|Shares Out. (in M):||24||P/E||NA||NA|
|Market Cap (in $M):||405||P/FCF||NA||40|
|Net Debt (in $M):||10||EBIT||-14||-2|
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Rosetta Stone (RST) | $16.90 | Market Cap: $407M | EV: $404M | EV/2020 Recurring Revenue: 2.0x
Executive summary: We believe Rosetta Stone has the best risk/reward ratio of any of the US publicly traded software firms. The stock has over 90% upside in our Base Case, only about 17% downside in our punitive Bear Case and 244% upside in our Bull Case (which is close to management’s guidance) which still puts it at about half the valuation of its trading comp group (4.3x EV/Sales versus ~8x for software firms growing 30%).
Rosetta Stone hasn’t yet been able to shake the negative stigma and jaundiced image from the time they were burning lots of cash and selling the ubiquitous yellow language CD boxes in mall kiosks. Many on the buy side react in disgust at the mention of the name and believe their consumer language learning business is “going away” or “worth zero.” Contrary to this misinformed and consensus view, they have in fact been growing the subscriber base at a brisk 23% CAGR over the last four years.
In addition to the now growing Language business, RST owns the leading Literacy software franchise, Lexia, which we believe the market is currently under valuing as well as missing the critically important and large opportunity forthcoming from their new English Language Learning (ELL) product that is launching in 2020. Rosetta is starting to screen better, as the company will return to 15-20% consolidated year-over-year revenue growth in 2020, with the more valuable business, Lexia, likely growing billings near 30% next year. With Lexia billings approaching $100 million next year, along with a 90% recurring mix with >100% revenue retention along with emerging profitability and evangelical user support, we believe Lexia on its own is worth $600-$800 million. Given the activist ownership and board representation, along with the upcoming ELL split, we believe the company will move to unlock this value in 2020 by either selling the company in two pieces, selling the entire company, or spinning off Lexia as its own public entity.
For several years now, RST has been screening poorly and hasn’t looked appealing to investors taking only a cursory glance. It hasn’t appealed to growth-oriented software investors as they’ve undergone a SaaS transition that has hurt revenue growth, and it hasn’t appealed to value investors who are screening on EBITDA or FCF. This is about to change as the company will begin to show accelerating revenue growth and expanding profitability simultaneously. If history is any guide, this combination in software stocks has been a recipe for our largest investment winners ever. While the stock did not get the respect or high multiple of the software high-flyers, it has caught all the downside in the internet and enterprise software stock correction of late. This initial reaction has created a very attractive entry point right as we believe the rubber will meet the road in their all-important third quarter. Namely, we believe the stock has already priced in a material miss in Q3 and has de-risked ahead of the quarter due to extreme investor skepticism over their ability to hit prior guidance in both 2019 and 2020/2021.
Rosetta is really three distinct businesses in one, although two have a lot of overlap, those being Education & Enterprise (E&E) and Consumer Language.
As we will discuss in detail below, Lexia will balloon to likely over 40% of total billings from 33% last twelve months and less than 7% when it was acquired.
Lexia is undoubtedly the crown jewel of Rosetta. It teaches children how to read with gamified software. The company was founded over 35 years ago and started as a product primarily for students with significant reading disabilities but has since evolved to become a product that entire classes use as a critical part of their reading curriculum. They have two literacy products--their Core5 product that covers kindergarten through 5th grade, and their PowerUP product that covers 6th to 12th grade, while also having a reading assessment product called RAPID and their portal product, MyLexia.
Core5, the undisputed flagship product, has a systematic and structured approach and targets six reading areas, which include:
Phonological Awareness (Pre-K through kindergarten)
Phonics (Pre-K through second grade)
Structural Analysis (third grade through fifth grade)
Fluency (Pre-K through fifth grade)
Vocabulary (Pre-K through fifth grade)
Comprehension (Pre-K through fifth grade)
Core5 is arguably tackling a national crisis. The National Center for Education Statistics claims that two-thirds of 4th grade students in the US are “non-proficient readers,” meaning they don’t read at their grade level. Once students fall significantly behind in their reading proficiency, there is strong correlation to future negative adverse events in their future.
US policy is encouraging the adoption of technology in the classroom, especially adaptive, personalized learning products. The now ubiquitous use of tablets and computers in classrooms promotes interactive courses and gamification of learning, all of which play to Lexia’s strengths. Here is a link to the National Education Technology Plan, the “flagship educational technology policy document for the United States”: https://tech.ed.gov/netp/
Summary of some key highlights from the report that are relevant to Lexia:
The #1 goal is empowering learning through technology
Educators are shifting away from a “one size fits all approach” - A focus will be given to using tech to personalize learning – one of the core strengths of Lexia
Increase the use of “sophisticated software” that allows for adaptive real-time assessment of each individual student’s progress that comes with personalized instructions/lesson plans for the teacher—this pretty much sums up what Lexia aims to accomplish: Personalized, adaptive, data-driven (and patented) “assessments without testing.”
