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 September 30, 2015

 

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 incorporation or organization)	(I.R.S. Employer 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 October 30, 2015, 66,574,193 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	Page
Item 1.	Financial Statements	3
	Consolidated Balance Sheets at September 30, 2015 and 2014 and March 31, 2015 (Unaudited)	3
	Consolidated Statements of Operations for the Three and Six Months Ended September 30, 2015 and 2014 (Unaudited)	4
	Consolidated Statements of Comprehensive Loss for the Three and Six Months Ended September 30, 2015 and 2014 (Unaudited)	5
	Consolidated Statements of Cash Flows for the Six Months Ended September 30, 2015 and 2014 (Unaudited)	6
	Notes to the Consolidated Financial Statements (Unaudited)	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	27
Item 4.	Controls and Procedures	28
	Part II. Other Information
Item 1.	Legal Proceedings	30
Item 1A.	Risk Factors	30
Item 6.	Exhibits	38
Signatures		39

 

 

 

PART I.

FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

 

LEAPFROG ENTERPRISES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)

(Unaudited)

 

		September 30,								March 31,
		2015				2014				2015
ASSETS
Current assets:
Cash and cash equivalents		$	52,604			$	111,344			$	127,176
Accounts receivable, net of allowances for doubtful accounts of $1,341, $402 and $854, respectively			60,504				98,965				19,618
Inventories			75,715				108,197				71,927
Prepaid expenses and other current assets			9,600				12,380				10,012
Deferred income taxes			964				23,708				553
Total current assets			199,387				354,594				229,286
Deferred income taxes			780				63,232				1,792
Property and equipment, net			702				36,769				1,676
Capitalized content costs, net			21,870				22,235				22,510
Goodwill			-				19,549				-
Other intangible assets, net			2,722				4,220				3,453
Other assets			751				1,365				1,475
Total assets		$	226,212			$	501,964			$	260,192
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable		$	37,792			$	56,967			$	16,578
Accrued liabilities			25,442				26,914				21,582
Deferred revenue			11,501				12,405				11,921
Deferred income taxes			530				-				1,630
Income taxes payable			465				298				267
Total current liabilities			75,730				96,584				51,978
Long-term deferred income taxes			452				-				323
Other long-term liabilities			444				459				1,365
Total liabilities			76,626				97,043				53,666
Commitments and contingencies
Stockholders' equity:
Class A Common Stock, par value $0.0001;
Authorized - 139,500 shares; Outstanding: 66,559 65,764 and 66,084, respectively			7				7				7
Class B Common Stock, par value $0.0001;
Authorized - 40,500 shares; Outstanding: 4,394 4,396 and 4,394,  respectively			-				-				-
Treasury stock			(185	)			(185	)			(185	)
Additional paid-in capital			439,673				428,546				434,728
Accumulated other comprehensive loss			(5,944	)			(1,251	)			(5,450	)
Accumulated deficit			(283,965	)			(22,196	)			(222,574	)
Total stockholders’ equity			149,586				404,921				206,526
Total liabilities and stockholders’ equity		$	226,212			$	501,964			$	260,192

 

See accompanying notes to consolidated financial statements

 

 

 LEAPFROG ENTERPRISES, INC.

 CONSOLIDATED STATEMENTS OF OPERATIONS

 (In thousands, except per share data)

(Unaudited)

 

		Three Months Ended September 30,								Six Months Ended September 30,
		2015				2014				2015				2014
Net sales		$	67,245			$	113,645			$	105,920			$	160,622
Cost of sales			60,987				76,635				92,430				114,779
Gross profit			6,258				37,010				13,490				45,843
Operating expenses:
Selling, general and administrative			23,070				20,321				44,953				41,365
Research and development			8,755				7,363				16,538				14,974
Advertising			6,686				9,717				8,111				12,758
Impairment of long-lived assets			1,114				-				3,884				-
Depreciation and amortization			634				2,758				1,086				5,600
Total operating expenses			40,259				40,159				74,572				74,697
Loss from operations			(34,001	)			(3,149	)			(61,082	)			(28,854	)
Other income (expense):
Interest income			29				26				63				61
Interest expense			-				-				(2	)			-
Other, net			95				124				(417	)			(230	)
Total other income (expense), net			124				150				(356	)			(169	)
Loss before income taxes			(33,877	)			(2,999	)			(61,438	)			(29,023	)
Provision for (benefit from) income taxes			189				(973	)			(47	)			(10,629	)
Net loss		$	(34,066	)		$	(2,026	)		$	(61,391	)		$	(18,394	)
Net loss per share:
Class A and B - basic and diluted		$	(0.48	)		$	(0.03	)		$	(0.87	)		$	(0.26	)
Weighted-average shares used to calculate
net loss per share:
Class A and B - basic and diluted			70,817				70,052				70,732				69,906

 

See accompanying notes to consolidated financial statements

 

 

 LEAPFROG ENTERPRISES, INC.

 CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

 (In thousands)

 (Unaudited) 

 

		Three Months Ended September 30,								Six Months Ended September 30,
		2015				2014				2015				2014
Net loss		$	(34,066	)		$	(2,026	)		$	(61,391	)		$	(18,394	)
Other comprehensive loss
Currency translation adjustments			(1,579	)			(1,563	)			(494	)			(673	)
Comprehensive loss		$	(35,645	)		$	(3,589	)		$	(61,885	)		$	(19,067	)

 

See accompanying notes to consolidated financial statements

 

 

LEAPFROG ENTERPRISES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

		Six Months Ended September 30,
		2015				2014
Operating activities:
Net loss		$	(61,391	)		$	(18,394	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization			8,003				13,233
Impairment of long-lived assets			3,884				-
Deferred income taxes			(379	)			(10,840	)
Stock-based compensation expense			5,116				5,680
Allowance for doubtful accounts			497				518
Other changes in operating assets and liabilities:
Accounts receivable, net			(41,635	)			(70,590	)
Inventories			(3,735	)			(57,464	)
Prepaid expenses and other current assets			518				(2,212	)
Other assets			721				103
Accounts payable			21,765				39,570
Accrued liabilities			4,158				2,104
Deferred revenue			(412	)			(341	)
Other long-term liabilities			363				(650	)
Income taxes payable			195				(387	)
Net cash used in operating activities			(62,332	)			(99,670	)
Investing activities:
Purchases of property and equipment and other intangible assets			(5,194	)			(15,066	)
Capitalization of content and website development costs			(6,545	)			(8,164	)
Net cash used in investing activities			(11,739	)			(23,230	)
Financing activities:
Proceeds from stock option exercises and employee stock purchase plan			146				1,479
Cash paid for payroll taxes on restricted stock unit releases			(317	)			(841	)
Repurchase of common shares			-				(38	)
Excess tax benefits from stock-based compensation			-				11
Net cash provided by (used in) financing activities			(171	)			611
Effect of exchange rate changes on cash			(330	)			1,645
Net change in cash and cash equivalents			(74,572	)			(120,644	)
Cash and cash equivalents, beginning of period			127,176				231,988
Cash and cash equivalents, end of period		$	52,604			$	111,344
Non-cash investing and financing activities:
Net change in accounts payable and accrued liabilities related to capital expenditures		$	(2,197	)		$	(404	)

 

See accompanying notes to consolidated financial statements

  

 

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.

 

The financial information included herein should be read in conjunction with the consolidated financial statements and related notes in the Company’s 2015 Annual Report on Form 10-K filed with the United States (“U.S.”) Securities and Exchange Commission (the “SEC”) on June 15, 2015 for the fiscal year ended March 31, 2015 (the “2015 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 2015 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.

 

Accumulated other comprehensive loss consists solely of currency translation adjustments.

 

2.

Fair Value 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 September 30, 2015 and 2014, and March 31, 2015, the Company’s Level 1 assets consisted of money market funds and certificates 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 September 30, 2015 and 2014, and March 31, 2015, the Company’s Level 2 assets and liabilities consisted of outstanding foreign exchange forward contracts used to hedge its exposure to certain of its major foreign currencies, including the British Pound, Canadian Dollar and Euro. The Company’s outstanding foreign exchange forward contracts, all with maturities of approximately one month, had notional values of $10,348, $60,622 and $4,760 at September 30, 2015 and 2014, and March 31, 2015, respectively. The fair market values of these instruments, based on quoted prices, were $(24) and $(83) on a net basis at September 30, 2015 and 2014, respectively, and recorded in accrued liabilities. The fair market value of these instruments, based on quoted prices, was $22 on a net basis at March 31, 2015, 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 for any period presented.

 

The following table presents the Company’s fair value hierarchy for assets and liabilities measured at fair value on a recurring basis as of September 30, 2015 and 2014, and March 31, 2015:

 

		Estimated Fair Value Measurements
		Carrying Value				Quoted Prices in Active Markets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
September 30, 2015:
Financial Assets:
Money market funds and certificate of deposit		$	17,307			$	17,307			$	-			$	-
Collateral certificates of deposit *			20,000				20,000				-				-
Total financial assets		$	37,307			$	37,307			$	-			$	-
Financial Liabilities:
Forward currency contracts		$	(24	)		$	-			$	(24	)		$	-
September 30, 2014:
Financial Assets:
Money market funds and certificate of deposit		$	25,011			$	25,011			$	-			$	-
Financial Liabilities:
Forward currency contracts		$	(83	)		$	-			$	(83	)		$	-
March 31, 2015:
Financial Assets:
Money market funds and certificate of deposit		$	62,810			$	62,810			$	-			$	-
Collateral certificates of deposit *			20,000				20,000				-				-
Forward currency contracts			22				-				22				-
Total financial assets		$	82,832			$	82,810			$	22			$	-

 

 

*

These certificates of deposit were collateral under the Company's asset-based revolving credit facility arrangement.

 

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 September 30, 2015 and 2014, and March 31, 2015:

 

		September 30,								March 31,
		2015				2014				2015
Raw materials		$	8,009			$	5,242			$	3,120
Finished goods			67,706				102,955				68,807
Total		$	75,715			$	108,197			$	71,927

 

Inventories are stated at the lower of cost or net realizable value (“NRV”). Inventories are initially recorded at cost. On a quarterly basis, the Company reviews its inventories that may be stated above NRV and reviews its estimate of the allowance for slow-moving, excess and obsolete inventories (“E&O reserves”). The Company’s E&O reserve estimate is based on management’s review of on-hand inventories compared to their estimated future usage, product demand forecast (including consideration of retail inventory levels, sales and promotions, among other factors), anticipated product selling prices, the expected product lifecycle, and products planned for discontinuation. When considered necessary, the Company makes adjustments to reduce inventory to its NRV with corresponding increases to cost of sales in its consolidated statement of operations. As of September 30, 2015 and 2014, and March 31, 2015, the Company had E&O reserves of $6,924, $3,769 and $4,157, respectively. The E&O reserves’ impact to the Company’s cost of sales was $3,603 and $3,712 for the three and six months ended September 30, 2015, respectively, and were $1,674 and $2,258 for the three and six months ended September 30, 2014, respectively. The increases in E&O reserves as of September 30, 2015 and for the three and six months ended September 30, 2015 were primarily associated with the Company’s recent price reduction of its LeapTV educational video game system, and the corresponding adjustment to the NRV of its inventory of this product.

 

 

4.

Property and Equipment, Net

 

As of September 30, 2015 and 2014, and March 31, 2015, property and equipment consisted of the following:

 

		September 30,								March 31,
		2015				2014				2015
Tooling, cards, dies and plates		$	21,944			$	23,678			$	23,976
Computers and software			45,455				72,817				45,782
Equipment, furniture and fixtures			6,100				5,669				3,769
Leasehold improvements			4,009				4,342				4,002
			77,508				106,506				77,529
Less: accumulated depreciation			(76,806	)			(69,737	)			(75,853	)
Total		$	702			$	36,769			$	1,676

 

During the quarters ended September 30, 2015, June 30, 2015 and March 31, 2015, the Company performed an impairment review of its long-lived assets. As a result, the Company recorded a permanent non-cash impairment charge of $1,114 and $3,884 for the three and six months ended September 30, 2015, respectively, and $36,461 for the quarter ended March 31, 2015, against its property and equipment, including primarily the Company’s recent investments in its internal business systems and the non-content related website systems costs under its computer and software category. Refer to Note 6 – “Impairment of Long-lived Assets” below for detailed information on the Company’s impairment testing for its long-lived assets.

