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LeapFrog Enterprises, Inc. (NYSE:LF)

Q1 2008 Earnings Call

May 5, 2008 5:00 pm ET

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

Sean McGowan - Needham & Company

Anthony N. Gikas - Piper Jaffray

Sara Gibbons

Edward Woo - Wedbush Morgan Securities

John Taylor - Arcadia

Gerrick Johnson - BMO Capital Markets

Operator

Good evening. My name is Keisha and I will be your conference operator today. At this time, I would like to welcome everyone to the LeapFrog Q1 2008 financial results conference call. (Operator Instructions) Ms. VanEss, you may begin your conference.

Eileen VanEss

Thanks, Keisha. Thank you. Good afternoon and welcome to LeapFrog Enterprise’s conference call to review the results of our first quarter ended March 31, 2008. 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 products, services, 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 included in our prepared remarks. This cautionary language concerns forward-looking statements 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 results, 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 2007 annual report on Form 10-K filed with the SEC on March 13, 2008, as well as in LeapFrog's other public statements and SEC filings. LeapFrog does not update forward-looking statements and we expressly disclaim any obligation to do so.

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

Jeffrey G. Katz

Thank you, Eileen and thank you, everybody for joining us today. Our Chief Financial Officer, Bill Chiasson, is going to get things started this afternoon with an update on our performance for the first quarter. I will then come back and provide you with an update on our 2008 product launches and with the progress of our strategy, which many of you have been monitoring these last many months. Bill.

William B. Chiasson

Thanks, Jeff. Overall our results for the quarter were in line with our expectations. Contributing to the sales performance was the strength in educational gaming product line, especially ClickStart and the Leapster hardware. There were offset by declines in products being discontinued and replaced later this year.

Gross profit, operating expenses, and income were all within expectations for the quarter. However, the strong Leapster hardware shipments did have the effect of reducing the gross margin in this quarter as compared to last year.

As you know, the first quarter represents a very small piece of our full year results and as a result, relatively small shifts in product mix can cause swings in margins. That’s what’s happened here.

With that said, this was in line with what we expected this quarter and we believe the higher margin software sales will follow the strong hardware shipments later this year.

Our balance sheet remains healthy. Cash has grown since year-end and stood at about $106 million at the end of the first quarter.

Now for the specific business results -- net sales for the first quarter were $58.3 million, a decline of 4% compared to last year. Using constant exchange rates, the decline was 6%. As noted in prior quarters, the sales decline can be traced to products that have been or will be replaced or phased out, while we are not yet benefiting from the positive sales impacts of new products, as they will be introduced later this year.

Looking at sales by segment, the U.S. consumer business decreased 6% to $40.6 million for the first quarter of 2008 compared to $43.4 million last year. The sales decrease can be traced to the declining sales of products that have been or will be retired, including LeapPad, Little Leaps, My first LeapPad, LMAX, and various standalone products.

These decreases were partially offset by an increase in sales of our educational gaming products, including ClickStart hardware and software, which was introduced in the second half of last year and therefore fully incremental in the first quarter this year, and Leapster hardware as retailers restock their inventories from the strong holiday season.

The relative mix of net sales from platform, software, and standalone products as a percentage of the segment’s net sales were as follows: hardware sales were 35% of net sales in the first quarter this year, compared to 23% in the first quarter last year. The significant increase in hardware sales as a percentage of total sales is largely due to Leapster hardware sales as retailers needed to replenish their stocks.

Software sales were 35% of net sales in the first quarter this year, the same as in the first quarter of last year. Normally we see good software sales in the first quarter and the tie ratio -- and higher tie rations than at year end, as consumers buy software in the first quarter following holiday hardware purchases.

The ratio of software sales to hardware sales, or tie ratio, remain good at retail in the first quarter. The tie ratio on a sell-through basis for Leapster was 7.1 in the first quarter of 2008 versus 7.2 in 2007.

We also saw sales declines of LeapPad, Little Leaps, and Little Touch software, ahead of these products being phased out.

And net sales of our standalone products were 30% of net sales in the first quarter this year compared to 42% of net sales recorded this time last year, with lower sales again due to products that have been or will be phased out.

Sales in our international segment were $12.7 million, an increase of $200,000. Foreign currency exchange rates favorably impacted our international segment’s results and excluding the impact of foreign currency, our international segment sales would have declined 5% instead of increasing 2%.

Sales declines in the United Kingdom and French markets were partially offset by sales increases in Canada and by our international distributors. The U.K. and France saw sales declines in older products that are being discontinued while Canada, as with the U.S., saw increases in Leapster hardware.

Our school segment’s net sales were essentially unchanged from the prior year at $5 million for the quarter.

