LeapFrog 2004 Annual Report Download - page 28

largest business segments, currently are generated in the toy aisles of retailers. The market for toy retailers has
seen, and continues to see consolidation. In addition to the traditional channel of specialty toy retailers, of which
Toys “R” Us has become the major player, the mass-market retail channel has grown in importance. For
example, Wal-Mart, Target and a number of regional mass-market retailers have seen growth in their market
shares within the U.S. toy retail market. The mass-market retailers have certain competitive advantages in the
highly seasonal toy market because they have the ability to dedicate a significant amount of shelf space to toys
during the Fall holiday season, and then reduce the allocated shelf space for toys during the rest of the year. We
anticipate that the toy industry’s dependence on mass-market retailers will continue to grow.
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. 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 2004, this segment represented approximately
67% of our total net sales. Although we are expanding our retail presence by selling our products to bookstores
and electronics and office supply stores, the significant majority of our U.S. Consumer sales are to a few large
retailers. Sales to Wal-Mart (including Sam’s Club), Toys “R” Us and Target accounted for approximately 86%
of our U.S. Consumer segment sales in 2004 compared to 79% in 2003 and 76% in 2002. As a percentage of our
consolidated net sales, sales to Wal-Mart (including Sam’s Club), Toys “R” Us and Target accounted for
approximately 64%, 68% and 75% of our consolidated net sales in 2004, 2003 and 2002, respectively. Net sales
in our U.S. Consumer segment decreased by 21% from 2003 to 2004 and operating income decreased from a
profit of $83.2 million to a loss of $49.9 million. Consistent with industry practice, we rely on short-term
purchase orders for the sale of our products to U.S. retailers. Although we believe net sales for this business
segment will grow in the future, we anticipate that this segment’s percentage of total company net sales will
decrease, as we expect our other two segments to grow at a faster rate than our U.S. Consumer segment.
In our International segment, we sell our products outside the United States directly to overseas retailers and
through various distribution and strategic arrangements. We have four direct sales offices in the United Kingdom,
Canada, France and Mexico, and maintain various distribution and strategic arrangements in countries such as
Australia, Japan and Korea among others. The International segment represented approximately 24% of our total net
sales in 2004. Net sales in our International segment increased 59% from 2003 to 2004 and operating income
decreased from $26.4 million in 2003 to $24.9 million in 2004. Despite the large increase in sales in our
International segment in 2004, we experienced a slowdown in LeapPad platform sales by our major customers in
Canada and the United Kingdom during the fourth quarter of 2004. This trend indicates that LeapPad platform sales
are maturing in these countries and that growth in our International segment in 2005 will be much lower than 2004.
Our Education and Training segment, which is represented almost entirely by our SchoolHouse division,
targets the school market in the United States, including sales directly to educational institutions, to teacher supply
stores and through catalogs aimed at educators. The Education and Training segment represented approximately
9% of our total net sales in 2004. Net sales in our Education and Training segment increased by 47% from 2003 to
2004, and the segment had operating income of $10.9 million in 2004 compared to an operating loss of $0.2
million in 2003. We expect growth in our Education and Training segment to continue in 2005.
Gross profit percentage in 2004 decreased by 9.5 percentage points from 50.0% in 2003 to 40.5% in 2004. This
decrease was primarily due to lower profit margins in our U.S. Consumer segment, partially offset by growth in our
higher margin Education and Training and International segments. The decrease in gross profit percentage in our
U.S. Consumer segment was the result of lower margin Leapster platform sales, as well as higher freight and
warehousing expenses. In addition, inventory reserves were increased by $14.6 million due to obsolete and
defective inventory of raw materials and discontinued finished goods. The increase in reserves was due, at least in
part, to significantly lower sales in the fourth quarter versus expectation for products to be discontinued in 2005.
Selling, general and administrative expenses consist primarily of salaries and related employee benefits,
legal, marketing expenses, systems costs, rent and office equipment and supplies. Our research and development
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