I’ve been busy reading quarterly reports.
One flashback from the past (something I flipped around within a single calendar year, many years ago) was a software company called Rosetta Stone (NYSE: RST). They have over the past decade shifted and adapted to the subscription-based system, and also bet a good chunk of their cash on Lexia Learning, an English language training software.
Today I examined them and read the financial statements of their last quarterly update without looking at their stock price, and see that the underlying operation still is not generating cash and they are struggling to keep their high margin revenues (namely – there is quite a bit of competition in the language learning space and also the barriers to compete in this market are not that high).
There are two salient accounting points to this firm that is relevant in the analysis – the product is sold in advance, which means that the company can collect the cash today but recognizes the revenues over the course of the term of the software license.
As a trivial example, if I write software and then sell it to you to use for two years for a hundred dollars, I would today show 100 dollars of cash on my balance sheet and 100 dollars of deferred revenue (50 current, 50 long-term). In the subsequent two years, I would book 50 dollars of revenue and reduce the deferred revenue amount accordingly – I do not receive any more cash.
Likewise, RST has $146 million in deferred revenues on their books which will be ‘guaranteed’ revenues over the next couple years. This is cash that is already collected, which means the valuation depends on how much future cash they can collect – the revenue figure is a lagging indicator.
In Q1-2018 to Q1-2019, deferred revenue climbed up from $140 to $146 million, which is a reasonable sign for the company. But hardly a rocket launch.
The other item that is worth pointing out is that RST capitalizes some of their “internal use software” expense – instead of expensing it out to R&D, they pack it on the balance sheet. This is expected to be around $20 million of expenses for the year, which is not a trivial amount – the way the company “masks” this is to focus on the operating cash flow figure, which does not include this inconvenient “internal use software” expense.
Certainly the projections from Q1-2018 to Q1-2019 and the year-end 2019 projection show a slow positive trajectory – EBITDA is up and the cash burn is slowing down to nearly nothing – and presumably more deferred revenues will show on the balance sheet. The entity is debt-free, has a bit of cash on the balance sheet (roughly $28 million now, projected $38 at the end of the year).
How much would this be worth? Let’s say 1.5 times sales – which is already generous given the competitive nature of their particular software market.
Then I looked at the stock price. Oops.
What the heck happened that warrants such a valuation?
I shook my head and moved on.
Whether it is marijuana or language learning software, there is a lot of capital being thrown into companies in industries that have relatively few competitive barriers. Is this just because the low interest rate environment has left nothing to throw capital into?