LeapFrog Enterprises has a lot to prove.

At the same time it has undergone the most sweeping purge and recasting of senior management in its 12 year life, the educational toy maker has launched the latest iteration of a turnaround plan, shorthanded by President and CEO Jeffrey Katz as "Fix, Reload and Grow."

It comes not a minute too soon. Fiscal 2006 was the worst in the company’s short public life and likely the worst since its founding. Sales declined another 23 percent to $502.3 million while profits simply vaporized: a $145.1 million loss compared to a profit of $17.5 million the year before. And that’s not the worst of it: try remembering a company with $649 million in sales on track, it said at the time, to chase down three-quarters of a billion in its top line. The performance last year was so dismal—and prospects for significant recovery soon so speculative—that one investment research firm, New Constructs, gave Leapfrog a "dangerous risk/reward rating."

The risks are clearly present, not the least of which is that 66 percent of LeapFrog's business is done with just three retailers: Wal-Mart, Toys “R” Us and Target. No matter what else happens, they alone will determine the success or failure of LeapFrog's turnaround. That doesn't even address whether the plan itself is adequate to drive the comeback.

“The strategy has a lot to prove,” offered one Wall Street portfolio manager, a former toy industry analyst who asked not to be identified. “But from an investment perspective, I'm just avoiding it. It's too early to short,

but with the stock in the double digits, the turnaround is more than discounted in the current stock price and I don't think it's a sure thing.”

Small shareholder dissatisfaction over LeapFrog's performance prompted one stockholder to propose at this month's shareholders' meeting that the company be sold to the highest bidder at auction. William Steiner of New York made the non-binding proposal with no realistic expectation it would pass, as a means of maximizing shareholder value that he said is not being realized in the operating business. However, with control of the company resting comfortably with two stockholders, Oracle Chairman Larry Ellison and Michael Milken of junk bond infamy, there was no chance his resolution would succeed.

The losses and declines in 2006 came from a variety of factors but were influenced in no small part by sales nosedives of two critical products. LeapPad, the company's star for many years, sank 63 percent in 2006, at the same time the product most identified with its future, The Fly, was off 68 percent—by itself a decline of $36 million. Among many other repairs the company is currently undergoing, the development of a successor to the LeapPad and the pending introduction of Fly Fusion are near the top of its priorities.

The goal of the turnaround effort, of course, is to return the company to profitability and positive sales growth as it recaptures shrinking market share and retail shelf space. But of equal measure and challenge, it must also regain trust and credibility among its investors and, even more importantly, its retail customers. Katz has made it clear he understands LeapFrog's place among its retailer's vendors. “It's fair to say that with retail you have to earn your keep every day,” Katz has said. “Our lackluster 2006 line generated unsatisfactory results for many retailers and our space has been correspondingly reduced. That's the way it works.”

Editor's Note: Katz, through a public relations agency executive, declined to be interviewed for this article, citing a regulatory “quiet period.” However, the Securities & Exchange Commission liberalized waiting period rules about a year ago so that company executives are largely free to comment on most aspects of their business not directly related to the pending registration statement. Katz' comments here have been culled from various public statements he has made, including investor conference calls and investor presentations.

After virtually reinventing the electronics learning aid category in the '90s, seizing dominant market share and shelf space, LeapFrog seemed to sputter and stall not long after going public. It happened, too, shortly after its first major change in leadership—when toy maven Tom Kalinske took the CEO reins from founder and near-spiritual presence Mike Wood. Since then, the company has tried—and mostly failed—to restart.

“This is a company that three, four, five years ago had a lot of innovative product,” said the investment manager. “They probably thought that the product could go further than it did. They lost their creativity. They had lots of management turmoil and they hit a wall, as we've seen happen in the toy industry many, many times before.

“I look at them as a company treading water, a company uninspired, a company bored, a company stuck. But when you have $200 million in the bank it's hard to say that you're in trouble.”

But LeapFrog's board, likely acting on behalf of its controlling shareholders, was clearly concerned last July when it kicked Kalinske upstairs, grabbing back the president and CEO title and, in a face-saving gesture, naming him vice chairman. The board then tapped Katz, a board member, to become its president and chief executive.

Katz, 51, hails from the airline industry. He is the former chairman and CEO of Orbitz, the former president and CEO of Swissair and a former executive with American Airlines. He's currently on the board of bankrupt Northwest Airlines.

The company's strategic review of its businesses yielded a handful of critical findings, among them that it needed to “retake” the reading market, build its business around platform architecture, age up to a stronger portfolio for 6 and up, Web-connect some products and create a metrics-driven company culture.

“The gadgets they have now I don't think will age up well,” said the investment manager, who currently has no holdings in LeapFrog. “Competing against Nintendo and Sony and Microsoft—you're not going to compete against them, and that's where the dollars are going once they're north of 9 years old.”

