Why the Kids Are Dissing LeapFrog
Its first product was a huge success. But the $640 million toymaker has since become too uncool for school.
By Susanna Hamner

(Business 2.0) – Two years ago, Bill and Stacey McGuire were looking for the perfect toy for their 7-year-old daughter, Maggie. They wanted to find something fun, of course, but they also wanted it to have educational value, to boost their daughter's learning skills. In a toy store near their beach home in Gulf Shores, Ala., they found it: the LeapPad, a $35 interactive reading toy made by LeapFrog. "I thought it would be great," Bill recalls. His daughter thought otherwise. Maggie played with her LeapPad a few times and then pushed it aside, preferring the educational games loaded on the family computer. "Kids today have different expectations than they did even five years ago," McGuire says with a sigh.

As it happens, LeapFrog is also struggling to figure out what kids do for fun nowadays. While the Emeryville, Calif., manufacturer of educational toys has long been regarded as an innovator, it hasn't produced a breakout hit apart from the LeapPad--which has remained largely unchanged since 1999. "They haven't been able to come up with new products that kids and parents want," says Piper Jaffray toy industry analyst Anthony Gikas.

What a change. When LeapFrog went public in 2002, it was the most successful IPO of the year, raising $117 million. In 2003 it zipped past competitors to become the third-largest U.S. toy company, behind Mattel and Hasbro. Then LeapFrog hit a wall. During the run-up to the holiday selling season, a supply-chain breakdown delayed toy shipments to retailers. In October 2003, when LeapFrog missed its third-quarter sales target by $31 million, the stock fell from $46 to $35 in a day.

Under a new management team led by CEO Thomas Kalinske, LeapFrog slashed about 200 jobs--a fifth of its workforce--and fixed the distribution problems. Yet the toymaker still isn't making money. The company lost $14 million last year despite sales of $640 million. During the first two quarters of this year, it lost another $29.7 million. LeapFrog's share of the electronic educational toy market dropped to 62 percent in 2004 from nearly 100 percent two years earlier. The stock now hovers around $14 a share.

Tough Customers

Cranking out smash hits is hard work in any business, but educational toys are particularly difficult. Kids want toys to be fun. But the consumers who actually purchase toys--moms and dads--also want their kids to learn reading and math. Meeting those competing requirements is a tall order.

Analysts say LeapFrog has struggled because many of its toys feel too much like homework. Sales of educational toys hit $1.1 billion for the 12 months ending in July, up 13 percent over the year before, according to NPD. But much of that growth has gone to LeapFrog's competitors, which have taken their cues from trends in the rest of the toy industry. For example, handheld and tabletop electronics, such as electronic card games, are red-hot, with sales up 57 percent to $348.8 million during the same period. Meanwhile, the Entertainment Software Association reports that gamers younger than 18 represent 35 percent of the $10 billion videogame market--a 17 percent increase over 2003. "Kids are into videogames and controllers they can manipulate," says toy industry consultant Chris Byrne. "LeapFrog should move in that direction."

The company's one smash hit, the LeapPad, has been a mixed blessing. When it was unveiled in 1999, it was unique: an electronic tablet that reads aloud when children touch the text of a book with a special pen. Parents loved it, and in 2001 the LeapPad became the top-selling toy in America. Today 16 million households own a LeapPad, but LeapFrog hasn't updated the underlying hardware, and it's introduced few compelling new features. "People don't have a reason to buy another one," says Edward Woo of Wedbush Morgan Securities.

Subsequent rollouts have fallen flat. In 2001, LeapFrog tried to make a splash among hard-to-please middle school kids with its iQuest, a handheld study aid that doubled as a personal organizer. Bulky and initially priced at $110, the iQuest never caught on. The Leapster, a Game Boy-style handheld videogame machine for 4- to 10-year-olds introduced in 2003, has been a modest success. But none of the new products has come close to matching the LeapPad's early triumph. Says Morningstar analyst Rick Summer, "I'd almost go so far as to call them a one-trick pony."

In Search of Serious Fun

Part of the problem may be that fun takes a backseat to educational content in LeapFrog's product development process. "We go to educators to find out about the problems kids are having, and then we come up with a solution," CEO Kalinske says. "We don't notice that school buses are popular with kids, for example, and then try to make them educational."

Some believe that LeapFrog should do just that--look at megahits like Nintendo's Game Boy, Sony's PlayStation 2, and Apple's iPod and make educational products that work with them. "They should go after what kids find attractive," says Piper Jaffray's Gikas. "If the LeapPad doesn't get used, parents won't buy a Leapster."

Making matters more difficult, Mattel and Hong Kong-based VTech are making inroads in the $1.1 billion educational toy industry by focusing on fun. VTech's V.Smile, a hit educational game console introduced in 2004, relies on superior aesthetics to outsell LeapFrog's Leapster L-Max, which went on sale this summer. "The L-Max is better educationally, but the V.Smile's graphics just look much better," says Harris Nesbitt Gerard analyst Sean McGowan. Meanwhile, $5.1 billion Mattel, the world's largest toymaker, has exploited its iconic Fisher-Price brand to gain a foothold. Mattel and VTech now hold a combined 30 percent of the educational toy market.

LeapFrog's Kalinske argues that his company is simply experiencing "a little slump in profitability and revenue" and that "each of our products has the potential to be the next LeapPad." As to the company's hopes for this Christmas season, Kalinske points to a new gadget called Fly, a $99 electronic pen that gives 8- to 13-year-old students audio feedback when they write on special sheets of paper. "We think it's going to be very successful," he says.

Outside the company, however, expectations aren't running high. During a demonstration for 150 journalists and analysts earlier this year, Fly proved buggy, misreading some of the numbers penned by LeapFrog president Jerry Perez. Worse, analysts worry that the device is too expensive, too large, and too constrained by its hard-to-find paper. "We've been blown away by the feedback we've received from industry experts, analysts, and teachers," counters LeapFrog marketing vice president Sharon Delman, adding that 50 kids from the target age group helped guide Fly's design. But if Fly doesn't fly, LeapFrog won't get the jump it needs to restore profitability.