Tom kalinske net worth

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________________________________________________________________________________________________________________ Professors Lynda M. Applegate, Harvard Business School, and Christopher Dede, Graduate School of Education, and Research Associate Susan Saltrick prepared this case. The Markle Foundation of New York provided support for the development of this case. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2003 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

L Y N D A M . A P P L E G A T E

C H R I S T O P H E R D E D E

S U S A N S A L T R I C K

Learning from LeapFrog: Creating Educational and Business Value

My kids actually ask to stay in from recess to play with their LeapPads! It’s the best educational investment

we’ve ever made. — An early childhood specialist, Oakland, California

Mike Wood, CEO of LeapFrog Enterprises, hustled through the narrow aisles of his cavernous corporate headquarters, a former warehouse located in a scrappy industrial zone in Emeryville, California. LeapFrog, since its founding in 1995, had leapt to the number three ranking among U.S. toy manufacturers in 2002. With revenues that year of $532 million, only the venerable industry powerhouses, Mattel (number one) and Hasbro (number two), were larger, a remarkable achievement for so young a company.

Wood paused as he rounded a corner, his attention caught by a small group crowded outside one of the cubicles that covered the building’s main floor. The group, members of the product- development team for a future LeapFrog offering, had gathered to look over the newest prototype created by one of the company’s model makers. LeapFrog’s explosive growth trajectory made such hallway meetings necessary, as conference rooms had been sacrificed to provide space for the firm’s many new hires.

LeapFrog, in fact, was one of the very few bright lights in the otherwise dismal Bay Area economy of the new millennium, which was still struggling in 2003 to wring out the excesses of the dot-com craze of the late 1990s. Surveying the former warehouse decked in trademark colors of brilliant purple and green and now home to 700-plus LeapFrog staff, one could see many such gatherings taking place—an advertising campaign being planned on the floor of a cubicle, a product team gathered in the kitchen debating voice talent for a new interactive book, a design group huddled in a corner over sketches of the company’s Leap™ characters. All these efforts were aimed at further solidifying LeapFrog’s position as one of the nation’s largest toy companies—and one of its largest publishers of children’s books.

Wood spotted Jim Marggraff, LeapFrog’s executive vice president for worldwide content, at the center of the group, holding a small foam model of its latest new product. Marggraff turned it over, pushed its pretend buttons, and examined it with an eye toward its ergonomics, its attractiveness, and its general ability to engage a child’s attention. He then passed it along to the others to try. One by one, members of the group offered their comments: a former teacher, now an artist for the

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company, approved of the model’s bright color scheme; a product manager commented on the positioning of the speakers; a writer, also a former educator, asked a software programmer if the screen display offered sufficient real estate for the planned content. The comments swirled as the team tested the mock-up against their vision of what this product might become.

A meeting like this was just one step in the highly iterative process of taking a LeapFrog product from concept to finished product. The model under study was the culmination of months of collaborative effort by dozens of people. More months, and many more such meetings, would be required before the final product would find its way to the shelves of LeapFrog’s retailers and from there into children’s hands in homes and schools across the globe.

Wood listened attentively to the exchange, which reflected the group’s hard work, expertise, and passion. He, too, examined the model with care, imagining it in the hands of his own children, then addressed the team. “From your comments, I think we’re on the right track here, but something is still missing,” he said, then, asking the question he was known for asking, “What can be done to make this product, not just great, but spectacular?”

In response to the question, a new round of comments bubbled up from the group. Wood directed a few more questions, made a couple of suggestions, then took his leave, mentally noting, with some pleasure, that the group’s ideas had advanced to a new level. Finding time to interact in such sessions was a top priority of Wood’s; it was perhaps the part of his job he loved the most—and he was widely recognized to have a certain genius at it. But with the wildfire growth of the company, his day was more and more filled with the details of running a half-billion dollar company. His energy and tenacity were already the subject of company legend, but there were still just 24 hours in a day.

Wood was absolutely committed to protecting and preserving the creative spirit at LeapFrog, even as the company grew, David-like, to challenge the industry giants. LeapFrog’s future depended on successfully balancing the excitement, energy, and spontaneity of the creative process with the rigor, accountability, and formal structures a large company required. Many young companies had foundered trying to steer this middle course. Would LeapFrog do the same, or would it continue to “leapfrog” its competitors, jumping ever higher, from one success to the next? Other challenges lay ahead as well. LeapFrog was one of the very few firms to have succeeded in building a consumer brand upon the educational claims of its products. But would those claims hold up under rigorous research? Were LeapFrog’s products promoting real and long-lasting learning gains? More specifically, what would the coming year bring as LeapFrog encountered its first real competition from industry leader Mattel? His thoughts racing, Wood hustled off to his next meeting.

