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EXCEL - IDEA: XBRL DOCUMENT - LEAPFROG ENTERPRISES INCFinancial_Report.xls
EX-32.01 - EXHIBIT 32.01 - LEAPFROG ENTERPRISES INCv399458_ex32-01.htm
EX-31.01 - EXHIBIT 31.01 - LEAPFROG ENTERPRISES INCv399458_ex31-01.htm
EX-31.02 - EXHIBIT 31.02 - LEAPFROG ENTERPRISES INCv399458_ex31-02.htm

 

         

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

         

 

FORM 10-Q

         

  

 (Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
  For the quarterly period ended December 31, 2014
   

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 For the transition period from           to           

 

Commission File Number: 001-31396

         
   

LeapFrog Enterprises, Inc.

(Exact name of registrant as specified in its charter)

 
         

 

DELAWARE   95-4652013
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)

 

6401 Hollis Street, Suite 100, Emeryville, California   94608-1463
(Address of principal executive offices)   (Zip Code)

 

 510-420-5000

(Registrant’s telephone number, including area code) 

         

  

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes x     No  ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes x     No  ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer     ¨   Accelerated filer x
Non-accelerated filer ¨ (Do not check if a smaller reporting company)   Smaller reporting company ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨    No x

 

As of January 30, 2015, 65,811,672 shares of Class A common stock, par value $0.0001 per share, and 4,394,354 shares of Class B common stock, par value $0.0001 per share, of the registrant were outstanding.

 

 

 

LEAPFROG ENTERPRISES, INC.

TABLE OF CONTENTS

 

  Part I.  
  Financial Information  
     
Item 1. Financial Statements 3
     
  Consolidated Balance Sheets at December 31, 2014 and 2013 and March 31, 2014 (Unaudited) 3
     
  Consolidated Statements of Operations for the Three and Nine Months Ended December 31, 2014 and 2013 (Unaudited) 4
     
  Consolidated Statements of Comprehensive Income (Loss) for the Three and Nine Months Ended December 31, 2014 and 2013 (Unaudited) 5
     
  Consolidated Statements of Cash Flows for the Nine Months Ended December 31, 2014 and 2013 (Unaudited) 6
     
  Notes to the Consolidated Financial Statements (Unaudited) 7
     
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 16
     
Item 3. Quantitative and Qualitative Disclosures About Market Risk 25
     
Item 4. Controls and Procedures 26
     
  Part II.  
  Other Information  
     
Item 1. Legal Proceedings 27
     
Item 1A. Risk Factors 27
     
Item 6. Exhibits 29
     
Signatures   30

 

2

 

PART I.

FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

 

LEAPFROG ENTERPRISES, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
(Unaudited)

 

   December 31,   March 31, 
   2014   2013   2014 
ASSETS               
Current assets:               
Cash and cash equivalents  $94,020   $168,053   $231,988 
Accounts receivable, net of allowances for doubtful accounts of $818, $139 and $306, respectively   100,810    133,221    29,920 
Inventories   77,796    54,290    52,293 
Prepaid expenses and other current assets   10,449    9,637    10,416 
Deferred income taxes   661    25,639    22,553 
Total current assets   283,736    390,840    347,170 
Deferred income taxes   1,498    45,252    53,998 
Property and equipment, net   38,191    29,644    30,765 
Capitalized content and website development costs, net   23,191    17,494    19,058 
Goodwill   -    19,549    19,549 
Other intangible assets, net   3,836    3,465    3,805 
Other assets   1,337    1,027    1,473 
Total assets  $351,789   $507,271   $475,818 
                
LIABILITIES AND STOCKHOLDERS' EQUITY               
Current liabilities:               
Accounts payable  $23,440   $22,110   $19,146 
Accrued liabilities   32,137    40,765    23,930 
Deferred revenue   12,526    14,467    12,808 
Deferred income taxes   1,290    -    - 
Income taxes payable   431    1,100    689 
Total current liabilities   69,824    78,442    56,573 
Other long-term liabilities   198    1,507    1,125 
Total liabilities   70,022    79,949    57,698 
Commitments and contingencies Stockholders' equity:               
Class A Common Stock, par value $0.0001;               
Authorized - 139,500 shares; Outstanding: 65,803, 64,916 and 65,229, respectively   7    7    7 
Class B Common Stock, par value $0.0001;               
Authorized - 40,500 shares; Outstanding: 4,394, 4,396 and 4,396, respectively   -    -    - 
Treasury stock   (185)   (185)   (185)
Additional paid-in capital   431,806    419,526    422,678 
Accumulated other comprehensive loss   (3,453)   (7)   (578)
Retained earnings (accumulated deficit)   (146,408)   7,981    (3,802)
Total stockholders’ equity   281,767    427,322    418,120 
Total liabilities and stockholders’ equity  $351,789   $507,271   $475,818 

 

See accompanying notes to consolidated financial statements

 

3

 

 

LEAPFROG ENTERPRISES, INC.
 CONSOLIDATED STATEMENTS OF OPERATIONS
 (In thousands, except per share data)
 (Unaudited)

 

   Three Months Ended December 31,   Nine Months Ended December 31, 
   2014   2013   2014   2013 
                 
Net sales  $144,598   $186,707   $305,220   $470,678 
Cost of sales   99,464    114,249    214,243    287,940 
Gross profit   45,134    72,458    90,977    182,738 
                     
Operating expenses:                    
Selling, general and administrative   23,338    23,620    64,703    64,327 
Research and development   8,993    10,688    23,967    26,925 
Advertising   26,773    34,815    39,531    44,130 
Goodwill impairment   19,549    -    19,549    - 
Depreciation and amortization   2,971    2,637    8,571    7,883 
Total operating expenses   81,624    71,760    156,321    143,265 
Income (loss) from operations   (36,490)   698    (65,344)   39,473 
                     
Other income (expense):                    
Interest income   10    14    71    44 
Interest expense   (16)   -    (16)   - 
Other, net   (516)   (364)   (746)   (641)
Total other expense, net   (522)   (350)   (691)   (597)
Income (loss) before income taxes   (37,012)   348    (66,035)   38,876 
Provision for (benefit from) income taxes   87,200    (63,589)   76,571    (48,144)
Net income (loss)  $(124,212)  $63,937   $(142,606)  $87,020 
                     
Net income (loss) per share:                    
Class A and B - basic  $(1.77)  $0.93   $(2.04)  $1.27 
Class A and B - diluted  $(1.77)  $0.90   $(2.04)  $1.23 
                     
Weighted-average shares used to calculate net income (loss) per share:                    
Class A and B - basic   70,169    69,038    69,997    68,601 
Class A and B - diluted   70,169    70,652    69,997    70,548 

 

See accompanying notes to consolidated financial statements

 

4

 

LEAPFROG ENTERPRISES, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(In thousands)
(Unaudited)

 

   Three Months Ended December 31,   Nine Months Ended December 31, 
   2014   2013   2014   2013 
Net income (loss)  $(124,212)  $63,937   $(142,606)  $87,020 
Other comprehensive loss                    
Currency translation adjustments   (2,202)   (131)   (2,875)   (202)
Comprehensive income (loss)  $(126,414)  $63,806   $(145,481)  $86,818 

 

See accompanying notes to consolidated financial statements

 

5

 

LEAPFROG ENTERPRISES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

 

   Nine Months Ended December 31, 
   2014   2013 
Operating activities:          
Net income (loss)  $(142,606)  $87,020 
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:          
Depreciation and amortization   19,869    15,662 
Goodwill impairment   19,549    - 
Deferred income taxes   75,531    (50,859)
Stock-based compensation expense   8,676    8,254 
Allowance for doubtful accounts   954    (291)
Other changes in operating assets and liabilities:          
Accounts receivable, net   (73,546)   (76,138)
Inventories   (27,804)   (8,969)
Prepaid expenses and other current assets   (520)   478 
Other assets   129    198 
Accounts payable   6,942    4,017 
Accrued liabilities   9,182    14,810 
Deferred revenue   (134)   6,798 
Other long-term liabilities   (910)   (894)
Income taxes payable   (220)   577 
Net cash provided by (used in) operating activities   (104,908)   663 
Investing activities:          
Purchases of property and equipment and other intangible assets   (21,085)   (15,267)
Capitalization of content and website development costs   (13,069)   (10,260)
Net cash used in investing activities   (34,154)   (25,527)
Financing activities:          
Proceeds from stock option exercises and employee stock purchase plan   1,512    4,232 
Cash paid for payroll taxes on restricted stock unit releases   (940)   (906)
Common stock repurchased   (38)   - 
Excess tax benefits from stock-based compensation   11    11 
Net cash provided by financing activities   545    3,337 
Effect of exchange rate changes on cash   549    (130)
Net change in cash and cash equivalents   (137,968)   (21,657)
Cash and cash equivalents, beginning of period   231,988    189,710 
Cash and cash equivalents, end of period  $94,020   $168,053 
           
Non-cash investing and financing activities:          
Net change in accounts payable and accrued liabilities related to capital expenditures  $(2,676)  $242 

 

See accompanying notes to consolidated financial statements            

 

6

 

LEAPFROG ENTERPRISES, INC.

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

 

1.Basis of Presentation

 

In the opinion of management, all normal, recurring adjustments considered necessary for a fair statement of the financial position and interim results of LeapFrog Enterprises, Inc. and its consolidated subsidiaries (collectively, the “Company” or “LeapFrog” unless the context indicates otherwise) as of and for the periods presented have been included. The accompanying unaudited consolidated financial statements and related disclosures have been prepared in accordance with United States generally accepted accounting principles (“U.S. GAAP”) applicable to interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. The consolidated financial statements include the accounts of LeapFrog and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.

 

On May 13, 2014, the Company’s board of directors approved a change in the Company’s fiscal year-end from December 31 to March 31 in order to better align the Company’s business planning and financial reporting functions with the seasonality of its business.

 

The financial information included herein should be read in conjunction with the consolidated financial statements and related notes in the Company’s 2013 Annual Report on Form 10-K filed with the United States (“U.S.”) Securities and Exchange Commission (the “SEC”) on March 14, 2014 for the fiscal year ended December 31, 2013 (the “2013 Form 10-K”).

 

The accounting policies used by the Company in its presentation of interim financial results are consistent with those presented in Note 2 to the consolidated financial statements included in the Company’s 2013 Form 10-K.

 

Due to the seasonality of the Company’s business, the results of operations for interim periods are not necessarily indicative of the operating results for a full year.

