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Rosetta Stone (NYSE:RST)

Q4 2012 Earnings Call

February 28, 2013 4:30 pm ET

Executives

Steve Somers

Stephen M. Swad - Chief Executive Officer, President, Principal Accounting Officer and Director

Thomas Pierno - Chief Financial Officer

Analysts

Peter P. Appert - Piper Jaffray Companies, Research Division

Jeffrey P. Meuler - Robert W. Baird & Co. Incorporated, Research Division

Joseph D. Janssen - Barrington Research Associates, Inc., Research Division

Matthew J. Kempler - Sidoti & Company, LLC

Zack Buckley

David P. Nierenberg - Nierenberg Investment Management Company, Inc.

William Zolezzi

Matthew Winthrop

Operator

Greetings, and welcome to the Rosetta Stone Fourth Quarter 2012 Financial Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Steve Somers, IR for Rosetta Stone. Thank you. Mr. Somers, you may begin.

Steve Somers

Thank you very much. Good afternoon, and let me welcome you to Rosetta Stone's fourth quarter 2012 earnings call. I'm Steve Somers, Vice President of Investor Relations. And I'm joined today by Steve Swad, Rosetta Stone's President and CEO; and Tom Pierno, CFO, to discuss the operations and financial results for the fourth quarter and our outlook.

In addition to our commentary, we have made our fourth quarter 2012 earnings results press release in a slide deck supporting this webcast available on our IR website at investors.rosettastone.com. Please review them to find important additional information.

As a reminder, There are or will be forward-looking statements in our press release, slides and conversation today. We offer these statements under the Safe Harbor provided by U.S. law. Of course, risks and uncertainties attached to any forward-looking statement. A detailed discussion of such risks and uncertainties is contained in our Form 10-K for the fiscal year ended December 31, 2011, filed with the SEC in March 2012, which is available in the Investor Relations section of our website.

We ask that you review those risk factors before you making any investment decision. Please note these forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation to provide or publicly release the results of any revision to the forward-looking statements in light of new information or future events. We also use non-GAAP numbers in our presentation. The definitions of those numbers and their reconciliation to GAAP numbers are available in today’s press release on our website and as filed with the SEC today on Form 8-K.

Now let me turn the call over to Steve Swad.

Stephen M. Swad

Thanks, Steve, and welcome, everyone. Overall, I am very pleased with how 2012 developed and finished. Early in the year, I articulated our strategy through 2015. I said we would focus on going deeper in language, as well as extending beyond language into adjacent areas like reading.

I also stated we would move our product to more relevant digital platforms, expand our distribution, focus on growing our consumer and institutional businesses, improve our cost structure relative to sales by cutting empty calorie marketing spend and increase financial discipline to drive expanded margins.

I believe we made good progress in most of these areas. During the year, we made key management changes to help execute our strategy with the addition of a new Chief Product Officer, a new Head of Business Development, a new CFO and a relocation of our Head of Global Consumer to Asia to improve our international operations.

We exceeded our key financial objectives by delivering modest gains in our top line and adjusted EBITDA that was 2x our initial guidance. We also made strides in moving the company's products to the cloud with triple-digit growth in online learners. And we introduced a digital download product that is more relevant, cheaper to deliver and demonstrating good customer acceptance.

We also began offering a new subscription product in our retail channels. And we struck new distribution relationships with Facebook and Groupon. These relationships have helped expand our audience and reach a younger demographic.

With respect to our institutional business, we saw steady gains all year with mid-single-digit growth in Q4. Importantly, in the second half of the year, we shifted almost all of the business in U.S. to a SAS-based renewal product, and we are seeing double-digit growth trends in the subscription portion of this business, driven by success in our corporate, international and emerging markets.

On the challenges side, the top line growth for the company was modest, as we stripped out empty calorie revenue and increased our subscription footprint in both consumer and institutional, which resulted in $11.5 million of new deferred revenue on the balance sheet.

Meanwhile, our international consumer segment continues to underperform versus its potential, particularly in Japan, as we still need to improve that business and then grow in that market.

Overall, I characterize 2012 as a year where the company turned around its financial performance, transitioned the business to a more relevant digital platform and executed on several key initiatives that provide for a solid 2013 and beyond.

Regarding future performance, I want to start by reaffirming my optimism about the opportunities that lie ahead for Rosetta Stone, as well our 2015 goal of $400-plus million of revenues and low double-digit adjusted EBITDA margins.

Future growth will come from launching new products, like Kids and advanced English, as well as introducing products beyond language, such as reading.

With respect to 2013, we're guiding to single-digit improvements in revenue and double-digit improvements in adjusted EBITDA.

The revenue growth is somewhat muted by continued tightening of empty calorie revenue and additional subscription growth, some of which sits on our balance sheet in deferred revenue.

To deliver on 2013, we are going to execute in the following 5 areas. First, 2013 will be a landmark year for our product and technology base. Our new Chief Product Officer, Westley Stringfellow, joined our company to take a fresh look at our product roadmap and enhance our product vision. We plan to launch a set of products into a new kids business, which is targeted for early in the second half of 2013.

