Rosetta Stone

My first equity purchase in 2012 was Rosetta Stone (NYSE: RST) at a basis of approximately $8.50. I had started accumulating shares at the $7.50 to $7 range and was hoping to obtain more of a position, but unfortunately the stock slipped away and the last pieces I acquired was at the $9-$10 level. My original wish was that their stock would decline down to $6.50-ish where I would have obtained a full position, but instead I got about half of my desired position, at a higher than desired basis – c’est la vie!

The company was compelling for a few reasons:

1. They had a well known, existing franchise in a sector (language learning) that clearly would benefit from globalization and not be whittled away by other companies’ offerings (which exist and are relevant competition);
2. Their balance sheet was very clean, having (assuming the $7.50 price point) about $100 million in the bank and a market cap of about $160 million; this means an investor was paying for very little to own the underlying franchise;
3. And speaking of the franchise, it is a $250M/year business selling software. Similar to selling pharmaceuticals, software tends to be a very capital-intense up-front business, and the main operating expenses tend to be sales and marketing. So for the princely sum of about $60 million, you could buy into a business at a P/R of about a quarter, fairly cheap if you assume that the software asset is actually worth anything (and indeed, it is, you just can’t see it on the balance sheet since R&D expenses are mostly expensed away and not capitalized).
4. Google Translator and other such “free” services (such as speaking into your iPhone) doesn’t really intersect too much with the language learning software market. If anything, these free services are a compliment.

There were some negatives, including:

1. The previous history of the company being an LBO target and then going public again; there were significant shareholders in the corporation that are actively divesting their interest. Correspondingly, management doesn’t have too much of an ownership stake in the firm – the new CEO has about a 1.5% stake in the company, while the former CEO has about 5%;
2. The profitability of the company has been low, but this is primarily due to marketing expenses;
3. Penetration into international markets has been less successful than originally desired by management;
4. Pressures dealing with US markets (specifically those somewhat exposed to government funding such as education);
5. Management changes – the CEO at the top recently stepped down and they have internally promoted their CFO to CEO and recently hired a new CFO.

I’ll leave out the hard-core quantitative metrics. I’ll condense it by saying the company appeared cheap at their single-digit valuation. Since I’m no longer interested in accumulating shares, I’m holding it in my portfolio since my price target has not been reached yet even with the past week’s action where a relatively rosy quarterly report took them up 30% and I am revealing this holding to the world.

All I have to do now is find 6 or 7 of them and start using the cash balances and who knows, 2012 might turn out to be profitable compared to the (relative) disaster I had in 2011.