LEAPFROG ENTERPRISES

INNOVATIVE CAPABILITIES AUDIT

MGMT 524
Winter 2011
March 14, 2011

Gautam Aggarwal
Vivek Durairaj
Alex Jukl
David McCullough
Melissa Revenaugh
Melodie Shimomura
Ashish Yajnik

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Executive Summary

LeapFrog Enterprises, Inc. is an educational game company that develops learning toys

for infants and children. Since launching its award-winning LeapPad in 1999, LeapFrog has

served a niche market in the toy industry, a segment in which leading competitors Mattel and

Hasbro have not fully delved into. LeapFrog utilizes its core competencies, such as the Anoto

optical reader technology and proprietary software that integrates with its Learning Path

content management system, to make incremental innovations to its existing products.

To combat threats caused by the recent recession, shifting consumer purchasing

behavior and an overall age compression phenomenon in children, LeapFrog has reorganized its

structure and strategy to operate more efficiently over the long-term. A critical element to its

success hinges on the Learning Path system, which functions as a technology base for

LeapFrog’s most popular toys. Learning Path is a key differentiator for LeapFrog, allowing

parents the capability to track their child’s educational progress through LeapFrog games and

to receive product recommendations based on their child’s unique learning aptitude.

LeapFrog is currently at a significant crossroads: management can either continue to

make incremental improvements and reduce operating costs to try and sustain profitability

over the longer-term, or it can attractively position the company for acquisition by a leading

competitor in the short-term. Our research favors the latter. Among its competitors, LeapFrog

would most strategically fit with Hasbro; LeapFrog’s competence in educational toys would

expand Hasbro’s product breadth with the least amount of redundancies, since Hasbro

operates primarily in the lower-end and traditional toys play space.

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 Table of Contents

Introduction .................................................................................................................................................. 5
Industry Analysis ....................................................................................................................................... 5
Competitors .............................................................................................................................................. 6
Firm Analysis ................................................................................................................................................. 7
High Level Strategy.................................................................................................................................... 7
Corporate Culture ..................................................................................................................................... 9
Financials....................................................................................................................................................... 9
Cost Controls ........................................................................................................................................... 10
Value Chain Analysis ............................................................................................................................... 10
Research & Development ................................................................................................................... 10
Manufacturing .................................................................................................................................... 11
Marketing & Distribution ........................................................................................................................ 12
Design Strategy ....................................................................................................................................... 13
Products & Pricing Strategy ........................................................................................................................ 13
Learning Path .......................................................................................................................................... 14
Learning toys ........................................................................................................................................... 14
Interactive reading systems .................................................................................................................... 15
Educational gaming systems ................................................................................................................... 15
Web-based products ............................................................................................................................... 16
Core Technology Competencies ................................................................................................................. 16
Hardware................................................................................................................................................. 16
Software .................................................................................................................................................. 17
Innovation Audit ......................................................................................................................................... 17
Technological leadership ........................................................................................................................ 17
Competitor and Trend Analysis Competencies....................................................................................... 19
Structural and cultural impact on innovation ......................................................................................... 20
Issues ........................................................................................................................................................... 20
Recommendations ...................................................................................................................................... 21
Implementation .......................................................................................................................................... 22

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 Cost Reduction ........................................................................................................................................ 22
Cut the development of low margin toys ........................................................................................... 22
Decrease R&D ..................................................................................................................................... 22
Decrease inventory costs .................................................................................................................... 23
Value Creation......................................................................................................................................... 23
Expand and deepen software products .............................................................................................. 23
Transition Learning Path into a subscription-based service ............................................................... 24
EXHIBITS ...................................................................................................................................................... 25
Exhibit 1: Toy and Games Sales by Type 2009 ........................................................................................ 25
Exhibit 2: Traditional Toys and Games Global Values Sales by Sector.................................................... 25
Exhibit 3: Toys and Games Company Shares by Value 2004 – 2008....................................................... 26
Exhibit 4: Toys and Games Industry Overview........................................................................................ 26
Exhibit 5: Competitive Positioning .......................................................................................................... 27
Exhibit 6: SWOT Analysis ......................................................................................................................... 28
Exhibit 7: High Level Strategy.................................................................................................................. 29
Exhibit 8: Business Strategy .................................................................................................................... 29
Exhibit 9: LeapFrog Timeline: Repositioned for Growth ......................................................................... 30
Exhibit 10: Key Financial Data ................................................................................................................. 30
Exhibit 11: Comparison of R&D Expenditure .......................................................................................... 32
Exhibit 12: LeapFrog’s Product Mix......................................................................................................... 33
Exhibit 13: Learning Path Ecosystem ...................................................................................................... 34
Exhibit 14: Product Life Cycle .................................................................................................................. 35
Exhibit 15: Product Pricing ...................................................................................................................... 36
Exhibit 16: Children’s Expectations of Technology, 2005 vs Present...................................................... 37
Exhibit 17: Product Technology Matrix ................................................................................................... 38
Exhibit 18: New Product Launch and Milestones ................................................................................... 39
Exhibit 19: Possible Disruption................................................................................................................ 40
Exhibit 20: Technology Portfolio ............................................................................................................. 40
Exhibit 21: Comparison of Competitive Educational Toy Products ........................................................ 41
REFERENCES ............................................................................................................................................ 42

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Introduction

Founded in 1995, LeapFrog Enterprises (NYSE: LF) is a global educational games

company that develops innovative technology-based learning platforms and related proprietary

content for infants and children. LeapFrog’s product portfolio encompasses learning toys,

interactive reading systems and books, and educational gaming systems and software. At

LeapFrog’s inception, the company vision was to enter the toy industry by developing and

producing educational-based toys targeted to a niche market. In 1999, LeapFrog launched the

LeapPad, its first technology-based educational platform, targeting parents of children ages 4 to

8. Through its use of custom-designed integrated circuits (ASICs), built-in speakers, innovative

software, and proprietary intellectual property, the LeapPad sought to change the way children

learned to read. This was one of the first products that demonstrated the core value that

LeapFrog has continued to provide to its customers: to change the way learning happens

through toys and interactive content.

