Tag: RST

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?

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.

Rosetta Stone (NYSE: RST) posted their second quarter results today and they were below analyst estimates by a fair chunk.

Investors should keep in mind the company is still in the middle of a turnaround process to get costs down and restore some semblance of profitability while keeping their main product line viable in the world of freely offered software. The current CEO is new to the position, but has been with the company as their CFO prior to being promoted to CEO. They are trying to optimize the revenue stream and milk it for what it is worth, and this is going to be a lumpy process as they figure out what is and what is not working – keep in mind that sales and marketing has crept up from 45.5% of revenues in 2009 to 50.6% in 2010 and 60.2% in 2011; assuming you can ratchet down this ratio without adversely affecting the top line, you will be adding significant incremental profit to the bottom line. It just isn’t going to be done in a quarter.

The stock will probably get hammered about 15% in Thursday’s trading and I will consider adding to my position if it goes to the single digits.

Keep in mind that the company does have $120 million cash on the balance sheet and at Wednesday’s closing price of $13.13/share, this does make an enterprise value of $156 million. This is sure to go lower on Thursday. When you consider this is a software company with a quarter billion in sales a year, this seems to be relatively cheap, albeit in a business that is not going to grow like a weed.

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.