Building LeapFrog

LeapFrog is an educational company selling things that look like toys. — Sean McGowan, toy industry analyst

From Inspiration to Incorporation

LeapFrog Enterprises began operations in 1995, but the origins of the company date to 1990 to an epiphany Wood, then a partner at a major San Francisco law firm, experienced while playing with his son, Mat, then three years old. (For LeapFrog executive team bios, see Exhibit 1.) Using a wooden ABC puzzle, Wood was attempting to help Mat recognize that letters have both names and sounds, for example, that the letter “A” is named “A” but it sounds like “ahh.” This concept is of central importance to the development of phonemic awareness, “a conscious perception of the sounds of

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language; that is, the recognition that what we may hear or think of as a single utterance or sound, such as a word, is actually made up of a string of smaller sounds, or phonemes.”1 According to educational researchers, children who can detect these small units of sound are more likely to be successful readers. Like most young children, though, Mat could recall the name of each letter but had difficulty correctly associating its corresponding sound. Wood, in a flash of insight, thought of making a set of 26 squeezable plastic letters, each equipped with a small sound chip (similar to those used in singing birthday cards) that would “say” the letter’s sound when pressed.

So taken was he by this idea that he invested $15,000 to file a patent and, on the advice of a friend in the toy industry, held a professionally organized focus group with mothers to test the product’s marketability. Of the 20 mothers he assembled, all 20 loved the concept. His hopes were dashed, however, when all 20 said they would buy the product at a $50 price point, but only two would do so at $100. As the product design at the time required a separate chip in each letter, the cost of those 26 chips would have necessitated a selling price near $100. Wood abandoned the notion of manufacturing the product at that time but continued to brainstorm the idea with his friends and work associates.

Recalling that early experience, Wood noted:

The parents in that focus group taught me a valuable lesson, one that’s stayed with me over the years. Whenever I’m considering a new product or innovation, I always ask myself four questions: (1) Does this product reflect a fundamental learning need? (2) Does it reflect best practice in teaching? (3) Does the technology truly enhance the learning process? (4) Do parents want to buy this at the price that we must sell it to make money? If I can say “Yes” to all these, I know we’ve got a fair chance at success, but if even one of them is “No,” it’s back to the drawing board.

We iteratively test our products throughout their development with four groups. We want teachers to tell us, “This is the way I want it taught.” We want kids to say, “This is the way I want to learn, and I want to learn this way again and again.” We want parents to say, “This is important, and I’ll buy it at this price.” And, finally, retailers have to say, “I’ll give you shelf space for this product.”

For four years after that initial focus group, Wood continued to explore new designs and new technology. As a partner in a law firm specializing in venture capital and technology law, he was well-positioned to come into contact with innovative technologies and product designs. Finally, after much tinkering, by 1994 the design had evolved to require just one battery, one speaker, and one chip. Wood felt he was close, at last, to building a product he could sell at a price parents were willing to pay.

His next step was to ensure the soundness of the product’s underlying phonics system. He called on Dr. Robert (Bob) Calfee, a reading specialist, then a professor at Stanford University’s School of Education,2 who confirmed that Wood’s instincts about phonics instruction were on target. Calfee commented, “Kids don’t hate to read, they hate not being able to read. Here was a product that had the potential to help kids crack the code of reading.”

Not only did Wood and Calfee concur on the educational value of the nascent product, but the men found themselves compatible professionally. Wood was impressed with Calfee’s emphasis on 1 Linda Bevilacqua, “Did Someone Say Phonemic Awareness?” ProTeacher, <http://www.proteacher.com> (accessed July 9, 2003).

2 Calfee was named dean of the School of Education at the University of California—Riverside in 1998.

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the positive: “Bob saw that his 30 years of work in phonemic awareness and phonics was going to be on the shelves at Wal-Mart. And he didn’t see it as a degradation of his expertise. In fact, he was thrilled at the prospect of getting all these kids started off on the right foot.” Shortly thereafter, Wood asked him to be the primary educational advisor to his soon-to-be-created company. Calfee recalled his thoughts about Wood: “From time to time, entrepreneurs had come to me to ask my advice on the educational value of their products. Mike, though, especially impressed me with his ideas and energy. He listened carefully to what I had to say, took careful notes, and then went away. I never expected to see him again, but he surprised me by coming back, just a month later, having completely redesigned the product for the better.” Showing his strong predilection for protecting intellectual property, Wood patented his effort as “The Phonics Learning System,” thus creating what would become one of LeapFrog’s core intellectual assets.

