| LEAPFROG ENTERPRISES INC Item 1A Risk Factors Our business and the results of its operations are subject to many factors, some of which are beyond our control |
| The following is a description of some of the risks and uncertainties that may affect our future financial performance |
| 15 ______________________________________________________________________ [50]Table of Contents If we fail to predict consumer preferences and trends accurately, develop and introduce new products rapidly or enhance and extend our existing core products, our sales will suffer |
| Sales of our platforms, related software and stand-alone products typically have grown in the periods following initial introduction, but we expect sales of specific products to decrease as they mature |
| For example, net sales of the Classic LeapPad and My First LeapPad in our US Consumer business peaked in 2002 and have been declining since |
| Therefore, the introduction of new products and the enhancement and extension of existing products, through the introduction of additional software or by other means, is critical to our future sales growth |
| To remain competitive, we must continue to develop new technologies and products and enhance existing technologies and product lines, as well as successfully integrate third-party technology with our own |
| The successful development of new products and the enhancement and extension of our current products will require us to anticipate the needs and preferences of consumers and educators and to forecast market and technological trends accurately |
| Consumer preferences, and particularly children’s preferences, are continuously changing and are difficult to predict |
| In addition, educational curricula change as states adopt new standards |
| In 2005, we introduced a number of new platforms, stand-alone products, interactive books and other software for each of our three business segments, including our FLY Pentop Computer, which is targeted at an older age group of consumers than we have focused on in the past, and our Leapster L-MAX handheld for television-based learning |
| We cannot assure you that these products will be successful or that other products will be introduced or, if introduced, will be successful |
| The failure to enhance and extend our existing products or to develop and introduce new products that achieve and sustain market acceptance and produce acceptable margins would harm our business and operating results |
| Our advertising and promotional activities may not be successful |
| Our products are marketed through a diverse spectrum of advertising and promotional programs |
| Our ability to sell product is dependent in part upon the success of such programs |
| If we do not successfully market our products, or if media or other advertising or promotional costs increase, these factors could have a material adverse effect on our business and results of operations |
| If we are unable to compete effectively with existing or new competitors, our sales and market share could decline |
| We currently compete primarily in the infant and toddler category, preschool category and electronic learning aids category of the US toy industry and, to some degree, in the overall US and international toy industry |
| We believe that we are also beginning to compete, and will increasingly compete in the future, with makers of popular game platforms and smart mobile devices such as personal digital assistants |
| Our SchoolHouse division competes in the US supplemental educational materials market |
| Each of these markets is very competitive and we expect competition to increase in the future |
| Many of our direct, indirect and potential competitors have significantly longer operating histories, greater brand recognition and substantially greater financial, technical and marketing resources than we do |
| These competitors may be able to respond more rapidly than we can to changes in consumer requirements or preferences or to new or emerging technologies |
| They may also devote greater resources to the development, promotion and sale of their products than we do |
| We cannot assure you that we will be able to compete effectively in our markets |
| Our business depends on three retailers that together accounted for approximately 64prca of our consolidated net sales in 2005, and 80prca of the US Consumer segment sales, and our dependence upon a small group of retailers may increase |
| Wal-Mart (including Sam’s Club), Toys “R” Us and Target accounted in the aggregate for approximately 64prca of our net sales in 2005 |
| In 2005, sales to Wal-Mart (including Sam’s Club), Toys “R” Us and Target 16 ______________________________________________________________________ [51]Table of Contents accounted for approximately 29prca, 20prca and 15prca, respectively, of our consolidated net sales |
| We expect that a small number of large retailers will continue to account for a significant majority of our sales and that our sales to these retailers may increase as a percentage of our total sales |
| We do not have long-term agreements with any of our retailers |
| As a result, agreements with respect to pricing, shelf space, cooperative advertising or special promotions, among other things, are subject to periodic negotiation with each retailer |
| Retailers make no binding long-term commitments to us regarding purchase volumes and make all purchases by delivering one-time purchase orders |
| If any of these retailers reduce their purchases from us, change the terms on which we conduct business with them or experience a future downturn in their business, our business and operating results could be harmed |
| Our business is seasonal, and therefore our annual operating results depend, in large part, on sales relating to the brief holiday season |
| Sales of consumer electronics and toy products in the retail channel are highly seasonal, causing the substantial majority of our sales to retailers to occur during the third and fourth quarters |
| In 2005, approximately 75prca of our total net sales occurred during the latter half of the year |
| This percentage of total sales may increase as retailers become more efficient in their control of inventory levels through just-in-time inventory management systems |
| Generally, retailers time their orders so that suppliers like us will fill the orders closer to the time of purchase by consumers, thereby reducing their need to maintain larger on-hand inventories throughout the year to meet demand |
| Failure to predict accurately and respond appropriately to retailer and consumer demand on a timely basis to meet seasonal fluctuations, or any disruption of consumer buying habits during this key period, would harm our business and operating results |
| If we do not maintain sufficient inventory levels or if we are unable to deliver our product to our customers in sufficient quantities, or if our retailers’ inventory levels are too high, our operating results will be adversely affected |