 

5.

Goodwill

 

The Company’s goodwill was related to its 1997 acquisition of substantially all the assets and business of its predecessor, LeapFrog RBT, and its 1998 acquisition of substantially all the assets of Explore Technologies. The Company’s goodwill, solely allocated to its U.S. segment, was $19,549 as of September 30, 2014.

 

During 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 value of the Company’s Class A common stock and the corresponding decline in the Company’s market capitalization. As a result, the Company performed goodwill impairment test using the required two-step process as of December 31, 2014.

 

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 during the quarter ended December 31, 2014 in its U.S. segment.

 

6.

Impairment of Long-lived Assets

 

The Company’s long-lived assets include property and equipment, capitalized content costs and other intangible assets. The Company evaluates its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset group may not be recoverable.

 

 

March 31, 2015 Impairment Testing

 

During the quarter ended March 31, 2015, the Company determined that testing for recoverability of its long-lived assets was required based on continued financial underperformance, and the continued decline of the trading value of its Class A common stock and the corresponding decline in its market capitalization. As a result, the Company performed step one of the impairment test and concluded that its long-lived assets in its U.S. reporting unit were impaired as of March 31, 2015 as their carrying value exceeded the cumulative undiscounted future cash flows that included an estimated residual market valuation. This result was primarily due to the significant decline of the trading value of the Company’s Class A common stock and the corresponding decline in its market capitalization during the fourth quarter of its fiscal year ended March 31, 2015 (“Fiscal 2015”). The Company’s long-lived assets were not considered impaired in its International reporting unit as of March 31, 2015 as their carrying value did not exceed the cumulative undiscounted future cash flows.

 

Accordingly, the Company performed step two of the impairment test and determined the fair value of its U.S. reporting unit using a combination of an income approach and a market approach. Under the income approach, the Company used a discounted cash flow 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. 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. This analysis yielded a fair value below the carry value of the reporting unit.

 

In general, the difference between the carrying value and the fair value would be allocated on a pro-rata basis to the assets using the relative carrying amounts of those assets. However, the individual assets should not be written down below their respective fair values. As such, the Company determined the fair values of the individual long-lived assets within the asset group and compared those values with the carrying values of those assets to measure the overall impairment amount.

 

The Company determined the value of the capitalized content costs and the other intangible assets using a cost approach analysis, which factors in technological and functional deterioration with a depreciated cost study used as a proxy for the fair value. Based on the result of these analyses, the Company concluded that the estimated fair values of its capitalized content costs and other intangible assets were greater than their carrying value. Therefore, no impairment was recorded against these assets.

 

The Company determined the value of the property and equipment assets using a depreciated replacement cost study which incorporated historical costs, published trends, market supported depreciation curves, and certain adjustments such as indirect costs, level of asset customization and general marketability. Based on significant economic obsolescence associated with these assets, the Company incorporated the valuation premise established at a “highest and best use” assessment, using a value-in-exchange concept. Fair value-in-exchange is defined as the estimated value that may reasonably be expected in an exchange for an asset between a willing buyer and seller in an orderly transaction between market participants as of the valuation date. Based on the results of this study, the Company concluded that the carrying value of its property and equipment assets, including primarily the Company’s recent investments in its internal business systems and the non-content related website systems costs, exceeded their fair value by $36,461, and recorded a permanent impairment charge to these assets.

 

The above mentioned valuation methodologies require significant judgment by management in grouping of assets, selecting an appropriate discount rate, terminal growth rate, weighted average cost of capital, projection of future net cash flows, market exit multiple, and determining fair value of individual assets, 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 and its individual assets determined in connection with the long-lived assets impairment test may not necessarily be indicative of the actual value that would be recognized in a future transaction.

 

June 30, 2015 Impairment Testing

 

During the quarter ended June 30, 2015, the Company determined that testing for recoverability of its long-lived assets was again required based on continued financial underperformance, and the continued decline of the trading value of its Class A common stock and the corresponding market capitalization. As a result, the Company performed step one of the impairment test and concluded that its long-lived assets in its U.S. reporting unit were impaired as of June 30, 2015 as their carrying value exceeded the cumulative undiscounted future cash flows that included an estimated residual market valuation.

 

Accordingly, following the same valuation methodologies as applied in the prior quarter, the Company performed step two of the impairment test and determined the fair value of its U.S. reporting unit, then determined the fair values of individual long-lived assets within the asset group, and compared those values with the carrying values of those assets to measure the overall impairment amount.

 

The Company concluded that the estimated fair values of its capitalized content costs and other intangible assets were greater than their carrying value as of June 30, 2015. Therefore, no impairment was recorded against these assets. As a result of the step two impairment test, the Company concluded that the carrying value of its property and equipment assets exceeded their fair value by $2,770 and recorded a permanent impairment charge to these assets.

 

 

 

September 30, 2015 Impairment Testing

 

During the quarter ended September 30, 2015, the Company determined that testing for recoverability of its long-lived assets was again required based on continued financial underperformance, and the continued decline of the trading value of its Class A common stock and the corresponding market capitalization. As a result, the Company performed step one of the impairment test and concluded that its long-lived assets in its U.S. reporting unit were impaired as of September 30, 2015 as their carrying value exceeded the cumulative undiscounted future cash flows that included an estimated residual market valuation.

 

Accordingly, the Company performed step two of the impairment test and determined the fair value of its U.S. reporting unit. The Company then determined the fair values of individual long-lived assets within the asset group, and compared those values with the carrying values of those assets to measure the overall impairment amount.

 

The Company concluded that the estimated fair values of its capitalized content costs and other intangible assets were greater than their carrying value as of September 30, 2015. Therefore, no impairment was recorded against these assets. As a result of the step two impairment tests, the Company concluded that the carrying value of its property and equipment assets exceeded their fair value by $1,114 and recorded a permanent impairment charge to these assets.

 

Impact on Financial Statements

 

For the three and six months ended September 30, 2015, the impairment charges of $1,114 and $3,884, respectively, were reported as a separate line item in the consolidated statement of operations. The full impairment charges were recorded against the Company’s long-lived assets under its U.S. reporting unit, and were non-cash in nature and do not directly affect the Company’s current or future liquidity. These permanent impairment charges significantly reduced the carrying value of the Company’s property and equipment, which has resulted and will continue to result in decreases in associated depreciation expenses in future periods. The Company will continue to review the recoverability of its remaining long-lived assets on a quarterly basis, which may result in additional impairment charges if future impairment testing shows that the carrying value of its long-lived assets exceeds their estimated fair values.

 

7.

Income Taxes

 

The Company’s provision for (benefit from) income taxes and effective tax rates were as follows:

 

		Three Months Ended September 30,								Six Months Ended September 30,
		2015				2014				2015				2014
Provision for (benefit from) income taxes		$	189			$	(973	)		$	(47	)		$	(10,629	)
Loss before income taxes			(33,877	)			(2,999	)			(61,438	)			(29,023	)
Effective tax rate			(0.6	)%			32.4	%			0.1	%			36.6	%

 

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 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 six months ended September 30, 2015, and the Company’s subsidiary in Mexico was excluded from the computation of its effective tax rates for the three and six months ended September 30, 2015 and 2014.

 

The Company’s effective tax rate and income tax provision for the three months ended September 30, 2015 were primarily attributable to tax provisions related to its foreign operations. The Company’s effective tax rate and income tax benefit for the six months ended September 30, 2015 were primarily attributable to discrete items including the recognition of previously unrecognized tax benefits, partially offset by tax provisions attributable to its foreign operations. The Company’s effective tax rates and income tax benefits for the three and six months ended September 30, 2014 were primarily attributable to the recognition of tax benefits relating to its domestic operating losses during the period.

 

During the three months ended September 30, 2015, the Company recognized $6,758 of previously unrecognized domestic income tax benefits due to expiration of statute of limitation, which was neither recognized as a tax benefit nor affected the effective tax rate due to the full valuation allowance recorded against the Company's domestic deferred tax assets. During the three months ended September 30, 2015, the Company did not recognize any previously unrecognized tax benefits related to its foreign operations. During the six months ended September 30, 2015, the Company recognized $162 of certain previously unrecognized tax benefits due to the settlement of an income tax audit in one of its foreign jurisdictions, which was recognized as a tax benefit and affected the effective tax rate. During the three and six months ended September 30, 2014, the Company recognized $450 of certain previously unrecognized tax benefits due to the expiration of the statute of limitations in one of its foreign jurisdictions, which was recognized as a tax benefit and affected the effective tax rate. The recognition of previously unrecognized tax benefits reduced other long-term tax liabilities.

 

As of September 30, 2015 and 2014, and March 31, 2015, the Company had $9,757, $15,901 and $16,677, 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 $275, excluding potential interest and penalties, related to its domestic operations, over the course of the next twelve months due to expiring statutes of limitations, which would not be recognized as a tax benefit nor affect the effective tax rate due to the full valuation allowance recorded against the Company’s domestic deferred tax assets.

 

The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. The tax provision and benefit for the three and six months ended September 30, 2015 did not include any release of accrued interest and penalties related to uncertain tax positions. The tax benefit for the three and six months ended September 30, 2014 included a release of $158 of accrued interest and penalties related to uncertain tax positions. As of September 30, 2015 and March 31, 2015, the Company had no accrued interest and penalties attributable to uncertain tax positions related to its foreign operations. As of September 30, 2014, the Company had approximately $36 of accrued interest and penalties attributable to uncertain tax positions related to its foreign operations.

 

The Company maintained a full valuation allowance against its domestic deferred tax assets as of September 30, 2015 and March 31, 2015, respectively. As of September 30, 2014, the Company maintained a valuation allowance against certain state net operating loss carryforwards and capital loss carryforwards. The Company also maintained a full valuation allowance against the deferred tax assets of its subsidiary in Mexico as of September 30, 2015 and 2014, and March 31, 2015, respectively. As of September 30, 2015, the Company also evaluated the need for a valuation allowance against the deferred tax assets of its other foreign jurisdictions, and believes that the benefit of these deferred tax assets will be realized at the required more-likely-than-not level of certainty. Therefore, no valuation allowance has been established against such deferred tax assets as of September 30, 2015. The Company will continue to evaluate all evidence 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.

 

As of September 30, 2015 and 2014, and March 31, 2015, the consolidated current deferred tax assets were $964, $23,708 and $553, respectively, and the consolidated non-current deferred tax assets were $780, $63,232 and $1,792, respectively. The decreases were primarily due to the full valuation allowances provided against the Company’s domestic deferred tax assets during the three months ended December 31, 2014.

 

 

As of September 30, 2015 and March 31, 2015, the Company had current deferred tax liabilities of $530 and $1,630, respectively, reported as current liabilities, and had non-current deferred tax liabilities of $452 and $323, respectively, reported as long-term liabilities on the consolidated balance sheet. As of September 30, 2014, the Company had no current deferred tax liabilities or non-current deferred tax liabilities on the consolidated balance sheet. As of September 30, 2015, the Company had no other non-current tax liabilities. As of March 31, 2015 and September 30, 2014, the Company had other non-current tax liabilities of $162 and $153, respectively, reported as long-term liabilities on the consolidated balance sheet.

 

8.

