Blue Pacific Partners Delivers Letter to LeapFrog Board

NEW YORK, July 15, 2015 /PRNewswire/ -- Blue Pacific Partners, (together with its affiliates, "Blue Pacific"), a shareholder of LeapFrog Enterprises, Inc. ("LeapFrog" or the "Company"), today announced that it has delivered a letter to the Company's Board of Directors, the full text of which is included below. Blue Pacific also announced the following as relates to the items up for a vote at LeapFrog's Annual Meeting of Stockholders scheduled for August 13, 2015:

- Blue Pacific intends to vote "AGAINST" LeapFrog's proposal to amend the Company's Equity and Incentive Plan in light of its serious concern that the amendment to this plan incentivizes and rewards poor operating and share price performance by giving away even more shares just because the stock price fell substantially;

- Blue Pacific intends to vote "AGAINST" Director Nominee John Barbour, noting that LeapFrog's cumulative net income is negative since Mr. Barbour joined LeapFrog as CEO in March 2011 and is expected to deteriorate even further this year;

- Blue Pacific intends to vote "AGAINST" Director Nominee William Chiasson, who has been with LeapFrog since November 2004. Since becoming a director in March 2010, LeapFrog's cumulative net income is negative;

- Blue Pacific intends to vote "AGAINST" Director Nominee Thomas Kalinske, who has been a director since 1997. During his almost 18-year tenure, LeapFrog's cumulative net income is greater than negative $200 million;

- Blue Pacific intends to vote "AGAINST" Director Nominee Stanley Maron, who has been a director since 1997.  During his almost 18-year tenure, LeapFrog's cumulative net income is greater than negative $200 million;

- Blue Pacific intends to vote "AGAINST" Director Nominee Stanton McKee, who has been a director since 2003. Cumulative net income during Mr. McKee's tenure is greater than negative $200 million; and

- Blue Pacific intends to vote "AGAINST" Director Nominee Caden Wang, who has been a director since 2005. Cumulative net income during Mr. Wang's tenure is greater than negative $200 million.

Blue Pacific notes that the Company's Class B shareholders, who have ten votes per share, may convert their Class B shares to Class A shares at any time, and such conversion would greatly improve shareholder democracy and governance.

Blue Pacific Partners also notes that Michael Milken, Sandra Milken and Lowell Milken have a combined voting power of 39.9% of LeapFrog, and looks forward to engaging with all voting shareholders at the Annual Meeting in August to review the Board's track record and discuss the merits and rationale for continuing to elect longstanding directors who have overseen substantial underperformance and a flawed strategy.

The full text of the letter Blue Pacific Partners delivered to LeapFrog's Board of Directors follows:

July 15, 2015

The Board of DirectorsLeapFrog Enterprises, Inc.6401 Hollis Street, Suite 100Emeryville, California 94608

Dear Members of the Board,

Blue Pacific Partners, LLC, together with its affiliates ("Blue Pacific", "we" or "us"), is a shareholder of LeapFrog Enterprises, Inc. ("LeapFrog" or the "Company"). LeapFrog represents a significant investment for us.  By way of background, Blue Pacific is an investment firm that uses a fundamental, research-driven process to identify suitable investment candidates.  We invested in LeapFrog because we believe that it is one of the most well-regarded and recognized brands in the infant and toddler toy industry.  Despite the Company's poor performance, we believe that with a new strategic direction there is a significant opportunity to enhance value for the benefit of all LeapFrog shareholders. 

We have carefully studied and analyzed LeapFrog's business and prospects. We are writing to you to express our concerns regarding the current direction of the Company and to outline our views regarding the strategic initiatives that we believe must be implemented in order to put the Company back on track toward profitability.  We hope that you will take our concerns and ideas seriously so that we can work constructively with you and members of the management team to enhance value at LeapFrog. 

