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Executives

Karen Sansot

John Barbour - Chief Executive Officer, Director and Member of Non-Executive Officer Stock Award Committee

Raymond L. Arthur - Chief Financial Officer

Christopher Bunn - Director of Investor Relations

Analysts

Scott W. Hamann - KeyBanc Capital Markets Inc., Research Division

Michael A. Swartz - SunTrust Robinson Humphrey, Inc., Research Division

Sean P. McGowan - Needham & Company, LLC, Research Division

Lee J. Giordano - Imperial Capital, LLC, Research Division

Gerrick L. Johnson - BMO Capital Markets U.S.

Edward M. Woo - Ascendiant Capital Markets LLC, Research Division

Elizabeth O. Pierce - Roth Capital Partners, LLC, Research Division

John Taylor

Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division

LeapFrog Enterprises (LF) Q3 2012 Earnings Call November 5, 2012 5:00 PM ET

Operator

Good evening. My name is Maya and I will be your conference operator today. At this time, I would like to welcome everyone to the LeapFrog Q3 2012 Earnings Conference Call. [Operator Instructions] Thank you. Ms. Sansot, you may begin your conference.

Karen Sansot

Thank you. Good afternoon, and welcome to the LeapFrog Enterprises conference call to review our results for the third quarter ended September 30, 2012. I'm Karen Sansot, Senior Director of Investor Relations. Today on the call, we have John Barbour, our Chief Executive Officer; and Ray Arthur, our Chief Financial Officer. Before we begin, I have a couple of housekeeping items to go over. Mark your calendars, we will be hosting our annual investor event in New York the morning of Tuesday, February 12. We'll send out details in a few weeks. This event will also be webcast on our Investor Relations website at www.leapfroginvestor.com. Please refer to this website for current information about LeapFrog.

And now for the Safe Harbor statement. We wish to remind you that our statements today will include forward-looking statements about management's expectations, including expectations regarding anticipated 2012 financial results, such as anticipated sales and earnings per share. In addition, we expect the questions posed in the Q&A portion of this call to prompt answers that contain additional forward-looking statements not included in our prepared marks. You should be aware that actual results might differ materially from those projected in any forward-looking statements. Some important factors that could cause actual results to differ materially from those in the forward-looking statements are described in our most recent Form 10-K filed with the SEC. LeapFrog makes these statements as of today, November 5, 2012, and disclaims any duty to update them. I would now like to turn the call over to John Barbour.

John Barbour

Good afternoon. As the CEO and a shareholder of LeapFrog, I'm very pleased with the quality of execution from the LeapFrog team as we transform our business and deliver another quarter of strong market leading performance. We're on a journey to transform LeapFrog from an educational toy company to the leading developer and distributor of educational entertainment. This year, we've made great strides in this journey. We successfully launched LeapPad2, the next generation of the #1 kids learning tablet; the LeapsterGS, our revolutionary new version of our award winning and top-selling learning game system; and we will more than quadruple our Explorer content library from approximately 100 titles to more than 400 of the best educational entertainment titles by the end of the year.

We continue to develop partnerships with leading children's entertainment companies to distribute their content across our platforms. We've now entered into distribution agreements with 26 different companies, including Disney, Sesame Workshop, PBS, Nickelodeon, Discovery Education, HIT Entertainment, Mattel, Hasbro, among many more. Another key element of our transformation is our growing investment and the expansion of our own character IP to the internal creation of more great LeapFrog titles across a variety of entertainment media. A good example of this is the announcement this morning of our agreement with Lionsgate, who will distribute 4 new LeapFrog Letter Factory movie DVDs that we will create and produce internally.

Our ability to create animated movies may not be well known, but our original Letter Factory DVD has more 5-star ratings in Amazon than the top 3 top -- by the 3 top grossing kids movies of all-time, with 991 5-star reviews.

LeapFrog's valuable home entertainment catalog has sold nearly 9 million units to date and continues to lead the industry for educational programming. Oh, and I nearly forgot to mention, we have retained the distribution rights for these new movies across our own propriety platforms. Another topic I'd like to touch upon before I discuss our year-to-date results is the competitive landscape in the tablet market. We all knew that the table market is going to be hot this holiday season and at the end of the second quarter, we knew there was going to be a number of new tablets hitting the market before the end of the year. But we had limited intel on how competitive they were going to be versus our new LeapPad2.

Today, we have a lot more clarity in the competitive landscape. I and many of the LeapFrog team members have spent hundreds of hours playing with and experiencing our competition. The bulk of these competitive tablets have been designed for adults, not children. And we believe most are quite unsuitable for unsupervised play by a child of 3 to 8 years old.

