10-K 1 d10k.htm FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2006 Form 10-K for the year ended December 31, 2006
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-K


 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2006

Or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period from              to             

Commission file number 001-31396

 


LEAPFROG ENTERPRISES, INC.

(Exact name of registrant as specified in its charter)


 

Delaware   95-4652013
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)

6401 Hollis Street

Emeryville, CA 94608

(Address of principal executive offices)

(510) 420-5000

(Registrant’s telephone number, including area code)

 


Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange on which registered

Class A common stock, par value $0.0001 per share   New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

 


Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    ¨  Yes    x  No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    ¨  Yes    x  No

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    x  Yes    ¨  No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ¨  Yes    x  No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    ¨  Large accelerated filer    x  Accelerated filer    ¨  Non-accelerated filer

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    ¨  Yes    x  No

The aggregate market value of the common equity held by non-affiliates of the registrant as of June 30, 2006 calculated using the closing market price as of that day, was approximately 180,992,000 Shares of common stock held by each current executive officer and director and by each person who is known by the registrant to own 5% or more of the outstanding voting power of the registrant’s common stock have been excluded from this computation in that such persons may be deemed to be affiliates of the registrant. Share ownership information of certain persons known by the registrant to own greater than 5% of the outstanding voting power of the registrant’s common stock for purposes of the preceding calculation is based solely on information on Schedule 13G filed with the Commission and is as of March 1, 2007. This determination of affiliate status is not a conclusive determination for other purposes.

The number of shares of Class A common stock and Class B common stock, outstanding as of February 28, 2007 was 35,588,364 and 27,614,176, respectively.

Documents Incorporated by Reference

Specified portions of the registrant’s proxy statement, which will be filed with the Commission pursuant to Regulation 14A in connection with the registrant’s 2007 Annual Meeting of Stockholders, to be held on May 1, 2007, are incorporated by reference into Part III of this annual report.

 



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SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS

This report on Form 10-K, including the sections entitled “Item 1.—Business,” “Item 1A.—Risk Factors,” and “Item 7.—Management’s Discussion and Analysis of Financial Condition and Result of Operations,” contains forward-looking statements. These statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to differ materially from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. These risks and other factors include those listed under “Risk Factors” in Item 1A of this Form 10-K and those found elsewhere in this Form 10-K. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “intend,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue” or the negative of these terms or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise after the date of this report.

TRADEMARKS AND SERVICE MARKS

LeapFrog, LeapFrog SchoolHouse, Alphabet Pal, Brightlings, ClickStart, FLY, FLY Through, FLY Fusion, Fridge Phonics, Language First!, Leap, LeapPad, LeapStart, LeapTrack, Leapster, Leapster L-MAX, LeapsterTV, Learn & Groove, Little Leaps, LittleTouch, NearTouch, Quantum LeapPad, and WordLaunch are registered trademarks or trademarks of LeapFrog Enterprises, Inc. Other trademarks in this report on Form 10-K are property of their respective owners.

 

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          Page
   PART I   

Item 1

   Business    1

Item 1A

   Risk Factors    15

Item 1B

   Unresolved Staff Comments    23

Item 2

   Properties    23

Item 3

   Legal Proceedings    24

Item 4

   Submission of Matters to a Vote of Securities Holders    24
   PART II   

Item 5

   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities    25

Item 6

   Selected Financial Data    27

Item 7

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    27

Item 7A

   Quantitative and Qualitative Disclosures About Market Risk    52

Item 8

   Financial Statements and Supplementary Data    53

Item 9

   Changes in and Disagreements With Accountants on Accounting and Financial Disclosure    53

Item 9A

   Controls and Procedures    53

Item 9B

   Other Information    57
   PART III   

Item 10

   Directors, Executive Officers and Corporate Governance    57

Item 11

   Executive Compensation    57

Item 12

   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    57

Item 13

   Certain Relationships and Related Transactions, and Director Independence    58

Item 14

   Principal Accountant Fees and Services    58
   PART IV   

Item 15

  

Exhibits and Financial Statement Schedules

   59

Signatures

   60

Power of Attorney

   60

Appendix A Schedule II—Valuation and Qualifying Accounts and Allowances

  

Index to Consolidated Financial Statements

   F-1

Report of Independent Auditors

   F-2

Consolidated Balance Sheets

   F-3

Consolidated Statements of Operations

   F-4

Consolidated Statements of Stockholders’ Equity

   F-5

Consolidated Statements of Cash Flows

   F-6

Notes to Consolidated Financial Statements

   F-7

Exhibit Index

 

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PART I

Item 1. Business

Overview

LeapFrog designs, develops and markets technology-based educational platforms with curriculum interactive software content and stand-alone products and these products are for sale through retailers, distributors and directly to schools. We operate three business segments, namely U.S. Consumer, International, and SchoolHouse (formerly referred to as “Education and Training”). To date, we have established our brands and products primarily for children up to age 12 in the U.S. retail markets and in a number of international retail markets. Sales in the U.S. Consumer and International segments, the largest business segments, currently are generated in the toy aisles of retailers. Sales of products in the SchoolHouse segment are predominantly to educational institutions. Our products are based on sound educational pedagogy under the guidance of our in-house educational experts and our Education Advisory Board. We use our proprietary technologies and content to make these products interactive and engaging.

In July 2006, our board of directors appointed Jeffrey G. Katz, as our President and Chief Executive Officer. Under Mr. Katz’s leadership, we commenced and completed a full strategic review of our business. This detailed review was substantially completed in the Fall of 2006, when we announced the Company’s plan to:

 

   

Regain market leadership in the learn-to-read market.

 

   

Build our business around key technology platform architectures.

 

   

Provide web connectivity for all our key products.

 

   

Strengthen our portfolio of products, including those for ages 6 and above.

 

   

Manage the business by creating a metrics-driven culture.

 

   

Continually review and strengthen our international product offering and distribution capabilities, as a significant part of our overall plan.

We expect sales productivity in 2007. For information on our operating plan that could affect our business, see “Item 1A.—Risk Factors—Our operating plan may not correct recent trends in our business.”

Our platform products provide us with a large installed base of platforms on which to build continued software content sales. For our LeapPad family of platforms, which includes our LittleTouch LeapPad, My First LeapPad, Classic LeapPad, LeapPad Plus Writing and Quantum LeapPad platforms, we sell a library of interactive content related to those platforms that consists of an audio software cartridge and a corresponding interactive book or activity card. For our Leapster and Leapster L-MAX handhelds and our FLY Pentop Computer, our content comes in software cartridges that slot easily into the platforms.

Users of our interactive content can hear information regarding various academic subjects, read engaging stories or play interactive, educational games. These titles feature our internally developed, branded LeapFrog characters, such as Leap, Lily, Tad and Professor Quigley, while others feature popular licensed characters such as Thomas the Tank Engine, Dora the Explorer, SpongeBob SquarePants, Bob the Builder, Winnie-the-Pooh, Disney Princesses, Batman, Spider-Man and characters from movies such as Madagascar, Finding Nemo and The Incredibles.

Our product line also includes a variety of stand-alone educational products for children from birth to12 years. These stand-alone products combine our proprietary technologies with a fixed set of content and include interactive plush toys, Learn & Groove Counting Maracas and Alphabet Drum, our LeapStart learning table, our Fridge Phonics magnetic set products for infants and toddlers, our The Letter Factory video and our Explorer interactive globes for older children.

 

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Our SchoolHouse segment offers supplemental pre-kindergarten through 5th grade school curriculum programs that incorporate our proprietary technology-empowered personal learning tools, or PLTs, and research-based instructional principles. Our SchoolHouse curriculum provides over 200 interactive book titles and over 450 interactive assessment cards, for a total of over 6,000 pages of interactive content. At the end of 2006, our SchoolHouse products could be found in more than 100,000 classrooms. The interactive content includes instruction and assessment for subject areas such as early literacy, early childhood, reading, language arts, math, science, English language development and special education.

In the fourth quarter of 2006, we restructured our SchoolHouse segment to focus on reading curriculum in core grade levels and to align the segment more effectively with our consumer market strategy.

Our net sales for our three business segments for the years ended December 31, 2006, 2005 and 2004, were as follows:

 

     Year Ended December 31,    % of Total Company
Net Sales
 
     2006    2005    2004    2006     2005     2004  
     (dollars in millions)                   

U.S. Consumer

   $ 350.7    $ 478.3    $ 431.9    70 %   74 %   67 %

International

     114.6      131.2      153.2    23 %   20 %   24 %

SchoolHouse

     37.0      40.3      55.2    7 %   6 %   9 %
                                       

Total Company

   $ 502.3    $ 649.8    $ 640.3    100 %   100 %   100 %
                                       

We believe that sound educational principles are at the core of our brands and products. Our grade-based content is aligned with state and national education standards. All LeapFrog content and curriculum is based on a proprietary method of learning, created by our in-house educational experts with the assistance of our Education Advisory Board, which identifies what children learn and when and how they learn it. The members of our Education Advisory Board meet with our creative design teams periodically throughout the year to participate in the design and development of our products. We believe that both our in-house experts and outside advisors are critical in the creation of our learning products.

Our Education Advisory Board

The members of our Education Advisory Board are extensively involved in the research of both education and reading development. As of February 17, 2007, the members of our Education Advisory Board are:

 

   

Robert Calfee, Ph.D. Dr. Calfee has chaired our Education Advisory Board since our business started in 1995. He has been a prolific researcher and author in the area of reading and reading development for the past 30 years. Dr. Calfee is presently Distinguished Professor and Dean Emeritus at the School of Education at the University of California, Riverside. He is professor emeritus at Stanford University’s School of Education, as well as a member of the board of the Society for Scientific Study of Reading.

 

   

Anne Cunningham, Ph.D. Dr. Cunningham is an associate professor of cognition and development at the University of California, Berkeley and the Director of the Joint Doctoral Program in Special Education. She is a past member of the board of the Society for Scientific Study of Reading and the board of directors for American Educational Research Association, Division C.

 

   

Karen Fuson, Ph.D. Dr. Fuson is a Professor Emeritus at the School of Education and Social Policy at Northwestern University. She is a mathematics educator and cognitive scientist whose work focuses on children’s mathematical understanding and the classroom conditions that can facilitate such understanding. Her past work has contributed to the understanding of children’s counting and understanding of whole number, fraction and decimal computation.

 

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Scott G. Paris, Ph.D. Dr. Paris is a professor in the School of Education and professor and Chair of the Graduate Program in the Department of Psychology at the University of Michigan. He was a founding member of the Center for the Improvement of Early Reading Achievement and served on the board of directors of the National Reading Conference.

 

   

Jeni Leta Riley, Ph.D. Dr. Riley is the head of the School of Early Childhood and Primary Education for the Institute of Education, University of London. Dr. Riley received her conferment of title of Reader in Literacy in Primary Education in 2000 and has been active in early childhood literacy development as a teacher, lecturer, examiner and researcher for nearly 30 years.

Our Products

U.S. Consumer Products

We have developed a variety of stand-alone products, learning platforms and a significant library of related content. Our platforms are hardware devices that work with multiple content sets. Our content comes in the form of memory cartridges used in interactive books, handheld video games, and educational software and games for use with specific platforms. Our stand-alone products combine our proprietary technology with a fixed set of content.

Aggregate sales of our LeapPad family of products, accounted for approximately 23%, 35% and 20% of our consolidated net sales in 2006, 2005, and 2004, respectively.

Aggregate sales of our Leapster and Leapster L-MAX handhelds and their related software titles accounted for approximately 37%, 28% and 19% of our consolidated net sales in 2006, 2005 and 2004, respectively.

For a discussion of risk factors related to our products, see “Item 1A—Risk Factors—“If we fail to predict consumer preferences and trends accurately, develop and introduce new products rapidly or enhance and extend our existing core products, our sales will suffer.”

Interactive Educational Games

The Leapster family of multimedia learning systems comprises our screen-based, learning initiative developed to encourage learning skills while allowing children to play action-packed learning games. The Leapster platform is a handheld device with backlit color animation, a multi-directional control pad and a touch-screen enabled by a built-in stylus. Our Leapster content allows game players to read electronic books, create works of art and watch interactive videos.

Current Products

 

   

Leapster Learning Game System (ages 4 to 10). An educational handheld device platform that utilizes an interactive touch screen and stylus pen.

 

 

 

Leapster L-Max (ages 4 to 10); LeapsterTV learning system (ages 4 to 8). Platforms that offer handheld educational games experience, using the television screen to expand learning. Leapster L-Max learning system uses many of the software cartridges developed for the original Leapster handheld and offers new Leapster L-MAX software cartridges with features designed to offer an enhanced screen-based learning experience.

 

   

Little Leaps Grow-with-Me Learning System (ages 9 months to 3 years). A DVD-based learning platform that delivers activities designed for young children and their parents to share. The platform features a two-in-one wireless controller that can be adjusted between models suitable for babies and toddlers.

 

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Leapster Software Library. Software titles to appeal to both boys and girls with educational games featuring licensed characters such as Disney Princesses, Dora the Explorer, SpongeBob SquarePants, and licensed characters from movies such as Finding Nemo, The Incredibles, Cars and Spider-Man. Digital Titles including art titles specifically designed for students in kindergarten, first through third grade; a Junie B. Jones journal title; educational titles focusing on phonics and math; and titles featuring our interactive The Letter Factory and The Talking Words Factory videos.

New Products for 2007 and 2008

 

   

ClickStart My First Computer System (ages 3 to 6). A new preschool learning system delivers a safe, age-appropriate computing experience through a series of engaging games, while simultaneously introducing core preschool skills and basic computer functionality. We will be launching this learning system in Fall 2007.

 

 

 

In Fall 2007, we plan to introduce new Leapster Family Software. These new titles are compatible with Leapster, Leapster L-Max and LeapsterTV learning systems. All the games provide in–depth tutorials and supporting hint structure that offer step-by-step assistance through reading, math, or spelling concepts. The new titles for Spring 2007 are Scholastic’s Clifford the Big Red Dog Reading, Sonic X. The new tittles for Fall 2007 are The Batman, Creature Create, Disney/Pixar Cars Supercharged, Disney/Pixar Ratatouille, Forster’s Home for Imaginary Friends, Nick Jr. Go Diego Go!, Pet Pals and Scholastic Get Puzzled!

 

   

In September 2006, we announced that we will be introducing in 2008, the next generation of Leapster platforms that will have web connectivity.

Reading Solutions

Reading Solutions consists of our LeapPad family of products that provide platforms for introducing basic vocabulary and concepts or reinforcing second-language learning to preschool children, thorough music and interactive play. Our LeapPad Learning System teaches fundamental reading skills and offers an extensive library of LeapPad books. Since 1999, the LeapPad platform has transformed our LeapPad books into audio-interactive learning devices. When children touch words and pictures with the stylus pen, they receive instant audio feedback that helps them sound out and pronounce words, learn to read and build vocabulary. The LeapPad learning system allows children to read and learn at their own pace, using educational games, activities, music and positive feedback. The LeapPad platform is available in English, French, German, Korean, Japanese and Spanish. A separate version of the LeapPad learning system is marketed by our SchoolHouse segment directly to U.S. school districts and sold under the “LeapTrack” system which provides assessment information to gauge the performance of individual students in a classroom environment.

Current Products

 

   

LittleTouch LeapPad learning system (ages 6 months to 3 years). A learning system designed for infants and toddlers that offers an opportunity for parents to introduce the reading experience and early learning concepts using finger touch-based interactivity.

 

   

My First LeapPad learning system (ages 3 to 5). A learning system that encourages preschoolers to take their first steps to develop pre-reading and pre-math skills. It incorporates the same proprietary NearTouch technology used in our LeapPad learning system.

 

   

LeapPad learning system (ages 4 to 8). An audio-interactive learning device and the first platform of our LeapPad family of platforms which is based on our proprietary NearTouch technology.

 

   

Retail LeapPad library. A collection of titles developed with guidance from our educational experts and is designed to help children build skills they need to excel in reading, math, vocabulary, science, music, logic and more. Our retail library includes titles featuring our proprietary LeapFrog and licensed

 

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characters. Also included in our retail library are licensed characters such as Winnie-the-Pooh and SpongeBob SquarePants and licensed characters from movies such as Madagascar, The Incredibles, Spider-Man, Batman, Bratz, Scooby-Doo, Toy Story 2, The Lion King, Monsters, Inc., and Finding Nemo.

New Products for 2007 and 2008

 

   

WordLaunch Learn-To-Read System (ages 4 and up). A learning system that interacts with the television users. This system is designed for ages 4 and up that offers an adventure to learn and play while building and reading 300 common 3- and 4-letter words. We will be launching this learning system in Fall 2007.

 

   

In September 2006, as part of the announcement of the results of our strategic review, we announced that we expect to introduce in 2008, our new reading solutions products (i.e., successor products to the LeapPad family).

FLY and Grade School

The FLY Pentop Computer is an optical scanning, audio-enabled digital pen that brings computer interactivity to the pen and paper experience which runs under a proprietary operating system and supports proprietary software applications. Using special FLY paper, cards or other materials enabled for the FLY Pentop Computer, users can get homework help in math or spelling, translate words into Spanish or English, play games with interactive collectible playing cards or compose music via real-time audio feedback as they write and draw.

Current Products

 

   

FLY Pentop Computer (ages 8 to 13). A consumer electronic device, introduced for the first time in Fall 2005, gives users real-time audio feedback as they write with special FLY paper. The FLY platform is designed for the “tween” and teen markets.

 

   

FLY Software Library. A collection of titles that span a variety of interests, learning needs and ages. For example, FLY Through Spanish provides real-time English-Spanish word translations; FLY Through Math provides step-by-step coaching on multiplication and division for grades 4 through 6 while FLY Journal provides interactive writing prompts and topics for consideration. In 2006, we expanded our software offering to include algebra, creative writing and other homework helpers.

New Products for 2007 and 2008

 

   

FLY Fusion Pentop Computer (ages 10 to 16). A high-speed web connected homework system which is our next-generation of FLY Pentop Computer. In September 2006, we announced our plans to launch our new FLY Fusion handheld Pentop Computer designed to enhance homework productivity by providing easy access to subject information for faster problem-solving and real-time homework support. We expect to launch this product in Fall 2007.

 

   

FLY Fusion Homework Applications. Interactive step-by-step applications for students in math, algebra, writing, language arts, and even Spanish and French language translation providing homework help. We expect to launch this product in Fall 2007.

Infant / Toddler / Preschool

Our software-centric Infant-Toddler and Preschool educational products are designed primarily for children who are too young to use our platforms effectively. These stand-alone products help develop fine motor skills and color, sound and letter recognition. The products are generally affordable and simpler to localize for foreign markets than our platform and content suites.

 

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Current Products

 

   

LeapStart Learning Table (ages 6 months to 3 years). A learning table designed for infants and toddlers to refine motor skills, introduce letters and numbers and encourage development.

 

   

Alphabet Pal Caterpillar (ages 12 months and up). A musical pull-toy that teaches letter names, letter sounds, learning songs and colors.

 

   

Fridge Phonics Magnet Set (ages 2 and up). A magnetic letter set designed for preschoolers and kindergarteners that teaches letter names, letter sounds and learning songs.

 

   

Learn & Groove collection. (ages 6 months to 3 years). Interactive instruments that introduce numbers, letters, colors, and shapes, in either English or Spanish through music and songs.

New Products for 2007 and 2008

 

   

Learn & Groove Animal Sounds Guitar (ages 6 months to 3 years). A colorful guitar designed for toddlers to learn numbers, animals and music in English or Spanish. We expect to launch this product in Fall 2007.

 

   

Brightlings Activity Line and Exploration Station (ages 6 months to 3 years). A discovery device with a collection of activities that revolves around a central discovery hub that teaches infants and toddlers shapes, colors, letter sounds, learning songs and first words in five languages. We expect to launch this product in Fall 2007.

International Products

Our international consumer strategy includes the creation of LeapFrog products in foreign languages as well as marketing English-language products as tools for learning English as a foreign language. As of December 31, 2006, our products have been marketed and sold in six languages, including Queen’s English, Spanish, French, Japanese and German, and in more than 25 countries. We currently sell our LittleTouch LeapPad, My First LeapPad and LeapPad platforms with localized content. Our Leapster platform is sold with the English content adapted for the British, Australian, and German and non-French-speaking Canadian markets. In 2006, we added French and Spanish versions of our Leapster learning system and began test marketing Leapster products in selected China markets. Some of our key infant items such as the LeapStart Learning Table, Learning Drum and Alphabet Pal caterpillar have also been adapted for markets outside of the United States.

SchoolHouse Products

Our SchoolHouse segment offers supplemental pre-kindergarten through 5th grade school curriculum programs that incorporate our proprietary technology-empowered personal learning tools and research-based instructional principles. Our SchoolHouse curriculum provides over 200 interactive book titles and over 450 interactive assessment cards, for a total of over 6,000 pages of interactive content. Our SchoolHouse products include:

 

 

 

LeapTrack instruction and assessment system (kindergarten through 5th grade). An integrated system to instruct and assess students in kindergarten through 5th grade. In 2006, we launched LeapTrack Reading Pro, a reading intervention product targeting struggling readers in grades 3 and up.

 

   

The Literacy Center (pre-kindergarten through 2nd grade). A product providing instruction and assessment on key literacy skills in pre-kindergarten, kindergarten and grade 1+ editions.

 

 

 

Language First! Program (kindergarten through 2nd grade+). An English language development program for kindergarten through 2nd grade. In 2006, we launched the English Picture Dictionary for Spanish Speakers.

 

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During 2006, we broadened our selection of screen-based Leapster handheld products to include Grades 1 and 2, and a Grade K offering was introduced in January 2007.

Licensing

In-bound Licensing: We license a portion of our content from third parties under exclusive and nonexclusive agreements, which allow us to utilize characters, stories, illustrations and trade names throughout specified geographic territories. Examples include Disney/Pixar’s latest Cars movies and classics like Scooby-Doo, which allow us to deliver curriculum with kids’ favorite characters. LeapFrog currently has agreements with Disney, Nickelodeon, Warner Brothers, Cartoon Network and HIT Entertainment.

Out-bound Licensing: We license our trademarks or service marks to third parties for manufacturing, marketing, distribution and sale of various products. Our licensing strategy concentrates on extending our current brand and developing brands into product categories that are consistent with our core commitment to design and develop educational products that make learning fun and engaging. Our comprehensive licensing program intends to expand the product range available to all of our consumers. In 2006, LeapFrog launched products including books with Scholastic Corporation, card and board games with Cardinal, puzzles with Masterpieces and workbooks with Learning Horizons.

Advertising and Marketing

Our advertising and marketing strategy is designed to position LeapFrog as the leader in engaging, effective, technology-based learning solutions primarily for children up to age 12. Our communication supports a strong brand that parents and educators seek out to supplement children’s educational needs. We strive to utilize the best practices in integrated marketing campaigns that combine the Internet and offline media. Our strategy includes cross-media advertising methodology, using network and national cable television, national print and online advertising. Our SchoolHouse segment uses leading education publications directed to school administrators and teachers. In addition, we periodically attend education trade shows and events. In 2006, as part of our marketing strategy to increase customer awareness of our products, we developed and expanded our online store to promote high-traffic and repeat customer visits.

We also seek promotional partners to extend our brands and message to a broader set of touchpoints. For example, we have pursued promotional campaigns with partners such as Tropicana Juices and Instant Quaker Oatmeal. We have well-established retailer relationships and communicate our messages and offers through advertisements in store and in local newspapers. These advertisements run by our retail partners such as Target, Toys “R” Us, and Wal-Mart highlight promotional activities and the availability of particular LeapFrog products at these retailers’ outlets. In key retail stores, we use in-store demonstration display units to highlight LeapFrog products and demonstrate the features of our products through in-store user experience.

We leverage public relations globally as a strategy to gain additional momentum for our brand and products through media outreach focused on garnering both product-specific and corporate media coverage. We strive to utilize best practices in media outreach campaigns that target both traditional print and broadcast media with Internet/viral media outreach globally.