On to gross margin, in the first quarter our gross margin decreased 4.2 percentage points to 36.3% for the first quarter of 2008 from 40.5% for the same period last year. Most of this, about 3.6 percentage points, was due to product mix, including the strong sales of Leapster hardware in the United States and Canada and lower software sales and sales of lower margin end-of-life products overseas.

While this mix negatively impacted the first quarter gross margin, we expect full year gross margins to improve over 2007 as new products are introduced and software sales improve.

Now turning to operating expenses, total selling, general, and administrative expenses for the quarter were $30.8 million, down about $1.6 million from the same time last year due to lower audit and legal fees and lower labor costs. Partially offsetting these decreases was about $400,000 in severance associated with the headcount reduction action announced in January 2008 and paid in the first quarter.

Research and development expenses were $12.1 million in the first quarter, down about $2.4 million from last year. The decrease in the first quarter 2008 was primarily the result of shifting aspects of the product development cycle to third party vendors for greater efficiency, and included in the research and development expense for the first quarter was $800,000 in severance associated with the headcount reduction announced in January and paid in the first quarter.

Both SG&A and R&D are benefiting from the lower headcount as a result of the actions we took at the beginning of the year. At March 31st, our full-time employee count was 772, down 80 people from year-end. We expect headcount to come down a little more in the second quarter as we complete the restructuring we announced in January.

Our advertising expense for the quarter was $4.5 million, a decrease of $1 million from a year ago. The decrease is in line with our plans to match advertising spending with our new product launches scheduled for the balance of the year.

Putting the pieces together, we reported an operating loss of $28.6 million for the first quarter 2008 compared to a loss of $30.2 million for the same quarter last year. The impact of lower sales was more than offset by lower operating expenses.

With regard to interest income, net interest income of $1 million was down $1.2 million from 2007. This decline was due primarily to lower cash balances and lower interest rates. In addition, we recognized $200,000 of additional impairment in our investments in auction rate securities in the first quarter of 2008.

We recorded a tax benefit of about $600,000 in the first quarter 2008 compared to tax expense of $2.2 million in the first quarter of 2007. Changes in tax [aspects] for our foreign operations resulted in a tax benefit in the first quarter of 2008 compared to an expense for the same period last year. This is primarily due to timing and we expect our full year tax expense to be in the range of $3 million to $5 million.

Our net loss for the quarter was $27.4 million, compared to a net loss of $30.4 million in the first quarter 2007. The decline was the result of a lower operating loss and lower tax expense, partially offset by lower interest income.

The balance sheet remains strong. At the end of the first quarter, we had about $106 million of cash and short-term investments, compared to cash and short-term investments of $93 million at year-end and $195 million at the end of the first quarter last year. The decline from a year ago was due to our 2007 operating loss and in addition, as a result of the continued auction failures, we have reclassified our $11 million of ARS holdings from short-term to long-term this quarter. Given the strength of our balance sheet, we do not believe this will significantly hamper our liquidity position. Additionally, we have $75 million of asset-back revolver at our disposal in the event that we need additional liquidity.

Accounts receivable fell to $45 million at the end of the first quarter from approximately $51 million at the same time last year and $137 million at year-end. Our day sales outstanding declined 70 days at March 31, 2008, from 77 last year. Our inventories remain in good shape. Inventories net of allowances were $56 million at March 31, 2008, compared to $76 million last year and $52 million at December 31 2007.

Accounts payable were $30 million at March 31, 2008, $39 million at March 31, 2007, and $47 million at December 31, 2007. The decrease in accounts payable from March 31, 2007 to March 31, 2008 primarily reflects the timing of inventory purchases.

Our outlook for the year remains strong. We are expecting sales growth in the mid to high teens, an improvement in gross margin from the 39.2% rate we achieved in 2007, a 10% to 15% reduction in SG&A and R&D, and a nominal loss for the year. Further, we expect improved financial performance in the second half of the year as we complete our 2008 new product launches.

Looking to the second quarter, we will begin shipments of Tag hardware and software in May and the consumer launch will be in June. In order to ensure a smooth launch, some expenses, such as advertising, quality assurance are also expected to increase somewhat in the quarter.

I’ll now turn things over to Jeff to talk about our product launches and the rest of 2008.

Jeffrey G. Katz

Thank you, Bill. We are now heads down managing the many aspects of our 2008 product launches. As you know, we have modest expectations for the first half of the year. We expect sales to be down as we complete the transition to a new product portfolio, followed by significant growth in the second half of the year. We are on track with our launch programs, the first and most significant of which is Tag.

Our new reading product, Tag is the biggest part of what will ultimately be the complete replacement of the LeapPad family of products. The first Tag shipment will actually occur next week and will wind its way to shelf in June when our first broad marketing activities begin. Shipments of Leapster 2, Didj, and our new learning toy products begin in June and Crammer will ship early in the fall.

