- The Washington Times - Friday, April 23, 2004

SAN FRANCISCO — In six months, educational toy maker LeapFrog Enterprises Inc. has gone from an industry leader to a Wall Street loser.

A startling first-quarter sales decline has investors and analysts worrying that management has lost its handle on the company.

“They have lost a lot of credibility,” said Natalie Walrond of Pacific Growth Equities. She is among several industry analysts who have soured on the Emeryville, Calif.-based maker of LeapPad, a top-selling line of electronic books that help children learn to read.

The company’s troubles prompted Bear, Stearns & Co. analyst Jennifer Childe to send a note of exasperation to investors last month: “We are throwing in the towel on shares of LeapFrog.”

So have many investors — LeapFrog’s stock has lost half its value since peaking at $47.30 in late October.

Responding to the backlash, LeapFrog Chief Executive Officer Thomas Kalinske contends that the company is a victim of Wall Street’s misconceptions and remains popular with customers.

“Moms love our products and preschool teachers love our products,” Mr. Kalinske said recently. “Right now, it’s only the investors that don’t love us.”

LeapPad is designed to make learning fun by using interactive technology to teach phonics, math and music. Children use a small console and an electronic wand to touch words, letters and symbols so they can listen to stories, problems and tunes.

Like video game makers, LeapFrog sells a range of interchangeable book cartridges, containing everything from Dr. Seuss tales to Mozart melodies, that work in the consoles. The company also has developed interactive toys for children in elementary and middle school.

The first serious signs of trouble emerged nearly six months ago when management blamed a disappointing third-quarter performance on shipping problems. The bungling raised doubts that became more acute last month when LeapFrog warned that its first-quarter results would be much worse than management previously projected.

LeapFrog lost $11.8 million on sales of $72 million in the three months ended in March. The results, released Wednesday, represent a step back for a company that had been growing steadily since its 1995 inception. LeapFrog lost $969,000 on sales of $77 million at the same time last year.

Mr. Kalinske brushes off the first-quarter setback as a hiccup that the company will overcome during the second half, the period when toy makers generally make all their money. LeapFrog expects to finish this year with a profit of $74 million to $81 million, with revenue of $770 million to $800 million.

The projected results would be an improvement from last year, when the company made $73 million on sales of $680 million, but are a drop from LeapFrog’s predictions in February. LeapFrog forecast at the time that its profit for the year might be as high as $95 million on revenue of $850 million.

“We will have another great year this year,” Mr. Kalinske said. “Having said that, any company that has grown like we have is going to make mistakes along the way. There are things we can improve upon, and we will do that.”

Mr. Kalinske, a former CEO at Mattel Inc. and video game maker Sega of America, is supposed to be part of the solution. LeapFrog brought him back for a second stint as CEO in February, replacing company founder Michael Wood, who now focuses on product development as chief creative officer.

In one of his first significant moves, Mr. Kalinske is lowering the prices of the company’s older LeapPad products. This is expected to cut the retail prices of the affected products from about $39.95 to $34.95 by fall. Mr. Kalinske hopes that the lower prices will result in more households buying LeapPad hardware, and in turn, more sales of book titles.

Mr. Kalinske, 59, first became LeapFrog’s CEO in 1997, shortly after Oracle Corp.’s Larry Ellison and former junk bond financier Michael Milken made major investments in the company. Mr. Ellison and Mr. Milken remain LeapFrog’s largest shareholders.

Mr. Wood, a lawyer who developed the LeapPad to help his young son learn how to read, took over as CEO in early 2002.

LeapFrog initially thrived under Mr. Wood’s leadership. Overcoming a gloomy investment climate, LeapFrog went public in July 2002 at $13 per share, and the company’s shares rocketed, as did its sales.

Since 1999, LeapFrog has sold more than 23 million units of its high-tech books and related products. By the end of last year, it passed Mattel’s Fisher-Price division to rank as the nation’s leading seller of preschool toys with a 27 percent market share, according to the NPD group, a market research group.

The recent bankruptcies of two big customers, KB Toys and the parent of FAO Schwarz, have further complicated matters for LeapFrog. The company says the cutbacks at KB and FAO cost LeapFrog about 10 percent of its first-quarter sales.

But Mr. Kalinski is confident.

“People need to look at the big picture,” he said. “We are gaining market share, and we are having a really big impact on children.”

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