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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the Quarterly Period Ended June 30, 2009

OR

Commission File Number 001-31396

LeapFrog Enterprises, Inc.

(Exact name of registrant as specified in its charter)

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, 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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    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. (Check one):

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 July 31, 2009, 36,793,684 shares of Class A common stock, par value $0.0001 per share, and 27,140,794 shares of Class B common stock, par value $0.0001 per share, respectively, of the registrant were outstanding.

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LEAPFROG ENTERPRISES, INC.

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PART I.

FINANCIAL INFORMATION

LEAPFROG ENTERPRISES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)

See accompanying notes

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LEAPFROG ENTERPRISES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

See accompanying notes

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LEAPFROG ENTERPRISES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

See accompanying notes

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

In the opinion of management, all normal and recurring adjustments considered necessary for fair presentation 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 accounting principles generally accepted in the United States (“U.S. GAAP” or “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 significant intercompany accounts and transactions have been eliminated in consolidation.

The balance sheet at December 31, 2008 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements. The financial information included herein should be read in conjunction with LeapFrog’s consolidated financial statements and related notes in the Company’s 2008 Annual Report on Form 10-K filed with the United States Securities and Exchange Commission (“SEC”) on March 11, 2009 (the “2008 Form 10-K”).

The accounting policies followed in the presentation of interim financial results are consistent with those followed on an annual basis. These policies are presented in Note 2 to the consolidated financial statements included in the Company’s 2008 Form 10-K.

Due to the seasonality of our business, the results of operations for interim periods are not necessarily indicative of the operating results for a full year.

Certain amounts in the financial statements for prior periods have been reclassified to conform to the current year presentation.

Inventories consisted of the following as of June 30, 2009 and 2008, and December 31, 2008:

At June 30, 2009 and 2008, the Company accrued liabilities for cancelled purchase orders totaling $147 and $532, respectively. At December 31, 2008, the Company accrued $751 for cancelled purchase orders. The inventories related to these purchase orders will be returned to the Company and recorded either in raw materials or work in process.

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

The carrying values and estimated fair values of the Company’s financial instruments, which include short-term money market funds, certificates of deposit, foreign exchange forward contracts and long-term investments in auction rate securities (“ARS”), are presented in the table below for the periods ended June 30, 2009, December 31, 2008 and June 30, 2008.

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”), the Company applies a fair value hierarchy to measure fair value based on three levels of inputs of which the first two are considered observable and the last unobservable. The three levels are as follows:

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

The Company accounts for its investments in debt and equity securities according to the provisions of SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”), which requires that a decline in the fair value of an investment security below cost that is deemed to be “other than temporary” results in a reduction of the carrying amount to fair value with the impairment charged to earnings. Subsequent recoveries in value are recorded to accumulated other comprehensive income. During the three months ended June 30, 2009, interest rates improved resulting in a $534 increase in the fair value of the Company’s ARS.

For the three and six months ended June 30, 2009, the Company accounted for gains and losses incurred on its ARS as shown below:

The Company’s goodwill is 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. All of the goodwill is allocated to the Company’s United States reporting unit pursuant to SFAS No. 141, “Business Combinations” (“SFAS 141”).

The Company tests its goodwill for impairment annually, and in between annual tests if an event occurs or circumstances change that indicate an impairment has more likely than not occurred, in accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). When evaluating goodwill for impairment, SFAS 142 requires the Company to first compare the fair value of the reporting unit to its carrying value to determine if there is an impairment loss. If the fair value of the reporting unit exceeds its carrying value, goodwill is not considered impaired; thus application of the second step of the two-step approach in SFAS 142 is not required.

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

The Company most recently performed the annual test for impairment as of December 31, 2008 and concluded that its goodwill balance of $19,549 had not been impaired. At least quarterly, the Company considers the need to update its most recent annual impairment test based on management’s assessment of changes in its business, economic environment and other factors occurring after the most recent annual evaluation. The most recent assessment was performed as of June 30, 2009, and as a result, management concluded that there were no impairment indicators and the assumptions used to base the year end assessment on remained appropriate.

The Company’s effective income tax rates were 33.6% and 13.7% for the three and six months ended June 30, 2009, respectively, compared with 12.2% and 6.7%, respectfully, for the same periods last year. The calculation of the effective tax rates for all periods included a non-cash valuation allowance recorded against the Company’s domestic deferred tax assets. Deferred tax liabilities and other long-term tax liabilities of $14,686 are reported as long-term liabilities on the balance sheet.