Sales and Distribution

Historically, our net sales to retailers have shown high concentration in a limited number of customers. In 2006, net sales to Wal-Mart (including Sam’s Club), Toys “R” Us and Target accounted for approximately 26%, 22% and 18% respectively, of our consolidated net sales. In 2005, sales to Wal-Mart (including Sam’s Club), Toys “R” Us and Target accounted for approximately 29%, 20% and 15%, respectively, of our consolidated net sales. For a discussion of this concentration risk see “Item 1A.—Risk Factors—Our business depends on three retailers that together accounted for approximately 66% of our consolidated net sales and approximately 70% of the U.S. Consumer segment sales in 2006 and our dependence upon a small group of retailers may increase.”

 

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U.S. Consumer

Our U.S. Consumer segment accounted for 70% and 74%, respectively, of consolidated sales in 2006 and 2005. We market and sell our products primarily through national and regional mass-market retail stores as well as specialty toy stores. Sales of our products to Wal-Mart (including Sam’s Club and Walmart.com), Toys “R” Us (including Toys “R” Us.com) and Target (including Target.com) accounted for approximately 27%, 22% and 21% of net sales in our U.S. Consumer segment in 2006 and 35%, 24% and 21% in 2005, respectively. Our remaining U.S. Consumer retail sales come from sales of our products to other mass marketers, club stores, electronic, office supply and specialty toy stores. In 2006, as part of our marketing strategy to increase customer awareness of our products, we developed and expanded our online store to promote high-traffic and repeat customer visits.

Our sales team works with store buyers from our key retailers to forecast demand for our products, develop the store floor footprint, secure retail shelf space for our products and agree upon pricing components, including cooperative advertising and promotional sales allowances. The large retail chains generally provide us with a preliminary forecast of their expected purchases of our products during the year. While these and subsequent forecasts are not contractually binding, they provide important feedback that we use in our planning process throughout the year. We work closely with our key retailers during the year to establish and revise our expected demand forecasts and plan our production and delivery needs accordingly. Most retailers issue purchase orders to us as they need product. Based on these purchase orders, we prepare shipments for delivery through various methods. We sell to smaller retail stores through a combination of independent sales representatives and direct salespersons.

International Consumer

Our International segment accounted for 23% and 20%, respectively, of consolidated sales in 2006 and 2005. As of December 31, 2006, we maintained overseas subsidiaries through which we sell our products directly to leading retailers in the United Kingdom, Canada, Mexico, and France. We currently have distribution arrangements in Korea, Australia, New Zealand, Latin America and Europe. Distribution of products to the Middle East, Southeast Asia and Eastern Europe are coordinated out of our United Kingdom office. In the third quarter of 2006, we established a marketing and sales office in Beijing, China.

SchoolHouse

Our SchoolHouse segment accounted for 7% and 6%, respectively, of consolidated sales in 2006 and 2005. Our SchoolHouse segment’s primary customers represent U.S. pre-kindergarten through 5th grade classrooms and also include teacher supply stores and catalog sales by our SchoolHouse segment. Using our in-house sales team as well as independent sales representatives, we sell directly to educational institutions at the classroom, school and district levels, and to resellers and retail outlets that target the education market. We also publish a catalog that is aimed at and distributed to educators.

Financial Information About Geographic Areas

The information about sales in geographic areas is included in Note 21 to the Consolidated Financial Statements in Item 8 of this report and is incorporated herein by reference.

Research and Development

Hardware and Software Development

To develop our products and content, we have assembled a team of technologists with backgrounds in a wide variety of fields including education, child development, hardware engineering, software development, video games and toys. We have developed internally each of our current platforms and stand-alone products, although we use licensed technology if it is advantageous to do so. For example, we use a version of

 

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Macromedia’s Flash player in our Leapster and Leapster L-MAX platforms. We also use optical scanning technology from Anoto AB in our FLY Pentop Computer platform, launched in Fall 2005, and its successor, our FLY Fusion platform, which we expect to launch in Fall 2007.

We have successfully developed proprietary technologies that we use across a number of products in the markets we serve. We have made innovations in the areas of touch detection technology, speech compression, music synthesis and content generation. By combining technology developments in mixed signal application-specific integrated circuits, or ASICs, we have been able to add features at comparatively low cost.

We have built internal expertise in hardware design, hardware synthesis, mixed signal custom ASIC design, real-time embedded systems, software design, tools for packaging and compiling product content and mechanical engineering. The research and development team participates in all phases of the product development process from concept through manufacturing launch.

We believe that investment in research and development is a critical factor in strengthening our portfolio of products, including aging-up our products offerings. In 2006, we completed consolidation of our office locations, moving our research and development offices from Los Gatos, California to our corporate headquarters in Emeryville, California, to better align our product development activities. As part of our strategy to improve our margins through increased efficiency in operating expenses, sourcing and design changes and production rationalization, we opened an office in Shenzhen, China to be able to work more closely with our suppliers to promote lower costs and operational flexibility.

Content Development

Our dedicated content production department has written scripts and designed a large majority of the art, audio and other content for our interactive books, activity cards and stand-alone products, applying our own pedagogical approach that is based on established educational standards. Most of the members of our content production team have prior experience in the education, entertainment and educational software or video game industries.

We have developed a portion of our content using licensed characters such as Disney Princesses, Thomas the Tank Engine, Scooby-Doo, Dora the Explorer, Spider-Man, SpongeBob SquarePants and characters from the movies Madagascar, Finding Nemo, The Incredibles and Cars.

We launched our Developer’s Studio in July 2001, which consists of a team dedicated to creating software tools that help turn the content designed by our content developers into interactive content that works with our various platforms. In an effort to increase the amount and variety of content available for our platform products, we make these tools available to outside developers. Our Developer’s Studio team trains and provides technical support to internal and external content development teams, and works with our production team to turn our internally developed content into interactive books and software. Finally, this team is responsible for managing the business relationships with our community of third-party developers that are trained to create content for our platforms.

Our research and development expense was $54.5 million in 2006, $52.3 million in 2005 and $70.0 million in 2004.

Intellectual Property

We believe that the protection of our patents, trademarks, trade dress, copyrights and trade secrets is critical to our future success, and we aggressively protect our proprietary rights through a combination of patents, trademarks, copyrights, trade secrets, confidentiality procedures, nondisclosure agreements and other contractual agreements. As of December 31, 2006, we had more than 60 utility and design patents issued by the U.S. Patent

 

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and Trademark Office, as well as more than 60 issued internationally. Additionally, we have filed more than 180 patent applications pending in the United States and in other countries. As of December 31, 2006, we also had over 80 U.S. trademark registrations, as well as over 310 foreign trademark registrations. We also rely upon trade secrets, technical know-how and continuing invention to develop and maintain our competitive position. For a discussion of how our intellectual property rights may not prevent our competitors from using similar or identical technology, see “Item 1A.—Risk Factors—Our intellectual property rights may not prevent our competitors from using our technologies or similar technologies to develop competing products, which could weaken our competitive position and harm our operating results.” For a discussion of how our intellectual property rights may not insulate us from claims of infringement by third parties, see “Item 1A.—Risk Factors—Third parties have claimed, and may claim in the future, that we are infringing their intellectual property rights, which may cause us to incur significant litigation or licensing expenses or to stop selling some or all of our products or using some of our trademarks.”

Manufacturing, Logistics and Other Operations

Our manufacturing and operations strategy is designed to maximize the use of outsourced services particularly with respect to the actual production and physical distribution of our products. We believe our outsourcing strategy enhances the scalability of our manufacturing efforts. In order to work closely with our manufacturing service providers, we have established subsidiaries in Hong Kong and Macau. We manage our outsourced manufacturing by allowing LeapFrog’s engineering resources to focus on the product design and manufacturability while our contract manufacturers manage the supply of raw materials. Most of our products are manufactured from basic raw materials such as plastic and paper, and the majority of our products require electronic components. These raw materials are readily available from a variety of sources, but may be subject to significant fluctuations in price. Some of our electronic components used to make our products, including our ASICs, currently come from sole suppliers. For information as to how this concentration of suppliers could affect our business, see “Item 1A.—Risk Factors—We depend on our suppliers for our components and raw materials, and our production or operating margins would be harmed if these suppliers are not able to meet our demand and alternative sources are not available” and “—Increases in our component or manufacturing costs could reduce our gross margins.”

We use contract manufacturers located in Asia, primarily in the People’s Republic of China or PRC, to build our finished products. These suppliers are selected based on their technical and production capabilities and are matched to particular products to achieve cost and quality efficiencies. For information as to how this concentration of manufacturing could affect our business, see “Item 1A.—Risk Factors—We rely on a limited number of manufacturers, virtually all of which are located in China, to produce our finished products, and our reputation and operating results could be harmed if they fail to produce quality products in a timely and cost-effective manner and in sufficient quantities.”

In our U.S. Consumer segment, some products are shipped directly to our contract warehouse in Fontana, California then they are later shipped to meet the demands of our major U.S. retailers and other smaller retailers and distributors throughout the United States. Some products are shipped directly to the retailers’ locations from our contract manufacturers. The products for our International segment are either shipped directly to our international distributors or to local country contract warehouses from which the products are then shipped to meet the demands of our international distributors and customers. The products for our SchoolHouse segment are shipped directly to our contract warehouse in Chino, California and are later shipped to meet the demands of the educational institutions and educators who purchase our products.

Information Technology

In 2005 and 2006, we implemented an information technology environment which is built around a single global instance of Oracle enterprise resource planning, or ERP, applications. This environment supports our core financial, order management, distribution, and supply chain operations. We are also in the process of implementing new data warehouse system and metrics capabilities for improved demand planning, sales

 

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analytics, financial planning and financial reporting. For information as to how our information technology environment could affect our business, see “Item 1A—Risk Factors—We have had significant challenges to our management systems and resources, particularly in our supply chain and information systems, and as a result we may experience difficulties managing our business.”

Retail Sales Service and Consumer Service

We believe that our ability to establish and maintain long-term relationships with consumers and retailers depends, in part, on the strength of our customer support and service operations. We encourage and utilize frequent communication with and feedback from our consumers and retailers to continually improve our products and service. We have a dedicated retail sales service team that works with our top retailers and provides point-of-sale related analysis for better forecasting and inventory plans. We believe that providing direct contact with our existing and targeted retailer customers is an efficient way to convey the value of our products and services and demonstrate the advantages of our products over those of our competitors.

We have contracted with an outside customer service provider who operates hours appropriate to our industry. The customer service provider’s schedule of operation varies to keep pace with the seasonality of our current business. We respond to email inquiries received through our website, and we have a team of in-house consumer service representatives who oversee and coordinate our customer service activities with our third-party customer service providers. In addition, we have a knowledge resource link on our website that directs consumers to a frequently asked questions section, which we update as we receive consumer feedback.

Competition

We compete broadly within the U.S. and international toy industry in the Infant / Toddler / Preschool, and electronic learning aids categories. These categories continue to grow in size and importance, and as a result have become an increasingly competitive arena. Competitors in the educational toy market continue to increase their investment in product research and development and advertising, while focusing on management of global product launches and retail shelf space and market share of products sold directly through online internet based channels. We believe our products compete in these market segments based on brand, product design features, learning content and experience, quality and price. We believe the LeapFrog brand is recognized for quality educational products, enabling us to compare favorably with many of our current competitors on some or all of these factors. For a discussion of the possible effects that competition could have on our business, see “Item 1A.—Risk Factors—If we are unable to compete effectively with existing or new competitors, our sales and market share could decline.”

Our Infant / Toddler / Preschool category is strategically significant because it introduces parents to the LeapFrog line of educational products. While our products are differentiated by their educational branding, we face competition from a wide field of companies in all of our major markets. Historically, our principal competitors in the Infant / Toddler / Preschool category have included Mattel, Inc. primarily under its Fisher-Price brand, Hasbro, Inc. and Vtech Holdings Ltd. We also compete with companies that are relatively new to the educational product arena, many of which are smaller than our traditional competitors.

As we move forward with our strategies of providing web connectivity for all our key products and aging-up our portfolio to serve a wider age range of children, we will compete increasingly with products in a number of other categories and industries including computer products, electronic and online games and entertainment appliances. In 2005, we introduced our FLY Pentop Computer. The FLY Pentop Computer is targeted at the market for ages eight years and older. Our FLY marketing plan has allowed us to begin to merchandise our products away from the toy aisle and other LeapFrog branded products. Competitive products in this industry include handheld and console-based gaming platforms from Sony, Microsoft and Nintendo and games and other software produced for these platforms. Other products, such as MP3 music players, also compete for consumer disposable income currently allocated to educational toys. The FLY Pentop Computer and associated products,

 

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particularly our new FLY Fusion Pentop Computer (available in Fall 2007) can be found at retail stores with other electronic products, and may therefore compete with other electronic devices. Consequently, companies like Apple Inc., Fujitsu Limited, Texas Instruments, Hewlett-Packard Company, Microsoft Corporation, Palm, Inc., Sega Corporation and Toshiba can be considered competitors or potential competitors of LeapFrog.

Our SchoolHouse segment competes in the U.S. supplemental educational materials market. We believe the principal competitive factors affecting the market for our products in the school market are proven educational effectiveness, brand, features and price. Our SchoolHouse segment faces competition in the supplemental curriculum market from major textbook publishers such as Harcourt (a division of Reed Elsevier), Houghton Mifflin Company, McGraw-Hill, Pearson plc and Scholastic Corporation, as well as electronic educational material and service providers such as Knowledge Adventure, Compass Learning, PLATO Learning, Inc., Renaissance Learning and Riverdeep Group plc.

For a discussion of the possible effect the competition could have on our business, see “Item 1A.—Risk Factors—If we are unable to compete effectively with existing or new competitors, our sales and market share could decline.”

Seasonality

LeapFrog’s business is highly seasonal, with our retail customers making up a large percentage of all purchases during the back-to-school and traditional holiday seasons. Our business, being subject to these significant seasonal fluctuations, generally realizes the majority of our net sales and any of our net income during the third and fourth calendar quarters. These seasonal purchasing patterns and production lead times cause risk to our business associated with the under production of popular items and over production of items that do not match consumer demand. In addition, we have seen our customers managing their inventories more stringently, requiring us to ship products closer to the time they expect to sell to consumers, increasing our risk to meet the demand for specific products at peak demand times, or adversely impacting our own inventory levels by the need to pre-build products to meet the demand.

For more information, see “Item 7—Management’s Discussion and Analysis of Financial Condition and Result of Operations —Seasonality and Quarterly Results of Operations” and “Item 1A.—Risk Factors—Our business is seasonal, and therefore our annual operating results depend, in large part, on sales relating to the brief holiday season.” And “—If we do not maintain sufficient inventory levels or if we are unable to deliver our product to our customers in sufficient quantities, or if our inventory levels are too high, our operating results will be adversely affected.”

Employees

As of December 31, 2006, we had 916 full-time employees. We also retain independent contractors to provide various services, primarily in connection with our content development. We are not subject to any collective bargaining agreements and we believe that our relationship with our employees is good. In the third quarter of 2006, we reorganized our company to create four product groups: Reading Solutions, Interactive Educational Games, FLY and Grade School and Infant / Toddler / Preschool. There was little impact on headcount as a result of this organization. In the fourth quarter we restructured our SchoolHouse segment to focus our sales and product development resources on reading curriculum for core grade levels and to better align it with our consumer strategy. With these changes we expect the segment to have a positive earnings contribution in 2007. This restructuring led to termination of 59 full-time employees in the SchoolHouse segment. For more information about our workforce reduction and employees see “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Business Update” and “Item 1A.—Risk Factors—We depend on key personnel, and we may not be able to retain, hire and integrate sufficient qualified personnel to maintain and expand our business.”

 

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Executive Officers of the Registrant

The following table sets forth information with respect to our executive officers as of March 1, 2007:

 

Name

   Age   

Position Held

Jeffrey G. Katz

   51   

Chief Executive Officer and Director

William B. Chiasson

   54   

Chief Financial Officer, President

Nancy G. MacIntyre

   47   

Executive Vice President, Product, Innovation and Marketing

Martin A. Pidel

   42   

Executive Vice President, International

William K. Campbell

   45   

Senior Vice President, Consumer Sales

Michael J. Dodd

   47   

Senior Vice President, Supply Chain and Operations

Michael J. Lorion

   51   

President, SchoolHouse

Robert L. Moon

   57   

Senior Vice President, Chief Information Officer

Hilda S. West

   46   

Senior Vice President, Human Resources

Peter M. O. Wong

   40   

General Counsel and Corporate Secretary

Karen L. Luey

   46   

Vice President, Controller and Principal Accounting Officer

Jeffrey G. Katz has served as our Chief Executive Officer and President since July 2006 and as a member of our board of directors since June 2005. Mr. Katz served as the Chairman and Chief Executive Officer of Orbitz, Inc. from 2000 to 2004. From 1997 to 2000, Mr. Katz was President and Chief Executive Officer of Swissair. From 1980 to 1997, he served in a variety of roles at American Airlines, including Vice President of American Airlines and President of the Computerized Reservation System Division of SABRE. Mr. Katz serves on the board of directors of Northwest Airlines Corporation, a publicly held airline, and is a member of their Audit Committee. Mr. Katz received a B.S. in mechanical engineering from the University of California, Davis, and holds M.S. degrees from both Stanford University and the Massachusetts Institute of Technology.

William B. Chiasson has served as our Chief Financial Officer since November 2004. Prior to joining us, he served as Senior Vice President and Chief Financial Officer of Levi Strauss & Co., a marketer of apparel, from August 1998 to December 2003. From January 1988 to August 1998, Mr. Chiasson served in varying capacities with Kraft Foods, Inc., a division of Phillip Morris Companies and a manufacturer and seller of branded foods and beverages, most recently as Senior Vice President, Finance and Information Technology for Kraft Foods, Inc. From June 1979 to January 1988, Mr. Chiasson served in varying capacities with Baxter Healthcare, most recently as its Vice President and Controller for the Hospital Group. Mr. Chiasson is a certified public accountant and received his B.A. from the University of Arizona and his M.B.A. from the University of Southern California.

Nancy G. MacIntyre has served as our Executive Vice President, Product, Innovation, and Marketing since February 2007. From May 2005 through January 2007, Ms. MacIntyre served on the executive team at LucasArts, a LucasFilm company, most recently as Vice President of Global Sales and Marketing. Previously, Ms. MacIntyre had been with Atari, Inc as Vice President, Marketing from 2001 through 2005 and with Atari, Inc.’s predecessor Hasbro Interactive from 1998 to 2001 in senior sales and marketing positions. Between 1988 and 1998 Ms. MacIntyre held sales and marketing positions at Broderbund Software and Lotus Development Corp. Ms. MacIntyre received her B.S. in finance and accounting from Drexel University.

Martin A. Pidel has served as our Executive Vice President, International since January 2007. From 1997 through December 2006, Mr. Pidel served in varying capacities with HASBRO, Inc. including key roles in Europe and the US, most recently as Vice President of International Marketing. Prior to joining Hasbro, Mr. Pidel worked for Black & Decker in Germany and the U.K. from 1992 through 1997, where he worked in both product and brand marketing roles. Mr. Pidel received his B.S. in marketing from Albany State University and an M.B.A. at the Schiller International University in Heidelberg, Germany.

 

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William K. Campbell has served as our Senior Vice President, Consumer Sales since May 2006, as Vice President, Consumer Sales from December 2002 to May 2006 and as Director of Sales from January 2000 to December 2002. Prior to joining LeapFrog, he served in varying capacities at Lego Systems, Inc., most recently as national account manager from February 1989 to December 1999. Mr. Campbell received his B.A. from Stephen F. Austin State University.

Michael J. Dodd has served as our Senior Vice President, Supply Chain and Operations since April 2005. Prior to joining us, he co-founded Executive Technology, Inc., a value-added reseller and system integrator of information technology products, and served as its Chief Operating Officer from September 2003 through April 2005. From May 2002 to September 2003, Mr. Dodd served as Executive Vice President, Chief Marketing Officer and Chief Operating Officer at Targus Group International, Inc., a provider of mobile personal computers and wireless accessories. Mr. Dodd was a Vice President, Operations at Juniper Networks, Inc., a manufacturer of internal protocol, or IP, routers from September 2000 to May 2002. From November 1989 to September 2000, Mr. Dodd served in various capacities at Compaq Computer Corporation, a manufacturer of personal computers, most recently as Managing Director of operations and strategic procurement for the Presario personal computer business. Mr. Dodd received his B.B.A. from Texas A&M University.

Michael J. Lorion has served as our President, SchoolHouse since December 2006. Prior to that, Mr. Lorion served at varying capacities at LeapFrog since June 2005. Prior to joining us, Mr. Lorion served in different capacities at palmOne, Inc. from February 2000 to April 2005, most recently as Vice President, Vertical Markets Sales & Marketing. Prior to that, Mr. Lorion held various positions at Apple Computer, Inc. from August 1988 through January 2000, most recently as Vice President, Apple Americas Education Division. Mr. Lorion received his B.S. from Springfield College.

Robert L. Moon has served as our Senior Vice President, Chief Information Officer since February 2005. Prior to joining us, he served as Chief Information Officer and Vice President of Global Corporate Information Systems at Viewsonic Corporation, a global provider of visual display technology products, such as liquid crystal displays and cathode ray tube monitors, from January 2001 through February 2005. From November 1999 to December 2000, Mr. Moon served as Senior Vice President of Operations at Unibex, Inc., a business-to-business e-commerce exchange. Prior to that, from February 1995 to November 1999, Mr. Moon was the Chief Information Officer and Vice President at Micros Systems, Inc. a provider of hospitality point of sale and property management systems. Prior to entering the private sector, Mr. Moon served for 21 years as an officer of the United States Navy, retiring with the rank of Commander. His last assignment in the Navy was as Chief Information Officer and Deputy Director of Operations for the Office of Naval Research in Washington, D.C., for which he received the Navy’s Distinguished Service Medal. Mr. Moon received his B.S. from the United States Naval Academy and pursued graduate studies at George Washington University in the area of management of science and technology.

Hilda S. West has served as our Senior Vice President, Human Resources, since October 2006. Prior to joining us, Ms. West served in various capacities at Autodesk, Inc., a leading design software company, from February 2002 to October 2006, most recently as Senior Director, Talent Management. Prior to that, Ms. West served as Senior Director, Human Resources at Ninth House Network, an e-learning provider for organizational development from May 2000 through October 2002. Ms. West received her B.S. from Boston University and her M.B.A. from the Walter A. Haas School of Business at the University of California, Berkeley.

Peter M. O. Wong has served as our General Counsel since April 2006 and as our Corporate Secretary since February 2005. Mr. Wong served as our Vice President, Legal Affairs from August 2004 to March 2006 and as our Corporate Counsel from November 2001 to July 2004. From 1999 to 2001, he worked at Quokka Sports, Inc., a digital sports entertainment company, most recently as Associate General Counsel and Vice President, Corporate Development. Prior to that, he was a business attorney at Cooley Godward Kronish LLP (formerly Cooley Godward LLP) and Howard, Rice, Nemerovski, Canady Falk & Rabkin. Mr. Wong received his B.A. from the University of California, Berkeley, and his J.D. from the University of California, Hastings College of the Law.

 

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Karen L. Luey has served as our Vice President, Controller and Principal Accounting Officer since December 2005. Prior to joining us, Ms. Luey served as Vice President Finance and Corporate Controller of Sharper Image Corporation, a multi-channel specialty retailer of consumer products, from July 2000 to December 2005. From August 1997 to July 2000, Ms. Luey served as Vice President, Controller with Discovery Channel Retail, the retail division of Discovery Communications, a global media and entertainment company. From 1990 to August 1997, Ms. Luey served in various capacities at Sharper Image Corporation. Ms. Luey received her B.S. from California State University, Hayward.

