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Rosetta Stone: Limited Downside, Huge Upside

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

Typically, software companies have meaningful net profit margins, earning them premium valuations. Rosetta Stone (NYSE: RST), on the other hand, manages to earn investors losses. In turn, the stock is dirt cheap, trading at just 1 times sales. With a valuation like this, there is quite a bit of room for upside in the case that Rosetta Stone begins to earn a profit. Even better, Rosetta Stone's catalyst for increased profitability is already at work, to the tune of triple digit growth rates.

The Catalyst Is Already Here

What is the catalyst that will drive upside in margins, profits, and revenue? Rosetta Stone's Online Learners.

The company's Online Learners, or individuals who use Rosetta Stone's online platform, have increased 167%, year-over-year, to 57,000. This is clearly a favorable development for shareholders. Online Learners save the company two major expenses: (1) retail and (2) packaging and shipping. Rosetta Stone's institutional business, representing 29% of total revenue, is over 80% online.

Investors who follow Rosetta Stone's earnings calls carefully are well aware of the fact that Rosetta Stone's 167% year-over-year growth in Online Learners is just the beginning. Management is quick to remind Wall Street that most of these 57,000 individuals represent the company's test offerings that were conducted over the past year or so. Management explains that these offerings were not supported by "meaningful marketing spend." Rosetta Stone's prepared remarks for its FQ3 earnings call go on to say that, "As we go into 4Q and 2013 and begin to put our marketing muscle behind the online offerings, we think there exists significant opportunity to further penetrate the market and speak to those customers that prefer an online duration-based service."

No-Brainer Steps to Improving Operational Efficiencies

Beyond Rosetta Stone's fast growing Online Learners business, the company is taking some obvious and simple steps that will help the company become more profitable.

First, the company is reducing its kiosk footprint, dramatically reducing the number of its kiosks, resulting in a decline in kiosk revenue of 41%, year-over-year. Second, the company's retail sales are down 1%, reflecting its new emphasis on direct-to-consumer (DTC) business. DTC business is up 13%, year-over-year.

Both of these initiatives should help Rosetta Stone become more profitable.

They Are Doing It -- So Can We

Activision Blizzard (NASDAQ: ATVI) and Williams-Sonoma (NYSE: WSM) are two companies that are witnessing huge payoffs in a transition to e-commerce and DTC sales.

Activision, for example, saw gross margins increase 4% in FQ3, year-over-year -- mostly due to an increase in digital sales since its digital operating margins are much higher than retail margins. In 2009, 2010, and 2011, revenue from digital sales was $1.23 billion, $1.44 billion, and $1.64 billion, respectively. As a result, the operating margins were 25.8%, 28.5%, and 30.3%, respectively.

Williams-Sonoma's e-commerce net revenues were up 16.7% in FQ3, year-over-year. The payoff is substantial, with e-commerce margins doubling the margins of its retail store revenue. Management believes it can increase its more profitable e-commerce sales to more than half of revenue (currently at 42%), pretty impressive for a company with no digital products.

Activision and Williams-Sonoma are benefitting substantially from a shift to digital and e-commerce sales, respectively. If Rosetta Stone follows a similar pattern in its transition to increasingly more Online Learners and DTC business, the payoff could be significant. As a company with 100% of sales coming from digital products and online services, there is a very high likelihood that most sales will quickly shift from retail to online over the next two to five years.

Valuation

Rosetta Stone is dirt cheap when measured by both price-to-book and price-to-sales. In the chart below, there are two important trends to highlight. The first is that Rosetta Stone is historically cheap (or at least fairly priced) in relation to its own historical ratios. The second is that Rosetta Stone is drastically cheaper than both Intuit (NASDAQ: INTU) and H&R Block (NYSE: HRB), two software and service companies.

<img src="http://media.ycharts.com/charts/72ef1827a7c8109883eca2d016af4a29.png" />

RST Price / Book Value data by YCharts

Though Intuit and H&R Block are much larger, established, and diversified companies, it is still interesting to note the potential valuation premiums that profitable software and service companies can command. H&R Block, for example, trades at 1.8 times sales despite a heavy reliance on services and low growth expectations. Rosetta Stone, on the other hand, trades at just 1 times sales.

The Bottom Line

One baby step at a time, Rosetta Stone gets closer and closer to a profit. With a growing adoption of DIY online services and and increasing preference among consumers to purchase software online, Rosetta Stone's Online Learners and its DTC business will continue to represent a larger and larger portion of revenue, driving operational efficiencies. At today's conservative valuation, Rosetta Stone offers long-term investors an opportunity to jump in on an investment with limited downside and huge upside potential.


DanielSparks has no position in any stocks mentioned. The Motley Fool recommends Activision Blizzard, Intuit, Rosetta Stone, and Williams-Sonoma, Inc.. The Motley Fool owns shares of Activision Blizzard, Intuit, 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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