Could This Stock "Leap" Into a Rival's Arms?

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

 Are you interested in a profitable business with a strong balance sheet and a cheap valuation? If you answer yes, then you should take a closer look into this small-cap company that provides educational entertainment for children. It is LeapFrog Enterprises (NYSE: LF).

In the past three months, shares of LeapFrog have experienced a significant decline of more than 18%. Is LeapFrog a buy at this current trading price? Let’s find out.

A child-entertainment business with customer concentration

LeapFrog, founded in 1995, is a developer of multimedia learning platforms and learning toys for children. Its products include LeapPad learning tablets, Leapster handheld learning-game systems and the Tag and Tag Junior reading systems.

Nearly 80% of its total 2012 revenue, or $463.1 million, was generated from multimedia learning platforms, while learning toys contributed around $113.5 million in sales. Most of its revenue, or $424.8 million, came from the U.S. while $156 million was generated by the international segment.

The company has quite a customer concentration. Its biggest customers are Wal-Mart, Toy “R” Us, and Target, which combined accounted for 66% of the total U.S. gross sales in 2012.

Successful ongoing turnaround effort

After a number of years plagued with financial loss and negative cash flow, Leapfrog seems to be turning itself around and growing. The turnaround began in 2011 with new CEO John Barbour.

In 2012, LeapFrog generated $581 million in revenue and $86 million in net income, or $1.24 in EPS. The operating cash flow was $68 million while free cash flow stayed at $43 million.

What makes me interested in the company is its conservative capital structure. As of December 2012, it had $330 million in total stockholders’ equity, $120 million in cash and no debt.

Buyout target

Dating back to the middle of 2011, Barbour commented that LeapFrog was open to being bought out. He thought that LeapFrog could be a major asset for another company with a unique and valuable brand in the marketplace. According to him, consumer loyalty for the company’s brand was quite valuable.

Bigger peers, including Mattel (NASDAQ: MAT) and Hasbro (NASDAQ: HAS), could easily be the company’s potential acquirers. LeapFrog is trading at around $8 per share, with a total market cap of only $545 million, much lower than the current cash level of both Mattel and Hasbro. As of December 2012, Mattel and Hasbro were sitting on $1.3 billion and $850 million in cash, respectively.

Furthermore, LeapFrog's valuation is much cheaper than its larger peers. At $8 per share, the market values LeapFrog at only 6 times EV/EBITDA. Hasbro is trading at $45 per share, with a total market cap of $5.8 billion. Hasbro is valued higher at 8.7 times EV/EBITDA. Mattel is the biggest company and has the most expensive valuation of the trio. At $44 per share, Mattel is worth around $15.1 billion in market capitalization and is valued at 11.3 times EV/EBITDA.

Among the three, Mattel has the highest operating margin at 18.4% compared with Hasbro's 14.7%. LeapFrog generates the lowest operating income at only 11%.

Thus, by acquiring LeapFrog at a dirt-cheap valuation, both Mattel and Hasbro could benefit greatly from its current product portfolio and consumer-brand loyalty.

Mattel and Hasbro

Mattel has been concentrating its efforts on setting up new franchises and partnerships with entertainment players including Warner Bros, Nickelodeon and Disney. Recently, the multi-year global licensing partnership between Mattel and Nickelodeon was renewed so that Mattel could still be the master-toy licensee for all Nickelodeon entertainment properties. The licensing renewal and ongoing efforts could make Mattel's global footprint stronger in the near future. 

While Mattel is shaking hands with television and video cartoon makers, Hasbro is teaming up with gaming players. Hasbro has signed a multi-year strategic agreement with a leading game company, Electronic Arts. The agreement includes the creation of electronic versions of some of Hasbro's most famous games, such as Scrabble and Monopoly. The partnership is expected to keep broadening the reach of Hasbro's brands.

Income investors might love Mattel and Hasbro more with their decent dividend yields. Mattel offers investors dividends with a yield of 3.3%, while Hasbro's dividend yield is the highest, at 3.6%. LeapFrog does not pay any dividends at the moment.

My Foolish take

All of those three companies are worth investors’ consideration. Mattel and Hasbro, with their strong global positions in children products combined with their nice dividend yields, could be good long-term stocks for investors.

LeapFrog, on the other hand, is worth a buy due to its profitable turnaround effort and cheap valuation. If LeapFrog were to become valued similarly to Hasbro, its share price might reach around $11.60 per share, a 45% upside potential from the current trading price. 

Anh HOANG 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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