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Executives

Eileen VanEss – Vice President, Investor Relations, Treasurer

Jeffrey G. Katz - President, Chief Executive Officer, Director

William B. Chiasson - Chief Financial Officer and Principal Financial Officer

Analysts

Anthony N. Gikas - Piper Jaffray

Gerrick Johnson - BMO Capital Markets

Alex Beldman - Merrill Lynch

Sean McGowan - Needham & Company

John Taylor - Arcadia

Arvind Bhatia - Sterne, Agee & Leach

Edward Woo - Wedbush Morgan Securities

LeapFrog Enterprises, Inc. (LF) Q4 2007 Earnings Call March 3, 2008 5:00 PM ET

Operator

Good afternoon. My name is Krista and I will be your conference operator today. At this time, I would like to welcome everyone to the LeapFrog Q4 and full year 2007 financial results conference call. (Operator Instructions) Ms. VanEss, you may begin your conference.

Eileen VanEss

Thank you, Krista. Thank you. Good afternoon and welcome to LeapFrog Enterprise’s conference call to review the results of our full year and fourth quarter ended December 31, 2007. I’m Eileen VanEss, Vice President of Investor Relations and Treasurer.

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 financial results for 2008, forecasted achievement of business metrics, anticipated impact of future initiatives and objectives, planned launches of product, services, and features, and other similar matters.

In addition, we expect the questions posed in the Q&A portion of this call may prompt answers that contain additional forward-looking statements not contained in our prepared remarks. This cautionary language concerning forward-looking statements applies to both our prepared remarks and our impromptu answers to questions posed during the course of this conference call. A variety of factors, many of which are beyond our control, affect our operations, performance, business strategy and results, and could cause actual results to differ materially from those projected in such forward-looking statements. Some of these factors are described in our 2006 annual report on Form 10-K filed with the Securities and Exchange Commission on March 8, 2007, as well as in LeapFrog's other public statements and SEC filings. LeapFrog does not update forward-looking statements and expressly disclaims any obligation to do so.

And with that, I would like to turn the call over to Jeff Katz, President and CEO.

Jeffrey G. Katz

Thank you, Eileen and thanks everyone for joining us today. I’m going to begin with a recap of our fourth quarter and full year 2007 results and then I’ll talk about 2008, our biggest new product launch ever, and the beginning of a new growth phase for LeapFrog.

Fourth quarter revenue was $181 million, down slightly from the comparable 2006 quarter and in line with our expectations. Our net loss for the quarter was $32 million, or $0.51 per share.

Turning to the 2007 full year, our results met our expectations as weak sales of legacy products were only partially offset by sales of new products launched in the year. Throughout the year we invested in preparation for the launch of our new products that we will begin shipping this summer. All of this led to a substantial loss for the year, albeit a much lower loss than last year.

2007 sales totaled $442 million, a decline of about 12%. We effectively improved our gross profit for the year despite lower net sales. Gross margin improved by 10 percentage points to 39% for 2007.

Our net loss for the year was $1.60 per share, marking a significant improvement over the $2.31 loss for 2006 but still awful. I am pleased to report we ended the year with a healthy balance sheet to fund our ongoing product development and launch initiatives. During the year, we reduced our own inventory by 28% and retailer inventory by approximately 20% to $52 million, and we ended the year with over $100 million in cash and investments.

For a quick recap of the 2007 holiday selling season, while LeapFrog faced some cautious retailer purchasing, there were some bright spots. Several of our key products performed well, including ClickStart, My First Computer, our Learning Group toy line and our Leapster gaming system and software. Leapster’s strong sales continue to lead the educational gaming market and our sell-through tie ratio increased to 3.8 from 3.2 from last year through the fourth quarter of this year.

The performance of our Fly Fusion pen-top computer was an item of note. While the Fly Fusion hardware was nearly sold out in stores by year-end, retailers ordered fewer units than we had originally forecast. It’s tough to say what would have happened if retailers had purchased more. The product continues however to be listed in 2008.

Looking ahead, 2008 is a brand new year and we are positioned well with a great team and a robust new product line. We are making progress in developing connected products and we will launch four web-connect platforms along with greatly enhanced parents and kids sections on LeapFrog.com.

Now before I go further, I would like to turn the call over to Bill Chiasson for some additional detail on our financial results. Bill.

William B. Chiasson

Thanks, Jeff. I’d like to begin by first providing an overview of the key drivers of our 2007 financial performance and then move on to the detail of our full year and fourth quarter results. For the full year, our consolidated net sales in 2007 were $442.3 million, a decrease of $60 million or about 12% compared to last year. As we’ve discussed in prior quarters, the declines were driven entirely by products that have been or will be phased out by mid-2008.

ClickStart got off to a good start while the classic Leapster continues to do well with sales growth in both hardware and software. Both of these products are part of our educational gaming products, which make up about half of our business.

Operating expenses were up slightly this year versus last, with legal costs and settlement expense driving increases in selling, general, and administrative expenses. Research and development expense increased for 2007 compared to 2006 due to costs associated with the extensive new product introductions we will have in 2008 and 2009, and advertising expense for 2007 fell due to lower sales and promotion allowances.

