LeapFrog 2006 Annual Report Download - page 36

• 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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