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LeapFrog Enterprises Inc (NYSE:LF)

Q4 2013 Results Earnings Conference Call

February 12, 2014 / 5:00 P.M. E.T.

Executives

Karen Sansot – Senior Director, IR

John Barbour – CEO

Ray Arthur – CFO

Analysts

Stephanie Wissink – Piper Jaffray & Co.

Michael Swartz – SunTrust Robinson Humphrey

Dave King – ROTH Capital Partners

Sean McGowan – Needham & Company

Jim Chartier – Monness, Crespi, Hardt & Co.

Ed Woo – Ascendiant Capital Markets

John Taylor – Arcadia Investment Corporation

Presentation

Operator

Good afternoon. My name is Jennifer, and I will be your conference operator today. I’d like to welcome everyone to the LeapFrog Enterprises fourth quarter 2013 earnings call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions). Thank you. I would like to turn the conference over to Karen Sansot, Senior Director of Investor Relations. Ma'am, you may begin your conference.

Karen Sansot

Thank you. Good afternoon, and welcome to the LeapFrog Enterprises conference call to review our results for the fourth quarter and year ended December 31, 2013. I am 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 item to go over. Our closed communication period, during which we will be unavailable to talk with investors or analysts about our business will begin on Monday, March 31st and will last until we announce result our first quarter results, which we expect to announce in early May.

And now the Safe Harbor statement. We wish to remind you that our statements today will include forward-looking statements including management's expectations regarding anticipated first quarter and full-year 2014 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 being February 12, 2014, and disclaims any duty to update them.

I would now like to turn the call over to John Barbour.

John Barbour

Thank you Karen. Good afternoon everyone. As you have already had a number of holiday performance announcements and company earnings statements, 2013 was a challenging year to be in the kid business, especially in the US. I have been in the kid business for over 25 years, and 2013 was one of the toughest holiday seasons that I have been through. With over two-thirds of our sales coming from the US market, we felt more of the impact than our competitors who do a larger share of their business in international markets. We were unable to build on the 28% full year net sales growth that we achieved in 2012, and our net sales for the year declined 5%.

Our operating income and net income for the year also declined. We are disappointed with our financial performance, and in the quality of execution on a number of businesses across the year, including the lack of a sub-$99 LeapPad on the market until August, the additional firmware issues that we had in our LeapPad Ultra, and the delayed launch of our new app store. Despite these missteps and the substantial market challenges, we continue to be the clear market leader in children's educational entertainment, and we delivered our second most profitable year in the last 10 years. If you look at our results over the past four years, we have grown our net sales by a compound annual growth rate of 10%.

From a cash perspective, we increased our operating cash flow by 17% in 2013, and we finished the year with $168 million of cash, which is up 40% year on year. Which all made Holiday 2013 especially challenging, but we headed into the all-important fourth quarter with sales up 9% for the year, with better retail in-stocks, lots more quality inventory in the retail pipeline, more retail shelf space, and more promotional support to drive sales. But we had to deal with three very large challenges as we move through the season.

Firstly, extremely aggressive retail price promotions driven by the soft market. In US, slow overall retail stores heading into Thanksgiving led retailers to take some deep pricing discounts on a number of high profile children's products to try and stimulate demand, including our top selling tablet, the LeapPad2, with a price cut from $79 to $39. That is a 60% price reduction from its holiday 2012 price of $99. It helped the retailers drive consumer traffic to stores, and to sell a whole bunch of LeapPad2s, but it wiped out the value proposition of our new for the holidays LeapPad2 Power, which was a LeapPad2 bundled with a $40 battery pack and charger at the value price of $99. Had the same negative effect on our character license LeapPad value bundles that were priced at $129.

Secondly, a compressed holiday period that hurt retail execution, as the holiday progressed, US retailers continued to experience significantly less foot traffic year on year, which ShopperTrak reported at the end of the holiday season, down 15%. Retailers reacted to the situation by cutting more prices to drive foot traffic, yet, many consumers held off shopping, and waited for even better deals. This delay combined with six fewer shopping days between Thanksgiving and Christmas resulted in a compression of holiday shopping in the peak shopping weeks. These factors made store execution much more challenging for our retail partners.

For instance, we could see from our retail channel check from all across the US that in the peak weeks, key products have run out of stock on shelves, while in fact, many of the same stores still had inventory in the back stock rooms, or in trailers in the parking lot. It was very difficult for our retail partners to respond to the pace of demand in such a short, compressed timeframe. We tried to improve our on-shelf inventory by investing more in retail merchandising to restock shelves, but had little impact on the situation. These factors dramatically reduced the number and value of replenishment orders received in December. In addition, slower overall toy category sales through December resulted in numerous retailer open to buy issues across our markets.

Third, a more competitive tablet market. Many retailers expanded their tablet sections for 2013. A lot of the new tablets were targeted at adults or families with older children than our target market, but there were also some new entrants aimed at younger children. New competitive kids tablets gained significant traction in the market, but they still took up shelf space, and negatively impacted a portion of our sales.

Despite all of the retail and competitive challenges we faced, we still sold a record number of LeapPads in 2013. Our LeapPad sales grew 11%, and we were the market leader in children's learning tablets in most of the major markets for the third year in a row, including in the US and the UK. In addition, our library of educational game cartridges was the second best selling toy ranked in dollars in the US, and number seven in the UK, according to MPD. Our products received 18 awards this year, including the very prestigious Toy Industry Association's People's Choice Toy of the Year Award, and the Educational Toy of the Year Award. In total, our products have now received more than 1,250 awards and inclusions on top toy lists during the nearly 20-year heritage of making learning solutions for kids.

