Description

Buy RST.  It is both an attractive growth & value equity, obviously misunderstood by the market, and I honestly think it is impossible to lose money at these levels.  This is ¼ of my PA, and I got in after the irrational 3Q19 selloff. You should too. I think anything below $20 is a great entry point.

This has been written up twice before since it became primarily a Lexia biz, so I’ll refer you there for context.  The latest writeup was a good biz overview & validation of growth prospects, but I think was lacking in explaining why this is so obviously value.  The only tag on it was “poor FCF generation,” which implies to me that nobody understands what’s going on here, or maybe nobody read it.  Required reading:

• 2018: https://valueinvestorsclub.com/idea/ROSETTA_STONE_INC/1193337407
• 2019: https://valueinvestorsclub.com/idea/ROSETTA_STONE_INC/2553065619
  • You can skip this, honestly, if you read the 2018 one.  But the updated channel checks & insight on new product launches are very good for getting comfortable with the growth trajectory continuing.
• 2Q19 webcast: https://investors.rosettastone.com/events/event-details/rosetta-stone-q2-2019-earnings-conference-call
  • Look no further than the Q&A session to understand why the equity initially rocketed.
• 3Q19 webcast: https://investors.rosettastone.com/events/event-details/rosetta-stone-q3-2019-earnings-conference-call
  • Then refer to the Q&A session to see why this got irrationally puked following 3Q.

Hopefully by the end of brief note this you will understand why RST is, in my opinion, one of the most valuable strategic assets that exists in the EdTech universe today & why it is a miracle that it remains buried in a misunderstood public vehicle.  Focus will be on valuation & why these companies are worth their multiples, and you are gonna have to trust me on the comps – some EVs are round number estimates, but lets just say im 99% sure they are right. I cover edtech in the private market (which is where all EdTech companies except Lexia currently live) and its my job to know what private buyers are paying & why. 

State of edtech & where Lexia fits

For context, the edtech market is an unstoppable growth engine at this point.  For years, Pearson & Mcgraw had a lock on the ed market and were impossible to displace.  This is because 1) edtech was unproven, 2) there was a lack of districts/states that had taken the leap of faith into replacing books with tech, and 3) [most importantly] the sales cycle into public schools remains extremely long and difficult to crack. 

The first two issues have been solved by the edtech market overall, as there are now tons of schools/districts/states leading the charge into tech.  It has already been proven to be an effective/engaging replacement of books for the students, plus a budget saver for the districts overall because texts & workbooks are damn expensive.  There is broad acceptance at this point, and it continues to spread through the remaining districts with each passing year. Penetration of additional edtech products also expands within districts that have already been captured with each passing year. 

The 3rd issue has been solved by only the best edtech players around (which includes Lexia).  The sales cycle is about 3 months long at the beginning of the school year (Aug, Sept, Oct) due to who your core buyers are (school districts).  You must have an easy product to explain in a matter of minutes, plus you must be able to train the teachers to use it in under an hour in order to even get a look.  If you frame your product incorrectly, if you don’t get enough boots on the ground, or if you don’t get any traffic during those 3 months for whatever reason – then you are basically dead in the water with a cash burning R&D project for a full year with no hope of landing a single sale.  This is why the barriers to entry are so high, even if the products seems relatively simple to engineer – most of the battle is gaining initial credibility to sell into public institutions & sales know-how. However, once you have those two things, you are able to sell your products in tens of thousands of US schools by simply copy-pasting the same approach, then follow-up on that success by releasing adjacent products via the same sales force & established district connections (with a much greater success rate than any startup launching with the same standalone product would have).  This is where Lexia is today – launching a series on follow-on products that complement their original Core5 product. 

Once you capture a school and sell multiple products into them, the schools become much lower cost to service.  You no longer need to send sales reps out to them, and instead those expensive reps can be re-directed to originating new district sales (or eliminated).  Retention rates are high in the edtech world today, so long as you have a team that focuses on servicing the customer, monitoring the utilization stats, and sending people to occasionally do refresher courses with teachers. 

