Description

Rosetta Stone (RST)

Over the past 18 months, Rosetta Stone has undergone several strategic changes resulting in a revitalized company:

1. A new and well-qualified, management team led by CEO Steve Swad (former CFO of AOL) and Chief Product Officer Westley Stringfellow (former Global Head, Global Product Platform for PayPal);
2. Net cash represents approximately 50% of market cap, or $7 per share;
3. Solid Business Results:  Free Cash Flow for 4Q12 was $22 million alone or $1 a share and grew operating cash flow from $3 to $35 million from 2011 to 2012;
4. Strong growth in new subscription services: grew from $73m to $92m in 2012 (+26%) with material upside (630,000 units sold a year);
5. We estimate RST can generate free cash flow  of $35mn+ 2013 ($1.70 per share)  $45mn+ 2014 ($2.00 per share);
6. Nice business model: 82-85% gross margin, conversion to much more attractive SAAS business model underway that leads to higher margins and more recurring revenue;
7. Cheap valuation: 16% Free Cash Flow Yield for growing business for a business that should significantly grow FCF over the next few years;
8. We think upside could be $23-25  with Downside $12 (3.5x 2012 FCF+ $7 in Net Cash) over the next year.

Given the above characteristics, we believe that over the next three years RST will generate north of $125 million in free cash flow on a current $140mn EV.  This implies a valuation far higher than .5x of sales and 6x trailing free cash flow.

Before we get started, in our opinion, one of the reasons the stock is cheap is due to the following fact pattern: IPO with wrong strategy, consistent misses for first several quarters as a public company, heavy senior management turnover then new management, extremely conservative, and minimal promotion by company or Wall Street analysts.

The CEO said it best at their May 2012 Analyst Day, something to the effect of “we are only going to tell you what we know we can hit, because we have not earned investors confidence with our past guidance.”  EBITDA was twice what guidance was for 2012.  We think the management team is continuing its long term under promising and over delivering focus.  On their Q4 2012 conference call, RST’s CEO made the following comments regarding $22m in free cash flow:

• “I don’t want my employees or management team to think we are done. I am, as I said, very pleased with the year. I think you’ll get to know me. Im a mid westerner. Very pleased to me is the equivalent of many people dancing on furniture with excitement. I appreciate the compliment. I want you to know we’ve got our heads down and we’re driving for more.”
• “You know what, though? Just so you know, I tell the team we’re not going fast enough. I am happy with where we are, but I think we can do better.”

For 6x trailing Free Cash Flow, an investor picks up a lot of catalysts that we think should have a meaningful impact on the business over the next few years.

Bet 1 - Transitioning to Subscription Model:

The Rosetta Stone brand is known by 85% of Americans as a language learning software program.  Rosetta has an effective platform that is moving from CD’s to online subscriptions.  Subscription revenue increased from $73 million to $92 million from 2011 to 2012.  Subscribers stay an average of over 10 months and generate $26 in revenue per month.  In 2012, paid learners grew from 26,567 to 68,393 while paid online learner revenue grew from $8mn to $15mn.  This is a tiny business as total software units sold were 630,000.  Subscription services are a much better, higher margin, and more user friendly business model than CD’s.

Bet 2 - Leveraging the Brand and Platform:

RST’s stated goal is to acquire under-distributed educational software companies and create a family of high quality reading and language learning software products that more effectively leverage their brand and current customer acquisition spend (which is believed to be approximately $100 per sub).  In our minds, this high incremental margin strategy makes sense.  RST is NOT going to make very meaningful bets in terms of blowing their cash on a big acquisition.  On 4Q12’s investor call, management stated acquisitions are on the table in the $10-30 million range.  The brand has a very wide distribution with $150 million in Sales and Marketing and a platform that includes over 20,000 K-12 schools using RST products.  This is not only a $7 a share bet (50% of the market cap) for RST, but also a bet that it has the financial resources to reallocate this budgets from less efficient lower margin distribution channels such as kiosks, magazine ads, and offline retailers to as they mentioned on their conference call online partnerships through Groupon and Facebook, which are higher margin with a recurring revenue component (note the current interim Co-CEO of GRPN is a RST board member).