 

The Company has revised its consolidated balance sheets as of December 31, 2013 and March 31, 2014 to correct the classification of the capitalized development costs of its proprietary technologies included in certain key products from property and equipment, to other intangible assets. As compared to previously reported amounts, property and equipment, net, has been reduced and other intangible assets, net, have been increased by $3,415 and $3,805 for December 31, 2013 and March 31, 2014, respectively. Furthermore, the Company has revised its consolidated balance sheets as of December 31, 2013 and March 31, 2014 to present, on a net basis, its domestic non-current deferred tax liabilities and non-current deferred tax assets. As compared to previously reported amounts, deferred income taxes included in non-current assets and non-current deferred income taxes liabilities have been reduced by $3,801 and $3,812 for December 31, 2013 and March 31, 2014, respectively. These revisions represent errors that were not deemed material, individually or in aggregate, to the consolidated financial statements for the corresponding prior periods. These revisions do not impact the Company’s previously reported consolidated results of operations or statements of cash flows.

 

Accumulated other comprehensive income (loss) consists solely of currency translation adjustments.

 

7

 

LEAPFROG ENTERPRISES, INC.

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

 

2.Fair Values of Financial Instruments and Investments

 

Fair value is defined by authoritative guidance as the exit price, or the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants as of the measurement date. The guidance establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market participants would use in valuing the asset or liability and are developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the factors market participants would use in valuing the asset or liability. The guidance establishes three levels of inputs that may be used to measure fair value:

  

·Level 1 includes financial instruments for which quoted market prices for identical instruments are available in active markets. As of December 31, 2014 and 2013, the Company’s Level 1 assets consisted of money market funds. As of March 31, 2014, the Company’s Level 1 assets consisted of money market funds and a certificate of deposit with original maturities of three months or less. These assets were considered highly liquid and are stated at cost, which approximates market value.

 

·Level 2 includes financial instruments for which there are inputs other than quoted prices included within Level 1 that are observable for the instrument. Such inputs could be quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets with insufficient volume or infrequent transactions (less-active markets), or model-driven valuations in which significant inputs are observable or can be derived principally from, or corroborated by, observable market data, including market interest rate curves, referenced credit spreads and prepayment rates.

 

As of December 31, 2014 and 2013, the Company’s Level 2 assets and liabilities consisted of outstanding foreign exchange forward contracts used to hedge its exposure to certain foreign currencies, including the British Pound, Canadian Dollar and Euro. The Company did not hold any Level 2 assets as of March 31, 2014. The Company’s outstanding foreign exchange forward contracts, all with maturities of approximately one month, had notional values of $37,927 and $37,182 at December 31, 2014 and 2013, respectively. The fair market values of these instruments, based on quoted prices, were $69 and $6, on a net basis at December 31, 2014 and 2013, respectively, and recorded in prepaid expenses and other current assets.

 

·Level 3 includes financial instruments for which fair value is derived from valuation techniques, including pricing models and discounted cash flow models, in which one or more significant inputs, including the Company’s own assumptions, are unobservable. The Company did not hold any Level 3 assets as of December 31, 2014, March 31, 2014 and December 31, 2013.

 

The following table presents the Company’s fair value hierarchy for assets and liabilities measured at fair value on a recurring basis as of December 31, 2014, March 31, 2014 and December 31, 2013:

 

   Estimated Fair Value Measurements 
   Carrying Value   Quoted Prices in
Active Markets
(Level 1)
   Significant
Other
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs
(Level 3)
 
December 31, 2014:                
Financial Assets:                    
Money market funds  $48   $48   $-   $- 
Forward currency contracts   69    -    69    - 
Total financial assets  $117   $48   $69   $- 
March 31, 2014:                    
Financial Assets:                    
Money market funds and certificate of deposit  $118,795   $118,795   $-   $- 
December 31, 2013:                    
Financial Assets:                    
Money market funds  $44,263   $44,263   $-   $- 
Forward currency contracts   6    -    6    - 
Total financial assets  $44,269   $44,263   $6   $- 

 

8

 

LEAPFROG ENTERPRISES, INC.

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

 

3.Inventories

 

The Company’s inventories, stated on a first-in, first-out basis at the lower of cost or market, were as follows as of December 31, 2014 and 2013, and March 31, 2014:

  

   December 31,   March 31, 
   2014   2013   2014 
Raw materials  $3,782   $4,619   $4,594 
Finished goods   74,014    49,671    47,699 
Total  $77,796   $54,290   $52,293 

 

4.Other Intangible Assets and Goodwill

 

The Company’s other intangible assets and goodwill were as follows as of December 31, 2014 and 2013, and March 31, 2014:

 

   December 31,   March 31, 
   2014   2013   2014 
Intellectual property, license agreements and other intangibles  $21,555   $20,170   $20,560 
Less: accumulated amortization   (17,719)   (16,705)   (16,755)
Total  $3,836   $3,465   $3,805 
                
Goodwill  $-   $19,549   $19,549 

 

The Company evaluates long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset group may not be recoverable. For the quarter ended December 31, 2014, based on various qualitative factors, the Company determined that testing for recoverability of its long-lived assets, including other intangible assets, was required. These qualitative factors included, among others, the Company’s performance during the 2014 holiday season being significantly lower than anticipated, which included the underperformance of products and product lines newly introduced to the market, and the continuing decrease in trading values of the Company’s stock and corresponding decline in the Company’s market capitalization. As a result, the Company performed an impairment review of its long-lived assets, including other intangible assets, by comparing the cumulative undiscounted future cash flows with their carrying value as of December 31, 2014. Upon completion of the assessment, the Company concluded that its long-lived assets were not impaired as of December 31, 2014 as their carrying value did not exceed the cumulative undiscounted future cash flows. The principal assumptions used in the Company’s undiscounted cash flow analyses consisted of projections of future net cash flows, which are considered as Level 3 inputs within the fair value hierarchy. 

 

The Company’s goodwill, solely allocated to its U.S. segment, was $19,549 as of March 31, 2014 and December 31, 2013. The Company performs goodwill impairment testing at least annually on its fiscal year end date, and between annual tests if events occur or circumstances change that warrant a review. The Company performed the qualitative assessment for impairment as of December 31, 2013 and concluded that its goodwill had not been impaired.

 

For the quarter ended December 31, 2014, based on various qualitative factors, the Company determined that sufficient indicators existed warranting a review to determine if the fair value of its U.S. reporting unit had been reduced to below its carrying value. These qualitative factors included, among others, the Company’s performance during the 2014 holiday season being significantly lower than anticipated, which included the underperformance of products and product lines newly introduced to the market, and the continuing decrease in trading values of the Company’s stock and corresponding decline in the Company’s market capitalization. As a result, the Company performed goodwill impairment testing using the required two-step process as of December 31, 2014. The first step of this process includes comparing the fair value to the carrying value of the reporting unit to which the goodwill is allocated to identify potential impairment. If the fair value of the reporting unit exceeds its carrying value, goodwill allocated to that reporting unit is considered not impaired. If the inverse result is observed, the reporting unit is considered to be impaired and the Company must then complete step two of the test to measure the amount of impairment. Step two compares the implied fair value of the goodwill with the carrying value of that goodwill. If the carrying value of the goodwill exceeds its implied fair value, an impairment loss is recognized in an amount equal to that excess. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination. That is, the fair value of the reporting unit is allocated to all of its assets and liabilities as if the reporting unit had been acquired in a business combination and its fair value was the purchase price paid to acquire the reporting unit.

 

9

 

LEAPFROG ENTERPRISES, INC.

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

 

The Company determined the fair value of its U.S. reporting unit by using a weighted combination of income based approach and market based approach, as this combination was deemed the most indicative of the Company’s fair value in an orderly transaction between market participants. Under the income approach, the Company used a discounted cash flow (“DCF”) methodology which recognizes that current value is premised on the expected receipt of future economic benefits. Indications of value are developed by discounting projected future net cash flows to their present value at a rate that reflects both the current return requirements of the market and the risks inherent in the specific investment. The DCF methodology requires significant judgment by management in selecting an appropriate discount rate, terminal growth rate, weighted average cost of capital, and projection of future net cash flows, which are inherently uncertain. The inputs and assumptions used in this test are classified as Level 3 inputs within the fair value hierarchy. Due to these significant judgments, the fair value of the U.S. reporting unit determined in connection with the goodwill impairment test may not necessarily be indicative of the actual value that would be recognized in a future transaction. Under the market based approach, the Company utilized its own information to determine earnings multiples and sales multiples that are used to value its U.S. reporting unit.

 

The result of the Company’s step one test indicated that the carrying value of the Company’s U.S. reporting unit exceeded its estimated fair value. Accordingly, the Company performed the step two test and concluded that its goodwill was fully impaired and thus recorded a permanent impairment charge of $19,549 for the quarter ended December 31, 2014 in its U.S. segment. This impairment charge was reported as a separate line item in the consolidated statement of operations. The tax benefit associated with this charge was $3,812. The impairment charge is non-cash in nature and does not affect the Company’s current or future liquidity.

 

5.Income Taxes

 

The Company’s effective tax rate is affected by recurring items, such as tax benefit or expense relative to the amount of loss incurred or income earned in its domestic and foreign jurisdictions. The Company’s tax rate is also affected by discrete items, such as tax benefits attributable to the recognition of previously unrecognized tax benefits and changes in valuation allowance, which may occur in any given year but are not consistent from year to year.

 

The Company maintains valuation allowances against its deferred tax assets related to various federal, state, and foreign net operating loss carryforwards, tax credits, and capital loss carryforwards. The Company evaluates its ability to realize the benefit of its deferred tax assets in each of its jurisdictions, at the required more-likely-than-not level of certainty, based on the existence of sufficient taxable income of the appropriate character within the carryforward period. In determining the need for a valuation allowance, the Company weighs all available positive and negative evidence, both objective and subjective in nature. The weight given to the positive and negative evidence is commensurate with the extent to which the evidence may be objectively verified. Due to the high seasonality of the Company’s business with a significant portion of its annual income earned late in the year, the final determination for the need for valuation allowances is generally made at the end of the December quarter, after the critical holiday season has passed.

 

A full valuation allowance was recorded against the Company’s domestic deferred tax assets starting in 2006. As of December 31, 2012, based on its evaluation of all evidence available, the Company determined that a portion of its domestic deferred tax assets would be realized. Accordingly, $21,614 of the Company’s domestic valuation allowance was released and recorded as an income tax benefit for the year ended December 31, 2012.