The LeapPad2 was specifically designed for children. We only make products for children. Over the last 17 years, we've successfully launched more revolutionary products that deliver intensely fun learning experiences for children than any other company in the tablet space. Every element of the LeapPad2 has been created with a child in mind, right down to its kid-tough design. And as we all know, hardware is only a small part of the equation when you buy a tablet for a child. It's the content that the child experiences in the tablet that keeps them entertained and helps them learn. The LeapPad2 is supported by a content library of hundreds of cartridges, videos, games, e-books and apps, all of which have been codeveloped or selected by our in-house team of highly experienced child development and educational experts.

We have created a hardware content combination that I firmly believe is the best in the market for children. A tablet designed specifically for kids and a safe place for parents to find all that's best and fun, compelling and engaging content that delivers life-changing learning and helps children achieve their potential.

Those of you that are still concerned over the competitive impact of LeapPad2, I suggest you look at a few more other important market elements:

One, if you go to most retail stores that sell these products, you will see that most of the tablets are merchandised in the electronic section and a lot of times, they're behind glass. On the other hand, the LeapPads are featured in the kids and toy section, easy for most consumers to find.

Two, the LeapPad2 continues to win far more independent awards and gets dramatically better online consumer reviews for a children's tablet than the competition.

And three, the LeapPad2 has been selected as a top toy for holiday 2012 by far more retailers and kid experts than any other tablet. Perhaps that's why major retailers are telling the world that the LeapPad2 is already one of their best selling layaway products of 2012.

So let's look at our year-to-date 2012 performance. As result of our company's transformation and improved business execution, we delivered exceptional financial growth and built cash while continuing to invest in the future of our company. Year-to-date, we have increased net sales by more than $91 million or 37% compared to 1 year ago. We're gaining share and growing on all of our key markets. Year to date, U.S. net sales are up 36% and International net sales have grown 41%.

Our gross margins to date have expanded by 200 basis points year-on-year, driven largely by volume and a higher mix of content sales. Our operating profit to date is nearly as much as we earned in all of 2011 and is up $31 million from 1 year ago. On a per-share basis, we increased EPS by $0.55 and have already reported more earnings per share to date in 2012 than all of 2011. And we're building cash.

Our cash balance has nearly doubled compared to 1 year ago. Our terrific financial performance has been driven by high consumer demand for a leading educational entertainment portfolio, which is experiencing strong double-digit POS growth in the U.S. and many international markets. As a leader in children's educational entertainment, we benefit from the universal desire by parents to help their children get the best start in life and by the growing global need for supplemental education.

As schools face budget cuts, it's more important than ever to provide children with the tools that extend learning beyond the classroom. Research shows that achievement at kindergarten directly relates to later academic success. However, almost half the students are not prepared or not fully prepared when they enter kindergarten.

To be successful in the 21st century, children need a broad set of skills ranging from reading, writing math; to problem-solving, social skills, science; to art, music and much more. LeapFrog is unique in that we offer fun and engaging education entertainment learning solutions for children that cover a wide range of subjects and skills, and are carefully created and selected by an inhouse team of education experts. Our learning content is grounded in the latest research and draws on a comprehensive curriculum that covers more than 2,500 skills across 100 skill categories. We help parents prepare their children for life success.

At LeapFrog, we believe that play is an essential part of learning. And if you make learning fun, it will be dramatically more effective. We know how children like to play and how they learn and we sweat the details with each and every one of our products. As a result, we have the #1 kids learning tablets with the LeapPad, the #1 kids learning gaming system with Leapster and the #1 learn-to-read systems with Tag, and a strong line of preschool learning toys and valuable home entertainment catalog of educational videos and DVDs.

Reviews of our products are exceptionally high and I believe no other company has won more parenting and education awards than LeapFrog. Children love our products and parents love the impact our products have on children. Millions of parents love and trust the LeapFrog brand. They know that we provide the best and the most engaging and the most nutritional entertainment in the market.

With our leading product portfolio, terrific year-to-date results, and parents increasingly looking for learning solutions for their children, we head into the holidays with good momentum. We're entering the fourth quarter this year in much better position than we did last year. Exceptional execution from our supply chain team, has resulted in us having far better inventory of LeapPads in our pipeline, and we have a lot more inventory already on retail shelves. At the same time, the major children's product markets, toys and video games, are experiencing significant declines and we're facing an uncertain economy in an election year.

And the impact of major retailers' very successful layaway programs pulling forward consumer demand at the quarter 3 from quarter 4 is unknown. We continue to be energized by the opportunity ahead of us. Last quarter, we made great strides in our transformation, delivered market-leading financial performance and added 3 world-class leaders to our senior management team. This is important. We're really excited about the positive impact our products are having on millions of children around the world. I'd now like to turn over to Ray, who will discuss our financial performance.