Industry Analysis

The toys and games industry is viewed by most analysts as being recession-proof.

Euromonitor states “the traditional toys and games market has been less affected by the

financial crisis that hit the US at the end of 2008 than the video games market.”1 2011 will likely

prove to be good for the toy and games industry as the economy improves. Toy and game sales

by product type are shown in Exhibit 1. Despite declining birth rates in several key markets, pre-

school toys and games have continued to do well over the past ten years with global unit sales

increasing by 7.7% between 2004 and 2009 alone (Exhibit 2). In 2009, North America had the

1
From Euromonitor “Toys and Games – USA” Report

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greatest share of the global toys market with $50 billion in sales. Software-based video games

and console hardware sales increased by approximately 12% in the same period.

As competition in the toys and games industry grows and the phenomenon of “age

compression” (where children begin to act older sooner) impacts the market, hardware and

content providers will have to find new ways of creating value for customers. As parents

become more familiar with newer technologies and look to interactive toys to improve their

child’s learning process, the interactive toys market is forecasted to exhibit a strong growth

trend over the next 5 to 10 years.

Competitors

LeapFrog’s primary competitors are Fisher-Price (Mattel), Playskool (Hasbro) and Vtech

Kids (Vtech Holdings Ltd). These competitors are comparatively bigger and financially strong,

but aside from Vtech Kids, have very few (or zero, in Playskool’s case) products in the high tech

educational toys market. Vtech offers close substitutes of LeapFrog’s most popular products,

but lacks web integration and suffers from a smaller content library. However, Vtech features

lower pricing on its Tag competitor equipment and books, parity pricing on games, and a higher

price on its Leapster competitor.2 From our research, it appears as though Vtech is a ‘fast

follower’ of LeapFrog in the high-tech educational toys market; the company has been present

in the educational toys market since 2001 with toys on par with LeapFrog’s Scout.3 Although

building up a respectable library of games featuring licensed franchises, it may still lack the

brand equity of LeapFrog in this space although it appears to be successful in securing shelf

2
VTech website (www.vtechkids.com)
3
“VTech's new variety of learning products”. Playthings; Feb2001, Vol. 99 Issue 2, p120

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space in toy stores. As a subsidiary of Vtech Holding Company, little information on Vtech Kids

is publically available.

From 2004 to 2008, LeapFrog lost nearly 1% in marketshare as customers shied away

from premium products like those developed by LeapFrog (Exhibit 3). To increase sales,

LeapFrog introduced the Scout line of products at lower price points in 2009, helping the

company regain some of its lost market share. According to Euromonitor’s 2010 Toys and

Games report4, LeapFrog has moved up to the 7th position relative to its competitors (0). The

market capital of LeapFrog’s main competitors is shown in Exhibit 4. LeapFrog’s competitive

positioning in the educational toys market is shown in Exhibit 5.

Firm Analysis

High Level Strategy

In the early 2000s, LeapFrog’s focus was to create a bottom-up strategy with LeapPad as

the base. Though successful at the onset, this strategy could not sustain LeapFrog’s rapid

growth, resulting in faltering revenues and decreased market share.

At the end of 2006, LeapFrog realized that a change was needed to compete effectively

in the toy industry. Upon assessing its strengths and weaknesses (Exhibit 6), top management

devised a plan to improve operations, referred to as “Fix, Reload and Grow”.5 From a strategic

perspective, LeapFrog’s management believed that the company needed to first recognize and

fix its existing structural and operational problems that had led to decreased sales. The next

phase would be to release new products to strengthen LeapFrog’s exposure and expand its

4
From Euromonitor “Toys and Games – USA” Report
5
From the Leapfrog Enterprises, Inc. Form 10-K (2007) filed 3/13/2008

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product lines. Once the core issues were resolved and new products were developed and

introduced to the market, management believed the company would be able to grow

sustainably and maintain profitability. LeapFrog created its corporate building blocks of brand

awareness, mass distribution/retail, feedback systems, and technology innovation to initiate

this improved top-down strategy. With the introduction of Learning Path, an online content

management system (CMS) that offers proprietary curriculum and technology to foster better

customer engagement, LeapFrog’s brand image improved, allowing the company to focus on

incremental innovation that would further strengthen its position in consumers’ minds. The

success of this top-down strategy is dependent on strong brand image, effective channels,

strong customer mind share and streamlined production to customer supply chain (Exhibit 7).

Business Level Strategy

Since its inception, LeapFrog has implemented a niche-differentiation business strategy

(Exhibit 8). LeapFrog’s target is to be ranked within the top 3 in all product categories; if a

product is not one of the market leaders, it is either phased out or more features are added on

to make it a hit. In light of LeapFrog’s weakening market share in the reading space, the

company is trying to regain its position by leveraging the brand’s strength in all other learning

products through the Learning Path system to make parents aware of the strengths of the

company’s reading products. This reveals LeapFrog’s integrative approach at building customer

share across segments. Exhibit 9 shows LeapFrog’s strategic evolution to position itself for

growth.

LeapFrog is also trying to increase its presence in multiple geographical markets like the

United Kingdom, Canada, France, Mexico, China, Australia, Germany, Japan, and Korea. These

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global markets offer new opportunities for LeapFrog, as electronic-based educational toys are

not yet adopted in these markets. By developing these new markets LeapFrog can cultivate a

loyal customer base from the ground up.

Corporate Culture

LeapFrog’s success depends greatly on the innovation of its learning products. Well

aware of this fact, the company encourages entrepreneurial behavior and innovative ideas by

offering commissions and monetary incentives to engineers who come up with new ideas.

Business unit and product managers are also compensated for new ideas and products coming

out of their group, giving them incentive to promote and support engineers in their respective

groups to develop new concepts and build upon them. Additionally, stock options are granted

to managers with delayed vesting timelines that incentivize them to stick around and

contribute to the company’s growth.

