Investors have mostly shrugged off Rosetta Stone's (NYSE:RST) appalling first quarter results, released May 9. Rosetta Stone lost $9.3 million, or 45 cents per share. This result was much worse than the 33 cents per share loss analysts had forecast, and represents a huge swing from the same quarter last year, when Rosetta Stone earned 24 cents per share. Furthermore, RST announced that it expects to lose between 41 and 62 cents in the 2nd quarter of 2011 -- far worse than the 7 cent loss analysts had expected.
Value investors have been drawn to Rosetta Stone for its debt-free balance sheet and well-known brand name. But it makes no sense to invest in Rosetta Stone as its business becomes obsolete. Unless RST completely overhauls itself and finds a new business model, it will soon become a digital dinosaur. Its shares represent a value trap rather than a genuine bargain. Here are nine reasons why the worst is yet to come for investors in Rosetta Stone.
#1: Q1 was no aberration
Rosetta Stone faces a powerful secular decline in its core business. For several quarters now, Rosetta Stone's management has tried to paint its worsening results as one-time events driven by outside events such as the recent attempt to blame the Borders bankruptcy for Rosetta Stone's problems in Q4 of 2010. But the truth is that Rosetta Stone's best days are behind it. The company's famed direct-to-consumer sales model (think Foreman grills) peaked several years ago. As Rosetta Stone saturated the market with advertising, its sales pitch lost effectiveness. According to Rosetta Stone's most recent 10-K, nearly 80 percent of Americans are familiar with the Rosetta Stone brand. The easy sales have already been made, as consumers who wanted Rosetta Stone software have, by and large, already purchased it. In addition, the whole software (including languages) industry has been in rapid decline in recent years.
#2: Technological change threatens to make Rosetta Stone obsolete
Rosetta Stone's core business – selling language software – puts it in the same place as Encyclopedia Britannica two decades ago. Then, Britannica's $500 encyclopedia sets' sales were at an all time high. Britannica's sales have fallen more than 80% as computers and then the internet destroyed its niche.
Similarly, Rosetta Stone's niche – high-price branded language software – is being destroyed by the internet. Today, Rosetta Stone faces a strongly competitive market with challengers on many fronts. From other software publishers to downloadable smartphone apps to online language-learning sites, competition abounds. And, some people have decided language learning is no longer a necessity, given the increasing accuracy and speed of automated free translation from sources such as Google's (NASDAQ:GOOG) Google Translate.
#3: Revenue decline is accelerating; consumer market hard-hit
Rosetta Stone has been experiencing falling sales across its spectrum of distribution channels; the headline drop in year-over-year revenue was 9.6%. The most shocking decline was the 73% plunge in retail sales to less than $3 million in Q1 2011 versus the same time last year. But all segments except institutional were stagnant or fell (and according to the company, institutional sales are expected to fall next quarter as well). The following table of Rosetta Stone's revenues by segment comes directly from Rosetta Stone's latest 10-K.
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In particular, it is worth looking at the decline in Rosetta Stone's retail sector. Retail sales dropped an eye-popping 73% from Q1 2010 to Q1 2011 from $9.6 million in 2010 to only $2.6 million in 2011. This is due to the massive underperformance of Rosetta Stone's products in the 2010 holiday season which led to much slower than normal reordering by retailers. But while the 73% decline is somewhat exaggerated, it is indicative of a larger problem. Retail software sales are in an unrelenting decline. The amount of shelf space across the electronics retailers is falling drastically. Retailers such as Best Buy (NYSE:BBY) and Office Depot (NASDAQ:ODP) have eliminated much of their shelf space for software and further cuts are likely forthcoming. You can't sell product without shelf space.
It's worth noting that Rosetta Stone includes Amazon.com (NASDAQ:AMZN) in the retailer channel rather than a Direct-to-Consumer channel (according to its latest 10-Q, page 27) and so the 73% decline in year-over-year sales included Amazon purchases. Rosetta Stone's retail sales are not moving to the internet; they are simply disappearing.
#4: Rosetta Stone faces sharp margin compression
In the face of sharply falling sales, you'd expect that Rosetta Stone costs would also fall so as to preserve the company's margins. The exact opposite has occurred. Though revenues fell 9.6% over the past 12 months, costs of goods sold surged 32.6%, leading to a more than 6 point drop in Rosetta Stone's gross margin (86.3 to 79.9).