Our global sales were down 5% for the year. We continued to grow our international business. Net sales in our international segment increased 6% for the year, and grew in every key international market. The international share of our business increased from 27% to 30% last year. Our newest market France, did particularly well, as its sales were up over 40%. We are especially happy about the success of our new LeapReader line in international markets, where our sales grew versus tag by 16%.

From a product prospective, we made important strides in 2013, in our tablet business, we launched LeapPad Ultra, our first wireless device that allows for peer-to-peer play, makes downloading content easier, and also provides access to a safe browsing experience developed specifically for children. Every piece of content available on LeapSearch, our kid experience, is reviewed by learning experts, and is organized into topic categories appropriate for each age range, as opposed to our competitors, who mainly just compile white lists of websites.

Along with Ultra, we vastly expanded our content library for tablets, and now offer over 1,200 global app titles, which is more than two times the number of titles we offered last year. The quality of our content library dramatically differentiates our product from our competition, with every piece of content carefully created or curated by our team of learning experts. Since we have launched the LeapPad Ultra, we have seen our user connectivity and connector issues improve for our tablet line. Wireless also enables us to more easily provide personalized feedback to parents about how their children use our products through our proprietary learning path system.

In our reading business, we launched LeapReader, which is our new reading and writing system, it holds many more books than Tag, our previous learn to read product line, and also offers audio books, discovery kits, and writing activity sets. We know from research that kids learn best when they learn how to read and write together, and this new product helps to develop both skills. LeapReader and LeapReader Junior offer more than 150 books, audio books, and discovery packs. We launched new toys, such as Read with Me Scout and Violet, and new app activity toys, such as the Creativity Camera app and case, and the Learn to Write with Mr. Pencil app and stylus.

In 2013, we also launched a significantly improved learning path experience, which includes an IOS mobile app for parents, a weekly newsletter, and a fresh, new easy to use parent resource center on our website. With the learning path, parents can get personalized learning ideas to help their children grow, share and discuss hot topics with each other, and track the progress of their child's development skills. So where do we go from here? How do we build on the 46% sales growth that LeapFrog has achieved since 2009? Our mission is clearly defined. We will continue to create great products to help children achieve their potential. Products that provide fun, engaging entertainment for children, and are filled with the nutrition of learning.

Our strategic priorities fall mainly into the following four buckets. One, major new platforms and innovative new products that diversify our portfolio. Two, continued innovation and expansion of our current categories. Three, geographical expansion, building on the success we have achieved in France. And four, significant infrastructure investments that will help us to become more efficient and scale as we grow. In recent customer pre shows and private toy fairs, we launched a major new platform in a new category that we do not currently participate, in some very innovative new products for 2014, that all deliver incredibly fun learning for children. Response to these introductions from our customers was very positive.

In March, Lionsgate and LeapFrog will launch the first of four new Letter Factory Learning Video with the next generation of our popular frog characters. The original Letter Factory continues to be one of the most highly consumer rated pieces of children's animation. Over 2.5 million copies have been sold to-date. Our collection of learning videos is very popular on Netflix. We continue to explore additional animation opportunities. For 2014, we will expand and refresh our best selling content libraries with a whole bunch of exciting new cartridges, books, and apps. Last year we did not have a sub-$99 tablet on shelf in the US and other markets until August, and we believe we lost sales to lower priced alternatives.

Our new LeapPad Custom Edition for 2014 is already on the shelf for $79, and is selling fairly well despite continued retail challenges. In addition, we have other exciting new LeapPads for 2014 that will help us to continue to be the market leaders in the kids learning tablet space. Our International team is working on a number of potential market expansion opportunities for 2015 and beyond. Many countries around the world are focused on improving education for their children, and we believe that this opens significant opportunities for LeapFrog. We are investing heavily in new information technology systems that will improve our business processes, help us serve and connect with our customers and consumers more effectively, and deliver efficiencies as we scale our Company. We will launch a new version of our app store in the middle of this year that will be easier to shop, and should help drive tie ratios.

We believe these significant, long-term, strategic investments together with our leading brand of product portfolio positions us well for continued market leadership, long-term sales, earnings, and cash flow growth. In summary, despite a disappointing performance in 2013, I believe we have made strong progress over the last few years on our journey to transform LeapFrog into an education entertainment company, and we have lots of exciting opportunities to help children achieve their potential ahead of us.

I frequently get asked, what makes LeapFrog unique and special. I believe it is a combination of our team members and our 20 years of brand heritage of delivering pure learning fun to children around the globe, creating highly engaging, fun experiences for children that are filled with the nutrition of quality learning is incredibly difficult, and few companies beyond LeapFrog have achieved it consistently. Our team is full of experienced, quality professionals, who are passionate about helping children achieve their potential. That is why our products have had a profound impact on millions of children around the world, and will continue to have a positive impact for many years to come.

I would like to close by thanking all of the LeapFrog team for their incredible passion and commitment to our mission. I will now turn the call over to Ray Arthur, LeapFrog's CFO, who will talk more about our Q4 and full year 2013 performance and 2014 outlook in more detail.

Ray Arthur

Thank you John, and good afternoon everyone. While we are disappointed with our 2013 results versus our expectations, we delivered our second most profitable performance in the last 10 years. Our compound annual net sales growth rate for the last four years was 10%, operating income, as a percentage of net sales was 6.3% for this most recent year, down from 11% in 2012, but still a solid return.

