Description

Rosetta Stone (RST) - Short

Stock Price: US$18.00

12 Month Price Target: $12

Shares Outstanding: 20.4M shares

Market Capitalization:  365M

Enterprise Value:  200M

Revenues             

2008A:      209M

2009E:      245M

2010E:      265M

EBIT    

2008A:      29M (11x)

2009E:      34M (9x)

2010E:      28M (11x)

EPS       

2008A:    $0.88 (20x)

2009E:    $1.02 (17x)

2010E:    $0.90 (20x)

Summary and Conclusion:

Rosetta Stone is the most recognized US name in language learning.  With the bright yellow box found in mall kiosks, book stores, and television advertisements, the software product's unique brand stands out in a crowded industry.  The company claims that RST's proprietary immersion-based experience - using minimal English instruction - translates to better outcomes for beginners.  Our research indicates that the teaching method is neither proprietary nor the most successful.  However, the competition has been unable to match RST's marketing prowess, and as the undisputed leader, RST has continued to penetrate with only saturation as an obstacle.  New data points suggest we are near the end of the runway.  With a high dependence on customer acquisition cost that continues to spiral upward, the economics of the model should quickly unravel.

Sales and Marketing per customer unit climbed over 20% in 4Q08 and 1Q09, and soared 35% in 2Q09.  After the disappointing internet marketing campaign launched and cancelled during 3Q09, CAC rose 25% year over year - a deceleration from Q2 but still an unsustainable rate for future profitability.  As RST moves from high income, high density markets (Manhattan, San Francisco) into Midwest markets, we forecast CAC to continue to increase at a rate of 20% throughout 2010.

Rising marketing costs in isolation are no issue.  However, progression of unit sales has moved the opposite direction.

                Unit Growth            Kiosk SSS           Average Order Value          AOV Y/Y               Direct Consumer Rev Chg

3Q08               42%                     -4%                                   $315                         +30.8%                                +84%

4Q08               13%                   -10%                                  $331                         +31.9%                                +51%

1Q09                 8%                     -7%                                   $347                         +31.0%                                +32%

2Q09                -9%                   -11%                                  $361                         +28.7%                                +25%

3Q09                -1%                   -30%                                  $355                         +12.6%                                  +7%

Clearly an expanding average order size/pricing has driven revenue growth.  Mechanically, RST has focused on driving bundling - i.e. encouraging a purchase of Levels 1-3 ($485 at retail) or 1-5 ($630!) at the point of sale, as opposed to just one level.  The reasoning makes sense, as consumers generally did not return to purchase level 2 after buying level 1.  Why?  The time and effort required to maneuver through a language course is almost always underestimated at the time of initial sale.  However, bundling only helps sales once, as customers return even less with more product to work through.  The tailwinds of 30% AOV increases drift lower over the next four quarters: up mid single digits in 4Q09, and should drop to flat by 2Q10.  Meanwhile, units keep falling (channel checks below).

As summarized above, we believe RST is a growth story set to collapse, with revenue drivers fading and marketing expenses escalating.  With a contracting EBIT margin (16% in '08 to 11% in '10), and sinking EPS, we believe at most, a multiple of 12x 2010 earnings is warranted.  Our target is $12, derived from 13x 2010 EPS of $0.90 (6x EBIT).  As competition likely repositions under RST's massive pricing premium (detailed below), we expect earnings slip in 2011 as well.

Business History:

Rosetta Stone launched an initial public offering on April 15^th, 2009.  Participating sellers included financial backers Norwest Equity Partners and ABS Capital Partners, which each sold one third of holdings.  The company originated in 1992 as Fairfield Language Technologies, and current management has been in place since 2003.  In 2006, the founders sold the firm to private equity firms mentioned above, and with the sale came a name change to Rosetta Stone.  The IPO was filed on September 23, 2008.

Rosetta Stone employs four main distribution channels for product sales.  Direct to consumer sales, commonly from TV or internet ads, constitute 48% of '09 revenue.  Kiosk revenue comprises 17%, while sales through retail partners total 14%.  Major retail partners include Barnes and Noble and Office Depot.  Institutional revenue from government and corporate sources represents the remaining 21%.  Rosetta Stone has achieved several significant institutional wins in the military and educational arenas, and considers the area a strong pathway to growth.  However, pressure on state and local budgets will likely limit real traction for RST as a major learning tool within schools.

Investment Analysis:

We believe the playbook on RST is assembled using the same pages as those on Crocs, Nutrisystem, and Bare Escentuals - all high flying consumer products companies that reached saturation and tipped over.  However, short sellers took serious pain for entering early.  For RST, recent channel checks encourage us to short now.

Books a Million

We had a conversation with a regional manager at Books a Million, a vendor of RST since holiday 2007.  This contact has sales visibility for all 147 BAM stores carrying RST products.  He couldn't be more complimentary of the marketing ability of the RST team, or the tremendous positive impact of '07 and '08 sales.  However, our contact noticed weakness that began in early 2009.  January '09 comps fell 5%, and despite the addition of several SKUs (other languages) the slump continued, with total RST sales at BAM now down 15% Y/Y.  A quote: "we still sell it, but it doesn't fly out the door anymore."  He still commends RST's "smooth merchandising effort" but his neighbors as Borders and Barnes and Noble "are seeing the same trends."  Meanwhile, sales of competing products haven't slowed.

Barnes and Noble

We spoke with the manager of the B2B channel of Barnes and Noble (B&N).  She has visibility into the retail channel as well.  The main take away from the call was the performance of the product recently: down 20-30% at retail year over year.  Rosetta Stone product was now underperforming competing product from a y/o/y comp standpoint.  B&N also offered more SKUs from the prior year, meaning that the comp for the core languages (Spanish, French) would have been worse.  While the manager still thought RST was the product to beat, "all the major publishers now offer something" and "people just aren't rushing out to learn a language right now."

She did share one material positive.  B&N is often used by governmental departments to fulfill purchasing requirements.  For example, quotes from 3 vendors are needed for the sourcing of a new product - Barnes and Noble, Amazon, and Borders are often used for books and software.  The B2B channel serving government orders continues to be strong (up double digits).  For example, B&N has filled RST orders from divisions within the Army and Navy serving in Iraq.  However, reviews have been mixed from military leadership - the soldiers have enjoyed the product, but have made disappointing progress in learning the relevant language. 

We currently are modeling a 15% increase in wholesale institutional revenue for the next 4 quarters.  Institutional revenue represents about 25% of total sales.

Product Comparisons

Amazon.com serves as a powerful research tool for consumer products.  With a worldwide reach and endless selection, the universe of competing products is easy to access and evaluate.  We have pulled the price points and average review score of the top six selling level 1 Spanish language software products.  We rank the products first by price, then by review score (5.0 is highest).

By Price (cheapest to most expensive):

By Review Score (highest to lowest):

Despite the disconnect between pricing and customer satisfaction, we rate the competitive set to RST rather weak.  But at the very least, claims of a best in class product seem overstated.  Given time, customers tend to do some research, and we note that Learn to Speak Spanish Deluxe recently surpassed Rosetta Stone as the number one Spanish language product on Amazon. 

 Product Sales Rankings

While the RST product rates inferior to competitors, given the marketing power behind the brand, saturation is a more likely threat than a competing product.  To track online sales, we have followed the ranking of the best selling RST packages on Amazon for several months.  Our conclusion is that on the whole, demand seems to be flagging.  The below figures represent where each product falls in the top software sales on Amazon.com (lower is better).  Important Note:  RST cut prices in Dec '09 - the final entry is with prices about 10% lower!  We received a email discount offer from Borders before Christmas, where the company was discounting the product at retail for the first time in the store (10-15% off depending on the package).

Valuation:

Despite an earnings miss in the first quarter as a publicly traded firm, and a disappointing quarter in 3Q09 RST is still priced for growth at 16.5x '09 earnings.  We expect earnings to peak in 2009, as cheap ad rates become more expensive and the bundling push to raise order values no longer overcomes a decline in unit sales.

What is the right multiple for declining earnings?  For this writeup, we use 12x, but the exact multiple contraction as the street shifts from expectations of 15% earnings growth to a significant decline is unimportant.  The short should work as numbers are taken down to reflect the current trends.

Our earnings estimate of $0.90 in 2010 assumes flat unit growth, a 2% higher average order value, and 15% higher marketing expenses.  Should unit growth decline, earnings will unravel much quicker, but current assumptions give a margin of safety surrounding new retail wins (Best Buy?) and further success in the institutional channels.  Our target price of $12 (13x '10 EPS of $0.90) provides ~30% downside from current market value.              

Catalyst

Further discounting, continued unit volume erosion.  Multiple compression as earnings growth disappoints.