 

For the three months ended December 31, 2013, the Company again evaluated its ability to realize the benefit of its domestic deferred tax assets. Consideration was given to negative evidence such as: the duration and severity of losses in prior years, high seasonal revenue concentrations, increasing competitive pressures, and a challenging retail environment. However, after considering four consecutive years of profitability and a significant three year cumulative domestic income position as of December 31, 2013, the Company believed the weight of the objectively verifiable positive evidence was sufficient to overcome the weight of the existing negative evidence. Accordingly, the Company determined that the benefit of a signification portion of its domestic deferred tax assets would be realized and $62,759 of the Company’s domestic deferred tax valuation allowance was released and recorded as an income tax benefit for the quarter ended December 31, 2013.

 

10

 

LEAPFROG ENTERPRISES, INC.

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

 

For the three months ended December 31, 2014, the Company again evaluated its ability to realize the benefit of its domestic deferred tax assets. The Company considered existing positive evidence available such as: historic profitability, lack of expiring net operating loss and tax credit carryforwards, and viable tax strategies that could potentially impact the likelihood of realizing its deferred tax assets. However, the Company’s performance during the 2014 holiday season was significantly lower than anticipated and the underperformance of products and product lines newly introduced to the market had a considerable impact on its projections of future taxable income. Consequently, the Company anticipates a three year cumulative domestic loss position within the current fiscal year. In determining if sufficient projected future taxable income exists to realize the benefit of its deferred tax assets, the Company considers cumulative losses in recent years as significant negative evidence that is difficult to overcome. In addition, the goodwill impairment recorded in the quarter ended December 31, 2014 was considered additional significant negative evidence indicating the benefit of its deferred tax assets would not be realized. After weighing all evidence available, the Company believed there was not sufficient positive evidence to overcome the significant negative evidence and so determined that sufficient projected future taxable income did not exist to realize the full benefit of its domestic deferred tax assets before expiration. As a result, the Company concluded a full valuation allowance against its domestic deferred tax assets was warranted. Accordingly, the Company established an additional valuation allowance of $101,773, of which $90,769 was recorded as an income tax provision and impacted the Company’s effective tax rate for the three and nine months ended December 31, 2014. The remaining $11,004 of additional valuation allowance was established against deferred tax assets attributable to current period losses, the respective tax expense and tax benefits of which were fully offset during the period, and therefore did not impact the Company’s effective tax rate for the three and nine months period ended December 31, 2014.

 

The Company maintained a valuation allowance of $109,961, $8,065 and $8,188 against its domestic deferred tax assets as of December 31, 2014 and 2013, and March 31, 2014, respectively. The Company also maintained a valuation allowance of $1,502, $1,676, and $1,697 against the deferred tax assets of its subsidiary in Mexico as of December 31, 2014 and 2013, and March 31, 2014, respectively, which was initially established during 2012. As of December 31, 2014, the Company also evaluated the deferred tax assets associated with its other foreign jurisdictions, and believes that the benefit of these deferred tax assets will be realized. Therefore, no valuation allowance has been established against such deferred tax assets as of December 31, 2014. The Company will continue to evaluate all evidence, positive and negative, in all jurisdictions in future periods, to determine if a change in valuation allowance against its deferred tax assets is warranted. Any changes to the Company’s valuation allowance will affect its effective tax rate, but will not affect the amount of cash paid for income taxes in the foreseeable future.

 

The consolidated current and non-current deferred tax assets were $661 and $1,498 at December 31, 2014, respectively, as compared to $25,639 and $49,053 at December 31, 2013, respectively, and $22,553 and $57,810 at March 31, 2014, respectively. The decreases in the current period were primarily due to the full valuation allowance recorded against the Company’s domestic deferred tax assets as of December 31, 2014.

 

The Company’s effective tax rates and income tax provisions for the three and nine months ended December 31, 2014 were primarily attributable to recording a full non-cash valuation allowance against its domestic deferred tax assets during the periods, partially offset by a tax benefit of $3,812 associated with the non-cash goodwill impairment charge as described in Note 4. The Company’s effective tax rates and income tax benefits for the same periods in 2013 were primarily attributable to the release of a substantial portion of its valuation allowance previously recorded against its domestic deferred tax assets. The Company excludes jurisdictions with tax assets for which no benefit can be recognized from the computation of its effective tax rate. Accordingly, the Company’s domestic loss was excluded from the computation of its effective tax rates for the three and nine months ended December 31, 2014, and the Company’s subsidiary in Mexico was excluded from the computation of its effective tax rates for the three and nine months ended December 31, 2014 and 2013.

 

During the three and nine months ended December 31, 2014, the Company recognized $154 and $604, respectively, of certain previously unrecognized tax benefits, including a release of $37 and $195 of accrued interest and penalties, respectively, due to the expiration of the statutes of limitations in some of its foreign jurisdictions. During the three and nine months ended December 31, 2013, the Company recognized $401 of certain previously unrecognized tax benefits, including a release of $312 of accrued interest, due to the expiration of statutes of limitations in some of its foreign jurisdictions. As of December 31, 2014 and 2013, and March 31, 2014, the Company had $15,880, $20,319 and $16,280, respectively, of unrecognized income tax benefits. The Company believes it is reasonably possible that the total amount of unrecognized income tax benefits could decrease by up to $7,033 over the course of the next twelve months, due to expiring domestic statutes of limitations, which would not affect its effective tax rate due to the full valuation allowance recorded against its domestic deferred tax assets. As of December 31, 2014, the Company had no accrued interest and penalties related to uncertain tax positions. As of December 31, 2013 and March 31, 2014, the Company had approximately $362 and $187, respectively, of accrued interest and penalties related to uncertain tax positions. The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. The recognition of previously unrecognized tax benefits and the release of associated accrued interest reduced other non-current tax liabilities.

 

11

 

LEAPFROG ENTERPRISES, INC.

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

 

As of December 31, 2014, the Company had current deferred tax liabilities of $1,290 reported as current liabilities on the consolidated balance sheet, and had no non-current deferred tax liabilities or other non-current tax liabilities. As of December 31, 2013 and March 31, 2014, the Company had no current deferred tax liabilities and had non-current deferred tax liabilities of $3,801 and 3,812, respectively, which were netted against non-current deferred tax assets on the consolidated balance sheet. As of December 31, 2013 and March 31, 2014, the Company had other non-current tax liabilities of $832 and $607, respectively, reported as long-term liabilities on the consolidated balance sheet.

 

6.Stock-Based Compensation

 

The Company currently has outstanding two types of stock-based compensation awards to its employees, directors and certain consultants: stock options and restricted stock units (“RSUs”), which are more fully described in Note 13 to the Consolidated Financial Statements: Share-Based Compensation in its 2013 Form 10-K. Both stock options and RSUs can be used to acquire shares of the Company’s Class A common stock, are exercisable or convertible, as applicable, over a period not to exceed ten years, and are most commonly assigned four-year vesting periods. The Company also has an employee stock purchase plan (“ESPP”).

 

Stock plan activity

 

The table below summarizes award activity for the nine months ended December 31, 2014:

 

   Stock       Total 
   Options   RSUs   Awards 
Outstanding at March 31, 2014   6,774    1,476    8,250 
Grants   1,278    1,110    2,388 
Stock option exercises/vesting RSUs   (296)   (348)   (644)
Retired or forfeited   (768)   (287)   (1,055)
Outstanding at December 31, 2014   6,988    1,951    8,939 
                
Total shares available for future grant at December 31, 2014             5,792 

 

As of December 31, 2014, the total shares available for future grant under the ESPP were 762.

 

Impact of stock-based compensation

 

The following table summarizes stock-based compensation expense charged to selling, general and administrative (“SG&A”) and research and development (“R&D”) expenses for the three and nine months ended December 31, 2014 and 2013:

 

   Three Months Ended December 31,   Nine Months Ended December 31, 
   2014   2013   2014   2013 
SG&A:                    
Stock options  $1,390   $1,591   $4,177   $4,331 
RSUs   1,130    1,006    3,108    2,623 
ESPP   99    108    262    333 
Total SG&A   2,619    2,705    7,547    7,287 
R&D:                    
Stock options   206    207    634    619 
RSUs   171    131    495    348 
Total R&D   377    338    1,129    967 
Total expense  $2,996   $3,043   $8,676   $8,254 

 

12

 

LEAPFROG ENTERPRISES, INC.

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

 

Valuation of stock-based compensation

 

Stock-based compensation expense related to stock options is calculated based on the fair value of each award on the grant date. In general, the fair value for stock option grants with only a service condition is estimated using the Black-Scholes option pricing model with the following weighted-average assumptions for the three and nine months ended December 31, 2014 and 2013:

  

   Three Months Ended December 31,   Nine Months Ended December 31, 
   2014   2013   2014   2013 
Expected term (years)   4.60    4.44    4.70    4.64 
Volatility   59.7%   70.3%   59.9%   72.0%
Risk-free interest rate   1.41%   1.27%   1.56%   0.86%
Expected dividend yield   - %   - %   - %   - %

 

RSUs are payable in shares of the Company’s Class A common stock. The fair value of these stock-based awards is equal to the closing market price of the Company’s common stock on the date of grant. The grant-date fair value is recognized on a straight-line basis in compensation expense over the vesting period of these stock-based awards, which is generally four years.

 

Stock-based compensation expense related to the ESPP is estimated using the Black-Scholes option pricing model with the following assumptions for the three and nine months ended December 31, 2014 and 2013:

 

   Three Months Ended December 31,   Nine Months Ended December 31, 
   2014   2013   2014   2013 
Expected term (years)   0.49    0.49    0.49    0.49 - 0.5 
Volatility   42.0%   36.0%   34.8% - 42.0%   36.0% - 57.5%
Risk-free interest rate   0.05%   0.05%   0.05% - 0.08%   0.05% - 0.12%
Expected dividend yield   - %   - %   - %   - %

 

7.Share Repurchase Program

 

On February 10, 2014, the Company’s board of directors approved a stock repurchase program authorizing the Company to repurchase up to an aggregate of $30,000 of its Class A common stock through December 31, 2014. The Company intended, from time to time, as conditions warranted, to repurchase stock in the open market. The plan did not obligate the Company to repurchase any specific number of shares and was suspendable at any time at management’s discretion. During the three months ended June 30, 2014, the Company repurchased approximately 6 shares of its common stock at an average price of $6.50, which were retired upon repurchase. The Company did not repurchase any of its common stock during the three months ended December 31, 2014. This stock repurchase program expired on December 31, 2014.

