Is LeapFrog Enterprises, Inc. Destined for Greatness?

Investors love stocks that consistently beat the Street without getting ahead of their fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with robust and improving financial metrics that support strong price growth. Does LeapFrog Enterprises  (NYSE: LF  ) fit the bill? Let's take a look at what its recent results tell us about its potential for future gains.

What we're looking for
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: Are profits, margins, and free cash flow all increasing?
  • Valuation: Is share price growing in line with earnings per share?
  • Opportunities: Is return on equity increasing while debt to equity declines?
  • Dividends: Are dividends consistently growing in a sustainable way?

What the numbers tell you
Now, let's take a look at LeapFrog's key statistics:

LF Total Return Price Chart

LF Total Return Price data. Source: YCharts.

Passing Criteria

3-Year* Change

Grade

Revenue growth > 30%

22.8%

Fail

Improving profit margin

874.7%

Pass

Free cash flow growth > Net income growth

438.7% vs. 1,100%

Fail

Improving EPS

1,620%

Pass

Stock growth (+ 15%) < EPS growth

63% vs. 1,620%

Pass

Source: YCharts. * Period begins at end of Q1 2011.

LF Return on Equity (TTM) Chart

LF Return on Equity (TTM) data. Source: YCharts.

Passing Criteria

3-Year* Change

Grade

Improving return on equity

478.4%

Pass

Declining debt to equity

No debt

Pass

Source: YCharts. * Period begins at end of Q1 2011.

How we got here and where we're going
We first looked at LeapFrog last year. It's lost one of its passing grades in this second assessment, but it nonetheless finishes with a solid five out of seven possible passing grades. LeapFrog's revenue began to slide last year, while its net income growth continues to outpace gains in free cash flow during our three-year tracking period. Will the children's tablet specialist be able to turn its sliding top line around to earn a rare perfect score when we look at it in 2015? Let's dig a little deeper to find out.

LeapFrog suffered a gory first quarter, as parents increasingly prefer traditional tablets and online apps over LeapFrog's electronic learning toys. The only real bright spot in the quarter was that Wall Street has all but given up on the company, so even a weak performance was enough to beat analyst estimates. CEO John Barbour blamed a dramatic shift in consumer buying habits and high levels of inventory after a weak holiday season for the drop in revenue and net income.

LeapFrog now expects full-year earnings to fall closer to the lower end of its earlier guidance, as excitement for the LeapPad among children and parents continues to fade away. However, LeapFrog remains committed to rolling out new products in the second quarter, which should, if not return it to meaningful growth, at least do something to reverse its slide. Fool analyst Blake Bos notes that LeapFrog's products still occupied 15 out of the top 20 ranks for children's electronics on Amazon earlier this year, which shows a great deal of brand strength despite sliding sales. In addition, the company also expects strong international growth, with revenue from France projected to grow by as much as 40% year over year. The company's debt-free and cash-rich balance sheet also allowed it to begin a share repurchase program this year, which could help sustain bottom-line growth even if the top line continues to stall.

LeapFrog has faced fierce competition from Amazon.com (NASDAQ: AMZN  ) and Samsung, which have both made fully functional all-purpose tablets at reasonable price points, which in many cases now compare quite favorably to the LeapPad's price tag. Amazon's entry-level Kindle Fire, at $140, costs less than the $150 LeapPad Ultra, while Samsung's Galaxy Tab 3 Kids tablet, with parental controls and pre-loaded educational content, offers a robust experience for kids at a somewhat higher price point.

Fool consumer goods specialist Rick Munarriz notes that LeapFrog's recently unveiled wearable fitness tracker, the kid-friendly LeapBand, will be available in the U.S. and Canada this summer for $40. This device, which comes with a high-resolution color screen to run 50 different free apps, won't compete directly with adult-oriented products from Fitbit, Jawbone, or Nike's FuelBand, which should help the company carve out a niche in the relatively underserved kids' wearables market. The company is also expected to roll out a video game console based on its new LeapTV platform this fall.

Putting the pieces together
Today, LeapFrog has many 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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