Available Information

We are subject to the information requirements of the Securities Exchange Act of 1934, or the Exchange Act. Therefore, we file periodic reports, proxy statements and other information with the Securities and Exchange Commission, or SEC. Such reports, proxy statements and other information may be obtained by visiting the Public Reference Room of the SEC at 100 F Street, NE, Washington, DC 20549 or by calling the SEC at 1-800-SEC-0330, by sending an electronic message to the SEC at publicinfo@sec.gov or by sending a fax to the SEC at 1-202-777-1027. In addition, the SEC maintains a website (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically.

We make our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, available (free of charge) on or through our website located at www.LeapFroginvestor.com, as soon as reasonably practicable after they are filed with or furnished to the SEC. Information contained on or accessible through our website is not deemed to be part of this report on Form 10-K.

Item 1A. Risk Factors

Our business and the results of its operations are subject to many factors, some of which are beyond our control. The following is a description of some of the risks and uncertainties that may affect our future financial performance.

Our operating plan may not correct recent trends in our business.

In July 2006, our board of directors appointed Jeffrey G. Katz as our President and Chief Executive Officer. Under Mr. Katz’s leadership, we commenced and completed a full strategic review of our business. The critical strategic themes of the plan that resulted from this review are detailed in “Item 1-Business—“Overview.”

We may encounter difficulties executing our new business strategy. Among other things, we may not have sufficient resources to make the necessary investments to develop and implement the technological advances required to maintain our competitive position in our industry. Therefore, we cannot provide any assurance that we can successfully implement this strategic plan, or if implemented, that it will appreciably improve sales and earnings. Failure to execute our operating plan may have an adverse impact on our operating results and financial condition.

If we fail to predict consumer preferences and trends accurately, develop and introduce new products rapidly or enhance and extend our existing core products, our sales will suffer.

Sales of our platforms, related software and stand-alone products typically have grown in the periods following initial introduction, but we expect sales of specific products to decrease as they mature. For example, net sales of the Classic LeapPad and My First LeapPad platforms in our U.S. Consumer business peaked in 2002 and have been declining since. Therefore, the introduction of new products and the enhancement and extension of existing products, through the introduction of additional software or by other means, is critical to our future sales growth. To remain competitive, we must continue to develop new technologies and products and enhance existing technologies and product lines, as well as successfully integrate third-party technology with our own.

 

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The successful development of new products and the enhancement and extension of our current products will require us to anticipate the needs and preferences of consumers and educators and to forecast market and technological trends accurately. Consumer preferences, and particularly children’s preferences, are continuously changing and are difficult to predict. In addition, educational curricula change as states adopt new standards.

We cannot assure you that these products will be successful or that other products will be introduced or, if introduced, will be successful. The failure to enhance and extend our existing products or to develop and introduce new products that achieve and sustain market acceptance and produce acceptable margins would harm our business and operating results.

We depend on key personnel, and we may not be able to hire, retain and integrate sufficient qualified personnel to maintain and expand our business.

Our future success depends partly on the continued contribution of our key executives and technical, sales, marketing, manufacturing and administrative personnel. In July 2006, our board of directors appointed Jeffrey G. Katz as our President and Chief Executive Officer. Subsequent to Mr. Katz’s appointment, we reorganized our management team and appointed new global business leaders for our product lines. During 2006, we hired a new Vice President of Software Engineering, Vice President of Web Products, Vice President of Hardware Engineering, and Senior Vice President of Human Resources, and in early 2007, we hired a new Executive Vice President, International and a new Executive Vice President of Product, Innovation and Marketing. We also commenced a full strategic review and planning process, which will require us to add new strategic capabilities and related management personnel. We have experienced significant turnover in our management positions. If our new leaders are unable to properly integrate into the business or if we are unable to appropriately replace personnel or functional capabilities on a timely basis or at all, our business will be adversely affected.

In October 2006, we completed consolidation of our office locations, moving our research and development offices from Los Gatos, California to our corporate headquarters in Emeryville, California, approximately 50 miles away. We may face the challenge of retaining our Los Gatos personnel due to the change of location and may be unable to hire skilled personnel to replace them. The loss of services of any of our key personnel could harm our business. If we fail to retain, hire, train and integrate qualified employees and contractors, we will not be able to maintain and expand our business.

Part of our compensation package includes stock and/or stock options. If our stock performs poorly, it may adversely affect our ability to retain or attract key employees. In addition, because we have been required to treat all stock-based compensation as an expense as of January 1, 2006, we experienced increased compensation costs in 2006. Changes in compensation packages or costs could impact our profitability and/or our ability to attract and retain sufficient qualified personnel.

Our advertising and promotional activities may not be successful.

Our products are marketed through a diverse spectrum of advertising and promotional programs. Our ability to sell product is dependent in part upon the success of such programs. If we do not successfully market our products, or if media or other advertising or promotional costs increase, these factors could have a material adverse effect on our business and results of operations.

If we are unable to compete effectively with existing or new competitors, our sales and market share could decline.

We currently compete primarily in the Infant / Toddler / Preschool category, and electronic learning aids category of the U.S. toy industry and, to some degree, in the overall U.S. and international toy industry. We believe that we are also beginning to compete, and will increasingly compete in the future, with makers of popular game platforms and smart mobile devices such as personal digital assistants. Our SchoolHouse segment competes in the U.S. supplemental educational materials market. Each of these markets is very competitive and

 

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we expect competition to increase in the future. Many of our direct, indirect and potential competitors have significantly longer operating histories, greater brand recognition and substantially greater financial, technical and marketing resources than we do. These competitors may be able to respond more rapidly than we can to changes in consumer requirements or preferences or to new or emerging technologies. They may also devote greater resources to the development, promotion and sale of their products than we do. We cannot assure you that we will be able to compete effectively in our markets.

Our business depends on three retailers that together accounted for approximately 66% of our consolidated net sales and 70% of the U.S. Consumer segment sales in 2006, and our dependence upon a small group of retailers may increase.

Wal-Mart (including Sam’s Club), Toys “R” Us and Target accounted in the aggregate for approximately 70% of our net sales in 2006. In 2006, sales to Wal-Mart (including Sam’s Club), Toys “R” Us and Target accounted for approximately 26%, 22% and 18%, respectively, of our consolidated net sales. We expect that a small number of large retailers will continue to account for a significant majority of our sales and that our sales to these retailers may increase as a percentage of our total sales.

We do not have long-term agreements with any of our retailers. As a result, agreements with respect to pricing, shelf space, cooperative advertising or special promotions, among other things, are subject to periodic negotiation with each retailer. Retailers make no binding long-term commitments to us regarding purchase volumes and make all purchases by delivering one-time purchase orders. If any of these retailers reduce their purchases from us, change the terms on which we conduct business with them or experience a future downturn in their business, our business and operating results could be harmed.

Our business is seasonal, and therefore our annual operating results depend, in large part, on sales relating to the brief holiday season.

Sales of consumer electronics and toy products in the retail channel are highly seasonal, causing the substantial majority of our sales to retailers to occur during the third and fourth quarters. In 2006, approximately 73% of our total net sales occurred during the latter half of the year. This percentage of total sales may increase as retailers become more efficient in their control of inventory levels through just-in-time inventory management systems. Generally, retailers time their orders so that suppliers like us will fill the orders closer to the time of purchase by consumers, thereby reducing their need to maintain larger on-hand inventories throughout the year to meet demand.

Failure to predict accurately and respond appropriately to retailer and consumer demand on a timely basis to meet seasonal fluctuations, or any disruption of consumer buying habits during this key period, would harm our business and operating results. We expect that we will continue to incur losses in 2007 and in the first and second quarters of each year for the foreseeable future.

If we do not maintain sufficient inventory levels or if we are unable to deliver our product to our customers in sufficient quantities, or if our retailer’s inventory levels are too high, our operating results will be adversely affected.

The high degree of seasonality of our business places stringent demands on our inventory forecasting and production planning processes. If we fail to meet tight shipping schedules, we could damage our relationships with retailers, increase our shipping costs or cause sales opportunities to be delayed or lost. In order to be able to deliver our merchandise on a timely basis, we need to maintain adequate inventory level of the desired products. If our inventory forecasting and production planning processes result in us manufacturing inventory levels in excess of the levels demanded by our customers, our operating results could be adversely affected due to additional inventory write-downs for excess and obsolete inventory. If the inventory of our products held by our retailers is too high, they will not place orders for additional products, which would unfavorably impact our future sales and adversely affect our operating results.

 

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We depend on our suppliers for our components and raw materials, and our production or operating margins would be harmed if these suppliers are not able to meet our demand and alternative sources are not available.

Some of the components used to make our products, including our application-specific integrated circuits, or ASICs, currently come from a single supplier. Additionally, the demand for some components such as liquid crystal displays, integrated circuits or other electronic components is volatile, which may lead to shortages. If our suppliers are unable to meet our demand for our components and raw materials and if we are unable to obtain an alternative source or if the price available from our current suppliers or an alternative source is prohibitive, our ability to maintain timely and cost-effective production of our products would be seriously harmed and our operating results would suffer. In addition, as we do not have long-term agreements with our major suppliers, they may stop manufacturing our components at any time.

We rely on a limited number of manufacturers, virtually all of which are located in China, to produce our finished products, and our reputation and operating results could be harmed if they fail to produce quality products in a timely and cost-effective manner and in sufficient quantities.

We outsource substantially all of our finished goods assembly, using several Asian manufacturers, most of who manufacture our products at facilities in the Guangdong province in the southeastern region of China. We depend on these manufacturers to produce sufficient volumes of our finished products in a timely fashion, at satisfactory quality and cost levels and in accordance with our and our customers’ terms of engagement. If our manufacturers fail to produce quality finished products on time, at expected cost targets and in sufficient quantities, our reputation and operating results would suffer. In addition, as we do not have long-term agreements with our manufacturers, they may stop manufacturing for us at any time, with little or no notice. We may be unable to manufacture sufficient quantities of our finished products and our business and operating results could be harmed.

Increases in our component or manufacturing costs could reduce our gross margins.

Cost increases for our components or manufacturing services, whether resulting from shortages of materials, labor or otherwise, including, but not limited to rising cost of materials, transportation services, labor, commodity price increases and the impact of foreign currency fluctuations could negatively impact our gross margins. Because of market condition and other factors, we may not be able to offset any such increased costs by adjusting the price of our products.

Any errors or defects contained in our products, or our failure to comply with applicable safety standards, could result in delayed shipments or rejection of our products, damage to our reputation and expose us to regulatory or other legal action.

We have experienced, and in the future may experience, delays in releasing some models and versions of our products due to defects or errors in our products. Our products may contain errors or defects after commercial shipments have begun, which could result in the rejection of our products by our retailers, damage to our reputation, lost sales, diverted development resources and increased customer service and support costs and warranty claims, any of which could harm our business. Individuals could sustain injuries from our products, and we may be subject to claims or lawsuits resulting from such injuries. There is a risk that these claims or liabilities may exceed, or fall outside the scope of, our insurance coverage. Moreover, we may be unable to retain adequate liability insurance in the future. We are subject to the Federal Hazardous Substances Act, the Flammable Fabrics Act, regulation by the Consumer Product Safety Commission, or CPSC, and other similar federal, state and international rules and regulatory authorities. Our products could be subject to involuntary recalls and other actions by such authorities. Concerns about potential liability may lead us to recall voluntarily selected products. Recalls or post-manufacture repairs of our products could harm our reputation, increase our costs or reduce our net sales.

 

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We have had significant challenges to our management systems and resources, particularly in our supply chain and information systems, and as a result we may experience difficulties managing our business.

We rely on various information technology systems and business processes to manage our operations. We are currently implementing modifications and upgrades to our systems and processes. There are inherent costs and risks associated with replacing and changing these systems and processes, including substantial capital expenditures, demands on management time and the risk of delays or difficulties in transitioning to new systems or of integrating new systems into our current systems. Any information technology system disruptions, if not anticipated and appropriately mitigated, could have an adverse effect on our business and operations.

Our international consumer business may not succeed and subjects us to risk associated with international operations.

We derived approximately 23% of our net sales from markets outside the United States in 2006. As part of our business review, we announced in July 2006, we are in the process of reviewing our international business and expect to strengthen our international product and distribution effectiveness. However, our efforts to increase sales for our products outside the United States may not be successful and may not achieve higher sales or gross margins or contribution to profitability.

Our business is, and will increasingly be, subject to risks associated with conducting business internationally, including:

 

   

developing successful products that appeal to the international markets;

 

   

political and economic instability, military conflicts and civil unrest;

 

   

greater difficulty in staffing and managing foreign operations;

 

   

transportation delays and interruptions;

 

   

greater difficulty enforcing intellectual property rights and weaker laws protecting such rights;

 

   

complications in complying with laws in varying jurisdictions and changes in governmental policies;

 

   

trade protection measures and import or export licensing requirements;

 

   

currency conversion risks and currency fluctuations; and

 

   

limitations, including taxes, on the repatriation of earnings.

Any difficulties with our international operations could harm our future sales and operating results.

Our financial performance will depend in part on our SchoolHouse segment, which may not be successful.

We launched our SchoolHouse segment in June 1999 to deliver classroom instructional programs to the pre-kindergarten through 5th grade school market and explore adult learning opportunities. To date, the SchoolHouse segment, has incurred cumulative operating losses. In December 2006, we announced a reorganization of the SchoolHouse segment, which reduced the size of our SchoolHouse organization by half. Going forward, the segment is focusing sales and product development resources on reading curriculum for core grade levels. However, if we cannot continue to increase market acceptance of our SchoolHouse segment’s supplemental educational products, the segment’s future sales and profitability could suffer.

Our intellectual property rights may not prevent our competitors from using our technologies or similar technologies to develop competing products, which could weaken our competitive position and harm our operating results.

Our success depends in large part on our proprietary technologies that are used in our learning platforms and related software. We rely, and plan to continue to rely, on a combination of patents, copyrights, trademarks,

 

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service trademarks, trade secrets, confidentiality provisions and licensing arrangements to establish and protect our proprietary rights. The contractual arrangements and the other steps we have taken to protect our intellectual property may not prevent misappropriation of our intellectual property or deter independent third-party development of similar technologies. The steps we have taken may not prevent unauthorized use of our intellectual property, particularly in foreign countries where we do not hold patents or trademarks or where the laws may not protect our intellectual property as fully as in the United States. Some of our products and product features have limited intellectual property protection, and, as a consequence, we may not have the legal right to prevent others from reverse engineering or otherwise copying and using these features in competitive products. In addition, monitoring the unauthorized use of our intellectual property is costly, and any dispute or other litigation, regardless of outcome, may be costly and time-consuming and may divert our management and key personnel from our business operations. However, if we fail to protect or to enforce our intellectual property rights successfully, our rights could be diminished and our competitive position could suffer, which could harm our operating results. For additional discussion of litigation related to the protection of our intellectual property, see “Part I, Financial Information, Note 11 to the Consolidated Financial Statements—“Commitments and Contingencies,”—Legal Proceedings.—LeapFrog Enterprises, Inc. v. Fisher-Price, Inc. and Mattel, Inc.

Third parties have claimed, and may claim in the future, that we are infringing their intellectual property rights, which may cause us to incur significant litigation or licensing expenses or to stop selling some of our products or using some of our trademarks.

In the course of our business, we periodically receive claims of infringement or otherwise become aware of potentially relevant patents, copyrights, trademarks or other intellectual property rights held by other parties. Responding to any infringement claim, regardless of its validity, may be costly and time-consuming, and may divert our management and key personnel from our business operations. If we, our distributors or our manufacturers are adjudged to be infringing the intellectual property rights of any third-party, we or they may be required to obtain a license to use those rights, which may not be obtainable on reasonable terms, if at all. We also may be subject to significant damages or injunctions against the development and sale of some of our products or against the use of a trademark or copyright in the sale of some of our products. Our insurance may not cover potential claims of this type or may not be adequate to indemnify us for all the liability that could be imposed. For more information regarding this see “Part I, Financial Information, Note 11 to the Consolidated Financial Statements—“Commitments and Contingencies,”—Legal Proceedings—Tinkers & Chance v. LeapFrog Enterprises, Inc.

Our net loss would be increased and our assets would be reduced if we are required to record impairment of our intangible assets.

Intangible assets include the excess purchase price over the cost of net assets acquired, or goodwill. Goodwill arose from our September 1997 acquisition of substantially all the assets and business of our predecessor, LeapFrog RBT, and our acquisition of substantially all the assets of Explore Technologies in July 1998. Our intangible assets had a net balance of $25.9 million and $27.6 million at December 31, 2006 and 2005, respectively, which are allocated to our U.S. Consumer segment. Pursuant to Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), goodwill and other intangibles with indefinite lives are tested for impairment at least annually. In determining the existence of impairment, we consider changes in our strategy and in market conditions and this could result in adjustments to our recorded asset balances. Specifically, we would be required to record impairment if the carrying values of our intangible assets exceed their estimated fair values. Such impairment recognition would decrease the carrying value of intangible assets and increase our net loss. At December 31, 2006 and 2005, we had $19.5 million of goodwill and other intangible assets with indefinite lives. We tested our goodwill and other intangible assets with indefinite lives for impairment during the fourth quarter by comparing their carrying values to their estimated fair values. As a result of this assessment, we determined that no adjustments were necessary to the stated values.

 

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We are subject to international, federal, state and local laws and regulations that could impose additional costs or changes on the conduct of our business.

We operate in a highly regulated environment with international, federal, state and local governmental entities regulating many aspects of our business, including products and the importation of products. Regulations with which we must comply include accounting standards, taxation requirements (including changes in applicable income tax rates, new tax laws and revised tax law interpretations), trade restrictions, regulations regarding financial matters, environmental regulations, advertising directed toward children, safety and other administrative and regulatory restrictions. Compliance with these and other laws and regulations could impose additional costs on the conduct of our business. While we take all the steps we believe are necessary to comply with these laws and regulations, there can be no assurance that have achieved compliance or that we will be in compliance in the future. Failure to comply with the relevant regulations could result in monetary liabilities and other sanctions which could have a negative impact on our business, financial condition and results of operations. In addition, changes in laws or regulations may lead to increased costs, changes in our effective tax rate, or the interruption of normal business operations that would negatively impact our financial condition and results of operations.

From time to time, we are involved in litigation, arbitration or regulatory matters where the outcome is uncertain and which could entail significant expense.

We are subject from time to time to regulatory investigations, litigation and arbitration disputes. As the outcome of these matters is difficult to predict, it is possible that the outcomes of any of these matters could have a material adverse effect on the business. For more information regarding litigation see “Part I, Financial Information, Note 11 to the Consolidated Financial Statements—“Commitments and Contingencies,”—Legal Proceedings—in this report.

Weak economic conditions, armed hostilities, terrorism, natural disasters, labor strikes or public health issues could have a material adverse effect on our business.

Weak economic conditions in the U.S. or abroad as a result of lower consumer spending, lower consumer confidence, higher inflation, higher commodity prices, such as the price of oil, political conditions, natural disaster, labor strikes or other factors could negatively impact our sales or profitability. Furthermore, armed hostilities, terrorism, natural disasters, or public health issues, whether in the U.S. or abroad could cause damage and disruption to our Company, our suppliers or our customers or could create political or economic instability, any of which could have a material adverse impact on our business. Although it is impossible to predict the consequences of any such events, they could result in a decrease in demand for our product or create delay or inefficiencies in our supply chain, by making it difficult or impossible for us to deliver products to our customers, or for our manufacturers to deliver products to us, or suppliers to provide component parts.

Notably, our U.S. distribution centers, including our distribution center in Fontana, California, and our corporate headquarters are located in California near major earthquake faults that have experienced earthquakes in the past. In addition to the factors noted above, our existing earthquake insurance relating to our distribution center may be insufficient and does not cover any of our other operations.

If we are unable to maintain the effectiveness of our internal control over financial reporting, we may not be able to accurately report our financial results and our management may not be able to provide its report on the effectiveness of our internal control over financial reporting as required by the Sarbanes-Oxley Act.

Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2006 and December 31, 2005. The assessment as of December 31, 2006, concluded that these controls were effective, and the assessment as of December 31, 2005 identified a material weakness in our internal control over financial reporting for our financial statement close process. For more information, see

 

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“Item 9A. Controls and Procedures” in this report on our assessment of our internal control over financial reporting. We received an unqualified opinion from our external auditors on our financial statements for the years ended December 31, 2006 and 2005. Areas of our internal control over financial reporting may require improvement from time to time. If management is unable to assert that our internal control over financial reporting is effective at any time in the future, or if our external auditors are unable to express an opinion that our internal control over financial reporting is effective, investors may lose confidence in our reported financial information, which could result in the decrease of the market price of our Class A common stock.

One stockholder controls a majority of our voting power as well as the composition of our board of directors.

Holders of our Class A common stock will not be able to affect the outcome of any stockholder vote. Our Class A common stock entitles its holders to one vote per share, and our Class B common stock entitles its holders to ten votes per share on all matters submitted to a vote of our stockholders. As of December 31, 2006, Lawrence J. Ellison and entities controlled by him beneficially owned approximately 16.7 million shares of our Class B common stock, which represents approximately 53% of the combined voting power of our Class A common stock and Class B common stock. As a result, Mr. Ellison controls all stockholder voting power, including with respect to:

 

   

the composition of our board of directors and, through it, any determination with respect to our business direction and policies, including the appointment and removal of officers;

 

   

any determinations with respect to mergers, other business combinations, or changes in control;

 

   

our acquisition or disposition of assets;

 

   

our financing activities; and

 

   

payment of dividends on our capital stock, subject to the limitations imposed by our credit facility.

This control by Mr. Ellison could depress the market price of our Class A common stock or delay or prevent a change in control of LeapFrog.

The limited voting rights of our Class A common stock could negatively affect its attractiveness to investors and its liquidity and, as a result, its market value.

The holders of our Class A and Class B common stock generally have identical rights, except that holders of our Class A common stock are entitled to one vote per share and holders of our Class B common stock are entitled to ten votes per share on all matters to be voted on by stockholders. The holders of our Class B common stock have various additional voting rights, including the right to approve the issuance of any additional shares of Class B common stock and any amendment of our certificate of incorporation that adversely affects the rights of our Class B common stock. The difference in the voting rights of our Class A common stock and Class B common stock could diminish the value of our Class A common stock to the extent that investors or any potential future purchasers of our Class A common stock attribute value to the superior voting or other rights of our Class B common stock.

Provisions in our charter documents, Delaware law and our credit facility agreement may delay or prevent an acquisition of our Company, which could decrease the value of our Class A common stock.

Our certificate of incorporation and bylaws and Delaware law contain provisions that could make it harder for a third-party to acquire us without the consent of our board of directors. These provisions include limitations on actions by our stockholders by written consent and the voting power associated with our Class B common stock. In addition, our board of directors has the right to issue preferred stock without stockholder approval, which could be used by our board of directors to affect a rights plan or “poison pill” that could dilute the stock ownership of a potential hostile acquirer and may have the effect of delaying, discouraging or preventing an

 

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acquisition of our Company. Delaware law also imposes some restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding voting stock. Although we believe these provisions provide for an opportunity to receive a higher bid by requiring potential acquirers to negotiate with our board of directors, these provisions apply even if the offer may be considered beneficial by some stockholders. In addition, under the terms of our credit agreement, we may need to seek the written consent of our lenders of the acquisition of our Company.

Our stockholders may experience significant additional dilution upon the exercise of options or issuance of stock awards.

As of December 31, 2006, there were outstanding awards under our equity incentive plans that could result in the issuance of approximately 9.7 million shares of Class A common stock. To the extent we issue shares upon the exercise of any of options, performance-based stock awards or other equity incentive awards issued under our 2002 Equity Incentive Plan, investors in our Class A common stock will experience additional dilution.

Our stock price could become more volatile and your investment could lose value.

