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LeapFrog's Competition Heats Up

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Wall Street pros have nothing on retail investors who stake small sums of money monthly on undervalued small-cap stocks. Because the big guns mostly ignore them, these types of stocks offer the best, outsized opportunities for growth.

I screened for stocks under $3 billion in market cap, offering earnings surprises of 15% or more in the previous quarter, with long-term earnings growth forecast to be at least 15%. One stock that floated to the top was toymaker LeapFrog Enterprises (NYSE: LF  ) , perhaps best known for its line of LeapPad tablet computers for kids. It saw earnings jump 24% ahead of Zack's analyst expectations even as they still expect its earnings to grow 20% annually for the next five years. With a $535 million market cap, it easily makes it into our range for potential investment candidates.

Of course, don't jump on a stock just for those reasons. It should just be a starting point for more research as we need to look more closely to see whether analysts' faith in them is well-founded.

It's a matter of trust
When does a beat-and-raise earnings release really amount to cutting guidance? When a toy seller beats third-quarter estimates and raises its forecasts for the full year -- which leads to fourth quarter results that actually come in below last year's results.

That's what results in the start of a sell-off in LeapFrog shares earlier this month after posting earnings of $0.60 per share compared to analyst expectations of $0.42 and raising full year guidance to $0.75 to $0.81 a share. Except that means it anticipates its fourth quarter earnings to be in a range of $0.40 to $0.46 per share, not enough to meet the $0.49 it posted in the fourth quarter of 2011.

The Fool's James Brumley correctly called the anticipated collapse in its share price and just as smartly its rebound. LeapFrog's stock is up almost 30% from its most recent low point as the start of the Christmas shopping season, a hot "toy" making all the must-have lists Toys R Us to Wal-Mart (NYSE: WMT  ) , and a valuation that still offers some upside combine to make it a stock ready to leap forward.

They say a frog will allow itself to be boiled alive if you turn the heat up on it slowly. Will investors get scalded by hanging around too long?

Oh, about that margin call ...
The buzz about LeapFrog is its LeapPad 2 tablet computer for kids, which, despite significant competition from rival manufacturers, still holds mind share and market share among parents of toddlers to whom the computer is targeted. Its biggest threat is probably Toys R Us' Tabeo tablet that's powered by Google's (Nasdaq: GOOG  ) Android operating system, though as I've noted there are features that might not appeal to all parents. And though there are a slew of other tabs on the market also targeted toward kids, most will probably have a negligible impact on the LeapPad's sales.

The features of the Tabeo -- full Internet access -- are also why I wouldn't worry too much about low-cost tablets from (Nasdaq: AMZN  ) , as many parents might want to shield kids from the Internet in all its glory, parental controls available or not (the LeapPad offers kids a nice, safe, secure milieu to explore the interwebs in), though it might have dodged a bullet with Apple (Nasdaq: AAPL  ) pricing its iPad Mini well above what most analysts had expected, as it effectively removes the device even from consideration.

Besides, those aren't designed like the LeapPad is for the rough-and-tumble world of a toddler's handling of it.

Did we forget to mention this, too?
Although some investors got spooked by earnings guidance, LeapFrog has raised guidance for 2012 all year long. At the end of last year it forecasted full-year earnings of just $0.40 to $0.45  per share and then got a boost to $0.52 to $0.57  after the first, followed by $0.61 to $0.66 after the second. Its current estimates are now double what they were at the start of the year, so it wouldn't surprise me to see LeapFrog actually surpass those forecasts. In fact, the toymaker has posted 10 straight quarters of analyst-beating results.

At 11 times earnings and 10 times estimates, LeapFrog is valued less than either Mattel (Nasdaq: MAT  ) or Hasbro (Nasdaq: HAS  ) , the top two toymakers. JAKKS Pacific (Nasdaq: JAKK  ) , itself once possessing the top-selling toy on the market, has become less of an influence these days.

Yet LeapFrog's enterprise value trades at 22 times its free cash flow while Mattel goes for 20 times FCF and Hasbro trades at just 13 times its excess cash. While I like Hasbro's stock at these values (and I own its shares), I think LeapFrog can make a case for greater price appreciation based not only on the LeapPad series but on its whole portfolio of toys.

Tell me in the comments box below whether you agree LeapFrog Enterprises won't be slowly boiled by the competition.

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