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 14 to the Consolidated Financial Statements: Share-Based Compensation in its 2015 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 six months ended September 30, 2015:

 

		Stock								Total
		Options				RSUs				Awards
Outstanding at March 31, 2015			6,838				1,757				8,595
Grants			1,540				1,437				2,977
Exercises			-				(448	)			(448	)
Retired or forfeited			(415	)			(59	)			(474	)
Outstanding at September 30, 2015			7,963				2,687				10,650
Total shares available for future grant at September 30, 2015											7,223

 

As of September 30, 2015, the total shares available for future grant under the ESPP were 388.

  

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 six months ended September 30, 2015 and 2014:

 

		Three Months Ended September 30,								Six Months Ended September 30,
		2015				2014				2015				2014
SG&A:
Stock options		$	1,130			$	1,236			$	2,293			$	2,787
RSUs			1,035				784				2,105				1,978
ESPP			(38	)			70				44				163
Total SG&A			2,127				2,090				4,442				4,928
R&D:
Stock options			180				214				371				428
RSUs			147				145				303				324
Total R&D			327				359				674				752
Total expense		$	2,454			$	2,449			$	5,116			$	5,680

 

 

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 six months ended September 30, 2015 and 2014:

 

		Three Months Ended September 30,								Six Months Ended September 30,
		2015				2014				2015				2014
Expected term (years)			5.72				4.93				4.82				4.70
Volatility			57.6	%			59.7	%			53.2	%			59.9	%
Risk-free interest rate			1.63	%			1.60	%			1.32	%			1.56	%
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 six months ended September 30, 2015 and 2014:

 

		Three Months Ended September 30,								Six Months Ended September 30,
		2015				2014				2015				2014
Expected term (years)			0.49				0.49				0.49				0.49
Volatility			67.2 - 71.7	%			34.8%-42.0	%			67.2% - 71.7	%			34.8%-42.0	%
Risk-free interest rate			0.08 - 0.26	%			0.05%-0.08	%			0.08% - 0.26	%			0.05% - 0.08	%
Expected dividend yield			-	%			-	%			-	%			-	%

 

Options to purchase shares of the Company’s common stock and RSUs, totaling 10,499 and 10,410 were excluded from the calculation of diluted net income per share for the three and six months ended September 30, 2015 and 8,999 and 9,115 for the three and six months ended September 2014, respectively, as the effect would have been antidilutive.

 

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 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 the App Center.

 

 

The table below shows certain information by segment for the three and six months ended September 30, 2015 and 2014:

 

		Three Months Ended September 30,								Six Months Ended September 30,
		2015				2014				2015				2014
Net sales:
United States		$	45,399			$	77,558			$	73,458			$	108,266
International			21,846				36,087				32,462				52,356
Totals		$	67,245			$	113,645			$	105,920			$	160,622
Income (loss) from operations:
United States		$	(36,507	)		$	(8,865	)		$	(63,101	)		$	(34,155	)
International			2,506				5,716				2,019				5,301
Totals		$	(34,001	)		$	(3,149	)		$	(61,082	)		$	(28,854	)

  

For the three and six months ended September 30, 2015 and the six months ended September 30, 2014, the U.S. and the United Kingdom individually accounted for more than 10% of the Company’s consolidated net sales, respectively. For the three months ended September 30, 2014, only the U.S. accounted for more than 10% of the Company’s consolidated net sales, respectively.

 

10.

Commitments and Contingencies

 

Legal Proceedings

 

Federal Securities Class Action

 

A consolidated securities class action captioned In re LeapFrog Enterprises, Inc. Securities Litigation, Case No. 3:15-CV-00347-EMC, is pending in the United States District Court for the Northern District of California against LeapFrog and two of its officers, John Barbour and Raymond L. Arthur (the “Class Action”). The consolidated complaint, filed on June 24, 2015, alleges that 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 regarding the Company’s financial projections, financial results, and development of new products between May 5, 2014 and June 11, 2015. The complaint also alleges that defendants are liable as control-person under Section 20(a) of the Exchange Act. The complaint seeks 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 complaint and is subject to the text of the complaint, which is on file with the Court. Based on a review of the allegations, the Company and the individual defendants believe that the plaintiffs’ allegations are without merit, and intend to vigorously defend against the claims. A hearing on the Company’s motion to dismiss was held on October 8, 2015. At the hearing on the defendants’ motions to dismiss, the Court stated that it perceived significant problems with the plaintiff’s allegations and directed the plaintiff to file a further amended complaint that pleads more particularized facts. The amended complaint is due on or before November 23, 2015.

 

Shareholder Derivative Action

 

A consolidated shareholder derivative action captioned In re LeapFrog Enterprises, Inc. Derivative Litigation, Lead Case No. RG15757609 (the “Derivative Action”) is pending in the Superior Court of California, County of Alameda, purportedly on behalf of LeapFrog against current and former members of our board of directors and certain of our officers. The various plaintiffs in the Derivative Action, who filed their complaints between February 5 and July 13, 2015, allege that the defendants breached their fiduciary duties, committed waste, were unjustly enriched, and aided and abetted fiduciary violations by causing LeapFrog to issue materially inaccurate financial guidance and making false and misleading statements about the Company’s business between May 5, 2014 and June 11, 2015. The statements at issue in the Derivative Action are substantially similar to those at issue in the Class Action described above. The plaintiffs in the Derivative Action seek, purportedly on behalf of LeapFrog, an unspecified award of damages including, but not limited to, fees and costs associated with the pending Class Action, 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 complaints filed in the Derivative Action, and is subject to the text of the plaintiffs’ complaints, which are on file with the Court. Based on a review of the plaintiffs’ allegations, the Company believes that the plaintiffs have not demonstrated standing to sue on its behalf. The Court has granted the parties’ stipulation to defer litigation activity, subject to certain conditions and pending certain developments in the Class Action.

 

 

Patent Litigation

 

On February 26, 2014, a patent holding company named Celebrate International, LLC (“Celebrate”) sued LeapFrog, Target, Wal-Mart, Amazon and Toys R Us in the United States District Court for the District of Delaware alleging that the Company’s Tag and LeapReader product lines and related content infringe U.S. Patent Nos. 6,256,398 and 6,819,776. Celebrate is seeking unspecified monetary damages and attorney’s fees. The Company and the accused retailers filed answers to the suit denying infringement and alleging that the asserted patent claims are invalid. The Markman hearing was held on January 22, 2015 and on August 28, 2015 the Court issued a claim construction order. The trial date has been indefinitely postponed pending resolution of plaintiff’s attempt to obtain fact discovery in Sweden from Anoto AB, the licensor of optical scanning technology used in the Tag and LeapReader products. The Company believes that the claims are without merit and intends to contest the case vigorously. Given the status of the case and the uncertainties inherent in patent litigation, possible losses, if any, associated with the case are not reasonably estimable at this time.

 

Other Matters

 

In addition, from time to time, the Company is 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. 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.

 

Commitments

 

As of September 30, 2015, the Company had commitments to purchase inventory under normal supply arrangements totaling approximately $24,784. In addition, as of September 30, 2015, the Company had two stand-by-letters of credit totaling $236 issued under its revolving credit facility as credit support for potential future payment obligations, which were off-balance sheet arrangements.

 

11.

Subsequent Events

 

On August 13, 2009, the Company, certain financial institutions and Bank of America, N.A., entered into an amended and restated loan and security agreement for an up-to-$75,000 asset-based revolving credit facility, with a term through May 1, 2017. On October 19, 2015, the Company partially drew down $10,000 on this revolving credit facility at an annual interest rate of 1.97%. The proceeds will be used to fund seasonal working capital needs.

 

On October 22, 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 $1,909 in the quarter ending December 31, 2015 for employee severance benefits and other costs related to this plan.

 

12.

Other Item

 

On September 4, 2015, the Company was notified by the New York Stock Exchange (“NYSE”) that the average closing price of the Company’s common stock had fallen below $1.00 per share over a consecutive 30 trading-day period, which is the minimum average share price for continued listing on NYSE under Rule 802.01C of the NYSE Listed Company Manual.

  

Under NYSE rules, the Company has six months following receipt of the notification to regain compliance with the minimum share price requirement. On September 10, 2015, the Company notified the NYSE of its intent to cure the deficiency and restore its compliance with the listing standards of Section 802.01C. The NYSE notice has no immediate impact on the listing of the Company’s common stock, which will continue to be listed and traded on the NYSE during this period, subject to the Company’s compliance with other listing standards.

 

 

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 the undistributed earnings of our foreign subsidiaries, our intention to repatriate any remaining residual cash from our Mexico subsidiary to the U.S. and the associated tax treatment of such repatriation, the funding, nature and amount of future capital expenditures, the future funding of our working capital needs and planned capital expenditures and our intent to cure the deficiency with the NYSE’s minimum share price requirement and restore our compliance with the listing standards of the NYSE. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can also be identified by words such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” and similar terms. Forward-looking statements are not guarantees of future performance and actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the subsection entitled “Risk Factors” under Part II, Item 1A of this Quarterly Report on Form 10-Q. 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 LeapPad family of learning tablets, the LeapTV educational video game system, 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. 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 popular My Pal Scout line. 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 LeapFrog App Center (“App Center”).

 

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 September 30,								% Change 2015 vs.					Six Months Ended September 30,								% Change 2015 vs.
		2015				2014				2014					2015				2014				2014
		(Dollars in millions, except per share data)
Net sales		$	67.2			$	113.6				(41	)%			$	105.9			$	160.6				(34	)%
Cost of sales			61.0				76.6				(20	)%				92.4				114.8				(19	)%
Gross margin *			9.3	%			32.6	%			(23.3	)	**			12.7	%			28.5	%			(15.8	)	**
Operating expenses			40.3				40.2				-%					74.6				74.7				-%
Operating expenses as a percent of net sales			60	%			35	%			25		**			70	%			47	%			23		**
Loss from operations			(34.0	)			(3.1	)			(980	)%				(61.1	)			(28.9	)			(112	)%
Net loss per share - basic and diluted		$	(0.48	)		$	(0.03	)		$	(0.45	)	***		$	(0.87	)		$	(0.26	)		$	(0.61	)	***

 

*

Gross profit as a percentage of net sales

**

Percentage point change

***

Dollar change

 

Net sales for the three months ended September 30, 2015 decreased $46.4 million, or 41%, as compared to the same period in Fiscal 2015, which included a decrease of $34.0 million in net sales of multimedia learning platforms and a decrease of $12.1 million in net sales of learning toys. Net sales for the six months ended September 30, 2015 decreased $54.7 million, or 34%, as compared to the same period in Fiscal 2015, which included a decrease of $41.4 million in net sales of multimedia learning platforms and a decrease of $12.9 million in net sales of learning toys. Our LeapPad line of tablets experienced decreased consumer demand as the overall market for children’s tablets continued to decline. In addition, net sales of our LeapReader learn-to-read system and toys decreased as sales fell in key markets and retailers ran tighter inventories. During the three and six months ended September 30, 2015, we recorded a $5.2 million and $7.0 million allowance, respectively, as part of increased trade discounts against net sales, associated with the recent LeapTV price reductions implemented to stimulate consumer demand. Net sales for the three and six months ended September 30, 2015 included a negative $2.3 million, or 2%, and a negative $3.7 million, or 2%, impact from changes in currency exchange rates, respectively.

 

Cost of sales for the three months ended September 30, 2015 decreased $15.6 million, or 20%, as compared to the same period in Fiscal 2015 driven by lower net sales resulting in a decrease of $13.6 million in product costs, a decrease of $0.9 million in freight costs, a decrease of $0.8 million in royalty costs, and a decrease of $0.6 million in depreciation costs resulting from the permanent impairment of our long-lived assets, which significantly reduced the carrying value our property and equipment. The decreases were offset by an increase of $1.9 million in inventory allowances. Cost of sales for the six months ended September 30, 2015 decreased $22.4 million, or 19%, as compared to the same period in Fiscal 2015 driven by lower net sales resulting in a decrease of $19.7 million in product costs, a decrease of $1.2 million in freight costs, a decrease of $1.3 million in royalty costs, and a decrease of $1.3 million in depreciation expenses. The decreases were offset by an increase of $1.5 million in inventory allowances.