 

8.Net Income (Loss) Per Share

 

The following table sets forth the computation of basic and diluted net income (loss) per share for three and nine months ended December 31, 2014 and 2013:

 

   Three Months Ended December 31,   Nine Months Ended December 31, 
   2014   2013   2014   2013 
(Numerator)                    
Net income (loss)  $(124,212)  $63,937   $(142,606)  $87,020 
(Denominator)                    
Weighted average shares outstanding during period:                    
Class A and B - basic   70,169    69,038    69,997    68,601 
Common stock equivalents   -    1,614    -    1,947 
Class A and B - diluted   70,169    70,652    69,997    70,548 
Net income (loss) per share:                    
Class A and B - basic  $(1.77)  $0.93   $(2.04)  $1.27 
Class A and B - diluted  $(1.77)  $0.90   $(2.04)  $1.23 

 

All options to purchase shares of the Company’s common stock and RSUs, totaling 8,980 and 9,070 for the three and nine months ended December 31, 2014, respectively, were excluded from the calculation of diluted net loss per share due to the net loss during the periods. Options to purchase shares of the Company’s common stock and RSUs excluded from the calculation of diluted net loss per share were 4,202 and 3,499 for the three and nine months ended December 31, 2013, respectively, as the effect would have been antidilutive.

 

13

 

LEAPFROG ENTERPRISES, INC.

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

 

9.Segment Reporting

 

The Company’s business is organized, operated and assessed in two geographic segments: U.S. and International.

 

The Company attributes sales to non-U.S. countries on the basis of sales billed by each of its foreign subsidiaries to its customers. Additionally, the Company attributes sales to non-U.S. countries if the product is shipped from Asia or one of its leased warehouses in the U.S. to a distributor in a foreign country. The Company charges all of its indirect operating expenses and general corporate overhead to the U.S. segment and does not allocate any of these expenses to the International segment.

 

The primary business of the two operating segments is as follows:

 

·The U.S. segment is responsible for the development, design, sales and marketing of multimedia learning platforms, related content and learning toys, which are sold primarily through retailers, distributors, and directly to consumers via the leapfrog.com online store and the LeapFrog App Center (“App Center”) in the U.S. The App Center includes both content developed by the Company and content from third parties that the Company curates and distributes.

 

·The International segment is responsible for the localization, sales and marketing of multimedia learning platforms, related content and learning toys, originally developed for the U.S. This segment markets and sells the Company’s products to national and regional mass-market and specialty retailers and other outlets through the Company’s offices outside of the U.S., through distributors in various international markets, and directly to consumers via online stores and the App Center.

 

The table below shows certain information by segment for the three and nine months ended December 31, 2014 and 2013:

 

   Three Months Ended December 31,   Nine Months Ended December 31, 
   2014   2013   2014   2013 
Net sales:                    
United States  $99,183   $123,697   $207,449   $328,886 
International   45,415    63,010    97,771    141,792 
Totals  $144,598   $186,707   $305,220   $470,678 
Income (loss) from operations:                    
United States  $(39,822)  $(12,231)  $(73,977)  $7,994 
International   3,332    12,929    8,633    31,479 
Totals  $(36,490)  $698   $(65,344)  $39,473 

 

For the three and nine months ended December 31, 2014 and 2013, the U.S. and the United Kingdom individually accounted for more than 10% of the Company’s consolidated net sales, respectively.

 

10.Commitments and Contingencies

 

Two purported securities class actions were filed in the United States District Court for the Northern District of California against the Company and two of its officers, John Barbour and Raymond L. Arthur on January 23 and February 2, 2015, respectively. A stockholder derivative action was filed on February 5, 2015, in the Superior Court of California, County of Alameda, purportedly on behalf of the Company against current members of the Company’s Board. See Note 11 for additional information.

 

In addition, from time to time, the Company is subject to legal proceedings and claims in the ordinary course of business, including claims of alleged infringement of patents and other intellectual property rights, claims related to breach of contract, employment disputes and a variety of other matters. The Company records a liability when the Company believes that it is both probable that a loss will be incurred, and the amount can be reasonably estimated. In the opinion of management, based on current knowledge, it is not reasonably possible that any of the pending legal proceedings or claims will have a material adverse impact on the Company’s financial position, results of operations or cash flows. Regardless of the outcome, litigation can have an adverse impact on the Company because of defense costs, diversion of management resources and other factors. In addition, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a particular reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements of the same reporting period could be materially adversely affected.

 

14

 

LEAPFROG ENTERPRISES, INC.

 

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

 

As of December 31, 2014, the Company had commitments to purchase inventory under normal supply arrangements totaling approximately $27,822 and had no outstanding off-balance sheet arrangements.

 

11.Subsequent Events

 

Two purported securities class actions (the “Class Actions”) were filed in the United States District Court for the Northern District of California against the Company and two of its officers, John Barbour and Raymond L. Arthur. The Class Actions, which were filed on January 23 and February 2, 2015, respectively, are captioned: Newett v. LeapFrog Enterprises, Inc. et al., Case No. 3:15-cv-00347 and Farias v. LeapFrog Enterprises, Inc. et al., 3:15-cv-00478. The complaints filed in the Class Actions, which are substantially identical, allege that all defendants violated Section 10(b) the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and SEC Rule 10b-5, by making materially false or misleading statements to purchasers of the Company’s stock regarding the Company’s financial projections and performance between May 5, 2014 and January 22, 2015. The complaints also allege that Messrs. Barbour and Arthur violated Section 20(a) of the Exchange Act. The complaints seek class certification, an award of unspecified compensatory damages, an award of reasonable costs and expenses, including attorneys’ fees, and other further relief as the Court may deem just and proper. The foregoing is a summary of the allegations in the complaints and is subject to the text of the complaints, which are on file with the Court. Based on a review of the complaints, the Company and the individual defendants believe that the plaintiffs’ allegations are without merit, and intend to vigorously defend against the claims. The Company believes that the amount of liability related to these matters, if any, is not currently probable or estimable.

 

A stockholder derivative action captioned Ziemann v. Chiasson, et al., Case No. RG15-757609 (the “Derivative Action”) was filed on February 5, 2015, in the Superior Court of California, County of Alameda, purportedly on behalf of the Company against current members of the Company’s Board. The complaint in the Derivative Action alleges that the Company’s Board members breached their fiduciary duties, aided and abetted each other's alleged breach of fiduciary duties, and committed corporate waste by permitting the Company to make allegedly false or misleading statements between May 5, 2014 and January 22, 2015. The statements at issue in the Derivative Action are substantially similar to those at issue in the Class Actions described above. The plaintiff in the Derivative Action seeks, purportedly on behalf of the Company, an unspecified award of damages including, but not limited to, fees and costs associated with the pending Class Actions, various corporate governance reforms, an award of restitution, an award of reasonable costs and expenses, including attorneys' fees, and other further relief as the Court may deem just and proper. The foregoing is a summary of the allegations in the complaint filed in the Derivative Action and is subject to the text of the complaint, which is on file with the Court. Based on a review of the complaint, the Company believes that the plaintiff has failed to establish standing to sue on the Company’s behalf. The Company believes that the amount of liability related to this matter, if any, is not currently probable or estimable.

 

On February 4, 2015, the Company implemented a restructuring plan to reduce its global workforce in an effort to streamline its operations and reduce its cost structure. The Company will record a restructuring charge of approximately $1,394 in the quarter ending March 31, 2015 for employee severance benefits and other costs related to this plan.

 

15

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Forward-looking Statements

 

This Quarterly Report on Form 10-Q contains forward-looking statements about management’s expectations, including, without limitation, our expectations regarding cash provided by operations in the quarter ending March 31, 2015, the anticipated failure to realize the full benefit of certain deferred tax assets, the indefinite reinvestment of the undistributed earnings of our foreign subsidiaries, our intention not to repatriate any foreign earnings to the U.S., expectations regarding the effect of our net operating loss or tax credit carryforwards on any tax liability associated with the repatriation of cash held by our foreign subsidiaries, the tax treatment of the repatriation of cash from our subsidiary in Mexico, the anticipated impact of our accumulated deficit and net cash used in operating activities during the current quarter on our future ability to operate, the funding, nature and amount of future capital expenditures, the future funding of our working capital needs, and the timing and seasonality of cash flows from operations. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “expect,” “intend,” “plan,” “anticipate,” “believe,” “future,” “potential,” or the negative of these terms or other comparable terminology. Our actual results, levels of activity, performance, achievements or the timing of events may differ materially from those expressed or implied by such forward-looking statements. The risks that could cause our results to differ include, without limitation, our ability to correctly predict highly changeable consumer preferences and product trends, our ability to continue to develop new products and services and successfully manage frequent product introductions and transitions, our ability to compete effectively with competitors, deterioration of global economic conditions, our reliance on a small group of retailers for the majority of our gross sales, the effectiveness of our marketing and advertising efforts, the seasonality of our business, system failures in our online services or web store, our dependence on our suppliers for our components and raw materials, our reliance on a limited number of manufacturers, our ability to maintain appropriate inventory levels, our ability to maintain or acquire licenses, our ability to protect or enforce our intellectual property rights, defects in our products, the risks associated with international operations, costs or changes associated with compliance with laws and regulations, negative political developments, changes in trade relations, armed hostilities, terrorism, labor strikes, natural disasters, or public health issues, our ability to attract and retain highly skilled personnel, the sufficiency of our liquidity, impacts from acquisitions, mergers, or dispositions, continued ownership by a few stockholders of a significant percentage of the voting power in the company, the volatility of our stock price, the impact of potential impairment charges or valuation allowances against our deferred tax assets, and failure to successfully implement new strategic operating initiatives. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, achievements or the timing of any events. We make these statements as of the date of this Quarterly Report on Form 10-Q and undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise after the date of this report, except as required by law.

 

The following management’s discussion and analysis of financial condition and results of operations (“MD&A”) is intended to help the reader understand the results of operations and financial condition of LeapFrog Enterprises, Inc. and its consolidated subsidiaries (collectively, “LeapFrog,” “we,” “us” or “our”). This MD&A is provided as a supplement to, and should be read in conjunction with, our Consolidated Financial Statements and the accompanying Notes in Part I, Item 1 of this Quarterly Report on Form 10-Q.