We are also targeting an improved offering for K-12 that will help expand our institutional business. And while we made some progress on our platform in 2012, we need to bring products to market much faster, so we're investing to make our platform more modular, more flexible and more mobile so we are able to move quicker.

To do this, we need to invest incrementally in product development versus 2012 to drive growth in Q4 2013 and beyond. We are also opening new product development offices in San Francisco and Austin to tap into the leading technology talent in those locations. All of these efforts are being led by Wes, who brings a wealth of experience from Silicon Valley, specifically, Amazon and PayPal, as well as several startups. I believe his track record, relentless customer focus, broad technical expertise, data-driven approach and overall sense of urgency and intensity is exactly what's needed to help me take this company to the next level.

Second, we're going to invest in our institutional business with both new products and improved customer support systems. These will allow us to broaden our customer base, improve renewals and accelerate growth to low double-digit rates in this key segment.

In the North America consumer business, we expect growth to continue in our DTC and independent retail and e-tail channels. This growth comes as we continue to expand, upgrade and optimize our points of sales, improve our own website and continue to shift more of the sales mix into digital formats. Plus, we will introduce the new kids product, leveraging our brand equity, technology and distribution to actively build the kids business.

Fourth, we must stabilize our consumer business outside North America. While we've created a solid brand in these strategic markets, we've not yet delivered on the international promise. With our Head of Consumer, Prag Shah, now based in Asia, as well as having new local management -- a new local management team in place in Japan, we expect the downward trends we saw during most of 2012 to stabilize.

In Korea, we're developing a new distribution network built around established afterschool proctor programs to complement our current sales channels.

In Europe, the introduction of our downloadable product and other marketing changes should drive nice growth. Finally, we plan to accelerate growth through acquisition. We have developed a healthy cash position and plan to use our balance sheet to fuel our strategy.

We believe M&A will provide a way to efficiently leverage our brand and broaden our reach. While it's hard to predict the timing, we intend to complete at least one acquisition this year.

To sum up, 2012 was a year with solid gains, and I'm excited about the prospects for 2013, and I'm convinced we have many more opportunities ahead of us.

Now let me turn the call over to Tom, who will review our financials in detail.

Thomas Pierno

Thanks, Steve, and good afternoon, everyone. I think the fourth quarter was the best evidence yet that the strategy that we put in place last year is taking hold, culminating in a strong financial performance for 2012. We delivered full year revenues of $273 million, even as we closed half of our kiosks, which impacted revenues by approximately $11 million and move more towards selling subscription products, which moderates revenue in the short run but contributes to bookings.

Adjusted EBITDA for the year came in at $13.8 million, exceeding the high end of the raised guidance that we gave last quarter of $10 million. Of course, this was not just a one quarter improvement, rather, we demonstrated steady improvement as we move through 2012 and closed out the year on a strong note with $9.1 million of adjusted EBITDA in the fourth quarter.

Total bookings in the quarter were $84.3 million and were flattish versus prior year of $84.8 million. However, North American consumer bookings grew 5% to $57.9 million and were up 13%, excluding the kiosk channel, where we operated 94 fewer average locations in the quarter versus the prior year.

Growth in North America was offset by a 29% decrease from our international consumer bookings in the quarter. The main drivers of the decline in bookings was continued weakness in Japan and softer performance in Germany related to robust sales a year ago, as we liquidated a significant level of our box product in advance of shifting our German business to online only offers.

Our institutional business continued to show improving momentum in the quarter with 6% bookings growth to $16.4 million from $15.5 million a year ago. This is the fourth consecutive quarter of improving growth, which allowed us to show full year growth of 4% compared with negative 2% in 2011. Strength in institutional, again, came mainly from the corporate vertical, and international and emerging markets, offset partially by softness in K-12.

Because of the shift in our models and more online offerings, bookings exceeded revenues and we grew our deferred revenue balance by $5.6 million to $63.4 million in the quarter.

For the full year, we added $11.5 million of deferred revenue, as we built our recurring book of business and improved our revenue visibility.

Once again, some of the strength in our consumer business can be seen in the continued strong growth of our online business, with paid online learners growing 157% year-over-year to 68,000 at the end of the year from 27,000 at the end of last year, and up 19% from 57,000 at the end of the third quarter, mainly due to increases in the U.S. Pricing in the quarter for online learners was flat compared to the third quarter with monthly average revenue per unit, or ARPU, of $24.

Product units increased 4% in the fourth quarter against a difficult comparison to 211,000 units versus 203,000 last year. We achieved this increase despite the absence of product units sold in Germany. Importantly, we began promoting digital download of our perpetual product in our U.S. DTC channel towards the end of December with positive results.

The margin profile of the download is attractive as box and shipment costs are 0 and support costs are generally lower than our traditional product. Product ARPU in the quarter decreased 11% from a year ago to $277, as we stayed on promotion longer during the holiday period, had a lower mix of higher ARPU kiosk sales and lower ARPU from social media offerings.

