- Platform sales key to attach high-margin content, but niche positioning limits appeal to a wide set of customers.
- LF should look at expanding its content on to Android and IOS platforms to hedge against losing the tablet war to more richly funded competitors.
- Shares have taken a beating post earnings - now is the time to buy.
LeapFrog (NYSE:LF) shares are hovering close to their 52-week lows, after the company reported weak Q4 performance with a 24% decline in sales driven by very high levels of discounting on its most popular Leappad2 line of kids' tablets.
At the time of writing, LF shares are trading at $7.49 with a P/E of 6.3. However, the P/E ratio and the 2013 EPS are artificially buoyed by one-time income tax benefits; the normalized EPS is $0.48/share (against reported EPS of $1.23) which implies an adjusted P/E ratio of 15.6.
LF has a cash balance of $168M and no long-term debt. The current market value is $519M, so the implied value of forward-looking cash flows is $351M.
A discounted cash flow analysis of LeapFrog reveals potential opportunity, but also risk, based on your view of LeapFrog's future. As always, I tried to balance the two positions and arrive at a mid-range outlook, and what that would mean in terms of potential upside.
To analyze LeapFrog's business, one has to break out the tablet (hardware) business from the content business. Unfortunately, LF does not break out its business into these segments, so I have made assumptions around the mix of these two segments, in order to highlight how much share LeapFrog would need to take (or maintain) in the tablet market to have a viable business. LeapFrog's gross margin of 39% is very healthy, and indicates that the majority of this is driven by the content, since very few hardware companies command the pricing power to justify such high margins. LeapFrog tablets range in price from $39 (discounted over the holidays) to $149. From the analysis I am assuming a 15% gross margin on tablets, with an ASP of $70. I also look at 3 scenarios where hardware sales are 50%, 60% and 70% of LeapFrog's sales; and back into the content revenues and gross margin to get a sense of the dynamics of the two segments.
Analyzing the segments shows that the 60% assumption seems the most likely scenario, where LeapFrog sold around 4.7M tablets in 2013, for a 2.2% share of the total tablet market [Source: IDC]. The content business accounts for the lion's share of profit, at 75% gross margin, and this seems to make sense as well. So the future of the company is highly dependent on its ability to monetize content, rather than sell hardware (though of course monetization is significantly more profitable on its own platform).
In my base case, I assume a 5% revenue growth rate for LF through 2020, with stable gross margins at 39% and operating expenses growing 1% annually. Using a discount rate of 12% and a terminal growth rate of 0%, I get to an implied valuation of $646M, which is 24% upside to today's market cap (implying a price of $9.3/share). If you believe LF has a chance to carve out a profitable niche in the kids' tablet market, there seems to be upside at these prices. LeapFrog's CEO also alluded to new product releases during the latter half of 2014, which could aid in margin (and revenue) expansion.
Monetizing content will continue to be key for LF, as tablet margins are competed away and hence attaching apps to the IOS and Android platforms, even at the cost of giving away some margin to the Apple and Google ecosystems, could be an effective hedging strategy for the company if it finds itself unable to compete against higher-speced tablets that can serve more than just a niche.
The Bear Case:
LeapFrog needs to invest substantial resources into content development and acquisition, marketing, and R&D in order to maintain its competitive positioning. If these efforts do not succeed in spurring on sales, and gross margins stay flat or contract, profitability will be impacted significantly. If you assume that growth flattens out to around 1% annually, there is a 29% downside to current prices, without any further margin erosion.
To sum up, a bet on LeapFrog assumes that the company will continue to serve a niche market in kids' tablets (which seems pretty reasonable, as the company only has an estimated 2% of the market today), and will expand its content offerings on other ecosystems. I believe LF has significant assets that will enable it to pivot in either of these directions. It is adequately funded, profitable and debt-free. Shares are a buy.