Seeking Alpha
Long/short equity, growth, investment advisor, small-cap
Profile| Send Message| ()  

I have been following LeapFrog Enterprises (LF) for quite some time now. LeapFrog has a fascinating history. Last week, LeapFrog beat analyst expectations by $.11, but shareholders appeared disappointed and fled the stock, leaving it in the red during the next trading session. Why do some shareholders have outsized expectations in the stock? How can we make sense of such a confusing performance? I try and make sense of LeapFrog's history so far and argue below that LeapFrog still has significant potential for investors.

LeapFrog's History

LeapFrog was founded in 1995 when Michael Wood realized that there was a lack of educational products to help his son learn to read. LeapFrog was born to bridge that learning gap for youngsters; the company carries various products that include math, reading, writing, and phonics.

LeapFrog started to pick up steam when Knowledge Universe backed the company in 1997, followed by the launch of its flagship product, the LeapPad, in 1999. The LeapPad received moderate success although it faced competition from Mattel's (MAT) Power Touch from 2003 to 2006. The company decided to discontinue the LeapPad in 2007 before shifting its focus to the Leapster Explorer in 2010, followed by the LeapPad Explorer in 2011 and the Leapster 2 in 2012. It's important to note that in addition to electronic toys, LeapFrog also generates revenue through toys such as the LeapFrog My Pal Scout and through licensing its characters to third parties.

A Colorful Past

LeapFrog was at a major crossroads in October 2003. The company announced dismal 3rd quarter results in its Q3 2012 Earnings Press Release as the company faced a slowdown in growth from its main US consumer base. A bad quarter was not LeapFrog's only concern as investors noticed that the company's executives sold numerous shares before releasing the poor results, prompting six class action lawsuits in December 2003, April 2005 and June 2005, before finally reaching a settlement in 2008.

The company continued to experience changes through 2004 as Michael Wood resigned as CEO in February 2004, eventually leaving the company in September. In October 2004, LeapFrog's turmoil struck again. The company had given investors strong Q3 guidance, claiming that its supply chain and distribution problems had been fixed, before announcing significantly worse guidance ($.40-$.60 vs. $1.18-$1.20) than previously reported, sending the stock in a tailspin.

It was a tough year for LeapFrog. The most important thing to notice here is how aggressively LeapFrog gave expectations and the market repercussions for not meeting those expectations - this history plagues the stock even today

Leaping Forward To 2012

It's no surprise that retail investors were extremely disappointed from the market's reaction to LeapFrog's Q4 2012 results after capping off a near perfect year. When situations like this arise, theories abound from stop-loss manipulation to future guidance concerns. The real question is whether investors should have been surprised, given similarly strong results and guidance in previous quarters.

I won't summarize what hundreds of articles have already summarized, but I'd like to offer one interesting statistic regarding LeapFrog's previous market fluctuation post earnings:

Q1, 2012

Q2, 2012

Q3, 2012

Q4, 2012

EPS Estimate

-0.26

-0.18

0.42

0.49

EPS Actual

-0.14

-0.12

0.60

0.60

Surprise %

46.20%

33.30%

42.90%

22.40%

Change % (Next trading session)

14.59%

-11.93%

-10.76%

-0.22%

Source: SEC Filings, Market Activity

The chart above shows that LeapFrog has a history of beating analyst expectations and has been punished for this performance 3 out of the last 4 quarters. Investors are told until they're blue in the face that past performance does not guarantee future results, but it is helpful to look at previous statistics before mistakenly thinking that a strong quarter means a strong stock price the next trading day.

2013 Outlook And Beyond

One of the benefits of following a stock for a number of years is that you start to realize the ebb and flows of the business. Wall Street Analysts are no doubt brighter that most of us, but one has to realize that Wall Street itself is transient and an extremely deep expertise in a stock comes with time, which not all Wall Street analysts have on their side.

Here are the five reasons I like LeapFrog in 2013:

1) The management team - the LeapFrog executive team consists of many new faces. With the exception of Michael Dodd (Chief Operating Officer) and Robert Lattuga (VP General Counsel), most of the executive team has been with the company less than two years. Although the team may be new to LeapFrog, the top executives are not novices to the industry with executive experience at Toys "R" Us before making the transition. I also appreciate the executives' tone last week in the conference call; each one of them was extremely passionate about the product and the work they're doing.

2) Insider purchases - Throughout my years of investing, I have found that insider purchases are almost always a good sign. While there may be multiple reasons for executives to sell the stock, there is generally only one reason for them to buy it. After the Q3, 2012 results, insiders purchased 109,177 shares. I would not be surprised if insiders continued to purchase more shares after the Q4, 2012 results.

3) P/E ratio - LeapFrog continues to operate at a very favorable P/E ratio of 11.17 in comparison to players such as Mattel and Hasbro (HAS) with a P/E ratio of 18.22 and 15.63 respectively. Last week, Ray Arthur gave conservative guidance, stating that LeapFrog expects high single digit growth going into 2013. I expect LeapFrog to beat, as usual, with 12-15% sales growth in 2013.

4) 2013 product offerings - LeapFrog continues to innovate. The new learn-to read-system and the new iPhone and iPad app products will help them further penetrate new markets, and I firmly believe that the new LeapPad tablet will address the numerous battery issue complaints and be adaptable to many different platforms.

5) The competition is weak - Do your own research here. V-tech's Innotab 2 is LeapPad 2 Explorer's only real competition and most consumers give LeapPad 2 the edge. My research includes scouring hundreds of consumer and tech reviews and numerous conversations with industry experts.

Conclusions

My first conclusion is that LeapFrog sandbags its numbers. LeapFrog's management doesn't do this maliciously, instead almost naturally after the company's previous aggressive guidance wreaked havoc. I constantly ask myself whether I would act the same way if I were in management's shoes.

My second conclusion is that this stock is undervalued, and I have been and will continue to purchase LeapFrog at these levels. I don't expect the stock to increase significantly in the near future, but no story like LeapFrog (although not perfect by any means) remains unnoticed forever.

Source: 5 Reasons Why I'm Still Buying LeapFrog In 2013