We generated $78.9 million in operating cash flow and ended 2013 with more cash on-hand than we have ever had at that time of year, and with no debt. Our results for the current and prior year include some non-recurring items that impacted our year-over-year and quarter-over-quarter comparisons, most notably in our tax line. In the fourth quarter of 2012, we released $21.6 million of an allowance against our domestic deferred tax assets that was originally put in place in 2006.

In the fourth quarter of 2013, we released an additional $62.8 million, which represents approximately 90% of the allowance that remained. The decision to release in both years was based on many factors, including three and four years of successive net income, which allowed us to conclude that we would generate enough future income to utilize these deferred tax assets. In addition, our results included $700,000 and $6.4 million in 2012 and 2013 respectively of previously unrecognized tax benefits, due to the expiration of statute of limitations in certain of our foreign jurisdictions.

Now let me provide insight into our fourth quarter financial performance, summarized in the financial tables accompanying the press release. For the first three quarters of 2013, net sales were up 9%. At that time, we were well positioned with sufficient inventory on-hand at retail for a robust fourth quarter. Unfortunately, the fourth quarter turned out to be disappointing at retail, with lower foot traffic, steep price discounting of our and competitors products, significant out-of-stock on shelves when recently shipped 2013 products were in retailers back rooms or storage containers available to replenish those shelves, and more competitors in the tablet market versus the same quarter of the prior year.

Worldwide sales for the quarter were $187 million, down 24% compared to a year ago, and were not materially impacted by changes in currency exchange rates. Net sales declined across all lines of our business in the fourth quarter for the reasons I previously mentioned. Our US segment sales were $124 million, down 30% compared to a year ago, and in our international segment, net sales were $63 million, down 6% compared to a year ago and were negatively impacted by 1% from changes in currency exchange rates. While the tough retail environment impacted our international segment, the impact was less pronounced than in our US segment.

Gross profit for the quarter was $72 million, a decrease of 34% compared to the prior year due to reduced sales, increased discounts and allowances, and changes in product mix. Gross margin rate was 38.8%, down 590 basis points compared to 44.7% a year ago, due primarily to proportionately higher sales of our lower margin platforms, increased discounts and allowances, reduced sales of our higher margin content and accessories, and overall lower sales levels resulting in less effective leverage of fixed costs.

Operating expenses for the fourth quarter were $71 million, up 7% compared to $66 million in the prior year period. SG&A decreased slightly as a result of lower variable compensation expenses. We missed our established annual established financial performance targets. This was offset by increased employee expenses related to higher headcount in line with our long-term strategic objectives. R&D expense increased by 10% for the period as we investing development of innovative new platforms and associated content. Our advertising expense was up 17% year-over-year due to higher cooperative advertising expense, and marketing efforts to stimulate POS and reduce inventory at year-end, to lessen this impact on future periods and shift in certain spending from the third to fourth quarter. Operating profit declined for the fourth quarter by $42 million as a result of the aforementioned conditions.

Net income per diluted share was $0.90, up 1% compared to $0.89 a share a year ago. Net income for the fourth quarter of 2013 included an $0.89 per share-diluted benefit from the reversal of a valuation allowance established in 2006 against our deferred tax assets. Net income for the fourth quarter of 2012 included a $0.31 per diluted share benefit from the reversal of a valuation allowance established in 2006 against our deferred tax assets. So normalized net income per share, which is a non-GAAP number which reflects an effective 37.5% tax rate, and excludes actual tax benefits and tax expenses, produced EPS of zero compared to $0.38 a year ago.

Now we will review our full-year 2013 results. Worldwide net sales for the year were $554 million, down 5% compared to a year ago, and we are not materially impacted by changes in currency exchange rates. The sales decline was mainly driven by our multimedia learning line that was down 4%, handheld gaming systems and associated content accessories drove much of the decline, but our tablet cartridge content sales and accessories also dropped as a result of retail inventory reductions over the year, higher cost discounts to support retail price promotions, and a greater mix of bundles containing accessories and content. Sales of our LeapPad line of platforms actually increased 11%, and the reading systems business was up 5% with the launch of our new Learn to Read and Write LeapReader and LeapReader Jr. junior.

Our US segment net sales were $387 million, down 9% compared to a year ago. Net sales for our international segment were $167 million, up 6% compared to a year ago, and we were negatively impacted by 1 percentage point from changes in currency exchange rates. POS was down in all of our key markets expect France, resulting higher than desired yearend inventory levels, which will negatively impact sales in 2014. Gross profit for the year was $216 million, a decline of 12% compared to the prior year. Gross margin rate was 39%, down 310 basis points, compared to 42.1% a year ago. Due to unfavorable changes in our product sales mix with proportionately higher hardware sales, higher discounts and allowances of percentage of sales, lower sales of our higher margin accessories and content, higher royalty costs resulting from higher sales of licensed content, and all of this was partially offset by lower inventory allowances.

Operating expenses for the year were $181 million, flat, as compared to the prior year, but up 160 basis points as a percentage of net sales. SG&A and R&D decreased 4% and 2% respectively due to lower provision for incentive compensation expense, as we missed our established annual financial performance targets. Partly offset by higher employee related expenses as a result of an increase in headcount to support our strategic initiatives. In addition, SG&A in the prior year included $3.1 million in bad debt expense due to an isolated supplier bankruptcy. Advertising expense was up $5 million or 12% year-over-year due to higher cooperative advertising expense and marketing efforts to stimulate POS and minimize retailer-ending inventory.