For Core5, assessment is incorporated throughout the content, meaning there is no pausing to take an extra assessment test. It offers dynamic feedback student-by-student, and the teacher can monitor and receive suggested lesson plans to help students with their weaknesses. Per the report linked above, many school districts have been left behind “which underscores the need to accelerate and scale up adoption of effective technologies.”
We believe part of Lexia’s competitive moat is the 17 peer reviewed studies supporting Lexia’s validity and efficacy claims. Lexia is proven to help close the achievement gap.
Lexia primarily competes against small, private companies like Curriculum Associates, iStation, and Imagine Learning, each of which have their own strengths and weaknesses. iStation and Curriculum Associates for instance are known for their strong assessment products, while Imagine Learning is known for its strong English language learning (ELL) product.
Lexia has shown rolling billings growth of 24-25% for the past several quarters and we believe this will continue in 2019 and into 2020/2021. We believe they will approach $100 million in 2020 billings (~$95mm) and over $80 million in ARR by the end of 2020, clocking in at a 25-30% growth rate.
We believe if you look at the profile of Lexia in isolation, you are looking at a business that is currently worth at least $400 million and could easily grow to in excess of a billion-dollar valuation over the next few years with continued sharp execution.
Consider Lexia’s attractive business characteristics:
Underlying customer retention: low to mid 90%, which is extremely high in the Ed Tech space
Revenue retention: at 100% but will likely move materially higher in 2020/2021 with their ELL launch
~90% of bookings are pure recurring, high margin software revenue, with the remaining 10% training revenue also highly recurring (~70%)
Aggregate gross margins (we believe) in the 75-80% range and climbing as they scale
Emerging profitability with management citing incremental revenue dollars coming in at 40-50% margin
A large TAM with a large opportunity to develop or acquire adjacent products (for instance, a math product) and become a platform play
Strong growth visibility due to its go to market approach of infiltrating districts in one school, showing efficacy at that school, then getting rolled out to the full district over time
A newly upgraded direct salesforce that is now much larger and fully seasoned since they transitioned away from resellers
Relatively strong moat in that this product has been built and iterated upon for over 35 years and has many PhDs in language and language development. In other words, you won’t get a couple Silicon Valley bros in a garage coming up with a product that disintermediates this product over a weekend (or a year)
Lexia as a product is:
Tackling a core problem facing the US today
At the core of most curriculums--reading is consistently cited as the most important and challenging elementary school subject
Has scientific and state-wide studies showing strong efficacy and usage of the product
Unusually beloved by its users, boding well for product upsell
Can be seen (and should be marketed by Rosetta from an IR standpoint) as a socially responsible product
Not in danger of becoming obsolete (reading will always be an important skill)
Taking this all together, we believe Lexia should be worth at least 4x 2020 billings (~$100 million*4= $400 million). With the current EV of the whole company at around $350 (end of year cash balance of ~$42 million from seasonal low point in Q2), we believe this significantly de-risks the story even if growth comes up a little short or if software/internet multiples continue to compress. However, we view that $400 million valuation on Lexia alone as quite conservative. If Lexia were a public company and didn’t have the Rosetta Stone “stink” associated with it, we believe Lexia would be valued in the $600-$800 million range right now, or 6-8x 2020 billings, taking all of the characteristics listed above and comparing to other 25-30% software growers (see 10/14 DDOG initiation by Goldman Sachs showing 30% software growers at 16x sales).
Below we touch on and expand on some of the areas described above to help clarify the opportunity and visibility.
Lexia History and Progression
When Lexia was acquired by Rosetta Stone in July of 2013 , it looked very different from the company it is now and the company we believe it will become in 2019-2021. At that time, Core5, the flagship product that has resulted in an explosion of growth the last few years, was just being released for the first time. The company primarily sold their product as a perpetual license (as opposed to subscription), sold mostly through the channel (versus direct salesforce), and was primarily selling on a per student basis as opposed to a school wide license.
We believe the company made a lot of difficult decisions that we are now starting to see the fruits of, including:
Significant ramp in R&D investments, consistently encompassing close to 30% of sales, to build out new products and improve the Core5 product, resulting in an industry leading Literacy product, a strong Assessment product in RAPID (2016), a strong middle school and high school product in PowerUP (2018), and in 2020 an ELL product. All growth has been organic, impressive in this day and age of bolt on acquisitions.
Completely building out a direct sales force and removing all but the most successful channel sellers, temporarily disrupting sales. We believe 2019 is the first year a fully polished, larger direct sales force is selling their product base, although we got a taste of it in 2018.