Raymond L. Arthur

Thank you, John, and good afternoon. In the third quarter, we delivered solid sales growth, which combined with continued expense control, drove significant improvements in both operating and net income. With 3 quarters of the calendar year behind us, we're pleased with our results and we believe we are well-positioned heading into the all-important holiday season. This belief is based on our strong product portfolio, including our extensive educational entertainment content library; our newest educational children's tablet, LeapPad2; and continued POS growth and higher retail inventory levels versus the same period last year.

In addition, our holiday advertising campaigns, retail promotions and messaging at shelf have all been significantly improved. While we are cautious about the economy and, as you know, there's still more than 50% of our POS sell-through that happens between now and the end of the year, we have built momentum to carry us into the holiday season.

Now let me provide a bit more insight into our third quarter financial performance as summarized in the financial tables accompanying the press release. Worldwide sales for the quarter were $193 million, up 28% compared to $151 million 1 year ago and were negatively impacted by 1% due to changes in currency exchange rates. The worldwide growth was largely driven by the introduction of new products, including LeapPad2, as well as LeapsterGS and our Touch Magic toy line. Consumer demand for both LeapPad hardware platforms and content continues to be high.

In addition, we do believe that some of our growth was driven by our building a better inventory position this year and a potential shift of some sales from the fourth quarter to the third quarter. Net sales for our U.S. segment were $146 million, up 26% compared to 1 year ago. POS for our U.S. segment remained robust in the quarter. Strong sales of LeapPad, LeapPad2 and content drove the year-over-year improvement.

In our International segment, net sales were $47 million, up 36% compared to 1 year ago and were negatively impacted by 3 percentage points from changes in currency exchange rates. Momentum in our International segment remained very strong in the quarter with robust selling growth and strong double-digit POS growth in all key markets.

Turning to line of business. Worldwide net sales of multimedia learning platforms and content were up 48% year-over-year, driven by LeapPad platforms and sales of LeapPad2 hardware in the quarter, more than double that of LeapPad1 in Q3 of the prior year. LeapPad cartridge and accessory sales were particularly strong, also more than doubling.

Within our gaming business, sales of our new GS gaming system are meeting our expectations, but were more than offset by declines in gaming platforms, which are nearing the end of their life cycle. Within multimedia learning platforms and content, our traditional reading business, which includes Tag and Tag Junior hardware and the related physical books, was down year-over-year given the planned transition to our new reading solution plan-o-gram and new book packaging, which began late in the quarter.

However, our holistic reading business, which in addition to the Tag and Tag Junior platforms also includes e-books for our gaming and tablet platforms, was flat compared to the prior year. Moving on to learning toys. According to NPD's most recent year-to-date toy industry report through September, toy industry sales are down about 6% in the U.S. Our learning toy sales are consistent with this trend with the overall decline partly offset by the launch of our new Touch Magic line in the quarter.

Gross profit for the quarter was $77 million, an increase of 25% compared to the prior year. Gross margin was 40% for the quarter, down 100 basis points year-over-year, primarily driven by higher inventory allowances as a percentage of net sales due to product transitions; partially offset by proportionally lower trade allowances and discounts; and higher sales volume, which reduced the impact of fixed logistics costs. Impact from increased sales of lower margin in mobile learning platforms was generally offset by increased sales of higher-margin content and accessories.

Operating expenses for the quarter were $40 million, up 10% compared to $37 million 1 year ago, though down more than 300 basis points as a percentage of net sales. SG&A and R&D both increased due to higher employee related expenses, while advertising spend was slightly lower than the same period last year. As result of significant sales growth and operating leverage offset by slight gross margin contraction, we once again drove significant bottom line improvement.

Net income was $42 million, an improvement of almost $19 million year-over-year, and net income per diluted share was $0.60, an improvement of $0.25 compared to the $0.35 net income per diluted share 1 year ago. Net income included a nonrecurring tax benefit of $6.4 million in the current quarter and $2.9 million in the third quarter of 2011. Excluding the impact of nonrecurring tax benefits, net income per share would have increased by $0.20 per share.

So let's move on to the balance sheet. Cash and cash equivalents finished at $49 million, almost double the $26 million of 1 year ago. And as result of stronger cash position, we do not anticipate drawing down on our ABL this year as we have in past years. Our accounts receivable balance was $170 million, an increase of 25%, which trailed our 28% net sales increase. Our portfolio remains healthy and our DSO decreased by over 2 days compared to the year ago period due to improved collections.