Income from operations was $35 million, down $29 million, or 45% compared to the year ago period. Net income was $84 million, or $1.19 per share, compared to $86.5 million, or $1.24 per diluted share reported in the prior year. A significant reversal of tax valuation allowances, as well as benefits from tax adjustments due to statute of limitations expirations are included in the results of 2013 and 2012. Normalized net income per share, which is a non-GAAP number that reflects an effective tax rate of 37.5%, and excludes tax benefits and tax expenses, actuals, was $0.30 compared to $0.56 compared to a year ago.

Now turning to our balance sheet. Cash and equivalents at year-end were up to $168 million that is an increase of $48 million, or up 40% compared to last year. Operating cash flow remains strong, and increased by $11 million, or 16% to $79 million for the year, and our cash balance continues to grow as we collect our year-end receivables, and as of this morning, our cash balance is just over $220 million. Our Accounts Receivable balance was $133 million, a decrease of 26%, due primarily to the 24% decrease in net sales in the fourth quarter. Our portfolio is in great shape and our collections have remained strong, with DSO declining by 2 days to 64 days in Q4 2013, compared to 66 days in Q4 2012. Our inventory balance was $54million, up $14 million, or 35% compared to a year ago, largely due to the decrease in sales during the fourth quarter. In addition, we believe inventories at retail are up a low double-digit growth rate from last year, and we believe this will negatively impact sales in 2014.

Now let me turn to the 2014 outlook. We are very excited about our market-leading portfolio and new product launches for 2014, including new innovative products that address new categories of business. As a result, despite a global economy that is running sluggish, a US toy industry that declined in 2013, and our current retail inventory position, we plan for net sales to increase in 2014. We also plan to make significant long-term investments in content, international expansion, online communities, new platforms, and information system capabilities.

So specifically for the full-year of 2014, our guidance is as follows, we expect net sales to be in the range of $554 million to $580 million, we expect EPS to be in the range of $0.18 to $0.25 per share compared with normalized EPS of $0.30 in 2013. You will the GAAP EPS in 2013 was $1.19, but that included significant one-time tax benefits. We expect capital expenditures to be in the range of $35 million to $45 million, this range includes approximately $12 million for the re-implementation of the Company's integrated enterprise resource planning systems, and capital expenditures for 2013 of $34 million.

Specifically, as to the first quarter of 2014, guidance is as follows, net sales in the range of $45 million to $50 million, due to higher than desired ending 2013 inventory levels at retail, and a very weak current retail climate in the US, compared to $83 million in net sales for the first quarter of 2013. We expect net loss per share to be in the range of $0.20 to $0.23, compared to a loss of $0.05 in the prior year.

Our next issue is the share repurchase. Our Board of Directors has approved a share repurchase program that authorizes us to repurchase up to $30 million of our common stock through December 31, 2014. This share repurchase takes advantage of our strong cash position, helps offset dilution inherent in our employee equity plans, and reflects to Board and the leadership team's continued confidence in LeapFrog's strategic direction, and ongoing commitment to maximizing shareholder value. At this time, our EPS guidance does not reflect an impact from the share repurchase, since it is not feasible to currently estimate the exact timing and size of such purchases.

In closing, as we look to 2014 and beyond, we are very encouraged and believe that we are well positioned to grow and deliver strong cash flow. We are the leader in children's educational entertainment, with a brand that parents and children love, and exceptionally strong innovative product portfolio.

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

Question-and-Answer Session

Operator

Our first question comes from the line of Steph Wissink with Piper Jaffray.

Stephanie Wissink – Piper Jaffray & Co.

Hi, thank you. Good afternoon everyone. A couple of questions for us, Ray, first one for you. If you could just talk a little bit about the flexibility and the variable expense structure in the model. I think you mentioned that operating expenses were up slightly, but it sounds like you did pull on some of the various expense levers that you had. Secondly, maybe for you John, just related to the advertising and some of merchandising expenses that you incurred, to try to really facilitate getting that product out of the back room and onto the shelves. Do you feel like that was an effective strategy, or was that just something that was just an effort to really assist the retailers, where you were seeing them slip on some of their commitments? Thank you.

Ray Arthur

As to the variability of the cost structure, we do have, the biggest change is really incentive compensation, which is a significant number that declines as our results decline. In addition to that, we do use a number of outside contractors that we are able to easily engage or disengage, and the balance of the variable portions relate primarily to head count, and as we have said, we have added some additional head count for strategic purposes over the prior year, probably about 5%.

John Barbour

If we are going to talk about the merchandising, I mean a couple of things that I would say, I am in stores every couple of days over the holiday season, so I have got a pretty good sense of what is happening out there, and Ray and I both have got a number of years of experience at working in the retail business, and this year was just an especially unique year with just amazing compression that happened this year. Unfortunately, we were seeing significant out-of-stocks on shelf of our key products. Products like LeapPad Ultra. I was finding that when I was in stores, it was out-of-stock in as many as 30% or 40% of the sales that I was going into, that drove us to invest in putting more money and putting more merchandise into the store. In the end, it felt like in some way, you are fighting against a very big tide there, so whether merchandisers can go in and put product on shelf one day, when you are dealing with that type of tidal wave of demand, it is very tough to keep it up , so in the end, I am not sure it was the most effective of investments just because of the compression we were dealing with.

Stephanie Wissink – Piper Jaffray & Co.

If I could, just two follow-ups to that. As you look at 2014 in contrast to 2013. It looks like the back half of the year, the guide implies a pretty significant lift year-over-year. Is that based on a change in the calendar, or are you thinking differently about your business? Maybe a question for you, Ray. Based on the mix of business, stronger sales of lower margin segments, how do you start to balance out better sales of your higher margin segments?

