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LeapFrog Enterprises, Inc ($LF) is the maker of educational toys for children such as the LeapPad tablet for kids. The company classifies themselves as a leading developer of educational entertainment for children. The stock has struggled recently as the Christmas season has been deemed to be a concern for the industry and in particular LeapFrog. The main threat is the entrance of competition from some big names, Samsung and Amazon, who will be offering electronic tablets for children.
LeapFrog’s Strategy
The company’s strategy is to build high quality educational devices for children while offering a wide selection of digital content for both educational and entertainment purposes. The sole focus of the company is to build high quality products for children and help parents by creating toys that have high educational content to supplement learning development. The LeapPad was first launched in 2011 and new versions released over the past couple of years. The LeapPad was a tablet designed and built for a child and marketed as a device that can run child safe content that is vetted by LeapFrog. Other products include the LeapsterGS, Leapster Explorer, Tag and LeapReader. The LeapPad really catapulted the company forward as parents and children loved the product which can be attributed to the success of Apple and the iPad. Since kids see their parents using tablets, they also want to play with a tablet and LeapFrog created a tablet specifically for kids with the benefit of providing educational content in a rugged form. To Sum up, LeapFrog sells hardware products in addition to content sales in the form of downloadable apps, ebooks and game cartridges. The sale of hardware products drives the success of the higher margin content sales.
The learning toys (or educational toys) segment of the overall toy market has changed over the most recent years and become much more popular. Thanks to the love affair with smartphones, tablets, tv’s and other electronics that adults are purchasing, kids are now interested in electronic toys. Parents are still interested in educating their kids, so the blending of electronics and education is a strong market segment within the toy market which LeapFrog solely focuses on with products and content.
Brand Recognition
Brand awareness of LeapFrog is very strong among parents looking for electronic educational toys. Strong competition exists within the toy market with names such as Mattel and Hasbro and niche player VTech. Hasbro has a 40% market share within the overall toy market with Mattel garnering a 30% share. Management has done a good job with marketing to establish LeapFrog as a strong competitor in the learning toys segment. With a strong product line up, parents associate LeapFrog with quality and child education and are very passionate about the company and products. Once a strong brand has been established it can be used as an advantage against incoming competition to reduce the impact on margins. I believe that $LF has established their brand among parents (and more importantly moms) which will help enable the company to earn profits for years to come without too much impact on their margins. Once a perception is developed it is very hard for others to change that perception. The quickest method to destroy a persons perception of a brand is for the company to destroy the brand themselves by making bad decisions or introduce products/solutions that are not indicative of the associated brand/perception. To date, the new management team has done a good job of keeping the high standards of the $LF brand intact and building upon the success of the LeapPad success.
11 of the Top 20 Best Sellers in Electronics for Kids on Amazon are LeapFrog products as of 12/18/2013 with all products averaging at least 4 out of 5 stars
Financials
LeapFrog has grown sales from $459m in 2008 to $581m in 2012. 2009 was a rough year with the recession and sales dipped to $379m. From 2009, the company has grown sales by 15% per year. Gross margins has stayed consistent from 2008-2012 ranging between 40-42%. Management has done a great job of fixing the expense side of the business as seen in the operating margins. In 2008 the company had a negative operating margin of 33%, which has transitioned to a positive 26% in 2012. Expenses have been reduced over the period from $241m to $180m all the while growing sales at an annual rate of 15%! The company does not use any leverage and has a pretty clean balance sheet with $120m in cash. At today’s market cap of $556m, cash comprises 21% of the total. Assets have grown from $306m in 2008 to $428m in 2012 and shareholder equity has increased from $180m to $330m. Along the four years, the return on invested capital (ROIC) has increased to 15% as of 2012 and ROE sits at 11%. The new management team has done a great job of turning around LeapFrog over the past 4 years.
All of the above numbers were used from annual reports and do not include FY2013 numbers.
Valuation
LeapFrog is not a stock that is selling for less than book value or a deep value play. The stock is trading for a decent price for a company that builds high quality products with a strong brand that has transformed the company over the past 4 years. FY 2012 EBITDA was $73m for an EV/EBITDA of 6.09 based on FY 2012 numbers. Trailing twelve month EBITDA is $88m for EV/EBITDA of 5.45. For a growing company with steady gross margins (~40% throughout FY2013) and a strong brand should trade for a much higher multiple.
Using 2012 EBIT of $0.92 per share the following values are derived using multiples of 5-10x EBIT plus cash on the balance sheet and Net Operating Losses(NOLs)
| 5x | 6x | 7x | 8x | 9X | 10x | |
| EBIT | $4.59 | $5.51 | $6.43 | $7.35 | $8.27 | $9.19 |
| . +Cash | $1.72 | $1.72 | $1.72 | $1.72 | $1.72 | $1.72 |
| . + NOL | $0.19 | $0.19 | $0.19 | $0.19 | $0.19 | $0.19 |
| . – Curr Debt | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 |
| . – LT Debt | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 |
| Value per share | $6.51 | $7.42 | $8.34 | $9.26 | $10.18 | $11.10 |
The values increase if the ttm values are used as EBIT has grown but cash is currently reduced as inventory has been built with the holiday season in full swing. It’s more accurate to use annual numbers since the CY 4Q is when most of the sales occur due to the holiday season.
Conclusion
With the share price sitting at $8.00 for a company growing sales with steady gross margins, the current multiple that the market is offering is undervaluing the company. It is reasonable for a company such as LeapFrog to sell at 10X offering upside of 37% at today’s prices. I believe that LeapFrog will compete against the new competitors very well using the strong brand that they have built up. $LF may also be a good acquisition target, and management has mentioned that they may be amenable to an offer. There may be some obstacles, as Larry Ellison (through Mollusk Holdings LLC) owns a large stake in LeapFrog. He has sold automatically over the past several years so that his stake has been reduced from years ago.
There is a lot of growth left for $LF with international expansion. Currently most of the sales are in the U.S. however they have grown the international market with good sales growth. If the products can support more languages and localization, the company can definitely grow the business outside of the English-speaking countries.
Disclosure: Long LF
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