Our inventory balance was $115 million, up $45 million or 64% compared to 1 year ago, due to improved timing and phasing of LeapPad production intended to deliver product to retailers earlier and at higher levels to address higher anticipated POS in 2012. Operating cash flow declined by $45 million in the quarter, largely as a result of significantly higher inventory balances as we better prepared this or for the upcoming holiday season and higher accounts receivable as a result of the third quarter sales performance.

In summary, our balance sheet is in excellent shape heading into this holiday season.

Now I'd like to finished my prepared remarks with insight into our full-year outlook. We remain committed to the financial goals we established at the beginning of the year, which were to drive significant earnings growth through increased net sales and tight expense control, while investing in future growth. While we are entering the holiday season with good POS momentum and strong retail and marketing plans, we remain cautious as the retail environment is competitive and the economy unsettled. The next couple of months at retail are critical and will largely determine our full-year profitability.

Regarding guidance, given the strength of our third quarter results, retail point-of-sale trends and inventory position, we are raising our full-year 2012 guidance. Our guidance is based on our best view as of today, but keep in mind that our full year 2012 results will be highly dependent on the economy and consumer sales during the all-important holiday season. In addition, please note that we expect our advertising expenditures to increase by approximately 20% to 25% in the fourth quarter compared to 1 year ago as we concentrate our advertising spend during the key holiday weeks when consumers are shopping for gifts.

Specific to forward-looking guidance, we now expect full year 2012 net sales to be in the range of $535 million to $550 million, up $80 million and $95 million or 18% and 21% compared to 2011; and net income per diluted share to be in the range of $0.75 to $0.81 compared to $0.30 in 2011. As we look to the future, we are well positioned to grow our earnings and deliver strong cash flow. We have good product momentum, the leading children's educational tablet and exciting new product launches. We are transforming to being the leading developer and distributor of educational entertainment.

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

Question-and-Answer Session

Operator

[Operator Instructions] Your first question is from Scott Hammond from KeyBanc Capital.

Scott W. Hamann - KeyBanc Capital Markets Inc., Research Division

Just in terms of some of the shelf space allocations you have going into holiday season and potentially expanded distribution relationships with any retailers, can you kind of speak to where you are year-over-year?

John Barbour

Yes. I mean, I think if you look at -- if you go into Walmart, Toys "R" Us, Target, you'll see that we've expanded our space in stores and you'll also see over the holiday season that we're going to expand our promotions with them as well. So we feel that our team has made good progress in that area.

Scott W. Hamann - KeyBanc Capital Markets Inc., Research Division

Okay. And then just in terms of the inventory levels in the channel, can you be a little bit more specific maybe with where you sit there versus trying to reconcile the inventory and the balance sheet and kind of how you see this playing out?

John Barbour

Yes, I mean, one of the things you'll see for our Q3 numbers is that we shipped significantly more inventory into the marketplace, prepared for the holiday season. And we've got -- came under some criticism last year for inventory levels on LeapPad, et cetera. So some of the volume in Q3 is certainly volume that we would've gotten in Q4 last year, but we're sitting with -- again, you can see it in stores. Anybody who goes into stores and talks to people in the stores will see that there's better inventory of our products in there. And fortunately, we have more inventory at the moment in our pipeline getting prepared for the holiday season.

Raymond L. Arthur

And we're seeing POS performing very well as a relation to that in-stock position.

Scott W. Hamann - KeyBanc Capital Markets Inc., Research Division

Okay. And then just finally on the gross margin, you kind of indicated there were some debt allowances that were recorded this quarter. Is that -- I mean, was that something that you had anticipated earlier? I guess, gross margins was a little bit less than I had anticipated. And then for the fourth quarter, how does that kind of look? Is there any guidance you can kind of give us on where that should shake out for the year based on where you see it now?

Raymond L. Arthur

Well, ultimately, we do expect some improvement in gross margin rate year-on-year in Q4 but it's really all dependent on what the product mix comes up to be. The more content that's sold in relation to hardware will, of course, push that margin percentage up. If more hardware is sold than content, sales spill into next year, there will be a little pressure down; but we do expect it to be somewhat better. As to the allowances that we recorded in the quarter, it's kind of normal course of business in bringing some products to their end of life.

John Barbour

Yes. On managing the transitions, we made it clear to people that this was going to be a year or 2 out and that we were going to execute in-store and we were going to launch the new new packaging on Tag. And that's all part of -- rolled up into what we're dealing with or we dealt with.

Operator

Your next question is from Mike Schwartz from SunTrust.