That same year, on a flight from Hong Kong, Wood was musing over the ways kids play and the notion of helping kids advance. The game of leapfrog came to mind, exemplifying both the notion of leaping ahead and the sense of play that Wood wanted to instill in his products. And so LeapFrog got its name. Reflecting on its core values, Wood noted: “When interacting with our products, we wanted to make sure kids never get the message that they are doing something wrong. The feedback they receive must always be positive and never discourage them from attempting new things.” Calfee noted, “It is easy to offer encouragement when the program promotes success.” He elaborated, “The key was to keep it simple and focus on the essential rules of phonics. We wanted kids to see that the basic syllabic unit is like a sandwich, with the consonants as the bread and vowels as the filling.”

Working with Calfee and technologists from Sandia National Labs, Wood further refined his one- chip design into a product that could be sold at a $50 price point. In 1995, he showed a prototype of what he called The Phonics Desk to a Toys “R” Us buyer, who promptly ordered 40,000 units for the holiday season. With a $2.4 million order under his belt and $800,000 in start-up capital from angel investors, Wood left his law practice, and the company was launched. (For a timeline of key events in the company’s history, see Exhibit 2.) Despite his connections with the venture capital world, Wood shunned VC funds and obtained start-up capital from family and friends. In contrast to many technology firms that were springing up in the over-exuberant climate of the late 1990s, LeapFrog made a retail product on which it would generate a real revenue stream—or not. “There’s no halfway,” Wood noted in a Fast Company article. “You execute and you get to do next year’s plan. You fail, and next year’s plan is irrelevant.”3

According to Sean McGowan, a toy industry analyst and senior vice president at Manhattan- based research firm Harris Nesbitt Gerard,4 “Launching a new toy is not necessarily harder than launching other consumer products. It’s a very trend-driven business, so the barriers to entry are relatively low. Retailers are willing to give a new company a try if they like the product, but if delivery dates or execution slips, that company won’t get a second chance. While the barriers to entry are low, the barriers to exit are even lower.”

In its first year, LeapFrog retained a consulting engineer to secure the services of a reputable agent to represent the company to manufacturers in China. The agent sourced factories, contracted for quality assurance, and arranged shipping, receiving in return a percentage fee based on the value of the goods produced. As a start-up, the company was not able to secure manufacturing at the biggest and most reliable factories. Robert Lally, cofounder and COO at the time, recalled that he, Wood, and other executives paid frequent trips to the manufacturing sites in an effort to keep the production line

3 Bill Breen, “LeapFrog’s Great Leap Forward,” Fast Company, June 2003.

4 In July 2003, McGowan’s firm, formerly known as Gerard Klauer Mattison, was acquired by a division of the Bank of Montreal. The firm is now known as Harris Nesbitt Gerard.

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running. Yet despite a LeapFrog presence on-site about 80% of that first year, the company encountered frequent production delays. To offset their impact, LeapFrog would rely on costly air freight to ship its products from Asia. Lally stated, “Of the initial $800,000 in start-up capital, $350,000 went to air freight. That essentially consumed our gross margin and made it necessary to raise another $1.2 million in capital in the fall of 1995. Fortunately, our investors—mostly drawn from Mike’s [Wood’s] family, friends, and law partners—had faith in what we were doing. The products were showing strong results at the retail stores.”

Lally commented that the company ran lean, air freight notwithstanding, in contrast to many start-ups in the late 1990s. Their first office was 1,000 square feet and featured used furniture. Executives flew coach, even on long-haul flights to Asia. Recalling those start-up days, he noted: “We were tenacious in our belief in the products and were completely committed to what we were doing. We were blind to failure.”

Independent manufacturers’ representatives, working on straight commission and representing many lines, pitched the products to the major retail buyers. With their reputation on the line, manufacturers’ reps were critical first “buyers” of The Phonics Desk and other stand-alone products built on the same phonics learning model. Fortunately, the products were a hit, resulting in bookings that first year of $6 million. Unfortunately, LeapFrog had to cancel almost half those orders as they were unable to manufacture enough products in time to meet demand. Still, with $3.5 million in revenues that first year, LeapFrog began to attract the notice of competitors—and investors.