| The high degree of seasonality of our business places stringent demands on our inventory forecasting and production planning processes |
| If we fail to meet tight shipping schedules, we could damage our relationships with retailers, increase our shipping costs or cause sales opportunities to be delayed or lost |
| In order to be able to deliver our merchandise on a timely basis, we need to maintain adequate inventory level of the desired products |
| If our inventory forecasting and production planning processes result in us manufacturing inventory levels in excess of the levels demanded by our customers, our operating results could be adversely affected due to additional inventory write-downs for excess and obsolete inventory |
| If the inventory of our products held by our retailers is too high, they will not place orders for additional products, which would unfavorably impact our future sales and adversely affect our operating results |
| We depend on our suppliers for our components and raw materials, and our production or operating margins would be harmed if these suppliers are not able to meet our demand and alternative sources are not available |
| Some of the components used to make our products, including our application-specific integrated circuits, or ASICs, currently come from a single supplier |
| Additionally, the demand for some components such as liquid crystal displays, integrated circuits or other electronic components is volatile, which may lead to shortages |
| If our suppliers are unable to meet our demand for our components and raw materials and if we are unable to obtain an alternative source or if the price available from our current suppliers or an alternative source is prohibitive, our ability to maintain timely and cost-effective production of our products would be seriously harmed and our operating results would suffer |
| In addition, as we do not have long-term agreements with our major suppliers, they may stop manufacturing our components at any time |
| 17 ______________________________________________________________________ [52]Table of Contents We rely on a limited number of manufacturers, virtually all of which are located in China, to produce our finished products, and our reputation and operating results could be harmed if they fail to produce quality products in a timely and cost-effective manner and in sufficient quantities |
| We outsource substantially all of our finished goods assembly, using several Asian manufacturers, most of who manufacture our products at facilities in the Guangdong province in the southeastern region of China |
| We depend on these manufacturers to produce sufficient volumes of our finished products in a timely fashion, at satisfactory quality and cost levels and in accordance with our and our customers’ terms of engagement |
| If our manufacturers fail to produce quality finished products on time, at expected cost targets and in sufficient quantities, our reputation and operating results would suffer |
| In addition, as we do not have long-term agreements with our manufacturers, they may stop manufacturing for us at any time, with little or no notice |
| We may be unable to manufacture sufficient quantities of our finished products and our business and operating results could be harmed |
| Increases in our component or manufacturing costs could reduce our gross margins |
| Cost increases for our components or manufacturing services, whether resulting from shortages of materials, labor or otherwise, including, but not limited to rising cost of materials, transportation, services, labor, commodity price increases and the impact of foreign currency fluctuations could negatively impact our gross margins |
| Any errors or defects contained in our products, or our failure to comply with applicable safety standards, could result in delayed shipments or rejection of our products, damage to our reputation and expose us to regulatory or other legal action |
| We have experienced, and in the future may experience, delays in releasing some models and versions of our products due to defects or errors in our products |
| Our products may contain errors or defects after commercial shipments have begun, which could result in the rejection of our products by our retailers, damage to our reputation, lost sales, diverted development resources and increased customer service and support costs and warranty claims, any of which could harm our business |
| Individuals could sustain injuries from our products, and we may be subject to claims or lawsuits resulting from such injuries |
| There is a risk that these claims or liabilities may exceed, or fall outside the scope of, our insurance coverage |
| Moreover, we may be unable to retain adequate liability insurance in the future |
| We are subject to the Federal Hazardous Substances Act, the Flammable Fabrics Act, regulation by the Consumer Product Safety Commission, or CPSC, and other similar federal, state and international rules and regulatory authorities |
| Our products could be subject to involuntary recalls and other actions by such authorities |
| Concerns about potential liability may lead us to recall voluntarily selected products |
| Any recalls or post-manufacture repairs of our products could harm our reputation, increase our costs or reduce our net sales |
| We have had significant challenges to our management systems and resources, particularly in our supply chain and information systems, and as a result we may experience difficulties managing our business |
| In recent years, we grew rapidly, both domestically and internationally |
| We have more than doubled our net sales from dlra314dtta2 million in 2001 and dlra649dtta8 million in 2005 |
| During this period, the number of different products we offered at retail also increased significantly, and we have opened offices in Canada, France, Macau and Mexico |
| This expansion presented, and continues to present, significant challenges for our management systems and resources and has resulted in a significant adverse impact on our operating and financial results |
| If we fail to improve and maintain management systems and resources sufficient to keep pace with our business needs, our operating results could continue to suffer |
| 18 ______________________________________________________________________ [53]Table of Contents We depend on key personnel, and we may not be able to hire, retain and integrate sufficient qualified personnel to maintain and expand our business |
| Our future success depends partly on the continued contribution of our key executives, technical, sales, marketing, manufacturing and administrative personnel |
| The loss of services of any of our key personnel could harm our business |
| Recruiting and retaining skilled personnel is highly competitive |
