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Rosetta Stone (NYSE:RST) is a $362 million company that provides technology-based language learning products. Rosetta Stone's customers include individuals in North America, global individuals, and institutions, including government agencies. RST generates revenues from product software sales and online learner subscriptions. Its shares have traded from a high of $30.69 on July 31, 2009 several months after its IPO in April to $7.63 by the end of 2011. The downward trend reversed, and by the end of 2012, RST gained 21% to $11.98. YTD, the shares have increased over 43% to its peak of $18.30. Given the extreme price volatility, I wanted to provide a method to value RST.

Rosetta Stone faces competition from Berlitz International, tellmemore.com, babble.com, as well as free programs like duolingo.com and even the British Broadcasting Corporation [BBC]. Despite the intense competition, Rosetta Stone has been able to grow its paid online learning subscribers from 16,762 in 2010, to 68,393 in 2012. However, product software sales have remained stagnant. In April, Rosetta Stone acquired Livemocha, one of its competitors offering free language lessons with paid premium content to over 16 million subscribers. Livemocha connects users to live instructor-led classes and private tutors - a different approach than Rosetta Stone's. Rosetta Stone displays a picture and the user selects the corresponding word or sentence, so it is difficult to note any synergies to this acquisition. There are several flaws to RST's approach, which are outlined by a blog in the Economist. Moreover, Rosetta Stone must deal with other issues, such as piracy.

Given the trends in paid online learners, revenues, profits, and free cash flow, I believe the fair value of Rosetta Stone should be $22.79.

Economic Profit Spread

To help determine Rosetta Stone's growth rate, a modified version of economic profit spread (return on invested capital minus weighted average cost of capital) will be assessed. The return on invested capital was measured using the value of cash flow from operations divided by equity plus debt.

(thousands)

2008

2009

2010

2011

2012

CFO

$18,338

$41,150

$31,706

$3,373

$34,901

Capital

$88,981

$157,446

$178,546

$177,381

$144,758

ROIC

20.61%

26.14%

17.76%

1.90%

24.11%

Next, the cost of equity was estimated using the capital asset pricing model (CAPM).

Stocks over T-Bills (1928-2012)

Stocks over Treasury Bonds (1928-2012)

Stocks over T-Bills (2003-2012)

Stocks over Treasury Bonds (2003-2012)

Implied Equity Risk Premium (2013)

Risk Premium

7.65%

5.88%

7.06%

3.90%

5.78%

The first four columns correspond to the historical spread of stock returns over government-issued debt securities. The equity risk premium in the last column was measured by estimating the required rate of return on equities through the calculation of the present value of dividend yields on the S&P 500, and then subtracting the yield on the 10-year treasury. For more information about the estimated risk premiums, see Damodaran, Aswath. Equity Risk Premiums [ERP]: Determinants, Estimation and Implications - the 2013 Edition. NYU Stern School of Business (March, 2013). Given that the beta of Rosetta Stone is 1.1 (calculated using YTD daily prices) and the 10-year Treasury yield, the risk-free rate, is 1.92%, the weighted average cost of capital [WACC] are given below. Rosetta Stone holds an insignificant amount of debt, so the cost of equity equals the WACC.

(Derived from previously estimated equity risk premiums)

Stocks over T-Bills (1928-2012)

Stocks over Treasury Bonds (1928-2012)

Stocks over T-Bills (2003-2012)

Stocks over Treasury Bonds (2003-2012)

Implied Equity Risk Premium (2013)

WACC

10.38%

8.44%

9.73%

6.26%

8.33%

The average WACC of the eight figures is 8.63%. Using this figure, Rosetta Stone's economic profit spread in 2012, 2011, 2010, 2009, and 2008 are, respectively, 15.48%, -6.73%, 9.13%, 17.51%, and 11.98%.

(thousands)

2008

2009

2010

2011

2012

Economic Profit Spread

11.98%

17.51%

9.13%

-6.73%

15.48%

Although, besides 2011, Rosetta Stone's return, based on CFO, on invested capital is significantly higher than WACC, these values are highly variable, adversely affecting the value of this company. Investors may find it difficult to estimate Rosetta Stone's potential for growth, and their investments, like in 2011, may even yield negative returns (by the end of 2011, RST stock decreased to 36% of its December 30, 2010 price). Given the risk, the fair growth rate that will be used in the subsequent discounted cash-flow analysis will be less than the average economic profit spread between 2008 and 2012, of 9.47%.