 

Gross margin for the three months ended September 30, 2015 was 9.3%, a decrease of 23.3 percentage points as compared to the same period in Fiscal 2015. Of this difference, 14.6 percentage points was due to higher trade discounts as a percentage of net sales to support sell-through of higher than desired inventory levels at retail, 5.0 percentage points was due to changes in sales mix with proportionally higher sales of lower-margin toys, offset by lower sales of lower-margin tablets, 3.0 percentage points was due to higher inventory allowances, 1.1 percentage points was due to proportionally higher content amortization costs, and 1.1 percentage points was due to lower sales volume which increased the impact of fixed logistics costs. These negative impacts were offset by increases of 0.7 percentage points due to proportionally lower freight costs and 0.5 percentage points due to lower depreciation costs. Gross margin for the six months ended September 30, 2015 was 12.7%, a decrease of 15.8 percentage points as compared to the same period in Fiscal 2015. Of this difference, 7.7 percentage points was due to higher trade discounts as a percentage of net sales to support sell-through of higher than desired inventory levels at retail, 3.6 percentage points was due to changes in sales mix with proportionally higher sales of lower-margin toys, offset by lower sales of lower-margin tablets, 2.0 percentage points was due to proportionally higher content amortization costs, 1.8 percentage points was due to higher inventory allowances, and 1.5 percentage points was due to lower sales volume which increased the impact of fixed logistics costs. These negative impacts were offset by increases of 0.8 percentage points due to lower depreciation costs and 0.6 percentage points due to proportionally lower freight costs.

 

Operating expenses for the three months ended September 30, 2015 remained relatively flat as compared to the same period in Fiscal 2015, which included an increase of $1.9 million in research and development (“R&D”) expenses due to lower gross spending but with a lower capitalization rate, an increase of $1.7 million in non-R&D related consulting and professional fees, an accrual of $1.1 million for employee retention bonus expenses, and the non-cash long-lived assets impairment charge of $1.1 million recorded during the current year period against our property and equipment. Operating expenses for the same period in Fiscal 2015 included the reversal of an accrual for performance-based incentive compensation of $1.3 million. These increases were offset by a decrease of $2.3 million in expenses due to lower headcount, a decrease of $2.1 million in depreciation expenses resulting from the permanent impairment of our long-lived assets, which significantly reduced the carrying value our property and equipment, a decrease of $1.9 million in spending on cooperative advertising, and a decrease of $1.6 million in spending on in-store displays. Operating expenses for the six months ended September 30, 2015 remained relatively flat as compared to the same period in Fiscal 2015, which included the non-cash long-lived assets impairment charge of $3.9 million recorded during the current year period against our property and equipment, an accrual of $2.8 million for employee retention bonus expenses, an increase of $2.6 million in R&D expenses due to lower gross spending but with a lower capitalization rate, and an increase of $1.4 million in non-R&D related consulting and professional fees. Operating expenses for the same period in Fiscal 2015 included the reversal of an accrual for performance-based incentive compensation of $2.4 million. These increases were offset by a decrease of $4.4 million in depreciation expenses resulting from the permanent impairment of our long-lived assets, which significantly reduced the carrying value our property and equipment, a decrease of $4.0 million in expenses due to lower headcount, a decrease of $3.0 million in spending on cooperative advertising, and a decrease of $1.8 million in spending on in-store displays.

 

 

Loss from operations for the three and six months ended September 30, 2015 worsened by $30.9 million and $32.2 million, respectively, as compared to the same periods in Fiscal 2015 driven by a decrease in gross profit of $30.8 million and $32.4 million, respectively.

 

Basic and diluted net loss per share for the three and six months ended September 30, 2015 worsened by $0.45 and $0.61, as compared to the same periods in Fiscal 2015.

 

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 September 30,								% Change 2015 vs.					Six Months Ended September 30,								% Change 2015 vs.
		2015				2014				2014					2015				2014				2014
		(Dollars in millions)
SG&A expenses		$	23.1			$	20.3				14	%			$	45.0			$	41.4				9	%
As a percent of net sales			34	%			18	%			16		*			42	%			26	%			16		*

  

*

Percentage point change

 

SG&A expenses for the three months ended September 30, 2015 increased $2.8 million, or 14%, as compared to the same period in Fiscal 2015, which included an increase of $1.7 million due to higher consulting and professional fees and an accrual of $0.8 million for employee retention bonus expenses. SG&A expenses for the same period in Fiscal 2015 included the reversal of an accrual for performance-based incentive compensation of $0.8 million. These increases were offset by a decrease of $1.2 million in expenses due to lower headcount. SG&A expenses for the six months ended September 30, 2015 increased $3.6 million, or 9%, as compared to the same period in Fiscal 2015 which included an accrual of $2.1 million for employee retention bonus expenses and an increase of $1.4 million due to higher consulting and professional fees. SG&A expenses for the same period in Fiscal 2015 included the reversal of an accrual for performance-based incentive compensation of $1.5 million. These increases were offset by a decrease of $2.0 million in expenses due to lower headcount.

 

 

Research and Development Expenses

 

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 September 30,								% Change 2015 vs.					Six Months Ended September 30,								% Change 2015 vs.
		2015				2014				2014					2015				2014				2014
		(Dollars in millions)
R&D expenses		$	8.8			$	7.4				19	%			$	16.5			$	15.0				10	%
As a percent of net sales			13	%			6	%			7		*			16	%			9	%			7		*

 

*

Percentage point change

 

R&D expenses for the three months ended September 30, 2015 increased $1.4 million, or 19%, as compared to the same period in Fiscal 2015 which included an increase of $1.9 million due to lower gross spending but with a lower capitalization rate, and an accrual of $0.3 million for employee retention bonus expenses. R&D expenses for the same period in Fiscal 2015 included the reversal of an accrual for performance-based incentive compensation of $0.5 million. These increases were offset by a decrease of $1.1 million in expenses due to lower headcount. R&D expenses for the six months ended September 30, 2015 increased $1.5 million, or 10%, as compared to the same period in Fiscal 2015, which included an increase of $2.6 million due to lower gross spending but with a lower capitalization rate, and an accrual of $0.7 million for employee retention bonus expenses. R&D expenses for the same period in Fiscal 2015 included the reversal of an accrual for performance-based incentive compensation of $0.8 million. These increases were offset by a decrease of $1.9 million in expenses due to lower headcount.

 

Advertising Expense

 

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

 

		Three Months Ended September 30,								% Change 2015 vs.					Six Months Ended September 30,								% Change 2015 vs.
		2015				2014				2014					2015				2014				2014
		(Dollars in millions)
Advertising expenses		$	6.7			$	9.7				(31	)%			$	8.1			$	12.8				(36	)%
As a percent of net sales			10	%			9	%			1		*			8	%			8	%			-		*

 

*

Percentage point change

 

Advertising expenses for the three months ended September 30, 2015 decreased $3.0 million, or 31%, as compared to the same period in Fiscal 2015, which included a decrease of $1.9 million in spending on cooperative advertising, and a decrease of $1.6 million in spending on in-store displays. Advertising expenses for the six months ended September 30, 2015 decreased $4.7 million, or 36%, as compared to the same period in Fiscal 2015, which included a decrease of $3.0 million in spending on cooperative advertising, and a decrease of $1.8 million in spending on in-store displays.

 

Impairment of Long-lived Assets

 

As of September 30, 2015, based on various qualitative factors, we determined that testing for recoverability of our long-lived assets was required. These factors included, among others, the continued underperformance of products and product lines newly introduced to the market, and the continued significant decline in trading value of our Class A common stock and the corresponding decline in our market capitalization. As a result, we performed a two-step impairment test for our long-lived assets. Based on the result of the test, we recorded permanent non-cash impairment charges of $1.1 million and $3.9 million for the three and six months ended September 30, 2015 in our U.S. segment, primarily for current period asset additions. These impairment charges, together with the long-lived assets impairment we recorded as of March 31, 2015, significantly reduced the carrying value of our property and equipment to $0.7 million as of September 30, 2015, which has resulted and will continue to result in decreases in associated depreciation expenses in future periods. We will continue to review the recoverability of our remaining long-lived assets on a quarterly basis, which may result in additional impairment charges in future periods. Refer to Note 6 – “ Impairment of Long-lived Assets” in our Consolidated Financial Statements included in this Quarterly Report on Form 10-Q for additional information on our impairment testing for our long-lived assets.

 

 

Depreciation and Amortization Expenses

 

		Three Months Ended September 30,								% Change 2015 vs.					Six Months Ended September 30,								% Change 2015 vs.
		2015				2014				2014					2015				2014				2014
		(Dollars in millions)
Depreciation and amortization		$	0.6			$	2.8				(77	)%			$	1.1			$	5.6				(81	)%
As a percent of net sales			1	%			2	%			(1	)	*			1	%			3	%			(2	)	*

 

*

Percentage point change

 

Depreciation and Amortization expenses for the three and six months ended September 30, 2015 decreased $2.2 million and 4.5 million, or 77% and 81%, respectively, as compared to the same period in Fiscal 2015 driven by the permanent impairment of long-lived assets charge we recorded as of March 31, 2015 and during the current year, which significantly reduced the carrying value of our property and equipment.

 

Income Taxes

 

Our provision for (benefit from) income taxes and effective tax rates were as follows:

 

		Three Months Ended September 30,								Six Months Ended September 30,
		2015				2014				2015				2014
		(Dollars in millions)
Provision for (benefit from) income taxes		$	0.2			$	(1.0	)		$	-			$	(10.6	)
Loss before income taxes			(33.9	)			(3.0	)			(61.4	)			(29.0	)
Effective tax rate			(0.6	)%			32.4	%			0.1	%			36.6	%

 

Our 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 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 exclude jurisdictions with tax assets for which no benefit can be recognized from the computation of our effective tax rate. Accordingly, our domestic loss was excluded from the computation of our effective tax rates for the three and six months ended September 30, 2015, and our subsidiary in Mexico was excluded from the computation of our effective tax rates for the three and six months ended September 30, 2015 and 2014.

 

Our effective tax rate and income tax provision for the three months ended September 30, 2015 were primarily attributable to tax provisions related to our foreign operations. Our effective tax rate and income tax benefit for the six months ended September 30, 2015 were primarily attributable to discrete items including the recognition of previously unrecognized tax benefits, partially offset by tax provisions attributable to our foreign operations. Our effective tax rates and income tax benefits for the three and six months ended September 30, 2014 were primarily attributable to the recognition of tax benefits relating to our domestic operating losses during the period. During the three months ended September 30, 2015, we recognized $6.8 million of previously unrecognized domestic income tax benefits due to expiration of statute of limitation, which was neither recognized as a tax benefit nor affected the effective tax rate due to the full valuation allowance recorded against our domestic deferred tax assets. During the three months ended September 30, 2015, we did not recognize any previously unrecognized tax benefits related to its foreign operations. During the six months ended September 30, 2015, we recognized $0.2 million of certain previously unrecognized tax benefits due to the settlement of an income tax audit in one of our foreign jurisdictions, which was recognized as a tax benefit and affected the effective tax rate. During the three and six months ended September 30, 2014, we recognized $0.5 million of certain previously unrecognized tax benefits due to the expiration of the statute of limitations in one of its foreign jurisdictions, which was recognized as a tax benefit and affected the effective tax rate.

 

 

As of September 30, 2015, we maintained a full valuation allowance against our domestic deferred tax assets and a full valuation allowance against the deferred tax assets of our subsidiary in Mexico. As of September 30, 2015, we also evaluated the need for a valuation allowance against the deferred tax assets of our other foreign jurisdictions, and believe that the benefit of these deferred tax assets will be realized at the required more-likely-than-not level of certainty. Therefore, no valuation allowance has been established against such deferred tax assets as of September 30, 2015. 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.