Financial Underperformance

Since LeapFrog's initial public offering in 2002, the Company has generated over $6.5 billion in sales and just under $3 billion in gross profit. Today, the brand is one of the most well-regarded and recognized brands in the infant and toddler toy industry.  Unfortunately, LeapFrog's business strategy has proven to be risky and unprofitable.  Despite generating healthy levels of gross profit, LeapFrog's cumulative losses since going public are in excess of $200 million, as displayed in the chart below.

Comparing LeapFrog to its publicly traded peers demonstrates that its underperformance is not a toy industry problem, but is rather unique to LeapFrog.

Why can't LeapFrog generate more consistent profits? A casual observer might suggest that LeapFrog simply lacks the size and scale of its competitors; however, this is clearly not the case.  LeapFrog competitor VTech's North American business, for example, is roughly the same size as LeapFrog's, yet VTech is very successful.  Further, private toy company Melissa & Doug continues to enjoy profitable growth despite its relatively small size.1

Flawed Strategy

We believe LeapFrog's financial woes are the direct result of a flawed strategy.  LeapFrog has continuously targeted a category that, while possessing strong consumer appeal and the illusion of growth, ultimately proves to have minimal barriers to entry.  Competition responds quickly, and sales and profits fall dramatically.

LeapFrog derives revenue from two key sources: Multimedia Learning Products (MLP) and Learning Toys. The MLP segment includes LeapPad, educational apps and content, the LeapReader, and LeapTV.  The Learning Toys segment is the more traditional toy category, and includes MyPal Scout, Fridge Phonics, and other learning toys that cultivate fine motor skills and other critical early-development skills.

As the table above illustrates, the MLP segment has been incredibly volatile, with sales rising dramatically in 2012 only to be nearly cut in half last year.  While the Company's Learning Toys segment has been more stable, its revenues have declined as well. Blue Pacific believes this decline is attributable to the Company's focus on the MLP segment at the expense of its Learning Toys segment as LeapFrog's competitors have experienced growth in their traditional learning toy categories.  

Consider VTech, a major competitor of LeapFrog. VTech employs a business strategy that is in stark contrast to LeapFrog's, by emphasizing traditional learning toys ("Standalone Products") over tablets and content (VTech refers to its tablet and content business as "Platform Products").  VTech's results are telling:

"In contrast to children's educational tablets, standalone products recorded growth in sales... In the US, VTech became the number one manufacturer in Infant and Preschool Electronic Learning toys. In the financial year 2015, standalone products accounted for approximately 77% of total ELPs revenue, while platform products accounted for about 23%."

                                                - VTech Letter to Shareholders, 2015 Annual Report

VTech has experienced fairly consistent and healthy operating margins, which we believe are the result of its implementation of a strategy that emphasizes traditional learning toys over tablets and content.  Similarly, competitor Melissa & Doug, which also focuses on traditional toys, continues to enjoy double-digit profitable growth despite the increased penetration of tablets and apps in the infant and toddler toy market.1

An argument that "it is hard to make money in traditional toys" is simply not true. While it is certainly not "easy" to make money in this space, a disciplined and consistent approach is certainly paying off for others. LeapFrog's primary competitors all do very well in the space, and we believe LeapFrog could do very well over time too, given its premium brand and broad distribution.

The problems with allocating time and resources to the tablet and content segment are simple: there are virtually no barriers to entry, penetration rates are now very high, and new competitors enter the field every year.  Earning any profit, let alone an acceptable return on capital, is incredibly difficult, and at this point in time, seemingly unattainable.

LeapFrog was an early innovator by developing a tablet aimed at toddlers, but the Company has failed to adequately react to an evolving market. Today, not only is the market flooded with both new and used tablets for people of all ages, but adults are often sharing their tablets with their children in light of the increased access to content geared toward children.  There are now hundreds of apps for tablets available for less than $5 (and often free) that compete directly with LeapFrog's content, which LeapFrog is still trying to sell for $25 to $30.