Michael A. Swartz - SunTrust Robinson Humphrey, Inc., Research Division

I guess, the marketing spend came in, obviously, lower year-over-year and below, I think, most people's expectations. Was there anything during the quarter that caused you maybe to push more of that out in the fourth quarter -- layaway, anything else? Or was that always your kind of your plan for third quarter?

John Barbour

We modify -- I mean, one of the things that -- we really manage and sweat the details everyday of how we're investing our money and we look at what activity we get in terms of the PR that we have out there. And we have a set amount of money we're going to invest in the business and fortunately, we've had incredible PR across our business and great support from our retailers and layaways. So it's just a wise move to move some of that advertising into the fourth quarter and get prepared. It's keeping our powder dry for the time when the fish are swimming.

Michael A. Swartz - SunTrust Robinson Humphrey, Inc., Research Division

And I guess, kind of to build on that answer, I mean, how flexible are your plans with ad spending in the fourth quarter? I mean, if you continue to see kind of the double-digit POS going through the heart of the holiday season, I mean, would you have to spend all of it? Would you pull back? Would you maybe invest in other platforms like you did last year?

John Barbour

We could move. I mean, it's not super flexible, but there's definitely some flexibility where we can move campaigns around. And we read it, as I say, literally every week where we're modifying and making tweaks to this campaign. And we can tend to put advertising to the products that need the extra help to drive them off the shelves. As you go into the fourth quarter, it's just the way the business rolls and the promotions -- much of these things are changing quite a bit by the minute.

Operator

Your next question is from Sean McGowan of Needham & Company.

Sean P. McGowan - Needham & Company, LLC, Research Division

I'm sure you're anticipating this question, so I'll just get right to it. So you've got inventory in place for a pretty good fourth quarter, you've got advertising plan to drive a pretty good fourth quarter and yet, the low end of your guidance implies a decrease in sales for the fourth quarter. So how are we supposed to think about that?

John Barbour

Well, I think the big part of -- you've got to look at the standpoint of what's happening in the economy. You got to look at the standpoint of shipping more inventory into the trade through the first 3 quarters of which it's sitting there right now in preparation for the holiday season, right? And you got to look at the fact that we believe that some level of demand has been pulled forward for these super successful layaway programs. So when you do all the math and you look at our guidance, I think you can see where there's some growth there.

Raymond L. Arthur

And, Sean, still well over 50% of our POS and retail is yet to occur at this point. So having a fairly reserved look at what's going to happening in Q4 is, in our mind, still appropriate.

Sean P. McGowan - Needham & Company, LLC, Research Division

All right. A couple of another numbers that kind of jump out here, bad debt reserve, what's behind that? I mean, are you anticipating something or is that just socking it away? And the tax benefit in the quarter, why is it so high? What does that mean for fourth quarter next year?

Raymond L. Arthur

Two things. The allowance for doubtful account is up due to a discreet issue that happened to us earlier in the year when one of our suppliers went out of business that cost us about $3 million -- the distributor, I'm sorry. And as to the tax benefits, those tax benefits have all been -- those were 1048 reserves related to some previous operations that we had where the statute of limitations has expired. As of this point in time, there are no further tax benefits in that regard. That being said, as I'm sure you know, we have significant NOLs that have been reported over the years that we do have a full valuation allowance on at this point. And as we move forward with continuing profitability, we'll have to reevaluate that situation and see whether a reduction in that valuation reserve is appropriate.

Sean P. McGowan - Needham & Company, LLC, Research Division

Right. So I think what you've been saying in the past was we should expect sort of nominal tax expense in the quarter for foreign results or something and here, we have this big benefits, what should we be looking for kind of going forward at this point?

Raymond L. Arthur

I think what you should be looking for going forward is a fairly low tax expense. Like I said, we do have those net operating losses that will offset U.S. taxes. So I would exclude the big benefits you're seeing prospectively with the one caveat that when we do look at the full valuation allowance we have against net operating losses, at some point, we're going to take that back if we continue to produce the kind of results we're seeing today.

Sean P. McGowan - Needham & Company, LLC, Research Division

And that would look like a big one-time gain and then followed by a normal tax rate?

Raymond L. Arthur

It's done 2 ways. Kind of the accounting firms, I believe, have different views on it. Some are proponents of taking the full valuation allowance back at one-time. Others will allow some partial recognition depending on facts and circumstances and we have yet to get to the point to conclude where we're headed there.

Sean P. McGowan - Needham & Company, LLC, Research Division

Quality problem, okay.

Raymond L. Arthur

Yes.

Operator

Your next question is from Lee Giordano of Imperial Capital.

Lee J. Giordano - Imperial Capital, LLC, Research Division

Could you talk a little bit more about your ability to chase demand during the holiday season? It seems like you're in a much better inventory position for the LeapPad. But let's just say the POS sales are better than you expected, what's your ability to chase demand into the channel this season?

