Should You Leap at This Opportunity?

John is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I've mentioned LeapFrog (NYSE: LF) before when discussing toy manufacturers and how it is a favorite of mine. The company has produced top-selling educational toys for the past two holiday seasons, and even managed to produce four of the top 10 toys last year in regards to sales. There's a good chance that it will end up doing well again this year as well with its new Leap Reader device. While one hot toy does not a good investment make, when a toy company starts showing consistency in regard to producing top holiday sellers year after year then it might be time to sit up and take notice.

The holiday shopping season

The time of the year is very important in the toy industry. While there will be sales throughout the year, they generally don't compare to the sales that are made leading up to Christmas. Falling flat when it comes to Christmas sales means that you're not only ending the year badly, but that you're also going to be stuck in a rut for a while since the months following Christmas are traditionally some of the worst for toy sales. Several "hot toys" lists are published each year in the months leading up to Christmas, tracking the trends that drive toy sales and predicting which toys will be at the tops of everyone's letters to Santa. If you're a toy manufacturer, you want your products to be on at least one of these lists.

This is one place that LeapFrog has excelled. A major trend in toys has moved toward electronics in recent years, especially into the realm of interactive toys similar to the tablets and other devices that parents use. LeapFrog has created several popular handheld devices as well as the LeapPad tablet line, and is also actively developing LeapFrog apps for other tablets such as Apple's iPad.

Comfortably behind the competition

In most cases, you wouldn't expect companies to brag about not being at the top of their industry. With LeapFrog, though, it could almost be seen as a badge of honor. The company prides itself in putting learning first in the toys it develops, making sure that its toys are fun and educational instead of just a tool to drive profits higher. While competitors such as Hasbro (NASDAQ: HAS) and Mattel (NASDAQ: MAT) grow faster than LeapFrog as a result of its more intense focus, they also suffer many more misses when trying to mass-produce toys in hopes of sparking a new toy trend.

Holding a 16% share of the toy market, Mattel reported a net income of $776.5 million in 2012 that included sales from perennial best-sellers such as the company's "Barbie" and "Hot Wheels" franchises. Unfortunately for Mattel, attempts to follow the trend toward electronic toys have fallen somewhat flat. While still the market leader, the company has suffered more misses than hits in recent years when trying to create electronic toys that kids want to play with.

Hasbro has also had its problems when trying to follow the electronic trend. With an 11% market share and a net income of $336 million in 2012, Hasbro owns the popular "Transformers" and "G.I. Joe" franchises as well as several game properties such as "Battleship" and "Monopoly." Hasbro has also licensed several of its properties for film and animation, though critical reviews of films based off of its properties haven't all been kind in recent years.

Attractive valuation and earnings potential

One benefit to trailing comfortably behind the competition is that LeapFrog gets to maintain its affordability while building momentum and improving its overall value. Though the company was hit hard by the recession, as consumers are spending more there is a building interest in LeapFrog's products. This is reflected in the company's stock prices when compared to trends of the last few years; the post-Christmas slump largely disappeared, and investor confidence has kept trading volumes near their pre-Christmas levels. Stock prices have nearly doubled in the past 12 months, with current share prices of around $9.50 inching closer to an all-time high for the company.

Of particular interest to investors is the growth and earnings potential of the company. The company's revenue grew by 28% in 2012 while net income tripled over the course of the year. This is due in large part to LeapFrog recognizing the trend toward digital toys and tablets and establishing an early foothold in the market for children's tablets, as well as an expansion of its animated educational videos starring popular LeapFrog characters. Sporting a low price-to-earnings ratio, impressive cash generation, a recent history of producing toys that sell well during the holiday season and plans to expand into international markets, the likelihood that LeapFrog will turn a profit for its investors is high.

An acquisition target?

There has been some speculation that either Mattel or Hasbro could start looking at LeapFrog as a potential target for acquisition. While it would be a smart move for either company as it would net the buyer a proven toy range and a trusted brand name, I can't help but hope that the larger players leave this little tadpole alone. Though if one of the larger companies does decide to purchase LeapFrog then there would be little that could be done to stop it; both companies have more than enough cash on hand to complete the purchase, with operating cash that exceeds LeapFrog's entire market cap of $580 million.

Making the leap

Investing in a toy company can be a bit anxiety-inducing since the companies tend to suffer from cycles in consumer interest throughout the year. Further, the recent recession has proven that companies like LeapFrog aren't immune from economic downturns. As I've said before, however, if you're going to invest in a toy company then LeapFrog is one of your best bets. It's a smart company making smart toys, and if it eventually gets bought out then whichever of the big boys buys it will likely pay a premium for it. Toys can be risky business, but this is the company that you want in your portfolio.

John Casteele has no position in any stocks mentioned. The Motley Fool recommends Hasbro, LeapFrog Enterprises, and Mattel. The Motley Fool owns shares of Hasbro and LeapFrog Enterprises. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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