The income tax benefit for both the three and six months ended June 30, 2009 was $6,180 and $6,230, respectively, compared with a tax benefit of $2,846 and $3,471, respectively, for the same periods last year. The second quarter of 2009 includes a $6,229 benefit from the recognition of previously unrecognized tax benefits including accrued interest of $2,509 due to the expiration of applicable statutes of limitations. The second quarter of 2008 includes a $1,917 benefit from the settlement of an audit by the IRS of our claim for a refund for tax credits.

The Company believes it is reasonably possible that the total amount of unrecognized tax benefits in the future could decrease by up to $2,041 over the course of the next twelve months due to reaching settlement on certain tax matters or expiring statutes of limitations, of which up to $1,140 will affect the effective tax rate.

In the fourth quarter of 2008, the Company vacated a portion of its leased headquarter facilities in Emeryville, California, and incurred lease restructuring costs that were recorded to the balance sheet and will be accreted into operating expenses over the life of the remaining lease. During the second quarter of 2009, the Company sublet a portion of the facility to a third party that will begin occupying such space beginning in the fourth quarter of 2009.

The following table sets forth facilities closure liability activity during the three months ended March 31, 2009 and three months ended June 30, 2009:

As of June 30, 2009 and 2008, and December 31, 2008, the facilities closure liability was approximately $1,099, $0 and $2,263, respectively, of which, $186 and $534 is included in the current liabilities and $913 and $1,729 is included in other long-term liabilities as of June 30, 2009 and December 31, 2008, respectively.

The Company offers three types of stock-based compensation awards to its employees, directors and certain consultants: stock options, restricted stock units (“RSUs”) and restricted stock awards (“RSAs”). The awards can be used to purchase shares of the Company’s Class A common stock and are exercisable over a period not to exceed ten years and are most commonly assigned four year vesting periods.

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

During the second quarter of 2009, LeapFrog made two stock option grants to certain executives and board members to purchase 2,705 shares of our Class A common stock that vest based upon a service condition and a market condition. Given the market condition, the fair value of these stock options was estimated on the date of the grant using a Monte-Carlo simulation. The simulation generates a defined number of stock price paths in order to develop a reasonable estimate of the range of future expected stock prices and minimize standard error. The simulations account for the vesting requirements and the assumed exercise behavior of the grants. If and when the vesting and market conditions are met in the simulation, the option is assumed to be exercised uniformly over the remaining life of the option. All other assumptions are consistent with option grants that vest solely upon a service condition. The fair value of stock options with a service condition only is estimated at the date of the grant using a Black-Scholes option pricing model and related assumptions.

The table below summarizes award activity for the six months ended June 30, 2009.

The Company accounts for stock-based compensation expense in accordance with SFAS No. 123(R), “Share-Based Payment” (“SFAS 123(R)”). The table below summarizes stock-based compensation expense for the three and six month periods ended June 30, 2009 and 2008.

In accordance with SFAS 123(R), stock-based compensation expense 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:

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

The fair value for the stock option grants with both a service and market condition is estimated using the Monte-Carlo simulation with the following weighted average assumptions:

On June 5, 2009, the Company announced a proposal, subject to approval by the Company’s stockholders, to exchange out-of-the money stock options held by employees and members of the Company’s board of directors under a voluntary stock option exchange program. Under this proposal, employees and directors who hold eligible options may exchange their out-of-the money stock options for new lower priced options covering fewer shares. Except as set forth below, the exercise price of the new options that would be issued upon the surrender of the out-of-the money stock options would be determined on the day the exchange expires and would be equal to the closing price of the Company’s Class A common stock as reported on the New York Stock Exchange for the business day prior to the date on which the exchange offer expires.

Any new options received by the Company’s CEO and non-employee directors would have an exercise price equal to the higher of $6.25 per share and the market price even though the exchange ratios used to calculate the number of new shares would be based on the market price. This means that, if the market price is lower than $6.25, the number of shares subject to the new options issued to the CEO and non-employee directors would be reduced in the same manner as those issued other participants even though such new options would have a premium exercise price.

Options issued in the exchange will have the same vesting schedules as the options they are replacing and their value will be estimated on the date of the grant using a Monte-Carlo simulation. The new options received will cover fewer shares than those surrendered, determined on the basis of specified exchange ratios derived from their relative market values. The exchange is designed to result in no additional compensation expense.

At June 30, 2009, December 31, 2008 and June 30, 2008, the Company had outstanding foreign exchange forward contracts with notional values of $8,893, $21,890 and $11,996, respectively. The gains and losses on these instruments are recorded in “other income (expense)” in the consolidated statements of operations. Gains and losses from foreign exchange forward contracts, net of gains and losses on the underlying transactions denominated in foreign currency, for the three and six month periods ended June 30, 2009 and 2008 are shown in the table below.