Our LeapFrog Learning Path, which we are ultimately quite excited about, is on track as well. We will likely phase in this web-based service based on initial usage rates of Tag. In particular, you may recall the Learning Path provides feedback for parents based on usage of our products, so we will want to accumulate a bit of data before we leverage, for example, the recommendation engine and other information the Learning Path facilitates for Mom and for Dad.

Bill mentioned that our guidance remains unchanged for the year. Of course, that is partly due to our first quarter results and partly due to our view of the year with respect to our new products.

Despite what most expect to be a difficult economic environment for consumers this year, retailers have shown us a positive reception to our new products. I think it’s accurate to say therefore that in a questionable year for consumer economics, it’s better to have a slate of new products than the portfolio we’ve been managing the last two years.

We have an early read on our product line and I want to caution that it’s just an early read and that we have purchase orders for well over half of our expected sales volume for the year already in-house. Frankly, that has never happened at LeapFrog before. It is a good indicator of retailer support of our new line and will help us with forecasting and manufacturing planning, which is so critical in this business.

It’s also frankly stimulating our confidence but the hard work, marketing to consumers, remains ahead and our ultimate sales performance will only be known as that starts to accelerate in the third and fourth quarters.

We do have a few real touch points. Our marketing micro-sites which feature our new products have had many thousands of visitors already, and that’s quite encouraging pre the launch of broadcast marketing.

And Tag was name Toy of the Year in Australia by that country’s Toy Association. We are thrilled about that and it does bode well for the product in Australia, but also the United States and other parts of the world, as does kids’ reaction to the product so far in testing. If you haven’t done so, I’d recommend you check out a few videos we have online at www.leapfrog.com/tag. If you’ve not had a chance to do so, I think you will have fun with it and see what mean when kids are enthused by the product.

Another strong point for us is our position in the educational gaming market. Last month the Wall Street Journal’s coverage of the toy industry made the following point about educational gaming -- that toy companies, and I quote, are still weathering slow demand for their toy lines as American children turn from traditional toys to videogames and consumer electronics at ever younger ages.

It seems that everywhere we look, there’s evidence that it is a very good time to be in the tech and educational gaming businesses. Leapster is doing quite well, as we have mentioned, and with the addition of Leapster 2 and Didj, we are strengthening our hand. That is clear.

Our title lineup, featuring Star Wars and Indiana Jones, both expected to be hits again in the theaters and on television this year, could not be better.

And we are continuing to manage our launch process and costs very closely. Looking ahead, we expect R&D and SG&A to decline year over year. That said, we may spend a bit more on R&D to speed up a few products for next year that we feel are important and to hammer out a few more testing cycles that will make for a smoother launch this year. But we still expect cost improvements in these areas, as Bill described, and as we have described in our 10-K a few weeks ago.

We continue to tightly control inventory and all other costs but with a bias I have mentioned to supporting very strong launches and strong sell-through performance this year.

So to summarize, we are on track so far but the first quarter represents just about 10% of our year, so I must ask you to stay tuned and we will do our best to keep you informed as the year progresses.

And so now I’ll ask the Operator, if we have any questions we are certainly ready to address them.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Sean McGowan.

Sean McGowan - Needham & Company

Thanks. I have a couple of questions but first, Bill, would you mind repeating the comment you made about the impact of the ARS in the quarter?

William B. Chiasson

Yeah, Sean, there are a couple of things. First of all, we did take an additional $200,000 impairment on the ARS that we mentioned when I talked about the impact, our interest expense for the quarter. Additionally, as we’ve seen that auctions have broadly been failing, we took the position this quarter to reclassify our auction rate securities, held at around $10 million, $11 million, and classified them at long-term from short-term that we had them classified at year-end. So that’s what happened.

Sean McGowan - Needham & Company

But there’s nothing that would suggest that it’s not in fact worth what you thought it was, other than the $200,000. I mean, in theory you should even get that back, right?

William B. Chiasson

Yeah, it’s generally right in that range is what we see it as.

Sean McGowan - Needham & Company

And that -- so interest expense went up by $200,000 and that’s fully tax deductible, right?

William B. Chiasson

It would be, yes.

Sean McGowan - Needham & Company

Okay, sales or gross margin by segment, you know, the hardware, software, standalone that you usually give -- could you go through that?

Eileen VanEss

Are you looking for the split of sales or are you looking for gross margin by segment?

Sean McGowan - Needham & Company

Gross margin.

William B. Chiasson

We don’t typically provide the gross margin by platform, by hardware, software, and standalone. We do do it by segment -- is that what you are looking for, the U.S. consumer segment? U.S. consumer segment gross profit was 34.9%, international, 33.2%, and our school division was 55.3%.