 

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 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 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.

 

		Three Months Ended September 30,								% Change 2015 vs.					Six Months Ended September 30,								% Change 2015 vs.
		2015				2014				2014					2015				2014				2014
		(Dollars in millions)
Net sales		$	45.4			$	77.6				(41	)%			$	73.5			$	108.3				(32	)%
Cost of sales			46.0				52.9				(13	)%				69.6				79.0				(12	)%
Gross margin *			(1.4	)%			31.8	%			(33.2	)	**			5.2	%			27.0	%			(21.8	)	**
Operating expenses			35.9				33.5				7	%				66.9				63.4				6	%
Operating expenses as a percent of net sales			79	%			43	%			36		**			91	%			59	%			32		**
Loss from operations		$	(36.5	)		$	(8.9	)			(312	)%			$	(63.1	)		$	(34.2	)			(85	)%

 

*

Gross profit as a percentage of net sales

**

Percentage point change

 

Net sales for the three months ended September 30, 2015 decreased $32.2 million, or 41%, as compared to the same period in Fiscal 2015, which included a decrease of $24.5 million in net sales of multimedia learning platforms and a decrease of $7.0 million in net sales of learning toys. Net sales for the six months ended September 30, 2015 decreased $34.8 million, or 32%, as compared to the same period in Fiscal 2015, which included a decrease of $27.4 million in net sales of multimedia learning platforms and a decrease of $6.8 million in net sales of learning toys. Our LeapPad line of tablets experienced decreased consumer demand as the overall market for children’s tablets has continued to decline. In addition, net sales of our LeapReader learn-to-read system and toys decreased as retail point-of-sale fell and retailers ran tighter inventories. During the three and six months ended September 30, 2015, we recorded a $5.2 million and $7.0 million allowance, respectively, as part of increased trade discounts against net sales, associated with the recent LeapTV price reductions implemented to stimulate consumer demand.

 

Cost of sales for the three months ended September 30, 2015 decreased $6.9 million, or 13%, as compared to the same period in Fiscal 2015 driven by lower net sales resulting in a decrease of $6.3 million in product costs, a decrease of $0.8 million in freight costs, a decrease of $0.6 million in depreciation costs resulting from the permanent impairment of our long-lived assets, which significantly reduced the carrying value our property and equipment, and a decrease of $0.5 million in royalty costs. The decreases were offset by an increase of $2.4 million in inventory allowances. Cost of sales for the six months ended September 30, 2015 decreased $9.4 million, or 12%, as compared to the same period in Fiscal 2015 driven by lower net sales resulting in a decrease of $8.5 million in product costs, a decrease of $1.0 million in freight costs, a decrease of $1.3 million in depreciation expenses, and a decrease of $0.9 million in royalty costs. The decreases were offset by an increase of $1.9 million in inventory allowances.

 

 

Gross margin for the three months ended September 30, 2015 was (1.4)%, a decrease of 33.2 percentage points as compared to the same period in Fiscal 2015. Of this difference, 23.0 percentage points was due to higher trade discounts as a percentage of net sales to support sell-through of higher than desired inventory levels at retail, 5.8 percentage points was due to changes in sales mix with proportionally higher sales of lower-margin toys, offset by lower sales of lower-margin tablets, 4.5 percentage points was due to higher inventory allowances, 1.2 percentage points was due to proportionally higher content amortization costs, and 1.1 percentage points was due to lower sales volume which increased the impact of fixed logistics costs. These negative impacts were offset by increases of 0.9 percentage points due to proportionally lower freight costs and 0.8 percentage points due to lower depreciation costs. Gross margin for the six months ended September 30, 2015 was 5.2%, a decrease of 21.8 percentage points as compared to the same period in Fiscal 2015. Of this difference, 12.7 percentage points was due to higher trade discounts as a percentage of net sales to support sell-through of higher than desired inventory levels at retail, 4.3 percentage points was due to changes in sales mix with proportionally higher sales of lower-margin toys, offset by lower sales of lower-margin tablets, 2.6 percentage points was due to higher inventory allowances, 2.3 percentage points was due to proportionally higher content amortization costs, and 1.6 percentage points was due to lower sales volume which increased the impact of fixed logistics costs. These negative impacts were offset by increases of 1.1 percentage points due to lower depreciation costs and 0.8 percentage points due to proportionally lower freight costs.

 

Operating expenses for the three months ended September 30, 2015 increased $2.4 million, or 7%, as compared to the same period in Fiscal 2015, which included an increase of $1.9 million in R&D expenses due to lower gross spending but with a lower capitalization rate, an increase of 1.7 million in non-R&D related consulting and professional fees, an increase of $1.7 million in media advertising, the non-cash long-lived assets impairment charge of $1.1 million recorded during the current year period against our property and equipment, and an accrual of $1.0 million for employee retention bonus expenses. Operating expenses for the same period in Fiscal 2015 included the reversal of an accrual for performance-based incentive compensation of $1.1 million. These increases were offset by a decrease of $2.3 million in expenses due to lower headcount, a decrease of $2.1 million in depreciation expenses resulting from the permanent impairment of our long-lived assets, which significantly reduced the carrying value our property and equipment, and a decrease of $1.5 million in spending on in-store displays. Operating expenses for the six months ended September 30, 2015 increased $3.5 million, or 6%, as compared to the same period in Fiscal 2015, which included the non-cash long-lived assets impairment charge of $3.9 million recorded during the current year period against our property and equipment, an increase of $2.6 million in R&D expenses due to lower gross spending but with a lower capitalization rate, an accrual of $2.5 million for employee retention bonus expenses, an increase of $1.7 million in media advertising, and an increase of $1.4 million in non-R&D related consulting and professional fees. Operating expenses for the same period in Fiscal 2015 included the reversal of an accrual for performance-based incentive compensation of $2.1 million. These increases were offset by a decrease of $4.3 million in depreciation expenses resulting from the permanent impairment of our long-lived assets, which significantly reduced the carrying value our property and equipment, a decrease of $3.8 million in expenses due to lower headcount, a decrease of $1.7 million in spending on in-store displays, and a decrease of $1.3 million in spending on cooperative advertising.

 

Loss from operations for the three and six months ended September 30, 2015 worsened by $27.7 million and $29.0 million, respectively, as compared to the same periods in Fiscal 2015 driven by a decrease in gross profit of $25.3 million and $25.5 million, respectively, and an increase in operating expenses of $2.4 million and $3.5 million, respectively.

 

International Segment

 

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 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.

 

 

		Three Months Ended September 30,								% Change 2015 vs.					Six Months Ended September 30,								% Change 2015 vs.
		2015				2014				2014					2015				2014				2014
		(Dollars in millions)
Net sales		$	21.8			$	36.1				(39	)%			$	32.5			$	52.4				(38	)%
Cost of sales			15.0				23.7				(37	)%				22.8				35.8				(36	)%
Gross margin *			31.5	%			34.3	%			(2.8	)	**			29.8	%			31.7	%			(1.9	)	**
Operating expenses			4.4				6.7				(34	)%				7.6				11.3				(32	)%
Operating expenses as a percent of net sales			20	%			18	%			2		**			24	%			22	%			2		**
Income from operations		$	2.5			$	5.7				(56	)%			$	2.0			$	5.3				(62	)%

 

*

Gross profit as a percentage of net sales

**

Percentage point change

 

Net sales for the three months ended September 30, 2015 decreased $14.2 million, or 39%, as compared to the same period in Fiscal 2015, which included a decrease of $9.5 million in net sales of multimedia learning platforms and a decrease of $5.4 million in net sales of learning toys. Net sales for the six months ended September 30, 2015 decreased $19.9 million, or 38%, as compared to the same period in Fiscal 2015, which included a decrease of $14.0 million in net sales of multimedia learning platforms and a decrease of $6.1 million in net sales of learning toys. Our LeapPad line of tablets experienced decreased consumer demand as the overall market for children’s tablets has continued to decline. In addition, net sales our LeapReader learn-to-read system and toys decreased as sales fell in key markets, sales continued to be impacted by retail store closures in Canada, and retailers ran tighter inventories Net sales for the three and six months ended September 30, 2015 included a negative $2.3 million, or 7%, and a negative $3.7 million, or 7%, impact from changes in currency exchange rates, respectively.

 

Cost of sales for the three months ended September 30, 2015 decreased $8.7 million, or 37%, as compared to the same period in Fiscal 2015 driven by lower net sales resulting in a decrease of $7.4 million in product costs, a decrease of $0.5 million in inventory allowances, and a decrease of $0.3 million in royalty costs. Cost of sales for the six months ended September 30, 2015 decreased $13.0 million, or 36%, as compared to the same period in Fiscal 2015 driven by lower net sales resulting in a decrease of $11.2 million in product costs, a decrease of $0.4 million in royalty costs, and a decrease of $0.4 million in inventory allowances.

 

Gross margin for the three months ended September 30, 2015 was 31.5%, a decrease of 2.8 percentage points as compared to the same period in Fiscal 2015. Of this difference, 4.3 percentage points was due to changes in sales mix with proportionally higher sales of lower-margin toys, offset by lower sales of lower-margin tablets, 1.0 percentage points was due to lower sales volume which increased the impact of fixed logistics costs, and 0.7 percentage points was due to proportionally higher royalty costs. These negative impacts were offset by increases of 2.0 percentage points due to lower trade discounts as a percentage of net sales and 1.1 percentage points due to lower inventory allowances. Gross margin for the six months ended September 30, 2015 was 29.8%, a decrease of 1.9 percentage points as compared to the same period in Fiscal 2015. Of this difference, 2.0 percentage points was due to changes in sales mix with proportionally higher sales of lower-margin toys, offset by lower sales of lower-margin tablets, 1.2 percentage points was due to lower sales volume which increased the impact of fixed logistics costs, and 0.7 percentage points was due to proportionally higher royalty costs. These negative impacts were offset by increases of 1.4 percentage points due to lower trade discounts as a percentage of net sales and 0.9 percentage points due to lower inventory allowances.

 

Operating expenses for the three months ended September 30, 2015 decreased $2.3 million, or 34%, as compared to the same period in Fiscal 2015, which included a decrease of $1.6 million in spending on cooperative advertising, and a decrease of $0.8 million in media advertising. Operating expenses for the six months ended September 30, 2015 decreased $3.7 million, or 32%, as compared to the same period in Fiscal 2015, which included a decrease of $1.7 million in spending on cooperative advertising, and a decrease of $0.8 million in media advertising.

 

Income from operations for the three and six months ended September 30, 2015 worsened by $3.2 million and $3.3 million, respectively, as compared to the same periods in Fiscal 2015 driven by a decrease in gross profit of $5.5 million and $6.9 million, respectively, offset by a decrease in operating expenses of $2.3 million and $3.7 million, respectively.

 

 

Liquidity and Capital Resources

 

Financial Condition

 

Cash and cash equivalents totaled $52.6 million and $111.3 million at September 30, 2015 and 2014, respectively. The decrease was primarily due to a decrease in net cash generated by operating activities as a result of reduced operating results as well as significant capital expenditures during the past several quarters. In line with our investment policy, as of September 30, 2015, all cash equivalents were invested in high-grade short-term money market funds and certificates of deposits with maturities of less than three months. Included in the certificates of deposit as of September 30, 2015, was $20.0 million of collateral under our asset-based revolving credit facility arrangement (the “revolving credit facility”).