John Barbour

Well, if you look at last year, most of you know, we actually airfreighted a whole bunch of product in the quarter that helped us meet the whole bunch of demand in Q4 last year. It, unfortunately, robbed us of hardware sales in Q1, but we were prepared to do that because of the ongoing opportunity of selling accessories and selling content to those customers. So that's always a strategy that we could use again this year if we needed to. And we have a stronger manufacturing, I believe. Our supply chain team have done a wonderful job this year of really improving our supply chain going forward. But you know as well as I do, in manufacturing timelines and just how complicated this product is, there's always limits to that flexibility.

Lee J. Giordano - Imperial Capital, LLC, Research Division

Great. And then secondly, can you talk some more about the Lionsgate agreement you announced and how the economics of that DVD business works?

John Barbour

Yes, I mean, it's one of the areas that I'm especially excited about. If you go and look at the original Letter Factory DVD, most people don't know this, but as I said in my prepared remarks, it's got more 5-star ratings than the top 3 highest grossing kids movies of all time. It's incredible. Our team have got an amazing ability to create really life-changing educational entertainment. And as we diversify our business and we become more of a broad-based, educational entertainment company, then, of course, animation, other elements of delivering entertainment to kids with education are going to be important. We've been working with Lionsgate now for a number of years. We've produced some really, I think, exciting product with them. And we're super excited about this new deal with them because this time we're actually taking the development in-house and managing that all in-house, and involving our educational experts more in the process. And within that, Lionsgate has the rights to go and distribute that product as they have done in the past, except for on our platforms, we have the right to distribute it ourselves.

Operator

Your next question is from Gerrick Johnson of BMO Capital Markets.

Gerrick L. Johnson - BMO Capital Markets U.S.

I was hoping you'd go over some numbers again. The gaming and toy numbers for the third quarter, how much were they up or down?

Raymond L. Arthur

The multimedia platforms?

John Barbour

Yes.

Raymond L. Arthur

Content and platforms were up 48% year-over-year. Yes, it was driven by LeapPad platforms and sale of LeapPad2 hardware in the quarter.

John Barbour

And toys?

Raymond L. Arthur

Toys were -- they kind of followed the industry trend, which was down about 6% in the U.S.

Gerrick L. Johnson - BMO Capital Markets U.S.

That's year-to-date, right?

Raymond L. Arthur

The U.S. trend is, yes.

Gerrick L. Johnson - BMO Capital Markets U.S.

Okay. So we were running down about 20% after the first 6 months, right?

John Barbour

I'm not sure we have that. We'll get back to you on that.

Raymond L. Arthur

I don't have the number with me.

Gerrick L. Johnson - BMO Capital Markets U.S.

So really, what I want to know is were toys up or down in the quarter?

John Barbour

Toys were down.

Raymond L. Arthur

Yes.

John Barbour

I mean, the toy business is down across the board at the moment just like the video game business and our toy business was down. But we're also going through a bunch of transitions there, and we're excited with the new products we shipped into the market. Early read across the Touch Magic line has been pretty strong and we've got a couple of winners across the rest of our toy business. So we're quietly optimistic for the quarter.

Gerrick L. Johnson - BMO Capital Markets U.S.

Okay. And then just a few more clarification of things. What does robust Point-of-Sale mean? Does that mean up double digits, up triple digits, up single digits? What does robust mean?

John Barbour

I think triple digits would be absolutely incredible Point-of-Sale, so we'll have that one up. Double-digit.

Gerrick L. Johnson - BMO Capital Markets U.S.

Okay. And one more clarification. If we took out the tax benefit, what would it have been EPS-wise, $0.51 something like that in the quarter?

Raymond L. Arthur

The difference year-on-year to the increased tax benefit is $0.05. I think on a static basis, if you just looked at the current year, it's $0.09. So it would be $0.51, yes, or $0.52.

Gerrick L. Johnson - BMO Capital Markets U.S.

Okay, all right. And we'll shift gears here. You're signing a lot of deals with third parties to provide content to LeapPad. Are these deals platform agnostic, meaning do they only apply to the LeapPad or can you use this content for any platforms, either present or future platforms that you may have coming out?

John Barbour

All of the deals that we have, they're quite unique depending upon how they come together. But today, they cover all of our -- well, it depends. I mean, each of the deal has a definition of what product it covers across that content. So some of them have Tag in there, some of them have the Explorer content, which, of course, covers both the GS and the LeapPad part of our businesses.

Raymond L. Arthur

Yes. LeapPad1 and LeapPad2.

John Barbour

Yes.