All the factors discussed in this section could affect our stock price. The timing of announcements in the public markets regarding new products, product enhancements by us or our competitors or any other material announcements could affect our stock price. Speculation in the media and analyst community, changes in recommendations or earnings estimates by financial analysts, changes in investors’ or analysts’ valuation measures for our stock and market trends unrelated to our stock can cause the price of our stock to change. A significant drop in the price of our stock could also expose us to the risk of securities class action lawsuits, which could result in substantial costs and divert management’s attention and resources, which could adversely affect our business.

Item 1B. Unresolved Staff Comments.

Not applicable.

Item 2. Properties.

The table below identifies a list of material property locations that we currently hold. In addition to these properties, we have leased properties for administration, sales and operations in Arkansas, Canada, England, France, Mexico and China, each of which is less than 10,000 square feet of space, respectively.

 

Location

  

Use

   Square Feet    Type of Possession    Lease
Expiration Date

Fontana, California

   Distribution Center    600,000    Lease    2010

Emeryville, California

   Headquarters-operations for our three business segments    137,200    Lease    2016

Fontana, California

   Distribution Center    126,672    Lease    2006

Ontario, California

   Distribution Center    109,000    Lease    2008

Los Gatos, California

   Engineering, research and development    19,300    Lease    2007

Beijing, China

   Administration and Logistics for China operations    14,531    Lease    2009

Shenzhen, China

   Technology Research & Development    13,262    Lease    2009

Hong Kong, China

   Asian administration and logistics    12,877    Lease    2007

Austin, Texas

   SchoolHouse Segment operations    10,000    Lease    2008

 

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In 2006, we completed consolidation of our office locations, moving our research and development offices from Los Gatos, California to our corporate headquarters in Emeryville, California; and opened an office in Shenzhen, China to expand our research and development activities.

Item 3. Legal Proceedings.

From time to time, LeapFrog is party to various pending claims and lawsuits. We are currently party to the lawsuits described below, and we intend to defend or pursue these suits vigorously.

Tinkers & Chance v. LeapFrog Enterprises, Inc.

In August 2005, a complaint was filed against us in the federal district court for the Eastern District of Texas by Tinkers & Chance, a Texas partnership. The complaint alleges that we have infringed, and induced others to infringe, United States Patent No. 6,739,874 by making, selling and/or offering for sale in the United States and/or importing our LeapPad and Leapster platforms and other unspecified products. Tinkers & Chance seeks unspecified monetary damages, including triple damages based on its allegation of willful and deliberate infringement, attorneys’ fees and injunctive relief. In the spring of 2006, the court granted Tinkers & Chance’s motions to amend the complaint to add claims of infringement of U.S. Patent Nos. 7,006,786; 7,018,213; 7,029,283 and 7,050,754 against our LeapPad, Leapster and L-Max platforms. A claim construction hearing is set for May 10, 2007 and trial is scheduled for November 2007.

LeapFrog Enterprises, Inc. v. Fisher-Price, Inc. and Mattel, Inc.

In October 2003, we filed a complaint in the federal district court for the district of Delaware against Fisher-Price, Inc., alleging that the Fisher-Price PowerTouch learning system violates United States Patent No. 5,813,861. In September 2004, Mattel, Inc. was joined as a defendant. We are seeking damages and injunctive relief. Following a trial in the district court, the court declared a mistrial because the jury was unable to reach a unanimous verdict, and the parties stipulated to have the case decided by the court based on the seven-day trial record. On March 30, 2006, the district court issued an order entering judgment in favor of Fisher-Price, Inc. with respect to patent infringement and invalidated claim 25 of our ‘861 patent. We have appealed this decision. The appeal has been fully briefed and a hearing on the appeal was held in March 7, 2007.

Stockholder Class Actions

In December 2003, April 2005 and June 2005, six purported class action lawsuits were filed in federal district court for the Northern District of California against Leapfrog and certain of our current and former officers and directors alleging violations of the Securities Exchange Act of 1934. These actions have since been consolidated into a single proceeding captioned In Re LeapFrog Enterprises, Inc. Securities Litigation. On January 27, 2006, the lead plaintiffs in this action filed an amended and consolidated complaint. In July 2006, the Court granted our motion to dismiss the amended and consolidated complaint with leave to amend. On September 29, 2006, plaintiffs filed a second amended consolidated class action complaint. This second amended complaint seeks unspecified damages on behalf of persons who acquired our Class A common stock during the period July 24, 2003 through October 18, 2004. Like the predecessor complaint, this complaint alleges that the defendants caused LeapFrog to make false and misleading statements about our business and forecasts about the financial performance, and that certain of our current and former individual officers and directors sold portions of their stock holdings while in the possession of adverse, non-public information. We have filed a motion to dismiss the second amended consolidated complaint, and a hearing on our motion is set for March 16, 2007. Discovery has not commenced, and a trial date has not been set.

Item 4. Submission of Matters to a Vote of Security Holders.

No matters were submitted to our stockholders during the fourth quarter of our 2006 fiscal year.

 

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PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Market Information and Holders

Our Class A common stock is listed on the New York Stock Exchange, or the NYSE, under the symbol “LF.” There is no established public trading market for the Class B common stock. On February 28, 2007, there were approximately 2,147 holders of record of our Class A common stock and nine holders of record of our Class B common stock.

The following table sets forth the high and low sales prices per share of our Class A common stock on the NYSE in each quarter during the last two years. The values stated below are actual high and low sales prices, inclusive of intra-day trading. The 2005 values differ slightly from our prior year filing due to a change in the source of the data.

 

2006

   High    Low

First quarter

   $ 12.72    $ 10.48

Second quarter

   $ 10.81    $ 9.35

Third quarter

   $ 10.75    $ 6.71

Fourth quarter

   $ 9.91    $ 7.58

2005

         

First quarter

   $ 13.85    $ 10.06

Second quarter

   $ 12.10    $ 9.24

Third quarter

   $ 15.23    $ 11.13

Fourth quarter

   $ 15.00    $ 11.37

Dividend Policy

We have never declared or paid any cash dividends on our capital stock. Our current credit facility prohibits the payment of cash dividends on our capital stock. We expect to reinvest any future earnings into the business. Therefore, we do not anticipate paying cash dividends on our common stock in the foreseeable future.

 

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Stock Price Performance Graph(1)

The following graph shows the total stockholder return of an investment of $100.00 in cash for (i) LeapFrog’s Class A common stock, (ii) the Standard & Poor’s 500 Index and (iii) the Standard & Poor’s Consumer Discretionary Index, for the period beginning on July 25, 2002 (based on the closing price of LeapFrog’s Class A common stock on the date on which LeapFrog’s Class A common stock began trading on the New York Stock Exchange) through December 31, 2006.

The stockholder return shown on the graph below is not necessarily indicative of future performance, and we do not make or endorse any predictions as to future stockholder returns.

LOGO


(1) This section is not “soliciting material,” is not deemed “filed” with the SEC and is not to be incorporated by reference in any filing of LeapFrog under the Securities Act or the Exchange Act whether made before or after the date hereof and irrespective of any general incorporation language in any such filing.

 

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Item 6. Selected Financial Data

The following selected consolidated financial data for the five years ended December 31, 2006, have been derived from our audited consolidated financial statements. The following information is qualified by reference to, and should be read in conjunction with, “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes thereto.

 

    For the Year Ended December 31,
    2006     2005   2004     2003   2002
    (In thousands, except per share data)

Consolidated Statements of Operations Data:

         

Net sales

  $ 502,255     $ 649,757   $ 640,289     $ 680,012   $ 531,772

Gross profit

    147,034       279,636     259,045       340,144     270,041

Income (loss) from operations

    (124,663 )     20,953     (13,983 )     109,458     71,351

Net income (loss)

  $ (145,092 )   $ 17,500   $ (6,528 )   $ 72,675   $ 43,444
                                 

Net income (loss) per common share:

         

Basic

  $ (2.31 )   $ 0.28   $ (0.11 )   $ 1.27   $ 1.09

Diluted

  $ (2.31 )   $ 0.28   $ (0.11 )   $ 1.20   $ 0.86

Shares used in calculating net income (loss) per share:

         

Basic

    62,818       61,781     59,976       57,246     39,695

Diluted

    62,818       62,329     59,976       60,548     50,744
    December 31,
    2006     2005   2004     2003   2002
    (In thousands, except per share data)

Consolidated Balance Sheet Data:

         

Cash, cash equivalents, and short-term investments

  $ 148,098     $ 72,072   $ 88,747     $ 112,603   $ 73,327

Restricted cash

    —         150     8,418       —       —  

Working capital (1)

    289,984       410,740     376,610       368,456     224,685

Total assets

    450,441       605,829     559,794       552,659     397,682

Long-term obligations—capital lease

    4       570     —         —       —  

Total stockholders’ equity

  $ 333,962     $ 466,323   $ 434,500     $ 415,146   $ 268,798

(1) Current assets less current liabilities

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation.

Overview

LeapFrog creates and markets products which make learning fun with connected, innovative technology that teaches and engages in the world’s largest markets. Our mission is to create educational products, content and services that kids love, parents trust, and teachers value.

To date, we have established our brand and products primarily for children up to age 12 in the U.S. retail market. We use the toy form and price points to make learning fun and cost-effective. As a result, sales in our U.S. Consumer and International segments, our largest business segments, currently are generated in the toy aisles of retailers. We have sold the products of our SchoolHouse (formerly referred to as “Education and Training”) segment predominantly to educational institutions.

We design, develop and market technology-based educational platforms with curriculum interactive software content and stand-alone products and these products are for sale through retailers, distributors and directly to schools. We operate three business segments, which we refer to as U.S. Consumer, International, and

 

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SchoolHouse. For further information regarding our three business segments, see Note 21 to our consolidated financial statements contained in Item 8 of this annual report.

In our U.S. Consumer segment, we market and sell our products directly to national and regional mass-market and specialty retailers as well as to other retail stores through sales representatives and through our online store. Our U.S. Consumer segment is our most developed business, and is subject to significant seasonal influences, with the substantial majority of our sales occurring in the third and fourth quarters. In 2006, this segment represented approximately 70% of our total net sales. Although we are expanding our retail presence by selling our products online as well as to electronics and office supply stores, the vast majority of our U.S. Consumer sales are to a few large retailers. Net sales to Wal-Mart (including Sam’s Club), Toys “R” Us and Target accounted for approximately 70% of our U.S. Consumer segment sales in 2006 compared to 80% in 2005 and 86% in 2004. As a percentage of our consolidated net sales, combined net sales to Wal-Mart (including Sam’s Club), Toys “R” Us and Target accounted for approximately 66%, 64% and 64% of our consolidated net sales in 2006, 2005 and 2004, respectively.

In our International segment, which accounted for 23% of our total net sales for 2006, we sell our products outside the United States directly to retailers and through various distribution arrangements. We have four direct sales offices in the United Kingdom, Canada, France, and Mexico. We also maintain various distribution and strategic arrangements in countries such as Australia, Japan, Germany, Korea and China among others. The International segment represented approximately 23% of our total net sales in 2006.

Our SchoolHouse segment, which accounted for 7% of our total net sales for 2006, currently targets the pre-kindergarten through 5th grade school market in the United States, including sales directly to educational institutions and teacher supply stores, and through catalogs aimed at educators.

Business Update

In July 2006, our board of directors appointed Jeffrey G. Katz, as our President and Chief Executive Officer. Under Mr. Katz’s leadership, we commenced and completed a full strategic review of our business. This review was substantially completed in the Fall of 2006 and when we announced the Company plan to:

 

   

Regain market leadership in the learn-to-read market.

 

   

Build our business around key technology platform architectures.

 

   

Provide web connectivity for all our products including those for ages 6 and above.

 

   

Strengthen our portfolio of products.

 

   

Manage the business by creating a metrics-driven culture.

We have begun to implement significant changes based on the findings of our full strategic review. In particular, we are focusing our resources and investments in a few key areas:

 

   

Reading solutions: We will introduce a set of successor products to our LeapPad line of business;

 

   

Interactive educational games: Our successful Leapster line will be updated, hardware margins improved, and our marketing will place a greater emphasis on software sales;

 

   

Across-the-board margin improvement: We are making sourcing improvements, changing the design of key products to reduce product cost, deleting slow-moving or weak margin stock-keeping units (SKUs), and reducing other operating costs that are not tied to product or earnings improvement;

 

   

Web connectivity: Key products will be web connected to support an improved play-experience and better software sales;

 

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Aging up: The FLY Fusion platform, our next generation FLY product will launch in 2007, and will expand LeapFrog’s age segment profile with an improved software library, web connectivity, and sleeker form factor, and enhanced and ease of use;

 

   

International expansion, including China, where test marketing has begun.

In the third quarter of 2006, we reorganized our Company to create four product groups: Reading Solutions, Interactive Educational Games, FLY and Grade School, and Infant / Toddler / Preschool. The head of each product group is accountable for the profit and loss of their group and directs all product development and marketing for their portfolio of products. We believe this new structure provides greater accountability for our key products and better aligns our resources to collaborate efficiently on our top priorities thereby enabling a faster return to profitability. There was little impact on headcount as a result of this re-organization.

In December 2006, we restructured our SchoolHouse segment to focus the sales and product development resources of this segment on reading curriculum for core grade levels, and to better align it with our consumer strategy. This restructuring led to the termination of 59 full-time employees. As a result, in the fourth quarter of 2006, we recorded a related expense in selling, general and administration expense of approximately $1.1 million.

Summary of Current Results

Our consolidated net sales in 2006 were $502.3 million, a decrease of $147.5 million or 23% compared to 2005, on a reported and on a constant currency basis, which assumes that foreign currency exchange rates were the same in 2006 as 2005. Sales in all segments declined during 2006 primarily as a result of significant reduction in the sales of our LeapPad family of products. We increased our promotional activities to reduce existing FLY Pentop inventories as we plan to replace our FLY Pentop Computer with the FLY Fusion Pentop Computer in 2007. Sales of our screen-based products were down slightly as retailers worked off excess inventories. Retailers’ inventories fell an estimated 40% at the end of 2006 compared to the same period last year, which also negatively impacted our 2006 sales.

Our gross margin decreased by 13.7 percentage points to 29.3% in 2006 compared to 43.0% in 2005. Gross margins declined in all segments of the business as a result of significant charges for allowance for excess and obsolete inventory, particularly in our U.S. Consumer and International segments. In addition, we recorded higher sales discounts and allowances mainly due to promotional efforts to assist retailers reduce their slow-moving inventories.

Our selling, general and administrative expense increased by $5.7 million, or 5%, in 2006 compared to 2005. Selling, general and administrative expense consists primarily of salaries and related employee benefits, legal fees, marketing expenses, systems costs, rent, office equipment, supplies and professional fees. The increase was primarily due to higher stock-based compensation expense associated with the adoption of Statement of Financial Standard No. 123(R), “Share-based Payments,” or SFAS 123(R), effective January 1, 2006, and severance expenses for terminated employees. These expenses are partially offset by lower legal fees resulting from settlement of outstanding litigation and less expense associated with patent enforcement in 2006.

Our research and development expense increased by $2.1 million, or 4%, in 2006 compared to 2005. Research and development expense consists primarily of costs related to content development, product development and product engineering. The increase was primarily due to expenses associated with the consolidation of our engineering facilities into our headquarters at Emeryville, California and additional expense for stock-based compensation upon the adoption of SFAS 123(R).

Our advertising expense increased by $5.4 million, or 8%, in 2006 compared to 2005. Advertising expense consists primarily of television advertising, cooperative advertising, online promotions and in-store displays. Advertising expense as a percentage of sales was 15% in 2006 compared to 11% in 2005. The increase was primarily attributable to our efforts to reduce inventory levels.

 

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Our loss from operations of $124.7 million, compared to income of $21.0 million in 2005, was primarily driven by the decline in our sales, lower gross margin and higher operating expenses in our U.S. Consumer and International segments.

Our provision for income taxes for 2006 was approximately $26.6 million, compared to $6.3 million for 2005. The increase in income tax expense was driven by the recognition of a non-cash charge to establish a valuation allowance against our gross domestic deferred tax assets in accordance with the criteria of Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”).

Our net loss was $145.1 million for 2006, respectively, compared to net income of $17.5 million for 2005. The change was primarily due to the decline in our sales, lower gross margin and higher income tax expense.

Our cash and cash equivalents combined with short-term investments increased to $148.1 million in 2006 from $72.2 million in 2005. The increase was primarily due to the reduction in our inventories and accounts receivable, partially offset by reduced earnings.

Inventories, net of allowances, were $73.0 million at December 31, 2006 and $169.1 million at December 31, 2005. Inventories decreased by $96.1 million, or 57%, from December 31, 2005 to December 31, 2006. In an effort to reduce inventory levels, we significantly curtailed 2006 inventory purchases, which resulted in lower inventory levels at December 31, 2006. Inventory levels also reflect an increase of $10.0 million in the allowance for excess and obsolete inventory. This increase was primarily due to our expectations related to future sales of existing products as well as products to be discontinued or replaced as a result of our updated strategic direction. We have implemented strategies intended to improve our capability to forecast and control our inventory.

We have made and continue to make substantive changes that we believe will correct recent trends in our business. Specifically, during 2006, we have taken the following actions:

 

   

We have consolidated some of our business groups and support functions based on the newly created core brands of our products. These changes are consistent with our ongoing strategic plan and goals and we expect clearer accountability and authority over resources to lead to improved performance.

 

   

We completed the consolidation of our engineering facilities with our corporate headquarters in Emeryville, California during the fourth quarter of 2006. We expect the improved integration of engineering with product and marketing to lead to product and cost improvements.

 

   

During 2006 and early 2007, we hired new employees that have relevant experience and expertise for our senior management team and skills consistent with our new plan. These include a new VP of Software Engineering, VP of Web Products, EVP of International, VP of Hardware Engineering, EVP of Product, Innovation and Marketing, and SVP of Human Resources. We have also promoted a number of our most successful employees to senior roles.

 

   

In July 2006, we completed the installation of the second phase of our Oracle 11i ERP system. This system will improve the linkage between sales forecasting and inventory planning, and improve customer service levels for our retail customers, as well as the quality and timeliness of information to facilitate decision-making. The benefits of the ERP installation will not be fully realized until after the 2006 season. This system is also facilitating inventory reduction by our retailers.

 

   

We completed our SKU “redesign” and rationalization, with total SKU reduction of 18% expected for 2007.

 

   

We selected strategic suppliers and manufacturers to help us deliver our product strategy and improve costs.

 

   

We established a China engineering office to allow us to improve product costs and cycle times.

 

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Our outlook for 2007 and 2008 is consistent with our new strategic plan introduced in Fall 2006.

 

   

We plan to strengthen our position in the reading market by developing new reading solutions products, historically, our most successful product line, which we will begin introducing in 2008.

 

   

We will leverage the success of our Leapster product by introducing 2008 significant updates to the product and to the Leapster family and expanding our software library.

 

   

We will “age-up” our portfolio (i.e., increase the percentage of our products aimed at children age 6 and above) by launching products which are aimed at children who are older than our historically successful grade school age segment, such as our new FLY Fusion, Fusion software and Fusion accessories. We anticipate that FLY Fusion will be utilized as well by our SchoolHouse division and by third party partners around the world.

 

   

We will utilize the web to improve our users’ product experience, and to drive sales, marketing and brand awareness

 

   

In the third quarter of 2007, we will launch a number of new products, including our new FLY Fusion Pentop Computer, our first web-connected platform, our new ClickStart My First Computer system and a number of products in our infant / Toddler / preschool category.

While we expect these and other changes to improve trends in our performance, we do not expect them to contribute substantially until after 2007, due to the lead time associated with our product development, sourcing and distribution aspects our business and also due to the year end seasonality that drives substantially all of our sales volume. Accordingly, we expect a modest sales decline in 2007, improved gross margins from 2006 due to 2006 inventory reduction efforts and improved product mix and a decline in operating expenses from 2006, consistent with the decline in sales. Overall, we expect a loss in 2007, which we expect to be significantly less than the loss for 2006.

For information on our operating plan that could affect our business, see “Item 1A.—Risk Factors—Our operating plan may not correct recent trends in our business.”

Critical Accounting Policies, Judgments and Estimates

Our management’s discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and reported disclosures. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, allowances for accounts receivable, inventory valuation, the valuation of deferred tax assets and tax liabilities, intangible assets and stock-based compensation. We base our estimates on historical experience and on complex and subjective judgments often resulting from determining estimates about the impact of events and conditions that are inherently uncertain. These estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Our significant accounting policies are described in Note 2 to our consolidated financial statements. Certain accounting policies are particularly important to the portrayal of our financial position and results of operations and require the application of significant judgment by our management. We believe the following critical accounting policies are the most significant in affecting judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We recognize revenue when products are shipped and title passes to the customer provided that there are no significant post-delivery obligations to the customer and collection is reasonably assured. Net sales represent

 

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gross sales less negotiated price allowances based primarily on volume purchasing levels, estimated returns, allowances for defective products, markdowns and other sales allowances for customer promotions. A small portion of our revenue related to training and subscriptions is deferred and recognized as revenue over a period of one to 18 months. We deferred less than 1% of net sales in 2006, 2005 and 2004.

Allowances for Accounts Receivable

We reduce accounts receivable by an allowance for amounts we believe will become uncollectible. This allowance is an estimate based primarily on our management’s evaluation of the customer’s financial condition, past collection history and aging of the accounts receivable balances. If the financial condition of any of our customers deteriorates, resulting in impairment of its ability to make payments, additional allowances may be required.

We provide estimated allowances for product returns, chargebacks, promotions and defectives on product sales in the same period that we record the related revenue. We estimate our allowances by utilizing historical information for existing products. For new products, we estimate our allowances for product returns on specific terms for product returns and our experience with similar products. We continually assess our historical experience and adjust our allowances as appropriate, and consider other known factors. If actual product returns, chargebacks, promotions and defective products are greater than our estimates, additional allowances may be required. Historically, our estimated allowances for accounts receivable, returns, chargebacks, promotions and defectives have been adequate to cover actual charges.

We disclose our allowances for doubtful accounts on the face of the balance sheet. Our other receivable allowances include allowances for product returns, chargebacks, defective products and promotional markdowns. These other allowances totaled $41.5 million and $44.4 million at December 31, 2006 and 2005, respectively. The decrease in other receivable allowances was primarily due lower sales volume, improved shipping operations and faster collection of outstanding amounts. These allowances are recorded as reductions of gross accounts receivable.

Inventory Valuation

Inventories, net are stated at the lower of cost, on a first-in, first-out basis, or market value. Our estimate of an allowance for slow-moving, excess and obsolete inventories is based on our management’s review of on-hand inventories compared to their estimated future usage, demand for our products, anticipated product selling prices and products planned for discontinuation. If actual future usage, demand for our products and anticipated product selling prices are less favorable than those projected by our management, additional inventory write-downs may be required. Management monitors these estimates on a quarterly basis. When considered necessary, management makes additional adjustments to reduce inventory to its net realizable value, with corresponding increases to cost of goods sold. Allowances for excess and obsolete inventory were $34.1 million and $24.2 million in 2006 and 2005, respectively, and are recorded as a reduction of gross inventories. The increase in allowances for excess and obsolescence reflects higher reserves for the LeapPad family of products, given their continuing sales declines and planned replacement in 2008, as well as higher reserves for the FLY Pentop Computer. The FLY Fusion Computer, the next generation of FLY, will be introduced in Fall 2007.

Intangible Assets

Intangible assets include the excess purchase price over the cost of net assets acquired, or goodwill. Goodwill arose from our September 23, 1997 acquisition of substantially all the assets and business of our predecessor, LeapFrog RBT, and our acquisition of substantially all the assets of Explore Technologies on July 22, 1998. Our intangible assets had a net balance of $25.9 million and $27.6 million at December 31, 2006 and 2005, respectively and are allocated to our U.S. Consumer segment pursuant to Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (SFAS 142), goodwill and other intangibles with indefinite lives are tested for impairment at least annually. At December 31, 2006 and 2005, we had $19.5 million of goodwill and other intangible assets with indefinite lives. We tested our goodwill and other

 

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intangible assets with indefinite lives for impairment during the fourth quarter by comparing their carrying values to their estimated fair values. As a result of this assessment, we determined that no adjustments were necessary to the stated values.