 

Cash and cash equivalents held by our foreign subsidiaries totaled $11.8 million and $17.9 million as of September 30, 2015 and 2014, respectively. As of September 30, 2015, we do not consider the undistributed earnings of our foreign subsidiaries as permanently reinvested outside the U.S. Consequently, we maintained a deferred tax liability of $3.4 million for U.S. income tax, which was offset by our domestic net operating losses and therefore did not impact our effective tax rate due to the full valuation allowance established against our domestic deferred tax assets. In addition, we maintained a deferred tax liability of $0.5 million for non-U.S withholding tax associated with the future repatriation of earnings from our foreign subsidiaries.

 

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. During the three months ended June 30, 2015, we repatriated approximately $3.8 million cash from our Mexico subsidiary to the U.S., and at the end of the liquidation process, we intend to repatriate any remaining residual cash to the U.S. We believe these cash repatriations are considered 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. As of September 30, 2015, we do not consider our Mexico subsidiary as substantially liquidated. Upon its future complete or substantially complete liquidation, we are required to release any cumulative translation adjustment related to our Mexico subsidiary into our consolidated statement of operations. As of September 30, 2015, the balance of such cumulative currency translation adjustment was a negative $2.6 million in “Accumulated Other Comprehensive Income (Loss)” on the consolidated balance sheet, which would result in a negative impact to our results of operations if it were to be released.

 

Our revolving credit facility has 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 $49.7 million as of September 30, 2015. As of September 30, 2015, we had two stand-by-letters of credit totaling approximately $0.2 million issued under our revolving credit facility as credit support for potential future payment obligations. There were no borrowings outstanding on our revolving credit facility as of September 30, 2015. On October 19, 2015, we drew down $10.0 million on the revolving credit facility at an annual interest rate of 1.97%. The proceeds will be used to fund seasonal working capital needs.

 

Capital expenditures were $11.7 million for the six months ended September 30, 2015 and $23.2 million for the same period in Fiscal 2015. Future capital expenditures are primarily planned for new product development. We expect that capital expenditures for the fiscal year ending March 31, 2016, including those for capitalized content costs will be funded with working capital on hand and availability under our revolving credit facility. We expect capital expenditures for the year ending March 31, 2016, including those capitalized content costs, to be in the range of $20.0 million to $25.0 million.

 

We believe that cash on hand, recent and planned reductions in operating expenses, amounts available under our revolving credit facility and measures we can take to manage operating cash flows, such as changing vendor terms and accelerating collection of accounts receivable balances, will provide adequate funds for our working capital needs and planned capital expenditures over the next twelve months. Our ability over this period 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.

 

 

The adequacy of our liquidity to fund our working capital needs and capital expenditures over the longer term will depend upon the magnitude of operating expense reductions we are able to achieve, the effectiveness of measures we adopt to manage our cash flows, the continued availability of a revolving credit facility to assist us in addressing the seasonality of our business, and our ability to improve our operating performance.

 

Cash Sources and Uses

 

The table below shows our sources and uses of cash for the six months ended September 30, 2015 as compared to the same period in Fiscal 2015:

 

		Six Months Ended September 30,								% Change 2015 vs.
		2015				2014				2014
		(Dollars in millions)
Net cash provided by (used in):
Operating activities		$	(62.3	)		$	(99.7	)			37	%
Investing activities			(11.7	)			(23.2	)			49	%
Financing activities			(0.2	)			0.6				128	%
Effect of exchange rate changes on cash			(0.3	)			1.6				(120	)%
Net change in cash and cash equivalents		$	(74.6	)		$	(120.6	)			38	%

 

Net cash used in operations for the six months ended September 30, 2015 decreased $37.4 million as compared to the same period in Fiscal 2015 primarily due to less inventory purchase offset by increased net loss related to operating activities.

 

Net cash used in investing activities for the six months ended September 30, 2015 decreased $11.5 million as compared to the same period in Fiscal 2015 primarily due to lower investments to upgrade our internal business systems.

 

Seasonal Patterns of Cash Provided By or Used in Operations

 

Historically, our cash flow from operations has been highest in the quarter ending March 31 of each year when we collect a majority of our accounts receivable booked in the quarter ending December 31 of the year. In 2013 and 2014, an increase in earlier sales to retailers during the quarters ended September 30 and December 31 and credit card-based sales through our App Center in the quarter ended December 31 resulted in higher cash flow from operations in the quarter ended December 31 than in the quarter ended March 31, a deviation from our historical norm. Cash flow used in operations tends to be highest in the quarter ending September 30, 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 December 31 as we begin to collect on the accounts receivable associated with the holiday season. However, this pattern did not continue for Fiscal 2015 due to later launches of new products as well as the deterioration of our overall financial performance in Fiscal 2015 as compared to previous years. Due to the significant reduction in cash generated from operations and increase in inventory levels during the December quarter in Fiscal 2015, we used more cash in operations than was provided. These factors also reduced our cash provided by operations in the quarter ended 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 six months ended September 30, 2015. As of September 30, 2015, we had commitments to purchase inventory under normal supply arrangements totaling approximately $24.8 million. In addition, as of September 30, 2015, we had two stand-by-letters of credit totaling approximately $0.2 million issued under our revolving credit facility as credit support for potential future payment obligations, which were 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 2015 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 2015 Form 10-K through September 30, 2015.

 

Recently Issued Accounting Guidance Not Yet Adopted

 

In July 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory, which requires that inventory be measured at the lower of cost and net realizable value. ASU 2015-11 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. The guidance should be applied prospectively with earlier application permitted as of the beginning of an interim or annual reporting period. We do not expect a material impact on our consolidated financial statement upon the adoption of this guidance.

 

In August 2014, the FASB issued 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.

 

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. 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. The original effective date of this guidance for public entities was for annual reporting periods beginning after December 15, 2016. In August 2015, the FASB issued ASU 2015-14, Revenue from Contracts with Customers (Topic 606), to defer the effective date of this guidance by one year, to the annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period, i.e. the first quarter of our fiscal year 2019. A reporting entity may choose to early adopt the guidance as of the original effective date. We do not anticipate an early adoption, and 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 2015 Form 10-K have not changed materially for our quarter ended September 30, 2015.

 

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 six months ended September 30, 2015 and 2014 are summarized in the table below:

 

		Three Months Ended September 30,								Six Months Ended September 30,
		2015				2014				2015				2014
		(Dollars In thousands)								(Dollars In thousands)
Gain (loss) on foreign exchange forward contracts		$	73			$	1,679			$	(105	)		$	1,662
Gain (loss) on underlying transactions denominated in foreign currency			126				(1,619	)			(72	)			(1,828	)
Net gains (losses)		$	199			$	60			$	(177	)		$	(166	)

 

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 September 30, 2015 is as follows:

 

		As of September 30, 2015
		Average Forward Exchange Rate				Notional Amount in Local Currency				Fair Value of Instruments in USD
						(1)				(2)
Currencies:
British Pound (GBP/USD)			1.516				3,557			$	(2	)
Euro (Euro/USD)			1.112				4,456				(22	)
Total fair value of instruments in USD										$	(24	)

 

(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 September 30, 2015 and 2014, and March 31, 2015, our excess cash was invested in money market funds and certificates of deposit.

 

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 effective as of September 30, 2015.

 

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

 

In July 2015, we completed a version upgrade to our enterprise resource planning (“ERP”) system for both the accounting and financial reporting modules. During the implementation period, we have reassessed and updated, as necessary, the design and documentation of internal controls processes and procedures relating to the upgraded system as appropriate and necessary to supplement and complement existing internal controls over financial reporting. Based on management’s assessment of the upgrade, it appears that the upgrade did not adversely impact our internal controls over financial reporting. We will continue to enhance our ERP system through the remainder of Fiscal 2016 and beyond, as necessary.

 

Except for the item discussed above, there were no changes in our internal control over financial reporting during the three months ended September 30, 2015 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

 

PART II.

 

OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

 

Refer to information under the heading “Legal Proceedings” in Note 10 — “Commitments and Contingencies” in our Consolidated Financial Statements included in this Quarterly Report on Form 10-Q.

 

ITEM 1A. RISK FACTORS

 

Our business, financial condition and operating results can be affected by a number of factors, including those described below, any one of which could cause our actual results to vary materially from recent results or from our anticipated future results. In addition to other information contained in this Quarterly Report on Form 10-Q and our other filings with the SEC, the following risk factors should be considered carefully before you decide whether to buy, hold or sell our common stock. Additional risks not presently known to us or that we currently deem immaterial may also impair our business, financial conditions, results of operations and stock price.

 

Our business depends on our ability to correctly predict highly changeable consumer preferences and product trends.

 

The preferences and interests of children and families evolve quickly, can change drastically from year to year and are difficult to predict. Even our successful products typically have a relatively short period of high demand followed by a decrease in demand as the product matures. We depend on our ability to correctly identify changing consumer sentiments well in advance and supply new products that respond to such changes on a timely basis. We also rely on our ability to identify third-party entertainment media that is likely to be popular with consumers and license rights to such media to incorporate into our products. In addition, we need to be able to accurately forecast sales of these products in order to optimize our production schedules and manage our inventory. Since our products typically have a long development cycle, in some cases lasting over a year, it can be difficult to correctly predict changing consumer preferences and accurately forecast optimal production and sales targets for these products. If we are unable to correctly predict consumer preferences, successfully integrate popular third-party media with our own or accurately forecast sales targets for our products, our current and future operating results could be materially and negatively impacted. For example, net sales of our both our LeapPad and LeapTV platforms in Fiscal 2015 were below our expectations, resulting in higher than anticipated inventory levels of the products at fiscal year-end and substantial operating losses, results that significantly underperformed our expectations.

 

To remain competitive and stimulate consumer demand, we must continue to develop new products and services and successfully manage frequent product introductions and transitions.

 

Due to the highly volatile and competitive nature of the industries in which we compete, we must continually introduce new products and services, enhance existing products and services, and effectively stimulate customer demand for new and upgraded products. We cannot be sure that any new products or services will be widely accepted and purchased by consumers or that we will be able to successfully manage product introductions and transitions. Failure by consumers to accept our new products and services or to pay a higher price for some of our key products, or our failure to manage product introductions and transitions, could adversely affect our operating results. For example, consumer demand and acceptance of our LeapTV platform in Fiscal 2015 was below our expectations, resulting in higher than anticipated inventory levels of the product at year end and contributing to our worse than anticipated financial results.

 

If inventory levels are too high, or if we do not maintain sufficient inventory levels to deliver our products to our customers in sufficient quantities, or on a timely basis, or our operating results will be adversely affected.

 

The high degree of seasonality of our business places stringent demands on our product planning, inventory forecasting and production planning processes. This inventory management approach may be particularly challenging when combined with “just-in-time” inventory management systems commonly used by retailers to minimize their inventory levels. If we fail to meet tight shipping schedules, we could damage our relationships with retailers, increase our shipping costs or cause sales opportunities to be delayed or lost. In order to be able to deliver our merchandise on a timely basis, we need to maintain adequate inventory levels of the desired products. This requires us to begin to place orders for components up to a year in advance, and we produce a significant amount of product months in advance, of the holiday season. At the time these orders are being placed and product is being produced, we generally do not have firm orders from retailers or a complete understanding of what the consumer demand for those products will be in the holiday season. If our product planning, inventory forecasting and production planning processes result in our manufacturing inventory in excess of the levels demanded by our customers, we could be required to record inventory write-downs for excess and obsolete inventory, which would adversely affect our operating results. In addition, if our processes result in our inventory levels being too low to meet customer demand, or if we fail to meet tight shipping deadlines, we may lose sales or increase our shipping costs, which would adversely affect our operating results.

 

 

We rely on a small group of retailers that together accounted for the majority of our annual gross sales such that economic or other difficulties that affect these retailers or changes in their purchasing or related decisions could have a significant impact on our business and operating results.

