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Summary

  • LeapFrog Enterprises, Inc. designs and manufactures electronic educational/entertainment devices and software for children.
  • Markets have overreacted to LeapFrog's troubles and at current prices LeapFrog offers incredible value and minimal downside risk.
  • LeapFrog retains significant long-term upside, especially via potential growth in new children's product categories like the LeapBand activity monitor and LeapTV video game console.

LeapFrog (NYSE: LF) recently announced disappointing earnings for the quarter ending June 30th (fiscal 1Q 2015). Quarterly revenues decreased to $46m, a decline of 43% year-on-year, and LeapFrog reported a loss of $16.4m or $0.23 per share. Management blames poor performance on seasonal cycles, new product development, difficult market conditions, and excess retail inventory. It expresses hope that new product lines (the newly-released LeapBand activity tracker and the upcoming LeapTV video game console, as well as refreshes of existing lines of LeapFrog hardware) will propel profitability and growth in the next few years.

Incredible Value, Minimal Risk

At the time of writing, LeapFrog has a market capitalization of $430m. This compares to a book value at the end of June of $405m (with a solid $360m in net tangible assets), which implies that LeapFrog is trading at an extremely attractive 1.06 times book value. Additionally, LeapFrog has no long term debt, and its assets include $199m in cash and cash equivalents. The company is fiscally healthy, and perfectly capable of weathering a storm like the current one without experiencing a liquidity crunch.

At these prices, the net present value of LeapFrog's future earnings is about $25m. LeapFrog management projects full fiscal year earnings at between a loss of about $2.6m or $0.04 per share and a profit of $6.5m or $0.10 per share. Given that the first fiscal quarter loss of $16.4m or $0.23 per share has already accrued, this implies projected earnings between $13.8m-$22.9m, or $0.21-$0.35 per share, over the next three quarters. Ceteris paribus, this would push LeapFrog's book value in March 2015 to $418m-$428m. If LeapFrog's share price remains unchanged, its future earnings would be valued at an underwhelming $2m-$12m in March 2015.

I believe that these current prices represent a significant discount on LeapFrog's future earnings. Given LeapFrog's recent troubles and lackluster performance, it is reasonable to think that the market has currently significantly overreacted to LeapFrog's situation. The overreaction is particularly sharp because LeapFrog makes most of its profits around the holiday season, so the numbers for this quarter are much more alarming than they will be in a couple of quarters.

Of particular solace to the LeapFrog investor should be the fact that LeapFrog's products are actually highly rated and innovative. The LeapFrog LeapPad 3 seems to me to be the best product in its category, and it currently enjoys an average customer rating of 4.4/5.0 on Amazon. The recently released LeapBand activity monitor for children aged 4-7 currently has an average customer evaluation on Amazon of 4.3/5.0. This number is especially impressive given that new consumer electronic products tend to be a little glitchy. LeapFrog also owns a library of acclaimed children's content for its various devices. LeapFrog's products have monetized quite well in past years: for instance, LeapFrog generated earnings of more than $80m in 2012 and 2013, and 19m in 2011.

Given its balance sheet and excellent products, the LeapFrog investor should not be overly concerned about the company's viability in either the short or long term. Moreover, LeapFrog's high book value provides a solid floor to market capitalization in the long run, resulting in potential downside of only about 5-6%.

Significant Upside Potential

In addition to strong financials and an established product line, LeapFrog offers investors significant upside potential. I see the following reasons for a higher profitability and valuation for LeapFrog:

  • LeapFrog's recently released LeapBand activity tracker and upcoming LeapTV offer potential for growth along both the top and bottom lines, especially in the long term. Although the LeapBand retails for only about $40, the LeapTV is expected to retail for about $150 per unit, which should help boost LeapFrog's margins.
  • LeapFrog could (and should) expand sales through improved international penetration. Last quarter about a third of LeapFrog's revenues came from outside the United States. This suggests that there is great room for international growth, especially given LeapFrog's relatively affordable prices.
  • LeapFrog could be the target of an acquisition, especially at currently low prices. At a market capitalization of $430m, LeapFrog could be acquired by a technology firm, a toy manufacturer, or a software house. Given LeapFrog's financial health and stability, strong brand, and high quality software and hardware, such an acquisition may very well be in the cards and offers significant upside potential.

Conclusion

To reiterate, given its extremely low current and expected ratio of market capitalization to book value, LeapFrog offers excellent value with minimal downside. As long as it does not keep losing money in the long term - a far cry from management guidance - LeapFrog's market capitalization should not drop below its book value (and if it were to do so, this would represent a buying opportunity). Additionally, a portfolio of high quality products and international growth opportunities offer significant upside for LeapFrog and its investors. This means that LeapFrog is a high value, low risk, high reward stock - a true rarity in the stock market.

Source: LeapFrog: Significant Growth Potential With Minimal Downside Risk