The editorial team at Time to Play, a website dedicated to providing information about products and services for children, recently announced that the winner of its third annual "Ultimate Wish" award was LeapFrog Enterprises (NYSE:LF) and its hugely popular LeapPad Explorer tablet for kids four- to eight-years old. Consumers nationwide voted for the toy at the top of their wish list and this year Leapfrog is the winner. This Christmas, investors are witnessing the continuing revival of this longtime producer of educational toys. Although its stock is up more than 80% since the introduction of its kids tablet in August, this is only the beginning. (For related reading, see 5 Most Profitable Toys Of Past Christmases.)

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LeapPad

I'll start my argument for buying LeapFrog's stock with the topic of the day. LeapPad isn't just popular, it's a must-have this Christmas. In a press release from December 9, Toys "R" Us announced it would have 30,000 LeapPad's available in its stores the next morning when it opened at 6am. Available on a first-come first-served basis, I'm sure most LeapPads were sold within the hour. Despite this frenzy, industry experts suggest this holiday season won't be a barn burner when it comes to toy sales. A recent survey conducted by UBS and America's Research Group suggests parents believe there is no must-have toy this year. Stephanie Lucy, vice president for toys at Target (NYSE:TGT) confirms this notion suggesting she isn't seeing people clamoring for any one product. While the LeapPad might not be a home run, it's a solid double and the proof lies in LeapFrog's third quarter report. Revenues increased 5% in its U.S. segment and 28% internationally. Most of those revenue increases are attributed to the "strong launch" of the LeapPad Explorer. In just 45 days, the LeapPad made that kind of difference. Imagine what it will do in a full 90-day quarter at its busiest time of the year.

Operating Cash flow

The first nine months of 2011 are a complete turnaround from last year. Its operating cash flow in the first three quarters was $20.6 million, $43.6 million higher year-over-year. The trailing 12-month operating cash flow is $21 million, which is higher than its net income of $17 million. This is important when you compare its current situation to 2003, its best year in the past decade, when it generated $680 million in revenue and net income of $73 million. Its operating cash flow in 2003 was $27 million, just 37% of net income, compared to 124% in the trailing 12 months. Furthermore, LeapFrog's operating cash flow in 2003 included a $39 million tax benefit. Without it, there would have been negative free cash flow that year instead of $11 million, the exact same amount as today on 56% higher revenues. Leapfrog is far more efficient these days and this reality will be reflected in a higher stock price soon enough. (To learn more, read 12 Things You Need To Know About Financial Statements.)

LeapFrog Enterprises and Peers

Company

P/S

P/CF

LeapFrog Enterprises (NYSE:LF)

0.8

17.6

Mattel (Nasdaq:MAT)

1.6

15.6

Hasbro (Nasdaq:HAS)

1.1

13.3

VTech Holdings (OTCBB:VTKLY)

1.2

13.6

Share Price

Now that I've established that LeapFrog is getting its act together, it's time we look at its share price both then and now. Its stock hit an all-time high of $47.30 in October 2003. At the time, it was trading at 60 times cash flow and 2.4 times sales. That was much higher than the multiples for the S&P 500 at the time. Today, LeapFrog trades at around 18 times cash flow and 0.8 times sales, very much in line with the index. The dissenting argument to this illustration is that its revenues and net profits back in 2003 were much greater and therefore more deserving of a higher multiple. That's true to an extent. However, if we are also considering the way a company allocates capital, the modern-day version is a superior beast deserving of higher multiples. (For related reading, see How To Choose The Best Stock Valuation Method.)

The Bottom Line

LeapFrog is more than the LeapPad. Its TAG interactive reading system won the educational toy of the year award this past February. What they do beyond the LeapPad is critical to its future success. Something tells me they'll be just fine coming up with new ideas to stimulate the minds of kids and that's a great thing to invest in.

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At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.
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