Leapfrog's Great Leap Forward

Seven seconds. For Jim Marggraff and his colleagues at toy maker LeapFrog, seven quick ticks on a stopwatch is all the time they have to win over the world's most discerning consumers: toddlers, grade-schoolers, and tweeners. It took years of watching kids interact with prototypical toys to yield Marggraff's Seven-Second Rule, which is scrawled across a whiteboard in his office: "If the product's art and audio fail to engage the user within 7 seconds, the user will never engage."

That homely, hard-won observation was foremost in Marggraff's mind in the autumn of 1999 as he and the LeapFrog team prepared to roll out a toy that took two years of late nights to produce. Based in Emeryville, California, LeapFrog was a niche entrant in the serious business of producing playthings that make kids go bonkers. It was embarking on an audacious challenge: to take on the $25 billion toy industry, a cutthroat world ruled by heavyweights Hasbro and Mattel -- a world where two-thirds of all new launches ultimately fail. LeapFrog was touting "a toy in its shape, but an educational product in its soul," as the company likes to put it. And in 1999, the year of such blockbusters as Hot Wheels and Poké mon, the educational-toy category was a dreary place to be.

LeapFrog's toy, dubbed the LeapPad, sought to bring 21st-century technology to paper. The company's claim: Using its custom-designed chip, software, and a built-in speaker, the LeapPad would make paper come alive with sound and music as young readers interacted with the device. LeapFrog called the technology "paper-based multimedia." Toy-industry veterans who had seen the prototype were less than sanguine about its chances, arguing that the cost of manufacturing the gizmo would keep it from denting the mass market. As the LeapPad's October launch date neared, even Marggraff, who shotguns all of the company's content development, conceded to some second-guessing. "Our worst nightmare was that kids would pick the thing up, play with it for a few minutes, and forget about it," he recalls. "There was a lot of paranoia and nervousness over whether we would succeed."

These days, the hyperdriven Marggraff still admits to nervousness, but the paranoia has subsided. Retailing at $49.99, the laptoplike device that makes books speak raced past the supercharged Razor scooter to become the top-selling toy in December 2000 -- the first time in at least 15 years that an educational toy took the number-one ranking. As anyone in the toy business will tell you, nothing is tougher than surpassing a past success. But here again, LeapFrog defied the odds: The LeapPad swept every industry category to become the number-one selling toy in the nation for all of 2001. So far, the company has sold more than 8.6 million LeapPad systems. In a little more than three years, sales of the LeapPad are almost equal to the early success of the Palm, one of the best-selling tech gadgets in recent years.

Now LeapFrog is attempting to leverage the runaway success of the LeapPad to become a powerhouse in its own right. To that end, the 8-year-old firm has won some big-name backing. Larry Ellison and Michael Milken hold a majority stake in LeapFrog through their educational holding company, Knowledge Universe Inc. They took LeapFrog public in last July's bear market, and its stock soared 93% for the year, making it the best-performing IPO of 2002. The infusion of capital (LeapFrog raised $115 million through the IPO) and the company's continuing success on Main Street is paying off. LeapFrog recently bounded past Lego Systems to become the third-largest toy maker in the United States.

Almost inevitably, LeapFrog's success has brought with it a new set of risks. Analysts worry that the young company is overly reliant on too few retailers for most of its sales, particularly the ailing Kmart and Toys "R" Us, whose debt rating was lowered in March. Meanwhile, the industry's big guns are setting their sights on the educational category that LeapFrog rules. In August, Mattel's Fisher-Price division is expected to launch its PowerTouch Learning System, which will compete head-to-head with the LeapPad. Now LeapFrog faces its toughest challenge of all: overcoming its stakeholders' expectations. The size of that challenge was made clear in February, when the company's shares sank 16% in a single day. The reason? Despite a robust year-end earnings report that saw 2002 revenue swell by 69%, LeapFrog's guidance for 2003 implied that revenue growth would drop to 25%.