Gerrick L. Johnson - BMO Capital Markets U.S.

Okay. And anything coming out next year?

John Barbour

That's a tough question to answer but I would say, certainly, in the tablet space, yes.

Operator

Your next question is from Ed Woo.

Edward M. Woo - Ascendiant Capital Markets LLC, Research Division

I have questions about International versus U.S. It looks like you have pretty good growth in both business. Was there any big difference in terms of reception to the LeapPad? And has the LeapPad2 been rolled out in all International markets yet?

John Barbour

No big difference in the reception to the product. It's just those markets are at different stages. We've launch the LeapPad in all of our English-speaking marketplaces. And for the first time, we've actually launched it also in France where -- we launched the LeapPad1 in France, not #2. And it was -- it's being -- it's so far, has been a terrific success.

Edward M. Woo - Ascendiant Capital Markets LLC, Research Division

Do you have plans to be rolling out the LeapPad2 in non-English speaking countries relatively soon or is that something that will be done more for next year?

John Barbour

We're going to -- well, for sure, we're not going to be anything between now and the holiday season. And we'll certainly look market by market next year as to when we actually get a chance to review the performance of how we've done through the end of this year as we go forward. As you can imagine, localization for us is quite different for than say, developing most other the toys where it's just a packaging change or an instruction change. For us, we actually have to go and make significant changes to the -- localize the curricular, localize all the content, et cetera. So we take each of those moves very seriously in terms of our investments and we're looking at it. We see a lot of opportunity as we move into the future to expand globally. And so far, so good on France. Our team in France have done a terrific job over there and early reads on the product have just been so exciting.

Edward M. Woo - Ascendiant Capital Markets LLC, Research Division

Well, I'm glad to see that you're promoting harmony between Parisians and Americans over there.

John Barbour

Yes. Well, I think it helps I'm a Scot.

Edward M. Woo - Ascendiant Capital Markets LLC, Research Division

Great. And the last question I have is, there's been a very good focus for you guys on digital content on app store. I was just wondering, have you seen a big shift in terms of people moving away from the cartridges and being exclusively on digital? Or do you see your LeapPad still kind of promoting both software?

John Barbour

We're super fortunate. Our cartridge business is way up year-on-year and we're excited about the plans that we've got for that business. And what we find is consumers tend to choose what they want at the time. And I think that's a great thing about our business as being highly focused on the consumer and giving the consumer the choice of how and where they want to shop. But again, it's funny, people for some time now have had this big expectation, our cartridge business is going to wane. And that's just not true. I mean, moms love cartridges. They're there. They're easy to interface across different products. They're easy for kids to share. There's something there substantial that they can -- kids can hold in their hands. And every so often, they lose them and it's a pain but cartridges are still a big favorite for today's mom.

Operator

Your next question is from Liz Pierce of Roth Capital Partners.

Elizabeth O. Pierce - Roth Capital Partners, LLC, Research Division

I just have a -- I think just a couple at this point. On the R&D, that was a little bit more than I anticipated, so I was kind of curious about your thoughts not only for Q4 but for the rest -- for next year on how we should be thinking about R&D?

John Barbour

Yes. I mean, it's interesting. As you can imagine, Liz, as you get more success and your eyes open to some of the other big opportunities that are out there, it does give us the chance to look at some exciting new things for next year. And we're pretty famous, I think, as a company of coming up with revolutionary formats to extend their business. And as we sit and looked at it, we got a couple of things we're working on that we're investing some money on for the future. But we're really excited, and you guys will see all of those when we launch them in April of next year.

Elizabeth O. Pierce - Roth Capital Partners, LLC, Research Division

Okay. So it sounds like, I think, I was under the impression that as content became a greater part of the mix that maybe that the R&D would start to come down a bit and maybe...

Raymond L. Arthur

Content development, content development. I said content development actually ends up in our R&D.

John Barbour

Yes, content development is part of that, too. But the answer to it is that R&D expenditure will develop as we look at new opportunities that come up. Some years it will be higher, some years it will be lower. I mean, the goal long-term will be to have a lower percent of sales but we're certainly -- if you look at our results so far and how we've invested over the last couple of years -- and some new things have popped up that we're really interested in and we're going to continue to invest as we go forward.

Elizabeth O. Pierce - Roth Capital Partners, LLC, Research Division

Okay, okay. And can you speak to the margins by country or by the U.S. versus International, just directionally?

Raymond L. Arthur

Not really. One of the things we have not covered traditionally is margin by area and for competitive reasons, I think we probably would not like to go into that.

Elizabeth O. Pierce - Roth Capital Partners, LLC, Research Division

But then it doesn't typically come out in the 10-Q? U.S. versus International?

