Novice Investing - Ditching Your Frog Away

Date: Friday 29th 2008f August 2008 12:57:57 PM

Ditching Your Frog Away - 08/03/2006

By: Novice Investing Staff

Late Wednesday, LeapFrog Enterprises Inc. (LF) reported earnings that disappointed most analysts and investors. This includes us at Noviceinvesting. For the second quarter of 2006, LeapFrog posted a net loss of $ 25.7 Million or 41 cents per share versus 16 cents analysts' estimate. Meanwhile, revenue fell to $ 68.1 Million from $ 87.1 Million last year. That is about 25% decline from the same period last year.

The decline is attributed to lower sales of LeapPad which causes a plunge in gross margin to 25.1% as well. Judging from this quarter, it looks like that LeapFrog will not make the $ 0.41 EPS predicted for the entire year of 2006. While we understand that business picks up during the latter half of the year, cumulative loss for the first half of the year is $ 0.71 per share already. Last year, LeapFrog made $ 0.75 per share for the second half of 2005. Therefore, it seems that LeapFrog can only break even at best, considering that the first half of 2006 has been so brutal to the company.

When we made our decision to invest in LeapFrog in our stock portfolio, we reasoned that LeapFrog will earn $ 1.19 per share for one whole year. It takes an awfully good second half to do that now. Therefore, after deciding to hold LeapFrog last February, we feel that it is time to move on. We will sell LeapFrog at today's price ($ 7.75) at a loss.

With every actions, there are lessons to be learned. What is our lesson learnt by investing in LeapFrog? First, it is harder to depend on growth when you invest in a company. Our assumption at the time was that LeapFrog can grow its revenue by 5-10% annually. This may result in a 10-15% increase in annual Earning per Share (EPS). Such assumptions led us to believe that the fair P/E value for LeapFrog is 18, or an earning yield of 5+% only.

Second, it is more dangerous to invest in companies that has a high seasonal revenue pattern. Once it fails, investors need to wait for another year to see sign of improvement. In LeapFrog's case, the company derives 75% of its sales and 100% of its profit in the second half of the year. That is a dangerous beast to invest. While not many companies have the same revenue pattern throughout the year, LeapFrog revenue is too concentrated during the latter half of the year.

END

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Disclaimer: The sole purpose of this article is educational. This article is merely the opinion of the writer and is not in any way a buy/sell recommendation regarding LeapFrog Enterprises Inc. (LF) or any other securities.

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