LeapFrog: A Strategic Review

MGMT102: Strategy
Professor Mats Lingsblad
T2 AY2012-13 Kelly CHEW Jiawen Hazwan Aziz Bin MOHD SIDIK WONG Ci Audrey YAP Kian Ting Ariella 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 LeapFrogs Value Chain 3. Industry Analysis: Global Learning Aids and Toys (Learning Aids) 3.1 Industry Definition 3.2 Porters 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. 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:

SELL

1) Loss of Value Proposition The companys 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 LeapFrogs brand value and poses a threat to the value proposition of its premium content, which is the companys core competency.

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.

2.3 Share Price Analysis

Strong Financial Performance

Compared to other toy companies such as Mattel and Hasbro, LeapFrogs 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, LeapFrogs 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.

2.4 Revenue Breakdown

2.4.1 Products The U.S. segment represented US$424.8m (73%) of LeapFrogs 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 LeapFrogs 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).

Learning Toys, 16%

U.S.

Others, 1%

Others, 1%

International

MMLP, 83%

Learning Toys, 47%

MMLP, 52%

2.4.2 Retailers 2012 Wal-Mart Toys R Us Target Total 23% 18% 13% 54% 2011 23% 18% 14% 55% 2010 21% 20% 17% 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 LeapFrogs 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 LeapFrogs sales are derived from within the United States, a substantial and increasing portion of its

Sramana Mitra, Feb 2012: LeapFrogs Toy Tablet Scores Succesful Turnaround http://www.sramanamitra.com/2012/02/22/leapfrogs-toy-tablet-scores-successful-turnaround/
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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 Porters 5 Forces An analysis of the learning aids market using Porters 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.

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. Additionally, 8

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.

Market Share by Sales, Global Toy Industry Companies Nintendo Co Ltd Sony Corp Mattel, Inc. Microsoft Corp Hasbro, Inc. Source: GMID 2008 15.5 7.2 6.5 4.4 4.4 2009 14.6 6.7 6.2 4.4 4.4 2010 11.7 7.1 6.5 5.3 4.3 2011 8.8 6.7 6.5 5.6 4.3

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 childs 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 industrys 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.

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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 LeapFrogs 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 childs 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 childs 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 childs 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

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Kid-tough design and materials for roughand-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. Instore 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 14

stringent web content control 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 LeapFrogs 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 15

fully-functional tablet as a better investment for their kids, since these protective 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 Mattels 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 LeapFrogs 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 3 rd-party developers, 1 of 16

which is free and the rest at US$1. LeapFrog has noted that these distribution 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 LeapFrogs 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. LeapFrogs 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 LeapFrogs 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 LeapFrogs brand value and poses a threat to the value proposition of its premium content, which is the companys core competency.

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-thansmartphone-ownership-in-developed-markets-25824/
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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 LeapFrogs MMLP content.

5.2.4 Concentration of sales Bulk of LeapFrogs 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 segments 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 companys 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 LeapFrogs 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.

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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.

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Appendix C Announcement of Q4 earnings, increase of 16% compared to a Q4 2011

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 childs progress and recommends additional products to aid their childs learning. 21