Completely moving to a subscription model, something they are still seeing reverberations from as they move perpetual license customers to a subscription model (modestly elevated churn)
Aggressively moving from a per student revenue model to a full school site license model, increasing the product’s stickiness
In retrospect these seem like the obvious right decisions, but at the time they were painful in the short term and risky. We applaud the management team for going through with them and building a sustainable franchise the right way, organically, at a time when Rosetta Stone as a company was in deep turmoil burning a lot of cash.
We believe the chess pieces have been placed and will see, shortly, how successful these major efforts were in the form of a large Q3 season. The third calendar quarter is by far the biggest quarter for Lexia. The product gets sold in the summer months, mostly July and August, in order to roll the product out for the school year starting in September/October. To this point, as a function of Lexia becoming more strategic with larger school districts, Q3 became by far the primary growth driver in 2018 and will become even more so in 2019. Some customers that might have used the product just for children with reading disabilities and bought the product on a per student basis are now waiting to renew in Q3 and upsize to a full school license.
The company does a reasonably good job in their presentation materials outlining the multiple levers for growth and how they believe they have more visibility than ever given a lot of the growth comes from expanding within the school and in turn expanding within the base.
Consider the following:
Lexia has a presence in 14,000 elementary schools (17,000 total schools) but only 4,000 have site wide licenses.
Only 1,823 schools have multiple products (e.g. have been cross sold either PowerUP or RAPID), although this is up from 131 at the beginning of 2018.
They have roughly 9% of students, 14% of schools, and 22% of districts on Lexia, but if they were to fully penetrate just the districts where they already have schools, they would cover 41% of total schools and 46% of students.
We estimate the average price they are getting where they don’t have a full site wide license (sold on a per student basis or for a limited number of seats) is around $2,000-$3,000, while a site wide school license is $8,800 just for the software. Thus, each school that converts to using Lexia site wide is an added ~$6,500/school/year, on average. Said another way, if they just converted all their schools with student licenses to site licenses, it would add an incremental $65 million in ARR (effectively doubling 2019 ARR).
President Nick Gaehde was asked where the focus was this year, and he noted that the focus the last couple years had been to land in new districts, while in 2019 they are emphasizing expanding out within their existing “base”:
“So it's really both, obviously we see the bigger opportunity in expanding and the footprint we are in right now and have certainly created a sales channel and a strategy to expand in the districts we are in. It's one of the reasons we are so excited now by having a comprehensive portfolio of curriculum and assessment because we can come to the district and talk about their needs as I said before from kindergarten through 12th grade. So that is absolutely a focus. But we also know that we need to continue to drive into districts that we're not in yet. And so we do both, but certainly this year there is more emphasis on expanding in the districts that we are already in than previously.”
Management claims they can go from $4k/year in revenue from a new school district in year one up to as high as $120k/year by year four.
Sample progression of school district relationship and penetration potential where the school district has 10 elementary schools, 2 middle schools, 1 high school
Year 1: $4k in sales from small pilot of Core5 at one school
Year 2: $40k in sales from 4 unlimited use site licenses + some Implementation Services revenue
Year 3: ~$78k in sales from renewal of previous schools + four more elementary schools, + 1 PowerUP and RAPID pilot of 100 licenses at a single middle school
Year 4: ~$120k in sales from all ten elementary schools on Core5, PowerUP and RAPID at 2 middle schools and 1 high school (30x increase over year 1)
Note we believe this is how management can forecast their projected growth with reasonable precision, as they are constantly rolling out larger implementations across districts
Finally, we would point out that this should be very high margin incremental revenue, as upsell revenue generally is, and is supportive of their 40% incremental margin target for 2020 and 50%+ in 2021.
The ELL Opportunity
In late 2018, Rosetta made a material announcement at its investor day. They announced that in 2019 they would be developing an English Language Learning (ELL) product that would roll out for the 2020 school season. As we move into late 2019, we believe this becomes a critical part of the Lexia and Rosetta story (that the market is missing) for five reasons:
It combines Rosetta and Lexia salesforce into an integrated force on the “school” side, meaning the company can gain S&M efficiencies and nearly doubles the size of their sales force (45 to 75) for Lexia and the Education language business.
It finally cleanly cuts the company into two distinct parts, which is the first step towards an eventual sale or split up of the company.
It materially expands Lexia’s TAM. ELL students are expected to be 25% of the total US student population by 2025 (from <10% currently).
It makes Lexia stickier and “core” to school’s budgeting as it offers yet another piece of the overall curriculum pie, which should improve customer retention. It also opens Lexia up to more federal and state funding that is made available for English Language Learners (e.g. Title 3 funding)
It will be the first major opportunity to upsell product at the individual school level, which should improve net revenue retention/expansion to above 100%.