 

Our Business

 

LeapFrog is a leading developer of educational entertainment for children. Our product portfolio consists of multimedia learning platforms and related content, and learning toys. We have developed a number of learning platforms, including the LeapTV educational video game system, the LeapPad family of learning tablets, the Leapster family of handheld learning game systems, and the LeapReader reading and writing systems, which facilitate a wide variety of learning experiences provided by our rich content libraries, available in cartridge, print and digital format. We have created hundreds of interactive content titles for our platforms, covering subjects such as phonics, reading, writing, mathematics, science, social studies, creativity and life skills. In addition, we have a broad line of stand-alone interactive learning toys, including the LeapBand activity tracker. Many of our products connect to our proprietary online LeapFrog Learning Path, which provides personalized feedback on a child’s learning progress and offers product recommendations to enhance each child’s learning experience. Our products are available in four languages (English, Queen’s English, French and Spanish) and are sold globally through retailers, distributors and directly to consumers via the leapfrog.com online store and the LeapFrog App Center (“App Center”).

 

16

 

Due to the seasonality of our business, our results of operations for interim periods are not necessarily indicative of the operating results for a full year.

 

Consolidated Results of Operations

 

   Three Months Ended
December 31,
   % Change
2014 vs.
   Nine Months Ended
December 31,
   % Change
2014 vs.
 
   2014   2013   2013   2014   2013   2013 
   (Dollars in millions, except per share data) 
Net sales  $144.6   $186.7    (23)%  $305.2   $470.7    (35)%
Cost of sales   99.5    114.2    (13)%   214.2    287.9    (26)%
Gross margin*   31.2%   38.8%   (7.6)**   29.8%   38.8%   (9.0)**
Operating expenses   81.6    71.8    14%   156.3    143.3    9%
Operating expenses as a percent of net sales   56%   38%   18**   51%   30%   21**
Income (loss) from operations   (36.5)   0.7    N/M    (65.3)   39.5    (266)%
Net income (loss) per share - basic  $(1.77)  $0.93   $(2.70)***  $(2.04)  $1.27   $(3.31)***
Net income (loss) per share - diluted  $(1.77)  $0.90   $(2.67)***  $(2.04)  $1.23   $(3.27)***

   
*       Gross profit as a percentage of net sales
**     Percentage point change
***   Dollar change

 

Net sales for the three and nine months ended December 31, 2014 decreased 23% and 35%, respectively, as compared to the same periods in 2013, primarily due to decreased consumer demand for our LeapPad line of children’s tablets and associated content, and lower than anticipated demand for our new LeapTV educational video game system and associated content. Tighter inventory management across a number of our retailer partners and the West Coast port slowdown in the U.S. also contributed to the decrease in tablet sales. Net sales for the nine months ended December 31, 2014 was also negatively impacted by higher than desired inventory levels at retail entering the fiscal year which reduced retailer replenishment orders, as well as retailers reducing inventory levels, partially offset by the calendar shift of Easter. Net sales for the three months ended December 31, 2014 included a 1% negative impact from changes in currency exchange rates. Net sales for the nine months ended December 31, 2014 were not materially affected by foreign currency exchange rates.

 

Cost of sales for the three and nine months ended December 31, 2014 decreased 13% and 26%, respectively, as compared to the same periods in 2013 primarily driven by lower net sales resulting in lower product costs. 

 

Gross margin for the three and nine months ended December 31, 2014 was 31.2% and 29.8%, respectively, a decrease of 7.6 and 9.0 percentage points, respectively, as compared to the same periods of 2013 primarily driven by significantly higher trade discounts as a percentage of net sales to support sell-through of higher than desired inventory levels at retail, higher inventory allowances, lower sales volume which increased the impact of fixed logistics costs, and higher content amortization costs. Gross margin for the three months ended December 31, 2014 was also negatively impacted by changes in product mix with proportionally higher sales of lower-margin hardware. Gross margin for the nine months ended December 31, 2014 was also negatively impacted by changes in product mix with proportionally higher sales of lower-margin toys partially offset by lower sales of lower-margin hardware.

 

Operating expenses for the three and nine months ended December 31, 2014 increased 14% and 9%, respectively, as compared to the same periods of 2013 primarily due to a $19.5 million non-cash goodwill impairment charge recorded during the current quarter and higher spending on in-store displays, partially offset by lower spending on cooperative advertising and content development, and the timing of capitalization of website development costs. Operating expenses for the three months ended December 31, 2014 were also impacted by a shift in timing of TV advertisement spending to the September quarter in 2014 as compared to the December quarter in 2013. Operating expenses for the nine months ended December 31, 2014 were also impacted by a decrease in incentive compensation expense, increases in headcount in the current year, and a one-time favorable settlement of a dispute with a supplier during the prior year period.

 

Income (loss) from operations for the three and nine months ended December 31, 2014 worsened by $37.2 million and $104.8 million, respectively, as compared to the same periods in 2013 driven by the decrease in net sales, reduced gross margin and higher operating expenses including the goodwill impairment charge.

 

17

 

Basic and diluted net income (loss) per share for the three months ended December 31, 2014 decreased $2.70 and $2.67, respectively, as compared to the same period of 2013. Basic and diluted net income (loss) per share for the nine months ended December 31, 2014 decreased $3.31 and $3.27, respectively, as compared to the same period of 2013. Basic and diluted net loss per share for the three and nine months ended December 31, 2014 included $(0.23) due to the non-cash goodwill impairment charge, net of the associated tax benefit, and $(1.29) due to the establishment of a non-cash valuation allowance against our deferred tax assets.

 

Operating Expenses

 

Selling, General and Administrative Expenses

 

Selling, general and administrative (“SG&A”) expenses consist primarily of salaries and related employee benefits, including stock-based compensation expense and other headcount-related expenses associated with executive management, finance, information technology, supply chain, facilities, human resources, other administrative headcount, legal and other professional fees, indirect selling expenses, systems costs, rent, office equipment and supplies.

 

   Three Months Ended
December 31,
   % Change
2014 vs.
   Nine Months Ended
December 31,
   % Change
2014 vs.
 
   2014   2013   2013   2014   2013   2013 
   (Dollars in millions) 
SG&A expenses  $23.3   $23.6    (1)%  $64.7   $64.3    1%
As a percent of net sales   16%   13%   3*   21%   14%   7*

 

 
 *  Percentage point change

 

SG&A expenses for the three months ended December 31, 2014 remained relatively flat as compared to the same period in 2013 without significant offsetting impacts. SG&A expenses for the nine months ended December 31, 2014 remained relatively flat, increasing 1% as compared to the same period in 2013, due to an increase in allowance for doubtful accounts largely offset by lower incentive compensation expense.

 

Research and Development Expenses

 

Research and development (“R&D”) expenses consist primarily of salaries and employee benefits, including stock-based compensation expense and other headcount-related expenses, associated with content development, product development, product engineering, third-party development and programming, and localization costs to translate and adapt content for international markets. We capitalize external third-party costs and certain internal costs related to content development, which are subsequently amortized into cost of sales in the statements of operations.

 

   Three Months Ended
December 31,
   % Change
2014 vs.
   Nine Months Ended
December 31,
   % Change
2014 vs.
 
   2014   2013   2013   2014   2013   2013 
   (Dollars in millions) 
R&D expenses  $9.0   $10.7    (16)%  $24.0   $26.9    (11)%
As a percent of net sales   6%   6%   -*   8%   6%   2*

   
 *   Percentage point change

 

R&D expenses for the three and nine months ended December 31, 2014 decreased 16% and 11%, respectively, as compared to the same periods in 2013 primarily driven by the timing of capitalization of web development costs, lower content development costs and lower incentive compensation expense, partially offset by higher expenses due to an increase in headcount to support our strategic initiatives.

 

Advertising Expense

 

Advertising expense consists of costs associated with marketing, advertising and promoting our products, including customer-related discounts and promotional allowances.

 

18

 

   Three Months Ended
December 31,
   % Change
2014 vs.
   Nine Months Ended
December 31,
   % Change
2014 vs.
 
   2014   2013   2013   2014   2013   2013 
   (Dollars in millions) 
Advertising expenses  $26.8   $34.8    (23)%  $39.5   $44.1    (10)%
As a percent of net sales   19%   19%   -*   13%   9%   4*

   
 *   Percentage point change

 

Advertising expenses for the three and nine months ended December 31, 2014 decreased 23% and 10%, respectively, as compared to the same periods in 2013 primarily due to less spending on cooperative advertising, TV advertising and online advertising, partially offset by higher spending on in-store displays during the current year periods. Advertising expenses for the nine months ended December 31, 2014 were also impacted by a favorable one-time settlement of a dispute with a supplier during the prior year period.

 

Goodwill Impairment

 

As of December 31, 2014, based on various qualitative factors, we determined that sufficient indicators existed warranting a review to determine if the fair value of our U.S. reporting unit had been reduced to below its carrying value. These qualitative factors included, among others, our performance during the 2014 holiday season being significantly lower than anticipated which included the underperformance of products and product lines newly introduced to the market, the continuing decrease in trading values of our stock and corresponding decline in our market capitalization. As a result, we performed a two-step quantitative goodwill impairment test as required. Based on the result of the two-step analysis, we concluded that our goodwill was fully impaired as of December 31, 2014. Accordingly, we have recorded a permanent non-cash pretax impairment charge of $19.5 million for the three months ended December 31, 2014 in our U.S. segment. The tax benefit associated with this charge was $3.8 million. See Note 4 in the accompanying consolidated financial statements for additional information on our goodwill impairment testing.

 

Income Taxes

 

Our tax rate is affected by recurring items, such as tax benefits or expenses relative to the amount of loss incurred or income earned in our domestic and foreign jurisdictions. Our tax rate is also affected by discrete items, such as tax benefits attributable to the recognition of previously unrecognized tax benefits and changes in valuation allowance, which may occur in any given year but are not consistent from year to year.

 

We maintain valuation allowances against our deferred tax assets related to various federal, state, and foreign net operating loss carryforwards, tax credits, and capital loss carryforwards. We evaluate our ability to realize the benefit of our deferred tax assets in each jurisdiction, at the required more-likely-than-not level of certainty, based on the existence of sufficient taxable income of the appropriate character within the carryforward period. In determining the need for a valuation allowance, we weigh all available positive and negative evidence, both objective and subjective in nature. The weight given to the positive and negative evidence is commensurate with the extent to which the evidence may be objectively verified. Due to the high seasonality of our business with a significant portion of our annual income earned late in the year, the final determination for the need for valuation allowances is generally made at the end of the December quarter, after the critical holiday season has passed.