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

Comprehensive net loss consists of net income loss and net losses incurred from translating the foreign currency-denominated financial statements of the Company’s subsidiaries into U.S. dollars, as follows:

The Company follows the provisions of SFAS No. 128, “Earnings Per Share” (“SFAS 128”), in calculating net income loss per share. The following table sets forth the computation of basic and diluted net loss per share for the periods presented:

In accordance with SFAS 128, unvested restricted stock units and certain stock options to purchase shares of LeapFrog Class A common stock (“Class A shares”) are excluded from the calculations of net loss per share for the three and six month periods ended June 30, 2009 and 2008, as their effect on net loss per share would be antidilutive. Outstanding weighted average common stock equivalents of Class A shares excluded from the calculations were 111 and 105, and 263 and 356 for the three and six month periods ended June 30, 2009 and 2008, respectively.

In November 2005, the Company entered into a $75,000 asset-based revolving credit facility with Bank of America. In May 2008 the Company, certain banks, financial institutions and other institutional lenders and Bank of America entered into Amendment No. 1 to the original credit facility agreement, increasing the maximum borrowing availability on the credit line from $75,000 to $100,000. The borrowing availability varies according to the levels of the Company’s eligible accounts receivable, eligible inventory and cash and investment securities deposited in secured accounts with the administrative agent or other lenders. The termination date of the agreement is November 8, 2010. Availability under this agreement was $43,203 as of June 30, 2009. Bank of America is committed to lend up to 75% of the total borrowing and Wachovia Capital Finance Corporation is committed to lend the remaining 25%.

The interest rate for the Company’s revolving credit facility is, at its election, the Bank of America prime rate (or base rate) or a LIBOR rate defined in the credit agreement, plus, in each case, an applicable margin. The applicable margin for a loan depends on the average monthly usage and the type of loan.

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

The revolving credit facility contains customary events of default, including payment failures; failure to comply with covenants; failure to satisfy other obligations under the credit agreements or related documents; defaults in respect of other indebtedness; bankruptcy, insolvency and inability to pay debts when due; material judgments; change in control provisions and the invalidity of the guaranty or security agreements. The revolving credit facility prohibits the payment of cash dividends on the Company’s common stock and contains a covenant requiring that a ratio of EBITDA to fixed charges be maintained, as defined in the agreement, of at least 1.0 to 1.0 when the covenant is required to be tested. The ratio is measured only if certain borrowing-availability thresholds are not met. The cross-default provision applies if a default occurs on other indebtedness in excess of $5,000 and the applicable grace period of the indebtedness has expired, such that the lender of, or trustee for, the defaulted indebtedness has the right to accelerate. If an event of default occurs, the lenders may terminate their commitments, declare all borrowings under the credit facility as due immediately and foreclose on the collateral. As of June 30, 2009, the Company was in compliance with all covenants under this agreement.

The current economic environment has led many contract manufacturers (CM) to delay placing purchase orders to preserve cash which has increased the risk of late delivery of parts from their suppliers that could lead to delays in production and ultimately lead to delays in delivery to retailers. Refer to Part II. Item 1A. - Risk Factors - “We depend on our suppliers for our components and raw materials, and our production or operating margins would be harmed if these suppliers are not able to meet our demand and alternative sources are not available.”

To mitigate such risks, the Company entered into a purchase obligation that includes a guaranteed purchase of component parts from a supplier to be purchased and used in production by one of the Company’s CMs. In the event that the CM fails to purchase the guaranteed volume by November 18, 2009, the Company will be required to purchase the remaining parts or compensate the supplier for material charges.

Accordingly, as of June 30, 2009, purchase obligations of approximately $7,275 have not been recorded in the Consolidated Balance Sheet. The component parts under obligation are an integral part of one of the Company’s best selling products and the volumes associated are in line with the Company’s forecasted production and sales volumes.

The Company has identified its operating segments in accordance with the guidance in SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“SFAS 131”). The Company’s business is organized, operated and assessed in two geographic segments, United States and International. The Company’s Chief Executive Officer (“CEO”) is the Company’s chief operating decision maker. The Company’s CEO allocates resources to and assesses the performance of each operating segment based on information about the segments’ net sales and operating income (loss) before interest and taxes.

Historically, the Company organized, operated and assessed its business in three segments, U.S. Consumer, International and School. During 2008, the Company ceased marketing directly to the educational channel, reduced headcount and direct facilities expenses accordingly, and transferred responsibility for this sales channel to the former U.S. Consumer operating segment. Accordingly, the two segments have been consolidated and their results have been reclassified into the United States segment throughout this Form 10-Q for all periods presented.

The Company charges all of its indirect operating expenses and general corporate overhead to the United States segment. The primary business of the two operating segments is as follows:

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

The table below shows certain information by segment for the three and six month periods ended June 30, 2009 and 2008.

