Earnings Preview – What to Look for from Rosetta Stone in Q2

By Brian Shaw - July 27, 2012 | Tickers: RST | 0 Comments

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On August 8, Rosetta Stone (NYSE: RST) will report its second quarter earnings.  To put expectations into perspective, let’s start with a look at management’s guidance for 2012 from last quarter’s earnings release:

• Net revenue growth of 1% to 5% to approximately $270 million to $285 million
  • North American Consumer revenues are expected to increase compared with 2011
  • International Consumer revenues are expected to decrease compared with 2011
  • Institutional revenues are expected to be approximately flat compared with 2011
• Adjusted EBITDA of $5 million to $8 million with adjusted EBITDA margin of approximately 2% to 3%
• Net Income of ($6) million to ($4) million
• Earnings per share of ($0.33) to ($0.20)
• Diluted weighted average shares outstanding of approximately 21 million
• Capital expenditures of $10 million to $13 million

On average, analysts have translated this guidance into Q2 revenues of $66.77 million and a loss per share of $0.16.  These estimates equate to flat revenue year-over-year and a slight improvement from the Q2 2011 loss per share of $0.22.  Let me reiterate that the expectation is that Rosetta Stone will post modest (if any) revenue growth and continue to generate a loss in Q2.

While Rosetta Stone’s actual results on the top and bottom lines compared to expectations will be important, the key factors in determining whether Rosetta Stone’s stock will resume its recovery or not will be buried within the comments made by CEO Steve Swad.  Here’s what to look for in the upcoming earnings release:

International Consumers

Rosetta Stone’s international business was once considered one of the major growth engines that would propel the stock upwards subsequent to the company’s IPO in 2009.  While international revenues have increased to 18% of total revenues for the company, the growth has come to a halt and management’s guidance for 2012 actually predicts a decline in international consumer revenues; Rosetta Stone reported a 14% decline in international revenues during Q1, which emphasizes just how fragile this portion of the business can be.  In addition to the global economic trends that everyone is aware of, Rosetta Stone suffered a series of setbacks in two of its biggest international markets, Japan and Korea, in late 2011.  Recently, Rosetta Stone announced that the head of the company’s global consumer business would relocate to Japan to re-focus the company’s efforts in Asia. 

Any additional insight into the situation in Japan and Korea, including a turnaround plan or the results of initial steps to stabilize the business, will speak volumes for both Rosetta Stone’s ability to react to changing dynamics in the market and the potential for the international business to resume a growth trajectory.

Institutional Customers

Once the second pillar of Rosetta Stone’s rapid growth, the institutional business (e.g., governments, schools and corporations) has also faced serious pressure as the result of the economic environment.  During Q1, institutional revenues accounted for 20% of Rosetta Stone’s revenue but declined 1% compared to the prior year primarily as the result of the previously announced loss of a large government contract during 2011 partially offset by an increase in revenues from other institutions.  Similar to the international business, the key to understanding Rosetta Stone’s institutional opportunity lies in management's comments regarding new initiatives and products designed to attract new customers as well as any large contracts that have been executed recently.

US Consumer

While international and institutional portions of Rosetta Stone’s business had previously been identified as the growth drivers for the company, it is impossible to ignore the US consumer market, which still accounts for over 60% of Rosetta Stone’s revenue.  Swad generated an impressive 52% year-over-year growth in the US consumer business in Q1 through a demonstration of how lowering average revenue per unit (or "ARPU") can drive increased volume and increased total revenue. 

It will be important to see what management can do for an encore performance; while 52% growth isn’t likely to continue throughout the year, management has the ability to grow both the top and bottom lines in the US Consumer business through better decisions than were made under the previous regime.  In particular, Swad talked about targeting “empty calorie” revenue on the Q1 earnings call, referring to an example of $0.75 of revenue that cost the company $1.00 to generate.  During Q2, it is important to pay attention to how this mindset translates into more profitable business decisions.  One example to look for will be the continued decline in the number of Rosetta Stone kiosks in malls and airports, which are frequently deserted. 

Confidence in Management

The final (and likely most impactful) takeaway from the upcoming earnings release is the answer to a question that is extremely hard to quantify: is the investing community confident in management?  As you can see from Rosetta Stone's share price over the past two years, poor management execution has had a dramatic effect:

After a steady decline from the mid $20s down to just $6.55 per share after a series of poor results, management excuses and the a lack of a clear plan, Rosetta Stone’s share price has effectively doubled since Swad became CEO less than six months ago and immediately took steps designed to lead the company toward recovery.  This is a direct reflection in the market’s confidence in management’s ability to drive the business back to profitability.  If the market perceives that Swad’s vision is working, we are likely to see another jump forward.  However, a significant failure in management’s turnaround plan could bring back doubt whether the company is making the right moves.

We will know significantly more about the direction of Rosetta Stone in less than two weeks!

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