Intangible assets with other than indefinite lives include patents, trademarks and licenses, one of which is a ten-year technology license agreement entered into in January 2005 to jointly develop and customize our optical scanning technology. The determination of related useful lives and whether the intangible assets are impaired involves significant judgment. Changes in strategy or market conditions could significantly impact these judgments and require that adjustments be recorded to asset balances. We review intangible assets, as well as other long-lived assets, for impairment at least annually or whenever events or circumstances indicate that the carrying value may not be fully recoverable.

Stock-Based Compensation

At December 31, 2006, we had stock-based compensation plans for employees and nonemployee directors which authorized the granting of various stock-based incentives including restricted stock, restricted stock units and stock options. The vesting periods for restricted stock and restricted stock units are generally three and four years, respectively. We also grant stock options to certain of our employees for a fixed number of shares with an exercise price generally equal to the fair value of the shares on the date of grant. These options generally vest over a four-year period.

Prior to January 1, 2006, we accounted for the stock-based compensation plans under the measurement and recognition provisions of APB Opinion No.25, “Accounting for Stock Issued to Employees,” and related Interpretations, permitted under Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). As a result, stock-based compensation was included as a pro forma disclosure in the Notes to the financial statements.

Effective, January 1, 2006, we adopted the recognition provisions of Statement of Financial Accounting Standard No. 123 (R), “Share-Based Compensation” (“SFAS 123(R)”), using the modified-prospective transition method. Under this transition method, compensation cost in 2006 included the portion vesting in the period for (1) all share-based payments granted prior to, but not vested, as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (2) all share-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). Results for the prior periods have not been restated.

The fair value of each stock option granted is estimated on the date of the grant using the Black-Scholes option-pricing model. The total grant date fair value is recognized over the vesting period of the options on a straight-line basis. The weighted-average assumptions for the expected life and the expected stock price volatility used in the model require the exercise of judgment. The risk-free interest rate used in the model is based on the assumed expected life. The expected life of the options represent the period of time the options are expected to be outstanding and is based on the guidance provided in the SEC Staff Accounting Bulletin No. 107 on Share-Based Payment. Expected stock price volatility is based on a consideration of our stock’s historical and implied volatilities as well as the volatilities of other public entities in our industry. The risk–free interest rate used in the model is based on the U.S. Treasury yield curve in effect at the time of grant and has a term equal to the expected life.

Restricted stock awards and restricted stock units are payable in shares of our Class A common stock. The fair value of each restricted stock or unit is equal to the closing market price of our stock on the trading day immediately prior to the date of grant. The grant date fair value is recognized in income over the vesting period of these stock-based awards. The cost of our performance-based stock awards is expensed based on achieving pre-established financial measures, including certain stock price milestones. We did not achieve the related financial goals in 2004, 2005, and 2006, resulting in cancellation of the associated share grants. Stock-based compensation arrangements to non-employees are accounted for using a fair value approach. The compensation costs of these arrangements are subject to re-measurement over the vesting terms.

 

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Income Taxes

We account for income taxes using the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using enacted tax rates and laws that will be in effect when the differences are expected to reverse. Valuation allowances are provided when it is more likely than not that all or a portion of a deferred tax asset will not be realized. In determining whether a valuation allowance is warranted, we take into account such factors as prior earnings history, expected future earnings, carryback and carryforward periods, and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset.

During 2006, we recorded a non-cash valuation allowance of $60.4 million against its gross deferred tax assets of $60.4 million, of which $24.9 million relates to pre-2006 deferred tax assets. The amount represents 100% of the domestic deferred tax assets. The valuation allowance is calculated in accordance with the provisions of SFAS 109, which requires an assessment of both positive and negative evidence when measuring the need for a valuation allowance. Our domestic net operating losses for the most recent four-year period, the expectation of additional net operating losses in 2007 and changes in our business strategy increased the uncertainty about whether the level of future profitability needed to record the deferred assets will be achieved and represented sufficient negative evidence to require a valuation allowance under the provisions of SFAS 109. We intend to maintain a valuation allowance until sufficient positive evidence exists to support its reversal. Should we determine that we would be able to realize all or part of our deferred tax assets in the future, an adjustment to the valuation allowance would be recorded in the period such determination was made. The majority of our domestic deferred tax assets generally have 0—20 years until expiry or indefinite lives.

Our financial statements also include accruals for the estimated amounts of probable future assessments that may result from the examination of federal, state or international tax returns. Our tax accruals, tax provision, deferred tax assets or income tax liabilities may be adjusted if there are changes in circumstances, such as changes in tax law, tax audits or other factors, which may cause management to revise its estimates. The amounts ultimately paid on any future assessments may differ from the amounts accrued and may result in an increase or reduction to the effective tax rate in the year of resolution.

Results of Operations

The following table sets forth selected information concerning our results of operations as a percentage of net sales for the periods indicated:

 

     Year Ended December 31,  
     2006     2005     2004  

Net sales

   100.0 %   100.0 %   100.0 %

Cost of sales

   70.7     57.0     59.5  
                  

Gross profit

   29.3     43.0     40.5  

Operating expenses:

      

Selling, general and administrative

   26.3     19.4     18.9  

Research and development

   10.8     8.1     9.5  

Advertising

   15.0     10.8     13.0  

Depreciation and amortization

   2.0     1.6     1.2  
                  

Total operating expenses

   54.1     39.9     42.6  
                  

Income (loss) from operations

   (24.8 )   3.1     (2.1 )

Net interest income and other income (expense), net

   1.2     0.4     0.2  
                  

Income (loss) before provision (benefit) for income taxes

   (23.6 )   3.5     (1.9 )

Provision (benefit) for income taxes

   5.3     1.0     (0.9 )
                  

Net income (loss)

   (28.9 )%   2.5 %   (1.0 )%
                  

 

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Twelve Months Ended December 31, 2006 Compared To Twelve Months Ended December 31, 2005

Net Sales

Net sales decreased by $147.5 million, or 23%, from $649.8 million in 2005 to $502.3 million in 2006, on a reported and on a constant currency basis, which assumes that foreign currency exchange rates were the same in 2006 as 2005.

Net sales for each segment and its percentage of total Company net sales were as follows:

 

     Year Ended December 31,              
     2006     2005     Change  

Segment

   $(1)    % of
Total
Company
Sales
    $(1)    % of
Total
Company
Sales
    $(1)     %  

U.S. Consumer

   $ 350.7    70 %   $ 478.3    74 %   $ (127.6 )   (27 )%

International

     114.6    23 %     131.2    20 %     (16.6 )   (13 )%

SchoolHouse

     37.0    7 %     40.3    6 %     (3.3 )   (8 )%
                                    

Total Company

   $ 502.3    100 %   $ 649.8    100 %   $ (147.5 )   (23 )%
                                    

(1) In Millions

U.S. Consumer. Our U.S. Consumer segment’s net sales decreased by $127.6 million, or 27%, from $478.3 million in 2005 to $350.7 million in 2006. In our U.S. Consumer segment, net sales of platform, software and stand-alone products in dollars and as a percentage of the segment’s total net sales were as follows:

 

       Net Sales                   % of Total  
       Year Ended
December 31,
     Change     Year Ended
December 31,
 
       2006(1)      2005(1)      $(1)      %     2006     2005  

Platform

     $ 123.8      $ 196.2      $ (72.4 )    (37 )%   35 %   41 %

Software

       105.1        145.7        (40.6 )    (28 )%   30 %   30 %

Stand-alone

       121.8        136.4        (14.6 )    (11 )%   35 %   29 %
                                           

Net Sales

     $ 350.7      $ 478.3      $ (127.6 )    (27 )%   100 %   100 %
                                           

(1) In millions

The net sales decrease in this segment was primarily the result of the following factors:

 

   

63% decline in sales volume of our LeapPad family of products, which is technologically past its prime.

 

 

 

Discounts and allowances mainly due to our promotional efforts to reduce retailers’ slow-moving inventories, increased by $5.0 million in 2006. Specifically, we reported 68% lower sales for our FLY Pentop Computer business compared to 2005, reflecting promotional and other activities to reduce existing FLY Pentop inventories in its last selling season. We plan to replace the FLY Pentop Computer with the FLY Fusion Pentop Computer in 2007.

These factors were partially offset by direct sales at our on-line store of approximately $8.0 million compared to $3.1 million in 2005. We plan to continue building our web products business. We expect to continue to improve our online sales principally by improving our sales efforts and methodologies at the web stores of our major retail customers and at the all-online e-tailers, and also at our own online web store.

 

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International. Our International segment’s net sales decreased by $16.6 million, or 13 %, from $131.2 million in 2005 to $114.6 million in 2006. On a constant currency basis, net sales decreased 14% from 2005 to 2006.

The net sales decrease in our International segment was primarily due to a significant reduction in our United Kingdom market, which represents approximately 28% of our International net sales. Factors driving this decline were:

 

   

Sales decline from $57.1 million in 2005 to $38.1 million in 2006 in the United Kingdom, which were driven primarily by the significant decline in sales of our LeapPad family of products. Approximately $5.0 million of the sales decline was due to discounts and other allowances to provide consumers with the incentive to purchase these products and reduce retailers’ inventories.

 

   

In other countries, we also incurred an additional $5.0 million sales allowances to reduce our inventories and those of our retailer customers.

These factors were partially offset by higher sales in Canada, Spain, Mexico and smaller markets in Asia and Europe in 2006 compared to 2005. Unlike the mature U.K. market, which is seeing declining LeapPad sales, many of these markets are relatively new and have strong LeapPad sales. Some of these countries’ sales were also aided by the introduction of Spanish and French versions of Leapster in 2006.

SchoolHouse. Our SchoolHouse segment’s net sales decreased by $3.4 million, or 8% from $40.3 million in 2005 to $37.0 million in 2006. We expect the decline to continue into 2007. On December 2006, we announced that we had decided to implement changes in our SchoolHouse segment to return it to positive earnings contribution, and more closely align it with our consumer strategy.

Gross Profit and Gross Margin

The gross profit for each segment and the related gross profit percentage of segment net sales, or gross margin, were as follows:

 

     Year Ended December 31,              
     2006     2005     Change  

Segment

   $(1)    % of
Segment’s
Net Sales
    $(1)    % of
Segment’s
Net Sales
    $(1)     %  

U.S. Consumer

   $ 96.7    27.6 %   $ 193.8    40.5 %   $ (97.1 )   (50 )%

International

     30.1    26.2 %     59.5    45.4 %     (29.4 )   (49 )%

SchoolHouse

     20.2    54.9 %     26.3    65.3 %     (6.1 )   (23 )%
                            

Total Company

   $ 147.0    29.3 %   $ 279.6    43.0 %   $ (132.6 )   (47 )%
                            

(1) In Millions

U.S. Consumer. Our gross margin for the year ended December 31, 2006 decreased by 13.2 percentage points compared to the same period in 2005. The decline was primarily due to the following factors:

 

   

Higher allowances for excess and obsolete inventory, which increased by $10.5 million to 20.8 million in 2006. The higher charges resulted from product sales declines combined with our new product development strategies formalized in the third quarter of 2006. This increase unfavorably impacted gross margin by approximately 3.0 percentage points.

 

   

Closeout and promotional arrangements caused by weaker demand for our LeapPad family of products and our planned replacement of FLY Pentop Computer in 2007 with the FLY Fusion Pentop Computer. This increase negatively impacted gross margin by approximately 5.7 percentage points.

 

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Cancellation charges on purchase orders for inventory that we cancelled, which increased by $5.9 million from $0.8 million in 2005. This increase impacted gross margin by approximately 1.7 percentage points.

International. Our gross margin for the year ended December 31, 2006 decreased by 19.2 percentage points compared to the same period in 2005. The decline was primarily due to the following factors:

 

   

Increased charges for inventory allowances by $6.5 million in 2006 compared to 2005. The increased charges resulted from our product sales decline and our updated strategic direction. This increase unfavorably impacted gross margin by approximately 5.7 percentage points.

 

   

Promotions and discounts to assist retailers reduce their inventory, which impacted gross margin by approximately 5.5 percentage points.

 

   

Operational costs associated with our new Canadian warehouse, which reduced gross margin by approximately 1.8 percentage points.

SchoolHouse. Our gross margin for the year ended December 31, 2006 decreased by 10.4 percentage points compared to 2005. The decrease is primarily due to higher charges for allowance for excess and obsolete inventory, which increased by approximately $3.5 million in 2006 compared to 2005. This increase unfavorably impacted gross margin by 9.5 percentage points.

Selling, General and Administrative Expense

Selling, general and administrative expense consists primarily of salaries and related employee benefits, legal fees, marketing expenses, systems costs, rent, office equipment, supplies and professional fees. We record all of our indirect expenses in our U.S. Consumer segment and do not allocate these expenses to our International and SchoolHouse segments.

The selling, general and administrative expense in dollars for each segment and the related percentage of our total net sales were as follows:

 

     Year Ended December 31,              
     2006     2005     Change  

Segment

   $(1)    % of
Segment
Net Sales
    $(1)    % of
Segment
Net Sales
    $(1)     %  

U.S. Consumer

   $ 91.9    26.2 %   $ 90.0    18.8 %   $ 1.9     2 %

International

     18.8    16.4 %     14.7    11.2 %     4.1     28 %

SchoolHouse

     21.2    57.4 %     21.5    53.4 %     (0.3 )   (1 )%
                            

Total Company

   $ 131.9    26.3 %   $ 126.2    19.4 %   $ 5.7     5 %
                            

(1) In Millions

The overall $5.7 million increase in selling, general and administrative expense during the year ended December 31, 2006 was primarily due to the following factors:

 

   

Higher compensation expense related to stock-based compensation costs. The increase over 2005 was approximately $4.6 million and is due to the adoption of SFAS 123(R), effective January 1, 2006, requiring expense recognition of stock options granted to employees as well as higher compensation expense for performance shares, restricted stock units and restricted stock awards.

 

   

Higher salary expense, which increased by $3.7 million, related to severance costs primarily associated with the resignation of former corporate officers and reduction in our SchoolHouse segment’s workforce.

 

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Bonus expense, which increased by approximately $1.7 million, associated with the 2006 bonus plan that rewards individual employee performance as well as our Company performance. In 2005, the bonus plan paid out was based solely on our Company business performance goals, whereas in 2006 employees were able to achieve a portion of the bonus opportunity based on achievement of individual goals that support our Company strategic objectives.

These factors were partially offset by a decrease of approximately $7.4 million for legal expense in 2006 compared to 2005 due to:

 

   

Lower legal costs resulting from the settlement of outstanding litigation.

 

   

Less patent enforcement fees in 2006 compared to 2005.

Research and Development Expense

Research and development expense consists primarily of costs associated with content development, product development and product engineering. We record all of our indirect expenses in our U.S. Consumer segment and do not allocate these expenses to our International and SchoolHouse segments.

The research and development expense in dollars for each segment and the related percentage of our total net sales were as follows:

 

     Year Ended December 31,              
     2006     2005     Change  

Segment

   $(1)    % of
Segment’s
Net Sales
    $(1)    % of
Segment’s
Net Sales
    $(1)     %  

U.S. Consumer

   $ 48.7    13.9 %   $ 46.2    9.7 %   $ 2.5     5 %

International

     2.5    2.2 %     2.7    2.0 %     (0.2 )   (7 )%

SchoolHouse

     3.3    8.8 %     3.4    8.5 %     (0.1 )   (3 )%
                            

Total Company

   $ 54.5    10.9 %   $ 52.3    8.0 %   $ 2.2     4 %
                            

(1) In Millions

We classify research and development expense into two categories, product development and content development. Product development expense reflects the costs related to the conceptual design, engineering and testing stages of our platforms and stand-alone products. Content development expense reflects the costs related to the conceptual, design and testing stages of our software and books. These expenses were as follows:

 

     Year Ended December 31,        
     2006     2005     Change  

Segment

   $(1)    % of
Total
Company
Net sales
    $(1)    % of
Total
Company
Net sales
    $(1)     %  

Product development

   $ 24.4    4.9 %   $ 26.1    4.0 %   $ (1.7 )   (7 )%

Content development

     30.1    6.0 %     26.2    4.0 %     3.9     15 %
                            

Research & Development

   $ 54.5    10.9 %   $ 52.3    8.0 %   $ 2.2     4 %
                            

(1) In Millions

 

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Research and development expense increased by $2.1 million for the year ended December 31, 2006 compared to 2005. In 2006, we decided to consolidate our office locations, moving our research and development offices from Los Gatos, California to our corporate headquarters in Emeryville, California, to better align our research and development, product and marketing activities. In addition, to the costs associated with this relocation, research and development expense also reflected compensation costs, which increased by approximately $1.4 million primarily related to stock-based compensation expense under SFAS 123(R). These factors were partially offset by capitalization of allowable content development costs.

Advertising Expense

The advertising expense in dollars for each segment and the related percentage of our total net sales was as follows:

 

     Year Ended December 31,             
     2006     2005     Change  

Segment

   $(1)    % of
Segment
Net Sales
    $(1)    % of
Segment
Net Sales
    $(1)    %  

U.S. Consumer

   $ 57.1    16.3 %   $ 52.5    11.0 %   $ 4.6    9 %

International

     17.6    15.4 %     17.0    13.0 %     0.6    4 %

SchoolHouse

     0.7    1.9 %     0.5    1.1 %     0.2    40 %
                           

Total Company

   $ 75.4    15.0 %   $ 70.0    10.8 %   $ 5.4    8 %
                           

(1) In Millions

Our advertising expense for the year ended December 31, 2006 was $75.4 million compared to $70.0 million in 2005. We increased our advertising expenditure to support our efforts to reduce retailer and LeapFrog inventory levels.

Depreciation and Amortization Expenses (excluding depreciation of tooling and amortization of content development costs, which are included in cost of sales)

Depreciation and amortization expenses decreased year-over-year by $0.3 million, or 3.0%, from $10.1 million in 2005, to $9.8 million in 2006. As a percentage of net sales, depreciation and amortization expense increased from 1.6% in 2005 to 2.0% in 2006. The decrease in depreciation and amortization expense was primarily due to lower amortization expense for intangible assets some of which were fully amortized during the year.

Income (Loss) From Operations

Income (loss) from operations in dollars and the related percentage of segment net sales were as follows:

 

     Year Ended December 31,              
     2006     2005     Change  

Segment

   $(1)     % of
Segment
Net Sales
    $(1)     % of
Segment
Net Sales
    $(1)     %  

U.S. Consumer

   $ (110.4 )   (31.5 )%   $ (4.9 )   (1.0 )%   $ (105.5 )   (2153 )%

International

     (9.3 )   (8.1 )%     24.9     19.0 %     (34.2 )   (137 )%

SchoolHouse

     (5.0 )   (13.5 )%     0.9     2.3 %     (5.9 )   (654 )%
                              

Total Company

   $ (124.7 )   (24.8 )%   $ 20.9     3.2 %   $ (145.6 )   (697 )%
                              

(1) In Millions

We record indirect expenses in our U.S. Consumer segment and do not allocate these expenses to our International and SchoolHouse segments.

 

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Other

Net Interest Income and Other Income (Expense), Net. Net interest income increased by $3.8 million from $3.4 million in 2005 to $7.2 million in 2006. This increase was due to higher market interest rates and from increasing the percentage of investments in higher-rate taxable interest securities in 2006, compared to tax-exempt securities in 2005.

Tax Rate. Our effective tax rate for the year ended December 31, 2006 was (22.5) % as compared to 26.5% in 2005. The negative tax rate for 2006 is currently affected by a $60.4 million non-cash valuation allowance recorded against our domestic deferred tax assets, of which $24.9 million relates to pre-2006 deferred tax assets and earnings being lower or losses being higher than anticipated in countries, where we have tax rates that are lower than the U.S. statutory rate. See “Critical Accounting Policies, Judgments and Estimates” for further details on the increase in the valuation allowance.

Net Income (Loss)

Our net loss for the year ended December 31, 2006 was $145.1 million as compared to a net income of $17.5 million in 2005 as a result of the factors described above.

Twelve Months Ended December 31, 2005 Compared To Twelve Months Ended December 31, 2004

Net Sales

Net sales increased by $9.5 million, or 1.5%, from $640.3 million in 2004 to $649.8 million in 2005. On a constant currency basis, which assumes that foreign currency exchange rates were the same in 2005 as 2004, total Company net sales increased 1.5% from 2004 to 2005.

Net sales for each segment and its percentage of total Company net sales were as follows:

 

     Year Ended December 31,              
     2005     2004     Change  

Segment

   $(1)    % of
Total
Company
Net Sales
    $(1)    % of
Total
Company
Net Sales
    $(1)     %  

U.S. Consumer

   $ 478.3    74 %   $ 431.9    67 %   $ 46.4     11 %

International

     131.2    20 %     153.2    24 %     (22.0 )   (14 )%

SchoolHouse

     40.3    6 %     55.2    9 %     (14.9 )   (27 )%
                                    

Total Company

   $ 649.8    100 %   $ 640.3    100 %   $ 9.5     1.5 %
                                    

(1) In millions.

U.S. Consumer. Our U.S. Consumer segment’s net sales increased by $46.4 million, or 11%, from $431.9 million in 2004 to $478.3 million in 2005. In our U.S. Consumer segment, net sales of platform, software and stand-alone products in dollars and as a percentage of the segment’s total net sales were as follows:

 

     Net Sales          % of Total  
     Year Ended
December 31,
   Change     Year Ended
December 31,
 
     2005(1)    2004(1)    $(1)    %     2005     2004  

Platform

   $ 196.2    $ 173.7    $ 22.5    13.1 %   41.0 %   40.2 %

Software

     145.7      128.9      16.8    13.1 %   30.5 %   29.9 %

Stand-alone

     136.4      129.3      7.1    5.6 %   28.5 %   29.9 %
                                   

Total U.S. Consumer Net Sales

   $ 478.3    $ 431.9    $ 46.4    10.8 %   100 %   100 %
                                   

(1) In millions.

 

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The net sales increase in this segment year-over-year was primarily a result of the following factors:

 

   

Introduction of our FLY Pentop Computer and related software and accessories, which began shipping to retail customers in the third quarter of 2005 for our October 2005 product launch.

 

   

Introduction of our Leapster L-MAX system in the third quarter which added to the increased demand for our screen-based platforms and related software products. In total sales of our screen-based products more than doubled.

 

   

Higher demand for our stand-alone products, specifically for our Fridge Phonics and Alphabet Pal products.

These factors were partially offset by continued decline in sales of our LeapPad family of products.

International. Our International segment’s net sales decreased by $22.0 million, or 14 %, from $153.2 million in 2004 to $131.2 million in 2005. On a constant currency basis, net sales decreased 14% from 2004 to 2005.

The net sales decrease in our International segment was primarily due to a significant decrease in our United Kingdom and Canadian markets. Factors driving this decline were:

 

   

Lower demand for our LeapPad family of products.

 

   

Weak sales forecasting and inventory production planning processes, which caused a few key items to be out of stock in the third and fourth quarters of 2005, resulting in lost sales.

 

   

Increased competition in our screen-based platforms.

These negative factors were partially offset by sales growth in Mexico, Spain and France.

SchoolHouse. Our SchoolHouse segment’s net sales decreased by $14.9 million, or 27.0% from $55.2 million in 2004 to $40.3 million in 2005. Our SchoolHouse segment’s net sales decline was primarily a result of the following factors:

 

   

Transition in management and attrition of key sales personnel due to an investigation related to a transaction in a large school district.

 

   

Lengthened sales cycle as we pursue orders involving larger installations, which require additional district and some state level approvals.

 

   

Release of federal funds to districts later in 2005 compared to 2004 in several key states.

By the end of 2005, we completed installation of a new leadership team, including a new SchoolHouse segment president, vice president of marketing and vice president of sales. In addition we replaced approximately 40% of our direct sales force.

