us what it would look like if you just looking at Leapster2?

Bill Chiasson

Leapster2 did perform very well, as you would expect it did grow during the year. I don’t have those specific numbers with me. Also those numbers, to remind you, also included some of Didj from last year as well.

Sean McGowan – Needham & Company

What do you think will be the main components that drive revenue growth, that 10% to 20%? Is that going to be mostly products already out there or new products that we’ll see in a couple of days?

Bill Chiasson

The Reading business we expect to be continuing to be very strong in 2010, it had a very good growth last year and this year, even though we just introduced it 18 months ago. We expect it to continue its strong performance with Tag and Tag Jr. and its software. We are expecting the Gaming business to hold its own during the year. You’ll join us next week, I know you’re joining us next Tuesday, we’ll talk more about what’s coming out in the Gaming segment for next year and we think that will help us there.

We feel good about what’s been happening in the Learning Toys business, the new Scout line, nicely priced products, good connection at early ages, we expect that to be a driver of performance as well. Another key component, a very, very important component is the Learning Path Connection strategy. We saw its affect this year. Even with a 40% reduction of marketing spending, having that ability to communicate in a personalized way and a customized way to consumers has really helped to drive that overall POS.

We exited the year, we finished it after the holiday season with about three million connected consumers and we expect that to grow significantly in 2010. Those are the key drivers to where the growth is coming from.

Jeff Katz

This is really now our first big experience to take a large population to whom we sold products to in 2009 and by the Learning Path now we can, by product, by age, by consumer, go back and market to them next appropriate product in our portfolio.

Sean McGowan – Needham & Company

I know, I get a couple emails a day.

Jeff Katz

That causes us to expect growth pretty much across the board because we’ll take the Scout user and bringing them into either Fridge Phonics or Tag Jr. and so forth. You’re seeing that in your inbox and I hope you’re connecting your toys as you play with them.

Operator

Your next question comes from Ed Woo – Wedbush

Ed Woo – Wedbush

Do you see any changes with the competitive landscape either this past holiday or upcoming for this year?

Jeff Katz

I think this will be another year where there’s just a lot of good product coming to the market from the industry across categories from what we are hearing a little bit of what we are seeing its various marketplaces. I think it’ll be a very, very competitive year not just in terms of product launches, this is one of the reasons we’re not going to go too crazy with LeapFrog’s expectation in gross margin, we just think there’s a lot of very good product coming out, some of it related to entertainment licenses, some of it just coming from a lot of the strong companies in the industry, there’s just a lot of what I think is going to be appealing product for the consumer to get intrigued with.

In that sense I think it’s going to be a little more competitive. It may be that in 2009 people we holding back a little bit on some of their launch opportunities because it was a bit of a rocky year. I think it’ll be more competitive across categories, in our category for sure too.

Ed Woo – Wedbush

You guys did a very good job with your co-op advertising with your retailers. Do you see that changing at all in 2010, particularly as you start adding new distribution channels?

Jeff Katz

No, we expect in 2010 to do a good job. To your point, I think we’ve been learning some hard learned lessons and we believe we have a really good program underway for 2010 with retail. We do have increased points of distribution and again we’ll be managing the balance those relative to our other distribution opportunities. Again, I think we do still expect to have a lot of strong promotional opportunities in the channel. In general we’ll continue to be mindful of the margins we need to get to over the next year, two and three years.

Bill Chiasson

You’re right, our co-op we have increased the emphasis on it in 2009 I think that will continue in 2010. It’s been very effective for us. We’ve also been driving consumers to retail through the LeapFrog Connect as well, connection click throughs and coupons going to retail. Clearly that was very effective for us in 2009.

Operator

At this time there are no further questions.

Karen Sansot

Thanks everyone for joining us on our call today. Please feel free to contact Bill, Mark or me with any follow up questions. I can be reached at 510-420-4803. We hope to see you next week at our event in New York.

Operator

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

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