As investors continue to recover from their post-Apple quarterly earnings call hangover (was it ok that they only earned $6.9 billion last quarter on a measly $35.3 billion in sales?) we would like to offer iAddicts a refreshing small cap palliative to help hold them over until the next show. However, mindful of what are sure to be withdrawal symptoms until the company’s next product release, we won’t stray too far afield and stick with another maker of popular tablet computers (sorry Microsoft and Blackberry, not you).  

Without throwing any dirt on Apple, a member of B400 and a company we still like very much, we would like to instead focus today on a small cap name ($711 million market cap) that we think has tremendous upside and plenty of room to grow: LeapFrog Enterprises, a member of B400 since last September. While the Emeryville, California company produces a diverse range of children’s educational toys, we think its popular LeapPad tablet has the potential to transform its business and turbo charge its growth. Think iTunes and the App Store. Just like Apple has cleverly introduced millions to their unique ecosystem through their iPods, iPhones and iPads, we think LeapFrog has an opportunity to build a very lucrative and expansive ecosystem of its own in the K-12 education space, on a global scale, in large part through the growing content library available for LeapPad.  

Last week LeapFrog unveiled the third generation version of its tablet, the LeapPad Ultra, a follow up to its popular LeapPad 2, last year’s #1 selling toy in the U.S. and the U.K. The new tablet is a significant upgrade from its predecessor, featuring a rechargeable battery (instead of LP2’s four AA batteries), front and back cameras, 8 GB of storage, a seven-inch high resolution screen and a 800 MHz processor (it’s no iPad but keep in mind it’s designed for 4-9 year olds). However, more impressive than the hardware is the company’s focus on producing educational content for it. There are already 800 apps, games, books and music titles available for LeapPad and the library is growing steadily. While this is significantly less than the zillion apps available on the App Store, it should give 4-year olds plenty of options. The new tablet is also Wi-Fi enabled, allowing “peer-to-peer” play across devices and it also comes with LeapSearch, the company’s kid-safe browser. 

  In the opening lines of its 2012 letter to shareholders the company’s Chairman emphasized LeapFrog’s ongoing transformation “into an educational entertainment company with a far greater focus on content.” This strikes us as farsighted and could be a potential catalyst for significant growth. Call it the intersection of Apple and the razor-blade model. No, we don’t expect 4-year olds to begin shaving anytime soon but instead we refer to consumer’s resiliency and willingness to continue to spend money on their kids, regardless of macroeconomic conditions. In fact, a report by Roth Capital Partners, which follows the stock, highlights that although overall spending on infants and toddlers fell during the recent economic downturn, mainly as a result of a drop off in birth rates, spending per child actually increased. As young couples faced the uncertainties of the recession and many decided to postpone their plans to have children, the fertility rate in the U.S. declined steadily from its 2007 peak through 2012. It has now stabilized and is expected to rise again in 2013 as the economy continues to recover and household formation also improves. This, we think, bodes well for LeapFrog, which has used the last few years to refocus its business away from easily commoditized toys to higher margin products focused on educational children content. This is where the growth story, for which B400 is a sucker, comes in.   

According to Barron’s, analysts expect the company to sell 2 million tablets this year out of 100 million tablets expected to be sold worldwide (the LeapPad Ultra retails for $149.99 with apps starting at $5 and games at $24.99—once again, think razor blades). The company’s 12-month trailing revenue, through the first quarter of this year, was $592 million. While 51% higher from the equivalent period ended three years earlier, this is quite a long ways away from reaching a saturation point. LeapFrog earned $93 million also for the 12 months ended in March, while generating $60 million in free cash flow, five times the amount from three years earlier. The company is debt-free, has $190 million in cash on hand and sports a return on equity of 33%. Amazingly, from our perspective, its shares trade at only 1.8 times tangible book value and 12 times next year’s estimated EPS. The company’s grades look very strong across the board, with B+ in both our Growth and Value categories and A- in both Profitability and Cash Flow.

While the company’s products are already sold in more than 45 countries, last year only 27% of its revenue was generated outside the U.S. We see this as a tremendous opportunity for expansion, which seems to be a priority of management, at least based on the language in their annual report and press releases. While the company has made good inroads on other English-speaking countries such as the U.K. and Canada, in our view a much larger prize looms on the horizon: India, another English-speaking country with a population of 1.3 billion, a strong emphasis on education and a growing middle class. While this may be a few years off, investors would be well advised to take the leap now. B400 has.