LeapFrog: A Strategic ReviewMGMT102: Strategy

Professor Mats Lingsblad

T2 AY2012-13

Kelly CHEW Jiawen Hazwan Aziz Bin MOHD SIDIKWONG CiAudrey YAP Kian TingAriella YEO Yun Jia

G4

1. Executive Summary

2. Company Overview

2.1 Company Background

2.2 Company Performance

2.3 Share Price Analysis

2.4 Revenue Breakdown

2.4.1 Products

2.4.2 Retailers

2.4.3 Hardware vs. Software

2.5 LeapFrog’s Value Chain

3. Industry Analysis: Global Learning Aids and Toys (Learning Aids)

3.1 Industry Definition

3.2 Porter’s 5 Forces

3.3 Key Industry Trends

4. Corporate Strategy Analysis

5. Business Unit Analysis: Multimedia Learning Platforms (MMLPs)

5.1 BU Strategy

5.2 Issues with Current and Future Business Strategies

5.2.1 Loss of value proposition

5.2.2 Entry into highly saturated apps markets

5.2.3 Brand erosion and higher fees

5.2.4 Concentration of sales

6. Conclusion

7. Appendix

1

1. Executive Summary

Even though LeapFrog has demonstrated strong performance with a yearly

compounded average growth rate of 15% in net sales since 2009, there are

many signs pointing towards its inability to remain competitive in the future.

Key Considerations:

1) Loss of Value Proposition

The company’s flagship product, the LeapPad, will be unable to keep up with the

proliferation of tablets from established brands such as Apple, Google & Samsung

which provide similar offerings.

2) Entry into Highly Saturated Apps Markets

LeapFrog will be unable to compete in highly saturated content markets such as

iTunes and Google Play which already have thousands of learning apps available.

By entering these markets, LeapFrog will effectively be cannibalizing its own

hardware sales as well.

3) Brand Erosion

By shifting to becoming a content curator rather than creator, LeapFrog may tarnish

its brand reputation. By offering 3rd-party apps on its App Cenre, which carry the

labels of their content-owners, LeapFrog could be perceived to be accepting these

apps as of similar quality to its “educator-approved” content. This greatly erodes

LeapFrog’s brand value and poses a threat to the value proposition of its premium

content, which is the company’s core competency.

2

SELL

2. Company Overview

2.1 Company Background

LeapFrog Enterprises, Inc. (“LeapFrog”, NYSE: LF) is a leading designer, developer

and marketer of innovative, technology-based educational products. Founded in

1995 and incorporated in 1997, the company is based in Emeryville, California and is

currently headed by John Barbour who has served as Chief Executive Officer since

March 2011. LeapFrog focuses on developing products that will provide the most

engaging, effective learning experience for children aged 0-9, in school or home,

around the world. Their philosophy is to put learning first, which distinguishes them

from their competitors and fuels the entire company. With products available in more

than 45 countries, the company has branded itself as a leader in educational

entertainment. A timeline of their achievements can be found in Appendix A.

2.2 Company Performance

In 2012, net sales were US$581.3 million, up 28% compared to 2011. This increase

was largely due to the continuous strong demand for their flagship product, the

LeapPad (Appendix B), which has been available since 2011. In August 2012, the

launch of the LeapPad 2 (Appendix B), an improved version from the previous

model, further drove sales as well.

Income from operations was US$64.1 million, up 170% from 2011, and grew 5.8

percentage points as a percentage of net sales to 11.0%. This strong performance

can be attributed mainly to increased net sales, increased gross margins and more

efficient use of higher operating expenses.

3

2.3 Share Price Analysis

Compared to other toy companies such as Mattel and Hasbro, LeapFrog’s share

price has performed relatively well, with a compounded average growth rate of 25%

over the last four years.

However, despite this increase, unlike Mattel and Hasbro, LeapFrog share price has

been largely volatile. This reflects the nature of their business which is highly

dependent on their ability to adapt to ever-changing consumer preferences and

product trends, especially within the multimedia industry. With the LeapPad driving

sales and being the flagship product of the LeapPad brand, LeapFrog’s share price

has been extremely sensitive to product launches such as the iPad Mini and Google

Nexus 7 which have similar offerings. For example, with the launch of the iPad Mini

in November 2012, LeapFrog share price dropped 25% from $9.57 to $7.22

(Appendix C). Furthermore, despite reporting good earnings for Q4 2012 in Feb

2013, up 16% from the same period a year ago, share price has remained largely

stagnant since its announcement. (Appendix C). Both these signs point towards

decreasing investor confidence in their ability to remain competitive.

