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 3

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, preschool 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

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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 3

VTech website (www.vtechkids.com) “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 5

From Euromonitor “Toys and Games – USA” Report 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 inhouse 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
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“LeapFrog’s Great Leap Forward”. By: Breen, Bill. Fast Company, Jun2003, Issue 71, p88-9 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
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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 thirdgeneration 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
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“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 11

“Adobe Success Story”. www.adobe.com. Retrieved February 2011. “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

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

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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.

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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”

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Leapfrog 2010 10K Report filed 2/22/2011

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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 standalone 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.

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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

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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 Nintendo of America Inc 3.8 3.8 4.7 11.5 Mattel Inc 13.2 13.1 12.9 10.9 Microsoft Corp 2.4 3 7.2 7.5 Sony Corp of America 7.6 8.5 9.1 9.6 Hasbro Inc 8.7 7.7 7.5 7.1 Electronic Arts Inc 5 5.1 3.8 3.8 Activision Inc 1.5 1.6 1.6 2.8 MGA Entertainment Inc 1.5 1.5 1.5 1.5 JAKKS Pacific Inc 1.7 1.8 2 1.9 LEGO Group 1.2 1.3 1.5 1.4 Bandai America Inc 1.8 1.8 1.8 1.6 Take-Two Interactive Software Inc 1.2 0.4 1.1 1.2 LeapFrog Enterprises Inc 2.1 2.1 1.7 1.2 THQ Inc 1.5 1.6 1.2 1.3 RC2 Corp 1.7 1.7 1.6 1.3 Vtech Holdings Ltd 0.5 0.8 1 1 Ubisoft Entertainment SA 0.3 0.9 0.9 1.1 Vivendi Universal SA 0.9 0.6 0.7 0.8 Konami Corp 0.7 0.5 0.5 0.5 LucasArts 0.6 1 0.5 0.3 Private Label 6.2 6.1 6.1 5.5 Others 35.9 35.1 31.2 26.3 Total 100 100 100 100

2008 12.1 9.5 8.8 6.9 6.5 4.6 2.7 1.9 1.7 1.4 1.3 1.3 1.1 1 1 1 0.8 0.7 0.4 0.3 4.9 30 100

Exhibit 4: Toys and Games Industry Overview
Description Consumer Goods Toys & Games Mattel Inc. Hasbro Inc. JAKKS Pacific, Inc. RC2 Corp. LeapFrog Enterprises Inc. Kid Brands, Inc. Gaming Partners International Mad Catz Interactive Inc. GameTech International Inc. Market Cap P/E ROE % Debt to Equity Price to Book Net Profit Margin (mrq) 73440.94B 24.565 18.944 78.391 0.448 8.296 15.96B 34.8 10.7 65.162 5.87 4.7 8.44B 12.626 26.148 42.541 2.958 15.453 6.08B 15.56 28.455 101.403 4.09 11.815 465.88M 13.389 9.379 21.698 1.116 11.575 427.08M 15.585 10.93 15.003 1.548 9.624 259.52M 28.511 5.376 NA 1.46 11.445 196.08M 8.004 27.411 69.36 1.869 5.567 52.18M 10.192 12.689 0.119 1.239 6.146 46.28M 7.304 68.575 364.983 3.907 3.015 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

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Exhibit 5: Competitive Positioning

Entertainment

PlaySkool
Innovative

Price Fischer Leap frog Vtech

Established

Educational

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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 - 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

THREATS

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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

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Exhibit 9: LeapFrog Timeline: Repositioned for Growth

Founded by Mike Woods

LeapFrog went IPO

Rebuild Product Portfolio Refocus on Reading Invest in connected strategy

Cost structure realigned

Leapster Explorer launched

1994

1999
LeapPad – Toy of the year

2002

2004

2006

2010

2013

Leapster handheld Introduced

Tag Named Toy of the year

LeapWorld online gaming

Exhibit 10: Key Financial Data
LeapFrog Income Statement
2003
Rev: US Segment Rev: International Rev: Total Gross Margin Gross Profit Operating Expenses Net Income

2004

2005
$518,526 $131,231 $649,757 43% $279,600 $258,600 $17,500

2006
$387,624 $114,631 $502,255 29% $147,000 $272,600 ($145,092)

2007
$338,856 $103,415 $442,271 39% $173,300 $275,600 ($101,315)

2008
$363,400 $95,700 $459,100 40% $181,500 $241,700 ($68,256)

2009
$306,500 $73,700 $380,200 41% $158,007 $166,420 ($2,688)

