One type of investment that I like to look for is a growing company trading at a value stock price due to a fundamental misunderstanding of the business. I believe LeapFrog Enterprises (LF) is exactly that type of investment. LeapFrog is the leader in educational entertainment for children, founded in 1995 by a father who wanted to change the way children learn to read. Since then, they have sold more than 100 million books, over 100 million educational toys and over 55 million tablet and gaming platforms. It has won the Toy Industry Association's "Educational Toy of the Year" award 9 out of the last 13 years and the LeapPad2 recently won the Association's first ever People's Choice "Toy of the Year" award, which is voted on exclusively by consumers.
The company had a fantastic year in 2012: net sales grew 28% to $581 million, international sales grew 38% to $156 million and operating income increased 170% to $64 million due in large part to the success of their LeapPad and LeapPad2 tablets and related software. The company had 3 of the top 4 selling toys in the U.S. during 2012, including the #1 selling toy overall. Additionally, cash and equivalents increased 67% while the company was able to completely self fund operations, not needing to access their asset-based credit line.
Despite this incredible growth and financial stability LeapFrog currently trades at less than 11x 2012 adjusted earnings of $0.86/share (GAAP earnings were actually $1.24/share but that includes unusual tax benefits that don't reflect the true underlying business). The multiple shrinks to around 7 if you subtract out the nearly $3/share in net cash that management expects to have at the end of Q1. A multiple that low obviously means the market doesn't believe this growth can continue and that the company will experience significant contraction, presumably from increased competition. This is despite a usually very conservative management's guidance to continued growth in 2013 (management originally guided EPS to a range of $.40 to $.45 for 2012 vs. $.86 actual).
I think both the threats and opportunities for this company are widely misunderstood but that the true value should become increasingly evident as management continues to execute their vision in 2013.
"The report of my death was an exaggeration" - Mark Twain
When a company dominates a space like LeapFrog has, the biggest threat is usually competition, and I suspect this concern is why LeapFrog has a short interest nearing 20% of the float. The shorts likely see LeapFrog as a one-trick pony with an easily replicable product and assume sooner or later a bigger company will come in and crush them. The company sells toys other than tablets, but the tablet and related software business is the real money maker at the moment. Competition in the tablet market is indeed my biggest concern about owning LeapFrog stock, but I feel the company has much more of a moat than the market gives them credit for and a business that would be very difficult and expensive to duplicate.
LeapFrog has a number of current competitors in both the traditional and kid-focused tablet space but they haven't managed to slow down Leapfrog's growth over the last couple of years. Traditional tablets like Apple's (AAPL) iPad and Amazon's (AMZN) Kindle are great products that have changed the way we use computers and the internet but they aren't direct competitors with Leapfrog for two crucial reasons:
- Many parents won't let a young child use a traditional tablet. These tablets aren't built to withstand the abuse a young child can inflict on fragile technology and it is difficult to prevent children from using the tablet in ways other than the parents intend.
- Traditional tablets also don't deliver the life changing educational content that Leapfrog prides itself in. The traditional tablets have educational apps, thousands of them, but they are of widely varying quality, aren't reviewed by experts for educational value and are at best only individual items not comprehensive solutions.
Competition from other kid-focused tablets has accelerated recently, but none were able to keep LeapFrog from increasing its market share of U.S. preschool electronic learning toys to 61.4% from 56.7% the year before. These tablets may be kid-friendly but they lack what truly sets Leapfrog apart, the content. Leapfrog has an 18-year track record of providing quality educational entertainment products for children. The company's in-house child development experts have built an extensive library of proprietary curricula that provide quality educational content while keeping children entertained.
Educational experts also review all 3rd party content to make sure it meets their incredibly high standards. The combination of proprietary curricula and high quality 3rd party content from companies like Disney (DIS), Mattel (MAT) and Hasbro (HAS) has allowed them to create an impressive ecosystem of over 500 books, games, apps and music. This content ecosystem is the result of years of work that would be very difficult and expensive to replicate and is what sets LeapFrog apart from other kid-focused tablets. Parents appear to agree, making LeapFrog cartridge content the #1 selling toy in the U.S. during 2012.
Another threat is that electronic learning toys are a temporary fad but I don't feel this is a legitimate concern. Technology should continue to be an increasingly prevalent tool in childhood education as the global markets for K-12 eLearning and Educational Gaming are expected to grow at annual rates of 33% and 30% respectively through 2017.
