LeapFrog: A Critical View From A Long Investor

Mar. 8.13 | About: LeapFrog Enterprises (LF)

If you search for LeapFrog (NYSE:LF) in Yahoo! Finance, you will come across many articles explaining to you why you should invest in the stock. In fact, for most stocks, the number of bullish articles tend to greatly outnumber bearish articles. There are many reasons for this, but the main ones I believe are: 1) most investors are long-only investors, so there are more people out there actively looking for buying opportunities, 2) writers tend to cater to a bigger audience (those looking to buy), and 3) most writers are not professional investors and do not respect the actual views of the market.

As a current long investor in LeapFrog, I believe I can add more value by publicly addressing my concerns rather than join the herd in screaming "buy, buy, buy!"

As an investor, LeapFrog has me worried for the following reasons:

1) Great Products, Badly Executed

Having great products is always a big plus in my book. But having great products also blind people with optimism. Why do I think LeapFrog has great products? First, I'd like to point out that the company's mission is to help our beloved children with fun and educational toys - I see the hearts melting already. If you go on Amazon.com (NASDAQ:AMZN), or Walmart.com (NYSE:WMT), or search online forums where moms discuss their favorite toys (and where weirdo investors like me lurk around hoping to gain some insights), you will find that LeapFrog is well received. If you go to glassdoor.com and read employees' review of the company, you immediately notice that LeapFrog employees truly believe in its products. Most people look at this and then look at the company's cheap price (less than 7x earnings), and they stop thinking with their head and start thinking with something else, "Oh boy, LeapFrog products have huge potential!"

Sorry to pour sweet and sour sauce on you, but LeapFrog has always had innovative products that are well regarded by the industry. So why did LF spend recent years bleeding money, and is still struggling to make up lost grounds? The company's poor performance is reflected in the stock. Obviously there are issues.

2. Revolving Door for Senior Management

I've heard good things about LF's current CEO, John Burbour. I've heard from employees and analysts that he is charming and a good leader. I've read in various random comments that Burbour is an industry veteran - just what the company needs.

Let's put aside any judgment of Burbour for a second and look at the facts: Burbour joined the company as CEO in March, 2011 and there is no publicly available track record to help determine how good he is as a leader of a company. Since 2005, the company has fired three CEOs, making Burbour CEO #4. In addition, turnover has been high in the senior leadership level.

A common employee complaint is that the company changes strategic directions too many times. In the past, the company has essentially behaved like a chicken with its head cut off.

3. Recent Strong Growth in Profits Must Be Ignored

LF just came out of a period of horrendous losses: LF lost money every year from 2006 through 2009 (I used my fingers to count this and came up with 4 consecutive years of losses), with a total loss of over $300 million. 2010 and 2011 net income are comparatively tiny at $5 million and $20 million, respectively. Any decent income will translate into a huge growth rate. Don't get fooled by this.

4. The Company Is Expanding Abroad... Again

Investors who read the latest annual report (for FY ending 2011) will no doubt stumble the following disclosure:

"The International segment represented approximately 25%, 20% and 19% of our consolidated net sales in 2011, 2010 and 2009, respectively."

The lazy investor no doubt jumps to the following conclusion: "Oh wow, the company is growing quickly abroad! They will benefit tremendously from the fast growing international markets!"

The slightly less lazy investor (but still lazy) will read the 2013 Investor Event presentation and jump to the following conclusion: "The Company is really focused on Asia now, and the kind people of Asia spends MORE of their income on education... it says it in a slide!"

Wait a minute! International sales was 24% of revenue in 2004. Doesn't look like growth anymore, does it? There is more! In the 10-K for 2006, the company disclosed that "In the third quarter of 2006, we established a marketing and sales office in Beijing, China." I can't find a single mention of Asian distribution in the latest 10-K. What happened to that? No really, can someone please help me answer this question? I haven't had the time to read everything you know!

I've only mentioned some of the concerns I have. For the sake of my cardiovascular health, I will end the list at this and encourage the reader to continue digging.

So why am I holding on this stock? The reasons are simple:

1. The company has solid balance sheet and no debt - I can't argue with $120 million in cash (as of 12/31/2012... it probably has more now as it collects on its considerable receivables). I don't like debt for a cyclical stock, and LF is a cyclical stock with no debt (I say it is cyclical because it is highly dependent on key products and product cycles... oh boy, another can of worms).

2. I really do like LF products and truly believe it has tremendous value that is under-appreciated. When I have a baby, I will be a LeapFrog customer, because I believe it makes products that are actually educational and beneficial.

3. Given 2, if the company is able to rebrand itself as an educational solutions company (which is it trying to do now) instead of its current image as a manufacturer of toys with an educational twist, there can be tremendous upside potential and may even reduce the cyclical nature of the company's sales.

4. In response to the possible accusation that I am speculating with point 3, I don't believe I am paying for this built in option. The stock is cheap at ~9x adjusted earnings (after adjusting net income down for tax benefits).

If the company has survived all these terrible years, through all these terrible CEOs, and is still alive and kicking, there must be a secret sauce in there somewhere. I'm long LF.

Please post comments below on why you agree or disagree. Thanks for reading.

Disclosure: I am long LF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.