Make Your Portfolio Leap (Frog)!

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

It is not often that the market provides a chance to buy a fast growing company at bargain prices, but LeapFrog (NYSE: LF) is just such an opportunity.  Robert Lally and Michael Wood founded Leapfrog in 1995 in order to fill a personal need not met in the marketplace-a tool to help Mr. Wood’s son learn to read.  LeapFrog went public in 2002, and is now a leading designer and developer of technology products with engaging content to create effective learning experiences for children.

While the company went through a period of growth stagnation, under the current CEO, John Barbour, who joined the company in 2011, along with the leadership team he put together, the company has exceled with a culture built around entrepreneurship and innovation.  They have revived the product line-up, especially with the advent of the Leap Pad, and created a stable of best-in-class content, making LeapFrog a leader in children’s multimedia production and distribution.  Moreover, they have created a combination of award winning easy to use hardware, combined with unique software content made up of engaging games, videos, books, e-books, apps and music to create effective learning solutions for children.

Content is King

A linchpin of Leapfrog’s creative team is a core group of child development and educational experts, setting LeapFrog’s content apart from competitors, and creating a brand that parents can rely upon.  The proof is in the sales; in 2012 multimedia sales grew 60%, and net sales of downloaded content from LeapFrog’s 475 titles (including proprietary titles and content from their 30 media partners), increased 400%.  LeapFrog’s award-winning line of Leap Pad cartridge content was the number one selling toy in the U.S. and a top ten selling toy in the UK.  According to NPD Group, LeapFrog had 3 out of the top 4, and 4 out of 10 of top selling toys in the U.S., and 2 out of the top 10 selling toys in the UK.  LeapFrog is continually expanding their market presence internationally, recently introducing the LeapPad to France and French Speaking Canada, with all products selling out. 

Larger toy companies like Hasbro (NASDAQ: HAS) and Mattel (NASDAQ: MAT), which by most considerations are competitors, are also content partners.  While Mattel experienced modest sales growth in 2012, Hasbro's sales dropped YOY, as overall conventional toy sales were lackluster.  Hasbro specifically saw a 5% drop in their preschool catergory and European sales, two areas that are a strength for LeapFrog. Neither company has a toehold in tablets, which should make them both nervous, as NPD Group reports growth in tablet use by children 4-14 years of age leapt from 3% in 2011 to 12% in 2012. According to Neilsen, 70% of children under 12 who live in households with tablet computers use those devices (57% use them for educational purposes). LeapFrog’s niche educational entertainment content and hardware has created an ecosystem that serves both children and parents’ needs, which has equated to outsized growth.  2012 revenue consisted of strong content sales, in tandem with strong hardware sales of LeapPads, and the Leapster GS system. The strength of sales of LeapPads was offset by slower growth in some toys, and platforms that are nearing the end of their product cycles.  U.S sales were up 24%, and international sales were up by 38%, for a combined increase of 28% year over year.  

The Numbers

LeapFrog’s niche strategy and recent success under new management is laudable, but for investors it becomes more compelling when you consider company performance in light of the valuation.  Prior to Mr. Barbour’s arrival, cash management and inventory were concerns plaguing LeapFrog.  At year-end 2012, the company’s cash balance was $120 million (67% increase YOY), which does not include receivables (which together equal $190 million).  Management has also streamlined inventory management.  In fact, the concern by one major vendor was that the company might have left sales on the table by not making enough-a good problem to have.  With a $120 million in cash and net global sales of $581 million, and a market cap of $623 million, Leapfrog is trading at 1.07 times sales, and with a per share price of $9, it is trading at just over 6 times cash flow with a .35 peg ratio.  To put it mildly, it is dirt cheap, and like the late Rodney Dangerfield, it gets no respect!

Gross profit for the year was 42.1%, or $245 million, an improvement of 32% year over year, driven by higher sales and proportionally lower discounts.  While operating expenses were up 11%, as a percentage of net sales they dropped 460 basis points, which accounts for the lowest percentage amount since LeapFrog became a public company.  LeapFrog is delivering on the bottom line as well, with a 170% increase operating income, and a 300% increase in net income in 2012.

Get it while it (is not) hot

Many investors seem to think recent performance is an aberration and unsustainable. It is not only trading at historic lows in deference to performance, but it also has a 15.86% short interest in the shares outstanding.  

For 2013, Leapfrog plans to strengthen its ecosystem and bring new products on the market, including a new learn-to-read system, a new iPhone/iPad App product, and a new series of LeapPad Tablets.  They also plan to continue their international expansion, invest in R & D, and create a closer relationship with customers through an online community for parents. Management forecasts that they will be able to make these investments while keeping the strong operating margin the company enjoyed in 2012. 

I initiated a small position in this company in Spring 2012, and since then the price has meandered, while the company has continued to beat expectations, and the stock has become increasingly cheaper.  In the meantime, I (and LF's management) have been buying shares on weakness.   I invested because I see a bright future for LeapFrog as an independent company, but if this market dislocation continues, I believe Mattel or Hasbro will also see it as an opportunity and buy LeapFrog, capturing one of the fastest segments of the toy market, and simultaneously gaining a competitive advantage over the other.

JAF1975 has a position in LeapFrog Enterprises.  Please follow James on twitter. 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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