LF - Leapfrog

[yudeng2004]

***Update 2/12/2013: Analyst Webcast taking place now: http://edge.media-server.com/m/p/8b63ox5z/lan/en

 

I would like to present a long case for LF (LeapFrog).

 

A brief overview of their latest quarter can be found here:

http://finance.yahoo.com/news/leapfrog-reports-2012-income-operations-210100514.html

The latest earnings call transcript can be found here:

http://seekingalpha.com/article/1162921-leapfrog-enterprises-ceo-discusses-q4-2012-results-earnings-call-transcript?part=single

 

Part 1 - The Story

A simple description of Leapfrog's business at present is that they are transforming from making traditional branded children's education products to digital forms of these products via the LeapPad, Leap explorer, and Tag Reader series.  You may get an overview of the products it sells here: http://shop.leapfrog.com/leapfrog/

 

In a way, you could see Leapfrog is sort of like Apple in a niche market, with a strong brand among parents (since they were a major children's brand even before this shift)  and being first in the trend of children's education products and toys shifting to digital forms.  Their hallmark product is the LeapPad series, essentially an iPad for children aged 5-9.  It is designed to withhold the beating young kids give to toys and is cheap at 79-99 dollars.  The money Leapfrog makes is not really from the hardware but from the software it sells through its App ecosystem including interactive books, games, and education software for children.

 

Hasbro and Mattel recently lamented that their results were negatively impacted by the shifting in consumer taste from traditional toys to digital forms and they are behind on this trend - which is exactly the trend that Leapfrog is the leader in.  As you can see from the article below, Leapfrog has 3 of the top 4 best-selling toys of 2012 and 4 out of the top 10 (they were not even in this market 2 years ago).  See details here: http://www.prnewswire.com/news-releases/leapfrogs-1-childrens-learning-tablets-and-educational-software-dominate-the-top-10-toys-of-2012-187138381.html

 

The new Leappad 2 is frequently sold out at ToyRUs, Amazon, and Walmart, and you may look at the reviews here:

http://www.amazon.com/LeapFrog-32610-LeapPad2-Explorer-Green/dp/B0089RPUHO

http://www.walmart.com/ip/LeapFrog-LeapPad2-Explorer-Learning-Tablet-Green/20926333

 

Leapfrog is also adding more 3rd party content to its offerings, such as a deal to add interactive books from Disney:

http://www.publishersweekly.com/pw/by-topic/childrens/childrens-industry-news/article/55816-leapfrog-gets-disney-e-books.html

 

The basic story is that Leapfrog is transforming from a niche in children's education into a digital education and toy company of the new age.

 

Part 2 - Analysis of Financials:

Detailed financial report is here:

http://yahoo.brand.edgar-online.com/displayfilinginfo.aspx?filingid=9060304&tabindex=2&type=html

 

The company earned 1.24 per share for 2012, and excluding special items it earned 0.95 per share in 2012.  It will likely earn something between 1.4 to 1.6 for 2013.  In the latest conference call the company stated "Our cash bond increased 67% to $120 million at the end of December and is likely heading to nearly $200 million over the next couple of months." - meaning nearly 3 dollars of cash/share at end of Q1 2013.  The valuation story here is very compelling, since you are paying basically 9 dollars for 3 dollars of cash and 1.4-1.6 dollars of earnings with no debt.

 

Inventory and Margin concerns:

In the past the company has faced concerns over inventory buildup and margin compression, but this quarter's results paints a different picture.  Basically inventory as a percentage of sales is down and margins have been maintained.  The company went into Q4 with huge inventory and advertising budget in anticipation of increased sales, but they pulled the advertising earlier since they realized they don't even need it for the products to sell out this Holiday season.  In fact their products are often sold out at all retailers and some had to put in a 2 item purchase limit per customer.

 

Part 3 - Constant short attack and the short thesis.

Leapfrog has consistently been under attack from short-sellers this past year and the bear case need to be laid out here, because I don't think you should invest in this company if you don't understand the short case, or maybe you even agree with it.

 

The short thesis has several points:

1) The product is a commodity and easily duplicable by competitors, and eventually will be replaced by low-end all-purpose tablets such as a low price Android tablet and iPad Mini, so it will soon be obsolete.

My refutation points: the commodity part is right, since one just has to add tough padding to say a cheap android tablet and you could get a device with similar capabilities.  That being said, that's not the reason why the LeapPad sell so well.  It does because it was already a trusted children's brand and parents want to make a simple and easy decision .  I would quote Buffet here:

 

Now picture yourself with a couple of young kids, whom you want to put away for a couple of hours every day and get some peace of mind. You know if you get one video, they will watch it twenty times. So you go to the video store or wherever to buy the video. Are you going to sit there and premier 10 different videos and watch them each for an hour and a half to decide which one your kid should watch? No. Let’s say there is one there for $16.95 and the Disney one for $17.95—you know if you take the Disney video that you are going to be OK. So you buy it. You don’t have to make a quality decision on something you don’t want to spend the time to do.

 

Granted LeapFrog's brand is not as strong as Disney, but the point is that the LeapPad can withstand a beating from young children, has all the apps very young children would want from a trusted brand, and has disabled web-browsing so you don't have to spend time configuring it.  So now imagine yourself giving your kids a device for them to spend a couple of hours on, are you going to research some 10 separate android tablets, find the ones that have padding, download the apps you want your kids to play with, then configure it for child safety with internet access settings etc etc.  Or are you just going to shell out 99 for a LeapPad and save yourself the trouble of all this time to get 10-20 bucks of savings?  Products for children are bought by parents, the people paying are not the end users so they want a convenience of purchase.  And LeapFrog has always been a children's brand name - one of the best - so that simplifies the decision of purchase from parents.  Plus I think the Dell vs. Apple story paints a clear picture of generic vs branded product performance.  Generally speaking, parents are more likely to buy generic products for themselves than their kids - you can't take a risk with your kids and LeapFrog products has all the features tailor made for your purchase decision.

 

2) Branded competitors:

Competitors such as ToyRUs, Mattel, Hasbro etc can create similar products and take away LeapFrog's market share.

Answer: well this would be true for any business that has high margins and is a market leader, so it all depends on execution.  We could say this about Apple in its earlier days facing competition from traditional players like BlackBerry and Nokia.  Or even right now, Netflix vs Amazon/ITunes can be put in the same light.  So if you are concerned about giant competitors, you need to take a look at how well those guys are executing.  ToysRUs did introduce their own children's tablet called Tabeo which is a flop basically.  Mattel and Hasbro admitted themselves this quarter that they are behind in the trend shift from traditional toys to digital toys, and they probably will do something about it just like every big company that falls behind.  They will either succeed or has to buy out LeapFrog to catch this trend.

 

 

3) Margin Compression and Rising Inventory:

The shorts are saying that rising inventory in the past is an indication that the company's products are a fad and sells are slowing down.  They are also concerned that LeapFrog will not be able to maintain their margin going forward (sort of the case against Apple). 

Answer: take a look at this latest quarter filings.  Inventory as a percentage of sales are down, and the Q3 inventory rise was in anticipation of the huge demand for the holiday season, all LeapPads are sold out and there were frequent shortages.  Also take a look at margins, they have maintained them, since they make a lot from content and software, so it's not like they are in the same business as Dell.

 

Special Downside Risk:

This stock is generally under high manipulation by the short sellers (sort of like Fairfax back in the day).  Just this morning after a 6% run-up, a "flash crash" occurred in about 2 minutes crashing the stock from +6% to -8%.  This crash took out all stop-loss orders on the exchange.  This also happend at the end of Q3 earnings as well, so although this is Leapfrog's best quarter ever, the stock may not move up for a long time.  Now the stock has recovered from the flash crash but will likely be kept at low prices to allow shorts to either exit or set up some other price-movement game they are playing.  The company has a habit of lowballing every guidance by a lot, sort of like Apple, and does not buyback shares when they are under short attack, meaning the float can be easily manipulated.  This is probably the 2nd most manipulated stock I have ever owned after Fairfax during its worst years, so you should probably take into account your own tolerance for this kind of stuff before you invest.

 

Special Upside Possibility

Leapfrog is the perfect acquisition candidate for companies like Mattel or Hasbro, or possibly even Disney.  These companies are behind in the new trend, and there is a possibility that one of them feels they need to do something to catch up through an acquisition.  LeapFrog's market size and their leading position makes them the ideal candidate.  Even if one of these big names executes well by itself, the other ones will likely feel even more pressured to catch up through an acquisition.  However, the stock is just fine even if they never get acquired - they are just very ideal for it.

 

 

In Conclusion:

Leapfrog is leading the education and toys market transformation from traditional forms to digital forms.  It trades at 9/share, will have 3 cash/share at end of Q1 2013, and will earn 1.4-1.6 this year.  It has the best-selling toys of all 2012, owning 3 of the top 4, and 4 of the top 10.  It is executing much better than any of its competitors and has a longshot to be acquired by a bigger name wanting to get into this new market.

 

Please study both the long and short case and make your decision wisely.

[rockket]

nice write up, interesting opportunity.

 

as for the two main bear points (undifferentiated, inevitability of competitive entry):

 

1) do you have any reason to believe what you suggest (ie the convenience value of leapfrog's brand) is playing out?

 

some links for consideration:

 

http://forums.redflagdeals.com/ipad-mini-vs-leappad-2-a-1247541/

 

http://www.dcurbanmom.com/jforum/posts/list/272254.page

 

 

2) do you think leapfrog has any competitive advantage versus the other Mattel/Hasbro other than a first-mover advantage? perhaps the educational focus? given leappad's relative youth and the fact that leapfrog didn't have any real technology background for this initially, i'd think that the replication cost for the pad would be relatively low.

 

 

also any views on valuation?

 

thanks,

rk

[yudeng2004]

nice write up, interesting opportunity.

 

as for the two main bear points (undifferentiated, inevitability of competitive entry):

 

1) do you have any reason to believe what you suggest (ie the convenience value of leapfrog's brand) is playing out?

 

some links for consideration:

 

http://forums.redflagdeals.com/ipad-mini-vs-leappad-2-a-1247541/

 

http://www.dcurbanmom.com/jforum/posts/list/272254.page

 

 

2) do you think leapfrog has any competitive advantage versus the other Mattel/Hasbro other than a first-mover advantage? perhaps the educational focus? given leappad's relative youth and the fact that leapfrog didn't have any real technology background for this initially, i'd think that the replication cost for the pad would be relatively low.

 

 

also any views on valuation?

 

thanks,

rk

 

I think the CEO addresses some of your questions here:

http://www.bing.com/videos/watch/video/leapfrog-tablet-apps-are-made-for-kids-ceo-says/2jivhj67t?from=

He mentioned that LeapFrog's apps are all made by child education experts, and Leapfrog's products are award-winning child education products.  This is a competitive advantage since we are not talking about say, a video game app here where it's all about having the most fun.  For kids, we have to think about which products has the best chance to increase their learning, instead of just letting them play angry birds all day long.  A well-developed child education app is like a tutor in a sense, were you let them spend time and you know they are getting a good use of their attention span. Leapfrog products has built-in features that let parents track of their child's development progress.  It offers peace-of-mind that the child is learning something with their time.

 

To your first point on consumer product comparison:

Well, the evidence would simply be the incredible sales LeapPad has and continue to have.  But to address the links you mentioned, choosing between Leappad, iPad Mini, and Kindle Fire has a lot of people preferring the iPad Mini.  The main arguments for iPad mini would be:

a) your kid can grow with it since it has functionality and variety even a 10+ year old or even yourself could use. 

So most parent would make a decision to buy an iPad mini for their pre-schoolers with the idea that they wouldn't outgrow it?  While I think rational and long-term thinking parent would think about this (which would be most value investors because this is how most value investors think), I seriously doubt the majority of parents think 5 years down the road when they buy a toy for their pre-schoolers.  To most parents, Leappad 2 is just a toy they can let their child to spend time with and know the material on there is safe and specifically made for children.  I think over time I learned that on consumer forums, the people on there are the type who do extensive research and active forum participants are generally not representative of the crowd.

 

I actually bought a LeapPad 2 for my 5 year old nephew for exactly this reason.  I don't want to spend too much time on this research, it was 99 bucks and the reviews on Amazon was great, there were hundreds of reviews.  So I bought it.  I did not go through the "find a consumer forum, talk to people, plot out actual cost, think about 5 years down the line" thinking process.

But this is MY POINT OF VIEW, so I think for this question you have to decide yourself which type of people is more representative: A) those who are sophisticated enough to research about those things or B)are they people like me who don't want to think about these things. 

 

Remember we are value investors and we have a tendency to be biased toward arguments that are rationalized and ignore the fact people generally are not optimal when they make purchases.  Convenience > optimization for most people.

 

Heck I got a Kindle PaperWhite for my uncle and I know the Fire HD is a better value proposition and he already has an iPad.  I know he likes to read and PaperWhite is superior for reading and worse at everything else.  So what? It's not something am gonna spend time to debate over.  He'll have uses for the PaperWhite from time to time and that's enough.  There are plenty of people like me as evidenced by PaperWhite sales.

 

So instead, why don't we just follow reality and look at the fact that Leappad 2 is often sold out and has great reviews at Amazon and Walmart?  Does the imagined rational debate paint a clearer picture or does the actual sales record paint a clearer picture?

 

b) the ipad mini is 329 + 15-30 apps at 0-5/each would be the same cost as LeapPad 2 at 99 plus 15-30 apps for the LeapPad 2 at 5-25/app. 

I have some counter-arguments to this:

  1) what if I only have 150 to 200 bucks? I can't even buy the Mini.

  2) initial low cost of 99 is a great purchase incentive, that's human psychology.  It's cheap at the purchase time.

  3) if I buy this as a gift, 329 is a lot to pay

  4) Ipad mini is a delicate device and I would hate for a kid to break it (even with a casing the mini is not specifically made for taking a beating).  Breaking the mini = lost 329.  Whereas breaking a Leappad 2 = lost 99.  When handing a toy to a kid, a lot of people will think about the downside more than the upside.  The mini may offer more upside if you can afford it, but it is also more risky.  And what about people who don't even know you could get a casing for the mini?  How much does the casing cost?  Again - that's just more things you have to think about for a purchase.

 

To conclude - am not taking my value investing habits and projecting it toward how people make purchase .  Thus I would avoid shorting say LuluLemon or Chipotle, as I believe consumer demand is the best evidence, as opposed to rationalized arguments.

 

On your 2nd point about Mattel/Hasbro competition:

To decide Mattel/Hasbro can easily duplicate what Leapfrog has done is to me pure speculation.  Those two are traditional toy companies, and have not yet demonstrated their capabilities in this area.  So what can we use to decide whether they can or cannot compete in this market?  Toys R US is as big a toy brand as there is, with huge distribution, and their Tabeo tablet based on Android can't stand a fight againt LeapPad.  That's what happened.  Could Mattel/Hasbro eventually take over this market?  I have no clue, and I can't speculate either way.  I just know for a fact that they are behind and Toys R Us has failed so far.  I will just admit am not smart enough to know these things.  But my experience observing market paradigm shifts does not give me much confidence in lagging big companies.  I mean look at Kodak sailing off the cliff when the digital age came, or Nokia and Blackberry with the smartphone market.  Or even Walmart vs Amazon - heck Walmart pioneered the modern day supply chain management system, with their own trucking network, satillites, the 2nd biggest database in the world after the Pentagon - all they had to do was build a website.  Now in HINDSIGHT, we could say well of course Walmart couldn't have competed against Amazon, it's not just about building a website.  But back then without knowing the future, you could easily make the argument "Amazon will just die if Walmart built a website".  People said this about Itunes econsystem too in its early days, they said well Microsoft can easily crush Itunes ecosystem with their media centers or XBox network or whatever. 

 

I mean these are all fair arguments and I don't have the answers to them. I tend to not have a lot of trust in big companies who fall behind, but that's just me.  I just know what am seeing now, which is Leapfrog is executing better than all of them.  If you find any evidence that show Leapfrog can be crushed by Mattel/Hasbro/ToysRUs etc, I'd like to know as well, since that would certainly be a real dent in this investment thesis and I would need to think about it more.  But the reality is we won't know unless we actually see these other companies execute.  So I'll focus on what I do know.

 

On your point about valuation:

2012 EBTIA was more than 90 million, this year will be higher, likely 110 million or so.  At end of Q1 there will be 200 million on the balance sheet.  International sales are growing rapidly, up 38% last year, and they are really focused on international expansion of their products this year plus introducing next generation of their products.  They said they don't expect new product development or operation expansion to have any impact on their margins in the latest conference call.

 

Realistic: 18/share at 9 x EBTIA + cash at end of 2013.

 

Conservative: 15/share at  7 x EBTIA + cash at end of 2013

 

Optimistic:  25/share  at 12 x EBTIA + cash at end of 2013

[mcliu]

Good write up.

 

What's the reason behind the poor performance between 2003 and 2010? Declining sales, poor margins.. Margins bottomed in 2006. Why did the sales drop off by so much in 2006 and 2007?

 

Not sure if 7x EBITDA is being conservative. Given the historical volatility of the business and the threat of competition..

[yudeng2004]

Good write up.

 

What's the reason behind the poor performance between 2003 and 2010? Declining sales, poor margins.. Margins bottomed in 2006. Why did the sales drop off by so much in 2006 and 2007?

 

Not sure if 7x EBITDA is being conservative. Given the historical volatility of the business and the threat of competition..

 

They were a different business from 2003 to 2010, completely different types of products and service model back then.  A lot of their margins now comes from content and software distribution, which they didn't have back then.  Take at look at Netflix - which went from a mail-order type of business to a streaming business, so looking at historical data on Netflix doesn't make a lot of sense, and wouldn't for LeapFrog either.  For these companies you have to look at their current market and the future.  I don't think LeapFrog's new business model is nearly as volatile as their historic model, they'll keep upgrading to the next generation of their new product lines - LeapPad 2 -> LeapPad 3 etc etc and make money from content and software distribution.

 

For the valuation, it's because this entire market is growing, we are at year 2 of the children's tablet market transformation, and Leapfrog just got started on international operations.  7x for me is conservative if you take into account that this entire market is growing rapidly for the next few years.  For the threat of competition, I think that's dependent on your own views there.  I don't see any evidence the competition is doing so well, but if you think they are a big deal you could of course assign a lower valuation, that's what makes a market.

[DCG]

For the valuation, it's because this entire market is growing, we are at year 2 of the children's tablet market transformation, and Leapfrog just got started on international operations.  7x for me is conservative if you take into account that this entire market is growing rapidly for the next few years.  For the threat of competition, I think that's dependent on your own views there.  I don't see any evidence the competition is doing so well, but if you think they are a big deal you could of course assign a lower valuation, that's what makes a market.

 

In my experience with my daughter and with other friends with kids, kids don't want Leapfrog tablets - they want iPads.

 

We tried getting our daughter a LF tablet. She didn't fall for it, and is obsessed with our iPad.

[PLynchJr]

Agreed about iPads being what the kids want.  My 2 year old son is the same way.  Loves the iPad.  Doesn't touch our Leapfrog laptop / tablet thing.  I hear the same thing from other parents.

[Kraven]

Agreed too.  We have some Leapfrog stuff and the kids do play with them, but if we let them have the Ipad they would much prefer that.  My daughter actually calls her Leapfrog tablet her Ipad.  She knows it isn't one, but pretends it is.

[enoch01]

Thanks for the writeup.

 

We bought leappad 2's for our kids for Christmas (one is 6, the other will be 3 soon).  Both kids love the devices, although the younger one isn't really old enough to get much out of it yet.  We like them partly because the kids have each dropped them about 15 times since Christmas, with no problems. 

 

We don't have ipads, otherwise I'm sure they'd gravitate towards the ipads and away from the leappads.  But then again, I'm pretty sure if we had an ipad in the house it would already be damaged.

 

FWIW.

[rkbabang]

This is a trend that will have an inpact on LFs buisness.  People are having fewer and fewer children and the more money they have the fewer children they have. (Of course this could be reversing cause and effect somewhat).

 

Middle Class and Affluent America Has an Informal One Child Policy and it is leading to big problems

 

"College Educated white couples in the United States have a fertility rate of 1.6 while in China with an oppressive one child policy has a fertility rate of 1.54.

 

Everything about modern life—from Bugaboo strollers to insane college tuition to government regulations—has pushed Americans in a single direction, making it harder to have children. And making the people who do still want to have children feel like second-class citizens.

 

Mexican Immigration has cratered and will be insignificant in the Future

 

Pew Research has shown that net migration from Mexico has fallen to zero and possibly is a net outflow back to Mexico.

 

After four decades that brought 12 million current immigrants—most of whom came illegally—the net migration flow from Mexico to the United States has stopped and may have reversed.

 

In the 1960s Mexican women had an average of seven children each; now they have only 2.4, and before 2020 the number is expected to drop below two."

 

[yudeng2004]

This is a trend that will have an inpact on LFs buisness.  People are having fewer and fewer children and the more money they have the fewer children they have. (Of course this could be reversing cause and effect somewhat).

 

Middle Class and Affluent America Has an Informal One Child Policy and it is leading to big problems

 

"College Educated white couples in the United States have a fertility rate of 1.6 while in China with an oppressive one child policy has a fertility rate of 1.54.

 

Everything about modern life—from Bugaboo strollers to insane college tuition to government regulations—has pushed Americans in a single direction, making it harder to have children. And making the people who do still want to have children feel like second-class citizens.

 

Mexican Immigration has cratered and will be insignificant in the Future

 

Pew Research has shown that net migration from Mexico has fallen to zero and possibly is a net outflow back to Mexico.

 

After four decades that brought 12 million current immigrants—most of whom came illegally—the net migration flow from Mexico to the United States has stopped and may have reversed.

 

In the 1960s Mexican women had an average of seven children each; now they have only 2.4, and before 2020 the number is expected to drop below two."

 

What about the trend that tax break is over and discretionary income will be down?  I think these macro trends take decades and other factors trump them.

 

I went back to read short thesis, forums, shopping guides all the way to the 2011 comparing iPad, then iPad mini, to LeapPad, I think we are making the mistake of making this a "Either this OR that" fight.  We are putting them in the same ring even tho one is a Toy Tablet with an education focus to it, has a low baseline cost, and is tough; the other is a more capable all-purpose tablet that is more expensive, is delicate (even with the casing it's not safe from child's temper tantrums is some parents' reviews), and can grow with child since they would still be able to use it when they get older.  Are these really the same market segment?

 

LeapPad 2 and its competitor's products were all out there this past Holiday season, how come LeapPad 2 still sold out like nuts?  I mean we can dig up arguments either way but how come the actual sale numbers show that LeapPads were in great demand even with these other products out there?  I am guessing we could say these people must be nuts and not making a great purchase decision and will soon regret it.  But then I go read the reviews on Amazon and Walmart, I just cannot conclude from the reviews and the actual sales data that iPad mini is a LeapPad killer. 

 

It's just interesting to me that we are not discussing say market saturation, growth potential left etc etc, but we are discussing why LeapPad may fail against these other products - but these other products were all out there this Holiday season, how come LeapPad 2 broke records and had constant shortages?  The reviewers on Amazon and Walmart must be nuts or paid by LeapFrog?

 

I would like to invert my investment thesis, so I would like to hear an argument against the latest sales data.

 

[rkbabang]

I would agree with that.  I wouldn't let a 2 year old have unsupervised access to my ipad.  It really is a different type of device, used for a different purpose.

[mcliu]

How proprietary do you think LeapFrog's software/hardware is? What prevents a Hasbro/Mattel from coming up with their own products? I don't think that's a factor that should be dismissed. Sure they may not be executing, but they may just as easily come up with the next "LeapPad" and you would be exposed to permanent impairment in the value of LF.

 

Sorry about the general question, I'm ramping up on the industry. This is looking quite interesting for a short-term investment, but I'm having trouble wrapping my mind around the competitive advantage of this company. One thing that's worrying is the "fad" associated with the product.

[yudeng2004]

How proprietary do you think LeapFrog's software/hardware is? What prevents a Hasbro/Mattel from coming up with their own products? I don't think that's a factor that should be dismissed. Sure they may not be executing, but they may just as easily come up with the next "LeapPad" and you would be exposed to permanent impairment in the value of LF.

 

Sorry about the general question, I'm ramping up on the industry. This is looking quite interesting for a short-term investment, but I'm having trouble wrapping my mind around the competitive advantage of this company. One thing that's worrying is the "fad" associated with the product.

 

 

I spent the last 2 days doing more research so I can answer your questions more thoroughly.  Here is the quick take:

1) This is definitely not a fad

2) LeapFrog has strong competitive advantages

3) Mattel/Hasbro threat is actually not that material, other concerns trump this competitive concern

 

 

1) This is not a fad

The biggest concern people have with LeapFrog is that it seems like a "fad" product company - after more research and some mental exercise  I concluded this is simply wrong.  The way I thought about was first asking the question "Is the children's tablet market itself a fad?".  The answer clearly is no - while children's tablet market is BROADLY CATEGORIZED under toys - it really is a segment of child edu-tainment. People made the mistake of thinking this is just a new toy, and next year the kids will love some other kind of toy - that's because this is being compared to pure toys like Barbie or Lego - which is wrong.  To me, children tablet is actually the new trend and ideal form factor for child edu-tainment and is clearly a growth market in this category.  I think children tablets are here to stay for the foreseeable future, but if you believe children tablets is a fad market in and of itself, then don't read on and don't invest in LeapFrog.

 

Now we have established that children tabletis the new trend that's here to stay, let's look at:

2) LeapFrog's competitive advantages in this new market and what made them the leader

An online survey on Squidoo asked parents the most important factor for choosing a child learning tablet, the top factor was High quality educational software(38.4%)" and "Good range of inexpensive apps to download (24.2%)".  What about technology/hardware? We have Long battery life(4.2%), Lightweight and easily portable (3.2%), Ability to play your own videos(9.8%), Support for SD media card for additional storage (1.8%).

 

So parents are mostly concerned with the quality of education their kids can get, and tech/hardware doesn't matter to them.  This led me to the next mental exercise "If I were a parent, how the heck do I determine the quality of education software?".  I think this is where LeapFrog shines and where we can draw parallel to what Buffet said about how parents choose to buy a Disney video for their kids.  Let's pretend that Mattel/Hasbro actually came out with their own tablet just for this exercise sake:

 

Imagine you are a parent shopping for a children tablet, you go on to Amazon or Walmart, and on there you see this one product - the LeapPad 2 - that has many times more reviews than the next best thing in this category.  You see that it won Toy of the Year in 2011 and 2012 in the child education category. You see that it won the People's Choice award for 2012 Toy of the Year.  You see this intro about the brand "LeapFrog learning games, apps and eBooks are  designed by our in-house educational experts and grounded in the latest research for the richest possible learning experience", and with a little more research you find that it has won a boatload of industry awards AND parent choice awards for child edu-tainment.  Then you see this other tablet - the InnoTab 2 - that actually has similar hardware capabilities as the LeapPad 2 AND IS CHEAPER - but isn't as decorated in awards.  Then you see a brand new tablet from Mattel/Hasbro that doesn't have many reviews since it is new, but you may know Hasbro/Mattel from famous brands like Barbie, Monopoly, and GI Joe, and Jurassic Park games.

 

Now imagine the most simple subconscious thought happening here for shoppers:

"From the makers of Barbie/Monopoly/GI Joe comes this new tablet for kids - you can do so much with it!"

"From an innovative company comes the next generation of child tablet the InnoTab 2 - cheaper than any other tablet of similar capability!"

"From the leading child edu-tainment brand with numerous industry and parent choice awards, comes the winner of Education Toy of the Year 2011 & 2012, People's Choice Best Toy of the Year 2012 - the LeapPad!"

 

I did this mental exercise with myself then asking several people - because I am certain the above is the most key and blatant message most people end up forming in their minds - and I now understand why LeapFrog has been leading this category and will continue to lead this category.  For every award they win, for every "best-selling" they can put in their title or description, their brand and mind-share expands (It just won yesterday yet another Education Toy of the Year and People's Choice Toy of the Year(any category) at the 2013 Toy Awards, so it actually INCREASED ITS MIND-SHARE & BRAND didn't it?)

 

Again I go back to Buffet: he said people will not watch every video out there to select the best one for their kids - so they buy the Disney one based on brand.  The InnoTab 1 and 2 were out there as the cheaper alternative of LeapPads. Then the iPad Mini - technologically superior and many children prefer it, not cheap but not back-breaking either - was out there this Holiday season.  Then LeapPad still marches on to record sales and had constant shortages.

Cheap alternative - could not stop it.

Technologically superior - could not stop it.

But this confirms the results of the survey earlier - that technology, or even cheapness, is not important here.  Mind-share and brand is more important, evidenced by the fact that LeapFrog pulled its advertising campaign earlier in November because it realized LeapPads were going to sell out and they didn't even need to spend all of its ad budget.

 

You know what is the mistake we have all been making debating about the LeapPad and its alternatives?  We are assuming people want to make a choice (and we are investors so we do this all day, we compare and we dig and we research). But guess what?  MOST PEOPLE WANT A CHOICE TO BE MADE FOR THEM.

 

Think deeply about what goes on in most parents' SUBCONSCIOUS when they see words like "Best-Selling", "in-house educational experts", "Education Toy of the Year", "People's Choice Toy of the Year" .  Put yourself in THEIR shoes and drop your habit of conscious comparison and research, It's not so hard to see the competitive advantage now is it? 

 

3) Mattel/Hasbro threat is actually not that material, other concerns trump this competitive concern

Mattel/Hasbro are conglomerates that own various unrelated toy product lines.  They are like Electronic Arts for video games or Proctor & Gamble for household items.  So just because they are huge and big players in the BROAD toy market, doesn't give them any advantages in the new growing segment of children tablets.  Would you say EA has any advantage over Blizzard for making massive online games when Blizzard was making World of Warcraft?  EA had way more sales and profit than Blizzard before WoW came out.  Would you say P&G has any advantages over a particular product category like say men's deodorants?  Can P&G really stop the rising popularity of Axe deodorants?

 

So what gives Mattel/Hasbro - makers of Monopoly, Barbie, GI Joe and other famous physical toys - any advantage at all over LeapFrog in the category of children tablets?  Or even more important - which existing brands that they own can they actually leverage here? Barbie? Monopoly?

 

Now compare:

Company A is small and has focus and history on interactive child edu-tainment products, with numerous industry awards and best-sellers in this category

Company B is huge and has various famous brands of physical toy product lines in all sorts of categories.

 

Now how exactly does B have an advantage over A for this new market segment?  In fact, shouldn't we instead be asking Mattel/Hasbro the question - what exactly is THEIR competitive advantage here?  Why are they MORE UNIQUELY SUITED for this category than LeapFrog?  My answer is I don't think they are.

 

Now comes the size question - is the bigger player at an advantage over a smaller player?  I don't think so either because for this category, it's about the brand of edu-tainment, as opposed to the technology, it's not like Intel vs. AMD.  It's also not like say Netflix or Amazon where you must pay huge upfront costs to establish your competitive position.  LeapFrog has 200M of cash, that's plenty for this category they are the leader in, in fact they didn't even need to spend all their advertising budget this past quarter, they sold out before they ran through the ad budget.  If LeapFrog is now trying to compete on a different turf like say Lego or something, that would be different.  But LeapFrog is not playing the "who can become the biggest toy conglomerate" game, so the capital and size issue here is irrelevant.

 

The real concerns I have with LeapFrog are:

1) They are slow on international expansion thus they may allow some foreign copy-cat to be first-to-market in their local turf. 

2) Another concern I have is LeapFrog should test lowering the price of some of its apps, since the survey said that abundance of cheap apps is 2nd most important factor after the quality of the education apps.  They should do more testing of volume vs price and I am sure they can do a better job before sticking a 25 buck price on some of their apps.  They might realize they can get more revenue through more copies sold. 

3) They are too conservative with inventory after they found out last November that LeapPads were going to sell out.  If they already knew that, why not order more inventory?  They say some of that sales is being made up in Q1 now, but that's BS since not everyone make up holiday gift shopping in Q1 because they probably chose to buy other gifts when they couldn't get a LeapPad, so some of those Q4 sales are lost forever.  The CEO himself said that they did leave some revenue on the table - that's just poor execution.

4) They don't do stock buybacks when valuations gets low.  Apple is setting a poor example here and maybe they consider Apple their idol or something.  It's just stupid not to do it when your valuation get that low and you have so much cash you can't actually spend.

 

I suppose some execution leeway should be given for leading such a new market.  But still, I am sure a more seasoned management could have done a much better job of optimizing the returns!  I wish some activists sit on their board and forced buybacks too.

 

I hope I have answered your concerns and feel free to poke at this from different angles.

[yudeng2004]

Leapfrog Analyst Presentation webcast happening right now: http://edge.media-server.com/m/p/8b63ox5z/lan/en

 

There are some good stuff in there, key emphasis here is they are entirely focused on Child Education.  That's just a niche they dominate and nobody else is even close to their brand in this category.  I think it answers a lot of the concerns people have about competitors - remember those guys are general Toy companies, not education focused.

 

[rockket]

re: your initial valuation, how do you come to your $1.40 EPS estimate for next year? consensus seems to be much lower, though that's partly because they're factoring in taxes. also management is guiding for 10% growth for next quarter - how do you arrive at your growth assumptions?

 

also on the point of taxes, how do you think about the tax benefit that they've been receiving? seems like normalized EPS should be closer to ~$0.60/share. would it be safer to just discount their tax assets and treat them as cash rather than factor it into their earnings?

[no_free_lunch]

I have some counter-arguments to this:

  1) what if I only have 150 to 200 bucks? I can't even buy the Mini.

  2) initial low cost of 99 is a great purchase incentive, that's human psychology.  It's cheap at the purchase time.

  3) if I buy this as a gift, 329 is a lot to pay

  4) Ipad mini is a delicate device and I would hate for a kid to break it

 

1,2,3) It is possible that within 2-3 years you will be able to buy an android tablet for $100 or less.  The RIM tablet was on sale for $200 this last year. You can buy a smart-phones with a cameras and 3" screen for $100 today.  We can debate the timing but prices will continue to decline on these devices and this will push the price of the leapfrog products down.

 

4) Competitors will design tougher devices.  As well there are already materials that protect an ipad/android tablet, these will likely get better as time goes on.  Tougher tablets will have a market beyond children's use, people are going to want to take their tablets with them just in general.  Manufacturers will respond by making sturdier versions.

 

In addition there are hundred of thousands of apps for android.  The selection for leap frog producs is much more limited.  Many android apps are free, most are $3 and under.  Charging $25 per title just isn't going to cut it.  Already the video game industry is getting whacked and being forced to find alternative sales methods, I think the same thing will hit leapfrog.  I think there will be a lot of educational titles, if there aren't already on android going forward.

[yudeng2004]

re: your initial valuation, how do you come to your $1.40 EPS estimate for next year? consensus seems to be much lower, though that's partly because they're factoring in taxes. also management is guiding for 10% growth for next quarter - how do you arrive at your growth assumptions?

 

also on the point of taxes, how do you think about the tax benefit that they've been receiving? seems like normalized EPS should be closer to ~$0.60/share. would it be safer to just discount their tax assets and treat them as cash rather than factor it into their earnings?

 

Management have sandbagged their guidance every quarter the past 2 years by a lot (they must think beating guidance can get their stock higher, but when they sandbag to the point of inaccuracy, it just adds to more confusion).  On average LF beat analysts expectations by over 20% the last 2 years.  They will have a lot more than 10% growth, they are going after international markets this year heavily, French, Germany etc etc.  Management need to realize that guiding accurately is a good way to build faith, it's not good to confuse people either way.

 

They won't be paying taxes for a few years, and you don't have to use the tax benefit in the multiple.  However, do realize the tax they are not paying means it goes to the balance sheet.  So just subtract the tax benefit for the multiple, then realize by Q1 of 2014 they'll likely have more than 300 million of cash on their balance sheet.

 

[yudeng2004]

I have some counter-arguments to this:

  1) what if I only have 150 to 200 bucks? I can't even buy the Mini.

  2) initial low cost of 99 is a great purchase incentive, that's human psychology.  It's cheap at the purchase time.

  3) if I buy this as a gift, 329 is a lot to pay

  4) Ipad mini is a delicate device and I would hate for a kid to break it

 

1,2,3) It is possible that within 2-3 years you will be able to buy an android tablet for $100 or less.  The RIM tablet was on sale for $200 this last year. You can buy a smart-phones with a cameras and 3" screen for $100 today.  We can debate the timing but prices will continue to decline on these devices and this will push the price of the leapfrog products down.

 

4) Competitors will design tougher devices.  As well there are already materials that protect an ipad/android tablet, these will likely get better as time goes on.  Tougher tablets will have a market beyond children's use, people are going to want to take their tablets with them just in general.  Manufacturers will respond by making sturdier versions.

 

In addition there are hundred of thousands of apps for android.  The selection for leap frog producs is much more limited.  Many android apps are free, most are $3 and under.  Charging $25 per title just isn't going to cut it.  Already the video game industry is getting whacked and being forced to find alternative sales methods, I think the same thing will hit leapfrog.  I think there will be a lot of educational titles, if there aren't already on android going forward.

 

The products you mention were already out there this past holiday season, one was the cheaper InnoTab 2(and this is already a 2nd generation product) at 79 specifically geared toward children, it is 20 bucks cheaper and had similar capabilities compared to LeapPad 2.  Last fall Toys R US, a major toy brand, introduced their android-based tablet called Tabeo for 149, it had all the good stuff Android offers, and who is better than Toys R US to introduce a new toy?

 

The sales result was the LeapPad 2 was constantly sold out. 

 

Also please read the entire thread, in the latter posts I addressed why LeapPad sells out against the competition.  The hardware is not what makes the money anyways, it's the content.  You say charging 25 is not going to cut it - this past Holiday season parents could have gotten the Android-based Tabeo and get all these free to low priced education software from the Android app store - that was not enough to entice them away from LeapFrog products.  It wasn't because LeapFrog spent a ton of money on marketing either - they pulled their marketing early in November when they realized they were going to have great sales this Holiday season and saved a bunch of advertising dollars.

 

I am confident that most parents make decisions based on: number of reviews and review score, awards won, and overall brand association with child education, as opposed to the other factors you mentioned. 

 

I am also confident that value investor parents, with their habit of research and comparison, are likely to make decisions based on the factors you mentioned.  Actual sales data and survey results prove that they are in the minority.  The majority of parents do not make decisions that way.

 

Value-for-money is great for picking stocks, not so great if you want to understand various consumer behavior. When it comes to education-related decisions, value-for-money is not how most people think.  Just look at college tuition as rising percent of income and the rising student debt.

 

Just two days ago at the Annual Toy Fair, the toy industry introduced the "People's Choice Toy of the Year" award for the first time (previously all awards were chosen by experts in the industry).  LeapPad was the first winner of this award ever.  They won the industry award for Best Education Toy of the Year as well.  They just increased their brand value and mind-share.

 

Next holiday season when people shop for children tablet, they see more awards, more reviews for LeapFrog products vs all these unknown products out there.  It's an easy decision for them.  I am convinced this is all about mind-share and come next holiday season we'll see if I am right.

[mcliu]

I'm still not comfortable at the valuation/sustainability of this company. Took a look at the tabeo/innotab and they all look quite similar. You can probably say LP2 is better than those tablets right now given the proprietary games, etc. The problem is, you can't ever know whether the Innotab 2 or Innotab 3, say two years from now, will be significantly better/worse than LP3, or whether there will be so many tablets in the market that it saturates the niche that LP2 was looking for. High profit margins/ROIC attracts competitors..

Isn't it too soon to jump to conclusions based on a year of record results?

[rkbabang]

4) Competitors will design tougher devices.  As well there are already materials that protect an ipad/android tablet, these will likely get better as time goes on.  Tougher tablets will have a market beyond children's use, people are going to want to take their tablets with them just in general.  Manufacturers will respond by making sturdier versions.

 

I disagree with this for the most part.  Yes, they might get incrementally better, but I don't see the demand for a full featured tablet,  a phone, or laptop that is designed to be used by adults and teens yet built to withstand the abuse of also being used by a 2-4 year old.  Cell phones, in one form or another, have been around for 40 years and common for almost 20 years, yet they are as delicate as ever. If you spill something on it, drop it, or throw it down the stairs or against the wall it will break.  In the end, most smartphones and tablets are products designed to be used by adults and teens not by toddlers.  I don't see that changing any time soon.

 

[wknecht]

A couple beginner LF questions:

• It seems 73% of their revenue comes from the multimedia division. Is this more or less all attributable to the one product (and the variations)?
  
• What is their relationship with Disney like? Seems they have done a couple small deals together, anyone know LF's goals here?
  

[yudeng2004]

I'm still not comfortable at the valuation/sustainability of this company. Took a look at the tabeo/innotab and they all look quite similar. You can probably say LP2 is better than those tablets right now given the proprietary games, etc. The problem is, you can't ever know whether the Innotab 2 or Innotab 3, say two years from now, will be significantly better/worse than LP3, or whether there will be so many tablets in the market that it saturates the niche that LP2 was looking for. High profit margins/ROIC attracts competitors..

Isn't it too soon to jump to conclusions based on a year of record results?

 

It's been two years, both the InnoTab and LeapFrog has had two iterations.  And I keep on stressing that from surveys and sales results, its not about the tablet itself.  It is about how parents shop.  Did InnoTab win any parent choice or industry awards?  Does it have more reviews and better reviews from consumers?  That's what I am stressing, is that the more reviews you get -> the more buyers -> more parent choice awards -> more reputation -> more buyers -> more reviews -> more rewards.

 

In a niche market that is like child education, most parents will not go and spend the time reviewing every app, every tablet.  They can make an easy choice with LeapFrog.

 

I predict that even if Tabeo and InnoTab are vastly improved and becomes better than LeapPad this year, the LeapPad will continue to crush them because of the fact that it won yet another 2 major awards just two days ago, has a faster review rate gain on Amazon, and is increasing their brand value in parent's mind faster than the competition.

 

It's not about who can make the best tablet, it's about who can increase their brand association with child edu-tainment the fastest, and LeapFrog is smoking the competition right now.  You should listen to the webcast - it's not just about the LeapPad - all of LeapFrog product lines are increasing and solidifying this reputation in parents' minds.  They are the leading brand in this niche.

 

Everything LeapFrog does is geared toward the message"By buying our products we guarantee you the best child edu-tainment experience for your kid" as opposed to "By guying our products we give you the most features for the least bucks". 

 

The more I research the more I realize how prudent their core strategy is.  I don't see how this is any different from what say Nike does with shoes or Coca Cola does with soda, there will always be cheaper and better alternatives, especially for Nike.

But Nike is not a shoe company, what Nike sells is "cool".

Coca Cola is not a drinks company, what it sells is "happy experience"

LeapFrog is not a toy technology company, it sells the best "child edu-tainment experience".

 

Whoever wins this niche is not someone has the best features for the cheapest price, it is someone who has the best reputation and brand  associated with child edu-tainment.

 

When I used to work at Microsoft, the product teams were all about "more features for cheap price" and they would look at Apple and say "I can't believe people are willing to buy that thing, such a ripoff" and they got smoked by Apple.  It might be counter-intuitive at first glance, but the "more features for cheap price" is generally a pretty crappy consumer proposition except to geeky gadget lovers.

 

You might be not be convinced about LeapPad and you might think it is a ripoff.  For most others - they want to be sold something - and multiple "Toy of the Year" awards, tons of reviews is an easy sell.

 

Of course you may not see it that way, that's what makes a market. 

 

[yudeng2004]

A couple beginner LF questions:

• It seems 73% of their revenue comes from the multimedia division. Is this more or less all attributable to the one product (and the variations)?
  
• What is their relationship with Disney like? Seems they have done a couple small deals together, anyone know LF's goals here?
  

 

It's the LeapPad and the content ecosystem.  Most of the profit is likely to come from the downloadable content - which quadripled in sales.  I seriously doubt they make much money on hardware.

 

Disney is publishing some digital interactive books on the LeapPad, they probably view it as another outlet for their content.  LF allow some 3rd party content creators make content for the LeapPad if they feel it is good for their audience.  Hasbro has a deal with LF too, but not sure of the details.

 

I think Disney/Hasbro/Mattel view LeapPad as another outlet for their branded content.  Maybe they will create some Barbie-themed app or game for the LeapPad. 

[mcliu]

I think what you're saying is LeapFrog will be the leading brand in this category, the Disney or Coke of child-hood entertainment. And I'm somewhat skeptical on whether that's a defendable position, and whether they can get the type of top-of-mind share that these other companies can have, particularly in this category. I mean, I would expect there to be a lot of competitors in the edu-tainment space that can easily get into this market and a lot of deeper pockets that can finance it..?

 

Obviously another worry is the sales around Christmas, etc, which makes it hard to distinguish from fad-ish toys that may be "hot" for one or two years and drop off subsequently.

 

Good analysis though. I'm more comfortable about the company now, than when we first started.