John Barbour

I think if you look at the season, hopefully everybody knows that we don't manage the business on a quarter-to-quarter basis. We are focused at building a great long-term business here, and we tend to focus on a yearly basis. I think what is lost a little bit in all of this conversation at times is, we grew the business in 2012 by 28%. We were 9% up going into the fourth quarter this year, so it just puts into perspective a little bit of how tough this holiday season was. We expect the season to be less difficult next year. I am sure we are not going to deal with some of the same economic factors that hit us in the US, and we can all learn a lot about what happened this year. The other thing you are seeing there as well is the addition of some quite exciting new products that are going to be launched later this year, especially a major new platform that we mentioned that we have shown at pre shows and we have shown privately to some of our customers at toy fairs, and has gotten a very good response. It is partly driven by the seasonality in the marketplace, and the new products we are bringing.

Ray Arthur

The second part of the question, I think, is how do we start selling more of the higher margin lines we have. I would say one of the issues that occurred during the year is retailers in general brought down their inventory of content that they kept online, so that had some impact on the business. In addition, accessories, we really built out the line in 2012, and sold a lot into retail. I think they came into this year with probably more accessories than they probably would have cared for. In addition, what we did is we bundled a lot of those accessories this year, so they weren't selling independently. But as we go forward, one of the big initiatives getting is our digital web store launched, and improving our interaction with our 13 million e-mail connected customers we have, and making it a more relevant experience and easier to buy. I think that as well as coming up with just more new, innovative and relevant content will drive the content sales over the longer term.

John Barbour

I think the other thing we are seeing as well, it is still in early days, our new Wi-Fi tablet, the LeapPad Ultra is driving greater connection rates and greater tie ratios, so we start to see that having a positive impact as we get through this year as well.

Stephanie Wissink – Piper Jaffray & Co.

All right guys, thank you. Best of luck.

John Barbour

Thank you.

Ray Arthur

Thanks.

Operator

Your next question is from the line of Mike Swartz of SunTrust.

Michael Swartz – SunTrust Robinson Humphrey

Good afternoon, everyone.

John Barbour

Hey, Mike.

Michael Swartz – SunTrust Robinson Humphrey

Just kind of digging into the inventory numbers. How did they look by region, if we look at the US versus some of your international markets? Are they more elevated here in the domestic market?

Ray Arthur

Yes, I think there was more here in the domestic market. The international was not as impacted by the overall weakness in fourth quarter anywhere near what the US was or North America.

Michael Swartz – SunTrust Robinson Humphrey

Okay.

Ray Arthur

I think inventory is internationally, we don't get a lot of information from retailers as to exactly what they have, but I would directionally believe that they are in better shape than the US is.

Michael Swartz – SunTrust Robinson Humphrey

Okay, thanks. And in terms of just the tablet and maybe the hardware side of the business, could you maybe give us some color on the competitive environment of what you saw this year versus what you have seen in the past and how you see that shaking out as we go into 2014?

John Barbour

I think a couple of things I would say. First of all, tablets are here to stay. Virtually every child wants one, and to be frank, needs to learn how to use one for the future. We have the best first tablets for children. All of our LeapPads are kid safe, right out of the box, kid tough so they can withstand drops. We have got the only created library of games, books, et cetera. The fact is, yes, there are more tablets in the marketplace, but we firmly believe, and if you look in terms of MPD, we have the number one tablet in the space. Our tablet sales grew last year 11%, despite all of the things that we have talked about today and the competition. Definitely there are more tablets in the marketplace, but many of those tablets are targeted for older kids than where we are at. Our core business here are young children from three to four years of age up to seven years. The bulk of the new tablets that were launched around the world last year, are totally unsuitable for those children.

At the same time, there were a number of kid-focused tablets that came on to the marketplace, but most of them didn't gain much traction in the marketplace, that is why we are still the number one seller of kid tablets in the marketplace, and we sell 40% more than our nearest competitor in the space. Yes, there is more competition out there, and it is something that we take very seriously, but I think the bulk of that competition is not really directly at our marketplace, and it is quite unsuitable about our marketplace. Again, we are paranoid about it, but most of the people who have targeted tablets to kids haven't really gained much traction. Many of them are actually being discounted and cleared from shelves right now. I think there has been some quite disappointment out there, in terms of people who brought a lot more tablets into their stores, and are finding that the marketplace is still highly focused on a few players in the marketplace. There are lots of products, but the bulk of sales are only going to a few players.

Ray Arthur

If I could add to that, just an item or two. A lot of it is the innovation in our product line. So for instance, our LeapSearch Browsing is really a kid browsing experience, where the content is age appropriate and categorized by different learning areas, where as others in the marketplace, simply put together a white list of sites that children can go to. We have a maniacal focus here on creating fun, engaging, age appropriate, safe content, and with the introductions we have planned in 2014, we expect that we will continue to be the market leader here.

Michael Swartz – SunTrust Robinson Humphrey

Okay, great, thanks guys.

Operator

Your next question comes from the line of Dave King with ROTH Capital.

Dave King – ROTH Capital Partners

Thanks, guys.

John Barbour

Hey, Dave.

Dave King – ROTH Capital Partners

First off, I wanted to dig into the comment and maybe follow-up on some of the other questions and the comment on some of the competition you are seeing, both in terms of retail losing shelf space it sounds like, but at the same time, those competitors aren't really seeing significant traction I think is what you said. Are you able to quantify that at all, and then more generally, how should we think about it? It sounds like you are still number one in terms of MPD data on tablets, but how has that changed over the past year in terms of share losses, gains, what have you?

