Rosetta Stone RST
August 23, 2011 - 2:29pm EST by
zach721
2011 2012
Price: 11.80 EPS $0.00 $0.00
Shares Out. (in M): 21 P/E 0.0x 0.0x
Market Cap (in $M): 243 P/FCF 0.0x 0.0x
Net Debt (in $M): 115 EBIT 0 0
TEV ($): 128 TEV/EBIT 0.0x 0.0x

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Description

We think Rosetta Stone is extremely misunderstood and trading for less than 50% of what we think the business is worth over the next year or so. Our thesis is at current prices an investor is paying .6x EV/Sales for a highly disruptive growth business with a unique business model (RST model spends 50% of revenue S&M and 15% on R&D with GM of 80+) that the business model should be able to achieve at least 15% EBITDA margins. This business model has allowed RST to at a 50% CAGR over the last five years while generating approximately $100mn in operating cash flow.  RST has substantial growth opportunities with a  50% growth rate in international (5% in 2009 projecting 40%+ by 2013), two new high growth SAAS based products Totale and Reflex (Subscription based revenue jumped from 15% to 27% yr/yr).  The business model is  transition from a product stand point moving from CD based to more of a recurring revenue Software-As-A-Service and customer acquisition channel from offline to online.  Guidance is for positive FCF for rest of 2011 and Jefferies has FCF of between $28-41 million for 2012. Over the last six years RST has spent $472 million on S&M, $92 million on R&D, $855 million in gross profit, while generating $127 million in operating cash flow. Today, RST is valued at only $135 million EV with $115 million in net cash.  We believe EBITDA margins are highly depressed from investing internationally (revenue is broken out but costs are not/and a transition to more online customer acquisition focus from offline) while improving the delivery and revenue model with web based recurring revenue components in high growth markets. As an added bonus, RST has a short interest of 25+ days which should help mitigate further downside given valuation and guidance.

 

Industry overview: The US is one of the least attractive markets in terms of per capita language learning spend ($13.33 per capita vs. world per capita $11.85) whereby Rosetta Stone has very significant market share.  Furthermore, US is characterized by less serious learners more prone to buy an app as US citizens have less economic incentive to learn foreign languages than those outside the US. Overall the market is highly segmented offline(classroom)/online(software)/mobile(apps). We believe that the least serious learners are mobile apps (want to learn enough for a trip overseas to get around or order off the menu) .  RST shows literally an L shaped graph based y axis revenue per student and x axis number of students. In 2010, Berlitz in the US generated $114mn in revenue with just over $4mn in EBITDA. To prove the L Shape, Berlitz charges approximately $71 per lesson and delivered over 6 million lessons on a global basis in 2010. Berlitz costs are mainly tutors and fixed overhead.  On the other end, competitor of the spectrum LiveMocha has a freemium models, but to purchase the software the price point is now close to RST.  We believe RST has several unique competitive advantages that are tough to compete with: the CMO recently was quoted in Adweek:   "We're sort of the only player in our space. The way I would describe it is there’s no Pepsi to our Coke." He added, however, that there are "a lot of low-priced digital apps that are showing up on iPhones, other platforms and some free Web services. But you pretty much get what you pay for there."

Unqiue aspects to RST model: Given RST software based business model vs. offline line and freemium we believe this creates an especially high barriers to entry as RST has significantly lower unit costs and significantly more dollars to invest in brand building and innovation. For illustrative purposes, when a student purchases RST level I at $179, around $80 goes to sales and marketing and $20 goes to R&D per unit sold which allows the company to build a brand and innovate aggressively to build a cumulative advantage vs. subscale competitors who have very different cost structures given different delivery formats models and which make it very difficult to compete with RST offerings. Second, RST has what we view as a number of effective subsidies in the form of the ability to leverage R&D on a global basis and lower customer acquisition costs in Education/Institution.  Kiosks, have low barriers to exit and are effective high traffic billboard/brand building that generate around 15% of total revenue.

 

 

Out of 4,232 companies that trade publicly in the US with enterprise values between $15 million to $3 Billion, Rosetta Stone is shockingly only one of 17 companies businesses that have greater than 75% Gross Margins and are valued at less than .75x EV/Sales. Only 6 out 4,233 trade for a lower valuation with similar business model dynamics which are: FXCM, TSRA, GLDC, EPAX, CPY, and RELV. Five out the last six companies are actively repurchasing their shares in the market place. We think RST, has one of the most dominant business models we have invested in with substantial growth opportunities.

 

If the business plays out as we see it in 2013 RST could reach $400-420 million in revenue with 15% EBITDA margins or $3.00+ in EBITDA per share on a current EV of $6+/-. We think this is a business that should trade around a 10x multiple of EBITDA possibly better. We think this would reach a price target of $40 when including our estimate for net cash. We think the downside is very well protected with new product Reflex launched, positive FCF, and sequential revenue growth at .6x sls and 45% net cash.

