By Jon Fortt
June 8, 2010

To reclaim its lost luster, LeapFrog is on a mission to remake itself with software

It has a full-color touchscreen, connects to a computer, plays video and music, and comes with its own unique software. But unlike the iPad, this device costs $69, not $500. And it’s not for techies.

It’s for tykes.

Meet the Leapster Explorer, the latest must-have gadget for the elementary school set. Educational toy company LeapFrog (LF) unveiled it this week as the ultimate digital companion for learners ages 4 to 9, and packed it with lessons that teach skills like spelling, matching, and tooth brushing. The company’s engineers took care to make it cool, since today’s kids are already used to reaching for mommy and daddy’s RIM BlackBerrys (RIMM) and Apple (AAPL) iPods.

Perhaps most important, the Leapster Explorer also serves as a statement about LeapFrog, its creator. After several rough years, the company appears poised for a comeback. Whether it’s a strong resurgence or merely a respectable return to profitability depends mainly on one thing: Whether new CEO Bill Chiasson can complete its transformation from an educational toymaker into a nimble digital company that’s as comfortable crafting apps as it is molding plastic.

It won’t be easy. To succeed, Chiasson will have to further distinguish LeapFrog from competitors Mattel (MAT) and Hasbro (HAS), and run a tighter ship than low-cost Chinese rival vTech. Wary investors will want to see proof that he truly has command of the manufacturing costs and inventories that have tripped LeapFrog before. And eventually he may have to diversify beyond the big three retailers, WalMart (WMT), Target (TGT), and Toys ‘R’ Us, which today account for a whopping two thirds of LeapFrog’s revenues.

The most promising path to achieve all that? Software. Instead of just selling toys that talk, LeapFrog is increasingly offering upgradable devices like Tag, an interactive pen that helps children learn to read books; and Explorer, which can load new content via both Internet downloads (two for $15) or more expensive physical cartridges ($25). To tie the whole ecosystem together LeapFrog has Learning Path, an online dashboard where parents can upload data from LeapFrog toys and track how well their children are doing with new concepts. Chiasson says besides being a great tool for customers, Learning Path is creating valuable customer loyalty; he said the number of “connected consumers” who use smarter LeapFrog technology should jump from 3 million to 7 million by the end of this year.

If he’s right, the Leapster Explorer could be the beginning of a renaissance for the company. It’s been a long time coming.

Turning things around

A tow-haired six-year-old is poking around on an interactive map of the world — one of educational toy company LeapFrog’s upcoming products — as a product manager observes behind a two-way mirror at LeapFrog headquarters. Odds are he won’t put the talking pen on the compass rose. “We’ve found that girls are more likely to touch it and let it guide them around the map,” she says. Go figure — even at a tender age, guys don’t like asking for directions.

LeapFrog too has had trouble finding its way. After enterprising dad Michael Wood founded the company 15 years ago with the premise that technology could help his toddler son to read, the company was hailed as a game-changer for the toy industry. The signature product, the Phonics Desk, was groundbreaking; it wasn’t just standalone computer software, it was an experience built into a sturdily built toy that even the youngest customer could use. The buzz around the product was strong enough to attract investors like Wall Street dealmaker king Michael Milken and Oracle (ORCL) CEO Larry Ellison, who still own the majority of voting shares.

Then came a blockbuster IPO in 2002 — and a decline. In a series of missteps, the company failed to develop the next “it” toy, repeatedly misjudged demand for its offerings, and found itself hemorrhaging cash. LeapFrog has spent the majority of its life as a public company in the red — it hasn’t posted an annual profit since 2005.

A multiple-year turnaround plan had just started to bear fruit in 2008 when the global economy collapsed. By early last year, the company’s stock was trading at just over $1 per share, and some investors wondered whether it was time to throw in the towel and sell to the likes of Hasbro or Mattel.

These days, however, the stock has a new lease on life. Despite a so-so earnings report last month in which LeapFrog lost 37 cents per share on $42 million during a seasonally slow quarter, the stock is up from 52-week lows of $1.89, trading these days at around $4.50. The market cap stands at just over $250 million. Gerrick Johnson, analyst at BMO Capital Markets, says things look promising. “They can still do a little bit more to eliminate some cost in their system, but at this point the top line will be good,” he says. “Any chance of achieving past glory? Yes, but in a different form. I don’t think they’ll have one grand-slam hit product. You’ll see more products in more categories.”