2010
$344,296 $88,268 $432,564 41% $178,974 $171,169 $4,945

2011 (Projected)
$344,296 $88,268 $432,564 40%

$680,012 50% $340,144 $230,686 $72,675

$640,289 40% $259,045 $273,028 ($6,528)

$4,900

LeapFrog Balance Sheet
2003
Current Assets Total Assets Current Liab Total Liab Total Stockholders Equity N/A N/A N/A N/A N/A

2004
$494,871 $558,794 $118,261 $124,294 $434,500

2005
$531,075 $605,829 $120,335 $139,506 $466,323

2006
$387,429 $450,441 $97,445 $116,479 $333,962

2007
$317,259 $380,143 $114,242 $136,670 $243,473

2008
$239,967 $306,073 $99,923 $126,147 $179,926

2009
$246,614 $305,995 $98,326 $113,302 $192,693

2010
$234,579 $293,480 $72,982 $87,915 $205,565

2011 (Projected)
N/A N/A N/A N/A N/A

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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 $0

Revenue Plot

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Exhibit 11: Comparison of R&D Expenditure
In millions of US Dollars LeapFrog Sales R&D % Hasbro(Playskool) Sales R&D % 2010 2009 380 35 9% 2009 4068 181 4% 2008 459 48.5 11% 2008 4022 191 5% 2007 442 59.4 13% 2007 3838 167 4%

2010 4002 201 5%

Mattel(Fisher-Price) Sales R&D %

2010 5856 176 3%

2009 5431 187 3%

2008 5918 190 3%

2007 5970 189 3%

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Exhibit 12: LeapFrog’s Product Mix
Product type Toys Online Tools Learning Path Learning Toys Scout, Zippity, Learn & Groove, Clickstart, My Own Leaptop Products developed to help increase motor skills, sound & color recognition. Reading Systems Tag, Tag Junior Educational Gaming Systems Leapster, Leapster 2, Didj, Crammer, Leapster Explorer Learning skills embedded in games, often featuring licensed content. Web-Based Products LeapWorld

Description

Details:

Online tool allowing parents the ability to monitor & track child’s learning progress based on LF’s webconnected products. Proprietary curriculum & technology combined w/ web capabilities. Major component of LF’s product strategy.

Pen-based reading system

Online learning center for children.

Age range

Ages infant – 9

Customer entry point to LeapFrog brand. Products “designed to ‘age up’ with our child end users.” Scout, Zippity, and My Own Leaptop products connect to Learning Path online. Ages infant – 5

Utilizes optical pattern reading HW & SW (technological competence). Connects to Learning Path online.

Tag: Ages 4 – 8 Tag Jr: Ages 2 – 4

Price

N/A

$ - $$$$

$$

Have expanded from Classic Leapster to Leapster2 & Didj (webconnected), CrammerStudy (study device targeted to older kids), and Leapster Explorer (webconnected). Leapster2: Ages 4–8 Leapster Explorer: Ages 4 –9 Didj: Ages 6 – 10 Crammer: Ages 8 – 12 $$$ - $$$$

Functionality: online games, access new content, view demos, customize offline gaming.

Ages 4 – 9

N/A

Source: LeapFrog Annual Report 2009

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Exhibit 13: Learning Path Ecosystem

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Exhibit 14: Product Life Cycle
Interactive Reading Systems Gaming Systems

Sales

Learning Toys

LeapWorld

Introduction

Growth

Maturity Time

Decline

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Exhibit 15: Product Pricing

Toy Collections
Learning Toys
Disney Zippity ClickStart My Own Leaptop Scout Collection Fridge Collection Everyday Play Toys Learn and Groove

Pricing

$79.99 $59.99 $24.99 $13.99 - $24.99 $15.99 - $24.99 $21.99 - $24.99 $14.99 - $39.99

Reading Systems
Tag Interactive Reading System Tag Junior Interactive Reading System Tag Software $49.99 $34.99 $10.99 - $19.99

Educational Gaming Systems
Leapster2 Leapster2 Software Didj Didj Softwares CrammerStudy Leapster Explorer Leapster Explorer Software $49.99 $24.99 $89.99 $29.99 $59.99 $69.99 $24..99

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Exhibit 16: Children’s Expectations of Technology, 2005 vs Present
14 12 Technolkogy Complexity 10 8 6 4 2 0 0-2 2-4 4 -6 Age Range 6-9 10+ 2011 Expectation of Technology LF Product 2005 Expectations of Technology

