The economy is just starting to work its way out of the funk brought by the historically cold winter last year. With still sluggish wage growth and retail demand, many consumer discretionary companies are trying to claw their way back from the dead.

And that is why it is the best time to be buying.

#-ad_banner-#While a bad selling season can wreck sentiment in a company’s shares, the institutional knowledge remains. Companies with a strong brand and a track record for surprising investors with innovative products are your best bet for a rebound to come.

Not only are these best-in-class innovators a great long-term bet, but the mountain of cash on corporate balance sheets have made them classic buyout targets.

From Darling to Dud

LeapFrog Enterprises, Inc. (NYSE: LF) surged after its 2002 market debut, jumping 167% in the following 15 months. The company’s LeapPad, released in 1999, revolutionized children’s electronics.

Then a drought in new releases and competition hit the company like a ton of bricks. No new major products were released in the five years to 2008, and other portable electronics started chipping away at the company’s market share. Sales growth slumped from an annualized rate of 143% in 2002 and 2003 to an annualized loss of 4.3% over the two years to 2008.

The company released the LeapPad Explorer in 2011 and shares surged again. The revolutionary product brought the company into the tablet age and shares jumped 294% in the twelve months to August 2012.

But it wasn’t to last for LeapFrog investors. Shares have fallen 43% from their 2013 high and got slammed nearly 19% on a miss in second quarter earnings. Recent weakness has come from increased competition of apps on regular smartphones and tablets and an inventory buildup after two product launches last year. The poor retail environment last holiday season led to an inventory buildup that brought steep price discounts and promotions.

Strong Brand Identity and a History of Product Innovations

While the 43% plunge in second quarter revenue to $47 million has the rest of Wall Street on edge, savvy investors may want to look at the company’s position in the market and its ability to shock with new products.  

While others compete in the children’s electronics space, Leapfrog commands a strong brand identity with several of its products taking the #1 spot in their category.

•    #1 selling preschool electronic learning toy
•    #1 selling learn-to-read system
•    #1 selling learning game system
•    #1 selling kids’ learning tablets
•    #1 selling learning content

This kind of strength develops into a strong brand and helps to make a market for new product releases. LeapFrog has two new releases coming that could leverage this strength and revitalize the company.

The most promising release is the LeapBand, a wearable device for kids that tracks activity and includes interactive features. The LeapBand will retail for $39.99, significantly less than the $100 LeapPad and other wearable devices. With obesity in children being a growing concern, the product could be a hit with parents.

The company is also unveiling LeapTV, a gaming console for kids also focusing on the shift to activity. The console has a suggested retail value of $150 — less than other gaming consoles — and should benefit from the company’s brand recognition for quality children’s learning and engagement products.

Value Play Or Takeover Target?

LeapFrog has just less than $200 million in cash on its balance sheet — almost half its market cap — and no debt. The company is still cash flow positive and priced at just 7.0 times earnings before interest, taxes, depreciation and amortization (EBITDA). This is well under 10.6 times EBITDA for Mattel, Inc. (Nasdaq: MAT) and 10.4 times EBITDA for Hasbro, Inc. (Nasdaq: HAS). If either of the company’s new products are able to hit, shares could jump on a return to the industry average EBITDA valuation.  

Net sales outside the United States have more than doubled over the last four years and now account for 30% of total sales — this accounts for the bulk of LF’s growth and could be an attractive asset for a buyer.

Mattel paid an enterprise value of nearly 10 times EBITDA for MEGA Brands earlier in the year, a deal made to help diversify California-based Mattel internationally. While I think investors could get a stronger multiple for LeapFrog’s considerable brand and products, that still represents a 43% upside and $9.08 per share for the small-cap company.

I like the shares’ potential going into the holiday season. Insiders hold 15% of the shares outstanding, while institutional investors own another 75% of the company. This leaves little room for the 10.16 million shorted shares, which amount to 14.5% of outstanding issued. Even marginal success with one of the two upcoming product releases could drive sentiment higher and cause a short squeeze.

Risks to Consider: LeapFrog still has some inventory to work through from a poor 2013 holiday season and its rollout of new products last year. Sentiment is still negative and volatility will likely be higher until sales come through on new products.

Action to Take: A rock-bottom valuation and catalysts for a turnaround make this leader in children’s electronics a good bet for your small-cap portfolio. Add shares up to $7.30 per share with a target of $8.25 over the next year.

LeapFrog is a strong acquisition target, but it also has the ability to be a market game-changer. StreetAuthority’s premium newsletter Game-Changing Stocks is devoted entirely to finding hidden gems that have the potential to turn an industry on its head. Some of these firms may be the next Apple and others may be acquisition candidates like Leap Frog. To learn more about Game-Changing Stocks, click here.