Hot List Toymaker Could Deliver Income for the Holiday Season

A recent sell-off has left the stock of educational toymaker LeapFrog Enterprises (NYSE: LF) oversold and undervalued at a time of year when the company is bound to attract the attention of traders. The decline seems to have been the result of two mistakes, but luckily those mistakes set up a promising income trade.


According to one analyst, when LF released earnings in early November, a wire service story initially reported that earnings came in below expectations. Within hours, the wire service issued an update that correctly said the company had beaten estimates by 27% rather than missing expectations by 5%.

The next week, an analyst said the company was again hurt by false perceptions. A Black Friday advertisement from Wal-Mart (NYSE: WMT) showed that the nation’s largest toy retailer would be offering the company’s Leapster 2 on sale for only $20.

Fearing deep discounting of LF products this holiday season, it appears traders panicked and sold the stock. In her bullish report, the analyst noted that the toy advertised by Wal-Mart was an older model. She said she does not expect to see any discounts on LF’s newer products, which she thinks will be strong sellers this year.

The nation’s second largest toy seller seems to agree, as the Leapster 2 is on the Toys “R” Us Fabulous 15 hot toy list for this year. That assures the product a prominent location in hundreds of Toys “R” Us stores and in millions of online and print advertisements.

The chart below shows the recent sell-offs in the stock:

LF Chart

Based on earnings, LF seems undervalued. Analysts expect the company to earn $0.82 a share this year and $0.86 next year. Nine analysts have raised their estimates for this year in the past 30 days, and seven have increased expectations for next year.

Looking past next year, analysts expect earnings growth to average about 20% a year. Using that growth rate as a fair value for LF’s price-to-earnings (P/E) ratio, the stock could be worth up to $17.20 (20 times the $0.86 a share of earnings expected next year). Even with a P/E ratio of less than 10, the stock is undervalued.

While LF may be a good buy now at around $7.22, I think it also represents an extraordinary income opportunity. March 2013 $7.50 puts on LF are trading at about $1.35. Buy selling these put options, we earn instant income, and if the share price stays put or continues to decline, we might be able to buy this already undervalued stock next spring at an even lower price.

If LF closes below $7.50 at expiration, put sellers would have to buy LF for $7.50 minus the amount of premium received, which would make the cost basis in LF about $6.15. If LF closes above $7.50 at expiration, the seller would keep the premium as their profit on this trade.

Selling a put requires a minimum margin deposit of about 20%, although it could be more at some brokers. For March $7.50 puts, the margin would be about $150, because each options contract is for 100 shares of stock. If the put expires worthless, the profit would be about 90%. If the put is exercised, traders get to own the stock of a great company at a P/E ratio of 7.

Recommended Trade Setup:

— Sell LF March 7.50 Puts at the market price
— Do not use a stop-loss
— If LF closes above $7.50, your profit will be about 90% in four months. If LF closes below that price, you will own LF with a cost basis of $6.15.