#5: Operating expenses continue to rise
Here is Rosetta Stone's table of operating expenses from its latest 10-Q:
Companies can survive falling revenues if their management team handles its business wisely. However, Rosetta Stone's management has shown no monetary restraint over the past year – it has ramped up expenses on all fronts despite the 9.6% drop in total revenue.
#6: Company using questionable marketing strategy
Sales and marketing represents the worst offender among the rising costs. Rosetta Stone spent $9.5 million more on marketing in Q1 2011 than in Q1 2010 to achieve a $6 million drop in revenue. That's outrageous. Rosetta was long known for its excellent marketing campaigns. But its latest campaign has reversed that reputation. Rosetta Stone has run a campaign with the puzzling tagline "Act like a baby." Making matters worse, recent magazine ads for this campaign have featured naked babies looking at a computer screen. Very few people are going to plunk down $500 for a software program based on this advertising. See for yourself (this ad found in the April 2011 edition of National Geographic magazine):
#7: Large management turnover
Rosetta Stone had both its CFO and COO leave the company last year. CFO Brian Helman left in August 2010 and was replaced by former Fannie Mae CFO Stephen Swad. COO Eric Eichmann also left Rosetta Stone last summer, and his position was not filled – Rosetta Stone CEO Tom Adams assumed the COO's duties. It seems these departing top executives foresaw the massive problems that were developing with Rosetta Stone's core business.
#8: Subscription model not working
Rosetta Stone tried a subscription model as early as 2001, and phased out subscriptions entirely in 2008. But with the release of Version 4 TOTALe, the online subscription model has returned. It is unlikely to have any more success than it did previously.
Already, we can see the subscription model isn't generating a whole lot of consumer interest. I've displayed four Alexa graphs for Rosetta Stone's web traffic. Since Version 4 TOTALe was released last fall, web traffic should have increased from fall 2010 onward, as subscribers go to Rosetta Stone's web site to use the online features. Instead, web traffic hasn't increased, and users are not viewing more pages or spending more time at Rosetta Stone's site:
As you can see, the launch of Version 4 made no discernible impact on Rosetta Stone's web traffic. In addition, Rosetta Stone's free community/language games portal, Rworld, has seen its web traffic continue to trail far behind free competition. Rworld has failed to become any sort of significant social community like Rosetta Stone had intended. Almost a year into its latest online experiment, Rosetta Stone's efforts to expand from software into an internet presence have met with little success.
#9: International growth is no magic bullet
It is unrealistic to think that international growth can reverse Rosetta Stone's fortunes. Unlike America, where roughly half of language learners want to learn Spanish, the global language learning market's demands are highly fragmented. The only other market that comes close to that of Americans learning Spanish is the Asian demand to learn English. However, it is highly difficult to monetize this demand, particularly in China, due to rampant software piracy. Rosetta Stone recently sued and won settlements from American software pirates. It would have no such luck in many overseas markets.
Even discounting piracy, it is hard to see international growth working. Rosetta Stone spent a great deal of money and energy to build its brand in the U.S. It can't replicate that brand awareness throughout the world on a tight budget. If it wants to build a powerful Direct-to-Consumer business as it has done in the U.S., it will need to figure out the intricacies of overseas retailers, distribution chains, and foreigners' distinct tastes and preferences.
These difficulties are already making their presence felt. Rosetta Stone's rising costs and operating expenses are largely due to the aggressive international expansion. And yet, despite the rising costs, revenues continue to fall.
Going the way of the dinosaur
Just as Encyclopedia Britannica has been decimated from digital competition, Rosetta Stone is also falling victim to technological change. The era of selling $500 software is over. Consumers want cheap or free alternatives. Rosetta Stone is far behind – its web presence is miniscule, and it is almost non-existent in the rapidly growing app space for smartphones and iPads. The company's attempts to switch to a subscription-driven model, combined with international growth are merely rehashes of previously failed strategies.
While Rosetta Stone still has a respectable pile of cash on its balance sheet, the company's prospects are dim and growing dimmer. Management has performed poorly, and with the recent loss of both the CFO and COO, there's no reason to expect the remaining management team to regain its touch in the near future. The company's revenues are shrivelling, and Rosetta Stone continues to increase its costs rather than controlling them. The company's plan to save itself through international growth is truly a pie-in-the-sky vision. Rosetta Stone had a great business model years ago. But it has failed to adapt to changing times and is now merely a dinosaur heading toward extinction.
An even longer version of this report can be found here.