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William Greenfield
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I am a CPA licensed in the State of New Jersey, currently working in a boutique accounting firm. I am an avid reader of Benjamin Graham's works and apply his methods of analysis when researching investment opportunities.
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  • Leaping For LeapFrog

    Around May 2013 I came across LeapFrog Enterprises (NYSE:LF), which was selling for ~$9. Given the facts at the time, I felt it was overpriced. Then the stock went to $11.50, so maybe I'm not such a genius after all. A few weeks ago, I ran a screener for stocks hitting new lows and LF came up. Surprised, I caught myself up with what's been happening at LF. I found that last year the bad weather caused a buildup in inventory, which created a drop in sales. To top it all off, instead of launching new toys this summer, as they have in the past, LF pushed off their launch of new toys to the fall 2014. All this caused the stock's sharp drop from $11.50 to $8 and then down to $4.50. Still I hesitated to buy LF, unsure if the drop was of a more permanent nature. Since running that screener, LF has leaped 25% to $5.50 because of investors hoping for a good holiday season. I still haven't bought though; I like to take my time and really try to research the stock before buying any.

    Looking into LF for the second time, I decided to go deeper and broader. Printing up their financials for the last 7 years, I put together a spreadsheet to run their numbers. What my research has shown me is that, LF is a great company but they've had trouble translating this into profitability in the past. Before 2010, LF had not been profitable since at least 2004. Their FCF fluctuates between positive and negative territory, which is consistent with a company that is dealing with stiff competition and needs to spend a lot on R&D to stay ahead. However, LF is leading the pack with their award winning multimedia toys.

    Given their inventory backup since last year, LF is looking at much lower margins this year, with weak guidance for the next 12 months. After that they are hoping to once again enter positive income territory. But given their history, one must wonder if they will be able to deliver. While their toys are usually top sellers, investors need to know where 2 years of weak sales and negative FCF will leave them.

    I will use 3 methods to analyze LF.

    1. Liquidation Value - Liquidation value an investor would get, if we assume the enterprise is closing up.
    2. Going Concern (Reproduction) Value- Value of enterprise's assets as a going concern. We will try to find the value that the company would either sell for or what a competitor would need to spend to reproduce an enterprise of equal value. This includes capitalizing R&D, advertising, and some SG&A. This method also looks for hidden assets that may not be showing up on the balance sheet.
    3. Earnings Value - The investor adjusts earnings to arrive at a cash flow he feels can be maintained by the enterprise given expenses used to keep sales steady (no growth), then uses a multiple he feels is right given the risks involved.

    Benjamin Graham discusses these methods in his books Security Analysis and The Intelligent Investor, with emphasis on methods 1 & 3. Bruce Greenwald deals with methods number 2 and 3 in more length in his book Value Investing: From Graham to Buffett and Beyond along with some other valuation theories.

    Note: All balance sheet amounts are based on the most recent 10-Q showing the values as of Sept. 30, 2014.

    #1) Liquidation Value

    Based on the most recent 10-Q filed by LF, we can calculate their liquidation value at $153 million or $2.17 per share.

    To get to this number, I took the balance sheet and multiplied the amount by what I believe is a sensible percentage of what would be received should LF liquidate.

    Cash - 100%

    A/R - 85%

    Inventory - 50%

    Liabilities - 100%

    We won't give any weight to the long-term assets such as deferred tax assets, PP&E or intangibles. If LF were liquidating it would most likely be a scenario where these assets were not worth the amount listed. This gives us a floor value for LF. However, since we do believe that LF is a going concern the liquidation value isn't much help in valuing the stock. This brings us to the second method.

    #2) Going Concern Value

    In this valuation we take the assets at book value and adjust them to what the enterprise would cost a competitor to either build from the ground up or to acquire from the existing enterprise. This is quite useful in spotting companies that you believe have a good chance of being acquired. After all, why should Mattel's Fisher-Price or Hasbro's Playskool spend all that money on developing toys if they can just buy the competition?

    We will value the current assets (excluding the tax deferred asset) at their stated value. These assets are easiest to measure and we can rely on their stated values on the balance sheet. The only adjustment that we will make is to add in the doubtful accounts from the A/R. Any competitor trying to build such an enterprise would inevitably have the same credit concerns.

    The next item on the balance sheet is LF's deferred tax assets (current and long-term). Unless one has access, time and expertise to research, understand and value this asset I would suggest taking the asset at its stated amount plus the valuation allowance and net the total against the tax deferred liabilities. Like the A/R in last paragraph, a competitor reproducing the assets in LF's balance sheet would need to have the same valuation concerns.

    LF's PP&E account doesn't seem to have any hidden asset in the form of real estate to adjust for. In fact, given the nature of their work most of the assets are equipment. Therefore, we will take this amount at the state value.

    Intangibles are much harder to evaluate, however we can assume (I know, I know, never assume; but in investing one must make assumptions) that the goodwill on their books has a value of at least what is accounted for on the balance sheet. I didn't see any write-offs pertaining to LF's goodwill, which makes me believe that the value of this asset should equal, at least, the amount on the balance sheet. This asset may be worth more, but we can't really come up with a value without trying to understand the earnings.

    Since LeapFrog deals with multimedia toys, their patents, software, and other intangibles have significant value to their enterprise as a going concern. Therefore, we must adjust these assets to come up with an amount that we believe gives a fair valuation to what these assets are worth to an acquirer. In calculating the value of their intangibles, I believe that taking the last 5 years of R&D at varying degrees would give us a better idea of their portfolio's value. In such a case, we would add this year's and last's (2013-2014) at full value, and then decline by 20% for each of the next 4 years. Thus, we will take 80% of 2012's R&D, 60% of 2011's R&D and so forth. This implies a 5 year life for LF's R&D, from concept to the products end-of-life. (Please note that, for this and the next paragraph I added in the 6 months of 2014. This shouldn't make significant changes to the end result.)

