LeapFrog: Ready to jump?

This education-based toy maker is set to outperform market expectations.

By TheStockAdvisors Nov 23, 2012 9:53AM

Nicholas Monu iStock Exclusive Getty ImagesBy Geoffrey Seiler, BullMarket.com

We've been tracking LeapFrog Enterprises (LF) for possible inclusion on the Recommended List ever since we looked at the California maker of educational toys back in March, and we recently stepped up to add the stock to our buy list.

The company's basic theory is that children learn more when they are having fun, so it designs educational toys that keep them engaged. LeapFrog produces books, games, and a tablet-based learning toy it calls the LeapPad, all of which are designed to help children prepare for school and education.

It begins with electronic-learning plush toys like its Pay Pal Scout, aimed at children aged six to 36 months, which can be personalized to say the child's name and favorite things to do.

Its Tag product is the nation's top-selling learn-to-read system. Explorer is its learning game systems, while LeapPad is the top-selling learning tablet.

The shares have been beaten up despite delivering solid, Street-beating increases in revenue and profit. LeapFrog did caution its results would ultimately depend on how well its products sell during the holiday season. Management also said it planned to boost its advertising spending by 20%-25% during the quarter.

The cautious statements and the increased spending may have spooked some investors that opted to book some profits. LeapFrog began the year trading at $5.60 per share and peaked at $12.28 in late July.

The beat-down the stock has suffered is truly perplexing given the solid results, strong guidance, and the distinct possibility the company could outperform in the fourth quarter if its holiday sales are better than expected.

We can understand some investor concern about consumer-oriented stocks generally given all the noise about the "fiscal cliff" and worries it could impact consumer sentiment. Competition is another factor, but we can't imagine many parents buying iPads or Kindle Fires specifically for a five-year old.

There is always the risk the company could fall short of its holiday sales expectations, or the advertising spending could cut into margins, either of which might send the stock into another tailspin.

Financially, the company has a solid balance sheet, with 79 cents per share in cash and zero debt. Excluding its cash, the stock has been trading at roughly nine times the current-year earnings per share consensus.

The stock is cheap at this level given its growth prospects and we would suspect that it also has to be on the radar of larger toy companies like Mattel and Hasbro.

We're going to start the stock with a "buy" rating and $11 target, which is a modest 12 multiple on 2013 consensus earnings, excluding its net cash.

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