Let’s talk about a stock that is not gracing the front pages of the Journal. Sexy biotech? Nope. Hot new IPO that everyone on Wall Street is talking about? Not even close.
The stock is Leap Frog (LF) — a developer of educational products for children. The company designs, develops and markets technology-based learnings products and related content for children worldwide.
Their primary products are LeapPad™ tablets designed for kids aged three to nine. Price points range from $79 to $149 and the tablets are accompanied by a full suite of games, apps and accessories on the back end. They also offer interactive reading systems, gaming systems, toys and iPad apps.
The stock IPO’d in mid-2002 with an opening price of $15.50. Demand was high among overly optimistic investors and shares surged 205% over the next 15 months.
Slow sales growth sent shares back to reality — plummeting 74.6% over the following year.
Leap Frog (LF) appeared to be facing extinction as it hit $1.00 per share in 2009, but the company maintained a healthy balance sheet and was able to emerge from the economic crisis.
Today’s balance sheet carries zero long-term debt. In fact the company has never borrowed money. This keeps it agile and able to withstand almost any market conditions.
The big numbers to examine with any potential grower are revenues and net income. We need to know what the company is bringing in the door and what they are able to convert to the bottom line. A quick glance at the first few line items of the company’s income statement tell the basic story.
The anticipated sales growth following the IPO did not occur, and sales actually decreased going into the 2009 depression. Since that time, metrics have improved and continue to do so.
Leapfrog (LF) earned $1.24 and $1.19 per share in each of the preceding two fiscal years. With today’s share price of $6.96, this equates to a P/E ratio of just under 6.
From a technical standpoint, it’s a bit like trying to catch a falling knife. The stock has trended downward since mid-2013 but seems to be finding support in the $7.00 area. This is no real surprise since the stock is trading at roughly book value. Half of the share price is held in cash, PP&E has already been depreciated by 70%, the balance sheet reflects minimal intangible assets, and Leap Frog carries no long-term debt as previously mentioned.
My knowledge of Leap Frog’s management team is limited. In fact, I prefer not to listen to company management at all. Quarterly earnings calls are nothing more than an investor sales pitch if you ask me. How many CEOs have you heard issue warnings that the company is in trouble? In my experience, the number has been zero. So instead of overly optimistic forecasts from motivated insiders, I prefer to judge them on corporate actions alone.
My main focus? Debt and share buybacks.
Leap Frog has maintained a debt-free balance sheet which is something all companies should aspire to. Do you know how many companies have gone bankrupt with no debt? Zero.
Buybacks have been light, however. The plus side is that it is not issuing any new shares. I would prefer to see it use more of the free cash flows to retire stock and increase per share metrics, but I’ll settle for its preference to hold it in cash on the balance sheet. It holds no marketable securities either. The risk-averse nature of the CFO puts me at ease as an investor and furthers my belief that it is prepared to withstand almost any economic front.
The largest risk I see, and what I suspect the market is factoring into the LF share price, is the relevance of toddler-oriented tablets going forward. Parents with iPads and other tablets can more easily download child-friendly games on their own devices for the kids to use. But how many parents really want their butter-fingered children handling their $700 iPad? In my view, the market for Leap Frog’s products remains strong. At $149 or less it is a fairly-priced children’s toy that will serve as an adaptive learning tool for at least the first few years of the child's life. Revenues have remained healthy and the company's products maintain valuable shelf space in preferred retailers.
From a valuation standpoint, the enterprise value/EBITDA comes in at a low 4.53. Shares trade below median P/S, the Graham number, and just above tangible book value. The simplistic Peter Lynch chart (below) better visualizes the company’s undervaluation and the stock price’s lag behind expanding earnings over the last two and a half years.
If the company remains healthy and grows earnings at just 5% per year, the stock should be worth over $16 today. Even if it never expanded and simply maintained its current level of earnings, the stock would still be trading 56% below its discount cash flow valuation of $10.86.
In my view, the stock is worth AT LEAST $14 per share which gives us more than 100% upside from today’s ask.