Sean McGowan - Needham & Company

U.S. was what again?

William B. Chiasson

34.9%.

Sean McGowan - Needham & Company

Okay, thank you. And final one then -- can you just give like operating income by segment? I know that will be provided in the Q but just something to chew on now?

William B. Chiasson

Operating income by segment for the U.S. consumer segment was $26.2 million loss; the international segment was a $2.5 million loss; and school was essentially break-even at about $100,000 gain. And I want to remind you that the -- most of the fixed corporate costs are charged to the U.S. consumer business and are not allocated out.

Sean McGowan - Needham & Company

Okay, and then final question and then I’ll shut up is in the -- obviously everybody talks about the consumer environment being challenging. You’ve got a lot of new products that can address that and I agree, Jeff, I’d rather be coming with new products than old products, but what happens in the school division? I mean, it seems like this could be a hostile environment, you get to the one yard line and someone say I just got my budget cut. Are you seeing that kind of happening?

William B. Chiasson

We are not seeing that yet. We didn’t see it in the first quarter and the marketplace to date, peak quarter tends to be the second quarter and a little too early to tell but there doesn’t -- there’s not any unusual budget pressure on school districts.

Sean McGowan - Needham & Company

Okay. Thank you very much.

Operator

Your next question comes from the line of Tony Gikas.

Anthony N. Gikas - Piper Jaffray

Good afternoon. Nice job on the quarter. I have a few questions as well. Could you share a little bit with us on calendar ’08, maybe just your breakdown of how you anticipate sales coming in for the year between hardware, software, and standalone?

William B. Chiasson

You know, we’re not providing that kind of specificity, Tony, but remember that we would expect that hardware this year will tend to pick up relative to historical levels as we introduce new product lines in the back half of the year. So we are anticipating that hardware on Tag, Leapster Connected, Didj, will be higher relative to software than we would expect on a longer term basis. So it’s going to be a somewhat disproportionately leaning towards hardware in the back half of the year, relative to our historical levels.

Anthony N. Gikas - Piper Jaffray

Sure. Okay, second question, could you maybe just talk a little bit more about your sales and marketing campaign, how that will spread -- those expenses will spread throughout the year as well with Tag coming here in the June quarter. Should we expect a big jump in advertising in the quarter or will it really be more back-end loaded? And then a following question would be maybe just a little bit on retailer shelf space, how you are setting up here as the Tag comes out in June and retailer feedback?

William B. Chiasson

Tony, let me handle the first one and then Jeff will talk about retail space. As far as advertising, we see our advertising really supporting the launches during the year. You can expect that most of that is obviously going to happen in the back-half of the year and since most of the consumer purchases are in the back-half, are in the final quarter, you would expect as we have historically, most of our expenses will be in that final quarter.

That said, there are launches occurring -- the launch of Tag really starts up in June and so on a percentage basis, there will be an increase in our advertising to support that happening at the end of the second quarter. And we’ll see somewhat of a slight increase in the third quarter as well but most of the advertising is allocated to the back half of the year.

And relative to shelf space, Jeff.

Jeffrey G. Katz

Shelf space for the holiday season sort of starting in June, depending on the retailer, will be up double-digits pretty much at every retailer, and so that’s probably the most tangible expression of support that one can get from retailers, as are the number of end caps, for example, and other features we are planning for in the second half of the year.

I think the biggest indicator of retailer support though, as I mentioned, has been the purchase order program we have going this year and that’s been implemented we think successfully, so it’s helped us get a much better indication early in the year of our overall planning and manufacturing for the year, and of course for the retailer it helps them make sure products they are supporting strongly that they try to avoid, and we hope they can avoid, we can avoid with them any allocation issues.

Anthony N. Gikas - Piper Jaffray

Okay, and then can I go back to the ad expense real quickly? Should we expect that the ad spending this year will be down slightly from last year?

William B. Chiasson

No, I think that our ad spending will probably move about the level of our sales increase, so we expect to continue to invest behind the business but at levels of growth rate essentially equal to the growth in revenues.

Anthony N. Gikas - Piper Jaffray

Okay, and then could you just remind us of the more specific timing of the Leapster 2 and the Didj? Did you say in the month of June?

Jeffrey G. Katz

They will start shipping in the month of June for Leapster 2 and for Didj.

Anthony N. Gikas - Piper Jaffray

Does that mean they will hit store shelves in June or is that more of a July, August --

Jeffrey G. Katz

It’s a July and August -- it varies by retailer but that’s right.

Anthony N. Gikas - Piper Jaffray

Okay, and then how about the international launch?

Jeffrey G. Katz

So Tag in particular will hit international shelves in July for the most part -- actually Australia in June, and by July and August we’ll hit Europe.