4

Strong Financial Performance

2.4 Revenue Breakdown

2.4.1 Products

The U.S. segment represented US$424.8m (73%) of LeapFrog’s consolidated net

sales in 2012 of US$581.3m. Multimedia Learning Platforms (MMLP) accounted for

83% of net sales, whilst 16% came from learning toys, and the remaining 1% from all

others.

The international segment represented US$156.5 million (27%) of LeapFrog’s

consolidated net sales in 2012. MMLPs accounted for 52% of net sales, whilst 47%

came from learning toys, and the remaining 1% from others.

As can be seen in the figure below, Leapfrog relies primarily on Multimedia Learning

Platforms to drive sales (83% US, 52% International).

2.4.2 Retailers

5

MMLP; 83%

Learning Toys; 16%

Others; 1%

U.S.

MMLP; 52%

Learning Toys; 47%

Others; 1%

International

2012 2011 2010

Wal-Mart 23% 23% 21%

Toys “R” Us 18% 18% 20%

Target 13% 14% 17%

Total 54% 55% 58%

Leapfrog is highly dependent on few retailers such as Wal-Mart, Toys “R” Us and

Target which contributed to 54% of total gross sales in 2012. Overall, they rely

heavily on large retail customers to sell their products to individual consumers.

2.4.3 Hardware vs. Software

Leapfrog does not provide a breakdown of their hardware vs. software revenue.

However, based on our calculations, with total net sales for Q4 2012 being $240m,

and analysts estimating that the Q4 2012 LeapPad 2 sales was $150m1, this shows

that hardware sales contributed to at least 60% of total sales. As such, compared to

software, LeapFrog generates significantly more revenue from hardware.

2.5 LeapFrog’s Value Chain

LeapFrog primarily focuses on R&D which includes designing and developing both

hardware and content. Manufacturing is outsourced to factories to China where costs

are much cheaper. Distribution is managed by their retail partners such as Walmart,

Toys ‘R’ Us and Target who have a large customer base. They have a small retail

presence through their online store which allows consumers to purchase both

hardware and software.

3. Industry Analysis : Global Learning Aids and Toys (Learning Aids)

3.1 Industry Definition

LeapFrog competes on an international basis in the learning aids and toys (learning

aids) category within the toy industry. While more than 50% of LeapFrog’s sales are

derived from within the United States, a substantial and increasing portion of its

1 Sramana Mitra, Feb 2012: LeapFrog’s Toy Tablet Scores Succesful Turnaroundhttp://www.sramanamitra.com/2012/02/22/leapfrogs-toy-tablet-scores-successful-turnaround/

6

sales (27%) is being generated through foreign markets such as the United

Kingdom, Canada and France.

The learning aids category comprises products which facilitate learning and skill

development, by engaging the user with an element of entertainment.

The industry comprises of firms primarily involved in development of learning aids,

although more established players such as Mattel have engaged in some degree of

downstream vertical integration, entering into manufacturing and distribution. An

increasing number of firms have also engaged in direct-to-consumer distribution and

sales (mostly through company-owned online sales portals), bypassing retailers and

distributors.

3.2 Porter’s 5 Forces

An analysis of the learning aids market using Porter’s 5 forces reveals that the

industry is highly unattractive.

Supplier Power: Weak

The threat from suppliers to the industry is low. Suppliers include manufacturers,

research and development (R&D) personnel, as well as advertisers.

7

Relative to the number of firms involved in the design of learning aids, there are a

large number of manufacturers available globally. This is especially so when the

materials and machinery required for the production of such toys are commoditized,

and hence easily accessible. This skews the balance of power in favour of the

learning aid product developers.

While the ability of the firm to create products with high learning content is crucial to

the survival of the firm, there are no specific skill prerequisites for the human

resource involved in the research and development of learning aids. The threat from

R&D personnel is thus low.