 

Our top four retailers, Wal-Mart Stores, Inc. (“Wal-Mart”), Toys “R” Us, Inc. (“Toys “R” Us”), Target Corporation (“Target”) and Amazon.com (“Amazon”), in the aggregate, accounted for approximately 69% and 60% of our consolidated gross sales for the six months ended September 30, 2015 and 2014, respectively. These top four retailers, in the aggregate, accounted for approximately 88% and 76% of the U.S. segment’s gross sales for the six months ended September 30, 2015 and 2014, respectively. In addition, these top four retailers, in the aggregate, accounted for approximately 25% and 28% of the International segment’s gross sales for the six months ended September 30, 2015 and 2014, respectively. For the foreseeable future, we expect to continue to rely on a small number of large retailers for the majority of our sales domestically and abroad.

 

We do not have long-term agreements with any of our retailers and retailers make all purchases by delivering one-time purchase orders. As a result, pricing, shelf space, cooperative advertising or special promotions, among other things, with each retailer are subject to periodic negotiation and alteration. In addition, Wal-Mart and Target have from time to time reduced the shelf space allocated to the electronic learning aids aisle within the toy department, which is where our multimedia platforms are merchandized and which may negatively impact our sales at these retailers.

 

In addition, we rely on our retail customers to successfully sell our products to consumers. Economic and other factors that adversely affect retailers, such as increased competition from online retailers, store closures, consolidation in the retail sector, bankruptcies and liquidity problems may adversely affect us. For example, the bankruptcy of Target Canada in 2014 resulted in bad debt expense of approximately $0.4 million. If any of these retailers reduce their purchases from us, reduce our shelf space at retail, materially change the terms on which we conduct business with them or experience a downturn in their business for any reason, our business and operating results could be adversely affected.

 

Our liquidity may be insufficient to meet the long-term or periodic needs of our business.

 

We anticipate that we will fund our operations through the collection of accounts receivable and borrowings under our line of credit. Depending on our operating results for the December quarter, we may need to make further adjustments in our operations in order to maintain sufficient liquidity at the low point in our annual cash cycle. In addition, if we continue to incur operating losses over an extended period of time, our cash plus borrowing availability under our line of credit may be insufficient to fund our operations at current levels. Our line of credit has numerous financial tests and covenants that affect the amount we can borrow, and includes various events of default that could impair our ability to access credit under the credit line. Any impairment of our ability to access, or extend the term of, our credit line could increase our cost of capital or limit our ability to secure capital needed to fund our operations and could materially impact our financial results and operations.

 

If global economic conditions deteriorate, our business and financial results could be affected.

 

We develop and distribute educational entertainment for children. Our performance can be materially impacted by the overall level of discretionary consumer spending. Consumers’ discretionary purchases of educational entertainment items for children may be impacted by unemployment, foreclosures, bankruptcies, reduced access to credit, interest rates, stagnant or declining wages, and other macroeconomic factors that affect consumer spending behavior. The current economic recovery in the U.S. may not be sustainable or may not be sufficiently broad-based to increase the spending throughout our consumer base. If these or other matters led to a deterioration of global economic conditions, it could potentially have a material adverse effect on our business and operating results.

 

 

If our marketing and advertising efforts fail to resonate with our customers, our business and operating results could be adversely affected.

 

Our products are marketed through a diverse spectrum of advertising and promotional programs. Our ability to sell our products and services is dependent in part upon the success of these programs. Additionally, given the importance of sales during the year-end holiday season, our marketing efforts tend to be concentrated in the quarter ending December 31. With this concentration, it can be more difficult to accurately assess the effectiveness of the advertising and make any necessary adjustments before the end of the December quarter. If the marketing for our products and services fails to resonate with consumers, particularly during the critical holiday season or during other key selling periods, or if we are unable to accurately assess the effectiveness of our advertising and make necessary adjustments, our business and operating results could be materially affected.

  

If we are unable to compete effectively with existing or new competitors, our sales and market share could decline.

 

We currently compete in the learning toy and electronic learning-aids categories of the U.S. and international toy market, with makers of children’s tablets and, to an increasing extent, with general purpose tablets, eBook readers, mobile devices and gaming platforms. Each of these markets is very competitive and we expect competition to increase in the future. The increasing choices for children’s educational entertainment can make it difficult for us to differentiate our products from our competition, causing consumers to select a competitor’s products.

 

Our LeapPad products face increasing competition from several tablets designed for children and from general-purpose tablets made by major electronics manufacturers. This means that we compete, to an increasing extent, with much larger makers of tablets such as Apple, Samsung and Amazon, as well as more traditional learning toy companies such as VTech, Mattel and Hasbro. Our digital content faces increasing competition from producers of low cost digital content for kids made for general purpose tablets and smart phones. This may adversely impact the prices we charge for content for our proprietary platforms and sales of such content, as well as our ability to charge a premium for any content we offer for Android and iOS tablets. We focus heavily on the educational aspect of our content, ensuring that each piece of content is based on age-appropriate educational curricula. In contrast, many of our competitors seek to compete primarily through aggressive pricing. We also face the challenge of competitors introducing similar products or functionality soon after we introduce our new products or product lines, and these competitors may be able to offer their products at lower prices using cheaper manufacturing processes or materials, more limited functionality, or reduced safety features.

 

Many of our competitors are significantly larger and have substantially greater financial, technical and marketing resources than we do. If we are is unable to compete effectively or successfully differentiate our products from the competition, our business and operating results could be adversely affected.

 

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. We implemented reductions in our workforce in February and October of 2015 to align our employee base and cost structure with our current and anticipated revenues and we have recently experienced greater turnover in our employee base. These reductions and turnover will result in reallocations of duties and may increase uncertainty and discontent among our employees, resulting in unintended attrition or performance issues. High levels of turnover may also impact our ability to execute against our business initiatives and make it more difficult for us to attract and recruit highly skilled employees. 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. 

 

 

 

If we are unable to maintain or acquire licenses to include intellectual property owned by others in our products, our operating results could suffer.

 

Among our proprietary rights are inbound licenses from third parties for content such as characters, stories, music, illustrations and trade names, and for technologies we incorporate in our products, including key technology used in our LeapReader reading systems. In particular, we rely on our ability to acquire rights to popular entertainment media properties for content on our multimedia learning platforms. Ownership of highly popular children’s properties has become increasingly consolidated with two large entertainment companies: Disney and Viacom. Our continued use of these rights is dependent on our ability to continue to obtain these license rights and at reasonable rates. Any failure to do so could significantly impact our content sales or interrupt our supply chain and require us to modify our products or business plans.

 

If we were required to record an additional 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, and adversely affect our results of operations. For example, for the fiscal year ended March 31, 2015 and six months ended September 30, 2015, respectively, we recorded a $36.5 million and $3.9 million long-lived assets impairment charge against our property and equipment. We will continue to review the recoverability of our remaining long-lived assets on a quarterly basis, which may result in additional impairment charges in future periods. 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 additional non-cash expense in the period in which the valuation allowance is adjusted and our results of operations would be adversely affected. For example, for the year ended March 31, 2015, we recorded a $90.8 million income tax provision as a result of establishing an additional valuation allowance against our domestic deferred tax assets. 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.

 

Our business is highly seasonal, and our annual operating results depend, in large part, on sales relating to the brief holiday season.

 

Sales of consumer electronics and toy products in the retail channel are highly seasonal, causing a substantial majority of our sales to retailers to occur during the quarters ending September 30 and December 31. Approximately 76% and 73% of our total net sales occurred during the six months ended December 31 of years ended March 31, 2015 and 2014, respectively; and approximately 70% and 75% of our total net sales occurred during the second half of the years ended December 31, 2013 and 2012, respectively. A decline of net sales, in the quarter ending September 30 or December 31 in particular, will have a disproportionate negative impact on our results for the year and can lead to ongoing weakness in sales to retailers well into the following year. Therefore, we may be significantly and adversely affected, in a manner disproportionate to the impact on a company with sales spread more evenly throughout the year, by unforeseen events such as economic crises, strikes, earthquakes, terrorist attacks or other catastrophic events that harm the retail environment or consumer buying patterns during our key selling season.

 

Significant increases in the cost of our components and raw materials or an inability to obtain these in sufficient quantities from our suppliers or alternative sources could negatively impact our financial results.

 

Because some of the components used to make our products currently come from a single or a limited number of suppliers, we are subject to significant supply and pricing risks. Many components that are available from multiple sources are at times subject to industry-wide shortages and significant commodity pricing fluctuations. If our suppliers are unable to meet our demand for components or raw materials and we are unable to obtain an alternative source or if the price available from our current suppliers or an alternative source is prohibitive, our ability to maintain timely and cost-effective production of our products would be seriously harmed and our operating results would suffer.

 

In addition, as we do not have long-term agreements with our major suppliers and cannot guarantee their stability, they may stop manufacturing our components at any time with little or no notice. If we are required to use alternative sources, we may be required to redesign some aspects of the affected products, which may involve delays and additional expense. If there are any significant interruptions in the supply of components or if prices rise significantly, we may be unable to manufacture sufficient quantities of our finished products or we may be unable to manufacture them at targeted cost levels, and our business and operating results could be harmed.

 

 

Our reliance on a limited number of third-party manufacturers to produce the majority of our products presents risks to our business.

 

We outsource substantially all of our manufacturing to a limited number of Asian manufacturers, most of which manufacture our products at facilities in the Guangdong province in the southeastern region of China. We depend on these manufacturers to produce sufficient volumes of our finished products in a timely fashion, at satisfactory cost and quality levels, and in accordance with our and our customers’ terms of engagement. If we determine that we need to order larger quantities of our products to meet customer demand, we may encounter delays and shortfalls in shipments based on manufacturer capacity issues. Economic and other factors that adversely affect these manufacturers may also adversely affect us. For example, labor costs in China continue to increase due to a variety of factors, including tightening Chinese labor markets, leading to increased prices for us with some of our contract manufacturers. Furthermore, in the past, there have been product quality and safety issues for other producers of toys and other companies that manufacture goods in China. If our manufacturers fail or are unable to produce quality finished products on time, at expected cost targets and in sufficient quantities, or if any of our products are found to be tainted or otherwise raise health or safety concerns, our reputation and operating results would suffer.

 

System failures in our digital services could harm our business.

 

The digital aspects of our business have grown substantially in strategic importance to our overall business. Any failure to provide a positive user experience in these services could have a negative impact on our reputation, sales and consumer relationships. In addition, we rely on third parties for certain critical aspects of the online user experience, such as payment processing and secure handling of credit card and other confidential information. If consumer demand for accessing our App Center or our website exceeds the capacity we have planned to handle during peak periods or if other technical issues arise, then we could lose sales and customers could be inconvenienced or become dissatisfied with our products. Any significant disruption to or cyber-attack on our App Center, website, internal computer systems, or those of our third-party service providers, or malfunctions related to transaction processing on our content management systems, could result in a loss of potential or existing customers and sales.

 

Although our systems have been designed to reduce downtime in the event of outages or catastrophic occurrences, they remain vulnerable to damage or interruption from earthquakes, floods, fires, power loss, telecommunication failures, terrorist attacks, computer viruses, computer denial-of-service attacks, and similar events. Many of our systems are not fully redundant, and our disaster recovery planning is not sufficient for all eventualities. Our systems are also subject to break-ins, sabotage, and intentional acts of vandalism. The occurrence of an earthquake, or other natural disaster or unanticipated problem at our hosting facilities, including those located in California, could result in lengthy interruptions in our services. We do not carry business interruption insurance sufficient to compensate us for losses that may result from interruptions in our service as a result of system failures. Any unplanned disruption of our systems could result in adverse financial impact to our operations.

 

We may not succeed in protecting or enforcing our intellectual property rights and third parties may claim that we are infringing their intellectual property rights.