Anthony N. Gikas - Piper Jaffray

Okay, and then the purchase order program that you were talking about, did you say that was for the 50% of your orders already in hand for the full fiscal year?

Jeffrey G. Katz

Yeah, more than that for new products for the full fiscal year.

Anthony N. Gikas - Piper Jaffray

Okay, and then my last question -- can you help us with modeling tie ratios a little bit, sort of at the launch of these hardware systems -- do you launch three pieces of software with each piece of hardware or -- how [should we] look at that?

Jeffrey G. Katz

Well, we -- of course we have a big library on the shelf but what typically happens if -- so we’ll have let’s say approximately 20 Tag books on the shelf, what we would expect to have happen though if an average tie ratio let’s say three years into the launch of the product would be in the three to five range, you are going to have less that in the launch year

Anthony N. Gikas - Piper Jaffray

Okay, so in the launch window, maybe it is three or four?

Jeffrey G. Katz

No, it will -- well, on a sell-through basis? It’s going to be probably less than three, Tony. You have -- the typical behavior is there is an included book in the case of Tag and typical behavior might be to pick up one to two more books. That would be a pretty strong acceptance for that first couple of selling months.

Anthony N. Gikas - Piper Jaffray

Okay. Thank you, guys.

Operator

Your next question comes from the line of Sara Gibbons.

Sara Gibbons

Thank you. Good afternoon. Bill, would you mind just repeating very quickly the percentage of U.S. consumer that came from software, hardware, and standalone? I think you read it in your prepared remarks.

William B. Chiasson

Sure. Let me just go right back to that. It was 35% hardware, 35% software, and 30% standalone.

Sara Gibbons

Okay, great. Thank you. And then on the tie ratios that you mentioned, I think you had mentioned on your last call that Leapster’s tie ratios were about 3.8 or so, if I remember correctly.

William B. Chiasson

That’s correct.

Sara Gibbons

Can you help explain how that jumps up to the 7 in the first quarter?

William B. Chiasson

That’s typical seasonality. What happens typically is after the holiday season, people will come back and buy software that will go along with their Leapster, and what you see in that -- so even with last year’s 3.8 for the full year, the first quarter was a 7.2, so that’s a typical seasonality we see at a retail level.

Sara Gibbons

Okay, and then in the purchase order comments that you mentioned, I just want to make sure I understand what that really means. That’s essentially that half of your sales volume from a sell-in perspective has already been accounted for for the year? And I guess what’s the timing of that? I mean, presumably that’s not falling in the second quarter?

Jeffrey G. Katz

No, that’s right. That’s right. So these are purchase orders for new products and they will ship as the retailer will sort of need them, so there are shipping dates that are as early as May and in some cases as late as November. And we will book the revenue obviously when we ship.

Sara Gibbons

And how firm of a commitment is that, in that can the retailer either -- presumably they could add to it but could they take away from it as well?

Jeffrey G. Katz

Well, there is always out-provisions in any purchase order. Generally speaking for this part of the purchase order proportion, I think we both have reasonable confident that will ship and they will want these, the real -- therefore the real -- now the real important will be -- that’s why I mentioned sell-through performance. Obviously all of their replenishment activity will be based on how the products begin to perform at shelf later in the year.

Having said that, we’ve not had demand for products where purchase orders have been -- where retailers have been supportive enough to actually make any frankly early quantity PO, let alone this proportion. And it has a lot to do with the specific programs the retailers are getting this year in terms of exclusives and features we are supporting and so forth.

Sara Gibbons

And then just a last question -- could you tell us where you are in revamping the schoolhouse operations?

Jeffrey G. Katz

So schoolhouse restructuring was completed last year and so the remaining activity in terms of revamping really has to do with the rolling out of new product rather than organizational type revamping, so they are rolling out -- actually, we’ll ship next month their first Tag School, which is a version of Tag meant to ultimately replace LeapPad as schools begin to adopt Tag into the schools. So we are looking for product revamping, if you will, but not organization revamping at this stage. That was completed last year.

Sara Gibbons

Great. Thanks very much.

Operator

Your next question comes from the line of Edward Woo.

Edward Woo - Wedbush Morgan Securities

Good job, guys. I had a question, going back on to the PO question, do you care to share any details about whether it was specifically for Tag or was it across the board on the new products?

Jeffrey G. Katz

Across the board basically on the big lines.

Edward Woo - Wedbush Morgan Securities

And then the other question I have is, is there any more [re-org] costs or has it been pretty much taken all in --

William B. Chiasson

It’s essentially all done in the first quarter, all but about $70,000.

Edward Woo - Wedbush Morgan Securities

All right, great. And then the last question I have is the Leapster and [now ClickStart] is going very well. Are there any plans to phase out the Leapster?