Bet 3 - New R&D Leadership :

We think the hiring of West Stringfellow could be a significant catalyst.  West came from Pay Pal where he was Group Head of Global Product Platform that supported 113 million users and $120 billion in payment volume.  Previously inside of Pay Pal, he was Senior Director of Emerging Products and Innovation and led a team of 1,000 employees.  Before that, he was Pay Pal’s Director of Product and Customer Experience.  Prior to Pay Pal, West spent time as Head of Marketing at GraysOnline, VP of Innovation and eCommerce for Visa in Europe, and Product Manager for European Merchant Risk Programs at Amazon.  West is only in his mid 30’s and has significant qualifications in global product development and payment systems, which are material for RST given their previous piracy issues.  The CEO, Steve Swad commented on West’s experience as, “I believe (West’s) track record, relentless customer focus, broad technical expertise, data driven approach, and overall sense of urgency and intensity is exactly what’s needed to help me take this company to the next level.”

Below is part of West’s Linkedin profile -

I [West] have a 15 year track record of:

1) building and leading teams that create disruptive products:
- founded and led a team of 1,000+ that designed, developed and launched PayPal's point of sale, multichannel, deferred payments and demand generation platforms and experiences - now integrating into Discover Card and live at 15 merchants nation wide. 
- designed, developed and launched Amazon’s digital video platform
- proposed, designed and launched Amazon’s 1st billable web service
- proposed and built Amazon’s 1st fraud operations and analytics teams in India 
- proposed, designed, patented and developed a new method of ecommerce authentication and payment at VISA, now live as V.me

2) revitalizing companies, teams, products and P&Ls:
- founded and led PayPal's Product Platform team, designed to make product and technology more collaborative, agile, SOA compliant, customer focused and efficient 
- led the redesign of PayPal's compliance infrastructure retaining 3M+ AU consumers
- led the redesign of Verified by VISA in Europe increasing usage by 130% YOY
- redesigned and led Amazon’s European Fraud program and team reducing fraud by 98%
- redesigned and led GraysOnline's marketing program and team growing active customers by 10%, improving onsite CTR by 300%, increasing PPC CTR by 23% while reducing CPC by 20%, and re-positioning natural search visibility from SERP 50+ to SERP 1

The numbers:
- 15+ years leading, building and optimizing products, programs, and P&Ls
- 9+ years building, mentoring and leading high performance teams
- 8+ years in big companies: Amazon, PayPal and VISA
- 7 years in start-ups: netLibrary, Alibris, Global Philanthropy Forum and VSpan
- 6 years working overseas in England, Australia and India

Specialties:

- Building and leading teams that excel in fast-paced, dynamic and unstructured environments
- Creating disruptive strategies and products and moving them rapidly from concept to market
- Data-driven and customer-focused iteration and optimization of businesses and products
- Mobile, online and multichannel retail and payment strategies and technologies
- Strong ability to rock

In early March 2013, RST announced firing essentially there CD development team (Google: Rosetta Stone, under news) and opened offices in San Francisco and Austin to hire 100 developers.

Bet 4 - New Product Pipeline:

Rosetta Stone will release a new product line aimed Kindergarten- 6^th grade aimed at language immersion that will be released around mid-year.  Additionally, advanced English is another area of product focus.  From the most recent quarterly call, much more is coming in Mobile, Social, and  likely reading software.