Gross margin continued to improve year-over-year, increasing 200 basis points in the quarter to 84% from 82%. The improvement in margin was due to lower hard product cost and increasing mix of digital downloads and online learners and efficiencies in our coaching operations, where per session costs were down from the third quarter.

On the operating cost side, we again lowered our operating expenses in the quarter. Our efforts to more effectively manage our sales and marketing spend resulted in sales and marketing expenses of $41 million, a margin of 49% of bookings. This compares to 51% of bookings a year ago, normalizing for last year's noncash stock comp expense related to the cancellation of the LTIP.

R&D expenses of $5.5 million were flat with last year, excluding last year's LTIP expense and remain 7% of revenue. G&A expenses were $14.2 million, down 26% from a recorded $19.3 million last year, and down 11% or $1.8 million, excluding the LTIP expense last year. This represents a margin of 18% of revenues, improving nearly 200 basis points from a year ago, as normalized for the LTIP expense.

Adjusted EBITDA for the quarter increased year-over-year for the fifth consecutive quarter, coming in at $9.1 million, up $2.1 million or 29% against last year's strong fourth quarter of $7.1 million. This level of adjusted EBITDA reflects the margin of 12%, a 280 basis point improvement from last year.

Adjusted EBITDA for the full year 2012 was $13.8 million, compared with the negative $6.1 million in 2011 and $19.9 million positive swing. This turnaround is a result of our efforts to grow the top line while operating more efficiently. Although full year revenues were only up 2%, bookings for the year were up 4%, both of which were affected by channel shift, as we sharply reduced our kiosk program.

As we mentioned through 2012, we continued our efforts to more efficiently spend and reduce low- or negative-yielding revenues in spending. This effort moderate top line growth in the short term, which sharply improved profitability, with full year adjusted EBITDA margin increasing over 700 basis points to 5% from a negative 2%.

Because we are also shifting towards digital model, where revenues are recognized over time, I think it is important to point out that if we take into account the additional $11.5 million that was added to deferred revenue, we generated $25.3 million of operating value during the year.

Turning to our financial position. The company added $22 million of cash in the quarter produced total cash, cash equivalents and short-term investments to $148.3 million versus $126.1 million at the end of the third quarter and up from $116.3 million at the end of 2011.

Part of the increase in cash was due to the $8 million of cash tax refunds received in the quarter. The increase in cash represents an increase of $1 of cash per share from the third quarter with almost $7 of cash per share on the balance sheet at the end of the year.

Taken together with the fact that we have no debt, the balance sheet remains very healthy. Deferred revenue again rose in the quarter, increasing sequentially by $5.6 million to $63.4 million from the previous quarter, reflecting both strength in our institutional business and growth in the number of consumer paid online learners. For the full year, we grew our deferred revenue balance by $11.5 million, reflecting the shift towards a more recurring revenue business.

Capital expenditures for the quarter were $1.2 million and just $4.2 million for the full year, well below initial guidance of $8 million to $10 million and below last quarter's guidance of $5 million to $8 million, as we more efficiently leveraged our infrastructure.

Before I talk about guidance for 2013, let me just recap where we finished 2012 relative to our 2015 objectives. 2015 goals are $400-plus million of revenues with $40 million to $50 million of adjusted EBITDA or a margin of 10% to 13%.

Although we came in the lower end of the revenue guidance for 2012, we added $11.5 million of additional deferred revenue, which benefits the future, and we think we've set ourselves up for improvements across the business, which will enable us to hit our $400 million in 2015.

We generated $13.8 million of adjusted EBITDA, which is 1/3 of the way to our goal, and we are 50% there in terms of adjusted EBITDA margin at 5% for 2012. With respect to the specific line item objectives, we generated gross margin of 82% in 2012, which is in the range of 82% to 85% that we laid out. The target for sales and marketing in 2015 is 45% to 50% of revenue, and we've made good progress in 2012 driving that figure down 500 basis points to 55%.

We expect to increase R&D to 9% to 11% of revenues versus 9% in 2012, but expect that to rise over the next couple of years, which we think will help lift revenue and contribute to efficiencies in sales and marketing.

With respect to G&A, we're targeting 500 to 800 basis point improvements to 15% to 18%, and we made nice gains pushing that to 20% from 23% of sales.

Looking into 2013, we expect that some of the momentum that we experienced in 2012 will carry into 2013. 2012 was a year of resetting the business, and 2013 will be a year of building on that success.

We are guiding full year 2013 revenues to a range of $280 million to $290 million, which reflects 2% to 6% growth. As Steve said, this assumes continued focus on the elimination of empty calorie revenues and the continuation of growth in deferred revenue as we transition the business to digital platforms. Although we aren't providing specific quarterly guidance, let me put some additional color around how we see the top line playing out over the year. As has been the case for the last 2 years, we expect the fourth quarter to be our strongest. As it relates to the first quarter, we are seeing a somewhat slower start to the year versus 2012 and expect 2013 top line results to be flat to down mid-single digits versus 2012 for the first quarter, primarily due to weakness in kiosk and the movement of our institutional business away from a perpetual one-time sales model to a renewable subscription business.

