LeapFrog 2005 Annual Report Download - page 35

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. In addition, these mass-market retailers have greater financial resources and lower
operating expenses than traditional specialty toy retailers and have driven down pricing and reduced profit
margins for us and other players in the retail toy industry. We anticipate that the toy industry’s dependence on
mass-market retailers will continue to grow. Partially as a result of the influence of the mass-market retailers,
Toys “R” Us conducted a strategic evaluation of its worldwide assets, and in July 2005 was acquired by a private
investment group. On January 9, 2006, Toys “R” Us announced it will close 75 store locations and convert
another 12 locations into Babies “R” Us stores. This restructuring will result in a reduction of the number of
products that Toys “R” Us purchases from us, though the dollar impact is currently unknown.
Our consolidated net sales in 2005 were $649.8 million, an increase of $9.5 million or 1.5% compared to
2004. 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. Sales growth in our U.S. Consumer segment
was partially offset by sales declines in our International and Education and Training segments. The U.S.
Consumer business grew primarily due to the introduction of our FLY Pentop Computer and related software and
accessories in the third quarter for the October 2005 product launch. In addition, the U.S. Consumer segment
experienced significant demand for our screen-based products including the Leapster L-MAX system, which was
introduced in the third quarter of 2005. These sales increases were partially offset by continuing declines in our
LeapPad family of products in the U.S. Consumer segment.
Our gross margins in 2005 increased by 2.5 percentage points to 43.0% in 2005 from 40.5% in 2004. Gross
margins improved in all segments of the business, particularly in our U.S. Consumer segment. Gross margins
improved in the U.S. Consumer segment primarily due to improved product mix, lower expense for excess and
obsolete inventory and lower freight expenses.
Our selling, general and administrative expenses increased by $5.4 million, or 4.5%, in 2005 compared to
2004. Selling, general and administrative expenses consist primarily of salaries and related employee benefits,
legal fees, marketing expenses, systems costs, rent, office equipment, supplies and professional fees related to
process improvements and Sarbanes-Oxley compliance. The increase was primarily due to higher legal expense
attributable to enforcing our patents, higher consulting and auditing fees resulting from process improvements
and other activities related to compliance with the Sarbanes-Oxley Act, as well as higher employee costs
resulting from restructuring related charges from our LeapFrog realignment plan.
Our research and development expenses decreased by $8.6 million, or 14.2%, in 2005 compared to 2004.
Research and development expenses consist primarily of costs associated with content development, product
development and product engineering. The decrease was primarily due to lower costs for the content and
development of our FLY Pentop Computer product in 2005 than in 2004.
Our advertising expense decreased by $13.2 million, or 15.9%, in 2005 compared to 2004. Advertising
expenses consist primarily of television advertising, cooperative advertising and in-store displays. The decrease
was primarily due to our cost containment efforts, higher advertising costs in 2004 for printing and distribution of
our U.S. Consumer catalogs, and higher 2004 in-store Leapster platform merchandising displays.
Our depreciation and amortization expenses consist primarily of depreciation of fixed assets and capitalized
website development costs and amortization of intangibles. These expenses exclude depreciation of
manufacturing tools and capitalized content development costs, which are classified in cost of sales.
28