We ended the year with a solid balance sheet. Cash and investments exceeded $100 million, while inventories fell to all-time low levels. We remain debt free and are well-positioned to enter our growth phase.

Let me run through sales by segment. Our U.S. consumer segment’s net sales decreased to $313 million or down 11% from $351 million in 2006. Retiring products drove the entire decline for sales in sales for the year as the decline in sales of these products that we are phasing out more than offset the increase in sales of continuing and new products. Specifically, the largest declines were experienced in the Little Leaps, Little Touch, Leapster TV, Leapster L-MAX, LeapPad, and My First LeapPad product lines.

Excluding the impact of products being phased out, sales of all other products were up 6% for the year. Sales of our Leapster line of products were particularly strong, as well as ClickStart, and sales through our e-commerce store at LeapFrog.com.

The mix of net sales of platform, software, and standalone products as a percentage of the segment’s net sales were as follows: platforms were 36% of sales in 2007 compared to 35% in 2006; software, 30% of net sales in 2007, unchanged from last year; and net sales of our standalone products were 34% of net sales in 2007 compared to 35% of net sales last year.

Our international segment’s net sales declined to $103.4 million, or 10% decline from $114.6 million in 2006. Excluding the impact of the weaker dollar on a constant currency basis, net sales declined 16% from 2006 to 2007. As with the U.S. consumer segment, retiring products drove the sales decline.

Also affecting our international sales was a decline in the markets managed by distributors. This was impacted by higher retail and distributor inventory levels at the end of 2006, which reduced distributors’ demand for products in 2007.

These factors were partially offset by higher Leapster sales in both France and Mexico. As you may recall, Leapster was only introduced to these countries last year and in addition, we’re benefiting from the launch of ClickStart in Mexico in 2007.

Our school segment’s net sales declined by $11 million, or 30%, from $37 million in 2006 to $26 million in 2007. In December 2006, we announced that we had decided to implement changes in the school segment designed to return it to positive operating income. These changes focus our sales efforts on profitable regions.

With respect to gross margins, our gross margin increased by almost 10 percentage points to 39.2% in 2007 compared to 29.3% in 2006. With a much healthier inventory position, we’ve significantly reduced the inventory write-off exposure. As a result, almost eight points of the improvement from 2006 was driven by the lower charges for excess and obsolete inventory and fewer purchase order cancellations. The stronger product mix benefited margins by 3.7 percentage points. As planned, we sold less low-margin legacy products, thereby raising overall higher gross margins. And partially offsetting these effects was the impact of a non-cash write-off associated with the Fly Fusion pen-top computer line, which accounted for 1.8 percentage points decline in the full year gross margin.

The $8 million non-cash accounting adjustment balances the revenue stream projections with the assets on the balance sheet.

On to operating expenses, our selling, general and administrative expenses increased by $9.7 million, or 7% in 2007 compared to 2006. The overall increase in selling, general, and administrative expense for 2007 was primarily due to the following factors: legal costs for patent defense and settlement expenses of approximately $11.4 million, which includes $7.5 million in settlement costs; higher expense related stock-based compensation costs of approximately $3.4 million; bonus expense, which increased by $3.2 million associated with the 2007 bonus plan that rewarded building the product line for 2008; and higher salary and temporary employee expenses, which increased $3 million due to the marketing, rebranding initiative, and web development.

These factors were partially offset by the expense decrease of $11.2 million in our school segment, which is the result of the workforce reduction in that segment announced in December 2006.

With regard to research and development expense, R&D increased by $4.9 million in 2007 compared to 2006, and this increase was due primarily to the higher labor expense in support of the new product launches in 2008 and 2009.

Our advertising expense for 2007 was $64 million compared to $75.4 million in 2006. The $11.4 million decline in advertising expense is primarily due to lower sales and promotion allowances. Putting it all together, our loss from operations was about $101 million compared to $125 million in 2006. The improvement was driven by higher gross profit despite the lower sales, while the pluses and minuses in the operating expenses essentially offset one another.

Interest income -- I want to comment briefly on interest income. Included in the interest income is approximately $2.5 million of unrealized losses in auction rate securities. This includes the latest valuations on the auction rate securities and the amount of the unrealized loss incurred since year-end was about $1.7 million, which is the reason for the slight change in earnings from the pre-announcement we issued last month.

Our provision for income taxes for 2007 was approximately $3.7 million compared to $26 million in 2006. As you may recall, 2006 reflects a non-cash $24.9 million valuation allowance for the pre-2006 domestic deferred tax assets, while this year’s tax expense reflects taxes primarily attributable to our foreign operations. We expect that for the foreseeable future, we will continue to record a valuation allowance against our domestic deferred tax assets, so the tax expense will be incurred for our taxes on our foreign operations.