In terms of how we see our business units playing out, we expect our global Consumer business for 2013 to grow mid-single digits. In terms of paid online learners, we again anticipate robust growth for the year.

On the institutional side, we expect low double-digit growth on the strength in our corporate higher ed and international and emerging markets verticals. With respect to adjusted EBITDA, we are guiding to be in the range of $16 million to $18 million, which represents year-over-year growth of roughly 16% to 30%. This range would also produce adjusted EBITDA margins between 5.7% and 6.2%.

Improvement in adjusted EBITDA and margin is driven by a continued modest improvement in gross margin as we deliver more services online and reduce our hard product costs, combined with continued efforts to drive down sales and marketing expenses percentage of revenue, as we have a slight improvements in G&A.

Improvement in sales and marketing will be offset by increased R&D spending and deliver the product initiatives that Steve described. These initiatives will require that our new CPO transform how we operate and recalibrate the balance of in-house and outsourced product development, ensuring that we can address variability and workloads and required skill sets for different types of products.

Therefore, we expect full year R&D to be between 9% and 11% of revenues, which is in the range of our 2015 objectives, reflecting that we are arriving at that level a bit earlier.

We also expect the continuation of cost optimization activities and focus to improve the yield on our marketing and product investment, which will likely result in additional restructuring charges that are excluded from our guidance.

Lastly, we expect capital expenditures to be approximately $5 million to $8 million for the year, broadly in line with our average spend over the last couple of years.

With that, operator, we are ready to take questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Peter Appert with Piper Jaffray.

Peter P. Appert - Piper Jaffray Companies, Research Division

So just on the pricing topic, Steve or Tom, the -- so we've got stabilization, it looks like, in the online side. So would it be safe to assume in 2013 it stays at roughly this $24 level?

Stephen M. Swad

Peter, this is Steve. We're not guiding specifics. But yes, we're doing a number of things on the product side and we're going to try some bundling things and some new offerings to hold ARPU. So I'm not going to give specific on quarter-by-quarter. But you're seeing some stabilization on that side. A lot of it has to do with the mix of business. So the longer the term, the better the value per month. The shorter the term, the more we charge. And so mix will play a role in that. But I would think we're going to be in that zone.

Peter P. Appert - Piper Jaffray Companies, Research Division

Okay. How about on the hard product side, where you've continue to see it come down, I know it's the same issue in terms of mix. Are you still experimenting with various price points there?

Stephen M. Swad

Yes, we are. And we made some explicit decisions with the holidays to lower price. We saw good returns on -- along the demand curve. And as you know, we get reads from our customer on our online business by the minute. And so we can do some pretty sophisticated price volume tests and get a read and implement. And that's what we did. But all year, we've been having pressure on ARPU. We implemented in -- after the end of the year, some new capabilities with our cart, which will enable us to kind of bundle some products together and offer some gift cards and buy one get one free. And so you're going to see us move to other promotional activities other than price. Price will continue to be a tool we use be it will be -- we're going to supplement that with other tools. And I'm hoping and thinking we're going to get some relief on that line.

Peter P. Appert - Piper Jaffray Companies, Research Division

Okay, fair enough. And then, I guess, tell me if I've got this right, it sounds like you're choosing to spend some more money on product development and some incremental product rollouts here, sacrificing a little bit of margin on a near-term basis. Because it seemed to me that the EBITDA expectation for 2013, given the progress you've made in '12, seems maybe a little bit more modest than I would have expected going in. So I guess the question out of all this, is this all about just the incremental product spend? And related to that, are there specific products you could call out, things that we should be really be watching to try to measure the progress?

Stephen M. Swad

Yes, yes, good point. A couple of things. Like the 16% to 30% EBITDA growth fits with the principle I shared with the investment community back in May, where we have a balance between current period returns in investment. And it also fits, if you look at the trajectory of margin expansion, we're kind of on a path toward low double-digit margins. I think, importantly, to reignite growth in top line, this company needs to invest in product. And we just hired a new CPO. And it's time to invest. He has had a remarkable impact in a very short time. It is clear to me and the employees of Rosetta Stone that our approach to development is changing. It's getting better. It's more agile. It's more customer-focused. It's going to be quicker. And I feel confident and comfortable in investing behind that. And I think that will pay dividends in the future. Where do I see us? If you -- 12 months from now, when we're having this call and I'm saying we had a strong 2013, I think the elements of that -- those comments will be, we launch into a kids franchise. And we're seeing movement on both the consumer side and the institutional side around kids. I think the institutional business, we will have migrated almost completely to a SAS-based product. And we're going to see renewals improve, so the institutional business will be stronger. We're also going to invest in products to help institutions. I think you'll see international stabilize. And you'll see the introduction of a product beyond language. And I referenced something adjacent like reading. And I think those are the things you should see coming from us over the next 12 months.

Peter P. Appert - Piper Jaffray Companies, Research Division

Got it. That's helpful. And just one last thing. In terms of your commentary on acquisitions, can you put any scale around the kind of things you'd be looking at?

