I am not usually inclined to invest in electronic gaming systems companies - there is a long trail of blood dating back to Atari and ColecoVision (although they were high fliers before their downfalls). That being said, LeapFrog (LF), with its LeapPad, seems to be onto something that presents an investment opportunity with an extremely asymmetric risk/reward profile.
For anyone without small kids, or who missed the press this holiday season, the LeapPad was the hot kids gift this year. It was so hot, that there were mass shortages with LeapPads selling for 2 times their manufacturer's recommended price of $99. Even now, after a short reprieve where prices fell to the $99 sticker price, the LeapPad Green is again being sold at a premium, with the lowest price on Amazon of $128.
My point is not just that the LeapPad is hot (that's important, but not the key) - the point is LeapFrog is taking a lesson from Apple (AAPL), and creating an ecosystem built around its platform. New software is downloaded from a LeapPad app store, with LeapFrog getting a cut of each sale. LeapFrog's near-term margins may be impacted by more hardware sales, but more hardware sales mean the potential for dramatically higher software sales over time.
LeapPad is intelligently positioned in the marketplace. It's cheap enough, at $99 suggested retail, to be significantly below Apple and the iPad, and not too expensive to be a special gift for its target of 4-8 year olds. LeapFrog is trying to serve a niche, and serve it extremely well.
Importantly, the LeapPad is actually a great product. It won the "Toy of the Year" award from the Toy Retailer Association during the British Toy & Hobby Association's annual awards ceremony held in London on January 24, and numerous accolades throughout the holiday season.
The success of LeapPad clearly caught even LeapFrog by surprise. There were shortages throughout 4Q. In addition, they signed numerous content deals in late December - Hasbro (HAS), Nickelodeon, Hit Entertainment - which suggests either LeapFrog or its new partners did not see the success coming or the deals likely would have been inked ahead of the holiday season. All that being said, the build-out of high margin content bodes extremely well for 2012 software sales, and margin expansion.
Given the shortages in 4Q, I would not anticipate meaningful upside for the quarter. However, given the ongoing demand, and the follow-on software purchases, I believe LeapFrog will guide to a much stronger 1Q than the 75% sequential revenue decline estimated by the Street.
Given the many moving parts to the business, it's hard to say exactly where 2012 falls, although I would anticipate material upside. Looking beyond to 2013, my model easily gets me EPS in excess of $1.00 a share.
As I see it, LeapFrog is a well-positioned, well-established brand, with John Barbour a savvy, extremely experienced and well-connected CEO who purchased 120,000 shares of LF last year. I'd expect limited downside to my investment, but if LeapPad stays hot and the app story gains traction, this could be a multi-year, multi-bagger.