Gross Profit Growth Rates

In April, Rosetta Stone undertook both cost-cutting and revenue-growing activities. All physical sales locations (kiosks) in the U.S. were closed; attention would be shifted toward cloud-based sales methods, reflecting Rosetta Stone's target market. Also in April, Rosetta Stone bought out a competitor, Livemocha Inc., but its effects on bottom- and top-line growth are not expected to be significant. Revenue guidance for 2013 is expected to increase to $280-290 million, while net income, without litigation, restructuring and other costs relating to mergers and acquisitions, is expected to be between $-1 to $1 million. This represents revenue growth of 2.47%-6.87%. RST's subscription and service revenue growth is on a strong upward trend, while product revenues are falling.

(thousands)

2008

2009

2010

2011

2012

Product Revenues

$184,182

$218,549

$215,590

$195,382

$180,919

Subscription and Service Revenues

$25,198

$33,722

$43,278

$73,067

$92,322

Total Revenues

$209,380

$252,271

$258,868

$268,449

$273,241

Gross Profit from Products

$157,643

$188,285

$183,041

$158,885

$147,235

Gross Profit from Subscriptions and Services

$23,061

$30,559

$36,828

$60,448

$77,096

Gross Profit

$180,704

$218,844

$219,869

$219,333

$224,331

Gross Margin from Products

85.59%

86.15%

84.90%

81.32%

81.38%

Gross Margin from Subscriptions and Services

91.52%

90.62%

85.10%

82.73%

83.51%

Net Profit

$13,892

$13,363

$13,284

($19,988)

($35,831)

Since 1Q2011, Rosetta Stone has delivered only one quarter where quarterly net profit was positive - the seasonally strong fourth quarter of 2012.

(millions)

2Q2011

3Q2011

4Q2011

1Q2012

2Q2012

3Q2012

4Q2012

1Q2013

Revenues

$66.70

$64.20

$80.50

$69.50

$60.80

$64.30

$78.70

$63.90

Gross Profit

$55.20

$52.90

$65.70

$55.90

$49.50

$53.10

$65.70

$53.70

Net Profit

($4.60)

($1.20)

($4.90)

($1.90)

($4.50)

($33.40)

$4.00

($4.70)

(click to enlarge)Historical Revenue and Profit

If the exponential trends continue, total revenue and gross profit will be $287,557 and $235,156 (thousands).

Estimates for Revenues and Gross Profit in 2013

(thousands)

Management Estimates, Low end

Management Estimates, High end

Exponential Trend

Revenues

$280,000.00

$290,000.00

$287,557.00

Gross Profit

$229,600.00

$237,800.00

$235,156.00

Growth (2011-2013)

4.68%

8.42%

7.21%

Gross Margin

82.00%

82.00%

81.78%

Free Cash Flow Valuation

Taking a weighted average of free cash flows (2012 values worth three times more than 2010; 2011 weighted two times more than 2010), and using the growth rates and WACC previously found, the value of Rosetta Stone was estimated.

Growth Rates

(thousands)

4.68%

7.21%

8.42%

9.47%

7.51%

Weighted FCF (2010-2012)

$17,077.33

$17,077.33

$17,077.33

$17,077.33

$17,077.33

Discount at WACC

8.63%

8.63%

8.63%

8.63%

8.63%

Value after 5 years

$76,513.78

$82,095.95

$84,891.83

$87,387.99

$82,644.07

Value of Perpetuity (2.5% growth)

$242,336.05

$279,654.86

$299,128.52

$316,943.10

$283,432.15

Non-operating Assets

$138,400.00

$138,400.00

$138,400.00

$138,400.00

$138,400.00

Value of RST

$457,249.84

$500,150.81

$522,420.35

$542,731.10

$504,476.23

Using the average growth rate, Rosetta Stone would be fairly valued at $504.5 million, valuing each share at $22.79, an increase of 33.9% from current prices, aided by their cash holdings and almost no debt. The fair price ranges from a low of $20.66 to an optimistic $24.52, assuming the growth rates and WACC are accurate. This will change if there are different estimates of free cash flow and growth rates. Given that there is a high level of variance in RST's historical growth rates, the value of Rosetta Stone may be lower than the most pessimistic estimate of $457.3 million due to risk-aversion. The company will need to be successful in increasing competitiveness through innovations, pricing, and marketing. As of April 30, 2013, 4.66% of RST shares were sold short. If RST stock increases, the shorts will be squeezed, adding to potentially greater share price appreciation.

Until growth trends, based on Rosetta Stone's future earnings reports change, I believe that Rosetta Stone is undervalued, and still has high upside potential in 2013.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Rosetta Stone: Still Undervalued, Despite 38% YTD Gains