Stephen M. Swad

I can but you should know it's just from the buyers' perspective. And for us to really have a meaningful discussion, I need a seller. But yes, what we're looking for are things to accelerate our strategy. And those things are -- they're multiple things, but things like products that are little diamonds in the rough that maybe need a little more investment or a little bit of brand or a little better distribution. So I could see us invest in companies that are product centric. I could also see us invest in acquiring capabilities. So to the extent there are companies that are good at building products, I could see an aqua hire [ph], if you will. In terms of dollar range, we have $148 million of cash. I do not expect one big investment at all. If things go the way I want them to and we can have a meeting of the minds with other parties, I'd like to see $10 million, $20 million, $30 million acquisition and more than one in 2013, although I'm committing to at least one.

Peter P. Appert - Piper Jaffray Companies, Research Division

And just lastly, from a products standpoint, would it be exclusively focused on language-based products? Or would you incorporate these products beyond language in the...

Stephen M. Swad

Both, both.

Operator

Our next question comes from Jeff Meuler with Baird.

Jeffrey P. Meuler - Robert W. Baird & Co. Incorporated, Research Division

I guess, first, just on the Q4 EBITDA performance, could you just talk a little bit more about what drove that especially in light of it looked like revenue was a little bit light?

Stephen M. Swad

Yes, Jeff, good question. I think the U.S. business outside of kiosk continued to perform well. We saw, as I mentioned, new distribution channels kicked in nicely. Facebook continues to be a good partner. Groupon continues to be a good partner. And we're reaching new audiences that are younger with those channels. And so, that's probably the first spot. We also saw small bits of evidence around our digital move, like our cost of sales are improved. And that's because we're delivering more digitally. And then just normal cost management outside of that. But those were the bigger things.

Jeffrey P. Meuler - Robert W. Baird & Co. Incorporated, Research Division

Okay. And then I wanted to ask you about your comments about being positioned for improvements across the business, that $400 million in revenue in 2015, because it does seem like you need to, I guess, accelerate bookings growth from here, it seems like, to hit those targets. As you think about it, how much of it is, I guess, accelerating the core, I'll call it, and some of it may come from once you kind of get through this headwind from flushing out the low-calorie revenue. How much of it is from adding new products? How much of it is from stabilizing the international and getting those back to growth? If you could just kind of bucket out where you see the biggest opportunities?

Stephen M. Swad

Yes, I think the biggest driver to that growth is going to be in new products. You heard me talk about kids. You heard me talk about advanced English. And think about those in both of our channels, both of our channels, consumer and institutional and domestic and Rest of World. And I think -- I believe that those are going to create growth. And we'll start seeing that in Q4 of this year. And then, certainly, into 2014 and beyond. But as I've said last May, we made some improvements around distribution. I think distribution could be a lot better than it is. And so I see that improving our core business. I also see a much improved SAS-based institutional business. So more focus on renewals, more focus on longer-term relationships with customers as opposed to single sales. And so, I'm not going to bucket specifically, but I think you hit it when you said it. It's new products. It's new distribution. And then it's better, call it, blocking-and-tackling around our core business.

Jeffrey P. Meuler - Robert W. Baird & Co. Incorporated, Research Division

Okay. And then just housekeeping. Can you help bridge us between the adjusted EBITDA guidance and the EPS the guidance? What are the stock comp and tax rate assumptions?

Stephen M. Swad

Tom, I don't know. We might want to handle that offline. I don't know of anything fancy. Like so...

Thomas Pierno

No, it's usual things. So it's the stock comp and...

Stephen M. Swad

Depreciation.

Thomas Pierno

Depreciation, and it is restructuring. No estimate that we have.

Stephen M. Swad

Good point. Yes, good point.

Jeffrey P. Meuler - Robert W. Baird & Co. Incorporated, Research Division

What's the approximate of all the restructuring?

Stephen M. Swad

We're not giving details on that and it's been excluded from our guidance. But, Jeff, just like this year, where we were active in turning the business around and focusing on areas that needed improvements, we plan on that continuing into 2013. So you will see some changes and you will see restructuring charges as a result of those changes.

Operator

Our next question comes from Joe Janssen with Barrington Research.

Joseph D. Janssen - Barrington Research Associates, Inc., Research Division

Steve, I just wanted to congratulate you and your team on what you've been able to do in such a short period of time.

Stephen M. Swad

Thanks, Joe. You know what, though? Just so you know, I tell the team we're not going fast enough. I am happy with where we are, but I think we can do better.

Joseph D. Janssen - Barrington Research Associates, Inc., Research Division

Most of my questions have been answered but I do have 2. Can you -- you mentioned, I think, the second or third quarter, you mentioned the kid-specific products, you're potentially going to launch that in the first half of this year, I'm assuming that's going to go out here in the next couple of months. Can you kind of give me what your kind of go-to-market strategy, how big, kind of what your expectations are in 2013?