LeapFrog maintains a startup culture even though it is publicly traded. Management

sees the company doing its greatest work when a flexible work atmosphere is permitted.

Restrictive bureaucracy is seen as the biggest threat to the company’s growth, with red-tape

being the biggest obstacle.

Financials

Fluctuating Revenue

Revenue picked up in 2001-2002 and peaked in 2003 at $681 million when LeapPad was

launched into the market; however, revenue has since declined to $433 million for FY 2009. No

major jumps in revenue are expected in 2011. An important contributor to this is increased

competition and a generally soft toys and games market going forward. Revenue from

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international markets is also weak, with less than 20% of revenues coming from international

markets. This is part of the reason the company is looking to make an aggressive push into new

foreign markets.

Net Income

Net income has generally been negative for most of the company’s history.

Aforementioned cost reductions were the main drivers for positive net income in 2010. Modest

revenue growth in 2010 also helped to increase net income (Exhibit 10).

Cost Controls

In order to improve its financials, LeapFrog began implementing multiple cost controls

from 2007. In 2008, LeapFrog experienced inventory management problems due to sudden

decreases in demand caused by the recession. To improve cash flow and inventory

management, the company has continued to work on lowering the direct cost of product

materials and components and reducing overhead costs, which, for LeapFrog, is primarily

warehousing and logistics costs. The company has consolidated contract manufacturers and

vendor logistics in order to simplify its supply chain. Inventory levels and turns have improved

significantly as a result. LeapFrog also announced a 10% reduction in force in 2008. All of these

aggressive cost reductions have led to reduced SG&A (selling, general and administrative)

expenses.

Value Chain Analysis

Research & Development

LeapFrog designs its hardware platforms and related software-based content using in-

house R&D. Since 2007, the company has sought to decrease its R&D overhead through

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increased value realization from outside consultants. Through outsourcing, the company is able

to utilize engineering talents from all over the world with diverse backgrounds, without having

to take on the burden of hiring a large R&D group. LeapFrog also licenses technologies like Flash

from Adobe Systems and optical pattern recognition hardware and software from Anoto Group.

LeapFrog embeds its proprietary pedagogical approach and uses licensed characters from

Disney and other studios to create popular software titles. From 2007 to 2009, the company

was able to reduce R&D outlays by nearly $30 million in total, or half of the R&D budget alone

in 2007, freeing up resources for the company to focus more on improving distribution

channels (Exhibit 11). LeapFrog holds a number of patents at home and abroad; the business

does not rely on these patents in its marketing strategy, but rather on the quality and breadth

of its product portfolio.

Manufacturing

LeapFrog outsources nearly all hardware manufacturing activities to bring down costs

and capital investments. As concerns over child safety and overall quality increase (i.e. lead

content, quality of plastics), the company has taken great precautions to align itself with a

strong and capable supplier base in China that meets all international safety standards.

LeapFrog’s management has mandated that its Chinese suppliers follow stringent safety

standards, based on those adopted by Europe and America. This is not just limited to product

manufacturing, but also includes packaging design and manufacturing, encompassing the final

product in its totality as delivered to the end user.

To ensure its products maintain consistency and demonstrate an evolution in quality

and performance, LeapFrog has a team in China that regularly audits suppliers to ensure

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consistency in output. LeapFrog also takes a very strict position in vetting out suppliers, only

partnering with those that have demonstrated superior technological capabilities and

specialization strengths. Given prices of raw materials such as petro-based plastics and

electronic components composed of copper wiring are constantly fluctuating, LeapFrog works

closely with suppliers to hedge against such fluctuation by guaranteeing orders throughout the

year and locking in rates. This allows the company to safeguard itself against variable cost

vulnerability, and thus keep margins intact.

Marketing & Distribution

Marketing and distribution are addressed here together as a great deal of LeapFrog’s

marketing strategy is integrated with its distribution strategy. The effectiveness of the

company’s direct marketing campaign rests firmly on the quality of relationships it develops

with channel partners. LeapFrog has created “learning centers” within retail outlets, which are

select areas of a store that are built around LeapFrog product offerings wherein customers can

come and try out LeapFrog products. The Learning Path system has also allowed the company

to speak directly to the vast online customer base, allowing easy plug-and-play marketing of

new products and features, while providing a fluid channel for feedback to the company.

Retailers can purchase directly from LeapFrog’s manufacturing plants in China, which is

already integrated with most retailers’ existing supply chains. This allows for consolidation of

shipments, and hence, reduced freight burden. LeapFrog also keeps short-term forecasted

stock in warehouses throughout the U.S.to meet any spikes in short-term demand that retailers

may be subject to. LeapFrog has a no-return policy with retailers except for manufacturing

defects in the products. The company uses both brick-and-mortar store channels and online

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retail channels. Amazon, Kmart, BestBuy, Toy-R-Us, Walmart, Target, and Barnes&Noble are

important LeapFrog channel partners.

Design Strategy

LeapFrog’s design methodology is to make interactive learning toys that look and feel

like toys, but place the greatest possible emphasis on being valuable educational tools. As a

company in the highly competitive toy market, LeapFrog designers discovered “the 7 second

rule”: if the user does not engage with audio and video in the first seven seconds, they will

never engage.6 If the product does not make a good instant impression on children, they are

very likely to discard it for something else, which oftentimes carried no educational value. To

test out the effectiveness of designs, LeapFrog uses both children and parents in its focus

groups during the design phases of its products. LeapFrog employees experts in early childhood

development in its product design process in order achieve effective hardware and software

designs that aid in the growth and development of children.

