LeapFrog Inexplicably Leaps Backward

By Will Ashworth | November 09, 2012 AAA

LeapFrog Enterprises (NYSE:LF), maker of the LeapPad 2 children's tablet, delivered third quarter earnings November 5 after the close of trading. The results exceeded expectations and yet its stock lost 15% of its value over the next two days of trading. What's up with LeapFrog's inexplicable leap backwards? That's what I hope to find out. What I do know is that with the holiday shopping season soon upon us, this drop provides investors with a much better entry point.

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Reuters Messes Up
Well, if you ever doubted the power of the mainstream media as one of the forces that moves stock prices, Reuters proves people still read their content. A division of media giant Thomson Reuters (NYSE:TRI), it published an original article Nov. 5 at 5:06 p.m. highlighting LeapFrog's earnings in the third quarter. The leading line mentioned an adjusted earnings per share of 40 cents, compared to the consensus estimate of 42 cents. Unfortunately, that wasn't even close. Two hours later it ran a correction revising the adjusted earnings per share number upwards to 52 cents. Instead of LeapFrog missing the estimate by two cents as Reuters originally reported, it actually beat earnings by 11 cents or 27%. That's a huge difference and while you can never be certain what causes a stock to move, that certainly didn't help.

A Beautiful Quarter
Where to begin? Let's start with revenues. They increased 28% to $193.1 million in the third quarter and 37% in the first nine months to $336.6 million. Its U.S. segment delivered 26% revenue growth to $145.7 million while its international segment grew sales by 36% to $47.4 million. Its international revenues now account for 25% of its overall revenue. Interestingly, CFO Ray Arthur mentioned in its earnings release that retailer layaways in the third quarter for its LeapPad were very strong, resulting in some revenues moving from Q4 into Q3. Investors should interpret that statement to mean fourth quarter revenue will be slightly lower than originally expected. LeapFrog sees full-year revenue of $550 million at the high-end of its range, which means Q4 sales would be $213.4 million or basically flat year-over-year and increasing by 18%-21% for all of 2012. When combined with a 20% increase in advertising spending, it does take some of the wind out of investors' sails, because it signifies lower overall earnings for the year than originally expected.

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While it raised earnings guidance to between 75 cents and 81 cents per diluted share for the entire 2012, when you back out year-to-date EPS of 35 cents, you're looking at Q4 2012 earnings of 46 cents at the high end, which is three cents lower than last year's final quarter. Obviously management sees a very competitive holiday season with Hasbro (Nasdaq:HAS), Mattel (Nasdaq:MAT) and other toy manufacturers and doesn't want to lose any momentum the LeapPad 2 has gained since its launch this past summer. Certainly you have to wonder why the jump in advertising when the product sell-throughs year-to-date appear strong. It sounds as though management is being extremely conservative in its guidance. I have to think both revenue and earnings in Q4 will beat last year's numbers as opposed to its guidance which suggests flat to slightly-negative results.

The Bottom Line
One of the major topics that came up during LeapFrog's conference call Nov. 5 was its level of inventory heading into the fourth quarter. Up 64% year-over-year at $115 million, LeapFrog is focused on having enough inventory on the shelves entering the holiday season, something it failed to do last year, which cost it sales. While it's unknown what percentage of sales moved from Q4 to Q3 because of layaways, CEO John Barbour believes if you were to move those revenues back to Q4, there would be revenue growth in the final quarter based on its revised guidance. I'm a glass half-full person, so I see LeapFrog's future as bright regardless of what happens in the fourth quarter. Its operating profit in 2012 based on company guidance will be $54 million, 128% higher than in 2011. Dissect its third and fourth quarters as you please. In the end, 2012 will go down as a big success. This time next year its share price will be in the mid-teens. You heard it hear first.

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

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