Divestor

My quarterly report will come out sometime after the end of March, but I have divested myself out of my position in Rosetta Stone (NYSE: RST). My average in was around 8.50, while my average out was around 13.40. I had written about them in the past on this site, albeit not in any comprehensive detail. I’ll give a little bit of my research here.

The reason for this sale is because although at current valuations the company appears to be cheap (2012 revenues at $273 million, cash at $148 million, no real debt, decent free-cash flow, diluted market cap of $316 million), and operationally they seem to be successfully executing their original plan which was to reduce the sales and marketing “bite” per dollar of revenue, my perception is that their revenue generation ability in absolute dollars-and-cents has flat-lined and that their initial attempts to get costs down are successful, they will be running up against incrementally more difficult decisions with respect to getting the expense side of their ledger under control.

For example, examine this chart (S&M = Sales and Marketing, R&D = Research and Development, G&A = General and Administrative):

	Total Revs	Bookings	S&M	S&M / Revs	R&D	G&A
31-Mar-09	$ 50,284	$        –	$   23,612	47.0%	$     4,843	$      9,887
30-Jun-09	$ 56,460	$        –	$   27,147	48.1%	$   10,101	$     23,167
30-Sep-09	$ 67,216	$        –	$   32,263	48.0%	$     6,125	$     11,914
31-Dec-09	$ 78,311	$        –	$   31,876	40.7%	$     5,170	$     12,207
2009:	$252,271		$ 114,898	45.5%	$   26,239	$     57,175
31-Mar-10	$ 63,014	$ 60,768	$   28,361	45.0%	$     5,470	$     13,643
30-Jun-10	$ 60,648	$ 64,033	$   29,441	48.5%	$     6,100	$     12,416
30-Sep-10	$ 60,926	$ 73,305	$   34,093	56.0%	$     6,030	$     12,048
31-Dec-10	$ 74,280	$ 81,814	$   38,984	52.5%	$     5,837	$     14,548
2010:	$258,868	$279,920	$ 130,879	50.6%	$   23,437	$     52,655
31-Mar-11	$ 56,978	$ 55,580	$   37,820	66.4%	$     6,484	$     14,808
30-Jun-11	$ 66,743	$ 66,711	$   40,535	60.7%	$     6,354	$     13,809
30-Sep-11	$ 64,202	$ 66,062	$   39,821	62.0%	$     4,991	$     14,115
31-Dec-11	$ 80,526	$ 84,834	$   43,316	53.8%	$     6,389	$     19,300
2011:	$268,449	$273,187	$ 161,492	60.2%	$   24,218	$     62,032
31-Mar-12	$ 69,449	$ 65,267	$   38,404	55.3%	$     6,273	$     13,657
30-Jun-12	$ 60,812	$ 63,043	$   35,125	57.8%	$     6,493	$     12,919
30-Sep-12	$ 64,279	$ 72,125	$   37,113	57.7%	$     5,177	$     14,474
31-Dec-12	$ 78,701	$ 84,327	$   41,005	52.1%	$     5,510	$     14,211
2012:	$273,241	$284,762	$ 151,647	55.5%	$   23,453	$     55,261

Management has expressed its intentions of having revenues grow to about $400 million in the year 2015 and “low double digit EBITDA margin”. If they can actually achieve this (which would represent about 14% revenue growth compounded over the three years) then yes, they are grossly undervalued.

I just don’t think they will realize this. In particular, they have already trimmed a good portion of the “empty calorie revenues”, as they like to call it, and indeed they have: in 2011 they spent 60.2% of revenues in sales and marketing, while in 2012 they spent 55.5%, so they have made fairly good progress in this. They should be able to get this down to somewhere close to 50% before they run into real difficulty. In their seasonally-low (with respect to their sales and marketing to revenue ratio) 4th quarter, this went to 52.1%.

Assuming no revenue growth and roughly equivalent profitability, if they did manage to find another 5% in cost savings, leaves the company with an extra $13.66 million pre-tax and applying a 30% tax rate, a $9.56 million post-tax increase to the bottom line in relation to their 2012 results. Pro-forma, applied to their 2012 results (which you have to adjust to account for their tax accounting decisions) would leave a $7.8 million pre-tax profit, or about $5.5 million after-tax, or about 25 cents per share.

Management has done a good job to this point getting the company in a position where they can actually make profits again. I just don’t think they will be able to get to the point where they can generate huge profits because they are locked into a very discretionary part of the software market and other factors.

Another positive is because they are shifting from traditional to subscription-based software, they have the benefit of racking up plenty of deferred revenues on the balance sheet, which translates into cash on the asset side (and the deferred revenues get converted into revenues as subscriptions continue). In this respect, they have done a masterful job of piling on cash from 2011 to 2012, with about $32 million extra packed onto the balance sheet.

Management does scare me when it openly talks about wanting to make strategic acquisitions and anybody in the software industry will tell you that integration of software is a pain in the rear end operationally. It takes a lot longer than top level executives usually appreciate.

This is a type of company that really should be private, but because they have already gone through the private-then-public route, I doubt there is much appetite within their insiders to go through the whole transformation again. Any strategic acquirer would be a consumer-oriented software provider.

Management has performed well under the circumstances. Valuations (especially the $168 million enterprise value) still look relatively cheap. I have just unsubscribed from my original investment reason that the company will be able to generate excessive profits through further cost cutting. It looks like the market has already priced most of this in with the 2014 analyst estimates of 28 cents per share.

I could be wrong with my rather flat revenue projections for RST, but whoever bought the shares from me will be their risk and reward if they believe in the growth story.