For the periods presented, no country other than the United States accounted for 10% or more of LeapFrog’s consolidated net sales. LeapFrog attributes sales to non-United States countries on the basis of sales billed by each of its foreign subsidiaries to its customers. For example, the Company attributes sales to the United Kingdom based on the sales billed by its United Kingdom-based foreign subsidiary, LeapFrog Toys (UK) Limited, to its customers. Additionally, the Company attributes sales to non-United States countries if the product is shipped from Asia or one of its leased warehouses in the United States to a distributor in a foreign country.

Recently Adopted Pronouncements

In February 2008, the FASB issued Staff Position (FSP) No. 157-2, “Effective Date of FASB Statement No. 157,” which deferred the application date of the provisions of SFAS No. 157 for all nonfinancial assets and liabilities to fiscal years beginning after November 15, 2008 except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis. The adoption of this Statement in the first quarter of 2009 did not impact our consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities — an amendment of FASB Statement No. 133.” This Statement amends and expands the disclosure requirements of Statement No. 133 to provide an enhanced understanding of why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for and how they affect an entity’s financial position, financial performance and cash flows. The Statement is effective for fiscal years and interim periods beginning on or after November 15, 2008. The adoption of this Statement in the first quarter of 2009 did not impact our consolidated financial statements.

In April 2008, the FASB issued FSP No. 142-3, “Determination of the Useful Life of Intangible Assets.” This FSP amends the factors to be considered in developing renewal or extension assumptions used to determine the useful life of intangible assets under SFAS No. 142, “Goodwill and Other Intangible Assets.” The intent of this FSP is to improve the consistency between the useful life of an intangible asset and the period of expected cash flows used to measure its fair value. This FSP is effective for fiscal years beginning after December 15, 2008. The adoption of this FSP in the first quarter of 2009 did not impact our consolidated financial statements.

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LEAPFROG ENTERPRISES, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

In April of 2009, the FASB issued FSP No. 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments.” This FSP amends FASB Statement No. 107 “Disclosures about Fair Value of Financial Instruments,” to require disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. This FSP also amends APB 28, “Interim Financial Reporting” to require those disclosures in summarized financial information at interim reporting periods. This FSP is effective for interim reporting periods ending after June 15, 2009. The adoption of this FSP in the second quarter of 2009 did not impact our consolidated financial statements.

Also in April of 2009, the FASB issued FSP No. 115-2 and 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments.” This FSP amends the other-than-temporary impairment guidance in U.S. GAAP for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements. This FSP does not amend existing recognition and measurement guidance related to other-than-temporary impairment of equity securities. This FSP is effective for interim reporting periods ending after June 15, 2009. The adoption of this FSP in the second quarter of 2009 did not impact our consolidated financial statements.

Also in April of 2009, the FASB issued FSP No. 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.” This FSP provides additional guidance for estimating fair value in accordance with FASB Statement No. 157, “Fair Value Measurements,” when the volume and level of activity for the asset or liability have significantly decreased. This FSP also includes guidance on identifying circumstances that indicate a transaction is not orderly. This FSP is effective for interim reporting periods ending after June 15, 2009. The adoption of this FSP in the second quarter of 2009 did not impact our consolidated financial statements.

In May of 2009, the FASB issued SFAS No. 165, “Subsequent Events.” This Statement establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. This Statement is effective for interim or annual reporting periods ending after June 15, 2009. Adoption of this Statement in the second quarter of 2009 did not impact on our consolidated financial statements but did require additional disclosures.

Recently Issued Pronouncements

In June of 2009, the FASB issued SFAS No. 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles—a replacement of FASB Statement No. 162.” On July 1, 2009, the FASB Accounting Standards Codification (Codification) became the source of authoritative U.S. generally accepted accounting principles (GAAP) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date of this Statement, the Codification will supersede all then-existing non-SEC accounting and reporting standards. All other non-grandfathered, non-SEC accounting literature not included in the Codification become non-authoritative. This Statement is effective for financial statements issued for interim and annual periods ending after September 15, 2009. Adoption of the Statement is not expected to impact our consolidated financial statements.

The Company evaluated subsequent events in accordance with SFAS No. 165, “Subsequent Events” through the financial statement filing date of August 3, 2009.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward Looking Statements

This report on Form 10-Q, including the sections entitled “Part I, Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Part II, Item 1A. Risk Factors,” contains forward-looking statements, including statements regarding; the effects of global economic conditions on our business, our expectations for sales trends, margins, profitability, liquidity, expenses, inventory or cash balances, capital expenditures, cash flows, or other measures of financial performance in future periods, future products and services we may offer, anticipated competitive benefits of our strategy or of current or future products or services, and the effects of strategic actions on future financial performance. These statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to differ materially from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. These risks and other factors include those listed under “Risk Factors” in Part II, Item 1A of this Form 10-Q and those found elsewhere in this Form 10-Q. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “intend,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue” or the negative of these terms or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We 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.