Gross Profit

The gross profit in dollars for each segment and the related gross profit percentage of segment net sales were as follows:

 

     Year Ended December 31,              
     2005     2004     Change  

Segment

   $(1)    % of
Segment’s
Net Sales
    $(1)    % of
Segment’s
Net Sales
    $(1)     %  

U.S. Consumer

   $ 193.8    40.5 %   $ 158.4    36.7 %   $ 35.4     22 %

International

     59.5    45.3 %     65.6    42.8 %     (6.1 )   (9 )%

SchoolHouse

     26.3    65.3 %     35.1    63.5 %     (8.7 )   (25 )%
                            

Total Company

   $ 279.6    43.0 %   $ 259.1    40.5 %   $ 20.6     8 %
                            

(1) In millions.

 

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U.S. Consumer. The 3.8 percentage point increase in our U.S. Consumer segment’s gross profit percentage year-over-year was primarily the result of the following:

 

   

Shipments to retail customers in the third and fourth quarters of our FLY Pentop Computer and related software and accessories, which have relatively strong margins.

 

   

Reduced sales allowances in 2005 compared to 2004 when customers received allowances to offset operational issues encountered during the start up of our new distribution facility in the third quarter of 2004.

 

   

Lower freight costs in 2005 compared to 2004 when costs were incrementally higher due to the use of air freight to address certain transition issues into our Fontana warehouse in the third quarter.

 

   

Lower expense for excess and obsolete inventory compared to 2004 when we had higher expense primarily related to raw materials at the factories and slow moving products.

These factors were partially offset by increased sales throughout 2005 of our screen-based platforms, which have lower margins, and price reductions on our older platforms.

International. The 2.7 percentage point increase in our International segment’s gross profit percentage year-over-year was primarily due to favorable product mix and lower freight, warehouse and royalty expenses.

SchoolHouse. The 1.2 percentage point increase in our SchoolHouse segment’s gross profit percentage year-over-year was primarily due to favorable product mix and lower freight, warehouse and amortization of content and video expenses.

Selling, General and Administrative Expense

The selling, general and administrative expense in dollars for each segment and the related percentage of our total net sales were as follows:

 

     Year Ended December 31,              
     2005     2004     Change  

Segment

   $(1)    % of
Total
Segment’s
Net Sales
    $(1)    % of
Total
Segment’s
Net Sales
    $(1)     %  

U.S. Consumer

   $ 90.0    18.8 %   $ 82.9    19.2 %   $ 7.1     9 %

International

     14.7    11.2 %     17.1    11.2 %     (2.4 )   (14 )%

SchoolHouse

     21.5    53.4 %     20.8    37.6 %     0.7     3 %
                            

Total Company

   $ 126.2    19.4 %   $ 120.8    18.9 %   $ 5.4     5 %
                            

(1) In millions.

We record all indirect expenses in our U.S. Consumer segment and do not allocate these expenses to our International and SchoolHouse segments.

The $5.4 million increase year-over-year in selling, general and administrative expense was primarily due to the following factors affecting our U.S. Consumer segment:

 

   

Higher legal expense of approximately $3.2 million primarily attributable to enforcing our patents.

 

   

External support costs of approximately $2.8 million primarily related to process improvements within our supply chain operation.

 

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Higher employee costs resulting from restructuring related charges from our LeapFrog realignment plan announced during the first quarter of 2005. During 2005, we incurred approximately $2.5 million of expense due to the workforce reduction.

 

   

Higher consulting and auditing fees of $2.2 million, which primarily include expenses resulting from compliance with the Sarbanes-Oxley Act internal control requirements.

These factors were partially offset by our cost containment efforts, especially in the U.S. Consumer and International segments.

Research and Development Expense

The research and development expense in dollars for each segment and the related percentage of our total net sales were as follows:

 

     Year Ended December 31,              
     2005     2004     Change  

Segment

   $(1)    % of
Total
Segment’s
Net Sales
    $(1)    % of
Total
Segment’s
Net Sales
    $(1)     %  

U.S. Consumer

   $ 46.3    9.7 %   $ 54.3    12.6 %   $ (8.0 )   (15 )%

International

     2.7    2.0 %     3.7    2.4 %     (1.0 )   27 %

SchoolHouse

     3.4    8.5 %     3.0    5.4 %     0.4     13 %
                            

Total Company

   $ 52.4    8.1 %   $ 61.0    9.5 %   $ (8.6 )   (14 )%
                            

(1) In millions.

We classify research and development expense into two categories, product development and content development. Product development expense reflects the costs related to the conceptual design, engineering and testing stages of our platforms and stand-alone products. Content development expense reflects the costs related to the conceptual, design and testing stages of our software and books. These expenses were as follows:

 

     Year Ended December 31,        
     2005     2004     Change  
     $(1)    % of
Net Sales
    $(1)    % of
Net Sales
    $(1)     %  

Content development

   $ 26.1    4.0 %   $ 32.0    5.0 %   $ (5.9 )   (18 )%

Product development

     26.3    4.0 %     29.0    4.5 %     (2.7 )   (9 )%
                                    

Research and development

   $ 52.4    8.1 %   $ 61.0    9.5 %   $ (8.6 )   (14 )%
                                    

(1) In millions.

The $8.6 million decrease in year-over-year spending for research and development was primarily due to decreased spending in our U.S. Consumer segment for our FLY Pentop Computer platform.

 

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Advertising Expense

The advertising expenses in dollars for each segment and the related percentage of our total net sales were as follows:

 

     Year Ended December 31,              
     2005     2004     Change  

Segment

   $ (1)    % of
Total
Segment’s
Net Sales
    $ (1)    % of
Total
Segment’s
Net Sales
    $ (1)     %  

U.S. Consumer

   $ 52.5    11.0 %   $ 63.2    14.6 %   $ (10.7 )   (17 )%

International

     17.0    13.0 %     19.6    12.8 %     (2.6 )   (13 )%

SchoolHouse

     0.5    1.1 %     0.4    0.7 %     0.1     25 %
                            

Total Company

   $ 70.0    10.8 %   $ 83.2    13.0 %   $ (13.2 )   (16 )%
                            

(1) In millions.

The $13.2 million decrease in year-over-year advertising expense was primarily related to:

 

   

Cost containment efforts.

 

   

Reduced spending in our U.S. Consumer segment on in-store display units and merchandising, and the elimination of our mail-order catalog costs.

Depreciation and Amortization Expenses (excluding depreciation of tooling and amortization of content development costs, which are included in cost of sales)

Depreciation and amortization expenses increased year-over-year by $2.2 million, or 27%, from $8.0 million in 2004, to $10.1 million in 2005. As a percentage of net sales, depreciation and amortization expense increased from 1.2% in 2004 to 1.6% in 2005. The increase in depreciation and amortization expense was primarily due to higher depreciation expense for computers, capitalized software and leasehold improvements.

Income (Loss) From Operations

Income (loss) from operations in dollars and the related percentage of segment net sales were as follows:

 

     Year Ended December 31,              
     2005     2004     Change  

Segment

   $(1)     % of
Segment’s
Net Sales
    $(1)     % of
Segment’s
Net Sales
    $(1)     %  

U.S. Consumer

   $ (4.9 )   (1.0 )%   $ (49.8 )   (11.5 )%   $ 44.9     90 %

International

     24.9     19.0 %     24.9     16.3 %     0.0     0 %

SchoolHouse

     0.9     2.3 %     10.9     19.8 %     (10.0 )   (92 )%
                              

Total Company

   $ 20.9     3.2 %   $ (14.0 )   (2.2 )%   $ 34.9     249 %
                              

(1) In millions.

We record indirect expenses in our U.S. Consumer segment and do not allocate these expenses to our International and SchoolHouse segments.

U.S. Consumer. The lower year-over-year loss from operations in our U.S. Consumer segment was primarily due to higher sales and stronger gross margins, as well as lower operating expenses.

International. The year-over-year operating income increase in our International segment was primarily due to lower operating expenses, partially offset by reduced sales.

 

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SchoolHouse. The year-over-year operating income decrease in our SchoolHouse segment was due to lower sales and higher operating expenses, primarily due to increased headcount in 2005 compared to 2004.

Other

Net Interest Income and Other Income (Expense), Net. Net interest income increased by $1.7 million from $1.7 million in 2004 to $3.4 million in 2005. This increase was due to higher interest rates in 2005 on invested balances.

Tax Rate. Our effective tax rate for the year ended December 31, 2005 is 26.5% as compared to 47.6% in 2004. The change in effective tax rate was due to the mix of United States and international pre-tax income in 2005 as compared to 2004, higher research and development tax credits in 2005 and higher exempt interest income in 2005, partially offset by reduced benefits from our international sourcing operations in 2005. In 2005, we reported a pre-tax loss from our United States operations of $1,297 and a pre-tax income from our international operations of $25,094. In 2004, we reported a pre-tax loss from United States operations of $13,514 and a pre-tax income from our international operations of $1,057.

Net Income (Loss)

Net income (loss) improved by $24.0 million from a loss of $6.5 million in 2004 to income of $17.5 million in 2005 due to increased net sales, lower operating expenses and higher interest income. As a percentage of net sales, net income increased from a loss of 1.0% in 2004 to a gain of 2.5% in 2005.

Seasonality and Quarterly Results of Operations

LeapFrog’s business is highly seasonal, with our retail customers making a large percentage of all purchases in preparation for the traditional holiday season. Our business, being subject to these significant seasonal fluctuations, generally realizes the majority of our net sales and all of our net income during the third and fourth calendar quarters. These seasonal purchasing patterns and production lead times cause risk to our business associated with the under- production of popular items and over-production of items that do not match consumer demand. In addition we have seen our customers managing their inventories more stringently, requiring us to ship products closer to the time they expect to sell to consumers, increasing our risk to meet the demand for specific products at peak demand times, or adversely impacting our own inventory levels by the need to pre-build products to meet the demand.

For more information, see “Item 1A—Risk Factors—Our business is seasonal, and therefore our annual operating results depend, in large part, on sales relating to the brief holiday season” and “—If we do not maintain sufficient inventory levels or if we are unable to deliver our product to our customers in sufficient quantities, or if our or our retailers’ inventory levels are too high, our operating results will be adversely affected.”

The following table sets forth unaudited quarterly statements of operations information for 2006 and 2005. The unaudited quarterly information includes all normal recurring adjustments that management considers necessary for a fair presentation of the information shown. Given the low sales volumes in the first half of the calendar year, and the relatively fixed nature of our operating expenses, historically we have been profitable in our third and fourth quarters and unprofitable in our first and second quarters. We expect that we will continue to incur losses during the first and second quarters of each year for the foreseeable future. In addition, we were unprofitable in the fourth quarter of 2005, due to higher sales allowances, higher operating expenses and higher expense for excess and obsolete inventory. We were also unprofitable in the third and fourth quarter of 2006, due to higher inventory reserves in both quarters and a non-cash valuation allowance against our deferred tax assets in the third quarter. Relatively low sales in the third and fourth quarter of 2006 also prevented us from being able to absorb our relatively fixed operating expenses in these quarters. Because of the seasonality of our business and other factors, results for any interim period are not necessarily indicative of the results that may be achieved for the full fiscal year.

 

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     First
Quarter
    Second
Quarter
    Third
Quarter
    Fourth
Quarter
    Year Ended
December 31,
 
     (In thousands, except per share data)  

2006

          

Net sales

   $ 66,548     $ 68,118     $ 184,718     $ 182,871     $ 502,255  

Cost of sales

     41,759       51,000       135,529       126,933       355,221  
                                        

Gross profit

     24,789       17,118       49,189       55,938       147,034  

Operating expenses:

          

Selling, general and administrative

     32,851       27,989       30,150       40,938       131,928  

Research and development

     12,440       12,871       14,513       14,651       54,475  

Advertising

     6,158       8,445       16,994       43,844       75,441  

Depreciation and amortization

     2,529       2,418       2,195       2,711       9,853  
                                        

Total operating expenses

     53,978       51,723       63,852       102,144       271,697  
                                        

Income (loss) from operations

     (29,189 )     (34,605 )     (14,663 )     (46,206 )     (124,663 )

Other items

     1,740       924       2,394       1,124       6,182  
                                        

Income (loss) before provision (benefit) for income taxes

     (27,449 )     (33,681 )     (12,269 )     (45,082 )     (118,481 )

Provision (benefit) for income taxes

     (3,853 )     (7,935 )     37,472       927       26,611  
                                        

Net loss

   $ (23,596 )   $ (25,746 )   $ (49,741 )   $ (46,009 )   $ (145,092 )
                                        

Net loss per common share:

          

Basic

   $ (0.38 )   $ (0.41 )   $ (0.79 )   $ (0.73 )   $ (2.31 )

Diluted

   $ (0.38 )   $ (0.41 )   $ (0.79 )   $ (0.73 )   $ (2.31 )
     First
Quarter
    Second
Quarter
    Third
Quarter
    Fourth
Quarter
    Year Ended
December 31,
 
     (In thousands, except per share data)  

2005

          

Net sales

   $ 71,859     $ 87,066     $ 242,820     $ 248,012     $ 649,757  

Cost of sales

     44,087       49,274       134,108       142,652       370,121  
                                        

Gross profit

     27,772       37,792       108,712       105,360       279,636  

Operating expenses:

          

Selling, general and administrative

     33,209       29,013       32,739       31,226       126,187  

Research and development

     14,739       14,580       13,958       9,063       52,340  

Advertising

     6,493       6,949       13,045       43,527       70,014  

Depreciation and amortization

     2,430       2,361       2,385       2,966       10,142  
                                        

Total operating expenses

     56,871       52,903       62,127       86,782       258,683  
                                        

Income (loss) from operations

     (29,099 )     (15,111 )     46,585       18,578       20,953  

Other items

     904       1,238       692       10       2,844  
                                        

Income (loss) before provision (benefit) for income taxes

     (28,195 )     (13,873 )     47,277       18,588       23,797  

Provision (benefit) for income taxes

     (8,316 )     (4,092 )     14,492       4,213       6,297  
                                        

Net income (loss)

   $ (19,879 )   $ (9,781 )   $ 32,785     $ 14,375     $ 17,500  
                                        

Net income (loss) per common share:

          

Basic

   $ (0.32 )   $ (0.16 )   $ 0.53     $ 0.23     $ 0.28  

Diluted

   $ (0.32 )   $ (0.16 )   $ 0.52     $ 0.23     $ 0.28  

During the first quarter, our net loss increased from $19.8 million in 2005 to $23.6 million in 2006. The higher net loss was primarily attributed to a reduction of $3.0 million in gross profit. Gross profit declined was primarily due to higher sales allowances, unfavorable product mix and the impact of fixed warehouse costs on a lower sales base.

 

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During the second quarter, our net loss increased from $9.8 million in 2005 to $25.6 million in 2006. The higher loss was due to a reduction of gross profit of $20.7 million. Gross margin was unfavorably impacted by higher sales discounts and allowances and higher sales of closeout products. In addition, gross margin in the second quarter of 2005 benefited from the reduction of allowance for defective products, while allowances for defective products increased slightly in the second quarter of 2006. In addition, sales declined in all three of our segments. The decline was primarily due to continuing sales volume decline in LeapPad family of products.

During the third quarter of 2006, our net loss increased by $82.5 million compared to the same period of 2005. Our gross profit had a reduction of $59.1 million in 2006 compared to 2005, due to lower sales and higher discounts and allowances. In addition, as a result of the sales decline, combined with changing priorities related to our updated strategic direction in 2006, we recorded $21.5 million of reserves for excess and obsolete inventories in the third quarter. We also we recorded a $43.2 million non-cash charge to establish a valuation allowance against our gross domestic deferred tax assets in accordance with the criteria of Statement of Financial Accounting Standards No. 109 “Accounting for Income Taxes” (“SFAS 109”), resulting to higher income tax expense.

During the fourth quarter, our net loss increased by $60.3 million from income of $14.3 in the fourth quarter of 2005. Net sales declined approximately 27% on a consolidated basis reflecting lower LeapPad sales, and lower sales of FLY in its last selling seasons, as well as the impact of retailers working off excess retailer inventories. Gross margin decreased to 30% from 43% in 2005, mostly due to sales discounts and allowances to clear our and retailer inventories. We also recorded a $3.1 million charge on purchase orders for inventory that we cancelled. In addition, during the fourth quarter of 2006, we recorded charges for employee termination costs in selling, general and administrative expense of $3.7 million.

Liquidity and Capital Resources

LeapFrog’s primary sources of liquidity in 2006 and 2005 have been:

 

   

Net cash flows provided by operating activities in 2006.

 

   

Proceeds from the exercise of employee stock options and the employee stock purchase plan in 2006 and 2005.

Cash and related balances are:

 

     December 31,  
     2006(1)     2005(1)     Change(1)  

Cash and cash equivalents

   $ 67.3     $ 48.4     $ 18.9  

Short-term investments

     80.8       23.7       57.1  
                        

Total

   $ 148.1     $ 72.1     $ 76.0  
                        

% of total assets

     33 %     12 %  

Restricted Cash

      

Short-term

   $ —       $ 0.2     $ (0.2 )

(1) In millions

Financial Condition

We believe our current cash and short-term investments, anticipated cash flow from operations, and future seasonal borrowings, if any, will be sufficient to meet our working capital and capital requirements through at least the end of 2007.

Cash and cash equivalents increased $18.9 million in 2006 to $67.3 million from $48.4 million in 2005. Together with short-term investments, the increase was $76.0 million. The increase was primarily due to the reduction in inventory and accounts receivable, partially offset by reduced earnings. At December 31, 2006, we

 

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had no restricted cash compared to $0.2 of restricted cash at December 31, 2005, which was used to collateralize a single standby letter of credit to an insurance provider. The standby letter of credit guarantees expected claims under our commercial and general liability protection policy.

The change in cash and cash equivalents is as follows:

 

     December 31,  
     2006(1)     2005(1)     Change(1)  

Net cash (used in) provided by operating activities

   $ 90.4     $ (24.7 )   $ 115.1  

Net cash used in investing activities

     (77.3 )     —         (77.3 )

Net cash provided by (used in) financing activities

     4.0       10.3       (6.3 )

Effect of exchange rate changes on cash

     1.8       2.3       (0.5 )
                        

Increase (decrease) in cash and cash equivalents

   $ 18.9     $ (12.1 )   $ 31.0  
                        

(1) In millions

Our cash flow is very seasonal and the vast majority of our sales historically occur in the last two quarters of the year as retailers expand inventories for the holiday selling season. Our accounts receivable balances are generally the highest in the last two months of the fourth quarter, and payments are not due until the first quarter of the following year. The following table shows quarterly cash flows from operating activities data that illustrate the seasonality of our business.

 

     Cash Flow From Operating
Activities
 
     2006(1)     2005(1)     2004(1)  

1st Quarter

   $ 133.1     $ 90.6     $ 108.3  

2nd Quarter

     (21.2 )     65.3       (31.8 )

3rd Quarter

     (40.1 )     (20.6 )     (48.5 )

4th Quarter

     18.5       (110.6 )     (27.9 )
                        

Total

   $ 90.3     $ 24.7     $ 0.1  
                        

(1) In millions

In November 2005, we entered into a $75 million asset-based revolving credit facility with Bank of America. Availability under this agreement was $74.95 million as of December 31, 2006. The borrowing availability varies according to the levels of our accounts receivable, cash and investment securities deposited in secured accounts with the administrative agent or other lenders. Subject to the level of this borrowing base, we may make and repay borrowings from time to time until the maturity of the facility. The interest rate for our revolving credit facility will vary based on utilization. The revolving credit facility contains a fixed charge coverage ratio, which is measured only if certain availability thresholds are not met. We are required to maintain a ratio of at least 1.0 to 1.0 when the covenant is required to be tested. We have not been required to test this covenant. The maturity date of the facility is November 8, 2010, at which time all borrowings under the facility must be repaid. We may make voluntary prepayments of borrowings at any time. We must pay an early termination fee of 0.5% if the facility is terminated prior to November 8, 2007.

The revolving credit facility contains customary events of default, including payment failures; failure to comply with covenants; failure to satisfy other obligations under the credit agreements or related documents; defaults in respect of other indebtedness; bankruptcy, insolvency and inability to pay debts when due; material judgments; change in control provisions and the invalidity of the guaranty or security agreements. The cross-default provision applies if a default occurs on other indebtedness in excess of $5.0 million and the applicable grace period in respect of the indebtedness has expired, such that the lender of, or trustee for, the defaulted indebtedness has the right to accelerate. If an event of default occurs, the lenders may terminate their commitments, declare immediately all borrowings under the credit facility as due and foreclose on the collateral.

 

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We estimate that our capital expenditures for 2007 will be similar to prior years. In 2006 and 2005, capital expenditures were $20.1 million and $16.7 million, respectively. The capital expenditures will be primarily for new products and purchases related to the upgrading of our information technology capabilities.

Operating activities

Net cash provided by operating activities was $90.4 million in 2006. In 2005, net cash used in operating activities was $24.7 million and $0.1 million was provided by operating activities in 2004. The $115.1 million increase in net cash provided by operating activities from 2005 to 2006 was primarily due to reduced inventory levels and improved accounts receivable collection.

Working Capital—Major Components

Accounts receivable

Gross accounts receivable decreased to $142.6 million at December 31, 2006 from $259.1 million at December 31, 2005. Allowances for doubtful accounts decreased to $0.8 million at December 31, 2006 from $1.3 million at December 31, 2005. As a percentage of gross accounts receivable, allowances for doubtful accounts increased to 0.6% at December 31, 2006 from 0.5% at December 31, 2005. The increase in the allowance for doubtful accounts percentage was primarily due to the reduction of sales and in customer claims caused by improved logistics and operational procedures in our U.S. Consumer segment. Our days-sales outstanding, or DSO, at December 31, 2006 was 70.7 days compared to 93.3 days at December 31, 2005. The decrease in accounts receivable was driven by lower sales and earlier cash collections.

Inventories

Inventories, net of allowances, were $73.0 million at December 31, 2006 and $169.1 million at December 31, 2005. Inventory decreased by $96.1 million, or 56% from December 31, 2005 to December 30, 2006. The decline in our inventory compared to 2005 is primarily caused by our continuing effort to reduce the levels of inventory. In addition, excess and obsolete allowance increased by $9.9 million to reflect our expectations about future sales decline of existing products as well as products that will be replaced or discontinued resulting from our updated strategic direction. We have implemented strategies to better forecast and control our inventories.

Inventories consisted of the following:

 

     December 31,  
     2006(1)     2005(1)     Change(1)  

Raw materials

   $ 6.7     $ 32.0     $ (25.3 )

Work in process

     8.1       11.2       (3.1 )

Finished goods

     92.3       150.6       (58.3 )

Allowances

     (34.1 )     (24.7 )     (9.4 )
                        

Inventories, net

   $ 73.0     $ 169.1     $ (96.1 )
                        

(1) In millions.

Raw materials reduced by $25.2 million reflecting the full implementation of our turnkey arrangements, which allows our engineering resources to focus on product design and manufacturability while our contract manufacturers manage the supply of raw materials.

Deferred income taxes

We recorded gross domestic current deferred tax assets of $15.1 million at December 31, 2006 and $16.6 million at December 31, 2005. The year-over-year decrease in our gross current deferred income tax asset was

 

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primarily due to the timing of realizing other deferred tax assets. The December 31, 2006 gross current deferred tax assets were offset with a valuation allowance of $15.1 million.

We recorded gross domestic non-current deferred tax assets of $45.3 million at December 31, 2006 and $16.6 million at December 31, 2005. The $28.8 million increase was primarily due to net operating losses and additional research and development credits available to be carried forward in future periods. The December 31, 2006 gross current deferred tax assets were offset with a valuation allowance of $45.3 million. Current and non-current deferred income taxes totaling $1.3 million on the balance sheet relate to our non U.S. jurisdictions.

Other assets

Other assets had a balance of $9.7 million December 31, 2006 and $6.8 million December 31, 2005, respectively. The increase over the previous year was primarily due to approximately $2.9 million for royalties prepaid for periods more than twelve months after December 31, 2006.