Now looking specifically at the fourth quarter, for the fourth quarter our consolidated net sales in 2007 were $181.3 million, a decrease of less than $1 million from last year. Net sales from the U.S. consumer segment totaled $128 million for the fourth quarter of 2007, up 2.1% from the fourth quarter 2006, which [is] reflecting the incremental sales from ClickStart, which was introduced in 2007, as well as continued growth in our classic Leapster line. These sales increases were largely offset by sales declines in the products that have been or will be phased out by mid 2008, as I mentioned before.

Net sales from the international segment totaled $46.9 million for the fourth quarter 2007, down $1.2 million from the fourth quarter 2006 or down 11% on a constant currency basis. Again, this is primarily driven by the declining sales in the LeapPad family of products.

Net sales from our school division totaled $6.4 million for the fourth quarter 2007, a decrease of $3.1 million from the fourth quarter 2006 due to the reorganization discussed previously.

With respect to gross margins, our gross margin increased by 6.7 percentage points to 37.3% in the fourth quarter 2007 compared to 30.6% in the fourth quarter of 2006. Gross margins improved in the U.S. consumer and international segments, mostly due to product mix which accounted for 6.2 percentage points improvement. This improvement reflects a shift in the portfolio towards our successful higher margin educational gaming products and away from the previously written down or low-margin legacy products.

The company also had lower charges for excess and obsolete inventory and fewer purchase order cancellations, both as a result of a healthier inventory position, and this accounted for a 4 percentage point improvement.

These factors were partially offset by the non-cash write-off associated with the Fly Fusion pen-top computer line, which accounted for a 4.4 percentage point decline in gross margin for the quarter.

With regard to operating expenses, our selling, general and administrative expenses decreased by $3.5 million, or 9% in the fourth quarter 2007, compared to the fourth quarter last year. The decrease is driven by the following -- costs in our school segment were $3.9 million lower as a result of our workforce reduction in that segment; outside fees, including audit and legal fees, decreased by $1.7 million, and these declines were partially offset by $2.4 million increase in bonus expense, which rewards building the product pipeline for 2008.

R&D increased by $2 million for the quarter ended 2007 compared to 2006. The increase was due primarily to costs associated with the development of the extensive new product introductions in 2008 and 2009, as well as the costs to create the web connectivity of those products.

Our advertising expense for the quarter was $41.4 million, down $2.4 million from last year’s $43.8 million, which reflects lower promotional spending as a result of the strong retail inventory positions.

Interest income declined in the fourth quarter due to the previously mentioned $2.5 million of unrealized losses on auction rate securities and our net loss was $32.6 million for the fourth quarter of 2007 compared to a net income of $46 million for the fourth quarter of 2006 -- I should say a net loss of $46 million for the fourth quarter of 2006. The change is primarily due to the result of higher gross margins and lower operating expenses, partially offset by the unrealized investment loss.

As for the balance sheet, we feel very good about the progress we’ve made over the last few years reducing working capital. Specifically inventories net of allowances were $52.4 million at the end of 2007 compared to $73 million at the end of 2006, a decline of 28%. Days inventory on hand have fallen to 96 days, which is down 19 days from last year and we’ve also lowered accounts receivable days by two days from last year to 68 days at the end of 2007. Additionally, accounts payable days improved 11 days.

Our cash and cash equivalents combined with short-term investments totaled $104.4 million in 2007 compared with $148.1 million in 2006. The decline in cash and investments is due to our operating loss partially offset by lower working capital balances and of course, we remain debt free.

With that, I would now like to turn the call back over to Jeff.

Jeffrey G. Katz

Thank you, Bill. So far in 2008, we have had our heads down preparing for the largest new product launch in our history. We have what we think is an outstanding lineup of new offerings in each of our major age range categories through age eight. We are particularly enthused about the new tag reading system, which is our first major reading platform that we have launched since our LeapPad system was introduced.

In reading, our strategy is to leverage our brand strength with parents and teachers and to retake a leading position in this market, which we estimate to be approximately $1 billion in the United States alone.

We recently unveiled our Tag reading system at the exclusive Demo ’08 conference in Palm Desert, California this January. Tag was selected from hundreds of emerging products that debuted at Demo ’08, as it represents a promising new technology that encourages and supports young children as they learn to read and it’s the first handheld learn-to-read technology that interacts directly with real books and the web.

This product continues to get accolades in the press, most recently from Children’s Technology Review, and it hasn’t even been launched. We have hugely popular licensed characters and some content exclusives for Tag. We’ve announced for example an all-star lineup of publishing licensing partners, which include Harper-Collins, Penguin, Simon & Schuster. We have Pixar’s Cars, Fancy Nancy, the classic Olivia, and The Little Engine That Could, as well as Miss Spider and iSpy from publishing partner, Scholastic.

Our new connected products all work hand-in-glove with a new software application called LeapFrog Connect, which launches when you connect your Tag, your Didj, your Leapster 2, or your Crammer to a PC or a Mac. This software lets the user manage the content on their LeapFrog product, connect to the learning path, or access [through rewards] earned from playing with our products.

Tag will be our most global launch ever. We plan to introduce a 21-volume library of interactive books and accessories at launch this summer. We don’t believe that there is any reading product on the market that can compete with our combination of content, web connectivity, and the equity associated with the LeapFrog brand behind it.

