LeapFrog: What a Difference 6 Weeks (and 21%) Makes

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

Back in early October I penned a less-than-bullish commentary on LeapFrog Enterprises (NYSE: LF), noting that a swelling amount of competition in the children's tablet space was apt to crimp sales during the critical fourth quarter. It was, shall we say, not a well received theory? While I thought the stock was overvalued and overestimated given what was on the horizon, most of you disagreed. Fair enough. Debates can be healthy, and nobody is infallible.

On the other hand, I'd be kidding myself if I said the 21% tumble that LeapFrog shares took between then and now wasn't at least a tad vindicating.

I didn't come here to gloat, however. I come here to reverse my call; a 21% whack on the stock's price makes that easy to do.

The question is, of course, how does a stock lose a fifth of its value in just a few weeks, particularly when the company posts great earnings news during that time?

Those who've been following the saga know the story all too well. On the Nov. 5, LeapFrog Enterprises knocked it out of the park, earning $0.60 per share last quarter versus expectations of only $0.42, and leaving the year-earlier figure of $0.35 in the dust. It was the tenth straight earnings beat. Yet, by the end of day on Nov. 6, LF had lost more than 10% of its value, and was en route to what would eventually be a 16% post-earnings pullback.

A bearish move on bullish news? Actually, we see it all the time, but in this case the news wasn't even all that bullish. Though the company technically upped its full-year earnings outlook to a per-share profit between $0.75 and $0.81, when one does the math, that actually translates into a fourth quarter profit of something between $0.40 to $0.46--less than the Q4-2011 earnings of $0.49. Yes, the full-year number is higher than 2011's, but if the fourth quarter outlook is a microcosm of the bigger trend, then LeapFrog is indeed going to be feel some pressure from a ton of new competition. The fact that the company plans to spend 20% to 25% more on advertising in the fourth quarter than it did in the fourth quarter of last year underscores my point that more and more competition is turning the heat up on LeapFrog.

So why am I bullish now? Because the new competition and the 20% bump in advertising expenses that competition is going to force LeapFrog to spend does NOT merit a 21% slide in the stock's value.

The numbers feel and sound big; a 20% to 25% increase in ad spending. Most investors may not actually realize how little that is, however, reacting before actually crunching the numbers.

In the last quarter of last year, LeapFrog spent $14.85 million on advertising. For perspective, LeapFrog generated $210.2 million in sales in the fourth quarter of 2011, and generated $32.8 million in profits that quarter. Point being, there's room for an extra $4 million in the budget if LeapFrog feels like it needs to bump up its advertising spending this quarter in order to meet the Q4 sales estimates of $217.6 million.  

Don't get me wrong - LeapFrog will still be dealing with good competition, forever. Around the time of my original write-up, the only competition in the space was The Toys "R" Us Tabeo, and the quickly-fading Fuhu Nabi, both of which were running a special kid-safe version of the popular Android operating system from Google (NASDAQ: GOOG). Since then, the Vtech Innotab 2, the MEEP, the Vinci Tab II, and the Kurio have surfaced as competition, and the iTikes add-ons for the Apple (NASDAQ: AAPL) iPad are still on the radar as well. I'm sure there are more kid-oriented tablets out there too. Every one of them will chip away at LeapFrog's potential revenue. Yet, thanks to the 21% selloff, the stock is priced fairly...perhaps even a little undervalued. Before, it was priced as if there were no other kiddie tablets on the market, and none on the way.

Bottom line? I didn't like LeapFrog on Oct. 4 when it was trading at $9.30, and fifteen times earnings. At $7.30 per share, however - and a forward-looking P/E ratio of 8.5 - I'm willing to change my stance.


jbrumley has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Google, and LeapFrog Enterprises. Motley Fool newsletter services recommend Apple, Google, 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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