Our Estimates and Valuation:

2013: $285mn with $35mn in Operating Cash Flow, $1.70 per share

2014: $345mn with $45mn in Operating Cash Flow, $2.00 per share

2015: $400mn with $55mn in operating cash flow, $2.50 per share (RST is guiding to $400m in 2015 in revenue)

Assumptions:

1) No acquisitions, driven by new products, growth in Education, Institutional, and International

2) No transition to deferred revenue model where FCF = Adjusted EBITDA + Change in deferred revenue (plus working capital and CAPEX adjustments).  2013 Adjusted EBITDA $17MN+ and $20MN+ in deferred revenue

• Management discussed cash flow as follows on their Q4 2012 Investor Call:
• Q:   “On cash flow, obviously a good year for cash flow in 2012.  Excluding the tax refund do you expect cash flow to improve in 2013?”
• A:   “I do. I think cash flow should flow the Adjusted EBITDA plus the amount we put on the balance sheet in deferred.  That’s a reasonable proxy.  And yes, of course, we have working capital and CAPEX. But back of the envelope adjusted EBITDA, plus something going on in the balance sheet should translate to cash.” - CFO Thomas Pierno

It’s our opinion that Rosetta Stone will reinvest the cash it generates into acquisitions in the software space.  We think this makes a lot of sense.  Access to distribution is the biggest issue in value creation for educational software companies.  There are a lot of very good products out there that lack brand/distribution.  This would also be very beneficial to RST, as the cost to acquire a customer is roughly $100.  Therefore by having a menu of educational software products to spread the customer acquisition costs over multiple new products, a significant proportion of revenue (typically 80%+ gross margins) would fall to the bottom line.  We are not assuming any success or revenue into our assumptions, but this could provide meaningful upside.  

Historical Transactions: 

Three educational software companies were taking private in the last four years (please see our RLRN write up).  We believe the multiples seen in these transactions are appropriate for RST as it continues its strategic transition. RST should probably be valued at 12x FCF on an EV basis $350mn + $150mn in cash or $23 per share  Institutional and Educational will go nearly 100% SAAS in 2013.

PSO 16x FCF

RLRN 16x FCF  (acquired)

ARCL 14x FCF  (acquired)

TUTR 1.8x sales (acquired)

RST .5x ev/sls and 6x trailing EV/FCF

Assorted Risks:

Issue #1: Competition
Live Mocha, Duolingo, Fluenz, Pimseuler, and Berlitz are several competitors.  Most of RST’s damage has been self-inflicted over the last three years.  Unit sales have been 526K (2010), 585K (2011) and 630K (2012).  During this time period, RST transitioned business models and switched distribution channels closing kiosks and going to online customer acquisition channels.

RST states that its competitors lack voice recognition files, $25 million R&D budget with a team of 200+ engineers and 12+ PHD ‘s in linguistics, and an improving 20+ year software platform that recently launched several online apps and live, online coaching. RST faces little competition in the Educational business and Institutional business. Both are mainly SAAS based businesses that are business to business sales with high renewals and limited competition. The US market on a per capita basis is the world’s worst to sell into with per capita spending of only $11 per capita in language learning. Japan and Korea are the best markets on a per capita basis. Despite these dynamics, RST generated approximately $40mn in EBITDA out of the US business in 2009.

Issue #2: 1Q13 will likely be weak, as RST runs off empty calorie revenue in Kiosks and transition to subscription business. However, for the year company is guiding to unit growth continued trend of mid single digit growth and “robust” growth in online learners.

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 without updating this board. 

RST Catalysts

• Strong balance sheet limits downside and we believe decent reinvestment opportunities: $7 in Net cash or approximately 50% of market cap
• Valued like dying CD company but in successfully transitioning to a high margin SAAS based model: 16% FCF yield on 2012 numbers for a business that should substantially grow FCF
• $1+ in FCF in 2012
• Strong brand with 8.5 out of 10 American’s recognizing the brand Rosetta Stone: Opportunities to leverage brand and expand outside just language learning
• Potential with new product pipeline: New products K-6, Institutional, and Advanced English
• Room for upside given last year of guidance combined with low expectations with conservative management
• Talented new management has joined in key roles over the last year or so. 

Catalyst