Jeffrey G. Katz

At this stage, Leapster is such a hot product that we are not planning to phase it out. We hope to get to a point where Leapster 2 is so dominating that we’ll have that choice but right now, Leapster Classic, as we refer to it, is just a really good low price entry into the Leapster and gaming family, so we are not talking about phasing it out, certainly not this year and --

Edward Woo - Wedbush Morgan Securities

Will your advertising be focused so that consumers will know the difference?

Jeffrey G. Katz

We are going to focus our advertising on Leapster 2 and on Didj but when they get to the retail planogram, it’s organized I think better than we’ve been able to do this before in that you will see the price leader will be there, Leapster 2 will be in the center of the planogram, and then Didj will be sort of at the right-hand side, if you will, along with Crammer on the -- so it will kind of be a natural line in terms of physical appearance but we’ll market to Leapster 2, which is really the product us and retailers want them to start buying. It’s got more of the -- you know, the whole connected value proposition is in Leapster 2 and not in Leapster, although the software is compatible.

Edward Woo - Wedbush Morgan Securities

Great. Well, definitely, good luck.

Operator

Your next question comes from the line of John Taylor.

John Taylor - Arcadia

I’ve got a couple of questions too; I wonder if you could start us out by talking a little bit about the third-party outreach program. You are kind of -- you know, Star Wars and Indy Jones, you are kind of doing two things different here. You are not only bringing in using external licenses but you are looking for third-party support in terms of software, so maybe give us an update on that to start with.

Jeffrey G. Katz

Well, I’ll touch a couple of those topics and bring me back on track if I’m not really -- not quite addressing your question. We definitely have worked very hard last year and this year and in the upcoming year, you’ll see the same thing to get strong licenses lined up early and to the degree that we can, which is the case with the Lucasfilms products, to have exclusives in the educational category.

We know from experience that these big licenses like Cars, for example, and we certainly expect Star Wars to be extremely strong and sell a large factor, you know, five to 10 X what an internal IP developed title might hope to produce. So that’s definitely a part of our strategy and we are really, really enthused about all of our content lineup for this year, books and games.

Another part of the third-party, I’m going to shift gears just a little bit to the way we are developing most -- almost all of our games are developed now external. That’s a huge shift from a year ago where almost all were developed in-house and we are moving that with book development as well. Our Tag books will be next year, the majority will be produced by external or third parties.

And then there is the business where we might go to other franchises that are different and that -- more to say on that I think in the third and fourth quarter but the big push we have made is really to go after really strong licenses, look where we can to get educational exclusives, and to market software as sort of a principal part of our marketing plan since the margins are attractive.

I hope that hits --

John Taylor - Arcadia

Maybe to clarify just a little bit -- so it sounded like you hinted at it with your comment about Q3 and Q4. My understanding was you were kind of doing an outreach to other software developers, publishers, IP owners to recruit titles basically to your platforms. Is that more to say down the road --

Jeffrey G. Katz

More to say downstream. We have a lot to execute with the current plan but yes, more to say on that downstream.

John Taylor - Arcadia

Okay, good. That’s what I was -- and then Bill, I wonder if you could talk about -- unwrap for us a little bit the discontinued impact on the first quarter, maybe what chunk of revenue and what the impact on gross margin was and how much is still in the barn that you’ve got to get rid of?

William B. Chiasson

The discontinued products had the most significant impact. I think that if you back that out, the discontinued products were up about the high single digits as a percent overall. In terms of impacting the gross margin, the most significant impact they had on impacting our gross margin was in the international segment where those discontinued products have dragged down the margins in our international segment.

As we see those coming out specifically by the end of the first half of the year, we see most of that getting behind us.

John Taylor - Arcadia

Right, so if we look at the -- I forget what you said, some 400 basis points or whatever, take out the 3.60 that you attributed to the mix shift, is the bulk of the remainder then that increase in discontinued or is there something else at --

William B. Chiasson

No, what that is, there’s a couple of different pieces. One of them is the fact that since our absolute sales are down for the quarter, there is a negative impact of leveraging of fixed costs, so that actually is probably one of the more significant pieces to that. That brings the margin down just a little bit more. And then there’s some other puts and takes of minor adjustments to margins, to discounts rather but the two biggest pieces are in rank order, number one is the mix, the mix of the hardware, the Leapster hardware and the products that are being discontinued; secondly, the impact of negative leveraging with that slight decline in sales, and then everything else is rounding.

