1 Reason LeapFrog Enterprises May Be Headed for a Slowdown

Here at The Motley Fool, I've long cautioned investors to keep a close eye on inventory levels. It's a part of my standard diligence when searching for the market's best stocks. I think a quarterly checkup can help you spot potential problems. For many companies, products that sit on the shelves too long can become big trouble. Stale inventory may be sold for lower prices, hurting profitability. In extreme cases, it may be written off completely and sent to the shredder.

Basic guidelines
In this series, I examine inventory using a simple rule of thumb: Inventory increases ought to roughly parallel revenue increases. If inventory bloats more quickly than sales grow, this might be a sign that expected sales haven't materialized. Is the current inventory situation at LeapFrog Enterprises (NYSE: LF  ) out of line? To figure that out, start by comparing the company's inventory growth to sales growth. How is LeapFrog Enterprises doing by this quick checkup? At first glance, not so great. Trailing-12-month revenue increased 25.8%, and inventory increased 63.6%. Comparing the latest quarter to the prior-year quarter, the story looks potentially problematic. Revenue expanded 28.0%, and inventory grew 63.6%. Over the sequential quarterly period, the trend looks healthy. Revenue grew 170.1%, and inventory grew 118.6%.

Advanced inventory
I don't stop my checkup there, because the type of inventory can matter even more than the overall quantity. There's even one type of inventory bulge we sometimes like to see. You can check for it by examining the quarterly filings to evaluate the different kinds of inventory: raw materials, work-in-progress inventory, and finished goods. (Some companies report the first two types as a single category.)

A company ramping up for increased demand may increase raw materials and work-in-progress inventory at a faster rate when it expects robust future growth. As such, we might consider oversized growth in those categories to offer a clue to a brighter future, and a clue that most other investors will miss. We call it "positive inventory divergence."

On the other hand, if we see a big increase in finished goods, that often means product isn't moving as well as expected, and it's time to hunker down with the filings and conference calls to find out why.

What's going on with the inventory at LeapFrog Enterprises? I chart the details below for both quarterly and 12-month periods.

Source: S&P Capital IQ. Data is current as of latest fully reported quarter. Dollar amounts in millions. FY = fiscal year. TTM = trailing 12 months.

Source: S&P Capital IQ. Data is current as of latest fully reported quarter. Dollar amounts in millions. FQ = fiscal quarter.

Let's dig into the inventory specifics. On a trailing-12-month basis, finished goods inventory was the fastest-growing segment, up 68.7%. That can be a warning sign, so investors should check in with LeapFrog Enterprises's filings to make sure there's a good reason for packing the storeroom for this period. On a sequential-quarter basis, finished goods inventory was also the fastest-growing segment, up 129.7%.

Foolish bottom line
When you're doing your research, remember that aggregate numbers such as inventory balances often mask situations that are more complex than they appear. Even the detailed numbers don't give us the final word. When in doubt, listen to the conference call, or contact investor relations. What at first looks like a problem may actually signal a stock that will provide great returns. And what might look hunky-dory at first glance could actually be warning you to cut your losses before the rest of the Street wises up.

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Seth Jayson had no position in any company mentioned here at the time of publication. You can view his stock holdings here. He is co-advisor of Motley Fool Hidden Gems, which provides new small-cap ideas every month, backed by a real-money portfolio. The Motley Fool recommends LeapFrog Enterprises. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 23, 2013, at 11:47 AM, sitrader70 wrote:

    This article contradicts 2 previous articles here at fool just 2 days ago!!!!!

    I tried to get one at Amazon a week ago but it was not in stock, I signed up for an alert as to when it will be back in stock.

    This weekend I went to get a LeapPad 2 at my local Toys R Us, I wanted a pink one, guess what? Not in stock, they only had 2 green ones.

    Then finally yesterday Amazon had the pink one in stock and will give it to my daughter for her birthday in a couple of weeks.

    In December around the 15th I could not get it anywhere online or at a physical store so I was not able to give to my daughter for Christmas.

    You say that expected sales have not materialized, I don't think you have an accurate assessment but we will find out when earnings are announcement in a couple of weeks.

  • Report this Comment On January 25, 2013, at 9:36 AM, Desmis wrote:

    I’m not sure the writer of the article has any knowledge of LF at all. If he would have been following the company rather than doing a quantitative analysis in a vacuum, he would know that there is no inventory to be had, also in the past the knock on LF was it never had enough inventory to meet demand. Additionally, when looking at inventory levels, wouldn't you expect a company that does majority of their sales in Q4 to plan inventory levels accordingly. Last week the top 10 toy list came out related to the holiday season LF was 3 of the top 4 on the list.

  • Report this Comment On January 25, 2013, at 10:00 AM, Snickersnee wrote:

    This is a hackjob.

    The author clearly did not do his research and wrote a blatantly misleading article.

    Motley Fool should be ashamed of themselves for hosting such drivel.

  • Report this Comment On January 25, 2013, at 10:20 AM, forthenews1 wrote:
  • Report this Comment On January 26, 2013, at 7:28 PM, tpozz wrote:

    This guy is a smuck, it would be irresponsible for LF not to build inventory going into the holiday season - especially when LF ran out of their tablets last Christmas (I tried like heck to get my then 3-year a LF tablet). Do this same analysis for 4Q12 (post holiday) and your analysis will be completely different. LF even ran out of tablets this Christmas season.

    I can't speak what will happen to this company years from now, but the near-term and intermediate-term looks great - ie. growth, no debt, etc. This company is also a buyout candidate, earnings would be immediately accretive to Hasbro, Mattel, etc - very low valuation (11x PE) for a company projected to grow 30%. Potential share buyback in 2013/2014 assuming all continues.

    What I hate most about Motley Fool is the extreme contradictory articles. Like Sitrader70 said, this article significantly contradicts the last several articles which essentially state that this is the stock of the year.

    Regards,

    Corporate Banker.

  • Report this Comment On February 06, 2013, at 5:15 PM, sitrader70 wrote:

    Today now tells you if this story was correct, LF reported, NO PROBLEMS WITH INVENTORY!!!!!!! 2012 Income From Operations Increased 170%!!!!!!! Everyone be beware of this author as he did do any research whatsoever.

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