Acquiring Capital—and Being Acquired

LeapFrog’s second year was much smoother, with far fewer production kinks and sales of $10.5 million, yet Wood realized he would need a major capital infusion to take it to the next level. Tom Kalinske, former CEO of Mattel and Sega of America, now LeapFrog’s chairman and one of the most respected figures in the toy industry, recalled: “As president of Knowledge Universe,5 I was very interested in LeapFrog, as we had an exact meshing of mission. We had capital and were looking to invest in educational technology; LeapFrog had educational technology and needed capital.” In September 1997, Knowledge Universe acquired 82% of LeapFrog.

The acquisition brought LeapFrog $50 million in much-needed growth capital, and just as valuable, Kalinske, assuming the CEO role, brought his 30-plus years of industry expertise and connections. He played a key role in reestablishing a relationship with Wal-Mart, which had dropped LeapFrog after its first year to focus on a competitor with a then-larger product line. It was Kalinske who was behind LeapFrog’s successful guerrilla marketing campaign, in which they posted a large LeapFrog billboard outside Wal-Mart’s Bentonville headquarters and sponsored the local county fair. And it was Knowledge Universe that brokered a meeting between LeapFrog and a small educational toy company, Explore Learning, developers of an interactive children’s globe. It was a meeting that would have dramatic consequences for both companies—and, indeed, for the toy industry at large.

Marggraff, then with Explore Technologies, subsequently in various LeapFrog management positions from 1998 to 2001 and executive vice president of content for LeapFrog since January 2002, told the story:

5 According to the company Web site, <www.knowledgeu.com>, “Knowledge Universe (KU) is the parent of a diverse group of operating companies with a common theme of building human capital by helping individuals and businesses to realize their full potential.” The educational holding company was founded by Larry Ellison, founder of Oracle, and Michael Millken.

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In 1996, Explore Technologies launched a high-end children’s globe which featured a technology we’d developed called NearTouch™. The interior of the globe was sprayed with a special conductive paint. When a point on the globe was touched with a special stylus, it triggered audio feedback, stored on a sound chip, corresponding to that point. Essentially, NearTouchTM technology and our passion for innovative learning spawned paper-based multimedia.

While the globe was a limited commercial success, the technology and Marggraff’s vision for “paper-based multimedia” had caught the attention of investors, including Kalinske of Knowledge Universe. He arranged for a meeting with Wood and Calfee. Calfee recalled, “I saw Jim’s demonstration of the prototype LeapPad and thought, ‘This is it! This has the potential to bring paper to life. Now, we can create a book that can read itself to kids.’”

LeapFrog acquired Explore Technologies in 1998, and Marggraff and the NearTouch technology came to LeapFrog, as well as Explore engineers who formed the nucleus of LeapFrog’s hardware and software development unit. Building on the product ideas discussed in that initial meeting, the LeapPad product emerged, aimed at the three- to seven-year-old age group. The LeapPad hardware featured a stylus and audio playback base unit, into which the “software,” a removable audio cartridge and a spiral-bound book about 20 pages in length, was inserted. Children used the stylus to touch various points on the book’s pages and received audio feedback to guide them through the product’s learning activities. (For more on the LeapPad and other LeapFrog platforms, see Exhibit 3.)

LeapPad: The Separation of Platform and Content

Key to the product’s design was the separation of the content (the book and its audio cartridge) from the platform itself (housing the speakers, batteries, stylus, and base). Launched into the market in 1999, LeapPad won the prestigious Toy Industry Association’s People’s Choice Educational Toy of the Year Award for 2000 and became the top-selling toy for that year. As LeapFrog’s core product, LeapPad again gained the top industry sales rank in 2001. It missed a “three-peat” in 2002 only because LeapPad books took the number one toy sales slot, while the LeapPad platform came in at number two. In total, LeapPad and its related titles accounted for 48% of the company’s total 2002 revenues.6

By making the platform and content separate, LeapFrog gained the advantages of the classic razors-and-blades marketing strategy. Unlike razors, though, which were often sold close to cost to drive sales of consumable blades, LeapFrog platforms were sold at a marked-up price ($29.99 to $59.99 suggested retail price), thus delivering gross margins of 30% on newer platforms, rising to 50%-plus margins for more mature platforms as economies of scale kicked in. But even better, margins of 50% to 60% were to be made on the sales of book/cartridge content, which sold at $9.99 to $14.99. What’s more, these add-on sales helped smooth the highly seasonal sales pattern of the typical toy, as parents bought titles throughout the year, not just at holiday time. In 2002 alone, over 18.5 million interactive books and cartridges were sold for use with various LeapFrog platforms. That same year, the company announced that over 8 million LeapPad systems had been sold since the product’s introduction in 1999.