We are also very excited about continuing our leadership position in the educational gaming market. Gaming growth is expected to be three times that of toys in the overall market over the next three years. Gaming is hot with adults and teenagers today but it is also hot with preschoolers. We are well-positioned to capitalize on that with a broad line of platforms from ClickStart to Crammer and a big library of top caliber licensed titles, including exclusives.

We will continue to lead with Leapster, one of the best selling products in gaming and entertainment, and we’re expanding our gaming line with Leapster 2 and Didj handhelds, which we introduced to the trade at Toy Fair New York in February. Both Leapster 2 and Didj are web-connected gaming systems tied to our learning path, which allows parents to see what their child is learning and to share in their accomplishments. The new Didj custom gaming system has online capabilities to connect game play with school work, allowing six, seven, and eight-year olds to customize the game with spelling lists, math problems, and more.

With these gaming products, we are delivering the strongest license -- content licenses we have launched in many years. Our new titles feature popular characters and stories from leading entertainment properties, including Lucasfilm’s Star Wars: The Clone Wars, Indiana Jones, and Warner Brothers’ Nancy Drew.

The learning path is both an important product feature and it’s a sales vehicle. You will see as we launch later in the year that through learning path, we are building a capability and a brand theme that unifies all of our major products.

Among other capabilities, it provides a mechanism to recommend LeapFrog products to customers on an ongoing basis. When used in conjunction with our new portfolio of web-connected products, parents gain personal insights into what their child is learning and how the child is progressing. They are also provided recommendations for the logical next products to support their child’s continued learning.

The LeapFrog learning path software is based upon our proprietary educational framework developed over the past nine years and used in classrooms since 2002. It is meant to empower parents with real learning insights and to provide highly relevant and enjoyable new activities for kids.

We believe that used in tandem with our connected products, the learning path increases the child’s engagement through online rewards and other fun activities. We found in testing we’ve done to date that today’s parents really do have a strong desire to do what we call [see-the-learning]. We expect that the learning path will provide us with marketing leverage and help us LeapFrog's already impressive brand equity among consumers and strengthen our relationship with retailers.

It’s early on in our launch year but I think it’s fair to say that we are seeing support from retailers and we have garnered more than our fair share of attention from the press. So far, the buzz in the market makes us feel good.

So what’s next? The significant changes we’ve made over the past year were designed to reestablish LeapFrog as a growing, profitable, and innovative company that can deliver consistent satisfactory financial performance and this brings us to the next phase of our strategic plans -- growing our business sustainably and profitably.

As we’ve stated in our press release this afternoon, our current outlook for 2008 is as follows: new products introduced in 2007 and 2008 are expected to comprise approximately half of 2008 net sales; net sales are expected to grow at an annual percentage rate in the mid to high teens; gross margin is expected to continue to improve; selling, general, and administrative expenses and research and development expenses are expected to decrease approximately 10% to 15% year over year; cash is expected to be approximately $100 million at year-end; and we expect a nominal loss for the year.

The second half of 2008 results are expected to show substantial improvement over second half 2007, reflecting the impact of new product introductions, while first half ’08 financial results are expected to be weaker than first half ’07.

2008 is the first year in our growth phase and we are focused on delivering solid financial performance this year, but it’s important to say that 2008 is going to be a strong product launch year, not a strong profit year. By the end of 2008, LeapFrog will have made the transition from a company with a single star product back in 2008 to a company at the end of 2008 with a broad portfolio of strong products, each with good margins.

We feel good about that and we feel that this will serve as a much better basis for growth and for earnings. There are a lot of variables that we’ll be managing closely to get there and we are looking forward to keeping investors briefed as we progress.

We are now ready to take your questions, so I’ll ask the operator to let us know who we have on the line.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Tony Gikas with Piper Jaffray.

Anthony N. Gikas - Piper Jaffray

Good afternoon and congratulations on a good year, [finish] to the year anyway. A couple of questions for you -- so coming out of Toy Fair, could you give us a little more color on some of the retailer feedback on products like Didj, Tag, and Crammer? And then also, maybe just a little bit more color on the timing of these new key product introductions [during the year]? Will there be any new products shipping in Q1? It sounds like it will be [inaudible] to ship some [inaudible] Tag.

Jeffrey G. Katz

Tony, you were breaking up a little bit so if I don’t get the question, if you’d correct me as I go. Color coming out of Toy Fair on key products -- certainly a lot of enthusiasm that will I think reflect itself on good year one launches for Tag in particular and certainly Leapster and Leapster 2 and Didj. It looks like we’ll have strong support. Crammer comes a little bit later in the season, to your point. It will ship in, if I’m remembering correctly, October, so it will be a little bit later in the season. I don’t think our expectations are on the same scale due to the late shipment.

The first shipments of in particular Leapster 2 and Tag will be in the second quarter. We expect earliest shelf date in particular for Tag to be the early part of June, Leapster 2 probably at the beginning of July, possibly slightly earlier but I think we are planning July for Leapster 2.