Stephen M. Swad

Just a small point there on timing. I said in this set of comments early half 2, we had a new -- Wes joined us. He has brought with him some phenomenal ideas, in particular, around kids. And so, we are accommodating and in fact, repositioning in some instances, around some of those ideas. I am going hold those ideas back mainly for competitive reasons, to be honest. I will tell you that this is the beginning of a business for us. So I would expect us in early half 2 to release the beginnings of what will be a portfolio of products around kids to drive a meaningful business into the future.

Joseph D. Janssen - Barrington Research Associates, Inc., Research Division

Okay. I won't dig too much deeper then. And then in Korea, you talked about the Proctor Home Learning. How big is that now? And then what other private partnerships that -- are you talking to out there that are focused on that, the tutoring English in Korea or this is the one?

Stephen M. Swad

Yes. As you know, we launched a test, I don't know, midyear or something, and we are doubling down right this minute around those tests. And it's sub 500,000 in Q4. And so it is not at scale. But early into Q1, we're seeing goodness. Again goodness off of sub 500,000 doesn't move the needle much. But I feel like we are on to another channel that is tailored to Korea and it fits right in our wheelhouse. Totally fits right in our wheelhouse.

Joseph D. Janssen - Barrington Research Associates, Inc., Research Division

Okay. And then if I could slip one more in there. This question came up last quarter on the online [ph] side of it in terms of retention. Can you -- I think, you had commented, saying it was low after the 12 months. Given you've gotten another 3, 4 months of data, I mean, have you seen that -- is that trend still there? Or have you seen some improvement in the retention side of it?

Stephen M. Swad

Still low, still low. I would say slightly better. And we have some energy going behind that in 2013. Let me be clear. Those comments are around our consumer business. Actually, kind of in our institutional business, we saw much improved renewal rates in Q4, particularly in the corporate side. And that wasn't accidental. We are much more focused. We made some alignment[ph] in our organization. We have some good leadership there, and we're seeing some good signs of renewals. I'm expecting that to continue. Underneath what is a modest or a mediocre 6% growth in Q4, I said we see double-digit growth in what we're calling the subscription business. This piece of business that comes up for renewal. And I'm expecting that to continue. It will be a little lumpy in the first half because we sold this, what we call network product, or one-time product. But I'm looking very closely at the subscription trends underneath that. And I see some arrows that are green. And it's not accidental. We're working it hard.

Operator

Our next question comes from Matthew Kempler with Sidoti & Company.

Matthew J. Kempler - Sidoti & Company, LLC

So we're looking on the institutional side to switch fully to subscription in 2013. What are the assumptions around the U.S. consumer that's embedded in your growth target?

Stephen M. Swad

Did we give that, Tom? Let me give you qualitatively what I'm seeing, Matt, or what I'm expecting. I'm expecting similar -- I'm expecting strength in the retail and DTC side of the business in the U.S. I'm expecting softness in kiosk, and we're going to manage that much the way we did last year. We're going to keep our eye on it and what we have to do to make sure we're getting returns on that capital deployed. So that will mute, in my mind, the top line because of those empty calorie revenues. That's what I see qualitatively. And I don't know that we gave numbers.

Thomas Pierno

We did not.

Stephen M. Swad

Okay.

Matthew J. Kempler - Sidoti & Company, LLC

Yes, I don't mean exact numbers but just -- I mean, are you -- do you think you're going to see an order of magnitude shift to subscriptions next year? And if so, do you expect your orders to meaningfully exceed the reported revenue growth?

Stephen M. Swad

Let me say this, we didn't give detail -- yes, the answer is yes. I expect the company to continue to move toward digital. I think that in the consumer side of the business, that comes in 2 forms. The subscription product, which, as you know, is building up on our balance sheet, not only in revenue, but 11/12 of that get deferred the day we sell it. But in institutional, the same thing that -- let me stick with consumers. So the subscription piece, were we're also -- we also introduced a digital download product, where it is our product only distributed over pipes much like a movie from Netflix. And so, I think, you're going to see increases in that, and you're going to see our deferred revenue grow because of the subscription portion. You're also going to see our cost of sales decline the more we move to these digitally-distributed products. With respect to -- in institutional, we made that flip or change in Q3. And so, we will lap quarter-over-quarter kind of apples-to-apples Q3 of 2013, when we compare it to 2012. I will be providing you insights along the way as the quarters kind of separating out historical one-time sales from this underlying more current SAS-based, cloud-based product.

Matthew J. Kempler - Sidoti & Company, LLC

Okay. And then internationally, we talked about some of the changes we've made there. But the business on an orders basis did deteriorate sequentially. Do you think we're any closer yet to addressing the challenges there? Or do you think it's still more of a work in progress?

Stephen M. Swad

I think it differs by market. I feel like the worst is behind us with Europe. If you recall, we transitioned Germany in 2012 to all online. I'm glad that's behind us. And I think we should be able to build off of that base nicely. I think, in Korea, I also believe the worst is behind us. So I think, this new proctor model will provide a new channel that will supplement and drive growth. Japan, I think we have more work to do. And we are spending money in evaluating the 4 Ps essentially, and we are testing and tweaking around the Ps. But I think we've got more work to do.