LeapFrog designs its toys to “hook” children by closely mimicking products that they

already consider entertaining and desirable; LeapFrog products are thus intuitive for children to

use. The Tag, for example, is shaped like a giant pencil, and requires children to point at words;

Leapster products look and feel like handheld gaming systems from Nintendo.7

Products & Pricing Strategy

LeapFrog’s product segments are defined as follows: Baby Toys (0 to 12 months),

Toddler Toys (12 to 36 months), Preschool Toys (3 to 5 years), Kids’ Toys (5 to 8 years), and Toys

(8+). Since 2007, the company has sought to increase its product offerings by shifting R&D and

6
“LeapFrog’s Great Leap Forward”. By: Breen, Bill. Fast Company, Jun2003, Issue 71, p88-9
7
Ibid

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marketing resources from the age six and younger segment to grade school children. Emphasis

has transitioned to a more innovative, unified technology architecture focused on connecting

products to the web. LeapFrog has mostly followed an incremental innovation process to refine

and extend its established designs. See Exhibit 12 for LeapFrog’s product mix.

Learning Path

Learning Path is an online content management system (CMS) that guides parents

through their child’s development with activity suggestions and new LeapFrog product

referrals. LeapFrog had originally developed Learning Path within its School House business unit

to help teachers assess their students’ learning abilities. The modified consumer version

provided value to parents by allowing them to customize educational skills and track learning

progress while using web-enabled LeapFrog products. It also differentiated LeapFrog from the

competition and created direct relationships with parents, thereby allowing the company to

gain timely insight to its customers, communicate directly with them, and market the right

products at the right time. Learning Path is currently used as a technology base for all of the

major electronic products within its four existing product categories (Exhibit 13).

Learning toys

With products designed for infants and children up to age three, these toys are

strategically priced at lower price points than competitors, making them more accessible to a

wider range of consumers and creating a gateway for further adoption. Learning toys fall

within the growth stage of the product life cycle (PLC), primarily due to the recent introductions

of new product lines such as the Scout collection, which have been designed to integrate with

Learning Path (Exhibit 14). There are, however, a range of learning toys that are not connected

14
to Learning Path, such as the Fridge collection, Everyday Play Toys, and the Learn and Groove

collection. Promotion of learning toys has relied on traditional forms of advertising versus the

direct marketing strategy used with Learning Path, as this category is the main entry point to

the LeapFrog brand and requires a wide adoption rate to achieve company goals.

Interactive reading systems

Reading has always been a primary emphasis for LeapFrog’s R&D. With the launches of

Tag and Tag Junior interactive reading systems, LeapFrog phased out its LeapPad line and

introduced the next generation of reading products which integrates optical pattern reading

hardware, and leverages LeapFrog’s stable of licensed characters and educational design. The

Tag systems are both web-enabled to integrate with Learning Path, further enhancing

LeapFrog’s product portfolio. The optical pattern reading hardware and software are exclusively

licensed from Anoto Group, but competitors like VTech are able to imitate with similar

products.

Educational gaming systems

LeapFrog’s secondary emphasis has been in hardware and software that cleverly

embeds educational content within a gaming context to make learning fun. LeapFrog has

expanded this category from its popular Leapster platform to incorporate different products

designed for different age groups. With the introduction of Leapster2 in 2008, and the third-

generation Leaspter Explorer in 2010, LeapFrog continues to produce sustaining, incremental

innovations that improve its existing platforms while aligning its educational gaming systems

with its overall business strategies. LeapFrog takes the razor-and-blade selling model with this

line - LeapFrog sells the core hardware console for a low $50 price and proceeds to sell

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inexpensively manufactured game cartridges for $20 each. See Exhibit 15 for pricing for

different LeapFrog products.

Web-based products

LeapWorld, launched in 2010, is an online learning center that allows children to link

their offline play on their web-enabled LeapFrog products, such as Leapster Explorer handheld

gaming systems, with online play. LeapFrog’s web-based products currently take advantage of

only one of LeapFrog’s four lines of distribution – direct to consumers, either directly to

children within the interface itself or to parents through the Learning Path system. As LeapFrog

continues to build out this category, senior management should be aware of how these

products fit into the organization’s existing strategies and exploit core competencies where

applicable.

Core Technology Competencies

Hardware

LeapFrog is a component integrator. In the Leapster and Leapster 2, the company

combined a 4MB ATI (graphics chip), a custom integrated circuit with an ARC Tangent CPU

running at 96MHz that supports Adobe Flash, and a 160px by 160px CSTN with touch screen.8

The Leapster Explorer, with 3D graphics, may have slightly higher specs in terms of the GPU

and CPU. For the Tag family of products, LeapFrog uses Anoto optical reader technology.This

product audibly reads letters directly from the page, plays sounds, and initiates games when

the appropriate software for the book is pre-loaded onto the Tag.9 Tag systems also include

8
“LeapFrog Leapster 2 Learning Game System”. LeapFrog Learning Games forum.
www.leapfroglearningfungame.com. Retrieved February 2011.
9
“Tag”. www.LeapFrog.com. Retrieved January 2011.

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32MB of onboard storage for digitally downloaded book content and for progress files.

LeapFrog is highly dependent upon very few suppliers for these materials in its hardware and its

ability to substitute these suppliers is questionable. The core electronic hardware is mainly

dependent on licensed technologies.

Software

LeapFrog has developed a proprietary software platform running Flash content for its

Leapster-series.10 Leapster and Leapster2 games can be played on Leapster Explorer. However,

games could feasibly be run on any PC or smart phone supporting Flash. Given that Leapster

games are programmed in an open source language, LeapFrog’s core competencies in software

are not in the actual language or engine, but in the quality of actual content being produced. In

this regard, they are similar to game development studios. Exhibit 17 shows the Product

Technology Matrix for LeapFrog Enterprises.

Innovation Audit

Technological leadership

LeapFrog is seen as a technological leader in the markets it serves. It has been

successful in introducing several innovative products and has received numerous industry

design awards.11 LeapFrog has done a good job leveraging its web based Learning Path and

learning model across its portfolio. With innovative products like the Tag reading system,

Learning Path, LeapWorld, and Leapster, LeapFrog has introduced technologies that have

created a paradigm shift in how educational toys are used in the household.