In order to understand how large the English Language Learning (ELL) opportunity could be for Lexia in 2020 we spoke with a couple of sales executives at competitor Imagine Learning, one on the west coast and one in the Midwest. When we were comparing competitor pricing, it seemed like Imagine Learning stuck out like a sore thumb. While other competitors like Curriculum Associates and iStation were in the same general ballpark as Lexia (around $8-$10k a school/year), Imagine Learning was often reporting per school licenses at price 4x times that number, in the $35-$40k range. Is Imagine Learning just a much better product? We don’t believe so. Rather, the delta seems to be primarily that Imagine Learning has an excellent ELL product, and they can charge a massive premium for this product because there is not a lot of viable competitors out there. We also believe in some regions there may be lots of extra funding available, sometimes in separate budgets that must be spent (Title III funding), that allows schools to pay Imagine Learning what seems like an exorbitant amount. The Imagine Learning salesperson commented that the “reason it’s more expensive is there was a huge amount of cost to develop the program, to have 15 languages fully supported other than English.”
Well that’s interesting to us. What’s another company that already has extensive curriculum built in many different languages? It’s Rosetta Stone, and we believe over the past year they’ve taken their admittedly weak ELL product on the Rosetta Stone side and built it anew under the Lexia umbrella. They allude to this project on conference calls as being a reason for elevated R&D spending that could be tempered. Here are the President of Lexia, Nick Gaehde’s comments on the ELL opportunity from the Q2 call:
“You know, the short answer to how is that need being met in the market right now is not very well. Unfortunately, there are not many products whether it's printed or digital that do a good job of supporting those emerging bilinguals. And that's especially true where the bulk of the market is in the K-6 segments, so products that are geared to those young learners that are appropriate for their age and yet build the skills they need to be successful in school and to access the rest of the curriculum. As John said in his remarks, it is the fastest growing segment of the student population. And we see just a phenomenal opportunity given our experience both on the literacy and language side and the strength of our brand to meet the needs of those students and meet the needs of schools who are increasingly, I think, struggling with how to help those students succeed.”
Assuming they’re able to release a compelling product, for which there is certainly an execution risk, they have a huge gap in pricing between the number one player, Imagine Learning, and themselves. If they were to bundle their Core5 product with the ELL and charge $19-$20k, it would save the schools ~$20k a year and would consolidate their vendor list as well. Channel checking with a few school principals and decision makers, they seem genuinely excited to try out Lexia’s forthcoming ELL product.
With Lexia in 14,000 elementary schools as of Q2 2019, we can do a little math on how much ARR could be added at various penetration levels:
Just getting 10% of their base to spend an extra $4,000 a year would result in an incremental $5.6 million in ARR, which seems extremely conservative given the implicit $20-$30k that Imagine Learning charges for ELL alone. That $5.6 million, though could be the growth driver that moves them from 25% growth to 30% growth.
We also believe there is potential for some “revenue multiple arbitrage,” as a portion of Rosetta Stone Language revenue will be converted (or they will attempt to convert) or re-classified to Lexia, which we believe will be ascribed a higher multiple than if the revenue was under the Rosetta Stone E&E umbrella. Of the ~$50 million of Enterprise & Education language revenue, we believe $25-30 million is K-12 and 50% of this is English language learning. We aren’t sure what percentage of this $12.5-$15.0 million is for elementary schools, as we believe a majority is likely middle school and up, but this means that potentially $5+ million of revenue could go from getting a 1-2x revenue multiple to 5-6x in most investors’ sum of the parts valuation.
The Texas and Other State Opportunities
We believe another shift that is occurring is states are moving away from forcing schools to package their reading assessment tools with their core digital curriculum tools. For example, as we understand it, for several years in the state of Texas a company called iStation effectively won a blanket mandate to use both iStation’s Reading Assessment product and their Reading product. This year, that market has materially opened up as teachers and administrators were simply not seeing the efficacy on the reading side.
In other words, iStation has a very good Reading Assessment product, but not such a great actual Literacy product, and there is no true reason you need to package both together. Since Lexia is able to demonstrate both efficacy and strong student/teacher engagement in various studies, we believe shifts like this are a great opening for Lexia to take market share. While other companies like Curriculum Associates are likely also taking advantage of this and winning business, management indicated on their Q2 call that they believe their “investment in Texas” would “pay off.”
Awards, Efficacy, and Passion for Lexia
One thing we were struck by when researching Lexia was how much teachers love it. The principals who implemented Lexia in their school were equally devout and passionate about the product. It tends to repeatedly win Educational awards from teachers. Lexia was voted #1 in every category by the teachers in a recent poll on the most popular education website. And the answers had to be written in, (not multiple choice) which shows they have great mind share and name recognition. Heck, there are even GoFundMe pages pleading to get funding for Lexia (it is unfortunate they aren’t getting funding by other means, but it does highlight the lengths they go to get Lexia-we donated :-).