6 Figures from analyst Howard Block’s report for Banc of America Securities, Equity Research, “LeapFrog Enterprises, Inc.: A Toy for All Seasons,” December 20, 2002.

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LeapFrog Goes to School

LeapFrog’s products did not escape the notice of teachers in the classroom, many of whom purchased LeapPads from retailers for use with their students. Writing in by the hundreds, offering suggestions, and asking for product modifications to better suit the classroom environment, these teachers inspired Wood to establish the company’s SchoolHouse division in June 1999. (For more details on the division, see Exhibit 4, LeapFrog business unit highlights.) Sales were first broken out from the U.S. consumer unit in 2000. Lally, LeapFrog’s cofounder and first COO, assumed the presidency of the division upon its creation. Said Lally in mid-2003:

To date we’ve invested close to $20 million to customize our content for the classroom. This content has to be a lot more granular, because teachers may be teaching the “th” sound for four days and need a book just on that concept. We need to deal, too, with the fact that the overall requirements are different for schools. With home products we’re competing with Nintendo, sports, and TV for a kid’s time; in the schools we’re competing against worksheets. So we have to build things that are exciting enough to engage kids and get them focused and learning, but not so much they get giddy.

We have also developed a special version of the LeapPad for the school market—you might say it’s “rugged-ized.” It’s got rubber corners, high-quality headphones, and AC adapters. Batteries are fine for 18 to 20 hours of home use, but not if you’re a teacher and you’ve got 20 LeapPads in the classroom.

SchoolHouse faced not just different product requirements but also a very different decision process for school materials than for toys. Lally commented: “You can show buyers at a mass market retailer, ‘Here’s a prototype and it’s going to work like this,’ and they’ll place an opening order and see how it sells. But schools are different. They say, ‘Alright, when it’s finished, we’ll buy one and try it out for a while.’ The cycles are much longer and the decisions much slower and more cautious.”

Competitors in the school market were different, too, as LeapPad went up against mainstream traditional educational publishers such as Harcourt, Houghton Mifflin, McGraw-Hill, Pearson, and Scholastic, as well as electronic publishers such as Knowledge Adventure, LightSpan, and Riverdeep. In the assessment area, it faced established test-prep competitors such as Sylvan, Princeton Review, and Kaplan (the latter was also a licensor of content for the iQuest platform).

The rapid top-line growth that characterized U.S. consumer sales had eluded SchoolHouse. According to the company’s annual report in 2002, “The division, which is accounted for under our Education and Training Segment, has generated limited sales and has incurred substantial losses,” contributing only 4% of total 2002 revenues. (See Exhibit 5 for LeapFrog 2002 sales by segment.) The report further noted that substantial losses were expected to continue into the foreseeable future. As of December 31, 2002, $3.2 million in content development costs for the division had been capitalized, with another $0.9 million of capitalization planned in early 2003. But optimism for the group still ran high, with 2002 revenues increasing 129% to $20 million versus those of 2001, with 21 new products launched that year. And at an investor’s conference in May 2003, Wood pointed out that first-quarter results for 2003 were up 67%, to $5.9 million from $3.6 million in 2002’s first quarter.7 Noting that the overall supplemental educational market was estimated at $4.7 billion for 2003, Wood indicated there was plenty of room to grow.

Lally provided another reason for entering this complicated market: “The company was making these huge investments in technology, so we wanted to find ways to leverage that investment into 7 Michael Wood, presentation to US Bancorp Piper Jaffray 23rd Annual Consumer Conference, July 11, 2003, New York.

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other markets. We really wanted our brand to be perceived not as a toy company, but as a company people look to for learning solutions.” As the SchoolHouse division leveraged the technology and design talents of the consumer division, the company also leveraged the research expertise of the SchoolHouse group as a resource for companywide use, guiding development of all products to ensure that they were appropriate for each target age or grade level.