10
“Adobe Success Story”. www.adobe.com. Retrieved February 2011.
11
“LeapFrog Reports Knowledge Universe Distributes 73% of Its LeapFrog Holdings”. LeapFrog Investor Relations:
Press Release. 5/1/2003. www.leapfrog.com

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 However, Leapfrog is threatened by children's growing expectations of technology. Per

Exhibit 16, Leapfrog's products in 2005 were mostly able to meet children's expectations until

they approached the age of 10, at which point they became familiar with using computers and

the internet. In 2011, we predict that this technological expectations curve will shift to the left

and become steeper. 80% of children under the age of 5 are on the internet at least weekly.12

As a result of earlier experience with the web, and exposure to smart phones and tablets, we

believe that Leapfrog will face even stiffer expectations from children older than 4 years of age.

These expectations may reduce product adoption, and make Leapfrog products look less

attractive and fun to kids.

Scope and rate of innovation

LeapFrog has been successful in launching a new innovative product almost every year,

with mostly incremental product innovations in recent years (Exhibit 18). This continuous

innovation for more than a decade has made it a leader in the electronics educational toys

segment. Aside from product innovation, LeapFrog adopted the Inshore Delivery Center model,

an innovative strategic sourcing model that focuses on continuous improvement in

procurement. Product innovation and innovation in its value chain has created a competitive

advantage for LeapFrog.

Resources available for innovative activity

LeapFrog has been investing considerably in R&D as a percentage of net sales compared

to its competitors, even though it has been decreasing this investment since 2007 due to cost

12
“Always Connected: The new digitial media habits of young children”. Aviva Lucas Gutnick et al. March 2011.
www.joanganzcooneycenter.org

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reduction initiatives and greater outsourcing efficiency. Exhibit 11 compares the R&D

investments of Hasbro and Mattel as compared to LeapFrog.

Competitor and Trend Analysis Competencies

Recognizing the competition from other handheld gaming consoles like the Nintendo

DS, LeapFrog launched Leapster, a handheld educational device in 2003 which became an

instant success. Compared to its competitors, LeapFrog has more innovative products in the

educational toys segment today (Exhibit 19).

Competitors were able to replicate functionalities similar to those of LeapFrog in their

own products. In response, LeapFrog management used the Learning Path strategy to provide

immediate brand differentiation on store shelves. With the customization of curriculum and its

proprietary pedagogical approach, LeapFrog has created greater value for its customers than its

competitors have.

Capacity to adapt

Mobile platforms like iOS and Android are becoming more popular, with a robust

gaming gaining in massive popularity on these mobile operating systems. LeapFrog responded

to this trend with the launch of its third generation Leapster handheld gaming console, the

Leapster Explorer. With the convergence of multiple platforms such as TV, mobile and web,

LeapFrog has been successful in creating an integrated learning platform that leverages its

proprietary curriculum along with the web connected Learning Path and its innovative

products. However, LeapFrog must still address the convergence of content consumption

devices and the overall push toward developing applications agnostic to LeapFrog devices.

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Structural and cultural impact on innovation

All design and critical development of product is done in the U.S. This centralization

aides in the learning of newer technologies and creates important component links in products

that are quicker and more efficient. This centralization of R&D also enables LeapFrog to bring

people with different disciplines and expertise in child development, learning systems, software

engineering, and hardware engineering together to work under one roof to develop superior

educational products. This increases the cohesiveness and efficiency with which product

development groups form and work together.

Issues

Until now, Leapfrog has developed its games and content within a closed ecosystem.

However, this closed system might not be enough to maintain sales with the changing

competitive landscape and the proliferation of a variety of methods to consume digital content.

With the tablet and Smartphone industry growing aggressively, and the accompanying app

markets continuing to expand with forays into educational games and content, LeapFrog is

beginning to be threatened in the area it once dominated. Earlier in the decade, LeapFrog met

the user expectations for fun to use, easy to use educational toys for the kids but with the

developments in multi touch, accelerometer, ARM processor and other mobile technologies,

the mobile devices (including tablets) which were once not considered for a child’s educational

needs, now have become a viable substitute. Exhibit 19 shows how mobile devices could be

disruptive to LeapFrog devices. Developing new mobile devices, instead of developing

educational applications for the dominant mobile eco-systems, would be highly capital

intensive.

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 In response to this threat, Leapfrog should reposition itself as a software company that

is platform agnostic. To do this, the company would need to reduce its emphasis on hardware,

and maximize deployment of its unique and successful learning model through software.

LeapFrog will need to jump a major hurdle in this transformation – studios from which LeapFrog

licenses characters are developing their own apps for mobile devices, and are in turn refusing

to allow other developers from using their brands in these app markets. Due to the decreasing

technological importance of its hardware competencies, LeapFrog should “cash in” on software

and its online Learning Path service (Exhibit 20).

Recommendations

We recommend that LeapFrog concentrate on decreasing its costs and increasing its

cash position and profits in order to make itself an attractive acquisition target within two

years. We propose that LeapFrog be open to acquisition by a larger company in the toy industry

where LeapFrog’s core competencies and products would provide a unique and non-redundant

strategic fit. Leapfrog’s new CEO, John Barbour, has previous experience in the turnaround of

Toy R Us and its sale to private equity firm KKR, and has also held senior-level positions at

Hasbro and Russ Berrie (makers of Russ stuffed animals).13 Barbour’s experiences in the

industry would help LeapFrog to successfully position for an acquisition.

Of all the big-name potential buyers, Hasbro seems to have the least redundancy in the

educational toy market. Hasbro’s subsidiary Playskool has been a competitor to LeapFrog, but

has been more focused on lower-end play toys rather than educational products. Exhibit 21

compares the product portfolio of Leapfrog against its main competitors. We believe that

13
“LeapFrog names ex-Toys R Us exec Barbour as CEO”. Bloomberg Businessweek. February 28, 2011.
www.businessweek.com

21
LeapFrog can fit into Hasbro’s corporate structure as an independent business unit, thereby

preserving LeapFrog’s entrepreneurial culture and managerial processes.