Further, the competitive landscape for toddler tablets now includes Amazon Fire Kids Edition, Nabi Jr, Dragon Touch, ProntoTec, and InnoTab, among others. The broader tablet offering is even more competitive, which includes manufacturers such as Apple, Samsung, Sony, Hewlett-Packard, LG, Dell, Toshiba, and Microsoft, to name a few.  In fact, there are over thirty (30) manufacturers of tablets today and penetration rates are very high.  We find it difficult to envision an outlook that suggests this intense level of competition is going to change any time soon.

The more traditional learning toy category is distributed through retailers such as Wal-Mart, Target, Toys R Us and Amazon.com.  There are only a handful of sizable competitors, which includes Playskool (Hasbro), Fischer-Price (Mattel), LeapFrog, VTech, Baby Einstein and Melissa & Doug. This market rarely attracts new entrants and enjoys more stable profitability.

New Strategic Direction

After a thorough assessment of the competitive landscape of both of LeapFrog's business lines, we believe the Company's shareholders would be better served by employing a strategic direction more focused on traditional toys.  We therefore believe the following strategic initiatives must be implemented immediately in order to increase value for the benefit of all LeapFrog shareholders:

1. Refocus development efforts on the traditional learning toy business;
2. Choose the most promising content and make it available for sale on competitive tablets at competitive price points;
3. Implement a plan to gradually phase out or substantially reduce the size of the tablet business; and
4. Realign the organization to enable profitability at current sales levels.

1. Refocus development efforts on the traditional toy business.

While the traditional toy business is not a high growth business, it has been fairly steady for many years.  Importantly, LeapFrog enjoys a strong reputation with broad brand recognition. A recent survey2 concluded that LeapFrog was one of the three most positively perceived brands in the industry (along with Lego and Fisher-Price).  In fact, LeapFrog not only received the highest level of positive perception at 77% but was the number one brand among moms of preschoolers ages three (3) to five (5) years.

Further, while LeapFrog may not have the economies of scale (e.g. purchasing bulk plastic and packaging) as some of its competitors, the strength of the brand should enable LeapFrog to achieve premium pricing to help offset any higher costs.  Even if LeapFrog's lack of scale requires it to pay more than Hasbro or Mattel, the penalty to gross margin is worth the trade off for stability.

In fact, a quick tour of any of the major retailers of LeapFrog's products demonstrates that LeapFrog has room for improvement in merchandising and shelf display.  LeapFrog's current offering is split between its MLP segment and traditional Learning Toys segment, the latter of which is so small that it lacks the presence of other competitors.  Enhancing the focus on learning toys should therefore yield opportunities on the merchandise front to help gain market share.

Further, LeapFrog has substantial growth opportunities abroad, particularly in Europe. International revenues represent less than one-third of LeapFrog's total sales with the United Kingdom as LeapFrog's only significant international market.  Contrast this with VTech, which had $360 million in sales in Europe in 2015 (compared to $300 million in the United States). VTech has leading positions in well-developed toy markets in the United Kingdom, Germany, France and Spain.  We believe international expansion in traditional learning toys will not only help leverage corporate overhead and R&D at LeapFrog, but will also produce purchasing synergies.

2. Choose the most promising content and make it available for sale on all tablet systems at competitive price points.

Developing educational and entertainment content and apps has become intensely competitive. Dozens of new industry participants have started offering apps and content for free or at very low prices with seemingly little or no profit motive, which is making the industry incredibly difficult to compete in profitably.

The old "razor and razor blade" model of pairing hardware and software is significantly challenged in today's world. There isn't money to be made on the razor (i.e. the tablet), and with the plethora of free to low cost apps, there is little if any money to be made on the "razor blade" now either.

While it is unclear whether developing educational and entertainment content can be a consistently profitable enterprise for any company in today's world, LeapFrog has already developed a substantial amount of content and apps over the years.  Management has been reluctant to make this content available on third party tablet platforms, however, seemingly based on its belief that it could dilute the value of the content.