In this way, existing edtech businesses become annuities.  You spend a ton on the upfront sales sprint to capture as much of the market as possible (resulting in zero or negative cashflow), plus the development of adjacent products (plate capex & R&D) – but then you just stop spending & focus on retention.  At this point, you sell the annuity you’ve created to a larger platform that already has an established cost structure & can immediately wipe out 90% of your costs (this ‘90%’ is meant literally). The contribution margins to a platform buyer are often 90%+, with those buyers running at 30-50% cash EBITDA margins within 1yr (despite the fact that just yesterday your company was viewed as a cash-burning, sales & R&D-oriented, yolo investment with no hope of ever breaking even).   

And that’s just the cost synergy & existing annuity value.  Don’t forget that there are several large platforms with full sales forces already selling into many more schools & districts.  Narrow products like Lexia’s could simply be added to the existing sales packet that these reps are going to districts with & immediately begin capturing revenue synergies by leveraging existing district relationships & the established credibility of their larger platforms.  This is what the industry refers to as the “land and expand” strategy. 

I will leave you with these market sizing datapoints to close the loop.  Ren, Weld, and Cambium are the 3 major private platforms that are rolling up the industry aggressively:

The acquirer’s multiple

It was tough for me, as a self-proclaimed value investor, to wrap my head around the lofty bookings & revenue multiples that are thrown around in this space.  But with the previous section’s context out of the way, I will try to explain with a tangible example that helped to see the light. (Note that I do not represent any numbers in this section as fact, and the numbers are instead based on mosaic & hearsay)

Renaissance bought MyON Reader for 5.8x LTM bookings (pretty close to revenue), or 60x LTM EBITDA, or 38x LTM CEBITDA standalone in 2018.  MyON by itself generated about $31M of bookings/revenue at the time of sale in early 2018 (see comp sheet below), and its EBITDA margin was like 10% ($3M).  The largest component of their cost structure was sales and marketing, which were north of 33% of total costs by itself. Bookings organic growth was over 20% in the last few years annually, similar to Lexia today, and at the time they were sold they were in only 5k schools (vs Ren’s 40k+).  MyON’s cashflow was negative after plate capex. 

And nonetheless, the strategic was willing to pay an eye-popping multiple for this asset.  Why?

Well, Renaissance generates EBITDA margins of about 50% with a fully developed cost structure.  They have tons of operating leverage at this point, and they just want additional high-retention annuities to run through their cost structure. 

When Ren bought MyON the intent was to generate about $26M of cost synergies by removing almost literally all of the costs.  That is $26M of cost synergies on $31M of total bookings. Of that $26M, about $12M was the entirety of their sales force & marketing spend.  Those synergies were 83% of total LTM bookings. Overnight this cash-burning one-product company flipped from 10% standalone margins to shitting cash at 93%+ contribution margins to Renaissance.  It has continued to grow through utilization of Ren’s much larger salesforce since then. 

Would Ren make that deal again if given the chance?  You bet. That’s why nothing besides LTM bookings and organic growth rate matter when valuing Lexia. 

Valuation

The recent selloff here was due to the huge miss around guidance in 3Q, and the subsequent restatement downward of 2019 & 2020 expectations.  I think the people who puked this on the sentiment change are momentum apes with no understanding of what this crown jewel is worth to a private buyer. 

Yes, Lexia missed the 30%+ organic booking growth target and will remain cashflow neutral for longer.  But who cares? They will still put up 20% organic booking growth this year, and have done north of 20% organic growth in each of the last 3 years, compounded.  The market is wide open for them, there is a ton of untapped TAM for them to capture in schools that are already open to the edtech transition, and they continue to launch new products into existing customers (which obliterates historical EBITDA margins & cashflow).