Implementation

To make itself an attractive acquisition target, LeapFrog should focus on cost reduction

and value creation.

Cost Reduction

Cut the development of low margin toys

LeapFrog should cease the development of its low-margin learning toys introduced in

2009. Low-margin, low-technology products like Scout and the Fridge collections do not fit well

with Leapfrog’s product portfolio and offer little differentiation when compared to similar

products offered by its competitors. By concentrating on its core products and streamlining its

product lines, LeapFrog should be able to build its cash position and improve profits.

Furthermore, LeapFrog could feasibly continue to extract profit from these toys without any

further development, as they do not require new software or content.

Decrease R&D

LeapFrog’s current R&D expenses are approximately 8% of sales, while Hasbro and

Mattel’s R&D expenses are 4% and 3%, respectively (Exhibit 11). LeapFrog should decrease its

R&D to be in line with its competitors. This would save the company about $17 million per year.

LeapFrog can achieve this by keeping R&D focused only in its core competencies and high

margin products, such as by developing game software and new Tag books.

22
Decrease inventory costs

LeapFrog had inventory control problems during the recession, which led to the

company becoming unprofitable. LeapFrog has indicated that its inventory levels are high,

which might affect sales growth in the first half of 2011.14 LeapFrog should invest in better

inventory control systems and consider delivering orders directly to its customers from the

manufacturing facility to decrease inventory costs.

Value Creation

Expand and deepen software products

LeapFrog should continue to invest in book content for its Tag interactive reader and

downloadable game content (AKA “Leaplets”) for its Leapster Explorer. LeapFrog has a

demonstrated track record of understanding the delicate marriage between fun and education;

learning games and content are what differentiate and set LeapFrog apart. As such, LeapFrog

should continue to invest in these areas of its business with new offerings, and if possible,

expand its stable of licenses.

To keep children engaged with the learning content, LeapFrog should also more fully

leverage the web connectedness of its devices. Currently, the Leapster appears to unlock new

content in the freely provided LeapWorld, but, as of yet, it does not appear that the Tag can

unlock new content on the Leapster. We propose that LeapFrog implement cross-platform

software improvements that incentivize children to continue learning by offering new

opportunities with each completed activity. These improvements would also create explicit

demand for LeapFrog products from the children themselves. For instance: a new “WALL-E”

14
Leapfrog 2010 10K Report filed 2/22/2011

23
mini-game on Leapster can only be unlocked and played if the “WALL-E” Tag book is logged as

complete in the Learning Path system. Leapfrog currently gives children codes to unlock

additional content on LeapWorld. However, this is a missed opportunity to drive greater

software and content sales.

Transition Learning Path into a subscription-based service

As previously noted, Learning Path not only tracks a child’s development, but also

provides parents with coaching and activity ideas. LeapFrog is not recognizing the deeper value

in this tool. Rather than simply augmenting its products, Learning Path can become a stand-

alone application, a Software-as-a-Service.

LeapFrog should charge an annual subscription fee (such as $19.99 per year) to parents

who want to provide new opportunities for their children to learn, but who are also hesitant to

purchase a Leapfrog product. This subscription could provide all the perks of Learning Path,

and may even be able to mimic some of the tracking functionality (such as through manual

entry of a child’s progress on worksheets and checklists provided by Leapfrog, in online games

in LeapWorld). Parents who may otherwise ignore Leapfrog products would benefit by

receiving guidance from a company that has demonstrated a track record of helping children

have fun while learning. LeapFrog would benefit from subscription fees and additional

opportunities to market and sell parents on the benefits of the Leapfrog products and libraries.

Because some of the content that would be leveraged for a subscription already exists within

Learning Path and the rest can be developed and delivered digitally through the Learning Path

CMS, this model would provide a low-cost method to generate additional revenue, and

potentially transform prospects into buyers.

24
 EXHIBITS

Exhibit 1: Toy and Games Sales by Type 2009

Source: Euromonitor “Toys and Games – USA” Report

Exhibit 2: Traditional Toys and Games Global Values Sales by Sector

From Euromonitor “Toys and Games – USA” Report

25
 Exhibit 3: Toys and Games Company Shares by Value 2004 – 2008

Table 4 Toys and Games Company Shares by Value 2004-2008 % retail value rsp
2004 2005 2006 2007 2008
Nintendo of America Inc 3.8 3.8 4.7 11.5 12.1
Mattel Inc 13.2 13.1 12.9 10.9 9.5
Microsoft Corp 2.4 3 7.2 7.5 8.8
Sony Corp of America 7.6 8.5 9.1 9.6 6.9
Hasbro Inc 8.7 7.7 7.5 7.1 6.5
Electronic Arts Inc 5 5.1 3.8 3.8 4.6
Activision Inc 1.5 1.6 1.6 2.8 2.7
MGA Entertainment Inc 1.5 1.5 1.5 1.5 1.9
JAKKS Pacific Inc 1.7 1.8 2 1.9 1.7
LEGO Group 1.2 1.3 1.5 1.4 1.4
Bandai America Inc 1.8 1.8 1.8 1.6 1.3
Take-Two Interactive Software Inc 1.2 0.4 1.1 1.2 1.3
LeapFrog Enterprises Inc 2.1 2.1 1.7 1.2 1.1
THQ Inc 1.5 1.6 1.2 1.3 1
RC2 Corp 1.7 1.7 1.6 1.3 1
Vtech Holdings Ltd 0.5 0.8 1 1 1
Ubisoft Entertainment SA 0.3 0.9 0.9 1.1 0.8
Vivendi Universal SA 0.9 0.6 0.7 0.8 0.7
Konami Corp 0.7 0.5 0.5 0.5 0.4
LucasArts 0.6 1 0.5 0.3 0.3
Private Label 6.2 6.1 6.1 5.5 4.9
Others 35.9 35.1 31.2 26.3 30
Total 100 100 100 100 100