Anthony N. Gikas - Piper Jaffray

And then maybe just a little bit about the shelf space -- do you know if you have some end caps on some of the new products?

Jeffrey G. Katz

We are currently planning a number of features for these products and I believe you will see Tag in particular as an example on end cap through the season.

Anthony N. Gikas - Piper Jaffray

Okay, a couple of quick follow-ups; maybe Bill, you could give us the cash position as of today, if you’re willing to share that. And then maybe for 2008, just a bit of guidance on percent of total sales that will be international during the year?

William B. Chiasson

The cash as of today is around $130 million -- that’s cash and short-term investments. International sales, I think we finished the year a little over 20%; around 23% of sales were from international. We see a lot of the growth in 2008 coming with most products being introduced in the U.S. Tag will be a global launch but some of the gaming products will not be as global, so the growth will be slightly below the U.S. growth rate in 2008.

Jeffrey G. Katz

I think on a percentage basis, we expect about the same but -- and due to what I would call some lag time issues, we’ll probably see a little bit more robust growth for ’09 than ’08 in international. It’s hard on a percentage basis when you do the arithmetic, as I’m sure you know, to keep up with all the new products, not all of which will be introduced abroad, as Bill mentioned.

Anthony N. Gikas - Piper Jaffray

Maybe just a little bit about the international rollout -- like, what countries and --

Jeffrey G. Katz

The Tag will be launched in eight countries. That would include U.K., France, Spain, Australia, New Zealand, Canada, Mexico -- I may have left something out. And Leapster 2 as just another example will be introduced in the U.K., Canada, Australia, and New Zealand but not France, by way of example. And Didj, with the exception of Canada, will not go to international markets this year.

Anthony N. Gikas - Piper Jaffray

Okay, and then last housekeeping question, Bill, maybe just help us with the tax rate for 2008 -- and sorry, I have one other one. It looked like you quietly did some headcount reductions around the holidays at the headquarters. Maybe you would quantify --

William B. Chiasson

A couple of things -- first of all, on the taxes, as we mentioned before, taxes are -- our tax expense we recognize is really based on our non-U.S. operations, so what you see in there for our taxes for 2007, you look at that mostly as a percentage of our revenues that we generate outside of the United States, you know, come to a pretty close approximation going forward. So it’s a relatively small number overall.

In terms of headcount, yes, we did see some headcount coming down towards the end of the year but most of the headcount reductions we talked about which were in our earlier announcements occurred in the first quarter or are occurring in the first quarter and the beginning of April of this year.

Anthony N. Gikas - Piper Jaffray

Thank you, guys.

Operator

Your next question comes from the line of Gerrick Johnson with BMO Capital Markets.

Gerrick Johnson - BMO Capital Markets

Good evening. Inventories down 20% at the channel -- are you comfortable with that or do you think perhaps they could have been or should have been lower? And should we anticipate in the first or second quarter any more charges to true-up inventory that’s still out there before the launches of the new platform?

William B. Chiasson

We feel good about where the inventory levels are at retail. If anything, we want to make sure that we keep them in stock of products that are selling well, so we don’t see any significant charges or promotions in order to move retail inventories. They’ve come down nicely and again, we feel good about the exit position.

Gerrick Johnson - BMO Capital Markets

Okay, great. And your plan to get to the 15% or so sales growth, are you anticipating more shelf space or just better productivity in the space that you already have?

Jeffrey G. Katz

We anticipate increased shelf space in the holiday season.

Gerrick Johnson - BMO Capital Markets

Okay, in the holiday season. And finally, last question, nice sales growth, looking forward into 2008 but going forward, not sure if we are going to have the same kind of sales growth. The disappointing part is we’re not yet looking for profits. How will we get to that profit situation beyond 2008? It looks like to me that there might be some cost cutting on that end, so just how do we turn a profit in 2009 and beyond?

William B. Chiasson

Yeah, we’re -- and as you would expect, we’re not ready to give guidance on 2009 but certainly with the products being introduced this year and the breadth of them, we certainly expect to see continued growth going into 2009 with the products we have and the new products that will come on the heels of that.

Also, as Jeff mentioned, international is an area where we are not realizing the full reflection of the new products in 2008 so we certainly expect to see more growth coming outside of the United States with our product introductions.

So at this time, we don’t see any -- we have no plans for any other further cost reductions or headcount reductions but we are very much aware of the fact that we need to make sure that the size of our cost structure is consistent with our revenue base and that we need to get to the point where we are driving profitability.

Jeffrey G. Katz

The other thing I might add is that certainly in ’09, we not only expect to have full year benefits of these launches, we expect to have additional new product launches and importantly, we expect to see -- begin to see the benefits of strong software sales related to products which were sold in and sold through in the fourth quarter of 2008, which is a fairly significant margin and earnings driver of our business model.

Gerrick Johnson - BMO Capital Markets

Okay, that makes sense. Thank you very much.

Operator

(Operator Instructions) Your next question comes from the line of Alex [Beldman] with Merrill Lynch.

