Rosetta Stone's Slide Intensifies With Slash to Q4 Outlook

| About: Rosetta Stone (RST)

I've long held to the opinion that companies who differentiate themselves based on flashy advertising, rather than on product quality, are bound to underperform. While there are exceptions, such as the Coke (NYSE:KO) and Pepsi (NYSE:PEP) duopoly, advertising, by and large, will only get you so far if your product does not outshine competitors' offerings. Rosetta Stone's (NYSE:RST) investors are starting to learn this the hard way, as the company's sales are starting to slide and earnings have all but disappeared.

Friday's dismal guidance from the company highlights the increasing peril the company finds itself facing. The company announced preliminary fourth-quarter results with earnings coming in at a very soft 23 cents a share versus expectations of 28 to 38 cents a share. This compares to 58 cents a share for Q4 of 2009 and 29 cents for Q4 of 2008. Earnings are already below even 2008 levels and falling further with a loss expected next quarter. The company blamed soft US consumer demand for the earnings miss along with the recent Borders bankruptcy filing (more on this in a minute).

Revenues also fell below even the low end of the company's previously stated expectations. This quarter adds another data point to the developing trend of consistently falling revenues for Rosetta Stone. Revenue for the fourth quarter of 2009 was $78 million and Friday's announcement stated that the company expects roughly $74 million for the same quarter this year.

While surprising to some, this lowering of guidance should not be surprising. The company has long been relying heavily on marketing to try to make a splash in the insanely crowded and competitive market for language learning products. The company's 10-K (see here) was incredibly prescient in laying out the very risk factors that have led to this quarter's massive earnings miss and now reads with hindsight as an eerily dark prophecy.

Among the risk factors, the 10-K stated:

Our future growth and profitability will depend in large part upon the effectiveness and efficiency of our marketing expenditures.

This has absolutely been a problem. Rosetta Stone appears to have saturated the market with their advertising and demand has declined. Rosetta Stone earned more in Q4 of 2008, when the economy was in crisis, than in Q4 of 2010 when things had turned around. US consumer demand this past holiday season wasn't particularly soft in general, just soft for Rosetta Stone. This is a failure of Rosetta Stone's marketing team to execute.

Another risk factor stated that:

Intense competition in our industry may hinder our ability to generate revenue and may diminish our margins.

The 10-K also noted Rosetta Stone's numerous well-respected competitors, stating:

Our competitors include Berlitz International Inc., Simon & Schuster, Inc. (Pimsleur), a subsidiary of CBS Corporation, Random House Ventures LLC (Living Language), Disney Publishing Worldwide, a subsidiary of Walt Disney Company, and McGraw-Hill Education, a subsidiary of The McGraw-Hill Companies. Many of our current and potential competitors have longer operating histories and substantially greater financial, technical, sales, marketing and other resources than we do, as well as greater name recognition worldwide.

This is absolutely true. Contrary to some people's beliefs, Rosetta Stone didn't create the language-learning industry. This industry has been around for ages, and Rosetta Stone's competitors are generally larger and more well-financed. Rosetta Stone has relied on marketing to try to unseat dominant industry players such as Pimsleur which have been building a brand for decades.

The same factors hurting the media industry in general have also damaged Rosetta Stone in particular. The 10-K warned that:

Demand for paid language learning solutions such as ours could decline if effective language learning solutions become available for free.

This is absolutely happening. Cheap or entirely free websites and sophisticated language-learning blogs are giving self-motivated language learners far more options than ever before. Sites like LingQ are mortal threats to Rosetta Stone in the long term. The future of Rosetta Stone looks bleak as margin compression and further declines in revenue are highly likely. Their best hope is to differentiate their product based on quality or to find an overseas market for sales, but both these initiatives have so far been failing.

The highly-touted new version 4 TOTALe has failed to move the revenue needle and Rosetta Stone doesn't appear to be making in-roads overseas nearly as quickly as had been hoped. And instead of owning up to failure and admitting that change might be needed, management seems content to try to disguise the problems and blame others. In 3Q of 2010, Rosetta Stone acted as if it had made a profit by brazenly taking out the cost of launching a new product from its earnings, as the Motley Fool's Anders Bylund noted.

Management got called on this absurd little gimmick, and now they've come back with another diversion for this quarter. They blamed Borders (BGP) for contributing to their latest shortfall. Rosetta Stone's press release states:

The major contributor to the underperformance is lower-than-expected sales from the US consumer market, principally in the global retail channel, exacerbated by the financial impact of the recently-announced Chapter 11 bankruptcy reorganization of Borders Group, Inc.

As Borders declared bankruptcy just this past week, it is hard to see how this filing would have put the kibosh on Rosetta Stone's entire quarter. It's true that Rosetta Stone is owed $2.2 million from Borders, which could have a small impact on earnings should Borders not be able to pay. However, I'd be surprised if any write-down of that receivable is included in Q4, and as such, Rosetta Stone's attempt to blame Borders for its shortcomings makes little sense.

I doubt that Rosetta Stone shares will trade at much over book value, which is presently around $9 a share, in the future. The company is facing margin compression, rising competition from both free and for-profit sources, and it appears the company's overaggressive advertising campaigns are rapidly losing effectiveness. Rosetta Stone's shares still look way overvalued at $17 and have a lot farther to fall.

Disclosure: Author recently taught himself Spanish. He experimented with Rosetta Stone but found it ineffective compared with other methods. He holds no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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