 

Why the language learning market is attractive:

a)      Conversational English should be a very big market: in China the ability to speak conversational English allows one to earn 3x a non-english speaker

b)      $80bn is spent annually in learning languages on a global basis ($11.40 per capita), To be clear we are not implying this is RST market opportunity, but it is a very significant market compared to where RST is today.

c)       In Korea where ReFlex was launched the per capita language learning spend is $183 per capita which is a big potential market for RST

c) Rosetta business model takes market share away at class room model because self paced at an effective price point.

 

Solid board: former CEO Tumi, former vice chairman and president of AOL, PE firms representation of ABS and Norwest which own 41% of RST

 

Short thesis:

There are no shortage of doubters and shorts (days to cover are 25+) from a mix of: high growth international whereby revenue is broken out and costs are not combined with a transition in customer acquisition cost channels. Additionally, there is May 2011 Seeking Alpha article by a recent college grad, which referred to Rosetta Stone as a “Digital Dinosaur” which we find amusing given our observations given: Rosetta’s Facebook Likes are up from 300,000 to nearly 600,000 from March 2011 to August 2011, Korea Rosetta Facebook likes are growing 5-7% week over week (only been tracking about a month), and on Google term Rosetta Stone increased 30% yr/yr as of June.

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Key CEO quotes from 2Q11 cc:

 

The reasoning behind the sequence was that while one of our biggest opportunities was always to solve the world's most pressing language learning issue, namely the lack of affordable conversational English proficiency training in Japan, Korea and China, we would need to have a steady source of cash from our US consumer business to fund the effort and a tried and tested marketing organization in the key Asian markets to promote it.

 

Of course we are spending to ramp up our presence internationally and the contribution margins are lower than we ultimately expect them to be when we achieve scale. We now anticipate international sales to be more than 40% of our business by 2013, mostly based on continued and deeper penetration of markets we are already in. (

 

 

So it is gratifying that on a year-over-year basis our English sales have more than doubled in each of the first two quarters of 2011, both domestically and internationally as Hispanics, Koreans and Japanese learners become a bigger part of our customer base. English is already one of our top two languages and based on our strategy and new product releases we expect to continue to see strong momentum. While success with ReFLEX and developing our international markets is likely to be a big long-term driver of growth, putting our US consumer business on better footing represents our biggest short-term priority.

 

 

US business on mend:

The positive trends we saw then have continued with sales steadily ramping upward in each month of Q2. The critical marketing shift underlying our new pricing strategy is that we are no longer focusing message on discounts or price promotions. Our communication strategy has shifted towards communicating our real value proposition, around the benefits of learning a language with our system. We expect that this shift will be beneficial to the brand in the long-term but we are also pleased to see a positive short-term impact, as demonstrated by Web sales being significantly higher than a year ago in June despite last year's performance having had a heavy dollar-off promotion. Our shift in media strategy towards more targeted audience reach as opposed to being just direct-response also led to positive results as we saw significant year-over-year increases in Web traffic. The metric that illustrates how well this is working is that 30% more people typed in Rosettastone.com in June 2011 than in June last year.

 

We are also focusing on doing a better job on following-up with prospects on email and leveraging our Facebook community which now exceeds half a million fans. We expect to continue to nurture our CRM capabilities as our business moves increasingly online.

 

More digitally oriented distribution activities are creating lower cost points of sale. And a multi-device technology approach allows us to handle the shifting pace of consumers over time. With good execution on the US consumer turnaround effort we are seeing some stabilization and with stronger performance coming through international, fueled by the launch of ReFLEX we should see the business return to stronger growth in the coming quarters.

 Disclosure: This does not constitute a recommendation to buy or sell shares of RST. We own shares in RST and we may buy or sell shares with out updating this board. 

Catalyst

 

 

 

Per guidance FCF for next two quarters, Jefferies has FCF of $28-41 million for 2012 on $135 EV.  

45% of market in net cash, opportunity for significant share repurchase

Significant conversational English market in Asia, ReFLEX just launched and appears to be gaining traction

@ .55x EV/Sales valued like the business will not grow or reach profitability, we expect both in the current quarter

Transition to a sticky business model from CD to SAAS

Subsidies: International leverages off domestic and sticky bsiness in institutional/Education high renewal rates and lower customer acquisition costs per sub due to mass sales

The business model spending 50% and 15% of revenue on S&M and R&D has led to 50% CAGR since 2005 while generating 12% OCF margins. This model has worked effectively in the US and 95% of the language learning spend is outside the US. 

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