 

A full valuation allowance was recorded against our domestic deferred tax assets starting in 2006. As of December 31, 2012, based on our evaluation of all evidence available, we determined that a portion of our domestic deferred tax assets would be realized. Accordingly, $21.6 million of our domestic valuation allowance was released and recorded as an income tax benefit for the year ended December 31, 2012.

 

For the three months ended December 31, 2013, we again evaluated our ability to realize the benefit of our domestic deferred tax assets. Consideration was given to negative evidence such as: the duration and severity of losses in prior years, high seasonal revenue concentrations, increasing competitive pressures, and a challenging retail environment. However, after considering four consecutive years of profitability and a significant three year cumulative domestic income position as of December 31, 2013, we believed the weight of the objectively verifiable positive evidence was sufficient to overcome the weight of the existing negative evidence. As of December 31, 2013, we concluded that the benefit of a significant portion of our domestic deferred tax assets would be realized. Accordingly, $62.8 million of our domestic deferred tax valuation allowance was released and recorded as an income tax benefit during the quarter ended December 31, 2013.

 

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For the three months ended December 31, 2014, we again evaluated our ability to realize the benefit of our domestic deferred tax assets. We considered existing positive evidence available such as: historic profitability, lack of expiring net operating loss and tax credit carryforwards, and viable tax strategies that could potentially impact the likelihood of realizing our deferred tax assets. However, our performance during the 2014 holiday season was significantly lower than anticipated and the underperformance of products and product lines newly introduced to the market had a considerable impact on our projections of future taxable income. Consequently, we anticipate a three year cumulative domestic loss position within the current fiscal year. In determining if sufficient projected future taxable income exists to realize the benefit of our deferred tax assets, we consider cumulative losses in recent years as significant negative evidence that is difficult to overcome. In addition, the goodwill impairment recorded in the quarter ended December 31, 2014 was considered additional significant negative evidence indicating the benefit of our deferred tax assets would not be realized. After weighing all evidence available, we believed there was not sufficient positive evidence to overcome the significant negative evidence and so determined, that sufficient projected future taxable income did not exist to realize the full benefit of our domestic deferred tax assets before expiration. As a result, we concluded a full valuation allowance against our domestic deferred tax assets was warranted. Accordingly, we established an additional valuation allowance of $101.8 million, of which $90.8 million was recorded as an income tax provision and impacted our effective tax rate for the three and nine months ended December 31, 2014. The remaining $11.0 million of additional valuation allowance was established against deferred tax assets attributable to current period losses, the respective tax expense and tax benefits of which were fully offset during the period, and therefore did not impact our effective tax rate for the three and nine months period ended December 31, 2014.

 

As of December 31, 2014, we maintained a valuation allowance of $110.0 million against our domestic deferred tax assets. We also maintained a valuation allowance of $1.5 million against the deferred tax assets of our subsidiary in Mexico, which was initially established during 2012. As of December 31, 2014, we also evaluated the deferred tax assets associated with our other foreign jurisdictions, and believe that the benefit of these deferred tax assets will be realized. Therefore, no valuation allowance has been established against such deferred tax assets as of December 31, 2014. We will continue to evaluate all evidence in all jurisdictions in future periods, to determine if a change in valuation allowance against our deferred tax assets is warranted. Any changes to our valuation allowance will affect our effective tax rate, but will not affect the amount of cash paid for income taxes in the foreseeable future.

 

Our effective tax rates and income tax provisions for the three and nine months ended December 31, 2014 were primarily attributable to recording a full non-cash valuation allowance against our domestic deferred tax assets during the periods partially offset by a tax benefit of $3.8 million associated with the non-cash goodwill impairment charge as described in Note 4 in the accompanying consolidated financial statements. In addition, during the three and nine months ended December 31, 2014, we recognized $0.2 million and $0.6 million, respectively, of certain previously unrecognized tax benefits due to the expiration of statutes of limitations in some of our foreign jurisdictions. Our effective tax rates and income tax benefits for the same periods in 2013 were primarily attributable to our release of a substantial portion of the valuation allowance previously recorded against domestic deferred tax assets. During the three and nine months ended December 31, 2013, we recognized $0.4 million of certain previously unrecognized tax benefits due to the expiration of statutes of limitations in some of our foreign jurisdictions. We exclude jurisdictions with tax assets for which no benefit can be recognized from the computation of our effective tax rate and tax provision. Accordingly, our domestic loss was excluded from the computation of our effective tax rates for the three and nine months ended December 31, 2014, and our subsidiary in Mexico was excluded from the computation of our effective tax rates for the three and nine months ended December 31, 2014 and 2013.

 

Results of Operations by Segment

 

We organize, operate and assess our business in two primary operating segments: U.S. and International. This presentation is consistent with how our chief operating decision maker reviews performance, allocates resources and manages the business.

 

United States Segment

 

The U.S. segment is responsible for the development, design, sales and marketing of multimedia learning platforms, related content and learning toys. The U.S. segment includes net sales and related expenses directly associated with selling our products to national and regional mass-market and specialty retailers, other retail stores, distributors, resellers, and online channels including our online store and our App Center. Certain corporate-level operating expenses associated with sales and marketing, product support, human resources, legal, finance, information technology, corporate development, procurement activities, R&D, legal settlements and other corporate costs are charged entirely to our U.S. segment.

 

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   Three Months Ended
December 31,
   % Change
2014 vs.
   Nine Months Ended
December 31,
   % Change
2014 vs.
 
   2014   2013   2013   2014   2013   2013 
   (Dollars in millions) 
Net sales  $99.2   $123.7    (20)%  $207.4   $328.9    (37)%
Cost of sales   69.6    77.7    (10)%   148.6    201.5    (26)%
Gross margin*   29.8%   37.2%   (7.4)**   28.4%   38.7%   (10.3)**
Operating expenses   69.4    58.2    19%   132.8    119.4    11%
Operating expenses as a percent of net sales   70%   47%   23**   64%   36%   28**
Income (loss) from operations  $(39.8)  $(12.2)   (226)%  $(74.0)  $8.0    N/M 

 

 

 *     Gross profit as a percentage of net sales  
 **   Percentage point change  
     

Net sales for both the three and nine months ended December 31, 2014 decreased 20% and 37%, respectively, as compared to the same periods in 2013, primarily due to decreased consumer demand for our LeapPad line of children’s tablets and associated content, and lower than anticipated demand for our new LeapTV educational video game system and associated content. Tighter inventory management across a number of our retailer partners and the West Coast port slowdown in the U.S. also contributed to the decrease in tablet sales. Net sales for the nine months ended December 31, 2014 was also negatively impacted by higher than desired inventory levels at retail entering the fiscal year which reduced retailer replenishment orders, as well as retailers reducing inventory levels, partially offset by the calendar shift of Easter.

 

Cost of sales for the three and nine months ended December 31, 2014 decreased 10% and 26%, respectively, as compared to the same periods in 2013 primarily driven by lower sales volume resulting in lower product costs.

 

Gross margin for the three and nine months ended December 31, 2014 decreased 7.4 and 10.3 percentage points, respectively, as compared to the same periods of 2013 primarily driven by significantly higher trade discounts as a percentage of net sales to support sell-through of higher than desired inventory levels at retail, higher inventory allowances, lower sales volume which increased the impact of fixed logistics costs, and higher content amortization costs. Gross margin for the three months ended December 31, 2014 was also negatively impacted by changes in product mix with proportionally higher sales of lower-margin hardware. Gross margin for the nine months ended December 31, 2014 was also negatively impacted by changes in product mix with proportionally higher sales of lower-margin toys partially offset by lower sales of lower-margin hardware.

 

Operating expenses for the three and nine months ended December 31, 2014 increased 19% and 11%, respectively, as compared to the same periods of 2013 primarily due to a $19.5 million non-cash goodwill impairment charge recorded during the current quarter and higher spending on in-store displays. The increases were partially offset by lower spending on cooperative advertising and content development, and the timing of capitalization of website development costs. Operating expenses for the three months ended December 31, 2014 were also impacted by a shift in timing of TV advertising spending to the September quarter in 2014 as compared to the December quarter in 2013. Operating expenses for the nine months ended December 31, 2014 were also impacted by a decrease in incentive compensation expense, increases in headcount in the current year, and a one-time favorable settlement of a dispute with a supplier during the prior year period.

 

Income (loss) from operations for the three and nine months ended December 31, 2014 worsened by $27.6 million and $82.0 million, respectively, as compared to the same periods in 2013 driven by the decrease in net sales, reduced gross margin, and higher operating expenses including the goodwill impairment charge.

 

International Segment

 

The International segment is responsible for the localization, sales and marketing of multimedia learning platforms, related content and learning toys, originally developed for the U.S. The International segment includes the net sales and related expenses directly associated with selling our products to national and regional mass-market and specialty retailers and other outlets through our offices in the United Kingdom, France and Canada and through distributors in markets such as Australia, Mexico, South Africa and Spain, as well as through our App Centers and online stores directed to certain international jurisdictions. Certain corporate-level operating expenses associated with sales and marketing, product support, human resources, legal, finance, information technology, corporate development, procurement activities, research and development, legal settlements and other corporate costs are allocated to our U.S. segment and not allocated to our International segment.

 

21

 

   Three Months Ended
December 31,
   % Change
2014 vs.
   Nine Months Ended
December 31,
   % Change
2014 vs.
 
   2014   2013   2013   2014   2013   2013 
   (Dollars in millions) 
Net sales  $45.4   $63.0    (28)%  $97.8   $141.8    (31)%
Cost of sales   29.9    36.5    (18)%   65.6    86.5    (24)%
Gross margin*   34.2%   42.0%   (7.8)**   32.9%   39.0%   (6.1)**
Operating expenses   12.2    13.6    (10)%   23.5    23.9    (2)%
Operating expenses as a percent of net sales   27%   22%   5**   24%   17%   7**
Income from operations  $3.3   $12.9    (74)%  $8.6   $31.5    (73)%

     
 *     Gross profit as a percentage of net sales  
 **   Percentage point change    

 

Net sales for the three and nine months ended December 31, 2014 decreased 28% and 31%, respectively, as compared to the same periods in 2013, primarily due to decreased consumer demand for our LeapPad line of children’s tablets and associated content, and lower than anticipated demand for our new LeapTV educational video game system and associated content. Tighter inventory management across a number of our retailer partners also contributed to the decrease in tablet sales. Net sales for the nine months ended December 31, 2014 was also negatively impacted by higher than desired inventory levels at retail entering the fiscal year which reduced retailer replenishment orders, as well as retailers reducing inventory levels, partially offset by the calendar shift of Easter. Net sales for the three and nine months ended December 31, 2014 included a 3% and a 1% negative impact, respectively, from changes in currency exchange rates.