Unfortunately, with the introduction of hundreds of learning and education apps by dozens of different companies, most selling below $5 per app, that ship has already sailed.  It is therefore imperative that LeapFrog move quickly to convert its most promising content to multiple operating systems so that it can be sold universally to all tablet users.

In the past four years, LeapFrog has sold over 50 million pieces of content3, or an average of over 12 million titles per year. LeapFrog may be successful selling several of its titles as "apps" at prices of $3-$4 per title, based on historical sales and current competitive offerings. Using mostly existing content, we believe this could be a high margin business for LeapFrog.  Because the future potential of this business remains uncertain, however, LeapFrog should limit its allocation of resources to this segment accordingly.

3. Implement a plan to substantially reduce and phase out of the tablet business.

In today's technologically reliant market, selling tablets is a difficult and hyper-competitive business. As described above, there are several large, well-capitalized competitors and an ever-growing inventory of new and used tablets, which makes the tablet space incredibly challenging moving forward.  Development efforts not only cost time and money, but product success is never guaranteed and typically short-lived, making the tablet industry a very competitive and high-risk industry.

Given LeapFrog's incumbent brand strength, it seems impractical for the Company to engage in such a high risk, speculative industry.  LeapFrog therefore should minimize inventory risk with these existing product lines. If the Company believes it is necessary to have a presence here, then inventory and sales need to be closely monitored and any significant forecast misses need to be held immediately accountable.

4. Realign the organization to enable profitability at current sales levels.

LeapFrog's gross profits in the last twelve months were approximately $95 million. The Company's guidance for this year estimates that sales and profits will be as bad as, or even worse than, the prior twelve (12) months. The Company's overhead and R&D costs alone are running at $125 million per year, with an additional $40 million spent on advertising per year.  LeapFrog needs to adjust its cost structure now for the realities of the business.

Shareholders can no longer afford to tolerate a wait-and-see approach with the expectation that new MLP products entering an ever-increasing marketplace will meaningfully improve gross profits in the future.  Not only is there simply too little predictability and visibility into these MLP product sales, but the current management team recently missed its own targets by more than 30% with less than nine weeks left in the forecast period! 4  

Conclusion

LeapFrog is not positioned to withstand multiple years of large financial losses, and we could not continue to sit idly by while management continues to allocate resources towards high-risk products. 

The tablet and software/app categories face immense competition, which is set to continue unabated into the future while the traditional Learning Toys segment has only a handful of meaningful competitors, which will likely continue over the next decade. While the traditional Learning Toys segment may lack the allure and appeal of the trendier MLP segment, it is less competitive and more stable.

Further, LeapFrog does not need to be a perennial high growth company, nor does it need to be the first to introduce the latest new product.  Clearly this strategy has only provided short-lived success and has not been successful over any sustained period for time for the Company in the past.  We believe shareholders deserve more.  

We hope that you will act with a great sense of urgency to engage with us and take our concerns and views seriously as time is of the essence in this continuously evolving market. 

                                                                                                Best Regards,                                                                                                Christopher Sommers                                                                                                Blue Pacific Partners, LLC

Sources:1) http://lanzandhaylz.weebly.com - Interview with Melissa Bernstein of "Melissa & Doug" Toy Company (Conducted on Monday, March 3rd, 2015)2) Piper Jaffray report cited on LeapFrog Fourth Quarter, 2015 Conference Call on June 11, 20153) LeapFrog Fourth Quarter, 2015 Conference Call on June 11, 20154) LeapFrog Third Calendar Quarter, 2014 Conference Call on November 3, 2014; Management provided calendar fourth quarter guidance of sales growth in the double digits, only to have sales fall by over 20% in the subsequent two months.

About Blue Pacific Partners, LLCBlue Pacific Partners, LLC is an investment firm that uses a fundamental, research-driven process to identify suitable investment candidates.

Investor ContactChristopher Sommers(914) 977-3405[email protected]

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SOURCE Blue Pacific Partners, LLC