Exhibit 4: Toys and Games Industry Overview

Description Market Cap P/E ROE % Debt to Equity Price to Book Net Profit Margin (mrq)
Consumer Goods 73440.94B 24.565 18.944 78.391 0.448 8.296
Toys & Games 15.96B 34.8 10.7 65.162 5.87 4.7
Mattel Inc. 8.44B 12.626 26.148 42.541 2.958 15.453
Hasbro Inc. 6.08B 15.56 28.455 101.403 4.09 11.815
JAKKS Pacific, Inc. 465.88M 13.389 9.379 21.698 1.116 11.575
RC2 Corp. 427.08M 15.585 10.93 15.003 1.548 9.624
LeapFrog Enterprises Inc. 259.52M 28.511 5.376 NA 1.46 11.445
Kid Brands, Inc. 196.08M 8.004 27.411 69.36 1.869 5.567
Gaming Partners International 52.18M 10.192 12.689 0.119 1.239 6.146
Mad Catz Interactive Inc. 46.28M 7.304 68.575 364.983 3.907 3.015
GameTech International Inc. 4.63M NA -121.231 282.336 0.467 -52.734

Source: Yahoo Finance ((http://biz.yahoo.com/p/315mktd.html) retrieved 1/23/2011

26
 Exhibit 5: Competitive Positioning

Entertainment

PlaySkool

Innovative Price Fischer Established

Leap frog
Vtech

Educational

27
 Exhibit 6: SWOT Analysis

STRENGTHS
- In-house concept designs
- Learning Path tracks child’s progress – creating a
direct relationship with parents
- Inshore strategic sourcing – agile development
- Brand recognition
- Software utilizes popular licensed content (e.g.
Disney, Star Wars)
- Core technology: Optical pattern reading HW & SW
- Connected, engaging learning platform
- Proprietary curriculum developed
by education experts
WEAKNESSES
- Perception of high retail prices
- Heavy reliance on 3 main customers (Walmart, Toys
R Us, Target) (Source: LeapFrog 10K)
- Concentration of suppliers in China (Source:
LeapFrog 10K)
- Weak business model
- Fewer number of proprietary characters – mostly
licensed

LeapFrog
SWOT Analysis

OPPORTUNITIES
- International expansion
- Lower tier of market- more affordable products
- Increasing investment in mobile applications
- Cloud based games and applications
- Expansion of Learning Path as subscription service
to non-buyers
THREATS
- Threat of imitation
- Recession= low sales
- Seasonality of business
- Increasing direct and indirect competition (e.g.
lower price points) – other gaming systems available
- High threat of rivalry – main competitors have
enough technology, marketing and financial resources
- Patent Infringements
- Age Compression - changing preferences

28
 Exhibit 7: High Level Strategy

Source: LeapFrog Investor Presentation March 24, 2010

Exhibit 8: Business Strategy

Cost Leadership Differentiation

Mass Hasbro

Mattel

Niche LeapFrog
Vtech

29
 Exhibit 9: LeapFrog Timeline: Repositioned for Growth

Founded LeapFrog Rebuild Product Cost Leapster

by Mike went IPO Portfolio structure Explorer
Woods realigned launched
Refocus on Reading

Invest in connected
strategy

1994 1999 2002 2004 2006 2010 2013

LeapPad Leapster Tag Named LeapWorld

– Toy of handheld Toy of the online
the year Introduced year gaming

Exhibit 10: Key Financial Data

LeapFrog Income Statement

2003 2004 2005 2006 2007 2008 2009 2010 2011 (Projected)
Rev: US Segment $518,526 $387,624 $338,856 $363,400 $306,500 $344,296 $344,296
Rev: International $131,231 $114,631 $103,415 $95,700 $73,700 $88,268 $88,268
Rev: Total $680,012 $640,289 $649,757 $502,255 $442,271 $459,100 $380,200 $432,564 $432,564
Gross Margin 50% 40% 43% 29% 39% 40% 41% 41% 40%
Gross Profit $340,144 $259,045 $279,600 $147,000 $173,300 $181,500 $158,007 $178,974
Operating Expenses $230,686 $273,028 $258,600 $272,600 $275,600 $241,700 $166,420 $171,169
Net Income $72,675 ($6,528) $17,500 ($145,092) ($101,315) ($68,256) ($2,688) $4,945 $4,900

LeapFrog Balance Sheet

2003 2004 2005 2006 2007 2008 2009 2010 2011 (Projected)
Current Assets N/A $494,871 $531,075 $387,429 $317,259 $239,967 $246,614 $234,579 N/A
Total Assets N/A $558,794 $605,829 $450,441 $380,143 $306,073 $305,995 $293,480 N/A
Current Liab N/A $118,261 $120,335 $97,445 $114,242 $99,923 $98,326 $72,982 N/A
Total Liab N/A $124,294 $139,506 $116,479 $136,670 $126,147 $113,302 $87,915 N/A
Total Stockholders Equity N/A $434,500 $466,323 $333,962 $243,473 $179,926 $192,693 $205,565 N/A

30
 Net Income
$100,000

$50,000

$0

($50,000)

($100,000)

($150,000)

($200,000)

Net Income 2 per. Mov. Avg. (Net Income)

Revenue Plot
$800,000
$700,000
$600,000
$500,000
$400,000
$300,000
$200,000
$100,000 Revenue Plot
$0

31
 Exhibit 11: Comparison of R&D Expenditure
In millions of US Dollars
LeapFrog 2010 2009 2008 2007
Sales 380 459 442
R&D 35 48.5 59.4
% 9% 11% 13%