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Exhibit 17: Product Technology Matrix
Main Product\ Technology Leapster2 Leapster Explorer Leappad Tag Reading system Tag Junior Text and Learn Scribble and Write Chat and Count Aplhabet Explorer Leaptop Didj Fusion Pentop Clickstart x x x x x x x x x X X X x Pattern Recognition Phonics Software/ Game Titles x x x x x Proprietary Curriculum x x x x x x x x x x x x x x x x x x x x x x x x x x Hardware/ Asic Chip x x Learning Path/ Learning Tracking system x x Web Connect

x

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Exhibit 18: New Product Launch and Milestones
Year 1995 1998 1999 New Product Launches Phonics Desk Learning System Little Leap Explorer Globe and Twist&Shout 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 2002 SchoolHouse LeapPad books and LeapPad system - #1 and #2 selling toys in US LittleTouch LeapPad, LeapPad Plus Writing and Leapster learning system LeapFrog Baby Leapster Learning system wins Best Educational Toy award Awards and milestones

2003

2004

2005

FLY Pentop Computer and Leapster L-Max Learning Game system Leapster TV learning system and Learn and Groove collection FLY Pentop Computer gets top Toy of the Year award

2006

2007

3 new platforms – FLY fusion Pentop Computer, Clickstart My first computer and WordLaunch Learn to Read System Leapster2,Crammer,Tag reading system Tag Junior,My Pal Scout,My Pal Violet and AlphaPet Explorer, Text&Learn and Scribble&Write Leapster Explorer, LeapWorld

– Clickstart earns Outstanding Products Award, MOM-Tested Toys of the Year Award

2008 2009

Tag Reading System wins Educational Toy of the Year award

2010

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

BET

Hardware (Leapster, Tag)

Low Tech Toys (Scout, Fridge)

CASH IN(Sell/Cut R&D) Low High

FOLD

Low Relative Technology Position

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Exhibit 21: Comparison of Competitive Educational Toy Products
LeapFrog Vtech Fisher –Price (Mattel) iXL Playskool (Hasbro)

Leapster2 Leapster Explorer Tag Reading system Tag Junior

Mobigo Bugsby Vreader Vsmile motion active learning system Touch&Learn Sort&Learn Slide&Learn Play&Learn Nitro Web Notebook Baby's Learning laptop Kidizoom

Text and Learn Scribble and Write Chat and Count Aphabet Explorer Leaptop Didj Clickstart MyPal Scout My Pal Violet Learn and Groove

Laugh&Learn

Explore&Grow Alphie

Smart Race Computer Cool School

Count with Me Hippo Winnie Pooh Collection

Mr. Potatohead

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REFERENCES
“Toys and Games 2010: Trends, Developments and Prospects”. Euromonitor International. December 2009 “Toys and Games: USA”. Euromonitor International. 2009 “VTech's new variety of learning products”. Playthings; Feb2001, Vol. 99 Issue 2, p120 Leapfrog Enterprises, Inc. Form 10-K (2007) filed 3/13/2008 “LeapFrog’s Great Leap Forward”. By: Breen, Bill. Fast Company, Jun2003, Issue 71 “LeapFrog Leapster 2 Learning Game System”. LeapFrog Learning Games forum. Retrieved February 2010. http://www.leapfroglearningfungame.com/LeapFrog-Leapster-2-Learning-Game-System.html “Tag”. www.LeapFrog.com. Retrieved January 2010. http://www.leapfrog.com/tag/#/learn_about_tag/see_how_tag_works/ “Adobe Success Story”. www.adobe.com. Retrieved February 2011. http://www.adobe.com/cfusion/showcase/index.cfm?event=casestudydetail&casestudyid=21019&loc= en_us “LeapFrog Reports Knowledge Universe Distributes 73% of Its LeapFrog Holdings”. LeapFrog Investor Relations: Press Release. 5/1/2003. http://www.leapfroginvestor.com/phoenix.zhtml?c=131670&p=irolnewsArticle&ID=408038&highlight= “LeapFrog names ex-Toys R Us exec Barbour as CEO”. Bloomberg Businessweek. February 28, 2011. http://www.businessweek.com/ap/financialnews/D9LLT41O0.htm “Always Connected: The new digitial media habits of young children”. Aviva Lucas Gutnick et al. March 2011. http://joanganzcooneycenter.org/Reports-28.html Mattel 2010 Form 10-K (www.mattel.com) Hasbro 2010 Form 10-K (www.hasbro.com) VTech 2010 Form 10-K (www.vtech.com)

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