 

Cost of sales decreased 18% and 24%, respectively, for the three and nine months ended December 31, 2014 as compared to the same periods in 2013 primarily driven by lower net sales resulting in lower product costs.

 

Gross margin for the three and nine months ended December 31, 2014 decreased 7.8 and 6.1 percentage points, respectively, as compared to the same periods in 2013 primarily driven by higher inventory allowances, lower sales volume which increased the impact of fixed logistics costs, and higher royalty costs due to proportionally higher sales of licensed content. Gross margin for the three months ended December 31, 2014 was also negatively impacted by changes in product mix with proportionally higher sales of lower-margin hardware. Gross margin for the nine months ended December 31, 2014 was also negatively impacted by significantly higher trade discounts as a percentage of net sales to support sell-through of higher than desired inventory levels at retail entering the fiscal year, and changes in product mix with proportionally higher sales of lower-margin toys.

 

Operating expenses for the three and nine months ended December 31, 2014 decreased 10% and 2%, respectively, as compared to the same periods in 2013 primarily driven by lower spending on cooperative advertising, partially offset by an increase in allowance for doubtful accounts. Operating expenses for the nine months ended December 31, 2014 was also impacted by lower incentive compensation expense.

 

Income from operations for the three and nine months ended December 31, 2014 decreased 74% and 73%, respectively, as compared to the same periods in 2013 due to the decreases in net sales and reduced gross margin, partially offset by lower operating expenses.

 

Liquidity and Capital Resources

 

Financial Condition

 

Cash and cash equivalents totaled $94.0 million and $168.1 million at December 31, 2014 and 2013, respectively. The decrease was primarily due to a decrease in net cash generated by operating activities as a result of reduced operating results, and increased inventory levels, as well as due to higher capital expenditures during the year. In line with our investment policy, cash equivalents were comprised of high-grade short-term money market funds as of December 31, 2014.

 

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Cash and cash equivalents held by our foreign subsidiaries totaled $25.5 million and $31.4 million as of December 31, 2014 and 2013, respectively. We consider the undistributed earnings of our foreign subsidiaries as of December 31, 2014 to be indefinitely reinvested, and accordingly, no U.S. income taxes have been provided thereon. We do not currently intend to repatriate any foreign earnings to the U.S. However, if we were to repatriate these amounts to the U.S., any associated tax liability would be fully offset by our domestic net operating loss or tax credit carry forwards for the foreseeable future. 

 

A change in business strategy for distributing product into Mexico will ultimately result in the liquidation of our subsidiary in Mexico as we outsource distribution to a third party. At the end of the liquidation process, we intend to repatriate any residual cash to the U.S. We believe this cash repatriation will be considered a return of capital and not a repatriation of earnings and therefore will not result in a U.S. tax liability. Accordingly we have not recorded a tax provision for such return of capital.

 

We have an asset-based revolving credit facility (the “revolving credit facility”) with a potential borrowing availability of $75.0 million for the months of September through December and $50.0 million for the remaining months. The borrowing availability varies according to the levels of our accounts receivable and cash and investment securities deposited in secured accounts with the lenders. Borrowing availability under this revolving credit facility was $45.3 million as of December 31, 2014. There were no borrowings outstanding on our revolving credit facility at December 31, 2014.

 

Our accumulated deficit of $146.4 million at December 31, 2014 and net cash used in operating activities during the current quarter are not expected to have an impact on our future ability to operate, given our anticipated cash flows from operations, cash position and the availability of our revolving credit facility.

 

Future capital expenditures are primarily planned for new product development and purchases related to the upgrading of our information technology capabilities. We expect that capital expenditures for the fiscal year ending March 31, 2015, including those for capitalized content and website development costs, will be funded with cash flows generated by operations. Capital expenditures were $34.2 million for the nine months ended December 31, 2014 and $25.5 million for the same period of 2013. We expect capital expenditures to be in the range of $40.0 million to $45.0 million for the fiscal year ending March 31, 2015, as we make significant investments to upgrade our internal business systems and invest in significant new product launches during the year. We expect capital expenditures to be lower than this level in future years.

 

On February 10, 2014, our board of directors approved a stock repurchase program authorizing us to repurchase up to an aggregate of $30.0 million of our common stock through December 31, 2014. During the three months ended June 30, 2014, the number of shares we repurchased was insignificant. The repurchased shares were retired upon repurchase. During the three months ended December 31, 2014, we did not repurchase any of our common stock. This stock repurchase program expired on December 31, 2014.

 

We believe that cash on hand, cash flow from operations and amounts available under our revolving credit facility will provide adequate funds for our working capital needs and planned capital expenditures over the next twelve months. Our ability to fund our working capital needs and planned capital expenditures, as well as our ability to comply with all of the financial covenants of our revolving credit facility, depend on our future operating performance and cash flows. 

 

Cash Sources and Uses

 

The table below shows our sources and uses of cash for the nine months ended December 31, 2014 as compared to the same period in 2013:

 

   Nine Months Ended
December 31,
   % Change
2014 vs.
 
   2014   2013   2013 
   (Dollars in millions) 
Net cash provided by (used in):               
Operating activities  $(104.9)  $0.7    N/M 
Investing activities   (34.2)   (25.5)   (34)%
Financing activities   0.5    3.3    (84)%
Effect of exchange rate changes on cash   0.5    (0.1)   N/M 
Decrease in cash and cash equivalents  $(138.0)  $(21.7)   N/M 

 

23

 

Net cash used in operations for the nine months ended December 31, 2014 increased $105.6 million as compared to the same period in 2013 primarily due to increased net loss related to operating activities and higher inventory levels at the end of the period.

 

Net cash used in investing activities for the nine months ended December 31, 2014 increased $8.7 million as compared to the same period of 2013 primarily due to an increase in investments to upgrade our internal business systems and to develop more complex new products.

 

Net cash provided by financing activities for the nine months ended December 31, 2014 decreased $2.8 million as compared to the same period of 2013 primarily due to a decrease in proceeds from stock option exercises and employee stock purchase plan.

 

Seasonal Patterns of Cash Provided By or Used in Operations

 

Historically, through 2011, our cash flows from operations has generally been highest in the quarter ending in March of each year when we collect a majority of our accounts receivable booked in the quarter ending in December of the prior calendar year. In 2013 and 2012, an increase in earlier sales to retailers in the quarters ending in September and December, and credit card-based sales through our App Center in the quarter ending in December resulted in higher cash flow from operations in the quarter ending in December than in the quarter ending in March, which was a deviation from our historical norm. Cash flow used in operations tends to be highest in the quarter ending in September, as collections from prior accounts receivable taper off and we invest heavily in inventory in preparation for the holiday season. Historically, cash flow generally turns positive again in the quarter ending in December as we begin to collect on the accounts receivable associated with the holiday season. However, this pattern has not continued for the current fiscal year due to later launches of new products as well as the deterioration of our overall financial performance in the current year as compared to previous years. Due to the significant reduction in cash generated from operations and increase in inventory levels during the December quarter, we used more cash in operations than was provided. These factors may also reduce our cash provided by operations in the quarter ending March 31, 2015 as compared to previous years. These seasonal patterns may vary depending upon general economic conditions and other factors.

 

Contractual Obligations and Commitments

 

We have had no material changes outside the ordinary course of our business in our contractual obligations during the nine months ended December 31, 2014. In addition, as of December 31, 2014, we had commitments to purchase inventory under normal supply arrangements totaling approximately $27.8 million and had no outstanding off-balance sheet arrangements.

 

Critical Accounting Policies

 

In the ordinary course of business, we make a number of estimates and assumptions relating to the reporting of results of operations and financial position in the preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the U.S. Actual results could differ significantly from those estimates under different assumptions and conditions. We included in our 2013 Form 10-K a discussion of our critical accounting policies that are particularly important to the portrayal of our financial position and results of operations and that require the use of our management’s most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

 

We have made no material changes to any of the critical accounting policies discussed in our 2013 Form 10-K through December 31, 2014.

 

Recently Issued Accounting Guidance Not Yet Adopted

 

In August 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-15, Presentation of Financial Statements - Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. This guidance requires management to evaluate, at each interim and annual reporting period, whether there are conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date the financial statements are issued, and provide related disclosures. This guidance will be effective for annual period ending after December 15, 2016, i.e. our fiscal year ending March 31, 2017, and for annual and interim periods thereafter. Early adoption is permitted. We do not expect a material impact on our consolidated financial statements upon the adoption of this guidance.

 

24

 

In May 2014, the FASB issued ASU 2014-09, Summary and Amendments That Create Revenue from Contracts with Customers (Topic 606) and Other Assets and Deferred Costs-Contracts with Customers (Subtopic 340-40). This guidance outlines a single comprehensive model for accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. The core principle of this guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This guidance also includes a cohesive set of disclosure requirements intended to provide users of financial statements with comprehensive information about the nature, amount, timing and uncertainty of revenue and cash flows arising from an entity’s contracts with customers. For public entities, this guidance will be effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period, i.e. the first quarter of our fiscal year 2018. Early application is not permitted. This guidance can be adopted either retrospectively to each prior reporting period presented, or retrospectively with a cumulative-effect adjustment recognized as of the date of adoption. We are currently evaluating the impact on our consolidated financial statements upon the adoption of this guidance.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Our market risk disclosures set forth in Item 7A of our 2013 Form 10-K have not changed materially for our quarter ended December 31, 2014.

 

We develop products in the U.S. and market our products primarily in North America and, to a lesser extent, in Europe and the rest of the world. We are billed by and pay our third-party manufacturers in U.S. dollars. Sales to our international customers are transacted primarily in the country’s local currency. As a result, our financial results could be affected by factors such as changes in foreign currency rates or weak economic conditions in foreign markets.