| If we fail to retain, hire, train and integrate qualified employees and contractors, we will not be able to maintain and expand our business |
| There can be no assurance that the members of our existing management team will be able to manage our company or our growth |
| Part of our compensation package includes stock and/or stock options |
| If our stock performs poorly, it may adversely affect our ability to retain or attract key employees |
| In addition, because we will be required to treat all stock-based compensation as an expense beginning in fiscal 2006, we may experience increased compensation costs |
| Changes in compensation packages or costs could impact our profitability and/or our ability to attract and retain sufficient qualified personnel |
| Our international consumer business may not succeed and subjects us to risk associated with international operations |
| We derived approximately 20prca of our net sales from markets outside the United States in 2005 |
| In 2006, we are planning to expand our international product offerings and markets |
| However, these and other efforts may not help increase sales of our products outside the United States, or achieve expected margins |
| Our business is, and will increasingly be, subject to risks associated with conducting business internationally, including: • developing successful products that appeal to the international markets; • political and economic instability, military conflicts and civil unrest; • greater difficulty in staffing and managing foreign operations; • transportation delays and interruptions; • greater difficulty enforcing intellectual property rights and weaker laws protecting such rights; • complications in complying with laws in varying jurisdictions and changes in governmental policies; • trade protection measures and import or export licensing requirements; • currency conversion risks and currency fluctuations; and • limitations, including taxes, on the repatriation of earnings |
| Any difficulty with our international operations could harm our future sales and operating results |
| Our future growth will depend in part on our Education and Training group, which may not be successful |
| We launched our Education and Training group in June 1999 to deliver classroom instructional programs to the pre-kindergarten through 8th grade school market and explore adult learning opportunities |
| To date, the SchoolHouse division, which accounts for substantially all of the results of our Education and Training segment, has incurred cumulative operating losses |
| Sales from our SchoolHouse division’s curriculum-based products will depend principally on broadening market acceptance of those products, which in turn depends on a number of factors, including: • our ability to demonstrate to decision-makers the usefulness of our products to supplement traditional teaching practices; 19 ______________________________________________________________________ [54]Table of Contents • the willingness of teachers, administrators, parents and students to use products in a classroom setting from a company that may be perceived as a toy manufacturer; • the effectiveness of our sales force; • our ability to generate recurring revenue from existing customers through various marketing channels; and • the availability of state and federal government funding to defray, subsidize or pay for the costs of our products which may be severely limited due to budget shortfalls and other factors |
| If we cannot continue to increase market acceptance of our SchoolHouse division’s supplemental educational products, the division may not be able to sustain its recent operating profits and our future sales could suffer |
| Our intellectual property rights may not prevent our competitors from using our technologies or similar technologies to develop competing products, which could weaken our competitive position and harm our operating results |
| Our success depends in large part on our proprietary technologies that are used in our learning platforms and related software |
| We rely, and plan to continue to rely, on a combination of patents, copyrights, trademarks, trade secrets, confidentiality provisions and licensing arrangements to establish and protect our proprietary rights |
| The contractual arrangements and the other steps we have taken to protect our intellectual property may not prevent misappropriation of our intellectual property or deter independent third-party development of similar technologies |
| The steps we have taken may not prevent unauthorized use of our intellectual property, particularly in foreign countries where we do not hold patents or trademarks or where the laws may not protect our intellectual property as fully as in the United States |
| Some of our products and product features have limited intellectual property protection, and, as a consequence, we may not have the legal right to prevent others from reverse engineering or otherwise copying and using these features in competitive products |
| In addition, monitoring the unauthorized use of our intellectual property is costly, and any dispute or other litigation, regardless of outcome, may be costly and time-consuming and may divert our management and key personnel from our business operations |
| However, if we fail to protect or to enforce our intellectual property rights successfully, our rights could be diminished and our competitive position could suffer, which could harm our operating results |
| For additional discussion of litigation related to the protection of our intellectual property, see “Item 3—Legal Proceedings |
| —LeapFrog Enterprises, Inc |
| Fisher-Price, Inc |
| ” Third parties have claimed, and may claim in the future, that we are infringing their intellectual property rights, which may cause us to incur significant litigation or licensing expenses or to stop selling some of our products or using some of our trademarks |
| In the course of our business, we periodically receive claims of infringement or otherwise become aware of potentially relevant patents, copyrights, trademarks or other intellectual property rights held by other parties |
| Responding to any infringement claim, regardless of its validity, may be costly and time-consuming, and may divert our management and key personnel from our business operations |
| If we, our distributors or our manufacturers are adjudged to be infringing the intellectual property rights of any third-party, we or they may be required to obtain a license to use those rights, which may not be obtainable on reasonable terms, if at all |
| We also may be subject to significant damages or injunctions against the development and sale of some of our products or against the use of a trademark or copyright in the sale of some of our products |
| Our insurance may not cover potential claims of this type or may not be adequate to indemnify us for all the liability that could be imposed |