Alex Beldman - Merrill Lynch

I’m just looking over the outlook for 2008 and had a few questions. Have your expectations for new product sales in ’08 changed much over the past few months? I know you said 50% of net sales, but given the retailer feedback for the new products and current macro environment, has that changed?

Jeffrey G. Katz

Well, this is the first time we’ve given formal guidance. I don’t think it’s changed. I would say we are more rather than less encouraged about all the new products. We are trying to sort of take a pragmatic approach to giving guidance for the new products. We haven’t yet seen of course mass scale response from consumers and like everybody else, I think we’re somewhat guarded about the economic environment out there. But from a retailer and LeapFrog perspective, I don’t think we’ve had anything but positive -- yet -- feedback or sort of refinements to our thinking.

Alex Beldman - Merrill Lynch

And the SG&A being down [inaudible] year over year, is that [inaudible] that settlement with [inaudible] --

William B. Chiasson

I’m sorry, you were breaking up. Could you repeat that?

Alex Beldman - Merrill Lynch

Yeah, the SG&A expenses expectation being down 10% to 15% year over year, does that include [Tinkers & Chance]?

William B. Chiasson

Yes, it does. That would compare against the Tinkers & Chance in 2007.

Alex Beldman - Merrill Lynch

Okay and I don’t know if you gave this out but operating margins by segment for 4Q, or for the full year, for that matter? Do you have that?

William B. Chiasson

We will get that and while we are still on the call, we’ll give that. We’ll look it up right now.

Alex Beldman - Merrill Lynch

Sure. Just one more follow-up on this -- if you could provide any more details I guess on the liquidity issues that you are seeing, auction rate securities [has sort of been] a hot topic lately. Could you provide any color on that for the --

William B. Chiasson

No, it’s the same thing that you read about in the press. Many of the auctions have failed since about September and as a result, the valuations of some of those auction rate securities have come down, so we’ve reflected that conservatively as a charge to our P&L during the -- for our 12/31 numbers.

We have also taken into account what’s happened to those auction rate securities since the end of the year, so we’ve taken into account literally through the valuations as of the end of February and identified what we saw as the reflection of those, what they did in terms of the reflection on the 12/31 balances of those auction rate securities.

Alex Beldman - Merrill Lynch

Going back to the liquidity area, are you seeing it clear up or are there expectations that it might -- the market will become a little bit more liquid?

William B. Chiasson

I would only be hypothesizing. I’m not that qualified to hypothesize on whether or not – you’re saying whether or not the auction rates will be successful going forward?

Alex Beldman - Merrill Lynch

Right.

William B. Chiasson

I would expect at some point they will be but when, I’m not sure.

Alex Beldman - Merrill Lynch

Okay.

William B. Chiasson

While you’re still there, the margins for each of the segments, U.S. consumer segment was a margin of a negative 31.5%; international, 8.1% negative; and the -- excuse me, wrong year -- hold on. We pulled up the wrong year.

Alex Beldman - Merrill Lynch

No problem. If I can ask one more, just on Fly Fusion, what are you expecting in 2008 for that product?

Jeffrey G. Katz

We're not going to give a product-specific outlook for it but it is listed in many of our big retailers and it's actually, although volumes are low this part of the year, it's actually been doing reasonably well in the market. So I think we expect it to be rather a niche product, candidly, and I’m actually interested to see how it does in the upcoming holiday season because I feel a little bit like we could have performed much, much better in 4Q. It was just retailers were just hedging their bets and we didn't get enough of it sold in.

Alex Beldman - Merrill Lynch

Okay, thanks a lot.

William B. Chiasson

Okay, and now, since I don't think you really wanted 2006 margins but rather the 2007, and as a reminder, we put our indirect expenses in our U.S. consumer segment and don't allocate those expenses to international and school. The margin for the U.S. business operating margin was a minus 32.9%, the international business was a minus 1.4%, and the school segment was a positive 12.7%.

Alex Beldman - Merrill Lynch

Okay. Thanks a lot, guys.

Operator

Your next question comes from the line of Sean McGowan with Needham & Company.

Sean McGowan - Needham & Company

A couple of questions -- would you mind, Bill, going through the -- I don’t think when you were recapping the fourth quarter that you gave us the percentage of sales by platform, software, standalone.

William B. Chiasson

Yeah, I did not. We'll put that in our 10-K, or we'll get that information later.

Sean McGowan - Needham & Company

Okay, I guess I have the same question for gross margin by each one of those.

William B. Chiasson

That will be in our -- gross margin by segment?

Sean McGowan - Needham & Company

Right.

William B. Chiasson

That will be in our K.

Sean McGowan - Needham & Company

And when will that be filed?

William B. Chiasson

Shortly. It's due on the 14th and we'll have it out before that, we expect.

Sean McGowan - Needham & Company

Okay, and in terms of -- just to follow-up on Tony's question earlier on tax expectation for ’08, is there -- at this stage, is it -- are you able to put a dollar figure on that rather than a rate? Do you know what I mean? Because it's kind of a -- is it actually a function of a rate or is it just sort of a minimum dollar number and there it's going to be?