LeapFrog Goes International

LeapFrog, like other U.S. toy companies, saw an opportunity to grow its presence internationally and launched its first international subsidiary in the United Kingdom in 2000. American culture was highly exportable. As analyst McGowan noted: “. . . the continued influence of American television, movies, and other content will spur more toy sales.” He went on to note that Toys “R” Us in 2002 operated 507 toy stores in 28 countries, including 282 licensed and franchised stores, and enjoyed its best year ever.8

LeapFrog planned to accelerate its international growth by establishing additional subsidiaries and using a combination of direct sales to retailers and distribution arrangements. Special partnerships were sought in countries where distribution and/or educational circumstances called for local expertise. In Japan, for instance, the company entered into relationships with both Sega and Benesse to develop customized versions of its platforms and content for both school and home markets. LeapFrog’s 2002 international results were $54 million, or about 10% of total sales.

Tim Bender, LeapFrog’s president, Global Consumer Group, commented on LeapFrog’s global strategy: “We’re trying to develop a product and market lifecycle that supports our international expansion. We want to build a global brand so that, whether we’re in France or China or the U.S., the product is consistent with the educational standards of that country.” (For more on LeapFrog’s international efforts, refer back to Exhibit 4, LeapFrog business unit highlights.) Second-quarter 2003 results for the division showed a sales increase of 94% from second-quarter 2002, with a higher gross margin (44.2%) than in the comparable period in 2002 (38.2%).

LeapFrog Goes Public

The year 2002 was a banner year for LeapFrog. Sales of $532 million, a 69% increase in revenues over the prior year, took the company to the third position among U.S. toy company rankings. The fast-growing library of titles for LeapPad and other LeapFrog platforms made the company one of the nation’s largest children’s publishers. LeapFrog totally dominated two product categories it had essentially created, preschool electronic learning aids (ELA), in which it held a 77% market share, and non-preschool ELA (for ages six to nine), with a 68% market share. With no long-term debt, top-line sales growth, and a strong balance sheet, LeapFrog’s management team felt well positioned to capitalize on the opportunities and challenges that lay ahead. (For more on LeapFrog’s financial performance, see Exhibits 6 and 7. Financial statements from the company’s 2002 annual report can be found in the Appendix.)

On July 25, 2002, in the midst of a grim capital market, LeapFrog (NYSE: LF) successfully issued 9 million shares in its initial public offering (IPO) at $13 per share, raising $115 million for the company. Share prices rose that day to close at $15.85. Shares continued their upward trend, peaking at just over $35 per share in December of 2002, making it the most successful IPO of 2002, before falling to a low in the mid-teens in February 2003 as earnings estimates were reduced in the climate of

8 Sean McGowan, “Toy Manufacturing and Retailing,” analyst report issued for Gerard Klauer Mattison, October 2002.

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uncertainty prior to the Iraq war. Share prices rebounded in the general market upswing of spring 2003 and by mid-July 2003 were trading in the $30 range, around 26 times earnings.

Barbara Miller, an analyst for The Federated Kauffman Fund, offered an investment perspective in mid-July 2003:

LeapFrog has built a strong brand in a short period of time. While their top-line growth is impressive, it’s good to see earnings growth occurring at an even higher rate. They are efficiently managing their operating costs, and their lack of debt shows they are able to fund their growth organically. The company has consistently outperformed expectations and has defied a difficult economic environment. I consider their P/E ratio of 26 to be fair for a growth company. Looking ahead, I would want to see the company demonstrate continued improvement in managing inventory, sales gains in the international sector, and movement into secondary retail channels, while maintaining share of shelf with the major retailers.

Background on the Toy Industry

LeapFrog’s unique dual nature—as both toy company and educational company—required that the young company meet the challenges inherent in not just one, but two sectors. In 2002, the global toy market was valued at approximately $70 billion according to industry estimates, with the North American market share almost half the total ($31 billion) despite there being fewer children in North America than on the other major continents. Average North American toy expenditures of $328 per child, driven largely by U.S. household figures of $405 per child, were 10 times the world’s per capita average of $32.9 (See Exhibit 8 for global toy market figures.) As one expert noted, “Only 2% of the world’s children reside in the U.S., yet those kids consume nearly half the world’s toys.”10 Totaling $25 billion in 2001 sales, the U.S. market was also mature, with a compound annual growth rate of just 2%.11 Long considered “a duopoly, with two large companies [Mattel and Hasbro] controlling almost one-third of the industry,”12 toy industry rankings had shifted to accommodate LeapFrog’s dramatic rise from 15th place in 2000, to 4th in 2001, to 3rd in 2002.