Chiasson says LeapFrog has streamlined its internal tracking systems and restructured to lower costs. After clearing out last year’s inventory glut he feels confident about the company’s upcoming products, and he has lined up new distribution deals that should expand LeapFrog’s reach beyond its core group of retailers and toy shops.

A few: Electronics retailer Best Buy (BBY) plans to prominently display the new Leapster Explorer as part of its plan to grow beyond its male customer base, and attract women who are making more electronics decisions. Walgreen Co. (WAG) will carry several learning toys. Book giant Barnes & Noble (BKS) plans to prominently display LeapFrog’s Tag devices and books in a redesign of the children’s areas in most of its stores.

“Best Buy is a perfect place for our mobile learning devices,” Chiasson says. “And something like Barnes & Noble we see as more than just a place to sell our products …. It’s really a reflection of the brand at that location. That’s where people go because they’re readers, they want their children to be readers.”

Chiasson, LeapFrog’s former finance chief, is sober about those deals — he knows they won’t become as significant as the biggest retail relationships overnight. “It’d be nice if it did in the sense that it would grow that fast,” he says. But sales are also growing at WalMart, Target and Toys ‘R’ Us, so these new relationships “not only would have to grow at a rate more rapid than the top three, it would have to be so much more rapid that it changes the mix.”

Like the former CFO he is, Chiasson played it extra safe on this point. While it’s true that the new deals won’t have an outsize impact on revenue, profit could be another story. The connected devices that will get the most face time at Best Buy and Barnes & Noble are LeapFrog’s most profitable — if those launches go well, there could be a real upside for the stock.

The future of educational toys

Will these latest efforts be enough? During a recent visit to LeapFrog headquarters in Emeryville, workers were brimming with new ideas. Besides the Leapster Explorer and new Tag books, there’s the interactive map, a virtual world, and exciting characters who could turn up in future products.

The bigger question, though, is perhaps more philosophical: As traditional toys like Legos and Lincoln Logs make a comeback and educational software begins to pop up on cutting-edge devices like iPods and iPads, will there still be a long-term future for the sort of electronic toys that LeapFrog makes?

As the father of a curious 23-month-old boy, it’s a question that particularly resonates for me. After my wife heard about a friend whose toddler was becoming an ace at iPhone games, she decided to download a couple (Where’s Gumbo? And Peekaboo Barn). This experiment yielded unintended consequences: our son Nathan did learn to say “fire truck” by looking for Gumbo, and he learned what sound lions make after opening the barn doors (seriously!). But he also developed a troublesome obsession with iPhones.

Cases like this, it seems, could pose a problem for LeapFrog. What if the next great educational software and toy company grows out of multi-purpose appliances like the iPad and iPod, not dedicated devices like the Leapster Explorer? Will LeapFrog be able to adapt? A look at the iTunes App Store already turns up fresh options like Elmo’s Monster Maker from Sesame Street. (If Nathan ever finds out about that, well, game over.)

When I ask Chiasson about this, he waves it off. Part of LeapFrog’s brand promise, he explains, is that its products help children to learn important skills, not just waste time. The company’s reputation with educators has been earned from years of inviting them to help design the products. And while toddlers might like iPods and iPads, those gadgets are neither cheap nor toddler-proof.

It’s a reasonable argument, but something about it doesn’t completely sit right with me. A few days after my talk with Chiasson, I realize why: it sounds eerily similar to the reasons why Nintendo and Sony (SNE) claimed the iPod would never be a first-class gaming device. Their devices were built for gaming, they were studier in the hands of kids, and they were cheap. You know what? The iPods caught on in gaming anyway.

Maybe LeapFrog won’t suffer the same fate; in any case Chiasson probably has a couple of years to tweak his strategy. And he’s not ignoring the iPad, of course. “We continue to look at those platforms as opportunities,” he says. “Whether it’s needed or we’re able to do it is still something we have to look at.”

In the meantime, he’s got to focus on making sure that in the second half of the year, LeapFrog’s newfound stability starts showing up consistently on the bottom line.

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