John Barbour

Let's look at it point-to-point, number one, we actually had more shelf space in the fourth quarter than we had the year before. That is not to say that retailers didn't give even more shelf space to some of the competition as they looked at marketplace as a big opportunity based upon the growth of 2012. We look at the numbers all of the time in the marketplace, so we have got a pretty good sense of what share all of the players have in the marketplace in our segment, and as I said earlier, we have sold 40% more tablets than our nearest competitor in the marketplace, and we are still significantly number one in the marketplace, that is not to say that when more tablets come into the marketplace that they don't take some share of our business. Our share did drop year-on-year, there is no question about that, but we still have got a significant share in the marketplace, we are still significantly number one, we have come into this year in the first three weeks of January, we are still significantly number one in the marketplace.

It is interesting because tablet competition and the question of how long will LeapPad be around the place is something that I think has danced around the place for quite some time. I get back to the bigger meta point here, which is tablets, are here to stay. Kids needs to be introduced to tablet play, and the best way, these are three, four, and five-year-old children, that to be frank as a parent, I would never give the bulk of tablets on the marketplace to my child to play in their room by themselves. Absolutely not. Every day there is a story on the internet about some story on the internet or apps, phishing, and all of this other stuff.

I think we sometimes lose perspective here. These are four to five and six-year-old kids, and today we have the best first tablet for those kids. The bulk of all of our content is either being curated or has been developed by learning experts. We get great creativity products in there. I think it is real important we recognize there is competition, we are not shying away from that, but I think sometimes the competitive thing is a little bit overblown as people look at our business. In saying that, we are super paranoid about it, super paranoid and we are constantly trying to push the envelope in the stuff we are doing as a Company.

Dave King

Fair enough. I guess playing devil's advocate a little bit, then maybe thinking big picture. At what point do you think, it sounds like tablets for you guys is also here to stay, but I guess how do you by about it vis-a-vis, some of these competitors their cost production is much lower, yes, they can't necessarily produce the same product that you guys can, or haven't been able to so far that you guys can, but at the same time part of your competitive advantage is on the content side, right, so is there something you guys can do to start to monetize that content side better, or figure out a way to do it, whether it is through app development what have you, to go after your core competency on that side some more, and maybe you can just update us on your current thoughts, and how you are thinking about that Android, and all of those things?

John Barbour

A couple of things, I can tell you right now there will always be somebody that can make cheaper tablets than us. I am not sure there will be anybody who will be able to make a better tablet for kids, especially the age band that we do. Beyond that it is not about the hardware. It is truly about the content. It is the content that changes kids lives, and nobody out there in the marketplace has the portfolio of content that we have got. Content that has personalization components built into it, so when you buy one piece of content it actually will help when the next kid comes home and the next piece of content, and level them properly. The sophistication, the quality of education that is in our content has not been beaten by anybody else on the marketplace.

If you look at beyond our platforms, yes there are people that have got lots of content out there. There are millions of free apps out there for kids, right. Many of them don't have much education in them at all, some are full of mistakes, some of them are not age appropriate for the kid. To be frank, most of the people that make that content don't make any money. I gave a speech at CS the other day there, and I asked the lady, I see a big time app developer. Are you making money in making apps for IOS, and she said, yes I am. I said how do you do it. She said, we don't pay ourselves any money.

I think the challenge here is that the idea that there are many companies out there that are coining it in big time by making apps for children of the age of three, four, five, six years old in the marketplace is a fallacy, because many of the monetization methods in that marketplace, advertising or inept purchases are massively frowned upon for children of that age, and it is not a place that we want to go as a Company. Yes, we would like to find a way to be able to monetize the great content we have got on other platforms, and we have a whole strategic team working on that right now. I hope we find the solution that nobody else or very few people of any scale have found so far. So far, we don't have a solution that allow to us put our content on other platforms and make the profitability that allows us to cover that investment for the long term.

Dave King – ROTH Capital Partners

That is extremely helpful. A quick follow-up for you, Ray. In terms of the buyback, how should we think about given the stock with where it is trading, how should we think about how aggressive you are planning to be, what is the thought process in how you think about the buyback? Thanks.

Ray Arthur

We will consult with an internal team here during open windows and determine whether we believe that it is an appropriate time to go into the market based on trading volumes, trading prices. I wouldn't provide a guide to you as to a per share price, but clearly we believe the stock is under-valued where it is, so I don't have timing at this point, or cash flow projections as to when we might complete that program.

John Barbour

Can I add something else, a little bit on content, which I think is real important, because it is the content that changes the kids lives. We have won more awards for content than anyone else in the space. It works on our tablets at the moment, right, and we have the best tablets for young children in the marketplace. It is not that we are closed to other platforms. It is just that we haven't found the model yet that works for us.

Dave King – ROTH Capital Partners

Okay, this has been extremely helpful. Thanks, guys.

Operator

And your next question is from the line of Sean McGowan with Needham.

Sean McGowan – Needham & Company

Thanks. Just wanted to go back over a couple of things. Hi, JB. A couple of things you said earlier, when you were making the comments about the best selling, whatever you were talking about kid directed tablets. Are you including there the Nabi stuff, would you consider that a kid directed tablet?

John Barbour

Yes, we would. On that one, we have got the MP data, and we have looked at the MP data, and I can tell you categorically, significantly more LeapPads were sold in the US through retail than Nabis from MPD.

