Don’t Write Off Rosetta Stone Just Yet…

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When Rosetta Stone (NYSE: RST) released earnings on Aug. 8, the market (myself included) was almost universally surprised by Rosetta Stone’s 9% revenue miss to both last year’s results and analysts’ expectations.  “So much for a turnaround!” is a common reaction, and it is not totally undeserved.  There are challenges internationally, particularly in Korea and Japan, that do not have an easy answer in sight.  There are also challenges in the institutional business, where the loss of a major contract with the Army in Q3 2011 is still impacting year-over-year comparisons.  

In fact, the story at Rosetta Stone has more than a few similarities to Netflix (NASDAQ: NFLX).  In both cases, there’s a great product with strong user support.  A shift in business strategy combined with a few management missteps led to similarly drastic declines in investor confidence for both companies.  But is either circling the drain towards bankruptcy?  Absolutely not.

The Thesis Is Still Intact

The investment thesis for Rosetta Stone has been (and continues to be) based on the fact that Rosetta Stone is the best technology-based language learning solution in the world.  The thesis contends that the combination of the product, brand recognition and planned expansion of distribution channels will result in an increase in market share within the hugely fragmented language learning market.   There are certainly competitors and more are likely to enter the market going forward, but to use a soft drink analogy there is no Pepsi to Rosetta Stone’s Coca-Cola.  The overall market is still there, and no competitor has comparable scale or products to Rosetta Stone.  

Things Are Turning Around

Steve Swad, Rosetta Stone’s new CEO, has a vision for success at Rosetta Stone that involves a lot of change.  His vision, which he outlined during a May investor conference, focuses on returning the company to healthy profitability.  To achieve this, Rosetta Stone has to be smart about how it spends money.  Among the culprits for Rosetta Stone’s Q2 revenue drop was the elimination of what Swad labels “empty calorie” revenue; $1.00 of revenue that costs Rosetta Stone $1.25 to generate is not exactly good over the long term. 

So Swad has taken efforts to reduce low-performing kiosks in favor of increasing more profitable channels like the company’s direct-to-consumer business (which actually increased during the quarter).   Early signs point to this being a success: adjusted EBITDA margins (excluding some one-time costs associated with headcount reductions) increased from -2% last year to +2% this year.  That’s a good start on the road back to profitability. 

Additionally, it is important to note that last year’s “disastrous” performance resulted in a 4% revenue INCREASE over 2010, and revenues in the first half of 2012 are 5% higher than 2011’s despite efforts to reduce certain sales channels.   Not stellar growth, but it is in fact growth.  That fact gets lost in many discussions of Rosetta Stone’s recent performance.

In the meantime, Rosetta Stone has a healthy balance sheet, with $120 million in cash (and no debt), which represents $5.75 per share or over half of the company’s current market cap.  Combined with three consecutive quarters of positive free cash flow, Rosetta Stone has the flexibility to allow its new management team’s recovery plan to play out.

Looking Ahead

I think the best view of Rosetta Stone's future comes right from the CEO’s commentary on the two earnings calls he has led as CEO.  During the most recent earnings call, Swad said: I will say that in May, I laid out 2015 at plus $400 million in revenue. And low double-digit operating margins and I felt good about it then, and I continue to feel good about that target now.”

Let’s take a moment to translate that statement into a stock price.  For assumptions, we can conservatively translate “plus $400 million” to be $400 million and “low double-digit operating margins” to mean an operating margin of 10%.  Since Rosetta Stone has no debt, its income statement below operating expenses needs to only be reduced for income taxes.  Again being overly conservative, we’ll assume a tax rate of 40%.  With these assumptions, here are some valuation scenarios for 2015 based on P/E ratios of 15 and 20 (in millions, except per share numbers):

