Description

LeapFrog Enterprises Inc. (NYSE: LF), is the leader in educational entertainment for children.  LF has the #1 kids learning tablets with the LeapPad, the #1 kids learning gaming system with Leapster and the #1 learn-to-read systems with Tag, and a strong line of preschool learning toys and valuable home entertainment catalog of educational videos and DVDs.  As the company and its value proposition are widely misunderstood, investors can buy LF today at a price that is less than 50% of its conservatively estimated private market value and 28% below its recent highs.

In summary, LF is not just a toy manufacturer; it has become the clear and dominant leader in educational entertainment for children.  It has become a “mini Apple” in a sense, due to its strong brand and large ecosystem of apps, games, videos and accessories.  Unlike an AAPL, which has already grown globally and which we believe to have unsustainably high 37% EBITDA margins, LF at present is essentially only an English-speaking company with a long global runway of growth and potential margin expansion in front of it (just launched in France).  

The company should be, and we believe will be, sold to a strategic (Mattel or Hasbro) or financial buyer for a very substantial premium in a transaction that will allow sophisticated owners Larry Ellison and Michael Milken to gain liquidity for their large supervoting stakes.  Mattel trades for 2.2x sales and 10.2x EBITDA, while Hasbro trades for 1.3x sales and 7.7x EBITDA.  Strategic value here is clearly enormous as traditional toy companies struggle to remain relevant.  In a sale event, substantial synergies would allow a strategic buyer to easily pay 2x sales/10x EBITDA for LF, which we believe results in a price of at least $16-17/share off mid-year 2013 numbers, while a financial buyer would likely pay 8x EBITDA, implying at least $13-14/share.

Keys to the thesis are as follows:

• LeapFrog dominates Amazon’s list of Best Sellers in Learning & Educational Toys:  http://goo.gl/9FNsU
  • 4 of the top 5
  • 11 of the top 20
  • 17 of the top 40
  • 27 of the top 60
  • 39 of the top 80
  • 43 of the top 100

• LF products have been a huge holiday season hit, and are differentiated in the minds of parents and retailers
  • LeapPad2, the next generation of the #1 kids learning tablet, was sold out at times at AMZN, WMT, TGT over the holidays
  • At Amazon, the green LeapPad2 is out of stock today, while the pink is in stock:  http://goo.gl/31IxG
  • At Walmart, the green LeapPad2 is out of stock today, while the pink is in stock:  http://goo.gl/RwHdP
  • In store, LeapPads are merchandised openly in the kids and toys section, not in the electronics section behind glass.

• Fast growth and expanding margins.
  • LF has grown its top line from $380mm in 2009 to >$560mm in 2012 and likely >$600mm in 2013.
  • Gross margins have risen from 41% in 2011 to 42% for the LTM 9/30/12.
  • EBITDA margin has risen from 7.7% in 2011 to 12.5% for the LTM 9/30/12.

• Very cheap.
  • With a cash balance estimated to be $140mm+ as of 12/31/12 and $210mm+ as of 12/31/13 ($3/share of cash), LF presently trades at ~5.7x our conservatively estimated 2012 EBITDA of $80mm and 4.8x our estimated 2013 EBITDA of $95mm.
  • Large cash balance creates potential large share repurchase.

• Strong free cash flow.
  • Capex has ranged from $6mm to $12mm in recent years, and we are expecting $15mm forward capex.
  • $201mm of Federal NOLs that expire between 2025 and 2029
  • $219mm of State NOLs that expire between 2012 and 2031

• Large insider equity ownership.
• Mollusk Holdings (Larry Ellison) owns 6.7mm shares (9.9%)
• Michael Milken and family own 5.3mm shares (7.8%)
• Insiders in total own nearly 20% of the shares

• Substantial recent insider buying.
  • Randy Rissman (director) bought 50,000 shares (Nov 8-9)
  • Raymond Arthur (CFO) bought 2,607 shares (Nov 12)
  • Raymond Arthur (CFO) bought 10,000 shares (Nov 14)
  • John Barbour (CEO) bought 15,000 shares (Nov 15)
  • Stanton McKee (director) bought 25,000 shares (Nov 16)
  • Greg Ahearn (Chief Marketing Officer) bought 6,570 shares (Nov 19)

• LF is not just a toy company, it has become the leading educational entertainment company for children aged 3-9.
  • Distribution agreements in place with 26 different companies, including Disney, Sesame Workshop, PBS, Nickelodeon, Discovery Education, HIT Entertainment, Mattel, Hasbro, etc.
  • Agreement with Lionsgate, which will distribute 4 new LeapFrog Letter Factory movie DVDs that LF will create and produce internally.  http://goo.gl/BcSbr

• Very high short interest creates short squeeze potential.
• 10.6mm shares sold short represents ~19% of the Class A Shares outstanding
• The short thesis is that LF’s products are fads and that hit products like the LeapPad and LeapPad2 will be replaced with adult tablets.  We believe this is mistaken, as adult tablets are simply unsuitable and unsafe (physically and content-wise) for the 3-9 year old market.

Risks

• New competition.  We believe that tech companies such as Apple, Samsung, Amazon, Microsoft will not bother with LeapFrog products due to the low price points (i.e. the LeapPad2 sells for $99 at retail) and small absolute revenue dollars available.  LeapFrog is so dominant and trusted by parents and grandparents that we believe it to be unlikely that it will be displaced.  LF management has stated exciting new products are in the pipeline for 2013.
• Poor execution.
• Dual share class structure, whereby Class B shares controlled by Ellison and Milken give them voting control of LF.

Catalyst