Firms in the industry rely heavily on marketing to bring across the non-price

differences of their products; the role of advertisers as a supplier to the industry is

thus crucial. It is likely that there are at least as many, if not more advertising firms

than the number of learning aid firms. The threat coming from advertisers is thus low.

Buyer Power: Strong

Buyers to the industry consist of distributors and mass retailers, such as Wal-Mart,

Target and Toys “R” Us in the United States, and Hamleys in the United Kingdom.

These distributors and mass retailers often have access to, or have the resources to

develop, an extensive network of distribution channels that firms in the industry do

not have within specific geographic regions. The bargaining power in the relationship

thus tends to be skewed towards the distributors and mass retailers. Compounding

on this is the fact that long-term contracts with retailers are uncommon, given the

relatively short product life cycle of less than two years.

Strong buyer power could be mitigated in some cases by the demand of end

consumers, assuming that the products prove popular with consumers, or when

learning aid firms have a proven track record of producing toys that are consistently

well-received by end consumers.

Threat of New Entrants: Moderate

The industry has no significant barriers to entry – the industry is not capital intensive,

and it is easy for new entrants to gain access to suppliers to the industry.

8

Additionally, because content and pedagogy associated with learning aids are often

hard to copyright, it is also easy for new firms to enter the market offering substitutes

following the introduction of a wildly successful product. However, it is still difficult for

new entrants to convince credible distributors and retailers to carry their products

due to the lack of track record and cost constraints. The threat of new entrants is

thus moderate.

It is important to note, however, that the threat of new entrants is increasing with the

greater ease of conducting direct-to-consumer marketing and sales through the

Internet, allowing firms to bypass retailers and distributors.

Degree of Rivalry: Strong

The industry is highly fragmented with a large number of firms competing for market

share. It is not uncommon for firms in the industry to have multiple brands and

characters spanning different toy categories under their umbrella. Competition is on

the basis of the learning content, performance, features, quality, brand recognition

and price of individual products, rather than the umbrella brand. Leading players in

the industry include Mattel, Inc., with its Fisher-Price brand, Hasbro, Inc. with its

Playskool division, LeapFrog and VTech Holdings Ltd.

Rivalry is intense with the high substitutability of different products within the industry

– customer loyalty is low, and switching costs are almost negligible. This is

evidenced through the heavy marketing expenditures and a constant effort to

procure intellectual property protection where possible by firms in the industry.

The table below shows the highly fragmented nature of the global toy industry, with

the top 5 players contributing 31.9% of total market value by sales in 2011. While

data on the learning aids category is unavailable, we believe that the structure of the

learning aids category can be proxied by the global toy industry.

9

Market Share by Sales, Global Toy Industry

Companies 2008 2009 2010 2011

Nintendo Co Ltd 15.5 14.6 11.7 8.8

Sony Corp 7.2 6.7 7.1 6.7

Mattel, Inc. 6.5 6.2 6.5 6.5

Microsoft Corp 4.4 4.4 5.3 5.6

Hasbro, Inc. 4.4 4.4 4.3 4.3

Source: GMID

Threat of Substitutes: Strong

A wide range of products and services exist as substitutes to learning toys. These

products do not possess the educational quality of learning aids, but yet are still able

to occupy and entertain the child. They include generic toys, mobile devices (both

gaming and non-gaming) and television programmes, just to name a few.

In particular, the rise of mobile devices such as mobile phones and tablets, along

with their educational mobile applications, has proven to be an increasing threat to

the learning aids industry. The threat of substitutes is thus strong.

Conclusion

We believe that the extremely strong power of substitutes, strong rivalry amongst

existing firms and low barriers to entry will prove to be compelling factors that create

a challenging operating environment for both incumbent firms.

3.3 Key Industry Trends

Going forward, we believe that two key trends are set to influence the growth

trajectory of the industry. The first comes from the dip in sales of products priced at a

premium arising as a result of the economic recession, and the second stems from

the increasingly prevalent use of mobile devices, such as tablets and smartphones,

as learning aids.

