Leapfrog’s Turnaround Strategy May Yield Success in ’08

LeapFrog Enterprises (LF) was last left off in this blog with the March 2007 analysis of a possible turnaround strategy. Unfortunately, if you compare the stock charts then and now, they are eerily similar. To understand what is going on over at its Emeryville headquarters, I sat down with CEO Jeff Katz (great guy) last week. My discussion with Jeff starts publishing today as a series.

The current strategy is focused on new products Leapfrog will begin selling this holiday season and next year, and believes will rejuvenate its sales. Leapfrog made some gross errors in understanding its core competency, channel strength and segment strength under previous management, besides missing the Internet altogether. This led to former CEO Tom Kalinske being removed from the top job, replaced by Board Member and former Orbitz CEO Jeff Katz.

The longterm approach aims at better retail execution while placing a big emphasis on new product launches in the last two quarters and 2008 (60% of Leapfrog’s 2008 product line is expected to be intro’d in late 2007 or early 2008). This includes the newly refurbished reading product, Tag, which will be launching at Demo next year. Leapfrog plans to relaunch its once substantial reading business (Leappad, which is end-of-lifing) in 2008, a strategy that I feel very good about, and hope that the new product line will be sufficiently “connected” to the Internet. For the moment, this product is under tight wraps, and Jeff could only discuss it superficially with me.

Further, its previous initiatives, geared toward driving operational efficiencies and reducing costs, are expected to continue into the first half of 2008. The cost-structure had gone out of whack, and needs to be normalized again.

Prior to the November 1 Q3 earnings (ended September 30) discussion, Jeff started the call using quotes such as:

“…third quarter revenue fell short of our expectations.”
“…third quarter sales were weaker than expected.”
“…we recently revised downward our 2007 full-year guidance.”

This verbal preparation of listeners translated into a reported net loss of $2.8 million versus a net loss of $49.7 million YoY.

Net sales from the U.S. Consumer segment totaled $109.5 million for Q3 2007 versus $138.3 million in 2006 Q3. This is following a 17.6% loss in the previous Q2. Net sales from the International segment totaled $30.2 million versus $39.6 million in 2006, and the SchoolHouse segment totaled $4.3 million in 2007 versus $6.8 million 2006 Q3.

However, while sales were down across the board, LeapFrog was able to keep operating expenses in check. Q3 operating expenses totaled $63.8 million compared to $63.9 million in 2006. Selling, general and administrative expense increased 13.9% YoY to $34.4 million and research and development expense decreased 2.1% YoY to $14.2 million. Advertising expenses decreased 24.7% YoY to $12.8 million for Q3, reflecting the Company’s decision to focus advertising spending towards the last quarter of the year in support of higher seasonal sales.

The revenue guidance for the Q4 2007 is a decrease of 10-15% in versus 2006. For the full year, Leapfrog expects a similar decrease in annual revenue with an improvement in gross margin versus 2006. Operating expenses are also expected to be lower versus the $271.7 million in 2006. In short, the bottom line will improve but the year will still end with a loss.

Given these predictions, LeapFrog management stressed looking forward to the next year instead of paying too much attention on the current figures. This is completely understandable, since a new CEO, a new product line launching mostly late this year and early next year, and operational streamlining would all take time to actually translate into revenue and earnings growth.

If you are willing to be patient, the stock may pay off. Before you make the decision to invest or not, please read my in-depth Q&A with Jeff Katz, to do your due diligence.

Leapfrog’s share price with a market cap of $431.7 million has continued to trend down to $6-7/share (down from $11 in the summer). Analysts are split between waiting for improvement and contrarians hoping for a quick profit on a bargain price. Christmas is the critical point in Leapfrog’s strategy, and Leapfrog’s new products are gaining early positive reviews (ex. Clickstart, Leapster). However, success may be not so much Leapfrog product attractiveness to consumers as much as whether retail shoppers are willing drop money for them this holiday season. Early consumer reports are showing signs of otherwise. But what works in Leapfrog’s favor is that their toys are affordable (games are $15-20 and game systems are $60 at Target).

So will the frog ever make it across the road to new Web 2.0 ponds on the other side? Is Leapfrog a contrarian bet for a quick doubling of investment? Or will it just be another holiday sales roadkill? Time and sales savvy will tell.