Sean McGowan – Needham & Company

Okay. And when you talk about the 11% increase in LeapPad, is that hardware only or the entire the entire system?

John Barbour

That is hardware.

Sean McGowan – Needham & Company

Okay. Can you give us at least some hint of what the new platform might be, what category it might be in? It is hard to imagine.

John Barbour

We could, we would have to kill you though.

Sean McGowan – Needham & Company

Kill me. Tell me, then kill me, and then everybody else will get it.

John Barbour

We can't, but we will show it to the world as we usually do in the middle of the year. As you know, another thing we are paranoid about is people copying our ideas. There is a fair amount of issues out there of people looking at us as being their source of innovation in the marketplace. We have got something here that we believe is very special, and a new character that we don't play in at the moment. I have been in meetings where we have shown this to retail partners and I have to say their response has been exceptionally positive.

We are looking to diversify our business. I think it is an important strategic initiative for us as a business, both diversifying in terms of our product categories and in terms of the markets we operate in. Our mission as a Company, as we look at is it, helping children achieve their potential. It is not just to be a tablet company or a toy company. An example of that is our investment into our four new frog movies, which again have been an important part of our business.

The essence of LeapFrog, I believe, and what makes us different from any other company out there is, we have a quality group of individuals here, who know how to make great, fun, entertainment for children, who work hand-in-hand with educators who are up-to-date with some of the best, most proven ways of teaching kids, and together they create these products that are incredibly engaging and compelling, that deliver this nutrition of education, and if you step back and think about our business that way, and ask yourself, what other ways are today's kids being entertained, it shows I think a wide variety of other opportunities where we can bring that magic to play in the marketplace, and help grow a great business here.

Sean McGowan – Needham & Company

Okay, then a couple of questions without getting into specifics of what it is. Is this a razor/razor blade type of model, where there is content to follow that would presumably be at a more healthier margin?

John Barbour,

What is that game that you Americans play with their kids? What is it called?

Sean McGowan – Needham & Company

It is called just tell me. It is called 20 questions.

John Barbour

The answer is 20 questions, yes. We are not playing 20 questions. The answer is, yes, it is.

Sean McGowan – Needham & Company

Not about the product, but how much of the stronger second half through 2014 that you are expecting would come from that platform and its related products?

John Barbour

The answer to that is, it is actually going to be launched quite late, so probably not as much as you would think. We see the big part of the business being next year, so it is a late launch. By the way, just so we are really clear, we have got a few things that are in different categories than we are in at the moment, but we have one major launch, but most of them are launching quite late, and I think there was certainly an impact on our business for this year, but a far bigger impact as we go into next year.

Sean McGowan – Needham & Company

I can't wait to see it. Thanks a lot.

John Barbour

I can't wait to show you. In all sincerity it is super exciting. I have got the opportunity, my office is only about 15 feet from our playroom in the office where we test all of our products, and therefore, I get a chance to watch kids playing with these products before anybody knows anything about them on the marketplace, and I have to tell you, they are real exciting.

Sean McGowan – Needham & Company

Thanks.

Operator

Your next question is from the line of Jim Chartier with Monness Crespi.

Jim Chartier – Monness, Crespi, Hardt & Co.

Good evening.

John Barbour

Hey, Jim.

Jim Chartier – Monness, Crespi, Hardt & Co.

Hi. The first question of gross margins, do you feel like the margin structure for the LeapPad business has changed and is now set at a lower rate, or with lower inventory levels can you guys get margins back to where they were historically?

Ray Arthur

I think we are going face some challenges early in the year with the inventory that is at retail, and we are going to have to work with our retailers to clear through what is out there. The plan though is to get our margin rates back up to at least where they are at the end of 2013, and ultimately to see those improve. I don't think there has been a structural shift in our margins structure at this point. I think we were really hurt by those early Black Friday deals that just ruined the value proposition of our bundle programs and LeapPad2 Power, which were going to be big items for us on holiday, and when their value proposition got destroyed, it hurt us in terms of margins, then we also had to support retailers and trying to stimulate POS and sell through that inventory, but we will recover from that.

Jim Chartier – Monness, Crespi, Hardt & Co.

And then on the guidance you mentioned GAAP guidance in the press release. What is the tax rate embedded in that? Can you give us some color on gross margin versus expenses for first quarter in the year?

Ray Arthur

I don't generally go into that amount of detail in the guidance going forward, but I would say, we are back to a normal tax rate situation now, so it is about a 37.5% effective rate we would be looking at.

Jim Chartier – Monness, Crespi, Hardt & Co.

Okay. And then do you have a sense for how long kids are using the LeapPads for? Is it more than a year? Just kind of how much of your software business is driven by LeapPads from the prior year versus current year?

John Barbour

We have a pretty good sense of the consumers who buy content from us online and the consumers who connect into our systems, but we are not going to disclose that because our competitors would love to know that, so sorry about that one.

Jim Chartier – Monness, Crespi, Hardt & Co.

Okay. Thanks, and best of luck.

John Barbour

Thank you very much.

Operator

And your next question is from the line of Ed Woo with Ascendiant Capital.

Ed Woo – Ascendiant Capital Markets

Thank you. I had a question in terms of you mentioned that there is a lot of weakness in the US specifically. What is your outlook for international, and do you have any differentiated, I guess a product launches coming out perhaps a strong market, or other non-English speaking countries for your LeapPads?

John Barbour

We are going to continue to expand in the markets we are in for this year. Some of those markets, each market has got its own economic opportunities and challenges, but we are going to continue to expand product lines in our existing markets. Then we have a whole strategic team at the moment that is working on our international team to look at potential new opportunities to expand, using a similar model to the model that has been very successful in France.