Matthew J. Kempler - Sidoti & Company, LLC

Okay. And then just, finally, on cash flow, obviously, a good year for cash flow in 2012. Excluding the tax refund, do you expect cash flow to improve in 2013?

Stephen M. Swad

I do. I think cash flow should follow the adjusted EBITDA plus -- roughly, plus the amount we put on the balance sheet in deferred. That's a reasonable proxy. And yes, of course, we have working capital and CapEx. But back-of-the-envelope adjusted EBITDA, plus something going on in the balance sheet should translate to cash.

Thomas Pierno

Before M&A.

Stephen M. Swad

Very good point. Before financing activities or M&A activities.

Operator

Our next question comes from Zack Buckley with Buckley Capital Partners.

Zack Buckley

Can you talk about plans for the cash balance? I'm just trying to get a sense. Is there a need for so much cash on the balance sheet given that you're generating public cash flow? It seems like you might be over capitalized at this point. I'm just trying to understand how you think about it.

Stephen M. Swad

Yes, we think about it a lot and we talk to our board a lot. And as you know, our board includes 2 big shareholders. And what we think is there's opportunity in the marketplace to put that to work and generate returns. We're going to do it in a reasoned way. We're not going to go on a buying binge. But there are opportunities available to us to accelerate growth. There a lot of companies with good products that don't have Rosetta Stone's touch nor distribution. And so, we believe -- I believe, and the board agrees, that we're best at the moment trying to deploy that in a reasoned way through acquisition.

Zack Buckley

Got it. So no buyback, no special dividends at this point?

Stephen M. Swad

Yes, nothing on our roadmap right now.

Zack Buckley

Okay. And then one other question. I'm trying to get a better sense of sort the investments you're making in general on the sales and marketing and R&D side. Am I correct in assuming that you'll kind of increase and get better returns on that capital over time? And can you just talk about how you think about that?

Stephen M. Swad

Yes, big time. I mean, if you look back at what we said in May, we said margins were going to expand from negative to low-double digits. And the biggest change was in the sales and marketing line, followed by G&A. And in fact, we said then that we were going to invest more in product. We call it R&D, but this is product. This is money spent on products that we're going to sell. And Wes, that's a bit -- not a big change -- it is a change that Wes is driving hard. And so, I think you're going to see sales -- you have seen and you'll continue to see sales and marketing efficiencies. One way to get efficiencies is by selling more than one product to your customer base. It's a simple as that. And so, I should be able to get efficiencies when a customer comes to me, either through my website or through my e-tail or retail distributions, and they see 2 products or 3 products rather than 1. And so, I believe you will see efficiencies grow that way. We are also going through what you'd expect, I call it just operational stuff, to get rid of the lower performing capital and replace it with higher performing capital. And things like Facebook are examples of that. We're moving or calling kiosk another examples, moving more to online marketing as opposed to offline print is another example. You'll continue to see tactical operational improvements. But big picture, selling more than one product to your customer base should generate improved yields on that spend.

Zack Buckley

Okay, that's helpful. And just one last question. Do you see any of the sort of free competition affecting you, something like Duolingo affecting your business at all or is it just very, sort of off the map?

Stephen M. Swad

No, it's very small. This is not new to us. The Duolingo is the company of the month, and God bless them. I put smaller companies in a bucket. And their first goal, I'm not sure if I had their business plan, their goal is, hey, let's get compared to Rosetta Stone. That's a win. Get compared to Rosetta Stone. That's fine. I'm not going to play that game. I believe our value proposition is compelling. We have an effective product that is not built by machines. It's built by PhDs in linguistics and it's effective and it works. It's delivered beyond demand, and it's a fraction of the cost of a tutor or a classroom. And that value proposition has legs to it. And we're just scratching the surface. It's got legs in the U.S., it's got legs outside the U.S.

Operator

Our next question comes from David Nierenberg with Nierenberg Investment.

David P. Nierenberg - Nierenberg Investment Management Company, Inc.

Steve, I want to pile on to that comment earlier by Barrington Research congratulating you and the team for blowing it away in 2012 and in the fourth quarter.

Stephen M. Swad

Thank you, David. I don't want my employees or management team to think we're done. I am, as I said, I'm very pleased with the year. I think you'll get to know me. I'm a Mid-westerner. Very pleased to me is the equivalent of many people dancing on furniture with excitement. I appreciate the compliment. I want you to know we've got our heads down and we're driving to do more.

David P. Nierenberg - Nierenberg Investment Management Company, Inc.

I know you're not done. I feel about this. It's a good start. It's like when a truckload of lawyers goes over a cliff. It's a good start. But I do want to note just a couple of things that you guys talked about because I think they deserved to be underscored. Your cash per share has now risen to approximately $7, $1 per share sequential increase is remarkable. And for the reasons that you mentioned, the EBITDA that you forecast and the growth in deferred revenue, it is not implausible that it will continue to grow as you have less invested on the balance sheet and physical inventory of products and less invested in accounts receivable because of deferred revenue growing. Not a surprise perhaps that a year from now, we'll be having a conversation when -- but for whatever you might spend on acquisitions, cash per share could be $8 or more. It's remarkable than that The Street at today's closing price, is valuing this company out $4.6 times your share count, or $97 million, net of cash, which is approximately 2 years of what prior management used to spend on marketing expense. And you have a colossal brand name, which is an off-balance sheet asset. The valuation of this company is ridiculous compared to what has been built and what you're going to be building. So thank you and congratulations and best of luck.