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. This MD&A is provided as a supplement to, and should be read in conjunction with, our Consolidated Financial Statements and the accompanying Notes to the Consolidated Financial Statements (“Notes”) in Part I, Item 1 of this report.

Our Business

We design, develop and market a family of innovative technology-based learning platforms and related proprietary content for children of all ages for use at home and in schools around the world. We have created more than 150 interactive software titles, covering important subjects such as phonics, reading, writing and math. In addition, we have a broad line of stand-alone educational products, or toys, that do not require the separate purchase of software and are generally targeted at infants through five year olds. Our products are available in six languages and are sold globally through retailers, distributors and directly to schools. Our goal is to create educational products that kids love, parents trust and teachers value.

We generate revenue from developing, manufacturing, and selling platform hardware including our Tag and Tag Jr. reading systems, our classic Leapster, Leapster2 and Didj educational gaming platforms, and Clickstart: My First Computer learning system, along with a range of other learning toys. We also generate revenue from developing and licensing a wide range of content for our platforms.

Our products compete most directly in the toy industry in the pre-school toy and electronic learning aids categories, both in the United States and in selected international markets. The educational toy category continues to attract new entrants as well as new innovative products, and competition is significant.

Our business is highly seasonal with a significant portion of our revenues occurring in the second half of the year. Given relatively low sales volumes in the first half of the calendar year and the relatively fixed nature of many of our operating expenses, which occur fairly evenly throughout the year, our results of operations are generally stronger in our third and fourth quarters relative to our first and second quarters. Conversely, our historical cash flow from operations tends to be highest in the first quarter of the year, when we collect the majority of our accounts receivable related to the prior year’s fourth quarter sales, and lowest in our third quarter as we begin building inventory in preparation for the fourth quarter holiday season.

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The global economic crisis led to a severe decline in our sales in the fourth quarter of 2008 resulting in a departure from our normal seasonal pattern described above. Our sales for the fourth quarter were significantly below our expectations and constituted a substantially smaller percentage of our annual sales than they have in previous years. Given the seasonality of our business, declines in sales in the third and fourth quarters generally have a disproportionate impact on our annual operating results as well as our cash flows from operations at the beginning of the following year which was the case for the first six months of 2009. As retailers continue to reduce their inventory levels that accumulated after consumer sales declined, our sales through at least the third quarter of 2009 are likely to continue to be lower than our corresponding sales in 2008.

We continue to improve efficiency in our operations by eliminating unnecessary expenditures. In the fourth quarter of 2008, we completed a restructuring that involved the closure of some of our offices and a company-wide reduction in force. In 2009, we have continued to streamline our cost structure by implementing further process improvements to create additional efficiencies. For example, during the second quarter of 2009, we sublet a portion of our headquarter facilities in Emeryville, California that we vacated in 2008 as a part of an overall restructuring. In addition, we have continued to adjust our staffing levels in the second quarter to reduce overhead, and we currently plan to spend less on non-targeted advertising. We intend to focus our resources on building out our core product lines and adding to our content library, as well as further reduce other expenditures, particularly those related to selling, general and administrative activities, to correspond to our best ongoing estimates of consumer spending trends.

We invest in research and development (“R&D”) of existing and new lines of business that we believe may contribute to our long-term growth. For example, we continue to invest in developing new hardware platforms and content based on new technologies for both stand-alone and online experiences. We believe delivering innovative and high-value platforms and online experiences is the key to meeting customer needs and to our future growth.

We face significant risks associated with the economic downturn and continuing uncertainty through at least 2009. Weak sales in the fourth quarter of 2008 meant that retailers built up inventories of our products, which negatively impacted our sales in the first two quarters of 2009. In addition, an increasing number of retailers have encountered liquidity problems. If any of our most significant retailers suspend or reduce payments to us, become insolvent or file for bankruptcy, the resulting bad debt expense we would incur would likely have a material adverse effect on our results of operations. Further, continued deterioration in economic conditions could trigger events or circumstances indicating goodwill impairment has more likely than not occurred. We considered the need to update our most recent annual goodwill annual impairment test as of June 30, 2009 and concluded that there were no impairment indicators and we believe the assumptions used during the year end assessment remained appropriate. The potential business risk for us from macroeconomic conditions anticipated for 2009 is discussed further in Part II. Item 1A.—Risk Factors—“The current economic crisis has had a material adverse effect on our sales, and we cannot be certain when sales will recover,” “Retailer liquidity problems could harm our liquidity and financial results,” “Our liquidity may be insufficient to meet the long-term or periodic needs of our business” and “Our net loss would be increased and our assets would be reduced if we are required to record impairment charges related to the value of our intangible assets.”