John Taylor - Arcadia

All right, and then -- let’s see. So in your guidance, you are kind of -- these are my words, not yours but I wonder if you could help us rank or think, you know, sort of apportion these; it sounds like revenues are going to be up roughly -- you are saying sort of high teens, so let’s call that 100, and that’s my number. Your gross margins are kind of running in the 40s, so you can make up about half of your -- you know, the delta from last year to roughly break even, or a marginal loss, whatever it is. Granted, there’s $5 million chunks here that I am leaving wiggle room on, but -- so that implies there is something like $40 million or $50 million of other leverage or something that has to come. And you are talking about G&A being down maybe 10%, 15%. It sounds like you are leaving yourself a little wiggle room on the R&D line in case you need to speed something up, and that’s totally understandable. And you are leaving some wiggle room on the advertising side in case you want to really stoke the fire a little bit coming out of the year.

So is there a piece there that I’ve missed or is that a good way to kind of think about things?

William B. Chiasson

You know, we’re just going to stay with the way we’ve put the guidance. I think that there are a lot of people who look at it a lot of different ways and we are going to stay with the way we’ve worded the guidance of sales growth in the mid to upper teens, growth in the gross margin, decline in SG&A and R&D combined in the 10% to 15%, and then the nominal loss for the year. So we’ll stay with it that way.

John Taylor - Arcadia

Okay, and then are you seeing any cost inflation in China that is different from what you anticipated?

William B. Chiasson

Most of it seems to be pretty much in line with what we’ve anticipated and negotiated in our contracts for this year.

John Taylor - Arcadia

Okay, great. Thank you.

Operator

You have a follow-up question from the line of Sean McGowan.

Sean McGowan - Needham & Company

On manufacturing, any comment on costs and whether that’s a factor to consider in the balance of the year? And to the extent that you can share it with us, can you give us some idea of what the capacity would be -- I mean, if you had a real runaway hit with any of these new platforms, would you be capacity constrained by the end of the year?

Jeffrey G. Katz

In terms of manufacturing costs, Bill indicated so far our expectations are pretty much in line. We have had -- to the degree that we’ve had some sort of problematic cost risks, we’ve had benefits on the electronics side, so we are a bit advantaged with our product line in that a big portion of our bill of material costs for things like screens and memory chips, which have continued to trend favorably vis-à-vis labor or plastics.

But there’s always issues that arise and we’ll just have to stay on top of it. When we are reading about the price of fuel or price of oil going up to $120 a barrel, I think everybody’s antenna go up. But so far, I would say so good.

In terms of capacity, if we had a runaway hit we do have some opportunity to [variablize] on the upside if we get an indication soon enough but we don’t -- it’s not like we can do 2X either. So to sort of pre-commit to that quantity of long lead time components is not something we’ve done. We’d rather kind of let the product develop a little legs.

And then certain things are easier to ramp up quickly, like the software we can do in a hurry but the optical components for Tag, for example, we have some long lead time components which we’ve done what we can to buy a little bit more early but not double our expectation. On the other hand, it’s just we don’t want to carry that much inventory.

Sean McGowan - Needham & Company

Is there anything that you have heard now that we are on the night before show time here, is there anything you have heard from the competition or about the competition that’s different from what you knew a couple of months ago?

Jeffrey G. Katz

No, we -- I mean, this sort of known, sort of products with hit potential this year are just sort of coming into clarity and each of the big players has a few. We have probably more than our fair share this year, which we are happy about but we haven’t learned anything that is concerning about the competitive scene. If anything, we feel a little bit better.

Sean McGowan - Needham & Company

Okay. Thank you.

Operator

Your next question comes from the line of Gerrick Johnson.

Gerrick Johnson - BMO Capital Markets

Good afternoon. I guess all the intelligent sounding questions have been asked already, so how about -- you sound very optimistic, as you have all year long so I was wondering if there were any concerns you might have. What are some of your bigger concerns going into this important back half?

Jeffrey G. Katz

Well, I think the concerns we have are probably not unusual to us nor unusual to the industry. We really want to see how consumers react to the new product. We do feel pretty good about Tag and Leapster is just doing really quite well, so we want to be optimistic about Leapster 2 because it is an enhancement to the product, so we feel like we have some basis for believing it should go well.

But we need to see consumers’ reaction and again it’s a real rough consumer economy out there today, and we would like to see that get at least to a degree healed. I would say those are the big concerns.

And then we hope to have a problem keeping up with demand but I think the main thing is we are going to be very focused on consumer reaction to the products and then we have an ability now because a part of our product experience is going to be on the web to actually tune the experience before the peak of the year happens, so we are kind of excited about that as a possibility rather than everything being in the box.

Gerrick Johnson - BMO Capital Markets

Okay, and your international sales about 25% or so in the quarter --

(Multiple Speakers)

-- giving it to us anyway. I can do the math myself. Never mind. All right. Thank you very much.

Operator

You have a follow-up question from the line of Tony Gikas.