Added a specialty chain retailer: “Usually kids in the 8 and up market wouldn't typically look at a LeapFrog product. They're all into iMacs and the Apple phones. They're using stuff from Best Buy. That would make me a little nervous.”

While working on the turnaround plan, Katz began to jettison executives he considered not up to the task.

Of the company's 10 most senior executives today, CFO Bill Chaisson has the longest tenure, being named to his post in 2004. During the company's fourth quarter and year-end conference call recently, Katz introduced seven “highly credentialed” senior execs that are the most recent hires, among them:

• Nancy MacIntyre, executive VP of product innovation and marketing, brought over from LucasArts.
• Martin Pidel, executive VP of International, lured away from Hasbro. “International is a largely untapped opportunity that has, frankly, held back LeapFrog's performance over the last few years,” Katz told analysts during the call.
• Steve Anderson, the new VP of software engineering, a former executive for Electronic Arts.

The others have backgrounds from places like Apple, Walmart.com, Orbitz and Toshiba. “Our new team is now essentially in place,” Katz said.

For its part, the turnaround plan, unveiled last November, acknowledged there would be continued pain as the company repositioned for growth. Beyond getting the right people in the right jobs, the “fix” portion of the plan sought to staunch operating losses, better manage SKUs, clean up inventories and build new infrastructure in the company. The inventories were a huge part of that.“When we initially laid out our plan, we thought the 'fix' phase might well take a few quarters,” Katz explained. “However, during the fourth quarter of 2006, we determined that we could expedite the fix phase and decided to go for it.

“All told, we cut our inventories in half and they are now at the lowest level since 2001. We also helped U.S. retailers reduce their inventories by 40 percent from year-ago levels. We spent more than we initially anticipated in marketing dollars and allowances on this effort, but in the end we cleaned up inventories faster than we had planned and we converted a lot of inventory to cash. We have now mostly cleared the decks.”

That helped add $148 million in cash by year's end—rising to $200 million by March of this year. If nothing else, that will buy added confidence and time for the turnaround to take hold.

The company also rationalized its SKU base by 18 percent, and downsized and restructured its SchoolHouse division, which will be profitable this year, the first LeapFrog division to return to profitability. While saying sales declines would moderate in 2007 and return to positive in 2008, Katz would not make the same claim for a return to profitability and remained silent on that issue.

Completion of the fix aspect has since led to the “reload” portion of the effort, which includes new products with sharper marketing. Katz promises a “much more disciplined approach” to introductions “while leaving room for an appropriate level of risk-taking for high-potential products that could result in a big upside. We are looking for new products to meet our target margin range of 40 percent—mid-40s, in fact. We have and will continue to manage up or manage out products that don't meet this hurdle.”

Katz said the return-on-investment period for new products ranges from one-to three years. He also cautioned that the plan to age up the portfolio overall did not mean an abandonment of the company's infant, toddler and preschool business, which include some of its most profitable items.

Among the notable new products for younger children is the ClickStart My First Computer learning system, which turns a television into part of a wireless preschoolers' computer, teaching both preschool skills and computer functionality. New titles for its ongoing Leapster system will ship in the third quarter.

“We estimate that the reading market is a $1 billion market in the U.S. alone and retaking that market is critical to our plan,” Katz said. As a result, the company will emphasize product development across a category rather that search for short-lived one-hit wonders.

Success of Fly Fusion will be largely determined by its Web connectivity and the fact that it will largely be sold outside the toy aisle as well as in alternate retail channels

Lastly, LeapFrog will move online in sales and development. It will support retailer Web sites as well as its own direct sales and will move toward providing downloadable content. It represents the fastest growing segment of retail and is unconstrained by the physical limitation of shelf space.

In 2006, LeapFrog spent essentially nothing on Web marketing but will spend 15 percent of its marketing budget this year toward developing that outlet. While plans call for there to be downloadable content available for its learning systems, the immediate business model will remain a traditional “purchase software at retailer” business, according to Katz.

“My guess is that retailers will give them the benefit of the doubt [about the turnaround plan] because, quite frankly, they'll go back and squeeze them if the product doesn't sell, so they're not really at risk,” the money manager offered. “So now the question is can the new management team reinvigorate the brand and, unlike some people on Wall Street, I think the jury is out for another two years. That's how long it will take until we discover whether or not the new product is going to catch on or not. But when you've got that kind of cash sitting there, you might even have four or five years to tinker.”

But Katz isn't thinking in those terms: “We realize without any naïveté and a very acute sense of our upside and downside risk exposures that 2007 will be all about execution and about reloading our product pipeline in preparation for 2008.”