 

We manage our foreign currency transaction exposure by entering into short-term forward contracts. The purpose of this hedging program is to minimize the foreign currency exchange gain or loss reported in our financial statements, but the program, when properly executed, may not always eliminate our exposure to movements of currency exchange rates. The results of our hedging program for the three and nine months ended December 31, 2014 and 2013 are summarized in the table below:

 

   Three Months Ended December 31,   Nine Months Ended December 31, 
   2014   2013   2014   2013 
   (Dollars In thousands)   (Dollars In thousands) 
Gain (loss) on foreign exchange forward contracts  $1,209   $(484)  $2,871   $(1,754)
Gain (loss) on underlying transactions denominated in foreign currency   (1,551)   185    (3,379)   1,254 
Net losses  $(342)  $(299)  $(508)  $(500)

 

Our foreign exchange forward contracts generally have original maturities of one month or less. A summary of all foreign exchange forward contracts outstanding as of December 31, 2014 is as follows:

 

   As of December 31, 2014 
   Average Forward
Exchange Rate
   Notional Amount
in Local
Currency
   Fair Value of
Instruments in
USD
 
       (1)   (2) 
Currencies:               
British Pound (GBP/USD)   1.559    15,364   $11 
Euro (Euro/USD)   1.217    9,521    57 
Canadian Dollar (USD/CAD)   1.158    2,763    1 
Total fair value of instruments in USD            $69 

   
(1)  In thousands of local currency
(2)  In thousands of USD

 

Cash equivalents are presented at fair value on our consolidated balance sheet. We invest our excess cash in accordance with our investment policy. As of December 31, 2014 and 2013, our excess cash was invested in money market funds. As of March 31, 2014, our excess cash was invested in money market funds and a certificate of deposit.

 

25

 

ITEM 4. CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls and Procedures

 

We have evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. This evaluation was performed by management, with the participation of our Chief Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”). Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), such as this Quarterly Report on Form 10-Q, is recorded, processed, summarized and reported, within the time periods specified in the rules and forms of the U.S. Securities and Exchange Commission (“SEC”) and include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

 

Based on this evaluation, our CEO and CFO have concluded that our disclosure controls and procedures were not effective as of December 31, 2014, because of the material weakness in internal control over financial reporting described below.

 

Completed or Planned Remediation Actions to Address Material Weakness

 

As of December 31, 2013, we did not maintain effective controls over our process for establishing reserves for customer-related discounts and promotional allowances. Specifically, controls were not adequately designed to ensure the completeness and accuracy of data entered into the accounting system and used to determine customer-related discounts and promotional allowances. As a result, it was necessary for us to make a post-closing adjustment to increase our reserve for customer-related discounts and promotional allowances. Additionally, this control deficiency could result in misstatements of the aforementioned accounts and disclosures that would result in a material misstatement of the consolidated financial statements that would not be prevented or detected.

 

We have undertaken the remediation steps described below to address the material weakness discussed above: 

 

·Modified the period-end close processes to capture and analyze a complete list of customer-related discounts and promotional allowances for financial statement impact as of period-end; and

 

·Modified the data review process associated with customer-related discounts and promotional allowances to ensure classification of promotional programs is subject to independent review.

 

We will continue to monitor the remediation steps throughout the year and a final assessment will be performed as part of the evaluation of disclosure controls and procedures for the fiscal year ending March 31, 2015. We have undertaken a number of procedures and instituted controls to help ensure the proper collection, evaluation and disclosure of the information included in our financial statements. As a result, we believe that the consolidated financial statements for the periods covered by and included in this Quarterly Report on Form 10-Q are fairly stated in all material respects.

 

Inherent Limitations on Effectiveness of Controls

 

A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Accordingly, our disclosure controls and procedures are designed to provide reasonable, not absolute, assurance that the objectives of our disclosure system are met. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Changes in Internal Control over Financial Reporting

 

As described above in the section “Completed or Planned Remediation Actions to Address Material Weakness”, there were changes in our internal control over financial reporting during the nine months ended December 31, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II.

 

OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

 

Two purported securities class actions (the “Class Actions”) have been filed in the United States District Court for the Northern District of California against us and two of our officers, John Barbour and Raymond L. Arthur. The Class Actions, which were filed on January 23 and February 2, 2015, respectively, are captioned: Newett v. LeapFrog Enterprises, Inc. et al., Case No. 3:15-cv-00347 and Farias v. LeapFrog Enterprises, Inc. et al., 3:15-cv-00478. The complaints filed in the Class Actions, which are substantially identical, allege that all defendants violated Section 10(b) the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and SEC Rule 10b-5, by making materially false or misleading statements to purchasers of our stock regarding our financial projections and performance between May 5, 2014 and January 22, 2015. The complaints also allege that Messrs. Barbour and Arthur violated Section 20(a) of the Exchange Act. The complaints seek class certification, an award of unspecified compensatory damages, an award of reasonable costs and expenses, including attorneys’ fees, and other further relief as the Court may deem just and proper. The foregoing is a summary of the allegations in the complaints and is subject to the text of the complaints, which are on file with the Court. Based on a review of the complaints, we and the individual defendants believe that the plaintiffs’ allegations are without merit, and intend to vigorously defend against the claims.

 

A stockholder derivative action captioned Ziemann v. Chiasson, et al., Case No. RG15-757609 (the “Derivative Action”) was filed on February 5, 2015, in the Superior Court of California, County of Alameda, purportedly on behalf of us against current members of our Board. The complaint in the Derivative Action alleges that our Board members breached their fiduciary duties, aided and abetted each other's alleged breach of fiduciary duties, and committed corporate waste by permitting us to make allegedly false or misleading statements between May 5, 2014 and January 22, 2015. The statements at issue in the Derivative Action are substantially similar to those at issue in the Class Actions described above. The plaintiff in the Derivative Action seeks, purportedly on behalf of us, an unspecified award of damages including, but not limited to, fees and costs associated with the pending Class Actions, various corporate governance reforms, an award of restitution, an award of reasonable costs and expenses, including attorneys' fees, and other further relief as the Court may deem just and proper. The foregoing is a summary of the allegations in the complaint filed in the Derivative Action and is subject to the text of the complaint, which is on file with the Court. Based on a review of the complaint, we believe that the plaintiff has failed to establish standing to sue on our behalf.

 

In addition, from time to time, we are subject to other legal proceedings and claims in the ordinary course of business, including claims of alleged infringement of patents and other intellectual property rights, claims related to breach of contract, employment disputes and a variety of other matters. We record a liability when we believe that it is both probable that a loss will be incurred, and the amount can be reasonably estimated. In the opinion of management, based on current knowledge, it is not reasonably possible that any of the pending legal proceedings or claims will have a material adverse impact on our financial position, results of operations or cash flows. Regardless of the outcome, litigation can have an adverse impact on us because of defense costs, diversion of management resources and other factors. In addition, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against us in a particular reporting period for amounts in excess of management’s expectations, our consolidated financial statements of the same reporting period could be materially adversely affected.

 

ITEM 1A. RISK FACTORS

 

There have been no material changes to the risk factors disclosed under Part I, Item 1A. “Risk Factors” in our 2013 Form 10-K, except for the risk factors below:

 

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If we were required to record an impairment charge related to the value of our long-lived assets, or an additional valuation allowance against our deferred tax assets, our results of operations would be adversely affected.

  

Our long-lived assets are tested for impairment if indicators of impairment exist. If impairment testing shows that the carrying value of our long-lived assets exceeds their estimated fair values, we would be required to record a non-cash impairment charge, which would decrease the carrying value of our long-lived assets, as the case may be, and our results of operations would be adversely affected. Our deferred tax assets include net operating loss and tax credit carryforwards that can be used to offset taxable income and reduce income taxes payable in future periods. Each quarter, we determine the probability of realizing the benefits of our deferred tax assets. If we determine that there is not sufficient anticipated future taxable income to realize the benefits of these assets, an additional valuation allowance would be required to reduce the value of our deferred tax assets. Such a reduction could result in a material non-cash expense in the period in which the valuation allowance is adjusted and our results of operations would be adversely affected. We will continue to perform these tests and any future adjustments may have a material adverse effect on our financial condition and results of operations.

 

Failure to successfully implement new strategic operating initiatives could have a significant adverse effect on our business, financial condition and results of operations.

 

We continually evaluate the opportunity to grow and improve our business processes in a variety of ways. For example, in the recent past, we have undertaken initiatives to change our fiscal year, update our enterprise resource planning system, reduce our costs, increase our efficiency, enhance product safety, and simplify processes. These initiatives involve investment of capital and complex decision-making as well as extensive and intensive execution, and the success of these initiatives is not assured. Failure to successfully implement any of these initiatives, or the failure of any of these initiatives to produce the results anticipated by management, could have a significant adverse effect on our business, financial condition, and results of operations. 

 

Our success is dependent on our ability to attract and retain highly skilled personnel, including senior management, and a recent reduction in force may impede our ability to do so. 

 

Our success depends on our ability to attract and retain highly skilled personnel in key functions, including senior management. We compete with many other potential employers in recruiting, hiring and retaining skilled officers and other key employees. Recently, we implemented a reduction in our workforce to align our employee base and cost structure with our current and anticipated revenues. These reductions will result in reallocations of duties and may increase employee uncertainty and discontent and may cause unintended or increased attrition. There is no guarantee that we will be able to recruit, hire or retain the senior management, officers and other employees we need to succeed and the reductions in force could make it more difficult to do so.

 

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ITEM 6. EXHIBITS

 

        Incorporated by Reference    
Exhibit Number   Exhibit Description   Form   File No.   Original Exhibit Number   Filing Date   Filed Herewith
3.01   Amended and Restated Certificate of Incorporation   S-1/A   333-86898   3.03   7/22/2002    
                         
3.02   Amended and Restated Bylaws   8-K   001-31396   3.01   11/20/2012    
                         
4.01   Form of Specimen Class A Common Stock Certificate   10-Q   001-31396   4.01   11/3/2011    
                         
4.02   Fourth Amended and Restated Stockholders Agreement, dated as of May 30, 2003, by and among LeapFrog Enterprises, Inc. and the other persons named therein   10-Q   001-31396   4.02   8/12/2003    
                         
31.01   Certification of the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                   X
                         
31.02   Certification of the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                   X
                         
32.01   Certification of the Chief Executive Officer and the Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                   X
                         
101   The following materials from the registrant’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2014, formatted in Extensible Business Reporting Language (XBRL), include: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Operations, (iii) the Consolidated Statements of Comprehensive Income (Loss), (iv) the Consolidated Statements of Cash Flows, and (v) Notes to the Consolidated Financial Statements                   X

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

LeapFrog Enterprises, Inc.  
(Registrant)  
   
/s/ John Barbour  
John Barbour  
Chief Executive Officer  
(Principal Executive Officer)  
   
Date: February 9, 2015  
   
/s/ Raymond L. Arthur  
Raymond L. Arthur  
Chief Financial Officer  
(Principal Financial Officer)  
   
Date: February 9, 2015  

 

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