Ed Woo – Ascendiant Capital Markets

Then in terms of some of the competition you are seeing in the US, would you say that is similar in the international market, or is it different?

John Barbour

Actually, it is quite different. It is actually very different I would say in some of the marketplaces around the world. Each market has its own nuance, but it is quite different. There is a lot less, there has been an immense amount of bad publicity in the UK for children getting their hands on some of these cheap Android tablets, it has been covered in the newspapers and TV, so many retailers have actually dropped the cheaper Android tablets there that are being targeted at kids. Those tablets that are really media tablets for older kids that somebody has throwing a rubber bumper around. The percentage of business that is done by cheaper Android type tablets focused on kids is a lot lower in the UK than it is in the US. Beyond that, I think it is really each market has its own nuance.

Ed Woo – Ascendiant Capital Markets

Great. The last question I have is, you mentioned that the retail calendar may be a little bit less challenging next year, partly due to a bigger timed holiday shopping season, but do you think there will be much changes in some of the other factors that you have particularly the competition?

John Barbour

Yes, there are a few things. I think that as you look to the year, you have got to hope that in the US we are not going to have to deal with some of the political challenges that it is pretty well-recorded right there, had an impact in consumer's confidence and spending, but none of us have a crystal ball and can really see what is happening. We know a couple of things are changing from a time point. Easter is later. You may look at that as just a shift. Traditionally when we were in retail, actually a later Easter actually meant a slightly better Easter, and there is a bigger space of time between the Thanksgiving and Christmas by a day, but I actually think the pains of this year are actually going to strike pretty much at people's throats, and everybody is going to be thinking their way around how they are going solve against those problems, and some of those solutions I think will work, and maybe there will be new problems that pop up as well. We have not planned in our business any dramatic improvement in either the economy, or in the way that our retailers are going to execute the business. All of our planning has been based upon the viewpoint by market, by product, by customer.

Ed Woo – Ascendiant Capital Markets

Great. Thank you and good luck.

John Barbour

Thanks, Ed.

Operator

And our last question comes from the line of John Taylor with Arcadia Investment.

John Taylor – Arcadia Investment Corporation

Hi guys.

John Barbour

Hey, J.T.

John Taylor – Arcadia Investment Corporation

In the past, you guys used to breakout hardware, software, standalone. Are you still doing that and if so, what does it look like?

John Barbour

No, we don't do it anymore, because again across all of our platforms it makes it a little bit more complicated and we don't disclose it.

John Taylor – Arcadia Investment Corporation

Let me go at it this way. I don't recall whether you said anything about the tie ratio or not. One of the things it seems to me like your curated software lineup and educationally intensive software ought to imply is nice long lives and higher tie ratios, and stuff like that. I wonder if you could tell us what the trend looked like from one year to the next, or maybe talk about things that you might be doing to increase that, and let me just tack this on because maybe it is related. I am kind of wondering if you might expand a little bit on the whole ecommerce platform expansion, and how that might show up, either in terms of tie ratios, or Ray, this might be for you, sorry for the long-winded question, but for you, what the timing of the investment might be, how much it might total, kind of what is involved and how that might be spaced out over 2014 and 2015? Thanks.

John Barbour

Let me give you a couple of thoughts. First of all, tie ratio improved 2013 versus 2012, and our new Wi-Fi tablet, the Ultra has a higher tie ratio in its LE reads than our regular tablets, and therefore, as we look forward to more Wi-Fi tablets we put into the marketplace, we think there is an opportunity to improve tie ratios, that aligned by a better app store that we will launch this year, should have a positive impact on the marketplace as well. I think that we are building on some growth here, and we have got some really good building blocks to build upon that so that we can extend the life of our tablet, and deliver more life-changing content onto it.

Ray Arthur

I think we spent a lot on the platform in the last year and a half, probably order of magnitude $10 million, and we will probably spend a few million more to complete it this year.

John Barbour

Unfortunately, it was delayed and it was supposed to launch for the holiday season 2014, but we had some issues with a supplier and some stuff, and it is going to be launched this year.

John Taylor – Arcadia Investment Corporation

Okay, good. So the period of investment may be the time to start harvesting from the investment really swaps over in 2015?

Ray Arthur

Yes, later this year, and then into 2015.

John Barbour

As you look across our business, the other thing to reflect on is, as you know, when we launch a major new platform at the end of this year, every time we launch a significant new platform, it imbalances that equation of harvesting the content on the back of it because again you are putting more hardware in there, so I think it is important to recognize that we did say that this big new thing we are launching a platform and does have content behind it, and much of the content sales tend to follow the tablet sales after the fourth quarter.

John Taylor – Arcadia Investment Corporation

Okay, good. The new thing you are not talking too much about, is that going to be launched globally or in the US only this year?

John Barbour

It is going to be launched in multiple markets, but not globally.

John Taylor

Alright. And as you look at the revenue mix, domestic versus international, last year it was about 2-1 I think. Which way do you think it will go into 2014?

Ray Arthur

It was 30% last year, and I would hope that it would continue to grow as a percentage of the total.

John Taylor – Arcadia Investment Corporation

Alright, great. Thank you much.

Karen Sansot

Operator any there more questions?

Operator

There are no other questions in queue at this time.

Karen Sansot

Great. Thank you everyone for joining us on the call today, and please feel free to call Ray or me with any follow-up questions. Bye.

Operator

Thank you. This does conclude today's conference call, and you may now disconnect.

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