William B. Chiasson

No, it's going to be a function of international earnings and you can think of the $3 million to $5 million range as being within that range.

Sean McGowan - Needham & Company

Okay, that's kind of consistent. All right, that’s it. Thank you.

Jeffrey G. Katz

Do you have another question, Operator? Hello?

Operator

Your next question comes from the line of John Taylor with Arcadia.

John Taylor - Arcadia

I just have a couple of questions. Some of them are housekeeping, some of them are a little -- Bill, what’s your U.S. NOL?

William B. Chiasson

Let me get that. Why don’t you go on to your next one and we’ll look that up.

John Taylor - Arcadia

Okay, great. And then, a similar kind of housekeeping thing; in a profitable quarter or a period of time, what would your shares, your [inaudible], your [count look] --

William B. Chiasson

I’m sorry. That broke up a lot. Could you repeat that question?

John Taylor - Arcadia

In a profitable quarter, what would your full dilution share count be?

William B. Chiasson

We’ll put that detail in our K, but it’s around 63 million shares.

John Taylor - Arcadia

Great. And when you guys did your analyst day as I recall, you talked about a -- you know, the prospects in 2008 as being potentially profitable, potentially not, depending on how much “investment” spending you wanted to do and keeping momentum going into ’09, and I’m totally on board with that idea. Does the kind of guidance you are giving us today reflect a full investment, partial investment? Is it pretty much full bore kind of thing and trying to drive momentum into ’09?

Jeffrey G. Katz

Yes, it’s full bore trying to drive momentum into ’09, so a pretty healthy marketing investment and we’d all love to see upsides on that, but it does reflect a bias towards earnings or to sales growth and therefore more earnings growth in ’09.

John Taylor - Arcadia

So that implies that the add to sales number in fourth quarter anyway is most likely going to show some growth?

Jeffrey G. Katz

That’s correct.

John Taylor - Arcadia

Okay, all right. And then I think you referenced sales, online sales or direct sales through your website and so on. Can you [give us a hint] to how big that is?

Jeffrey G. Katz

$14 million.

John Taylor - Arcadia

Growing nicely?

Jeffrey G. Katz

Yeah, it’s up about 74% year over year.

John Taylor - Arcadia

Okay, and then in terms of gross margin as you are looking forward, it seems like there are a lot of things going on. One is you are still working down the older legacy stuff that’s presumably got low margin and then you’ve got the benefit of a [buffer tie] ratio in the upside and you’ve also got the improved margin on the new hardware kind of thing. I wonder if you could, looking at those baskets, maybe if there’s a basket I left out kind of help us think in terms of priority what is most likely going to have the biggest dollar impact on gross profit in ’08 versus ’07?

Jeffrey G. Katz

Well, I think arithmetically the biggest dollar impact on gross profit will be Tag, and then that will be followed by Leapster 2.

John Taylor - Arcadia

I guess what I’m trying to get at is the segmentation between the hardware/software, and throwing that other one in there of old versus new, because you are still kind of weaning yourself off that older stuff.

Jeffrey G. Katz

Yeah, although by the time we get to the second half, the weaning will largely be accomplished so if you were doing your modeling, you probably would want to be looking at first half versus second half and then for the second half, sort of the big, bigger upsides will be Tag and Leapster 2, and that will be sort of heavily driven by the hardware rather than the software aspects of that in the ’08 year. I’m not sure I’ve answered your question very clearly --

William B. Chiasson

One thing I would just like to add to that is as a reminder, we’ve set strategic hurdles for our new product introductions and the new products are going to be driving that gross margin improvement we’re looking for. We’ve set a target hurdle rate for new products to be at that 45% range, so we see that as -- the single largest contributor is both the hardware and software but the new products we brought in at with the new strategic hurdles that we put into it.

John Taylor - Arcadia

And that’s a hardware hurdle, not a --

William B. Chiasson

No, it’s a combined hurdle. That’s a platform and software hurdle.

Jeffrey G. Katz

But as you may remember from investor day for Tag, Tag actually has a pretty healthy hardware only gross margin.

John Taylor - Arcadia

And then, of the 2007 -- in gross profit in 2007, you had still a pretty good contribution from lower margin older stuff. Is there any way you can kind of help us better get our arms around what that drag is? I understand it’s going away but in terms of a base upon which we can compare, give us any sense of what the older, discontinued stuff looked like as a percent of sales or whatever in ‘07? Product schedule --

William B. Chiasson

You mean as a -- the margin on those products were well below a 40% margin rate, is that what you are getting at?

John Taylor - Arcadia

Was it like a 20 or a 30 or a 10 or was it negative, yeah.

William B. Chiasson

Between a 30 and a 40.

John Taylor - Arcadia

Okay, so a little bit of a haircut but not a --

William B. Chiasson

Yeah.

John Taylor - Arcadia

And I wonder if you could -- so you had the legal costs and so on -- this will be my last question -- the legal costs. What other kind of non-recurring things come out of the base from ’07? I wonder if there’s a dollar amount in total we might --

William B. Chiasson

We had a small amount on operating expenses related to Fly, about $1 million, but also on a gross margin basis, gross profit basis there was about $8 million related to the write-off or the associated balancing of the Fly assets, so a total of about $9 million of Fly.

