Why Rosetta Stone's Strategy to Revitalize Itself Will Fail

| About: Rosetta Stone (RST)

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This article continues my series about Rosetta Stone (NYSE:RST) by examining the company's three-pronged approach to reversing the declining trend in earnings and revenues. The company is seeking to diversify its revenue stream by getting more institutional and more international buyers for Rosetta Stone's software. The company has also made efforts to become an online player that can generate a predictable recurring revenue stream.

As bullish fans of the stock, such as the Motley Fool, are most excited about the international element to the company's growth, I'll examine that first. Here's the bull case as laid out by Motley Fool Stock Advisor's Matt Argersinger, who said in a video pitch:

“We're really excited about the company for really one reason and that is that the language self-study global market is a $32 billion market. It's actually $30 billion outside the U.S. ... Well, Rosetta Stone only has about 2% market share of that global market ... We just think there are loads of growth, loads of upside ... We think it's going to dominate the language self-study space in the future.”

It's true that Rosetta Stone has been growing international revenue at more than 100% a year recently. International revenue now accounts for 14% of the company's total revenue. Certainly if international growth keeps up at such a torrid clip, the company's future will be bright. However, I doubt that international revenues will keep expanding rapidly for long.

The best thing in Rosetta Stone's favor is that its market penetration is still small enough that it can keep revenues rising just by offering the product in new markets. As best as I can tell, Rosetta Stone isn't even available on Amazon.com's Chinese or Italian websites. However, customer reviews on Amazon's other country sites (Japan, Canada, Germany, United Kingdom) have been less favorable than the reviews I found on Amazon's main American site.

There are several reasons Rosetta Stone will be less popular overseas than in the U.S. The first of these is that competitors are far more entrenched. According to a 2005 U.S. Senate resolution urging more foreign language learning, more than 50% of Europeans speak a foreign tongue, while less than 10% of Americans do so. Since Rosetta Stone has almost no market penetration yet in Europe, we can safely conclude that one in two Europeans successfully learned a language using other means than Rosetta Stone. There's a long tradition of using courses, real immersion and other language-learning products in Europe and consumers are used to spending their language-learning dollars on things other than software. Rosetta Stone has to change entrenched consumer behavior to make headway there.

This contrasts sharply with the U.S., where most consumers had no previous language-learning dollars, as most Americans have been content to be monolingual. It's much easier to convince an American to buy a Rosetta Stone software package when they've never tried any language learning before. It's much harder to convince an already bilingual European to trust software as compared to a method they've already used successfully. Europeans understand how to learn languages and as such, are less likely to be swept up by flashy advertising and huge promises.

Rosetta Stone doesn't just have to overcome competition from traditional courses. Online language-learning websites such as LiveMocha and LingQ are far more popular overseas than they are in the U.S. and their websites garner more traffic in many countries than Rosetta Stone's site does.

Also, Rosetta Stone faces another problem in that foreign consumers will demand more. Americans, so used to utter language-learning helplessness, are content (at least Amazon reviews would indicate) with software that doesn't bring them anywhere near fluency. Since English is all you need to survive in the U.S., this makes sense – there's no compelling need for fluency in another language here. But Europeans, Chinese or Indians buying Rosetta Stone's English software because they need it for their career or to study abroad are going to be much less tolerant of partial success. If a foreigner in a developing country buys Rosetta Stone English, it had better work. If English is the ticket to get to the middle class, Rosetta Stone's software better be more than an entertaining experience that teaches some handy phrases and basic conversational skill. As more foreigners buy Rosetta Stone, I expect it to gain negative word-of-mouth from foreigners who pluck down several months of income to buy a program that promises the world and doesn't give them fluency.

In addition to the international market, Rosetta Stone is also targeting more institutional buyers. The company made a high-profile sale in New Jersey where a school district laid off foreign language teachers and replaced them with Rosetta Stone to save money. Proponents of the company envision this happening on a large scale. However, this dream is already fading. Institutional sales were much weaker than expected in 2010 as state governments faced widespread monetary crunches. States are not going to buy expensive software when the economy is down because they are broke, and they won't buy expensive software to replace teachers when the economy is up because the unions would have a fit. It's hard to envision our government bureaucracy willingly firing teachers and replacing them with computers as it just won't go over well with voters. However, Rosetta Stone will continue to gain some sales to the military and other such institutional consumers, though these are unlikely to be a game-changer for investors.

The final tenet of Rosetta Stone's revitalization plan involves creating online recurring revenue. While focusing on international and institutional sales makes sense, this last priority just doesn't fly. The goal of a company that makes language-learning software should be to make its users fluent, right? If so, then why should there be recurring revenue? Rosetta Stone's software should make consumers fluent as quickly as possible. Once a consumer is fluent, they will no longer need the online service. While there are some people such as me who genuinely enjoy learning languages and could represent repeat business, most Rosetta Stone consumers are just going to learn the one language they need for work, a trip or to please a significant other and then be done. Once fluency is achieved, the subscription is terminated. You can't turn language-learning into DVD rentals; Rosetta Stone isn't going to be another Netflix (NASDAQ:NFLX).

Ironically, the online program provides a perverse incentive for Rosetta Stone to not improve its main program. The longer you need tutoring and other online services, the more revenue the company generates. Why make an effective program that leads people to fluency quickly when you can sell them an expensive program that only takes one part of the way to fluency and then forces them to pay you online subscription fees for years? Needless to say, the online initiative spotlights management's incentives. They are monetizing the inefficiency of their own program by tacking online services on as an additional fee to an already expensive software package. While that may be smart business strategy, it belies the inefficiency of the company's base software and should serve as a huge red flag for consumers who are considering Rosetta Stone over a competitor's language-learning solution.

None of these strategies will likely turn Rosetta Stone's future around. While international and institutional markets will provide some growth in coming years, it's not at all certain that the growth will be sufficient to offset further declines in the American market. And the online effort is unlikely to be an overall financial boon. It will either fizzle out, or if it becomes successful, end up cannibalizing the main product. Since there are already numerous competitors in the online space and Rosetta Stone has to pay its tutors, online margins should be much lower than what the company gets on its famous yellow boxes. With margin compression and a continuing fall in overall revenues likely in the future, the trend in Rosetta Stone's shares should remain downward.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.