 

We rely on a combination of patents, copyrights, trademarks, service trademarks, trade secrets, confidentiality provisions and licensing arrangements to establish and protect our intellectual property and proprietary rights. The steps we have taken may not prevent unauthorized use of our intellectual property, particularly in foreign countries where we do not hold patents or trademarks or where the laws may not protect our intellectual property as fully as in the U.S. Some of our products and product features have limited intellectual property protection, and, as a consequence, we may not have the legal right to prevent others from copying and using these features in competitive products. In addition, monitoring the unauthorized use of our intellectual property is costly, and any dispute or other litigation, regardless of outcome, may be costly and time-consuming and may divert our management and key personnel from our business operations. However, if we fail to protect or to enforce our intellectual property rights successfully, our rights could be diminished and our competitive position could suffer, which could harm our operating results.

 

 

In addition, we periodically receive claims of infringement or otherwise become aware of potentially relevant patents, copyrights, trademarks or other intellectual property rights held by other parties. Responding to any infringement claim, regardless of its validity, may be costly and time-consuming and may divert our management and key personnel from our business operations. If we, our distributors, our licensors or our manufacturers are found to be infringing on the intellectual property rights of any third party, we or they may be required to obtain a license to use those rights, which may not be obtainable on reasonable terms, if at all. We also may be subject to significant damages or injunctions against the development and sale of some of our products or against the use of a trademark or copyright in the sale of some of our products. Our insurance does not cover all types of intellectual property claims and insurance levels for covered claims may not be adequate to indemnify us against all liability, which could harm our operating results.

 

Any defects contained in our products, or our failure to comply with applicable safety standards, could result in recalls, delayed shipments, rejection of our products, product liability and damage to our reputation, and could expose us to litigation or regulatory action.

 

Our products may contain defects, which could lead to product liability, personal injury or property damage claims, or could result in the rejection of our products by retailers, damage to our reputation, lost sales, and increased customer service and support costs and warranty claims. There is a risk that these claims or liabilities may exceed, or fall outside the scope of, our insurance coverage. Moreover, we may be unable to retain adequate liability insurance in the future. Concerns about potential public harm and liability may involve involuntary recalls or lead us to voluntarily recall selected products. Recalls or post-manufacture repairs of our products could harm our reputation and our competitive position, increase our costs or reduce our net sales. In addition, recalls or post-manufacturing repairs by other companies in our industry could affect consumer behavior and cause reduced purchases of our products. Any such problems, or perceived problems, with our products could harm our operating results.

 

We face risks associated with international operations.

 

We derived approximately 31% and 33% of our net sales from markets outside the U.S. during the six months ended September 30, 2015 and 2014, respectively.

 

Our business is subject to additional risks associated with conducting business internationally, including:

 

·

the appeal of our products in international markets;

 

·

difficulties managing and maintaining relationships with vendors, customers, retailers, distributors and other commercial partners;

 

·

increased investment and operational complexity to make our multimedia platforms and App Center compatible with the systems in various countries and compliant with local laws;

 

·

greater difficulty in staffing and managing foreign operations;

 

·

transportation delays and interruptions, including cross-border delays due to customs clearance and other point-of-entry restrictions;

 

·

timely localization of products and content;

 

·

currency conversion risks and currency fluctuations; and

 

·

limitations, including taxes, on the repatriation of earnings

 

Our efforts to increase sales for our products outside the U.S. may not be successful and may not achieve higher sales or gross margins or contribute to profitability. Expansion plans will require significant management attention and resources and may be unsuccessful. We may have to compete with established local or regional companies which understand the local market better than we do. This expansion increases the complexity of our business and places strain on our management, personnel, operations, systems, technical performance, financial resources, and internal financial control and reporting functions. Any difficulties with our international operations could harm our future sales and operating results. In addition, we may not be able to manage international growth effectively, which could damage our reputation, limit our growth and negatively affect our operating results.

 

 

We are subject to international, federal, state and local laws and regulations, including those related to privacy, which could impose additional costs or changes on the conduct of our business.

 

We operate in a highly regulated environment with international, federal, state and local governmental entities regulating many aspects of our business. Regulations with which we must comply include accounting standards, taxation requirements (including income tax rates, tariff and import duties, new tax laws and revised tax law interpretations), regulations regarding financial matters, environmental regulations, privacy regulations, regulations regarding advertising directed toward children, safety and other administrative and regulatory restrictions. Our international business requires compliance with the Foreign Corrupt Practices Act, the UK Bribery Act and similar laws. We are also subject to regulation by the U.S. Consumer Product Safety Commission and other similar federal, state and international regulatory authorities, some of which have conflicting standards and requirements. In addition, numerous states have enacted, and many others are considering enacting, laws directed at manufacturers regarding recycling of electronic products and the disclosure of the chemical composition of consumer products, including toys. Compliance with the various laws and regulations and other requirements of regulatory authorities imposes significant costs on the conduct of our business.

 

Changes to privacy regulations in the U.S. or Europe could have a significant impact on our business, as a growing percentage of our sales come from our digital multimedia learning platforms and related content. As we focus on digital products and direct marketing to consumers through the Internet, regulatory changes regarding the collection, use, disclosure, or security of personal information or other privacy-related matters, could negatively affect our business. Furthermore, consumer concerns regarding such matters, even if unfounded, could damage our reputation and operating results.

 

While we take steps that we believe are necessary to comply with these laws and regulations, there can be no assurance that we have achieved compliance or that we will be in compliance in the future. Failure to comply with the relevant regulations could result in monetary liabilities and other sanctions, and could lead to significant negative media attention and consumer dissatisfaction, either of which could have a negative impact on our business, financial condition and results of operations. In addition, changes in laws or regulations may lead to increased costs, changes in our effective tax rate, or the interruption of normal business operations that would negatively impact our financial condition and results of operations.

 

Political developments, changes in trade relations, the threat or occurrence of armed hostilities, terrorism, labor strikes, natural disasters or public health issues could have a material adverse effect on our business.

 

Our business is international in scope. The deterioration of the political or socioeconomic situation in a country in which we have significant sales, operations or third-party manufacturers or suppliers, or the breakdown of trade relations between the U.S. and a foreign country in which we have or utilize significant manufacturing facilities or have other operations, could adversely affect our business, financial condition, and results of operations. For example, a change in trade status for China, where the vast majority of our contract manufacturers are located, could result in a substantial increase in the import duty of toys manufactured in China and imported into the U.S. In addition, armed hostilities, terrorism, natural disasters, or public health issues, whether in the U.S. or abroad, could cause damage and disruption to our company, our suppliers, our manufacturers, or our customers or could create political or economic instability, any of which could have a material adverse impact on our business. For example, our U.S. distribution center and our corporate headquarters are located in California near major earthquake faults that have experienced earthquakes in the past and that are expected to recur in the future. See also “ System failures in our online services or web store could harm our business ” above. Although it is impossible to predict the consequences of any such events, they could result in a decrease in demand for our product or create delay or inefficiencies in our supply chain by making it difficult or impossible for us to deliver products to our customers, for our manufacturers to deliver products to us, or for suppliers to provide component parts.

 

 

 

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 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.

 

We may engage in acquisitions, mergers, or dispositions, which may affect our financial results.

 

We may engage in acquisitions, mergers or dispositions, which may affect the profit, revenues, profit margins, debt-to-capital ratio, capital expenditures, or other aspects of our business. There can be no assurance that we will be able to identify suitable acquisition targets or merger partners or that, if identified, we will be able to acquire these targets on terms acceptable to us and to potential merger partners. There can also be no assurance that we will be successful in integrating any acquired company into our overall operations, or that any such acquired company will operate profitably or will not otherwise adversely impact our results of operations. Further, we cannot be certain that key talented individuals at those acquired companies will continue to work for us after the acquisition or that they will continue to develop popular and profitable products or services.

 

A few stockholders control a significant percentage of our voting power.

 

The majority of holders of our Class A common stock may not be able to affect the outcome of any stockholder vote. Our Class A common stock entitles its holders to one vote per share, and our Class B common stock entitles its holders to ten votes per share on all matters submitted to a vote of our stockholders.

 

As of September 30, 2015, Michael Milken and Lowell Milken together owned, directly and indirectly, approximately 3.6 million shares of our Class B common stock and Sandra Milken beneficially owned 0.8 million shares of our Class B common stock. Together, these three stockholders represented approximately 39.8% of the combined voting power of our Class A common stock and Class B common stock as of September 30, 2015. As a result, Messrs. Michael and Lowell Milken, and Ms. Milken, if voting together would have significant influence on stockholder vote outcomes, including with respect to:

 

·

the composition of our board of directors and, through it, any determination with respect to our business direction and policies, including the appointment and removal of officers;

 

·

any determinations with respect to mergers, other business combinations, or changes in control;

 

·

our acquisition or disposition of assets; and

 

·

our financing activities.

 

Messrs. Michael and Lowell Milken and Ms. Milken could have interests that diverge from those of our other stockholders. This significant influence by a few stockholders could depress the market price of our Class A common stock; deter, delay or prevent a change in control of LeapFrog; or affect other significant corporate transactions that otherwise might be viewed as beneficial for other stockholders.

 

Failure to regain compliance with New York Stock Exchange (“NYSE”) listing requirements could cause the NYSE to delist our stock, which is likely to have an adverse impact on the trading volume, liquidity and the market price of our stock.

 

Our Class A common stock is currently listed on the New York Stock Exchange (“NYSE”). In order to maintain this listing we must comply with the continued listing standards set forth in Section 802.01 of the NYSE Listed Company Manual, which require that we maintain a certain stock price in addition to certain other financial and share distribution targets.

 

On September 4, 2015, we received a written notice from the NYSE stating that we were not in compliance with one of the continued listing standards based on the average closing price of our Class A common stock being less than $1.00 per share over a period of 30 consecutive trading days. In accordance with NYSE rules, we have six months from the date of receipt of such notice to achieve compliance with this continued listing standard. We can regain compliance with the minimum per share average closing price standard at any time during the six-month cure period if, on the last trading day of any calendar month during the cure period, we have (i) a closing ordinary share price of at least $1.00 and (ii) an average closing ordinary share price of at least $1.00 over the 30 trading-day period ending on the last trading day of that month. While we cannot give assurances that we will be able to timely regain compliance with this standard, we responded to the NYSE on September 10, 2015 that we intend to cure this non-compliance. If we determine to remedy the non-compliance by taking action that will require shareholder approval, such as a reverse share split, we must notify the NYSE no later than expiration of the six month cure period, or March 4, 2016 that we intend to implement such action.

 

 

Our stock price has been subject to volatility.

 

Our stock has and may continue to experience substantial price volatility. Our future success depends partly on the continued contribution of our key executives and technical, sales, marketing, manufacturing and administrative personnel. Part of our compensation package is equity based. To the extent our stock performs poorly, it may adversely affect our ability to retain or attract key employees, potentially resulting in lost institutional knowledge and key talent. In addition, a significant drop in the price of our stock could expose us to the risk of securities class action lawsuits, which could result in substantial costs and divert management’s attention and resources. For example, the Company is currently defending itself against a securities class action lawsuit and has been named as a nominal defendant in a related stockholder derivative lawsuit. Continued stock price volatility could harm our ability to attract and retain sufficient qualified personnel by reducing the value of our equity compensation and could subject us to additional litigation.

 

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

10.01

Letter Agreement by and between LeapFrog Enterprises, Inc. and Anoto AB, among other parties, dated August 20, 2015, extending the term of the Technology License Agreement by and between LeapFrog Enterprises, Inc. and Anoto AB

X

10.02

Amendment to Offer Letter between LeapFrog Enterprises, Inc. and Raymond L. Arthur, dated August 5, 2015

X

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 September 30, 2015, 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 Loss, (iv) the Consolidated Statements of Cash Flows, and (v) Notes to the Consolidated Financial Statements

X

 

 

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: November 9, 2015
/s/ Raymond L. Arthur
Raymond L. Arthur
Chief Financial Officer
(Principal Financial Officer and Principal Accounting Officer)
Date: November 9, 2015