Accounts payable

Accounts payable was $46.7 million at December 31, 2006 and $74.3 million at December 31, 2005. The decrease in accounts payable reflect reduced inventory purchases during 2006 compared to 2005.

Investing activities

Net cash used in investing activities was $77.2 million in 2006, compared to net cash provided by investing activities of less than $0.1 million in 2005. The primary components of net cash used in investing activities for 2006 compared to 2005 were:

 

   

Net sales and purchases of short- and long-term investments of $57.0 million in 2006 compared with net sales and purchases of investments of $16.7 million in 2005.

 

   

Purchases of property and equipment of $20.1 million in 2006 related primarily to computers and software, capitalized content and leasehold improvements.

Financing activities

Net cash provided by financing activities was $ 3.1 million in 2006 compared to $10.3 million for the same period in 2005. The primary component of cash provided by financing activities in both years were proceeds received from the exercise of stock options and purchases of our common stock pursuant to our employee stock purchase plan.

Contractual Obligations

We conduct our corporate operations from leased facilities and rent some equipment under operating leases. Generally, these have initial lease periods of three to twelve years and contain provisions for renewal options of five years at market rates. The following table summarizes our outstanding long-term contractual obligations at December 31, 2006.

 

     Payments Due by Period
     Total(1)    Less Than 1
Year(1)
   1-3 Years(1)    4-5 Years(1)    More Than 5
Years(1)

Operating leases

   $ 43.7    $ 7.4    $ 18.8    $ 6.5    $ 11.0

Royalty guarantees

   $ 0.6      0.6      —        —        —  

Capital leases

   $ 1.4      1.2      0.1      0.1      —  
                                  

Total

   $ 45.7    $ 9.2    $ 18.9    $ 6.6    $ 11.0
                                  

(1) In millions

 

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At December 31, 2006, we had outstanding letters of credit of less than $0.1 million, which were cash collateralized under our 2005 credit facility with Bank of America. At December 31, 2005, outstanding letters of credit were $0.2 million. At December 31, 2006, we had $74.95 million of unused lines of credit available. In addition, we had commitments to purchase inventory totaling approximately $43.3 million at December 31, 2006.

Recent Accounting Pronouncements

In February 2006, the Financial Accounting Standard Board (“FASB”) issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments—An Amendment of FASB Statements No. 133 and 140” (“SFAS 155”). SFAS 155 permits hybrid financial instruments containing embedded derivative to be measured at fair value at acquisition, or at issuance. SFAS 155 requires that previously recognized financial instrument is subject to a remeasurement (new basis) event, on an instrument-by-instrument basis, in cases in which a derivative would otherwise have to be bifurcated. Change in fair value should be recognized in earnings. SFAS 155 establishes a requirement to evaluate interest in securitized financial assets to determine if they are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. The guidance is effective for all periods beginning after September 15, 2006. We do not believe that the adoption of SFAS 155 will have material impact in our consolidated financial statements.

In June 2006, the FASB ratified the consensus reached by the Emerging Issues Task Force on Issue No. 06-3, “How Sales Taxes Collected From Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement” (“EITF 06-3”). EITF 06-3 requires a company to disclose its accounting policy (i.e. gross vs. net basis) relating to the presentation of taxes within the scope of EITF 06-3. Furthermore, for taxes reported on a gross basis, an enterprise should disclose the amounts of those taxes in interim and annual financial statements for each period for which an income statement is presented. The guidance is effective for all periods beginning after December 15, 2006. We do not expect the adoption of this guidance to have material impact in our consolidated financial statements.

In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109” (“FIN 48”) which became effective for the Company on January 1, 2007. This interpretation clarifies the accounting for income tax benefits that are uncertain in nature. Under FIN 48, a company will recognize a tax benefit in the financial statements for an uncertain tax position only if management’s assessment is that its position is “more likely than not” (i.e., a greater than 50 percent likelihood) to be upheld on audit based only on the technical merits of the tax position. This accounting interpretation also provides guidance on measurement methodology, derecognition thresholds, financial statement classification and disclosures, interest and penalties recognition, and accounting for the cumulative effect adjustment. The new interpretation is intended to provide better financial statement comparability among different companies.

The expected impact of adopting FIN 48 is estimated to be an increase in our risk reserves associated with income taxes by $7—$8 million. Of this amount, less than $1 million will reduce beginning retained earnings for 2007, and the remainder will decrease net operating loss, or NOL carryforwards in the US, which are fully offset by a valuation allowance, and any subsequent impact may be recognized in provision for income taxes.

In addition to the financial statement impact of adopting FIN 48, future disclosures will also include a tabular roll-forward of unrecognized tax benefits at the beginning and end of the period; the amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate; the amounts of interest and penalties recognized in the financial statements; any expected significant impacts from unrecognized tax benefits on the financial statements over the subsequent twelve-month reporting period and a description of the tax years remaining to be examined in major tax jurisdictions. We accrued statutory interest and penalties, if any, related to liabilities for unrecognized tax benefits on our consolidated statement of operations in the provision (benefit) for income taxes.

 

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In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in the current year financial statements. SAB 108 requires registrants to quantify misstatements using both an income statement (“rollover”) and balance sheet (“iron curtain”) approach and evaluate whether either approach results in a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. If prior year errors that had been previously considered immaterial now are considered material based on either approach, no restatement is required so long as management properly applied its previous approach and all relevant facts and circumstances were considered. If prior years are not restated, the cumulative effect adjustment is recorded in opening accumulated earnings (deficit) as of the beginning of the fiscal year of adoption. SAB 108 is effective for fiscal years ending on or after November 15, 2006, with earlier adoption encouraged. We adopted the Bulletin during 2006. The adoption did not have any effect on our consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements and accordingly, does not require any new fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. We have not determined the impact of the adoption of SFAS 157 in our consolidated financial statements.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

We develop products in the United States and market our products primarily in North America and, to a lesser extent, in Europe and the rest of the world. We are billed by and pay our third-party manufacturers in U.S. dollars. Sales to our international customers are transacted primarily in the country’s local currency. As a result, our financial results could be affected by factors such as changes in foreign currency rates or weak economic conditions in foreign markets.

Beginning in the first quarter of 2004, we began managing our foreign currency transaction exposure by entering into short-term forward contracts. The purpose of this hedging program was to minimize the foreign currency exchange gain or loss reported in our financial statements. The net foreign currency exchange gain or loss for 2006, 2005 and 2004 was approximately loss of $1.0 million, gains of $0.1 million and $1.9 million, respectively.

Our foreign exchange forward contracts generally have original maturities of one month or less. A summary of all foreign exchange forward contracts that were outstanding as of December 31, 2006 follows:

 

     Average
Forward
Exchange
Rate per
$1
   Notional
Amount in
Local
Currency(1)
   Instrument
Fair Value(2)
 

British Pound (US$/GBP)

   1.974    8,448    $ 37  

Euro (US$/Euro)

   1.319    16,520      15  

Canadian Dollar (C$/US$)

   1.142    21,416      329  

Mexican Peso (MXP/US$)

   10.845    152,513      (10 )
              

Total

         $ 371  
              

(1) In thousands of local currency
(2) In thousands of U.S. dollars

Cash equivalents and short-term investments are presented at fair value on our balance sheet. We invest our excess cash in accordance with our investment policy. At December 31, 2006 and December 31, 2005, our cash

 

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was invested primarily in money market funds, municipal auction rate certificates and commercial paper. Any adverse changes in interest rates or securities prices may decrease the value of our short-term investments and operating results.

We are exposed to market risk from changes in interest rates on our outstanding cash and cash equivalents, investments and bank debt. On our cash equivalents and investments we are exposed to changes in interest rates, particularly short-term interest rates. With regards to our debt, the level of our actual average monthly borrowings determines the interest rates we pay on borrowings. The interest rate will be between prime and prime plus 0.50% or LIBOR plus 1.75% and LIBOR plus 2.50%. Prime rate is the rate publicly announced by Bank of America as its prime rate. The interest cost of our bank debt is affected by changes in either prime rate or LIBOR. We had no outstanding debt at December 31, 2006 and December 31, 2005, or any time during those years.

Item 8. Financial Statements and Supplementary Data.

Our Consolidated Financial Statements beginning at page F-1 below are incorporated herein by reference.

Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.

Not applicable

Item 9A. Controls and Procedures.

Attached as exhibits to this Form 10-K, there are the certifications of our Chief Executive Officer and the Chief Financial Officer required by Rule 13a-14(a) of the Securities Exchange Act of 1934 or the Rule 13a-14(a) Certifications. This Controls and Procedures section of the annual report on Form 10-K includes the information concerning the controls evaluation referred to in the Rule 13a-14(a) Certifications and it should be read in conjunction with the Rule 13a-14(a) Certifications for a more complete understanding of the topics presented.

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this annual report on Form 10-K, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures, or disclosure controls. This controls evaluation was performed under the supervision and with the participation of management, including our Chief Executive Officer, or CEO and Chief Financial Officer or CFO. Disclosure controls are controls and procedures designed to reasonably assure that information required to be disclosed in our reports filed under the Exchange Act, such as this report, is recorded, processed, summarized and reported within the time periods specified in the USEC’s rules and forms. Disclosure controls are also designed to reasonably assure that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

The evaluation of our disclosure controls included a review of the controls’ objectives and design, our implementation of the controls and the effect of the controls on the information generated for use in this report. In the course of the controls evaluation, we reviewed and identified data errors and control problems and sought to confirm that appropriate corrective actions, including process improvements, were being undertaken. This type of evaluation is performed on a quarterly basis so that the conclusions of management, including our CEO and CFO, concerning the effectiveness of the disclosure controls can be reported in our periodic reports on Form 10-Q and Form 10-K.

Based upon the controls evaluation, our CEO and CFO have concluded that our disclosure controls were effective as of December 31, 2006.

 

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Management’s Report on Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is a process designed by, or under the supervision of, our CEO and CFO, and effected by our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:

 

   

Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of our Company.

 

   

Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors.

 

   

Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.

Management assessed our internal control over financial reporting as of December 31, 2006, the end of our fiscal year. Management based its assessment on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO. Management’s assessment included evaluation of such elements as the design and operating effectiveness of key financial reporting controls, process documentation, accounting policies and our overall control environment.

Based on management’s assessment of our internal control over financial reporting as of December 31, 2006, management concluded that our internal control over financial reporting was effective.

Our independent registered public accounting firm, Ernst & Young LLP, has audited our Consolidated Financial Statements included in this annual report on Form 10-K and has issued a report on management’s assessment of our internal control over financial reporting as well as on the effectiveness of our internal control over financial reporting as of December 31, 2006. The report on the audit of internal control over financial reporting appears below.

Inherent Limitations on Effectiveness of Controls

LeapFrog’s management, including our CEO and CFO, does not expect that our disclosure controls or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of the effectiveness of controls to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.

Management intends to review and evaluate the design and effectiveness of its disclosure controls and procedures on an ongoing basis and to improve its controls and procedures over time and to correct any

 

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deficiencies that may be discovered in the future in order to ensure that we have timely access to all material financial and non-financial information concerning the business. While the present design of the Company’s disclosure controls and procedures is effective to achieve these results, future events affecting the Company’s business may cause management to modify its disclosure controls and procedures.

Changes in Internal Control over Financial Reporting

We took the following actions during the quarter ended December 31, 2006

 

   

Identified and hired seasoned personnel and external advisors with accounting experience commensurate with responsibilities.

 

   

Continued strengthening of personnel through training of existing staff.

 

   

Improved processes and procedures to manage oversight of control activities.

Except as noted above, there have been no changes in our internal control over financial reporting during the quarter ended December 31, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders of LeapFrog Enterprises, Inc.

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that LeapFrog Enterprises, Inc., (the “Company”) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). LeapFrog Enterprises, Inc’s. management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that LeapFrog Enterprises, Inc. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO control criteria. Also, in our opinion, LeapFrog Enterprises, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO control criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets, as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2006 and the financial statement schedule for the three years in the period ended December 31, 2006 listed in the Index at Item 15 of LeapFrog Enterprises, Inc., and our report dated March 1, 2007 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

San Francisco, California

March 1, 2007

 

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Item 9B. Other Information.

Not applicable

PART III

Certain information required by Part III is omitted from this Report on Form 10-K since we intend to file our definitive proxy statement relating to our 2007 annual meeting of stockholders, pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, also referred to in this Form 10-K as our 2007 Proxy Statement, no later than April 30, 2007, and certain information to be included in our 2007 Proxy Statement is incorporated herein by reference.

Item 10. Directors, Executive Officers and Corporate Governance

The information appearing in our 2007 Proxy Statement under the headings “Proposal 1: Election of Directors,” “Board of Directors and Corporate Governance—Committees of the Board—Audit Committee” and “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference. The information under the heading “Executive Officers of the Registrant” in Item 1 of this Form 10-K is also incorporated by reference in this section.

In April 2005, our Board of Directors adopted the LeapFrog Code of Business Conduct and Ethics, which applies to all of our employees and directors, including our Chief Executive Officer, Chief Financial Officer, who is our principal financial officer, and our Vice President and Controller, who is our principal accounting officer. In August 2006, our Board adopted a number of versions of our Code of Business Conduct and Ethics that are specifically tailored to the various international locations in which we have operations. These versions of our Code of Business Conduct and Ethics are posted in the corporate governance section of our website located at www.LeapFroginvestor.com. To date, there have been no waivers under our Code of Business Conduct and Ethics. We will disclose any reportable waivers, if and when granted, of our Code of Business Conduct and Ethics in the corporate governance section of our website located at www.LeapFroginvestor.com.

On July 17, 2006, we filed with the NYSE the Annual CEO Certification regarding LeapFrog’s compliance with the NYSE’s Corporate Governance listing standards as required by Section 303A.12(a) of the NYSE Listed Company Manual. In addition, we are filing as exhibits to this annual report, the applicable certifications of our Chief Executive Officer and our Chief Financial Officer required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, regarding the quality of the Company’s public disclosures.

Item 11. Executive Compensation

The information appearing in our 2007 Proxy Statement under the following headings is incorporated herein by reference:

 

   

“Board of Directors and Corporate Governance—Compensation of Directors”

 

   

“Board of Directors and Corporate Governance—Committees of the Board—Compensation Committee”

 

   

“Executive Compensation”

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information appearing in our 2007 Proxy Statement under the following headings is incorporated herein by reference:

 

   

“Security Ownership of Certain Beneficial Owners and Management”

 

   

“Equity Compensation Plan Information”

 

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Item 13. Certain Relationships and Related Transactions and Director Independence

The information appearing in our 2007 Proxy Statement under the following headings is incorporated herein by reference:

 

   

“Certain Relationships and Related Party Transactions”

 

   

“Board of Directors and Corporate Governance—Independence of the Board of Directors”

 

   

“Board of Directors and Corporate Governance—Committees of the Board” (first paragraph and table following only)

Item 14. Principal Accountant Fees and Services

The information appearing in our 2007 Proxy Statement under the heading “Independent Registered Public Accounting Firm Fee Information” is incorporated by reference.

 

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PART IV

Item 15. Exhibits and Financial Statement Schedules.

 

(1) Financial Statements: See “Index to Consolidated Financial Statements” at page F-1 below.

 

(2) Financial Statement Schedules: The following financial statement schedule is included as Appendix A of this report:

Valuation and Qualifying Accounts and Allowances

 

(3) The exhibits listed in the accompanying index to exhibits are filed or incorporated by reference as part of this Annual Report.

 

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

LEAPFROG ENTERPRISES, INC.
By:   /S/    WILLIAM B. CHIASSON        
 

William B. Chiasson

Chief Financial Officer and Principal Financial Officer

Date: March 8, 2007

POWER OF ATTORNEY

Each individual whose signature appears below constitutes and appoints Jeffrey G. Katz and William B. Chiasson, and each of them, his or her true and lawful attorneys-in-fact and agents with full power of substitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign any and all amendments to this report on Form 10-K, and to file the same, with all exhibits thereto and all documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or his, her or their substitute or substitutes, may lawfully do or cause to be done or by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

 

Signatures

  

Title

 

Date

/S/    JEFFREY G. KATZ        

Jeffrey G. Katz

   Chief Executive Officer (Principal Executive Officer), President and Director   March 8, 2007

/S/    WILLIAM B. CHIASSON        

William B. Chiasson

   Chief Financial Officer (Principal Financial Officer)   March 8, 2007

/S/    KAREN LUEY        

Karen Luey

   Vice President, Controller and Principal Accounting Officer   March 8, 2007

/S/    STEVEN B. FINK        

Steven B. Fink

   Chairman and Director   March 8, 2007

/S/    THOMAS J. KALINSKE        

Thomas Kalinske

   Vice Chairman and Director   March 8, 2007

/S/    STANLEY E. MARON        

Stanley E. Maron

   Director   March 8, 2007

/S/    E. STANTON MCKEE, JR.        

E. Stanton McKee, Jr.

   Director   March 8, 2007

 

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Signatures

  

Title

 

Date

/S/    DAVID C. NAGEL        

David C. Nagel

  

Director

  March 8, 2007

/S/    CADEN WANG        

Caden Wang

  

Director

  March 8, 2007

/S/    RALPH R. SMITH        

Ralph R. Smith

  

Director

  March 8, 2007

 

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LEAPFROG ENTERPRISES, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page

Report of Independent Registered Public Accounting Firm

   F-2

Consolidated Balance Sheets

   F-3

Consolidated Statements of Operations

   F-4

Consolidated Statements of Stockholders’ Equity

   F-5

Consolidated Statements of Cash Flows

   F-6

Notes to Consolidated Financial Statements

   F-7

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders of

LeapFrog Enterprises, Inc.

We have audited the accompanying consolidated balance sheets of LeapFrog Enterprises, Inc. (the “Company”), as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedule for the three years in the period ended December 31, 2006 listed in the Index at Item 15. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with the auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of LeapFrog Enterprises, Inc. at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

As discussed in Note 2 to the financial statements, effective January 1, 2006 the Company adopted FASB Statement No. 123(R), Share-Based Payments.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of LeapFrog Enterprises, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 1, 2007 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

San Francisco, California

March 1, 2007

 

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LEAPFROG ENTERPRISES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)

 

     December 31,  
     2006     2005  

ASSETS

    

Current assets:

    

Cash and cash equivalents

   $ 67,314     $ 48,422  

Short-term investments

     80,784       23,650  

Restricted cash

     —         150  

Accounts receivable, net of allowances of $785 and $1,328 at December 31, 2006 and 2005, respectively

     141,816       257,747  

Inventories, net

     73,020       169,072  

Prepaid expenses and other current assets

     23,339       21,319  

Deferred income taxes

     1,156       10,715  
                

Total current assets

     387,429       531,075  

Property and equipment, net

     27,794       23,817  

Deferred income taxes

     148       16,588  

Intangible assets, net

     25,933       27,574  

Other assets

     9,137       6,775  
                

Total assets

   $ 450,441     $ 605,829  
                

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Current liabilities:

    

Accounts payable

   $ 46,720     $ 74,329  

Accrued liabilities and deferred revenue

     50,001       44,225  

Income taxes payable

     724       1,781  
                

Total current liabilities

     97,445       120,335  

Long-term liabilities

     19,034       19,171  

Stockholders’ equity:

    

Class A common stock, par value $0.0001; 139,500 shares authorized; shares issued and outstanding: 35,455 and 34,853 at December 31, 2006 and 2005

     4       3  

Class B common stock, par value $0.0001; 40,500 shares authorized; 27,614 shares issued and outstanding at December 31, 2006 and 2005

     3       3  

Treasury stock

     (185 )     (148 )

Additional paid-in capital

     343,310       342,595  

Deferred compensation

     —         (9,855 )

Accumulated other comprehensive income

     3,122       925  

(Accumulated deficit) retained earnings

     (12,292 )     132,800  
                

Total stockholders’ equity

     333,962       466,323  
                

Total liabilities and stockholders’ equity

   $ 450,441     $ 605,829  
                

See accompanying notes.

 

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LEAPFROG ENTERPRISES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

 

     Year Ended December 31,  
     2006     2005     2004  

Net sales

   $ 502,255     $ 649,757     $ 640,289  

Cost of sales

     355,221       370,121       381,244  
                        

Gross profit

     147,034       279,636       259,045  

Operating expenses:

      

Selling, general and administrative

     131,928       126,187       120,810  

Research and development

     54,475       52,340       60,997  

Advertising

     75,441       70,014       83,263  

Depreciation and amortization

     9,853       10,142       7,958  
                        

Total operating expenses

     271,697       258,683       273,028  
                        

Income (loss) from operations

     (124,663 )     20,953       (13,983 )

Interest expense

     (97 )     (68 )     (15 )

Interest income

     7,186       3,366       1,717  

Other (expense) income, net

     (907 )     (454 )     (176 )
                        

Income (loss) before provision (benefit) for income taxes

     (118,481 )     23,797       (12,457 )

Provision (benefit) for income taxes

     26,611       6,297       (5,929 )
                        

Net income (loss)

   $ (145,092 )   $ 17,500     $ (6,528 )
                        

Net income (loss) per common share:

      

Basic

   $ (2.31 )   $ 0.28     $ (0.11 )

Diluted

   $ (2.31 )   $ 0.28     $ (0.11 )

Shares used in calculating net income (loss) per common share:

      

Basic

     62,817       61,781       59,976  

Diluted

     62,817       62,329       59,976  

 

See accompanying notes.

 

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LEAPFROG ENTERPRISES, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(In thousands)

 

    Class A
Common
Stock
  Class B
Common
Stock
  Treasury
Stock
    Additional
Paid-In
Capital
    Deferred
Compen-
sation
    Accumulated
Other
Comprehen-
sive (Loss/
Income)
    Retained
Earnings
(Accumulated
Deficit)
    Total
Stock-
holders’
Equity
 

Balances at December 31, 2003

  $ 3   $ 3   $ —       $ 294,976     $ (2,492 )   $ 828     $ 121,828     $ 415,146  

Amortization of deferred compensation

    —       —       —         —         1,691       —         —         1,691  

Deferred compensation

    —       —       —         1,523       (1,523 )     —         —         —    

Reversal of deferred compensation due to employee termination

    —       —       —         (324 )     324       —         —         —    

Class A common stock issued upon exercise of stock option and employee purchase plan (1,759 shares)

          13,016             13,016  

Issuance of stock options to nonemployees

    —       —       —         426       —         —         —         426  

Tax benefit of stock option exercises and other

          9,179             9,179  

Comprehensive income (loss):

                  —    

Net loss

    —       —       —         —         —         —         (6,528 )     (6,528 )

Cumulative translation adjustment

    —       —       —         —         —         1,570       —         1,570  
                     

Total comprehensive loss

    —       —       —         —         —         —         —         (4,958 )
                                                           

Balances at December 31, 2004

    3     3     —         318,796       (2,000 )     2,398       115,300       434,500  

Amortization of deferred compensation

    —       —       —         —         2,642       —         —         2,642  

Deferred compensation

    —       —       —         11,692       (11,692 )     —         —         —    

Reversal of deferred compensation due to employee termination

    —       —       —         (1,195 )     1,195       —         —         —    

Class A common stock issued upon exercise of stock option and employee purchase (1,421 shares)

          10,597         —         —         10,597  

Issuance of stock options to nonemployees

    —       —       —         43       —         —         —         43  

Tax benefit of stock option exercises

    —       —       —         2,662       —         —         —         2,662  

Treasury stock

    —       —       (148 )     —         —         —         —         (148 )

Comprehensive income:

    —       —       —         —         —         —         —         —    

Net income

    —       —       —         —         —         —         17,500       17,500  

Cumulative translation adjustment

    —       —       —         —         —         (1,473 )     —         (1,473 )
                     

Total comprehensive income

    —       —       —         —         —         —         —         16,027  
                                                           

Balances at December 31, 2005

    3     3     (148 )     342,595       (9,855 )     925       132,800       466,323  

Stock-based compensation

          (2,552 )     9,855           7,303  

Class A common stock issued upon exercise of stock option and employee purchase plan (602 shares)

    1         4,058             4,059  

Issuance of stock options to nonemployees

          8             8  

Tax related to stock-based compensation

          (321 )           (321 )

Treasury stock

        (37 )             (37 )

Other

          (478 )           (478 )

Comprehensive income (loss):

                  —    

Net loss

                (145,092 )     (145,092 )

Cumulative translation adjustment

              2,197         2,197  
                     

Total comprehensive loss

                  (142,895 )
                                                           

Balances at December 31, 2006

  $ 4   $ 3   $ (185 )   $ 343,310     $ —       $ 3,122     $ (12,292 )   $ 333,962  
                                                           

See accompanying notes.