Hasbro(Playskool) 2010 2009 2008 2007

Sales 4002 4068 4022 3838
R&D 201 181 191 167
% 5% 4% 5% 4%

Mattel(Fisher-Price) 2010 2009 2008 2007

Sales 5856 5431 5918 5970
R&D 176 187 190 189
% 3% 3% 3% 3%

32
 Exhibit 12: LeapFrog’s Product Mix
Product Online Tools Learning Toys Reading Systems Educational Web-Based
type Gaming Systems Products
Toys Learning Path Scout, Zippity, Tag, Tag Junior Leapster, LeapWorld
Learn & Groove, Leapster 2, Didj,
Clickstart, My Crammer,
Own Leaptop Leapster
Explorer
Description Online tool Products Pen-based Learning skills Online learning
allowing parents developed to reading system embedded in center for
the ability to help increase games, often children.
monitor & track motor skills, featuring
child’s learning sound & color licensed content.
progress based recognition.
on LF’s web-
connected
products.
Details: Proprietary Customer entry Utilizes optical Have expanded Functionality:
curriculum & point to pattern reading from Classic online games,
technology LeapFrog brand. HW & SW Leapster to access new
combined w/ Products (technological Leapster2 & Didj content, view
web capabilities. “designed to ‘age competence). (web- demos,
Major up’ with our Connects to connected), customize offline
component of child end users.” Learning Path CrammerStudy gaming.
LF’s product Scout, Zippity, online. (study device
strategy. and My Own targeted to older
Leaptop kids), and
products connect Leapster
to Learning Path Explorer (web-
online. connected).
Age range Ages infant – 9 Ages infant – 5 Tag: Ages 4 – 8 Leapster2: Ages Ages 4 – 9
Tag Jr: Ages 2 – 4 4–8
Leapster
Explorer: Ages 4
–9
Didj: Ages 6 – 10
Crammer: Ages 8
– 12
Price N/A $ - $$$$ $$ $$$ - $$$$ N/A
Source: LeapFrog Annual Report 2009

33
Exhibit 13: Learning Path Ecosystem

34
 Exhibit 14: Product Life Cycle

Interactive Reading
Systems

Gaming Systems
Sales

Learning Toys

LeapWorld

Introduction Growth Maturity Decline

Time

35
 Exhibit 15: Product Pricing

Toy Collections Pricing

Learning Toys

Disney Zippity $79.99

ClickStart $59.99

My Own Leaptop $24.99

Scout Collection $13.99 - $24.99

Fridge Collection $15.99 - $24.99

Everyday Play Toys $21.99 - $24.99

Learn and Groove $14.99 - $39.99

Reading Systems

Tag Interactive Reading System $49.99

Tag Junior Interactive Reading System $34.99

Tag Software $10.99 - $19.99

Educational Gaming Systems

Leapster2 $49.99

Leapster2 Software $24.99

Didj $89.99

Didj Softwares $29.99

CrammerStudy $59.99

Leapster Explorer $69.99

Leapster Explorer Software $24..99

36
 Exhibit 16: Children’s Expectations of Technology, 2005 vs Present

14

12
Technolkogy Complexity

10 2005 Expectations of
Technology
8
2011 Expectation of
6 Technology

4 LF Product

0
0-2 2-4 4 -6 6-9 10+
Age Range

37
 Exhibit 17: Product Technology Matrix

Main Product\ Pattern Phonics Software/ Proprietary Hardware/ Learning Path/ Web Connect
Technology Recognition Game Curriculum Asic Chip Learning Tracking
Titles system
Leapster2 x x x x

Leapster Explorer x x x x x

Leappad x X x x

Tag Reading system x X x x x x x

Tag Junior X x x x x

Text and Learn x x x

Scribble and Write x x

Chat and Count x x

Aplhabet Explorer x x x

Leaptop x x x x

Didj x x x x

Fusion Pentop x x x

Clickstart x x x

38
 Exhibit 18: New Product Launch and Milestones

Year New Product Launches Awards and milestones

1995 Phonics Desk Learning System

1998 Little Leap Explorer Globe and Twist&Shout

1999 Leapad Learning system Phonics Learning system wins Design of Decade
award from Business Week

LeapPad Learning system wins People’s Choice

Toy of the year award

2000 SchoolHouse

2002 LeapPad books and LeapPad system - #1 and #2

selling toys in US

2003 LittleTouch LeapPad, LeapPad Plus Writing

and Leapster learning system

2004 LeapFrog Baby Leapster Learning system wins Best Educational

Toy award

2005 FLY Pentop Computer and Leapster L-Max

Learning Game system

2006 Leapster TV learning system and Learn and FLY Pentop Computer gets top Toy of the Year
Groove collection award

2007 3 new platforms – FLY fusion Pentop – Clickstart earns Outstanding Products Award,
Computer, Clickstart My first computer and MOM-Tested Toys of the Year Award
WordLaunch Learn to Read System

2008 Leapster2,Crammer,Tag reading system

2009 Tag Junior,My Pal Scout,My Pal Violet and Tag Reading System wins Educational Toy of the
AlphaPet Explorer, Text&Learn and Year award
Scribble&Write

2010 Leapster Explorer, LeapWorld

39
 Exhibit 19: Possible Disruption

Performance
Performance – “Ease of Use and Fun to use for kids”

Mobile
User Expectations

Leapfrog Products

Launch of iPhone

1999 2007 DevicesT

Exhibit 20: Technology Portfolio

High
Technology Importance

Educational Software
Mobile (iOS, Android)
titles, Propreitary Content

BET DRAW

Low Tech Toys (Scout,

Hardware (Leapster, Tag)
Fridge)

CASH IN(Sell/Cut R&D) FOLD

Low

High Low

Relative Technology Position

40
 Exhibit 21: Comparison of Competitive Educational Toy Products

LeapFrog Vtech Fisher –Price Playskool

(Mattel) (Hasbro)

Leapster2 Mobigo iXL

Leapster Explorer

Tag Reading system Bugsby

Tag Junior Vreader
Vsmile motion active
learning system

Text and Learn Touch&Learn Laugh&Learn Explore&Grow

Scribble and Write Sort&Learn Alphie

Chat and Count Slide&Learn

Aphabet Explorer Play&Learn

Nitro Web Notebook

Leaptop Baby's Learning laptop
Didj Kidizoom Smart Race

Clickstart Computer Cool School

MyPal Scout Count with Me Hippo Mr. Potatohead

My Pal Violet Winnie Pooh Collection

Learn and Groove

41
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42