So what is this actually worth?  Well, here is my understanding of the valuation landscape in edtech throughout the current economic cycle (2010-2019):

I think there is no state of the world where Lexia sells for less than 4x bookings.  Pureplay edtech has broadly been valued at 4x-6x bookings through the cycle, and those multiples weren’t impacted at all by broad market valuations (public equities, S&P, etc) nor the cycle.  Instead, they were primarily predicated on the growth trajectory of the asset being acquired. No-growth or negative-growth annuities have typically traded closer to 4x, while growers were more in the 5x-6x range.  Renaissance’s latest transaction when they were bought by FP wasn’t really a bookings-based deal, but rather transacted on a traditional EBITDA multiple due to scale (but the things they bolt-on trade on bookings).  

I use a range of bookings multiples to value Lexia, centered around the average booking multiple derived from the comps above.  I think everything in the range I provided is achievable, and am pretty sure Ren could bid at the very high end & still make a killing due to Core5’s sales synergies with Ren’s existing STAR & reading practice products (which are far more relevant to Core5 than the products that Weld & Cambium are working with currently). 

It is important to note that I think the only way they get the low end is if everything at Lexia immediately goes to shit, all new products are complete flops, they never book a new sale again, and organic growth slows to 0%.  I view this as unlikely over the next 1-2years, but anything is possible & I have included that as my downside/low case. Please note I think the downside here is a positive 20% return from today’s prices & I see no realistic path to crystallizing a negative return on this. 

On Rosetta/Language (this is the only time I will mention it): I have no idea what this is worth, but I assume it can be run for cash by a middle market sponsor.  I don’t really know much about that sector, and the only private equity platform I can think of here who could pull a lot of value out of it would be Wall Street English.  Beneficially its all SAAS and has been making progress, and I comfortably think you would get at least 5x-7x EBITDA for it. But who knows – I will leave it to someone else to pick up the value there after Lexia is sold. 

The above valuation is my point-in-time EV if this thing were hypothetically sold today.  This is unlikely. I also doubt it will be sold in 2020 unless the new products are failures.  The chart simply indicates the value you are receiving today. 

The home-run case, which Im not going to bother to put into chart form, is that some maniac pays 4x for the whole portfolio.  There is precedent for this in the Cambium acquisition during 2018. But I think its low probability due to the lack of synergy between the Rosetta and Lexia, and there is no good reason to keep them together.

How this will play out

I like this investment because Hass (the CEO) was a banker & understands that he will create $70M of equity value (or $3 per share; assumes a 5x bookings fair value) in 2020 alone by holding Lexia & letting it grow bookings by 20%, then another $80M+ of value in 2021.  I encourage this, and am also happy to own Lexia until the easy growth has been squeezed out. When you think of it as a growing annuity that will be inevitably/eventually sold for 5x+, it is easy to see why you should be patient capital here.

I do not expect a sale in the near term for this reason, unless the growth prospects deteriorate rapidly.  Hass understands this & will only pull the rip cord when the trajectory changes (or when the impatient shareholders force him to).   Again, even no-growth edtech annuities have sold for 4x, which would still imply a material positive return from where we sit today. 

I think base case here is 20%+ growth in fair value annually over the medium-term, ending in a 5x-6x takeout by Renaissance in a couple years.  At that point, I don’t really care what happens to the rest of Rosetta, but there is probably some value there too. This base case results in a 70% return in 1yr if they hold on for a full year and realize 20% bookings growth, then sell at 5x.  If they hold on to Lexia for 2yrs, it’s a double from today at a 5x takeout. 

Other miscellaneous positives that aren’t really part of the thesis

• School budgets aren’t materially impacted by: the trade war, China, other misc foreign policy, who becomes president, recessions, etc.  This will continue to be a compounder regardless of what is going on in the world.
• K-6 budgets are supported by stable enrollments & sticky/diverse funding sources.
• The crystallized return here will not be impacted materially by the broader economic cycle or public valuations.  Its all about the synergies. 
  • I think this is timely if you spend a lot of time worrying about public valuations & investing in a world where everything is over-valued.

Risks:

• Key risk is that you only get a +20% return via downside takeout in the next year.

Catalyst

• Growth
• Inevitable sale of Lexia