Is LeapFrog Destined for Greatness?

Every investor can appreciate a stock that consistently beats the Street without getting ahead of its fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with improving financial metrics that support strong price growth. Let's take a look at what LeapFrog's (NYSE: LF  ) recent results tell us about its potential for future gains.

What the numbers tell you
The graphs you're about to see tell LeapFrog's story, and we'll be grading the quality of that story in several ways.

Growth is important on both top and bottom lines, and an improving profit margin is a great sign that a company's become more efficient over time. Since profits may not always reported at a steady rate, we'll also look at how much LeapFrog's free cash flow has grown in comparison with its net income.

A company that generates more earnings per share over time, regardless of the number of shares outstanding, is heading in the right direction. If LeapFrog's share price has kept pace with its earnings growth, that's another good sign that its stock can move higher.

Is LeapFrog managing its resources well? A company's return on equity should be improving, and its debt-to-equity ratio declining, if it's to earn our approval.

By the numbers
Now, let's look at LeapFrog's key statistics:

LF Total Return Price Chart

LF Total Return Price data by YCharts.

Passing Criteria

3-Year* Change 

Grade

Revenue growth > 30%

66.2%

Pass

Improving profit margin

235.2%

Pass

Free cash flow growth > Net income growth

120.1% vs. 174.5%

Fail

Improving EPS

169.4%

Pass

Stock growth (+ 15%) < EPS growth

135% vs. 169.4%

Pass

Source: YCharts.
*Period begins at end of Q3 2009.

LF Return on Equity Chart

LF Return on Equity data by YCharts.

Passing Criteria

3-Year* Change

Grade

Improving return on equity

156.7%

Pass

Declining debt to equity

No debt

Pass

Source: YCharts.
*Period begins at end of Q3 2009.

How we got here and where we're going
LeapFrog turns in a strong performance, missing one passing grade only by a technicality -- starting from negative income can skew the final percentage increase. If the company can maintain a similar track record in 2013, it's well within reason to expect a perfect score the next time we take a look at it. But will LeapFrog be able to sustain its momentum? Let's dig deeper.

We'll start with what proved to be LeapFrog's 52-week high, way back in July. At the time, LeapFrog was valued more highly than toymakers Mattel (NASDAQ: MAT  ) and Hasbro (NASDAQ: HAS  ) , which compete for "fun dollars" from parents looking to give their kids something to do. A focus on relatively low-cost electronic entertainment has been perfectly timed to capitalize on a shift from things like Barbies and board games to tablets and the apps therein. At the time, my fellow Fool Sean Williams noted that LeapFrog's forward P/E was higher than Mattel's or Hasbro's -- today, it's cheaper than both, both on a trailing and a forward basis.

Part of the weakness between then and now can be attributed to seasonality, increasing competition, and sky-high stock growth, which tamped down revenue growth expectations into single-digit territory even though the company's line of kid-friendly educationally focused tablets took three of the top four spots on NPD Group's best-selling holiday toys list.

The competitive issue is certainly the most prominent one, so let's focus on that. LeapFrog already does battle with Amazon.com (NASDAQ: AMZN  ) and Apple (NASDAQ: AAPL  ) in the tablet space, but its consistent advantage is both a lower price point and a more specialized experience. Well-heeled parents might prefer a $159 Kindle Fire or a $329 iPad Mini, but with median incomes stagnant and the job market still weak, there should be plenty of room for LeapFrog on the low end -- unless it gets more targeted competition, as was the case this fall, when Toys "R" Us unveiled a kid-friendly tab of its own.

While the Toys "R" Us tab is about twice as costly as LeapFrog's entry-level device, it still represents a threat, depending on how good its performance and app selection happen to be. What's more threatening is Amazon's dedication to continually slashing the prices on its low-cost Fires, which are already following a well-known trendl ine that pushes the cost of Amazon electronics lower and lower with each passing year. Right now, the baseline Fire is $159, down $40 from last year's introduction. Based on that rate of reduction, it might hit $129 by year-end, and then $99 at some point in 2014. It's still a bit costlier than the LeapPad, but there's certainly some appeal for a device that parents as well as kids can use.

Putting the pieces together
Today, LeapFrog has some of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.

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Read/Post Comments (3) | Recommend This Article (5)

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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 27, 2013, at 2:08 AM, jotenn wrote:

    Great analysis of LF fundamentals, and perhaps I can add some color on the company. As a dedicated LeapFrog parent and shareholder, I can tell you that there is no comparison between the learning apps that LF offers and its competitors. LF focuses on developing great learning apps (and they have a huge number) that are also fun for their target audience of kids between 3 and 8. Our LeapPad2 is not a toy, but a real learning tool for math, reading, logical thinking, and social development. The rapidly expanding number of apps are where the profit is for LF, as they are costly ( we have spent 3X the cost of the LeapPad on apps already over the past six months), but worth every penny. I think LF's next earnings will be a pleasant surprise to shareholders, given that they pretty well sold out their LeapPads this Christmas after substantially increasing their inventory from last year. Happy investing!

  • Report this Comment On January 27, 2013, at 10:32 AM, TMFBiggles wrote:

    @ jotenn -

    Great details! Thanks for filling in the cracks of my analysis a bit.

    - Alex

  • Report this Comment On January 28, 2013, at 3:37 PM, mdvoor wrote:

    My wife just went to shop for 2 year old grandchild's birthday. She returned with 3 of 4 purchases from LeapFrog. She does not do investing, just consuming.

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