LeapFrog Enterprises, Inc. Gets Schooled

A bad holiday season for toymakers got worse yesterday afternoon when LeapFrog Enterprises (NYSE: LF  ) reported disappointing quarterly results. The company behind the LeapPad learning tablet, LeapReader books, and Leapster handheld edutainment system stumbled badly during the holidays, sending the shares to their lowest level in two years.

LeapFrog may be trying to sugarcoat its results by pointing to 2013 as being its second most profitable year or pointing to international sales growth for the year, but neither accolade applies to the dreadful holiday quarter, where it merely broke even on an adjusted basis with sales plunging 24%.

Investors knew that this would be a rough quarter. LeapFrog warned in November that holiday quarter sales would fall by 9% to 17%. Clearly the market deteriorated after that. International sales that had been positive through the first nine months of the year declined in the fourth quarter, and U.S. sales -- still accounting for all but a third of LeapFrog's business -- plummeted 30%.

"As you have already had a number of holiday performance announcements and company earnings statements, [you know] 2013 was a challenging year to be in the kid business," CEO John Barbour began during last night's earnings call. 

Yes, industry leader Mattel (NASDAQ: MAT  ) set a negative tone when it reported uninspiring financials two weeks ago, weighed down by a 13% drop in Barbie sales. However, Mattel makes traditional toys. The reason that Babie dolls and Hot Wheels cars aren't selling the way they used to is because kids are moving on to new diversions. It's not traditional video games that kids are flocking to, since that industry has been declining for a few years now. The real culprits here are the mobile devices and the digital ecosystems that nickel-and-dime kids and parents out of the disposable income that used to be spent on toys.

Under that scenario, LeapFrog should be thriving. It has an iconic franchise that has earned the trust of parents, and its LeapPad tablet line feeds into its growing catalog of proprietary content and applications. Unfortunately for LeapFrog, parents and their children are favoring more traditional entry-level tablets that may not have the same parental controls and educational pedigree but ultimately do so much more.

LeapFrog isn't just in the wrong place at the wrong time. It didn't do itself any favors with buggy firmware issues on the high-end LeapPad Ultra, delaying the launch of its new app store, and taking too long to finally crack below the $99 price point on its LeapPad line. 

It won't bounce back right away, either. LeapFrog sees sales continuing to slide through the first half of this year before resuming its growth trajectory in the second half of the year. Then again, it's hard to take LeapFrog's guidance seriously as it looks out more than 10 months out through the end of this year when it was too conservative last November with just seven weeks left. 

LeapFrog had a lot to prove this week, and it came up short. Now it has a lot of questions to answer and doubts to eradicate.

It's a learning process, and a painful one at that.

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