Our strategic priorities for 2009 and beyond are to invest in the core categories of reading, educational gaming, our standalone toy line and in our Learning Path “ecosystem.” Our marketing will be aimed at increasing consumer sales in these categories, to drive a higher percentage of content sales, and to catalyze new growth in the learning category. We have launched new connected products and content in our reading and gaming categories, as well as our standalone learning toy line in 2009. Importantly, we also expanded our learning toy line, including our attractively-priced Scout line of learning toys, and the Zippity learning system, a gaming system featuring full body-movement controls, which is our first co-branded product with Disney.

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Consolidated Results of Operations

Net sales for the three and six months ended June 30, 2009 decreased 28% and 37%, respectively, as compared to the same periods in 2008 driven primarily by higher than expected 2008 year end retail inventory levels, which reduced demand for our products by our retail customers. The decline in net sales was global, though more pronounced in the United States. Foreign currency exchange rates accounted for approximately $1.3 and $2.9 million or 1.9% and 2.3% of the decrease in net sales during the three and six months ended June 30, 2009 respectively.

Gross margin for the three and six months ended June 30, 2009 declined one and four points, respectively, compared to the same periods in 2008. The decline was primarily due to lower sales relative to fixed costs and increased sales discounting given the higher than expected retail inventory levels at the end of 2008. These declines were partially offset by a reduction in allowance for defective products as claims have trended lower than expected as well as improvements in product mix.

Operating expenses for the three and six month periods ended June 30, 2009 declined 24% and 27%, respectively, from the same periods in 2008. This primarily reflects reduced headcount-related expenses in line with the continued focus on reducing our cost structure. Total fulltime employees declined by 153 or 21% from June 30, 2008 to June 30, 2009 due to a combination of reductions in force and the migration of certain aspects of our product development cycle to external parties.

Loss from operations for the three and six months ended June 30, 2009 improved slightly due to the recognition of a tax benefit related to the expiration of applicable statutes of limitation, as well as, the decline in operating expenses more than offset the decline in gross profit.

Our basic and diluted net loss per share improved for three and six months ended June 30, 2009 as compared to 2008 in line with the improvement in loss from operations.

2009 Outlook

The 2009 economic outlook remains unclear, but nearly all key economic indicators point to continuing challenges through the remainder of the year. We expect continued sales declines during the third quarter of 2009 as compared to the same period in 2008 given strong shipments we made for new product launches prior to the economic collapse in the prior year. We are taking actions to improve our products, stimulate content sales, adjust price points where sell-through velocity or competition warrant, and introduce new lower price-point products especially into the learning toy line. We also intend to continue to look for ways to run our business more efficiently and further reduce our cost structure while maintaining the quality and liquidity of our balance sheet. Such efforts are subject to many uncertainties, including the timing of any economic recovery and many other factors described below in Part II. Item 1A. – Risk Factors, and there can be no assurances that any such actions we take will actually result in greater sales or other improvements in our financial results.

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Selling, General and Administrative Expenses

Selling, general and administrative (“SG&A”) expenses consist primarily of salaries, employee benefits and stock-based compensation as well as other expenses associated with executive management, finance, legal, IT, facilities, human resources, indirect sales, marketing, rent, other professional services, office supplies and bad debt.

SG&A expenses for the three and six month periods ended June 30, 2009 declined 21% and 29%, respectively, primarily driven by a decrease in headcount due to natural attrition and workforce reductions implemented during 2008 resulting in lower overall salaries and bonus expenses. Total fulltime SG&A employees declined by 106 or 25% from June 30, 2008 to June 30, 2009.

Research and Development Expenses

Research and development (“R&D”) expenses consist primarily of salaries, employee benefits, stock-based compensation and other expenses associated with content and product development and product engineering, as well as third-party development and programming services and localization costs to translate content for international markets. We capitalize external third-party costs related to content development and amortize them as a part of cost of sales in our statements of operations.

R&D expenses for the three and six month periods ended June 30, 2009 declined 26% and 22%, respectively, as compared to the same periods in 2008, primarily driven by a decrease in headcount due to workforce reductions implemented during 2008, resulting in lower overall salaries and accrued bonuses and the migration of certain aspects of our product development cycle to external parties. Total fulltime R&D employees declined by 47 or 16% from June 30, 2008 to June 30, 2009.

Advertising Expenses

Advertising expenses consist of costs associated with marketing, advertising and promotion of our products including customer-related discounts and promotional allowances.