Overall I feel the concerns over LeapFrog's threats have been overblown but what I believe is even more misunderstood are its incredible growth opportunities in the near future.
About 95% of LeapFrog's current sales come from English-speaking countries, but those countries aren't the only ones with demand for English language educational toys. English speakers are expected to more than double to 2 billion within the next decade, making it the most spoken language on earth. Parents worldwide are realizing how valuable it is for their children to learn English as a second language and this is an area that LeapFrog management has publicly identified as something that they will focus on in 2013. One region they specifically mentioned at their recent analyst event was Asia, where consumer spending on supplemental education is 15% of the household budget, compared with only 2% in the U.S.
In addition to English language growth, LeapFrog has started venturing into other languages with the launch of a French language LeapPad in France and French-speaking Canada in 2012. Despite being new to the market, the French language LeapPad was the #4 selling toy in France in December 2012.
LeapFrog management has also indicated that they will release LeapPads for additional languages in the future which will significantly broaden its potential customer base. To my knowledge management hasn't specified which languages those will be but I would assume Spanish (500 million global speakers), Portuguese (240 million speakers), German (200 million speakers) and Mandarin (1.3 billion speakers) are all strong possibilities.
LeapFrog's international mix of global sales is 27%, well below other toy companies like Mattel and Hasbro at 44% and 46% respectively. It appears LeapFrog has only begun to scratch the surface of international possibilities.
There is still plenty of room for LeapFrog to grow within the U.S. as well. Despite massive growth, it makes up less than a 3% share of the U.S. toy industry. For 2013 LeapFrog has several new products in the pipeline including a new learn to read system, new iPhone and iPad activity products and new LeapPad tablets which could allow them to continue gaining share in the U.S. toy market.
Digital content sales quadrupled in 2012 vs. 2011 as parents took advantage of LeapFrog's 24/7 online app center. Likewise, LeapPad accessory sales tripled vs. the year before. These are very high margin products that underscore the huge amount of leverage in the tablet business.
The company is pursuing opportunities outside of the toy market as well. In November the company announced that they had signed a global agreement with Lionsgate (LGF) to develop, produce and distribute four "Letter Factory" movies to be released in early 2014. This is part of management's vision to transform LeapFrog from an educational toy company into an educational entertainment company. I expect to see more deals like this in the near future as the company looks to use its strong educational brand to gain share in the large market for children's movies.
Something to watch going forward is what LeapFrog does with the large cash balance it has been accumulating. On their most recent earnings call management said they expected the cash balance to reach $200 million within a couple months, nearly $3/share. When asked about what they planned to do with that cash the CFO indicated that they planned on developing international operations but also that strategic acquisitions of complementary businesses would be an excellent use for the cash. Additionally, at LeapFrog's analyst event on February 12th the CEO mentioned that they were also considering using cash for share buybacks. As a shareholder it is comforting to hear that management isn't content with just sitting on the cash pile.
A buyout by one of the major toy companies is also a possibility. It is no secret that traditional toys are losing share to electronic toys and traditional toy companies like Mattel and Hasbro currently don't have much of a presence in tablets (except for apps they developed for the LeapPad). They could always try to develop tablets and ecosystems of their own but doing that would be very expensive and there is no guarantee of success, as other competitors have found out. Even if an acquirer had to pay a 50% premium to the current stock price, Leapfrog could be acquired for around 8x 2012 adjusted EBITDA after subtracting out the net cash it will have at the end of Q1. Not only is it a value as a standalone company, but the acquirer could cut redundant overhead and other redundant costs of running a public company which would increase the value even more. Additionally, LeapFrog accumulated a large amount of net operating losses in the past that management has stated should prevent them from paying any significant amount of U.S. federal taxes in the next several years. These NOLs should substantially sweeten any potential deal. I don't know if any companies are actually looking to acquire LeapFrog, but if I were CEO of one of the major toy companies I would at least explore the option.
I feel LeapFrog is incredibly well positioned to take advantage of the large and fast growing global market for educational entertainment. Competition will likely remain strong but I'm confident LeapFrog will continue to innovate as it follows management's vision of transforming from an educational toy company into a global educational entertainment company. The stock price should remain volatile, but at the current price I believe it is considerably undervalued.