 

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LEAPFROG ENTERPRISES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

 

     Year Ended December 31,  
     2006     2005     2004  

Net income (loss)

   $ (145,092 )   $ 17,500     $ (6,528 )

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:

      

Depreciation

     16,285       17,579       16,186  

Amortization

     1,641       1,923       1,872  

Unrealized foreign exchange (gain) loss

     427       (3,733 )     (5,029 )

Provision for doubtful accounts

     (306 )     (123 )     3,225  

Deferred income taxes

     25,999       4,339       (19,252 )

Stock-based compensation

     7,303       2,642       1,691  

Tax benefit from stock-based compensation

     109       2,662       9,179  

Other changes in operating assets and liabilities:

      

Accounts receivable

     116,237       (29,437 )     52,445  

Inventories

     96,052       (37,883 )     (38,488 )

Prepaid expenses and other current assets

     (2,578 )     (7,998 )     (3,172 )

Other assets

     (2,361 )     (6,526 )     801  

Accounts payable

     (27,609 )     11,518       (23,667 )

Accrued liabilities and deferred revenue

     5,776       (10,007 )     7,683  

Long-term liabilities

     (136 )     12,138       727  

Income taxes payable

     (499 )     563       1,668  

Other

     (847 )     138       759  
                        

Net cash provided by (used in) operating activities

     90,401       (24,705 )     100  
                        

Investing activities:

      

Purchases of property and equipment

     (20,318 )     (16,668 )     (20,546 )

Purchase of intangible assets

     —         —         (6,320 )

Purchases of investments

     (509,395 )     (300,790 )     (260,467 )

Sale of investments

     452,261       317,467       287,216  
                        

Net cash provided by (used in) investing activities

     (77,452 )     9       (117 )
                        

Financing activities:

      

Cash used to collateralize letter of credit

     —         (150 )     —    

Proceeds from release of restricted cash

     150       —         —    

Purchase of treasury stock

     (37 )     (148 )     —    

Proceeds from the exercise of stock options and employee stock purchase plan

     4,059       10,597       13,016  
                        

Net cash provided by financing activities

     4,172       10,299       13,016  
                        

Effect of exchange rate changes on cash

     1,771       2,260       2,241  
                        

Increase in cash and cash equivalents

     18,892       (12,137 )     15,240  

Cash and cash equivalents at beginning of period

     48,422       60,559       45,319  
                        

Cash and cash equivalents at end of period

   $ 67,314     $ 48,422     $ 60,559  
                        

Supplemental Disclosure of Cash Flow Information

      

Cash paid during the year for:

      

Income taxes, net of refunds

   $ 4,321     $ 1,433     $ 2,111  

Noncash investing and financing activities:

      

Restricted stock and restricted stock units granted to employees

   $ 4,058     $ 11,692     $ 1,523  

Assets acquired under capital lease

     —       $ 1,192       —    

Technology license payable

   $ —       $ —       $ 1,000  

See accompanying notes.

 

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share and percent data)

 

1. Description of Business

LeapFrog Enterprises, Inc. (the “Company”), creates and markets products which make learning fun with connected, innovative technology that teaches and engages in the world’s largest markets. The Company designs and develops technology-based educational platforms with curriculum interactive software content and stand-alone products. These products are for sale through retailers, distributors and directly to schools. The Company operates three business segments namely U.S. Consumer, International, and SchoolHouse (formerly referred to as “Education and Training”). To date, the Company has established its brands and products primarily for children up to age 12 in the U.S. retail markets and in a number of international retail markets. Sales in the U.S. Consumer and International segments, the largest business segments, currently are generated in the toy aisles of retailers. Sales of products in the SchoolHouse segment are predominantly to educational institutions.

Based on voting control, the Company is a subsidiary of Mollusk Holdings, LLC.

 

2. Summary of Significant Accounting Policies

Basis of Presentation

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, primarily those organized in the United Kingdom, Canada, Macau (which includes Hong Kong), France, Mexico and China. Intercompany accounts and transactions have been eliminated in consolidation.

Certain amounts in the financial statements for prior years have been reclassified to conform to the current year presentation.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions affecting the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Revenue Recognition

The Company recognizes revenue when products are shipped and title passes to the customer provided that there are no significant post-delivery obligations to the customer and collection is reasonably assured. Net sales represent gross sales less negotiated price allowances based primarily on volume purchasing levels, estimated returns, allowances for defective products, markdowns, and other sales allowances for customer promotions.

Sales allowances may vary as a percentage of gross sales due to changes in the Company’s product mix, defective product allowances or other sales allowances. Sales returns, discounts and allowances were $132,343, $117,226 and $136,441 for the years ended December 31, 2006, 2005 and 2004, respectively. Actual amounts for returns and allowances may differ from the Company’s estimates.

Allowances for Accounts Receivable

The Company reduces accounts receivable by an allowance for amounts it believes will become uncollectible. This allowance is an estimate based primarily on management’s evaluation of the customer’s financial condition, past collection history and aging of the accounts receivable balances.

 

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share and percent data)

 

The Company also provides estimated allowances for product returns, chargebacks, promotions and defectives on product sales in the same period that it records the related revenue. The Company estimates allowances by utilizing historical information for existing products. For new products, the Company estimates allowances for product returns based on specific terms for product returns and its experience with similar products.

The Company discloses its allowances for doubtful accounts on the face of the balance sheet. Other receivable allowances include allowances for product returns, chargebacks, defective products and promotional markdowns. Other allowances totaled $41,522 at December 31, 2006 and $44,415 at December 31, 2005.

Shipping and Handling Costs

Costs to ship merchandise from the Company’s warehouse facilities to customers are recorded in cost of goods sold.

Content and Video Capitalization and Amortization

The Company capitalizes certain external costs related to the content development of its books. Amortization of these costs begins when books are initially released for sale and continues over a three-year life using the sum of the year’s digits method. In the years ended December 31, 2006, 2005, 2004, the Company capitalized $8,473, $3,915 and $1,965, respectively, and amortized $3,537, $2,643 and $3,261, respectively, of external content development costs. Capitalized content development is included in property and equipment, and the related amortization is included in cost of sales. In 2006, the Company accelerated amortization of $212 of capitalized content related to titles not planned to be sold.

The Company capitalizes costs related to the production of home video in accordance with AICPA Statement of Accounting Position No. 00-2, “Accounting by Producers or Distributors of Film.” Video production costs are amortized based on the ratio of the current period’s gross revenues to estimated remaining total gross revenues from all sources on an individual production basis. During the year ended December 31, 2006, the Company had no capitalized video production costs. In the years December 31, 2005 and 2004, the Company capitalized $213 and $1,364 respectively. For the years ended December 31, 2006, 2005 and 2004, the Company amortized $249, $1,038 and $684 of video production costs, respectively. Capitalized video production cost is included in property and equipment, and the related amortization is included in cost of sales. During the year ended December 31, 2005, the Company accelerated amortization of capitalized video production costs totaling $377.

Advertising Expense

Production costs of commercials and programming are expensed when the production is first aired. The costs of advertising, in-store displays and promotion programs are expensed as incurred. Advertising costs associated with cooperative advertising are accrued as the related revenue is recognized. Prepaid advertising was $198 and $294 at December 31, 2006 and 2005, respectively.

Translation of Foreign Currencies

Assets, liabilities and results of the Company’s operations outside of the United States are recorded based on their functional currency. When included in these consolidated financial statements, the assets and liabilities

 

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share and percent data)

 

are translated at period-end exchange rates and revenues and expenses are translated at the average of the monthly exchange rates that were in effect during the year. The resulting translation adjustments are included as a separate component of equity. Foreign currency transaction gains and losses are included in income as incurred.

Derivative Financial Instruments

The Company transacts business in various foreign currencies, primarily in the British Pound, Canadian Dollar, Euro and Mexican Peso. In order to protect itself against reductions in the value and volatility of future cash flows caused by changes in currency exchange rates, the Company implemented a foreign exchange hedging program for its transaction exposure on January 9, 2004. The program utilizes foreign exchange forward contracts to enter into fair value hedges of foreign currency exposures of underlying non-functional currency monetary assets and liabilities that are subject to remeasurement. The exposures are generated primarily through intercompany sales in foreign currencies. The hedging program reduces, but does not always eliminate, the impact of the remeasurement of balance sheet items due to movements of currency exchange rates.

The Company does not use forward exchange hedging contracts for speculative or trading purposes. In accordance with SFAS No. 133, “Accounting For Derivative Instruments and Hedging Activities,” all forward contracts are carried on the balance sheet at fair value as assets or liabilities and the corresponding gains and losses are recognized immediately in earnings to offset the changes in fair value of the assets or liabilities being hedged. These gains and losses are included in “Other income (expense), net” on the statement of operations. The estimated fair values of the Company’s forward contracts are based on quoted market prices.

Cash and Cash Equivalents

Cash and cash equivalents consist of cash and money market funds.

Investments

Short-term investments consist primarily of auction rate certificates and commercial paper. Interest rates on auction rate certificates are reset at every auction date, generally every seven to forty-nine days, depending on the certificate. Although original maturities of these instruments are generally longer than one year, the Company has the right to sell these securities each auction date.

The Company classifies all investments as available-for-sale. Available-for-sale securities are carried at estimated fair value, which approximately equals cost. The Company records gains and losses, which are not material in other (expense) income, net on the consolidated statements of operations. The cost of securities sold is based on the specific identification method.

Concentration of credit risk is managed by diversifying investments among a variety of high credit-quality issuers.

Inventories

Inventories, net are stated at the lower of cost, on a first-in, first-out basis, or market value net of allowance for slow-moving, excess and obsolete inventories. The allowance for slow-moving, excess and obsolete inventories is based on management’s review of on-hand inventories compared to their estimated future usage, demand for its products, anticipated product selling prices and products planned for discontinuation. If actual future usage, demand for its products and anticipated product selling prices are less favorable than those

 

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share and percent data)

 

projected by management, additional inventory write-downs may be required. Management monitors these estimates on a quarterly basis. When considered necessary, management makes additional adjustments to reduce inventory to its net realizable value, with corresponding increases to cost of goods sold. Allowances for excess and obsolete inventory were $34,103 and $24,153 in 2006 and 2005, respectively, and are recorded as a reduction of gross inventories.

Valuation of work-in-process inventory is an estimation of the Company’s liability for products in production at the end of each fiscal period. This estimation is based upon normal production lead-times for products the Company has scheduled to receive in subsequent periods, plus a valuation of products it specifically knows are either completed or delayed in production beyond the normal lead-time flow. To the extent that actual work-in-process differs from the Company’s estimates, inventory and accounts payable may need to be adjusted.

Property and Equipment

Property and equipment are stated at cost less accumulated depreciation. Depreciation expense is calculated using the straight-line method over the estimated useful life of the assets, generally two to five years, except for leasehold improvements, which are depreciated over the shorter of the estimated related useful life of the asset or the remaining term of the lease. Amortization of equipment under capital leases is included in depreciation expense.

Included in property and equipment are manufacturing tools used to produce the Company’s products. These tools are generally depreciated over two years on a straight-line basis. The Company periodically reviews its capitalized manufacturing tools to ensure that the related product line is still in production and that the estimated useful lives of the manufacturing tools are consistent with the Company’s depreciation policy. Depreciation expense for manufacturing tools is included in cost of goods sold. During the years ended December 31, 2006, 2005, and 2004, the Company recorded accelerated depreciation of $94, $559, and $785, respectively to write-off certain tooling that will not be used in future periods.

The Company capitalizes website development costs in accordance with Emerging Issues Task Force (“EITF”) No. 00-02, “Accounting for Website Development Costs.” The costs capitalized include those to develop or acquire and customize code for web applications, costs to develop HTML web pages or develop templates and costs to create initial graphics for the website that included the design or layout of each page. These costs are amortized on a straight-line basis over two years. In the years ended December 31, 2006 and 2005, the Company capitalized $859 and $1,167, respectively, and amortized $1,046 and $653, respectively, of website development costs.

Intangible Assets

Intangible assets include the excess of purchase price over the cost of net assets acquired (Goodwill). Goodwill arose from its September 23, 1997 acquisition of substantially all the assets and business of the Company’s predecessor, LeapFrog RBT, and its acquisition of substantially all the assets of Explore Technologies on July 22, 1998 and is allocated to the U.S. Consumer segment. Pursuant to the Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), goodwill is tested for impairment at least annually. The Company determined no adjustments to the stated value of goodwill were necessary.

Intangible assets with other than indefinite lives include patents, trademarks and licenses, and are amortized on a straight-line basis over their estimated useful lives, ranging from 3 to 15 years. At December 31, 2006, the

 

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share and percent data)

 

weighted average amortization period for these intangibles was approximately 6 years. At December 31, 2006, the Company tested these intangible assets for impairment and determined that no significant adjustments to the stated values were necessary.

Income Taxes

The Company accounts for income taxes using the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using enacted tax rates and laws that will be in effect when the differences are expected to reverse. Valuation allowances are provided when it is more likely than not that all or a portion of a deferred tax asset will not be realized. In determining whether a valuation allowance is warranted, the Company takes into account such factors as prior earnings history, expected future earnings, carryback and carryforward periods, and tax strategies that could potentially enhance the likelihood of realization of a deferred tax asset.

During 2006, the Company recorded a non-cash valuation allowance of $60,433, against its gross deferred tax assets at December 31, 2006 of $60,433, of which $24,993 relates to pre-2006 deferred tax assets. The amount represents 100% of domestic deferred tax assets. The valuation allowance is calculated in accordance with the provisions of SFAS 109, which requires an assessment of both positive and negative evidence when measuring the need for a valuation allowance. The Company’s domestic net operating losses for the most recent four-year period, the expectation of additional net operating losses in 2007 and changes in its business strategy increased the uncertainty about whether the level of future profitability needed to record the deferred assets will be achieved and represented sufficient negative evidence to require a valuation allowance under the provisions of SFAS 109. The Company intends to maintain a valuation allowance until sufficient positive evidence exists to support its reversal. Should the Company determine that it would be able to realize all or part of its deferred tax assets in the future, an adjustment to the valuation allowance would be recorded in the period such determination was made. The majority of LeapFrog’s domestic deferred tax assets generally have 10-20 years until expiry or indefinite lives.

The financial statements also include accruals for the estimated amounts of probable future assessments that may result from the examination of federal, state or international tax returns. The Company’s tax accruals, tax provision, deferred tax assets or income tax liabilities may be adjusted if there are changes in circumstances, such as changes in tax law, tax audits or other factors, which may cause management to revise its estimates. The amounts ultimately paid on any future assessments may differ from the amounts accrued and may result in an increase or reduction to the effective tax rate in the year of resolution.

Comprehensive Income (Loss)

Comprehensive income (loss) is comprised of net income (loss) and gains and losses on the translation of foreign currency denominated financial statements.

Stock-Based Compensation

At December 31, 2006, the Company had stock-based compensation plans for employees and nonemployee directors which authorized the granting of various stock-based incentives including restricted stock, restricted stock units and stock options. The vesting periods for restricted stock and restricted stock units are generally three and four years, respectively. The Company also grants stock options to certain of its employees for a fixed number of shares with an exercise price generally equal to the fair value of the shares on the date of grant. These options generally vest over a four-year period.

 

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share and percent data)

 

Prior to January 1, 2006, the Company accounted for the stock-based compensation plans under the measurement and recognition provisions of APB Opinion No.25, “Accounting for Stock Issued to Employees,” and related Interpretations, permitted under Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). As a result, stock-based compensation was included as a pro forma disclosure in the Notes to the financial statements.

Effective January 1, 2006, the Company adopted the recognition provisions of Statement of Financial Accounting Standard No. 123 (R), “Share-Based Compensation” (“SFAS 123(R)”), using the modified-prospective transition method. Under this transition method, compensation cost in 2006 included the portion vesting in the period for (1) all share-based payments granted prior to, but not vested, as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (2) all share-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). Results for the prior periods have not been restated.

The fair value of each stock option granted is estimated on the date of the grant using the Black-Scholes option-pricing model. The total grant date fair value is recognized over the vesting period of the options on a straight-line basis. The weighted-average assumptions for the expected life and the expected stock price volatility used in the model require the exercise of judgment. The risk-free interest rate used in the model is based on the assumed expected life. The expected life of the options represent the period of time the options are expected to be outstanding and is based on the guidance provided in the SEC Staff Accounting Bulletin No. 107 on Share-Based Payment. Expected stock price volatility is based on a consideration of the stock’s historical and implied volatilities as well as the volatilities of other public entities in the industry. The risk-free interest rate used in the model is based on the U.S. Treasury yield curve in effect at the time of grant and has a term equal to the expected life.

Restricted stock awards and restricted stock units are payable in shares of the Company’s Class A common stock. The fair value of each restricted stock or unit is equal to the closing market price of the Company’s stock on the trading day immediately prior to the date of grant. The grant date fair value is recognized in income over the vesting period of these stock-based awards. The cost of the performance-based stock awards is expensed based on achieving pre-established financial measures, including certain stock price milestones. The Company did not achieve the related financial goals in 2004, 2005, and 2006, resulting in cancellation of the associated share grants. Stock-based compensation arrangements to non-employees are accounted for using a fair value approach. The compensation costs of these arrangements are subject to re-measurement over the vesting terms.

Impairment of Long-Lived Assets Other Than Goodwill

Long-lived assets, other than goodwill, are reviewed for impairment whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. Recoverability of assets is measured by comparison of the carrying amount of the asset to the net undiscounted future cash flows expected to be generated from the asset. If the future undiscounted cash flows are not sufficient to recover the carrying value of the assets, the assets’ carrying value is adjusted to fair value. The Company regularly evaluates its long-lived assets for indicators of possible impairment.

Recent Accounting Pronouncements

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments—An Amendment of FASB Statements No. 133 and 140” (“SFAS 155”). SFAS 155 permits hybrid

 

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share and percent data)

 

financial instruments containing embedded derivative to be measured at fair value at acquisition, or at issuance. SFAS 155 requires that previously recognized financial instruments are subject to a remeasurement (new basis) event, on an instrument-by-instrument basis, in cases in which a derivative would otherwise have to be bifurcated. Change in fair value should be recognized in earnings. SFAS 155 establishes a requirement to evaluate interest in securitized financial assets to determine if they are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. The guidance is effective for fiscal years beginning after September 15, 2006. The Company does not believe that the adoption of SFAS 155 will have a material impact in the Company’s consolidated financial statements.

In June 2006, the FASB ratified the consensus reached by the Emerging Issues Task Force on Issue No. 06-3, “How Sales Taxes Collected From Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement” (“EITF 06-3”). EITF 06-3 requires a company to disclose its accounting policy (i.e. gross vs. net basis) relating to the presentation of taxes within the scope of EITF 06-3. Furthermore, for taxes reported on a gross basis, an enterprise should disclose the amounts of those taxes in interim and annual financial statements for each period for which an income statement is presented. The guidance is effective for all periods beginning after December 15, 2006. The Company does not expect the adoption of this guidance will have a material impact in the Company’s consolidated financial statements.

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109” (FIN 48), which became effective for the Company on January 1, 2007. This interpretation clarifies the accounting for income tax benefits that are uncertain in nature. Under FIN 48, a company will recognize a tax benefit in the financial statements for an uncertain tax position only if management’s assessment is that its position is “more likely than not” (i.e., a greater than 50 percent likelihood) to be upheld on audit based only on the technical merits of the tax position. This accounting interpretation also provides guidance on measurement methodology, derecognition thresholds, financial statement classification and disclosures, interest and penalties recognition, and accounting for the cumulative effect adjustment. The new interpretation is intended to provide better financial statement comparability among different companies.

The expected impact of adopting FIN 48 is estimated to be an increase in our risk reserves associated with income taxes by $7-$8 million. Of this amount, less than $1 million will reduce beginning retained earnings for 2007, and the remainder will decrease NOL carryforwards in the US, which are fully offset by a valuation allowance, and any subsequent impact may be recognized in provision for income taxes.

In addition to the financial statement impact of adopting FIN 48, future disclosures will also include a tabular roll-forward of unrecognized tax benefits at the beginning and end of the period; the amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate; the amounts of interest and penalties recognized in the financial statements; any expected significant impacts from unrecognized tax benefits on the financial statements over the subsequent twelve-month reporting period; and a description of the tax years remaining to be examined in major tax jurisdictions.

The Company accrued statutory interest and penalties, if applicable, related to liabilities for unrecognized tax benefits on its Consolidated Statement of Income in the Provision for income taxes.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of prior-year uncorrected misstatements should be

 

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share and percent data)

 

considered when quantifying misstatements in the current year financial statements. SAB 108 requires registrants to quantify misstatements using both an income statement (“rollover”) and balance sheet (“iron curtain”) approach and evaluate whether either approach results in a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. If prior year errors that had been previously considered immaterial now are considered material based on either approach, no restatement is required so long as management properly applied its previous approach and all relevant facts and circumstances were considered. If prior years are not restated, the cumulative effect adjustment is recorded in opening accumulated earnings (deficit) as of the beginning of the fiscal year of adoption. SAB 108 is effective for fiscal years ending on or after November 15, 2006, with earlier adoption encouraged. The Company adopted the bulletin during 2006. The adoption did not have a material effect on the Company’s consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosure of fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements and accordingly, does not require any new fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. We have not determined the impact of the adoption of SFAS 157 in our consolidated financial statements.

 

3. Fair Value of Financial Instruments

At December 31, 2006 and 2005, the carrying values of the Company’s financial instruments, including cash and cash equivalents, short-term investments, foreign exchange transactions, receivables, accounts payable and accrued liabilities, approximated their fair values.

 

4. Investments

Available-for-sale securities consisted of the following classified by original maturity date:

 

     Maturing within

At December 31, 2006

   1 YR    2 YR    5 YR    5 to 10
YR
   Over 10
YR
   Total

Auction rate certificates

   $ —      $ —      $ —      $ 8,499    $ 52,300    $ 60,799

Commercial Paper

     19,985      —        —        —        —        19,985
                                         

Total short-term investments

   $ 19,985    $ —      $ —      $ 8,499    $ 52,300    $ 80,784
                                         

At December 31, 2005

   1 YR    2 YR    5 YR    5 to 10
YR
   Over 10
YR
   Total

Auction rate preferred securities

   $ —      $ —      $ —      $ —      $ 1,300    $ 1,300

Auction rate certificates

     1,000      —        1,000      —        20,350      22,350
                                         

Total short-term investments

   $ 1,000    $ —      $ 1,000    $ —      $ 21,650    $ 23,650
                                         

At December 31, 2006 and 2005, short-term investments included certificates issued by various states of the United States totaling $43,250 and $19,350 respectively.

 

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share and percent data)

 

5. Restricted Cash

At December 31, 2006, the Company had no restricted cash. At December 31, 2005, restricted cash was $150 which cash was used to collateralize a single standby letter of credit to an insurance provider. The standby letter of credit guaranteed expected claims under the Company’s commercial and general liability protection policy.

 

6. Inventories

Inventories consisted of the following:

 

     December 31,  
     2006     2005  

Raw materials

   $ 6,755     $ 31,954  

Work in process

     8,093       11,220  

Finished goods

     92,301