Advertising expenses for the three and six month periods ended June 30, 2009 declined 45% and 47%, respectively, as compared to the same periods in 2008 resulting from a combination of our continued focus on driving efficiencies and reducing our cost structure as well as timing of key product launches.

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Other Income (Expense)

The components of other income (expense) were as follows:

Other income (expense) improved for the three and six month periods ended June 30, 2009 as compared to the same period of 2008.

Interest income decreased during both periods reflecting a reduction in the average balance of interest-bearing investments as well as lower interest rates in 2009 as compared to 2008. In addition, in the first quarter of 2008, we shifted from a combination of money-market funds, commercial paper and other similar short-term instruments to only certificates of deposit and money market funds invested in high quality short-term U.S. government obligations which have lower yields due to their relatively lower risk.

The improvement in “other, net” was due primarily to the stabilization of the fair values of our auction rate securities. We incurred $1.6 million and $1.7 million of impairment charges related to our investment in auction rate securities for the three and six months ended June 30, 2008 as compared to $0.1 million of charges in 2009.

Income Taxes

Our provision for income taxes and our effective tax rates were $(6.2) million and $(6.2) million, and 33.6% and 13.7%, respectfully, for the three and six months ended June 30, 2009. Our pretax losses were $18.4 million and $45.6 million for the same periods, respectively. Our provision for income taxes and effective tax rates for the same periods last year were $(2.8) million and $(3.5) million, and 12.2% and 6.7%, respectfully. The pretax losses for these time periods last year were $23.4 million and $51.5 million. Calculation of the effective tax rates for all periods included a non-cash valuation allowance recorded against our domestic deferred tax assets.

The tax benefit for 2009 was primarily attributable to the recognition of previously unrecognized tax benefits due to the expiration of applicable statutes of limitations, and the tax benefit for 2008 was primarily attributable to recognition of a tax benefit from the settlement of an audit by the IRS.

Results of Operations by Segment

Net sales, gross margin, operating expenses and operating loss amounts included in this section are presented on a basis consistent with accounting principles generally accepted in the United States (“GAAP”) and on an operating segment basis consistent with our current management reporting as defined by SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information” (SFAS 131). In 2008 we significantly reduced direct marketing, headcount and facilities expenses related to the educational channel and transferred responsibility for this sales channel to the former U.S. Consumer operating segment. Accordingly, we consolidated our School segment into our U.S. Consumer segment, now referred to as the United States (U.S.) segment. All prior period financial data has been recast to conform to the current presentation. Certain corporate-level operation expenses associated with sales, marketing, product support, human resources, legal, finance, information technology, corporate development, procurement activities, research and development, legal settlements and other corporate costs are charged entirely to our U.S. segment, rather than being allocated between the U.S. and International segments.

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United States Segment

The U.S. segment includes net sales and related expenses directly associated with sales of our products to national, regional mass-market, specialty, school-related and other retailers and distributors. This segment also includes sales of our products through our online store and other internet-based channels.

Net sales for the three and six months ended June 30, 2009 decreased 31% and 40%, respectively, from the same periods in 2008, primarily driven by higher than expected retail inventory balances at the end of 2008, which reduced demand for our products by our retail customers, as well as continued contraction of revenues from our school channel.

Gross margin for the three and six months ended June 30, 2009 declined three and five percentage points, respectively, year over year primarily due to lower sales relative to fixed costs, increased sales discounting given higher than expected retail inventory levels at the end of 2008, and lower sales through the school channel, offset partially by a reduction in allowance for defective products as claims have trended lower than expected as well as improvements in product mix.

Operating expenses for the three and six months ended June 30, 2009 declined 18% and 23%, respectively, year over year, primarily reflecting reduced headcount-related expenses in line with the continued focus on reducing our cost structure. Total U.S. based fulltime employees declined by 118 or 22% from June 30, 2008 to June 30, 2009 due to a combination of reductions in force and the migration of certain aspects of our product development cycle to external parties.

Loss from operations for the three and six months ended June 30, 2009 declined 4% and remained flat, respectively, year over year, primarily due to the decline in operating expenses offsetting the net sales and gross margin declines.

International Segment

The International segment includes net sales and related expenses directly associated with sales of our products to national, regional mass-market, specialty and other retailers through our offices in the United Kingdom, France, Canada and Mexico. This segment also includes sales through distributors in markets such as Spain, Germany and Australia.

Net sales for the three and six months ended June 30, 2009 decreased 14% and 27%, respectively, from the same periods of 2008, primarily driven by higher than expected retail inventory balances at the end of 2008, which reduced demand for our products by our retail customers. Excluding the impact of foreign currency, our International segment sales would have decreased by 3% and 15% for the three and six months ended June 30, 2009.