John Taylor - Arcadia

And then the legal and that’s pretty much it?

William B. Chiasson

Yeah, those are the two biggest pieces.

John Taylor - Arcadia

Would you call that a one-time ramp-up on R&D to get the --

William B. Chiasson

Well, R&D was higher and as we mentioned in our call, we expect to bring down SG&A and R&D in 2008.

John Taylor - Arcadia

Perfect. Okay. Thank you.

William B. Chiasson

One other thing you asked about, the question on the NOL. We dug through our tax reports and found it, and it will be -- actually, there will be details of this in the 10-K when we issue it but it’s about $165 million.

John Taylor - Arcadia

Okay. Thank you.

Operator

Your next question comes from the line of Arvind Bhatia with Sterne, Agee.

Arvind Bhatia - Sterne, Agee & Leach

Thank you. Good afternoon, guys. Just a quick question on the overall macro environment; you had mentioned how in the fourth quarter, retails had been extra cautious and I wonder in your forecasts for 2008, is there a way to look at how you are thinking of the environment? Do you expect things to get even tighter? Are you expecting things to stay how they are or better? Or you don’t think there’s going to be much of a difference and your forecast is conservative enough to account for any kind of scenario? I’m just curious how your model is built to guide for that nominal loss.

Jeffrey G. Katz

That’s a complicated question. I will attempt to give a point of view.

I will say that even in the fourth quarter of ’07, retailers were buying product and they certainly made bigger bets on sort of new products and hot products. We didn’t have in ’07 much that was new, as you know, so we may have disproportionately not done everything that could have been possible. And so with that lens, I think I have a bias towards believing we’ll be able even in a hard environment to do a little bit better just because so much of our portfolio is new and therefore it’s going to be somewhat more attractive to the consumer who has a tight budget. They are looking for what is exciting to spend perhaps tighter dollars on.

Year over year, tough to call but we’ve tried to create a forecast that has the lens of both we do have a lot of new product that will tend to be of interest to retailers as they sort of are doing their planning and marketing but what everybody believes will not be the robust year, for example, that 2006 was for the consumer.

Arvind Bhatia - Sterne, Agee & Leach

And then on your expenses, overhead, et cetera, how much flexibility do you have, for example, on the advertising line to adjust for a market that might be changing for the better or worse? Is there flexibility in your expense structure?

Jeffrey G. Katz

Yeah, there’s a few degrees of freedom. We can certainly choose to hold off as long as we are able to on the dollar commits for things like television and even more for the web portion of the spend, or -- and then importantly, now that we have a reasonably significant fraction of our spending -- I’m sorry, of our selling that’s actually having an -- on our website and on our retailers’ website, there’s actually a fairly good ability to make that, those channels, to make those spending decisions somewhat late, since such a big part of the web transaction actually is in December and you can move your spending a little bit later to -- whether you’re going to paid search or whether you are going to other kinds of online marketing executions.

So we will clearly, because of the uncertainty, try to do more of our spend commitments later in the year. But at the end of the day, we won’t be able to hold on until December 10th, either. It will be -- you’ll have to some time in the fall make your commitments.

Arvind Bhatia - Sterne, Agee & Leach

Great. Thank you, guys.

Operator

Your final question comes from the line of Edward Woo with Wedbush Morgan.

Edward Woo - Wedbush Morgan Securities

I have a quick question going back to the auction rates. You mentioned [that they are unrealized] -- you guys are still holding on to it. You guys can divest and [inaudible] --

William B. Chiasson

Edward, I’m sorry, you broke up completely there. Could you repeat that so I can get it right?

Edward Woo - Wedbush Morgan Securities

Sure. On the auction rate securities, you mentioned that there are unrealized losses, so in theory if the market comes back, the investment charge can be reversed, or if the market goes significantly worse, they could increase?

William B. Chiasson

That’s correct.

Edward Woo - Wedbush Morgan Securities

All right, and then on the gross margin improvement for 2008, how much of it is cost management, particularly manufacturing costs in China?

William B. Chiasson

The lion’s share of the gross margin improvement in 2008 is coming from the new products. That said, cost reductions and cost management in Asia is a small contributor but that partially offsets what we are seeing in terms of increased costs with fuel, with inspections, with other things that come in terms of cost increases that we are seeing from Asia as well. But we do have ongoing engineering initiatives to reduce costs of our products that come out of Asia.

Edward Woo - Wedbush Morgan Securities

Great. Thank you.

Jeffrey G. Katz

Any last questions, Operator?

Operator

There are no further questions at this time.

Jeffrey G. Katz

Thank you very much. So let me just close by thanking everybody for joining our call. If you do have any further questions later on, please feel free to contact Eileen VanEss here at the company. And we are looking forward to an exciting spring season here at LeapFrog and we’ll be presenting at a couple of conferences soon and I hope to have a chance to see some of you there. Thank you once again. Have a good evening.

Operator

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

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