    Of course any company would need to advertise to create brand recognition and foster sales. A conservative estimate would be about 3-year life for advertising. Like the R&D, we will capitalize the entire advertising expense of the last 6 months along with the entire 2013, and then take 2/3 of 2012 and 1/3 of 2011.

    I will not be adding any SG&A back since most of it is overhead and an acquiring company would be able to eliminate most of these expenses.

    We then subtract all liabilities at face value and we are left with $794.6 million or $9.04 per share. Here is a snapshot of the adjusted balance sheet.

    What this tells me is that LF has potential as a takeover target since their stock is currently selling for half their reproduction value. The reason that an acquisition hasn't occurred in the past may be due to the fact that Larry Ellison, CEO of Oracle Corp. (OCRL), held significant influence over LF. However, since March 2013 Ellison has sold most of his stock leaving the possibility of acquisition open.

    Now that we've worked out the asset value of LF, let's move on to valuing their earnings.

    #3) Earnings Value

    Most value investors use free cash flow to value a stock. This line of thinking can be traced back to Benjamin Graham's Security Analysis, in which he discusses the value of a security in terms of the cash that the business generates after deducting capital expenditures needed for maintenance as opposed to using the depreciation used by the corporation. Nowadays, most investors just take the FCF since determining what capital expenditures is needed for maintenance vs. growth is difficult. (In Value Investing: From Graham to Buffett and Beyond by Bruce Greenwald, Greenwald discusses a method for finding the maintenance capital expenditures [see footnote on pg. 94]).

    Graham was also a big believer in using the 7-year averages, unless other factors caused this to be poor comparison, which is LF's case. A quick look will show that using the 7-year average would not be a good comparison. LF's profit margins have changed significantly, as have the expenses. For this reason, I think it would be smarter to use the last 5 years as our comparison. This gives us averages of both good and bad years. However, we will not use the their 6 months fiscal 2015 data. I think that their current year is an outlier and not one that we can rely upon. Instead, when valuing their earnings we will have to take into account the weak guidance and slump in sales.

    The point of this analysis is not to predict what we think LF will earn in the future. Instead, we are trying to find only what LeapFrog NEEDS to spend in order to keep their sales, profitability, and market share stable. To do this we will find what LF has averaged in the past and adjust for expenses that we think were geared towards growth vs. maintaining their earnings to arrive at a number we think LF should be able to attain over a few years. This means we aren't trying to value their growth.

    The fastest way to finding distributable cash is to find the average unlevered free-cash-flow of the last 5 years. This is the amount of cash from operations less capital expenditures before taxes and interest. This will leave us the job of adding back the R&D, advertising, and capital expenditures and subtract the amount we feel were spent for maintaining sales and profit margins. When we calculated the asset value of LF we gave the R&D a 5-year life and the advertising a 3-year life. To maintain their current sales and margins I would imagine that LF will need to spend at least as much as the amount that would be depreciated. Therefore, we will use this amount for our maintenance expenses for these items.

    The reason we are using unlevered FCF is because LF's tax deferred asset has been causing a negative expense, raising the reported profits. This causes the bottom line to be a bit more difficult to determine. If our calculations are correct, the tax-deferred asset should last about 4 years but will probably last longer. For the sake of conservatism, I think we should look at earnings before this add back from the tax asset to value the earnings. This gives no value to the lack of taxes that LF will be paying for the next few years. To compensate, an investor will understand that there is more value than we may calculate here. How much more is perhaps something that no one can value, but we don't need to be exact in our calculations. We only need to determine if the stock is currently selling significantly below that value.

    Now it's just a matter of applying multiples to these adjusted earnings per share to find what we would pay for LF without giving any value to growth. I always try to find stocks with an earnings yield in the range of 8% - 12.5%. Simply put, earnings yield is a function of interest rates. With interest rates currently at the low end I am willing to go to a lower earnings yield. However, I am not really interested in going much lower than 8%, unless I think I'm dealing with a first class stock that has a great history, strong balance sheet, and the possibility of strong growth. Even then I am usually not going to buy for less than a 5% earnings yield. (Perhaps I am fooling myself into thinking that I can find undervalued stocks with such yields in today's market, but I am unwilling to take such risks.)

    Here is what we would be looking at in terms of stock prices based on the earnings we calculated.

    As we can see, the price at its lowest point is equal to about what it is selling for now. At its highest price, it gets close to our Going Concern Value that we calculated earlier. The average is the 10% yield, giving us a price of $7.50.

    Given that LF is selling at half its asset value (as per method #2) and about 27% below it's the $7.50 earnings value, I think an investor can do quite well buying some LF at its current price of $5.50. Obviously we can expect the next couple of years to be tough as LF gets its sales and profit margins back up but during this time I don't think an acquisition should be off the table. Should LF manage to execute on the earnings front, we can expect a nice upswing in the price of the stock over the next 2 years.

    Tags: LF, long-ideas
    Dec 01 2:50 PM | Link | Comment!
  • Bloodbath!

    (click to enlarge)

    Glad I have some CSCO. Only stock lighting up green!

    Disclosure: I am long CSCO.

    Tags: CSCO
    May 15 2:14 PM | Link | Comment!
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