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Gross margin for the three and six months ended June 30, 2009 increased nine and two percentage points year over year as improvements in product mix and quality of inventory offset increased sales discounting.

Operating expenses for the three and six months ended June 30, 2009 declined 60% and 52%, respectively, primarily reflecting reduced headcount-related expenses in line with the continued focus on reducing our cost structure. Total international fulltime employees declined by 57 or 31% from June 30, 2008 to June 30, 2009 due to a combination of reductions in force and normal attrition.

Gain (Loss) from operations for the three and six months ended June 30, 2009 improved as the decline in operating expenses more than offset the decline in net sales and gross profit.

Financial Condition

Cash and cash equivalents totaled $52.8 million and $68.3 million at June 30, 2009 and 2008, respectively. At the end of 2007, we made a policy decision to invest our excess cash in short-term U.S. government obligations due to the continuing financial market crisis. As such, all cash equivalents were invested in certificates of deposit and money market funds that held only high-grade United States government obligations at June 30, 2009.

As of June 30, 2009, we held $5.5 million in auction rate securities (ARS) classified as long-term investments. Uncertainties in credit and financial markets since the fourth quarter of 2007 have prevented us from liquidating our ARS holdings as the number of securities submitted for sale in periodic auctions has exceeded the number of purchase orders. Due to the illiquidity of these investments, we have not included and do not intend to include them as potential sources of liquidity in our future cash flow projections for the foreseeable future. Therefore, we do not anticipate that further declines in value, if any, will have an adverse impact on our future ability to support our operations or meet our obligations as they come due. We also do not anticipate any material adverse impact on our overall capital position should the fair value of these investments decline to zero as the fair value of $5.5 million for the auction rate securities investment constitutes less than 3% of our total assets at June 30, 2009.

We have an asset-backed revolving credit facility with a potential borrowing availability of $100.0 million discussed in more detail below. There were no borrowings outstanding on this line of credit at June 30, 2009.

Our retained deficit of $221.8 million at June 30, 2009 is not expected to impact our future ability to operate given our anticipated cash flows from operations, our strong cash position and the availability of our credit facility.

Our accounts receivable balance of $33.1 million at June 30, 2009 was down $56.8 million from the 2008 year end balance. This decrease was driven by aggressive cash collection efforts, the significant decline in sales and higher sales allowances. A majority of the allowances related to specific reserves established in the fourth quarter of 2008 as a result of the deteriorating economic environment and high retail inventory levels.

Future capital expenditures are primarily planned for new product development and purchases related to the upgrading of our information technology capabilities. We expect that capital expenditures for the remainder of 2009, including those for capitalized content and website development costs, will be funded with cash flows generated by operations and will be lower than in prior years. Capital expenditures were $6.2 million and $12.6 million for the six months ended June 30, 2009 and 2008, respectively.

We believe that cash on hand, cash flow from operations and amounts available under our revolving credit facility will provide adequate funds for our foreseeable working capital needs and planned capital expenditures over the next twelve months. Our ability 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 credit facility, depend on our future operating performance and cash flows, which in turn are subject to prevailing economic conditions.

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Liquidity and Capital Resources

Capital Resources

Our sources of capital include cash flows from operations and a credit facility with Bank of America.

In November 2005, we entered into a $75.0 million asset-based revolving credit facility with Bank of America. In May 2008, the credit facility agreement was amended to increase the maximum borrowing availability on the credit line from $75.0 million to $100.0 million and to include certain other financial institutions and institutional lenders. We granted security interests in substantially all of our assets as collateral for the loans under the amended credit facility agreement. Borrowing availability varies according to our level of eligible accounts receivable, eligible inventory and cash and investment securities deposited in secured accounts with the administrative agent or other lenders. Availability under this agreement was $43.2 million as of June 30, 2009.

The termination date of the agreement and the maturity date for any outstanding loans under the facility is November 8, 2010. The interest rate for our credit facility is, at our election, the Bank of America prime rate (or base rate) or a LIBOR rate defined in the credit agreement, plus in each case an applicable margin. The applicable margin for a loan depends on the average monthly usage and type of loan. The credit facility contains a covenant requiring that we maintain a ratio of EBITDA to fixed charges, as defined in the agreement, of at least 1.0 to 1.0 when the covenant is required to be tested. The ratio is measured only if certain borrowing-availability thresholds are not met.

The agreement also contains customary events of default and prohibits the payment of cash dividends on our common stock. In the event that default occurs, the lenders may terminate their commitments, declare all borrowings under the credit facility as due immediately, and foreclose on the collateral. As of June 30, 2009, we were in compliance with all covenants under this agreement. Bank of America is committed to lend up to 75% of the total borrowing and Wachovia Capital Finance Corporation is committed to lend the remaining 25%.