Stephen M. Swad

Thank you, sir.

Operator

Our next question comes from Jeff Meuler with Baird.

Jeffrey P. Meuler - Robert W. Baird & Co. Incorporated, Research Division

This is going to be quite dry after that. In terms of -- if you could just maybe characterize the -- where you're at in the process of culling the low-calorie revenue, marketing spent dollars. How far along are you in that process and what's left? At this point, is it more about kiosk than those types of things?

Stephen M. Swad

Yes, we're -- we made a lot of progress in 2012 on that front. I think we have more to do in kiosk. I also think we can do better deploying returns or getting returns internationally. Those are the areas that are getting focused right now.

Operator

Our last question comes from William Zolezzi with Prospect Capital.

William Zolezzi

My question is just -- isn't acquisition based -- baked into the top line guidance for 2013?

Stephen M. Swad

No.

William Zolezzi

Okay. And then my second kind of question will be kind of a little more color on the quarter. You kind of talked about you were seeing some softness. I was just wondering where and if you can give a little more detail on that?

Stephen M. Swad

Yes, we mentioned it. Our kiosks are not performing as well as they did last year. And so -- much like what you saw this year, where revenues declined because kiosk count is down, that holds true in Q1. And also, the performance of the kiosks are down. And then the second thing driving that comment around softness is our institutional business has low single-digit million, I'll call it. It's between $1 million, $2 million of network sales in Q1 of 2012, and it's going to have 0 in Q1 of 2013. And so, the comparison, therefore, is creating some softness. Underlying -- well, we'll talk more in Q1, but underlying institutional subscription business closed strong.

William Zolezzi

Okay. And then kind of my last one would be on the acquisition you guys were looking at. What kind of evaluation metrics would you be considering when looking at potential companies to acquire? I mean...

Stephen M. Swad

Yes, I mean, we are 100% focused on value creation. And that comes in a number of ways. It comes with more EBITDA. It comes with buying a product that is underutilized and that is if you invest a little bit in it and put it through your distribution channels and put this brand that is a beautiful brand, David actually said it better than I ever could, you create value that way. You could find value in humans that are super creative. And so, the kind of uber metric is value creation. But outside of that metric, there are a number of different types of companies and products that we're looking at.

William Zolezzi

Would the acquisition necessarily need to be accretive in 2013? Is that a metric?

Stephen M. Swad

It is a metric, it is a metric. You know what? I'm not going to close out an acquisition that makes sense for this company and would create value because it's not accretive. That is not a definitive metric, but it is a metric.

Operator

A final question just came in from Matt Winthrop with RBC.

Matthew Winthrop

I was just trying to get some color on the volume. Am I reading it incorrectly? You have 67,000 or 68,000 online subscribers right now that pay on a monthly basis?

Stephen M. Swad

They don't -- they pay -- the answer is yes on the account and no on the monthly basis. The ARPU per month, is -- I think, it was about $24.

Thomas Pierno

$24. They pay up front.

Stephen M. Swad

And they pay up front. But their term ranges from 1 month to 12 months. And in fact, at the end of the year, most of them SKU past 9 month.

Matthew Winthrop

So the average so far, the average has been a 9-month commitment?

Thomas Pierno

Yes, I mean, a little more.

Stephen M. Swad

Yes.

Matthew Winthrop

It sounds like you're doing a good job of cost controls and reducing old inventory from kiosk and stuff. But I don't understand with all the advertising, 68,000 seems like a very small number for a name as large as Rosetta Stone when I look at other consumer net -- Groupon having millions or Zipcar having millions of that. How could you only have 68,000? What am I missing?

Stephen M. Swad

It was a Q4 -- a very good point. Now you sound more like me. It's a Q4, we put more emphasis behind it in Q4. We are also changing our marketing and our messaging and the customer that, that product fits for. And that's going to take a little time. I think you're right though there is upside in that number.

Thomas Pierno

Over time.

Matthew Winthrop

A year from now, what would you hope to have as the number of subscribers without...

Stephen M. Swad

Yes, I'm not going to go there with you, Matt. I mean, I said robust or something. And I know that doesn't mean anything and I did that intentionally.

Operator

I would like to turn the call back over to management for closing comments.

Stephen M. Swad

Okay. I appreciate everybody's time. I'm pleased that you're excited as I am around the quarter. My take is the turnaround is taking hold. We are in a much different state the end of this year than we began. We have a much more relevant product. We have a much -- our performance is much better. Our management team is stronger. Our strategy is clear. And I'm excited about the opportunities in 2013 and beyond. And I look forward to talking to you next time. That's it.

Operator

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time, and thank you for your participation.

Stephen M. Swad

Okay, take care.

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