Raymond L. Arthur

Right, right. That does, yes.

Elizabeth O. Pierce - Roth Capital Partners, LLC, Research Division

So I guess, that's what I was really asking for, not necessarily by product.

Raymond L. Arthur

Oh okay, one sec.

Elizabeth O. Pierce - Roth Capital Partners, LLC, Research Division

And then maybe while you're looking at that, if you have any comments on your inventory for the LeapPad1?

John Barbour

The LeapPad1? Inventory in LeapPad1, I mean, we had a very clear transition strategy here, where we'd planned to bring the price down to $79.99 in the market place, which we've done and it continues to sell very well. And we believe that we'll be pretty much out of it on shelf before the end of the year.

Raymond L. Arthur

And as to margin, I mean, margin is going to be up internationally by 150 basis points and it's going to be down in the U.S. by 160 basis points. The end of life inventory allowances are primarily in the U.S. segment. They're not allocated out to International.

Operator

Your next question is from John Taylor of Arcadia Investment Corp.

John Taylor

So I got of couple questions. I want to pick up where Sean was trying to go on this inventory thing. So if you take a look -- I mean, don't I recall that there was some concern about a supply constraint on inventory earlier in the year and you've got a nice base here that you could feed out as demand shows up. Given where your guidance is, it's one of the lower turnover rates of Q4 cost of goods inventory -- not that, that necessarily means anything because you can airfreight stuff. But it's one of the lower numbers and it just seems like, I don't know, maybe you've built some for the first half so that you don't end up empty-handed in case things sell through. But I wonder, could you give us any more color on that?

John Barbour

I think we made a -- I mean, I think in Q2 we've kind of covered the base on it which is, bottom line of it is, we have better supply chain than we had last year. We certainly want the inventory getting through into the first quarter. We don't want to be like last year where we left the shelves empty for about 6 weeks at the beginning of the year. And if we really desperately need it, we can airfreight inventory in. It's all part of the plan. But at the same time, JT, nobody wants to do airfreight to keep products in warehouses or put it on shelves if it's not selling. So all of this is going to be determined by what consumer demand is of the product and how much of that demand was sucked up early by all these layaway programs. So we're just -- we're trying to manage the business as tightly as possible.

John Taylor

Okay. And then the economics on the -- like the Lionsgate film production and so on, so can you give us any rough idea of how much you expect one of these to cost to actually do?

John Barbour

No.

John Taylor

Not yet?

John Barbour

Not yet. Confidential, sorry.

John Taylor

Okay. Are those most likely -- are those costs most likely going to be expensed or capitalized until it ships? The way like Hasbro does with HUB programming, stuff like that.

Raymond L. Arthur

We'll capitalize them until it is out to market.

John Barbour

Yes.

John Taylor

Yes. Okay, good. All right, last question. The ad-to-sales number in the Q4, seems like, yes, you made it pretty clear, you're pushing some of that -- sorry, in Q3, you've pushed some of that into Q4. Is the Learning Path doing anything for you in terms of lowering ad-to-sales?

John Barbour

Yes. It helps us build the relationship with the customers and helps us build community. I think you're going to see a lot more of that in the future. But absolutely, the Learning Path program and our direct relationship with those consumers through Learning Path is helping us communicate more effectively with our customer base.

John Taylor

And would you tie that partly to the low ad-to-sales ratio in Q4 or probably not?

John Barbour

No. I think this is just more tactical managing the business on a day-to-day basis.

Operator

And your last question comes from Drew Crum of Stifel, Nicolaus.

Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division

So just a point of clarification on the guidance, does it include or exclude the tax benefit you recognized in the third quarter?

Raymond L. Arthur

It includes the tax benefit.

Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division

Okay, got it. And JB any impact from Hurricane Sandy on your business? Is that contemplated in any way in the guidance you provided?

John Barbour

That's a really tough one because I think things are still passing through at the moment. I think a lot of it depends upon how quick the East Coast recovers. I mean, I can give you an example. My home had no energy at all until this morning. And there's still probably millions of people that don't have energy and have difficulty who can't access the gas at the moment. If that continues, it's highly likely to have an impact across the marketplace but none of us really know that.

Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division

Okay, fair enough. And just last question, as far as tie ratios are concerned for the LeapPad2, can you compare that versus your experience with the LeapPad1? Is it too early to say?

John Barbour

Yes, it's too early to say.

Operator

There are no further questions at this time.

Karen Sansot

Great. Well, thank you, everyone, for joining us on our call today.

John Barbour

Thank you.

Christopher Bunn

Please feel free to contact Ray or me with any follow-up questions. Thanks and goodbye.

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