The recent economic recession has seen the demand for toys, and thus learning

aids, grow more price sensitive. The learning aid industry derives much of its value

and growth through mature economies such as the United States and Europe, where

10

the emphasis on education and childhood development is larger, and is backed by

purchasing power. However, the economic recession has hit these mature

economies especially hard, and the general reduction in disposable income that has

come with it has led parents to view toys and learning aids as increasingly

dispensable to their child’s development.

The effects of the recession on the learning aids market have started becoming

evident, and can be estimated by using the declining growth of the overall toy

industry over the past 5 years as a proxy.

Global Toy Industry

Note: market value is by sales

We believe that recovery in this industry will lag general economic recovery and that

the effect of the economic crisis on the industry will continue at least for the medium

term. Given that the learning aids industry is more heavily dependent on the hard-hit

mature economies than the global toy industry, the impact of the recession on the

industry’s growth, both present and future, can be reasonably expected to be

amplified.

As previously mentioned, smartphones and tablets have established themselves as

potentially strong substitutes for learning toys. This can be attributed to two factors:

the rise of the digital age and age compression.

11

The rise of the digital age has seen children being born into technology. As parents

are heavy consumers of technology through mobile platforms such as smartphones

and tablets themselves, these platforms are increasingly being used to double up as

edutainment devices for their children, especially with the increasing variety of

education applications available on these mobile platforms. We believe that the

convenience and low cost at which these applications can be downloaded will

continue to propagate this trend.

Age compression describes a phenomenon of children “growing old younger” – toys

which were once meant for a particular age group are being played with by younger

and younger children. In the same vein, younger and younger children now see the

technology that was once only accessible to those on the cusp of their teens as a

source of entertainment.

Learning aid developers and toymakers have recognized these threats and sought to

adapt. Toymakers are now incorporating both existing childhood brands and new

brands into smartphone and tablet applications, some with physical toys as a

necessary component to play. For example, Mattel launched Apptivity in May 2012,

a line that uses a patented Active Touch technology in which its physical toys are

recognized and can interface directly on the iPad.

However, we question the sustainability of such a move, as firms deviate from their

core competency of toy development and seek to challenge the tablet and electronic

industry. While not impossible, we believe that this will be an uphill task for toy

manufacturers as they reallocate their resources and rebuild core competencies.

4. Corporate Strategy Analysis

4.1 Use learning toys as entry point to the LeapFrog brand

LeapFrog’s corporate strategy is to use learning toys as an entry point to the

LeapFrog brand, facilitating graduation to its MMLPs. Such a strategy is logical. By

getting parents familiar with the LeapFrog brand at the beginning of their child’s

12

development, given the unique educational value and methodology that their

learning toys provide, there will be a higher likelihood that parents will trust the brand

and transition to using its MMLPs.

4.2 Use of Learning Path to maintain relationship with parents

The Learning Path (Appendix D) is an online platform which allows parents to track

their child’s development as they play with LeapFrog products. This superior after-

sales service allows LeapFrog to maintain a connection with parents and

consistently remind them of the value that their products provide. This platform also

allows LeapFrog to recommend new products to parents based on their child’s

performance and this furthers the likelihood that parents will remain long time

customers with the brand.

5. Business Unit Analysis: Multimedia Learning Platforms (MMLPs)

5.1 BU Strategy

Who US: 73% of gross 2012 sales. International: 27%

1. Distributors

a. US: resale to schools, school districts

b. International: resale to retailers

2. Retailers

a. Wal-Mart, Toys “R” Us and Target are top 3

customers, forming 55% of gross 2012 sales

b. Physical stores, online stores

c. US: top 3 retailers made up 48% of gross

2012 sales

d. International: Walmart, Toys “R” Us made up

7.3%

3. Direct consumers

a. Children below 10, parents

b. LeapFrog.com, App Center, iTunes Store

What 1. Hardware

Kid-tough design and materials for rough-

13

and-tumble play

a. LeapPad 2: US$100. Touchscreen tablet with

cameras, 4GB storage

b. Leapster: US$55. Handheld game system

c. Tag: US$40. Stylus-based reading system

2. Content

Educator-approved pedagogy and materials

covering subjects such as English, Math, and

reading skills

a. Game cartridges: US$25. For LeapPad,

Leapster

b. Ultra eBooks: US$20. For LeapPad

c. Apps: US$5-25, about 500 types featuring

LeapFrog-owned or licensed characters

d. Books: US$20. For Tag

How 1. Advertising and marketing

a. Direct consumers: integrated approach using

traditional and social media. Learning Path

recommendations personalized to parents

b. Retailers: well-established relationships. In-

store ads, signs, and features on promotional

newsletters

c. Public relations: brand and product-specific

media coverage, annual Toy Awards

2. Online services

Learning Path and Apps Center (AC) are key

differentiators that make LeapFrog unique

a. Learning Path: for parents to check kids’

