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Can LeapFrog Jump Back to the Black?

On Aug. 18, toy company LeapFrog (LF) celebrated its 10th anniversary with a company barbeque and five display booths. There employees could check out existing products and new prototypes while looking back at the company's history.

A short history, perhaps, but storied nonetheless. LeapFrog began as an innovative audio-alphabetic learning system that lawyer Michael Wood invented for his young son. But soon it was as if everyone wanted in on the act. No less than CEO Larry Ellison of software maker Oracle (ORCL) and philanthropist Michael Milken became shareholders. When LeapFrog went public in 2002, it became that year's most successful IPO.

In the fast-paced world of high-tech toys, however, that's all ancient history now. LeapFrog ended 2004 in the red, as revenues fell 6%, to $639 million, and so far this year it hasn't been able to recover. Its share price has fallen 60% since its all-time high of $46 in January, 2004, and now trades at around $12.60. Founder Wood has resigned, and a whole new management team led by CEO Thomas Kalinske is trying to turn the Emeryville (Calif.) company's fortunes around.

FIRST MOVER? Can LeapFrog leap back into the black? Long regarded as an industry innovator, it faces huge challenges in getting to consistent profitability. Mattel (MAT) has pushed hard into the $3.3 billion educational market for younger kids with products like the Fisher-Price PowerTouch, an interactive reading toy. Hong Kong-based VTech, whose V Smile gadget allows kids to play educational video games on their TV, is splashing into LeapFrog's pond as well.

"You are seeing a lot more new products that are as good or even more innovative than LeapFrog's," says Edward Woo, an analyst with Wedbush Morgan Securities.

What LeapFrog still has, Woo hastens to add, is a strong brand and first-mover advantage. And it's banking on two new products to propel it back to the top of this year's Christmas wish lists.

POSITIVE REVIEWS. First is Leapster L-Max, a next-generation handheld that debuted in July and plugs directly into the TV. LeapFrog says it's selling well but declines to give specifics. Kids can write letters on L-Max's little screen, then watch their scribbles appear on the TV and morph into stars in an animated story. It's designed to teach spelling, math, music, and art to an age group ranging from pre-schoolers to fourth-graders. "The early [sales] reads are very strong," says LeapFrog President Jerry Perez.

But all eyes are on LeapFrog's second new product, due out in mid-October and called the Fly pentop computer (see "Fly Should Soar with Kids"). Expected to sell for $99 in stores like Wal-Mart (WMT) and Target (TGT), the Fly will allow kids to keep a schedule, jot down notes, and play games on with it. It can "see" what children write through a special camera and responds to written commands.

The early response from toy reviewers has been quite positive: Influential toy-review newsletter Oppenheim Toy Portfolio just gave the Fly pentop an outstanding toy award. "Fly pen in particular caught imagination of our tween testers," says the outfit's co-founder Stephanie Oppenheim. "It's a home run." If Oppenheim places Fly on its popular top-40 best toys list this year -- a possibility, since Oppenheim often places its former award winners on the list -- that could fuel holiday sales.

GOING TO COLLEGE? Yet many financial analysts still harbor doubts. "If kids have $100, they'll spend it on an iPod [music player] or a video game," says Anthony Gikas, an analyst with Piper Jaffray. In fact, most analysts who follow the industry don't believe Fly will have a sizable impact on sales, adding that LeapFrog would have done better to focus on its core market of little kids instead of the notoriously difficult-to-please teen.

Who's right remains to be seen, but whatever the answer it will have a tremendous effect on LeapFrog's upcoming product lineup. Fly is pegged as the core technology for LeapFrog to use to expand into older demographics of high-school and even college-level learners in future years. "Fly has the potential to unlock the textbook," says Robert Calfee, dean of University of California, Riverside's Graduate School of Education and chairman of LeapFrog's advisory board of experts who come up with ideas for upcoming products.

Using a next-generation Fly, a student might interact with the textbook and solve problems as the pen provides vocal encouragement, such as an loud yee-hoo when a problem is solved correctly. Later, Fly might also get wireless capabilities, allowing classmates to interact in class, Calfee says.

NO MORE LAYOFFS? LeapFrog is also hoping that Fly will right its retail distribution troubles as well. Store chain Toys 'R' Us (TOY) has accounted for more than 20% of LeapFrog's orders over the years, yet the mega-retailer will be closing as many as 20% of its U.S. stores next year. LeapFrog execs portrays this development as an opportunity to branch out with other outlets. "A product like Fly, catering to an older audience, affords us an opportunity to go to electronics retailers," says Perez, who says LeapFrog is in talks with some unnamed retailers that don't normally carry children's toys.

Whether Fly soars or drops could well determine whether LeapFrog will need to deepen its restructuring efforts. It's trying to cut more than $30 million in annual expenses. Last February, it eliminated 180 jobs but it hasn't announced any more layoffs. "We are on track relative to our [internal] targets," says Perez. LeapFrog would not provide any timelines or targets.

It's also working to improve distribution. Perez boasts that LeapFrog has delivered 90% of customer orders on time this year, compared with 64% last year.

BLOCKBUSTER OR DUD. LeapFrog has plenty of baggage yet to sort through. It's in a legal battle with Mattel over a patent-infringement issue. And it's facing a number of shareholder lawsuits, alleging that it made misleading statements over its business results and guidance. LeapFrog declined to comment on its legal proceedings, and this year it has stopped giving guidance.

Perhaps most important, LeapFrog must remain an industry innovator. The toy industry is notoriously volatile, and a single blockbuster or dud has quickly brightened or shattered the prospects of plenty of toymakers in the past.

Just one winner could put LeapFrog on top again. "Even at 10 years, we have a lot of history worth repeating," says Perez. With the Fly pentop computer, LeapFrog will soon discover which part of its past that will be.

By Olga Kharif in Portland, Ore.

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