LeapFrog: Trouble In Toyland

By Larry Barrett  |  Posted 2003-11-04

LeapFrog: Trouble In Toyland

LeapFrog Enterprises may enjoy strong demand for its educational toys, but the Emeryville, Calif. manufacturer could use a primer on how a supply chain needs to work as Christmas approaches.

The basic lesson: a company should think twice before putting off the deployment of new software for managing the manufacturing and distribution of toys, when it is heading into a season that accounts for 75 percent of its annual sales.

That became obvious on Oct. 21, when this toymaker, whose key backers are former junk bond trader Michael Milken and Oracle chief executive Larry Ellison, blamed distribution and logistics problems for missing analysts revenue estimates by $32 million in the third quarter. The revenue may be made up in the last three months of the year, but the disclosure damaged managements credibility and ended the companys 18-month run as a darling of Wall Street.

Shares fell $11.65, or 25 percent, to $24.89, when the maker of LeapPad and Leapster interactive learning games said it would earn $33.4 million, or 55 cents a share, on sales of $203.9 million in the quarter. Sales had been expected to come in at $236 million with earnings of 61 cents a share.

The real problem: LeapFrog suspended deployment of new supply-chain software—before the third quarter began.

"We started the implementation in the first half of this year but didnt complete it," says LeapFrog spokeswoman Cherie Stewart. "Were just moving into pilot right now."

LeapFrog is installing version 6.15 of logistics software from Manugistics. The automation is designed to link up and synchronize orders from retailers to the inventory the company already has on hand to fulfill orders, and to run the rest through factories in China.

Stewart says the company plans to fully implement the new supply-chain management system in the first half of 2004—when the hectic holiday shopping season is over.

In the meantime, LeapFrog is using a combination of its own existing software and some pieces of the Manugistics system. LeapFrog officials declined to comment on its internally developed system or how the eventual deployment will be an improvement.

Analysts say the companys decision to run the not-yet-ready-for-prime-time Manugistics software in unison with their customized supply-chain system made sense at midyear, even if it meant the companys ability to forecast fourth-quarter demand would be limited.

"Supply chain is a complicated thing so stalling the implementation probably isnt such a bad thing," says Chad Eschinger, an analyst at Gartner. "You dont want to be distracted and trying to implement something that can be very painful during your busiest time of the year."

But the suspension of the project produced pain anyway. Big customers, such as Wal-Mart, Target, Toys R Us and Amazon.com, like to wait until the last two weeks of the quarter to place orders. That lets them get goods they want "just in time" for the need. But LeapFrog didnt see the rush of orders coming, and was therefore unable to foresee discrepancies between demand from consumers, orders from retailers and levels of inventory.

As a result, chief executive Mike Wood told analysts on its earnings conference call that LeapFrog failed to respond adequately to orders placed during the last two weeks of the quarter. All of its toys, notably, are manufactured at eight plants in China, which puts a premium on advance planning and fast shipment.

That led investors to wonder whether management was on top of its planning for the critical holiday season in the first place—and whether LeapFrog executives understand what it takes to deal with retailers who have come to rely heavily on "just-in-time" purchasing for their stores.

"LeapFrog wasnt able to handle [the late orders] in time to book the sales for its third quarter," says Natalie Walrond, an analyst at Pacific Growth Equities in San Francisco. "Its hard to say how much of this was a software problem.

Next Page: Supply capability issues, high-standard vendors and majority voting rights for Milken and Ellison.

Supply Chain Issues

Manugistics CEO Greg Owens, speaking at his companys user conference in Washington, D.C., says the LeapFrog implementation is on schedule and that LeapFrog is "very happy" with Manugistics work. The problem: Demand for the toys has "been outstripping [LeapFrogs] supply capability."

Shareholders will watch LeapFrog closely in the fourth quarter and into 2004, to see if it can rectify its third-quarter miscues. If the Manugistics implementation goes well, the sales shortfall will be viewed as a hiccup. In the twelve months leading up to the third-quarter disappointment, LeapFrog sales had grown 55 percent over the prior 12-month period.

That growth pushed shares to a high of $46.54 minutes before its earnings release, from $13, when it first went public in July 2002. Although LeapFrog is independent, Milken and Ellison retain majority voting rights on major corporate decisions.

"They are growing in terms of being an important toy company and vendors are holding them to a very high standard. The challenge for them now is to get their internal forecasting up to that standard," says Pacific Growths Walrond.

With such demanding and high-volume customers as Wal-Mart, Target and Amazon.com, LeapFrog "is eventually going to have to tie into some of these retail goliaths with their supply-chain and demand-forecasting models," says Gartners Eschinger. "Its going to be the only way to do business going forward."

LeapFrog appears confident it can recapture investor confidence and prove that it can deliver its popular toys to retail partners in a timely fashion.

"Late-building demand from our key retailers resulted in lower net sales growth for the third quarter," Wood said in the companys third-quarter earnings release. "This resulted in a shift of deliveries from the third quarter to the benefit of the fourth quarter. Our underlying sell-through at the retail level remained very strong throughout the third quarter."

Along with its third-quarter earnings, LeapFrog raised its sales forecast for the fourth quarter to a range of $316 million to $334 million, up from an original estimate of $277 million to $297 million.

Will that optimism be enough to make LeapFrog a Wall Street darling again?

"We really think most of the sales missed in the third quarter have already been shipped in the first week or two of the fourth quarter," Walrond says. "But anytime theres a miss with a company thats done nothing but impress, it does raise the issue of credibility."

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