progress, receive product advice. Available in

US, UK, Canada

b. AC: purchase of software. Available in US,

Canada and other countries with less

stringent web content control

14

c. Online store: purchase of hardware, with

home delivery

3. iOS and iTunes Store

a. Free or US$1.

b. 8 basic apps currently, developed through 3rd-

parties

4. Research & Development

2012: US$36.6m expenditure (6% of sales)

a. Design: in-house team and external

consultants. R&D critical in strengthening

product portfolio. Platforms created using

licensed technology e.g. Java

b. Content development: mostly in-house, but

started 3rd-party liaisons in late 2011

c. Remaining development: outsourced

5. Content curator

a. Offer 3rd-party developed apps on AC,

alongside LeapFrog-generated content

b. 3rd-party apps labelled under developer

6. International expansion

a. Make AC and Learning Path accessible to

users in more countries

b. Create content in different languages

5.2 Issues with Current and Future BU Strategies

5.2.1 Loss of value proposition

LeapFrog’s hardware is specially designed to withstand rough-play by kids, and also

has simple kid-friendly functions and buttons. These used to be strong selling-points,

as parents did not have to worry about children spoiling these MMLPs easily,

especially given their high cost. However, the explosion of offerings in accessories

for the iPad and other tablets has seen the emergence of kid-friendly casings that

make these tablets equally kid-tough. Hence, parents may see the purchase of a

fully-functional tablet as a better investment for their kids, since these protective

15

cases can be removed when the child is older, and the tablet put to other uses.

Furthermore, parents have the option to kid-proof and hand-down their old tablets

when they upgrade and purchase a new tablets for themselves.

Toymakers have also started offering more MMLPs, with Toys “R” Us and Mattel’s

Furby each creating their own line of kid-friendly tablets. Being kid-tough is thus

inadequate as a differentiating factor as these offerings have similar characteristics.

Decreased demand for LeapFrog toys from end-consumers, and potential

protectionism by retailers with in-house brands, will see a fall in orders from retailers,

which make up a substantial proportion of sales. This is especially easy since

retailers do not have long-term contracts with LeapFrog.

The value proposition of LeapFrog’s content perceived by consumers is in its

“educator-approved” label. However, the ambiguity and lack of an official standard or

regulatory body for such a label makes its true value less credible, and would also be

difficult to bring across geographical boundaries when it comes to international brand

establishment. Such a value proposition may also not be unique to LeapFrog, as

competitors can easily create similar labels for themselves. Nonetheless, the

extensive use of LeapFrog products in US schools lends some credibility to the

quality of its content, hence repeat purchases are more likely. The main difficulty

LeapFrog faces is convincing new international customers to purchase its products.

LeapFrog currently plans to release a new LeapPad in 2013, and this may be a

misallocation of R&D resources. With falling demand for higher-priced toys, stiff

competition from fully-functional tablets, and loss of hardware value proposition,

sales of the new LeapPad are expected to be dismal. It may be wiser for LeapFrog

to direct more resources into its international marketing efforts, or in online services

development.

5.2.2 Entry into highly saturated apps markets

LeapFrog has realised the inevitable need to enter the iTunes and Android apps

markets due to the widespread popularity of these platforms. Since its foray into iOS

apps in 2011, it has created 8 simple apps with the help of 3rd-party developers, 1 of

which is free and the rest at US$1. LeapFrog has noted that these distribution

16

platforms are heavily populated by thousands of other apps that are mostly free.

While it can be argued that LeapFrog content is “educator-approved”, the

international market may not recognise any marginal utility over other free apps.