Anthony N. Gikas - Piper Jaffray

Bill, a couple of quick housekeeping questions, since we haven’t had a profitable quarter for a while -- what would the fully diluted share count be either in the quarter or for the year if you were profitable? And then you’ve indicated that you expect just a nominal loss for the year. If you care to define nominal, that would be great, but my question is how about cash flows for the year? Would that also be sort of a nominal negative number or cash flow neutral?

William B. Chiasson

First of all, we’ll stay with the word nominal. And the other thing is as it relates to cash, what we are projecting is that we are seeing cash and cash equivalents at the end of the year around that $100 million level. Last year we finished at around $107 million, or -- so it’s pretty much consistent with that, so we see that kind of a level and we are still digging to see what the shares would be.

Anthony N. Gikas - Piper Jaffray

Okay, and then Jeff, maybe a quick question for you on the retailers while they are digging up that number -- any additions or deletions of retailers this year that are noteworthy?

Jeffrey G. Katz

Nothing that I would call your attention to. There are some additions but nothing that will set our world on fire.

Anthony N. Gikas - Piper Jaffray

Okay.

William B. Chiasson

For the shares, that would be 120 --

Eileen VanEss

You can’t read my handwriting -- 126,000 as of March 31st but again, that would be dependent on the March 31 stock price.

Anthony N. Gikas - Piper Jaffray

So add 126,000 to the --

William B. Chiasson

[63 million].

Anthony N. Gikas - Piper Jaffray

Okay.

Eileen VanEss

Yeah, add 126,000.

Anthony N. Gikas - Piper Jaffray

Terrific, thanks.

Operator

(Operator Instructions) You have a follow-up question from the line of John Taylor.

John Taylor - Arcadia

So two questions, one kind of more qualitative -- I don’t know, two anyway. Could you talk a little bit about this tuning thing -- I mean, what does that look like? What are you looking for? How do you respond? What’s your base look like that you work with? Can you go over any of that with us?

Jeffrey G. Katz

A good example of tuning is a recommendation engine, so when we launch Learning Pad, for example, we’re going to be pretty light on when a parent gets a what we call a progress e-mail from the Learning Pad. They are going to be pretty light on the sales pitch. As we get to the holiday and we get a little experience with how click-through rates and so forth on these progress report e-mails that come out of the Learning Path, we can push harder, if you will, on the sales message or you know, you bought Tag with the included title Ozzy and Mac. You know, based on usage, we think your child would really like Olivia. So that’s an example of what tuning could well look like, is how strongly or not to turn up a sales message, even reshaping in effect certain aspects of the look and feel of certain web applications, just to make them either more user friendly or more likely to push an important marketing initiative as we get closer to real holiday sales.

John Taylor - Arcadia

What’s cool is you can kind of gradually do this -- it’s not like an on or an off.

Jeffrey G. Katz

That’s right, and that’s going to apply to online game play and things of that nature as well, that -- just every aspect of the web application can be -- in fact, the whole -- there’s an application that comes in the box called LeapFrog Connect that is in effect your -- like iTunes, in effect. You load it up when you get your Tag and so forth. And even the whole application can be updated on the fly, just as it is for your typical Microsoft or camera sort of accessory application. So we are pretty pumped about the possibilities but we are mostly going to do that based on user -- the user experience that we monitor.

John Taylor - Arcadia

Okay, good. And then my last question is -- so you set plans, you set expectations internally and with us a few -- a couple of months ago, whenever it was. Now you’ve got what sounds like firm POs in hand that is increasing your confidence. I’m wondering what impact that is having on your willingness to build what might be called spec inventory above and beyond what you would have done.

Jeffrey G. Katz

You know, at this stage, we are not -- I don’t want to say we are unwilling to build spec inventory but we are pretty close to unwilling. So what we’ve been willing to do is by a certain degree of long lead-time components for things like Tag but not to a level, as I mentioned earlier, that we could do an order of magnitude upsizing in manufacturing. We are going to have to leave that until 2009, which is a bit how we’ve built our plan and we hope we are able to have such great sell-through that we are going to do that. So we have a little bit of upsizing but we’ve been -- you know, we are very adverse to having excess inventory and frankly, so are retailers. So we would rather have a great success and scurry to fulfill, even if we have some shortages sort of going into the New Year.

John Taylor - Arcadia

Thank you.

Operator

There are no further questions at this time. Do you have any closing remarks?

Jeffrey G. Katz

Yes, let me just close by thanking everybody for joining our call. I appreciate all the questions and if you have any other questions later on, please feel free to contact Eileen VanEss here at the company. We are, Eileen and myself and Bill are going to be at a couple of conferences in the next two months, so I hope we have a chance to see some of you there. We are definitely gearing up for an exciting summer season and holiday season thereafter. We look forward to seeing you and talking with you through the course of the year. Thanks once again and have a great evening.

Operator

This concludes today’s LeapFrog Q1 2008 financial results conference call. You may now disconnect.

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