This Toy Maker Should Leap Higher in 2013

Two of the main criteria for growth-oriented investors are revenue growth and earnings quality. According to data from FactSet Research, overall revenue for S&P 500 companies is expected to have grown 2.4% during fourth quarter 2012, compared to more than a 1% decline during the calendar third quarter. The current price-to-earnings ratio for the S&P 500 is 16.5x, which is right in the middle of its historical valuation.

Although the balance sheet of corporate America is healthier than anytime in the last decade, revenue and earnings growth is expected to be very modest in 2013. At a recent CFA Society of South Florida conference, economist Don Rissmiller of Strategas reminded me that the economy needs a full 2% real GDP growth for corporate profits to break even. The Conference Board believes that gross domestic product will increase by only 1.8% in real terms during 2013, less than the requirement for baseline corporate profitability.

Given the lukewarm expectations for the overall market, I'd like to introduce readers to an individual company that experienced 25% revenue growth and record profitability during the past year. Even better, this small-cap stock is priced at an attractive 12x price-to-earnings.

Consider the case of LeapFrog Enterprises (NYSE: LF), which is dedicated to the development of educational toys for children. The Emeryville, CA-headquartered company was founded in 1995 by a technology-oriented father who wanted to help his child learn to read. LeapFrog became a publicly traded company on July 25, 2002. While the company has seen its shares decline approximately 27% since the IPO, LeapFrog is beginning to regain ground. The stock has rallied 81% in the last 5 years, including a 55% return in the last 52 weeks.

There is good reason for the market's newfound bullishness on LeapFrog, as the company has emerged as the undisputed leader in children's learning toys. LeapFrog's products simply dominate their respective categories: the best-selling kids tablet computer, learning game system, learn-to-read system, and overall electronic toy line. Although the company has only recently begun to satisfy Wall Street's strict demands, the consistency of quality and innovation in LeapFrog's products is reflected by the fact that the company has earned the Toy Industry Association's Toy of the Year award an astonishing 8 of the last 12 years.

Here are four reasons why this toy maker should continue leaping higher in 2013:

• The company recently introduced LeapPad2, a new version of their electronic learning tablet in advance of the holiday season. Channel checks indicate the toy was a top seller at retailers during the Black Friday holiday weekend in late November. While Black Friday is known for promotional pricing, LeapPad2 devices were in high demand at the $99 MSRP given a complete sellout on Amazon, Target, Toys R Us, and Walmart.
• During 2011, the company's original LeapPad became an industry best seller. Since this time, competitors simply haven't done enough to neutralize LeapFrog's new leadership in children's toys. The company's main tablet competitors are Barnes and Noble's Nook Color and Amazon.com's Kindle Fire, which are seeing low adoption given higher price points and unnecessary technology for children ages 3 through 9.
• Boutique investment research firm Monness Crespi Hardt recently initiated coverage of LeapFrog Enterprises on January 14 with a buy rating and $12 price target. Monness Crespi is based in New York City and its client base consists solely of investors seeking portfolio advice, not corporations.
• Wall Street analysts are unanimously positive on LeapFrog. The consensus analyst opinion on LeapFrog is overweight and the mean price target is $14.00. The high price target is $15 and the low price target is $12, all above the current market price. Notable value investor Karen Finerman also maintains a large position in the stock.

When LeapFrog issued third quarter results back on November 7, the company crushed Wall Street expectations on both earnings and revenue. However, the stock moved lower following the earnings release, as investors expressed concerns over increased product inventories and moderate guidance. LeapFrog had $115 million in inventories on its balance sheet as of September 30, a $34 million increase over the prior year. Analysts believe this former negative is becoming a positive as LeapFrog is able to replenish emptying shelves at toy retailers nationwide. In addition, management's initial guidance ($535 " $550 million revenue; $0.75 " $0.81 EPS) appears conservative as Wall Street is factoring in higher sales across the board.

Declining Revenue Growth in Toy Sector

LeapFrog's growth in educational learning also makes the company a compelling takeover candidate for a larger competitor, such as Hasbro or Mattel. Revenue at LeapFrog has grown a massive 25% during the last 12 months. In contrast, Hasbro's revenue declined 2% during the past year and Mattel experienced only 1% in revenue growth.

Despite the modest revenue growth, shares of Mattel are currently trading at fourteen year highs. The world's largest toy maker has a host of upside drivers for the New Year including Thomas the Train (my personal childhood favorite), Disney's Planes and Sofia the First, and Max Steel action figures. Mattel releases fourth quarter 2012 results on February 1.
In addition, the company hosts its 2013 analyst meeting on February 8.

Hasbro has seen its shares rise a respectable 19% in the last 52 weeks. Wall Street is noticeably less bullish on Hasbro going forward than either LeapFrog or Mattel, as the second largest toy maker has fewer levers to trigger for potential upside in 2013. On December 23, the Financial Times published an article titled Toymakers tremble as tots turn to tablets, reflecting the fact that Hasbro and Mattel have yet to adapt to a new normal in digital technology. Hasbro also has greater exposure to games and puzzles than Mattel, which could explain the reason for its relative underperformance and higher short interest.

Foolish Bottom Line

Overall, I believe the LeapFrog story continues to trend under-the-radar, in addition to being misunderstood and unappreciated. If history serves as a reliable indicator, Apple enjoyed tremendous success in its heyday with the introduction of the iPad 2, following a great response to the original iPad. In my opinion, LeapFrog is poised to deliver a stellar 2013 performance for shareholders as I view the LeapPad children's tablet being very similar to the iPad product line in its infancy.

LeapFrog is scheduled to release fourth quarter 2012 earnings on Wednesday, February 6. Consensus analyst estimates stand at $0.48 earnings per share on revenue of $223 million, well above management's guidance. A second near-term catalyst exists in the form of the American International Toy Fair, where the LeapPad 2 and Leapster GS have been nominated for 2013 Toy of the Year awards. The annual conference is being held February 10 " 13 in New York City.

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