Apart from moving into a highly price-competitive segment, this also conflicts with

LeapFrog’s current apps on its AC, which cost US$25. These apps would

undoubtedly contain more premium content that are tailored to heightened

experiences on its hardware, but the large difference in prices may cause potential

consumers to purchase its cheaper non-AC apps instead. This is especially if they

already own tablets or other smart devices, since they would not have to purchase

additional LeapFrog hardware. Existing LeapFrog hardware users may also hold off

future purchases on the AC, in anticipation of cheaper versions for smart devices

that their families most likely already own2.

LeapFrog’s foray into creating apps for other platforms hence creates strategic

conflicts between its premium AC content and lower-priced alternative apps, which

may lead to cannibalisation of both hardware and software sales. The near-zero

contribution margins from these apps would also see a large proportion of profit

being eroded. LeapFrog may also face difficulties convincing overseas audiences to

purchase its general apps since there is little brand recognition, hence decreasing

the possibility of using these apps as teasers to encourage full-fledged hardware and

AC software purchases.

5.2.3 Brand erosion and higher fees

LeapFrog’s greatest shift in focus comes from its intention of becoming a content

curator, rather than creator. In offering 3rd-party apps on its AC, which carry the

labels of their content-owners, LeapFrog could be perceived to be accepting these

apps as of similar quality to its “educator-approved” content. This greatly erodes

LeapFrog’s brand value and poses a threat to the value proposition of its premium

content, which is the company’s core competency.

2 Deloitte, Jan 2013: 65% of 35-44 year-olds in developed countries own smartphones or tablets http://www.marketingcharts.com/wp/topics/demographics/tablet-adoption-less-age-dependent-than-smartphone-ownership-in-developed-markets-25824/

17

Furthermore, LeapFrog has to compete for the attention of content developers with

iTunes and Android, which have far greater market shares and outreach in the apps

realm. Developers may hence require greater incentives to create content

specifically for use on LeapFrog hardware, since sales would be far lower in quantity.

This may translate into higher royalty or purchase fees, causing lower profit margins

for LeapFrog’s MMLP content.

5.2.4 Concentration of sales

Bulk of LeapFrog’s sales lie in the hands of 3 retailers, 2 of which are both national

and international. In 2012, Wal-mart, Toys “R” Us and Target accounted for 66% of

the US segment’s gross sales, and the former two for 27% of the international

segment as well. By having just 3 customers accounting for such a substantial

proportion of the company’s gross sales, LeapFrog exposes itself to significant buyer

risk. This risk is further compounded by the fact that no long-term agreements exist

between LeapFrog and its retailers, who make all purchases through one-time

purchase orders. Economic factors that adversely affect retailers, such as increased

competition from online retailers, reduced access to credit given the tighter bank

lending environment, and store closures, would inevitably affect LeapFrog’s sales

too. For example, the bankruptcy of one of its customers in 2012 caused bad debt

expense of US$3.1 million.

Moreover, without long-term agreements, pricing, shelf space, cooperative

advertising or special promotions with each retailer are exposed to renegotiation and

amendments periodically. Any alterations to the disadvantage of LeapFrog would

adversely affect its operating results.

6. Conclusion

LeapFrog is operating in an extremely risky environment. Their ability to survive in

the long run is largely dependent on their ability to keep consumers convinced of the

value of their hardware and unique educator approved content. However, given the

erosion of their hardware value proposition and the fact that they are moving away

from their core competency which is content creation, our groups feels that they will

18

not be able to remain competitive In the long run. Taking these factors into account,

we recommend a sell call.

19

7. Appendices

Appendix A

Appendix B

The LeapPad is a tablet specially designed for kids. Similar to any tablet, it allows users to download apps, play music and read e-books. More importantly, unlike other tablets, it is designed for rough play and can withstand drops and hard knocks. It is packed with educator approved content and there are several kid safe features which prevent kids from viewing age sensitive content as well.

20

Appendix C

Appendix D

The Learning Path is designed to show parents how their kids are learning from LeapPad products. It gives them a visual overview of their child’s progress and recommends additional products to aid their child’s learning.

21

Announcement ofQ4 earnings, increaseof 16% compared to a Q4 2011