Rosetta Stone Is Under Pressure

Well, it took longer than I expected, but Rosetta Stone Inc. (RST) is finally challenging its IPO price. In April, the stock was offered to investors at $18.00 which was above the posted range, and while the proceeds were more than $112 million, roughly half of the capital went directly to the selling shareholders. Shortly after the IPO, ZachStocks noted that RST had significant risk due to a high multiple and weakening consumer traffic in malls as well as airports where a significant portion of sales take place.

After peaking at the end of July (at a gain of 83% from the IPO price) the stock has recently given up the majority of its gain and was especially hard hit Monday after a disappointing announcement. Management issued a press release, lowering profit guidance for the fourth quarter. Higher than expected expenses was the headline excuse for the miss, and great care was taken to explain that the lower profit was a result of increased expenses and not a weakening demand for the company’s language teaching products.

According to the release, adjusted EPS for the third quarter will come in at $0.25 to 0.27 per share compared to previous guidance of $0.33 to 0.35. Even on the high end of the range, this represents a 20% decline which spooked investors enough to cause the stock to drop 27% in one day’s trading. For the year, RST is now expected to earn $1.14 to $1.18 although analysts now appear to be expecting much lower profits at $1.09 per share. While the information was certainly disappointing, management did the best they could to excuse the shortfall:

During the current quarter, the company has incurred higher sales and marketing costs and higher product development costs than previously anticipated. In addition, in the ordinary course of business, we frequently test new types of marketing media. In the current quarter, we experimented with a significant amount of internet and television test marketing programs and we did not expeditiously terminate certain of those programs that were not yielding acceptable results. ~Brian Helman, CFO

Quite honestly, the expenses are more concerning than management is letting on. Since traffic in shopping malls and airports has become relatively weak, the company is struggling to find ways to compensate for this lost revenue. In order to track down more sales, the company has been allocating significant capital towards marketing to the point where it has crimped margins. It stands to reason that if you spend enough capital on marketing, eventually you will meet your sales targets. This is the argument that management is taking in explaining that investors should not be overly concerned with the lower profitability.

Over time, if the cost of acquiring new customers becomes prohibitively expensive, the company will simply have to accept lower sales figures. But for the time being, the strategy is to buy sales and right now they are paying out the nose for them. Despite the sharp stock decline, I expect future weakness as investors grapple with the prospect of permanently impaired profits or sales (or both).

Currently the stock is within striking distance of the $18 IPO price level. If it crosses below that line, you can quickly expect shareholders to bail as they lose patience with a “round trip” IPO. The company is still profitable and has a low debt level which should help to cushion the blow to some extent. But until demand picks up (without increasing marketing budgets) and the company can regain margins, I would not be interested in owning the stock anywhere above $15.

Disclosure: Author does not have a position in RST

Comments

[Jon408:]

I think it's a shame that the company uses what I would call false advertising. They're advertisements say that they teach language the way babies learn, but it just isn't true. Babies learn through actions, not memorization. There is a direct connection between body movements and the right brain, which imprints the understanding of language; it's actually the best way to learn anything. But Rosetta doesn't use it. Instead they use an immersion technique, which has some value, but it isn't the same. Without body movement, learning is very difficult, very tedious - and long term retention is a fraction of what it should be.

Their method has value, but it should be used as a support system for the main learning process, which should involve a physical movement in response to language. (Native speaker says to stand up in the target language, student mimics teacher by standing up at the same time, and with repetition, stands up when hearing the words.) Simple, but brilliant, because that is how our brains are wired. Rosetta talks a good game, but their product doesn't support their advertising claims.

Aug 19 10:19 AM

[Zachary Sch...:]

Thanks for the analysis Jon,

I've never actually used their products before but your insight might explain why they are finding it necessary to spend more on advertising in order to maintain sales growth. The trend is alarming and should cause investors to think twice before jumping in even at these lower prices.

zachstocks.com

Aug 19 02:54 PM