<table> <tbody> <tr> <td> <p>Revenue</p> </td> <td> <p>  $400</p> </td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td> </td> </tr> <tr> <td> <p>Operating Income</p> </td> <td> <p> $40</p> </td> <td> </td> </tr> <tr> <td> <p>Less: Income Taxes</p> </td> <td> <p><span> $(16)</span></p> </td> <td> </td> </tr> <tr> <td> <p>Net income</p> </td> <td> <p> $24</p> </td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td> </td> </tr> <tr> <td> <p>Valuation Scenarios</p> </td> <td> <p>P/E of 15</p> </td> <td> <p> P/E of 20</p> </td> </tr> <tr> <td> <p>Market Cap</p> </td> <td> <p> $360</p> </td> <td> <p> $480</p> </td> </tr> <tr> <td> <p>Price Per Share</p> </td> <td> <p> $17.14</p> </td> <td> <p> $22.86</p> </td> </tr> <tr> <td> <p>Increase over 8/15/12 Share Price of $10.97</p> </td> <td> <p>56.3%</p> </td> <td> <p>108.4%</p> </td> </tr> </tbody> </table>

A 3-year return on shares of somewhere between 56% to 108% is not bad!  Plus, this very simplified model rounded down at every opportunity possible.  Using the scenario above, here’s what altering the assumptions to $450 million and 12% operating margin would look like (in millions, except per share numbers):

<table> <tbody> <tr> <td> <p>Revenue</p> </td> <td> <p>  $450</p> </td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td> </td> </tr> <tr> <td> <p>Operating Income</p> </td> <td> <p> $54</p> </td> <td> </td> </tr> <tr> <td> <p>Less: Income Taxes</p> </td> <td> <p> $(22)</p> </td> <td> </td> </tr> <tr> <td> <p>Net income</p> </td> <td> <p> $32</p> </td> <td> </td> </tr> <tr> <td> </td> <td> </td> <td> </td> </tr> <tr> <td> <p>Valuation Scenarios</p> </td> <td> <p>P/E of 15</p> </td> <td> <p> P/E of 20</p> </td> </tr> <tr> <td> <p>Market Cap</p> </td> <td> <p> $486</p> </td> <td> <p> $648</p> </td> </tr> <tr> <td> <p>Price Per Share</p> </td> <td> <p> $23.14</p> </td> <td> <p> $30.86</p> </td> </tr> <tr> <td> <p>Increase over 8/15/12 Share Price of $10.97</p> </td> <td> <p>111.0%</p> </td> <td> <p>181.3%</p> </td> </tr> </tbody> </table>

Am I saying that Rosetta Stone will reach $30 by 2015?  No, but it is a possibility if the market gains confidence that Swad's vision is likely to materialize.  The new management team at Rosetta Stone seems confident that its first two quarters in control have put it on the path of reaching goals that would have seemed perfectly reasonable just a year or two ago before the previous regime’s series of miscues resulted in Rosetta Stone's recent struggles.  So I wouldn't be quick to dismiss Swad's target. 

Keep an Eye on Results and Guidance 

The 2015 targets for Rosetta Stone are by no means a certainty.  There are plenty of hurdles to overcome, so any investment in Rosetta Stone requires keeping tabs on how progress is being made toward the vision described above.  If management appears to be on track, the share price will grow to the ranges listed above.  If not, somewhere between the current price and the $5.75 cash per share is certainly possible; at this point, I don’t see enough evidence to think such a decline is all that likely given all of the pessimism already priced into the stock.  

In my opinion, the primary threat to Swad’s 2015 vision is the entry of a competitive offering from a digital powerhouse such as Google (NASDAQ: GOOG); it would not be a stretch to see a premium extension of Google Translate that provides premium language learning capabilities.  Presently, any such competition is completely hypothetical, so the current focus should be on management's forward-looking statements for signs of success or failure in the achievement of the 2015 vision.  

BrewCrewFool owns shares of Rosetta Stone, Google and Netflix. The Motley Fool owns shares of Google, Netflix, and Rosetta Stone. Motley Fool newsletter services recommend Google, Netflix, and Rosetta Stone. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus